Tariff strategies and small open economies

This paper examines the issue of optimal tariffs for a small economy that trades with a large economy. We define `small' and `large' in the sense that the world prices are determined solely by the large country and, therefore, the small country faces exogenously given world prices. Within this framework it is shown that the small country has an incentive to behave as a Stackelberg leader by committing itself to a non-zero optimal tariff. Although the small country is unable to directly affect world prices, by pre-committing to a non-zero trade tax it induces a reduction of the large country's optimal trade tax, thereby indirectly improving its terms of trade and welfare.