American Economic Association

Substitution and Two Concepts of Effective Rate of Protection Author(s): James Anderson and Seiji Naya Reviewed work(s): Source: The American Economic Review, Vol. 59, No. 4, Part 1 (Sep., 1969), pp. 607-612 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1813225 . Accessed: 19/02/2012 06:26
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607

Substitutionand Two Conceptsof Effective Rate of Protection

By JAMES ANDERSON AND SEIJI NAYA*
The concept of protection on value-added or the effective rate of protection has received much support as a measure of the impact of protection on primary factors of production. It is predicted by H. G. Grubel and H. G. Johnson [5, p. 76] that effective rates of protection will receive at least as much attention as nominal rates in future international tariff negotiations. The analysis and applications of the concept are generally carried out with the crucial assumption that the physical input-output relationships remnainthe saine before and after the imposition of tariffs. This is convenient and often necessary since information on input coefficients is available only for the protected state. It has been argued that this assumiiption introduces a bias in the measurement of effective rates; W. M. Corden [4, pp. 233-35] has suggested that the bias is in the direction of overstating the effective rates. Oine complication is, however, that once substitution is allowed, two definitions of the concept are possible. Under one definition, the overstatement occurs but not necessarily so under the other definition. The purpose of this paper is to present the different behavior of bias in the two concepts under substitution. Following a brief introduction to these two concepts, the analysis is developed using the constant return constant elasticity, (CES) production function with two inputs (one primary and one intermediate) for the sake of simplicity. The analysis
* The authors are, respectively, assistant professor, Boston College, and associate professor, the University of Hawaii. The latter wishes to acknowledge support provided by a research fellowship at the National Bureau of Economic Research and from the Center for Economic Development at the University of Wisconsin. The analysis has benefitted from helpful discussions with Robert Baldwin and Clark Leith, and the authors are grateful to a referee for his valuable comments and suggestions.

is then applied in evaluating briefly the computational formulas and results of studies by B. Balassa [1] and G. Basevi [2]. I. The Two Concepts The effective rate of protection (ej) measures the increase in industry's value added per unit of output under protection (4fj)over the value-added per unit under a free trade situation (vj) as a proportion of vj:
d
ej=Vj

Vi

Vi

The coefficient ej can be defined in two different ways, depending on whether it refers to the change in value-added per unit (i) before or (ii) after any resources move in response to the institution of protection as explained below. In the absence of tariffs, vi can be defined as follows: (2)
vj
=

pj -

pj(l -aij)

where pj and pi are prices of j and i respectively; qij, physical input i per unit of output j; and aij, input value coefficient. When tariffs are instituted, the domestic prices will change and v, value-added made possible by the tariff structure, can be defined as follows: () pi(1 + tj)q1j = pj[(1 + t1) -(1 + tI)aij] pJ(1 + t)
-

where tj and ti are tariffs on output and input respectively. The change in the domestic price relationship is likely to bring about substitution between primary and intermediate inputs and consequently alter the input coefficients. Incorporating this latter change, the domestic value-added will now be v':

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4)
=

THE AMERICAN ECONOMIC REVIEW

p,( + t,) pi(1 + t,)q'
-

= pi(l + t.) (I

a',)

where a prime is attached to qij and ai, to denote the changed physical and value input coefficients. For the first definition of effective protection (i), v is substituted for v< given in ej, while v,' is used for the second definition (ii). The first definition indicates the pressure on and the direction of the resource change as a result of tariff impositions, whereas the second incorporates the effect of the changed resource allocation. With definition (i), ej is reduced to c; as follows:
tj-

the situation before or after protection. If substitution takes place, cj and cJ differ; and if they are estimated assuming no substitution, estimates will involve biases that are different in degree and kind. Moreover, the behavior of biases will depend on whether estimation is made using free trade or protected coefficients. II. EffectiveRates Under Substitutioit For clarification of these arguments, assume that the economy is composed of CES production functions, follows marginal productivity factor pricing, and that all inputs are produced. It can be shown that

aij
a,j1=-ti

(I
+

(5)

tj-)aii
Pj

cy=
I1-

This is the basic formula used by Balassa [1]. Notice that only one set of input coefficients, the free trade as,, enters into the formula." With the alternative definition, ej incorporates two sets of input coefficients, ai, and a.,! (input value coefficient under protection). Then e, can be reduced to cl as follows:
=

where ki is a distribution parameter; si, elasticity of substitution; and pi and pj, prices of i and j respectively [3, p. 62]. It follows that when protection is introduced,
(7)
=

az:P hV

+-,))

Ta- ij

ci =

(1+ti)(1-al,)1-ij (1 + t~)(a,j -a)

(1

aij)

(6)

1-aij

It is interesting to note that cj tj depending on whether tj <ti straightforwardly; but Itt depending on a ij ak,. The coefficient cj can be regarded as a special case of c since c, is reduced to cj under the assumption of fixed physical input coefficients. To see this, note that
qii
=

qij,

aij

aij

: +

and so cj = c,.

