Specific Tariff versus Ad valorem Tariff: Choice of a Policy
Instrument in Agricultural Trade Negotiations
Mémoire
Abdelaziz Tidjani Serpos
Maîtrise en économie rurale
Maître ès sciences (M.Sc.)
Québec, Canada
© Abdelaziz Tidjani Serpos, 2013
Résumé
La conversion des tarifs spécifiques en leur équivalent ad valorem est un sujet d‟actualité en
ce sens qu‟elle fait partie des priorités dans les discussions des membres de l‟Organisation
Mondiale du Commerce (OMC). Peut-on mieux comprendre et anticiper les choix de tarifs par les
pays dans un contexte de négociation commerciale? Le présent mémoire se propose d‟apporter une
réponse à cette question. Nous avons utilisé un modèle à deux étapes. La première consiste au choix
du type de tarif par les pays. La deuxième, quant à elle, est la phase de négociation. Le modèle est
composé de deux pays et deux biens, des fonctions d‟utilité Cobb Douglas et des dotations comme
fonctions de production (tel que développé par Kennan and Riezman (1988)). La détermination des
équilibres de négociation a été possible grâce au produit de Nash (Nash, 1950). Nous avons trouvé
que le petit pays a tendance à utiliser un tarif ad valorem et que le grand pays est indifférent entre
un tarif spécifique et un tarif ad valorem lorsque celui-ci négocie avec un petit pays. Lorsque les
deux pays sont de même taille, l‟équilibre de négociation est le libre-échange. L‟apport à la
recherche scientifique dans le domaine est d‟une importance à préciser. Cette étude est la première à
investiguer le choix des instruments de politique commerciale par un pays dans un contexte de
négociation. En effet, jusque-là, très peu de travaux scientifiques se sont intéressés aux questions de
modélisation des négociations commerciales. Le présent mémoire est donc une esquisse de
compréhension des équilibres de négociation via une modélisation mathématique s‟inspirant de
travaux précédents sur la guerre des tarifs.
iii
Abstract
The conversion of specific tariff into its ad valorem equivalent is one of the key issues for
current World Trade Organization (WTO) discussions. An important question this thesis addresses
is whether we are able to anticipate and understand the choice between specific and ad valorem
tariffs by a country in trade negotiations. We use a two-stage model to find the solutions for trade
negotiations between two countries. In the first stage, countries choose between specific and ad
valorem tariffs. In the second stage, they negotiate over tariff rates. The model includes two
countries and two goods, Cobb Douglas utility functions and endowments as production functions
as in Kennan and Riezman (1988). To find the negotiation solutions, we use the Nash bargaining
solution (Nash, 1950). This thesis is the first to investigate the choice of policy instrument in trade
negotiations. We find that a large country is indifferent between specific and ad valorem tariffs
when negotiating with a small country. We also find that a small country prefers ad valorem tariff.
Finally, when two countries are equal in size, the negotiation equilibrium is free trade.
v
Table of Contents
Résumé.................................................................................................................................. iii
Abstract ................................................................................................................................... v
Table of Contents ................................................................................................................. vii
Avant-Propos .........................................................................................................................ix
List of Tables .........................................................................................................................xi
List of Figures ..................................................................................................................... xiii
1. INTRODUCTION .............................................................................................................. 1
2. LITERATURE REVIEW ................................................................................................... 5
2.1. Previous studies on the equivalence between specific tariff and ad valorem
tariff............................................................................................................................ 5
2.2. Optimal tariff argument and terms of trade manipulations................................ 6
2.3. Cooperative trade policy ......................................................................................... 8
2.4. Trade policy and non-economic determinants: a political-economy criterion 10
3. THEORETICAL MODEL ................................................................................................ 13
3.1. Ad valorem tariff game .......................................................................................... 14
3.2. Specific tariff game ................................................................................................ 19
3.3. Specific tariff vs. ad valorem tariff game ............................................................. 22
3.4. Ad valorem tariff vs. specific tariff game ............................................................. 26
4. GOVERNMENT CHOICE OF POLICY INSTRUMENT .............................................. 31
4.1. Country A is large and has a comparative advantage in the production of good
1 ................................................................................................................................ 31
4.2. Country A and country B are equal size and country A has a comparative
advantage in the production of good 1 .................................................................. 33
4.3. Country A is strictly larger and has a comparative advantage in the
production of good 1 ............................................................................................... 34
4.4. Country A is strictly larger but does not have a comparative advantage in the
production of good 1 ............................................................................................... 36
5. DISCUSSION ................................................................................................................... 39
6. CASE STUDY AND EVIDENCE: URUGUAY ROUND AND NORTH AMERICAN
FREE TRADE AGREEMENT (NAFTA) ............................................................................ 41
vii
7. CONCLUSION ................................................................................................................. 45
References ............................................................................................................................. 47
Avant-Propos
Je voudrais en premier lieu dédier le présent mémoire à ma feue mère Siaratou Essou
Abogounrin à qui je dois tout ce que j‟ai accompli jusqu‟à présent. De plus, je dédie ce travail à
mon père Ismail Tidjani Serpos, qui a donné à mes sœurs/frères et moi le goût du travail bien fait et
de l‟excellence. Enfin, je dédie ce mémoire à mes frères, sœurs et à toute la famille Tidjani Serpos
pour le soutien et les encouragements qu‟ils n‟ont cessé de me porter. Merci de croire en moi.
Ce mémoire n‟aurait pas vu le jour sans le financement de ma formation en Maîtrise
d‟Agroéconomie à l‟Université Laval par la Banque Mondiale. Je lui témoigne ici toute ma
gratitude.
Qu‟il me soit permis de remercier le Professeur Bruno Larue, mon directeur de recherche.
Plus qu‟un simple encadreur, il est devenu un conseiller à qui l‟on peut poser toutes sortes de
questions, mêmes les plus personnelles. En lui, je reconnais de grandes qualités intellectuelles et
morales. Je témoigne ici de sa disponibilité sans limite. Le Professeur Larue a manifesté un soutien
inconditionnel à mes travaux dès le premier jour où il m‟a rencontré et a stimulé ma volonté de faire
un doctorat en économie agricole. C‟est aussi le moment de remercier le Professeur Larue pour sa
volonté de faire de ses étudiants les meilleurs en mettant la barre très haute. Avec lui, j‟ai atteint un
niveau intellectuel et critique dont je suis fier. Bruno, sincèrement, merci!
Je voudrais remercier le Professeur Sébastien Pouliot, mon co-directeur de recherche pour
le suivi et la rigueur dans son travail. Malgré ses diverses activités, il a toujours du temps à
consacrer à mes questions. Je me rappelle encore des discussions intéressantes que nous avons eues
dans son bureau lorsque j‟avais des difficultés dans ma recherche. J‟ai beaucoup apprécié sa rigueur
sur certains aspects de mon travail et cela m‟a amené à développer un esprit critique de ce que je
fais comme travail scientifique. Sébastien, merci pour tout!
Bruno et Sébastien, merci de votre soutien moral et intellectuel pendant les moments difficiles!
Je remercie tous mes amis du Centre de Recherche en Économie Agroalimentaire CREA
(actuellement Centre de Recherche de l‟Économie Agroalimentaire, des Transports et de l‟Énergie
(CREATE)) avec qui j‟ai développé une grande amitié. Des remerciements particuliers aux
Professeurs Abdesalem Abbassi et Lota D. Tamini. Vous avez toujours été à mon écoute pour
m‟encourager.
Je remercie ma fiancée Senandé Ramata-Laye Diane Savi pour l‟amour et le soutien qu‟elle
n‟a cessé de me porter, mon ami Jelili Adégboyéga Adébiyi pour son amitié et enfin Elizabeth Ford
pour son aide lors du formatage final du mémoire.
ix
List of Tables
Table 1: Tariffs solutions when country A is large and has a comparative advantage in the
production of good 1 (   0.75 and   0.6 )...................................................... 32
Table 2: Payoffs for games where country A is large and has a comparative advantage in
the production of good 1 (   0.75 and   0.6 .)............................................... 32
Table 3: Export, import, world price, consumption in negotiation for   0.75 and   0.6 .
............................................................................................................................ 33
Table 4: Tariffs solutions when country A and country B are equal size and country A has a
comparative advantage in the production of good 1 (   0.6 and   0.6 )
........................................................................................................ ……………33
