How Tariffs Can Improve World Welfare:

Variety Gains in a Dixit-Stiglitz World*

Volodymyr Lugovskyy*

April 2003

Abstract

Using a standard model of trade with a numeraire agricultural sector and a manufacturing sector producing differentiated goods under monopolistic competition, I show that free trade does not maximize world welfare. Placing tariffs on agricultural imports shifts resources to the differentiated sector and expands the set of globally produced varieties. If consumers value variety, this gain can offset other allocative inefficiencies from the tariff.

This result relies on the Dixit and Stiglitz (1977) finding that monopolistic pricing of differentiated goods distorts resources away from the differentiated goods sector and prevents the economy from achieving the social optimum. However, while Dixit and Stiglitz state that the social optimum requires pricing of differentiated goods below average cost, I claim that the social optimum can be also achieved by the counteractive distortion of the numeraire sector.

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* I thank David Hummels for his helpful comments. All the remaining errors are mine.

* Purdue University, Krannert Graduate School of Management. Email: lugovsky@mgmt.purdue.edu