Trade Essay Michael Fargher In the 19th and early 20th century trade barriers were prominent features

s of international trade. As poor nations seek to develop their economies, the question of whether there is a case for them to enact trade barriers, and in particular tariffs, has become important. In this essay I will consider 3 cases in which trade protection would theoretically be justified: first, for terms of trade gains, second in industries with economies of scale and third, in industries with externalities. Finally, I will consider how practical in promoting development such policies might be. There are a number of arguments for tariffs and other forms of protection which various interest groups make. While these sometimes take the disguise of overall economic welfare arguments, they are often arguments that relate to the impact on specific factors or have moral, distributional or national security justifications at their core. The Stopler-Samuelson theorem states that removing barriers, and hence lowering the price, for a good will negatively impact the factor used relatively intensively in the goods production. (Krugman, et al. 2012) For example, it is often argued by the UAW (United Automobile Workers Union) that without tariffs to protect the automobile industry in America from cheap imports from countries that pay workers unacceptably low wages, the automobile industry would not survive and thus wide-scale unemployment and falling wages would ensue. Even if the automobile industry were to collapse, the argument does nothing to relate the welfare costs of losing the automobile industry to the welfare gains the average American would receive. One could argue that if overall welfare to the economy increased then transfers from the gainers - the American consumer - should be made to the losers, potentially in the form of unemployment grants, to address any distributional or moral arguments rather than the maintenance of trade barriers. It is in light of this, that I will not be considering many of the popular arguments for tariffs, but rather I will ask the question of whether there is a case in which tariffs and protection more generally might be welfare enhancing for a developing country on the whole, either dynamically or statically. Many developing countries are small economies that have little to no impact on the world price of their imports and exports. In such a case, the statically pareto efficient trade policy is zero tariffs. However, in the instance where a developing country is a major producer or consumer of a good, then there may indeed be a case for the use of tariffs as a first-best tool. The idea stems from the concept that charging a tariff will increase the domestic price, but by less than the tariff because the foreign exporter will lower the world price. The result is a terms of trade improvement for the large country and producer surplus gains that exceeds consumer surplus losses. It can be shown for a large country under perfect competition that the total derivative of social welfare is =

Where m is import, p is domestic price,

, and t is the tariff

The first term is the marginal dead weightloss and the second is the marginal benefit to decreases in the foreign price. Using first order conditions and the constraint that foreign imports must equal domestic imports, we arrive at

Where

is the optimal tariff

The first bracket is the import demand elasticity which would normally be negative and we assume that > 0. For the optimal tariff to be positive, would need to be negative. Why would be negative? If foreign firms choose the price strategically they might absorb some of the price increase to maximize profit - resulting in a terms of trade gain. So if 0< <1 and the smaller it is, then the more positive the optimum tariff would be. (Feenstra, 2004) The corollary of this is if ones exports are large enough to influence world prices, an export tariff should be imposed to gain more favourable terms of trade. This is in fact the case with Saudi Arabia. Practically speaking, a country would need to be particularly large in order to influence world markets to the extent required. And for the majority of developing countries, import tariffs will not induce significant, if any, terms of trade gains. (Neary, 2001) Importantly, this represents a gain to the individual country but a decrease in world welfare. As such, countries would likely experience retaliatory measures more than off-setting any gains from terms of trade effects. In fact, this practical consideration applies to all the arguments for tariffs in this essay. Another popular justification for import tariffs is the existence of industries with economies of scale. The argument says that if firms can serve the domestic market, they will reach a scale that will allow them to compete internationally. Thus protecting infant industries domestically will eventually allow them to be internationally competitive. Arguments for the existence of external economies would also apply since they suggest that economies of scale are generated at the industry level as well as the firm level. These arguments also rely on the notion that there are capital market failures that wouldnt allow firms to borrow against future profits to finance short-run losses and expansion. (Krugman et al, 2012). There are a number of different ways in which external economies or economies of scale might apply. As a result, I wish to focus on a specific case of economies of scale that includes the question of strategic trade policy in an oligopolistic industry. I will then consider the practical limitations of protection in light of these arguments. Consider a market that has large economies of scale, requires particularly large fixed investment and that investment commits companies to a band of production possibilities. Many industries, such as aircraft manufacturing and microprocessor production, feature such investments. Industries such as these are often dominated by a few firms. This has two results: first, firms decisions are believed to affect each other and hence they act strategically. Second, these firms act as Cournot oilgopolists since their output capacity is fixed by the large investment. Both firms would produce a particular output level (or one firm might not enter the market if there is a first mover). Now consider the dynamic equilibrium of a Cournot game where one firm is able to provide a credible threat of investing to increase output. In such a case, especially in the presence of economies of scale, the other firm will not invest to increase output or even exit the industry. Thus this strategic approach to trade policy may produce benefits for a particular nation. One of the most well-known examples of this is the aircraft manufacturing industry with Boeing and Airbus. Baldwin and Krugman (1988) conduct analysis and in their estimates conclude that the US, and Boeing, suffered at the hands of European implicit subsidies to Airbus and the European consumer had a net gain of close to zero.

