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TARIFF PROTECTION IN THE U.K0,

PRICE-COST MARGINS

AND

CONSUMER WELFARE

A thesis submitted to the

University of Surrey

in fulfilment of the requirements for the degree of

Doctor of Philosophy

in

Economics

by

JAMSHID DAMOOEE

A u g u s t 1 9 8 1

t

To t h e l o v i n g m em ory o f my m o t h e r

( i )

SYNOPSIS

This thesis undertakes theoretical and empirical analyses to estimate

the welfare effects of tariffs on U.K. imports of manufactured products.

The analyses differ from the standard model of tariffs and welfare by

explicitly allowing for product differentiation between imports and home

products and for home firms’ prices exceeding their costs of production.

The theoretical analysis makes use of a simple partial equilibrium model

to examine the effects of tariffs on home industry’s profit and on the

welfare of consumers of home and foreign products. A prediction of the

model is that tariffs may generate welfare gains as well as losses.

Estimation of the welfare gains and losses required quantitative

information about the manner in which home firms' prices and output are

affected by tariffs. This information was obtained with the help of

multiple regression analyses involving a sample of forty.U.K. industries.

The regression estimates of the price-output response of home firms were

then used to estimate the welfare effects of a hypothetical cut in U.K.

tariffs. The calculations suggest that tariff reduction may generate

welfare losses well in excess of any corresponding welfare gain.

(ii)

ACKNOWLEDGEMENT

My greatest intellectual debt is to my supervisor, Mr. H. Katrak,

for his encouragement, useful comments and intellectual stimulus

•throughout the course of this research.

I am grateful to all my colleagues and friends in the Department

of Economics of the University of Surrey, and in particular to

Miss C.A. Blades, for their help and assistance.

Thanks are due to the Ministry of Economic Affairs and Finance of

Iran, for providing me with the necessary finance for this research.

I am also grateful to my family and especially to my brother Mr. H.

Damooee, whose encouragement and financial support have been of an

immeasurable value during the last few years.

Also deserving of very special thanks is Mrs. D. Aldous who patiently

tolerated the difficulties of typing this thesis.

CONTENTS

CHAPTER 1

CHAPTER 2

CHAPTER 3

CHAPTER 4

: TARIFFS AND ECONOMIC WELFARE: TRADITIONAL

Page

THEORY

1 .1 Introduction 1

1 .2 The Traditional Theory of Tariffs 2

1.2.1 The 1 Small' Country Case1.2.2 The 'Large' Country Case

37

OLIGOPOLY AND PROTECTION

2 .1 Home Firm is a Monopoly, Foreign Firms are Price Taker

12

2 .2 Oligopolistic Market with Product Differentiation

15

2.3 Summary and Conclusions 23

SURVEY OF THE RELEVANT LITERATURE

3.1 Import Competition, Domestic Market Structure, and Price-Cost Margin 263.1.1 Import Competition and Price-

Cost Margin3.1.2 Concentration and Price-Cost

Margin3.1.3 Barriers to Entry and Price-

Cost Margin3.1-.4 Report on the Empirical Findings

27

28

31

34

3.2 Protection and Employment 39

IMPORT-COMPETITION, PROTECTION, PRICE-COSTMARGINS AND OUTPUT OF U.K. MANUFACTURINGINDUSTRIES

4.1 The Models 454.2 The Variables and Data 464.3 Statistical Results

%

49

(iv)

CHAPTER 5 : ESTIMATES OF THE WELFARE EFFECTS OF THETARIFFS

5.1 Formulation of the welfare effects 595.2 Data Employed 675.3 The Estimates 725.4 Extensions and Limitations of the 80

Analyses

APPENDIX A 83

APPENDIX B 85

APPENDIX C . . . 89

APPENDIX D 96

BIBLOGRAPHY 98

Page

( v )

CHAPTER 1-

TARIFFS AND ECONOMIC WELFARE :

Traditional Theory

1.1 Introduction :

Tariff policy has in most countries been a widely discussed issue,

because it is believed to have important implications for the

welfare of the countries concerned. Tariffs have been imposed at

various times in history. During the eighteenth century and at the

beginning of the nineteenth century tariffs were used primarily to

raise government revenue, but since that time other motives have

also played a part.

At the beginning of the present century and up to World War I,

England and other European countries were free trading nations.

However, the period between the two wars, particularly the period

of the Great Depression, witnessed an increase in the use cf tariffs

and other trading impedi m e n t s ^ . Since World War II and until the

early 1970s, the trend, especially among leading industrial nations,

has been towards trade liberalisation. The Bretton Woods Conference

held in 1944 was the starting point for a new world economic order.

The "International Monetary Fund" (IMF, established in 1944) and the

"International Bank for Reconstruction and Development" (IBRD,

established in 1946) were all designed to take care of international

economic affairs among the nations.

(1) Bo SiJderstan (1971). International Economics, Macmillan Student Editions, London, pp. 342.

The establishment of these organisations was followed by the signing

of the "General Agreement on Tariffs and Trade" (GATT, established

in 1947); the latter provided the framework for international

negotiation for tariff reduction.

The rules of GATT have two main provisions. They require that :

any proposed change in the tariffs (or any other type of

commercial policy) of a member country should not be

undertaken without prior consultation of other parties

to the. agreement, and

the contracting parties should work towards the reduction

of tariffs and other international trade impediments, and

these efforts must be conducted within the framework of

GATT.

The major principle of GATT is the maintenance of non-discrimination.-

This requires that a member country's tariffs, on a particular

commodity, should not discriminate between other member countries.

Our major interest here is to study the effects of protection on the

welfare of a country. These effects are likely to vary according

to the method of analyses employed. Let us commence with a review

of the "traditional model" for analysing the welfare cost of tariffs.

1.2 The Traditional Theory of Tariffs :

The traditional theory of tariffs has been formulated in the framework

(i)

(ii)

- 2 -

of-perfect competition, by which all the products in market are

homogeneous, and there are no barriers to entry. In this theory

the costs or' gains of protection stem from the following sources :

(a) A misallocation of resources among producers

(b) A misallocation of expenditure among consumers

(c) The terms of trade effect

In the first instance let us ignore the effect of terms of trade.

This means we are only concerned with "small" countries, whose tariffs

do not affect the world price of the commodity in question.

1*2.1. The 'Small* Country Case :

The analysis can be presented with the use of Fig.(1). Importables

are shown along the horizontal axis, while prices are represented

vertically. The supply curve for the importables of domestic

producers is S S 1. The domestic demand curve for the product is d d 1.

This represents the demand for -imports and domestic production

combined. It is a compensated demand curve. This means that

consumers are compensated against the loss of utility in their income.

Thus the price change has only a substitution effect. OP is the

world price. At this price home consumption is OC, of which OK is

produced by domestic producers, and the rest is supplied by imports

KC. With a tariff of P P ’/OP per cent, the home market price will

increase to O P 1. This price rise will encourage the domestic

producers to increase their output to O K ’, while home consumption

will be reduced to 0 C ‘, and imports will fall to K'C1. Now consider

- 3 -

FIGURE 1

P r i c e s

- 4 -

the welfare effects of the tariff; the consumer surplus is reduced

by PP'EF. This is partly offset by an increase in producers'

surplus PP'HG, and revenues collected by the government HJDE.

Therefore, two triangles GHJ and DEF represent the net welfare loss.

These are called the production cost and the consumption cost

respectively.

An alternative way of explaining the net welfare costs is as follows:

The production cost is the excess of the domestic cost of producing

the amount of KK' compared with the cost of importing the same amount.

Correspondingly, the consumption cost measures the loss of utility

when consumption decreases by CC' over and above the saving in the

cost of importing that amount. The above argument may easily be

extended to deal with' the case of a domestic monopoly. The main

point is that, since the country is a price taker in world market,

the monopolistic marginal revenue will equal the average revenue.

Consequently, the price and output of the monopolist would be the same

as that of uhe perfectly competitive industry, analysed above.

The two above-mentioned costs may be formulated as follows : If dC

is the decrease in consumption, dQ is the increase in the production

of home products, P is the world price of the product, and t is thewtariff rate, expressed as a proportion of the world price. We can

write :

Consumption cost = h dCt Pw ( 1 )

Production cost = h dQt P .w (2)

- 5 -

I

T h e r e f o r e

Total Costs = h (dC + dQ) t P W (3)

The decrease in the values of imports (dM), resulting from the

imposition of a tariff is equal to the sum of the decrease in

consumption (dC) - the direct price effect - and the increase in

production (dQ) - the substitution effect. Thus :

dM = dC + dQ

substituting equation (4) into (3) we have

(4)

Total costs = h (dM) tP,

where dM = e .m

W

dP,WW.

M

(5)

(6)

Therefore :

Total costs = hdP e W

m —W

MtP,W

(7)

where e^ is the price elasticity of imports, and M is the volume of

imports before tariff imposition. It is well known that the price

elasticity of imports is a weighted average of the price elasticity

of domestic demand and of domestic supply. This is proven as follows:

We had :

w h ere

dM

dC

dQ + dQ

dP e W

(4)

(8 )

- 6 -

T h e r e f o r e :

dM Wpr, (e C - e O) W ( c Q J ( 1 0 )

Dividing both sides by M, we obtain :

dMM P,W

W e C( 1 1 )

so that: edMM

( 1 2 )m dP,W

e CC 77

P,w

where is the price elasticity of demand for the product, and e^

is the price elasticity of the domestic supply of the product.

The "large" country case :

Up to this point the analysis has considered the case of a "small"

country, which is a price taker in the world market. Relaxing this

assumption leads to the possibility that the tariff will improve the

country's terms of trade. This "terms of trade" effect is a source

of welfare gain to the country and must be set against the two

elements of welfare loss discussed above. This case is presented

in Fig.(2). Imports are shown on the horizontal axis and prices on

the vertical axis. The foreign supply curve is HH'0 The domestic

demand for imports is shown by DD' ; this is obtained by subtracting

the domestic supply of the product from the home demand for the

product. OW is the import price under free trade. The amount

imported is OM. Now suppose a tariff of WU q_/0W per cent is imposed.

The tariff-inclusive foreign supply curve is W . The equilibrium

Prices

FIGURE 2

- 8 -

domestic price will now be OZ^ the foreign price will be OZ and the

quantity of imports will be OM^. In comparison with the free trade

situation the foreign price has been lowered by Z^W. The amount of

duty collected by the government will be ZZ^GJ. Against this is the

welfare loss WZ^GQ, showing the loss to consumer surplus (net of the

gain to produce surplus) . This means that the country has a welfare

gain if ZWKJ exceeds GKQ. The essence of the above argument is that

a "large" country may benefit from imposing an appropriate rate of

tariff. .The present study is concerned with the U.K. manufacturing

industries in 1963 and 1968. At that time the U.K. had not yet

become a member of European Economic Community (EEC). The imports

of the manufacturing goods to the U.K. in comparison with the world

demand for these goods were not at that time large enough to

characterise the U.K. as a large country0 We are therefore faced

with a "small" country case with respect to the purpose of this

research.

The analysis has so far dealt with the simple case of only one

imported good. Extending the analysis to the case of two or more

imported goods raises two problems, discussed among authors by

H.G. Johnson (1971). Firstly, tariffs may lead to substitution

between foreign goods and domestic goods, and secondly, some goods

may begin to be produced for the first time. However, as Johnson

had shown an evaluation of the effects of these two possibilities

requires information concerning the substitution elasticities among

different foreign and domestic goods. As such information cannot

readily be obtained for the U.K* we will therefore abstract from

- 9 -

t h e s e p r o b le m s i n t h i s s t u d y .

Ihe standard model assumes that domestic firms set their prices equal

to marginal costs, which - in equilibrium - equals the long-run average

cost. This assumption, however, is at variance with empirical (1 )evidence , which suggests that, firms are able to raise their prices

above long-run marginal costs, and thereby earn excess profits. In

In view of such evidence it seems desirable to extend the welfare

analysis of tariff and explicitly allow for situations in which firms

set their prices above the competitive level. This is the subject

of the next chapter.

