International Trade Theory and Policy
by Steven M. Suranovic

Trade 120-4

Economic Efficiency with Imperfectly Competitive Markets or Market Distortions:
The Case for Selected Protection

An argument for selected protection arises in the presence of imperfectly competitive markets and/or market distortions. In these cases it is often possible to show that an appropriately targeted trade policy (selected protection) can raise aggregate economic efficiency. In other words, free trade need not always be the best policy choice when the objective is to maximize national welfare. There are numerous examples found in the trade literature which demonstrate that selected protectionism applied under certain circumstances can raise national welfare. These results are in contrast with the standard trade models which show that free trade is the best policy to maximize economic efficiency. The reason for the conflict is that the standard trade models, in most cases, explicitly assumed that markets were perfectly competitive and implicitly assumed that there were no market distortions.

This general criticism of the standard case for free trade, then, begins by noting that the real world is replete with examples of market imperfections and distortions. These include the presence of externalities, both static and dynamic, both positive and negative, in both production and consumption; markets in which production takes place with monopolistic or oligopolistic firms making positive profits; markets that do not clear, as when unemployment arises; the presence of public goods; the presence of imperfect or asymmetric information; the presence of distorting government policies and regulations; and the presence of national market power in international markets. When these features are included in trade models it is relatively easy to identify trade policies which can sufficiently correct the market imperfection or distortion so as to raise aggregate efficiency.

For example, an optimal tariff or optimal quota set by a country that is large in an international import market can allow the nation to take advantage of its monopsony power in trade and cause an increase in national welfare. Similarly, an optimal export tax or VER set by a large country in an international export market will allow it to take advantage of its monopoly power in trade and generate an increase in welfare. This argument for protection is known as the "terms of trade argument".

A tariff applied to protect an import-competing industry from a surge in foreign imports may reduce or eliminate the impending unemployment in the industry. If the cost of unemployment to the affected workers is larger than the standard net national welfare effect of the tariff then the tariff may improve national welfare.

A tariff used to restrict imports of goods from more efficient foreign firms may sufficiently stimulate learning effects within an industry to cause an increase in productivity which, in time, may allow the domestic firms to compete with foreign firms - even without continued protection. These learning effects - in organizational methods, in management techniques, in cost-cutting procedures - might in turn spill-over to other sectors in the economy stimulating efficiency improvements in many other industries. All together, the infant industry protection may cause a substantial increase in the growth of GDP relative to what might have occurred otherwise and thus act to improve national welfare.

A tariff used to stimulate domestic production of a high-technology good might spillover to the research and development division and cause more timely innovations in next-generation products. If these firms turn into industry leaders in these next-generation products then they will enjoy the near monopoly profits that accrue to the original innovators. As long as these long-term profits outweigh the short-term costs of protection, then, national welfare may rise.

An import tariff applied against a foreign monopoly supplying the domestic market can effectively shift profits from the foreign firm to the domestic government. Despite the resulting increase in the domestic price, national welfare may still rise. Also, export subsidies provided to domestic firms who are competing with foreign firms in an oligopoly market, may raise domestic firms profits by more than the cost of the subsidy, especially if profits can be shifted away from the foreign firms. These two cases are examples of strategic trade policy.

If pollution, a negative production externality, caused by a domestic import-competing industry is less than the pollution caused by firms in the rest of the world, then a tariff which restricts imports may sufficiently raise production by the domestic firm relative to foreign firms and cause a reduction in world pollution. If the benefits that accrue due to reduced worldwide pollution is larger than the standard cost of protection then the tariff will raise world welfare.

Alternatively, if pollution is caused by a domestic export industry, then an export tax would reduce domestic production along with the domestic pollution that the production causes. Although the export tax may act to raise production and pollution in the rest of the world, as long as the domestic benefits from pollution reduction outweigh the costs of the export tax, domestic national welfare may rise.

If domestic production of certain high technology goods could wind up in the hands of countries who are our potential enemies and if these goods would allow those countries to use the products in a way that undermines our national security, then the government could be justified to impose an export prohibition on those goods to those countries. In this case if free trade were allowed in these products it could reduce the provision of a public good, namely national security. As long as the improvement in national security outweighs the cost of the export prohibition, national welfare would rise.

These are just some of the examples (many more are conceivable) in which the implementation of selected protectionism, targeted at particular industries with particular goals in mind, could act to raise national welfare or aggregate economic efficiency. Each of these arguments is perfectly valid, conceptually. Each case arises because of an assumption that some type of market imperfection or market distortion is present in the economy. In each case, national welfare is enhanced because the trade policy acts to reduce or eliminate the negative effects caused by the presence of the imperfection or distortion and because the reduction in these effects can outweigh the standard efficiency losses caused by the trade policy.

It would seem, then, from these examples that a compelling case can certainly be made in support of selected protectionism. Indeed Paul Krugman (1987) once announced that, "never before has the case for free trade been so much in doubt". [get exact quote]. Many of these arguments showing the potential for welfare improving trade policies have been known for more than a century. The infant industry argument can be traced in the literature as far back as a century before Adam Smith argued against it in "The Wealth of Nations" (1776). The argument was later supported by writers such as Friedrich List in "The National System of Political Economy" (1841) and John Stuart Mill in his "Principles of Political Economy" (1848). The terms of trade argument was established by Robert Torrens in 1844 in "The Budget: On Commercial and Colonial Policy". Frank Graham in his 1923 article "Some Aspects of Protection Further Considered", noted the possibility that free trade would reduce welfare if there are variable returns to scale in production. During the 1950s and 60s market distortions such as factor-market imperfections, and externality effects were introduced and studied in the context of trade models. The strategic trade policy arguments, conceived in the 1980s, are merely the latest formalization showing how market imperfections can lead to welfare improving trade policies. Despite this long history, economists have generally continued to believe that free trade is the best policy choice. The main reason for this almost unswerving support for free trade is because as arguments supporting selected protectionism were developed, equally, if not more compelling counter-arguments were also developed.(4)

International Trade Theory and Policy - Chapter 120-4: Last Updated on 7/19/97