the Lerner symmetry theorem allows us to focus only on the trade policy in one sector. Import policies are certainly more common in practice. We express the trade policy parameter as t, which is one plus the non-prohibitive ad valorem tariff rate in the domestic market. This implies p _=_ tpw, since pZ = pZ. We further have that _dp/dt_ > 0 and Op.OIt _=_ 0, since this is a small country.

Production of the import and the export goods in this country is characterized by a production possibilities frontier. The domestic price ratio p determines the marginal rate of transformation and the production levels (QX (p) and _Q_<sup>_m_</sup> (p)) of the two goods.<sup>9</sup> The demand functions _D_<sup>_m_</sup> _(p,_ T) and D' _(p, T)_ are also determined by the domestic price ratio p and the overall tariff revenue T, which is distributed to the consumer. Tariff revenue is a function of domestic and world prices, which makes domestic demand a function of these as well. Next we impose a balanced trade constraint: **_Pw [Din_** _(Ppp)_ - **_Qrn_** (p)] _=_ [Q<sup>m</sup> _(p)_ - _D_<sup>_m_</sup> _(p, p.)]-_ Thus, the exogenous world price _Pw_ and the tariff rate t determine the domestic price level p, and this, in turn, determines the demand and supply levels of both goods as well as the tariff revenue.lU Government preferences are represented through a very general objective function that depends on endogenous domestic and exogenous world prices as parameters, following Bagwell and Staiger [19991: _G_ (p,pw) _=_ G (p _(t,pW) ,Pw)_ . This is somewhat different than the norm in most papers, where the objective is a simple function of the tariff rate, but there is no loss of generality. We impose the restriction that the improved terms of trade lead to higher welfare for the government when the domestic prices are fixed: _9G_ (p, _p,,) /lPw_ < 0. 11 This structure is quite general: most models of trade policy formation'<sup>2</sup> can be represented this way.

The optimal trade policy tP is given by the first order condition: We assume that the second order condition is satisfied: _Gpp <_ 0. We should note that the optimal policy is free trade (t _=_ 1) in most models regardless of world prices if the government were to maximize social welfare. The presence of positive tariffs _(t >_ 1) implies that political economy motivations are in place. The optimal trade policy might also be a function of exogenous world prices pw*

> 9The production possibilities frontier can be derived from a specific factors model in which each sector employs two factors. One of these factors (capital) is sector-specific and is supplied in fixed quantities while the other (labor) is mobile. An increase in the price of the import good (and thus an increase in p) increases the demand for labor employed in that sector and the wage which, in turn, decreases the profit level in the export sector. This structure is quite different than the ones found in some papers (such as Grossman and Helpman [1994]) where labor is assumed to be in excess supply and to have a constant price so that are there are no production externalities between sectors. This model is presented in more detail in an earlier version of the paper. It is available upon request.

> lf)For a more detailed version of this setting, see Bagwell and Staiger [19991.

> We should note that **_Pw_** is the inverse of the terms of trade given the way we defined our variables.

> 12Grossman and Helpman [1994] and see Rodrik [1995] for an extensive survey.

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