Table 5: Payoffs for games where country A is large and has a comparative advantage in
the production of good 1 (   0.6 and   0.6 ) ........ ………………………….34
Table 6: Export, import, world price, consumption in negotiation for   0.6 and   0.6
……………… .................................................................................................... 34
Table 7: Tariffs solutions when country A is strictly larger and has a comparative
advantage in the production of good 1 (   0.75 and   0.4 ) .......................... 35
Table 8: Payoffs for games where country A is strictly larger and has a comparative
advantage in the production of good 1 (   0.75 and   0.4 ) .......................... 35
Table 9: Export, import, world price, consumption in negotiation for   0.75 and   0.4
............................................................................................................................ 36
Table 10: Percentage share of ad valorem and non-ad valorem tariffs on agricultural
products in 2008, 2009 and 2010. ....................................................................... 42
xi
List of Figures
Figure 1: Game tree for trade negotiation ....................................................................... 13
Figure 2: Reaction functions for ad valorem tariff for imports by country A and ad valorem
tariff for imports by country B with   0.75 and   0.6 ................................ 17
Figure 3: First order conditions for bargaining solutions for ad valorem tariff for imports by
country A and ad valorem tariff for imports by country B with   0.75 and
  0.6 ................................................................................................................ 18
Figure 4: Reaction functions for specific tariff for imports by country A and specific tariff
for imports by country B with   0.75 and   0.6 ......................................... 21
Figure 5: First order conditions for bargaining solutions for specific tariff for imports by
country A and specific tariff for imports by country B with   0.75 and   0.6
............................................................................................................................ 22
Figure 6: Reaction functions for specific tariff for imports by country A and ad valorem
tariff for imports by country B with   0.75 and   0.6 ................................ 25
Figure 7: Bargaining solutions for specific tariff for imports by country A and ad valorem
tariff for imports by country B with   0.75 and   0.6 ................................ 26
Figure 8: Reaction functions for ad valorem tariff for imports by country A and specific
tariff for imports by country B with   0.75 and   0.6 ................................ 28
Figure 9: Bargaining solutions for ad valorem tariff for imports by country A and specific
tariff for imports by country B with   0.75 and   0.6 ................................ 29
Figure 10: Share (in %) of specific and mixed tariffs in the total line tariff schedule for
primary products ................................................................................................. 43
xiii
1. INTRODUCTION
Agriculture has been at the core of the negotiations during the Uruguay Round of the
General Agreement on Tariffs and Trade (GATT). A key development was the tariffication of nontariff barriers. Tariffication is the replacement of non-tariff trade barriers, such as quotas, by tariffs.
This was undertaken to make trade policy more efficient, simpler and more transparent.1 Yet tariffs
can be complex and not so transparent. This is why “tariff simplification” is among the 10 key
outstanding issues identified by the Chairperson of the negotiating group on Agriculture that must
be resolved if the on-going Doha Round is to be completed (WTO, 2012a).
An ad valorem tariff is a tax in percentage of the value of a shipment while a specific tariff
is a per unit tax (e.g. $/kg, etc). Ad valorem and specific tariffs can be used as alternative for one
another or in combination. The WTO defines a compound tariff as a combination of an “ad
valorem” duty and a “specific” duty, added together or one subtracted from the other. The term
composite tariff is sometime used to mean compound. A mixed tariff is expressed as a conditional
combination of an “ad valorem” duty and a “specific” duty, one applying below a limit, and the
other applying above it, WTO, 2012b). For instance, Canada‟s over-quota tariff on imports of
frozen chicken parts is the maximum of 249% and $3.78/kg. Thus, when the world price is above
(below) $1.52/kg, the ad valorem (specific tariff) applies. The revised modalities for agriculture call
for either the conversion of all specific tariffs into ad valorem equivalents or that “no less than 90
percent of bound tariffs on products in a developed country Member‟s Schedule be expressed as
simple ad valorem tariffs” (WTO, 2008c). The countries with the largest proportion of specific
tariffs in their tariff schedule are Russia and the United States, with respectively 12.6% and 8.2% of
their 2010 final bound tariffs (WTO, 2012c).
The protective margin provided by an ad valorem tariff is sensitive to prices and
exchange rates while a specific tariff is not. For instance, consider that one unit of a product
is worth $1,000 and that a country applies a $50 per unit tax. Equivalently, the country
could impose a 5% ad valorem tariff. If the price of the product drops to $500, the per unit
revenue from the specific tariff remains the same. However, for the ad valorem tariff, the
per unit revenue drops to $25. By the same token, the ad valorem equivalent of the $50/unit
tax increases from 5% to 10% when the world price falls from $1,000 to $500.
1
There is much evidence that tariffs dominate quotas in most situations. The classic reference on the subject
is Anderson (1988).
1
Chowdhury (2011) argues that specific tariffs used by rich countries discriminate
against low-income countries because these countries‟ export prices tend to be lower and
their export composition is heavily skewed toward agricultural products. Most countries
use ad valorem tariffs for most of their tariff lines, but specific tariffs are still used mainly
for agricultural products. Ad valorem tariffs are more transparent than their specific
counterparts and this is why the agriculture modalities are calling for the replacement of
many or all of the specific tariffs by ad valorem tariffs. This might have significant
implications for the trade in agricultural products.
When the tariffication of non-tariff barriers was first implemented, some WTO
members proposed prohibitive tariffs that would have curbed market access below
historical levels. Tangermann (1996) refers to the process that went on as “dirty
tariffication”. However, because the outcome of the Uruguay Round could not be trade
reductions, even for greater transparency, and because import quotas and variable levies
could no longer be used to preserve market access, tariff-rate quotas (TRQs) were created.
A TRQ consists of an in-quota tariff applied to a level of imports, the quota, and an overquota tariff applied on imports in excess of the quota. According to Gibson et al. (2001),
the average over-quota tariff was 128%, and for most countries, the average over-quota
tariff is several-fold the country‟s average agricultural tariff. Thus, the replacement of
import quotas and variable levies resulted in very high tariffs. Do we have the same
consequence for the replacement of specific tariffs by ad valorem tariffs? Could the
replacement of specific tariff by ad valorem tariffs cause a digression in trade
liberalization?
The objective of the thesis is to explore countries‟ preferences for ad valorem or
specific tariff in trade negotiations. Prior contributions show that a specific tariff is
equivalent to an ad valorem tariff under perfect competition, but non-equivalence is
possible under imperfect competition. The outcome of negotiation for countries of different
sizes is the focus of this study.
Our model features two countries with identical preferences and non-identical
production endowments. The model is a two-stage game in which countries choose the type
of tariff before the level or rate of their tariffs. The choice of tariff affects countries
bargaining position as it anchors their fall-back position if negotiations fail. Then in a
2
second stage, countries negotiate over the trade liberalization. We use the Nash bargaining
solution
(Nash, 1950, 1953) to find the outcomes of trade negotiations between the
two countries.
Our specific objectives are:
1) To derive non-cooperative Nash equilibrium for ad valorem and specific tariffs and to
compare equilibrium quantities consumed and traded as well as world prices under the two
tariff regimes;
2) To derive cooperative Nash equilibrium tariffs given the fall-back positions from noncooperative Nash equilibrium tariffs;
3) To evaluate the importance of country size and consumer preferences on tariff equilibria;
4) To endogenize the selection of the type of tariff used by countries.
The next section reviews related literature. Much of the discussion revolves around
literature on the differences between specific and ad valorem tariffs and the choice of trade policy
instrument. We then present a detailed description of the theoretical model, the results, and one
example that supports our results.
3
2. LITERATURE REVIEW
We begin by reviewing the literature on the equivalence and non-equivalence of specific
and ad valorem tariffs. Afterward, we discuss trade policy when the objective of governments is to
maximize welfare. Because the main interest of this analysis is on the outcome of negotiations, we
analyze the incidence of replacing specific tariffs by ad valorem ones on the Nash bargaining
solution. Finally, we discuss another explanation for trade policy choice: the political-economy
criterion.
2.1. Previous studies on the equivalence between specific tariff and ad valorem tariff
Many papers have investigated differences between tariffs and quotas since the seminal paper
by Bhagwati (1971), but only a few have investigated the choice between specific and ad valorem
tariffs in the context of trade negotiations. Specific and ad valorem tariffs are equivalent under
perfect competition when countries do not cooperate (Suits and Musgrave, 1953). However, in a
model of two countries and two tradable goods, Lockwood and Wong (2000) show that in a tariff
