Specific Tariff versus Ad valorem Tariff: Choice of a Policy

Instrument in Agricultural Trade Negotiations

Mémoire

Abdelaziz Tidjani Serpos

Maîtrise en économie rurale

Maître ès sciences (M.Sc.)

Québec, Canada

© Abdelaziz Tidjani Serpos, 2013

iii

Résumé

La conversion des tarifs spécifiques en leur équivalent ad valorem est un sujet d‟actualité en

ce sens qu‟elle fait partie des priorités dans les discussions des membres de l‟Organisation

Mondiale du Commerce (OMC). Peut-on mieux comprendre et anticiper les choix de tarifs par les

pays dans un contexte de négociation commerciale? Le présent mémoire se propose d‟apporter une

réponse à cette question. Nous avons utilisé un modèle à deux étapes. La première consiste au choix

du type de tarif par les pays. La deuxième, quant à elle, est la phase de négociation. Le modèle est

composé de deux pays et deux biens, des fonctions d‟utilité Cobb Douglas et des dotations comme

fonctions de production (tel que développé par Kennan and Riezman (1988)). La détermination des

équilibres de négociation a été possible grâce au produit de Nash (Nash, 1950). Nous avons trouvé

que le petit pays a tendance à utiliser un tarif ad valorem et que le grand pays est indifférent entre

un tarif spécifique et un tarif ad valorem lorsque celui-ci négocie avec un petit pays. Lorsque les

deux pays sont de même taille, l‟équilibre de négociation est le libre-échange. L‟apport à la

recherche scientifique dans le domaine est d‟une importance à préciser. Cette étude est la première à

investiguer le choix des instruments de politique commerciale par un pays dans un contexte de

négociation. En effet, jusque-là, très peu de travaux scientifiques se sont intéressés aux questions de

modélisation des négociations commerciales. Le présent mémoire est donc une esquisse de

compréhension des équilibres de négociation via une modélisation mathématique s‟inspirant de

travaux précédents sur la guerre des tarifs.

v

Abstract

The conversion of specific tariff into its ad valorem equivalent is one of the key issues for

current World Trade Organization (WTO) discussions. An important question this thesis addresses

is whether we are able to anticipate and understand the choice between specific and ad valorem

tariffs by a country in trade negotiations. We use a two-stage model to find the solutions for trade

negotiations between two countries. In the first stage, countries choose between specific and ad

valorem tariffs. In the second stage, they negotiate over tariff rates. The model includes two

countries and two goods, Cobb Douglas utility functions and endowments as production functions

as in Kennan and Riezman (1988). To find the negotiation solutions, we use the Nash bargaining

solution (Nash, 1950). This thesis is the first to investigate the choice of policy instrument in trade

negotiations. We find that a large country is indifferent between specific and ad valorem tariffs

when negotiating with a small country. We also find that a small country prefers ad valorem tariff.

Finally, when two countries are equal in size, the negotiation equilibrium is free trade.

vii

Table of Contents

Résumé .................................................................................................................................. iii

Abstract ................................................................................................................................... v

Table of Contents ................................................................................................................. vii

Avant-Propos ......................................................................................................................... ix

List of Tables ......................................................................................................................... xi

List of Figures ..................................................................................................................... xiii

1. INTRODUCTION .............................................................................................................. 1

2. LITERATURE REVIEW ................................................................................................... 5

2.1. Previous studies on the equivalence between specific tariff and ad valorem

tariff ............................................................................................................................ 5

2.2. Optimal tariff argument and terms of trade manipulations................................ 6

2.3. Cooperative trade policy ......................................................................................... 8

2.4. Trade policy and non-economic determinants: a political-economy criterion 10

3. THEORETICAL MODEL ................................................................................................ 13

3.1. Ad valorem tariff game .......................................................................................... 14

3.2. Specific tariff game ................................................................................................ 19

3.3. Specific tariff vs. ad valorem tariff game ............................................................. 22

3.4. Ad valorem tariff vs. specific tariff game ............................................................. 26

4. GOVERNMENT CHOICE OF POLICY INSTRUMENT .............................................. 31

4.1. Country A is large and has a comparative advantage in the production of good

1 ................................................................................................................................ 31

4.2. Country A and country B are equal size and country A has a comparative

advantage in the production of good 1 .................................................................. 33

4.3. Country A is strictly larger and has a comparative advantage in the

production of good 1 ............................................................................................... 34

4.4. Country A is strictly larger but does not have a comparative advantage in the

production of good 1 ............................................................................................... 36

5. DISCUSSION ................................................................................................................... 39

6. CASE STUDY AND EVIDENCE: URUGUAY ROUND AND NORTH AMERICAN

FREE TRADE AGREEMENT (NAFTA) ............................................................................ 41

7. CONCLUSION ................................................................................................................. 45

References ............................................................................................................................. 47

ix

Avant-Propos

Je voudrais en premier lieu dédier le présent mémoire à ma feue mère Siaratou Essou

Abogounrin à qui je dois tout ce que j‟ai accompli jusqu‟à présent. De plus, je dédie ce travail à

mon père Ismail Tidjani Serpos, qui a donné à mes sœurs/frères et moi le goût du travail bien fait et

de l‟excellence. Enfin, je dédie ce mémoire à mes frères, sœurs et à toute la famille Tidjani Serpos

pour le soutien et les encouragements qu‟ils n‟ont cessé de me porter. Merci de croire en moi.

Ce mémoire n‟aurait pas vu le jour sans le financement de ma formation en Maîtrise

d‟Agroéconomie à l‟Université Laval par la Banque Mondiale. Je lui témoigne ici toute ma

gratitude.

Qu‟il me soit permis de remercier le Professeur Bruno Larue, mon directeur de recherche.

Plus qu‟un simple encadreur, il est devenu un conseiller à qui l‟on peut poser toutes sortes de

questions, mêmes les plus personnelles. En lui, je reconnais de grandes qualités intellectuelles et

morales. Je témoigne ici de sa disponibilité sans limite. Le Professeur Larue a manifesté un soutien

inconditionnel à mes travaux dès le premier jour où il m‟a rencontré et a stimulé ma volonté de faire

un doctorat en économie agricole. C‟est aussi le moment de remercier le Professeur Larue pour sa

volonté de faire de ses étudiants les meilleurs en mettant la barre très haute. Avec lui, j‟ai atteint un

niveau intellectuel et critique dont je suis fier. Bruno, sincèrement, merci!

Je voudrais remercier le Professeur Sébastien Pouliot, mon co-directeur de recherche pour

le suivi et la rigueur dans son travail. Malgré ses diverses activités, il a toujours du temps à

consacrer à mes questions. Je me rappelle encore des discussions intéressantes que nous avons eues

dans son bureau lorsque j‟avais des difficultés dans ma recherche. J‟ai beaucoup apprécié sa rigueur

sur certains aspects de mon travail et cela m‟a amené à développer un esprit critique de ce que je

fais comme travail scientifique. Sébastien, merci pour tout!

Bruno et Sébastien, merci de votre soutien moral et intellectuel pendant les moments difficiles!

Je remercie tous mes amis du Centre de Recherche en Économie Agroalimentaire CREA

(actuellement Centre de Recherche de l‟Économie Agroalimentaire, des Transports et de l‟Énergie

(CREATE)) avec qui j‟ai développé une grande amitié. Des remerciements particuliers aux

Professeurs Abdesalem Abbassi et Lota D. Tamini. Vous avez toujours été à mon écoute pour

m‟encourager.

Je remercie ma fiancée Senandé Ramata-Laye Diane Savi pour l‟amour et le soutien qu‟elle

n‟a cessé de me porter, mon ami Jelili Adégboyéga Adébiyi pour son amitié et enfin Elizabeth Ford

pour son aide lors du formatage final du mémoire.

xi

List of Tables

Table 1: Tariffs solutions when country A is large and has a comparative advantage in the

production of good 1 ( 0.75 and 0.6 ) ...................................................... 32

Table 2: Payoffs for games where country A is large and has a comparative advantage in

the production of good 1 ( 0.75 and 0.6 .) ............................................... 32

Table 3: Export, import, world price, consumption in negotiation for 0.75 and 0.6 .

............................................................................................................................ 33

Table 4: Tariffs solutions when country A and country B are equal size and country A has a

comparative advantage in the production of good 1 ( 0.6 and 0.6 )

........................................................................................................ ……………33

Table 5: Payoffs for games where country A is large and has a comparative advantage in

the production of good 1 ( 0.6 and 0.6 ) ........ ………………………….34

Table 6: Export, import, world price, consumption in negotiation for 0.6 and 0.6

……………… .................................................................................................... 34

Table 7: Tariffs solutions when country A is strictly larger and has a comparative

advantage in the production of good 1 ( 0.75 and 0.4 ) .......................... 35

Table 8: Payoffs for games where country A is strictly larger and has a comparative

advantage in the production of good 1 ( 0.75 and 0.4 ) .......................... 35

Table 9: Export, import, world price, consumption in negotiation for 0.75 and 0.4

............................................................................................................................ 36

Table 10: Percentage share of ad valorem and non-ad valorem tariffs on agricultural

products in 2008, 2009 and 2010. ....................................................................... 42

xiii

List of Figures

Figure 1: Game tree for trade negotiation ....................................................................... 13

Figure 2: Reaction functions for ad valorem tariff for imports by country A and ad valorem

tariff for imports by country B with 0.75 and 0.6 ................................ 17

Figure 3: First order conditions for bargaining solutions for ad valorem tariff for imports by

country A and ad valorem tariff for imports by country B with 0.75 and

0.6 ................................................................................................................ 18

Figure 4: Reaction functions for specific tariff for imports by country A and specific tariff

for imports by country B with 0.75 and 0.6 ......................................... 21

Figure 5: First order conditions for bargaining solutions for specific tariff for imports by

country A and specific tariff for imports by country B with 0.75 and 0.6

............................................................................................................................ 22

Figure 6: Reaction functions for specific tariff for imports by country A and ad valorem

tariff for imports by country B with 0.75 and 0.6 ................................ 25

Figure 7: Bargaining solutions for specific tariff for imports by country A and ad valorem

tariff for imports by country B with 0.75 and 0.6 ................................ 26

Figure 8: Reaction functions for ad valorem tariff for imports by country A and specific

tariff for imports by country B with 0.75 and 0.6 ................................ 28

Figure 9: Bargaining solutions for ad valorem tariff for imports by country A and specific

tariff for imports by country B with 0.75 and 0.6 ................................ 29

Figure 10: Share (in %) of specific and mixed tariffs in the total line tariff schedule for

primary products ................................................................................................. 43

1

1. INTRODUCTION

Agriculture has been at the core of the negotiations during the Uruguay Round of the

General Agreement on Tariffs and Trade (GATT). A key development was the tariffication of non-

tariff barriers. Tariffication is the replacement of non-tariff trade barriers, such as quotas, by tariffs.

