Protection (or imposition of tariff) improves a nation’s terms of trade and secures for it larger gains from international trade. By imposing tariff duty on imports, a country improves the rate at which its exports are exchanged for imports from abroad.
When a country imposes tariff duty, its willingness to take imports is reduced. It means for any quantity of exports, it requires larger quantity of imports, or putting it another way, it is willing to offer less of exports for a given quantity of imports from abroad.
The result is an improvement in the tariff imposing counties terms of trade; tariff reduces the home country’s offer of exports for imports.
The terms of trade argument is also known as the foreigner pays the duty argument. The terms of trade will improve for the tariff imposing country if the foreigners are made to pay for the duty.
Imposition of tariff raises the price in the imposing country which reduces the demand for imports from abroad. Reduced demand compels the producers in the exporting country to lower the price in order to reduce the foreign supply to match the reduced demand in the imposing country.
The extent to which the terms of trade improves and the extent to which the foreigners are made to pay the duty depends upon the extent to which the price rises in the importing country and falls in the exporting country.
If the demand for foreign good in the home country is elastic and if the supply of the foreign producers is inelastic, then there will be a greater price rise in the importing country and a greater price fall in the exporting country.
Main defects of the terms of trade arguments are given below:
(i) Tariffs will improve the terms of trade only when the foreign offer curve is less elastic. The terms of trade will, however, not improve in case of poor countries which generally face elastic foreign offer curves.
(ii) The gains in the terms of trade through tariff duty are secured only at the cost of other countries. Thus, other countries will also retaliate by imposing tariffs on their imports. The process of retaliation and counter-retaliation will benefit none and will turn the policy of protection self-defeating.
(iii) Imposition of tariff may improve the terms of trade, but such restrictions will curtail the world output in absolute terms.
(iv) Tariffs higher than the optimum level will be detrimental to the national economic welfare. An optimum tariff is that which maximises the gains from the improved terms of trade minus the loss from the reduced volume of trade.
Although the terms of trade may continue to improve at tariff levels even above the optimum tariff, the resultant reduction in the volume of trade will more than offset this improvement. This will lower the welfare level of the country.
(v) Tariffs increase the prices of the imported goods and are against the interests of the consumers.