The Impact of Optimal Tariffs and Taxes on Agglomeration

integration has proceeded.

6 Transfers

The last section has demonstrated that maximizing aggregated welfare may
go ahead with losses of the less developed region. Therefore the question
arises why regions who loose by cooperation may agree in common tariff
reductions. One possible answer can be that the loosing regions are some-
how compensated for the expected welfare loss, for instance by correspond-
ing monetary transfers. Introducing transfers in the model requires some
changes of the basic assumptions. To hold these changes as simple as pos-
sible transfers R are assumed to be paid from the foreign to the domestic
region. Then, a positive sign of R indicates transfers to and a negative sign
indicates transfers from the domestic region. Furthermore, these transfers
are financed by government revenues such that government spending is given
by G = GI + GA + R in the domestic region and by G* = GI + G*A — R in
the foreign region. Under these assumptions the wage rates from (9) change
to:

σ(1 + R)P^1-σTΘ* + (1 — R) [σP*^1-σT*+γ(1 — L)(ΘΘ*-1)]
w = ^Y (σP*^1-σT* — γ(1 — L))(σP ^1-σT — γL) — γ²ΘΘ*(1 — L)L

(16)

_*_ ^ σ(1 — R)ΘP*^1-σT* + (1 + R) [σP^1-σT + γL(ΘΘ* — 1)]

w = ^Y (σP *^1-σ T * — γ(1 — L))(σP^1-σ T — γL) — γ ²ΘΘ*(1 — L)L

and income from (7) modifies to

Y(R) = T [1 + Lw + R],    Y*(R) = 1 [1 + (1 — L)w* — R] ,    (17)

depending now on the level of transfers. Optimal tariffs and taxes with and
without cooperation, (12, 14, 15) stay valid and do not have to be modified
as can be prooved easily.

The interesting question is now whether optimal policy under cooperation
generates enough additional wealth to finance transfers compensating the

14

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