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IB Diploma Economics:
Arguments for and against trade protection
Discuss the arguments in favour of trade protection, including:
A summary of the effects of trade protection
Figure 1: The main effects of trade protection measure: tariffs, quotas, production subsidies, and administrative barriers
In general, economists tend to favour free trade and are rather critical of measures to protect domestic firms from international trade. Typically, large benefits accrue to a small number of stakeholder groups (e.g., firms and employees in protected industries), but the cost to a much larger number of stakeholders outweigh these gains, especially consumers who pay higher prices and other firms who face higher costs of production. Most importantly, in a world of scarce resources, trade protection inarguably results in a misallocation of resources and decreased efficiency – more could be produced with the same finite resources, or the same global production could be achieved using less resources.
Industry lobby groups will focus media attention on the threats to firms and employment of lifting trade protection measures, and the smaller, but more widespread and far greater cumulative gains to consumers and firms in non-protected industries.
In section 3.4 of the IB Economics course we examined the stakeholder groups that benefited from trade protection measures such as tariffs, quotas, subsidies and administrative barriers to trade, and those groups who are disadvantaged by such measures.
ARGUMENTS against protection
Figure 1 above summarises the effects of trade protection on specific stakeholder groups (e.g., taxpayers) and on certain economic issues (e.g., income distribution). From this, we can draw the following conclusions:
Summary of arguments
Figure 2: The disadvantages of trade protection
In addition to these main adverse effects of protectionist trade policies, there are several other important points to consider:
1. Corruption and trade protection are correlated. Trade protection potentially allows for corruption to enter and become entrenched in an economy. For example:
2. Trade wars may arise from trade protection measures. A vicious cycle of tit-for-tat trade reprisals may follow from one country imposing quotas, tariffs and other protectionist measures; and it is easy to see why. A tariff imposed on a good will benefit domestic firms and disadvantage foreign firms. The governments of these foreign firms may well decide to try to limit the harm to their firms by then imposing tariffs of their own. This cycle can see countries becoming ever more protectionist, resulting in serious negative effects for resource allocation and global output.
3. Trade protection may harm an economy’s export competitiveness. Not only are firms in protected industries less efficient than their worldwide competitors, they also pass on some of these inefficiencies to other domestic industries who face increased costs of production. This is compounded if domestic industries rely on goods and services these protected industries produce. For example, if a domestic steel industry is supported by tariffs, then the price of steel used in car manufacturing is going to be higher than that of other car manufacturing firms. In export markets, those car firms having to use higher priced steel will not be as competitive as other foreign manufacturers who have the benefits of a competitive steel industry.
Trade protection has its adherents, and these proponents have arguments to support their stance. Some of these arguments can be justified under particular conditions, other arguments are rather weak and very questionable, and some arguments in favour of trade protectionism are just incorrect. Here, in IB Economics, we will examine the best arguments first.
Why countries restrict trade
Qualified arguments favouring trade protection
There are particular arguments that could be justified in certain circumstances. The validity of such arguments depend heavily considerations that do not have an economic basis, or that there could be longer term economic benefits to be gained from trade protection what will outweigh shorter-term economic costs. There are five of these qualified arguments to consider, as can be seen in figure 3, right.
The infant industry argument
Mature foreign firms operating in industries that are internationally competitive have become very efficient and often very large, which have conferred them economies of scale. In developing economies, domestic firms are new, small and unable to compete with these low cost producers. Thus, smaller domestic firms establishing themselves in an industry may require the protection of the state to shield them from imports for a period of time that allows them to develop to a size where they achieve competitive economies of scale themselves, and become internationally competitive.
It is held that infant industries during the early stages of their development require protection from competition from foreign exporters. An infant industry is one which has been established itself comparatively late in a developing economy and/or it is a new industry. In either case, domestic firms are not yet seen as mature enough to face competition from long-established and/or better resourced foreign firms in the industry.
Such an industry, in the initial stages of its growth, requires the full protection of the state without which it could not survive. For an infant industry, operating costs during the transition period are high. As such, it cannot compete with established and efficient foreign exporters.
This is particularly true of a country that is attempting to initiate industrialisation. By imposing a tariff on imports, the domestic price is, therefore, raised sufficiently to allow the relatively high cost domestic producers to survive and develop themselves.
However, exponents of the infant industry argument emphasise that protectionism should be temporary and should be removed immediately after it has performed its function of “nursing.”
