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 that restricts exports or imports (optimally), its national welfare will rise. 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. Thus the use of an optimal tariff, export tax, import quota, or voluntary export restraint (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 a reduction in national welfare for both countries.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. See Harry G. Johnson, “Optimum Tariffs and Retaliation,” Review of Economic Studies 21, no. 2 (1953): 142–53. 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 a 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.Indeed, Robert Torrens, the originator of the terms of trade argument, was convinced that a large country should maintain protective barriers to trade when its 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.

Perhaps the best empirical support for this result is the experience of the world during the Great Depression of the 1930s. After the United States imposed the Smoot-Hawley Tariff Act of 1930, raising its tariffs to an average of 60 percent, approximately sixty countries retaliated with similar increases in their own tariff barriers. As a result, world trade in the 1930s fell to one-quarter of 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, a 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 the 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.One exception arises in the model by J. Eaton and G. Grossman, “Optimal Trade and Industrial Policy under Oligopoly,” Quarterly Journal of Economics 101, no. 2 (1986): 383–406. Thus one country’s gains are other country’s 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, retaliation would not pose the same problems. There are other problems, though.

The Theory of the Second Best

One of the more compelling counterarguments to potentially welfare-improving trade policies relies on the theory of the second best. This theory shows that when private markets have market imperfections or distortions present, it is possible to add another (carefully designed) distortion, such as a trade policy, and improve economic efficiency both domestically and worldwide. The reason for this outcome is that the second distortion can correct the inefficiencies of the first distortion by more than the inefficiencies caused by the imposed policy. In economist’s jargon, the original distorted economy is at a second-best equilibrium. In this case, the optimal trade policy derived for an undistorted economy (most likely free trade) no longer remains optimal. In other words, policies that would reduce national welfare in the absence of distortions can now improve welfare when there are other distortions present.

This argument, then, begins by accepting that trade policies (protection) can be welfare improving. The problem with using trade policies, however, is that in most instances they are a second-best policy choice. In other words, there will likely be another policy—a domestic policy—that could improve national welfare at a lower cost than any trade policy. The domestic policy that dominates would be called a first-best policy. The general rule used to identify first-best policies is to use that policy that “most directly” attacks the market imperfection or distortion. It turns out that these are generally domestic production, consumption, or factor taxes or subsidies rather than trade policies. The only exceptions occur when a country is large in international markets or when trade goods affect the provision of a public good such as national security.

Thus the counterargument to selected protection based on the theory of the second best is that first-best rather than second-best policies should be chosen to correct market imperfections or distortions.

Since trade policies are generally second best while purely domestic policies are generally first best, governments should not use trade policies to correct market imperfections or distortions. Note that this argument does not contend that distortions or imperfections do not exist, nor does it assume that trade policies could not improve economic efficiency in their presence. Instead, the argument contends that governments should use the most efficient (least costly) method to reduce inefficiencies caused by the distortions or imperfections, and this is unlikely to be a trade policy.

Note that this counterargument to protection is also effective when the issue is income distribution. Recall that one reason countries may use trade policies is to achieve a more satisfying income distribution (or to avoid an unsatisfactory distribution). However, it is unlikely that trade policies would be the most effective method to eliminate the problem of an unsatisfactory income distribution. Instead, there will likely be a purely domestic policy that could improve income distribution more efficiently.

In the cases where a trade policy is first best, as when a country is large in international markets, this argument does not act as a counterargument to protection. However, retaliation remains a valid counterargument in many of these instances.

Information Deficiencies

The next counterargument 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, stimulate positive externality effects, or shift foreign profits to the domestic economy, 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 government’s decision-making 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 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 was relatively high. In the case of a strategic trade policy, the government would have to identify which industries are oligopolistic and exhibit the potential to shift foreign profits toward 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 case of an infant industry. 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 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 case of optimal tariffs, there would be a range of tariff levels that would raise national welfare above the level attained in free trade. A similar range of welfare-improving protection levels would also hold in all the other cases of selected protection.

