Trade Policy with Intermediate Inputs Trade

The paper aims to characterize the tariff policy for final goods as well as for intermediate inputs in the model of heterogeneous firms. We developed a theoretical model to show how the tariff on final goods and intermediate inputs affect the welfare, productivity, and the entry of firms in a country. We formulate the tariff level selection choice available to the policymaker with respect to four policy experiments. These policy experiments include; unilateral tariff selection, cooperative tariff selection, non-cooperative tariff selection, and political tariff selection. Our results show that at the Stackelberg equilibrium, which results from the unilateral tariff selection, the policy level selected by the leader is higher compared to the rest of the experiments. While, in the case of cooperation, free trade will be the equilibrium outcome. Since, the welfare gains of one country come at the cost of others, therefore, zero tariffs are the optimal strategy for both countries. At Nash equilibrium, which results of non-cooperative tariff policy selection, both countries select policy level simultaneously and applied positive tariff rates for both intermediate inputs and final goods. Lastly, at political equilibrium, which results after considering lobby by the heterogeneous firms, the policy level selection diverges from benchmark unilateral level. To illustrate our tariff policy formulations quantitively, we use the US import data to estimate the policy levels. These estimates are then compared the factual tariff rates to evaluate the degree of political interference of lobbying firms in the policy level selection.