On Tariffs and Smuggling

YEONG-HER YEH"

The purpose of this paper is to show that if a country wants to eliminate smuggling, it may have to increase rather than decrease the tariff. This paradoxical case could take place if the country in question is large and the foreign elasticity of demand for imports is inelastic. (JEL F~3)

Introduction

There have been many discussions in literature on the welfare effect of smuggling [Bhagwati and Hansen, 1973; Bhagwati, et al. 1998]. The purpose of this paper is to show that if a country wants to eliminate smuggling, it may have to increase rather than decrease the tariff. This paradoxical case could take place if the country in question is large and the foreign elasticity of demand for imports is inelastic. The offer curve approach [Meade, 1952] is used in this study.

In Figure 1, OA and OB are the free trade offer curves of the home country, A, and the foreign country, B, respectively. It is assumed that the foreign elasticity of demand for imports is inelastic. The horizontal axis and vertical axis measure the home exportable good, X, and importable good, Y, respectively. Q1 is the free trade equilibrium point.

Now suppose that A imposes a tariff. The tariff-distorted offer curve is OA' , which intersects OB at Q2" The terms of trade after the tariff is measured by OQ2 (not shown) and the domestic relative price of Y is measured by the slope of the trade indifference curve at Q2"

OS measures the terms of trade under smuggling and is less steep than OQ2 because it is assumed that it costs more to import one unit of Y through smuggling. Since the domestic relative price of Yunder smuggling (measured by OS) is lower than that under the tariff (measured by the slope of the trade indifference curve at Q2), smuggling takes place. The welfare of A is represented by the trade indifference curve at Qs under smuggling.

Next, suppose that A wants to eliminate smuggling. IC is the income consumption curve corresponding to the domestic relative price of Y under smuggling. The IC curve is bounded by Qs a and Qs b under the assumption that neither X nor Y is an inferior good. The IC curve intersects OB at Q3' To reach Q3, A must increase the tariff. The tariff-distorted offer curve after the increase in the tariff (not shown) will pass through Q3" Since the domestic relative price of Yafter the increase in the tariff (measured by the slope of the trade indifference curve at Q3) is equal to that under smuggling, smuggling

*University of Hawaii--U.S.A.

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is eliminated. This means that A must increase the tariff to eliminate smuggling. However, if the income consumption curve IC intersects OB at a point below Q2, such as Q4, then A must reduce the tariff to reach Q4 and eliminate smuggling. 1

FIGURE 1 Smuggling Under an Inelastic Foreign Demand for Imports

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The above paradoxical outcome (for example, to increase the tariff to eliminate smuggling) never arises ifA is facing an elastic foreign demand for imports, as shown in Figure 2 (notations in Figure 2 are the same as in Figure 1). In this case, the income consumption curve IC always intersects OB at a point above Q2, such as Qa .2 Therefore, A must reduce the tariff to reach Q3 and eliminate smuggling. 3

We will get the same result if A is a small country and faces a perfectly elastic foreign offer curve. In other words, A must reduce the tariff to eliminate smuggling.

In conclusion, this paper shows that if a country wants to eliminate smuggling, it may have to increase rather than decrease the tariff, assuming that the country in question is large and faces an inelastic foreign demand for imports. However, if the country is small or is large but facing an elastic foreign demand for imports, then the country must reduce the tariff to eliminate smuggling.

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F I G U R E 2 Smuggling Under an Elastic Foreign Demand for Impor t s

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Footnotes

1. Figure 1 shows the case where the welfare of A is decreased after smuggling. However, the analysis can be applied to the case where the welfare of A is increased or remains the same after smuggling. The result is that A must increase the tariff to eliminate smuggling.

2. As we move down from Q2 to the origin on the foreign offer curve, OB, the successively lower trade indifference curves cut will have successively smaller slopes. Therefore, thelC curve never intersects OB at a point below Q2"

3. Figure 2 shows the case where the welfare of A is decreased after smuggling. However, the analysis can be applied to the case where the welfare of A is increased or remains the same after smuggling. The result is that A must reduce the tariff to eliminate smuggling.

References

Bhagwati, Jagdish N.; Hansen, B. "A Theoretical Analysis of Smuggling," Quarterly Journal of Economics, 87, 2, May 1973, pp. 172-87.

Bhagwati, Jagdish N.; Panagariya, Arvind; Srinivasan, T. N. Lectures on International Trade, Cambridge, MA: MIT Press, 1998, pp. 476-81.

Meade, James E. A Geometry of International Trade, London, United Kingdom: George Allen and Unwin, 1952.