Protection of domestic industries from international competition is a common policy of many countries. Tariffs on imported goods (and services) are just one form, albeit the most common one, of such protection. A tariff of 10 percent (for example) allows domestic industry an “inefficiency cushion,” that is, it allows the domestic firms to be about 10 percent less efficient in their production costs and still be able to compete with imported products. If, however, domestic firms have to obtain their inputs at higher prices than their international competitors, their “inefficiency cushion,” more precisely their effective rate of protection, is reduced. Government’s efforts to protect the input producing industries, in this case, reduce (or even negate) the protection that the government wishes to provide the downstream industries. Generally the effective rate of protection for an industry will be higher than the nominal tariff rate when its input producing industries are not protected, and lower when its input producing industries are protected even more.
Effective rate of protection can be calculated by isolating the value added of an industry. Consider the case of the barbed wire industry. Assume that the international price for barbed wire is $1,200/ton and, for the sake of simplicity, that the only input required to produce barbed wire is steel. Further assume that the international firms can purchase steel at $1,000/ ton and need one ton of steel to produce one ton of barbed wire. Given this price structure, international firms add a value of $200/ton to steel to produce barbed wire. Now consider the domestic industry in a country where the government wishes to protect its barbed wire industry and imposes a tariff of 10 percent on imports. If there were no tariffs on steel, domestic firms would import steel at $1,000/ton and could compete with imports as long as they could produce and sell barbed wire at $1,320/ton. This allows them a margin of $320/ton compared to a margin of $200/ ton for international producers. Their effective rate of protection is, therefore, 60 percent, much higher than the nominal protection rate of 10 percent.
Suppose now that the government also wishes to protect the steel industry and imposes a tariff of 20 percent on steel imports. Domestic producers of barbed wire now have to pay $1,200/ton for their raw material and have to convert steel into barbed wire at a maximum cost of $120/ton. They have to be more efficient than their international competitors. Their effective rate of protection is minus 40 percent.
In a situation where the only protection is provided in the form of tariffs, the effective rate of protection (ERF) can be calculated as follows:
ERP = (tf – i . ti) / (1 – i)
Where tf is the tariff on the finished products, ti is the tariff on inputs and “x” is the proportion of the value of the finished product accounted for by the inputs in the international (tariff-free) environment.
The difference between nominal and effective rates of protection helps in understanding the arguments behind imposition and lifting of tariffs on steel by the U.S. Government. The steel industry in the United States used to have significant political clout and since the early 1970s, it had successfully lobbied for protection. The last round of tariffs on steel was approved by President George W. Bush in March 2002 and all tariffs were finally removed in December 2003. The removal of these tariffs was cheered by steel importing firms that needed steel as an input. Higher cost of one of their imports had required them to be more efficient than their international competitors.
Effective rates of protection are notoriously difficult to calculate. Last known estimates were quoted by Giancarlo Gandolfo (1994). In the United States, the soft drink industry had a nominal tariff rate of 1 percent but an effective rate of minus 9.5 percent. Similar numbers for the soybean oil industry were 22.5 percent and 253 percent. In the European Economic Community the median tariff rate of 12.1 percent resulted in an effective rate of 33.1 percent. Similar numbers for Japan were 16.5 percent and 45.4 percent. These examples merely highlight the importance of examining effective rates of protection rather than making policy based solely on the nominal rates.
- Giancarlo Gandolfo, International Economics I: The Pure Theory of International Trade, 2nd ed. (Springer Verlag, 1994).
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