On optimal second-best trade intervention in the presence of a domestic divergence

Abstract

When a domestic divergence such as an externality is associated with the production (or consumption) of a good, the optimal first-best intervention typically is a production (or consumption) tax-cum-subsidy (Meade 1955; Bhagwati and Ramaswami 1963; Johnson 1965). Sometimes this first-best policy instrument cannot be used, perhaps because the government dislikes explicit subsidies for political reasons or because of high costs of raising or dispersing government revenue. In extreme cases the government may allow only a trade intervention on this good. The question then arises as to what is the optimal second- best trade intervention in the presence of an externality associated with the production or consumption of a tradable. To our knowledge only two studies have addressed this question previously, and both analyses contain errors.