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a basic symmetry in argument, subsequent arguments for tariffs except the revenue argument also constitute cases for protective devices such as subsidies (including supporting industrial policy by the state). Most arguments imply a reduction in world welfare: the country levying the tariffs gains at the expense of other countries. An LDC might justify this by the fact that usually this means a poorer country (with relatively poor individuals) gaining at the expense of a richer country.
The most frequent rationale for tariffs is to protect infant industries. Alexander Hamilton, the first U.S. secretary of the treasury, criticized Adam Smith’s doctrine of laissez-faire (governmental noninterference) and free trade. Hamilton supported a tariff, passed in 1789, partly designed to protect manufacturing in his young country from foreign competition. Infant industry arguments include (1) increasing returns to scale, (2) external economies, and (3) technological borrowing.
Increasing returns to scale. A new firm in a new industry has many disadvantages: It must train specialized management and labor, learn new techniques, create or enter markets, and cope with the diseconomies of small-scale production. Tariff protection gives a new firm time to expand output to the point of lowest long-run average cost.
An argument against this notion is illustrated by a world of two countries, each of which initially produces a different good with decreasing costs at the lowest long-run average cost. Assume that later both countries levy tariffs to start an infant industry in the good produced by the other country, so that the market is divided and both countries produce both goods well below lowest average cost output. In this case, the world loses specialization gains and economies of scale. The world would be better off if each country specialized in one decreasing-cost product, exchanging it for the decreasing-cost product of the other country.
But some may ask if infant industry protection would not be warranted for the firm in a newly industrializing country competing with firms in well-established industrial countries. In this instance, however, tariff protection, by distributing income from consumers to producers, amounts to a subsidy to cover the firm’s early losses. Why should society subsidize the firm in its early years? If the enterprise is profitable over the long run, losses in the early years can be counted as part of the entrepreneur’s capital costs. If the enterprise is not profitable in the long run, however, would not resources be better used for some other investment?
Yet government might still want to protect infant industry. First, government support may cover part of the entrepreneur’s risk when average expected returns are positive but vary widely. Second, the state may support local technological learning and knowledge-creating capabilities. Third, government planners may better forecast the future success of the industry than private entrepreneurs but protect or subsidize private investment to avoid direct operation of the industry themselves. Fourth, protecting the new industry may create external economies, or promote technological borrowing, both discussed later.
Ha-Joon Chang (2002) contends that the United States and other present-day DCs relied heavily on tariffs and subsidies during the 19th and early 20th century. But after DCs had used the protectionist ladder to climb to high levels of development they
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kicked away the ladder for contemporary LCs, arguing for a free-market liberalism that they did not adopt. Although there is truth to the charge of DCs’ hypocrisy on liberalism, Michael Clemens and Jeffrey Williamson (2002) show that increasing tariffs after 1970, when average tariff rates were low, hurt growth, while protection would have helped growth when tariffs were moderately higher. Thus, protection during the 19th and early 20th centuries would have stimulated growth. Wilfred Ethier (2002) shows that tariff rates in the early period were much higher than in the last three to five decades, when U.S. and DC leadership contributed to multilateral, nondiscriminatory tariff reductions to historically low levels.
External economies. These are production benefits that do not accrue to the private entrepreneur. One example is technological learning, measured by a learning curve that shows how much unit cost falls with the increased labor productivity from cumulative experience. This curve, which is downward sloping over time, is a source of dynamic increasing returns. Related to these, external economies also include the training of skilled labor, and lower input costs to other industries, all of which cannot be appropriated by the investor but may be socially profitable even if a commercial loss occurs. Government can make a rational case for protecting or subsidizing such investment. However, political leaders who discover immeasurable externalities for pet projects can easily abuse the argument.
Technological borrowing. Classical economists assumed a given technology open to all countries. In reality much of the world’s rapidly improving technology is concentrated in a few countries.
Much international specialization is based on differences in technology rather than resource endowment. Assume both Italy and Indonesia can produce corn, but only Italy has the technical capacity to manufacture spectrometers. Thus, Italy trades spectrometers, in which it has a comparative advantage, for Indonesia’s corn. Yet Indonesia has the necessary labor and materials, so that if Italy’s technology could be acquired, Indonesia’s comparative advantage would shift to spectrometers. If Indonesia levies a tariff on spectrometers, Italian companies may transfer capital and technology to produce spectrometers behind Indonesia’s tariff wall. Once Indonesia acquires this technology, its average costs will be lower than those in Italy.
