International Trade Theory and Policy
by Steven M. Suranovic

Trade 90-22

Price Effects of an Export Tax: Large Country Case

Suppose the US, the exporting country in free trade, imposes a specific export tax on exports of wheat. A tax on exports will reduce the flow of wheat across the border. It will now cost more to move the product from the US into Mexico.

As a result the supply of wheat to the Mexican market will fall inducing an increase in the price of wheat. Since the US is assumed to be a "large" country, the price of all wheat sold in Mexico, both Mexican wheat and US imports will rise in price. The higher price will reduce Mexico's import demand.

The reduced wheat supply to Mexico will shift supply back to the US market and induce a reduction in the US price. The lower price will reduce US export supply.

These price effects are identical in direction to the price effects of a tariff, an import quota, and a voluntary export restraint.

A new tax-ridden equilibrium will be reached when the following two conditions are satisfied.

where T is the export tax, is the price in Mexico after the tax, andis the price in the US after the tax.

The first condition represents a price wedge between the final US price and the Mexican price, equal to the amount of the export tax. The prices must differ by the tax because US suppliers of wheat must receive the same price for their product, regardless of whether the product is sold in the US or Mexico and all wheat sold in Mexico must be sold at the same price. Since a tax is collected at the border, the only way for these price equalities within countries to arise is if the price differs across countries by the amount of the tax.

The second condition states that the amount the US wants to export at its new lower price must be equal to the amount Mexico wants to import at its new higher price. This condition guarantees that world supply of wheat equals world demand for wheat.

The export tax equilibrium is depicted graphically on the adjoining graph. The Mexican price of wheat rises from PFT to which reduces its import demand from QFT to QT. The US price of wheat falls from PFT to which reduces its export supply, also from QFT to QT. The difference in the prices between the two markets is equal to the export tax rate T.

Notice that there is a unique set of prices which satisfies the equilibrium conditions for every potential export tax that is set. If the tax were set higher than T, the price wedge would rise causing a further increase in the Mexican price, a further decrease in the US price and a further reduction in the quantity traded.

At the extreme, if the x were set equal to the difference in autarky prices, (i.e. ) then the quantity traded would fall to zero. In other words the export tax would prohibit trade. Indeed any tax set greater than or equal to the difference in autarky prices would eliminate trade and cause the countries to revert to autarky in that market. Thus we define a prohibitive export tax as any tax, Tpro, such that,

International Trade Theory and Policy - Chapter 90-22: Last Updated on 2/25/97

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