Unilateral Trade Liberalization and Welfare Analysis: Iceberg Trade Costs versus Tariffs

Abstract

A large body of literature in international economics has tried to explain the effect of asymmetric changes in trade barriers in welfare of the liberalizing country, however, there is no consensus on this issue. In this paper, I focus on the implications of a decline in import costs in welfare of the liberalizing country. I utilize a version of computational general equilibrium model of international trade (based on Armington assumption) where countries are potentially asymmetric in terms of labor endowment, productivity, trade barriers etc. under two different specifications of trade costs: (i) standard iceberg cost formulation and (ii) tariffs. The model numerically proves that unilateral trade liberalization is welfare improving for the liberalizing country in Armington setup with iceberg costs. However, when using tariffs, I numerically show that there exists a positive optimal tariff rate which maximizes welfare. This result indicates that a reduction in tariffs may either benefit or immiserize the liberalizing country depending on the pre-liberalization value of tariff. In the literature, a simple formula has been driven which shows the gains from trade for the case of iceberg costs. I generalize this formula in Armington setup with tariffs and highlight the importance of revenue generating tariffs.