Protecting Port Awarua's Steel Mill
The government of a small open economy is considering a 15% tariff on imported structural steel. The only domestic mill, at Port Awarua, employs 420 workers directly and 180 in related logistics; it has been loss-making for three years and says it needs protection for five years to install a $90 million electric-arc furnace. Downstream, 2,400 people work in firms that use structural steel - fabricators, construction and marine engineering - and steel is 18% of their input costs. The country imports 70% of its structural steel. The world price is $1,100 per tonne; at that price domestic demand is 240,000 tonnes while domestic supply is 90,000 tonnes. With the tariff, domestic supply is projected to rise to 130,000 tonnes and demand to fall to 210,000 tonnes. Trade advisers warn that retaliatory tariffs on the country's dairy exports (worth $4.3 billion) are likely. Adjustment assistance is estimated at $35 million over five years.
1. Calculate and explain the welfare effects of the 15% tariff. Identify the gain to domestic producers, the loss to consumers, the tariff revenue and the deadweight loss.
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World price = $1,100/t; tariff = 15% × $1,100 = $165/t; domestic price = $1,265/t.
- Consumer loss: $165 × (240,000 + 210,000)/2 = $37.125m. This is a rectangle of $34.65m on the 210,000 t still bought, plus a triangle of $2.475m.
- Producer gain: $165 × (90,000 + 130,000)/2 = $18.15m (rectangle $14.85m plus triangle $3.3m).
- Tariff revenue: $165 × (210,000 − 130,000) = $13.2m.
- Deadweight loss: $37.125m − $18.15m − $13.2m = $5.775m, made up of a production distortion of $3.3m (0.5 × 40,000 × 165) and a consumption distortion of $2.475m (0.5 × 30,000 × 165).
Interpretation: the tariff transfers about $18.15m to the mill and $13.2m to the government, costs consumers $37.1m and destroys $5.8m of value. The redistribution is regressive, since steel users include construction and lower-income households. Support per mill job is roughly $43,200 ($18.15m ÷ 420), before the deadweight loss and retaliation are counted. A temporary, declining tariff with a sunset clause would reduce the deadweight loss compared with a permanent one.
2. Evaluate whether the tariff is justified, considering the downstream industry, the risk of retaliation and the alternative of adjustment assistance. Justify your judgement.
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Arguments for: the infant-industry case - the mill needs five years to install the electric-arc furnace and move down its cost curve; employment of 420 direct and 180 logistics jobs; national resilience given 70% import dependence; and possible regional external benefits.
Arguments against:
- The effective rate of protection is higher than 15% because steel is an input, and the downstream 2,400 jobs bear the cost. A 15% steel price rise with steel at 18% of input costs raises downstream costs by about 2.7%, eroding their competitiveness.
- Retaliation against $4.3bn of dairy exports is a serious risk; even a 10% retaliation ($430m) dwarfs the mill's value added.
- Protection weakens the mill's incentive to become efficient - dynamic inefficiency.
- The infant-industry case requires eventual competitiveness without protection, and the setup provides no evidence of that.
Judgement: the tariff is not justified in this form. A better package is the $35m adjustment assistance for workers and downstream firms, plus conditional support tied to productivity milestones, rather than a price distortion that spreads costs across 2,400 downstream jobs and exposes exporters to retaliation.
3. Explain how the tariff would be likely to affect the country's current account and exchange rate.
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The tariff reduces steel imports, which improves the goods balance directly - imports fall by 70,000 tonnes, worth about $77m at the world price. But the current account effect is more complex. If downstream firms lose competitiveness and export less, or if retaliation cuts dairy exports, the net effect could be a deterioration. The current account is ultimately driven by national saving and investment, not by trade policy alone.
On the foreign exchange market, lower imports mean fewer units of domestic currency are sold to buy foreign currency, which tends to appreciate the exchange rate. An appreciation makes exports dearer and imports cheaper, partly offsetting the tariff's protective effect - the quantity effect on import substitution is dampened. It also means the domestic price of imports may not rise by the full 15%, reducing the consumer cost but also reducing protection for the mill.
In a floating exchange rate regime, a tariff is partly offset by the exchange rate, so the general-equilibrium effect is smaller than a partial-equilibrium calculation suggests. This is a key reason economists are sceptical of using tariffs to manage the current account.