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Commodity Duty & When They Are Imposed
Commodity Duty & When They Are Imposed
Implications
How should you read an import duty?
How does an import duty change the financial situation of a supplier of that product or service on which the
import duty has been put?
And finally which business will give you the highest return when an import duty has been put in the sector it
operates in?
I think these are very basic yet important questions for any investor who is reading any sector and specifically
commodity businesses which are highly susceptible to these import duty implications.
Very recently President of the United States of America, Donald Trump proposed policy on steel, of which his
country is the planets biggest importer, this may cause a supply glut in India if we cant hurdle across the
American tariff walls.
This reading will try to answer these questions from an academic point of view with linkage to very basic
microeconomics concepts and i am hopeful that you will be able to understand any import duty impact on any sector
going forward. This reading can be read again and again for future references and this reading will be very helpful in
understanding businesses which sell commodities like steel, paper, rubber, cotton etc, i.e. cyclical businesses.
ADVICE
This Is Also A Lengthy Reading But Definitely An Interesting One, You Can Browse Through The Headings To
See If Any Of The Headings Interest You To Read The Whole Article.
In the end we have a Takeaway Section where we will consolidate our learning in few points.
To understand the implication of import duties, we will read through various scenarios and try to answer a lot of What
IF’s and understand it end to end.
The Law Of Demand – The Law of Demand says that, when price of a product rises, quantity demanded of product
falls. This is how all of us react, we definitely buy a product or service when it is put on sale ‘season sale of an e
commerce company’.
Law Of Supply – We now turn to the other side of the market and examine the behavior of sellers, the quantity
supplied of any product or service is the amount the sellers are willing and able to sell at a particular price. When price
of steel is high, selling steel is profitable, and so the quantity supplied is large and conversely when the prevailing steel
prices are low, selling steel is not much profitable therefore quantity supplied falls.
These were two very important concepts and we have tried to explain them in couple of sentences.
Consumer Surplus – Suppose you want to buy a television and you have allocated a budget of $1000 for it. You now
go to the market and to your surprise you find a television matching your specifications and brand for $800. You are
so delighted and you immediately decide to buy it. You reach home and happily tell your family that you saved $200
on the television.
We calculate our savings like this on a daily basis with every transaction, you will be surprised but this is your
consumer surplus ($200). Consumer surplus is the amount a buyer is willing to pay for the product minus the amount
the buyer actually pays for it.
For gaining a quick handle on consumer surplus, ‘the area below the demand curve and above the price the consumer
pays, measures the consumer surplus in the market ’
Producer Surplus – Now let’s say that you are maker of television. You can make a television out of your factory for
$600 per piece and this $600 includes all expenses incurred by you to manufacture the television and put it on display
in a store.
You ship the television to the store and to your surprise you find that consumers are buying your television for $1000
per piece, you become happy and sit down to calculate your gains if you tag your television for $!000. You find that
you can make $400 for every television sold, and this $400 is nothing but your producer surplus. Producer surplus is
the amount a seller receives for the product minus the amount he incurs in producing it.
For gaining a quick handle on producer surplus, just memorize this ‘the area above the supply curve and the price
seller receives, measures the producer surplus’.
Total Surplus – The sum of consumer and producer surplus measures the total benefits that buyers and sellers receive
from the market of the Television.
Fig 1 shows intersection of the demand and supply curve and the corresponding equilibrium price and quantity of
goods or services.
The figure shows the consumer and producer surplus in equilibrium without trade.
We now have very basic understanding of few concepts, we can now begin our study of the Indian steel industry.
Assumption – Indian Government is protectionist on steel, we do not import and export steel, we have domestic
suppliers of steel and domestic buyers.
Our story begins, Indian steel market is isolated from the rest of the world. By government decree, no one in India is
allowed to import or export steel, and the penalty for violating the decree is so large that no one dares try.
In the absence of international trade, the market for steel in India consist of Indian buyers and sellers, as shown in Fig
2, the domestic price adjusts to balance the quantity supplied by domestic sellers and quantity demanded by domestic
buyers.
Fig 2
Now suppose the president elect formulates a committee of economist to evaluate the trade policy on steel and the
president asks them to report back on 3 questions-
Question: if Govt allowed import and export of steel, what would happen to the price of steel and quantity of steel sold
in the domestic market?
Question: Who would gain from free trade in steel and who would loose, and would gains exceed the losses?
Question: Should a Import duty or an import quota be part of the new trade policy?
Now we begin with the analysis.
Once free trade is allowed, the domestic prices rises to equal to the world price. No seller would accept less than the
world price and no buyer would pay more than the world price.
With domestic prices equal to the world prices, we see that domestic quantity supplied differs from the domestic
quantity demanded.
Quantity supplied by the sellers is more than the quantity demanded by the buyers therefore India becomes an
exporter.
One can view the horizontal line at the world price as demand for steel from the world, this demand is perfectly elastic
because India, a small economy can sell as much steel as it wants at the world price.
Opening to international trade clearly does not benefit everyone, trade forces the domestic prices to rise to the world
price. Domestic suppliers are better off because they can now sell at higher price, but domestic buyers are worse off
because they have to buy at higher prices.