If this assunmptionis correct, it does not miatter whether the effective rate is estimated fromi input coefficients pertaining to

where T,j= (1+t,)/(1+tj). Using (7), the two definitions of effective rates (c; and c;) can be expressed either in terms of observed protected coefficient a,! or free trade coefficient aij. In the analysis that follows, cj and c?expressed in terms of a1! are denoted as gj and b, respectively, while the corresponding definitions in terms of a,j are given as zj and rj. For gj and bj, the comiputed free trade value added is assumed to be positive (the occurrence of the negative value added is discussed in the end of the paper). A bar placed above the effective rates refers to the assumption of fixed coefficients. Corden [4] employs definition (i), (cj), and shows that the use of coefficients under protection (ai'j) for estimating effective tariffs (gj) will lead to an upward bias. He arrives at this result by incorporating the direction of change in the physical input coefficient but not the values of s;. To show this result in terms of s, and to compare later the behavior of gj with that of bj under substittution, (7) is substituted into (5) first to have

COMMUN'ICAT'IONS &gj
)sj (t a'- t,)c4rT'1[log
(1-a' si

609

(1 + t1) - log (1 + tj)]

TRi-1)2
ii

abj
dsj

aIj(1-

a')(1 + tj)Tt1 [log (1 + t) -log

(I
a' Tsft)2 02bi ~ Ii, while - > 0s4

(I + t)]

abi
-

Os,

5 0 depending on 1,

0 dpedig

tts

whle

'

0.

(8)

tj +

1 -a'

ii

Ti-1
ij
tj >tL

The effect of sj on gj is seen in equation (9). This is always negative, implying overstatement of gj for both Ij>tj and tK<tj.
&2gj
2>
,

if t, > tI; and

_2__

2-

<O

if tK < ti.
FIGURE 1

tj<ti

The results are summarized in Figure 1 for the two cases (tj>ti and tj<t,). Turning now to the behavior of bi under varying sj, (7) is substituted into (6) to have
ati(1

(10) bj = tj

+ tj)(1 ii

a'-T-ii

Ts')

If sj= 1, bj= tj as the second term of the right side in (10) vanishes. Now, considering the effect of different values of s, on bj in (10), we have equation (11), The results are summarized in Figure 2. If sj>O, bj overstates the true rate of bj for tj>ti. However, bj understates the true rate for tj<ti. Furthermore, the larger s,, the smaller the rate of overstatement for tj>ti, and the greater the rate of understatement for tj<ti. It is clear that gj and bj behave quite differently although g;=-j. When sj>O, gj>bj for tj>ti; but gj<bj for tj<ti. For tj>t,, gj becomes smaller at a decreasing rate as is the case of bj, but gj approaches I, when sj approaches infinity. We will have

bi=Ij at Sj 1. For tI<It, gi becomes increasingly smaller as sj rises (or never reaches tI, unlike the case of b,). The bias of g1 as a measure of gj is in one direction but tha of bi at a measure of bi is in opposite direct.tons for tj>ti and Ij<tj. One is, therefore, cer tain of overstatement for gj though not neces arily for b,. Also, tj>ti, overstatement of gj is always less than that of b, for any given value of elasticity of substitution, sj,
bi tj< ti

bj\

bj=tj
bj

_tj >t,

FIGuRE2

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THE AMERICAN ECONOMIC REVIEW

The analysis so far has been on how substitution affects the two measures of effective protection (cj and cj) when they are measured in terms of given protected input coefficients. Expressing the corresponding rates in terms of free trade coefficients, z; is first considered, followed by rj. Since cj refers to the proportionate change in value added before input substitution takes place, once aij is known, zj is correctly measured by cj in equation (5). That is, zj does not require information on sj unlike the case for gj. The value of zj or the unbiased measure of cj will correspond to one point (each for tj>ti and ij<ti) along gj shown in Figure 1. When c< is expressed in terms of ai,, we have (12) rj =j +1 a13(1+ I}) (l
-

rj- rj tjS zj rj =zje\

lti

ti

FiGuRE3

the other at sj= 1. However, if the true value of sj is one, r, and bi will be tangent to each
other at this Sj.

ii',,)

i-li

As mentioned earlier cJ is reduced to cj by assuming sj to be zero. That is, ?j= zj. Differentiating rj with respect to s,, we obtain equation (13), where Or,/9ssj,O depending on ti Z tj while C2ri/ls, < 0. The results are summarized in Figure 3.

