What Is Term Of Trade Or Optimal Tariff Argument?

One valid argument for imposing tariffs is that doing so will shift the terms of trade in a country's favor and against foreign countries.  The idea is that when a large country levies tariffs on its imports, the tariffs will reduce the world price of its imports while increasing the prices of its exports. Such a change will be n improvement in the terms of trade. By shifting the terms of trade in its favor, the United States can export less wheat and fewer aircraft in order to pay for imports of oil and cars. The set of tariffs that maximizes our domestic real incomes is called the optimal tariff.

The terms of trade argument goes back 150 years to the free trade proponent John Stuart. It is the only argument for tariffs that would be valid under conditions of full employment and perfect competition. We can understand it by considering the simple case of an optimal tariff on oil. The optimal tariff on oil will raise the domestic price above the foreign price. But because our demand is curtailed as a result of the tariff, and because we are a significant part of the world demand for oil, the world market price of oil will be bid down. So part of the tariff really falls on the oil producer.

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