Is There Any Role For Protectionist Trade Policies? – Economics Essay

Is There Any Role For Protectionist Trade Policies? – Economics Essay
Paul Krugman (1987) once declared that “if there was an Economist’s Creed, it would surely contain the affirmations, “I believe in the Principle of Comparative

Advantage,” and “I believe in free trade.” In theory, free trade is seen as a positive sum game that maximises world output and consumers’ choices, fosters peace and harmony among nations, and spurs domestic efficiency (Friedman, 1988). As its corollary, protectionism is regarded as a zero or negative sum game that should play no part in world affairs, a view strongly supported by the World Trade Organisation. Nevertheless, protectionist trade policies are still adopted in both highly developed countries like the USA and in developing countries like India. This phenomenon hints that there could be justification for protectionist trade policies, a view that is echoed by Corden’s (1974) declaration that “theory does not say that trade is best … it says that trade is best under certain conditions”. However, this essay will argue that while free trade may not be ideal, adopting protectionist trade policies can lead to more problems especially when interventionism goes astray. Hence, while free trade may not be optimal under all circumstances due to market imperfections, it is still a better rule of thumb to avoid protectionism in a world whose politics are as imperfect as markets.

Theoretical gains from free trade
First of all, it is important for us to establish what the theoretical gains from free trade are, and we will do so by taking a closer look at the principle of comparative advantage. According to Ricardo, a country has a comparative advantage in the production of a certain good or service when its opportunity cost of producing that particular good or service is lower than in other countries. Hence, if countries all concentrate their productive efforts in activities that they possess comparative advantages in and trade, the total world output of these goods and services will necessarily increase and all countries will become better off through trade as their consumption possibilities will be expanded. Furthermore, participating in international trade exposes domestic producers to more competitive pressure than faced internally, and this could lead to greater efficiency of domestic firms through reorganisations and innovations. Technological diffusion between trading partners can also contribute to the innovative process, and in turn boost economic growth of the countries that are open to free trade. This might explain why some of the most open economies in the world like Finland and Sweden have been the source of some of the most innovative and successful firms in the world (i.e. Nokia from Finland, Ikea from Sweden).

Besides promoting economic gains, Milton Friedman also argued that free trade also gives rise to political gains by improving international relations between countries and fostering peace and harmony. Indeed, as countries rely more on one another for goods and services, they are more likely to settle international disputes through negotiation rather than hostility. A good example is the significant reduction in tensions amongst Western European countries after the adoption of internal free trade policies post World War II. Furthermore, regular communications amongst countries allow more opportunities for cultural exchange and learning, and this can be highly beneficial in promoting greater understanding between disparate nations with historical feuds. Conversely, restricting free trade will only lead to beggar-thy-neighbour policies that lead to retaliation between nations and more protection. Such a phenomenon occurred during the 1930s depression, and it caused many countries to take a very long time to recover from the economic stagnation.

Why free trade may not be optimal – arguments for protection
Nevertheless, one must be aware that the law of comparative advantage makes many unrealistic and over-simplified assumptions like the existence of perfect competition and constant returns to scale. If certain conditions are not fulfilled, there is a possibility that restricted trade via protectionist trade policies can prove to be more optimal than free trade. But although we will entertain this possibility in the next section by examining the various arguments for protectionism, we will show that each of the arguments have flaws that make protectionism worse than sub-optimal free trade. Let us begin with an increasingly popular argument known as strategic trade policy.

(1) Strategic trade policy
The strategic trade policy argument states that imperfect competition exists in the world, therefore governments should intervene to tilt the terms of oligopolistic competition and shift excess returns from foreign to domestic firms. For instance, it is argued that a protective government policy such as the provision of an export subsidy to a domestic firm will cause a rival firm to contract its own output. A popular example of how this can work is the Airbus-Boeing example used by Brander and Spencer (1985), and this is illustrated in the game theoretic matrix below.
Airbus versus Boeing: no export subsidy

Produce Not produce
Boeing Produce -5, -5 100, 0
Not produce 0, 100 0, 0

Assume there are two firms, A (Airbus) and B (Boeing), and that B has some form of head start that enables it to commit to production before A’s decisions. In the absence of government intervention, the outcome will be the upper right hand corner (100, 0) such that B earns large profits and deter A’s entry. A’s government would obviously like to change such an outcome, and STP says that if A’s government can credibly commit itself to subsidising A (regardless of what B does), then this result can reverse the game’s outcome, as seen below:

Airbus versus Boeing: with export subsidy

Produce Not produce
Boeing Produce -5, 20 100, 0
Not produce 0, 125 0, 0

The hypothetical pay-off matrix above, after a subsidy of 25 to A, means that B now knows that it will make losses if it produces. So B will be induced to cease production and thus a subsidy of 25 raises A’s profit by 100, since the outcome shifts from (100, 0) to (0, 125). Note that Boeing and Airbus are often used as examples by economists because the wide-body aircraft industry is one of the best examples of classic oligopolies. Industrial analysts argue that the market can probably accommodate only two firms producing the next generation of wide-body jets, in which case the subsidy of the European Airbus competitor would dissuade other firms like McDonnell-Douglas and Lockheed from entering the market, assuming of course that these rivals are rational players.

