When a tariff is imposed by a country, her gain of improvement in terms of trade is visualised only in the absence of retaliation by the other trading countries.
But what will happen if the opposite trading country also retaliates by imposing a custom duty on her imports? Obviously then, not only the first country cannot improve her terms of trade to any extent, but even the foreign trade of both the countries will contract to a greater extent, thus wiping out even their existing gains.
In our example, when England gets the benefit by the movement of equilibrium from TV to M by imposing a tariff, her gain is equal to Portugal’s loss to that extent. Obviously, when the terms of trade become favourable to England, they will become unfavourable to Portugal. As such, Portugal may be provoked to retaliate by impo- sing a tariff on her imports of English cloth. Thus, by imposing tariff, Portugal too will shift her offer curve.
The new offer curve of Portugal OP and that of England OE intersect each other at point Z, determining OT as the new line of terms of trade, which is very close to the original one (OT). Then, England’s gain is wiped out in the process. At the new equilibrium point Z, England may again think of raising the level of tariff further. Portugal, in turn, will move in retaliation.
This kind of development will cause diminution of gain as well as volume of trade. A point may ultimately be reached where foreign trade of the two countries will cease to exist or become insignificant, while the new equilibrium terms of trade will tend to be nearer the original terms of trade.
Thus, under retaliation, both the countries are losers, and their gains due to the raising of tariffs prove to be indecisive and illusory. In short, retaliation is hazardous to the growth of international trade. During the Great Depression of the thirties when all the countries waged on economic war of retaliation, it resulted in stagnation of world trade and consequently unhealthy international economic relations.
This in effect gave birth to the trade liberalisation movement in the later period. Under the trade liberation era, many bilateral and multilateral trade agreements emerged with a view to eliminating tariff walls and promoting foreign trade. The General Agreement on Tariffs and Trade (GATT), for instance, today works as an institution for tariff regulations and pleads for the reduction of tariffs and for preferential treatment for the development of growing trade relations between the developed and developing countries.