This chapter has two purposes: To present a framework and a rule for evaluating arguments offered in favor of limiting imports, and to apply the framework and rule to several prominent arguments for protection. 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. When external cost, 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. We mention the approach of creating new property rights, but we focus in this chapter on the tax-or-subsidy approach to eliminate distortions in private incentives.
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. (Toward the end of 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.)
The specificity rule is powerful in its applications. If the problem is that a distortion results in too little domestic production, 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). The tariff is indirect and not the best policy to address the production distortion. 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 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 becomes 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. 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).
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 (more direct). The U.S. government does offer adjustment assistance to some workers who lose their jobs because of rising imports. 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 exports 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.
The chapter concludes with a look at several arguments in favor of protection that involve national pursuit of "noneconomic objectives." 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. Income redistribution is best achieved through income taxes and transfers. 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 to acquire items during peacetime for consumption or to build up the stockpiles.
■ This chapter extends and qualifies the arguments presented in Chapters Seven and Eight. The arguments for and against a tariff are more varied than those presented earlier. Specifically, the chapter puts into perspective the limits for the case of free trade by identifying the conditions under which imposing a tariff is beneficial. There are valid arguments for the "optimal tariff' and "second best" cases. A tariff is particularly desirable (up to a limit) when the defect in the economy relates to international trade.
After studying Chapter Nine you should be able to identify:
1. Where the limits to the case of free trade lie.
Adjustment assistance: Government financial assistance to relocate and retrain workers (and firms) for re employment in expanding sectors and away from sectors that are declining as a result of import competition.
Distortions: Restrictions that prevent the market from equating social benefits and costs of an economic activity. For example, the market price of cigarettes does not reflect the indirect effect (externally) on third parties (other than the producer and the smoker), resulting in too many cigarettes being produced and consumed. The total social cost of smoking is higher than the private cost.
Infant government argument: The notion that in poor countries taxes cannot be effectively collected and, hence, tariffs are an important source of public revenues.
Infant industry argument: The argument that a new industry (especially in less developed countries) needs protection until it attains a competitive level of cost (and output) in world markets.
Second best world: A world that contains market distortions.
Specificity rule: This guideline states that it is more efficient to use those policy tools that are closest to the sources of the distortions separating private and social benefits or costs.
Warm up Questions
2. T / F National defense and pride arguments for protection are basically second best.
3. T / F If "learning by doing" means that more production now translates into lower costs later, the best policy is a protective tariff.
4. T / F "Learning by doing" is what study guides in international economics are for.
5. T / F Some "infant industries" never grow up.
1. Imposing a tariff aimed at counteracting the undesirable effects of domestic distortions:
2. In which case is the national defense argument a valid one for tariff protection?
3. Which of these arguments in favor of a tariff is most likely to be valid for poor countries?
4. In which of the following cases does economic analysis (using the "one‑dollar, one‑vote" yardstick) justify the use of tariffs as better than adopting other policies?
5. Compared with a tariff, a subsidy for import‑competing producers:
1 . Because it is a small country, if Saxony placed a tariff on telephones imported from Leinster, it would cause a net reduction in Saxon welfare. What then could be the second‑best arguments for the imposition of such a tariff? Can you think of methods other than a tariff to achieve the country's goals?
2. If an infant industry tariff is removed in the future, is society made better or worse off? Why?
3. There has been an increase in brain tumors recently in our otherwise happy country of Saxony. The cost of treating people stricken with these tumors is growing rapidly and is starting to deplete the resources of the national healthcare system. After some years of research, doctors at the Saxon Institutes of Health have determined these tumors result from the overuse of telephones. Could an economist make an argument for levying a tariff on telephone imports from Leinster?
4. Trade barriers which protect the income of a scarce factor of production (such as unskilled labor in the United States) are really income redistribution tools. What are the costs associated with using tariffs to meet this goal? What are more economically efficient means of accomplishing this goal?
5. Studies have shown that practice makes perfect in building airplanes. For new firms, there is an early "learning by doing" period in which the costs are high, but the production experience itself is guaranteed to reduce later costs. Japan cannot yet produce airplanes as efficiently as Boeing or Airbus, but could ultimately produce at a lower cost if given the chance to survive against competition from cheaper imported airplanes. Should Japan use a tariff on imported airplanes, forcing Japan airlines and others to pay more until Japan's airplane industry "gets off the ground?" Discuss carefully.
1. Is "adjustment assistance" a logical response to a non‑Stolper‑Samuelson world in which laborers are somehow not freely mobile between sectors?