Critics raise one question: If Indonesia is open to foreign investment and if foreign technology gives Indonesia a comparative advantage, why is a tariff necessary to induce the foreign entrepreneur to produce spectrometers there? Should not the foreign spectrometer producers see the opportunity and bring capital and technology to Indonesia?
Tariffs, subsidies, exchange controls, and quantitative restrictions may shelter inefficient technological transfers from abroad. In India, in the 1960s, protection conferred such monopoly power on automobile manufacturers Hindustan Motors and Premier Automobiles (in a joint venture with Fiat and later Nissan) that they subtracted value from raw materials and purchased inputs. The automobile industry had an effective rate of protection (that is, protection as a percentage of value
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added by production factors at a processing stage) of 2,612 percent (Bhagwati and Desai 1970:335–367); indeed the foreign-exchange cost of the inputs used in producing a domestic automobile was higher than the foreign-exchange cost of buying an automobile directly from abroad! India acquired few technical learning gains from protection, which instead supported technological sloth. Moreover, India’s high rates of protection reduced the rupee price of the dollar below the equilibrium price, thus shortchanging (or discriminating against) exporters who exchanged their dollars for rupees. Later, we will discuss protection of infant entrepreneurship as an alternative to protecting infant industry.
Politically, it is difficult to end tariff protection for infant industries. When governments feel compelled to protect infant industry, they could instead provide subsidies that are politically easier to remove rather than tariffs.
Intraindustry trade. Ironically, about one-fourth of international trade consists of intraindustry trade, exchanges by two countries (primarily DCs) within the same industry (or standard industrial classification). Examples include the automobile (Germany exports Mercedes-Benz to the United States, which exports Cadillacs to Germany), office machinery, and running-shoe industries. Intraindustry trade plays a particularly large role in trade in manufactured and high-technology goods among DCs. The markets for these goods are monopolistically competitive, an industry structure characterized by a large number of firms, no barriers to entry, and product differentiation, in which corporations proliferate models, styles, brand names, and other positive distinguishing traits, such as image, service, and unique taste or components, sometimes enhancing different identities through advertising.4 Product differentiation assures each firm a monopoly in its particular product within an industry and is thus somewhat insulated from competition. Each firm takes the prices charged by its rivals as given, ignoring the effect of its own price on its competitors’ prices. Monopolistic competition assumes that although each firm faces competition from other producers, it behaves as if it were a monopolist. Thus, Mexico, in which General Motors, Ford, Daimler-Chrysler, Toyota, Nissan, and Volkswagen offer substantially different yet competing automobiles, is characterized by monopolistic competition.
Intraindustry trade among DCs, which is a major source of gains from trade, arises
(1) when countries are at similar stages of economic development, usually similar in their relative factor supplies (abundant human capital and sparse unskilled labor), so that there is little interindustry trade, and (2) when gains from economies of largescale production and product choice are substantial (Heilbroner and Galbraith 1990: 575–576; Case and Fair 1996:350–376; Krugman and Obstfeld 1997:137–142).
4According to Addison (2003:4), variety is associated with a high income per capita when preferences are diverse and goods not infinitely divisible. With a given income, you might own a car but not a motorcycle because both goods are not sold in fractions. But with a higher income, you might own both. Or “both will be sold if the number of consumers with diverse tastes is large enough.” Broda and Weinstein (2004:139–144) show that one of the principal means through which countries benefit from international trade is by expansion of varieties.
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What are the implications of intraindustry trade for developing countries? Perhaps only a few newly industrialized countries (NICs), such as South Korea, Taiwan, and Singapore, have attained the human capital abundance, technological sophistication, and level of demand that would allow them to gain from specialized intraindustry trade in differentiated products. But once you have reached the DC “big leagues,” where the technological frontier changes incessantly, you probably gain more by the bracing challenge of rivals than by building a wall of protection around you. William Lewis’s study (1993:A14) of global manufacturing competitiveness concludes: “Global competition breeds high productivity; protection breeds stagnation.”
Changes in factor endowment. A government might levy a tariff so that entrepreneurs modify their output mix to match a shifting comparative advantage perhaps because of a change in resource proportions. Thus, as its frontier pushed westward and capital expanded, the United States changed from a country rich in natural resources, exporting a wide variety of metals and minerals, to a capital-rich country. Analogously, the rapid accumulation of capital and technology may alter comparative advantage from labor-intensive to capitaland technology-intensive goods. Thus, in the 1950s and 1960s, Japan’s Ministry of International Trade and Industry (MITI, now METI, the Ministry of Economy, Trade and Industry) tried to establish capitaland technology-intensive industries, which appeared not to be to Japan’s static comparative advantage but offered more long-run growth because of rapid technical change, rapid labor productivity growth, and a high income elasticity of demand (percentage change in quantity demanded/percentage change in income). South Korea followed a similar strategy in the 1960s, 1970s, and 1980s, but established performance standards for each industry protected (Chapter 3).
