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.
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