Evidently, the infant industry argument is not against free trade per se. Rather, it advocates protection temporarily and only in the initial stages of domestic industry development. This enables countries to develop themselves fully and the volume of trade is maximised. Once the industry becomes mature enough, protection should be withdrawn.
Tariffs, quotas, production subsidies and the like can be defensible when they are imposed temporarily in the hope of nurturing a foreign industry that is in itself perfectly suitable to the circumstances of the country. But it is essential that protection should be confined to cases in which there is an assurance that the industry which trade protection fosters will, after a time, be able to dispense with such protection and become internationally competitive. Domestic producers cannot be allowed to expect that this protection will continue beyond the time necessary for a fair trial that allows policy makers to see what these protected firms are capable of accomplishing.
Some argue for a policy of discriminating protection. For, protection does not provide any incentive to the industry to become efficient. Because it puts a premium on inefficiency, it should not be granted to every industry but should be given only to those industries which are capable potentially of becoming viable units.
Theoretically, the infant industry has some validity. However the infant industry argument is opposed by economists for the following reasons:
In fact, the infant industry argument has wider scope of applicability in lesser developed and developing countries. As such, the infant industry argument gradually becomes the infant country argument, when the government of an underdeveloped country is inclined to extend the list of infant industries in order to augment the quantity and quality of scarce resources, of creating infrastructure, and of increasing basic economic and social requirements.
National security: The argument is often made that an industry should be protected for national security, an argument that is often used by the industry itself because it doesn't want to compete with foreigners. In some cases, this is a legitimate argument. Certainly, manufacturing H-bombs or printing domestic currency should not be outsourced. However, the national security argument cannot be applied to most goods and services. And there are some cases where the national security argument would be plausible, but because the country does not have an absolute or comparative advantage in producing the product, it would have little choice but to trade. For instance, the United States is highly dependent on oil, which can certainly be considered a strategic resource, since a significant part of the United States economy is dependent on it, but it would be very difficult for the United States not to import oil. Even military hardware is composed of parts that are made in other countries.
Diversification and balance
Diversification of industry: Protection is advocated by some to diversify the industries of a country. It is argued that an economy becomes ‘unbalanced’ as a result of excessive specialisation, as excessive specialisation leads to over-dependence of a country on other countries for the goods and services they do not now produce. This is in direct contradiction to the theory of comparative advantage. However, allowing such specialisation is dangerous politically, as well as economically. For example, in times of war imports from foreign countries become difficult to source and domestic consumers and producers will suffer hardships.
Economically, there is danger of serious economic dislocation in case adverse circumstances affect these few industries on which the country is dependent. Thus, in order to achieve a harmonious working together of industries, the balanced growth of all industries and self-sufficiency, it is necessary to bring about a diversification of industries through trade protection. This argument seems to have some merit, especially in times of tension when there are more and vocal advocates for rational self-sufficiency.
However, it has been criticised on the following counts:
trade protection arguments
Figure 3: Qualified trade protection arguments
the infant industries argument
Strategic Trade Policy
Strategic trade policy
Strategic trade policy bears a close resemblance to the infant industry argument for trade protection examined above. The only real difference is that strategic trade theory applies to both developed and developing economies. Strategic trade theory argues that significant economic gains can be made by a country if it protects high technology industries in order to help them achieve economies of scale and achieve a comparative advantage.
The main thrust of the argument is that certain industries, namely those engaged in advanced technology such as telecommunications, computers and nanotechnology, are more important to a nation’s future economic development than other industries. If these industries can receive protection from international competitors then they could achieve economies of scale and become champions of the international stage. For example, successive Taiwanese governments supported their computer chip industry to the point where the domestic industry is very efficient and technologically innovative, and are fierce international competitors. The industry also brings positive externalities in the form of advanced science, technology, nanotechnology and materials knowledge and knowhow which provide other Taiwanese firms with a competitive advantage. Likewise, the same support of the Japanese semiconductor industry has led to a cluster of Japanese firms becoming world leaders in this industry. The two main aircraft manufacturers, Airbus and Boeing, have both enjoyed the support of strategic trade policies in the European Union and the US, respectively.
Protection to strategic industries includes trade protection measures such as tariffs, but more often than not, other strategic supply side support to these industries is granted. These can include tax advantages, government grants and subsidised finance, and government sponsored research and development (tax credits and financial support to university research departments).