We must ask why private entrepreneurs would not perceive the changing comparative advantage and plan accordingly. Even in Japan, although MITI facilitated the output of memory chips for semiconductors, it did not encourage electronics production and tried to consolidate Japan’s automobile production into a few giant corporations, attempting to prevent Soichiro Honda from producing cars! Indeed, although MITI was accommodating and supportive, private entrepreneurs invested and coordinated the essential resources (Schultze 1983:3–12). Government protection (or subsidy) is appropriate only if government foresees these changes better than private entrepreneurs.
Revenue sources. As indicated in Chapter 14, tariffs are often a major source of revenue, especially in young nations with limited ability to raise direct taxes. In fact, U.S. tariffs in 1789, despite Hamilton’s intentions, did more to raise revenue than protect domestic industry.
Even for a government unconcerned about the losses a tariff imposes on other people, tariffs have limits. At the extreme, a prohibitive tariff brings no revenue. And a tariff that maximizes revenue in the short run will probably not do so in the long run. In the short run, before domestic production has moved into import-competing
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industries, demand is often inelastic (that is, the absolute value of the percentage change in quantity is less than the absolute value of the percentage change in price). However, once productive resources adjust, demand elasticities increase; and a greater relative quantity decrease – in response to the increased price from the tariff – occurs. Thus, a government setting a maximum revenue tariff must take account of the longrun movement of production resources.5
Improved employment and the balance of payments. The rules of the World Trade Organization allow LDCs to impose trade restrictions to safeguard its balance of payments (World Bank 2004f:221). A rise in tariff rates diverts demand from imports to domestic goods, so that the balance on goods and services (exports minus imports), aggregate demand, and employment increase.6 The economic injury to other countries, however, may provoke retaliation. Furthermore, the effects of import restrictions and increased prices spread throughout the economy, so that domesticand export-oriented production and employment decline (Black 1959:199–200) In fact Lawrence B. Krause’s (1970:421–425) study of the U.S. economy indicates that jobs lost by export contraction exceed jobs created by import replacement. It is probably more effective to use policies discussed in Chapter 9, and when possible, financial policies (Chapter 14) for employment and home currency devaluation to improve employment and the balance of payments.7
From another perspective, Amelia Santos-Paulino and A. P. Thirlwall (2004:F50– F72) find that trade liberalization stimulates export growth (especially through more efficient resource allocation) but raises import growth more, leading to a worsening balance on current account. The shock to international payments is especially great when a highly protected country liberalizes. However, trade liberalization increases income and price elasticities of demand, making it easier for producers to shift resources to the trade sector. Moreover, the timing of this liberalization should recognize interaction with other policies; trade liberalization is more effective when undertaken as part of well-sequenced liberalization of foreign exchange, capital movement, banking, fiscal policy, commodity markets, and institutions (ibid.; Winters 2004: F4–F21).
Reduced internal instability. The sheer economic cost of periodic fluctuations in employment or prices from unstable international suppliers or customers may justify tariffs to reduce dependence on foreign trade. According to the World Bank, commodities accounting for one-third of LDC nonfuel primary exports fluctuated in price by over 10 percent from one year to the next, 1955 to 1976. By encouraging import substitution, tariff protection can reorient the economy toward more
5 Arguments 1–3 and 5–6 are from Black (1959:191–208); Kindleberger (1963:124–134).
6When demand is elastic, the percentage decline in the quantity imported exceeds the percentage increase in price from the tariff, so that import value, price multiplied by quantity, falls. When demand is inelastic, import payments increase, but by less than the government’s gain in tariff revenue.
7Bhagwati (1994:231–246) argues that the case for protection is valid only when the distortion is foreign, not domestic, for surely the country has some policy discretion in changing domestic distortion.
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stable domestic production. Losses in allocative efficiency might be outweighed by the greater efficiency implicit in more rational cost calculations and investment decisions. Yet such a policy may be costly. Tariffs on goods with inelastic demand, such as necessities, increase import payments.
Policy makers should compare the costs of alternative ways of stabilizing the internal economy, such as holding reserves. A LDC with adequate foreign exchange reserves can maintain its purchasing power during times of low demand for its exports. Moreover, a country can use reserves from import commodities to offset the destabilizing effects of sudden shortages on domestic prices and incomes (World Bank 1978i:19–20; Black 1959:206–208).