war between two countries, a switch from specific tariffs to ad valorem tariffs makes at least one
country better off. The result hinges on the effect of the tariffs on the curvature of offer curves.
Conversely, some studies show that when the market structure changes, the equivalence of specific
and ad valorem tariffs does not hold. For Wicksell (1959), when a country‟s market structure is a
monopoly, the ad valorem tariff is superior to the specific tariff welfare-wise. Larue and Lapan
(2002) find that the optimal specific tariff dominates the optimal ad valorem tariff when domestic
production is monopolized because the residual demand is more elastic under the specific tariff.
This result holds as well when illegal trade occurs. Larue et al. (2006) show similar results. Both
Wicksell (1959) and Larue and Lapan (2002) consider a monopoly, but Larue and Lapan (2002)
show that the specific tariff is better than the ad valorem one with or without smuggling. Shea and
Shea (2006) find the same result in a quantity conjectural variation model.2 Similarly, Jorgensen
and Schroder (2005), using a monopolistic competition model, find that import reductions from a
specific tariff generate more utility for consumers in the domestic country than the ones resulting
from an ad valorem tariff.
Several studies show that the ranking of specific and ad valorem tariffs is sensitive to model
assumptions. Kowalczyk and Skeath (1994) compare the two types of tariffs when a utilitymaximizing country imports from a foreign monopolist. They conclude that there is no general
2
Cournot competition arises as a special case in this model (Shea and Shea, 2006).
5
ranking between the two types of tariff in this particular case because the outcome of the model
depends on the shape of the demand curve. Young and Anderson (1982) find non-equivalence
under risk between quota and tariff. This is due to the fact that the quota dominates only under
stringent conditions on risk aversion.
Overall, when there is market power in the domestic market, the residual demand is more
elastic under a specific tariff than under an ad valorem tariff. Many comparisons are anchored on
different variables (imports or domestic price, profits, etc) and this has an impact on the models
results.
2.2. Optimal tariff argument and terms of trade manipulations
Economists often compare policy instruments assuming that governments seek to
maximize welfare. Bagwell and Staiger (2002), in their book about the WTO, contend that
terms of trade manipulation to maximize welfare is the main driver for government
intervention in trade. Empirical evidence about welfare maximization and terms of trade
considerations can be found in Broda and al. (2008) where it is shown that tariff rates are
conditioned by foreign export supply elasticities. More recently, Bagwell and Staiger
(2011) have shown that the pattern of negotiated tariff cuts by new WTO members fit the
predictions of a “terms of trade” theoretical model.
Welfare maximization is not the only motivation for trade policy. In fact, the
"Protection-for-Sale" model of Grossman and Helpman (1994) has inspired many
contributions. In essence, it assumes that the government is motivated by social welfare as
well as by contributions from lobbies. Some studies introduce non-economic objectives and
determine which policy instrument achieves the highest level of welfare while meeting a
given non economic objective. As such, the exercise is one of constrained welfaremaximization. In that contexts, domestic policy instruments are often more efficient than
trade policy instruments. This is the case, for example when employment is taken into
account or there is a production target. The next section dwells on literatures in which
government chooses trade policy in order to maximize welfare or revenue.
2.2.1. Welfare and revenue maximization without retaliation
Some authors refer to the non-cooperative tariff as the orthodox optimal tariff. This
terminology was first introduced by Bickerdike (1906). One result regarding non cooperative tariffs
is that a “large” country can increase its welfare by imposing a tariff that optimizes the trade-off
6
between terms of trade improvements and reductions in the volume of trade. This optimal tariff
assumes away possible retaliations on the part of the trade partners of the policy-active country.
Johnson (1953) shows that the tariff that maximizes government revenues under perfect competition
is at least as large as the one that maximizes welfare. Larue and Gervais (2002) compare the
orthodox optimal tariff and the one that maximizes revenue in the presence of few domestic firms
and three different hypotheses regarding the control of imports. They find that the welfaremaximizing tariff can be lower or higher than the revenue-maximizing tariff and that the specific
tariff that maximizes welfare is never worse than its ad valorem counterpart.
Lin and Mai (1993) use a trade model between a country with a labor union and a capitalist
country without a labor union to study the short and long term optimal policies of each country
when firms are imperfectly competitive and constrained by organized labor. The authors argue that
the greater the expansion elasticity of labor demand with respect to output in the labor exporting
country, the greater the possibility of an optimal trade intervention in the capitalist importing
country. Hatta and Ogawa (2007) study optimal tariffs in the presence of a constraint on
government revenues and find that the optimal tariff is lower for imported goods that are close
substitutes to exported goods.
Larue, Gervais and Pouliot (2008) show that the ranking of specific and ad valorem tariffs
generating the same domestic prices when domestic production is monopolized is ambiguous, but
that the specific tariff is better when the variable anchoring the comparison is the volume of
imports.
Itagaki (1985) analyzes optimal tariff for small and large country under uncertain of terms
of trade. The result is that the optimal tariff for the small country remains zero when policy makers
take into account the change of producers/consumers behavior after observing market prices.
In summary, even if specific and ad valorem tariffs are equivalent in a competitive
environment, there is no general or unambiguous ranking between the two types of tariff when
markets are imperfectly competitive.
2.2.2. Welfare maximizing with retaliation (Tariff war)
Johnson (1953) showed that a country can improve its welfare by imposing a tariff even if
its trade partner retaliates, but he pointed out that tariff wars are more likely to make all countries
worse off. Tariff wars are usually analyzed using the concept of Nash equilibrium. This is the case
with the model developed by Kennan and Riezman (1988). The authors develop a model of two
countries with identical Cobb Douglas preferences. Countries have different endowments of
tradable goods. Kennan and Riezman (1988) find that large countries win tariff wars when the big
country has larger endowments of both goods or a lot more of one good and “enough” of the other
7
to be “big enough” to win a tariff war. Similarly, Syropoulos (2002), using the ratio of factor
endowments between countries for their relative size, finds with a more general model that a
country prefers a Nash non-cooperative equilibrium to free trade when it is relatively large.
Other studies have compared domestic and foreign trade policies. Tanaka (1992) concludes
that, with integrated markets3, a small specific (ad valorem) tariff in the domestic country has the
same effect as a small specific (ad valorem) tariff in the foreign country provided the original
equilibrium is free trade. Burbidge and Myers (2004) use a tariff war model to show that high
revenue collection and redistribution costs by governments might lead to low non-cooperative
tariffs. The authors also observe that there is a possibility for a government with low collection cost
to win a tariff war.
Opp (2010), using a 2-country Ricardian model with a continuum of goods, find that
countries tend to apply higher tariff rates when specialization gains from comparative advantage are
high and transportation cost is low. A sufficiently large economy prefers the Nash tariffs
equilibrium to free trade, but the required threshold size is increasing in comparative advantage.
Ogawa (2012) analyzes the properties of Nash equilibrium tariffs when two countries trade a large
number of goods. Uniform tariffs emerge when the elasticities with respect to the price of the
numeraire good are equal across all non-numeraire goods in both countries. It is also shown that if
the optimal intervention on a given good by the home country is an import subsidy, that of the
foreign country is an export tax and the home subsidy cannot be higher than the foreign tax.
Finally, another strand of the literature studies optimal tariffs under uncertainty. For
instance, Choi and Lapan (1991) study optimal trade policies for a developing country that relies on
trade policy revenues to finance the supply of a public good under international price uncertainty.
They find that the optimal specific tariff dominates the optimal quota when demands for private
goods are independent of the public good, but the ranking between the two instruments generally
depends on risk attitude and ordinal preferences.
2.3. Cooperative trade policy
The interest of this essay is in the outcomes of tariff negotiations, more specifically the
endogenous choice between specific and ad valorem tariffs and the implications of constraining the
choice. Nash (1950, 1953) formally explores the outcome of negotiation under what has become the
concept of Nash bargaining solution. The solution derives from a set of axioms that defines the
properties that the outcome of negotiations should have. It does not model the bargaining game, but
it is often used as an approximation to a formal bargaining model like the alternating offer in
3
8
Integrated markets are those in which prices are equal over the world because of arbitrage (Tanaka, 1992).
Rubinstein (1981) and Stahl (1972). The axioms are invariance to equivalent utility representations,
Pareto efficiency, symmetry and independence of irrelevant alternatives4. In our context, the Nash
bargaining solution solves:

