Question

1. Explain what would happen to the terms of trade if home imposes a tariffs on imports from the rest of the world under the two set of assumptions below (10 points, 5 points for each case):
   1. Home is considered a large country (hence, it is able to affect world prices)
   2. Home is considered a small country (unable to affect world prices)

(Noted: Assume no retaliations from the foreign countries.)

Answer 1

a. Home is considered a large country

Suppose Mexico, the free trade importing nation, imposes a particular tariff on wheat imports. The tariff will impede the flow of wheat across the frontier as a tax on imports. Moving the item from the U.S. to Mexico will now cost more.

As a consequence, wheat supply to the Mexican economy will decrease, leading to an rise in wheat prices. Because wheat is homogeneous and the market is highly competitive, the cost of all wheat sold in Mexico, Mexican wheat as well as U.S. imports, will increase in cost. The greater cost will lower the demand for imports from Mexico.

Mexico's decreased wheat supply will move the supply back to the U.S. market. Since Mexico is supposed to be a big importer, supply moved back to the U.S. market will be sufficient to cause a fall in the U.S. price. The reduced cost reduces the supply of U.S. exports.

For this reason, it is said that a nation which is a big importer has monopsony power in commerce. A monopsony occurs when a single purchaser of a product is present. To induce a cost decrease, a monopsony can achieve an benefit for itself by decreasing its demand for a commodity. Similarly, a nation with monopsonic energy can decrease its import demand (by setting a tariff) to decrease its cost for the imported product. Note that these price effects are identical in direction to the price effects of an import quota, a voluntary export restraint, and an export tax

b. Home is considered a small country

The small-country hypothesis implies that imports from the country are a very tiny share of the world market — so tiny that even a full elimination of imports would have an imperceptible impact on the product's world supply and would therefore not impact the world price. Therefore, when a tiny nation implements a tariff, there is no impact on the world price.

The tiny nation hypothesis means that at world price level the export supply curve is horizontal. The small importing country considers the world price to be exogenous as it can not affect it. The exporter is prepared to deliver the product at the specified world cost as much as the importer likes.

An import tariff will increase the national price, leaving the overseas price unchanged in the event of a tiny nation.
An import tariff will lower the import amount.
An import tariff will increase by the complete quantity of the tariff the national price of imports and import-competing products.
Export supply at the unchanged overseas cost will be equivalent to import demand at the greater national cost with the tariff in place in a two-country model.