SC2016
Assignment
Due Date: 7 October 2016 4pm
The assignment will be marked out of 60. The allocation of these marks among parts of the assignment is clearly indicated.
This assignments accounts for 10% of the final grade.
The government of Tropicana, a small island economy, has traditionally maintained high tariffs in order to encourage domestic economic activity. A standard tariff rate of 40% applies to both finished manufactured goods and to intermediate goods used as inputs by the domestic manufacturers. Some time ago the government also decided to support the development of a domestic rice industry, and for this purpose entered into a contractual arrangement with the domestic rice producer, whereby a tariff of 80% is to apply to imported rice for the next 10 years. Rice is a staple food for the people of Tropicana, and rice is accordingly an important item in their consumption.
(a) The world rice price is $1 per kg. At this price it is estimated that 1 million kgs of rice per year would be produced domestically in Tropicana, and annual domestic consumption of rice would be 4 million kgs. With the 80% tariff in place domestic consumption and domestic production of rice are both equal to 3 million kgs per year, and there are no imports (i.e. the 80% tariff is prohibitive). It has been calculated that at the “standard” tariff of 40% domestic production of rice would be 2 million kgs per year and domestic consumption would be 3.5 million kgs per year.
Calculate the effect of (a) the 80% tariff and (b) a 40% tariff on:
• consumer surplus
• producer surplus
• government revenue
• net national welfare
(8 marks)
Illustrate your answer by means of a diagram. Be sure to show prices on the vertical axis, and the quantities produced, imported and consumed on the horizontal axis.
(7 marks)
Comment briefly on how the effect on net national welfare of the 80% tariff differs from the effect of a 40% tariff.
(2 marks)
(b) Consider three domestic industries in Tropicana, as follows:
(i) Delicious Ltd is an instant rice noodle manufacturer, protected by the standard 40% tariff on imported instant rice noodles, which could be imported and sold at $15 per carton in the absence of the 40% tariff. Rice is obviously a significant cost in instant rice noodle production. If imported duty-free Delicious Ltd’s rice requirements would cost $3 per carton of instant rice noodles, but in fact it must purchase its requirement from the local producer at a price that reflects the 80% tariff. Inputs other than rice would cost $1.50 per carton of instant rice noodles if imported duty-free, but in practice are subject to the 40% tariff.
(ii) Steadfast Ltd is a typical manufacturer. It produces metal office furniture. The standard 40% tariff applies to both its finished products and the intermediate goods that it utilises as inputs. On average, the items that it produces would cost $100 per unit if imported duty-free, and the inputs required for each unit would cost $60 if imported duty-free.
(iii) Biosolutions Ltd is a producer and exporter of virgin coconut oil, which it collects from a network of local village operators. Intermediate goods used in virgin coconut oil production would account for 40% of its production cost if imported duty-free, but in practice are subject to the 40% tariff. The virgin coconut oil produced by Biosolutions Ltd is of high quality, and has established a place for itself in the value chain of Body Health Ltd, an international producer of organic cosmetics. Its entire output is exported to production facilities operated by Body Health Ltd, but competition is fierce and Biosolutions Ltd is constrained to sell at the world market price. It has had difficulty keeping up with the demand from Body Health Ltd because the price it has been able to pay its village operators, based on the world market price, has not been sufficient to attract the desired increase in output, given the alternative employment opportunities available in protected industries, including the rice industry. Biosolutions Ltd has been concerned for some time that its inability to fully meet Body Health Ltd’s demand could result in it losing its business to competitive producers from other countries, who have a greater production capacity.
Calculate the effective rate of protection for the output of each of the above industries.
(6 marks)
Comment briefly on the result in each case. (3 marks)
Comment briefly on the overall pattern of protection in Tropicana as indicated by your results. (3 marks)
(c) Delicious Ltd is attempting to convince the government of Tropicana that it needs special tariff treatment, because of the high cost of the rice that it must purchase from the local producers. It argues that the nominal tariff on instant rice noodles should be set so as to provide it with the same effective rate of protection as that enjoyed by other manufacturers such as Steadfast Ltd, because otherwise it will be unable to compete with the other manufacturers to attract suitable labour for its operations, and/or will be unable to earn an adequate return on the capital invested by its overseas owners, who might then be prompted to close the operation down.
You are asked to calculate the nominal tariff rate on instant rice noodles that would be required to yield the same effective rate of protection as that enjoyed by Steadfast Ltd, assuming that the 80% tariff on rice remains in place, and that the tariff on other goods remains at 40%. Comment on your result. (4 marks)
(d) The government of Tropicana has become concerned at the inefficiency and lack of competitiveness in its manufacturing sector, and at the slow growth of its export industries. It has decided that economic policy needs to change in order to give greater encouragement to activities that are internationally competitive, or that can become internationally competitive in the future. As a first step it proposes to reduce tariffs on all finished goods (including goods used as inputs by Biosolutions Ltd) to 25%, and tariffs on all intermediate goods such as those used by Steadfast Ltd and Delicious Ltd (except rice) to 10%. The tariff on rice however must remain at 80% because of the government’s contractual commitment to the rice producer.
Calculate the effect of the proposed tariff changes on the effective rate of protection for the products of each of the three industries. (6 marks)
Briefly comment on the indicated outcome for each industry, and also on how and why the outcome differs between industries. (6 marks)
Briefly comment also on the extent to which the overall outcome is consistent with the stated outcome of the government’s proposed tariff changes. (4 marks)
(e) Delicious Ltd reacts to the government’s proposed changes by complaining that they fail to address the disadvantage that it faces because of the high cost of rice that it must purchase from local producers. It demands that the government’s proposal should be modified to allow the nominal rate of protection for instant rice noodles to be set so as to provide it with the same effective rate of protection as that will be enjoyed by other manufacturers such as Steadfast Ltd under the new tariff structure.
Calculate the nominal rate of protection that would have to be applied to instant rice noodles in order to provide Delicious Ltd with the same rate of effective protection as enjoyed by Steadfast Ltd and other manufacturers, assuming that in other respects the government proceeds with its proposed changes as set out in (d) above. Comment briefly on your results.
4 marks)
(f) The government’s proposed tariff changes are criticised in a review by independent consultants, who argue that the government’s stated objective will be better served by a uniform reduction in the tariff rate for both finished goods and intermediate goods, for example to 25% or 10%. The consultants further argue that the new uniform tariff rate should be applied to the rice industry as well. They argue that the cost of the compensation that might have to be paid to the rice producer in order to do this might be less than the cost to the economy of maintaining such a high tariff on rice. In support of this argument they estimate that a reduction in the tariff on rice from 80% to 25% would increase net national welfare by almost $1.1 million per year.
Provide a brief assessment of the arguments put forward by the independent consultants. Include a brief explanation of how a move to a uniform tariff rate on 25% on all imports would affect effective rates of protection for the three industries. (7 marks)