   U t   U t  .
Max NP  U A  t2   U Ath t2 N
t1 ,t2
B
Bth
N
1
(1)
1
In this formula, in the context of trade, U A  t2  is the utility of consumers in country A written as a
function of country A‟s tariff on good 2 (imported from country B). U B  t1  is the utility of
consumers in country B which is a function of country B‟s tariff on good 1 (imported from Country
A). U Ath (t2 N ) is country A‟s consumer threat point utility (th superscript for threat) which is
defined as a function of country A‟s non cooperative tariff, t2 N , and U B th (t1N ) is country B‟s
consumer threat point utility that is expressed as a function of country B‟s non-cooperative tariff ,
t1N .
The intuition behind the Nash product is that the stakeholders must reach an agreement which
improves their welfare in comparison to their respective threat points. Moreover, each country
wants to be as far as possible to the threat point. Consequently, the solution of the negotiation game
comes from the maximization of the Nash product. For asymmetric games, a parameter representing
the bargaining power (  ) could be used as in Beghin (1996) and Binmore et al. (1986). The
formula becomes:

   U t   U t 
Max NP  U A  t2   U Ath t2 N
t1 ,t2

B
Bth
1
N
1
1
.
(2)
The country which has a higher negotiation power has the greatest value between 1   and
 . Copeland et al. (1989) show that in a bargaining game, the player endowed with the
most bargaining power prefers a tariff to a quota regardless of the strategy of its trade
partner. Assumptions about the functional forms for the utility and production function
often affect the outcome of the Nash bargaining solution. Indeed, Butler (2004) finds that a
linear utility function is not a good choice to generate meaningful Nash bargaining solution.
The author notes that quadratic utility functions are more appropriate in the Nash
bargaining game because the quadratic form allows for more compromise. For the
production function, many functional forms perform well. A common simplification, like in
Kennan and Riezman (1988) and Epifani and Vitaloni (2003), is to replace the production
4
For an insightful discussion of the axioms and the interpretation of the Nash bargaining solution, see
Muthoo (1999).
9
function by endowments. This simplifies the model and makes it easier to find analytical
solutions. It is also consistent with supply being perfectly inelastic in the short run, which is
a common assumption for agricultural production.
Mayer (1981) develops a theoretical framework to analyze outcomes of tariffs
negotiations. The author compares tariff negotiation outcomes with Nash non-cooperative
outcomes or free trade. The comparison with the retaliation outcomes makes it possible to
ascertain the extent by which negotiations improve a country‟s welfare. The noncooperative solution is used as a fall-back position when negotiations fail. The comparison
with free trade provides an assessment of the distortions embodied in bilateral trade
agreements. The tariff resulting from a negotiation game can be negative. In fact, Mayer
(1981) shows that a small country has incentives to subsidize imports in a negotiated tariff
agreement. Syropoulos (1994) discusses a case involving a negative tariff. The intuition
behind the negative tariff is that it is a mean to make one‟s trade partner less aggressive in
the setting of its tariff. Copeland et al. (1989) consider the possibility of lump sum
transfers to enlarge the set of possible solutions to the implicit negotiation game. When one
of the tariffs is negative, the country subsidizing removes the option of retaliation by the
other country. In our case, we assume that all tariffs are weakly positive. We posit that
import subsidies would not be sustainable politically as it would prove difficult for a
government to deflect accusations of being manipulated by foreign interests to the
detriment of domestic producers.
2.4. Trade policy and non-economic determinants: a political-economy criterion
According to Baldwin (1989), two main approaches are used to incorporate political
influence in the determination of trade policy: one approach focuses on political agents‟ self-interest
while the other approach revolves around social concerns of voters and public officials. For the
same author, trade policy should include both self and social interests. As mentioned in a previous
paragraph, Grossman and Helpman (1994) posit that there are motives other than welfare
maximization to rationalize trade policies. For instance, powerful lobbies invest financial resources
to influence trade policy. Grossman and Helpman (1995) find that government action in the
international arena reflects domestic concerns. Traditionnally, studies on trade policy have
considered governments as social welfare maximizers. Since the 1990s, a growing number of trade
policy studies have allowed domestic and foreign lobbies to influence the policy process. Gawande
et al. (2005), McCalman (2004) and Dutt and Mitra, (2005) have estimated the weight of social
10
welfare in the objective function of governments as a way to provide empirical support for the
classic Grossman and Helpman (1994) model. In general, they find that relatively high weights are
on social welfare. Facchini et al. (2006) empirical analysis reveals that the government is the
stakeholder who captures most rent from trade policy through tariff revenue collection. The above
studies dwell into the possibility of non-exclusivity of economic determinants of trade policy. The
debate in this literature is on the empirical estimate of the weight on political contributions and
welfare in the governments‟ objective function. Maggi and Rodríguez-Clare (2007) also state that
apart from classical terms of trade, domestic lobbies influence trade agreements. They find that, in
the presence of strong domestic lobbies, trade liberalization is deeper when the capital is more
mobile across sectors.
Hillman and Ursprung (1988) use political support, proxied by producer support, as the main
element in the objective function to optimize. They find that tariffs divide stakeholders, but that
voluntary export restrictions conciliate the stakeholders‟ interests. Chang (2005) analyzes the
impact of politics on trade policy under monopolistic competition. He finds that the endogenous
optimal tariff is always a tariff and the welfare-maximizing import policy is a positive import tariff.
Finally, Mitra (2002) uses a bargaining model with endogenous protection and fixed costs for
political organization. He finds that low bargaining import competing lobby leads to free trade.
When the cost of organizing the lobby is high, the government prefers free trade.
11
3. THEORETICAL MODEL
We investigate the choice of policy instrument in trade negotiations using a trade model of
two countries and two goods. Country A and country B both produce goods 1 and 2. Consumers in
the two countries have the same Cobb Douglas utility functions and production of goods is modeled
using endowments as in Kennan and Riezman (1988). We assume that country A has a comparative
advantage in the production of good 1 and country B a comparative advantage in the production of
good 2. Countries impose tariff on their imports. Thus, country A imposes tariff on the imports of
good 2 and country B imposes a tariff on the imports of good 1. Endowments are different such that
trade is potentially welfare increasing for both countries. This simplification allows for more
manageable expressions.
To find the type of tariff that each country chooses in trade negotiations, we use a two-stage
approach. First, country A and country B simultaneously choose between specific and ad valorem
tariffs. Second, countries negotiate tariffs. Figure 1 shows the two stages of the game along with
each country‟s payoffs. The payoffs (a, b, c, d, e f, g, h) of the game in figure 1 are the consumer
indirect utility function obtained by replacing the tariffs by their Nash bargaining solution values.
Negotiation
A
Specific
Ad valorem
B
Ad valorem
(a, b)
Specific
(c, d)
B
Specific
Ad valorem
(e, f)
(g, h)
Figure 1: Game tree for trade negotiation
We will solve the model by backward induction. First, we will calculate welfare for each
branch of the game in figure 1. That is, we will find values for a, b, c, d, e, f, g, h. Then, we will
find what type of tariff countries choose and find the outcome of negotiations.
13
3.1. Ad valorem tariff game
This section presents the solution for the case in which both countries use an ad valorem
tariff. That is, we seek final values for a and b in figure 7. Recall from expression (2) that the
outcome of negotiations depends on the threat point of each country. In our case, the threat points
are the welfare in each country in a tariff war. This would constitute the outcome if negotiations
were to fail. Thus, we first solve for solutions for the tariff war. Then we use those solutions to find
the negotiation solutions using the Nash bargaining solution.
Let us first consider the outcome of tariff war for country A. The Cobb Douglas utility
function of country A is: U A  D1 A D2 A , where D1 A is country A‟s consumption of good 1 and D2 A
is country A‟s consumption of good 2. The Lagrangian of the maximization of country A‟s utility
under its budget constraint is:
A
A

Lad ,ad  D1 A D2 A    P1 X1 A  1   2  P2 X 2 A   2 P2 M 2  PD
1 1  1   2  P2 D2  .
(3)
In this maximization problem, P1 and P2 are respectively the world prices for good 1 and 2,  1 and
 2 are respectively country B‟s ad valorem tariff on good 1 and country A‟s ad valorem tariff on
A
A
good 2. X 1 and X 2 are respectively country A‟s production of good 1 and country A‟s
production of good 2. The budget constraint is the difference between the total revenue of country
A (given by the sum of the producers total revenue in good 1, the revenue from good 2 and the
government revenue (which is the tariff times the total revenue from the imports of good 2) and its
expenditures) and, the total
expenditure (given by the sum of country A‟s expenditures on good 1
and the expenditures on good 2).
The ratio of the first order necessary conditions for utility maximization by country A for an
interior solution is:
D2 A
P1

.
A
D1
1   2  P2
(4)
A
A
To express the ratio in (4) as a function of exports and imports, we write D1 and D2 as a
function
of good 1‟s import and export. Country A‟s production of good 1 ( X 1 A ) is replaced by its
endowment (  ) and country A‟s production of good 2 ( X 2 A ) is 1   . E1 is country A‟s exports
of good 1 and
M 2 , country A‟s imports in good 2. Hence, D1 A and D2 A are
D1A  X1A  E1    E1 and D2 A  X 2 A  M 2  (1     M 2 .
14
Expression (4) becomes:
1     M 2
  E1

P1
1   2  P2
.
(5)
We can replace the ratio P1 / P2 using the budget constraint in (5) and substitute for the expressions
for D1 A and D2 A . Then normalizing the price of good 2 to one, the price ratio is:
P1 
M2
.
E1
(6)
Then using (6) in (5), letting P2  1 , yields country A‟s implicit offer curve for good 1:

E1
 2  2  
1   1   2  .
(7)
M2
For country B, we can derive an expression for the implicit offer curve using a similar
procedure. After a few calculations, we can obtain country B‟s implicit offer curve for good 2 as:

M2
 2  1 
1   1  1  .
(8)
E1
As in Kennan and Riezman (1988), expressions (7) and (8) define a system of equations that
describes trade volumes as a function of ad valorem tariffs. Thus, solving (7) and (8) yields
solutions for E1 and M 2 .
E1 
1    1  1     2  1 1   2    
;
 2    2   1 1   2    1  2
M2 
1    1  1     2  1 1   2    
.
 2   1  1   2   2 1      2
(9)
(10)
Using (9) and (10) in the first order necessary conditions for the utility maximization for the two
countries, we can solve for the quantities demanded by both countries:
D1 A   
1    1  1     2  1 1   2    
;
 2    2   1 1   2    1  2
D2 A  1   
1    1  1     2  1 1   2    
;
 2    2   1 1   2    1  2
(11)
(12)
15
D1B  1   
D2 B   
1    1  1     2  1 1   2    
;
 2    2   1 1   2    1  2
(13)
1    1  1     2  1 1   2    
.
 2    2   1 1   2    1  2
(14)
Using these solutions in the utility functions of country A and country B yields indirect utility
functions defined in term of tariffs and endowments of goods:

1    1  1     2  1 1   2    
T A   

 2    2   1 1   2    1  2


1    1  1     2  1 1   2    
1   

 2    2   1 1   2    1  2


1    1  1     2  1 1   2    
T B  1   

 2    2   1 1   2    1  2


1    1  1     2  1 1   2    
  

 2    2   1 1   2    1  2


;


(15)

.


(16)
The solutions in (15) and (16) are the threat points that enter into the Nash product.
The next step is to find the reaction functions  2 ( 1 ) for country A and  1 ( 2 ) for country B.
The reaction function of a country is obtained by taking the first derivative of its utility with respect
to its imports‟ tariff and by solving for this tariff as a function of the foreign country‟s tariff. The
first order necessary conditions are: T A  2  T B 1  0. We will not write these expressions
as they are too cumbersome to be insightful.
The reactions functions cross multiple times and therefore there are several solutions for the
tariff
war.

