Abstract
The use of tariffs in the absence of subsidies in small countries is an empirical observation which stands in sharp contrast to the theoretical literature of trade policy. We analyze the welfare effects of tariffs and subsidies in a homogeneous good duopoly game with cost asymmetries between the two firms, allowing for distortionary taxation. We find that for reasonable values of the distortion parameter or for a large cost disadvantage of the home firm, a tariff is the optimal policy tool.
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