GLOBE

Information Deficiencies

by Steven Suranovic ©1997-2004

Trade 120-5c  

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The next counter-argument against selected protectionism concerns the likely informational constraints faced by governments. In order to effectively provide infant industry protection, or to eliminate negative externality effects, or stimulate positive externality effects, or shift foreign profits to the domestic economy, etc., the government would need substantial information about the firms in the market, their likely cost structures, supply and demand elasticities indicating the effects on supply and demand as a result of price changes, the likely response by foreign governments, and much more. Bear in mind that although it was shown that selected protection could generate an increase in national welfare, it does not follow that any protection would necessarily improve national welfare. The information requirements arise at each stage of the governments decision process.

First, the government would need to identify which industries possess the appropriate characteristics. For example, in the case of infant industries, the government would need to identify which industries possess the positive learning externalities that are needed to make the protection work. Presumably some industries would generate these effects while others would not. In the case of potential unemployment in a market, the government would need to identify in which industries, facing a surge of imports, the factor immobility were relatively high. In the case of strategic trade policy the government would have to identify which industries are oligopolistic and exhibit the potential to shift foreign profits towards the domestic economy.

Second, the government would need to determine the appropriate trade policy to use in each situation and set the tariff or subsidy at the appropriate level. Although this is fairly straightforward in a simple theoretical model, it may be virtually impossible to do correctly in a real world situation. Consider the infant industry case. If the government identified an industry with dynamic intertemporal learning effects, it would then need to measure how the level of production would influence the size of the learning effects in all periods in the future. It would also need to know how various tariff levels would affect the level of domestic production. To answer this requires information about domestic and foreign supply and demand elasticities. Of course, estimates of past elasticities may not work well, especially if technological advances or if preference changes occur in the future. All of this information is needed to determine the appropriate level of protection to grant as well as a timetable for tariff reduction. If the tariff is set too low or for too short a time, the firms might not be sufficiently protected to induce adequate production levels and stimulate the required learning effects. If the tariff is set too high, or for too long a period, then the firms might become lazy. Efficiency improvements might not be made and the learning effects might be slow in coming. In this case the production and consumption efficiency losses from the tariff could outweigh the benefits accruing due to learning.

This same information deficiency problem arises in every example of selected protection. Of course, the government would not need pinpoint accuracy to assure a positive welfare outcome. As demonstrated in the optimal tariff case, there would be a range of tariff levels which would raise national welfare above the level attained in free trade. A similar range of welfare improving protection levels would also hold in all of the other cases of selected protection.

However, there is one other informational constraint that is even ignored in most economic analysis of trade policies. This problem arises when there are multiple distortions or imperfections present in the economy simultaneously (exactly what we would expect to see in the real world!). Most trade policy analysis incorporates one economic distortion into a model and then analyzes what the optimal trade policy would be in that context. Implicitly this assumes either that there are no other distortions in the economy or that the market in which the trade policy is being considered is too small to have any external effects in other markets. The first assumption is clearly not satisfied in the world while the second is probably not valid for many large industries.

The following example suggests the nature of the informational problem. Suppose there are two industries that are linked together because their products are substitutable in consumption to some degree. Suppose one of these industries exhibits a positive dynamic learning externality and is having difficulty competing with foreign imports (an infant industry). Assume the other industry heavily pollutes the domestic water and air (i.e. it exhibits a negative production externality). Now suppose the government decides to protect the infant industry with an import tariff. This action would, of course, stimulate domestic production of the good and also stimulate the positive learning effects for the economy. However, the domestic price of this good would rise, reducing domestic consumption. These higher prices would force consumers to substitute others products in consumption. Since the other industries products are assumed to be substitutable, demand for that industry's goods will rise. The increase in demand would stimulate production of that good and, because of its negative externality, cause more pollution to the domestic environment. If the negative effects to the economy from additional pollution are greater than the positive learning effects then the infant industry protection could reduce rather than improve national welfare.

The point of this example, however, is to demonstrate that in the presence of multiple distortions or imperfections in interconnected markets (i.e. in a general equilibrium model), the determination of optimal policies requires that one consider the inter-market effects. The optimal infant industry tariff must take into account the effects of the tariff on the polluting industry. Similarly if the government wants to set an optimal environmental policy it would need to account for the effects of the policy on the industry with the learning externality.

This simple example suggests a much more serious informational problem for the government. If the real economy has numerous market imperfections and distortions spread out among numerous industries which are interconnected through factor or goods market competition, then, in order to determine the true optimal set of policies which would correct or reduce all of the imperfections and distortions simultaneously would require the solution to a dynamic general equilibrium model which accurately describes the real economy, not only today but in all periods in the future. This type of model , or its solution, is simply not achievable today with any high degree of accuracy. Given the complexity, it seems unlikely that we would ever be capable of producing such a model.

The implication of this informational problem is that trade policy will always be like a shot in the dark. There is absolutely no way of knowing, with a high degree of accuracy, whether any policy will improve economic efficiency or not. This represents a serious blow to the case for government intervention in the form of trade policy. If the intention of government is to set trade policies that will improve economic efficiency, then since it is impossible to know whether any policy would actually achieve that goal, it seems prudent to avoid the use of any such policy. Of course, the goal of government may not be to enhance economic efficiency, and that brings us to the last counter-argument against selected protection.


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International Trade Theory and Policy Lecture Notes: ©1997-2004 Steven M. Suranovic
Last Updated on 7/19/97