However,

we
are
interested
in
the

nonnegative

solutions
which
are:
1N  1       /    1   / 1      1 and  2 N  1       /   1    / 1      1 . The
0.5
0.5
model uses the same assumptions as in Kennan and Riezman (1988) and thus yields the same
solutions. Proposition 1 in Wong (2009) states that equilibrium uniqueness is assured if countries
have identical CES utility functions. Since the Cobb-Douglas utility function is a special case of the
CES utility function, equilibrium uniqueness follows.
Figure 2 shows an example of reaction functions for the ad valorem tariff game assuming
  0.75 and   0.6 . The intersection of the reaction functions is the non cooperative
equilibrium described in the previous paragraph. In this example, the reaction functions are
downward sloping and convex. Tariffs are strategic substitutes as an increase in one tariff is
matched by a decrease in the other. One implication is that both countries would prefer to be firstmover in a sequential game than playing simultaneously. Country A chooses a tariff rate of certain
percentage and country B opts for a tariff rate of another percentage. The difference is due to the
negotiation power of one country on the other and the fall-back position obtained with the threat
point.
16
2
1 ( 2 )
0
1
.2
.4
.6
.8
.0
 2N
 2  1 
1
1
N
Figure 2: Reaction functions for ad valorem tariff for imports by country A and ad valorem tariff
for imports by country B with   0.75 and   0.6
From expression (1), the Nash product for negotiation when both countries use ad valorem
tariffs is:



NPad ,ad  Tad A  Tad AN Tad B  Tad B N .
(17)
Tad AN and Tad BN are respectively the indirect utility functions for country A and country B
under ad
valorem tariff war obtained by substituting for  1N and  2 N in (15) and (16).
Tad
AN





1    1  1     2 N  1N 1   2 N   

  
 2 N    2   1N 1   2 N    1  2









1    1  1     2 N  1N 1   2 N   

Tad BN  1   
 2 N    2   1N 1   2 N    1  2










1    1  1     2 N  1N 1   2 N   

1   
 2 N    2   1N 1   2 N    1  2





1    1  1     2 N  1N 1   2 N   




 2 N    2   1N 1   2 N    1  2













(18)
(19)
The Nash bargaining solutions are given by the first order necessary conditions for the
maximization of the Nash products:
NPad ,ad
1

NPad ,ad
 2
 0.
(20)
Figure 3 shows a graph of the first order necessary conditions for the bargaining game in addition to
the reaction functions for the tariff war for   0.75 and   0.6 .
17
Figure 3 illustrates two equilibria at the intersections of reaction functions: 1) an
unconstrained equilibrium featuring a negative tariff, and 2) a constrained equilibrium
with non-
negative tariffs. The unconstrained equilibrium stems from the solution of the first order conditions.
This is Mayer‟s (1981) classic result that points out that a small country prefers to subsidize imports
rather than adopt a free trade policy when bargaining with a large country. We will limit our
analysis to non-negative tariffs as imports subsidies are seldom used except under unusual
circumstances like the 2008 food crisis (Throstle, 2008). This constrained solution will be dubbed
by our tariff war solution. It is a solution because the threat point bounds the Nash product, but, it is
not the bargaining solution that we seek as no country imposes its welfare at the bargaining
solution.
1.0
0.8
0.6
0.4
0.0
0
0.
0.2
6
2
1  2 
 2  1 
 2  1 
*
 1  2 
*
1
Figure 3: First order conditions for bargaining solutions for ad valorem tariff for imports by country
A and ad valorem tariff for imports by country B with   0.75 and   0.6
The solution for the bargaining game that we will use is given by the constraint on the non
negativity of tariffs. The curve for the first order conditions for the bargaining solutions both cross
the vertical axis in figure 3. In this case, a successful negotiation yields an equilibrium where  1 = 0
and  2 > 0. The first order conditions for  2 , holds with the equality, NPad ,ad  2  0. We use the
second solution to complete the game tree in figure 1.
18
3.2. Specific tariff game
This section considers that country A and country B use specific tariffs such that   0.75
and   0.6.
The method to find solutions is the same as in section 3.1. First, we can write the Lagrangian
for the welfare maximization in country A when countries do not collaborate:
A
A

Lsp,sp  D1A D2 A    P1   P2  t2 1     t2 M 2  PD
1 1   P2  t2  P2 D2  .
(21)
Maximizing (21) with respect to D1 A and D2 A , the ratio of the first order conditions for utility
maximization by country A for an interior solution is:
D2 A
P1

.
A
D1
P2  t2
(22)
A
Expression (22) is different from (4) because country A is now using a specific tariff. We write D1
A
A
and
and D2 as a function of good 2 imports (M2) and good 1 export (E1): D1    E1
D2 A  1     M 2 . Expression (22) becomes:
1     M 2
  E1

P1
.
P2  t2
(23)
We can replace the ratio P1 / P2 using the budget constraint in (23) and substitute for the expressions
for D1 A and D2 A . Then normalizing the price of good 2 to one, the price ratio is as follows:
P1 
M2
.
E1
(24)
Then using (23) in (24), normalizing P2  1 , yields country A‟s implicit offer curve for

E1
  2  t2  
1   1  t2  .
M2
good 1.
(25)
For country B, we can derive an expression for the implicit offer curve using a similar procedure.
After a few calculations, we find that country B‟s implicit offer curve for good 2 is:

M2
 2
1   t1 1    E1 

.
E1
M2
(26)
We can find the solutions for E1 and M 2 using the offer curves in (25) and (26). The solutions are:
19
E1 
M2 

2  2t2  t1  t2 (  1)  3  2   t2   t12 t2   1    2
2  t    2  22  2t  1  t    2  t     2  t 2  
2
1
2
2
2
2t1  2  t2 

 
;

2
2

2 
4  2  2t1  t1 2  2t22 1   1     4  t2  6  t1 2  6    t1  3  4     t12 t2   1    2  t2    2   2  2t1  1  t2    2  t2     2  t2   





2  2  t2  t2   1  2

.
Using these expressions for E1 and M 2 in the first order conditions for the utility maximization for
the two countries, we can solve for the quantities



 
demanded by both countries:

2
2
2
2  2t2  t1 t2    1  3  2  t2   t12 t2   1    2  t2    2   2  2t1  1  t2    2  t2     2  t2   


D1   
,
2t1  2  t2 
A
A
D2  1   

 

2
2



2
4  2  2t1  t1 2  2t22 1   1     4  t2  6  t1 2  6    t1  3  4     t12 t 2   1    2  t 2    2   2  2 t1  1  t2    2  t2    2  t2  





2 2 t
2




t 2    1  2
 

,

2
2
2
2  2t2  t1 t2    1  3  2  t2   t12 t2   1    2  t2    2   2  2t1  1  t2    2  t2     2  t2   


D1  1   
,
2t1  2  t2 
B
B
D2   

 

2
2



2
4  2  2t1  t1 2  2t22 1   1     4  t2  6  t1 2  6    t1  3  4     t12 t2   1    2  t2    2   2  2 t1  1  t2    2  t2    2  t2  





2  2  t2  t2   1  2

.
Using these solutions in the utility functions of country A and country B yields indirect utility
functions. As the expressions are too cumbersome, we will not write them.
The next step is to find the reaction functions t2 (t1 ) for country A and t1 (t2 ) for country B.
We proceed exactly as in section 3.1. That is, the reaction function of a country is obtained by
taking the first derivative of its utility with respect to its
imports‟ tariff and by solving for this
tariff as a function of the foreign country‟s tariff. The first order necessary conditions are:
T A t2 T B t1  0. As the expressions are difficult to interpret, we will not write them.
Conversely to the case of ad valorem tariff game where we were able to find analytical expressions
for the non cooperative ad valorem tariffs, it is difficult to find such expressions for the non
cooperative specific tariff game. The derivation of the ad valorem tariffs in Kennan and Riezman‟s
working paper is highly complex, even though it rests on several simplifying assumptions.
We instead rely on numerical examples. Let us show graphically the solutions for the
specific tariffs. Figure 4 shows reaction functions for specific tariff war assuming
  0.75 and
  0.6 . The reaction functions are downward-sloping and concave. As such, their curvature
differs from the one associated with ad valorem tariffs. The intersection of the reaction functions is
the non-cooperative equilibrium.
20
t2
t1 (t2)
t2 N
t2 (t1)
t1
t1N
Figure 4: Reaction functions for specific tariff for imports by country A and specific tariff for
imports by country B with
  0.75 and   0.6
We can investigate the cooperative equilibrium. From expression (1), the Nash product for
negotiation when both countries use specific tariffs is:



NPsp ,sp  Tsp A  Tsp AN Tsp B  Tsp BN .
Tsp AN and Tsp BN are respectively the indirect utility functions for country A and country B under
specific tariff war, obtained by substituting for t1N and t2N in TAN and TBN.
Nash bargaining solutions are given by the first order necessary conditions for the
maximization of the Nash products:
NPsp , sp
t1

NPsp , sp
t2
 0.
Figure 5 shows a graph of the first order necessary conditions for
  0.75 and   0.6 .
Note first that there is an equilibrium with negative tariffs, but again, we will limit ourselves to
nonnegative tariffs. As in figure 2, there are two equilibria to the negotiations. The first is at the
intersection of the tariff war solution and is therefore not the outcome of the negotiation that we are
looking for.
21
2
4
6
8
0
1.
0.
t 1( t2)
t2
t 2( t1)
t2  t1 
*
t1  t2 
*
t1
Figure 5: First order conditions for bargaining solutions for specific tariff for imports by country A
and specific tariff for imports by country B with
  0.75 and   0.6
The second solution is given by the constraint on the non negativity of tariffs. The
curve for the first order conditions for the bargaining solutions both cross the vertical axis
in figure 5. In this case, it means that the second equilibrium is at t1 = 0 and t2 > 0. Thus, a
successful negotiation yields an equilibrium where t1 = 0 and t2 > 0.We use these solution as
the outcome of the negotiation if both countries use specific tariff as in the game tree in
figure 1.
3.3. Specific tariff vs. ad valorem tariff game
This section considers that country A uses a specific tariff and country B uses an ad valorem
tariff. This will give us the solutions for e and f in figure 1. We use the same procedure as in the
previous sections to find the trade negotiation outcome.
The Lagrangian for the maximization of the utility function of country A subject to its budget
constraint is:
A
A

Lsp,ad  D1 A D2 A    P1 X1 A   P2  t2  X 2 A  t2 M 2  PD
1 1   P2  t2  P2 D2  .
(27)
This maximization problem is essentially the same as country A imposes a specific tariff on
imports of good 2 from country B.
22
The ratio of the first order necessary conditions for utility maximization by country A for an
interior solution is:
D2 A
P1

.
A
D1
P2  t2
(28)
We want to find expression for the implicit offer curves for country A and country B. Hence,
we express (28) such that it contains E1 and M2. Using the market clearing conditions for country A,
expression (28) becomes:
1     M 2
  E1

P1
.
P2  t2
(29)
Replacing the ratio P1 / P2 using the budget constraint in (29) and normalizing P2 to one yields,
after few manipulations, the following price ratio:
P1 
M2
.
E1
(30)
The expression in (30) is the same as in section 3.1 and 3.2 because of the normalization of the
price of good 2 to one.
Using (30) in (29), letting P2  1 , yields good 1‟s implicit offer curve for country A.

