What are the Effects of Tariffs on the Terms of Trade?

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A tariff may be imposed by a country with a view to improving its terms of trade. The specific effects of a tariff, however, depend on the way the tariff is imposed and on the elasticities of the offer curves. A tariff will improve the terms of trade if the elasticity of the opposing offer curve is greater than unity but less than infinity.

Supposing England imposes some tariff (import duty) on its imports of Portuguese wine. As such, traders in England would have to give to the government an amount of their import purchases equivalent to the import duty. England’s offer curve thus shifts upwards to OE’.

It can be seen that before tariff was imposed, England was willing to offer (export) OB of its cloth in exchange for AB of import of wine. But when the tariff (import duty) is imposed, she will be willing to offer OB of cloth in exchange for a larger amount of imports -AB plus amount equal to import duty, say AA, i.e., A ‘B of wine.

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Therefore, OE shifts upwards to OE’. Now, the terms of trade change as indicated by the slope of line ON’. Since the ling of terms of trade (ON) moves away from the tariff-imposing country towards the opposite side (as ON0 the terms of trade for the imposing country improve.

In the domestic economy of the tariff-imposing country (England in our illustration), the price ratio between exports and imports alters from the slope of ON to OH, indicating a rise in the price of imports relative to exports.

It must be remembered that, a tariff can improve terms of trade only when the offer curve of opposite country is not perfectly elastic and it (the opposite country) does not retaliate by imposing a tariff on its imports from the country concerned. In the case of retaliation, however, the final effect of tariffs on the terms of trade of both the countries will decline as a result of rising prices of imports under retaliation consequent to tariff imposition, so both countries will lose.

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