International Trade - Theory and Policy, 2010a

lower economic cost than the import tariff. Thus we say that the domestic consumption tax is a first-best
policy, while the import tariff is a second-best policy.
The previous result corresponds to the general theory of the second best, which says that the first-best
policy will be the policy that targets a distortion or imperfection most directly. In most cases, a domestic
policy will be better than a trade policy. In this example, a domestic consumption tax is clearly superior
to a trade policy.
EXERCISE
1. Consider a perfectly competitive market for steel in a small exporting country. Suppose that
steel production causes local air and water pollution. Assume that the larger is steel output
and the higher is the social cost of pollution; thus, steel production creates a negative
externality.
1. Explain what type of trade tax or subsidy policy could be used to reduce the negative
effects of pollution. Demonstrate the welfare effects using a partial equilibrium diagram. Assume that
your policy reduces social costs by R dollars. Under what condition would the policy raise national
welfare?
2. Explain what type of purely domestic policy could be used to reduce the pollution. Use a
partial equilibrium diagram to demonstrate the welfare effects of this policy. Again assume
that your policy reduces social costs by R dollars.
3. Explain why the purely domestic policy may be superior to the trade policy.
[1] Sierra Club, “A Fair Trade Bill of Rights,” Responsible
Trade,http://www.sierraclub.org/trade/ftaa/rights.asp.
[2] World Trade Organization, “Environment Issues: Sustainable
development,”http://www.wto.org/english/tratop_e/envir_e/sust_dev_e.htm.
[3] World Trade Organization, “Trade liberalization reinforces the need for
environmental cooperation,” press release, October 8,
1999,http://www.wto.org/english/news_e/pres99_e/pr140_e.htm.
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