Domestic Distortions and Trade Policy

When a country possesses a monopoly power in the international markets in which it trades, a competitive free trade situation will be characterized by a disparity between the domestic and foreign rates of transformation. Achievement of an optimal solution requires that this disparity be eliminated in a manner which does not simultaneously destroy the equality between the domestic rate of substitution and the domestic rate of transformation. To this end, the theory of optimum tariffs provides a criterion for appropriate intervention in foreign trade by means of duties and subsidies on trade. A tax-cum-subsidy policy of intervention in domestic production, on the other hand, is not appropriate, because in removing the existing distortion it creates a new inequality between the domestic rate of substitution in consumption and the domestic rate of transformation. Consequently, a tax-cum-subsidy policy of intervention is necessarily inferior to an optimum tariff