Steel Tariff in a Small Open Economy
Steelville is a small open economy that imports steel at the world price of $450 per tonne. At that price, domestic producers supply 20 million tonnes and domestic consumers demand 50 million tonnes. The government imposes a specific tariff of $75 per tonne. After the tariff, the domestic price rises to $525; domestic supply increases to 30 million tonnes and domestic demand falls to 40 million tonnes. Steel is an input for construction and vehicle manufacturing, which employ 600,000 workers. The tariff raises revenue for the government, but the finance ministry estimates administrative and compliance costs at $120 million. The country's currency has appreciated by 10% against its trading partners over the past year. Trading partners are threatening retaliation against the country's agricultural exports.
1. Calculate the change in consumer surplus, producer surplus, tariff revenue, and deadweight loss. Show your working.
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Consumer surplus loss = area between $450 and $525 over the demand quantities 50m to 40m = 0.5 x (50 + 40) x 75 = $3,375m. Producer surplus gain = area between $450 and $525 over supply quantities 20m to 30m = 0.5 x (20 + 30) x 75 = $1,875m. Tariff revenue = $75 x (40 - 30)m = $750m. Deadweight loss has two triangles: production distortion = 0.5 x 75 x (30 - 20) = $375m; consumption distortion = 0.5 x 75 x (50 - 40) = $375m; total DWL = $750m. Net welfare loss = 3,375 - 1,875 - 750 = $750m, plus $120m administrative cost, giving $870m. The tariff transfers surplus from consumers to producers and the government, but the economy as a whole loses because domestic production replaces cheaper imports and some consumption is discouraged.
2. Evaluate the infant industry argument for this tariff.
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Infant industry protection is justified if the domestic industry has latent comparative advantage, learning-by-doing spillovers, and protection is temporary. Steel is a mature, capital-intensive industry with global overcapacity; the domestic supply response from 20m to 30m tonnes suggests some capacity, but not necessarily efficiency. The tariff protects 10m tonnes of domestic output at a cost of $750m deadweight loss plus $120m administration. Downstream construction and vehicle manufacturers pay $525 instead of $450, raising costs and reducing competitiveness; they employ 600,000 workers, far more than steel. Retaliation against agricultural exports could cost more than the steel jobs saved. The argument would be stronger for a temporary, performance-conditioned subsidy tied to productivity, not a tariff. As presented, the infant industry case is weak.
3. Explain how the 10% currency appreciation affects the tariff's protective effect and welfare costs.
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A 10% appreciation lowers the domestic-currency price of imported steel. If the world price is $450 and the exchange rate moves so that imports become 10% cheaper, the pre-tariff domestic price falls to about $409. With the $75 specific tariff, the domestic price becomes about $484, not $525. The protective effect of the tariff is reduced: domestic producers face a lower import price and must cut costs or lose market share. Consumer loss is smaller, and the volume of imports may rise, so tariff revenue changes. The welfare cost of the tariff may fall, but the country's exporters face a less competitive exchange rate, worsening the trade balance. The appreciation therefore erodes the tariff's intended protection and shifts the burden toward exporters. If the government wants to maintain protection, it would need a higher tariff, which would increase welfare costs.