What is GDP? Distinguish between real GDP and nominal GDP. What are the three ways of measuring GDP?

University Degree Business and Administrative studies

Principles of Economics ECON11026

Assignment 2

1 (a) What is GDP? Distinguish between real GDP and nominal GDP. What are the three ways of measuring GDP?

Gross domestic product or , or GDP, is the value of all final goods and services produced in the economy in a year. Final goods and services are goods and services are goods and services that are bought by their final user and not used as inputs in the production of other goods and services. the key thing to note is that GDP does not include all the goods and services- called intermediate goods and services – that businesses buy from each other to use in producing what they eventually sell to final users. To measure GDP, we add together the value of final goods and services produced. So we measure GDP in dollars. As a result, GDP is a mixture of real quantities- the amounts of final goods and services produced- and dollar quantities – the prices of the goods and services. A change in GDP, therefore, contains a mixture of the effects of changes in prices and changes in the quantities of final goods and services produced. to distinguish price changes from quantity changes , we use the concepts of nominal GDP and real GDP.

(Mc Taggart & Findlay& Parkin, 1999)

Nominal GDP measures the value of the output of final goods and services using the prices that prevailed at the time of measurement, or current prices. It is sometimes called current dollar GDP.

Real GDP measures the value of the output of final goods and services using the prices that prevailed in some given or base year. It is sometimes called constant dollar GDP.

Comparing real GDP from one year to another enables us to say whether the economy has produced more or fewer goods and services. Comparing nominal GDP from one year to another does not permit us to compare the quantities of goods and services produced in those two years , because some or all of the increase in nominal GDP could come about simply because prices rose in that year. (Mc Taggart & Findlay& Parkin, 1999)

GDP can be calculated in three different ways. The first method of measuring GDP is to add up the value of all the goods and services produced in the country, industry by industry.

This first method is known as the product method

The production of goods and services generates incomes for households in the form of wages and salaries, profits, rent and interest. The second method of measuring GDP, therefore, is to add up all these incomes. This is known as the income method.

The third method focuses on the expenditures necessary to purchase the nations production. In this simple model of the circular flow of income, with no injections or withdrawals, whatever is produced is sold. The value of what is sold must therefore be the value of what is produced. The expenditure method measures this sales value. Because of the way the calculations are made, the three methods of calculating GDP must yield the same result. (Mc Taggart & Findlay& Parkin, 1999)

What are its limitations?

The figures do give quite a good indication of the level of the production of goods and the incomes generated from it, provided we are clear about the distinctions between the different measures. But when we come to ask the more general question of whether the figures give a good indication of the welfare or happiness of the country’s citizens, the there are serious problems in relying exclusively on GDP statistics.

Problems of measuring national output

The main problem here is the the output of some goods and services goes unrecorded and thus the GDP figures will understate the nations output. There are two reasons why these items are not recorded.

Non Marketed Items. If you employ a decorator to paint your family room, this will be recorded in the GDP statistics. If however, you paint the room yourself, it will not. Similarly, If a former grows lettuces and sells them, this output will form part of GDP. If, however, you grow lettuces in your backyard, it will not. The exclusion of these ‘do it yourself’ activities means that the GDP statistic s understate the true level of production in the economy. If overtime there is an increase in the amount of such do-it-yourself activities, the figures will also understate the rate of growth of national output. On the other hand, if in more or more families both partners go out to work and employ people to do housework, this will overstate the rate of growth in output.

The underground economy. The underground ( or black) economy consists of illegal and hence undeclared transactions. These could be transactions involving goods and services that are illegal, such as drugs and prostitution. Alternatively, they could be transactions that are illegal only in that they are not declared for tax purposes.

Problems of using GDP statistics to measure welfare

GDP is essentially an indicator of a nation’s production. But production may be a poor indicator of society’s well-being for the fallowing reasons.

Production does not equal consumption. Production is desirable only to the extent that it enables us to consume more. If the GDP rises as a result of rise in investment, this will not lead to an increase in current living standards. It will, of course, help to raise future consumption.

