Solution to Question 3:

1. A tariff is a tax imposed by a government on goods and services imported

from other countries that serves to increase the price and make imports
less desirable, or at least less competitive, versus domestic goods and
services. Tariffs are generally introduced as a means of restricting trade from
particular countries or reducing the importation of specific types of goods and
services.

2. A tariff is a tax on imports or exports between sovereign states. It is a form of

regulation of foreign trade and a policy that taxes foreign products to encourage
or safeguard domestic industry. Traditionally, states have used them as a source
of income. Now, they are among the most widely used instruments of
protectionism, along with import and export quotas. In addition to discouraging
the purchase of imported goods, tariffs at one time were also the major source of
governmental income. Until the income tax was introduced in 1913, tariff revenue
comprised as much as 95% of governmental funding. Back then, typical tariffs
were 20% of the product’s value.

3. Tariffs can be fixed (a constant sum per unit of imported goods or a

percentage of the price) or variable (the amount varies according to the
price). Taxing imports means people are less likely to buy them as they become
more expensive. The intention is that they buy local products instead – boosting
the country's economy. Tariffs therefore provide an incentive to develop
production and replace imports with domestic products. Tariffs are meant to
reduce pressure from foreign competition and reduce the trade deficit. They have
historically been justified as a means to protect infant industries and to allow
import substitution industrialization. Tariffs may also be used to rectify artificially
low prices for certain imported goods, due to 'dumping', export subsidies or
currency manipulation.

4. Until the early 1960’s, the official rate of tariff was intended to discourage the
import of final product and to promote the domestic production in the protected
industry. The rate of tariff ad valorem on the import of final product was called as
the nominal rate of tariff. A ten per cent tariff on a finished imported good was
supposed to have a ten per cent protection to the domestically produced import
substitute. Higher the rate of nominal tariff, it was assured, higher would be the
degree of protection and vice-versa. In other words, the nominal rate of tariff was
used to be regarded as a measure of the degree of protection.

5. The effective rate of protection (ERP) is a measure of the total effect of the
entire tariff structure on the value added per unit of output in each industry, when
both intermediate and final goods are imported.
6. The effective rate of protection is a commonly used measure of net effect of trade
policies on the incentives facing domestic producers. The measurement of
effective protection is clearly a two stage process – first determining the nominal
protection of the policies in question, and second, analysing the implications for
effective protection of different firms, sectors or activities.

7. Just as increases in nominal protection reduce overall economic welfare by

distorting the information provided by domestic prices about relative scarcities of
different goods, increases in effective protection cause economic waste by
inducing producers to supply goods domestically even when their domestic costs
are higher than their opportunity costs through trade. At the same time, producers
of goods with relatively low levels of effective protection are induced to refrain
from producing goods domestically even when this could be done at a lower cost
than in international markets.

8. The nominal tariff rate can be expressed through the following formula:

H = (P’ – P) / P

9. Effective Rate of Protection

• Nominal tariff rate
–Gives a general idea of the level of protection
– Applies only to the total value of the final import product

• Effective tariff rate

– Indicator of actual level of protection that a nominal tariff rate provides
– Total increase in domestic productive activities in comparison with the
occurrence under free-trade conditions.

10. Effective Rate of Protection

• Effective tariff rate

– e: effective rate of protection
– n: nominal tariff rate on the final product
– a: ratio of the value of the imported input to the value of the final product.
– b: nominal tariff rate on the imported input.
11. The effective rate of protection can also be determined diagrammatically as
shown below. Since the demand is not supposed to be affected by tariff, it has
not been shown.

12. S1 is the supply curve of the final product machine and S0 is the supply curve
of labour, which is the only primary factor. The quantity of machines is measured
along the horizontal scale and price is measured along the vertical scale.

13. AQ or OP is the constant free trade international price of the machine and OQ is
the input of labour employed. The unit value added is measured by BQ/AQ. As
tariff is imposed upon the imported machine, its domestic price rises from OP to
OP2 and the domestic production of machine expands form OQ to OQ2.

14. If an additional tariff is levied upon the imported inputs of this commodity, the
supply curve shifts up from S1 to S2. Consequently, the production of machine
contracts from OQ2 to OQ1. However, there is a net increase in production to the
extent of QQ1. This is on account of PP1 which is the difference between the
increase in the domestic price (PP2) and increase in the unit cost of production
(P1P2), i.e., PP1 = PP2 – P1P2. The effective rate of production (g) is measured
by dividing PP1 by the value added or the contribution of the primary factor.

Therefore,
 g = PP1/BQ = CD/EQ1.

15. Welfare Effect of a Tariff-Small Nation Model

•Changes in the country’s imports or exports are small relative to the world
market.

•The world price is independent of changes in the quantity of the country’s

imports or exports.
•Costa Rica in the world oil market.
•Norway in the world cotton market.
•US in the world rice market.

