The Simple Economics of Optimal Sanctions: The Case of EU-Russia Energy Trade

Abstract

In the wake of Russia’s invasion of Ukraine, EU policymakers are weighing the costs and benefits of restrictions on imports of Russian oil and gas. This paper seeks to inform the debate by studying tariff and embargo policies through the lens of a formal economic model of global energy markets. Our main theoretical result is a formula for the EU’s optimal tariff on Russian energy imports. The optimal tariff balances competing domestic effects—on tariff revenue, on terms of trade with Russia, and on terms of trade with the rest of the world—and also reflects the EU’s desire to damage the Russian economy through worsened terms of trade with both the EU and the rest of the world, as well as lost profits and export tax revenue. While for policymakers willing to accept large enough costs to the EU in order to harm Russia, the optimal tariff is effectively an embargo, those with a lower “willingness to pay” for damage to Russia, in terms of reduced EU welfare, should prefer a tariff that prevents some but not all trade. We also discuss how raising tariffs can, in theory, harm Russia while actually making the EU better off, and we provide a simple, quantitative test for when this is the case. Finally, we use a simple, game-theoretic model to assess the possibility that Russia may retaliate to EU tariffs with an energy embargo. We discuss what factors determine how high the EU can set tariffs before such retaliation becomes economically rational for Russia.

Keywords: Economic sanctions, tariffs, oil and gas trade

JEL Classification: F51, F13