THE OPTIMAL TARIFF FOR A SMALL COUNTRY UNDER INTERNATIONAL PRICE UNCERTAINTY *

Abstract

THE optimal tariff argument is widely acknowledged as an exception to the dictum of the classical doctrine of free trade. With a given income distribution and no foreign retaliation, this argument demonstrates that a large trading country can improve its welfare by imposing a tariff to distort domestic prices away from the international terms of trade. The optimal tariff equals 1h/f 1, where qf is the elasticity of the foreign offer curve. For a small country which cannot influence world prices, i.e., qf = 0o, the optimal tariff rate is zero [Kahn (1947), Little (1948), Johnson (1950)]. Because many less developed countries (LDC's) are small trading countries, the prescription of classical economic theory is that the optimal (welfare maximizing) trade policy is free, undistorted trade. However, in recent years due to the uncertainty which characterizes international markets, many developing countries have implemented development programs to promote self-sufficiency and to decrease dependence on external sources of strategic imports. Common policy instruments used to accomplish this are domestic price regulation, import tariffs and/or export taxes to distort internal prices away from the international terms of trade. Traditional trade theory suggests that developing countries impose welfare losses on themselves by so distorting international prices. The theory of the optimal tariff was developed under the assumption of perfect certainty in the international terms of trade. However, due to stochastic elements in the supply as well as demand for certain internationally traded commodities, international trade is not characterized by certainty in trading prices. Future international prices can be known, at best, in a probabilistic sense. This is particularly true in the case of agricultural products, whose supply schedule contains a stochastic weather argument. Recently, several theoretical contributions to the international trade literature have incorporated price uncertainty into formal trade models [e.g., Feder, Just, and Schmitz (1977), Brainard and Cooper (1968), Batra and Russell (1974), Turnovsky (1974), Anderson and Riley (1976)]. However, none of these studies carries the analysis through to draw conclusions for optimal tariff policy of a small trading country which faces uncertainty in international prices. In this paper the formulation of the international price uncertainty problem differs from that in all the above studies except Feder,