Arguments for and Against Protection

Chapter 9

Arguments for and against Protection

Overview

This chapter has three purposes:

-To present a framework and a rule for evaluating arguments offered in favor of limiting imports,

to apply the framework and rule to several prominent arguments for protection,

-and to examine the political processes that result in government policies toward imports.

The framework allows us to look at situations in which the free market may not result in economic efficiency, because of incentive distortions that result in market failures. In the “first-best” world with no distortions, private marginal benefits (MB) to consumers who make buying decisions equal social marginal benefits (SMB), because there are no consumption externalities or spillovers, private marginal costs (MC) recognized by sellers equal social marginal costs (SMC), because there are no production externalities or spillovers, and all of these are equal to market price, because the market is perfectly competitive and there are no distorting taxes.

=An externality is said to exist is one agents behaviour affects another agents satisfaction or profit. E.g. pollution, neighbour with a beautiful garden, smoking…

When external costs, external benefits, a distorting tax, monopoly power, or monopsony power exists, the market will usually not yield the first-best outcome, because social marginal benefit will not equal social marginal cost.

-In situations in which the free-market outcome is second-best, there is a potential role for government policy to contribute to economic efficiency.

-This could done through creation of new property rights (e.g. case of two roomates-smoker and non-somker-specifify clearly the rights)

-The other procedure is by imposing tax or providing a subsidy to eliminate distortions in private incentives.

This ensures that SMB=SMC.

We focus on the later since trade policy isa concern with taxes (tariffs) and subsidies.

If SMC > MC=P=MB=SMB-impose tax. Size of the tax should be equal to (SMB-SMC)

If SMB >MB e.g education, R & D.

Can trade barriers help deal with these distortions?

Fortunately, there is a useful rule that works well in most cases. If the problem is an incentive distortion, the specificity rule indicates that government policy should intervene at the source of the problem, to act as directly as possible on the source of the distortion. (Later in the chapter, we offer a second version of the specificity rule. If the government has a noneconomic objective, the government policy to achieve this noneconomic objective with the least economic cost is usually the policy that acts directly to achieve it.)

Externalities

The specificity rule is powerful in its applications. Consider the situation in which there is too little domestic production in an import-competing industry, because of marginal social side benefits from this production say employment. What is the best government policy to address the distortion?

-A tariff can be used to increase domestic production, so it may be better than doing nothing, but it is not the direct policy, because it acts on imports directly, not on domestic production. The best government policy is a subsidy to domestic production. Domestic production is increased, correcting the distortion. The production subsidy is better because it does not distort domestic consumption.

-A tariff would squeeze some consumers out of buying, resulting in the inefficiency of the consumption effect (triangle d). See Fig. 9.2.

With Tariff loose b and d and gain g is one social side benefits. The tariff is indirect and not the best policy to address the production distortion.

-Subsidy-optimal price $330.Market price 300. Offer subsidy to producers of $30. In fact, if we can be more specific about exactly what the source of the distortion is, we should employ a more specific policy. If the distortion arises from external benefits (e.g., training or acquiring better work habits) to working in the industry, then the best government policy acts directly, by subsidizing employment or training in the industry.

The box “How Much Does It Cost to Protect a Job?” (another Focus on Labor) examines the cost of maintaining jobs in import-competing industries using trade barriers. Estimates for highly protected industries in the United States and in Europe show that the costs (to consumers or to the nation) can be very high. For the typical highly protected industry, it would be less expensive to pay workers not to work.

Infant industry argument

The infant industry argument leads to another application of the specificity rule, as well as raising a set of other interesting issues.

-The argument is that import competition prevents an initially uncompetitive domestic industry from starting production. But, if the industry is shielded from foreign competition, it can begin production, and over time it will be able to lower its production costs, so that it become competitive.

-At that time in the future the protection can be removed, and the industry will provide national benefits in the form of producer surplus.

See Fig. 9.3. Note in this analysis it is assmed that the world price and Domestic Demand do not change.

In this scenario, a tariff can be better than doing nothing, for national well-being over the long term. But the specificity rule indicates that the better government policy is one that acts directly on the source of distortion.