2. What goods do you think are justified in receiving a national defense tariff?
3. Think about the international trade consequences of balancing the federal budget by reducing subsidies to American manufacturers and farmers.
Suggested answers to questions and problems (in the textbook)
2. The specificity rule is a guide to government policy that tries to enhance economic efficiency by addressing incentive distortions or market failures. It states that it is more efficient to use a policy that is closest to the source of a distortion separating private and social benefit or cost. It is also useful as a guide to government policy that tries to achieve a noneconomic objective with the least economic cost. For a noneconomic objective, it is least costly to use a policy that acts directly to achieve the objective.
4. The infant industry argument states that a country can benefit by shielding an industry (the infant) that is currently uncompetitive against foreign rivals, if that industry can lower its costs over time and become competitive in the future. It is potentially a valid argument for the government to do something to assist the infant industry, because the future benefits can be larger than the current costs of doing so. But, it has a number of weaknesses. First, even if some form of government assistance is appropriate, the specificity rule indicates that the best form of assistance is not a tariff or other barrier to imports. Rather, a subsidy to initial production or to whatever is the source of cost reductions over time is usually the best policy. Second, if the industry is so promising, it is often the case that no government assistance to the initial firms is needed. Instead, these firms should borrow from private lenders to cover their initial losses and repay these loans from future profits. Third, the argument is subject to abuse, because it is speculative. Will the industry really grow up—lower its costs to become competitive over time?
6. The national defense argument states that the government must limit imports during peacetime to be assured that the country can meet its needs for defense goods during times of war. While the need to provide for the national defense is clear, the specificity rule says to think clearly about what the actual problems are, and then use policies that act directly on them. If the need is for production capabilities for a product, then the government should subsidize production capacity. If the need is for materials that can be stockpiled, then the government should build these. If the need is for access to depletable mineral resources, then the government should forego domestic production during peacetime, but have production capability ready if needed. Barriers to imports would achieve some of these objectives, but at a higher economic cost. In fact, imports during peacetime may be part of the solution, for building stockpiles or acquiring depletable resources so that domestic supplies are not used up.
a. 1. The tariff would raise the domestic price from the world price P0 to the tariff-inclusive price P1. Domestic production increases from S0 to S1, and domestic consumption falls from D0 to D1.
2. By increasing domestic production from S0 to S1, the country gains social side benefits (worker training and skills) equal to area g.
3. The tariff causes the usual production and consumption inefficiencies equal to areas b and d. The net gain or loss to the country is the difference between area g and areas (b + d).
4. With a production subsidy instead of a tariff, the market price remains at P0. Domestic consumption remains at D0. Producers receive revenue per unit produced equal to P1, which includes both the market price and the government subsidy per unit produced. They increase domestic production from S0 to S1. By increasing domestic production from S0 to S1, the country gains social side benefits (worker training and skills) equal to area g. The production subsidy causes a production inefficiency equal to area b, but it does not distort domestic consumption. The net national gain or loss to the country is the difference between area g and area b. As we expect from the specificity rule, the production subsidy is the better policy—it creates a larger net economic gain (or smaller economic loss) for the country, because it acts more directly on the source of the incentive distortion.
5. The tariff creates revenue for the government equal to area c. The production subsidy creates a cost to the government equal to area (a + b). The deficit-conscious finance minister, looking only at the government budget, would favor the tariff.
b. The specificity rule indicates that the best policy is to subsidize or support worker training directly.
10. The interests of the sock exporting countries are probably to export a large quantity of socks and to receive a high price for the socks that are exported. Presume that the sock importing countries are going to use one of these policies to achieve a specific target quantity of domestic sock production. Consider first the effect on quantity of sock imports/exports. To achieve the target domestic production in the sock importing countries, the tariff and the VER would reduce sock imports by the same amount. But a production subsidy in the importing countries could achieve the same production objective with a smaller reduction in sock imports, because domestic consumers continue to be able to buy socks at the world price and do not cut back on their purchases. The sock exporting countries would tend to favor the production subsidy, because it results in a smaller decrease in the quantity that they export. Consider next the effect on the price received by the sock exporters. Both the tariff and the production subsidy reduce sock import demand, so that they would tend to put downward pressure on sock export prices. (The downward pressure is larger for the tariff, because the reduction in sock imports is larger.) The VER could be used by the exporting countries to form a kind of sock exporting cartel and raise export prices. The sock exporting countries would tend to favor the VER, because it will "force" them to raise sock export prices. Overall, the sock exporting countries would rate the tariff as the least desirable. Their rating of the production subsidy and the VER would depend on their priority between a smaller reduction in quantity exported (favors the production subsidy) or a higher price for sock exports (favors the VER).