If the correct value of sj is substituted into relevant equations, the unbiased estimates will be the same for gj and zj, and also for bj and rj. If this value of sj is zero, all four measures are identical. Finally, if sj is greater than zero, the effective rate, calculated by incorrectly assuming a zero elasticity, will be the same for bj and gj and also for r, and zj, but the estimate from the protected coefficients will be larger than that from the

(3Orj
(13) js;

aij(l + t1)T,1^ V[log (1 + ti) - log (1 + ti)j

1-a,,

The implications that can be drawn from Figure 3 are basically the same as those from Figure 2, i.e., fj>rj for t1>ti but fj<rj for tj<ti. But there is a difference in the behavior of r, and bj, namely d2rjl/3s2<0 but O2b,/&s>O, reflecting the difference that in the former, a'>is varied while aij is held constant; and in the latter, the reverse applies. Note that rj is identical to b3 at the correct value of sj. It is noticed further that the behavior of rj and bj under varying sj is such that the identity (rj- b,) holds also at sj= 1. This is so whether this sj is correct or not, since a'j= aij when sj is assumed to be one. If this sj is not the true value, rj and bj intersect twice, one at the correct value of sj and

free trade coefficients. The latter provides an unbiased estimate of effective rate of protection under definition (i) and a biased estimate under definition (ii), while the former gives biased measures for both definitions. III. An Evaluation A number of empirical studies of effective rates of protection have shown that on the average the effective rate substantially exceeds the nominal rate. The escalation of the nominal tariff structure is given as the reason for these findings [1, p. 579] [2, p. 157]. W. Travis [8, pp. 446-48], however, casts doubt on the escalation argument. He rea-

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sons that the "overstatement" of the effective rate under the fixed coefficient assumption can explain the divergence between effective and nominal rates found by Balassa and Basevi. As an example of the overstatement, Travis cites a Cobb-Douglas case under which no amount of escalation could lead to any divergence between the effective and nominal rates. It is obvious that he is referring to the concept c1 and not cj although he does not differentiate the two concepts. As we have shown, even with the Cobb-Douglas assumption, the divergence will hold in cj if there is an escalation of tariff structure. A major difficulty in empirical application is the unavailability of free trade coefficients necessary to measure effective protection so that aij will have to be approximated. Balassa, in testing for several developed countries, used largely the input coefficients of Belgium and the Netherlands. He reasons that because of little or no duty on most commodities in 1959 [1, p. 578], " . . . the distortion in input-output relationships, due to the existence of duties, is relatively small." In terms of our notation, Balassa has applied the concept cj and also used the computational form zj, adopting the Belgium-Netherlands' value coefficients to represent the free trade aij for the countries tested. Therefore, his finding of divergence can be easily explained by escalation. Basevi's work on U.S. data is apparently based on the concept cj in view of his discussion of cj, e.g., the relationship between cj and tj and ti. The computational format used is gj which is, however, identical to bj. If cj is intended and sj> 0, his results are overstated.' But the diversion implied by the escalation argument would hold even under a large value of sj such as unity since predominant cases in his results are those of gj>tj>ti. The seriousness of the fixed coefficient assumption is noted by Basevi in finding that
I Clark Leith [6, pp. 594-95] briefly considers bj under substitution although he does not formulate it explicitly. However, if we apply the concept c, with sj>O, his results of bj are overstated for t>1tj but undert. stated for tj &lt;

