Effective Rate of protection:

So far we have concentrated  on  tariffs imposed on a final good. But tariffs may be imposed on intermediate goods as well. Obviously tariffs on raw materials and  intermediates would raise the cost of production  for domestic industry. This  factor  needs to be  taken  into acc6unt while measuring the extent of protection  awarded  to domestic industry  by  any  given tariff structure
(comprising tariffs on final goods and intermediates).

The Effective  Rate ofprotection  (ERP) measures  the extent of protection  granted to domestic industry  by the given structure of nominal tariff rates. It measures the change in value added in domestic industry due to tariff protection. By definition,

where  ERPF  is  the ERP on the final good F; V_T, is value added in  the production of F after tariff;  and V_w, is value added in the production of F at world market prices, i.e. V_w  is  the value added under 'free trade'.

Remember, value added is the difference between the price of the 'final good produced by an industry,  less the cost of inputs  iequired per unit of  production of the final good.

Intuitively the following should be clear  to you  :

• under free  trade, value added in domestic  industry  would be determined by world market prices of the final good and imported inputs ;
• with a tariff, domestic prices can exceed the world market prices. How this affects domestic value added would depend on the extent of price increase of  the final good ivis a vis  that of intermediates and on the  importance  of the intermediates  in he  production process ;
• if production of the final good  requires no  intermediates, then  the ERP equals the nomidal rate of tariff on the final good;
• if  the tariff on  final goods  is higher than that on intermediates, then the ERP would be higher than the nominal rate of protection;
• ERP  could actually  be  negative, when tariffs on  imports are too high compared to the  tariff on the final good. Negative ERP indicates that trade protection could actually  lower domestic value added as compared to free trade.

Actual  calculation of ERP may be  difficult, owing to  the fact  that different inputs used by a single industry may be subjected  to differential rates of tariff and also owing to the difficulty of obtaining reliable 'free trade' prices of the final and intermediate goods.
You  should also note a couple of shortcomings of the concept of ERP. First, ERP calculations assume fixed coefficients of production (i.e. input require- ments per unit of output are taken to be fixed), which do not allow for factor substitution possibilities. Secondly,  the underlying assumption of a small open economy  that cannot affect world market prices, may not apply  in practice.