National defense. A developing country may want to avoid dependence on foreign sources for essential materials or products that could be cut off in times of war or other conflict. A tariff in such a case is only worthwhile if building capacity to produce these goods takes time. Otherwise, the LDC should use cheaper foreign supplies when they are available.
Policy makers will want to examine alternatives to a national defense tariff, such as stockpiling strategic goods or developing facilities to produce import substitutes without using them until the need arises.
In a period of rapid technical change in military and strategic goods, a government must ask whether it is worth increasing costs through tariffs to avoid hypothetical future dangers. Would it not be better to divert these resources to investment, research, and technical education to increase the economy’s overall strength and adaptability?
Extracting foreign monopoly or duopoly profit. An LDC facing a foreign monopoly supplier of a good may levy a tariff to transfer some of the monopoly profit to revenue for the LDC. Although world welfare falls, the home country levying the tariff increases its welfare at the expense of the foreign producer.
Assume an LDC firm is competing against a foreign firm: (1) in a duopoly, that is, where there are two firms in an industry, (2) where price and output decisions are interdependence, and (3) where both are characterized by internal economies of scale, that is, a falling average-cost curve. A tariff can increase exports for the protected firm in any foreign market in which the firm operates. However, if the foreign country retaliates with a tariff, the two firms are likely to maintain previous market shares, with a greatly reduced volume of trade (Brandner and Spencer 1981:371–389; Krugman 1984:180–193; Appleyard and Field 1992:162–169).
Antidumping. Dumping is selling a product cheaper abroad than at home. Why should a country object to it? If a foreign country is supplying cheap imports favorable to consumers, should not such action be considered as a reduction in foreign comparative costs? Yes and no. If the foreign supplier is dumping as a temporary stage
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in a price war to drive home producers out of business and establish a monopoly, a country may be justified in levying a tariff (Black 1959:201–204).8
Antidumping actions in the United States and the European Union are known to be linked to macroeconomic conditions. In part, this is because positive injury findings may be easier to make in a downturn.
Reduced luxury consumption. Government may wish to levy a tariff to curtail the consumption of luxury goods. As indicated in Chapter 14, however, an excise tax is probably preferable to a tariff on luxuries, which would have the unintended effect of stimulating domestic luxury goods production.
CONCLUSION
From our arguments, it should now be clear that tariff protection need not necessarily be attributed to analytical error or the power of vested interests, but may be based on some genuine exceptions to the case for free trade. Yet many of the most frequent arguments for tariffs, such as protecting infant industry, are more limited than many LDC policy makers suppose. In fact, a critical analysis of the arguments for tariffs provides additional support for liberal trade policies.
Path Dependence of Comparative Advantage
Paul A. David (1995:332–337) indicates that comparative advantage is path dependent, in which historically remote events influence subsequent patterns of specialization. An early Milwaukee printer, Chrisopher Latham Sholes, designed the typewriter’s topmost row of letters to spell QWERTYUIOP to reduce jamming from rapid typing in the dominant right hand and to provide salepersons easy access to the typewriter’s brand name in one row. The market position of QWERTY, which established it over other keyboards, has provided a continuing advantage so that even today QWERTY dominates computer keyboard layouts. David contends that there are many other instances in which sequences of choices made close to the beginning of the process determined the path of subsequent location and technological change. California’s and Bangalore, Karnataka, India’s Silicon Valleys are examples (see also Krugman 1994:221–244).
The Application of Arguments for and against Free Trade to Developed Countries
Dani Rodrik (1998:16–34) argues that DCs have the right to restrict trade when trade creates conditions that conflict with widely held domestic norms (see Chapter 15). Let’s examine arguments against free trade to improve DC unskilled labor wages
8Antidumping actions in Europe, North America, and Mexico are linked to a downturn in the economy, when positive injury findings are easier to make (Francois and Neils 2003).
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and income distribution, to reduce LDC use of child labor, and to prohibit polluting processes in LDCs.
Income distribution. Most of the major arguments for protection for LDCs, such as the infant-industry and revenue arguments, have little validity for DCs. However, improving income distribution is a serious argument for protection. The Stolper– Saumuelson (SS) (1941:58–73) theorem used Heckscher–Ohlin factor proportions theory to examine the implications of free trade for the wage of unskilled labor (the scarce factor) relative to skilled labor (the abundant factor). Won’t free trade raise the skill premium (skilled labor wage/unskilled labor wage), supporting an argument for tariffs to increase the relative wage of the unskilled labor and reduce income inequality? This argument might support 1992 U.S. presidential candidate Ross Perot’s contention that trade contributed to a “giant sucking sound” moving jobs from the United States abroad.