The human costs of production. If production increases, this may be due to technological advance. If, however, it increases as a result of people having to work harder or longer hours, its net benefit will be less.

GDP ignores externalities. The rapid growth in industrial society is recorded in GDP statistic. What the statistics so not record are the environmental side effects: the polluted air and rivers, the ozone depletion, the problem of global warming. If these external costs were taken into account, the net benefits of industrial production might be much less.

The production of certain ‘bads’ leads to an increase in GDP. In some cases production of undesirable things can actually count as an increase in GDP. If you have to travel a long distance to work, this is a personal cost to you, in both money and lost leisure. Yet the provision of these transport services count as part of GDP.

Total GDP figures ignore the distribution of income if some people gain and other lose , we cannot say that there has been a unambiguous increase in welfare. A typical feature of many rapidly growing countries is that some people grow very rich while others are left behind. The result is growing inequality. If this see undesirable, then clearly total GDP statistics are inadequate measure of welfare.

2 (a) Distinguish between the key features of Keynesian and Classical economics.

Keynesian argue that aggregate demand determined the level of economic activity in the economy. In the other words, the nation’s production and employment depend on the amount of spending.

In the simple Keynesian theory, the consumption of domestically produced goods (Cd) and the three withdrawals (W)-net saving (S), net taxes (T) and spending on imports (M) all depend on the level of the GDP. In fact, , in the model, GDP must always equal consumption of domestic goods plus withdrawals: there is nothing else people can do wif their incomes. (Sloman & Norris, 1999)

A Keynesian economist believes that:

Economic fluctuations arise from changes in expectations affecting aggregate demand.
Prices and wages adjust slowly
Fiscal policy is powerful, and monetary policy is weak.
Overall Keynesians believe the economy is inherently unstable. It can remain in an unemployment equilibrium long enough to require government intervention.

The impulse in the Keynesian theory of the business cycle is expected future sales and profits. A change in expected future sales and profits changes the demand for new capital and so changes the level of investment

Keynes had a sophisticated theory about how expected sales and profits. ...

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A Keynesian economist believes that:

Economic fluctuations arise from changes in expectations affecting aggregate demand.
Prices and wages adjust slowly
Fiscal policy is powerful, and monetary policy is weak.
Overall Keynesians believe the economy is inherently unstable. It can remain in an unemployment equilibrium long enough to require government intervention.

The impulse in the Keynesian theory of the business cycle is expected future sales and profits. A change in expected future sales and profits changes the demand for new capital and so changes the level of investment

Keynes had a sophisticated theory about how expected sales and profits. A change in expected future sales and profits are determined. He reasoned that these expectations would be volatile because most of the events that shape the future are unknown and impossible to forecast. So he reasoned, news or even rumors about future tax rate changes , interest rate changes , advances in technology , global economic and political events, or any other of the thousands of relevant factors that influence sales and profit change expectations in ways that cannot be quantified but that have large effects.

To emphasize the volatility and diversity of sources of changes in expected sales and profits , Keynes described these expectations as animal spirits. In using this term, Keynes

was not saying that expectations are irrational. Rather he meant that because future sales and profits are impossible to forecast , it might be rational to take a view about them based on rumors, guesses, intuition, and instinct.

2 (b) Illustrate and explain the multiplier effect.

The Multiplier effect is a basic economic concept, which refers to changes in the level of activity that brings further changes in the level of other activities throughout the economy. When an injection of expenditure into an economy leads to an increase in national income more than the original injection, this is the multiplier effect. In other words, the multiplier effect is the effect from continuous responding of incomes. There are different types of multipliers, such as the sales or transaction multiplier, the output multiplier the employment multiplier, government revenue multiplier and the import multiplier.

