StudySpace: Economics in Development, 6th Edition

Worked Example: Effects of a Protective Tariff

The Republic of Ecouter imports radios. Figure 19–2 shows that the supply of radios to Ecouter from the world market is perfectly elastic at a price of Pw = $18 = F6,000 (where F stands for francs, the local currency). At this price, the domestic demand curve (D) shows that 1,000 radios per year are purchased. The market equilibrium is at point E. The line S is the potential domestic supply curve; high-cost domestic producers cannot compete against imports as long as the price is under F7,000.

To promote domestic production of radios, the government decides to levy a 50 percent tariff, which increases the domestic market price of imported radios to PD = PW (1 + t) = 6,000 ×(1.5) = F9,000. This is the protective effect of the tariff. The new market equilibrium is at point E′. As you can see from the supply curve S, domestic producers now can compete against imports up to Q = 500 units of output. (But it remains unprofitable for them to produce more than 500 radios because the marginal cost of further output exceeds F9,000.) In addition to stimulating domestic production, the high market price reduces the equilibrium quantity demanded to 800 radios. The gap between domestic consumption and production, 300 radios, is filled by imports. With the tariff in place, consumers spend F7.2 million on radios (F9,000 ×800). Of this total expenditure, F1.8 million (area f in the figure) is to pay the world price of the imported radios—quite a drop from the F6.0 million spent on imported radios (area e + f + g) before the tariff was imposed. In addition, the consumer expenditure includes F900,000 (area c) that goes to the government as tariff revenue on the imported radios, and F4.5 million (area a + b + e) paid to domestic producers.

FIGURE 19-2

The height of the demand curve at each point indicates consumers’ willingness to pay for the marginal unit of the product. Hence, the area under the demand curve up to any point is a measure of the total value accruing to consumers. Subtracting from this the amount consumers pay for radios gives the consumer surplus. Prior to the tariff, at point E, the consumer surplus equaled the entire area enclosed by the demand curve and line PW. Once the tariff is in place, at point E′, consumers pay more and get less. They suffer a loss of consumer surplus equal to area a + b + c + d. The protective tariff stimulates domestic production at the expense of consumer welfare; less is available and at higher cost.

Part of the loss to consumer welfare, of course, is offset by the government’s gain in tariff revenues (area c). Another part (area a) represents a net gain to domestic producers from receipts in excess of marginal costs. This is the producers’ surplus. The remainder of the loss in consumer surplus (area b + d) is a deadweight loss in terms of social welfare. Notice that area b is part of the revenue earned by domestic producers, but it is not part of the producers’ surplus because it represents the resource cost of diverting resources to radio production rather than other productive uses.

The welfare and efficiency costs of protection might be worth bearing if the radio industry ultimately became efficient enough to overcome its cost disadvantage and if the interim loss of welfare were more than offset by the subsequent net benefits (all calculated in present-value terms). In the figure, this happy outcome would appear as a downward shift in S large enough to allow domestic producers to compete against imports without protection. The irony is that domestic producers find it easier to lobby for continued protection than to improve efficiency and compete head-on with imports. As a result, the jobs created in radio production end up reducing overall welfare in Ecouter. That is not a winning formula for sustainable gains in living standards.

The outcome would be even worse if the government used quotas to limit radio imports to 300 units. Once the quota is filled, domestic producers would have monopoly power in the small domestic market, allowing them to boost their profits at the further expense of consumer welfare. In contrast, the government could provide subsidies to lower production costs (and the supply curve) to the point where the domestic industry achieves the same market penetration—500 radios—without causing the price of radios to rise. This would burden the government budget, but the deadweight loss would be much smaller and the cost of protection would be easier to monitor.

Exercises

1. Now it is your turn to analyze the effects of a protective tariff.

a. Figure 19–3 shows the domestic supply (S) and demand (D) curves for tires in Kayak.

FIGURE 19-3

(i) Domestic production will be undertaken only if the market price of tires is at least Ksh . (Ksh stands for the Kayak shilling, the local currency.)

(ii) Imported tires sell for Ksh400. Draw the line representing supply from the world market, and label it Pw.

(iii) Under these conditions the quantity demanded is thousand tires. The market price is Ksh per tire. Consumer spending on tires totals Ksh million.

(iv) Imports account for percent of the market.

(v) The exchange rate is Ksh10 = $1. Hence, the foreign exchange cost of imported tires is $ .

b. To foster domestic tire production, the government introduces a 100 percent tariff on imports.

