Evaluating the Controversy between Free Trade and Protectionism
This chapter argues for economic free trade through the lens of trade theory. While free trade may not be optimal, many consider it to be the most pragmatic policy option for a country. During the 19th and 20th centuries, policymakers asked whether free trade was in everyone's best interest. The modern case for free trade argues that government intervention in trade is impractical. Free trade is not always the best policy choice when the objective is to maximize national welfare. Free trade is pragmatically, rather than technically, optimal because it is attainable and most likely to produce the highest level of economic efficiency.
The Case for Selected Protection
Learning Objective
- 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
protection 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". 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) and John Stuart Mill in his Principles of Political Economy (1848).
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. 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
- 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?"
- The term used to describe market conditions that open up the possibility for welfare-improving trade policies.
- The term used to describe a market equilibrium in which market imperfections or distortions are present.
- Of very many or very few, this is the amount of market imperfections likely to be present in modern national economies.
- Of true or false, a tariff can raise a nation's welfare when it is a large importing country.
- Of true or false, a tariff can raise national welfare in the presence of an infant industry.
- 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.
- The term used to describe market conditions that open up the possibility for welfare-improving trade policies.
- Identify a trade policy that can potentially raise national welfare in each of the following situations.
- When a foreign monopoly supplies the domestic market with no import-competing producers.
- 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.
- When a positive production externality is caused by a domestic industry that competes with imports.
- 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.
- When a country is large in an export market.
- When a foreign monopoly supplies the domestic market with no import-competing producers.