Optimal Tariffs Are Not Optimal

The other day, I had a brief discussion on optimal tariffs.  I wanted to expand a little on that topic.  Warning: what follows is somewhat wonky.

In a world without a perfectly elastic world supply curve, it is possible to institute a tariff that would raise the total surplus of the nation, strictly defined.  The mechanism through which this occurs is the tax revenue.  Since some of the tax burden would be borne by foreign producers, part of the foreign producer surplus (which was not counted before) is now counted as tax revenue, leading to a net gain in total surplus (in theory, the increased tax revenue would be used to compensate the consumers who are made worse off by the tariff).  However, as I pointed out in my last post, the only reason this tariff looks optimal is because the foreign producers are excluded from the calculation.  This, of course, is a violation of one of the principles of economics: all costs and all benefits must be measured for all participants, not just some who happen to be on one side or another of an arbitrary dividing line.  When we add in the loss of producer surplus, we find we have a net loss of surplus overall.

But politicians are not economists.  They don’t care about foreign producers (and why should they?  A politicians job is to represent his country).  If foreign producers are made worse off and domestic people are made better off, what’s it matter?  I’d argue that, when we move beyond the initial time period and if all governments adopt an optimal tariff, everyone is made worse off.

Let’s assume we have a two-country world: Abeland and Beeland.  Both countries trade with one another and both are, to some arbitrary extent, price makers (that is, they both have downward sloping demand curves and upward sloping supply curves).  In short, we are not operating in a perfectly competitive world.  Given the upward-sloping supply curves, both countries’ governments can implement some kind of optimal tariff.  Let’s further assume that both countries’ governments are entirely self-interested; they want to advance their country and don’t care at all about the other country.  Additionally, assume both countries initially have completely open free trade and there is no knowledge problem or public choice problems.

Abeland discovers that they can pass a tariff and increase their net welfare.  Being self-interested, they do so.  Abeland’s net welfare increases.  However, Beeland’s net welfare decreases.  Beeland decides “two can play that game” and passes their own optimal tariff.  Beeland’s net welfare increases somewhat (but not to the level that it was before: deadweight loss) and Abeland’s net welfare falls below where it was initially (again, deadweight loss).  Despite the tariff being “optimal” for both parties, both are made worse off than absent the tariff.  The reciprocal “optimal” tariffs both result in deadweight loss in both countries, leading to a highly inefficient new equilibrium.  In short, we have something of a prisoner’s dilemma: both countries would have been better off if they had simply cooperated, but by acting in their self-interest, they both end up worse off.

There are some interesting implications from this discussion.  First, it would suggest that, even in an optimal tariff world, the best option is for countries to have bilateral free trade.  Second, it would suggest that free trade agreements between countries are likely necessary to enforce free trade (to solve the Prisoner’s Dilemma, you need some kind of enforcement mechanism.  A free trade agreement could potentially be that enforcement mechanism).  Third, it would suggest that unilateral free trade may not be the best option.  These implications, however, need to be kept in the context of the discussion: I assumed away a lot of inconveniences such as the knowledge problem and public choice concerns.  If we weaken those assumptions, then the second and third implications become much weaker: a free trade agreement could potentially become a weapon for protectionism instead of one against it and the requisite knowledge needed to determine tariffs isn’t there, making unilateral free trade a comparatively better option.

The above discussion on optimal tariffs was between two countries, but I think it can be expanded to an arbitrary number of countries without any loss of generality.  In fact, if we increase the number of countries in the analysis, I think the case against the optimal tariff becomes even stronger.