The multiplier indicates how many times that the injection of original spending circulates through a local economy. As a result of responding, it benefits the local people. According to "Tourism: Economic, Physical and Social Impacts", "tourists expenditures in a destination creates new incomes and outputs in the region which, in turn, produce further expenditures and incomes (Mathieson, p. 64)." How to calculate the multiplier and how does it work in tourism? Some examples will be given to illustrate the economic concept of multiplier effect.

The income multiplier considers three levels of impact created by the change in tourist expenditure, which includes direct spending, indirect spending and induces spending. Let us look at the illustration in the following Example.

Impacts of Tourism

* Direct impact:

A tourist stays in a hotel and eats at the food establishment there. The tourist pays for the hotel accommodation, food and beverages. (This is the tourist’s initial spending in a hotel, which creates direct revenue to the hotel).

* Indirect impact:

Upon receipt of the tourist dollars, the process of responding begins. The hotel makes pay-ments to its employees, suppliers, and so on. (This is the indirect effect of the tourist’s initial expenditure, which creates additional income and employment for the local economy).

*Induced impact:

The employees receive incomes and consume on goods and services. The supplier replenishes its stock makes payments of wages to their employees etc. (This is induced effect of the tourist’s initial expenditure, which creates further economic activities.

Most people living on Guam recognize that Guam is heavily dependent on the tourism income to create additional income and jobs for the economy. If tourist arrivals and their expenditures decrease, the island will experience an economic slump.

The Asian financial crisis which occured since July 1997 is a good example. The decline in international arrivals has made many tourist destinations suffer. On Guam, many organizations have either closed down or reduced the number of working hours or number of employees. When the recession begins, it is difficult to generate additional incomes throughout the economy for the limited spending in the economy. This is the multiplier effect. Guam needs tourist discretionary income to strengthen its economy.

3 Illustrate and explain how equilibrium in the money market is determined and its impact on interest rate real GDP, investment, aggregate expenditure and savings.

Equilibrium in the money market occurs when the demand for money ( L) equal to the supply of money (M) . This equilibrium is achieved by changes in the rate of interest.

In appendix 1 equilibrium is achieved with a rate of interest re and a quantity of money Me. If the rate of interest exceeded re people would have money balances surplus to their needs. They would use these to buy securities and other assets. This would drive up the price of the securities and drive down the rate of interest. As the rate of the interest fell, there would be a contraction of the money supply (a movement down along the Ms Curve) and an increase in the demand for money balances. The interest rate would go on falling until it reached re.

A shift in either Ms or L will lead to a new equilibrium quantity of money and rate of interest at the new intersection of the curves. In practice there is no single rate of interest.

Equilibrium in money markets, therefore, will be first where the total demands for and supply of money is equal. This is achieved by adjustments in the average rate of interest. Second, it will occur when demand and supply of each type financial asset separately excess supply of money to invest in long term assets ( like bonds), short term rates of interest would rise relative to long term rates.( Sloman & Norris, 1999)

Equilibrium in both the money market and GDP

Changes in money supply ( or demand) affect GDP via changes in the rate of interest it is a three-stage process illustrated in appendix 2

In diagram (a) a rise in money supply ( Ms) will lead to a fall in the rate of interest ( r ) : this is necessary to restore equilibrium in the money market.
In diagram (b) the fall in r will lead to a rise in investment and other forms of borrowing (I) since borrowing money will be cheaper, investment will cost less.
In diagram © the rise in investment ( being an injection ) will lead to a multiplied rise in GDP and aggregate demand (AD)

The ultimate rise in GDP will be less than that shown in diagram ( c), however , since any rise in income will lead to a rise in the transactions demand for money, L1. L will shift to the right in diagram (a), and thus r will not fall as much as shown. Thus investments (diagram (b)) and income (diagram (c)) will not rise as much shown either (Sloman & Norris, 1999)

Illustrate and explain the objectives and instruments of monetary policy and its effectiveness

The effectiveness of monetary policy, measure by the magnitude of the increase in equilibrium real GDP resulting from a given increase in the money supply, depends on the same two factors that influence the effectiveness of fiscal policy (Mc Taggart & Findlay& Parkin, 1999)

