Normally, when a tariff is imposed, the terms of trade improve and gain accrues to the imposing country. But the tariff rate should be within a limit. If excessive tariff is imposed total gain resulting from improved terms of trade will not be large enough due to decline in the volume of trade. Hence, the question arises as to what should be the ideal rate of tariff? In this regard economists have devised the concept of ‘optimum tariff.’ The optimum tariff is one which maximises imposing country’s gain or welfare from trade.
In technical jargon, however, optimum tariff implies that rate of tariff which intersects the opposite country’s offer curve at a point which is tangent to the imposing country’s highest community indifference curve.
In, the pre-tariff curves are OE and OP for England and Portugal respectively and the terms of trade are expressed by the slope of OT line. ClC1 CIC2 are community indifference curves of England. At point T England has ClC, community indifference curve.
Now, ClC2 is the highest possible community indifference curve which is tangent to Portugal’s offer curve at point. Hence, England should impose a tariff such that her new distorted offer curve (OE’) will intersect at point h, so that, the new terms of trade are expressed by the line OT. Such rate of tariff which produces this condition is termed as optimum tariff. Indeed, any rise in tariff rate beyond this (optimum) rate will though, mean an improvement in terms of trade, it will not lead the country to the highest community indifference curve, as net gain will deteriorate due to contraction in the volume of trade.
It must be noted that a tariff can improve the terms of trade of imposing country only if the offer curve of the opposite country is less than perfectly elastic. If, however, the offer curve of the opposite country is infinitely elastic, i.e., when it is a straight line from the origin, the tariff imposing country gets no benefit as the terms of trade will not change. This is illustrated in.
In, when England imposes tariff and shifts its offer curve from OE to OE’ , the volume of trade is reduced, but the terms of trade remain unaltered, so tariff brings no good result.
Kindleberger presents a simple formula to measure the optimum tariff rate as under:
E stands for the point elasticity of the offer curve of the opposite country.
Thus, if the offer curve of the opposite country is a straight line implying infinite elasticity, the optimum tariff is:
Which suggests that no tariff can improve the terms of trade. Thus, only a lower elasticity (e < a) implies that a higher commodity indifference curve (i.e., higher level of welfare) is reached by a tariff.