Appendix E: Welfare Analysis in the Car Market
Quantifying the size of the welfare impact following a change in import restrictions is not an easy task. The New Zealand car market is the closest we can come to a controlled experiment with the import restrictions abolished in 1988/89. The change in consumer welfare in the motor vehicle market from before to after the removal of import restrictions can, in principle, be measured. Unfortunately, the change in welfare is obscured by a host of different effects all operating at the same time. To measure the impact of the removal of import restrictions, this change must be isolated.
The effect an import restriction has on the market for a particular good can be represented diagrammatically. Figure 9 represents the New Zealand car market with no import restriction in place. SNZ is the domestic supply curve for cars, that is, a curve showing the amount of cars New Zealand producers are prepared to supply at each given price. SW is the foreign or world supply curve for cars. The world supply curve is horizontal implying that New Zealand can buy as many cars as it requires without affecting the world price.16 Under this scenario the price of a car in New Zealand will be equivalent to the world price of a car. Point h would be the economic equilibrium giving QNR as the quantity of cars demanded and sold and Pw as the price at which the transactions would take place. QD would represent the amount of cars domestically produced and the difference between QNR and QD the amount of cars imported. Area R represents the surplus to domestic producers as they are willing to supply cars up to QD at a lower price than they actually receive. Areas X and Y represent the surplus to consumers as they are willing to buy cars up to QNR at a higher price than they actually pay.
Figure 9 Domestic Market Where Imports and Local Production Are Possible |
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| Note: | NR = no restriction |
| Source: | NZIER (ref car1) |
Suppose that an import restriction is imposed on the number of cars entering the country. Figure 10 depicts this scenario. The Snz and Sw curves remain in the same place as producers, both foreign and domestic, are still willing to supply the same amount of cars given the same price as before. However, now the entire difference between Qnr and Qd is no longer allowed to be imported. Assuming that only the difference between Qi and Qd is allowed to be imported, the remaining unsatisfied demand must be supplied by domestic producers. Under this scenario, Qqr is the amount of cars demanded and sold and Pqr is the price at which the transactions would take place. The question is: what are the impacts on the economy following the introduction of the import restriction? (The same analysis can be applied in reverse, for the abolition of a restriction).
Figure 10 Effect of a Quantity Restriction on the Domestic Market |
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| Notes: | NR = no restriction |
| | QR = quantity restricted |
| Source: | NZIER (ref car2) |
From the consumers' point of view, they have lost part of their surplus (what they are willing to pay, as represented by the demand curve, minus what they actually pay). The loss of surplus equates to areas A, B, C, D and E in Figure 10. However, all is not a loss to the economy. Areas A and C are transferred to domestic producers increasing their surplus and Area B is transferred to import license holders. Area D is the extra cost to the economy of making cars at home that could have been imported cheaper. Area E is the uncompensated loss of consumer surplus. Areas D and E are the deadweight losses to the economy as a result of the import restriction. Here, we estimate the size of Area E and note that the overall impact of the import restriction will be underestimated as a result of excluding a measurement of Area D.
As mentioned above, the advantage that the New Zealand car market has over other markets when trying to estimate an import restriction impact is we have two distinct periods. One period is when a restriction was in place and one when no restriction was present in the market. We have chosen the two periods to be 1984 and 1996. The two periods were deliberately chosen far enough away from the import restriction removal in 1988 so expectations and lagged effects of the removal do not affect the results. Assuming all lagged effects from the removal of the import restrictions in 1988 had ceased by 1996, point h in Figure 10 can be thought of as 1996's price and quantity. Likewise, assuming no import restriction removal expectation effects altered the market in 1984, point I in Figure 10 can be thought of as 1984's price and quantity. This kind of welfare analysis would be reasonably easy if the full impact of removing the import restriction happened very quickly, with nothing else changing between the two time periods. The problem with comparing welfare changes between 1984 and 1996 is that different prices in the two periods reflect not only the abolition of import restrictions but also general inflation, exchange rate changes, tariff and tax changes, as well as the effects of general technological and economic development. Similarly, quantities demanded cannot be thought of entirely as movements along the demand curve. Demographic factors and changes in the general economic cycle also need to be taken into account. We must, therefore, adjust the curves and thus points (i and h) so that these other affects are accounted for.
Figure 11 shows the adjusted curves which take account of the price, exchange rate, tax and tariff changes that occurred between 1984 and 1996. Point i' corresponds to the price of a motor vehicle in 1984 at 1984 tariff levels, but expressed in 1996 dollars. The Sw curve is horizontal on the price of a motor vehicle in 1996 at 1996 tariff levels. Adjusting this curve to reflect the 1996 price of a motor vehicle at 1984 tariff levels repositions it at Sw'. Now with both the 1984 and 1996 price expressed in 1996 dollars and at 1984 tariff the two prices become directly comparable. That is, the difference between P84-84T and P96-84T is caused by the import restriction alone.
Figure 11 Effect of Tariffs and a Quantity Restriction in the Car Market |
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| Notes: | p = price |
| | T = tariff level |
| Source: | NZIER (ref car3) |
What about the effects of the exchange rate and change in taxes over the 1984 to 1996 period? The introduction of GST and the increase shortly after will impact on the prices of all consumer goods. The impact on prices of a change in tax structure due to GST will be included in the CPI. To express the 1984 motor vehicle price in 1996 dollars, the 1984 price is inflated by the CPI. By doing this, the impact on prices from the tax change will be incorporated in the 1984 price expressed in 1996 dollars. A similar simplifying assumption can be used for exchange rate changes over the period. Exchange rate impacts on prices of all consumer goods will be reflected in the CPI. Assuming that exchange rate pass through is similar for all imported consumer goods, and that the proportion of tradeable and non-tradeable goods in the CPI basket in unchanged, the exchange rate changes will be accounted for when we inflate the 1984 price by the CPI.
The reason the import restriction removal will not be picked up by the CPI is that the impact of the restriction was market specific, although most manufacturers were protected by licensing to varying degrees. Motor vehicles make up a small proportion of the overall CPI and the price change from the restriction removal will be swamped by the higher weights of other goods. This does not happen in the tax and exchange rate cases as these changes are not market specific, they affect all consumer good prices.
So an estimate of Area E in Figure 11 will provide the welfare impact of the import restriction. Information on the average price in 1984 (adjusted for inflation) and 1996 (adjusted for tariff changes) and quantities for 1984 and 1996 (adjusted for tariff changes) is required.
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