The sensitivity of investment demand to do interest rate
The sensitivity of the demand for money to the interest rate

The monetary policy reserve is under the control of the Reserve Bank, not the government. Thus, in Australia at least,, monetary policy should not be seen as an alternative to fiscal policy, as the latter is obviously under the control of the government but the former is not. (Mc Taggart & Findlay& Parkin, 1999)

In practice we have seen in recent years within the of 2-3% over the business cycle, over the business cycle – a target which has been achieve that target have been market operations which alter the cash receives (Mc Taggart & Findlay& Parkin, 1999)

It has already been emphasised that in order to attain the requisite level of market interest rates, central banks make use of various monetary policy instruments at their disposal.

Two types of policy instruments can be distinguished, namely indirect measures and direct measures. Indirect policy (market oriented) measures are actions taken by the central bank whereby it achieves its monetary policy aims by encouraging market participants to take particular actions as regards their lending and borrowing behaviour as a result of price and interest rate incentives or disincentives brought about in the financial markets. More particularly these incentives or disincentives arise out of technical intervention by the Central Bank in the various financial markets involving the buying and selling of specified financial claims such as government stock, Treasury bills, bankers' acceptances and foreign exchange in order to influence prices and therefore interest rates and exchange rates.(Sloman& Norris,1999)

Direct (or non-market oriented) policy instruments refer to those measures taken by the central bank that seek to attain the aims of monetary policy by means of certain rules prescribing the behaviour pattern of banks and possibly other financial institutions. These instruments are usually associated with a suspension of market forces, involving either rigid behaviour rules or the fixing of certain variables. If the relevant market participants do not adhere to these prescriptive rules, they may be liable to prosecution or at least certain penalties. Examples include instructions sent to banks under which the latter are requested not to exceed a certain amount of lending to domestic private sector borrowers over a specified period, and instructions that banks must not quote interest rates above or below a certain maximum or minimum level on their various credit and deposit facilities made available to customers. Exchange control regulations also form part of the group of direct monetary policy instruments.

Nevertheless, as already indicated, direct instruments of monetary control have been used by most countries in the past. They have a superficial attraction in the sense that on the face of things they seem able to achieve given quantitative targets for such as the extension of bank credit. However, they are likely to have serious drawbacks since they tend to be partially ineffective, and they are not conducive to gains in economic efficiency. Credit ceilings, the most common direct instrument, tend to be inefficient, while curbing competition among banks in the granting of credits. In addition, direct monetary controls tend to spawn yet more controls; there is a tendency for administrative controls to multiply as the authorities try to thwart attempts to circumvent the initial controls. This leads to disintermediation of credit out of the formal banking sector; in other words investors who are so-called 'primary lenders' start to bypass the banks by lending directly to the so-called 'ultimate borrowers', rather than holding deposits with the banks who then extend credits. This in turn means that targets for aggregates such as banking lending, that superficially appear to have been achieved, in reality only mask a declining share of official financial sector activity within the economy. (Mc Taggart & Findlay& Parkin, 1999)

The adoption of indirect or market-oriented instruments of monetary policy brings with it a number of advantages. It can depoliticise the allocation of credit and reduce the protection of existing large financial institutions by fostering greater competition in the banking sector. Greater competition tends to decrease the cost of banking services, and fosters the re-integration of the informal with the formal banking sector, by encouraging the process whereby "primary lenders" place their funds with banks rather than try to lend directly to "ultimate borrowers". In general the use of indirect instruments of monetary policy enables a central bank to better manage monetary conditions in the economy as a whole, thereby rendering monetary policy more effective. (Mc Taggart & Findlay& Parkin, 1999)

The cash rate and other rates

The importance of the official cash rate is that changes in it tend to ripple through the whole term structure of interest rates. There are multitudes of interest rates.

Bank bills are issued by corporation and banks charge and interest rate for endorsing. The prime rate is charged by banks on loans to first class (least risk) business barrowers.