(i) With this tariff, the domestic price of imported tires rises to Ksh .

(ii) Draw a line in Figure 19–3 showing this new price of imports; label it Pw ′.

(iii) Label as point E the new market equilibrium, showing the price and quantity of tires bought and sold after imposition of the tariff. (Hint: Think carefully about the new equilibrium, this problem is a bit different from the Worked Example.)

(iv) At the new market equilibrium the quantity demanded is thousand tires; label this QE. The new equilibrium price is Ksh ; label this PE.

(v) Total spending on tires now equals Ksh million, and imported tires account for percent of the market.

(vi) Government tariff revenues total Ksh .

(vii) The foreign exchange cost of tire imports is $ .

(viii) The tariff’s protective effect stimulates new domestic production of thousand tires.

c. Carefully add labels a, b, c, and so forth, as needed, in Figure 18–3 to identify:

(i) The loss of consumer surplus due to imposition of the tariff.
(ii) The producer’s surplus resulting from the tariff.
(iii) The deadweight loss associated with the tariff.

d. Still maintaining the 100 percent import tariff, how would domestic tire production, the volume of tire imports, and the equilibrium price change if

(i) Domestic production becomes less efficient, and this causes costs to rise 50 percent?

(ii) Demand increases by 50 percent?

In both cases you should find that import competition protects consumers from excessive domestic price increases, even with the 100 percent tariff.

This stands in sharp contrast to the situation under import quotas, examined below.

e. What long-run change in the supply curve in Figure 19–3 would characterize successful import substitution in Kayak’s tire industry?

f. Rather than levying a tariff, suppose the government of Kayak simply bans tire imports by setting a zero quota, which is enforced by denying import licenses for procuring foreign-made tires.

(i) Under these conditions what point in Figure 19–3 represents the equilibrium price and quantity in the domestic tire market?

(ii) Compare the market outcome with a ban on tire imports against the outcome with a 100 percent tariff. In particular, compare these two alternative forms of protection in terms of their effect on domestic production and consumption of tires.

g. With tire imports banned, how would the domestic price and quantity adjust if

(i) Domestic producers became less efficient, and this caused supply costs to rise by 50 percent?

(ii) Demand increased by 50 percent?

(iii) The minimum efficient scale for tire production exceeded the size of the domestic market, and this led to the emergence of a monopoly producer?

Your answers should reveal why tariffs are more efficient than import quotas as an instrument for protection. Even with a high tariff, imports can serve as a buffer to cushion changes in demand, without pushing up prices. The use of tariffs limits the extent to which high costs and inefficiencies can be foisted onto consumers. It also limits the potential for abuse of domestic market power by monopolistic producers. And not incidentally, tariffs generate revenue for the government.

2. This exercise works through several calculations of the effective rate of protection (ERP).

a. Automobiles can be imported into the Republic of Motokah at a cost of P_w = $10,000 = 100,000 rupees (the local currency is the rupee, at Rs10 = $1).

(i) Component kits for assembling automobiles in Motokah can be imported at a cost of C_w = $9,000 per car. In local currency, the component kits cost rupees per car.

(ii) What is the value added at world prices of the car assembly operations in Motokah?

V_w = P_w– C_w= $ .

Expressed in local currency units, the value added at world prices is

V_w = Rs .

b. The government of Motokah levies a tariff of to = 25 percent on imported cars. Component kits for domestic assembly can be imported duty free, so ti = 0 percent. (The text uses to for the tariff on imported output and ti for the tariff on imported inputs.)

(i) With this tariff structure, the domestic price of an imported car is

P_d = Rs .

(ii) The domestic price of imported component kits is

C_d = Rs .

(iii) Domestic automobile assemblers can compete against import competition as long as the cost of the domestic resources used to convert component kits into finished products (that is, the value added at domestic prices) is no higher than

V_d = P_d – C_d = Rs .

(iv) Compare V_d with V_w , both in rupee units. Domestic assembly can compete with imports as long as the resource cost of domestic assembly (V_d ) exceeds value added at world prices (V_w ) by no more than percent.

(v) The effective rate of protection for domestic automobile assembly operations is ERP = percent, even though the nominal rate of protection is only 25 percent.

c. Suppose all conditions remain the same except that the government switches to a uniform 25 percent tariff on all imports. This means that t_o = t_i = 25 percent.

