Consumption Taxes as a Source of Trade

This section will show how a consumption tax can cause trade for a small perfectly competitive open economy. (Click here to see a list of other major reasons for trade) In other words, even if countries were identical with respect to their resource endowments, their technology and their preferences and even if there were no economies of scale or imperfectly competitive markets, a purely domestic policy, such as a consumption tax, could induce trade between countries.

Consider a small open economy with a perfectly competitive industry. Let the domestic market be represented by the supply and demand curves in the adjoining diagram. Suppose initially that free trade is allowed with the rest of the world, but, by coincidence, (actually by assumption) let the free trade price be exactly equal to the autarky price for the good. This is shown as the price, P_FT. At that price both supply and deman equals Q₁ and thus no imports or exports occur even though there is free trade.

Next suppose that the government of this country imposes a specific (per unit) consumption tax. Let the tax rate be set at "t". This means the government will collect "t" dollars for every unit of the good sold in the domestic market, regardless of whether the product is produced domestically or is imported.

The tax will raise the domestic consumer price of the good by the full amount of the tax to P_C and reduce domestic demand to Q₂. Domestic producers will not be affected by the consumption tax since continued competition in free trade with firms in the rest of the world will maintain their profit maximizing price at the world price of P_FT. This means that the producer price P_P will remain equal to the free trade price P_FT.

Since the tax has no effect upon the producer price but raises the consumption price, domestic demand falls to Q₂ while domestic supply remains at Q₁. The difference Q₁ - Q₂ (the red line) represents the amount exported to the rest of the world. This implies that the consumption tax will induce exports of the good. Thus, this is an example in which a domestic policy (a consumption tax) can cause trade to occur (exports).

International Trade Theory and Policy - Chapter 95-2A: Last Updated on 10/17/02