Introduction When a country engages in trade, the government of that country will build various barriers to restrict trade. The most common of these barriers are taxes levied on the importation (may also be levied on exports as well as imports) of foreign goods. These taxes, commonly refered as tariffs, are simply a form of commodity taxation. There may be several reasons to levy taxes on trade.
For example, a government can use tariffs to protect the operations of domestic industries that compete with imports. Taking the H-O model, we may expect government to protect the companies that use that country's scarce factors. Another reason to use tariffs would be to raise revenues for the government The effects of Tariffs In this section I will focus on the welfare loss because of the tariffs, the effects on small counties and the effects on large countries. a) The welfare loss from tariffs Lets assume there is a small country, a country which can trade as much as it wants at the fixed world price ratio p . In this situation, tariffs will affect the equilibrium price ratio facing domestic producers and consumers, not the world price ratio. Lets assume the small country exports Y and imports X and the government puts a tax, t on each X imported to country.
Because p is fixed, the domestic price of X will rise by the full amount of the tax. If the world price ratio, p = px / py then the domestic price ratio will be p = p (1+t). Because of the tariff on X, the domestic price ratio will be more than the world price ratio. Since the country still does trade with the rest of the world the trade balance, p , still remains the same.