E1
  2  t2  
1   1  t2  .
M2
(31)
After solving the analogous problem for country B, good‟s 2 implicit offer curve is given by:

M2
 2  1 
1   1  1  .
E1
(32)
We can solve for E1 and M2 using expressions (31) and (32) as a system of equations. The solutions
are as:
E1 
1    1  1     t2  1 1  t2    
;
t2    2   1 1  t2    1  2
(33)
M2 
1    1  1     t2  1 1  t2    
.
t2   1  1    2  t2 1      2
(34)
To find the consumptions for good 1 and 2 for both countries, we replace expression (33)
and (34) in the first order necessary conditions for the utility maximization for the two countries.
The solutions are:
23
D1 A   
1    1  1     t2  1 1  t2    
;
t2    2   1 1  t2    1  2
(35)
D2 A  1   
1    1  1     t2  1 1  t2    
;
t2    2   1 1  t2    1  2
(36)
D1B  1   
1    1  1     t2  1 1  t2    
;
t2    2   1 1  t2    1  2
(37)
D2 B   
1    1  1     t2  1 1  t2    
.
t2    2   1 1  t2    1  2
(38)
Replacing (35), (36), (37) and (38) in the utility function yields the indirect utility functions. We
will not write these expressions because they are cumbersome to interpret.
In the tariff war, countries maximize their indirect utility function such that
T A t2  T B 1  0. We will not write these expressions as they are cumbersome to be
insightful. The first order conditions give the reaction functions. The functions cross at multiple
points but the only plausible solutions for the tariff are: 1N  1        /    1   / 1      1
0.5



and t2 N  1       /   1   / 1   

0.5
 1. These solutions are the same as in
Kennan and Riezman (1988), replacing  2 N with t2 N .
Figure 6 shows an example of reaction functions assuming
  0.75 and   0.6 . The non
cooperative equilibrium, as described in previous paragraphs, is the intersection of the reaction
functions.
24
t2
0
1
 1  t2 
.2
.4
.6
.8
.0
t2 N
t2 1 
1
 1N
Figure 6: Reaction functions for specific tariff for imports by country A and ad valorem tariff for
imports by country B with
  0.75 and   0.6
When country A uses a specific tariff and country B an ad valorem tariff, the Nash product
to find the bargaining solution is:



NPsp ,ad  T Asp  T AN sp T B ad  T BN ad .
AN
In this expression, T sp and T BN ad are respectively indirect utility functions when
country A uses a specific tariff and country B an ad valorem tariff.
We obtain the bargaining solutions by taking the first order necessary conditions of the Nash
product:
NPsp ,ad
 1

NPsp ,ad
t2
 0.
Figure 7 shows a graph of the first order necessary conditions in addition to the reaction functions
for the tariff war for
  0.75 and   0.6 .
We have two equilibria in figure 7, but, as before, we will limit ourselves to nonnegative
tariffs because of reasons stated in section 3.1.
25
1.0
0.8
0.6
0.4
0.0
0.2
 1  t2 
t2
t2 1 
t2 (1 )*
 1 (t2 )*
RBGB
1
Figure 7: Bargaining solutions for specific tariff for imports by country A and ad valorem tariff for
imports by country B with
  0.75 and   0.6
As we limit ourselves to nonnegative tariffs, the outcome of the negotiations is such that
 1 = 0 and t 2 > 0.
3.4. Ad valorem tariff vs. specific tariff game
In this section, country A uses an ad valorem tariff and country B a specific tariff. This will
give us solutions for c and d in figure 1. The derivations are very similar to those in the previous
sections. However, we provide details of the procedure to find the solutions.
The Lagrangian for the welfare maximization in country A when countries do not collaborate
is:
A
A
 (39)
Lad ,sp  D1 A D2 A    P1 X1 A  1   2  P2 X 2 A   2 P2 M 2  PD
1 1  1   2  P2 D2  .
To obtain the consumptions for country A and country B for both goods, we maximize the
A
A
Lagrangian in (39) with respect to D1 et D2 . The ratio of the first order necessary conditions for
an interior solution is:
D2 A
P1

.
A
D1
1   2  P2
26
(40)
Expression (40) is different from (22) because country A is now using specific tariff. Using
the market clearing condition, expression (40) becomes:
1     M 2
  E1

P1
1   2  P2
.
(41)
We replace the ratio P1 / P2 in (41) using the budget constraint in (41) and substituting for D1 A (by
(35)) and D2 A (by (36)). Then normalizing the price of good 2 to one, the analytical expression of
the price ratio is:
P1 
M2
.
E1
(42)
We obtain country A‟s implicit offer curve for good 1 by replacing expression (42) in (41).
The expression of country A‟s implicit offer is as follows:

E1
 2  2  
1   1   2  .
(43)
M2
For country B, we can derive an expression for the implicit offer curve using a similar procedure.
After a few manipulations, we find country B‟s implicit offer curve for good 2 as:

 2
M2
1   t1 1    E1 

.
E1
M2
(44)
Expressions (43) and (44) form a system of equations with unknowns E1 and M2. Solving this
system for E1 and M2 yields:


2  2 2  t1  2 (  1)  3  2   2  

2      2   2 2  2t  1      2       2   2  
;
2  
t12  2   1    2
E1 
2t1
1
2
2
2
2

2
2
2 
4  2  2t1  t1 2  2 2 2 1   1     4   2  6  t1 2  6    t1  3  4     t12  2   1    2   2    2   2  2t1  1   2  2   2   2   2  







M2 
2

 

2 2   2  2   1  2






.
Using these expressions in the first order conditions for the utility maximization for the two
countries, we solve for the quantities demanded by both countries:
D1A   



2      2  2 2  2t  1      2       2   2  
,
2t  2   
2  2 2  t1  2   1  3  2   2   t12  2   1    2
1
D2 A  1   
1
2
2
2
2
2

2
2
2 
4  2  2t1  t1 2  2 22 1   1     4   2  6  t1 2  6    t1  3  4     t12  2   1    2   2    2   2  2t1  1   2  2   2   2   2  








2 2 
2
 
2
 



 

  1  2 
,
2
2
2 

2  2 2  t1  2   1  3  2   2   t12  2   1    2   2    2   2  2t1  1   2  2   2   2   2  


D1B  1   
,
2t1 2   2



 
 


 
 
,

27
D B 

2
2
2 
4  2  2t1  t1 2  2 2 2 1   1     4   2  6  t1 2  6    t1  3  4     t12  2   1    2   2    2   2  2t1  1   2  2   2   2   2  







 



 

.
 

We find the indirect utility functions, for both countries by replacing D1A, D2A, D1B and D2B in the
2 2   2  2    1  2
2
utility functions. We choose not to write these expressions because they are too cumbersome.
The next step is to find the reaction functions  2 (t1 ) for country A and t1 ( 2 ) for country B.
We proceed analogously as is previous sections. That is, we solve the first order necessary
conditions of the Nash product, T A  2  T B t1  0, for  2 and t1 . As the expressions are
cumbersome, we will not write them. Conversely to the case of specific-ad valorem tariff game
where we were able to find non cooperative ad valorem tariffs analytical expressions, it is difficult
to find such expressions for the non cooperative specific tariff game in this case.
Figure 8 shows reaction function for tariff war assuming
  0.75 and   0.6 . The equilibrium of
the non cooperative game is at the intersection of the reaction functions.


t1 ( 2 )
2
N
2
 t
2
1

t1
t1 N
Figure 8: Reaction functions for ad valorem tariff for imports by country A and specific tariff for
imports by country B with
  0.75 and   0.6
The next step is to find negotiation solutions using the Nash product below:



NPad ,sp  T Aad  T AN ad T B sp  T BN sp .
BN
T AN ad and T sp are respectively the indirect utility functions when country A uses an ad
valorem tariff and country B uses a specific tariff. We obtain the Nash bargaining solutions
with the first order necessary conditions of the Nash product:
28
NPad ,sp