This was undertaken to make trade policy more efficient, simpler and more transparent.1 Yet tariffs

can be complex and not so transparent. This is why “tariff simplification” is among the 10 key

outstanding issues identified by the Chairperson of the negotiating group on Agriculture that must

be resolved if the on-going Doha Round is to be completed (WTO, 2012a).

An ad valorem tariff is a tax in percentage of the value of a shipment while a specific tariff

is a per unit tax (e.g. $/kg, etc). Ad valorem and specific tariffs can be used as alternative for one

another or in combination. The WTO defines a compound tariff as a combination of an “ad

valorem” duty and a “specific” duty, added together or one subtracted from the other. The term

composite tariff is sometime used to mean compound. A mixed tariff is expressed as a conditional

combination of an “ad valorem” duty and a “specific” duty, one applying below a limit, and the

other applying above it, WTO, 2012b). For instance, Canada‟s over-quota tariff on imports of

frozen chicken parts is the maximum of 249% and $3.78/kg. Thus, when the world price is above

(below) $1.52/kg, the ad valorem (specific tariff) applies. The revised modalities for agriculture call

for either the conversion of all specific tariffs into ad valorem equivalents or that “no less than 90

percent of bound tariffs on products in a developed country Member‟s Schedule be expressed as

simple ad valorem tariffs” (WTO, 2008c). The countries with the largest proportion of specific

tariffs in their tariff schedule are Russia and the United States, with respectively 12.6% and 8.2% of

their 2010 final bound tariffs (WTO, 2012c).

The protective margin provided by an ad valorem tariff is sensitive to prices and

exchange rates while a specific tariff is not. For instance, consider that one unit of a product

is worth $1,000 and that a country applies a $50 per unit tax. Equivalently, the country

could impose a 5% ad valorem tariff. If the price of the product drops to $500, the per unit

revenue from the specific tariff remains the same. However, for the ad valorem tariff, the

per unit revenue drops to $25. By the same token, the ad valorem equivalent of the $50/unit

tax increases from 5% to 10% when the world price falls from $1,000 to $500.

1 There is much evidence that tariffs dominate quotas in most situations. The classic reference on the subject

is Anderson (1988).

2

Chowdhury (2011) argues that specific tariffs used by rich countries discriminate

against low-income countries because these countries‟ export prices tend to be lower and

their export composition is heavily skewed toward agricultural products. Most countries

use ad valorem tariffs for most of their tariff lines, but specific tariffs are still used mainly

for agricultural products. Ad valorem tariffs are more transparent than their specific

counterparts and this is why the agriculture modalities are calling for the replacement of

many or all of the specific tariffs by ad valorem tariffs. This might have significant

implications for the trade in agricultural products.

When the tariffication of non-tariff barriers was first implemented, some WTO

members proposed prohibitive tariffs that would have curbed market access below

historical levels. Tangermann (1996) refers to the process that went on as “dirty

tariffication”. However, because the outcome of the Uruguay Round could not be trade

reductions, even for greater transparency, and because import quotas and variable levies

could no longer be used to preserve market access, tariff-rate quotas (TRQs) were created.

A TRQ consists of an in-quota tariff applied to a level of imports, the quota, and an over-

quota tariff applied on imports in excess of the quota. According to Gibson et al. (2001),

the average over-quota tariff was 128%, and for most countries, the average over-quota

tariff is several-fold the country‟s average agricultural tariff. Thus, the replacement of

import quotas and variable levies resulted in very high tariffs. Do we have the same

consequence for the replacement of specific tariffs by ad valorem tariffs? Could the

replacement of specific tariff by ad valorem tariffs cause a digression in trade

liberalization?

The objective of the thesis is to explore countries‟ preferences for ad valorem or

specific tariff in trade negotiations. Prior contributions show that a specific tariff is

equivalent to an ad valorem tariff under perfect competition, but non-equivalence is

possible under imperfect competition. The outcome of negotiation for countries of different

sizes is the focus of this study.

Our model features two countries with identical preferences and non-identical

production endowments. The model is a two-stage game in which countries choose the type

of tariff before the level or rate of their tariffs. The choice of tariff affects countries

bargaining position as it anchors their fall-back position if negotiations fail. Then in a

3

second stage, countries negotiate over the trade liberalization. We use the Nash bargaining

solution (Nash, 1950, 1953) to find the outcomes of trade negotiations between the

two countries.

Our specific objectives are:

1) To derive non-cooperative Nash equilibrium for ad valorem and specific tariffs and to

compare equilibrium quantities consumed and traded as well as world prices under the two

tariff regimes;

2) To derive cooperative Nash equilibrium tariffs given the fall-back positions from non-

cooperative Nash equilibrium tariffs;

3) To evaluate the importance of country size and consumer preferences on tariff equilibria;

4) To endogenize the selection of the type of tariff used by countries.

The next section reviews related literature. Much of the discussion revolves around

literature on the differences between specific and ad valorem tariffs and the choice of trade policy

instrument. We then present a detailed description of the theoretical model, the results, and one

example that supports our results.

5

2. LITERATURE REVIEW

We begin by reviewing the literature on the equivalence and non-equivalence of specific

and ad valorem tariffs. Afterward, we discuss trade policy when the objective of governments is to

maximize welfare. Because the main interest of this analysis is on the outcome of negotiations, we

analyze the incidence of replacing specific tariffs by ad valorem ones on the Nash bargaining

solution. Finally, we discuss another explanation for trade policy choice: the political-economy

criterion.

2.1. Previous studies on the equivalence between specific tariff and ad valorem tariff

Many papers have investigated differences between tariffs and quotas since the seminal paper

by Bhagwati (1971), but only a few have investigated the choice between specific and ad valorem

tariffs in the context of trade negotiations. Specific and ad valorem tariffs are equivalent under

perfect competition when countries do not cooperate (Suits and Musgrave, 1953). However, in a

model of two countries and two tradable goods, Lockwood and Wong (2000) show that in a tariff

war between two countries, a switch from specific tariffs to ad valorem tariffs makes at least one

country better off. The result hinges on the effect of the tariffs on the curvature of offer curves.

Conversely, some studies show that when the market structure changes, the equivalence of specific

and ad valorem tariffs does not hold. For Wicksell (1959), when a country‟s market structure is a

monopoly, the ad valorem tariff is superior to the specific tariff welfare-wise. Larue and Lapan

(2002) find that the optimal specific tariff dominates the optimal ad valorem tariff when domestic

production is monopolized because the residual demand is more elastic under the specific tariff.

This result holds as well when illegal trade occurs. Larue et al. (2006) show similar results. Both

Wicksell (1959) and Larue and Lapan (2002) consider a monopoly, but Larue and Lapan (2002)

show that the specific tariff is better than the ad valorem one with or without smuggling. Shea and

Shea (2006) find the same result in a quantity conjectural variation model.2 Similarly, Jorgensen

and Schroder (2005), using a monopolistic competition model, find that import reductions from a

specific tariff generate more utility for consumers in the domestic country than the ones resulting

from an ad valorem tariff.

Several studies show that the ranking of specific and ad valorem tariffs is sensitive to model

assumptions. Kowalczyk and Skeath (1994) compare the two types of tariffs when a utility-

maximizing country imports from a foreign monopolist. They conclude that there is no general

2 Cournot competition arises as a special case in this model (Shea and Shea, 2006).

6

ranking between the two types of tariff in this particular case because the outcome of the model

depends on the shape of the demand curve. Young and Anderson (1982) find non-equivalence

under risk between quota and tariff. This is due to the fact that the quota dominates only under

stringent conditions on risk aversion.

Overall, when there is market power in the domestic market, the residual demand is more

elastic under a specific tariff than under an ad valorem tariff. Many comparisons are anchored on

different variables (imports or domestic price, profits, etc) and this has an impact on the models

results.

2.2. Optimal tariff argument and terms of trade manipulations

Economists often compare policy instruments assuming that governments seek to

maximize welfare. Bagwell and Staiger (2002), in their book about the WTO, contend that

terms of trade manipulation to maximize welfare is the main driver for government

intervention in trade. Empirical evidence about welfare maximization and terms of trade

considerations can be found in Broda and al. (2008) where it is shown that tariff rates are

conditioned by foreign export supply elasticities. More recently, Bagwell and Staiger

(2011) have shown that the pattern of negotiated tariff cuts by new WTO members fit the

predictions of a “terms of trade” theoretical model.

Welfare maximization is not the only motivation for trade policy. In fact, the

"Protection-for-Sale" model of Grossman and Helpman (1994) has inspired many

contributions. In essence, it assumes that the government is motivated by social welfare as

well as by contributions from lobbies. Some studies introduce non-economic objectives and

determine which policy instrument achieves the highest level of welfare while meeting a

given non economic objective. As such, the exercise is one of constrained welfare-

maximization. In that contexts, domestic policy instruments are often more efficient than

trade policy instruments. This is the case, for example when employment is taken into

account or there is a production target. The next section dwells on literatures in which

government chooses trade policy in order to maximize welfare or revenue.

2.2.1. Welfare and revenue maximization without retaliation

Some authors refer to the non-cooperative tariff as the orthodox optimal tariff. This

terminology was first introduced by Bickerdike (1906). One result regarding non cooperative tariffs

is that a “large” country can increase its welfare by imposing a tariff that optimizes the trade-off

7

between terms of trade improvements and reductions in the volume of trade. This optimal tariff

assumes away possible retaliations on the part of the trade partners of the policy-active country.

Johnson (1953) shows that the tariff that maximizes government revenues under perfect competition

is at least as large as the one that maximizes welfare. Larue and Gervais (2002) compare the

orthodox optimal tariff and the one that maximizes revenue in the presence of few domestic firms

and three different hypotheses regarding the control of imports. They find that the welfare-

maximizing tariff can be lower or higher than the revenue-maximizing tariff and that the specific

tariff that maximizes welfare is never worse than its ad valorem counterpart.

Lin and Mai (1993) use a trade model between a country with a labor union and a capitalist

country without a labor union to study the short and long term optimal policies of each country

when firms are imperfectly competitive and constrained by organized labor. The authors argue that

the greater the expansion elasticity of labor demand with respect to output in the labor exporting

country, the greater the possibility of an optimal trade intervention in the capitalist importing

country. Hatta and Ogawa (2007) study optimal tariffs in the presence of a constraint on

government revenues and find that the optimal tariff is lower for imported goods that are close

substitutes to exported goods.

Larue, Gervais and Pouliot (2008) show that the ranking of specific and ad valorem tariffs

generating the same domestic prices when domestic production is monopolized is ambiguous, but

that the specific tariff is better when the variable anchoring the comparison is the volume of

imports.

Itagaki (1985) analyzes optimal tariff for small and large country under uncertain of terms

of trade. The result is that the optimal tariff for the small country remains zero when policy makers

take into account the change of producers/consumers behavior after observing market prices.

