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 Economic Case against Selected Protection
Learning Objective
- Learn the valid counterarguments to the use of selected protection when market imperfections or distortions are present.
The
economic case against selected protectionism does not argue that the
reasons for protection are conceptually or theoretically invalid.
Indeed, there is general acceptance among economists that free trade is
probably not the best policy in terms of maximizing economic efficiency
in the real world. Instead, the counterarguments to selected
protectionism are based on four broad themes: (1) potential reactions by
others in response to one country's protection, (2) the likely presence
of superior policies to raise economic efficiency relative to a trade
policy, (3) information deficiencies that can inhibit the implementation
of appropriate policies, and (4) problems associated with lobbying
within democratic political systems. We shall consider each of these
issues in turn.
The Potential for Retaliation
One of the
problems with using some types of selected protection arises because of
the possibility of retaliation by other countries using similar
policies. For example, it was shown that whenever a large country in the
international market applies a policy that restricts exports or imports
(optimally), its national welfare will rise. This is the terms of trade
argument supporting protection. However, it was also shown that the use
of an optimal trade policy in this context always reduces national
welfare for the country's trade partners. Thus the use of an optimal
tariff, export tax, import quota, or voluntary export restraint (VER) is
a "beggar-thy-neighbor" policy - one country benefits only by harming
others. For this reason, it seems reasonable, if not likely, that the
countries negatively affected by the use of such policies, if they are
also large in international markets, would retaliate by setting optimal
trade policies restricting their exports and imports to the rest of the
world. In this way, the retaliating country could generate benefits for
itself in some markets to compensate for its losses in others.
However,
the final outcome after retaliation occurs is very likely to be a
reduction in national welfare for both countries.Harry Johnson (1953)
showed the possibility that one country might still improve its national
welfare even after a trade war (i.e., optimal protection followed by
optimal retaliation); however, this seems an unlikely outcome in
real-world cases. Besides, even if one country did gain, it would still
do so at the expense of its trade partners, which remains an unsavory
result. This occurs because each
trade policy action results in a decline in world economic efficiency.
The aggregate losses that accrue to one country as a result of the
other's trade policy will always exceed the benefits that accrue to the
policy-setting country. When every large country sets optimal trade
policies to improve its terms of trade, the subsequent reduction in
world efficiency dominates any benefits that accrue due to its
unilateral actions.
What this implies is that although a trade
policy can be used to improve a nation's terms of trade and raise
national welfare, it is unlikely to raise welfare if other large
countries retaliate and pursue the same policies. Furthermore,
retaliation seems a likely response because maintenance of a free trade
policy in light of your trade partner's protection would only result in
national aggregate efficiency losses.Indeed, Robert Torrens, the
originator of the terms of trade argument, was convinced that a large
country should maintain protective barriers to trade when its trade
partners maintained similar policies. The case for unilateral free trade
even when one's trade partners use protective tariffs is only valid
when a country is small in international markets.
Perhaps the
best empirical support for this result is the experience of the world
during the Great Depression of the 1930s. After the United States
imposed the Smoot-Hawley Tariff Act of 1930, raising its tariffs to an
average of 60 percent, approximately sixty countries retaliated with
similar increases in their own tariff barriers. As a result, world trade
in the 1930s fell to one-quarter of the level attained in the 1920s.
Most economists agree that these tariff walls contributed to the length
and severity of the economic depression. That experience also stimulated
the design of the reciprocal trade liberalization efforts embodied in
the General Agreement on Tariffs and Trade (GATT).
The issue of
retaliation also arises in the context of strategic trade policies. In
these cases, a trade policy can be used to shift profits from foreign
firms to the domestic economy and raise domestic national welfare. The
policies work in the presence of monopolistic or oligopolistic markets
by raising the international market share for one's own firms. The
benefits to the policy-setting country arise only by reducing the
profits of foreign firms and subsequently reducing those countries'
national welfare. Thus one
country's gains are other country's losses, and strategic trade policies
can rightfully be called beggar-thy-neighbor policies. Since foreign
firms would lose from our country's policies, as before, it is
reasonable to expect retaliation by the foreign governments. However,
because these policies essentially just reallocate resources among
profit-making firms internationally, it is unlikely for a strategic
trade policy to cause an improvement in world economic efficiency. This
implies that if the foreign country did indeed retaliate, the likely
result would be reductions in national welfare for both countries.
