occurrence associated with imported input is zI per unit, and imported output does not bring any
risk. Consistent with many cases of IS, suppose the effects of zI on the economy translate into an
increase in the cost of production of the domestic input D. The total cost function is written as
TCD =FC+0.5αD2+βD,
where β = zII reflects the IS externality associated with imports. The marginal cost is
MCD = αD + β.
Profit maximizing behavior of D producer leads to marginal cost pricing behavior, which defines
the supply of input D
PD = αD+ β.
Since DFG and IFG are homogenous commodities, in equilibrium, they face the same price in
1
domestic market:
=P=P=WP(1+t) =τ
DFG =IFG =FG =IFG +IFG = τIFG ,
and the same for D and I:
PD =PI=PDI=WPI(1+tI)=τI.
Initial equilibrium with tariff escalation
Denoting (*) for the equilibrium level, after some simple calculation, we get:
FG* = τ -γ
= τIFG
(1)
DFG* =
IFG* =τ -γ
=τIFG
τι
θτIFG
τι
θτIFG
θ
θ-1 ___
K,
θ
θ-1
, and
(2)
(3)
1 We assume that these tariffs are not prohibitive, i.e., imports take place at equilibrium.
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