In summary, even if specific and ad valorem tariffs are equivalent in a competitive

environment, there is no general or unambiguous ranking between the two types of tariff when

markets are imperfectly competitive.

2.2.2. Welfare maximizing with retaliation (Tariff war)

Johnson (1953) showed that a country can improve its welfare by imposing a tariff even if

its trade partner retaliates, but he pointed out that tariff wars are more likely to make all countries

worse off. Tariff wars are usually analyzed using the concept of Nash equilibrium. This is the case

with the model developed by Kennan and Riezman (1988). The authors develop a model of two

countries with identical Cobb Douglas preferences. Countries have different endowments of

tradable goods. Kennan and Riezman (1988) find that large countries win tariff wars when the big

country has larger endowments of both goods or a lot more of one good and “enough” of the other

8

to be “big enough” to win a tariff war. Similarly, Syropoulos (2002), using the ratio of factor

endowments between countries for their relative size, finds with a more general model that a

country prefers a Nash non-cooperative equilibrium to free trade when it is relatively large.

Other studies have compared domestic and foreign trade policies. Tanaka (1992) concludes

that, with integrated markets3, a small specific (ad valorem) tariff in the domestic country has the

same effect as a small specific (ad valorem) tariff in the foreign country provided the original

equilibrium is free trade. Burbidge and Myers (2004) use a tariff war model to show that high

revenue collection and redistribution costs by governments might lead to low non-cooperative

tariffs. The authors also observe that there is a possibility for a government with low collection cost

to win a tariff war.

Opp (2010), using a 2-country Ricardian model with a continuum of goods, find that

countries tend to apply higher tariff rates when specialization gains from comparative advantage are

high and transportation cost is low. A sufficiently large economy prefers the Nash tariffs

equilibrium to free trade, but the required threshold size is increasing in comparative advantage.

Ogawa (2012) analyzes the properties of Nash equilibrium tariffs when two countries trade a large

number of goods. Uniform tariffs emerge when the elasticities with respect to the price of the

numeraire good are equal across all non-numeraire goods in both countries. It is also shown that if

the optimal intervention on a given good by the home country is an import subsidy, that of the

foreign country is an export tax and the home subsidy cannot be higher than the foreign tax.

Finally, another strand of the literature studies optimal tariffs under uncertainty. For

instance, Choi and Lapan (1991) study optimal trade policies for a developing country that relies on

trade policy revenues to finance the supply of a public good under international price uncertainty.

They find that the optimal specific tariff dominates the optimal quota when demands for private

goods are independent of the public good, but the ranking between the two instruments generally

depends on risk attitude and ordinal preferences.

2.3. Cooperative trade policy

The interest of this essay is in the outcomes of tariff negotiations, more specifically the

endogenous choice between specific and ad valorem tariffs and the implications of constraining the

choice. Nash (1950, 1953) formally explores the outcome of negotiation under what has become the

concept of Nash bargaining solution. The solution derives from a set of axioms that defines the

properties that the outcome of negotiations should have. It does not model the bargaining game, but

it is often used as an approximation to a formal bargaining model like the alternating offer in

3 Integrated markets are those in which prices are equal over the world because of arbitrage (Tanaka, 1992).

9

Rubinstein (1981) and Stahl (1972). The axioms are invariance to equivalent utility representations,

Pareto efficiency, symmetry and independence of irrelevant alternatives4. In our context, the Nash

bargaining solution solves:

1 2

2 2 1 1,

.A Ath N B Bth N

t tMax NP U t U t U t U t (1)

In this formula, in the context of trade, 2

AU t is the utility of consumers in country A written as a

function of country A‟s tariff on good 2 (imported from country B). 1

BU t is the utility of

consumers in country B which is a function of country B‟s tariff on good 1 (imported from Country

A). 2( )Ath NU t is country A‟s consumer threat point utility (th superscript for threat) which is

defined as a function of country A‟s non cooperative tariff, 2

Nt , and 1( )th N

BU t is country B‟s

consumer threat point utility that is expressed as a function of country B‟s non-cooperative tariff ,

1

Nt .

The intuition behind the Nash product is that the stakeholders must reach an agreement which

improves their welfare in comparison to their respective threat points. Moreover, each country

wants to be as far as possible to the threat point. Consequently, the solution of the negotiation game

comes from the maximization of the Nash product. For asymmetric games, a parameter representing

the bargaining power ( ) could be used as in Beghin (1996) and Binmore et al. (1986). The

formula becomes:

1 2

1

2 2 1 1,

.A Ath N B Bth N

t tMax NP U t U t U t U t

(2)

The country which has a higher negotiation power has the greatest value between 1 and

. Copeland et al. (1989) show that in a bargaining game, the player endowed with the

most bargaining power prefers a tariff to a quota regardless of the strategy of its trade

partner. Assumptions about the functional forms for the utility and production function

often affect the outcome of the Nash bargaining solution. Indeed, Butler (2004) finds that a

linear utility function is not a good choice to generate meaningful Nash bargaining solution.

The author notes that quadratic utility functions are more appropriate in the Nash

bargaining game because the quadratic form allows for more compromise. For the

production function, many functional forms perform well. A common simplification, like in

Kennan and Riezman (1988) and Epifani and Vitaloni (2003), is to replace the production

4 For an insightful discussion of the axioms and the interpretation of the Nash bargaining solution, see

Muthoo (1999).

10

function by endowments. This simplifies the model and makes it easier to find analytical

solutions. It is also consistent with supply being perfectly inelastic in the short run, which is

a common assumption for agricultural production.

Mayer (1981) develops a theoretical framework to analyze outcomes of tariffs

negotiations. The author compares tariff negotiation outcomes with Nash non-cooperative

outcomes or free trade. The comparison with the retaliation outcomes makes it possible to

ascertain the extent by which negotiations improve a country‟s welfare. The non-

cooperative solution is used as a fall-back position when negotiations fail. The comparison

with free trade provides an assessment of the distortions embodied in bilateral trade

agreements. The tariff resulting from a negotiation game can be negative. In fact, Mayer

(1981) shows that a small country has incentives to subsidize imports in a negotiated tariff

agreement. Syropoulos (1994) discusses a case involving a negative tariff. The intuition

behind the negative tariff is that it is a mean to make one‟s trade partner less aggressive in

the setting of its tariff. Copeland et al. (1989) consider the possibility of lump sum

transfers to enlarge the set of possible solutions to the implicit negotiation game. When one

of the tariffs is negative, the country subsidizing removes the option of retaliation by the

other country. In our case, we assume that all tariffs are weakly positive. We posit that

import subsidies would not be sustainable politically as it would prove difficult for a

government to deflect accusations of being manipulated by foreign interests to the

detriment of domestic producers.

2.4. Trade policy and non-economic determinants: a political-economy criterion

According to Baldwin (1989), two main approaches are used to incorporate political

influence in the determination of trade policy: one approach focuses on political agents‟ self-interest

while the other approach revolves around social concerns of voters and public officials. For the

same author, trade policy should include both self and social interests. As mentioned in a previous

paragraph, Grossman and Helpman (1994) posit that there are motives other than welfare

maximization to rationalize trade policies. For instance, powerful lobbies invest financial resources

to influence trade policy. Grossman and Helpman (1995) find that government action in the

international arena reflects domestic concerns. Traditionnally, studies on trade policy have

considered governments as social welfare maximizers. Since the 1990s, a growing number of trade

policy studies have allowed domestic and foreign lobbies to influence the policy process. Gawande

et al. (2005), McCalman (2004) and Dutt and Mitra, (2005) have estimated the weight of social

11

welfare in the objective function of governments as a way to provide empirical support for the

classic Grossman and Helpman (1994) model. In general, they find that relatively high weights are

on social welfare. Facchini et al. (2006) empirical analysis reveals that the government is the

stakeholder who captures most rent from trade policy through tariff revenue collection. The above

studies dwell into the possibility of non-exclusivity of economic determinants of trade policy. The

debate in this literature is on the empirical estimate of the weight on political contributions and

welfare in the governments‟ objective function. Maggi and Rodríguez-Clare (2007) also state that

apart from classical terms of trade, domestic lobbies influence trade agreements. They find that, in

the presence of strong domestic lobbies, trade liberalization is deeper when the capital is more

mobile across sectors.

Hillman and Ursprung (1988) use political support, proxied by producer support, as the main

element in the objective function to optimize. They find that tariffs divide stakeholders, but that

voluntary export restrictions conciliate the stakeholders‟ interests. Chang (2005) analyzes the

impact of politics on trade policy under monopolistic competition. He finds that the endogenous

optimal tariff is always a tariff and the welfare-maximizing import policy is a positive import tariff.

Finally, Mitra (2002) uses a bargaining model with endogenous protection and fixed costs for

political organization. He finds that low bargaining import competing lobby leads to free trade.

When the cost of organizing the lobby is high, the government prefers free trade.

13

3. THEORETICAL MODEL

We investigate the choice of policy instrument in trade negotiations using a trade model of

two countries and two goods. Country A and country B both produce goods 1 and 2. Consumers in

the two countries have the same Cobb Douglas utility functions and production of goods is modeled

using endowments as in Kennan and Riezman (1988). We assume that country A has a comparative

advantage in the production of good 1 and country B a comparative advantage in the production of

good 2. Countries impose tariff on their imports. Thus, country A imposes tariff on the imports of

good 2 and country B imposes a tariff on the imports of good 1. Endowments are different such that

trade is potentially welfare increasing for both countries. This simplification allows for more

manageable expressions.

To find the type of tariff that each country chooses in trade negotiations, we use a two-stage

approach. First, country A and country B simultaneously choose between specific and ad valorem

tariffs. Second, countries negotiate tariffs. Figure 1 shows the two stages of the game along with

each country‟s payoffs. The payoffs (a, b, c, d, e f, g, h) of the game in figure 1 are the consumer

indirect utility function obtained by replacing the tariffs by their Nash bargaining solution values.

Negotiation

Figure 1: Game tree for trade negotiation

We will solve the model by backward induction. First, we will calculate welfare for each

branch of the game in figure 1. That is, we will find values for a, b, c, d, e, f, g, h. Then, we will

find what type of tariff countries choose and find the outcome of negotiations.

A

Specific Ad valorem

B B

Specific Specific Ad valorem

Ad valorem

(e, f) (g, h) (c, d) (a, b)

14

3.1. Ad valorem tariff game

This section presents the solution for the case in which both countries use an ad valorem

tariff. That is, we seek final values for a and b in figure 7. Recall from expression (2) that the

outcome of negotiations depends on the threat point of each country. In our case, the threat points

are the welfare in each country in a tariff war. This would constitute the outcome if negotiations

were to fail. Thus, we first solve for solutions for the tariff war. Then we use those solutions to find

the negotiation solutions using the Nash bargaining solution.

