Uncertainty, Price Stabilization, and Welfare

Abstract

<p>This paper investigates whether a small country facing foreign price instability benefits from active stabilization of the domestic price of the importable. For example, the European Community can be treated as a small open economy facing price instability of agricultural products originating in the United States. A tariff is out of the question because it is not optimal for a small open economy. However, the European Community may stabilize the domestic price of the importable. It is shown that, if the random tariff revenue ex post, domestic price stabilization increases income instability and nonintervention is optimal. If an ex ante rebating scheme is employed, a small country can benefit from domestic price stabilization and there exists a partial stabilization policy that dominates free trade. Partial stabilization of the domestic price with the ex ante rebate requires a variable import levy inversely related to the foreign price of the importable. However, complete stabilization of domestic price, which requires setting a target price and a variable import levy as currently used in the European Community, is not optimal.</p>