611

the computed value added under free trade approaches zero and even becomes negative in a small number of cases where tj> tI. Correspondingly, the effective rates approach positive infinity and then switch to negative infinity. Basevi, attributing these cases to the fixed coefficient assumption simply discards them as "absurd." This problem does not occur in Balassa's work as he uses the form z;. Negative value added occurs if the value of intermediate inputs exceeds the value of output when these values in domestic prices are converted into free trade prices assuming the fixed physical input coefficient. Algebraically, a' T-'> 1. In addition to the assumption of fixed production coefficients, there are many possible factors that might explain negative estimated free trade value added, although the relative influence of individual factors is difficult to ascertain. For example, such factors as different production functions between countries; inefficient use of inputs in highly protected import competing industries; and nonincorporation of nontariff protective measures could very well be the important causes of the phenomenon (especially in a developing country such as Pakistan).2 In terms of fixed production coefficients as a possible explanation, note that a' T-1 would not measure aij but aijT-si or ai, On this point see equation (1+t,/l+ti)8j. (7). This estimated measure of aij or ajjT8i would overstate the intended measure aij for tj>ti. Furthermore, the larger the true sj and also the greater the excess of tj over ti, the greater the bias toward the overstatement (aajjT-,3i/asj>0 for tj>ti and aa jT`I/ Ntj>0). Therefore, for some values of sj>0 and tb>,tl it is possible to find the biased estimate of aij greater than unity and consequently possible to observe the measured vj to be negative. This paper has discussed two different interpretations of effective rates when the
2 In contrast to relatively few such cases in Basevi's work, on testing for Pakistan, R. Soligo and J. Stern [71find such cases to be 23 out of a total 48 industries. While Basevi discards his cases, Soligo and Stern rely on them to analyze Pakistan's investment criteria.

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THE AMERICAN ECONOMIC REVIEW

4. W. M. CORDEN, "The Structure of a Tariff System and the Effective Protective Rate," J. Polit. Econ., June 1966, 74, 221-37. 5. H. G. GRUBEL AND H. G. JOHNSON, "Nominal Tariffs, Indirect Taxes and Effective Rates of Protection: The Common Market Countries, 1959," Econ. J., Dec. 1967, 77, 761-76. 6. J. C. LEITH, "Substitution and Supply Elasticity in Calculating the Effective Protective Rate," Quart. J. Econ., Nov. 1968, 82, 588-601. 7. R. SOLIGO AND J. STERN, "Tariff Protection, Import Substitution and Investment Efficiency," Pakistan Develop. Rev., summer 1965, 5, 249-70. 8. W. P. TRAVIS, "The Effective Rate of Protection and the Question of Labor Protection in the U.S.," J. Polit. Econ., May/June 1968, 76, 443-61.

elasticity of substitution is greater than zero and shown the bias in the computed measure of each assuming CES production functions. A better understanding of the role of substitution in effective protection theory is thereby attained. At the same time, since information on substitution parameters is hardly available, care has to be exercised in interpreting empirical results.
REFERENCES

1. B. BALASSA, "Tariff Protection in Industrial Countries: An Evaluation," J. Polit. Econ., Dec. 1965, 73, 573-94. 2. G. BASEVI, "The U.S. Tariff Structure Estimate of Effective Rates of U.S. Industries and Industrial Labor," Rev. Econ. Statist., May 1966, 158, 147-60. 3. J. S. CHIPMAN, "A Survey of the Theory of International Trade, Part 3," Econometrica,Jan. 1966, 34, 18-76.

A Competitive Theory of the Housing Market

By EDGAR 0. OLSEN*
In his article on the demand for nionfarm housing, Richard Muth [11] rigorously developed a competitive theory of the housing market.' Muth used this theory in the statistical estimation of the demand functioin for housing service and of the speed of adjustment to long run equilibrium in this market. His theory also makes possible the translation of some of the idiosyncratic concepts used by housing, specialists into the familiar terms of microeconomic theory. A secondary purpose of this article is to make
* The author is on the staff of the RAND Corporation. However, this paper was written while he was a postdoctoral fellow in The Institute for Applied Urban Economics at Indiana University. He is indebted for helpful criticisms of earlier drafts to H. James Brown, David Greytak, W. David Maxw-ell, J. W. Milliman, Richard F. Muth, and R. L. Pfister. The author is also grateful to Resources for the Future for the grant which financed his postdoctoral fellowship.

these translations. More importantly, this theory has implications for a number of
1 There are clearly two housing markets. There is a demand for and supply of a consumer good which we shall call housing service. There is also a derived demand for and supply of an investment good which we shall call housing stock. These two markets are integrally related. Indeed, Muth [11, p. 321 defines one unit of housing service to be that quantity of service yielded by one unit of housing stock per unit of time. Thus, he assumes that housing stock is the only input in the production of housing service. Although all buyers of housing stock are also sellers of housing service, there are many people who participate in one market but not in the other. Consumers who occupy rental housing are not typically in the market for housing stock. They are not buyers or sellers of this capital asset. Builders who construct housing for sale are sellers of housing stock but not of housing service. This paper will focus primarily on the market for housing service. Finally, it must be emphasized at the outset that this paper abstracts from consideration of the land on which dwelling units stand.