Search frictions reduce optimal tariffs and welfare gains
A Federal Reserve International Finance Discussion Paper studies the interaction of tariffs with goods-market search frictions. The research finds that search frictions reduce optimal unilateral and Nash tariffs and attenuate welfare responses to tariff changes.
Beyond standard optimal tariff theory
A new Federal Reserve International Finance Discussion Paper introduces a general equilibrium dynamic model to study tariffs, incorporating search frictions between heterogeneous exporting producers and importing retailers.
The research by Pawel M. Krolikowski and Andrew H. McCallum demonstrates that search frictions add two novel terms to the standard optimal tariff expression.
One term suggests lower tariffs when contact rates are low, while the other applies when private export costs exceed social opportunity costs.
Furthermore, search frictions create new incentives to subsidize imports due to market thickness effects, extending existing frameworks to account for these real-world complexities.
The model is calibrated using U.S. and Chinese data from 2016, providing a realistic basis for its quantitative findings.
Lower tariffs, attenuated welfare gains
The quantitative analysis reveals significant impacts of search frictions on trade policy outcomes.
The optimal U.S. unilateral tariff, when accounting for baseline search frictions, is approximately 20 percentage points lower than in a counterfactual scenario where international search costs are reduced to domestic levels.
Crucially, search frictions attenuate welfare gains from optimal tariff policies.
For instance, moving from baseline tariffs to optimal unilateral tariffs raises U.S. welfare by only about 0.03 percent with baseline frictions, compared to a 1.0 percent increase with reduced frictions.
This attenuation occurs because search frictions lead to fewer matched varieties, and tariffs primarily affect aggregates through the intensive margin of already matched varieties.
Frictions reshape trade policy
This study significantly advances trade policy modeling by integrating realistic search frictions, a prevalent firm-level obstacle for exporters.
Its quantitative results underscore that traditional tariff models may substantially overestimate both welfare impacts and optimal tariff levels.
Policymakers should consider these nuanced effects when designing trade strategies, moving beyond simplified assumptions to account for the complexities of international market interactions.