Lecture 3

Protection of Domestic Industries

Rationale:

This lecture looks both at the reasons given for protecting domestic industries from overseas competition and at the forms of protection and strategies that can be used to protect domestic industries.

Outline:

➢ Reasons for protection

➢ Forms of protection

➢ Trade policies used to overcome the balance of payments constraint to domestic growth.

I. Reasons for Protection

➢ To foster infant industries

➢ To improve the nation’s terms of trade (for a large importing nation)

➢ To offset distortions in the nation’s domestic economy (eg maintaining jobs during a recession)

➢ To follow strategic trade policy (eg government subsidies for exporters in oligopolistic markets)

Note:

Protecting industries from import competition can lead to:

➢ Resources being attracted into relatively inefficient import competing industries

➢ A deterioration in the terms of trade for a small importing nation

II. Forms of Protection

1. Tariff

Definition of tariff: tax levied on an import

Design of tariff:

A revenue tariff is designed to raise revenue for the government

A protective tariff is designed to protect domestic industries from competition from imports

Types of tariff:

An ad valorem tax is assessed as a percentage of the cost of the import

A specific duty is a lump sum tax per unit of import

Effects of a tariff on a small importing nation:

If an importing nation cannot affect the world price for a product then, for that product, the nation is considered a small importing nation

If a small importing nation places a tariff on an import, then:

➢ The price of the import will rise

➢ The quantity of imports will fall

➢ Consumers will lose (demand will contract)

➢ Domestic producers will gain (domestic supply will expand)

➢ The government will gain revenue

➢ The small importing nation’s terms of trade will deteriorate

With no imports:

The domestic equilibrium is at point e (s = d)

Domestic price = Pd

Domestic quantity bought and sold = Qd

PRICE

Pd E

SUPPLY DEMAND

QUANTITY Qd

Assume tariffs (small importing country)

If the domestic price of a commodity without trade is P1 ($50) then the equilibrium point is E.

However, the world market price is $20 (P3).

There is therefore excess demand at points a-b which is imported.

A domestic tariff increases the price to P2 ($40).

The quantity imported falls to c-d (ef).

However, this reduction in imports does not affect world prices because the country is a price-taker (prices are inelastic).

Therefore the consumers pay for the tariff represented by the rectangle G.

The government gains from the tariff by multiplying the quantity imported (c-d) by the tariff ($20).

P S D

P1 ($50) E P2 ($40) c d G P3 ($20) g e f h S D

0 a c d