A Welfare Ranking of Multilateral Reductions in Real and Tariff Trade Barriers when Firms are Heterogenous

Abstract

Trade liberalization comes about through reductions in various types of trade barriers. This paper introduces, apart from the customary real trade costs (i.e. iceberg and fixed export costs), two revenue generating trade barriers (i.e. an ad valorem tariff and a trade license) into a standard heterogeneous-firms-trade model with Pareto distributed productivities. We derive analytical welfare rankings of all four liberalization channels for an equal effect on two openness measures, for any trade cost level and while all four barriers are simultaneously present, i.e. for any initial equilibrium. We show that when openness is measured at retail prices, not border prices, the welfare rankings are sensitive to the degree of efficiency in revenue redistribution, e.g. the share of tariff revenues wasted on rent-seeking activities. As a result, multilateral tariff reductions can switch from the least to the most preferred mode of liberalization. Among the other three barriers we establish a universal welfare ranking for any strictly positive level of revenue redistribution and for either measure of openness.