(1) Bain J.S. (1972). Essay on Price Theory and Industrial Organisation. Boston, Little Brown and Co.

CHAPTER 2

OLIGOPOLY AND PROTECTION

This chapter extends the analysis of tariffs and their welfare

effects by incorporating the role of large domestic firms, whereas

in the traditional theory of tariffs, concerned with situations of

pure competion, the equilibrium market price always equals the long-

run marginal costs cf production. The existence of large firms in

the economy suggests that prices are likely to exceed the marginal

cost even in the long-run. The ability to raise price above the

marginal cost may be greater the greater the market power of the firm.

Market power in the present context should allow for the degree of

foreign competition. Imports are likely to exert an important

negative influence on profit margins. Conversely, tariff may

increase the margins.

The important implication of the above argument is that if the home

industry is dominated by few large firms, the imposition of tariffs

may generate welfare gains as well as losses.

The task of this chapter is to analyse these gains and losses.

Ideally, such analysis requires a model of tariffs in the context of

an oligopolistic market. In practice, however, such a model would

face the problem that an oligopolistic firm's reaction to tariffs

may depend on the reactions expected from home and foreign rivals.

Archibald (1959) has argued that the number of competing firms is not

an important factor. What is important is the firm's presumption of

its rivals behaviour. The firm concerned may simply ignore the

- 1 1 -

entire matter, or, alternatively, it may attempt to anticipate the

nature of its competitor's reactions. In order to avoid the

problem of interdependency, we will assume that the home industry

consists of either a monopoly, or in the instance of an oligopoly,

the firms pursue a policy of joint profit maximisation. With

regard to the relationship between the home firms and the foreign

rivals, we will consider two alternative cases.

2*1 Home Firm..' is a Monopoly, Foreign Firms are Price Followers

Here, we assume that home and foreign firms produce homogeneous

products. The dominant home firm seeks to maximise its profits

subject to the constraints of import competition. Foreign suppliers

behave as atomistic firms: they perceive their average revenue curve

in the home market to be perfectly elastic at each price and set their

marginal cost equal to their price. In Figure (1) prices and tariffs

are shown along the vertical axis, while output and imports are

measured on the horizontal axis. DD* is the domestic demand curve for

the commodity.

Initially, we will consider the case to be linear, the non-linear case

will be explained later. In the absence of imports, DD* is also the

average revenue curve facing the home firm.: MC is the marginal cost

curve for the domestic producer. SF is the supply curve of foreign

firms. The average revenue curve for the home producer is now

obtained by the horizontal differences between DD' and SF. The

resulting curve is shown by HH', the corresponding marginal revenue

curve is r r 1. Before the imposition of tariffs, the home firm produces

OQq and sets the price at 0Po . Given the price, the foreign producers

- 1 2 -

sell the amount QoQy. Now consider an ad-valorem tariff of, say,p p-jffl Per cent* The tariff shifts SF to S'F', and consequently the OPoexcess demand curve will shift upward to JJ*. Following the shift

in the excess demand, the marginal revenue curve rr* will also shift

upward to UU’. The profit maximising price for the home firm will now

be OP 3 and at this price the home firm can increase its production to

OQ 2 . Given this price (OP3 ), the foreign suppliers (behaving as atomistic

firms) will lower their price (the tariff exclusive price) to OPf, and

the quantity of imports will also be reduced to Q2 Q 3 , (Q0 Q 2 + Q 3 Ql less

than its free trade level). In comparison with the free trade situation

the foreign price is reduced by PQP f . The amount of duty collected by

the government will be PfP^KL, against this is the loss of consumer surplus

represented by the area PqP^N^M-^. Moreover, what is new is that the

tariff increases the profit of the home firm by (P0 pdN 2 M 2 + WQ£ M 2 W 2 ) r and

that this may, together with the effect of the "Terms of Trade", offset

and even exceed the loss of consumer surplus. Thus we find that the tariff

brings a net gain (loss) in welfare accordingly:

+ PfP0KoL < M 3N 3 M 2,

The results here are not surprising in view of the analyses of J. Bhagwati

and V.K 0 Ramasawi (1963) and Johnson (1971) which argued that in the

presence of domestic distortion tariffs may increase or decrease welfare.

That is, free trade is not optimal, and thus tariffs as a second distorting

factor may help the attainment of an optimum s i t u a t i o n ^ .

The diagram indicates the possibilities in which welfare increases or

decreases. As can be seen, the welfare loss increases as price goes up,

and the possibility of the welfare gain increases as output expands. In

(1) R 0 G 0 Lipsey and Kelvin Lancaster (1956). "The General Theory of Second Best". Review of Economic Studies, Vol.24, p p ell-32.

- 14 -

a linear case, price and output will both rise, but in non­

linear cases other outcomes are possible* For example, in a

constant elasticity case (explained in Appendix A ) , where the

elasticity of foreign supply equals the elasticity of home demand,

the tariff will not affect the price, so the output will increase.

However, there are other cases in which the non-linearity of

foreign supply and domestic demand is accompanied by changeability

in these price elasticities. In such a case as Finger (1973) has

argued an upward shift of demand may coincide with a sufficiently

large reduction of the elasticity ofNdemand, that the monopolist's

marginal revenue curve shifts downward and it becomes profitable

for the monopolist to further restrict its output or reduce its

price.

2.2. Oligopolistic Market With Product Differentiation

In the previous model we assumed that home and foreign products were

homogeneous - that was in keeping with the assumption of the standard

theory of tariffs. However, this assumption seems at variance with

the conditions in the U.K. case. Casual observations show that the

competing imports are often differentiated from the home goods. It

therefore seems desirable to relax the assumption of product

homogeneuity and this will also allow us to distinguish between groups

of consumers according to whether they consume home or foreign goods.

To simplify the analysis we will make the following assumption in

addition to those which have already been imposed by the previous

model.

(i) All imports consist of a single homogeneous product.

(ii) The C.I.F. price of import is independent of the home

price.

- 15 -

The latter assumption enables us to avoid the problem of interdependent

pricing discussion under oligopoly. This is justified if foreign firms"

sales to the U.K. are a small proportion of their total sales. The price-

quantity relationship for the home products and imports are shown in Fig.(2).

Quantities produced and imported are shown on the orizontal axis; prices

and tariffs are along the vertical axis. is the demand curve for home

products when the price of foreign products equal their C.I.F. price. Before

the imposition of a tariff the marginal revenue curve interesects the marginal

cost curve (MC) at Cty. Therefore, the price is set at °dpl and the quantity

is . At this price the demand curve for foreign goods is shown by

F^F]_. As can be seen, the foreign suppliers sell the amount of OfNfy.

W1 W2Let us now suppose that a tariff of ■■ per cent is imposed. The price of

imports rises to OfW 2 . This will reduce the imports of Of M 2 . There will

consequently be a loss of consumer surplus equal to t^WfTS. Of this, WfV^TR

will be offset by the collection of tariff duties by the government. The( 1 )remaining segment TRS is a welfare loss for the country. The rise in

the import price will also shift the home firms1 demand curve to D 2 D 2 .j

Those firms may now increase their output and/or increase their price in

order to maintain maximum profits. The policy to pursue will depend on

the consequent change in the price elasticity of the shifted demand curve.

Initially, we can assume that the elasticity is not affected by the

shift of the curve. Considering firms do not increase their price,

(1) The assumption of import prices being independent of home pricesenables us to abstract from the terms-of-trade effect. Relaxation of this assumption will necessitate the inclusion of the effect of the terms-of-trade in our analysis: VtyW^TR will be the lower boundof the. government revenue, while VtyV^TS will be the upper bound of the loss of consumer surplus to the consumers of foreign goods.

- 1 6 -

(a) (b)

Price ofHomeProducts

Price ofForeignGoods

Domestic Output Imports

FIGURE 2

- 1 7 -

but' merely increase their output. This means that consumers who

had bought the home products before the tariff will not suffer any

loss of welfare. The firms' profit will increase by

indicating a welfare gain for the country. Thus the net welfare

change will be a gain or loss according to >< TRS.

We will now allow for the possibility that the tariff induces an

increase in the price of the home producers as well as in their

output. Let the price rise to 0dP 2* increase the profit will

now be C^C 2 H^H 2 +P-j/p2 A 3 H 3 ~C^H 2 H 2 C 2 • total loss of consumer

surplus is suffered by consumers of home produced goods plus

W i W 2TS suffered by consumers of foreign produced goods. The net

welfare effects will, therefore, be a gain or a loss according to

^ l ^ l ^ ^ ><7^ 2 ^ 3 + Clearly, the likelihood of a welfare gain

(loss) is smaller (greater) than that in the previous case where the

home price was not affected by the tariff. Thus, as in the

homogeneous products model, we can state that the possibility of a

welfare loss increases the greater the increase in the home firm's

price and the smaller the increase in its output.

Up until now we have assumed that home producers perceive their

demand curve as smooth, continuous and downward sloping. However,

it is interesting to note that the same results will be obtained under

an alternative model, namely the kinked demand curve model.

The kinked demand curve argument is that a firm in an oligopolistic

setting views its average revenue curve as consisting of two parts.

- 1 8 -

The firm believes that its rivals have asymetric response to price

changes. It believes that they will quickly match its own price

reductions, but only hesitantly and incompletely (if at all) follow

its price increases. This pattern of expected behaviour produces

a kink in the perceived demand curve facing the oligopolist. The

argument is presented with the use of Figure (3). Output is shown

on the horizontal axis, while price is on the vertical axis.

is the perceived demand curve by the individual firm, while the

curve shows the amount of demand going to a firm when all firms are

charging the same price.

As the average revenue curve is kinked at point K , the associated

marginal recenue curve will be discontinuous below this point.

Consequently there is a "gap" between the two segments (r-Lri' r ] r-[)

of the marginal revenue. As Stigler (1947) argues, the length of

the discontinuity in marginal revenue is proportional to the

differences between the slopes of the demand curve on the two sides

of the kink. He also states that the discontinuity will be larger

the more similar the products, because customers will shift more rapidly

to the low-price firms. The marginal cost curve is shown by MC.

If the marginal cost curve intersects the marginal revenue curve in

either of the two segments, the price and the output will be determined

in accordance with the profit-maximisation conditions. However if

the cost curve cuts the discontinuous part of the marginal revenue

curve the price-output combination will coincide with the kink at K.

Now let us turn to the effect of trade and tariffs. To simplify the

analysis we hold to the assumptions set out for the previous model.

P r ic e

FIGURE 3

- 2 0 -

Figure (4a) shows the output of the home firms, while (4b) shows

imports. d^fflD^ is the kinked demand curve for the home products,

which is regarded as the average revenue curve by home producers.

The lower part of the- kinked demand curve (fflffl) expresses the

behaviour of all firms (foreign and domestic) in the market. Thus

a price change in the lower part of the curve will stimulate

retaliatory reactions of foreign films, while in the upper part

(d ffl) a price rise will not necessarily be copied. The relevanti i

marginal revenue curves are fflffl ancl fflffl* MC xs the marginal cost

curve. FF is the demand curve for imports. Before the imposition

of a tariff the kink is at price (fflffl* Home firms produce 0 Q-, andW1 W2 ° 'total imports are 0 A - Now supposing a tariff of Q ™ per cent

f 1is imposed. The price of imports rises to 0_Wn and the demand for

± 2

imports falls to fflffl . The result is a loss of VfflfflTS in the

consumer surplus of those who consumed foreign goods. Of this amount

W^fflTR will be offset by the collection of tariff duties by the

government. The remaining segment TRS is a welfare loss for the

country. This loss should be set against any losses or gains obtained

from the induced changes in the price and/or the output of home firms.