The issues associated with strategic trade policy are numerous, and include:
Health, safety and environmental standards: Many countries have requirements that imported goods and services must meet certain health, safety and environmental standards. Those goods that fail to meet such requirements cannot then be sold in the domestic market. The standards differ between countries, but if taken at face value, such an argument is easily justified. Consumers want to know that any imported food is safe to eat and is actually what it reports to be. They want to know the toys that their children play with are not dangerous and will not cause harm, and that the medicines they consume are efficacious. It seems reasonable to penalise foreign firms that exploit the environment and pollute to achieve their low costs of production.
However, health, safety and environmental compliance can often be used as a direct barrier to trade. Take environmental concerns for example. In this argument, free trade leads to greater pollution as production expands in the trading countries. Therefore, only environmentally “safe” industries should be allowed in the newly industrialising countries, or trade policy should be linked to tough environmental pollution control laws in the developing countries. However, the greatest cause of human misery in the underdeveloped nations is poverty. Free trade and free markets are the best way to achieve sustained growth and alleviation of this poverty. Restricting trade or slowing growth for environmental reasons will continue and perpetuate human misery in these nations. The existence of the knowledge problem implies planners cannot know enough to achieve environmentally responsible managed trade and economic growth.
In fact, if the economic development of the industrialised countries is any guide, free trade and free market policies will most likely lead to a cleaner environment. Economic development in the context of a free market, private property rights economy would more likely lead to a cleaner environment while simultaneously alleviating poverty. Further, since the richer countries pollute less, and trade makes countries richer, protection or managed trade is likely to cause more, not less, pollution. For example, it has been shown that air pollution in cities rises with national per capita income to around $5,000, but then falls as income increases further. Trade also helps cleaner technologies to spread.
Arguments with limited merit
These are arguments put forward in favour of trade protection that have limited validity and could be seen as being not entirely incorrect. These arguments might have some merit or value in a set of very limited and highly prescribed set of circumstances. The solutions they propose, trade protectionism in the forms of tariffs, quotas, production subsidies and administrative barriers, offer temporary solutions to problems that could be linked with free international trade. There are four of these arguments that are often mentioned in the debate about free trade.
Poor protectionism arguments
Figure 4: Poor arguments for trade protection
Protecting domestic employment: It is believed that imposition of barriers to trade leads to expansion of employment and incomes. The belief was extremely popular in the thirties, the period of the Great Depression, when cyclical unemployment was prevailing throughout the world. The tariff was then regarded as a fairly practicable means of lessening cyclical unemployment.
Trade barriers work to restrict certain imports so that some consumer spending remains an injection into the domestic economy which will be spent upon the purchase of the products of protected home industries, and not a leakage where import payments flow overseas. As protected industries expand, employment therein increases and average incomes within the economy rise. This generation of income will have a multiplier effect.
There will be expansion of employment and income in other sectors of the economy as well. The overall rise in output will require more capital. Hence, net investments in capital goods industries will rise which will stimulate further investment, employment and income through ‘acceleration effect’. Hence, the final increase in employment and income is greater than that initially generated by the expansion of protected industries.
Moreover, tariffs and the like may even attract foreign capital as producers abroad seeing their market threatened, may set up plants within the country to prevent its passing to domestic producers. Therefore, the existence of unemployment in an industry is usually one of the most heard when trade protection is being considered.
However, trade creates jobs as economic activity expands. The experience of the most free-trading nation on earth, Hong Kong, clearly illustrates this point. With no natural resources, except its people and one of the world’s finest natural harbours, but with complete free trade, Hong Kong has witnessed an increase in its per capita income over twenty-five fold and an increase in employment of over twenty times within a short span of forty years. Today, its per capita income is greater than that of the United Kingdom, of which it is still a colony. This stellar economic performance has been achieved while the population of this largely barren island-peninsula colony increased from around 300,000 to six million over this period. The experience of the other “tigers,” Singapore, Taiwan, and South Korea, is similar. Lest these examples be considered atypical, the cases of Western Europe, North America, and Japan have been similar both before and especially after the two World Wars.
The common argument that is advanced in favour of “fair” trade is that trade deficits (i.e., excesses of imports over exports) cause job losses. While this argument reveals a lack of understanding of what trade deficits imply in the standard system of balance of payments accounting, it is pertinent to note that over 21 million new jobs were added between 1980 and 1990 even as the US ran up huge trade deficits with the rest of the world. And the majority of these jobs paid rather well, contrary to the “McJobs” myth. Job growth was mainly in those sectors that were largely unprotected against foreign competition such as computers and data processing, telecommunications, petroleum and chemicals, pharmaceuticals and health-related products, scientific and photographic equipment, banking and finance, entertainment, leisure and recreation, hospitality and tourism, and the service professions.
