The structure of optimal tariffs

We have discussed in class that a tariff can increase a country's welfare if the term of trade gain exceed the total dead weight losses. It is possible because a tariff imposed by the large country can influence the world price thus increase its term of trade. How to determine the optimal tariff is a very tricky question for a policy maker. When imposing a tariff that is good for the country itself, other countries might retaliate. A optimal tariff for one country might not be the optimal tariff for its trading partner. 

The link article is a paper about how to determine the optimal tariff level in a two-country economic with more than two traded goods. The paper examines the structure of the Nash equilibrium tariff rates within the same trade group in a model with an asymmetric structure that allows general utility and production functions. It assume the condition that equilibrium tariff rate are uniform in both countries, and explore the relative size of the equilibrium tariff rates in each country when the uniform tariff condition is not satisfied. The paper found out that the elasticity of compensated excess demand for goods is a key factor of determining the equilibrium tariff.

What make this model meaningful is that it can be extend to more than two countries. In the paper, the model assume that the home (foreign) country exports (imports) only one good, but it can be extend to more goods which make this model useful for customs unions and trading blocs that use a common external tariff. This paper can be regarded as an investigation of the structure of common external tariff rates on different traded goods by assuming that the country is an entity of a customs union.

In all, the theory of the optimal tariff and its implications play an important role in tariff-imposing countries, it give the policy maker an idea of how to set a tariff. Besides, the theories are useful and suggestive for trading blocs and multilateral trade agreements for setting an common external tariff.