Chapter 11 Evaluating the Controversy between Free Trade and Protectionism

11.1 Introduction

For hundreds of years, at least since Adam Smith’s publication of The Wealth of Nations, the majority of economists have been strong supporters of free trade among nations. Paul Krugman once wrote that if there were an economist’s creed, it would surely contain the affirmation, “I advocate free trade.”See Paul Krugman, “Is Free Trade Passe?” Journal of Economic Perspectives 1, no. 2 (1987): 131–44.

The original arguments for free trade began to supplant mercantilist views in the early to mid-eighteenth century. Many of these original ideas were based on simple exchange or production models that suggested that free trade would be in everyone’s best interests and surely in the national interest. During the nineteenth and twentieth centuries, however, a series of objections were raised suggesting that free trade was not in everyone’s interest and perhaps was not even in the national interest. The most prominent of these arguments included the infant industry argument, the terms of trade argument, arguments concerning income redistribution, and more recently, strategic trade policy arguments. Although each of these arguments might be thought of as weakening the case for free trade, instead, each argument brought forth a series of counterarguments that have acted to reassert the position of free trade as a favored policy despite these objections. The most important of these counterarguments include the potential for retaliation, the theory of the second best, the likelihood of incomplete or imperfect information, and the presence of lobbying in a democratic system.

What remains today is a modern, sophisticated argument in support of free trade among nations. It is an argument that recognizes that there are numerous exceptions to the notion that free trade is in everyone’s best interests. The modern case for free trade does not contend, however, that these exceptions are invalid or illogical. Rather, it argues that each exception supporting government intervention in the form of a trade policy brings with it additional implementation problems that are likely to make the policy impractical.

Before presenting the modern argument, however, it is worth deflecting some of the criticisms that are sometimes leveled against the economic theory of free trade. For example, the modern argument for free trade is not based on a simplistic view that everyone benefits from free trade. Indeed, trade theory, and experience in the real world, teaches us that free trade, or trade liberalization, is likely to generate losers as well as winners.

The modern argument for free trade is not based on unrealistic assumptions that lead to unrealistic conclusions. Although it is true that many assumptions contained within any given trade model do not accurately reflect many realistic features of the world, the modern argument for free trade is not based on the results from any one model. Instead, the argument is based on a collection of results from numerous trade models, which are interpreted in reference to realistic situations. If one considers the collection of all trade models jointly, it is much more difficult to contend that they miss realistic features of the world. Trade theory (as a collection of models) does consider imperfectly competitive markets, dynamic effects of trade, externalities in production and consumption, imperfect information, joint production, and many other realistic features. Although many of these features are absent in any one model, they are not absent from the joint collection of models, and it is this “extended model” that establishes the argument for free trade.Ideally, we would create a supermodel of the world economy that simultaneously incorporates all realistic features of the world and avoids what are often called “simplifying assumptions.” Unfortunately, this is not a realistic possibility. As anyone who has studied models of the economy knows, even models that are very simple in structure can be extremely difficult to comprehend, much less solve. As a result, we are forced to “interpret” the results of simple models as we apply them to the complex real world.

11.2 Economic Efficiency Effects of Free Trade

The main source of support for free trade lies in the positive production and consumption efficiency effects. In every model of trade, there is an improvement in aggregate production and consumption efficiency when an economy moves from autarky to free trade. This is equivalent to saying that there is an increase in national welfare. This result was demonstrated in the Ricardian model, the immobile factor model, the specific factor model, the Heckscher-Ohlin model, the simple economies-of-scale model, and the monopolistic competition model. The result can also be shown if there are differences in demand between countries. Each of these models shows that a country is likely to have greater national output and superior choices available in consumption as a result of free trade.

11.3 Free Trade and the Distribution of Income

A valid criticism of the case for free trade involves the issue of income distribution. Although most trade models suggest that aggregate economic efficiency is raised with free trade, these same models do not indicate that every individual in the economy will share in the benefits. Indeed, most trade models demonstrate that movements to free trade will cause a redistribution of income between individuals within the economy. In other words, some individuals will gain from free trade while others will lose. This was seen in the immobile factor model, the specific factor model, the Heckscher-Ohlin model, and the partial equilibrium analysis of trade liberalization.

There have been two general responses by economists concerning the income distribution issue. Some have argued that the objective of economics is solely to determine the most efficient policy choices. Introductory textbooks often suggest that the objective of the economics discipline is to determine how to allocate scarce resources toward production and consumption. Economists describe an allocation as “optimal” when it achieves the maximum level of aggregate economic efficiency. Put in these terms, economic analysis is “positive” in nature. Positive economics refers to studies that seek to answer questions pertaining to how things work in the economy and the subsequent effects. Positive economic analysis does not intend to explain what “should” be done. Issues pertaining to income distribution are commonly thought of as “normative” in nature, in that the concern is often over what the distribution “should” be. If we apply this reasoning to international trade, then, issues such as the appropriate income distribution are beyond the boundaries of the discipline and should be left to policymakers, government officials, or perhaps philosophers to determine.