 2
For
NPad ,sp
t1
 0.
  0.75 and   0.6 , we show in figure 9 the first order necessary conditions for the Nash
product. We have two equilibria in this figure, but as before we focus on nonnegative tariffs. The
bargaining equilibrium is the one where t1 = 0 and  2  0 .
2
4
6
8
0
1.
0.
t1  2 
2
 1  t2 
 2  t1 
*
 2 (t1 )*
RBGB
t1
Figure 9: Bargaining solutions for ad valorem tariff for imports by country A and specific tariff for
imports by country B with
  0.75 and   0.6
29
4. GOVERNMENT CHOICE OF POLICY INSTRUMENT
The previous section describes the method to obtain solutions for bargaining between two
countries. In this section, we look at the outcome of each bargaining solution under different
assumptions for the endowments by country A and country B. In all scenarios, we will find the
solution in the figure 1, thus establishing each country preference for trade instrument.
Previous literature shows that country size matters when it comes to setting tariff (e.g.
Kennan and Riezman, 1988). Accordingly, we will explore the effect of country size on the game in
figure 1. We will consider the four following scenarios:
(1) country A is large and has a comparative advantage in the production of good 1;
(2) country A and country B are equal size but country A has a comparative advantage in the
production of good 1;
(3) country A is strictly larger and has a comparative advantage in the production of good 1;
(4) country A is strictly larger but does not have a comparative advantage in the production of
good 1.
We define a country as large if the sum of its endowments in good 1 and 2 is larger than the
sum of the endowments of another country. Similarly, we define a country as strictly larger if its
endowments for both goods strictly dominate the size of the endowments of the other country.
Typical of the trade literature, a country has a comparative advantage in good 1 if the ratio of the
endowment in good 1 and good 2 is higher than the same ratio for the other country.
4.1. Country A is large and has a comparative advantage in the production of good 1
The first case we examine is when country A is large and has a comparative advantage in the
production of good 1. This is the same as in the presentation of the model in the previous sections
with parameters
  0.75 and   0.6 . Table 1 shows the solutions for the outcome of the
negotiation between country A and B under the four combinations of ad valorem and specific tariff.
These solutions follow from the solutions as described in figures 3, 5, 7 and 9. Note that because we
normalize the price of good 2 to one and that country A imports good 2, then solutions for tariffs by
country A are all in the same units.
Note in table 1 that the outcomes of the negotiation are such that the small country always set
a tariff equal to zero. For the large country, the tariff is always positive as it still wishes to exploit
terms of trade when negotiating. The threat points from the tariff war allow the large country to
obtain this concession from the small country. Observe that the large country (A) imposes a larger
31
tariff if country B chooses specific tariff over an ad valorem tariff. This is because when country B
chooses a specific tariff, it gives a more favorable fall-back position to country A.
Table 1: Tariffs solutions when country A is large and has a comparative advantage in the
production of good 1 (   0.75 and   0.6 )
Country B
Country A
Ad valorem
Specific
Ad valorem
(0.18, 0)
(0.19, 0)
Specific
(0.18, 0)
(0.19, 0)
Table 2 shows the payoffs of country A and country B from the negotiation. Table 2 is the
normal form of game in figure 1. For country B, ad valorem tariff is a dominant strategy, so that
country B will always use an ad valorem tariff. For country A, there is no dominant strategy
because its payoff stays the same whether it uses a specific or an ad valorem tariff. That is, the
larger country, which has the comparative advantage in the production of good 1, is indifferent
between using a specific or an ad valorem tariff whereas the small country will always choose an ad
valorem tariff. The trade negotiation equilibria are reached when country B uses an ad valorem
tariff.
Table 2: Payoffs for games where country A is large and has a comparative advantage in the
production of good 1 (   0.75 and   0.6 .)
Country B
Ad valorem
Country A
Specific
Ad valorem (0.337, 0.176) (0.340, 0.174)
Specific
(0.337, 0.176) (0.340, 0.174)
From Lockwood and Wong (2000), we know that when two countries switch from ad
valorem tariff to specific tariff, at least one of the countries is better off. That is the case here
because country A improves its situation when using an ad valorem tariff instead of the specific
one.
We then describe solutions for single variables (imports and exports values, the world price,
consumptions for good 1 and good 2 for country A and country B for the negotiation game. Table 3
summarizes the values for these variables for
32
  0.75 and   0.6 .
Table 3: Export, import, world price, consumption in negotiation for   0.75 and   0.6
M2
E1
P
D1A
D2A
D1B
D2B
Ad-Ad 0.162 0.1470 1.101 0.6023 0.562 0.398 0.438
Sp-Sp
0.162 0.1461 1.107 0.6040 0.562 0.396 0.438
Sp-Ad
0.162 0.1470 1.101 0.6030 0.562 0.397 0.438
Ad-Sp
0.162 0.1460 1.107 0.6040 0.562 0.396 0.438
Exports of good 1 and imports of good 2 by country A in the ad valorem tariff negotiation
are respectively higher than exports and imports of country A in a specific tariff negotiation.
Conversely, the world price in an ad valorem tariff negotiation is lower than that of specific tariff
negotiation. Consumptions of good 1 by country A in an ad valorem tariff negotiation is less than
that of specific tariff negotiation. Consumption of good 2 in country A is higher in an ad valorem
tariff negotiation. We have the converse situation for the consumptions of good 1 and good 2 in
country B. Overall; a trade negotiation under ad valorem tariff seems to improve traded volumes
and terms of trade.
4.2. Country A and country B are equal size and country A has a comparative advantage in
the production of good 1
The second case we examine is when country A and country B are equal size and country A
has a comparative advantage in the production of good 1. This is the case considered where
  0.6 and   0.6 . This scenario allows us to isolate the effect of the comparative advantage on
the outcome of the negotiation.
Table 4 shows the tariffs of the negotiation. The two countries set tariffs equal to zero
because no country is larger, no country can exploit terms of trade and no country „‟wins‟‟ a tariff
war. Also, when countries are equal size, specific and ad valorem tariff are equivalent in a tariff
war. Thus, the outcome of the negotiation is free trade.
Table 4: Tariffs solutions when country A and country B are equal size and country A has a
comparative advantage in the production of good 1 (   0.6 and
  0.6 )
Country B
Ad valorem Specific
Country A
Ad valorem (0, 0)
(0, 0)
Specific
(0, 0)
(0, 0)
33
Unlike the results in table 2, all the outcomes of the present scenario are zero. Table 5
presents the payoffs of the negotiation of the game in figure 1.
Table 5: Payoffs for games where country A is large and has a comparative advantage in the
production of good 1 (   0.6 and
  0.6 )
Country B
Ad valorem
Country A
Specific
Ad valorem (0.25, 0.25) (0.25, 0.25)
Specific
(0.25, 0.25) (0.25, 0.25)
All the payoffs are 0.25 in table 5. Consequently the type of tariff does not matter for each
country and there is no dominant strategy, and countries are indifferent between ad valorem and
specific tariffs.
Table 6 shows the values for the variables described in table 3 but
  0.6 and   0.6 .
When the two countries are the same, the world price is equal to one. The trade volumes are all
equal to 0.1 and the consumptions of good 1 and good 2 for both countries are equal to 0.5.
Table 6: Export, import, world price, consumption in negotiation for   0.6 and   0.6
M2
E1
P D1A D2A D1B D2B
Ad-Ad 0.1 0.1 1
0.5
0.5
0.5
0.5
Sp-Sp
0.1 0.1 1
0.5
0.5
0.5
0.5
Sp-Ad
0.1 0.1 1
0.5
0.5
0.5
0.5
Ad-Sp
0.1 0.1 1
0.5
0.5
0.5
0.5
4.3. Country A is strictly larger and has a comparative advantage in the production of good 1
In the third case, we examine is when a country A is strictly larger and has a comparative
advantage in the production of good 1. We assume in this case endowment values of
  0.75 and
  0.4 . We examine this case to determine whether the negotiation is different if a country is
strictly larger.
As in the previous scenarios, table 7 shows that the outcomes of the negotiation are such that
the small country always set a tariff equal to zero. For the large country, the tariff is always positive
as it exploits terms of trade in the negotiation. Again, it is the threat point from the tariff war that
allows the large country to obtain these concessions from the small country. The small country
34
always set a tariff equal to zero. Country A imposes a larger tariff if country B chooses specific
tariff over an ad valorem tariff. When country B chooses a specific tariff, it gives a more favorable
fall-back position to country A.
Table 7: Tariffs solutions when country A is strictly larger and has a comparative advantage in the
production of good 1 (   0.75 and
  0.4 )
Country B
Country A
Ad valorem
Specific
Ad valorem
(0.13, 0)
(0.14, 0)
Specific
(0.13, 0)
(0.14, 0)
Table 8 presents the payoffs of the negotiation as described in figure 1 (game tree). As in
section 4.1, ad valorem tariff is a dominant strategy for country B. Consequently, country B uses an
ad valorem tariff. For country A, there is no dominant strategy because its payoff stays the same
whether it uses specific or ad valorem tariff. That is, the large country, which has the comparative
advantage in the production of good 1, is indifferent between using specific or ad valorem tariff
whereas the small country will always choose an ad valorem tariff. The trade negotiation
equilibrium is when country B uses an ad valorem tariff and country A uses either an ad valorem or
specific tariff (in bold in table 9). This result is consistent with Lockwood and Wong (2000) as table
9 shows that when the two countries switch from specific tariff to ad valorem tariff, at least one of
the countries is better off. In fact, country B improves its situation when it switches from specific to
ad valorem tariff.
Table 8: Payoffs for games where country A is strictly larger and has a comparative advantage in
the production of good 1 (   0.75 and
  0.4 )
Country B
Country A
Ad valorem
Specific
Ad valorem
(0.459, 0.1038)
(0.459, 0.1037)
Specific
(0. 459, 0.1038) (0.459, 0.1037)
Table 9 shows the values for trade volumes, world price and consumptions for both good in
both countries. The pattern is the same as in section 4.1. In fact, country A displays higher trade
volumes under ad valorem trade negotiation whereas the consumptions of good 1 and good 2 are
35
respectively lower and higher. The world price is higher under an ad valorem tariff trade
negotiation.
Table 9: Export, import, world price, consumption in negotiation for   0.75 and   0.4
M2
E1
P
D1A
D2A
D1B
D2B
Ad-Ad 0.0642 0.0590 1.083 0.691 0.664 0.391 0.336
Sp-Sp
0.0630 0.0580 1.093 0.692 0.663 0.308 0.337
Sp-Ad
0.0642 0.0590 1.083 0.691 0.664 0.391 0.336
Ad-Sp
0.0630 0.0580 1.093 0.692 0.663 0.308 0.337
4.4. Country A is strictly larger but does not have a comparative advantage in the production
of good 1
We assume in this section that country A is strictly larger but does not have a comparative
advantage in the production of good 1. Consistently, we assume that
  0.6 and   0.4 . As the
two countries have the same ratio of dotations, let us check whether there is trade or not. To do this,
we compare the ratio of price in autarky in country A and country B. If the ratio is different from
one country to the other, then there is trade. Otherwise, there is no trade and trade negotiation is
irrelevant. The Lagrangian for utility maximization in autarky is:
A
A