Other business barrowers are charged other various additional amounts of interest over and above the prime rate. (Mc Taggart & Findlay& Parkin, 1999)

The transmission mechanism by which changes in monetary policy affect output, employment and the inflation rate operates not through the official cash rate per se but through the other interest rates , notably those charged by banks to their customers. While short term interest rates adjust quickly to changes in the official cash rate it may take months before some long rates of interest adjust. This is one of lags in the operation of monetary policy. (Greenwood, Jeremy 1999).

Lags in monetary policy

Time lag before recognition

This lag between a change in the economy and the recognition that the change needs correction, arises because vital information on the rate of inflation becomes available only every quarter. Also the reserve bank nay wish to wait until the figures for two quarters , plus a range of other indicators, are available before taking action.

Time lag between recognition and action

Here the lag involved in monetary policy is much shorter than that associated with fiscal policy. It simply requires a meeting of the Board of the Reserve Bank to change the official; cash rate.

Time lag between action and changes taking effect.

A time lag occurs between changes in the official cash rate and changes in the interest rates charged by banks to their customers.

Time lag between interest rate changes and the resulting change in the GDP, prices and employment. This lags is of a magnitude similar to that encountered in fiscal policy.

Because of these time lags monetary policy is, like fiscal policy. (Mc Taggart & Findlay& Parkin, 1999)

Objectives of Monetary Policy

The framework for the operation of monetary policy is set out in the Reserve Bank Act 1959 which requires the Board to conduct monetary policy in a way that, in the Board's opinion, will best contribute to the objectives of:

the stability of the currency of the country;
the maintenance of full employment in that country; and
the economic prosperity and welfare of the people

The first two objectives lead to the third, and ultimate, objective of monetary policy and indeed economic policy as a whole. These objectives allow the Reserve Bank to focus on price (currency) stability while taking account of the implications of monetary policy for activity and, therefore, employment in the short term. Price stability is a crucial precondition for sustained growth in economic activity and employment.

(http://www.rba.gov.au/MonetaryPolicy/statement_on_the_conduct_of_monetary_policy_1996.html)

Both the Bank and the Government agree on the importance of low inflation and low inflation expectations. These assist businesses in making sound investment decisions, underpin the creation of new and secure jobs, protect the savings of Australians and preserve the value of the currency. (Mc Taggart & Findlay& Parkin, 1999)

In pursuing the goal of medium term price stability the Reserve Bank has adopted the objective of keeping underlying inflation between 2 and 3 per cent, on average, over the cycle. This formulation allows for the natural short run variation in underlying inflation over the cycle while preserving a clearly identifiable benchmark performance over time.

The Governor (designate) takes this opportunity to express his commitment to the Reserve Bank's inflation objective, consistent with his duties under the Act. For its part the Government indicates again that it endorses the Bank's objective and emphasizes the role that disciplined fiscal policy must play in achieving such an outcome. ()

What are the causes of economic growth, and the relationship between investment and technological program in the growth process

Economic Growth is caused by improvements in the quantity and quality of the factors of production that a country has available i.e. land, labor, capital and enterprise. Conversely economic decline may occur if the quantity and quality of any of the factors of production falls.

Improving the Quantity and Quality of Land Resources

Increases in the quantity of land available for agriculture will increase economic growth. However, the extent to which this happens is limited to the extent to which bush land can be converted to agricultural land. All economic resources are scarce and have an opportunity cost. As bush land is increasingly used for agricultural purposes it is no longer a habitat for wildlife. The relative scarcity of land in the face of a growing population means that the law of diminishing returns might also become relevant. The law predicts that an increasing amount of labor applied to a fixed quantity of land the marginal productivity of the labor will fall. This was the basis of the argument put forward by the Reverend Thomas Malthus. To prevent this loss in productivity the quality of the land must be improved. This can be done through the application of better technology through improved irrigation, fertilizers and pest control. (Mc Taggart & Findlay& Parkin, 1999)

