Question

Essay question:

Explain the effective rate of protection and the conditions under which it can be larger, equal to, or smaller than the nominal tariff

Answer 1

An effective rate of protection (ERP) calculation takes into account the fact that domestic value-added might be less than total value added – i.e., there is substantial imported value added in the final good. Suppose a 10% tariff is applied to motorcycles so that a totally the US made motorcycle which originally sold for $25000 (under free trade) can now sell for $27500 because of the protection from foreign imports. In this calculation, effective protection equals nominal, i.e., 10%. However, suppose imported inputs used in motorcycles were $15000. Then the effective rate of protection is 25% (=((27500-15000)/10000))-1). And that’s a final good tariff just to even out things domestically. If you want to export the motorcycles, well, you’ll need an export subsidy. Under current WTO agreements, those are generally illegal.

Some things to consider as we go down the path of protection — and protection that is unlikely to reduce the trade deficit.

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 the tariff was used to be regarded as a measure of the degree of protection.

The writers like B. Balassa, W. Corden and H.G. Johnson suggest that the nominal rate of the tariff was not the appropriate measure of the degree of protection. According to them, the concept of nominal rate of tariff had a serious flaw that it considered only the effect of the tariff on final imported product.

It did not recognize the structure of duties applied to the imported raw materials and intermediate goods required in the processing of the import substitutes. A country, many often, imports a raw material either duty-free or imposes a very low tariff rate on the imports of inputs than on the import of the final commodity.

Such a policy is adopted for encouraging domestic production and expansion of employment. For instance, a country may import raw cotton duty-free but impose a stiff rate of tariff on the import of cloth. Such a structure of import tariff brings about a relatively larger increase in the domestic value added.

The effective protective rate is the percentage increase in value added per unit in an economic activity which is made possible by the tariff structure relative to the situation in the absence of tariff but with the same exchange rate.

The domestic value added equals the price of the final commodity minus the cost of the imported inputs going into the production of the commodity. When no or lower tariffs are applied on imported inputs than on the final imported product, the rate of protection, called as the effective rate of production, exceeds the nominal tariff rate.

The concept of effective rate of protection has been defined by Balassa in these words- “Under the usual assumptions of international -immobility of labor and capital, the effective rate of duty will indicate the degree of protection of the value added in the manufacturing process.” In other words, the effective rate of tariff establishes a relationship between the tariff and the domestic value added. Such a tariff rate can be a true measure of the actual rate of protection that the nominal tariff affords to the domestic import-competing industries.