Retaliations
would only result in losses for both countries when the original trade
policy does not raise world economic efficiency. However, some of the
justifications for protection that arise in the presence of market
imperfections or distortions may actually raise world economic
efficiency because the policy acts to eliminate some of the
inefficiencies caused by the distortions. In these cases, retaliation
would not pose the same problems. There are other problems, though.
The Theory of the Second Best
One
of the more compelling counterarguments to potentially
welfare-improving trade policies relies on the theory of the second
best. This theory shows that when private markets have market
imperfections or distortions present, it is possible to add another
(carefully designed) distortion, such as a trade policy, and improve
economic efficiency both domestically and worldwide. The reason for this
outcome is that the second distortion can correct the inefficiencies of
the first distortion by more than the inefficiencies caused by the
imposed policy. In economist's jargon, the original distorted economy is
at a second-best equilibrium. In this case, the optimal trade policy
derived for an undistorted economy (most likely free trade) no longer
remains optimal. In other words, policies that would reduce national
welfare in the absence of distortions can now improve welfare when there
are other distortions present.
This argument, then, begins by
accepting that trade policies (protection) can be welfare improving. The
problem with using trade policies, however, is that in most instances
they are a second-best policy choice. In other words, there will likely
be another policy - a domestic policy - that could improve national
welfare at a lower cost than any trade policy. The domestic policy that
dominates would be called a first-best policy. The general rule used to
identify first-best policies is to use that policy that "most directly"
attacks the market imperfection or distortion. It turns out that these
are generally domestic production, consumption, or factor taxes or
subsidies rather than trade policies. The only exceptions occur when a
country is large in international markets or when trade goods affect the
provision of a public good such as national security.
Thus the
counterargument to selected protection based on the theory of the second
best is that first-best rather than second-best policies should be
chosen to correct market imperfections or distortions.
Since
trade policies are generally second best while purely domestic policies
are generally first best, governments should not use trade policies to
correct market imperfections or distortions. Note that this argument
does not contend that distortions or imperfections do not exist, nor
does it assume that trade policies could not improve economic efficiency
in their presence. Instead, the argument contends that governments
should use the most efficient (least costly) method to reduce
inefficiencies caused by the distortions or imperfections, and this is
unlikely to be a trade policy.
Note that this counterargument to
protection is also effective when the issue is income distribution.
Recall that one reason countries may use trade policies is to achieve a
more satisfying income distribution (or to avoid an unsatisfactory
distribution). However, it is unlikely that trade policies would be the
most effective method to eliminate the problem of an unsatisfactory
income distribution. Instead, there will likely be a purely domestic
policy that could improve income distribution more efficiently.
In
the cases where a trade policy is first best, as when a country is
large in international markets, this argument does not act as a
counterargument to protection. However, retaliation remains a valid
counterargument in many of these instances.
Information Deficiencies
The
next counterargument against selected protectionism concerns the likely
informational constraints faced by governments. In order to effectively
provide infant industry protection, or to eliminate negative
externality effects, stimulate positive externality effects, or shift
foreign profits to the domestic economy, the government would need
substantial information about the firms in the market, their likely cost
structures, supply and demand elasticities indicating the effects on
supply and demand as a result of price changes, the likely response by
foreign governments, and much more. Bear in mind that although it was
shown that selected protection could generate an increase in national
welfare, it does not follow that any protection would necessarily
improve national welfare. The information requirements arise at each
stage of the government's decision-making process.
First, the
government would need to identify which industries possess the
appropriate characteristics. For example, in the case of infant
industries, the government would need to identify which industries
possess the positive learning externalities needed to make the
protection work. Presumably, some industries would generate these
effects, while others would not. In the case of potential unemployment
in a market, the government would need to identify in which industries
facing a surge of imports the factor immobility was relatively high. In
the case of a strategic trade policy, the government would have to
identify which industries are oligopolistic and exhibit the potential to
shift foreign profits toward the domestic economy.
