A CASE FOR
PROTECTION?
Robert Lawrence
ITF225/Ec 1400
September 15 2015
Trade with competitive markets is a good
thing
We have learned that countries as a whole gain from trade when
there are competitive markets and prices reflect social costs.
i.e. demand curves (benefits) and supply curves (costs) reflect
social benefits and costs.
But what about when markets don’t
produce the best outcome?
• Markets may not produce an equitable outcome if
benefits are not distributed fairly.
• Markets may not produce an efficient outcome if market
failures exist.
What is market failure? Market failure occurs when the prices
in the market are “wrong”: they do not reflect social costs and
benefits.
• Even in these cases, we will see that to correct such
failures intervention should be directed in the most
targeted way possible.
Should we just leave it up to the market?
• Winners and Losers.
• Externalities.
• Infant industry argument.
• Optimal tariff argument.
• Strategic trade policy.
Free trade creates winners and losers
Free trade creates winners and losers: how do we deal with this?
• Should we give up on social gains from trade?
• OR is it better to redistribute the gains using taxes and transfers
and provide adjustment assistance and wage loss insurance to
those who are dislocated?
Should we just leave it up to the market?
• Winners and Losers.
• Trade with Market Failure.
• Infant industry argument.
• Optimal tariff argument.
• Strategic trade policy.
What if prices do not reflect social costs?
• Classic case of market failure:
unregulated pollution (negative
externality)
• Suppose we open up to trade and
we have not regulated pollution.
Will the nation gain from trade?
We cannot say: It could gain even more, or could even lose.
Gain more: If we now import the product, the gains from less pollution
would be added to the gains from lower prices.
Lose?: If we export the product the gains from higher export prices
could be offset by losses from more pollution
Similarly if there are positive externalities.
• Suppose there are benefits if some firms can copy others-
i.e. positive externalities.
• Again we cannot say if trade will make matters better or
worse.
• Gain more: If these externalities occur in export
industries.
• Gain less (or lose): If the positive externalities occur in
import-competing industries that contract.
Implications: Get The Prices Right
• Trade flows will respond to prices prior to trade.
• To be sure of gains from trade, prices need to reflect social
costs and benefits.
• So get the prices right in the first place. One way is to use
taxes and subsidies.
• If local pollution was taxed, we’d get a better idea of whether
the country actually had a comparative advantage in steel.
Then we could be sure the country would gain.
• Major Lesson: Globalization alone may not be sufficient.
Need Good Domestic Policies Too.
Are these examples of market failure?
Firms will not enter the market because:
• they will not earn enough money?
• they can’t get start-up capital?
• they do not have enough experience?
• other firms will not enter?
Should we just leave it up to the market?
• Winners and Losers.
• Trade with Market Failure.
• Infant industry argument.
• Optimal tariff argument.
• Strategic trade policy.
Why do similar firms stick together?
Where would you go in New York for...
Chinese food?
Financial services?
Economies of Scale: External to the
firms, internal to the industry
As more firms enter the market, the costs of the existing firms fall (through
supply-side and demand-side effects.
Agglomeration economies are an example.
This implies the social costs of production are less than the private costs.
Costs,
prices
Number of Firms
External Scale Economies
Social costs lower than private costs
• Each firm reduces the costs of the others: social costs are
lower than private costs (opposite of congestion).
Average
Cost
Private cost
Social cost
Number of Firms
Does Infant Industry Protection Work?
Costs,
prices
Demand: World
Co
If Korean Demand is
DK1 the industry
needs permanent
protection.
If DK2 it becomes
globally competitive.
PK1
PW
Supply: USA
PK2
DK1
DK2
Supply: Korea
Number of firms
So what does it take to use infant industry
protection effectively?
(a) Government knowledge.
How does government get knowledge?
(b) Government political capacity.
To say yes and no.
But even then trade protection
may not the best instrument:
 Tariff will raise domestic price.
 Higher price will induce more production.
Using Tariffs is Like
Trying to hit a bulls-eye
with a pitchfork!
 Higher price will induce less consumption.
Why Protect?
 Save jobs, but then why reduce
consumption at same time.
 Reduce consumption (e.g. cigarettes) but
why increase production at same time?
Subsidies (or even government loan
guarantees) would be better instruments
because they would not raise input costs!
Collateral
Damage!
19
Robert Lawrence
Price
Tariffs: small country
Sh
Consumers: -1, -2, -3, -4
Producers: +1
Pw+T
Government: +3
Society: -2, -4.
1
2
3
4
PW
Dh
QP
QPt
QCt
QC
Quantity
Should we just leave it up to the market?
• Winners and Losers.
• Trade with Market Failure.
• Infant industry argument.
• Optimal tariff argument.
• Strategic trade policy.
Optimal Tariff
• The optimal tariff maximizes the difference between terms
of trade gains and deadweight losses. Only case where
tariff may be an efficient instrument.
• What is a terms of trade gain? It means that imports
become cheaper in terms of exports  a good thing.
• Small country: no gains; only deadweight losses
• Large country:
• zero tariff – no gains from tariff (just gains from trade)
• prohibitive tariff – no gains from tariff (because no imports)
• optimal tariff – somewhere between zero and prohibitive
Optimal Tariff
National welfare
zero tariff – no gains from tariff (just gains from trade)
prohibitive tariff – no gains from tariff (because no imports)
optimal tariff – somewhere between zero and prohibitive
Free trade
Optimum Tariff
Prohibitive Tariff
Tariff rate
Should we just leave it up to the market?
• Winners and Losers.
• Trade with Market Failure.
• Infant industry argument.
• Optimal tariff argument.
• Strategic trade policy.
Example: Boeing and Airbus
• Economies of scale in the market imply that it can only
support one firm
• The firm that wins gets monopoly profits or “rents”
• Should a government intervene to make sure the firm is
located in their country?
ITF210
Strategic Trade Policy: Boeing vs. Airbus (First Mover
Advantage) If Boeing Produces Airbus does not enter
Boeing
Enter
Do Not Enter
Airbus
-10
Enter
-10
100
100
Do Not Enter
0
0
ITF210
EU Provides Subsidy of 20 
Boeing Leaves, EU Gains 100 Net
USA
(Boeing)
Enter
EU
(Airbus)
Do Not Enter
-10
Enter
10
0
120
0
Do Not Enter
0
How does the EU government know how much subsidy to give?
What if the US government subsidizes Boeing?
A case for Protection?
• Winners and losers....
• Market failures? ...
• Infant industry protection? ...
• Better to redistribute gains
• Better to correct them directly.
• May work, but there are better
instruments. Need to say no as
well as yes.
• Optimal tariffs ...
• Better be sure no retaliation.
• Strategic Trade ...
• Need to really understand the
market – and better be sure no
retaliation