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11.4 The Case for Selected Protection

Learning Objective

  1. Identify the cases in which the implementation of selected protectionism, targeted at particular industries with particular goals in mind, could raise national welfare.

An argument for selected protectionA trade policy that is appropriately selected so as to raise national welfare in a market containing market imperfections or distortions. arises in the presence of imperfectly competitive markets, market distortions, or both. In these cases, it is often possible to show that an appropriately targeted trade policy (selected protection) can raise aggregate economic efficiency. In other words, free trade need not always be the best policy choice when the objective is to maximize national welfare. Numerous examples found in the trade literature demonstrate that selected protectionism applied under certain circumstances can raise national welfare. These results are in contrast with the standard trade models, which show that free trade is the best policy to maximize economic efficiency. The reason for the conflict is that the standard trade models, in most cases, explicitly assume that markets are perfectly competitive and implicitly assume there are no market distortions.

This general criticism of the standard case for free trade begins by noting that the real world is replete with examples of market imperfections and distortions. These include the presence of externalities both static and dynamic, both positive and negative, and in both production and consumption; markets in which production takes place with monopolistic or oligopolistic firms making positive profits; markets that do not clear, as when unemployment arises; the presence of public goods; the presence of imperfect or asymmetric information; the presence of distorting government policies and regulations; and the presence of national market power in international markets. When these features are included in trade models, it is relatively easy to identify trade policies that can sufficiently correct the market imperfection or distortion so as to raise aggregate efficiency.

For example, an optimal tariff or optimal quota set by a country that is large in an international import market can allow the nation to take advantage of its monopsony power in trade and cause an increase in national welfare. Similarly, an optimal export tax or voluntary export restraint (VER) set by a large country in an international export market will allow it to take advantage of its monopoly power in trade and generate an increase in welfare. This argument for protection is known as the “terms of trade argument.”

A tariff applied to protect an import-competing industry from a surge in foreign imports may reduce or eliminate the impending unemployment in the industry. If the cost of unemployment to the affected workers is greater than the standard net national welfare effect of the tariff, then the tariff may improve national welfare.

A tariff used to restrict imports of goods from more-efficient foreign firms may sufficiently stimulate learning effects within an industry to cause an increase in productivity that, in time, may allow the domestic firms to compete with foreign firms—even without continued protection. These learning effects—in organizational methods, in management techniques, in cost-cutting procedures—might in turn spill over to other sectors in the economy, stimulating efficiency improvements in many other industries. All together, the infant industry protection may cause a substantial increase in the growth of the gross domestic product (GDP) relative to what might have occurred otherwise and thus act to improve national welfare.

A tariff used to stimulate domestic production of a high-technology good might spill over to the research and development division and cause more timely innovations in next-generation products. If these firms turn into industry leaders in these next-generation products, then they will enjoy the near-monopoly profits that accrue to the original innovators. As long as these long-term profits outweigh the short-term costs of protection, national welfare may rise.

An import tariff applied against a foreign monopoly supplying the domestic market can effectively shift profits from the foreign firm to the domestic government. Despite the resulting increase in the domestic price, national welfare may still rise. Also, export subsidies provided to domestic firms that are competing with foreign firms in an oligopoly market may raise domestic firms’ profits by more than the cost of the subsidy, especially if profits can be shifted away from the foreign firms. These two cases are examples of a strategic trade policy.

If pollution, a negative production externality, caused by a domestic import-competing industry is less than the pollution caused by firms in the rest of the world, then a tariff that restricts imports may sufficiently raise production by the domestic firm relative to foreign firms and cause a reduction in world pollution. If the benefits that accrue due to reduced worldwide pollution are greater than the standard cost of protection, then the tariff will raise world welfare.

Alternatively, if pollution is caused by a domestic export industry, then an export tax would reduce domestic production along with the domestic pollution that the production causes. Although the export tax may act to raise production and pollution in the rest of the world, as long as the domestic benefits from the pollution reduction outweigh the costs of the export tax, domestic national welfare may rise.

