TARIFF REDUCTIONS, TERMS OF TRADE AND PRODUCT VARIETY

In a two-country synthesis model we examine implications of a tariff reduction on the gains at extensive margin and the diversification of export basket through development of new varieties of a horizontally differentiated good. Through its resource allocation effect, the tariff reduction raises the number of varieties produced and exported by the Home country if the differentiated good is relatively labour intensive. Though, the worsening of terms of trade (TOT) consequent upon the tariff reduction has a dampening effect, overall, the number of varieties increases. The number of varieties produced and exported by the Foreign country, on the other hand, falls which makes the overall variety gains or gains at the extensive margin due to tariff reduction ambiguous.