However, we believe that strategic trade policy is not a sound argument for protectionism. Firstly, governments require a lot of information before they can decide what an appropriate industry to protect is and what kind of protection to use for that industry, and it is unlikely that they will be able to have perfect information in a world full of distortions. Furthermore, protecting certain sectors will bid resources away from other sectors of the economy, causing the untargeted sectors to suffer. For example, Japan’s narrow focus on protecting the electronics export sector in the 1980s has led to problems of high factor costs in other areas like textiles and agriculture even up till today. Finally, strategic trade policy is a beggar-thy-neighbour policy that provokes retaliation – if all countries start subsidising some domestic industries, there will be excess investment in these selected domestic industries and no one will gain.

(2) Infant industry and breathing room arguments
Another argument for protectionism is the infant industry argument made by John Stuart Mill. It is argued that developing countries depend too heavily on exporting agriculture and raw materials, and since these goods tend to be income inelastic, as world income increases, demand for these products will fall and these developing countries will suffer from massive unemployment and falling prices. For example, when countries started switching from copper to synthetic material in the 1970s, Zambia suffered very high unemployment because it was almost fully specialised in copper. Hence, some authors argue that it is important for such developing countries to develop comparative advantages in other sectors like manufacturing in order to diversify and prevent large-scale unemployment in future. It is believed that these developing countries do have potential comparative advantages especially in manufacturing, but that they cannot initially compete with well-established manufacturing in developed countries and thus protection is important in temporarily supporting these industries until they have grown enough. After all, USA, Japan, and Germany all had high tariff rates on manufacturing when they began their industrialisation.
However, it may not be a good idea to move into an industry that has yet to develop a comparative advantage. Protecting a potential winner is often permanent and this may result in continued inefficiency and economic stagnation, as the protected firm would see no need to innovate. Pakistan’s failure in heavy manufactures despite its high level of protection illustrates that such protection can generate inefficiencies through a lack of competition. Alfred Marshall further argued that “in becoming intricate, (protection) became corrupt and tended to corrupt general politics.” It is difficult for a government to identify with certainty, which is the potential winner, and government decisions may reflect lobbying by various pressure groups. According to Arthur Bowley, lobbying may thus “lead to defects in the visible hand that outweigh ones in the invisible hand for which remedy is sought”.
A variation of the infant industry argument is the breathing room argument often used by developed countries. This argument was used in the USA to give “temporary” protection to the mature auto, steel and textile industries. According to this line of reasoning, the government provides temporary protection so that an ailing industry can retool, become more productive, and strengthen its international competitive position. Not only so, many jobs in the protected industries could be saved. However, what is not seen is the jobs that will be destroyed or the jobs that will never be created as a result of protectionism. The Cline study in America found that 16,900 jobs in the steel industry were saved as a result of the 1984 voluntary restraints on steel imports, but 52,400 jobs were destroyed in the industries that use steel, for a loss/gain ratio of 3.1 to 1. And like the infant industry argument above, the breathing room argument suffers from the problem of excessive lobbying that can interfere with objective decision making. Hence, even if there are circumstances when these arguments may hold, it is safer to adopt a pro-free trade policy in order to avoid the risk that special interests will dominate the reasons for government intervention.

(3) Inequality argument
Finally, the rise in inequality in many developed countries has led to increasing calls for protection in recent years. One of the predictions from using the law of comparative advantage is that as countries specialise in activities that they are more productive in, factors that are used in these activities will gain rising returns while factors used in other activities will face falling returns. For instance, developed countries are argued to have a comparative advantage in high-tech, high-skilled industries due to the abundance of technology and skilled labour in their countries. Hence, we would predict that skilled labour in developed countries would face rising wages, while unskilled labour would face falling wages. Conversely, in developing countries that have a comparative advantage in low-skilled manufacturing due to an abundance of unskilled labour, skilled labour would face falling wages and unskilled labour would face rising wages. Clearly, it appears that there will be a convergence of low-skilled wages in developed and developing countries, a phenomenon described by Samuelson as factor price equalisation.

Bhagwati (1997) concluded that this fear of the “immiseration of the proletariat” is what led to the recent rise in calls for protectionism – unskilled workers in the developed countries are worried about competing with the unskilled workers in developing countries as they anticipate that free trade will result in lower wages for them. Proponents of factor price equalisation theory claim that it is most clearly seen in studies of North-South trade over the past 30 years. Wood (1994) found that in 1979, the premium earned by college-educated workers in USA was only 30%, but by 1995, the premium had risen to 70%. This coincided with the growing exports of manufactured goods from newly industrialising countries like South Korea, China, and Latin America, which led Wood to argue that the rising premiums in the USA was a result of trade with the South that depressed the wages of low-skilled workers in USA. It thus appears that the idea of factor price equalisation provides a rationale for adopting protectionism.

