through a decrease in the tariff on imported processed good and holding the tariff on imported
raw input constant, increases total welfare by increasing allocative efficiency and reducing IS
risk and externality.
Proof: Comparing producer surplus in DI market before and after reforms, we have PS** > PS*
since by lemma 1, D **> D * and I **< I *. Comparing deadweight loss associated with
supply of DI, since τN <τ and θ< 1 we get that DWL** d< DWL* d. We also know that
, IFG IFG DId DId
welfare in the final-good market, which is the sum of consumer surplus, producer surplus and
tariff revenue increases as the tariff on the final good falls. Therefore, total welfare, the sum of
welfare in final-good and input market increases after reforms. The IS risk and externality
decrease because of the reduction in imports of raw inputs I.h
Some interesting situations lead to special cases of proposition 1. The results stated in
proposition 1 hold when the tariff on imported final good is lowered to any level below its initial
level, hence when it is equal to tariff on imported raw inputs, or when it is removed.
Corollary 1: Under assumptions of sections 3.1.and 3.2., starting from initial tariff escalation,
(i) removing the tariff on the final good increases welfare and reduces IS risk.
(ii) a uniform tariff structure that equates tariff on processed good to tariff on raw input
increases welfare and reduces IS risk.
Finally, we note the special case of a zero the tariff on the raw input in presence of tariff
escalation. In the latter case moving to free trade in all markets is welfare improving and reduces
the externality from IS.
Reducing tariff escalation by joint tariff reduction
We now consider a second policy menu reducing the escalation by reducing both tariffs or
11