Second, the
government would need to determine the appropriate trade policy to use
in each situation and set the tariff or subsidy at the appropriate
level. Although this is fairly straightforward in a simple theoretical
model, it may be virtually impossible to do correctly in a real-world
situation. Consider the case of an infant industry. If the government
identified an industry with dynamic intertemporal learning effects, it
would then need to measure how the level of production would influence
the size of the learning effects in all periods in the future. It would
also need to know how various tariff levels would affect the level of
domestic production. To answer this requires information about domestic
and foreign supply and demand elasticities. Of course, estimates of past
elasticities may not work well, especially if technological advances or
preference changes occur in the future. All of this information is
needed to determine the appropriate level of protection to grant as well
as a timetable for tariff reduction. If the tariff is set too low or
for too short a time, the firms might not be sufficiently protected to
induce adequate production levels and stimulate the required learning
effects. If the tariff is set too high or for too long a period, then
the firms might become lazy. Efficiency improvements might not be made
and the learning effects might be slow in coming. In this case, the
production and consumption efficiency losses from the tariff could
outweigh the benefits accruing due to learning.
This same
information deficiency problem arises in every example of selected
protection. Of course, the government would not need pinpoint accuracy
to assure a positive welfare outcome. As demonstrated in the case of
optimal tariffs, there would be a range of tariff levels that would
raise national welfare above the level attained in free trade. A similar
range of welfare-improving protection levels would also hold in all the
other cases of selected protection.
However, there is one other
informational constraint that is even ignored in most economic analyses
of trade policies. This problem arises when there are multiple
distortions or imperfections present in the economy simultaneously
(exactly what we would expect to see in the real world). Most trade
policy analyses incorporate one economic distortion into a model and
then analyze what the optimal trade policy would be in that context.
Implicitly, this assumes either that there are no other distortions in
the economy or that the market in which the trade policy is being
considered is too small to have any external effects on other markets.
The first assumption is clearly not satisfied in the world, while the
second is probably not valid for many large industries.
The
following example suggests the nature of the informational problem.
Suppose there are two industries that are linked together because their
products are substitutable in consumption to some degree. Suppose one of
these industries exhibits a positive dynamic learning externality and
is having difficulty competing with foreign imports (i.e., it is an
infant industry). Assume the other industry heavily pollutes the
domestic water and air (i.e., it exhibits a negative production
externality). Now suppose the government decides to protect the infant
industry with an import tariff. This action would, of course, stimulate
domestic production of the good and also stimulate the positive learning
effects for the economy. However, the domestic price of this good would
rise, reducing domestic consumption. These higher prices would force
consumers to substitute other products in consumption. Since the other
industry's products are assumed to be substitutable, demand for that
industry's goods will rise. The increase in demand would stimulate
production of that good and, because of its negative externality, cause
more pollution to the domestic environment. If the negative effects to
the economy from additional pollution are greater than the positive
learning effects, then the infant industry protection could reduce
rather than improve national welfare.
The point of this example,
however, is to demonstrate that in the presence of multiple distortions
or imperfections in interconnected markets (i.e., in a general
equilibrium model), the determination of optimal policies requires that
one consider the intermarket effects. The optimal infant industry tariff
must take into account the effects of the tariff on the polluting
industry. Similarly, if the government wants to set an optimal
environmental policy, it would need to account for the effects of the
policy on the industry with the learning externality.
This simple
example suggests a much more serious informational problem for the
government. If the real economy has numerous market imperfections and
distortions spread out among numerous industries that are interconnected
through factor or goods market competition, then to determine the true
optimal set of policies that would correct or reduce all the
imperfections and distortions simultaneously would require the solution
to a dynamic general equilibrium model that accurately describes the
real economy not only today but also in all periods in the future. This
type of model, or its solution, is simply not achievable today with any
high degree of accuracy. Given the complexity, it seems unlikely that we
would ever be capable of producing such a model.
The implication
of this informational problem is that trade policy will always be like a
shot in the dark. There is absolutely no way of knowing with a high
degree of accuracy whether any policy will improve economic efficiency.
This represents a serious blow to the case for government intervention
in the form of trade policies. If the intention of government is to set
trade policies that will improve economic efficiency, then since it is
impossible to know whether any policy would actually achieve that goal,
it seems prudent to avoid the use of any such policy. Of course, the
goal of government may not be to enhance economic efficiency, and that
brings us to the last counterargument against selected protection.
Political Economy Issues: The Problem with Democratic Processes
In
democratic societies, government representatives and officials are
meant to carry out the wishes of the general public. As a result,
decisions by the government are influenced by the people they represent.