- If the issue is to foster initial domestic production, then a production subsidy is a better government policy. One may even wonder why this is needed. Why cannot the firms in the infant industry borrow to finance initial losses and then pay back the loans using future profits when the industry is grown up? If there are defects in the lending markets, then the government could extend loans. If the industry will create external benefits, such as training workers or new technologies, then the best government policy acts directly on the source of the external benefits (for instance, subsidies to training, or subsidies to research and development). In addition, one may wonder if the infant industry will actually “grow up.”

Another argument in favor of protection is assistance to industries that are declining because of rising import competition. Moving resources out of an industry is costly. People who lose their jobs because of increased imports often have a difficult time finding new jobs and often suffer substantial declines in earnings. The marginal social side benefit of continuing domestic production in this industry is avoiding these costs of moving resources to other uses. Again, a tariff can be used to maintain domestic production, and it may be better than doing nothing (so that the industry shrinks). But again the specificity says to attack the externality directly. A subsidy to domestic production will be better than a tariff, and other policies like subsidizing retraining of workers can be even better and more direct. Unfortunately, the retraining offered through this program is generally not that effective.

A different argument in favor of protection is that the government gains revenue. For a poor country with a weak tax system, the lack of government revenue can lead to inadequate supply of public goods (disease control, schooling, infrastructure).

-Tariffs and taxes on imports may be some of the few taxes that the government can collect effectively—they are a direct response to the source of the distortion.

- The benefits from better public goods can be much larger that the deadweight losses from the trade taxes.

-While this is potentially a valid argument for taxing trade, there is no guarantee that the government will use the revenues to fund socially useful investments.

- And as the country develops, it should shift toward broader-based taxes that are less distorting.

Non-Economic factors

-National pride gained by production of a product calls for a production subsidy as the least-cost way to achieve the objective. National pride in self-sufficiency calls for a tariff or other import limit, because in this case the objective is specifically to reduce or eliminate imports.

-National defense

Have products that will be important in future military emergency. Food, ships, fotwear..providing for the national defense is usually least costly using a subsidy to domestic production capacity, leaving depletable resources in the ground, or building stockpiles. In the latter two cases imports can be part of the solution, if they are the least costly way to acquire items during peacetime for consumption or to build up the stockpiles.

-Third, income redistribution is best achieved through income taxes and transfers and not by trade restrictions.

The Politics of protection

The chapter concludes by surveying the political economy of trade policy, using analysis based on five major elements:

• how much the winners gain from protection and how many benefit.
• how much the losers are harmed by protection and how many lose.
• what reasons individual people and companies have for taking positions for or against protection.
• what types of political activities people and companies can use and their costs.
• what the political institutions and processes are.

Tariffs and other trade barriers are unlikely under at least two combinations of these elements:

• when decisions are made by direct voting and people vote based on whether they are winners or losers from protection, or
• when individuals are willing to devote all of their gains from winning (for or against protection) to lobbying or contributions and elected representatives (or other government officials) decide on the basis of the amount of lobbying or contributions they receive.

Tariffs and other trade barriers are more likely to be adopted when the group that will gain from protection is better organized in its lobbying and contributions.

In fact, we often expect that the group with the smaller number of individuals can be more effective, because the larger gain per individual is likely to result in more activity by the smaller group, and because the smaller group is more likely to find ways to overcome the free-rider problem.

The small number of import-competing producers are motivated to participate and overcome the free-rider problem, so they become a well-organized group with substantial resources to use politically to seek protection. The outcome is that the well-organized protectionist lobby sways a majority of politicians to enact tariffs or other import barriers. (The box on sugar protection provides an example of these forces and the outcome).

In addition to explaining the general political process that leads to protection, this model of political activity can explain several specific features of trade policy. Tariff escalation occurs because the buyers of materials and component are firms that can organize to oppose tariffs on these intermediate goods.

Offers to reduce tariffs in a multilateral trade negotiation are called concessions because producer groups are politically powerful.

In addition, sudden damage creates sympathy, so that even those who are hurt by protection sometimes say that they favor protection to assist those hurt by rising imports. In fact, given this discussion, the surprising thing is not that there is some protection, but that there is not more protection that we actually have in countries with representative democracies.

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