However, we argue that correlation is not causation – rising premiums to high-skilled workers could very well be the result of myriad other reasons like skill-biased technological progress that raised the demand for high-skilled workers. Hence, clamouring for protectionism on the basis of some correlations between rising trade and rising inequality seems unsound. Furthermore, Slaughter (1998) studied the same data as Wood and found no clear relationship between trade and inequality, and also identified various problems with Wood’s methodology that might have led to exaggerated results. Finally, if factor price equalisation really holds, then we should have observed falling inequality in developing countries (as described above) with high-skilled workers facing falling wages and low-skilled workers facing rising wages. But in reality, the latest World Bank reports show that inequality have been rising even more rapidly in the South (developing countries) than in the North (developed countries), and hence it looks like the theoretical predictions do not bear out in reality. And even if there is some truth in the phenomenon, the best way to deal with rising inequality is to use internal policies such as the welfare state and minimum wages, instead of using indirect external policies like protectionism. Hence, we once again do not support the view that there is a role for protectionist trade policies.

Who does protectionism really benefit?
“In every country, it always is the interest of the great body of the people to buy whatever they want of those who sell it the cheapest. The proposition is so very manifest it seems ridiculous to take any pains to prove it; nor could it ever have been called in question, had not the interested sophistry of merchants and manufacturers confounded the common sense of mankind. Their interest is, in this respect, directly opposite to that of the great body of the people”.
Adam Smith, 1776

According to Adam Smith, the chief culprits of restricting trade are some groups of producers. Protectionism tends to provide large benefits to a small number of people while causing a very great number of consumers a slight loss, and it is the possibility of reaping these large benefits that attracts rent-seeking behaviour by special interest groups. Essentially, protectionist trade policies cause consumers to pay higher prices because producers are receiving something they are not entitled to – the patronage of consumers who would otherwise choose to buy the products of foreigners. McGee (1996) showed that trade restrictions on automobiles, clothing, and sugar cost American consumers $14 billion in 1984, which amounted to a 23% income tax surcharge for families that had less than $10,000 in income, but amounted to only 3% for families with incomes of over $60,000. Protection in the textile industry alone has been estimated to cost poor families almost 9% of their disposable income. Another study cited by McGee found that textile quotas cost the poorest fifth of the U.S. population 3.6% of their incomes, compared to 0.3% for the top fifth. Thus it is apparent that protectionism not only sacrifices the consumer, it sacrifices the consumer who can afford it the least. Overall, this fact that protectionism benefits the wealthy minority at the expense of the majority only makes us conclude that there is no role for protectionist trade policies.

Overall, we have shown that Cordon (1974) was right – “theory does not say that free trade is best… it says that given certain assumptions, it is best”. Indeed, free trade is not the ideal case that many economists once believed it was, because many of the assumptions made by theorists do not hold in reality. However, the case against free trade has not been established as strongly as many businesses clamouring for protection would like. The economic cautions about the difficulty of formulating useful interventions are important to the concern that interventionism may go astray. Free trade may not be optimal under all circumstances since markets are not always efficient, but it is still the better rule of thumb in a world whose politics are as imperfect as markets, if not more. To abandon the free trade principle so as to pursue gains from sophisticated intervention could open the door to the problems of the crude hand of intervention, and will also, by discarding the overall benefits of free trade, certainly throw the baby out with the bath water. Hence, we argue that protectionist trade policies should not play a role in our world.
Brander, J.A. (1985), “Strategic Trade Policy,” Chapter 27 in G.M. Grossman and K. Rogoff (eds.) Handbook of International Economics, Volume 3.
Bhagwati, J. (1997), “The causes of regionalism”, The World Economy, 20 (7): 865-888.
Bowley, A. (1893), A Short Account of England’s Foreign Trade in the Nineteenth Century
Corden, W. M. (1974), Trade Policy and Economic Welfare, Oxford: Clarendon Press
Friedman, M. (1990), Free to Choose: A Personal Statement, Harcourt
Krugman, P. and Obstfeld, M. (2000), International Economics: Theory and Policy, 5th edition, Pearson Education
McGee, R. (1996), The Philosophy of Trade Protectionism, Its Costs and Its Implications, Dumont Institute Policy Analysis, Issue 10
Slaughter, M.J. (1998) “International Trade and Labour Market Outcomes: Results, Questions and Policy Options” Economic Journal Vol. 108, pp. 1452-1462
Wood, A. (1994), North-South Trade, Employment and Inequality, Oxford: Clarendon Press