International Trade - Theory and Policy, 2010a

Import tariff effects on the importing country’s government. The government receives tariff revenue given by
the per-unit tax (t) multiplied by the quantity of imports (QT). Who gains from the tariff revenue depends
on how the government spends the money. Presumably these revenues help support the provision of
public goods or help sustain transfer payments. In either case, someone in the economy ultimately
benefits from the revenue. Refer to Table 9.9 "Welfare Effects of a Tariff" and Figure 9.5 "A Tariff on Imports
from a Foreign Monopoly Firm" to see how the magnitude of the subsidy payments is represented.
The aggregate welfare effect for the importing country is found by summing the gains and losses to
consumers, producers, and the government. The net effect consists of two components: a positive effect
on the recipients of the government tariff revenue (d) and a negative effect on consumers (a + b + c), who
lose welfare due to higher prices.
If demand is linear, it is straightforward to show that the gains to the country will always exceed the losses
for some positive nonprohibitive tariff. In other words, there will exist a positive optimal tariff. Thus a
tariff can raise national welfare when the market is supplied by a foreign monopolist.
One reason for this positive effect is that the tariff essentially shifts profits away from the foreign
monopolist to the domestic government. Note that the original profit level is given by the large blue
rectangle shown in Figure 9.5 "A Tariff on Imports from a Foreign Monopoly Firm". When the tariff is
implemented, the monopolist’s profit falls to a level given by the red rectangle. Thus, in this case, the tariff
raises aggregate domestic welfare as it reduces the foreign firm’s profit.
First-Best Policy
Although a tariff can raise national welfare in this case, it is not the first-best policy to correct the market
imperfection. A first-best policy must attack the imperfection more directly. In this case, the imperfection
is the monopolistic supply of the product to the market. A monopoly maximizes profit by choosing an
output level such that marginal revenue is equal to marginal cost. This rule deviates from what a perfectly
competitive firm would do—that is, set price equal to marginal cost. When a firm is one among many, it
must take the price as given. It cannot influence the price by changing its output level. In this case, the
price is its marginal revenue. However, for a monopolist, which can influence the market price, price
exceeds marginal revenue. Thus when the monopolist maximizes profit, it sets a price greater than
marginal cost. This deviation—that is, P > MC—is at the core of the market imperfection.
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