L  D1 A D2 A    P1 X1 A  P2 X 2 A  PD
1 1  P2 D2  .
A
(45)
P1 and P2 are respectively autarky prices for good 1 and good 2 in country A. The budget
constraint is the difference between the total revenue of the country and the total
expenditure. The ratio of the first order necessary conditions for utility maximization in
country A for an interior solution is:
D2 A P1
 .
D1 A P2
(46)
For country B, the Lagrangian for utility maximization in autarky is:
LB  D1B D2 B    P1* X1B  P2* X 2 B  P1* D1B  P2* D2 B  .
(47)
P1* and P2* are respectively prices in autarky for good 1 and good 2 in country B. The ratio of the
first order conditions for utility maximization in country B for an interior solution is:
D2 B P1*

.
D1B P2*
Substituting the values for the dotations in (46) and (48) respectively yields:
36
(48)
D2A P1* X1A 1    0.6
 


 1,
D1A P2* X 2A

0.6
and
D2B P1* X1B

0.4
 * B

 1.
B
D1 P2 X 2 1   0.4
Thus, as prices are equal, there is no trade. Consequently, there is no need for one country to buy
one product from the other one.
37
5. DISCUSSION
Our results deserve further discussion. First, we show that in two-country trade negotiations,
the small country strictly prefers an ad valorem tariff. Second, when the two countries are equal
size, the outcome of the negotiation is free trade regardless of the choice of trade instrument.
This essay suggests that in practice, small countries push for the use of ad valorem tariffs
rather than specific tariffs. The reason is that a small country has a better fall-back position if
negotiations break down when it uses an ad valorem tariff.
The model also shows that free-trade as the outcome in negotiation with countries of equal
size is robust to choice of trade instrument. The result contrasts with previous literature. Unlike
Lockwood and Wong (2002), we show that converting specific tariff into its ad valorem equivalent
does not always increase the welfare of at least one of the countries. In our model, countries may be
indifferent between the types of tariff as free trade is always the outcome of negotiation between
countries of same size regardless the type of tariff. This result shows that countries of equal size
negotiating a trade agreement will agree on trade liberalization regardless of the basis on which
negotiations take place.
The comparison between trade volume for negotiations with ad valorem tariff vs specific
tariff negotiation shows that ad valorem tariff negotiation allows for more commerce and lower
world price. Country A‟s consumptions in good 1 and good 2 in an ad valorem tariff negotiation are
respectively higher and lower than that of a specific tariff negotiation. The converse situation is
observed for country B.
39
6. CASE STUDY AND EVIDENCE: URUGUAY ROUND AND NORTH
AMERICAN FREE TRADE AGREEMENT (NAFTA)
We discuss in this section examples of the use of ad valorem and specific tariffs by large
and small countries. We provide examples from the NAFTA.
According to OECD (1999), after the Uruguay Round, most of Canada‟s in-quota tariffs are
ad valorem while most of its over-quota tariffs are specific or of mixed forms. For Mexico, all the
in-quota tariffs are ad valorem while 22% of the over-quota tariffs are specific. In contrast, for the
United States, OECD (1999) reports that the in-quota tariff is about evenly split between ad
valorem or specific forms. Thus, Canada and Mexico, which are small countries in comparison to
the United States, tend to use ad valorem tariff for most of their in-quota tariffs. This is conform to
our results that the large country is indifferent between specific and ad valorem tariff when
negotiating with small countries.
The United States, Canada and Mexico signed NAFTA on January 1, 1994. This agreement is
one the most important trade multilateral in terms of volume of trade, (Public Citizen, nd). NAFTA
allows free trade between the United States, Canada and Mexico except for the following
agricultural products considered sensitive (usually protected by specific tariffs):
- United States: dairy products, eggs, peanuts, peanut butter, sugar, sugar containing products
and cotton;
- Canada: dairy products, eggs, poultry and margarine;
- Mexico: dairy products, poultry, eggs and sugar.
Table 10 summarizes the share of ad valorem and non-ad valorem (specific and mixed) tariffs
in the total tariff line on agricultural products in 2008, 2009 and 2010.
41
Table 10: Share of ad valorem and non-ad valorem tariffs on agricultural products in 2008, 2009
and 2010.
Non-ad valorem duty Ad valorem duty > 15%
Country
MFN
Bound
MFN
2008 6.9
4.7
95.0
43.3
2009 7.0
4.9
95.0
45.8
2010 6.9
5.1
95.0
43.8
2008 17.7
13.8
6.2
10.2
2009 17.8
20.3
6.1
6.1
2010 19.2
12.3
9.7
5.8
2008 39.4
41.1
5.0
6.3
United States 2009 39.5
50.8
4.6
6.0
2010 40.0
40.6
5.8
5.4
Mexico
Canada
Year
Bound
Note: Adapted from WTO (2008b), WTO (2009) and WTO (2010).
In table 10, “Bound” is the share of agricultural products containing at least one bound tariff
line, and “MFN” stands for Most Favored Nation. Non-ad valorem (bound) share for agricultural
products is 6.93% for Mexico, 18.23% for Canada and 39.63 % for the United States. The
frequency of non- ad valorem tariff on agricultural products seems to be increasing with country
size. Ad valorem tariffs in excess of 15% (bounded) made up 95% of all agricultural tariffs in
Mexico, 7.33% in Canada and 5.13% in the United States between 2008 and 2010. The frequency
of high ad valorem tariffs on agricultural products is higher for a smaller economy like Mexico.
Other data would be required to test whether small countries tend to use more intensively ad
valorem tariffs than non-ad valorem tariffs. The data for Canada and the United States suggests that
large countries rely relatively more on non ad valorem tariffs.
Another database from the World Bank allows us to observe the choice of policy
instruments in taxing imports, (The World Bank, 2012). Figure 10 shows the share in percentage for
specific/mixed tariffs for primary products.5
5
Primary products are commodities classified in the Standard International Trade Classification (SITC) in
categories 0 to 4, which include food and live animals, beverage and tobacco, crude materials, inedible,
except fuels, mineral fuels, lubricants and related materiel, animal and vegetable oils, fats and waxes. Primary
commodities also include category 68 which are nonferrous metals. See UNCTAD STAT (2011) for more
information.
42
60
50
40
Mexico
30
Canada
20
United States
10
0
Years
Note: Adapted from The World Bank (2012).
Figure 10: Share (in %) of specific and mixed tariffs in the total line tariff schedule for primary
products
The gaps in the graphs correspond to years for which no information was available.
Overall, Mexico‟s share of specific/mixed tariffs on primary products is less than that of
Canada and the United States, except for 1999 and 2000. It also appears that Canada uses
less specific/mixed tariffs than the United States. Figure 10 supports our finding that small
countries tend to rely less on specific/mixed tariffs compared to large countries.
43
7. CONCLUSION
The conversion of specific tariffs into their ad valorem equivalent was one of the issues
debated during the Uruguay Round of multilateral negotiations. On one side, many countries prefer
specific tariffs as they are not sensitive to price change. Ad valorem tariffs however, facilitate
negotiation as they are unitless and therefore easier to compare across countries and commodities.
This thesis studies preference for specific tariff or ad valorem tariff for countries in a trade
negotiation context. We use a two stage model to find bargaining solutions. In the first stage,
countries choose simultaneously specific and ad valorem tariffs. In the second stage, they negotiate.
Countries‟ tariff choice affects their bargaining solutions. In case the negotiation fails, countries
have their respective threat point as fall-back position. We use a trade model with two countries and
two goods. Consumers‟ utility follows a Cobb Douglas function as in Kennan and Riezman (1988)
and the production consists of country-specific endowments. We use the concept of bargaining
solution as described in Nash (1954) to find the negotiation equilibrium. This research is the first to
investigate the choice of tariff type in trade negotiations.
In the first stage of the model, countries choose simultaneously the type of tariff that they
prefer. Their choice determines their bargaining position. Then countries negotiate a trade
agreement. In investigating the outcome of negotiations, we consider four scenarios:
(1)
country A is larger and has a comparative advantage in the production of good 1;
(2)
country A and country B are equal size and country A has a comparative advantage
in the production of good 1;
(3)
country A is strictly larger and has a comparative advantage in the production of
good 1;
(4)
country A is strictly larger but does not have a comparative advantage in the
production of good 1.
Numerical solutions show interesting results. We find that when a large country negotiates
with a small country, the large country is indifferent between specific and ad valorem tariffs
whereas the small country always prefer an ad valorem tariff. When two countries are equal size,
both are indifferent between specific and ad valorem tariff. Unlike Lockwood and Wong (2000),
switching from a specific tariff to an ad valorem does not always improve the welfare of at least one
country. In fact, switching from a specific tariff to an ad valorem tariff has no impact on the welfare
when countries are equal size.
45
Evidence from NAFTA supports our results in the sense that Mexico and Canada (which are
considered as small countries in comparison to the United States) tends to use ad valorem tariff
more often than the United States.
This thesis brings new insights on how trade negotiations take place. It shows that the choice
of tariff instrument that countries may have an impact on the outcome of trade negotiations. In
particular, it supports the choice of ad valorem tariff by small countries.
46
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