There are different approaches to define small economies. Besides usual quantitative ways to measure country’s smallness by its population, territory, GDP and other criteria, there some qualitative factors that are used to define the economy’s scale. Some economists state that small economies are those that adopt “price taking” policies as they cannot dictate their rules in the market, neither significantly influence trade rules. This peculiarity of small economies mainly lies in the fact that such countries have limited resources. Hereby, small countries are more dependent on imports and are forced to accept trade agreements offered by large exporters. Limited domestic competition makes inner market highly sensitive to any tariffs and taxes imposed, as they reflect immediately on the prices and consumption level. (Commonwealth Secretariat, 2008, p.22)
Modern economy is characterized by rapid globalization process and fasten transportation and delivery of goods and services throughout the world. Therefore, international trading occupies one of the key positions in the country’s economic development and welfare growth. Since the appearance of the cross border trade, each country uses a number of tolls to gain the maximum benefit from the trade as well as these measures are called to protect national producers and consumers from unfair market conditions. Amongst these tools there are tariffs, subsidies, taxes, licensing and law restrictions. Tariffs and taxes have a fast economic effect, thus they are used in case results are needed in a short term period or must be achieved at soonest. Meanwhile, licensing and law restrictions require long time preparation and adoption, and show effects in a longer period of time. Therefore, they are used in case long term and long lasting results are required.
Some researchers claim that increasing of tariffs mostly leads to the economy slowing down both in log and short terms, therefore differential tariffs are named to be the most effective for the welfare increase in a short time period.(Pereira & Osang, 1996, n.p.) Lee states, that high import tariffs may generate only short term benefits but long run losses for the intervening country. Thus, he suggests that greater openness can lead to a higher growth, in case the government lowers the tariffs and supports national producers simultaneously. (Lee, 2005, pp.93-95) The country can improve its welfare in case total trade results overcome the total deadweight losses.
Small country’s imports are very small, thus there is no benefit from the import tariffs imposed, as the country does not trade internationally. While export tariffs imposed by a small economy will not have any effect on the global trading, except of the country itself. Therefore, small countries can easily use this tool to regulate their trade balance and improve the economic situation. In order to have clear understanding of the way tariffs can influence the country’s welfare, a trade equilibrium should be analyzed. (Figure 1) As it is shown in the figure below, the export supply curve is horizontal and lies on the level of the world price, as small economies do not influence the pricing level. Although, small countries have no effect on the world prices, they can change the import’s price in the local market. Thus, the exporter will supply the amount that is demanded in the market for the world price, while the burden of tariffs will be put on the local purchasers. Hereby, the higher the tariff is the lower demand for the imported goods is.
Figure 1. Trade Equilibrium in a Small Open Economy (Suranovic, 2016, n.p.)
The equilibrium with the tariff imposed is a distorted equilibrium, which does not satisfy the optimum conditions of the economic model. Lipsey and Lancaster describe the theory of “the second best”, which is used to describe the equilibrium situation in case one of the conditions assumed for the optimal model is not satisfied. In case of the small economies, the optimal conditions would be if the principle laissez-faire is followed, which basically means that the market runs under a free trade policy. Such an optimal market equilibrium is called “the first best”. However, due to the before mentioned reasons, ideal market conditions in a small economy are almost impossible. The introduction of even one distortion into such economy will either increase or lower the level of a national welfare. Nonsensitive world pricing plays a role of such distortion. Thus, an equilibrium in the market with a horizontal export supply curve is called “the second best”. (Schmitz, 2012, n.p.)
The government regulates the market once any imperfections or distortions are noticed. Small economies constantly require government’s interventions in terms of regulation of the international trade. Government actions are mostly oriented on reverting the economy to “the first best” equilibrium; however, the economy can only be improved but never can be put into the ideal market circumstances. Tariffs are usually used in such cases so that to influence the flow of goods and services between countries. Based on the Lipsey and Lancaster’s theory a number of “first best” and “second best” imperfection policies was suggested. (Schmitz, 2012, n.p.) Some researchers state that directional tariff and transfer reforms may be considered are a first best trade policy as they tend to move the prices toward the world price vector, and also lead to proportional reductions, and reductions of extreme tariffs. (Diewert, Woodland, and Turunen-Red, 1991, n.p.)The first best policy is called to improve the welfare level, while the second one is the policy, which has lower improvement economic effect. Since any policy adopted to correct the trade balance is used to eliminate distortions, it is considered to be the second best one.(Schmitz, 2012, n.p.)
The following example describes how the tariffs implication can regulate the Infant industry in a small country. First of all, it is necessary to state that there is no single definition of what is an infant industry. In most sources this term is used to define either a new company in a developing country, or a business in a small country. Basically, an infant industry refers to a company or business which is less competitive in the market than an international company of the same industry. Secondly, protection policy held by the government has a great impact on the infant industry. Thus, imposing of the import tariffs will reflect on the aforementioned business. (Nathan Associates, 2004,pp.1-3)
Figure 2. An Infant Industry in a Small Country. (Schmitz, 2012, n.p.)
