Import subsidy and import tariff
Overvalued exchange rate
Foreign exchange allocation
Food aid distribution
Before embarking on an empirical analysis of the causes and effects of dairy imports and import policy in sub-Saharan Africa, the theoretical framework for such an analysis must be established. In this chapter, we consider the economic effects of such policy instruments as import tariffs and subsidies, exchange rate setting, foreign exchange allocation, and targeted and untargeted distribution of food aid.
In economic terms, an import subsidy has the reverse effect of an import tariff. The effects of both instruments on the quantities imported are shown in Figure 6.
Figure 6. Economic effects of import subsidy and tariff.
In a free-trade situation, the domestic market price Pd is equal to the world market price Pw9. The difference between domestic supply SS and demand DD at the price Pw is met by imports of the quantity Mo (i.e. imports in free-trade situation). If the government introduces an import subsidy s (a fixed amount per tonne in this case), the effective domestic price is reduced to Pd = Pw - s and imports increase from Mo to Ms (i.e. imports after import subsidy has been introduced).
9 The following assumptions are made: a small country without influence on the world market price; an infinitely elastic world market supply; negligible transport costs between the world and the domestic markets; and all changes treated ceteris paribus.
The consumers benefit, for their additional welfare10 is equal to the area a + b + c + d + e, but the producers lose the equivalent of the area a + b. The government's subsidy (loss) amounts to the area b + c + d + e + f (imports Ms × subsidy s), which is the difference between the import bill and the value of the imports at the domestic price Pd = Ps. The net social gain (loss) is determined by subtracting the losses from the gains, i.e.
consumer gains - producer losses - government costs ora + b + c + d + e - a - b - b - c - d - e - f = -b - f.
There is thus a substantial net social loss (represented by the shaded areas b and f) resulting from the import subsidy. This loss is referred to as a 'dead weight loss' in welfare economics (Just et al, 1982).
10 For a discussion of the concept of economic welfare see Corden (1974), Meade (1966) and Samuelson (1972, p. 480 et seq.).
To summarise, the introduction of an import subsidy (without further specification) will cause consumers to buy more of the imported goods since they can buy them at a lower unit price. The reduced price will cause a reduction or cessation of domestic production. The government outlays are funded from the national budget, but, depending on the relative tax burden, consumers and producers share the cost of the additional government expenditure, and together incur a dead weight loss.
Import tariffs generating funds for the national budget are more common than import subsidies. In Figure 6, let us assume that Ps is equal to the world market price Pw and t is the tariff (a fixed amount per tonne), then the domestic price increases from Pd = Ps to Pd = Ps + t and imports decrease from Ms to Mo.
The consumers' loss is equal to the benefit accrued in the subsidy example (a + b + c + d + e), while the producers' gain is a + b. The government collects tariff revenues equal to the area b + c + d + e + f (imports Ms × tariff t), which represents the amount by which the value of imports at domestic prices exceeds the import bill. The effect of an import tariff is thus the opposite from that of an import subsidy in every aspect except the dead weight loss which is again b + f.
To summarise, when import tariffs are charged, the consumers buy fewer imported products since they are more expensive, and producers expand production in response to the higher domestic price. The government collects the tax revenues which may be used to the benefit of society, but in the process generates an overall dead weight loss. The amount of revenues, as well as the changes in consumer and producer welfare and the overall net social loss, depend on the level of the tariff and the price elasticities of domestic demand and supply.
The effects of an overvalued exchange rate can be deduced from Figure 6. Let us take again the free-market situation, where domestic price Pd is equal to the world market price Pw, and give a numerical example. If Pw = US$ 250 is equal to Pd = DC 100011 (at the undistorted exchange rate of US$ 1 = DC 4), then by fixing the exchange rate at US$ 1 = DC 3 the government reduces the domestic price of the import to Pd = DC 750.
11 DC = domestic currency.
The effect of an overvalued exchange rate is identical to that of an import subsidy: imports increase, consumers benefit by area a + b + c + d + e and producers lose by area a + b. Overvaluing the domestic currency does not have any direct budgetary implications and there appears to be a net social gain of c + d + e, but the analysis of this is incomplete. While government saves on expenditures (b + c + d + e + f in Figure 6), the bill is paid elsewhere in the economy. For example, consumer expenditures are diverted from domestic consumables to imported goods, or domestic production of the commodities that are being imported is reduced. Exports are equally discouraged, which reduces income and employment in all export commodity sectors.