Meanwhile, protectionist measures designed to save jobs in such industries as automobiles have not kept employment in them from shrinking drastically and, in fact, may have added to their troubles. The quotas against Japanese autos imposed by the Reagan administration in the early eighties did not prevent the net loss of over 200,000 jobs in the US auto industry.
It has been estimated that the 27 000 direct jobs that were saved in the US auto-manufacturing sector cost around $160,000 per job saved (in 1984 dollars) in terms of economic welfare losses in production and consumption. The quotas added about $2,000 to the price paid by consumers, reduced consumer choice, reduced the competitiveness and efficiency of American producers, and resulted in windfall profits for American and Japanese (and other foreign) automobile manufacturers, leading to the shift of Japanese auto production to luxury cars and further exacerbating Detroit’s woes in this high-margin segment of the industry. Japanese transplant factories that were set up in the US in order to avoid protectionist sentiment and restraints reduced the magnitude of the job losses in the auto industry and the other pernicious effects of the quotas.
The experience in steel, textiles, and a host of other industries such as dairy products, shipping, and meat-packing was similar. These industries continued to shrink while protective tariffs and subsidies were lavished on them to save jobs. For example, in the late eighties, consumers spent $27 billion on textile and apparel subsidies alone, and the cost per direct job saved was $42 000 in an industry with an average wage of $12 000. In the protected dairy products and shipping industries the cost per job saved was estimated as $220 000 and $270 000 respectively in 1987. In the carbon-steel industry for the 9 000 direct jobs saved, the cost was a phenomenal $750 000 per job. The impact of these high-cost saved jobs is the diversion of scarce resources from other, more market-oriented industries with perhaps a much larger number of jobs that never came into existence.
Restricting steel imports destroyed jobs. It is estimated that in the 1980s, steel restraints protected 17 000 jobs in the whole industry, while they cost 54 400 jobs in steel-related industries, for a net loss of over 35 000 jobs. Higher steel costs added to the burden of steel-using industries that were trying to compete against foreign manufacturers. Thus, for example, expensive steel raised the cost of building cars in Detroit and promoted Japanese auto imports.
An invalid argument: Wage protection
Incorrect arguments: wage protection. Advocates of trade protection argue the commonsense notion that high-wage countries like the United States cannot compete with low-wage countries. If workers are paid $12 an hour in America and less than $2 in Bangladesh, and both countries have access to world markets for capital and technology, Bangladeshi companies can always underprice US companies. In free trade between such countries, workers in the high-wage economy face two disastrous options: unemployment or slave-level wages.
However, any inspection of this argument reveals its poor foundations. For example when the US trade deficit mushroomed in the 1981 to 1985 period, developing countries outside OPEC gained only slightly in their share of US manufactured imports. Moreover, the United States now imports far less from low-wage countries than it did in 1960 (when Japan was in that category).
Since wage levels tend to reflect productivity levels, the truth is that the United States, like other high-wage countries, can compete with low-wage countries because its superior productivity compensates for higher wage rates. If developing countries had the skills, technology, and capital levels of the US economy, their wages would not be so low.
Indeed, the long-run evidence throws even greater doubt on the cheap-wage argument, which implies an inexorable rise in the share of imports from countries with low labour costs. In fact, statistics on US manufactured imports show precisely the opposite: in 1960, two-thirds of these imports came from countries with less than half US income (and wage) levels, whereas by 1985, the proportion had dropped to less than one-third. In 1960, of course, Japan and many European countries had cheap labour by this definition; today that is not the case. If cheap labour really determined trade deficits, the United States should have had a much larger deficit in the 1960s, when much more of the world had lower relative wages than it does today.
The progressive lowering of trade barriers between developed countries was connected not with any comparative wage rises in developed foreign countries but with a period of fast growth both here and abroad. Moreover, instead of staying at low levels, Europe’s and now Japan’s wages have converged to US standards roughly in parallel with productivity levels in those countries.
