Assuming that the revenue collected by the government is a benefit to the economy, the net benefit of tariff T on G is measured by the algebraic total of (revenue effect + change in producers’ surplus + change in consumers’ surplus). This is also known as the protection cost or the deadweight loss of the tariff.
Incomplete Estimate:
However, it is obviously an incomplete measure, and leaves out several ingredients which should be taken into account even in the first approximation. They, for example, include the following:
Resource Cost:
It is misleading to assume that the revenue collected by the government represents a gain to the society. There are several reasons for it. Firstly, the tax yield is only a transfer of resources from the taxpayers to the government, and not an addition to the society’s resources.
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Secondly, the government itself incurs resource expenditure in setting up and maintaining tax collection machinery. For the society as a whole, it is an addition to consumption of resources without any corresponding productive effect.
Trade Volume:
Imposition of a tariff reduces the volume of trade. And, other things being equal, this means a corresponding welfare loss for the society.
Retaliation:
If imposition of a tariff provokes a retaliatory action by the trading partners of the tariff-imposing country, there is a further reduction in the trade volume with an additional loss of gains from trade.
Resource Allocation:
On account of an import tariff and, therefore, a reduction in import of G, there is a reallocation of productive resources within the country. It is an activity of import substitution.
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Its net effect on the growth and welfare of the economy, however, is unpredictable, since it can lead to alternative developments, which may be either beneficial or harmful.
Thus, the process of import substitution (if successful) may have the beneficial effect of increasing domestic employment and a reduction in income inequalities. It may contribute to the process of economic growth if the protected industry has a role to play in the technological development of the economy.
The Case of Constant Returns:
The foregoing analysis undergoes an important transformation if we assume that the production of G in the home country (H) obeys the law of constant returns to scale. In that case, its supply becomes perfectly elastic with its supply curve running parallel to the quantity axis.
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In the absence of trade, as before, the domestic equilibrium position of G given by the intersection of its supply curve S, and its demand curve D, at point P2 resulting in an output of OQ2 and price PjQ2. the world supply curve is W, and lies below S,.
When trade opens, the buyers buy only imported G OQ, because of its lower price and the domestic industry is totally wiped out.
The outcome of levying an import duty on G depends upon the rate of duty (T) and the difference between its import price and its domestic price (that is, WPh).
So long as T < WPh, entire demand for G is met by imports and the domestic industry goes out of business. However, once T > WPh, import of G drops to zero and the consumers in H satisfy their entire demand for G by buying only from its domestic production.
It follows, therefore, that in the case of constant returns, either an import duty is totally ineffective, or it is fully prohibitive.