(i) With a uniform 25 percent tariff on all imports, the effective rate of protection on domestic car assembly is ERP = .

(ii) In this case the domestic industry can compete against imported automobiles as long as the resource cost of domestic assembly exceeds V_w by no more than percent.

Notice that a uniform import tariff covering inputs as well as outputs causes the effective and nominal rates of protection to converge.

3. This exercise examines how foreign exchange controls can be used as a tool to protect domestic industry. In the republic of Cabana, the supply of foreign exchange (dollars) is generated entirely by coffee exports. The demand for foreign exchange comes from importing machinery and blue jeans. In Figure 19–4, curves S and D show the supply and demand for dollars as functions of the exchange rate R, which is measured in pesos per dollar.

FIGURE 19-4

a.

(i) The market equilibrium exchange rate is R = pesos per dollar.

(ii) At this exchange rate (and with no tariffs or quotas to muddy the exercise), coffee that sells for $1 per pound in the world market is worth pesos per pound to Cabanian exporters.

(iii) For a machine priced at $5,000 on the world market, the equivalent price in Cabana is pesos.

(iv) For a pair of blue jeans selling at $20 on the world market, the equivalent price in Cabana is pesos.

b. The government passes a law requiring coffee exporters to turn over all their foreign exchange earnings to the central Bank of Cabana at an exchange rate of R' = 50 pesos per dollar. The central bank then sells available dollars to licensed importers at the rate R'. At the controlled exchange rate of R' = 50 pesos per dollar:

(i) Coffee selling for $1 per pound in the world markets is worth pesos per pound to Cabanian exporters.

(ii) A machine selling for $5,000 on the world market costs pesos to a buyer in Cabana.

(iii) A pair of blue jeans selling for $20 on the world market costs pesos to a buyer in Cabana.

c.

(i) Compared to the equilibrium exchange rate, Cabana’s peso in part b has become -valued.

(ii) At the controlled exchange rate R', exporting coffee becomes profitable, while imports become expensive.

(iii) Figure 18–4 shows that at R' = 50 pesos per dollar, the quantity of foreign exchange demanded equals $ million; the quantity of foreign exchange supplied equals $ million.

(iv) Hence, there is $ million of excess demand for foreign exchange.

d. To cope with this disequilibrium in the market for foreign exchange, the government begins to license access to dollars sold by the Bank of Cabana. Officials decide that no licenses will be granted for importing blue jeans, in order to promote import substitution in the clothing industry. But licenses are readily available to obtain foreign exchange for importing machines.

(i) The new system of foreign exchange licensing is equivalent to a quota of on imports of blue jeans.

(ii) Comparing the peso prices of coffee before and after imposition of exchange controls, one finds that the exchange-rate policy imposes an implicit tax of percent on coffee exporters.

(iii) Comparing the peso prices of imported machinery before and after imposition of exchange controls, one finds that the exchange-rate policy creates an implicit subsidy of percent on purchases of imported machines.

(iv) How does the protectionist exchange-rate policy affect incentives for producing coffee, clothing, and machines in Cabana?

(v) How does the exchange-rate policy affect incentives for using capital-intensive versus labor-intensive techniques to produce trousers? What does this imply about job growth?

e. Return to the initial situation in which the market determines the exchange rate, without direct government interventions. Let’s see how protectionist policies affect the exchange rate anyway.

(i) The government of Cabana decides to protect the domestic clothing industry by setting a high tariff rate on imports of blue jeans. This makes imported jeans so expensive that the demand curve for foreign exchange shifts to the left by 25 percent. Carefully draw the new demand curve in Figure 19–4. Label it D′.

(ii) What is the effect of the import tariff on the equilibrium exchange rate? Why?

(iii) How does this change in the exchange rate affect the peso earnings from coffee exports and the peso price of imported machinery? Be as specific as possible.

(iv) Compared to the free-trade situation, how does the protectionist tariff for trousers affect incentives for exporting coffee? Explain.

(vi) Qualitatively, what does the 33.3 percent tariff on imported shovels do to profitability of copper exports? Plug appropriate numbers into the ERS formula to compute the ERS for the copper industry, and briefly explain the result.

(vii) Briefly, how do Zimba’s trade policies alter the allocation of resources between the three industries?

4. The real effective exchange rate (REER) is a comprehensive indicator of the influence of trade and exchange-rate policies on incentives for resource allocation. Study the text discussion of REER carefully, including the notation, before tackling this exercise.

