Effective Rate of Protection
What is Effective Rate of Protection?
The effective rate of protection measures how much a tariff structure raises an industry's value added per unit, accounting for tariffs on both outputs and imported inputs.
The nominal tariff on a finished good understates true protection because firms also pay tariffs on imported inputs. The effective rate compares protected value added (output price plus output tariff, minus input costs inflated by input tariffs) to free-trade value added. If input tariffs exceed output tariffs, effective protection can be negative, meaning the policy actually disadvantages the domestic industry.
Effective Rate of Protection: a worked example
A bicycle sells for $200 at world prices and its imported components cost $140, so domestic value added is $60. Add a 10% tariff on finished bicycles and a 5% tariff on components. The bicycle can now be sold at $200 x 1.10 = $220 while the components cost $140 x 1.05 = $147, so protected value added is $220 - $147 = $73. The effective rate of protection is ($73 - $60) / $60 = 21.7%. A 10% nominal tariff has handed the assembly stage better than twice that in real shelter.
The mistake students make with effective rate of protection
The frequent error is quoting the nominal tariff as the protection an industry receives. The tariff raises the price of the whole $200 bicycle by $20, but the domestic assembler earns only the $60 of value it adds, so the gain is measured against a base under a third the size and comes out far larger. Thinner value added widens the gap: with components at $170 and value added of just $30, the same tariff pair gives ($41.50 - $30) / $30 = 38.3% from an unchanged 10% headline rate.
Effective Rate of Protection questions
Can the effective rate of protection be negative?
The effective rate of protection turns negative when tariffs on imported inputs cost an industry more than the tariff on its output earns it. Take the bicycle again, but with a 20% component tariff against the 10% output tariff: components cost $140 x 1.20 = $168, value added falls to $220 - $168 = $52, and the effective rate is ($52 - $60) / $60 = -13.3%. The tariff wall is working against the domestic assembler.
What is the difference between the nominal and effective rate of protection?
The nominal rate of protection is simply the tariff on the finished product, while the effective rate measures the change in value added per unit once input tariffs are counted too. Nominal protection describes a price; effective protection describes the margin a domestic producer actually keeps. Effective rates usually exceed nominal rates and can even be negative, so the two answer different questions about the same tariff schedule.
What is tariff escalation?
Tariff escalation is a tariff schedule that charges low rates on raw materials and progressively higher rates on processed and finished goods. It gives domestic processing industries very high effective protection, because their inputs enter cheaply while their output is shielded. The mirror effect falls on exporting countries, whose raw commodities face little duty but whose processed versions face a wall, discouraging them from processing at home.
Formula / Example
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