Uncertainty, Domestic Distortions, and the Optimal Tariff

Abstract

A number of studies have appeared in recent years incorporating uncertainty in a two sector general equilibrium model of trade; particularly noteworthy are the contributions by Batra [1] and Ingene and Yu [4,283-95], among others [3; 6,326-31]. The literature on the optimal trade policies under domestic factor market distortion in a non-stochastic framework is also vast [8], but there has not been any attempt to formulate optimal tariff policy in a stochastic model of international trade characterized by uncertain relative price and factor market distortion. Recently, Itagaki [5,292-97] has analyzed the issue of optimal tariff under relative price uncertainty but without any domestic distortions.' In this context, he has shown that for a small open economy facing uncertain terms of trade, the optimal tariff is not zero. However, the analysis of optimal trade policies under domestic distortion along with uncertain terms of trade is conspicuously absent. This paper extends their analysis and derives a generalized formula for the optimal tariff in such an economy, where a tariff is considered as the only available trade policy. A thorough understanding of the optimal trade policies in the presence of domestic factor market distortion and uncertain terms of trade will be useful for many LDC's plagued by growing distortions. In this paper we assume that producers maximize their profits and consumers maximize their utility after the import tariff is levied by the policymakers and both international and domestic prices have been observed. And, the policymakers take into account the behavior of the producers and consumers when they are choosing the optimal tariff rate. In the next section, the model is presented. Then we derive the optimal tariff formula for the economy with uncertain terms of trade in the presence of domestic factor market distortions. Section III contains a summary and some concluding remarks.