However, there is one other informational constraint that is even ignored in most economic analyses 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 analyses incorporate one economic distortion into a model and then analyze 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 on 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 (i.e., it is 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 other products in consumption. Since the other industry’s 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 intermarket 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 that are interconnected through factor or goods market competition, then to determine the true optimal set of policies that would correct or reduce all the imperfections and distortions simultaneously would require the solution to a dynamic general equilibrium model that accurately describes the real economy not only today but also 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. This represents a serious blow to the case for government intervention in the form of trade policies. 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 counterargument against selected protection.

Political Economy Issues: The Problem with Democratic Processes

In democratic societies, government representatives and officials are meant to carry out the wishes of the general public. As a result, decisions by the government are influenced by the people they represent. Indeed, one of the reasons “free speech” is so important in democratic societies is to assure that individuals can make their attitudes toward government policies known without fear of reproach. Individuals must be free to inform the government of which policies they approve and of which they disapprove if the government is truly to be a representative of the people. The process by which individuals inform the government of their preferred policies is generally known as lobbying.

In a sense, one could argue that lobbying can help eliminate some of the informational deficiencies faced by governments. After all, much of the information the government needs to make optimal policies is likely to be better known by its constituent firms and consumers. Lobbying offers a process through which information can be passed from those directly involved in production and consumption activities to the officials who determine policies. However, this process may turn out to be more of a problem than a solution.

One of the results of trade theory is that the implementation of trade policies will likely affect income distribution. In other words, all trade policies will generate income benefits to some groups of individuals and income losses to other groups. Another outcome, though, is that the benefits of protection would likely be concentrated—that is, the benefits would accrue to a relatively small group. The losses from protection, however, would likely be dispersed among a large group of individuals.

This outcome was seen clearly in the partial equilibrium analysis of a tariff. When a tariff is implemented, the beneficiaries would be the import-competing firms, which would face less competition for their product, and the government, which collects tariff revenue. The losses would accrue to the thousands or millions of consumers of the product in the domestic economy.

For example, consider a tariff on textile imports being considered by the government of a small, perfectly competitive economy. Theory shows that the sum of the benefits to the government and the firms will be exceeded by the losses to consumers. In other words, national welfare would fall. Suppose the beneficiaries of protection are one hundred domestic textile firms that would each earn an additional $1 million in profit as a result of the tariff. Suppose the government would earn $50 million in additional tariff revenue. Thus the total benefits from the tariff would be $150 million. Suppose consumers as a group would lose $200 million, implying a net loss to the economy of $50 million. However, suppose there are one hundred million consumers of the products. That implies that each individual consumer would lose only $2.

Now, if the government bases its decision for protection on input from its constituents, then it is very likely that protection will be granted even though it is not in the nation’s best interest. The reason is that textile firms would have an enormous incentive to lobby government officials in support of the policy. If each firm expects an extra $1 million, it would make sense for the firms to hire a lobbying firm to help make their case before the government. The arguments to be used, of course, are (1) the industry will decline and be forced to lay off workers without protection, thus protection will create jobs; (2) the government will earn additional revenues that can be used for important social programs; and (3) the tax is on foreigners and is unlikely to affect domestic consumers (number 3 isn’t correct, of course, but the argument is often used anyway). Consumers, on the other hand, have very little individual incentive to oppose the tariff. Even writing a letter to your representative is unlikely to be worth the $2 potential gain. Plus, consumers would probably hear (if they hear anything at all) that the policy will create some jobs and may not affect the domestic price much anyway (after all, the tax is on foreigners).

The implication of this problem is that the lobbying process may not accurately relate to the government the relative costs and benefits that will arise due to the implementation of a trade policy. As a result, the government would likely implement policies that are in the special interests of those groups who stand to accrue the concentrated benefits from protection, even though the policy may generate net losses to the economy as a whole. Thus by maintaining a policy of free trade, an economy could avoid national efficiency losses that could arise with lobbying in a democratic system.