International Trade Theory and Policy
by Steven M. Suranovic

Trade 120-5A

The Potential for Retaliation

One of the problems with using some types of selected protection arises because of the possibility of retaliation by other countries using similar policies. For example, it was shown that whenever a large country in the international market applies a policy which restricts exports or imports (optimally), it would raise its national welfare. This is the terms of trade argument supporting protection. However, it was also shown that the use of an optimal trade policy in this context always reduces national welfare for the country's trade partners. See 1, 2, 3, and 4. Thus, the use of an optimal tariff, export tax, import quota or VER is a "beggar-thy-neighbor" policy - one country benefits only by harming others. For this reason it seems reasonable, if not likely, that the countries negatively affected by the use of such policies, if they are also large in international markets, would retaliate by setting optimal trade policies restricting their exports and imports to the rest of the world. In this way the retaliating country could generate benefits for itself in some markets to compensate for its losses in others.

However the final outcome, after retaliation occurs, is very likely to be reductions in national welfare for both countries.(1) This occurs because each trade policy action results in a decline in world economic efficiency. The aggregate losses that accrue to one country as a result of the other's trade policy will always exceed the benefits that accrue to the policy setting country. When every large country sets optimal trade policies to improve its terms of trade, the subsequent reduction in world efficiency dominates any benefits that accrue due to its unilateral actions.

What this implies is that although trade policy can be used to improve a nation's terms of trade and raise national welfare, it is unlikely to raise welfare if other large countries retaliate and pursue the same policies. Furthermore retaliation seems a likely response because maintenance of a free trade policy in light of your trade partner's protection would only result in national aggregate efficiency losses.(2)

Perhaps the best empirical support for this result is the experience of the world during the Great Depression of the 1930s. After the US imposed the Smoot-Hawley tariff act of 1930, raising its tariffs to an average of 60%, approximately 60 countries retaliated with similar increases in their own tariff barriers. As a result, world trade in the 1930s fell to one-quarter the level attained in the 1920s. Most economists agree that these tariff walls contributed to the length and severity of the economic depression. That experience also stimulated the design of the reciprocal trade liberalization efforts embodied in the General Agreement on Tariffs and Trade (GATT).

The issue of retaliation also arises in the context of strategic trade policies. In these cases, trade policy can be used to shift profits from foreign firms to the domestic economy and raise domestic national welfare. The policies work in the presence of monopolistic or oligopolistic markets by raising international market share for one's own firms. The benefits to the policy-setting country arise only by reducing the profits of foreign firms and subsequently reducing those countries' national welfare.(3) Thus one country's gains are other countries' losses, and strategic trade policies can rightfully be called beggar-thy-neighbor policies. Since foreign firms would lose from our country's policies, as before, it is reasonable to expect retaliation by the foreign governments. However, because these policies essentially just reallocate resources among profit-making firms internationally, it is unlikely for a strategic trade policy to cause an improvement in world economic efficiency. This implies that if the foreign country did indeed retaliate, the likely result would be reductions in national welfare for both countries.

Retaliations would only result in losses for both countries when the original trade policy does not raise world economic efficiency. However, some of the justifications for protection that arise in the presence of market imperfections or distortions may actually raise world economic efficiency because the policy acts to eliminate some of the inefficiencies caused by the distortions. In these cases retaliations would not pose the same problems. There are other problems though.

1. Harry Johnson (1953) showed the possibility that one country might still improve its national welfare even after a trade war (i.e. optimal protection followed by optimal retaliation), however, this seems an unlikely outcome in real world cases. Besides, even if one country did gain, it would still do so at the expense of its trade partners which remains an unsavory result. Go Back

2. Indeed Robert Torrens, the originator of the terms of trade argument, was convinced that a large country should maintain protective barriers to trade when one's trade partners maintained similar policies. The case for unilateral free trade even when one's trade partners use protective tariffs is only valid when a country is small in international markets. Go Back

3. One exception arises in the model by Eaton and Grossman (1986) who show that when the government implements an export tax in the presence of an international duopoly following a Bertrand pricing strategy, then the profits of both the domestic and the foreign firm will rise. However, the losers in their model are the consumers in the third-country market who must face higher prices. Potentially that country could retaliate with import tariffs to protect its consumers and negate the benefits of the strategic trade policy. Go Back

International Trade Theory and Policy - Chapter 120-5A: Last Updated on 7/19/97