The increase in the price of imported goods results in an increase in

the demand for home produced goods. This will shift the two parts of

the kinked demand to a new position. The effect on price and/or

output of the home producers will therefore depend on how these shifts

come about, or in other words, where the new kink is set up. Initially,

we assume that the kink shifts in such a way that home price remains

The a n a l y s i s i s p r e s e n t e d w it h th e h e lp o f F ig u r e s (4 a ) and (_4b) .

- 2 1 -

P r ic e P r ic e

Output . Imports

FIGURE 4

- 2 2 -

to 0-0 . Since the cost is assumed to be constant, the result will d 2be an increase in the profits of home firms, by an amount CyKlK2C2'

The net welfare effect will be a gain or a loss according to ;

C1 K 1 K 2C 2 >< TOS

However, the kink may shift to such a position that the expansion of

output is accompanied by a price.increase. This is shown on the

Figure when the kink is at K . The increase in the profit will now

be C2.K1K2C 2 + LP2K 3Z ~~ ZK2C2C 3* <Ile total loss °f the consumersurplus i s E L,P2 K 3 K 2 suffered by consumers of home produced goods, plus

^ l ^ T S suffere(3 by consumers of foreign produced goods. The net

welfare effect will therefore be a gain or loss according to

C 1K1ZC3 >< TRS + ZiyK .

As can be observed, a rise in the home price brings an additional loss

of consumer surplus (suffered by those who consume home products) and

reduces the level of domestic output. It is therefore justified to

state that the larger the increase in the home price, the larger the

loss of consumer surplus and the smaller the level of home products.

In other words, the likelihood of a welfare loss will be smaller

(greater) the smaller (greater) the increase in the home price. The

same conclusion can be drawn from the analysis of the former model.

2.3 Summary and Conclusions

In our first model we have shown that in a market where products are

homogeneous and foreign firms take the price set by the domestic

u n ch a n g e d . The o u t p u t o f th e home p r o d u c e r s w i l l t h e r e f o r e i n c r e a s e

- 23 -

monopoly, the imposition of tariffs may increase the profits of home

firms as well as reducing the consumer surplus. The increase in the

profit occurs through an increase in the price or/and an expansion in

the firm's output. The derived conclusion seems consistent with

those found by J. Bhagwati and V.K. Ramasawi (1963) and H. Johnson

(1971) that tariffs in the presence of domestic distortion may increase

or decrease welfare.

\In our second model, we relaxed the assumption of product homogenuity.

Correspondingly, consumers were divided into two groups according to

whether they preferred home or foreign goods. As in the homogeneous

product case, price and/or output could both be affected by the tariff.

The analysis of the model indicated that welfare gain (loss) would be

smaller (greater) if the home price was not affected by the tariff.

Finally, we showed that the same conclusion could be reached from a

third model, namely that involving the kinked demand curve.

In brief, the analysis of our three models showed that the imposition

of a tariff may generate either a welfare gain or a loss. The

welfare gain is the result of the impact of tariff on the profits of

the home firms. The increase in the prof its occur through either an

expansion of the home firms1 output or an increase in their price or

a combination of both. Furthermore, the analyses showed that the

likelihood of a gain (loss) is smaller (greater) if the price of

domestic firms is affected by the tariff.

Our main purpose now is to use the above analysis to estimate the

welfare effect of tariffs in the United Kingdom. To do this we will

- 24 -

need to run some econometric tests in order to examine the effects

of tariff and import-competition on the prices and output of home

firms. But before carrying out such tests we will review the

empirical work undertaken in the field by other economists.

- 25 -

CHAPTER 3

SURVEY OF THE RELEVANT LITERATURE

The theoretical analysis of the previous chapter indicated that in

an oligopolistic market tariffs may either increase or decrease home

welfare depending on the effects of the tariffs on the price and

output of domestic firms. This chapter surveys the relevant economic

literature to discover what the empirical evidence indicate about the

effects of tariffs and import competition.

Strictly speaking, the empirical literature is not directly concerned

with the effect on home price. However there are a considerable

number of investigations into the effects on the price-cost margin.

Since protection is unlikely to have any systematic effect on the

firm's costs, the results for the price-cost margins may be considered

as indicative of the effects on home prices.

3.1 ’import Competition, Domestic Market Structure, and price-cosc margin:

Economic theory suggests that the structural feature of an industry

influences the performance - price, output, and profits - of the firms

in the industry. During the last three decades several empirical

studies have examined the relationship between the market structure

and profitability. Initially, these investigations were concerned

only with the closed economy, indicating that profitability is

influenced only by the structure of the domestic market. More recent

studies have also incorporated foreign competition and protection as

contributory factors.. Here we will primarily survey the latter type

of studies.

- 26 -

3 . 1 . 1 . Im p o rt C o m p e tit io n and P r i c e -C o s t 'M a r g i n

Import competition may reduce the market power of the dominant firms

in a given industry. In effect, this represents entry by foreign

competitors and therefore distorts domestic seller concentration.

The effect of foreign entry on home firms1 prices and consequently

on their price-cost margins to a great extent depends on the existing

product differentiation between home and foreign goods. In a

situation that imported and domestic products are homogeneous, a

substantial amount of imports or the threat thereof may encourage

domestic firms to set import-entry forestalling prices approaching

competitive prices. This view was first advocated by Esposito and

Esposito (1971). The implication of this view is that imports have

a negative impact on the price-cost margin of import competing

industries.

In the presence of product differentiation the behaviour of competitive

import prices may have no significant effect on the price of

domestically produced manufacturers. This view is backed by the

empirical findings of Coutts, Godley, and Nordhaus (1978). However

the effect of foreign entry on home firms' concentration may

contribute to a reduction in the home firms' profitability.

In brief, if import competition is believed to have a negative effect

on the home firms' profitability, tariffs will conversely be expected

to exert a positive effect on price-cost margins. We are, therefore,

faced with a choice of using either imports or tariffs as a measure of

- 2 7 -

t h e i n t e n s i t y o f f o r e i g n c o m p e t i t io n .

There is further the question of which type of tariff rates can most

suitably be employed. Some economists, like Mcfetridge (1973) and

Hitiris (1978), advocated the choice of effective tariff rates in

preference to the nominal tariff rates. The argument is, that

tariffs simultaneously provide subsidies to the domestic production

of the goods on which they are levied, and impose taxes on the

domestic goods which are inputs. Thus, a tariff on inputs used in

the import competing industries constitutes a subsidy on imports.

Effective protective rates emphasize the importance of tariffs,

taxes and subsidies, on the final products and intermediate inputs.

They are therefore a measure of the afforded degree of protection

most relevant for the study of profits.

The opposing views are based on the fact that the effective tariff

rate is usually calculated under conditions of perfect competition,

and therefore cannot be an appropriate measure, used in a study based

on the conditions of an oligopolistic market.

3.1.2. Concentration and Price-Cost Margin

■ Given the cost conditions of the firms and the market demand, we

expect that prices will be higher under conditions of monopoly than

under conditions of competitions. In an oligopolistic situation

we expect to observe a positive relationship between industry price

and the degree of seller concentration. The reason for expecting

such a positive relationship is that the higher the level of seller

- 28 -

concentration, the more likely it is that the dominant firms will be

able to collude, tacitly or expressly, to raise prices above the

long-run average cost.

Ihe theoretical relationship between the market power of firms and

the degree of concentration has been shown by T.R. Saving (1970).

He made use of a model in which an industry consists of a few large

firms that function as a cartel and a large number of smaller firms.

The operating assumption is that the dominant firms set the price

and allow the smaller firms to sell at that price. Thus the latter

firms behave as atomistic firms in perfect competition. Let there

be (n) minor firms and (K) dominant firms. Market demand (D) is a

function of the market price (P).

The quantity supplied by the (n) smaller firms is a function of

As the market is cleared at all times, the demand function for the

large firms is the difference between (1) and (2) .

Now assuming that f and g are continuously differentiable, we have :

D = f(P) (1).

the price (P) .

Sn g (P ) (.2)

DK f(P) - g(P) (3)

K f' (P) - g T (P) (4)dP

- 29 -

and s o t h e e l a s t i c i t y o f demand f a c i n g l a r g e f i r m s i s :

\f (P)

Kg(P)

K(5)

Where n and ri are respectively the demand elasticities for the K Dlarge firms and for the market, and is the supply elasticity for

the smaller firms.

Equation (5) may be related to L e m e r ' s (1933) measure of monopoly

power. L e m e r ' s measure is defined as :

P-MC.KK (6)

Where A is the K firms L e m e r index and MC is the joint marginal K Kcost for the K largest firms. If we assume that joint profits are

maximised at all times, (6) becomes :

P-P 1-fK (7)

'K

Since the R.H.S. of (7) is simply the negative invers of (5), the

Lerner's index may be written as :

K f (P)K

!g(P)i DK

E(8)

Defining the concentration ratio as the percentage of industry sales

accounted for by the K firms ffl = ° K , equation (8) can now be expressedD

in terms of C (industry concentration ratio). K

- 3 0 -

Therefore given the framework of the dominant firms’ model, the

degree of monopoly power is positively related to the concentration

ratio.

Barriers to Entry and Price-Cost Margin

Concentration itself may be a parameter. In fact it may be

influenced by barriers to entry to the industry. Established firms

may create entry barriers to deter new-comers to the industry. These

barriers may directly and indirectly enable established firms to earn

excess profits. As Bain (1956) suggested the conditions of entry

may have a significant influence on the pricing behaviour of existing

firms. Given significant barriers the price can exceed the minimum

long-run average cost.

Entry barriers arise from the following sources : scale economies,

product differentiation, absolute cost advantages, and capital

requirements.

(a) Scale Economies :

Production and distribution costs per unit of output may

decline as the scale of plant or firm is expanded. The

smallest scale of operation at which a plant or firm may

achieve the lowest attainable unit cost is referred to

as the minimum optimal scale of the plant or the firm.

An entrant to industries where the minimum optimal scale

is significantly large would anticipate higher than

minimum attainable costs (due to suboptimal scale).

This is likely to deter entry. This entry-barrier

may enable the established firms to raise their prices

at least somewhat above their minimum attainable

average costs without attracting entry. Thus

relatively large minimum optimal scales may make for

high concentration and high margin.

(b) Product Pi fferentiation Advantages :

Product differentiation is propagated by differences

in the design or quality of competing products and by

the sales and advertising efforts of sellers. Buyers

may have a preference for the products of established

firms as compared with the products of new entrants.

This may itself be a source of barriers to entry.

Economic theory suggests that as a consequence of

product differentiation, the seller gains some independent

jurisdiction over his price, relative to the price of his

rivals, which he would not have if the competing products

were part of a single homogeneous, standardised commodity.

Thus, firms producing such products may raise their prices

somewhat above those of their rivals without losing all of

the customers.

- 32 -

(c) Absolute Cost Advantages ;

Established firms may also have an absolute cost

advantage over potential firms. The long-run

average cost curve of the new entrant (showing the

relation of the scale of operation to unit costs of

a firm) would then lie above that for the established

firms. The sources of absolute cost advantages are

as follows :

(i) Established firms may control superior

production techniques.

(ii) There may be imperfections in the markets

for productive factors purchased by all

firms which permit established firms to

employ such factors at relatively lower

prices.

(iii) Strategic factor supplies; established

firms may have control over factors such

as new materials.

(d) Capital Requirements :

Capital costs are fixed costs which are incurred regardless

of the level of output. These costs differ between

industries. High capital requirements thu.s insulate

existing firms from the potential competition of new-comers.

We may expect capital intensive industries to make for

higher concentration and higher price-cost margins.

- 3 3 -

Here we report the findings- of eight studies which have examined

the relationship between price-cost margin (or profit margin) and

market structural factors in an open economy.