Let us first consider the outcome of tariff war for country A. The Cobb Douglas utility

function of country A is: 1 2

A A AU D D , where

1

AD is country A‟s consumption of good 1 and

2

AD

is country A‟s consumption of good 2. The Lagrangian of the maximization of country A‟s utility

under its budget constraint is:

, 1 2 1 1 2 2 2 2 2 2 1 1 2 2 21 1 .A A A A A A

ad adL D D PX P X P M PD P D (3)

In this maximization problem, 1P and 2P are respectively the world prices for good 1 and 2, 1 and

2 are respectively country B‟s ad valorem tariff on good 1 and country A‟s ad valorem tariff on

good 2. 1

AX and 2

AX are respectively country A‟s production of good 1 and country A‟s

production of good 2. The budget constraint is the difference between the total revenue of country

A (given by the sum of the producers total revenue in good 1, the revenue from good 2 and the

government revenue (which is the tariff times the total revenue from the imports of good 2) and its

expenditures) and, the total expenditure (given by the sum of country A‟s expenditures on good 1

and the expenditures on good 2).

The ratio of the first order necessary conditions for utility maximization by country A for an

interior solution is:

2 1

1 2 2

.1

A

A

D P

D P

(4)

To express the ratio in (4) as a function of exports and imports, we write 1

AD and 2

AD as a

function of good 1‟s import and export. Country A‟s production of good 1 (

1

AX ) is replaced by its

endowment ( ) and country A‟s production of good 2 (2

AX ) is 1 . 1E is country A‟s exports

of good 1 and 2M , country A‟s imports in good 2. Hence, 1

AD and 2

AD are

1 1 1 1

A AD X E E and 2 2 2 2(1A AD X M M .

15

Expression (4) becomes:

2 1

1 2 2

1.

1

M P

E P

(5)

We can replace the ratio 1 2/P P using the budget constraint in (5) and substitute for the expressions

for 1

AD and 2

AD . Then normalizing the price of good 2 to one, the price ratio is:

21

1

.M

PE

(6)

Then using (6) in (5), letting2 1P , yields country A‟s implicit offer curve for good 1:

2

2

1 2

1 12 .

E M

(7)

For country B, we can derive an expression for the implicit offer curve using a similar

procedure. After a few calculations, we can obtain country B‟s implicit offer curve for good 2 as:

1

1

2 1

1 12 .

M E

(8)

As in Kennan and Riezman (1988), expressions (7) and (8) define a system of equations that

describes trade volumes as a function of ad valorem tariffs. Thus, solving (7) and (8) yields

solutions for 1E and 2M .

2 1 2

1

2 1 2

1 1 1 1;

2 1 1 2E

(9)

2 1 2

2

2 1 2

1 1 1 1.

1 2 1 2M

(10)

Using (9) and (10) in the first order necessary conditions for the utility maximization for the two

countries, we can solve for the quantities demanded by both countries:

2 1 2

1

2 1 2

1 1 1 1;

2 1 1 2

AD

(11)

2 1 2

2

2 1 2

1 1 1 11 ;

2 1 1 2

AD

(12)

16

2 1 2

1

2 1 2

1 1 1 11 ;

2 1 1 2

BD

(13)

2 1 2

2

2 1 2

1 1 1 1.

2 1 1 2

BD

(14)

Using these solutions in the utility functions of country A and country B yields indirect utility

functions defined in term of tariffs and endowments of goods:

2 1 2 2 1 2

2 1 2 2 1 2

1 1 1 1 1 1 1 11 ;

2 1 1 2 2 1 1 2

AT

(15)

2 1 2 2 1 2

2 1 2 2 1 2

1 1 1 1 1 1 1 11 .

2 1 1 2 2 1 1 2

BT

(16)

The solutions in (15) and (16) are the threat points that enter into the Nash product.

The next step is to find the reaction functions 2 1( ) for country A and 1 2( ) for country B.

The reaction function of a country is obtained by taking the first derivative of its utility with respect

to its imports‟ tariff and by solving for this tariff as a function of the foreign country‟s tariff. The

first order necessary conditions are: 2 1 0.A BT T

We will not write these expressions

as they are too cumbersome to be insightful.

The reactions functions cross multiple times and therefore there are several solutions for the

tariff war. However, we are interested in the nonnegative solutions which are:

0.5

1 1 / 1 / 1 1N

and 0.5

2 1 / 1 / 1 1N . The

model uses the same assumptions as in Kennan and Riezman (1988) and thus yields the same

solutions. Proposition 1 in Wong (2009) states that equilibrium uniqueness is assured if countries

have identical CES utility functions. Since the Cobb-Douglas utility function is a special case of the

CES utility function, equilibrium uniqueness follows.

Figure 2 shows an example of reaction functions for the ad valorem tariff game assuming

0.75 and 0.6 . The intersection of the reaction functions is the non cooperative

equilibrium described in the previous paragraph. In this example, the reaction functions are

downward sloping and convex. Tariffs are strategic substitutes as an increase in one tariff is

matched by a decrease in the other. One implication is that both countries would prefer to be first-

mover in a sequential game than playing simultaneously. Country A chooses a tariff rate of certain

percentage and country B opts for a tariff rate of another percentage. The difference is due to the

negotiation power of one country on the other and the fall-back position obtained with the threat

point.

17

Figure 2: Reaction functions for ad valorem tariff for imports by country A and ad valorem tariff

for imports by country B with 0.75 and 0.6

From expression (1), the Nash product for negotiation when both countries use ad valorem

tariffs is:

, .A AN B BN

ad ad ad ad ad adNP T T T T (17)

ad

ANT and ad

NBT

are respectively the indirect utility functions for country A and country B under ad

valorem tariff war obtained by substituting for 1

N and 2

N in (15) and (16).

2 1 2 2 1 2

2 1 2 2 1 2

1 1 1 1 1 1 1 11

2 1 1 2 2 1 1 2ad

N N N N NN

AN

N N N N N NT

(18)

2 1 2 2 1 2

2 1 2 2 1 2

1 1 1 1 1 1 1 11

2 1 1 2 2 1 1 2ad

N N N N NN

N

N N N N N N

BT

(19)

The Nash bargaining solutions are given by the first order necessary conditions for the

maximization of the Nash products:

, ,

1 2

0.ad ad ad adNP NP

(20)

Figure 3 shows a graph of the first order necessary conditions for the bargaining game in addition to

the reaction functions for the tariff war for 0.75 and 0.6 .

0

.0 0

.2 0

.4 0

.6 0

.8 1

.0 0

.0 0

.2 0

.4 0

.6 0

.8 1

.0

1N

2 1

1 2( )

2

2

N

1

18

Figure 3 illustrates two equilibria at the intersections of reaction functions: 1) an

unconstrained equilibrium featuring a negative tariff, and 2) a constrained equilibrium with non-

negative tariffs. The unconstrained equilibrium stems from the solution of the first order conditions.

This is Mayer‟s (1981) classic result that points out that a small country prefers to subsidize imports

rather than adopt a free trade policy when bargaining with a large country. We will limit our

analysis to non-negative tariffs as imports subsidies are seldom used except under unusual

circumstances like the 2008 food crisis (Throstle, 2008). This constrained solution will be dubbed

by our tariff war solution. It is a solution because the threat point bounds the Nash product, but, it is

not the bargaining solution that we seek as no country imposes its welfare at the bargaining

solution.

Figure 3: First order conditions for bargaining solutions for ad valorem tariff for imports by country

A and ad valorem tariff for imports by country B with 0.75 and 0.6

The solution for the bargaining game that we will use is given by the constraint on the non

negativity of tariffs. The curve for the first order conditions for the bargaining solutions both cross

the vertical axis in figure 3. In this case, a successful negotiation yields an equilibrium where 1 = 0

and 2 > 0. The first order conditions for 2 , holds with the equality, , 2 0.ad adNP We use the

second solution to complete the game tree in figure 1.

0.2 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.

6 0

1

2 1

1 2

*

2

1 2

2 1

*

19

3.2. Specific tariff game

This section considers that country A and country B use specific tariffs such that 0.75

and 0.6.

The method to find solutions is the same as in section 3.1. First, we can write the Lagrangian

for the welfare maximization in country A when countries do not collaborate:

, 1 2 1 2 2 2 2 1 1 2 2 2 21 .A A A A

sp spL D D P P t t M PD P t P D (21)

Maximizing (21) with respect to 1

AD and 2

AD , the ratio of the first order conditions for utility

maximization by country A for an interior solution is:

2 1

1 2 2

.A

A

D P

D P t

(22)

Expression (22) is different from (4) because country A is now using a specific tariff. We write 1

AD

and 2

AD as a function of good 2 imports (M2) and good 1 export (E1):

1 1

AD E and

2 21AD M . Expression (22) becomes:

2 1

1 2 2

1.

M P

E P t

(23)

We can replace the ratio 1 2/P P using the budget constraint in (23) and substitute for the expressions

for 1

AD and 2

AD . Then normalizing the price of good 2 to one, the price ratio is as follows:

21

1

.M

PE

(24)

Then using (23) in (24), normalizing2 1P , yields country A‟s implicit offer curve for good 1.

2

2

1 2

1 12 .

tt

E M

(25)

For country B, we can derive an expression for the implicit offer curve using a similar procedure.

After a few calculations, we find that country B‟s implicit offer curve for good 2 is:

1 1

2 1 2

112 .

t E

M E M

(26)

We can find the solutions for 1E and 2M using the offer curves in (25) and (26). The solutions are:

20

2 2 2 1 2 2 1 2 2 21

1

21

2 2 222 2 ( 1) 3 2 1 2 2 2 2 1 2 2

;2 2

t t t t t t t t t t t

Et t

1 1 2 2 1 1 1 2 2 1 2 2 2

2

2 2

2 2 22 2 2 24 2 2 2 1 1 4 6 6 3 4 1 2 2 2 2 1 2 2

.2 2 1 2

t t t t t t t t t t t t t

Mt t

Using these expressions for 1E and 2M in the first order conditions for the utility maximization for

the two countries, we can solve for the quantities demanded by both countries:

2 2 222 1 2 2 1 2 2 1 2 2 2

1

21

2 2 1 3 2 1 2 2 2 2 1 2 2

,2 2

A

t t t t t t t t t t t

Dt t

2 2 22 2 2 21 2 2 1 1 1 1 2 2 21 2 2

2

22

4 2 2 2 1 1 4 6 6 3 4 1 2 2 2 2 1 2 2

1 ,2 2 1 2

A

t t t t t t t t t t t t t

Dtt

2 2 222 1 2 2 1 2 2 1 2 2 2

1

1 2

2 2 1 3 2 1 2 2 2 2 1 2 2

1 ,2 2

B

t t t t t t t t t t t

Dt t

2 2 22 2 2 21 1 2 2 1 1 1 2 2 1 2 2 2

2

2 2

4 2 2 2 1 1 4 6 6 3 4 1 2 2 2 2 1 2 2

.2 2 1 2

B

t t t t t t t t t t t t t

Dt t

Using these solutions in the utility functions of country A and country B yields indirect utility

functions. As the expressions are too cumbersome, we will not write them.

