Theory and Policy
Table of Contents
Hecksher Ohlin (H.O.)
theory of trade leads to factor reward equalisation over time with free trade 3
Impact of tariff
protection over the welfare of a small country. 9
effects that would follow from such a policy: 11
This report has been developed for describing the different
issues of the international trade in the context of the two trading countries
that are engaged in free trade. The issue that may arise under international
trade has been discussed on the basis of different assumptions and theorems. In
this report discussion has been done regarding the factor price equalization
concept following the Hecksher Ohlin (H.O.) theory of trade. Besides, the
assignment also studies that how the imposition of tariff on free trade in the
context of a small country influences the overall welfare of that country (Viner,2016. ).
Hecksher Ohlin (H.O.) theory of trade leads to factor
reward equalisation over time with free trade
According to the Hecksher Ohlin (H.O.) theory of trade when
the prices of the outputs that are exported between the two countries become
equal under free trade, then the prices of the inputs which are mainly the capital
factor and the labour factor will eventually be at equal level between the two
trading countries that have participated in the free trade (Deardorff, 2011).
Under “autarky” (when a country has not
participated in international free trade) the prices of exportable outputs
differ in the different courtiers which in turn creates the differences between
the prices of labour (wage ) and the price of capita(interest)
assumptions of the theory are as follows:
Absence of transport cost and perfect
competition in both the goods market and the input market where the inputs are
used for producing the goods
The production function for a particular good or
the product that are going to be exported by the two courtiers that are
participating in free international trade are same in both the countries but
the production function for the different goods will be different in the two countries.
Country-X is producing the two commodities A
& B where Country-X is capital abundant as in the pre-trade situation the
price of capital is relatively lower in Country-X compared to that of
Another initiator of trade between the two countries is the
difference in factor intensity of the two goods or commodities that are traded
by the two countries that are engaged in trade. In the above discussion the
commodity-A is capital intensive & Commodity-B is labour intensive. In
other words the commodity-A uses more capital than labour and commodity-B uses
more labour than capital(Nishimura
Another initiator of the trade between the two countries is
the difference between the commodity prices in the two countries which exists
in the situation of autarky or in no trade situation due to the different
factor intensity of the different countries. That is the price of Commodity –A
will be lower in Country-X (as the Commodity –A uses more capital than labour
& capital is cheaper in Country-X) compared to the price of commodity in
Country-Y .Again the price of Commodity –B will be lower in Country-Y (as the
Commodity –B uses more labour than capital & labour is cheaper in
Country-Y) compared to the price of commodity-B in Country-X(Caliendo, 2010)
Thus Country-X can produce Commodity-A at a lower cost than
Country-Y and that is why Country-X is capable to charge a lower price for
Commodity-A than the international market. In other words Country-X has
comparative advantage in producing the Commodity-A. For the same reason
Country-Y has comparative advantage in producing the Commodity-B and is capable
to charge a lower price for Commodity-B(due to low cost of production).
Thus Country-X will specialise in the production of
Commodity-A and the Country-Y will specialises in the production of Commodity-B
when the cost of capital is lower in Country-X and cost of labour or wage is
lower in Country-Y(Costinot,
As per the theory, the two countries participate under free
international trade that ensures perfect mobility of the factors of production
in the two countries(Hamminga
2012). Sometimes it is seen that perfect mobility of the physical
factors is not possible, in such a situation when Country-X exports Commodity-A
that is capital intensive in nature and thus Country-X sells the inexpensive
capital in exchange of insufficient
labour that is highly priced in that country. On the other hand Country-Y sells
the inexpensive labour in exchange of insufficient capital that is highly
priced in that country(Fisher, 2011).
That is why it is described that free proxy movement of factors of production
is ensured by the free movement of the products that are exchanged between the
Finally under free trade in Country-X the export of
commodity-A(capital rich product) will increase the demand for capital as a
well as price of capital and import of commodity-B(Labour rich product) will
also reduce the scarcity of labour in country-X which will finally lead to the
decline in price of labour or wage in that country(Krugman, 2009).
Similarly in Country-Y the export of commodity-B(labour rich
product) will increase the demand for labour as well as wage and reduce the
scarcity of capital which in turn will pull down the cost of capital in
Country-Y(Baskaran et al.,2011)
Thus under free trade the two countries will continue to
make trade and will gain up to the point where the commodity price equalization
will lead to equalisation of relative price of the factors of production
Impact of tariff protection over the welfare of a
Welfare of a small country with the imposition of tariff
Generally the small courtiers find it difficult to handle the
global competition and often imposes tariff over the prices of the imports so
that the indigenous producers can get a protective shield from the
international competition in the form of increased price of the imported goods
that is expected to reduce the domestic demand for the imported goods and will
enhance the demand for the indigenous goods (Cadot et al.,2015).
Thus the producers of the small country is expected to enjoy the welfare due to
the increased demands for the products
generated by the shield of increase in the price of the imported goods
through the imposition of tariff(Felbermayr et al.,2013).
As explained in the above figure at the free trade price of
a product that a small country faces when it is part of the international trade
in a tariff free situation is PF. At this price PF the
domestic demand for the product was DF & domestic Supply was SF.