These are: G. Esposito and F. Esposito (1971); D.C. McFetridge (1973);

J. Khalilzadeh-Shirazi (1974); H. Bloch (1974); E* Pagoulatos and

R. Sorensen (1976); P.E. Hart and E. Morgan (1977); J.C.H. Jones,

L. Laudadio, and KU Percy (1977); and T. Hitiris (1978).

Most of the above studies employed multi-variate regression analysis

in order to explain the relationship in question. However,

E.Pagoulatos and R. Sorensen (1976) used joint generalised least

s q u a r e s ^ in addition to multi-variate regression analysis in their

investigation.

In general, an industry’s profit ratio is measured.by one of the two

following fractions :

3 . 1 . 4 . R e p o r t o n t h e E m p i r i c a l F i n d i n g s

(1) A. Zeller (1962). "An efficient method of estimating seemingly unrelated regressions and tests for aggregations bias",Journal of the American Statistical Association, p . 548-68

A. Zeller (1963). "Estimate for seemingly unrelated regression equations, some exact finite results". Journal of the American Statistical Association, o.977-92

H.Theil, (1971). Principles of Econometrics, New York,

John Wiley and Sons Inc. p. 294-303

- 3 4 -

( T o t a l I n d u s t r y ( P a y r o l l + D e p r e c i a t i o n + O t h e rP r i c e - c o s t Sales)■ Fixed and Variable Costs)

MarginTotal Industry Sales

Profit (Net Output) (Payroll + Depreciation + Other _________ Variable Costs)

MarginNet Output

However in some of the above-mentioned studies, the adopted measures

were slightly different from those given above. L. Esposito and

F. Esposito (1971) took profit (after tax) as a percentage of net

worth (instead of total sales) to measure profit ratio. E. Pagoulatos

and R. Sorensen (1976) defined price-cost margin as the net return

(valued added - payroll - depreciation) expressed as a percentage of

industry sales. J. Jones, L. Laudadio, and M. Percy (1977) took the

ratio of profits plus interest to total assets in order to measure

industry profit ratio.

The empirical results of the above-mentioned studies are summarised

as follows :

Import Competition or Trade Protection

The effect of foreign competition bn price-cost margin has been

tested either by using the import/sales ratio or the tariff rates.

Esposito and Esposito (1971), Khalilzadeh-Shirazi (1974)., Pagoulatos

and Sorensen (1976), and J. Jo'nes, L. Laudadio and M. Percy (1977)

found the import-sales ratio had a significant negative effect on

industry price-cost margins. Though Hart and Morgan (1977) found

3 5

l e s s s a t i s f a c t o r y r e s u l t s .

McFetridge (1973) seems to have been the first who investigated the

effect of tariff protection. Using the effective rate as a measure

of protection, he failed to find any significant effect on the profit

margin. On the other hand, T. Hitiris (1978) who also used the

effective rate measure, found a highly significant relationship with

the price-cost margins. H. Bloch (1974) was concerned to see whether'

the effects of tariffs were interdependent with those of concentration.

He found that the interdependence is such that the price-cost margin

tends to be higher when tariffs and concentration are both high, but

high tariffs and low concentration have no significant influence on

the margins.

Concentration:

Overall, concentration showed a positive, consistent, and statistically

significant relationship with price-cost margin in almost all the

studies concerned. There is, however, some evidence of nultico.llinearity

between concentration ratio and the capital intensity factor. The

other important outcome of these studies is the appearance of less

significant results for small economies. This is shown in the

empirical findings of E. Pagoulatos and R. Sorensen (1976). The

study in part tries to explain the relationship between price-cost

margin and concentration for five EEC countries (France, Italy,

Netherlands, Germany, and Belgium). The results of the study

suggest that domestic industry concentration does not necessarily

reflect the degree of monopoly power in small relatively "open"

economies.

(1976) , and T. Hitiris (.1978) , the other aforementioned studies

included scale economies in their analyses in order to explain the

changes in price-cost margins. L. Esposito and F. Esposito (1971)

took the ratio of average plant size to total industry output as a(1)measure of scale economies . Average plant size was calculated

for the largest plants supplying apprximately fifty per cent of the

industry. D„ McFetridge (1973) took the percentage of industry

shipments accounted for by the largest four establishments as a

measure of scale economies. J. Khalilzadeh-Shirazi (1974) took the

size of the "mid-point” plant as a percentage of industry net(2)output to measure scale economies . Size is determined by

employment. The same technique was employed by Jones, Laudadio,

and Percy (1977) . However, due to data constraints there was a

slight difference in their calculation of the average plant size

for Canada and America. The authors took the average plant size

of the largest establishments accounting for 50 per cent and 80

per cent of the industry output for the U.S.A. and Canada respectively.

These were expressed as percentages of industry output. Hart and

Morgan (1977) took the medium size of enterprise by employment as a

measure of scale economies.

B a r r i e r s t o E n t r y

W i t h t h e e x c e p t i o n o f H. B l o c h ( 1 9 7 4 ) , E . P a g o u l a t o s a n d R . S o r e n s e n

(1) Camanor and Wilson (1967) were the first who used this method

(.2) L. Weiss (1963) was the first one who employed this methodto estimate "minimum optimal scale".

Esposito and Esposito (1971). collected varying results. The

relationship between scale economies and price-cost margin was

negative and significant for producer good industries but not for

the consumer good industries. McFetridge (1973) and Hart and

Morgan (1977) found insignificant relationship between scale

economies and price-cost margin. Jones, Laudadio and Percy (1977)

found a positive and significant relationship for consumer good

industries only for the American sample. For other samples the

results were insignificant. Since there was evidence of

multicollinearity between scale economies and concentration ratio,

the authors regarded their results with caution. Khalilzadeh-Shirazi

(19.74) found the relation very significant.

Product differentiation is measured as the percentage of advertising

expenditure on total industry sales. All of the above-mentioned

studies, with the exception of Hitiris (1978) found support for the

hypothesis and there is a positive relationship between industry's

price-cost margin and its advertising intensity.

Capital requirement, often expressed as the ratio of an industry's

capital assets on sales, has also.been used in some of the studies

e.g. Esposito and Esposito (1971), Khalilzadeh-Shirazi (1974),

Jones, Laudadio and Percy (1977) and Hart and Morgan (1977). Ifost

of these studies found a statistically significant relationship with

the price-cost margin. The interpretation of this result, however,

is problematical, because of evidence of multicollinearity between

this factor and the concentration ratio.

- 3 8 -

In assessing the effects of protection on the output of a firm, the

measurement of output appears as a problem. Ideally, one would

like to employ a physical measure in quantifying the real change in

output. But such a measure has little practical use in a study

concerned with a group of commodities. The alternative is to either

use the money value of output (total sales) or an input factor

related to output, such as the level of employment or capital.

Neither of the above measures (for the following reasons) can

adequately express the real change in output. The price of a

product may change and consequently increase the total revenues, but

such an increase could have also occurred if the level of output had

risen. Therefore, it is difficult to specify the reason for which

the value of output has risen. One can directly relate employment .

to output, but a change in employment can also be due to changes in

factors like productivity or capital intensity, and not necessarily

to the change in output.

However, in economic literature one does not often come across

empirical studies which investigate the effect of protection on

industries1 output. Thus this section surveys some relevant

economic literature to observe the impact of protection on employment.

The empirical evidence of the effects of protection on employment may

be classified into two groups. The first group considers the effect

of protection on employment, as the outcome of a direct relationship

between the number of job losses, and the import/output or tariff

ratio. From this group of studies we will mention three pieces of

3 . 2 . P r o t e c t i o n a n d E m p lo y m e n t

- 39 -

work, two conducted by the International Labour Office (ILO) and

one by the Organisation of Economic Co-operation and Development

(OECD).

In the second type of studies, employment is an endogenous variable

which may be related to international trade, labour productivity,

consumption, and various other factors. From this group two recent

studies will be mentioned.

The first ILO study (1968) attempted to assess the number of

employment opportunities lost, as the result of increasing imports

from developing countries. The study treated the imports of

manufacturers and semi-manufacturers from developing countries as

competitors of the product of domestic manufacturers in the

developed countries. This was undertaken for the period 1961-65

and dealt with eight selected groups of industrial products in the

three major industrial areas, namely North America, the EEC, and

the EFTA. The study considered the direct employment effects

only; the indirect effects from other inter-industry relations

were not taken into account. Its procedure assumed that, during

the period under study, everything else but imports and employment

remained unchanged.

The results suggest a displacement of less than 0.2% of the total

manufacturing employment in each industrial area.

The second study of the ILO (.1971). aimed at estimating the effect

of removal, or reduction of trade barriers (against imports of

- 4 0 -

manufacturers of developing countries) on employment in the

developed countries. These estimates were based on Professor

Balassa's (1968) study of the probable increase in imports of

manufactures from developing countries to the U.S.A., the U.K.,

the EEC, and the EFTA. He forecasted the increase in imports' due

to the elimination of tariffs. The ILO study showed that the

Kennedy round had only negligible effects. For the hypothetical

case of the total elimination of tariffs, the results were rather

interesting. For example, in the U.S.A. the decrease in employment

caused by the increased importation of manufactures from developing

countries, amounted to less than 0.16% of the total manufacturing

employment. The results for the U.K., EEC, and EFTA, were a decrease

of 0.027%, 0.083%, and 0.071% respectively in the total employment

of the manufacturing industries.

A similar approach was taken in the study by J. Little, T. Scitovski,

and M. Scott (1970) for the OECD Development Centre. The authors

attempted to measure the level of unemployment in the OECD countries,

which would result from a hypothetical expansion in imports of

manufactures from the developing countries. The results showed a

loss of 750 thousand jobs in these countries. The lost jobs

consisted of a reduction of 0.5% and 4.9% in the employment of the

manufacturing sectors in the U.S.A. and the U.K. together with EEC

countries, respectively.

/

In a more recent study E.E. Learner, R.M. S t e m and C.F. Boun (1977)

took a different approach to study the effect of foreign competition

on manufacturing employment in the industrial countries. They

- 4 1 -

assumed that the level of employment in an industry can be explained

partly by a set of "resource variables" and partly by a set of

"resistance factors". The "resource variables", such as factor

endowments, determine the special productive capacities of the

country, while the "resistance factors", such as tariffs and

transportation costs, determine the country's access to international

markets. The authors general hypothesis was that, countries

economise on their relatively scarce resources. Thus relative

scarcity of resources and openness of markets determine the

allocation of production across industries. Their model is

specified as follows :

| n Q = a + £X + ( Y + A x ) / ( 1 + t )

Where Q = output, X = level of resource variables, and t = a

measure of tariff,

the authors argued that the relationships involving resource levels,

tariffs, and output can also be applied to factor inputs. Thus

they estimated the above equation with a measure of employment as

the dependent variable. The model was tested with reference to 20

industries in each of the world's 18 major industrial countries.

They used tariffs from the post Kennedy Round (1972) as a measure of

the degree of openness.

The results were the estimated tariff elasticities with, respect to

employment shares for each industry in the 18 countries. For a

number of industries the signs- were incorrect. However, these

incorrect signs did not appear to be consistent in all countries.

The exceptions to this were leather products, pottery, electrical

machinery, and transport equipment. The results had the correct

signs (positive) for the remaining industries, which indicated a

positive relationship between tariffs and employment.

V. Cable (1978) examined the effect on unemployment in the U.K.

industries, which resulted from the increased competition of LDC's

imports. The author tried to decompose employment changes and to

quantify the separate influences of trade flows as well as the

changes in other factors. This decomposition rests on the use of

two identities :

0 = C + X - M (1)

P ■ | (2)

Where 0 = output., C = domestic consumption, X = exports, M = imports,

P = productivity of labour, defined as output per man year, and

E = employment.

Substituting (2) into (1) and differentiating with respect to time,

gives an expression for the change of employment, which Cable

approximated by :

- E. . = — ^— (C - c. _ ) + — — (X - X ,) t t-1 P. , ( t t-1) P. . t t-1)t-1 t-1

: pt iCM - M . ) - E , -------i j( t t-1) t 1 t-i )

- 4 3 -

The four terms on the right-hand side represent the employment

changes due to a shift in domestic consumption, exports, imports,

and productivity, respectively. The four factors are assumed

to be independent of each other. The model was tested for 34

three digit SIC industry groups for the period 1970-75. These

industries are selected on the criteria that the LDC's share of

U.K. consumption is at least 2%.