We know from the theory of comparative advantage, specialisation and international trade that low wages will be a source of comparative advantage, and that low-wage countries should be specialising in the production of goods and services that are labour intensive. As the country develops and more effective use of capital goods transforms productivity and drives economic development. Developed economies have highly productive labour that is only expensive at face value. If the wage rates are examined in terms of the output per worker, these wage rates are comparatively low. Conversely, the nominally low wages of developing countries reflect the low productivity that can be measured in terms of output. There is no reason for high wage and developed countries to impose import restrictions on the labour intensive goods produced by developing countries.
Anti-dumping measures in the EU
Anti-dumping: Dumping, in international trade, is the export by a country or company of a product at a price that is lower in the foreign market than the price charged in the domestic market, and/or selling goods and services in international markets at a price that is below the cost of producing it. Typically such low prices are indicative of foreign firms receiving large export subsidies.
Dumping is illegal in international trade agreements. The WTO proposes, monitors and governs disputes over anti-dumping legislation. As dumping usually involves substantial export volumes of the product, it often has the effect of endangering the financial viability of manufacturers or producers of the product in the importing nation.
Thus, if one country suspects that another country’s firms are dumping goods into the domestic market, then they can enact retaliatory trade measures of their own. A recent example of this is US tariffs of over 500 per cent being unilaterally imposed (i.e., without WTO authorisation) on Chinese steel imports.
However, it is extremely difficult to definitively establish and prove that dumping is being practiced. As such, many governments will use trade protectionist measures on the excuse that the domestic industry requires protection from lower cost competitors, when such protection is neither justifiable nor necessary.
What is dumping?
A balance of payments deficit
Overcoming a balance of payments deficit: A balance of payments deficit occurs when the money flows out of a country are greater than the flows of money into a country. One of the leading causes of a balance of payments deficit is that a country is importing more than it exports. Implementing trade protection measures to reduce the amount of imports, and thus the outflows of import payments, could correct a disequilibrium in the balance of payments.
Restrictions on imports through tariffs and quotas may become inevitable in a country if it does not possess sufficient reserves of foreign exchange to make payments with the surplus country. Thus, import restriction measures could be used as a last resort and as a short-term emergency measure to rectify the balance of payments deficit.
However, it is bad policy that is attempting to make good other bad policies. Foreign exchange crises usually arise from a badly run domestic economy that relies heavily on government intervention. In these cases, domestic export firms would not list international competition as their major burden, it would be the costs of doing business being imposed by their governments such as legislating a low maximum price for certain goods (e.g., Venezuela in recent times).
Further, lower import volumes would likely come at the expense of lower export volumes, and there is always the risk of tit-for-tat trade retaliations from other countries. If the country’s exporters faced new and/or greater trade barriers then lower export receipts would offset the lower import payments such a policy was trying to manage.
Also, having a floating exchange rate acts as an automatic stabiliser. As more currency flows out, the exchange rate decrease making imports relatively more expensive. Less imports are demanded and less foreign exchange flows out of the country. A lower exchange rate makes a country’s exports more competitive on international markets and more foreign exchange flows into the country. Thus, the balance of payments should be self-correcting.
What is the balance of payments?
A source of government revenue
Tariffs as government revenue: The main aim of tariffs is to protect domestic firms and employment, that they also raise government revenue is a secondary effect. In the past, tariffs have generated substantial government revenue and have been used to finance government spending. For example, in the US tariff revenue comprised over 40 per cent of all government revenues (compared to less than one per cent in 2000).
There are much more efficient ways of obtaining government revenues that do not wreak so much economic damage, especially in terms of allocative efficiency. Direct taxes such as income taxes and indirect taxes such as sales taxes are much more efficient ways of raising government revenues. We know from our earlier study of the effects of tariffs that they are a particularly regressive kind of tax, in that they fall disproportionally on consumers with lower incomes. Higher prices become widespread throughout an economy, directly from the tariff tax, and indirectly from the higher costs of production forced upon other domestic firms reliant on imported machinery, components and raw materials used in the production of goods and services.
However, in developing countries institutions may not be developed enough to collect such tax revenues and tax avoidance by consumers and businesses is rife. A system of taxing physical goods as they enter a border and pass customs is relatively easy to set up and monitor by government. The ease of collecting government revenue from tariffs may in fact delay necessary tax reforms. As such, a reliance on tariffs for revenue should be at best a temporary measure that need to be phased out gradually as economies undergo the process of economic development.
paying for production subsidies
Student focus: Listen to the podcast above and answer the following question: Explain why US taxpayers are subsidising the production of Brazilian cotton.
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