Perhaps a more common response by economists concerning the income distribution issue is to invoke the compensation principle. A substantial amount of work by economists has been done to show that because free trade causes an increase in economic efficiency, it is generally possible to redistribute income from the winners to the losers such that, in the end, every individual gains from trade. The basic reason this is possible is that because of the improvement in aggregate efficiency, the sum of the gains to the winners exceeds the sum of the losses to the losers. This implies that it is theoretically possible for the potential winners from free trade to bribe the losers and leave everyone better off as a result of free trade. This allows economists to argue that free trade, coupled with an appropriate compensation package, is preferable to some degree of protectionism.

One major practical problem with compensation, however, is the difficulty of implementing a workable compensation package. In order to achieve complete compensation, one must be able to identify not only who the likely winners and losers will be but also how much they will win and lose and when in time the gains and losses will accrue. Although this is relatively simple to do in the context of a single trade model, such as the Heckscher-Ohlin model, it would be virtually impossible to do in practice given the complexity of the real world. The real world consists of tens of thousands of different industries producing millions of products using thousands of different factors of production. The sources of trade are manifold, including differences in technology, endowments, and demands, as well as the presence of economies of scale. Each source of trade, in turn, stimulates a different pattern of income redistribution when trade liberalization occurs. In addition, the pattern of redistribution over time is likely to be affected by the degree of mobility of factors between industries as the adjustment to free trade occurs. This was seen in the context of simple trade models, from the immobile factor model to the specific factor model to the Heckscher-Ohlin model.

Even in the context of simple trade models, a workable compensation mechanism is difficult to specify. An obvious solution would seem to be for the government to use taxes and subsidies to facilitate compensation. For example, the government could place taxes on those who would gain from free trade (or trade liberalization) and provide subsidies to those who would lose. However, if this were implemented in the context of many trade models, then the taxes and subsidies would change the production and consumption choices made in the economy and would act to reduce or eliminate the efficiency gains from free trade. The government taxes and subsidies, in this case, represent a policy-imposed distortion that, by itself, reduces aggregate economic efficiency. If the compensation package reduces efficiency more than the movement to free trade enhances efficiency, then it is possible for the nation to be worse off in free trade when combined with a tax/subsidy redistribution scheme.Dixit and Norman (1980) showed that under some conditions it is possible to specify a tax and subsidy policy that would guarantee an increase in aggregate economic efficiency with free trade. See A. Dixit and V. Norman, Theory of International Trade: A Dual General Equilibrium Approach (Cambridge: Cambridge University Press, 1980). The simple way to eliminate this problem, conceptually, is to suggest that the redistribution take place as a “lump-sum” redistribution. A lump-sum redistributionA redistribution of income that takes place after the free trade equilibrium is reached—that is, after all production and consumption decisions are made but before the actual consumption takes place. is one that takes place after the free trade equilibrium is reached—that is, after all production and consumption decisions are made but before the actual consumption takes place. Then, as if in the middle of the night when all are asleep, goods are taken away from those who have gained from free trade and left at the doors of those who had lost. Lump-sum redistributions are analogous to Robin Hood stealing from the rich and giving to the poor. As long as this redistribution takes place after the consumption choices have been made and without anyone expecting a redistribution to occur, then the aggregate efficiency improvements from free trade are still realized. Of course, although lump-sum redistributions are a clever conceptual or theoretical way to “have your cake and eat it too,” it is not practical or workable in the real world.

This implies that although compensation can solve the problem of income redistribution at the theoretical level, it is unlikely that it will ever solve the problem in the real world. Although some of the major gains and losses from free trade may be identifiable and quantifiable, it is unlikely that analysts would ever be able to identify all who would gain and lose in order to provide compensation and assure that everyone benefits. This means that free trade is extremely likely to cause uncompensated losses to some individuals in the economy. To the extent that these individuals expect these losses and can measure their expected value (accurately or not), then there will also likely be continued resistance to free trade and trade liberalization. This resistance is perfectly valid. After all, trade liberalization involves a government action that will cause injury to some individuals for which they do not expect to be adequately compensated. Furthermore, the economic efficiency argument will not go very far to appease these groups. Would you accept the argument that your expected losses are justifiable because others will gain more than you lose?

One final argument concerning the compensation issue is that compensation to the losers may not even be justifiable. This argument begins by noting that those who would lose from free trade are the same groups who had gained from protectionism. Past protectionist actions represent the implementation of government policies that had generated benefits to certain selected groups in the economy. When trade liberalization occurs, then, rather than suggesting that some individuals lose, perhaps it is more accurate to argue that the special benefits are being eliminated for those groups. On the other hand, those groups that benefit from free trade are the same ones that had suffered losses under the previous regime of protectionism. Thus their gains from trade can be interpreted as the elimination of previous losses. Furthermore, since the previous protectionist actions were likely to have been long lasting, one could even argue that the losers from protection (who would gain from free trade) deserve to be compensated for the sum total of their past losses. This would imply that upon moving to free trade, a redistribution ought to be made not from the winners in trade to the losers but from the losers in trade to the winners. Only in this way could one make up for the transgressions of the past. As before, though, identifying who lost and who gained and by how much would be virtually impossible to achieve, thus making this compensation scheme equally unworkable.