In over half of the cases considered, the employment effect of

LDC trade was positive. But only in few cases the effects were

of significance. In the aggregate estimates, the potential change

in employment, as a result of trade with the rest of the world, was

much higher than that with the LDC's.

The aim of the above studies has primarily been to show that the

effect of the LDC's import competition on the industrialised

countries' employment is less significant than the effects of other

contributory factors. This, however, is not the concern of our

study, but it nevertheless helps us to understand that there is a

positive relationship between tariff rates and the industries' level

of employment.

In brief, the survey provided us with enough evidence to indicate a

positive relationship between trade protection and the industry profit

and output. The same effects were suggested in our second theoretical

model in the previous chapter. The next step is to test the hypothesis

econometrically. This will be undertaken in the next chapter.

- 4 4 -

IMPORT COMPETITION, PROTECTION, PRICE-COST MARGINS AND OUTPUT OF U.K. MANUFACTURING INDUSTRIES

This Chapter aims to quantify the effects of import competition and

protection on the price-cost margins and output of the United Kingdom

manufacturing industries. This analysis will cover each of the years

1963 and 1968. The methodology used builds upon those of the earlier

studies discussed in Chapter 3.

4.1 The Models ;

The relationship between price-cost margins, output and the

independent variables will be estimated with the following

equations :

H = a + a nCR + a„CLR + a_GD + a.AR + a_DIC o i 2 3 4 5

V = b + b.CR + b^ODI + b DIC o 1 2 3

where II is the price-cost margin, V is the money value of

output produced and consumed in U.K., CR is the seller

concentration, CLR is the capital intensity, GD is the growth

of demand, AR is the advertising intensity, DIC is the degree

of import competition (or alternatively tariff protection),

and ODI is the correction for the industry size (imports of

OECD countries) , while a a_ and b b. are theo . 5 o 3estimated coefficients of the explanatory variables. The

tests will be undertaken with a sample of 40 non-food

manufacturing industries; the selection of the sample was

CHAPTER 4

based mainly on the availability of data"1". The reasons for

limiting the analysis to the non-food industries are two-fold.

Ideally, the tests should incorporate a measure of the price

elasticity, of demand for each industry, since the domestic

response to foreign competition may depend on the elasticities.

Unfortunately, lack of systematic information on elasticities

makes this rather difficult. However, we do know that food

industries have comparatively lower price elasticities than

non-food industries and consequently a sample including both

groups may give misleading results. The exclusion of food

industries reduces the problem. The second reason for excluding

food industries was that our chosen source of tariff (Kitchin, 1975)

does not provide any figures for food industries, although the

required tariff rates could have been obtained from other sources.

This however could cause inconsistencies and it seemed desirable

not to resort to this solution.

4.2 The Variables and Data :

The variables used in the regression analysis are defined as

follows. The sources of data are described in Appendix C.

YPrice-Cost Margin

Price-cost margin is defined as the percentage of gross returns

(before tax) on the sales of the industry. It can be formulated

1 Nationalised and government owned industries were excludedbecause these industries may follow somewhat different pricing policies from the privately owned industries.

- 46 -

(I + GTP + TSP) - (W + SA)Price-cost margin = --------------------------------

v S

where I = factor income, GTP = gross trading profits of private

companies, TSP = total trading surplus of.public corporations,

W = wages and salaries, SA = stock appreciation and S = total sales

of the industry.

Output

It would be desirable to use a quantitative measure of output.

However data for such a measure is not readily available in the

published sources. The other problem is that the quantitiative

measures are unlikely to be uniform in a study concerned with a group

of industries. We, therefore, had the choice of measuring the output

by its money value in either gross or net terms. Gross output, however,

appeared to be the b e t t e r .ch o i c e . . Because (as explained on page 51) our

corrective measure for the industry size is the imports of the OECD.

Consequently, we decided to measure industry output by the money value

of the gross domestic output consumed at home.

Seller concentration

Among the various measures for seller concentration the Herfindahl

(1950), and the n-firm concentration ratios are best known. The

Herfindahl measure is designed to incorporate information on the

market share of all firms'*'. It can therefore be regarded as a

weighted average, where the weights used are the firms' shares.

In the n-firms ra t i o s , n most frequently takes on the value of

1 Herfindahl index (H) is defined as follows •n ?

H = £ S i i = 1

where Si is the share of the ith firms and there are n firms in the industry.

a s f o l l o w s :

- 4 7 -

The practical choice of the measure of concentration is usually

determined by the nature of the data available. For the

present study the most readily available measure is the share

of the five enterprises with the largest sales on total industry

s ales.

Capital intensity

Capital intensity is ideally measured by the ratio of capital

assets to total employment. The problem in calculating such

ratios for U.K. industries is that data on capital assets are

available only for the "quoted" companies. Because of this we

decided to compile a proxy measure by using instead the data on

capital expenditures. This procedure may be justified on the

grounds that there may be a close relationship between capital1expenditure and capital assets . Using the capital expenditure

data we estimated a proxy measure of capital intensity for each

industry; these rates are the capital/labour ratios.

3 t o 5 , t h o u g h v a l u e s o f 8 , 1 2 a n d 2 0 h a v e a l s o b e e n u s e d .

1 The estimated relationships between the "quoted" companiescapital assets (F )and their corresponding capital expenditure (C) for 1963 and 1968 are as follows :

1963 F = 124.01 + 10.84 C(6.15) R = 0 . 7 2 and corrected R = 0 . 7 0

1968 F = 120.18 + 9.98 C 2(4.83) R = 0 . 6 1 and corrected R = 0 . 5 8

t-values are in parentheses

Proxy variables for capital intensity have been used in all previous studies of the U.K. industries. We can for example mention Holterman, S.E. (1973), Khalilzadeh Shirazi, J. (1974) and H i t i r i s , T. (1978).

- 4 8 -

The rate of growth of demand should, ceteris paribus, positively

affect industry price-cost margins through increases in market prices,

and the possible relaxation of competitive pressures. This effect

is ideally expressed by the ex-ante shift of demand schedule. As lack

of information inhibited the use of such a measure, we employed instead

the ex-post change in the value of industry sales. This is calculated

by the annual rates of growth of sales (at current prices) between 1958

and 1963, and between 1963 and 1968. These served as proxies for the

growth of demand in the two periods under consideration.

Advertising Intensity

Advertising by the established firms can forestall the entry of new

firms by influencing their cost conditions. In other words the new

entrants would have to bear the high costs of advertising in order

to achieve a desired level of sales. . Furthermore, advertising can

create brand loyalty and so discourages the entry of new competitors.

Thus advertising b y differentiating products, acts as a barrier to

entry and the relationship between advertising and profitability

is expected to be positive, reflecting the relationship between

product differentiation and profitability. In this study, advertising

intensity is measured by the ratio of advertising expenditures over

industries’ total sales.

Foreign competition

It is generally understood that free trade increases the competition

between foreign and domestic producers, while protection has the

opposite effect. This suggests that our analysis may use a measure

of either import competition or of tariff protection. But it may

also be interesting to employ each in turn. The intensity of import

G r o w th o f D em and

- 4 9 -

competition may be measured by the ratio of total competing

imports to the home consumption of that commodity which is

produced domestically.

Tariff protection is measured here by the nominal tariff rates.

The reasons for using nominal rates in preference to the

effective rates was discussed in Chapter 3: briefly, since the

effective protection concept holds only under conditions of

perfect competition in the home market, the effective rates are

unsuitable for studies of price-cost margins in oligopolistic

m a r k e t s . The use of tariff rates involves a practical problem.

As the statistical analysis is at the industry level and as the

original tariff data relates to commodities (or commodity groups)

a choice had to be made between using unweighted or weighted

averages of the original data. The weighted averages may use

either imports or homeproduction as weights. However as those

variables may themselves be influenced by the tariff the weighted

average may have a- systematic bias. On the other hand, the use

of unweighted rates has its own shortcoming in that, unweighted

averages may depend on the amount of detail in the original tariff

schedule, though unlike the weighted average these are unlikely to

have a systematic bias. For the present study we made a pragmatic

decision, and employed weighted nominal tariff rates, as they are

readily available.

Correction for the industry size

Some industries are greater than others. This may be due to

reasons other than differences in the industries' concentration or

in their import intensities. One important reason could be the

- 5 o -

differences in the consumption of different commodities. It thus

seemed appropriate to take a corrective measure to explain the

differences in the consumption of various chosen commodities.

Practical obstacles prevented us from choosing this corrective

measure on the basis of U.K. consumption of these commodities. This

is because the dependent variable in our model is the industry's sales

in the U.K. An alternative would have been a measure of consumption

from other western countries on the grounds that the pattern of

consumption in those countries is likely to be similar to that in the

U.K. In search for the best obtainable measure we decided to employ

the imports of OECD countries as proxies for the consumption of the

chosen commodities in these countries. This decision is however based

on the assumption that the demand functions are similar for the U.K.

and for the other OECD countries.

OECD imports are exclusive of U.K. and Japan's imports. The reasons

for this are :

(i) to include the U.K. imports may give rise to certain biases;

(ii) Japan was not a member of OECD in 1963 and was excluded in

an attempt to keep the member groups consistent.

4.3 Statistical R e s ults:

We employed OLS (ordinary least square) multivariate regression

analysis to examine the effect of the market structure factors on

industry price-cost margins and output. The regressions were tried

in the linear and log-linear forms. The results for the former

were more significant and consistent and therefore only these results

are reported.

- 5 1 -

Correlation coefficients between the independent variables were

examined for 1963 and 1968. The results are presented in

Table 1.

Using Fisher's Z transformation we tested the null hypotheses'*',

that the correlation coefficients at the population level are

equal to zero. The test showed little correlation between the

variables excpet for those between concentration and capital

intensity, growth of demand and capital intensity and between

tariff rates and import competition.

The high correlation between seller concentration and capital

intensity is not surprising and is consistent with similar findings2in the aforementioned studies ; it suggests that capital intensity

may be a barrier to entry and makes for higher seller concentration.

The implication of this high correlation is the possibility of

multicollinearity in the regression analyses.

The high correlation between the tariff rates and import intensity

is also important because it shows that there is a negative

1 The confidence interval at the 95% level is

where N is the number of observations in the. sample. There is a one-to-one relationship between Z and the correlation coefficient r. Kane, E.J. (1969). Economic Statistics and Econometrics, Harper and Row, International edition.

2 C h a p t e r 3 , p p . 3 4 .

- 5 2 -

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relationship between the chosen tariff rates and the relevant

import/home consumption r atios. The high correlation between

tariffs and import intensities however would not cause any

multicollinearity since these varaibles are used as alternatives

in the relevant regression equations.

Table 2 reports the estimated equations, explaining the price-

cost margins.

The coefficients for the tariff rates (TR) are positive and

significant for both years (eqs. 1 and 3), indicating that

protection allows domestic industries to raise prices and earn

higher rates of profit than they could have under free trade'*'.

Correspondingly the negative and satistically significant impact

of import-competition (eqs. 2 and 4) suggests that an increase in2imports may force firms to lower their prices .

The coefficients for seller concentration are positive but

statistically insignificant. The insignificant results have

been caused by multicollinearity between the seller concentration

and the capital intensity. The re-estimation of the equations

with the exclusion of capital intensity confirmed that Seller

concentration and price-cost margins are positively related.

1 The same outcome is shown in the study by Hitiris T. (1978)

2 This relationship for the first time was shown in the study by Esposito, L. and Esposito, F. (1971).

- 54 -

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The reason for a positive relationship between seller concentration

and profitability is well known, namely: high concentration enables

collusion among the dominant firms, which consequently refrain from

excessive competition, raise their prices and earn excess profits.