To measure the gains and losses we will now measure the changes in consumer and producer surplus from the Fig 4
Before the trade is allowed, we have an equilibrium price and quantity. Consumer surplus is equal to A+B (area
between the demand curve and the equilibrium price) and the producer surplus is C (area between the equilibrium
price and the supply curve), and the total surplus before the trade is the sum of consumer and producer surplus
(A+B+C).
After trade is allowed, the consumer surplus contracts to only area A and the producer surplus is the area B+C+D. Total
surplus is the sum of consumer and producer surplus (A+B+C+D).
If India is a net exporter of steel then in the short term sellers benefit because the producer surplus increases by area
B+D. Consumers are worse off because consumer surplus decreases by area B.
Fig 4
Conclusion
When a country allows trade and becomes a net exporter of goods, domestic producers of goods are better off
and domestic consumers are worse off.
In this case the horizontal line represents the supply of the rest of the world, which is perfectly elastic because India
is a small economy and you can buy as much steel as you want at world price.
Once again, trade forces the domestic prices to fall, domestic consumers are better off (they can buy steel at lower
prices) and domestic sellers are worse off (they have to sell steel at lower prices).
To measure the gains and losses we will now measure the changes in consumer and producer surplus from the Fig 6.
Before trade, consumer surplus is area A, producer surplus is area B+C and total surplus is area A+B+C.
After trade is allowed the consumer surplus expands to area A+B+D, producer surplus is area C and total surplus is
area A+B+C+D.
In an importing country buyers benefit as consumer surplus expands and sellers are worse off because their producer
surplus contracts by area B.
The gains of buyers exceed the losses of sellers and total surplus increases by area D.
Fig 6
Conclusion
When a country allows trade and becomes an importer of goods, domestic consumers of goods are better off and
domestic suppliers of goods are worse off.
Now we have completed our analysis of trade and we can say that compensation for losers in international trade is
rare. Opening up to international trade expands the economic pie, while leaving some participants in the economy
with a smaller pie.
Now we move on to pick businesses in a commodity industry like steel, we will try to break it down into points
which should guide us in picking businesses.
Steps To Pick A Commodity Business Under Import Duty Implementation:
1. Government of India has a ministry by the name of Director General of Anti Dumping And Allied Duties,
this is official source of information on anti dumping duties in India. link – http://www.dgtr.gov.in
2. Generally we see petition filed by various associations like of the steel, Tyre etc to the ministry. These
association represent the industry and they talk to the ministry to implement safeguards duties for themselves.
Go to the following link – http://www.dgtr.gov.in/anti-dumping-cases and read any document with status
‘Concluded Investigation’.
3. Generally in the very first page you will find petitioners names, these petitioners should be your investing
universe if the Import Duty has been implemented in that sector.
How To Pick A Business As An Investment Candidate?
After understanding the concept of producer surplus, we can conclude that any producer who can produce goods at
the lowest cost will have the Greatest Producer Surplus post Import Duty implementation and it should also be your
investment candidate.
Why?
The largest producer surplus candidate has advantages when compared to its peers, He may have captive mines for
raw material which will bring down COGS and raise Gross Margins, lowest labor cost in the industry, lowest interest
burden etc. These are very important cost which are essentially fixed in nature and will remain fixed, generally at all
times.
Post Import Duty implementation, the top-line of the lowest cost producer will expand because price of commodity is
rising and the fixed cost will remain fixed thus expanding the bottom line (PAT).
The lowest cost producer will command high multiples in the industry.
Conclusion
Identify the lowest cost producer among the petitioners of import duty.
When Should You Sell The Business?
This is again a very important question, i will try to answer this with whatever we have learnt until now.
We know import duties are bad for general consumers because they cause inflation in the economy, so as long as you
do not find petitioners representing consumers chasing the ministry to abolish the import duty in place, you should
do fine, so in short term track the consumer industry of the commodity, for steel it could be auto sector, infra, housing
etc.
Current Situation Of The Domestic Steel Industry
Prior to implementation of the import duty on steel, the world price of steel was lower than the domestic price and
India was an importing nation.
Soon the situation worsened for the domestic producers and they ran to the ministry to implement the import duty,
which the ministry did seeing huge NPA’s on the books of PSU banks.
Producers like Tata, JSW, JSPL and SAIL flourished as seen by their financial statements and growing stock prices post
implementation of import duty.
Surprisingly what happened post implementation of anti dumping duty was that the world steel price also started
rising on the back of china, which said that they will cut production of steel to reduce pollution, soon the world steel
price rose which gave further room for domestic price of steel to rise.
How Long Can This Continue?
If you can track the world steel price of steel and domestic steel price on a regular basis, you will accurately come to
know when you have to sell the business.
As long as there is a Positive delta in the world steel price and the domestic steel price, you can stay invested and when
this reverses you will find petitioners from the consumer of steel in India going to the ministry to abolish the import
duty.
World Steel Price – Domestic Steel Price = Positive DELTA, stay invested.
World Steel Price – Domestic Steel Price = Negative DELTA, time to start folding your position in the stock.