An increase in the productivity of factors. Here we would include an increase in the skills of workers, a more efficient organization of inputs by management and more productive capital equipment. Most significant here is technological progress, developments of computer technology , of new techniques in engineering , of lighter, stronger and cheaper materials, of digital technology in commutations and of efficient motors have all contributed to a massive increase in the productivity of capital. Machines today can produce much more output than machines in the past that cost the same to manufacturers. (Sloman& Norris, 1999)

Improving the Quantity and Quality of Human Resources

Increases in the supply of labor can increase economic growth. Increases in the population can increase the number of young people entering the labor force. Increases in the population can also lead to an increase in market demand thus stimulating production. However, if the population grows at a faster rate than the level of GDP the GDP per capita will fall.(Gordon & Robert, 1990)

It is not simply the amount of labour that will lead to economic growth. It is often the quality of that labour. This will depend on the educational provision in countries. Improving the skills of the work force is seen as being an important key to economic growth. Many LDCs have made enormous efforts to provide universal primary education. As more and more capital is used, labour has to be better trained in the skills to use them, such as servicing tractors and water pumps, running hotels and installing electricity. It should always be remembered that education spending involves an opportunity cost in terms of current consumption and thus it is often referred to as investment spending on human capital. . ( Atkenson& Kehoe, 2001)

Improving the Quantity and Quality of Capital Resources

One can distinguish between:

Directly productive capital - plant and equipment e.g. factories
Indirectly productive capital - infrastructure or facilitating capital e.g. roads and railways.

The process of acquiring capital is called investment. The opportunity cost of capital investment is the current consumption foregone. The level of investment and the quality of investment will directly affect the level of economic growth. The efficiency of the labour force and the other factors of production will depend upon the amount and quality of capital they have. In LDCs some investment comes from abroad in the form of foreign direct investment. This is usually through multinational enterprises locating in a country. There has been criticism of some investment in LDCs as to whether it is appropriate. If production moves from being labour intensive to capital intensive, unemployment and poverty increases. ( Atkenson& Kehoe, 2001)

The level of economic growth may be slowed down if there is a lack of entrepreneurial and risk taking managers. For growth to take place inventions and innovations must be encouraged. Again the role of education is seen as being essential here. Multinational enterprises also can provide training in management skills. (Sloman& Norris, 1999)

Thus there are many potential economic, cultural and social barriers to economic growth.

Investment - Investment is the purchase of capital equipment. i.e. the purchase of machines, equipment, factories etc. that firms need to enable them to produce. It is usually split into two parts: (Mc Taggart & Findlay& Parkin, 1999)

1. Replacement investment - this is where companies buy new machinery and equipment that simply replaces something they had already that was worn out or inefficient. Depreciation is often used as an approximation for this.

2. Net investment - this is where companies buy new machinery or equipment. It is this type of investment that actually adds to the capital stock of the economy.

Investment can also refer to changes in the level of stocks.

Technological Progress

The effect of technological progress on output

Technological progress has the effect of increasing the output from a given amount of investment. This is shown in appendix 3 initial investment and income curves are I1 and Y1; steady –state income as at a level of Y1. A technological advance has the affect of shifting the Y line upwards, say to Y2. The higher income curve leads to a higher investment curve( for a given rate of saving). This is shown by curve I2. The new long term equilibrium capital stock is thus K2, and the new steady state level of income is Y2 (point p).

Income rises to a higher level, but does not go on rising once the new steady –state level has been reached . but technological progress marches on over time. New inventions are made ; new processes are discovered; old one are improved. In terms of appendix 4, the Y curve shift upwards over time. The faster rate of technological progress, the faster will the Y curve shift upwards and the higher will be the rate of economic growth. (Sloman& Norris, 1999)

Discuss in detail the method and arguments for restricting trade with examples.

Tariffs (customs duties) raise import prices. This will either restrict imports (if demand is price-elastic); or will raise tax revenue (if demand is price-inelastic).