16. Consumer & Producer Surplus

1) Consumer surplus – additional benefit obtained by the buyer of a
good
 difference between the maximum that the buyer is willing to pay
and the actual price
 Area below demand and above price.
2) producer surplus – additional benefit obtained by the seller of a good
• Difference between the minimum that the seller is willing to accept
and the actual price
• Area above supply and below price.

17. When combined, the areas of consumer surplus and producer surplus represent
the total welfare to the nation resulting from the sale of this good.
18. Consumer surplus is derived whenever the price a consumer actually pays is
less than they are prepared to pay. A demand curve indicates what price
consumers are prepared to pay for a hypothetical quantity of a good, based on
their expectation of private benefit.

19. Producer surplus is the additional private benefit to producers, in terms of profit,
gained when the price they receive in the market is more than the minimum they
would be prepared to supply for. In other words they received a reward that more
than covers their costs of production.
The producer surplus derived by all firms in the market is the area from the
supply curve to the price line, EPB.

20. Economic welfare

Economic welfare is the total benefit available to society from an economic
transaction or situation.
Economic welfare is also called community surplus. Welfare is represented by
the area ABE in the diagram below, which is made up of the area for consumer
surplus, ABP plus the area for producer surplus, PBE. In market analysis
economic welfare at equilibrium can be calculated by adding consumer and
producer surplus.
21. Tariff Welfare Effects – Small Country
With Open Trade: Consumer surplus increases by areas a,b,c,d,e,f and g.
Producer surplus decreases by areas a and e. The overall increase in welfare is
b,c,d and f.

22. With Tariff:

c = revenue effect = lost consumer surplus now government revenue.
a = redistributive effect = shift from consumer to producer surplus .
b + d = deadweight loss = benefits lost to all parties b = protective effect d =
consumption effect.
23. Consider a market in a small importing country that faces an international or world
price of PFT in free trade. The free trade equilibrium is depicted in the adjoining diagram
where PFT is the free trade equilibrium price. At that price, domestic demand is given by
DFT, domestic supply by SFT and imports by the difference DFT - SFT (the blue line in the
figure).
When a specific tariff is implemented by a small country it will raise the
domestic price by the full value of the tariff. Suppose the price in the importing

country rises to because of the tariff. In this case the tariff rate would

be  , equal to the length of the green line segment in the

diagram.
 Tariff Effects on:

24. Importing Country Consumers - Consumers of the product in the importing

country are worse-off as a result of the tariff. The increase in the domestic price
of both imported goods and the domestic substitutes reduces consumer surplus
in the market. Refer to the Table and Figure to see how the magnitude of the
change in consumer surplus is represented.

25. Importing Country Producers - Producers in the importing country are better-off
as a result of the tariff. The increase in the price of their product increases
producer surplus in the industry. The price increases also induces an increase in
output of existing firms (and perhaps the addition of new firms), an increase in
employment, and an increase in profit and/or payments to fixed costs. Refer to
the Table and Figure to see how the magnitude of the change in producer surplus
is represented.

26. Importing Country Government - The government receives tariff revenue as a

result of the tariff. Who will benefit from the revenue depends on how the
government spends it. These funds help support diverse government spending
programs, therefore, someone within the country will be the likely recipient of
these benefits.

27. Importing Country - The aggregate welfare effect for the country is found by
summing the gains and losses to consumers, producers and the government.
The net effect consists of two components: a negative production efficiency loss
(B), and a negative consumption efficiency loss (D). The two losses together are
typically referred to as "deadweight losses."
28. Because there are only negative elements in the national welfare change, the net
national welfare effect of a tariff must be negative. This means that a tariff
implemented by a "small" importing country must reduce national welfare.

29. In summary,

1) whenever a "small" country implements a tariff, national welfare falls.

2) the higher the tariff is set, the larger will be the loss in national
welfare.

3) the tariff causes a redistribution of income. Producers and the

recipients of government spending gain, while consumers lose.

3) because the country is assumed "small," the tariff has no effect upon
the price in the rest of the world, therefore there are no welfare
changes for producers or consumers there. Even though imports are
reduced, the related reduction in exports by the rest of the world is
assumed to be too small to have a noticeable impact.

30. To sum up, the concept of effective rate of protection attempts to measure the
rate of protection in case of specified home industries by taking into account
only the direct effects of tariff upon those industries. The tariffs also have certain
indirect effects including the counterveiling measures adopted by foreign
countries. As these effects remain neglected, the effective rate of protection
cannot measure precisely the degree of protection.
Despite its deficiencies, the concept of effective rate of protection has vital
importance because it measures the extent to which the home market of a
country is sheltered. This issue has assumed significance in international
negotiations related to trade and tariff. It must be fully recognised that the
lowering down of nominal tariff rates does not actually ensure trade liberalisation.
It is the reduction in effective rates of tariffs that constitutes a move
towards freer international trade.