Smuggling and welfare in a Ricardo-Viner economy

Introduction Since the inauguration of modern, general equilibrium analysis of smuggling by Bhagwati and Hansen (1973), the standard framework for analysis has been some version of the Hecksher-Ohlin-Samuelson (HOS) model. Moreover, with the notable exception of Sheikh (1974), the standard framework depicts smuggling as an activity that uses no domestic resources. In this article we alter the standard framework by treating smuggling as a resource-using activity occurring at legal entry points within a Ricardo-Viner (RV) economy. We pursue this alternative framework for several reasons. First, not only has the RV model become a standard tool of trade policy analysis, but recent research by Grossman and Levinsohn (1989) suggests that markets react to trade-related information releases in a manner consistent with the short-run time horizon. If we follow Mayer (1974), Mussa (1974), and Neary (1978) in treating the RV model as representative of the short run, analysis in the RV context provides a useful depiction of the immediate welfare effects of policy changes in the presence of smuggling[1]. Second, descriptions of smuggling provided in Norton (1988) and in Deardorff and Stolper (1990) suggest that domestic resources are absorbed by smuggling activity and, thus, that smuggling shrinks the productive sectors. Third, the descriptions of smuggling provided by Pitt (1981) for Indonesia and Jenkins (1992) for containerized shipping suggest the importance of camouflaged illegal trade occurring at legal entry points. We consider the effect on welfare of the existence of a smuggling sector. We find that the presence of smuggling is welfare-improving only if the resulting reduction in the domestic price distortion outweighs the loss caused by the