Therefore the volume of import of the country was around SF- DF
Now let the small country is imposed a
tariff to the amount of PT-PF as indicated by the vertical blue line
Due to the full inclusion of the volume of tariff the price
of the product has increased from OPF to OPT. At this
increased price the demand for the product has decreased to DT and
the domestic Supply of the product has increased to ST.
Thus the volume of external import has decreased toST- DT
imposition of tariff has drastically reduced the consumer surplus by an amount
of the areas of
The underlying reason behind such decline in consumer’s
surplus is that the consumers are paying a high price for both the imported
goods as well as for the indigenous substitutes whose price has increased
following the price of the imported goods(Harrison and Rodríguez-Clare, 2009).
the imposition of tariff has helped the produces to enjoy a surplus that is
indicated by the area marked by
The main reason behind the increase in producers’ surplus is
the increase in output and employment as well profit generation capacity of the
exiting firms of the industry of the small country where tariff has been
The revenue earnings
of the government has been incised by the amount as indicated by the region
The revenue generation that has increased through the
collection of tariff revenue help the government organization to generate more funds
which help the government to enhance the spending for the purpose of overall
welfare of the country(Topalova
and Khandelwal, 2011).
The total deadweight
loss of the small country due to the imposition of tariff is given by the sum
of production efficiency loss as the production loss occurs due to the
imposition of tariff.
And the consumption
efficiency lossrise in price of import due to the imposition of tariff has led
to the reduction of consumption
Thus from the above discussion it is clear that imposition
of tariff on a small country lead to the reduction in over all national welfare
and higher will be the volume of tariff higher will be loss of welfare(Gamberoni and Newfarmer, 2009) .
Income distribution effects that would follow from
such a policy:
Thus it can be seen that imposition of tariff over the trade
of a small country leads to the redistribution of income. Under the
redistribution effect the income or the surplus is getting redistributed in
favour of the producers as well as the government as both are gaining due to
the imposition of tariff. The producers are gaining in the form of surplus
production where as the government is gaining in the form of increased revenue
or fund that can be used for meaningful spending(Caliendo, and Parro, 2015). But the consumers are the
worst suffers and losing a large share of surplus after the imposition of
tariff due to the increase in the price of
both domestic and the imported products. As the loss of consumer surplus
is much higher than the gain of the producers as well as government; therefore
there will be an overall decrease in the welfare of the country due to the redistribution
of income(Ethier and Horn,2014.).
Thus from the above
discussion it can be seen that the imposition of tariff over free trade
situation in case of a country leads to
the loss of welfare mainly due to the dead weight loss which arises due to the loss
of economic inefficiency.This economic inefficiency arises due to the loss of
consumption efficiency and loss of
production efficiency as indicated by the area
Thus the imposition of tariff
reduces the total volume of trade in a country to the amount of deadweight loss
as consumers demands less due to the increased price of the product that has
incorporated the tariff and the and the reduction in demand has led to the
reduction in production. As a result when a tariff is imposed in case of the
small country for redistribution of income among the different participants of
the market(consumers, producers & the government of the country) the production
and consumption loss(which sums up to the deadweight loss ) becomes greater than
the producer’s surplus or the gain of the producers as well as the gain of the
government in the form of tariff revenue collection and the overall welfare of
the economy tends to decrease.
More over higher will be the
magnitude of the tariff, grater will be the rise in price of the imported
products and grater will be the protect ion of the producers from the
international competition and consequently grater will be the loss of welfare
in case of a small country(Dixon
As the country is a small country
it is having a small economy with small manufacturing industry and therefore
mostly dependent on imports for meeting the demands of the different products.
In such a situation the imposition of an import tariff drastically reduces the consumers’
surplus and enhances the consumers’ surplus and governmental revenue(Blomquist and Simula, 2010).
Redistribution effect in brief
Thus the revenue effect (revenue earned by the
government) =lost consumer surplus as
indicated by area “C” (due to the imposition of tariff) = Government revenue (has transformed in to)
has shifted from consumer surplus to
of production efficiency due to protective effect) + Area “d”(loss of consumption demand due to protective effect) = dead weight loss
Finally imposition of tariff by a small country
over their import fails to make any impact over the international price at
which it is traded in the other countries and therefore the tariff imposition
by a small country will not be able to influence the welfare of the producers
and consumers of the other country even if the volume of import in the small
country will decrease due to the imposition of tariff.
From the discussion of the above report it can be said that
in absence of any kind of restriction on trade which leads to the fee trade
situation the perfect mobility of commodity prices between two countries where the product is cheaper in one country and is exported to another country where the product is
dearer, the cost or prices of inputs that are used for producing the product
also moves freely and this free movement leads to the increase in the volume of
scare product and decrease in the volume of the abundant product and creates a
level playing field which in turn equate the product prices as well as factor
prices between the two countries and each country ultimately lose their
respective comparative advantage in production due to factor abundance(Feenstra,
2015). Again any imposition of
tariff for giving protection from international competition to the producers of
the small country leads to loss of overall welfare due to the dead weight loss.
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