The next step is to find the reaction functions 2 1( )t t for country A and 1 2( )t t for country B.

We proceed exactly as in section 3.1. That is, the reaction function of a country is obtained by

taking the first derivative of its utility with respect to its imports‟ tariff and by solving for this

tariff as a function of the foreign country‟s tariff. The first order necessary conditions are:

2 1 0.A BT t T t As the expressions are difficult to interpret, we will not write them.

Conversely to the case of ad valorem tariff game where we were able to find analytical expressions

for the non cooperative ad valorem tariffs, it is difficult to find such expressions for the non

cooperative specific tariff game. The derivation of the ad valorem tariffs in Kennan and Riezman‟s

working paper is highly complex, even though it rests on several simplifying assumptions.

We instead rely on numerical examples. Let us show graphically the solutions for the

specific tariffs. Figure 4 shows reaction functions for specific tariff war assuming 0.75 and

0.6 . The reaction functions are downward-sloping and concave. As such, their curvature

differs from the one associated with ad valorem tariffs. The intersection of the reaction functions is

the non-cooperative equilibrium.

21

2t

Figure 4: Reaction functions for specific tariff for imports by country A and specific tariff for

imports by country B with 0.75 and 0.6

We can investigate the cooperative equilibrium. From expression (1), the Nash product for

negotiation when both countries use specific tariffs is:

, .sp

A AN B BN

sp sp sp sp spNP T T T T

sp

ANT and BN

spT are respectively the indirect utility functions for country A and country B under

specific tariff war, obtained by substituting for t1N

and t2N in T

AN and T

BN.

Nash bargaining solutions are given by the first order necessary conditions for the

maximization of the Nash products:

, ,

1 2

0.sp sp sp spNP N

t t

P

Figure 5 shows a graph of the first order necessary conditions for 0.75 and 0.6 .

Note first that there is an equilibrium with negative tariffs, but again, we will limit ourselves to

nonnegative tariffs. As in figure 2, there are two equilibria to the negotiations. The first is at the

intersection of the tariff war solution and is therefore not the outcome of the negotiation that we are

looking for.

t1 (t2)

t2 (t1)

1t 1

Nt

2

Nt

22

Figure 5: First order conditions for bargaining solutions for specific tariff for imports by country A

and specific tariff for imports by country B with 0.75 and 0.6

The second solution is given by the constraint on the non negativity of tariffs. The

curve for the first order conditions for the bargaining solutions both cross the vertical axis

in figure 5. In this case, it means that the second equilibrium is at t1 = 0 and t2 > 0. Thus, a

successful negotiation yields an equilibrium where t1 = 0 and t2 > 0.We use these solution as

the outcome of the negotiation if both countries use specific tariff as in the game tree in

figure 1.

3.3. Specific tariff vs. ad valorem tariff game

This section considers that country A uses a specific tariff and country B uses an ad valorem

tariff. This will give us the solutions for e and f in figure 1. We use the same procedure as in the

previous sections to find the trade negotiation outcome.

The Lagrangian for the maximization of the utility function of country A subject to its budget

constraint is:

, 1 2 1 1 2 2 2 2 2 1 1 2 2 2 2 .A A A A A A

sp adL D D PX P t X t M PD P t P D (27)

This maximization problem is essentially the same as country A imposes a specific tariff on

imports of good 2 from country B.

0.

2 0.

0 0.

2 0.

4 0.

6 0.

8 1.

0 0.

0 0.

2 0.

4 0.

6 0.

8 1.

0

1t

2t

*

1 2t t

t 2( t1)

t 1( t2)

*

2 1t t

23

The ratio of the first order necessary conditions for utility maximization by country A for an

interior solution is:

2 1

1 2 2

.A

A

D P

D P t

(28)

We want to find expression for the implicit offer curves for country A and country B. Hence,

we express (28) such that it contains E1 and M2. Using the market clearing conditions for country A,

expression (28) becomes:

2 1

1 2 2

1.

M P

E P t

(29)

Replacing the ratio 1 2/P P using the budget constraint in (29) and normalizing 2P to one yields,

after few manipulations, the following price ratio:

2

1

1

.M

PE

(30)

The expression in (30) is the same as in section 3.1 and 3.2 because of the normalization of the

price of good 2 to one.

Using (30) in (29), letting2 1P , yields good 1‟s implicit offer curve for country A.

2

2

1 2

1 12 .

tt

E M

(31)

After solving the analogous problem for country B, good‟s 2 implicit offer curve is given by:

1

1

2 1

1 12 .

M E

(32)

We can solve for E1 and M2 using expressions (31) and (32) as a system of equations. The solutions

are as:

2 1 2

1

2 1 2

1 1 1 1;

2 1 1 2

t tE

t t

(33)

2 1 2

2

2 1 2

1 1 1 1.

1 2 1 2M

t t

t t

(34)

To find the consumptions for good 1 and 2 for both countries, we replace expression (33)

and (34) in the first order necessary conditions for the utility maximization for the two countries.

The solutions are:

24

2 1 2

1

2 1 2

1 1 1 1;

2 1 1 2

At t

Dt t

(35)

2 1 2

2

2 1 2

1 1 1 11 ;

2 1 1 2

At t

Dt t

(36)

2 1 2

1

2 1 2

1 1 1 11 ;

2 1 1 2

Bt t

Dt t

(37)

2 1 2

2

2 1 2

1 1 1 1.

2 1 1 2

Bt t

Dt t

(38)

Replacing (35), (36), (37) and (38) in the utility function yields the indirect utility functions. We

will not write these expressions because they are cumbersome to interpret.

In the tariff war, countries maximize their indirect utility function such that

2 1 0.A BT t T

We will not write these expressions as they are cumbersome to be

insightful. The first order conditions give the reaction functions. The functions cross at multiple

points but the only plausible solutions for the tariff are: 0.5

1 1 / 1 / 1 1N

and 0.5

2 1 / 1 / 1 1.Nt These solutions are the same as in

Kennan and Riezman (1988), replacing 2N with 2 .Nt

Figure 6 shows an example of reaction functions assuming 0.75 and 0.6 . The non

cooperative equilibrium, as described in previous paragraphs, is the intersection of the reaction

functions.

25

Figure 6: Reaction functions for specific tariff for imports by country A and ad valorem tariff for

imports by country B with 0.75 and 0.6

When country A uses a specific tariff and country B an ad valorem tariff, the Nash product

to find the bargaining solution is:

, .A AN B BN

sp ad sp sp ad adNP T T T T

In this expression, AN

spT and BN

adT are respectively indirect utility functions

when

country A uses a specific tariff and country B an ad valorem tariff.

We obtain the bargaining solutions by taking the first order necessary conditions of the Nash

product:

, ,

1 2

0.sp ad sp adNP N

t

P

Figure 7 shows a graph of the first order necessary conditions in addition to the reaction functions

for the tariff war for 0.75 and 0.6 .

We have two equilibria in figure 7, but, as before, we will limit ourselves to nonnegative

tariffs because of reasons stated in section 3.1.

0

.0 0

.2 0

.4 0

.6 0

.8 1

.0 0

.0 0

.2 0

.4 0

.6 0

.8 1

.0

1N 1

2 1t

1 2t

2t

2Nt

26

Figure 7: Bargaining solutions for specific tariff for imports by country A and ad valorem tariff for

imports by country B with 0.75 and 0.6

As we limit ourselves to nonnegative tariffs, the outcome of the negotiations is such that

1 = 0 and 2t > 0.

3.4. Ad valorem tariff vs. specific tariff game

In this section, country A uses an ad valorem tariff and country B a specific tariff. This will

give us solutions for c and d in figure 1. The derivations are very similar to those in the previous

sections. However, we provide details of the procedure to find the solutions.

The Lagrangian for the welfare maximization in country A when countries do not collaborate

is:

, 1 2 1 1 2 2 2 2 2 2 1 1 2 2 21 1 .A A A A A A

ad spL D D PX P X P M PD P D (39)

To obtain the consumptions for country A and country B for both goods, we maximize the

Lagrangian in (39) with respect to 1

AD et 2

AD . The ratio of the first order necessary conditions for

an interior solution is:

2 1

1 2 2

.1

A

A

D P

D P

(40)

0.2 0.0 0.2 0.4 0.6 0.8 1.0 0.0 0.2 0.4 0.6 0.8 1.0

2t

2 1t

*

1 2( )t

RBGB

1

1 2t

*

2 1( )t

27

Expression (40) is different from (22) because country A is now using specific tariff. Using

the market clearing condition, expression (40) becomes:

2 1

1 2 2

1.

1

M P

E P

(41)

We replace the ratio1 2/P P

in (41) using the budget constraint in (41) and substituting for

1

AD (by

(35)) and2

AD (by (36)). Then normalizing the price of good 2 to one, the analytical expression of

the price ratio is:

2

1

1

.M

PE

(42)

We obtain country A‟s implicit offer curve for good 1 by replacing expression (42) in (41).

The expression of country A‟s implicit offer is as follows:

2

2

1 2

1 12 .

E M

(43)

For country B, we can derive an expression for the implicit offer curve using a similar procedure.

After a few manipulations, we find country B‟s implicit offer curve for good 2 as:

1 1

2 1 2

112 .

t E

M E M

(44)

Expressions (43) and (44) form a system of equations with unknowns E1 and M2. Solving this

system for E1 and M2 yields:

1 1 12 2 2 2 2 2 2 2

1 2

2 2 222 2 ( 1) 3 2 1 2 2 2 2 1 2 2

;12 2

t t t

Et

1 1 1 1 1 12 2 2 2 2 2 2

2 2

2 2 22 2 2 24 2 2 2 1 1 4 6 6 3 4 1 2 2 2 2 1 2 2

.22 2 1 2

t t t t t t

M

Using these expressions in the first order conditions for the utility maximization for the two

countries, we solve for the quantities demanded by both countries:

1 1 12 2 2 2 2 2 2 2

1 2

1

2 2 222 2 1 3 2 1 2 2 2 2 1 2 2

,2 2

A

t t t

Dt

1 2 2 1 1 1 11 2 2 2 2 2

2

22

2 2 22 2 2 24 2 2 2 1 1 4 6 6 3 4 1 2 2 2 2 1 2 2

1 ,

2 2 1 2

A

t t t t t t

D

1 1 12 2 2 2 2 2 2 2

1 2

1

2 2 222 2 1 3 2 1 2 2 2 2 1 2 2

1 ,2 2

B

t t t

Dt

,

28

1 1 1 1 1 12 2 2 2 2 2 2

22 2

2 2 22 2 2 24 2 2 2 1 1 4 6 6 3 4 1 2 2 2 2 1 2 2

.2 2 1 2

t t t t t t

D B

We find the indirect utility functions, for both countries by replacing D1A, D2

A, D1

B and D2

B in the

utility functions. We choose not to write these expressions because they are too cumbersome.

