When considering a tariff, one normally thinks of the duty compared to the cost of the import; thus a Rs 25 tax on a Rs 100 item would be a 25% tariff. Economists refer to this as the nominal tariff. However, the actual amount of protection is measured by something called an effective tariff. The effective rate compares the tariff to the value added in the country, not to the total value of the product.
The formula to figure the effective rate of protection is as follows:
(y – b) – (x – a)/ x – a
where x = the international price of the finished commodity, y = the domestic price of the finished commodity, including the tariff, a = the international price of the imported component, and b = the domestic price, including the tariff, of the imported component. The formula assumes producers do not substitute cheaper inputs for more expensive ones as tariffs are imposed, and it does not take into account any effect of quotas.
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In the vast majority of cases, the effective tariff is positive; that is, the more finished product pays the higher tariffs. Bela Balassa compared average nominal tariffs to average effective tariffs, based on rates before the last major round of tariff cuts.
Because effective tariffs are so much on finished goods than they are on raw materials, economists speak of a phenomenon called tariff escalation. The greater the extent of processing, the greater the effective tariff. The tariff system is, in effect, rigged against the developing countries that wish to export more manufactures, or to export their primary products in a more finished form.