Scale Economies, Country Size, and Tariff Wars
Johnson (1953-54) offered a powerful explanation for the existence of equilibrium tariffs when he showed that governments face incentives to deviate from free trade even in the face of retaliation by their trading partners. Subsequent analyses by Kennan and Riezman (1988) and Syropoulos (2002) identify the relationship of country size to import demand elasticities and, hence, confirm the view that large countries win trade wars. This paper explores an additional route by which country size systematically determines the net benefit of retaliation across trading partners. Using a models in which one industry exhibits scale economies, we identify circumstances under which the ability to win a tariff war shifts in favor of the smaller country. We show that this shift is not dependent on decreasing opportunity costs but rather flows from the asymmetric benefits of protection on the existing (uncorrected) production distortion. These findings on comparative country size suggest new issues for research on whether the formation of trade blocs undermines or facilitates the attainment of global free trade.
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