While this might suggest that such a policy is unwarranted, that interpretation would not consider the technological development that competition has introduced into the industry and potentially ignores the gain that nations around the world have been able to reap as a result of lower prices induced by competition. (Krugman, 1984) This brings me onto the practical side of such strategic trade policy for developing nations. The first consideration is that many developing countries would find it difficult to compete in these types of industries with the subsidies that their governments could offer. Policies such as import tariffs rely on the domestic market itself being large enough to reach the levels required which would seem implausible for many, although not all, developing countries. It must also be remembered that artificial support of an industry would drive up the prices of the factors it uses, potentially crowding out the competitiveness of other industries. The practical considerations for the more general arguments of economies of scale are important. If it were known a priori with certainty that an industry would exhibit economies of scale, then it would be hard to argue against some form of intervention. Such discussion would focus on the type of intervention that governments could make. The basis of these criticisms would be that in the presence of a market failure, first-best responses are most appropriate and the arguments presented are ones for general government intervention rather than explicit trade protection. (Neary, 2001)Thus a production subsidy would be more appropriate. But while import tariffs would cause firms to favour domestic markets at the expense of exports, an export subsidy could help offset this effect and achieve similar results in a more politically expedite fashion. However, even if such second-best trade policies were acceptable, the primary problem remains one of identification. In the mid-20th century, the idea of importsubstitution by encouraging local manufacturing was popular. But the failure of these domestic firms to eventually compete internationally brought the concept of infant industries into question. I believe that this experience in the past does not necessarily negate the arguments supporting the existence of infant industries, and certainly anecdotal evidence out of South Korea would suggest the same. What it does highlight is that there is little point in supporting an industry that will not strive for or is unable to achieve international competitiveness. And the question is clearly that identifying these industries has not been effectively done by many governments in the past. Can such identification issues be overcome? Before I address this question, I want to explore what I consider one of the primary reasons developing countries should consider trade protection. An economist advocating government intervention can always find a friend in externalities. And it is the concept of externalities that also offer some justification for the use of tariffs by developing countries . Redding (1999) illustrates that a country might specialize in the wrong sector if individual agents fail to internalize productivity growth externalities. If a developing countrys static comparative advantage might be in an industry with low learning-by-doing externalities; and if the pattern of comparative advantage is driven endogenously by technical progress, then a country might specialise in a sector that would dynamically lead to a lower state of welfare. As such, a developing country might employ trade protection and promotion (Redding specifically analyses the provision of production subsidies) to overcome static comparative disadvantage. This would certainly imply static losses as the country initially gives up the advantages of free trade and secondly because the subsidy would need to be financed either via a tax on consumers or by consumer forgoing some benefit. Ultimately, if the sector provides higher rates of learning externalities through higher productivity growth, then under certain conditions, inter-temporal welfare might be maximized through the subsidy changing the comparative advantage over time. What conditions might these be? According to the Redding model, the first is obvious: a necessary