If certain domestically produced high-technology goods could wind up in the hands of countries that are our potential enemies, and if these goods would allow those countries to use the products in a way that undermines our national security, then the government could be justified to impose an export prohibition on those goods to those countries. In this case, if free trade were allowed in these products, it could reduce the provision of a public good, namely, national security. As long as the improvement in national security outweighs the cost of the export prohibition, national welfare would rise.

These are just some of the examples (many more are conceivable) in which the implementation of selected protectionism, targeted at particular industries with particular goals in mind, could act to raise national welfare, or aggregate economic efficiency. Each of these arguments is perfectly valid conceptually. Each case arises because of an assumption that some type of market imperfection or market distortion is present in the economy. In each case, national welfare is enhanced because the trade policy reduces or eliminates the negative effects caused by the presence of the imperfection or distortion and because the reduction in these effects can outweigh the standard efficiency losses caused by the trade policy.

It would seem from these examples that a compelling case can certainly be made in support of selected protectionism. Indeed, Paul Krugman (1987) wrote that “the case for free trade is currently more in doubt than at any time since the 1817 publication of [David] Ricardo’s Principles of Political Economy.”See Paul Krugman, “Is Free Trade Passe?” Journal of Economic Perspectives 1, no. 2 (1987): 131–44. Many of the arguments showing the potential for welfare-improving trade policies described above have been known for more than a century. The infant industry argument can be traced in the literature as far back as a century before Adam Smith argued against it in The Wealth of Nations (1776). The argument was later supported by writers such as Friedrich List in The National System of Political Economy (1841)See Friedrich List, The National System of Political Economy, McMaster University Archive for the History of Economic Thought, http://socserv2.socsci.mcmaster.ca:80/~econ/ugcm/3ll3/list/index.html. and John Stuart Mill in his Principles of Political Economy (1848).See John Stuart Mill, Principles of Political Economy, McMaster University Archive for the History of Economic Thought, http://socserv2.socsci.mcmaster.ca:80/~econ/ugcm/3ll3/mill/index.html. The terms of trade argument was established by Robert Torrens in 1844 in The Budget: On Commercial and Colonial Policy.See Robert Torrens, The Budget: On Commercial and Colonial Policy (London: Smith, Elder, 1844). Frank Graham, in his 1923 article “Some Aspects of Protection Further Considered,” noted the possibility that free trade would reduce welfare if there were variable returns to scale in production.See Frank Graham, “Some Aspects of Protection Further Considered,” The Quarterly Journal of Economics 37, no. 2 (February 1923): 199–227. During the 1950s and 1960s, market distortions such as factor-market imperfections and externality effects were introduced and studied in the context of trade models. The strategic trade policy arguments are some of the more recent formalizations showing how market imperfections can lead to welfare-improving trade policies. Despite this long history, economists have generally continued to believe that free trade is the best policy choice. The main reason for this almost unswerving support for free trade is because as arguments supporting selected protectionism were developed, equally if not more compelling counterarguments were also developed.

Key Takeaways

  • In the presence of market imperfections or distortions, selected protection can often raise a country’s national welfare.
  • Because real-world markets are replete with market imperfections and distortions, free trade is not the optimal policy to improve national welfare.

Exercises

  1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”

    1. The term used to describe market conditions that open up the possibility for welfare-improving trade policies.
    2. The term used to describe a market equilibrium in which market imperfections or distortions are present.
    3. Of very many or very few, this is the amount of market imperfections likely to be present in modern national economies.
    4. Of true or false, a tariff can raise a nation’s welfare when it is a large importing country.
    5. Of true or false, a tariff can raise national welfare in the presence of an infant industry.
    6. Of true or false, a tariff can raise national welfare if all markets are perfectly competitive and if there are no market imperfections or distortions.
  2. Identify a trade policy that can potentially raise national welfare in each of the following situations.

    1. When a foreign monopoly supplies the domestic market with no import-competing producers.
    2. When a domestic negative production externality is caused by a domestic industry that exports a portion of its production to the rest of the world.
    3. When a positive production externality is caused by a domestic industry that competes with imports.
    4. When a domestic negative consumption externality is caused by domestic consumers in a market in which the country exports a portion of its production to the rest of the world.
    5. When a country is large in an export market.