What is the effective rate of Protection

What is the effective rate of Protection also implications and arguments for protection?

The effective protection rate measures the degree of protection given to domestic production activities. It is defined as the percentage increase in domestic value-added per unit of output made possible by the tariff structure compared to a situation under free trade.

The effective protection for a final product increases as the nominal rate imposed as imported materials used in the production process decrease.

It also varies with the proportion of imported inputs that constitute the final value of the product. Consider a leather wallet whose C.I.F. imports price in Belgium under free trade is $20.

The cost of the leather of which the wallet is made is $10 on the world market so that a wallet made in Belgium out of imported leather would have a domestic value-added of $10 at free trade prices.

Translated into Belgium frames at an exchange rate of $1 = 50 frames, we obtain a product price of 1,000 frames, a world cost of inputs of 500 frames, and a free trade domestic value-added of 500 frames.

Case No.1

When the tariff rate on the final output exceeds the rate levied on the input, the effective protection on the output exceeds the nominal rate imposed on it.

If  tj > ti than gi > tj

40% tariff on the wallet (tj)

Price after tariff = 1400

Tariff 20% on leather

20% of 500 =100

Price of leather after tariff = 500+100=600

Value-added 1400-600=800

%age increase in value-added =800/500×100=60%

If tj > ti the gi > tj

gi = effective rate of protection

Case No. 2

When the tariff rate on the import exceeds that of the final goods, the effective protection accorded the final output, falls short of the nominal rate imposed on it.

If  tj < ti than gi < tj

30% tariff on wallet, price after tariff = 1300

40% tariff on leather, price after tariff=700 value added.

Pj – Pi = 1300-700=600

%age increase in value-added = 600-500=100/500×100=20%

If tj < ti than gi < tj

Case No. 3

In addition to the tariff on the output and inputs, the effective rate of protection depends also on the share of domestic value-added in the product price.

30% tariff on the wallet, price of wallet after tariff =1400

30% tariff on leather, price of leather after tariff =550

Value-added 850 = 1400-550

%age increase in value-added = 850 = 70%

Implications

Several important implications follow from the concept of effective protection and they will be considered in turn.

First, it is the effective rate of protection that indicates the degree of resource misallocation caused by the tariff structure.

Second, the recent calculations suggest that the effective rate on many finished products are double their nominal counterparts.

Third, applicable to developed and developing countries alike, is that changes in tariff rates on imported inputs have an inverse effect on the level of protection accorded to final products.

Fourth, this analysis has implications for a country’s export position as well.

Finally, rates of effective protection can be used indirectly as a rough guide to determine comparative advantage.

Arguments for protection

We can briefly evaluate some of the arguments heard in political and economic circles on behalf of the tariff.

The most popular claim made for tariff protection is the so-called “infant-industry” argument.

It asserts that industries that may benefit from large-scale operations because of the existence of external economies, should be allowed to grow to optimum size under a protective tariff.

Once the industry attains the desired size, the tariff can be removed. Often there are difficulties with the practical application of this theory.

First, the arguments can be abused, as it has been at times by declining industries that attempt to protect their position in the market and thereby perpetuate inefficiency.

Second, once it has been imposed, a tariff is rather difficult to eliminate, regardless of the industry’s competitive standing.

Finally, even in cases where the infant-industry position applies, it is more efficient to offer a production subsidy as a means of helping the industry to expand.

While the tariff imposes both production and consumption costs on the economy, a subsidy embodies only production costs, not consumption costs.

More generally, a tariff is equivalent to a tax on the consumer plus a subsidy to the producer.

From the point of view of an individual nation taken as a whole, the only rational argument for the tariff is an improvement in the terms of trade.

However, this applies only to the major importers that are large enough to affect the terms at which they trade, and assumes that other countries would not retaliate.

The gain to the importing country is matched by a terms-of-trade loss to the exporting country. Tariff may at times be used to increase employment.

But both objectives can be met more effectively and more efficiently by fiscal monetary, or exchange-rate policies.

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