There is also a contesting view that higher profitability in

concentrated industries is due to their higher efficiency. The

coefficients for capital intensity, growth of demand, and advertising

intensity are all positive and statistically significant for both

years, 1963 and 1968.

Table 3 presents the equations explaining industry output. The

results show a positive and statistically significant relationship

between tariffs and industry output (Table 3, equations 1 and 3).

This indicates that protection enables domestic firms to expand

their production. Correspondingly a negative and statistically

significant impact of import-competition (Table 3, equations 2

and 4) may force firms to restrict their production.

The coefficients for seller concentration are negative and

significant in all the equations. This is an interesting outcome,

as it gives support to the argument that dominant firms may collude

in keeping their output low, in order to raise or maintain their

p r i c e s .

The other interesting outcome is the positive and highly significant

relationship between U.K. industries' output and OECD imports. This

supports our hypothesis that, the differences in the output of the

chosen industries are partly related to the differences in the

- 56 -

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In brief, the above results suggest that home firms might take

advantage of the tariff protection and increase their prices

as well as their production. Correspondingly an increase in

import-competition may lead to a decrease in the prices and in

the level of output.

We are now able to use these results to estimate the welfare

effects of tariffs. This will be carried out in the next

chapter.

- 58 -

CHAPTER 5

ESTIMATES OF THE WELFARE EFFECTS OF THE TARIFF

This chapter aims to estimate the welfare effects of the tariff. The

procedure will draw upon the theoretical analysis of chapter 2 and will

make use of the regression estimates reported in chapter 4.

5.1 Formulation of the Welfare Effects :

The welfare effects are illustrated in Figure 1 which is a

reproduction of Figure 2 , chapter 2.

D1D1 -s hk® compensated demand curve for home products under

free trade, i.e. when the domestic price of the imports

is OfW-L

D2D2 is the corresponding demand curve under the tariff

situation, (the tariff is assumed to be such as to

raise the domestic price of the imports to 0^ 2)

CfflP is the price of home products when there is no tariff on

the inqports

0^P2 is the price of home products under tariff protection

CC is the home producers' marginal cost curve

FF is the compensated home demand curve for foreign products

under free trade, i.e. when price of the home product is

Price ofHomeProducts

Price of Foreign

F

W,

w .

Domestic Output

FIGURE 1

As explained in chapter 2 the imposition of tariffs initially

causes a loss in consumer surplus only to those who consume the

foreign goods; consumers of home products would suffer a loss

only if the tariffs induced an increase in the price of home products.

Moreover, these two items of welfare costs may be offset by a possible

benefit in the form of additional profits of the home firms. In

terms of Figure 1, the net welfare effect is an increase in home

country welfare if :

P 1P2 A 3H 3 + C1H1H 3C 3 =• P 1P 2 A 3H2 + TRS

where (P, P 0 A_EY + C.ELH_C_) shows the increase in the home firms'( 1 2 3 3 1 1 3 3)profits resulting from the tariff, P^P^A^H^ is the loss.'of.

consumer surplus for consumers of home goods, TRS is the net loss

of surplus for consumers, of foreign goods.

The above can be simplified and the condition for a welfare gain may

be written as :

C 1H 1H 3C 3 > A 3H 2B 3 + TRS

The net effect of eliminating tariffs is the converse of the above.

Tariff elimination will increase home country welfare if :

A 3H 2H 3 + TRS ” C1H 1H 3C 3

The above analyses clearly indicate that the elimination of tariffs

may create welfare losses as well as gains. This implies that

there will be an optimum tariff for each industry which will

maximise the net welfare gain. Thus the welfare estimates of

tariffs could be made with reference to either :

(i) the optimum rate of tariff for each industry and

- 61 -

However, the main purpose is to compare the welfare estimates from

the present model with that of the traditional theory. This can

be done most readily by the latter alternative. Thus in this

study we will keep to the latter only, i.e. examine the welfare

effect of moving from the existing tariffs to free trade.

( i i ) t h e c o m p le t e e l i m i n a t i o n o f t a r i f f s .

The task now is to express each o f the above three areas in terms

of empirically measurable variables.

The area TRS can be approximated as :

TRS = V 2 dM.dP (1)

= ^ dM.T.P (2)

where dP is the decrease in home price of foreign goods due

to the elimination of tariffs;

dM is the corresponding increase in imports;

t is the tariff rate [= ;( pw'

Pw is the world price of the importst ( jtt \T is ^ + |= -^-j which is the proportionate decrease

in the price of foreign goods.

We know that :

dM = e„ M (3)'m ( p

where e' is the compensated price elasticity of impart demand (ignoring

the s i g n ) . We assumed that this elasticity is. constant and

independent of the price of the home'products.

- 62 -

I

Substituting (3) into (2) we can write

TRS - \[em i M.P.T

= \ em T2. M.P (4)

Alternatively equation (4) can be expressed in terms of the

world price of the imports.

1 4-21, tTRS = / em -r M.PW (1 + t)2 U + t J 2

4 e m 1 + 1 M‘Pw

In order to estimate TRS we will use previous researchers

empirical estimtes of e m .

Next let us consider the area A^fflffl . This can be approximated

as :

W 3 - " W s X H 3H 2 (6)

Where A^ffl is the change in the price of home products due to the

elimination of tariffs, fflffl is the change in the consumption of

home goods, due to that change in price.

A^ffl can be estimated as :

- 63 -

P d an ( l )

a 3h 3 = apd = - j - y (7)

where n is the price-cost margin under the tariff and dn is the change

in the price-cost margin resulting from the elimination of tariffs.

The change in production H 3H 2 can be measured as :

p a jH 3H 2 = ,ea Q j— j (8)

where e^ is the compensated price elasticity of demand for home products

(ignoring the sign), and Q is the Level of home production under the

tariff.

Substituting (7) and (8) into (6) we can write :

p d an d p .A 3H 2H 3 = 35 i T n " x e d Q

, a n _ * * * *x ed Q1 - n u * i-n

an2= h ed (Q-Pd) "(Y - n)2 (9)

The value of dll can be obtained from the regression equation (1) in(2 )chapter 4 which equals a $ ft . We can thus rewrite (9) as follows:

2 4-2a5 *A H2 H 3 = ^ e d (Q o P d ) 0 ( IO )

a - n r

(1) Price-cost margin II is defined as :

pd - c • cn = — _ _ = 1 -P d P d

where P d is the domestic price under the tariff, C is the cost of production of one unit of home commodities. We thus have :

an _ c _ 1 - n^ a ~ Pd2 " Fa

or = d IIp d 1 - n

_ p d d nand finally : dP. - ______d 1 - n“ ^ 4 ~ c o n ' t d .

It is interesting to show that under certain conditions the price

elasticity of demand for home products (e^) may be equal to the price

elasticity of demand for imports (era) . In order to present this

condition we employed the following Cobb-Douglas utility function :

a 6U = A q n f

where U is the utility enjoyed by the consumers, q is the consumption of

home products and m is the consumed imports, while a and 3 are respectively

the exponents of q and m f which can be expressed as utility elasticities

( dU , dq Q dU , dmfa = -— / - + and 3 = — / ~ }C U q U m )

We than showed (Appendix D) that, when a equals 3, the price elasticity

of demand for home products equals the price elasticity of demand for imports,

Finally we turn to area This can be measured as :

C1H 1H 3C 3 = h 1h 3 x E y C y (11)

where H 1 H 3 is the change in home output resulting from the elimination of

the tariff, and ItyCq is the profit per unit of home production under free

trade.

Cont'd..(2) From chapter 4 we have :

TI = aQ + a^C R + a 2 CLR + a^GD + a^A R + a^ D IC

where II is the industry price-cost margin under the tariff, CR, CLR,GD, AR andDI-CJ are respectively the Seller Concentration, Capital Intensity, growth of demand, advertising intensity and degree of import competition (or tariff protection). Using (t) as the nominal tariff rate, we can have the following specification from the above equation :

II — + a^CR + a2CLR + a^GD + a^AR + ^5 -we now have

a n > n— = a5 or d n = a5dt

Due to the elimination of tariffs dt = t and thus we have: d II = a^t

(1) See Appendix D.

- 65 -

fflffl can be obtained from the regression equation (2) of chapter 4,

Denoting this by dQ we have

- n i ddQ =b^t (1 - II) - QP^.dll

Pd (1 - n ) (12)

as dH = we get

dQ «jb3,t - b 3 H t - as QPdtj

Pa (i - n> (13)

(1) From chapter 4 we have :

V = ffl + fflCR + b20DI + b 3DIC (equation 2 , chapter 4)

where V is the money value of home production under the tariff and is equal to (Q . P<rf , Q is the level of home production consumed domestically, Pd is the/price of home goods under tariffs, and CR, ODI' and DIC are respectively the seller concentration, correction for the industry size and degree of import competion (or tariff protection). Using (t) as the nominal tariff rate, we can have the following specification from the above equation.

V = bQ + fflCR + fflODI + b 3t

We can now have :

av , dQ— = b 3 = _ . P fl + — . Q

Due to the elimination of tariffs dt = t and thus we have :

bdQ.Pd + QdPd

3 = tfflt - QdPd

Thus dQ =a q p an

p a a n b a t " “ TKnowing that dP^ = ------ we can write : dQ = — ------------d 1 - n p a

b 3t(l - n) _ QPddHpffl (I ~ n)

- 66 -

5.2

(1 )

C1H 1 iS tbe amount of tbe P rofit P?r o n ± t under free trade and

is given by the relationship

• k ‘kC1H1 = n p (14)

* * where II is the price-cost margin in free trade, and P is the

corresponding price of the home products. We know that

n* = n - a n (15)

P* = p d “ dPd (16)

Substituting (15) and (16) into (14) we get

c l H l = ( n - d H ) ( P d - dP d j

( n - a n ) p , -d l - ni

As dll = a_.t we can write :5

C H _ pa (n - a 5t j j i - n - a 5tjC1 H1 - X - II u n

Substituting (17) and (13) into (11) we get :

Sb 3t “ b 3 11 b ^ d ^ l ( n " a5t-S j1 “ 11 " a5bJC H H C =-----------------------------— 5 — --( i - n )

(18)

Data Employed :

In order to estimate the welfare effects of tariff elimination we

need data on the price-elasticity of demand for imports and home

products, tariff rates, imports, industries’ output and price-cost

margins. Data on the tariffs, the imports, the output, and the price-cost(1)margins are the same as m the previous chapter ' . The remaining data are

D e t a i l e d i n f o r m a t i o n i s a v a i l a b l e i n A p p e n d ix C .

- 67 -

a s f o l l o w s .

Price-elasticities :

Ideally we need estimates of price elasticities for home products and

for competing imports, disaggregated for each U.K. industry (or commodity

group). Unfortunately, such detailed data are not available for all the

industries concerned.

Stern, Francis and Schumacher (1976) provide a rather comprehensive set

of estimates collected from various studies for a group of different

countries, including the U . K . ^ However, there are three problems in

applying these estimates for the U.K.

(i) The estimates are only available for certain groups of

industries. Hence to complete the data for the U.K.

we can make use of the estimates given for other

countries. Critics might be sceptical about using the

elasticity estimates of other countries for the U.K.,

because the share of U.K. imports in its consumption

might be different from the share of other countries'

imports in their consumption. Alternatively, we can

use the aggregated price elasticity which is readily

available for the U.K. The afoxementioneri study

contains a range of the aggregated estimates (collected

(1) S t e m , Francis and Schumacher (1976) . Price Elasticities inInternational Tra d e . Macmillan Press Ltd., pp.2

- 60 -

from various studies) as' well as the best suggested

estimates Naturally, our choice was the best

estimate of the price elasticity of imports for non-food

manufactures.i

(ii) The second problem is that the chosen price elasticity is

an estimate derived from an ordinary demand curve, whereas

our study requires a compensated price elasticity of import

demand. Hence we use the following formula to calculate(2)the compensated price elasticity

em = e 'm + ar>

where em is the compensated price elasticity of import demand,

e'm is the price elasticity of the ordinary demand curve, a is

the proportion of total expenditure spent on imports, and n is

the income elasticity of import demand.

