Wednesday, 8 January 2014

Holden and the limp.

The effect of subsidies and tariffs on the Australian Automotive industry.

The car industry has limped along for some time now, and has seen its fair share of market cycles. In the most recent recession demand for cars fell sharply, accentuating the difficulties of excess production and deepening the crisis in the major car producing countries.

Australian protectionist policy seeks to limit the flow of free trade in order to preserve the production of vehicles in this country. A few examples of protectionism are:
  •  Tariffs
  • Quotas 
  • Subsidies   
  •  Export restraints
Import controls are barriers to the free movement of goods and service that seek to distort the pattern of trade between countries.

Despite the use of these policies in other countries, evidence suggests that the reduction in available credit is to blame for the downturn.

Car scrapping - Subsidies

Australia has not used this scheme, but out of interest I have included some information on the scheme. Many countries have introduced car scrapping schemes to cushion the overall downturn in economic activity, boosting sales in the short term. However, crowding-out effects whereby the demand for new cars dampens the demand for other products are likely to have lowered their final impact on economic activity. Essentially delaying the inevitable.

As most of the schemes have already ended or will expire at the end of  2009, the GDP impact expected for next year will depend on the size of the “payback effect”, i.e. to what extent programmes pulled forward sales which will then not occur in the near future. Past experience suggest that the size and the timing of this payback effects is variable. In most episodes, sales appear to have been depressed after the termination of car scrapping schemes.


A tariff is a tax on imports and is used to restrict imports and raise revenue for the government. We assume in the diagram below that producers from other countries can supply the good at a constant price of Wp - their supply curve is perfectly elastic.

A tariff is placed on the value of imports. This raises the price of imports and as a result, domestic demand contracts and domestic supply expands. Home producers can supply more at the new higher price. The tariff gives domestic firms a competitive boost. The volume of imports has reduced.

When a tariff or other price-increasing policy is put in place, the effect is to increase prices and limit the volume of imports. In the diagram price increases from the non-tariff Wp to Wp + Tariff. Because price has increased, more domestic companies are willing to produce the good, so Qs moves right. This also shifts Qw left. The overall effect is a reduction in imports, increased domestic production and higher consumer prices.
The effect of the tariff depends on the price elasticity of demand and the price elasticity of supply. A tariff will have a greater effect the more elastic the demand and supply. If the demand is inelastic then the imposition of a tariff will have little effect on the level of imports. The introduction of tariffs by one country can lead to retaliation responses from other countries. This retaliation can lead to damaging trade-wars.

Tariffs come with a number of costs and benefits. They allow a political leverage and can present the polis with the image of saving jobs, boosting the economy and so on. Next the unemployment debate can usually be swung in. The argument often shifts to domestic industries complaining about cheap foreign labor, and how poor working conditions and lack of regulation allow foreign companies to produce goods more cheaply.

One distinct advantage is that it is much easier to charge tax on an imported good. Thereby further boosting the GDP.

The subsidy, which is essentially extra spending money specifically for that good, artificially shifts the consumer’s demand curve outward (upward or rightward) and creates a greater demand for the good.

The concept of producer surplus goes together with the concept of consumer surplus. Understanding one helps to understand the other. These concepts are used by economists to measure the relative economic value of produced goods and services across the economy. Think of these concepts as representations of what a consumer and producer each will give up for a market transaction to take place. Understanding these concepts should help you price products at your small business.

In a free market, prices are set according to how much demand there is for a product relative to its supply. For example, many people appreciate Mercedes automobiles for their styling, mechanical performance and status appeal. Those who favor owning a Mercedes will pay what they must to have the car of their choice. The manufacturer of Mercedes automobiles tries to produce the exact number of high-end, mid-price and low-end autos to meet consumer demand for cars at those price levels. Consumers who can't afford a new Mercedes at the lowest price level or who want the top of the line but can't pay the price can always buy their favored Mercedes in the used car market. So, the price of a Mercedes, whether new or used, is set by the price the buyer will pay relative to the price the seller will charge. This sets up a situation where buyers and sellers often negotiate final transaction prices, which are based on the seller's supply of cars in relation to the buyer's desire to buy or demand for the product.