The expenditure of foreign exchange may be restricted by a licensing system. In a free-trade situation, the world market price Pw prevails in the country (Figure 7), and domestic supply So and imports Mo meet the total demand for dairy products at this price. A fixed allocation of foreign exchange of Pw × M* will reduce imports to M* and the domestic price will increase to Pd, causing local production to increase to S*.
As in the case of import tariffs (Figure 6), consumption is reduced and consumers lose the area a + b + c + d + e while producers gain a + b. The country's savings in foreign exchange are equal to Pw × Mo - Pd × M* (i.e. the area g + h + i - d - h in Figure 7). The effects of foreign exchange allocation on producers and consumers are thus identical to those of import tariffs, but the government loses revenue when restricting foreign exchange expenditure.
Area d in Figure 7, which is equal to (Pd - Pw) × M*, is a quota rent created by the allocation of foreign exchange, and its existence shows that restrictive allocation of foreign exchange has the same effect as any other quantitative import restriction. The rent is usually acquired by the importing traders, but the government can impose a tariff for the same amount or auction the foreign exchange licenses12.
12 See Rom (1979) for a further discussion of different forms of import restriction. The likely beneficiaries of such rents are discussed in Rom (1979, p. 143 et seq.) and Tollison (1982).
Figure 7. Economic effects of restrictive foreign exchange allocation.
Food aid is distributed in many ways, but we shall discuss only two: untargeted food aid, which adds to or substitutes for commercial dairy imports, and targeted food aid, which is reserved for specific regions or consumer groups.
In Figure 8, the free-trade situation is depicted by domestic production So and commercial imports Mo providing market equilibrium at the world market price Pw. If food aid M1A is available, the domestic supply curve SS shifts to S1S1 (domestic supply plus food aid), and commercial imports Mo decrease to M1 since some of them are replaced by food aid.
If the food aid is distributed at the existing world price, neither domestic producers nor consumers are directly affected by it. They are, however, affected indirectly since the country as a whole benefits by the value of the food aid, which is equal to Pw × M1A or the shaded area in Figure 8. However, for these effects to be valid, a perfectly elastic supply of commercial imports at the world market price Pw has to be assumed.
Consider now the case when the amount of food aid M2A coming in is larger than the commercial imports Mo in the free-trade situation. In a case like this the supply curve (domestic supply plus food aid) shifts from SS to S2S2, providing market equilibrium at a domestic price Pd which is below the world market price Pw.
When food aid M2A more than substitutes for all commercial imports, domestic producers have to decrease their output from So to S2, thereby incurring a welfare loss equal to the area a in Figure 8. Bringing in more dairy food aid than commercial imports thus acts as a disincentive to domestic production. Total consumption, on the other hand, increases from So + Mo to S2 + M2 and consumer welfare increases by the area a + b + c + d + e. The country as a whole also gains, in the form of the value of the food aid (the dotted area in Figure 8).
Figure 8. Economic effects of untargeted distribution of food aid.
Again, a perfectly elastic supply of commercial imports is assumed. It is also assumed that all those who benefit from the food aid are established consumers of dairy products, i.e. the demand curve DD remains unchanged. This last assumption does not apply in the case of targeted food aid, since this is distributed to groups that have so far been excluded from the market because they either lack the necessary buying power or are far from the existing outlets.
Targeted distribution of dairy food aid is illustrated in Figure 9. Providing dairy food aid M1A to an urban slum area where no dairy products were previously consumed shifts the demand curve from DD to D1D1 (i.e. additional demand appears on the market), with S1S1 being the aggregated supply of domestic production, commercial imports and food aid.
Figure 9. Economic effects of targeted distribution of food aid.
Targeted food aid does not affect the domestic market price or producer welfare, or for that matter the consumers of commercial dairy imports. Only the target group benefits from the food aid, the benefit equaling the product value (the shaded area) plus the welfare effect (the dotted area).
The real effects of the policy instruments discussed may differ substantially if some or all of the assumptions made do not apply. They also depend on the administrative processes involved, as the marked difference between the effects of targeted and untargeted food aid distribution have shown. Nevertheless, such generalised presentations are very useful in pointing out the underlying implications of different policy instruments, such as whether their effects on consumers and producers are complementary or in conflict, and whether overall social gains are positive or negative.