11.4 The Case for Selected Protection

An argument for selected protectionA trade policy that is appropriately selected so as to raise national welfare in a market containing market imperfections or distortions. arises in the presence of imperfectly competitive markets, market distortions, or both. 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. Numerous examples found in the trade literature 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 assume that markets are perfectly competitive and implicitly assume there are no market distortions.

This general criticism of the standard case for free trade 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, and 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 that 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 voluntary export restraint (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 greater 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 that, 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 the gross domestic product (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 spill over 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, 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 that 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 a 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 that 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 are greater 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 the pollution reduction outweigh the costs of the export tax, domestic national welfare may rise.

If certain domestically produced high-technology goods could wind up in the hands of countries that 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 reduces or eliminates 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 from these examples that a compelling case can certainly be made in support of selected protectionism. Indeed, Paul Krugman (1987) wrote that “the case for free trade is currently more in doubt than at any time since the 1817 publication of [David] Ricardo’s Principles of Political Economy.”See Paul Krugman, “Is Free Trade Passe?” Journal of Economic Perspectives 1, no. 2 (1987): 131–44. Many of the arguments showing the potential for welfare-improving trade policies described above 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)See Friedrich List, The National System of Political Economy, McMaster University Archive for the History of Economic Thought, http://socserv2.socsci.mcmaster.ca:80/~econ/ugcm/3ll3/list/index.html. and John Stuart Mill in his Principles of Political Economy (1848).See John Stuart Mill, Principles of Political Economy, McMaster University Archive for the History of Economic Thought, http://socserv2.socsci.mcmaster.ca:80/~econ/ugcm/3ll3/mill/index.html. The terms of trade argument was established by Robert Torrens in 1844 in The Budget: On Commercial and Colonial Policy.See Robert Torrens, The Budget: On Commercial and Colonial Policy (London: Smith, Elder, 1844). Frank Graham, in his 1923 article “Some Aspects of Protection Further Considered,” noted the possibility that free trade would reduce welfare if there were variable returns to scale in production.See Frank Graham, “Some Aspects of Protection Further Considered,” The Quarterly Journal of Economics 37, no. 2 (February 1923): 199–227. During the 1950s and 1960s, 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 are some of the more recent formalizations 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 counterarguments were also developed.

11.5 The Economic Case against Selected Protection

The economic case against selected protectionism does not argue that the reasons for protection are conceptually or theoretically invalid. Indeed, there is general acceptance among economists that free trade is probably not the best policy in terms of maximizing economic efficiency in the real world. Instead, the counterarguments to selected protectionism are based on four broad themes: (1) potential reactions by others in response to one country’s protection, (2) the likely presence of superior policies to raise economic efficiency relative to a trade policy, (3) information deficiencies that can inhibit the implementation of appropriate policies, and (4) problems associated with lobbying within democratic political systems. We shall consider each of these issues in turn.

11.6 Free Trade as the “Pragmatically Optimal” Policy Choice

In summary, the economic argument in support of free trade is a sophisticated argument that is based on the interpretation of results from the full collection of trade theories developed over the past two or three centuries. These theories, taken as a group, do not show that free trade is the best policy for every individual in all situations. Instead, the theories show that there are valid arguments supporting both free trade and protectionism. To choose between the two requires a careful assessment of the pros and cons of each policy regime.

The argument for free trade presented here accepts the notion that free trade may not always be optimal in terms of maximizing economic efficiency. The argument also accepts that free trade may not generate the most preferred distribution of income. In theory, there are numerous cases in which selected protectionism can improve aggregate welfare or could establish a more equal distribution of income. Nevertheless, despite these theoretical possibilities, it remains unclear and perhaps unlikely that selected protectionism could achieve the intended results. First, in many instances, a trade policy is not the best way to achieve the intended improvement in economic efficiency, nor is it likely to be the most efficient way to achieve a more satisfactory distribution of income. Instead, purely domestic tax and subsidy policies dominate. Second, even when a trade policy is the best policy choice, the possibility of retaliations and the likelihood of informational deficiencies or distortions caused by the lobbying process are sufficiently large as to make the intended outcomes unknowable.

In addition, the process of information collection, lobbying, and policy implementation is a costly economic activity. Labor and capital resources are allocated by interest groups attempting to affect policies favorable to them. The government also must expend resources to gather information, to implement and administer policies, and to monitor the effectiveness of these policies. In the United States, the following agencies and groups devote at least some of their time to trade policy implementation: the Office of the United States Trade Representative, the International Trade Commission, the Department of Commerce, the Federal Trade Commission, the Department of Justice, the Congress, and the president, among others. One must wonder whether the cost of this bureaucracy, together with the cost to the private sector to influence the decisions of the government, is worth it, especially when the outcomes are virtually unknowable.

Thus the conclusion reached by many economists is that while free trade may not be “technically optimal,” it remains “pragmatically optimal.” That is, given our informational deficiencies and the other problems inherent in any system of selected protectionism, free trade remains the policy most likely to produce the highest level of economic efficiency attainable.