The Republic of Pampas exports wheat and produces clothing as an import-substitution industry. Table 19–1 presents data for both goods on world prices, tax and tariff rates, domestic production costs, and the exchange rate in pesos per dollar for 1995. Notice that wheat exports are subject to a 10 percent tax while clothing imports bear a 25 percent tariff to protect domestic producers. To keep things simple, the quota premiums and all forms of subsidy equal zero initially.

Click here for Table19-1

a. In 1996, world prices for all tradable goods rose by 10 percent, while prices and production costs in Pampas rose 25 percent. The official exchange rate, the tax rates, and the tariff rates were still at 1995 levels.

(i) On the basis of this information, fill in the column headed 1996 in Table 19–1. (To assist you, some numbers are provided.)

(ii) To facilitate calculation of the REER, Table 18–2 restates the basic data for the wheat industry as index numbers, defined so that 1995 = 100. As shown in the book, the REER for exportables is given by the formula

where N_e is a measure (in decimal format) of nominal protection:

There are no changes in trade policy here, so N_e stays fixed at 1.00. Fill in the 1996 column in Table 19–2.

Click here for Table 19-2

(iii) Briefly explain how the change in REER_e has affected the profitability of producing wheat for export in 1996.

b.

(i) Using Table 19–2 as your model for tabulating the required information, calculate the 1996 REER_m for clothing imports.

REER_m = .

(ii) How does the change in REER_m between 1995 and 1996 affect the profitability of producing clothing as an import substitute?

c. Let’s rerun history. This time the government of Pampas decides to devalue the peso by 15 percent, to 23 pesos per dollar, to offset (approximately) the excess of domestic inflation over world inflation. All other conditions for 1996 remain as above.

(i) Fill in the columns labeled 1996a in Tables 19–1 and 19–2, as appropriate to reflect the new official exchange rate.

(ii) Using Table 19–2 as a model, calculate the 1996 value of the real effective exchange rate for clothing imports after the devaluation.

REER_m = .

(iii) Looking at your calculations, how does the 1996 devaluation affect the profitability of producing exportables (wheat) and importables (clothing) in Pampas?

d. Wind the clock back once again. This time the government chooses to maintain the fixed exchange rate and to support domestic producers using tax and tariff policies, instead. Stated more formally, the government aim is to hold REER_e = 100 and REER_m = 100 in 1996 by altering N_e and N_m , while holding R_o fixed at 20 pesos per dollar.

Wind the clock back once again. This time the government chooses to maintain the fixed exchange rate and to support domestic producers using tax and tariff policies, instead. Stated more formally, the government aim is to hold REER_e = 100 and REER_m = 100 in 1996 by altering N_e and N_m , while holding Ro fixed at 20 pesos per dollar. (i)

(i) Compute the value for N_e required to maintain REER_e = 100 in 1996. Write the answer in the column labeled 1996b in Table 19–2. (Hint: In this case R= 100; given P_w and P_d for 1996, find N_e such that REER_e = 100.)

(ii) From the formula

use the value for N_e that you just calculated to find the necessary export tax rate t_e for 1996:

t_e = .

(Hint: The answer is negative; this indicates that an export subsidy is needed. Note that the textbook formula for N_e adds a term se for export subsidies; it is easier here just to treat subsidies as negative taxes.)

e.

(i) Following a parallel procedure, calculate the value of Nm needed to maintain REER_m = 100 in 1996, if the peso is not devalued.

N_m = .

(ii) In the absence of any quota premium, the formula for the nominal protection index for importables is

Find the tariff on clothing imports, t_m needed to achieve REER_e = 100 in 1996.

t_m = .

In general, domestic producers of exportables and importables suffer when domestic inflation outpaces world inflation. The government can cure the adverse effects by devaluing the home currency or by increasing protection for tradables producers. Of the two options, devaluation is far simpler to administer—especially in countries where domestic inflation exceeds world inflation year after year. Also, ever increasing protection invites all the distortions commonly associated with import-substitution regimes. The best policy, of course, is to avoid high inflation in the first place.

5. This exercise examines the dynamics of import substitution using a general equilibrium framework like the one in the textbook. Figure 19–5 shows the production possibilities frontier (PPF) for Anglia back in 1970. The world price was $1,000 per ton for both coconuts (C) and steel (S). Hence, line TT, showing the world terms of trade, has a slope equal to –1.0. With free trade, Anglia produces at point Aand trades along TTto the optimal consumption point A′.