The next step is to find the reaction functions 2 1( )t for country A and 1 2( )t for country B.

We proceed analogously as is previous sections. That is, we solve the first order necessary

conditions of the Nash product,2 1 0,A BT T t for 2 and 1t . As the expressions are

cumbersome, we will not write them. Conversely to the case of specific-ad valorem tariff game

where we were able to find non cooperative ad valorem tariffs analytical expressions, it is difficult

to find such expressions for the non cooperative specific tariff game in this case.

Figure 8 shows reaction function for tariff war assuming 0.75 and 0.6 . The equilibrium of

the non cooperative game is at the intersection of the reaction functions.

Figure 8: Reaction functions for ad valorem tariff for imports by country A and specific tariff for

imports by country B with 0.75 and 0.6

The next step is to find negotiation solutions using the Nash product below:

, .A AN B BN

ad sp ad ad sp spNP T T T T

AN

adT and BN

spT are respectively the indirect utility functions when country A uses an ad

valorem tariff and country B uses a specific tariff. We obtain the Nash bargaining solutions

with the first order necessary conditions of the Nash product:

2

21( )t

1

Nt

2

N

1t

12

t

29

2 1

, ,0.

ad sp ad sp

t

NP NP

For 0.75 and 0.6 , we show in figure 9 the first order necessary conditions for the Nash

product. We have two equilibria in this figure, but as before we focus on nonnegative tariffs. The

bargaining equilibrium is the one where t1 = 0 and 2 0 .

Figure 9: Bargaining solutions for ad valorem tariff for imports by country A and specific tariff for

imports by country B with 0.75 and 0.6

0.2

0.0

0.2

0.4

0.6

0.8

1.0

0.0

0.2

0.4

0.6

0.8

1.0

21t

1 2t

2

*

2 1( )t

RBGB

1t

1

*

2 t

31

4. GOVERNMENT CHOICE OF POLICY INSTRUMENT

The previous section describes the method to obtain solutions for bargaining between two

countries. In this section, we look at the outcome of each bargaining solution under different

assumptions for the endowments by country A and country B. In all scenarios, we will find the

solution in the figure 1, thus establishing each country preference for trade instrument.

Previous literature shows that country size matters when it comes to setting tariff (e.g.

Kennan and Riezman, 1988). Accordingly, we will explore the effect of country size on the game in

figure 1. We will consider the four following scenarios:

(1) country A is large and has a comparative advantage in the production of good 1;

(2) country A and country B are equal size but country A has a comparative advantage in the

production of good 1;

(3) country A is strictly larger and has a comparative advantage in the production of good 1;

(4) country A is strictly larger but does not have a comparative advantage in the production of

good 1.

We define a country as large if the sum of its endowments in good 1 and 2 is larger than the

sum of the endowments of another country. Similarly, we define a country as strictly larger if its

endowments for both goods strictly dominate the size of the endowments of the other country.

Typical of the trade literature, a country has a comparative advantage in good 1 if the ratio of the

endowment in good 1 and good 2 is higher than the same ratio for the other country.

4.1. Country A is large and has a comparative advantage in the production of good 1

The first case we examine is when country A is large and has a comparative advantage in the

production of good 1. This is the same as in the presentation of the model in the previous sections

with parameters 0.75 and 0.6 . Table 1 shows the solutions for the outcome of the

negotiation between country A and B under the four combinations of ad valorem and specific tariff.

These solutions follow from the solutions as described in figures 3, 5, 7 and 9. Note that because we

normalize the price of good 2 to one and that country A imports good 2, then solutions for tariffs by

country A are all in the same units.

Note in table 1 that the outcomes of the negotiation are such that the small country always set

a tariff equal to zero. For the large country, the tariff is always positive as it still wishes to exploit

terms of trade when negotiating. The threat points from the tariff war allow the large country to

obtain this concession from the small country. Observe that the large country (A) imposes a larger

32

tariff if country B chooses specific tariff over an ad valorem tariff. This is because when country B

chooses a specific tariff, it gives a more favorable fall-back position to country A.

Table 1: Tariffs solutions when country A is large and has a comparative advantage in the

production of good 1 ( 0.75 and 0.6 )

Country B

Ad valorem Specific

Country A Ad valorem (0.18, 0) (0.19, 0)

Specific (0.18, 0) (0.19, 0)

Table 2 shows the payoffs of country A and country B from the negotiation. Table 2 is the

normal form of game in figure 1. For country B, ad valorem tariff is a dominant strategy, so that

country B will always use an ad valorem tariff. For country A, there is no dominant strategy

because its payoff stays the same whether it uses a specific or an ad valorem tariff. That is, the

larger country, which has the comparative advantage in the production of good 1, is indifferent

between using a specific or an ad valorem tariff whereas the small country will always choose an ad

valorem tariff. The trade negotiation equilibria are reached when country B uses an ad valorem

tariff.

Table 2: Payoffs for games where country A is large and has a comparative advantage in the

production of good 1 ( 0.75 and 0.6 .)

Country B

Ad valorem Specific

Country A Ad valorem (0.337, 0.176) (0.340, 0.174)

Specific (0.337, 0.176) (0.340, 0.174)

From Lockwood and Wong (2000), we know that when two countries switch from ad

valorem tariff to specific tariff, at least one of the countries is better off. That is the case here

because country A improves its situation when using an ad valorem tariff instead of the specific

one.

We then describe solutions for single variables (imports and exports values, the world price,

consumptions for good 1 and good 2 for country A and country B for the negotiation game. Table 3

summarizes the values for these variables for 0.75 and 0.6 .

33

Table 3: Export, import, world price, consumption in negotiation for 0.75 and 0.6

M2 E1 P D1A D2A D1B D2B

Ad-Ad 0.162 0.1470 1.101 0.6023 0.562 0.398 0.438

Sp-Sp 0.162 0.1461 1.107 0.6040 0.562 0.396 0.438

Sp-Ad 0.162 0.1470 1.101 0.6030 0.562 0.397 0.438

Ad-Sp 0.162 0.1460 1.107 0.6040 0.562 0.396 0.438

Exports of good 1 and imports of good 2 by country A in the ad valorem tariff negotiation

are respectively higher than exports and imports of country A in a specific tariff negotiation.

Conversely, the world price in an ad valorem tariff negotiation is lower than that of specific tariff

negotiation. Consumptions of good 1 by country A in an ad valorem tariff negotiation is less than

that of specific tariff negotiation. Consumption of good 2 in country A is higher in an ad valorem

tariff negotiation. We have the converse situation for the consumptions of good 1 and good 2 in

country B. Overall; a trade negotiation under ad valorem tariff seems to improve traded volumes

and terms of trade.

4.2. Country A and country B are equal size and country A has a comparative advantage in

the production of good 1

The second case we examine is when country A and country B are equal size and country A

has a comparative advantage in the production of good 1. This is the case considered where

0.6 and 0.6 . This scenario allows us to isolate the effect of the comparative advantage on

the outcome of the negotiation.

Table 4 shows the tariffs of the negotiation. The two countries set tariffs equal to zero

because no country is larger, no country can exploit terms of trade and no country „‟wins‟‟ a tariff

war. Also, when countries are equal size, specific and ad valorem tariff are equivalent in a tariff

war. Thus, the outcome of the negotiation is free trade.

Table 4: Tariffs solutions when country A and country B are equal size and country A has a

comparative advantage in the production of good 1 ( 0.6 and 0.6 )

Country B

Ad valorem Specific

Country A Ad valorem (0, 0) (0, 0)

Specific (0, 0) (0, 0)

34

Unlike the results in table 2, all the outcomes of the present scenario are zero. Table 5

presents the payoffs of the negotiation of the game in figure 1.

Table 5: Payoffs for games where country A is large and has a comparative advantage in the

production of good 1 ( 0.6 and 0.6 )

Country B

Ad valorem Specific

Country A Ad valorem (0.25, 0.25) (0.25, 0.25)

Specific (0.25, 0.25) (0.25, 0.25)

All the payoffs are 0.25 in table 5. Consequently the type of tariff does not matter for each

country and there is no dominant strategy, and countries are indifferent between ad valorem and

specific tariffs.

Table 6 shows the values for the variables described in table 3 but 0.6 and 0.6 .

When the two countries are the same, the world price is equal to one. The trade volumes are all

equal to 0.1 and the consumptions of good 1 and good 2 for both countries are equal to 0.5.

Table 6: Export, import, world price, consumption in negotiation for 0.6 and 0.6

M2 E1 P D1A D2A D1B D2B

Ad-Ad 0.1 0.1 1 0.5 0.5 0.5 0.5

Sp-Sp 0.1 0.1 1 0.5 0.5 0.5 0.5

Sp-Ad 0.1 0.1 1 0.5 0.5 0.5 0.5

Ad-Sp 0.1 0.1 1 0.5 0.5 0.5 0.5

4.3. Country A is strictly larger and has a comparative advantage in the production of good 1

In the third case, we examine is when a country A is strictly larger and has a comparative

advantage in the production of good 1. We assume in this case endowment values of 0.75 and

0.4 . We examine this case to determine whether the negotiation is different if a country is

strictly larger.

As in the previous scenarios, table 7 shows that the outcomes of the negotiation are such that

the small country always set a tariff equal to zero. For the large country, the tariff is always positive

as it exploits terms of trade in the negotiation. Again, it is the threat point from the tariff war that

allows the large country to obtain these concessions from the small country. The small country

35

always set a tariff equal to zero. Country A imposes a larger tariff if country B chooses specific

tariff over an ad valorem tariff. When country B chooses a specific tariff, it gives a more favorable

fall-back position to country A.

Table 7: Tariffs solutions when country A is strictly larger and has a comparative advantage in the

production of good 1 ( 0.75 and 0.4 )

Country B

Ad valorem Specific

Country A Ad valorem (0.13, 0) (0.14, 0)

Specific (0.13, 0) (0.14, 0)

Table 8 presents the payoffs of the negotiation as described in figure 1 (game tree). As in

section 4.1, ad valorem tariff is a dominant strategy for country B. Consequently, country B uses an

ad valorem tariff. For country A, there is no dominant strategy because its payoff stays the same

whether it uses specific or ad valorem tariff. That is, the large country, which has the comparative

advantage in the production of good 1, is indifferent between using specific or ad valorem tariff

whereas the small country will always choose an ad valorem tariff. The trade negotiation

equilibrium is when country B uses an ad valorem tariff and country A uses either an ad valorem or

specific tariff (in bold in table 9). This result is consistent with Lockwood and Wong (2000) as table

9 shows that when the two countries switch from specific tariff to ad valorem tariff, at least one of

the countries is better off. In fact, country B improves its situation when it switches from specific to

ad valorem tariff.

