Now, let's consider the theory of optimal tariffs.
What we'll see here is that, sometimes, a tariff can help an individual nation, --
but without helping the world as a whole.
I'll show this with a simple example, but the key assumption is going to be
that the tariff-imposing nation is economically large
in the sense that it can, to some extent, alter world prices.
So, examples of economically large nations would be, for instance,
China or also the United States.
In this example, let's consider the United States
which is buying oil from Saudi Arabia.
To make this as simple as possible, let's use some assumptions.
For instance, we'll assume that the Saudis have market power over oil,
that they are selling only to the United States,
and, also, let's assume that the Saudis are producing oil
at a marginal cost of zero.
The point here is not that these are realistic,
but that they will help us focus in
on the one key mechanism behind optimal tariff theory,
and I'll again stress the key assumption
is that the United States is an economically large country
in the sense that its buying decisions, its taxes, its policies
can affect global prices as a whole.
So, here we can see the demand curve for Saudi oil,
first, in the absence of a tax.
And to maximize profit with zero marginal cost,
the Saudis will choose this point on the demand curve,
and we will get this market quantity in equilibrium and this year market price.
And profit of the Saudis will be given by the size of this rectangular box here.
Now, let's assume that the United States is imposing an import tax
and the value of that import tax will be at, by assuption, 50%.
In essence, we are now seeing that one half of this profit's box
is going to the United States in the form of a revenue
from the import tax rather than going to the Saudis.
The price paid by U.S. buyers won't change,
but the price received by the Saudi suppliers; well, --
that will be half of the old price.
But you'll see, in this setting, the quantity of oil sold will not change.
Without the tax, the Saudis were basically maximising P x Q
to get their profit.
And now, in essence, they're maximizing one half of P x Q
and the way to maximize one half of P x Q is still to maximize P x Q.
And that will mean the same quantity of oil supplied to the market,
but, at better terms for the Americans.
Just to recap that all in written form:
After the import tax, U.S. buyers are paying the same price for oil;
the quantity of oil sold is the same as before the tax;
and some of the proceeds go to the U.S. Treasury
rather than to the Saudis.
That is, indeed, a better outcome for the United States.
But, note carefully, it is not a better outcome for the world as a whole.
In more complicated examples,
we may find that the Saudis shift some of their sales to other markets,
perhaps with lower taxes.
It may be the case that the price to U.S. buyers will indeed go up
and there also may be some output cost
in the sense of the Saudis end up selling less oil to the United States.
Still, if the United States can use the tariff to get a terms of trade effect,
it's still the case that they will be able to redistribute income
away from the Saudis and toward the United States.
In general, the optimal tariff for the importing country is higher
when supply, in this case supply of the oil, is inelastic
because then you can impose the tariff
and there are a fewer other places the oil might go.
We can think of this import tax as replicating a form of buyer collusion.
If all of the U.S. buyers of Saudi oil could get together in a room,
and collude, and agree not to buy the oil unless the Saudis lower their price,
well, that would redistribute income away from the Saudis
and toward the United States.
The import tax, in essence, is replicating a form of that collusion.
By imposing the tax,
the U.S. government is getting U.S. buyers to be less willing to buy Saudi oil.
And the only way the Saudis can counteract that
is, indeed, to lower the price of their oil.
Note, also, in international trade theory,
anytime you have an argument about imports,
you can actually flip it into an argument about exports
because, indeed, in this case we have a two country model
and the trade which is going on is actually a form of barter.
So, you also can think of this tax on oil imports
as being like a tax on U.S. exports to the Saudis.
In essence, that tax is cartelizing the U.S. exporters
and getting them a higher price,
noting that the revenue from that higher price may be flowing
to the U.S. Treasury rather than to the U.S. exporters themselves.
And that's simply the flip of the argument about the import tax.
So, just to state the key result again,
a tariff can help a large country by shifting the terms of trade in its favour.
But, of course, in the real world, this is actually not so simple
and one problem is quite simply the other country,
the Saudis, in this example; they may retaliate.
But, in general, this is not the end of the story.
So, imagine that the Saudis or maybe
a bunch of other countries acting together in concert;
they impose a tariff on U.S. exports.
Well, in that case then, these terms of trade gains may go away.
We'd end up with a situation where consumers in both countries
or all the countries would face higher prices,
but again there's not necessarily a terms of trade shift
in the favour of the United States.
One rationale for free trade agreements and free trade zones
may simply be that they help us to avoid these mutually destructive outcomes
whereby a bunch of individual countries
try to shift the terms of trade in their favour,
they all do this and no one ends up better off.
To pursue this topic further, well, one thing you can do
is simply Google "optimal tariff theory" or put that in scholar.google.com.
There's the Feenstra and Taylor book, "International Trade."
Thomas Humphrey has a good article on the intellectual roots
of optimum tariff theory.
See also our videos on John Stuart Mill and Torrens on this.
And, also, there's a very interesting piece,
"Optimal Tariffs and Market Power: The Evidence,"
and that looks at the question of whether optimal tariff theory
actually predicts to some extent where and when countries actually levy tariffs.