FIGURE 19-5

a. At point A the slope of the PPF equals ; if resources were reallocated to produce one extra ton of steel, the opportunity cost would be a reduction in coconut output by .

b. To promote the domestic steel industry, the government levies a 100 percent tariff on steel imports, which doubles the domestic price of steel. The domestic price of coconuts remains initially unchanged.

(i) At domestic prices, 1 ton of steel is now worth tons of coconuts.

(ii) The protective tariff gives entrepreneurs an incentive to reallocate resources to produce more steel and fewer coconuts. To be precise, it is profitable to shift resources in this manner as long as each ton of lost coconut output is replaced by at least of additional steel production.

(iii) So entrepreneurs continue to shift resources to the northwest from point A as long as the slope of the PPF is greater than (in absolute value).

(iv) In Figure 18–5, carefully determine the outcome of this tariff-induced reallocation process. Label the new production choice as point B.

c.

(i) Carefully construct a line showing the various trade possibilities open to Anglia when the economy produces at point B. Label this line T′T′. (Hint: World prices have not changed, so the slope of the line showing the world terms of trade has not changed either.)

(ii) When producers operate at point B in response to the tariff, Anglia trades along line T′T′to achieved its preferred consumption outcome. Label as B′some plausible point on T′T′showing the consumption outcome. (Point B′should entail lower consumption of both goods compared to the original free-trade outcome at A′.)

d. Figure 19–6 reproduces Anglia’s PPF for 1970.

FIGURE 19-6

(i) Over the ensuing 25 years, Anglia’s import-substitution policy is successful. Draw in a new production frontier for 1995 showing a successful growth outcome. Label it PPF₉₅.

(ii) For simplicity, suppose the tariff on steel is still in force in 1995 and relative prices remain unchanged in the world markets. Identify the point along PPF₉₅ showing the production outcome in 1995. Label it B₉₅.

(iii) Draw the line through point B₉₅ showing the world terms of trade. Label this T₉₅T₉₅. What is the slope of this line?

(iv) Identify a plausible point on line T₉₅ representing the preferred consumption outcome, given production at B₉₅ and the prevailing terms of trade. Label this point as B´_95.

e. The success of Anglia’s import substitution policy means that the country’s GDP has grown rapidly and consumption of both steel and coconuts is much higher than in 1970.

(i) Even so, is point B₉₅ the best production point for the country in the year 1995? In particular, would the country be better off by eliminating the tariff on steel imports and moving toward less distorted trade flows in 1995? Explain.

(ii) What would a case of unsuccessful import substitution 25 years later look like on the graph? (Don’t draw it; just explain it in words.)

(iii) What accounts for the fact that import-substitution strategies have more often than not turned out to be unsuccessful in the long run?

6. Harder. This exercise explores the trade creation and trade diversion effects of a customs union between Tanya and its neighbor Kenzania. The exchange rate between the Kenzanian shilling and the Tanyan shilling is Ksh1 = Tsh1; each currency is worth $0.10. Consider first the static effects for Tanya.

a. Tanya can obtain gaskets, pumps, and tractors from three supply sources: the goods can be produced in Tanya, imported from Kenzania, or imported from other countries. Initially, Tanya levies a 40 percent tariff on all imports. Table 19–3 shows how the acquisition cost of each product varies according to the source of supply. Take a moment to study the setup of this table.

Click here for Table 19-3

(i) Fill in the blanks in the left-hand side of Table 19–3, to find the domestic price in Tanya for each good, for each supply source. The column for gaskets is worked out in full as an example. This calculation reflects conditions prior to the creation of a customs union between Tanya and Kenzania.

(ii) With a 40 percent tariff on all imports into Tanya, the cheapest source of supply:

For gaskets is ,

For pumps is ,

For tractors is .

b. After entering the customs union Tanya sets to zero the tariff on imports from Kenzania. Imports from other countries still face a 40 percent tariff.

(i) Based on the new tariff structure, fill in the blanks in the right-hand side of Table 19–3.

(ii) How does Tanya’s entry into the customs union alter its pattern of production and trade?

For gaskets:

For pumps:

For tractors:

c.

(i) In what sense does Tanya benefit from trade creation as a result of the customs union?

(ii) In what sense does Tanya lose from trade diversion as a result of the customs union?

 

---

 

Fill out the information and press the button to Print.

Your Name:
Professor's Name:
Class Name: