Variable returns to scale and the pure theory of international trade.

Abstract

Recently, trade theorists have shown that perfect competition and static increasing returns can be reconciled by the introduction of external economies and the competitive output is efficient when the externalities are output generated. This study deals with some previously unexplored but important aspects of international trade in light of this type of economics of scale. The topics under investigation are the gains from trade, the theory of customs unions, the theory of nominal tariffs and economic expansion. Most of the conventional results based on the assumption of constant returns to scale do not carry over to the case of variable returns to scale in a straightforward manner. For example, in a small country model, the optimality of free trade breaks down if the industry production functions are subject to divergent returns to scale. Furthermore, social welfare can be maximized by introducing, in addition to free trade, a policy of production tax-cum-subsidy such that the output of the industry exhibiting greater (smaller) elasticity of returns to scale is pushed to the maximum (minimum). In addition, the introduction of tariffs and production subsidies may be either harmful or beneficial whereas the imposition of consumption taxes is always harmful. A production subsidy is superior to an equivalent rate of tariff while a consumption tax may be either superior or inferior to an equivalent rate of tariff.