Large Country Tariffs and Retaliation

This is a partial equilibrium model that features two economies that are large relative to one another. The demand and supply curves are linear, and trade interventions (tariffs and export taxes) can be controlled by the user. The equilibrium values and welfare measures are calculated within the sheet as the intervention levels change, and autarky and free trade equilibria are provided as a basis of comparison. The solution is embedded in the sheet, so no special measures are required to use it. It should work with any version of Excel. The sheet was originally designed for examining the implications of a trade war, but it can be used for examining any scenario involving large country trade interventions. Cells in white represent the model parameters, which can be changed to any sensible value. 'Spinners' allow for smooth manipulation of the policy instruments. The model is fully described in Gilbert (2005).

Model Layout Guide


Large Country and Optimal Tariffs

The large country tariff argument is one of the oldest arguments for protection. As Home increases its tariff (use the spinner next to cell D31), the world price falls and total surplus rises. In effect, Home exploits its monopsony power to extract a lower price from Foreign. But this process cannot continue forever, Home is still limited by Foreign's willingness to supply. As you increase the tariff, keep a close eye on total surplus in Home. Eventually its rate of increase will slow, and then it will fall. When you find the tariff that maximizes total surplus, you have determined the 'optimal' tariff. Points to note: 1) Tariff revenue will still be increasing at the optimal tariff. Can you find the revenue maximizing tariff? It must be larger than the optimal tariff. 2) The optimal tariff depends on the elasticity of foreign supply. Try decreasing the slope of the Foreign supply curve (cell P30). What happens to the optimal tariff of Home? You should find that the optimal tariff is smaller. The reason is that the elasticity of Foreign supply is decreased, giving Home less market power to exploit. 3) There is an optimal export tax too, where Foreign exploits its monopoly power. Is there an optimal export subsidy? If so, what is it? 4) When Home imposes an optimal tariff or Foreign  imposes an optimal export tax the other country is hurt. An implicit assumption of the optimal tariff argument is the the other country does not respond. But what would happen if it did?   

Trade Wars and Retaliation

A trade war can be simulated in which the countries alternately impose optimal tariffs (export taxes) on each other, taking the intervention imposed by the other country as given. Start by finding the optimal tariff for Home. Now find the optimal Foreign response, leaving the original intervention in place. Since welfare increases, it is in Foreign's interest to respond to the original tariff. Once Foreign does respond, what is the best option for Home? Perhaps surprisingly, it is in Home's best interest to lower its original tariff. After a few rounds, we reach a point where neither country can move without lowering total surplus. This is a Nash equilibrium. Points to note: 1) Total surplus is lower for both countries at the end of the war relative to free trade. For some configurations of demand and supply it is possible that one country may be better off, but not both. 2) The outcome is not autarky, some trade is always better than none so it doesn't pay for either country to eliminate trade entirely. 3) It doesn't matter which country initiates the war. To verify, try the experiment again with Foreign the initiator.

Countervailing Export Subsidies

The sheet can handle subsidies too, which are just negative taxes. Consider an export subsidy imposed by Foreign (a negative value in cell M31). What are the consequences? For Foreign the export subsidy forces the world price down, in addition to introducing a deadweight loss. Home on the other hand experiences a net welfare gain from its improved terms of trade. How should Home respond? From a net welfare perspective they should do nothing, but domestic producers are hurt. Under WTO rules, Home can apply a countervailing duty equal to the value of the export subsidy. To simulate this put a tariff of the same magnitude as the export subsidy (it will be a positive value) in cell D31. What is the net result? The free trade world prices are restored - the countervailing duty cancels out the export subsidy. From a global perspective it is efficient. However, the interaction has resulted in a transfer from Foreign taxpayers to the Home government...