Figure 2 depicts the free trade market conditions for an infant industry. P1 on the figure shows the world price in the market. However, national producers are willing to sell their goods at a higher price, thus the supply curve is higher the D1, a preferred demand for a P1. This situation usually occurs due to lack of domestic resources, which makes producers to use more expensive raw materials, hence they cannot sell the product cheaper. The free trade supply and demand level will thus meet at a D1 point, as P1 is the lowest price offered in the market. However, the government is interested in protection of the national producer, which is why a tariff will be implemented in order to increase the market price to the P2 level and allow the infant industry to compete in the local market. The positive impact of this policy is that domestic supply may be stimulated to the S2 level, regardless the fact that demand will decrease to theD2 level, hence leading to the import failure (red line in the chart). The government and producers will benefit from the situation, section C and A in the chart respectively. Meanwhile, consumers will lose greatly, as the burden of price increase will fall on them. Even though some parties benefit from the situation and a short time welfare improvement was gained through this policy, the economy loss was in a production efficiency loss (B section), and consumption efficiency loss (D section). (Schmitz, 2012, n.p.)
During the past decades the general level of tariffs across the world has dropped down. Which is why, trading costs have decreased and logistics management became more difficult, as more and more countries have to be involved in a trade relation. Export and import prices increased due to the fact that supply chain management became more complex and expensive.( Reinsdorf, 2009, p.1) From an example provided, it is clear that in order to gain the highest welfare effect the government should not only support the producers, but also stimulate the demand growth. This may be achieved by increasing the income level or by providing specific consumer groups with subsidiaries. (Fan & Fan, 2005, pp.2-4)
Regardless any tariffs or other trade restrictions, most countries remain open for international business. Small economies are mostly limited in the resources available for any kind of production, or even services. However, modern era of new technologies and science allows such economies to compete in the market. Furthermore, most of small countries manage to use their limited resources to produce some rare and luxury goods, so that to be able to export them. Therefore, there is no pure import or export economies. Nevertheless, small countries are more interested in imports, as they have to support all consumers’ needs and demands at the lowest price. So, once the country allows free foreign trade in its market, consumers benefit from the lower prices, while local companies lose; in case the government decides to support local producers, consumers lose but companies benefit. The country’s welfare raises in case total benefits of the winners (either consumers or producers) are higher than the total loss of the ones who lose in the trade. Therefore, adopting any trade policy usually requires lots of analysis and causes many debates. (Gans et al, 2014, p. 198) If the country follows the same policy during a long period, there will always be those, who constantly loose,and those, who always benefit. Thus, in case producers will face losses for a long period, they may switch to other markets, or even relocate the business; while customers may go for substitutes to reduce their constant expenses. Therefore, the government should choose an optimal strategy so that to get the maximum benefits and to satisfy needs of all parties. The government should also consider the fact that too high tariffs may force importers to quit the market.
As a conclusion, it is important to state that international trade nowadays is an engine that boosts and defines a country’s economic growth in a long-term perspective. Tariff policy adopted by the national government has a direct impact on the small open economy’s growth. High import tariffs limit the access of the foreign gods and services into the local market, thus demand overcomes the supply, which in its turn stimulates national producers to enlarge their business. High incomes of the national producers increase the overall economic standards. Lowering the import tariffs will have the opposite effect on a small economy. Which means that national producers will face a strong competition in the market along with the oversupply of the goods, which will lead to the price reduction and economic losses.
Companies of the small countries, which are also named as an infant industry, are very important for the national welfare. However, they cannot compete in the international market due to their small resource base, as well as they cannot be equally strong players in the domestic market, when an import company suggests lower prices. Therefore, the government should use import tariffs as a tool of the protection trade policy so that to support national producers.
Import tariffs allow local producers to sell items for the price, which is higher than the world price suggested, and thus they can cover their expenses for raw materials. Meanwhile, increased prices force customers to spend more, hence they lose more to support the economy. Recent openness of the economics led to a tariff’s lowering. Many countries are now joined into different economic unions and free trade zones, which prohibits implementation of tariffs among its members. Imposing tariffs has its pros and cons, although small countries can get their welfare increased in case total benefits exceed total expenses after the tariff was imposed.
Tariffs is an effective tool to regulate the country’s trade balance, especially for a small country. However, in real economies, one regulating method is never used solely. In most cases, international trade policy is a complex set of financial tools, political agreements and specific restrictions, which allows the government to control, monitor and support the economic situation in the country.
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Lee, Hongshik. 2005. Import Tariffs and Growth. THE JOURNAL OF THE KOREAN ECONOMY, Vol. 6, No. 1 (Spring 2005), 91-102. Retrieved from: <http://www.akes.or.kr/akes/downfile/5.lhs6-1final050518.pdf> [Accessed 9th Feb 2016]
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Diewert, W.E., Woodland, A. and Turunen-Red, A.H. Jan 1991. Tariff Reform in a Small Open Multi-household Economy with Domestic Distortions and Nontraded Goods. INTERNATIONAL ECONOMIC REVIEW 32(4):937-57 Retrieved from: <https://www.researchgate.net/publication/5109885_Tariff_Reform_in_a_Small_Open_Multi-household_Economy_with_Domestic_Distortions_and_Nontraded_Goods>[Accessed 9th Feb 2016]
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