Table 8: Payoffs for games where country A is strictly larger and has a comparative advantage in

the production of good 1 ( 0.75 and 0.4 )

Country B

Ad valorem Specific

Country A Ad valorem (0.459, 0.1038) (0.459, 0.1037)

Specific (0. 459, 0.1038) (0.459, 0.1037)

Table 9 shows the values for trade volumes, world price and consumptions for both good in

both countries. The pattern is the same as in section 4.1. In fact, country A displays higher trade

volumes under ad valorem trade negotiation whereas the consumptions of good 1 and good 2 are

36

respectively lower and higher. The world price is higher under an ad valorem tariff trade

negotiation.

Table 9: Export, import, world price, consumption in negotiation for 0.75 and 0.4

M2 E1 P D1A D2A D1B D2B

Ad-Ad 0.0642 0.0590 1.083 0.691 0.664 0.391 0.336

Sp-Sp 0.0630 0.0580 1.093 0.692 0.663 0.308 0.337

Sp-Ad 0.0642 0.0590 1.083 0.691 0.664 0.391 0.336

Ad-Sp 0.0630 0.0580 1.093 0.692 0.663 0.308 0.337

4.4. Country A is strictly larger but does not have a comparative advantage in the production

of good 1

We assume in this section that country A is strictly larger but does not have a comparative

advantage in the production of good 1. Consistently, we assume that 0.6 and 0.4 . As the

two countries have the same ratio of dotations, let us check whether there is trade or not. To do this,

we compare the ratio of price in autarky in country A and country B. If the ratio is different from

one country to the other, then there is trade. Otherwise, there is no trade and trade negotiation is

irrelevant. The Lagrangian for utility maximization in autarky is:

1 2 1 1 2 2 1 1 2 2 .A A A A A A AL D D PX P X PD P D (45)

1P and 2P are respectively autarky prices for good 1 and good 2 in country A. The budget

constraint is the difference between the total revenue of the country and the total

expenditure. The ratio of the first order necessary conditions for utility maximization in

country A for an interior solution is:

2 1

1 2

.A

A

D P

D P (46)

For country B, the Lagrangian for utility maximization in autarky is:

* * * *

1 2 1 1 2 2 1 1 2 2 .B B B B B B BL D D P X P X P D P D (47)

*

1P and *

2P are respectively prices in autarky for good 1 and good 2 in country B. The ratio of the

first order conditions for utility maximization in country B for an interior solution is:

*

2 1

*

1 2

.B

B

D P

D P (48)

Substituting the values for the dotations in (46) and (48) respectively yields:

37

*

2 1 1

*

1 2 2

1 0.61,

0.6

A A

A A

P

P

D X

D X

and

*

2 1 1

*

1 2 2

0.41.

1 0.4

B B

B B

P

P

D X

D X

Thus, as prices are equal, there is no trade. Consequently, there is no need for one country to buy

one product from the other one.

39

5. DISCUSSION

Our results deserve further discussion. First, we show that in two-country trade negotiations,

the small country strictly prefers an ad valorem tariff. Second, when the two countries are equal

size, the outcome of the negotiation is free trade regardless of the choice of trade instrument.

This essay suggests that in practice, small countries push for the use of ad valorem tariffs

rather than specific tariffs. The reason is that a small country has a better fall-back position if

negotiations break down when it uses an ad valorem tariff.

The model also shows that free-trade as the outcome in negotiation with countries of equal

size is robust to choice of trade instrument. The result contrasts with previous literature. Unlike

Lockwood and Wong (2002), we show that converting specific tariff into its ad valorem equivalent

does not always increase the welfare of at least one of the countries. In our model, countries may be

indifferent between the types of tariff as free trade is always the outcome of negotiation between

countries of same size regardless the type of tariff. This result shows that countries of equal size

negotiating a trade agreement will agree on trade liberalization regardless of the basis on which

negotiations take place.

The comparison between trade volume for negotiations with ad valorem tariff vs specific

tariff negotiation shows that ad valorem tariff negotiation allows for more commerce and lower

world price. Country A‟s consumptions in good 1 and good 2 in an ad valorem tariff negotiation are

respectively higher and lower than that of a specific tariff negotiation. The converse situation is

observed for country B.

41

6. CASE STUDY AND EVIDENCE: URUGUAY ROUND AND NORTH

AMERICAN FREE TRADE AGREEMENT (NAFTA)

We discuss in this section examples of the use of ad valorem and specific tariffs by large

and small countries. We provide examples from the NAFTA.

According to OECD (1999), after the Uruguay Round, most of Canada‟s in-quota tariffs are

ad valorem while most of its over-quota tariffs are specific or of mixed forms. For Mexico, all the

in-quota tariffs are ad valorem while 22% of the over-quota tariffs are specific. In contrast, for the

United States, OECD (1999) reports that the in-quota tariff is about evenly split between ad

valorem or specific forms. Thus, Canada and Mexico, which are small countries in comparison to

the United States, tend to use ad valorem tariff for most of their in-quota tariffs. This is conform to

our results that the large country is indifferent between specific and ad valorem tariff when

negotiating with small countries.

The United States, Canada and Mexico signed NAFTA on January 1, 1994. This agreement is

one the most important trade multilateral in terms of volume of trade, (Public Citizen, nd). NAFTA

allows free trade between the United States, Canada and Mexico except for the following

agricultural products considered sensitive (usually protected by specific tariffs):

- United States: dairy products, eggs, peanuts, peanut butter, sugar, sugar containing products

and cotton;

- Canada: dairy products, eggs, poultry and margarine;

- Mexico: dairy products, poultry, eggs and sugar.

Table 10 summarizes the share of ad valorem and non-ad valorem (specific and mixed) tariffs

in the total tariff line on agricultural products in 2008, 2009 and 2010.

42

Table 10: Share of ad valorem and non-ad valorem tariffs on agricultural products in 2008, 2009

and 2010.

Country Year

Non-ad valorem duty Ad valorem duty > 15%

Bound MFN Bound MFN

Mexico

2008

2009

2010

6.9

7.0

6.9

4.7

4.9

5.1

95.0

95.0

95.0

43.3

45.8

43.8

Canada

2008

2009

2010

17.7

17.8

19.2

13.8

20.3

12.3

6.2

6.1

9.7

10.2

6.1

5.8

United States

2008

2009

2010

39.4

39.5

40.0

41.1

50.8

40.6

5.0

4.6

5.8

6.3

6.0

5.4

Note: Adapted from WTO (2008b), WTO (2009) and WTO (2010).

In table 10, “Bound” is the share of agricultural products containing at least one bound tariff

line, and “MFN” stands for Most Favored Nation. Non-ad valorem (bound) share for agricultural

products is 6.93% for Mexico, 18.23% for Canada and 39.63 % for the United States. The

frequency of non- ad valorem tariff on agricultural products seems to be increasing with country

size. Ad valorem tariffs in excess of 15% (bounded) made up 95% of all agricultural tariffs in

Mexico, 7.33% in Canada and 5.13% in the United States between 2008 and 2010. The frequency

of high ad valorem tariffs on agricultural products is higher for a smaller economy like Mexico.

Other data would be required to test whether small countries tend to use more intensively ad

valorem tariffs than non-ad valorem tariffs. The data for Canada and the United States suggests that

large countries rely relatively more on non ad valorem tariffs.

Another database from the World Bank allows us to observe the choice of policy

instruments in taxing imports, (The World Bank, 2012). Figure 10 shows the share in percentage for

specific/mixed tariffs for primary products.5

5Primary products are commodities classified in the Standard International Trade Classification (SITC) in

categories 0 to 4, which include food and live animals, beverage and tobacco, crude materials, inedible,

except fuels, mineral fuels, lubricants and related materiel, animal and vegetable oils, fats and waxes. Primary

commodities also include category 68 which are nonferrous metals. See UNCTAD STAT (2011) for more

information.

43

Note: Adapted from The World Bank (2012).

Figure 10: Share (in %) of specific and mixed tariffs in the total line tariff schedule for primary

products

The gaps in the graphs correspond to years for which no information was available.

Overall, Mexico‟s share of specific/mixed tariffs on primary products is less than that of

Canada and the United States, except for 1999 and 2000. It also appears that Canada uses

less specific/mixed tariffs than the United States. Figure 10 supports our finding that small

countries tend to rely less on specific/mixed tariffs compared to large countries.

0

10

20

30

40

50

60

Mexico

Canada

United States

Years

45

7. CONCLUSION

The conversion of specific tariffs into their ad valorem equivalent was one of the issues

debated during the Uruguay Round of multilateral negotiations. On one side, many countries prefer

specific tariffs as they are not sensitive to price change. Ad valorem tariffs however, facilitate

negotiation as they are unitless and therefore easier to compare across countries and commodities.

This thesis studies preference for specific tariff or ad valorem tariff for countries in a trade

negotiation context. We use a two stage model to find bargaining solutions. In the first stage,

countries choose simultaneously specific and ad valorem tariffs. In the second stage, they negotiate.

Countries‟ tariff choice affects their bargaining solutions. In case the negotiation fails, countries

have their respective threat point as fall-back position. We use a trade model with two countries and

two goods. Consumers‟ utility follows a Cobb Douglas function as in Kennan and Riezman (1988)

and the production consists of country-specific endowments. We use the concept of bargaining

solution as described in Nash (1954) to find the negotiation equilibrium. This research is the first to

investigate the choice of tariff type in trade negotiations.

In the first stage of the model, countries choose simultaneously the type of tariff that they

prefer. Their choice determines their bargaining position. Then countries negotiate a trade

agreement. In investigating the outcome of negotiations, we consider four scenarios:

(1) country A is larger and has a comparative advantage in the production of good 1;

(2) country A and country B are equal size and country A has a comparative advantage

in the production of good 1;

(3) country A is strictly larger and has a comparative advantage in the production of

good 1;

(4) country A is strictly larger but does not have a comparative advantage in the

production of good 1.

Numerical solutions show interesting results. We find that when a large country negotiates

with a small country, the large country is indifferent between specific and ad valorem tariffs

whereas the small country always prefer an ad valorem tariff. When two countries are equal size,

both are indifferent between specific and ad valorem tariff. Unlike Lockwood and Wong (2000),

switching from a specific tariff to an ad valorem does not always improve the welfare of at least one

country. In fact, switching from a specific tariff to an ad valorem tariff has no impact on the welfare

when countries are equal size.

46

Evidence from NAFTA supports our results in the sense that Mexico and Canada (which are

considered as small countries in comparison to the United States) tends to use ad valorem tariff

more often than the United States.

This thesis brings new insights on how trade negotiations take place. It shows that the choice

of tariff instrument that countries may have an impact on the outcome of trade negotiations. In

particular, it supports the choice of ad valorem tariff by small countries.

47

References

Anderson, J. (1988). On the Relative Inefficiency of Quotas (MIT Press, Cambridge).

Bagwell, K., & Staiger, R. W. (2002). The Economics of the World Trading System. MIT Press.