We calculate a by dividing the value of U.K. imports of non-food

manufacturers by the total domestic consumption of these

commodities. For ri we use the estimate given in the study by

Hauthakker and Magee (1969) . By substituting the relevant

values for e'm , a, and n into the above formula, the value of

em was estimated to be -1*02*

(1) S t e m , R.M. et al (1976) compiled the results of nine separate estimates given.for the price elasticity of U.K. demand of non­food manufactures. The value of the estimates range from- 0.66 to -6.00 and the best suggested estimate is -1.22 ibid, pp.. 16

(2) Henderson, J.M. and Quandt, R.B. (1971). Microeconomic Theory: a Mathematical Approach, McGraw-Hill Ltd., p p . 32.

- 69 -

(iii) We also require an estimate of the price elasticity of

compensated demand for .home products. Unfortunately,

such an estimate is not readily available, and its direct

. estimation, though useful, would be to some extent outside

the scope of this study0 However as we have shown before,

under certain conditions (described in Appendix D ) , the

price elasticity of demand for imports can be used for the

price elasticity of demand for home productsc

Given that there are problems concerning the estimate of the

price elasticity, it would be interesting to use an alternative

• measure in addition to the one described above. Such an

alternative estimate might be inferred from the concept of

the assumed profit maximisation of the home producers.

Economic theory suggests that in a profit maximising monopoly,

the price elasticity of demand is equal to the inverse of the

monopoly's price-cost margin We therefore have :

1ed ~ n

(1) The following expression gives the marginal revenue of a monopoly:

MR = p f l ~( e d ) (r)where MR is the marginal revenues, P is the price and ed is theprice elasticity of demand.We know that a profit maximising monopoly uses the following relationship to set its price.

MR = MC (ii)where MC is the marginal cost. We would therefore have :

M r = M P = P M - 1 1

where e^ is the price elasticity of demand for home products, and

II is the price-cost margin of home producers. In order to estimate

e^ we use the value of II from oufr regression equation: the average

value of II for the years 1963 and 1968 is approximately 10.5 per

'cent. We thus obtain

1 1 r-ed = 0.105 =

Admittedly, this estimate of e^ seems rather high in comparison

with our previous estimate (1.02). This may be for the following

reason. The estimate of the price-cost margin II pertains to the

industries as a whole, whereas the above formula applies only to

those firms that act as profit maximisers. The implication of this

is that the average price-cost margin employed above might be an under­

estimation of the required margin and as a result we may have over­

estimated the relevant price elasticity (e^).

It would, therefore, be more appropriate to employ the price-cost

margins of the dominant firms in each industry, i.e. a few firms

with the greatest share of the industry1s total sal e s . Such a

procedure is, however, inhibited by the lack of necessary data for

1963 and 1968. '

(1) Cont'd..

By definition we have :

P-MC (iv)

where II is the price-cost margin. Substituting (iv) into(iii) will give the following :

(v )

- 7 1 -

5 . 3 T h e E s t i m a t e s :

The analysis of the preceding section will now be used to estimate

the welfare effects of a hypothetical elimination of the tariffs.

Equations (5) and (10) will be used to estimate the welfare gains

while equation (18) will be used to estimate the welfare loss.

Bringing these together the net welfare effect is :

If our empirical estimates show that this expression to be positive

(negative) we will state that tariff elimination will increase

(decrease) home welfare.

Our interest is not only in the absolute magnitude of the welfare

estimates but also in how they compare with the estimates that may

be obtained from the traditional model of tariffs. The latter

makes no distinction between the consumers of foreign and home g o o d s .

Moreover it abstracts from the effect on the profits of home producers.

The implication of the latter point is that all consumers are assumed

to experience the same proportionate decline in prices, and thus

the welfare gain is dependent only on the increase in imports.

Accordingly the traditional measure of the welfare gain i s ^ :

(1) Johnson, H.G. (1971). Aspects of the Theory of Tariffs, London, George Allen and Unwin Ltd.

fcNet welfare effect = h e™ -— -— —m 1 + t5 *

+ 'S e d ( Q * ^ ) (]_ _ n ) 2

(b3t - b^IIt - QP^aj-t) (II - a,_t) (1 - IT - a,_t)

- 7 2 -

Net welfare gain = h em -— 7— — MoPmi + t \

t (20)

The three separate components of equation 19 (equations 5, 10

and 18) and the net welfare effects are shown in tables 1 and 2 .

The only difference between the tables is the application of two

different price elasticities (-1.02 in table 1 and - 9 C5 in table 2 ) c

Hence, the gain of consumer surplus in table 1(A]_) is much smaller

than that in table 2 (A2)o

A comparison between the results of this model and those obtained

from the application of the traditional model, gives rise to

interesting implications« With regard to the consumer, our model

shows an overall higher gain of consumer surplus (Aq > a]_i and A 2 > a2]_) .

This is because our model allows for the gains to the consumers of

home goods as well as the gains to the consumers of foreign goods.

In contrast with the traditional model, this study shows a loss of

welfare caused by the fall in home production and profit. The

loss of welfare derived from our model (in both tables) outweights

the welfare gains of the tariff elimination. The estimates of

welfare loss, expressed as percentages of home industry output,

range from 0.819% to 1.276% and from 0.5.97% to 1.045% for 1963 and

1968 respectively.

Finally, it would be interesting to compare the outcome of this

study with those of previous studies. Such a comparison will

however be neither easy nor accurate. The difficulty in accuracy

arises from the differences between the methodologies used and the

objectives pursued in this and other studies. For example, some

studies are undertaken within a general equilibrium framework,

- 7 3 -

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whereas our model is based on a partial equilibrium analysis.

The objective of some studies is' to estimate the static and

dynamic consequences of trade liberalisation, while our study

‘is concerned only with the former. Tariff elimination

(or reduction) by one country is often assumed to be a part of

a multilateral trade policy followed by a group of countries,

whereas our study assumes a unilateral tariff elimination.

However, whilst acknowledging the existence of these problems,

we decided that a limited comparison of findings may give a more

comprehensive view of our results. A s a consequence we chose to

compare our findings with two recent studies; namely, Batchelor, r.

and Minford, P. (1977) and Cambridge Economic Policy Group

(CEPG, 1977).

The intention in the study by Batchelor and Minford is to compare

the short and the long-run costs of devaluation and import controls.

Our interest here, is to make a comparison between the findings of

this study as regards to the welfare costs of tariff protection, with

those of our own study. The authors calculate the short-run welfare

loss of tariffs on the basis of an imperfect competition model. The

model assumes that, in the short-run, when a tariff is imposed, the

price of the import substitute need not increase by the same

percentage as the import price. This is because there is only a

limited switch out of imports into the domestic substitute. However,

for the calculation of long-run welfare losses, the import-substitute

price is raised by the same percentage as the import price. Thus,

by using different price elasticities for the short and the long-run

(-1.2 for the short-run and-8.1 for the long-run), the authors

- 76 -

calculate the costs of protection for different tariff l e v e l s ^ .

For an eight per cent increase in the existing tariff rate, the

costs of protection, as a percentage of U.K. GDP, amounts to 0.04%(2)in the short-run, and to 0.22% in the long-run

The average rate of tariffs in our study is approximately 8.1 per cent (averaged over 1963 and 1968 for the chosen industries). Our study shows that the elimination of tariffs, i.e. the reduction of tariffs by the average rate of about 8.1 per cent, would benefit

(1) In this study the welfare loss of a tariff at rate T is,

w = h nT2v

Where W is the welfare loss, h is the corresponding elasticity of import demand with respect to tariff, V isthe value of imports prior to the tariff. Only the valueof ri differ according to whether we are considering a short-run limited substitution environment or a long-run competitive environment. In terms of the demand, supply and substitution we have;

n s = ( 1 - f r ) c r

nL = £s + U d " ES > / m

Where n and r\ are respectively the short-run and the long- S Lirun elasticities of imports, X is the reaction coefficient of home price with respect to the increase in the price of competitive imports, c is the price elasticity of import substitutions, ffl and ffl are respectively the long-run elasticities of supply and demand, and m is the share of imports in the British market.

(2) In this study the existing rate of tariffs (on average) is about 5 per cent, the 8 per cent increase is in addition to the existing rate, Op. cit, pp.68.

- 7 7 -

the consumers of imported goods by 0.033% (averaged over 1963

and 1968 and expressed as percentage of the value of domestic

output) when price elasticity is -1.02, and 0.30% when price-

elasticity is - 9 . 5 ^ . As the above figures show, there is

close correspondence between our estimates and those of the

aforementioned study.

A comparison of the outcome of our study with that of the CEPG

is a rather more difficult task. The comparison we intend to

make is based on the estimate given by CEPG (1977). According

to the CEPG, average rate of tariff , on imports entering domestic

expenditure, would have to be about 31% in order to raise the(2)volume of U.K. GDP by lO% Our model does not give any direct

estimate of changes in the domestic producers' output. In order to

make possible a comparison between the CEPG and our own estimates,

we therefore need to calculate the change in the volume of output for(3) .our model, when the existing tariffs are all raised to 31% The

change in the volume of output is given by equation (13)

(1) It should be noted that we only compare the gain of consumersurplus to the consumers of imported goods with the estimates of Batchlor and Minford. This is because their study doesnot differentiate between imported goods and the goods whichare produced domestically.

(2) Godley, W. and May, R.M. (1977). "The MacroeconomicImplication of Devaluation and Import Restriction", Cambridge Economic Re v i e w , N o . 3, p p . 36.

(3) As mentioned before, the average rate of tariff in our studyis about 8.1 per cent. Hence, the increase of the existingrate to 31 per cent would mean to increase the existing rateby 300% on average.

- 78 -

i n o u r m o d e l (1) We t h e r e f o r e h a v e :

B3t - b 3l l t - a g Q P ^ t

dQQ

pd(i - n) (21)Q

- b 3l t t - a ^ Q P ^ t

QPd (l ~ n)x 100 (22)

We then used equation (22) to calculate the percentage change

in the level of domestic output, when the existing tariffs are

all raised to 31%* Our estimate shows an average (over 1963

and 1968) increase of about 38% in the level of domestic output*

It is obvious that our estimate of the tariff - induced change

of domestic output is much higher than that of the CEPG. The

difference may be partially explained by the following reasons*

(i) The CEPG's estimate is derived from a macroeconomic

model designed within a general equilibrium framework,

whereas our model is based on a partial equilibrium

analysis* Hence we have assumed that there are

sufficient resources to increase the industries' output.

(ii) Our model assumes that the industries' costs are

constant* Relaxation of this assumption may reduce

the level of output that the industries are prepared

to produce in order to maintain maximum profits*

(1) Equation- (13) is as follows :

dQb^t - b 3nt - a^QP^t

P a d - f i )

where t is the difference between 31% and the existing

tariffs of the industries. The other characters are

d e f i n e d a s b e f o r e■ ' 79

However, the extent of the difference between our study

and that of the CEPG (1977), causes us to be cautious

about our estimate of the change in domestic output.

5.4 Limitations and Extensions of the Analyses :

The above estimates of the welfare effects of the tariff have gone

beyond the estimates that could have been obtained from the application

of the traditional theory of tariffs, by incorporating suck likely

phenomena as product differentiation between foreign and home products

and pricing in excess of marginal costs. However, our procedure has

involved some simplifying assumptions, some of which may be mentioned.