Consumer surplus is defined as the difference between a consumer’s willingness to pay and what he or she actually has to pay (the price of the good). When analysing a market, CS is just the area under the demand curve and above the price. If the demand curve is linear, it is easy to calculate total CS as the area of the triangle formed by the P-axis intercept, the market price, and quantity demanded.

If the price of a car is $24,000 and 60,000 are sold CS is the area of the resulting triangle, so CS = (1/2)(60,000)($26,000) = $780,000.

Basically, this means that consumers gain $780,000 from the opportunity to buy 60,000 cars at a price of $24,000 each. Consumer surplus is the amount of money a consumer is willing to pay above the absolute lowest reasonable price to buy the car. Included in the consumer surplus is the amount of money the buyer does not spend on other purchases to have enough money to buy a Mercedes.

Producer surplus is the difference between the price (what the seller actually gets) and cost (what the seller would have settled for). Again, notice that producer surplus corresponds to an area. In this case, it is the area below price and above supply. If the supply curve were linear, it would be easy to calculate PS for the industry.

Here, PS = (1/2) ($19,000) (60,000) = $570,000.

When a market reaches equilibrium, we can calculate Total Surplus, which is the sum of CS and PS. e.g. Suppose the supply and demand for cars are as above. The equilibrium price is $24,000, the equilibrium quantity is 60,000, and TS = $780,000 + $570,000 = $1.35 mil.

One of the major arguments in favor of free markets is that they maximize total surplus. Note that any price above or below the equilibrium price would cause total surplus to fall. This decrease in total surplus is called a deadweight loss.

Consumer and Producer Surplus and the Market
Now, let us examine the economic effects of levying an excise duty on the importation of a product. If the government sets an excise duty of τ on a product, it is applied to the supply of the product which raises the supply price (Ps) by the amount of the tax. This shifts the supply curve up or to the left of where it was before (S’S’), thereby lowering the supply of the product. Given the demand for that product, the equilibrium quantity exchanged will fall to Q1, as fewer consumers will afford the product and raises the equilibrium market price to P1.

As you can see from the figure above, the implementation of an excise tariff, will reduce the consumer surplus by an amount equal to the area of the trapezoid PeP1E1Eo and reduce the producer surplus by an amount equal to the area of the trapezoid PeEoJP1-τ. Consumers will end up paying more per unit and buying fewer units, producers will sell fewer units and receive a price net of the duty which will be lower than before. A tariff reduces the welfare of both consumers and producers.

On the other hand, the government benefits from the newfound flow of revenue, equal to the area of the rectangle P1E1JP1-τ. Since the government benefits both consumers and producers, the welfare gain for the government offsets most of the welfare lost by consumers and producers.
But if you look closely not all of the loss is offset. There is still a net loss of welfare for the whole society equal to the small triangle E1E0J. This net loss in societal welfare is called deadweight loss. It means that there are people who were not able or willing to pay the higher price which includes the duty and as a result are obliged to go without consuming this product. This reduces the overall welfare of society.


When one analyzes the costs and benefits of international trade on a country’s economy one must recognize that protecting domestic producers is not always in the best interest of a nation. True, tariffs, quotas and non-tariff barriers may help provide protection for domestic producers which are the firms and those working for them, but they also raise the cost of products for all consumers and reduce the consumer surplus that all consumers enjoy, thus lowering buying power and reducing living standards. While the producers are few, the consumer is everyone. Protection for home producers should not be equated as being necessarily in the public interest. Very often, those routing for protection are not the firms that produce the products, but their workers. 
Unionized labour has a vested interest in preserving jobs and almost always will demand protectionism, even if this works against the best interests of their workers. Why? first because protectionist measures raise the cost of living and reduce the buying power of workers and secondly because protectionism limits the potential for growth in the industry and growth in future jobs.

As the world automotive industry continues to grow (i.e. producers form China and India are now gaining credibility) the price of the units reduces. The industry also enjoys economies of scale. A combination of lower prices and lower trade barriers will result in the same welfare effects as what is currently being produced in Australia by the policy.