Tariffs as Insurance: Optimal Commercial Policy When Domestic Markets Are Incomplete
Free trade is not optimal for a small country that faces uncertain terms of trade if some factors are immobile - ex post, and markets for contingent claims are incomplete. The government can improve social welfare by using commercial policy that serves as a partial substitute for missing insurance markets. Using a combination of analytical and simulation techniques we demonstrate that optimal policy for this purpose will often have an anti-trade bias. We also show that the usual preference by economists for factor or product taxes and subsidies over tariffs and export subsidies may not be justified in this context.
Published: Eaton, Jonathan and Gene M. Grossman. "Tariffs as Insurance: Optimal Commercial Policy When Domestic Markets are Incomplete." Canadian Journal of Economics, Vol. 18, No. 2, (May 1985), pp. 258-272.