Indeed, one of the reasons "free speech" is so important in democratic
societies is to assure that individuals can make their attitudes toward
government policies known without fear of reproach. Individuals must be
free to inform the government of which policies they approve and of
which they disapprove if the government is truly to be a representative
of the people. The process by which individuals inform the government of
their preferred policies is generally known as lobbying.
In a
sense, one could argue that lobbying can help eliminate some of the
informational deficiencies faced by governments. After all, much of the
information the government needs to make optimal policies is likely to
be better known by its constituent firms and consumers. Lobbying offers a
process through which information can be passed from those directly
involved in production and consumption activities to the officials who
determine policies. However, this process may turn out to be more of a
problem than a solution.
One of the results of trade theory is
that the implementation of trade policies will likely affect income
distribution. In other words, all trade policies will generate income
benefits to some groups of individuals and income losses to other
groups. Another outcome, though, is that the benefits of protection
would likely be concentrated - that is, the benefits would accrue to a
relatively small group. The losses from protection, however, would
likely be dispersed among a large group of individuals.
This
outcome was seen clearly in the partial equilibrium analysis of a
tariff. When a tariff is implemented, the beneficiaries would be the
import-competing firms, which would face less competition for their
product, and the government, which collects tariff revenue. The losses
would accrue to the thousands or millions of consumers of the product in
the domestic economy.
For example, consider a tariff on textile
imports being considered by the government of a small, perfectly
competitive economy. Theory shows that the sum of the benefits to the
government and the firms will be exceeded by the losses to consumers. In
other words, national welfare would fall. Suppose the beneficiaries of
protection are one hundred domestic textile firms that would each earn
an additional $1 million in profit as a result of the tariff. Suppose
the government would earn $50 million in additional tariff revenue. Thus
the total benefits from the tariff would be $150 million. Suppose
consumers as a group would lose $200 million, implying a net loss to the
economy of $50 million. However, suppose there are one hundred million
consumers of the products. That implies that each individual consumer
would lose only $2.
Now, if the government bases its decision for
protection on input from its constituents, then it is very likely that
protection will be granted even though it is not in the nation's best
interest. The reason is that textile firms would have an enormous
incentive to lobby government officials in support of the policy. If
each firm expects an extra $1 million, it would make sense for the firms
to hire a lobbying firm to help make their case before the government.
The arguments to be used, of course, are (1) the industry will decline
and be forced to lay off workers without protection, thus protection
will create jobs; (2) the government will earn additional revenues that
can be used for important social programs; and (3) the tax is on
foreigners and is unlikely to affect domestic consumers (number 3 isn't
correct, of course, but the argument is often used anyway). Consumers,
on the other hand, have very little individual incentive to oppose the
tariff. Even writing a letter to your representative is unlikely to be
worth the $2 potential gain. Plus, consumers would probably hear (if
they hear anything at all) that the policy will create some jobs and may
not affect the domestic price much anyway (after all, the tax is on
foreigners).
The implication of this problem is that the lobbying
process may not accurately relate to the government the relative costs
and benefits that will arise due to the implementation of a trade
policy. As a result, the government would likely implement policies that
are in the special interests of those groups who stand to accrue the
concentrated benefits from protection, even though the policy may
generate net losses to the economy as a whole. Thus by maintaining a
policy of free trade, an economy could avoid national efficiency losses
that could arise with lobbying in a democratic system.
Key Takeaways
- Selected protection may fail to raise national welfare when foreign country retaliations occur. This is a potential problem when many countries are large in international markets.
- Selected protection with a trade policy is typically second best. A purely domestic policy to correct the market imperfection is often the better, or first-best, policy.
- Selected protection requires detailed information in order to set the policy at a level that will assure an improvement in national welfare. Because the necessary information is often lacking, getting selected protection right may be impossible.
- Selected protection can be captured by special interests in the lobbying process in representative democracies, thereby making it less likely that maximum national welfare will be achieved.
Exercise
-
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 a potentially welfare-reducing reaction to beggar-thy-neighbor trade policies.
- The term used to describe the lowest-cost policy action that corrects for market distortions or imperfections.
- The often overlooked deficiencies that affect the ability of government to set effective policies.
- The term used to describe the process by which individuals inform the government of their preferred policies.
- Economists applying the theory of the second best would argue
that free trade is appropriate in spite of market imperfections because
these types of policies are usually first best.
- The term used to describe a potentially welfare-reducing reaction to beggar-thy-neighbor trade policies.