DI * =
τι
θτIFG
(4)
Since PD=τI=αD*(α-1)+zII*, and D*+I*=DI*, we solve for D* and I*:
D* =τI
α-zI
z1K
α-zI
τI
θτIFG
1
θ—1
and
(5)
αK
I * =
α-z
τI
θτIFG
1
θ-1 t
τI
α-zI
(6)
Parameter zI is assumed to be small enough so that α> zI . This leads to a condition for both
domestic and imported input to be positive as the following:
_ 1 θ _ 1 θ
z1DI* < Pi < αD1 * , or z1K [Θtifo ]1-θ [τ1 ]1-θ < 1 < αK [Θtii,g ]1-θ [τ1 ]1-θ . (7)
Total welfare of the economy include the following components: the consumer surplus
associated with FG consumption, the surplus from the derived demand of DI captured in the
profit equivalent to the producer surplus associated with the supply of DFG, the producer surplus
associated with the supply of D, and the tax revenues generated by the imposition of τIFG and τI .
Reducing tariff escalation via a final-good tariff decrease
We now reduce the tariff escalation by reducing the tariff (and the associated factor) on the
processed final good, tIFG , to tINFG < tIFG ( τINFG < τIFG ) and keeping tI constant. The new
equilibrium, denoted by the double asterisk (**), is:
FG**=τN -γ
IFG
DFG**=
τι
Θun
τIFG
θ
θ-1___
K,
(8)
(9)
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