condition is that the developing country has the dynamic ability to gain comparative advantage in the subsidized sector either by technological progress, skilling-up or through learning-by-doing. While necessary, this is not sufficient. It further depends on a number of factors including the pattern of domestic consumption, the potential for learning by doing in different sectors and the size of the countrys population (Redding, 1999). It seems plausible that we may find industries that display low levels of learning-by-doing externalities or low productivity growth, such as those related to primary resource extraction. The difficulty lies in identifying an industry with high productivity growth in which a country might dynamically develop a comparative advantage. The informational requirements and practical ability of policy makers to realistically make such a calculation would be difficult. And once again, we find ourselves at the question of identification. Misidentification can be a costly exercise. Problems of identification not only include identifying which industries ones own country could become competitive in but also which industries are worth entering. Nothing has illustrated this as clearly as the dynamic random access memory (DRAM) industry in which Baldwin and Krugman (1986) identify that Japan is providing large implicit protection. Elpida Memory, Hynix Semiconductors and other Asian memory producers spent $37 billion in building new factories anticipating the continued growth in DRAM demand but with the rise of tablet computers, which do not use DRAM, they have lost a combined $14 billion in the past three years alone. (Bloomberg, 2011). Furthermore, there may be a more endemic problem with trade protectionist policies. The establishment of these policies can result in wasteful avoidance schemes by firms, rent-seeking activities and may incentivize the development of lobby and interest groups . These groups may start exerting political pressure that might result in inappropriate protection or even in the continuation of welfare-enhancing beyond its optimal point. While these practical arguments are all very important and indeed the political economy and institutional quality of developing countries might make them binding, there is certainly a question of if this can be systematically overcome. Many countries have invested significant political and intellectual capital in the establishment of independent monetary policy institutions. These institutions are often considered to be credibly avoiding rent-seeking activities as well as doing increasingly better in the management of macro-economic stability. Perhaps in the same way, countries should be investing in independent industrial policy boards that might be able to identify and offer protection to industries that are believed to have economies of scale or externalities. Such an institution should attempt to employ first-best policies where possible, require measurable levels of competitiveness and have transparent performance and support timelines. By no means should such an institution expect to never misidentify industries, but it would hopefully do so less than a haphazard approach influenced by political pressure. And it should be one in which misidentification is considerably less costly as set performance timelines are adopted. In conclusion, the theory suggests that there are cases in which activist trade policies would be justified for developing countries. Practical reasons, ranging from international retaliation and rentseeking to identification and implementation, make the actual benefit of tariffs and other trade protections unlikely. If it were possible to establish an independent industrial and trade policy board, while there may or may not be a case for import tariffs specifically, I would argue that there may be a limited case for more general and active trade protection policies in developing countries.

Bibliography Baldwin, R., Krugman, P. 1988. Industrial Policy and International Competition in Wide-Bodied Jet Aircraft. Trade Policy Issues and Empirical Analysis. University of Chicago Press. Baldwin, R., Krugman, P. 1989. Market Access and International Competition:A Simulation Study of 16K Random Access Memories National Bureau of Economic Research. Working Paper 1936 Bloomberg, 29 November 2011. Chipmakers Lose Billions as IPad Challenges Computers Feenstra, R. 2004. Advanced International Trade: Theory and Evidence Krugman, P.,Melitz, M., Obstfeld, M. 2012 International Economics: Theory and Policy. 12 ed. Krugman, P. 1984 Import protection as export promotion: International competition in the presence of oligopoly and economies of scale. Clarendon Press Oxford Neary, P. 2001. International Trade: Commercial Policy. University College Dublin, Working Paper 200123 Redding, R. 1999. Dynamic Comparative Advantage and the welfare effects of trade. Oxford Economics Papers. Winters, A. 2004. Trade Liberalisation and Economic Performance: An Overview. The Economic Journal