Firstly, in estimating the profits of the home firms, no distinction

was made between the private costs and the social costs. However, if

the protected industries were to draw resources from industries where

prices exceed the social marginal cost, the private marginal cost of

the protected industry may exceed the social cost. In such a case

our procedure would in general under-estimate the adverse effect of

tariff removal. There may, however, be an important exception to this

point. One reason for the excess of private over social cost is. that

the protected firms may use imported inputs that are subject to tariffs.

This may be of importance in the event of a general reduction in

tariffs. A general tariff cut will mean that the firms concerned will

experience a downward shift in its cost curve as well as its demand

curve. This may induce a decrease in the price charged to home

consumers and would add to the welfare gains of tariff reduction. In

such a case our procedure might have led to an under-estimation of the

welfare gain of tariff removal.

- 8 0 -

Secondly, we implicitly assumed that there are sufficient resources

to increase industry output. In reality the resources are scarce.

It would, therefore, be more realistic to consider an upward sloping

cost curve in the place of the simplifying horizontal cost curve.

Thirdly, we have assumed that the home output is sold entirely in

the home market. Allowing for the possibility that a proportion

of the output may be exported leads to two further considerations:

(a) If the tariff brought about a decrease in the home price

of the home product there would (in the absence of price-

discrimination) also follow a decrease in the export price.

In other words, the welfare gain by way of the additional

surplus to the consumers of home products might partly be

offset by a reduction in the export profits. To this

extent the study might have over-estimated the welfare

gains of removing t a r iffs.

(b) Tariff elimination^by the home country may be part of an

agreed exercise in multilateral tariff elimination (or

reductions). In such case home firms would face reduced

tariffs in export m a r k e t s . By ignoring this possibility

the study might have under-estimated the welfare gains of

tariff elimination.

Finally, our study is based on a partial equilibrium analysis. A

more complete- study would involve a general equilibrium analysis: two

implications of such an extension may be mentioned. A decrease in

tariffs for the industries concerned will release resources from these

- 8 1 -

industries. If these resources can be employed in some

firms which can earn super-nbrmal profits, these gains

should be added to our calculation; by ignoring these gains

we have underestimated the benefits of tariff reduction.

However, some of the released resources may not be employed

elsewhere. In such case it would be necessary for the

government to implement a monetary and fiscal policy to

maintain full employment with price stability. This in turn,

would mean that the analysis must take account of the possible

effects of trade liberalisation on the exchange rate, and other

macroeconomic variables such as the rate of interest.

A more complete analysis of the welfare effects of tariff

elimination would need to take these limitations into consideration.

- 8 2 -

APPENDIX A

This appendix proves that in a particular case of constant elasticity

schedule the tariff may have no effect on the industry price. In

other w o r d s , this appendix is to show that in such a c a s e , the

elasticity of excess demand curve will not be affected by the tariff.

Thus the profit-maximizing price will remain unchanged. Consider a

system described by the following equations :

price elasticity of home demand, Q g is the foreign supply of the product,

P g is the world price, (3 is the price elasticity of foreign supply,

rate of tariff. Eq. (1) states that the home demand is a function

of the home price, (2) reveals that the foreign supply is a function

of the price received by foreign firms, (3) defines the demand for the

monopolist’s product and (4) expresses that the price in the tariff

imposing country will exceed the world price by the amount of tariff.

From the above equations we can formulate the price elasticity of the

excess demand curve. Denoting the elasticity by E^ we have :

A P aA P d (1)

Q, C2)s s

DE (3)

P d P (1 + t) s (4)

Qd is the home demand for the product, P^ is the home price, a is the

D is the demand for the monopolist's product, and t is the ad-valorem E

- 8 3 -

dD.E = x

E-dP D_ C5)

By using equations (1) to (4) we get,

dD_EdP dP

AQ\-ZldP

CLAP a - l P3B d- 1

( 1+ t f

(6)

Now substitute (6) into C5), shows that

EX

OfAP & P3B -d(1 + 1 ) AP _ p 3- B d

(1+t)^

(7)

Now if | a | = 3 e cg. (7) can be simplified to

Since a is a constant, we have

dEdt = o

In other words when the price elasticity of home demand (ignoring the

sign) equals the elasticity of foreign supply, the price elasticity of

excess demand will equal each of these and be independent of the tariff

rate,,

~ 84 __

APPENDIX B

Throughout this study it was often necessary to aggregate or

disaggregate different classification in order to fit U.K. 1963

input-output classification. This appendix gives the correspondence

between the 1963 U.K. input-output classification and other

classifications used in this study.

- 85 -

ASSU

MED

C

OR

RES

PON

DEN

CE

BETW

EEN

UNIT

ED

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DOM

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PUT

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IFIC

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TS

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0 •EhHCOUi§1

H

P

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Dcpa8

8OBap15

■—i fcCN t~fcin fc 00

r-H CN ft vo fc• fc • ft ro 00

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H ft i—1 NF► x. fc fc $ fc fc • • • *ro rH rH rH CN r—i NF CN NF CN CO CN CN in in rH r- coro Njl i—1 00 rH ro uo VO 00 00 CO ■—1 ■—1 ft rH rH rH rHin in NF in in uo uo CO vo vo vo O' r" VD O' r- f" r -

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00 m 00 O'O' O' O' CN roCN CN CN ro ro

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0 OB H!« rnQ

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inCN

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• • • ■« • CO • • • • B •H CO cn cn cn CN CN CN CN ■vl* cn ft• ft ft ft ft B cn ft ro ro ro • LOP C/5 ft ft ft ft LO cn ro ft ft ft ft CN LOH LO CN CN roB *. *. B CO ft ft B B B B B ft B5 ft in ft CN in CN m LO• • * • V B B • • t » I B *CO CO cn cn ft ft CN ro uo CN LO ft CN CN 1—1 ft ftft ft ft ■—I ft in LO CN CN CN CN Ol CO ft ro ro ft ro inft ft ft ft ft cn CO ft ft ft ft LO ft ft ft ft ft ft LO

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o£ H 8 Wo£ P H W « WP >U SCOvoCDrH

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i—1 sF sF sF SF sF «vF • SF sFfc fc •» N fc V. V. k. fc fc

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tovoLO

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LO ovo

APPENDIX C

This Appendix discusses the sources and description of the data used

in the regression analyses. The data are shown in statistical tables

below.

1 o Price-Cost Margin;

Price-cost margin is the gross profit before tax expressed as

a percentage of the sales of the industry,, Gross profit and

other trading income is defined as factor income (except income

from employment) plus gross trading profits of companies minus

stock appreciationo Sales are defined as the total commodity

supply. These definitions and the data for gross profit and

total sales are taken from the United Kingdom Input-Output Tables

for 1963 and 1968, Central Statistical Office (1970 and 1973).

2. Output :

Output is measured by the money value of the domestic output

consumed at home. This was calculated by subtracting the value

of import and export of each commodity from its total sales value.

Sales of commodity are defined as above. The relevant figures

are taken from U.K. Input-Output Tables for 1963 and 1968, Central

Statistical Office (1970 and 1973).

3. Seller Concentration :

Seller concentration, is measured by the share of the five largest

enterprise in the industry's total sales. The data for sales of

the five leading enterprises were taken from the census of

production (Summary Tables) for 1963 and 1968, Board of Trade (1970)

and Department of Trade and Industry, Business Statistics Office (1972).

- 89 -

Capital intensity is measured by the ratio of the industry capital

expenditure over its total number of employees. Capital

expenditure is defined as the total acquisition of land and new or

existing buildings, plant and machinery and vehicles less disposal.

Data on these items were obtained from the United Kingdom Census

of Production (Summary Tables) for 1963 and 1968, Board of Trade

(1970) and Department of Trade and Industry Business Statistics

Office (1972).

Growth of Demand :

Growth of demand is measured by the annual rate of growth of sales

(at current prices) between 1958 and 1963 and between 1963 and

1968. Sales figures are taken from U.K. Input-Output Tables

(1963 and 1968) and U.K. Census of Production (Summary Tables) for

1958 and 1963.

Advertising Intensity :

Advertising intensity is measured by the ratio of advertising

expenditure over industries' total sales* Advertising expenditures

are taken from the U.K. Census of Production (Summary Tables) for. ;•

1963 and 1968.

Foreign Competition :

Foreign competition is measured by either import competition or

tariff protection.

Import competition is measured by the ratio of import/home

consumption, where' consumption is that of the home production only.

C a p i t a l I n t e n s i t y :

- 90 -

The data were taken from the United Kingdom Input-Output Tables

for 1963 and 1968, Central Statistical Office (1970 and 1973).

Tariff protection is measured by the weighted nominal tariff

rate. The relevant tariff rates are taken from the study by

Kitchin, P.D. (1975.) .

8. Correction for the Industry Size :V

The chosen corrective measure ia the imports of OECD countries

exclusive of the imports of U.K. and Japan. OECD imports are

taken from Statistics of Foreign Trade, OECD (1963 and 1968)

Trade by Commodities, Series B .

DATA

FO

R TH

E 40

NON

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DUST

RY

SAM

PLE

, 19

63

TABLE

C01^

(con

t'd

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H

05HQO

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ft

ft ai CO ro cn LO m LO LO p CN CN m m ft o' O ft in CO LO ft VP. • « • • • * • • * * • • • * • « • » • • * •in ft LO in CN CO in VP CN o ft ft in in • co ft ft CO co ft CO CO CN

CN ft ro in CN m ro1 VP ft CN

ft .E~l M 5 t-yffl 2 D g fflO O W H Uft ® 0 S Hh a

a ffl 8 H

g *fflEn

incn

OrH

LO COCNH Oft

ft inon ft

ft CO t> ft ft CO CO cn ft ft in LC in ft LO cn CN• # • » » • • • • » • • * . • » *oCN 21 12

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f t o

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g LO o ft cn VP ft CN CO CN cn 01 ft Vp fr- ft cn o CN LO CO ft vp infflCft

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PRIC

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ft 53 feH ft 2 p O S £ ^

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3 o TO 0 a f i 0 0 0> j s Cn 0 a i fi Cn f t rHft s o

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0TO

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TO0 £ •h cn -p rfi 0 f t 0 0 0 .fi 0 0 0 rfi f t f i f t f t f t

-p 0o

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Imcn»

APPENDIX D

This appendix derives the conditions under which the price elasticity of

import demand is equal to the price elasticity of demand for home products.

Let us consider the following Cobb-Douglas utility function for a consumer

who consumes home products as well as imported goods.

U = Aqa m^

Where U is the utility enjoyed by the consumer, q is the consumption of

home products and m is the consumed imports, while a and 3 are the exponents

of q and m respectively. These components (a and 3) can be expressed as

the utility elasticities of the consumption of home products and of imports

respectively1 .

The equality of the price elasticity of home demand and that of the import

demand requires the following relationship :

e _ _ ed - m

.dP

^ d q ^ m m (2)n r ■ ■ := ~ .

* p T dm * pm

„ a 3U = Aq m

In U = In A + ct. In <J + 3 In m

din U = din q

dU U

• dq q

= a din U din m

dUUdmm

- 9 6 -

Where is the price elasticity of home demand, em is the price elasticity

of import demand, P3 is the price of domestic products and Pm is the price

of imports.

Assuming that the price of a commodity (domestic or foreign product) is

equal to the marginal utility derived from its consumption, P3 and Pm can

be calculated as follows :

du _ « - l 3= dq = q m

dUP = — =■ m dm3 -1 a A 8 m q

(3)

(4)

It follows from the above that :

dqa -2 6A.a (a-l) q m

and similarly we can write :

(5)

dP.mdm

n *1 \ 3“2 aA.3 (3-1) m q (6)

Substituting (3), (4), (5) and (6) into (2) give the following :

q_______. . . ot" 2 3 A. a (a-l) q m _ a-l 3 A a q mA.6 (8-l)mS' 2 q“ m

_ q 3-1 a A 3 m q

a-l = 3 -1

and finally a = (7)

The above expression therefore is the condition for equality of the price

elasticity of import demand and that of the demand for home products.

- 9 7 -

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