Bagwell, K. and Staiger, R.W. (2011). What Do Trade Negotiatiors Negotiate About? Empirical

Evidence from the World Trade Organization. American Economic Review 101(June), 1238-

1273.

Baldwin, R. E. (1989). The Political Economy of Trade Policy. The Journal of Economic

Perspectives, 3 (4), 119-135.

Beghin, J. (1996). Trade Unions and Firms‟ Product Market Power. The Journal of Industrial

Economics, 44 (3), 289-307.

Bhagwati, J. N. (1971). The Generalized Theory of Distortions and Welfare, in: Jagdish Bhagwati

et al., eds., Trade, balance of payments and growth: Essays in honor of Charles P. Kindleberger

(North-Holland, Amsterdam).

Bickerdike, C. F. (1906). The Theory of Incipient Taxes. Economic Journal, 16(64), 529–35.

Binmore, K., Rubinstein, A., & Wolinsky, A. (1986). The Nash Bargaining Solution in Economic

Modelling. The Rand Journal of Economics, 17(2), 176-188.

Broda, C., Limão, N., & Weinstein, D. E. (2008). Optimal Tariffs and Market Power: The

Evidence. American Economic Review, 98 (5), 2032-65.

Burbidge, J., & Myers, G. (2004). Tariff Wars and Trade Deals with Costly Government. Review of

International Economics, 12(3), 543–549.

Butler, C. K. (2004). Modeling Compromise at the International Table. Conflict Management and

Peace Science, 21(3), 159-177.

Chang, P-L. (2005). Protection for Sale under Monopolistic Competition. Journal of International

Economics, 66, 509-526.

Choi, E. K., & Lapan, H. E. (1991). Optimal Trade Policies for a Developing Country under

Uncertainty. Journal of Development Economics, 35, 243-60.

Chowdhury, S. (2011). The Discriminatory Nature of Specific Tariffs. The World Bank Economic

Review. Advance access published July 12 2011.

Copeland, B., Tower, E., & Webb, M. (1989). On Negotiated Quotas, Tariffs and Transfers. Oxford

Papers, 41, 774-788.

Dutt, P., & Mitra, D. (2005). Political Ideology and Endogenous Trade Policy: An Empirical

Investigation. The Review of Economics and Statistics, 87 (1), 59-72.

Eipifani, P., & Vitaloni, J. (2003). GATT-Think‟ with Asymmetric Countries. CESPRI, WP n. 141,

march 2003.

Facchini, G., Van Biesebroeck, J., & Willmann, G. (2006). Protection for Sale with Imperfect Rent

Capturing‟, Canadian Journal of Economics 0008-4085, 06, 845-873.

Gawande, K., Krishna, P., & Robbins, M. J. (2006). Foreign Lobbies and US Trade Policy. The

Review of Economics and Statistics, 88 (3), 563-571.

Gibson, P., Wainio, J., Whitley, D. & Bohman, M. (2001). Profiles of Tariffs in Agricultural

Markets. Market and Trade Economics Division, Economic Research Service, U.S. Department

of Agriculture. Agricultural Economic Report No. 796.

Grossman, G. M., & Helpman, E. (1994). Protection for Sale. American Economic Review, 84 (4),

833-850.

48

Grossman, G. M., & Helpman, E. (1995). Trade Wars and Trade Talks. Journal of Political

Economy, 103 (4), 675-708.

Hatta, T., & Ogawa, Y. (2007). Optimal Tariffs under a Revenue Constraint. Review of

International Economics, 15 (3), 560-573.

Hillman, A. L., & Ursprung, H. W. (1988). Domestic Politics, Foreign Interests, and International

Trade Policy. The American Economic Review, 78 (4), 729-745.

Itagaki, T. (1985). Optimal Tariffs for a Large and a Small Country under Uncertain Terms of

Trade. Oxford Economic Papers, 37 (2), 292-297.

Johnson, H. G. (1953). Optimum Tariffs and Retaliation. The Review of Economics Studies,

Cambridge, 21, 142-153.

Jørgensen, J., & Schröder, P. J. H. (2007). Effects of Tariffication: Tariffs and Quotas under

Monopolistic Competition. Open Economies Review, 18, 479-498.

Keen M (1998). The Balance between Specific and Ad-valorem Taxation. Fiscal Studies, (19), 1-

37.

Kennan, J., & Riezman, R. (1988). Do Big Countries Win Tariff Wars? International Economic

Review, 29 (1), 81-85.

Kowalczyk, C., & Skeath, S. E. (1994). Pareto Ranking Optimal Tariffs under Foreign Monopoly.

Economics letters, 45, 355-359.

Larue, B., & Gervais, J-P. (2002). Welfare-maximizing and Revenue-maximizing tariffs with a few

domestic firms. The Canadian Journal of Economics, 35 (4), 786-804.

Larue, B., Gervais, J-P., & Pouliot, S. 2006. Price-Equivalent and Revenue- Equivalent Tariffs and

Quotas with Smuggling and Monopolized Domestic Production. (September 8, 2006). Essays in

Honor of Stanley R. Johnson. Article 10.

Larue, B., Gervais, J-P, & S. Pouliot. 2008. Price Equivalent Tariffs and Quotas under a Domestic

Monopoly. Journal of International Trade & Economic Development 17: 315-326.

Larue, B., & Lapan, H. (2002). Smuggling and Bhagwati‟s Nonequivalence Between Tariffs and

Quotas. Review of International Economics, 10(4), 729-748.

Lin, Y-S., & Mai, C-C. (1993). Optimum Tariff on Imports from Imperfectly Competitive Labor-

Managed Firms. Managerial and Decision Economics, 14, 469-474.

Lockwood, B., & Wong, K-Y. (2000). Specific and Ad Valorem Tariffs are Not Equivalent in

Trade Wars. Journal of International Economics, 52, 183-195.

McCalman P. (2004). Protection for Sale and Trade Liberalization: An Empirical Investigation.

Review of International Economics, 12 (1), 81-94.

Maggi, G., & Rodríguez-Clare, A. (2007). A Political-Economy theory of trade Agreements. The

American Economic Review, 97 (4), 1374-1406.

Mayer, W. (1981). Theoretical Considerations on Negotiated Tariff Adjustments. Oxford Economic

Papers, 33, 135-153.

Mitra, D. (2002). Endogenous Political Organization and the value of Trade Agreements. Journal of

International Economics, 57, 473-485.

Muthoo, A. (1999). Bargaining Theory with Applications, Cambridge University Press.

Nash, J. F. (1950). The Bargaining Problem. Econometrica, 28, 152-155.

Nash, J. F. (1953). Two-Person Cooperative Games. Econometrica, 21, 128–140.

OECD, 1999. Post-Uruguay Round Tariffs regimes Achievements and outlook.

Ogawa, Y. (2012). The Structure of Nash Equilibrium Tariffs. Economic Theory, 51, 139-161.

49

Opp, M. M. (2010). Tariff Wars in the Ricardian Model with a Continuum of Goods. Journal of

International Economics, 80:212-225.

Public Citizen. (n:d). “The Ten Year Track Record of the North American Free Trade Agreement:

U.S., Mexican and Canadian Farmers and Agriculture.” Retrieved

11/18/2012. http://www.citizen.org/documents/NAFTA_10_ag.pdf.

Rubinstein, A. (1981). Perfect Equilibrium in a Bargaining Model. Econometrica, 50, 97-109.

Shea, K. L., & Shea, E. Y. P. (2006). On the Equivalence of Ad Valorem Tariffs and Specific

Tariffs under Duopoly. Review of International Economics, 14(3), 445-451.

Stahl, I. (1972). Bargaining Theory. The Swedish Journal of Economics, 75 (4), 410-413.

Suits, D. B., & Musgrave, R. A. (1953). An Ad-valorem and Unit Taxes Compared. The Quaterly

Journal of Economics, 67 (4), 598-604.

Syropoulos, C. (1994). Endogenous Timing in Games of Commercial Policy. Canadian Journal of

Economics. 22, 847-864.

Syropoulos, C. (2002). Optimum Tariffs and Retaliation Revisited: How Country Size Matters.

Review of Economic Studies, 69(3), 707-727.

Tanaka, Y. (1992). Tariffs and Welfare of an Exporting country in a Free Entry Oligopoly under

Integrated markets. Oxford Economic Papers, 44 (2), 317-321.

Tangermann, S. (1996). Implementation of the Uruguay Round Agreement on Agriculture: Issues

and Prospects. Journal of Agriculutral Economics. 47(3), 315-337.

The World Bank. (2012). Share of tariff lines with specific rates, primary products (%)

http://data.worldbank.org/indicator/TM.TAX.TCOM.SR.ZS.

Trostle, R. (2008), Global Agricultural Supply and Demand: Factors Contributing to the Recent

Increase in Food Commodity Prices. USDA/ERS Report WRS-0801, Revised July 2008.

Washington DC: USDA.

UNCTAD STAT. (2011). Standard International Trade Classification (SITC) Revision 33.

Retrieved online on 11/18/12 at,

http://unctadstat.unctad.org/UnctadStatMetadata/Classifications//UnctadStat.SitcRev3Products.

Official.Classification_En.pdf.

Wicksell, K. (1959). Taxation in the Monopoly Case In: Musgrave, R., Shoup, C. (Eds.), Readings

in the Economics of Taxation. Allen and Unwin, London. An extract from Finanztheoretische

Untersuchungen nebst Darstellung and Kritik des Steuerwesens Schwedens, Gustav Fisher,

Jena, 1896.

Wong, S-K. (2009). Uniqueness and Comparative Statics of Nash Equilibrium in a Tariff

Retaliation Model. Journal of Economics 96,169-188.

WTO. (2008a). Revised Draft Modalities for Agriculture. Retrieved online on 12/04/12 at,

http://www.wto.org/english/tratop_e/agric_e/agchairtxt_dec08_a_e.pdf.

WTO. (2008b). World Trade Profiles 2008. WTO Secretariat, Switzerland: WTO Publications.

WTO. (2009). World Trade Profiles 2009. WTO Secretariat, Switzerland: WTO Publications.

WTO. (2010). World Trade Profiles 2010. WTO Secretariat, Switzerland: WTO Publications.

WTO, (2012a). Negotiators need more time to reflect on how to move farm talks forward, chair

says. Retrieved online on 11/26/12 at

http://www.wto.org/english/news_e/news12_e/agng_22mar12_e.htm .

WTO, (2012b). Briefing notes, Jargon buster. Retrieved online on 11/26/12 at

http://www.wto.org/english/tratop_e/dda_e/status_e/jargon_e.htm.

50

WTO. (2012c). Participation in Regional Trade Agreements. Retrieved online on 12/04/12 at,

http://www.wto.org/english/tratop_e/agric_e/agchairtxt_dec08_a_e.pdf.

Young, L. & Anderson, J.E. (1982). Risk Aversion and Optimal Trade Restrictions. Review of

Economic Studies 48, 291-305.