Tariffs are used to restrict imports are most effective if demand is elastic ( e.g. when there are close domestically produced substitutes. Tariffs can also be used as means of raising revenue, but in this case they are more effective if demand is inelastic. They can also be used to raise the price of imported goods to prevent “unfair” competition for domestic producers .in this case the rate of tariff would have to rise if the world price fell and vice versa(Sloman& Norris, 1999)

Quotas: government imposes a limit on quantity of goods imported. Sometimes governments negotiate quotas, which are then referred to as Voluntary Export (Import) Restraints.

Export subsidies reduce prices of exported goods, leading to dumping of exported goods at artificially low prices in foreign markets.

Non-tariff (administrative) barriers may exclude imports (e.g. quality standards, product safety rules). (Sloman& Norris, 1999)

Exchange controls: limits on amount of foreign exchange available to importers.

Import licensing: The imposition of exchange controls or quotas often involves licenses to help the government enforce its restrictions on importers.

Embargoes: These involve total government bans on certain imports (e.g. drugs) or exports to certain countries (e.g. to enemies during war)

Export taxes : These can be imposed to increase the price of exports when a country has a monopoly on the supply of a particular product. (Sloman& Norris, 1999)

Subsidies: These can be applied to domestic goods to protect them from competition from cheaper imports. They also can be applied to exports in a process known as dumping. The goods are “dumped” at artificially low prices in the foreign market. (Sloman& Norris, 1999)

Administrative barriers: Regulations may be designed to exclude imports. For example in Germany all lagers not meeting certain purity standards could be banned. Taxes may be imposed to give local products or ingredients an advantage. (Sloman& Norris, 1999)

Reasons for Restricting Trade: World Economy Benefits

Infant industry argument: protect new industries until they can compete.

Prevent dumping by imposing tariffs.

Prevent establishment of a foreign-based monopoly (would lead to higher prices).

Promote economic growth by reducing reliance on goods with low growth potential

Restricting Trade: Gains at Other Nations’ Expense

Use national monopoly power to cut import prices and raise export prices.

Protect declining industries and alleviate unemployment.

Improve balance of payments

Non-economic factors:

Self-sufficiency in strategic industries

Preserve tradition or diversity

Opposition to political regimes

Nominal and Effective Rates of Protection

In examining the amount of p[protection that a tariff offers an industry it is important to distinguish between the nominal and the effective rate of protection.

The nominal rate of protection is the tariff expressed as a percentage of the landed value of an import. Thus if a tariff of 25% is levied on the value of an import the nominal rate of protection is 25%.

Domestic manufacturers normally use some imported materials or components. If these are subject to either no tariff or a lower rate of tariff than the one imposed on the manufactured good, then the effective rate of protection will be higher than that indicated by the nominal rate.

In Australia effective rates of protection for most manufactured goods have normally been higher than normal rates. In 1970, for example, when the average nominal rate of protection on manufactured goods as a whole 23%, the average effective rate of protection was 36%. (Sloman&Norris ,1996)

Economic Arguments having some general validity

The infant industry argument. Some industries in a country may be in their infancy but have a potential comparative advantage. This is particularly likely in developing countries. Such industries are still too small to have gained economies of scale; their workers are inexperienced; they lack back up facilities such as communications networks, specialist suppliers, and they may have only limited access to finance for expansion. Without protection, these infant industries will not survive competition from abroad.( Sloman & Norris,1999)

Protection from foreign competition, however, allows them to expand and become more efficient . once they have achieved a comparative advantage, the protection can then be removed to enabled them to compete internationally. .( Sloman & Norris,1999)

The senile industry argument: Some industries with potential comparative advantage have been allowed to run down and can no longer compete. They may be simply unable to make enough profit to afford the investment they need to reach full potential, so they warrant some temporary protection. This is one of the most powerful arguments used to justify special protection for the automobile and steel industries in the USA.( Sloman & Norris,1999)

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