Economic arguments for trade protection

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Economic arguments for trade protection

• Applied International Trade Analysis
• Lecture 4

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• Departure from free trade has theoretical
  justification in following cases
• Terms of trade argument
• Optimal tariff rate argument
• Infant-industry argument
• Product market distortion
• Factor market distortion
• Gandolfo 1994 135-143

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OFFER CURVE

• The locus of the combination of a countrys
  imports and exports
• How much is a country willing to export for a
  quantity of imports at a given international
  price

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Derivation of the offer curve
Y
Q
U0
U1
U2
Q
R
p
p
p
p
X
0
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Offer curve (tariff on x)
I1
I0
T
W
Y
E
R
R
0
X
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TERMS OF TRADE ARGUMENT

• Figure 1 Free trade equilibria and terms of
  trade

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• Figure 2 Tariff and terms of trade

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Imposing a TARIFF by country 2 yields

• Offer curve of a country 2 shifts downwards (from
  G2 to G2)
• Terms of trade of country 2 increase
  (tariff-levying country needs to export less of
  good A for the imports of good B than before)
• Volume of trade contracts (imports of country 1
  reduces from EB to EB, imports of country 2
  reduces from EA to EA) and
• Terms of trade of country 1 deteriorate (country
  2 improves its welfare on the account of country
  1).

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OPTIMAL TARIFF RATE ARGUMENT

• Figure 3 Optimal tariff rate

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• Maximizing own welfare by imposing an optimal
  tariff leads to
• retaliation by the other country
• possible tariff war
• trade reduction
• both countries are worse off comparative to free
  trade
• Imposing an optimal tariff pays off only if
  tariff-levying country has some monopoly power
  (large country)

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Figure 4 Maximizing welfare by using an optimal
tariff
welfare
Tariff rate
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• In principle, by imposing a tariff a country can
  improve its welfare, but only up to the certain
  point (C), where
• foreign country retaliates
• home welfare starts to contract
• A tariff war can lead trade to cease completely,
  which results in a lower welfare of the home
  country relative to the free trade

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INFANT-INDUSTRY ARGUMENT

• The oldest theoretical argument for protection
• Two conditions have to be satisfied in order to
  justify this argument
• home firms in the protected industry have to
  develop gradually until they are ready to compete
  internationally (at world prices) and
• if the infant industry has been wisely chosen,
  the gains from trade in the sheltered industry
  after protection has been abandoned have to more
  than compensate for the losses the country had to
  suffer under previous protection.

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SUMMARY

• in principle, tariff protection can raise
  domestic sectors
• however, losses under tariffs are higher than
  losses suffered under production subsidies given
  to import-competing sectors
• tariff protection does not necessarily make a
  country to become a net exporter of the protected
  goods

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Figure 5 Infant-industry argument and choice of
the optimal trade measure
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SUMMARY

• using a subsidy instead of a tariff effects in
  lower losses (consumption is less reduced)
• in the long run, country remains net importer of
  the protected goods if consumer preferences are
  biased towards this good
• country has neglected development of the
  comparative-advantage sector

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PRODUCT MARKET DISTORTIONS

• Product prices can be distorted due to
• monopoly of individual firms results in product
  prices exceeding respective marginal cost, or
• external dis/economies of scale lead to
  differences between marginal cost of individual
  producers and social marginal cost (no tangent
  solution anymore).
• Consequences
• free trade leads to specialization in the wrong
  direction
• Solution
• product subsidy

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Figure 6 Distorted relative product prices and
specialization in the wrong direction
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• PROBLEM
• free trade leads to specialization in the wrong
  direction
• SOLUTION
• imposing a product subsidy is superior to tariff
  as it results in lower welfare losses

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FACTOR MARKET DISTORTION

• Factor prices can be distorted due to
• factor prices differ from their respective
  marginal productivities or
• factor prices are not equalized across sectors
• PROBLEM
• country produces at the suboptimal transformation
  curve

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• Two key issues
• how to get to the optimal production and
  consumption equilibria on the distorted
  transformation curve
• by imposing a production subsidy or tax to
  producers
• how to get to the optimal production and
  consumption equilibria on the optimal
  transformation curve
• by imposing a production subsidy or tax to
  production factors

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Figure 7 Distorted factor prices and 2-step
solution
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• PROBLEM
• distorted factor prices lead to production at the
  suboptimal transformation curve
• 2-STEP SOLUTION
• production subsidy/tax to producers leads to
  optimal production and consumption equilibria on
  the distorted transformation curve
• production subsidy/tax to individual production
  factors leads to optimal production and
  consumption equilibria on the optimal
  transformation curve.

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NONECONOMIC MOTIVES FOR PROTECTION

• Noneconomic motives may prevail over economic
  ones in designing trade policy
• NATIONAL DEFENSE of certain strategic sectors
  (military, agriculture, shipping)
• NATIONAL PRIDE, certain goods raise specific
  sentiments in individual countries and justify
  use of different trade measures in order to
  preserve its production notwithstanding the
  price
• FOREIGN POLICY OBJECTIVES (such as U.S. embargo
  of Libya or Cuba) often justify use of different
  trade measures