Given the restrictive assumptions behind the global factor price equalization theorem from which SS derived, Stolper and Samuelson regarded their theorem as a mere curiosity. However, the steady increase in U.S. and U.K. wage inequality from the late 1970s through the 1990s revived interest in SS as a long-run tendency. Economists found that expanded physical capital was complementary to skilled labor but competitive with unskilled labor. Moreover, empirical economists began testing whether increased U.S. wage inequality during this period resulted from growing trade liberalization. Lacking wage data that provided a pure test of skilled and unskilled wages, economists used wages of nonproduction versus production workers, college graduates versus high school dropouts, skill intensity of imports, decline in the relative wage of unskilled-intense (textile, apparel, and leather) manufacturing, and sector- by-sector comparisons as proxy tests for finding the causes of the skill wage premium (Cline 1997).
Most tests from the early 1990s found that skill-biased technological progress (information technology, biotechnology, and R&D spending) was the major factor increasing wage inequality. The relative demand for skilled labor increased even more rapidly than the continuing enskilling of labor supply, largely a result of an increase in the proportion of college graduates in the labor force during the two decades. These same tests found that the reduced relative demand for unskilled-labor- intensive products resulting from expanded skill-intensive exports and unskilledintensive imports had little, if any, adverse effect on wage inequality (Cline 1997). Krugman (1995:327–377) provided strong support by arguing that as most U.S. trade is with other DCs, a substantial share of which is intraindustry trade, differences in skill intensity would have little relevance for trade.
Many later analyses questioned these findings. William Cline (1997:173–283) disagreed with the assumptions in the prevailing literature of a relatively small difference between the factor intensity of commodities. This literature implicitly assumed that the skill intensities varied between, for example, 0.6 for goods embodying skilled labor, and 0.4 for goods embodying unskilled labor; Cline assumed figures more like 0.8 and 0.2, respectively. Moreover, Cline rejected the others’ assumption of a
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high elasticity of substitution for labor (percentage change in the skilled–unskilled ratios/percentage change in skilled wages/unskilled wages). That is, Cline believed that trade and the skilled wage premium were more sensitive to changes in the ratio of skilled to unskilled labor.
For Adrian Wood (1994), increasing the assumed differences between the factor intensity of commodities is not enough. He assumes that LDCs have a higher unskilled-labor intensity than DCs in producing the same commodity. In fact, DC firms no longer manufacture many labor-intensive goods imported from LDCs. Most of these imports are noncompeting goods. In calculating factor intensities, economists must consider LDC production of labor-intensive products that DCs have had to abandon. Compared to conventional calculations by trade economists, Wood finds a much larger demand for unskilled labor in LDCs, whereas the demand for skilled labor in DCs is substantially larger. Critics contend that Wood has overstated the variation in factor intensity between the same good produced in both DCs and LDCs as well as the extent of LDC production of noncompeting goods.
Cline (1997:147) finds that trade and immigration caused the skilled wage premium in the 1980s to increase by one-third more than otherwise, an increase that continued into the 1990s. Moreover, his projections through 2015 show that despite the continuing enskilling of the U.S. population, falling protection, falling transport and communication costs, increased unskilled immigrants, deunionization, continuing skill-biased technological change, and an increased portion of the economy producing tradable goods and services should substantially increase the relative demand for the abundant factor, and, thus, the skilled wage premium (Cline 1997: 173–283).
How do we explain the increase in the skill premium amid the relative increase in skilled or educated labor, that is, a continual expansion in college graduates in the United States since the 1960s. Cline (1997:25–29) indicates that U.S. real wages for a given education category declined during the last quarter of the 20th century, but that median and average real wages overall did not plummet because of an increasingly educated population. Moreover, as Daron Acemoglu (2003:199–230) explains, an increase in supply of skills spurs skill-biased technological change that, together with increased factor-biased trade, feeds back to increase the demand for skills.
This enskilling and its increase in the skill premium are a general phenomenon among DCs, although, except for the United Kingdom, other DCs did not experience the same rising income inequality during the last two decades of the 20th century.
The enskilling and skill premium trend in Russia after the fall of communism in 1991 was similar to the U.S.’s trend, and took place with increasing globalization and a rising share of trade with regions outside Eastern Europe and Central Asia. These changes reflected intraindustry skill-biased technological change, institutional change, and increased market pressures. Moreover, the skill premium and the increased returns to schooling it reflected helped spur an increase in the supply of university educated and other skilled people (Peter 2003).
Subsequent studies for LDCs and NICs are mixed, although Forbes (2001:175– 209) reinforces Stolper–Samuelson by finding increased wage inequality (in, for