Unit 3: The Case for Protection

Part 3: The Theory of Protectionism: Tariffs and Quotas

Protection essentially takes one of three forms: tariffs, quotas, and non-tariff barriers. Tariffs are taxes levied on a commodity crossing an international border. Quotas are restrictions on the number of a certain good that can be imported. Non-tariff barriers include all kinds of subsidies and regulatory protection that doesn’t count as either a tariff or a quota.

The basic motive for using tariffs is twofold: to protect domestic industry from import competition and to generate revenues for the government. For developing nations—such as China—tariffs afford developing “infant” industries the protection they need to mature. Moreover, tariffs are an important source of revenue for such countries—as they were for the United States until the early part of the 20th century—since, even if developing countries have income taxes in place (and can collect them), incomes are frequently not high enough to sustain government operations necessary for increasing economic growth. While tariffs are more likely to be about revenue and fostering newly developed industries in the developing world, for developed nations the argument for their use rests squarely on jobs.

The effects within a given industry of a tariff include higher prices, more domestic production, fewer imports, tax revenue, and market inefficiencies because of the increase in higher cost domestic production and loss of consumer purchases caused by the higher market price. For example, consider the following economic market analysis:

 

VIDEO: The Revenue and Protective Effects of Tariffs

 

When tariffs are levied against foreign imports, domestic production and prices rise, imports decline, and the government increases tax revenue.

In the absence of any trade with the rest of the world, this market would be in equilibrium where the supply of the product produced by US firms equals the demand for the product by US consumers – at a price of 10 and a quantity of 22. According to economic theory, this would be an efficient outcome because at $10 there are 22 buyers paying less than they are willing to pay (based on their demand curve) and 22 sellers being paid more than they are willing to accept (based on their supply curve). In other words, each of these 22 market transactions is transferring a product from someone who places a lower value on the product (the seller) to someone who places a higher value on the product (the buyer). And this is the fundamental argument in favor of market systems.

Now, let’s consider what would happen in this market if the rest of the world, which could profitably sell this product for $5, were permitted into the US. Facing competition, domestic producers would be forced to lower their price to $5, making them only willing to sell 10 units and causing job losses. On the other hand, at a price of $5, there are 34 buyers who would willingly pay at least that, so they buy the 10 units domestic producers are willing to make and import the remaining 24. Theoretically, this outcome is more efficient than a market without trade for two reasons: First, at a lower price, there are more market transactions—which are beneficial to consumers—and second, the higher cost domestic production, which would have only been produced and sold at prices above $5 (units 10–22) are now replaced by lower cost—more efficiently produced—imports.

Indeed, free trade by almost any empirical account, is more efficient than no trade, and on average benefits consumers more that it harms producers. But the distribution of trade effects are very skewed: millions of consumers pay lower prices—and this adds up to a lot—but some workers lose their jobs. So while it is reasonable to favor trade on the grounds that the gains are bigger than the costs, neither can one ignore the devastating impact it has on an unfortunate few.

Now let’s suppose that lobbying efforts by the workers and the domestic industry that is hurt from free trade are successful, and the government imposes a $3 per unit tariff on the import competition. In order to recover the cost of the paying the tariff, the rest of the world is forced to raise their price to $8 ($5 free trade price + $3 tariff = $8). This higher price has two main effects:

Additionally, the government collects $36 in revenue from the tariff since each consumer is paying $3 more for each of the 12 units imported (28 demanded – 16 domestically supplied = 12 units imported). In the end analysis, whether protectionism is good or bad for you is really a matter of where you stand, realizing, of course, that on average the total costs to consumers almost always outweighs the total benefits to the workers and industry being protected.

 

VIDEO: Supply and Demand Analysis of Protectionism

 

And finally, outside of the industry receiving protectionism, tariffs have other, secondary effects which must also be considered. For example, fewer imports means fewer dollars in the hands of foreigners that can be used to buy home country exports. Tariffs on imports (such as steel or parts assemblies for cars, etc.) increase domestic production costs. In general, they also raise the cost of living, and they have a dampening effect on foreign GDP—which will tamp down their demand for goods of all kinds, including exports from the home country. For example, it is estimated that the steel tariffs mentioned above cost far more Americans their jobs in industries which relied on steel as an import than steel workers jobs were saved.

 

VIDEO: Non-industry Effects of Protectionism clip 1

 

VIDEO: Non-industry Effects of Protectionism clip 2

 

It’s important to keep in mind the general context in which the debate about tariffs takes place. The claim that imports cost jobs looks self-evidently true on the face of it, and so looks like a good case for tariffs. However, empirical evidence clearly suggests that relatively few jobs in the US economy as a whole are lost due to import competition. In a recent speech, Ben Bernanke, a member of the Board of Governors of the Federal Reserve, quoted an estimate that suggested that about 2% of total American job loss per year was due to trade. Moreover, tariffs often temporarily put off a day of reckoning that an inefficient industry ought to have faced long ago. Concern for displaced workers, in other words, need not lead to advocacy of tariffs.

WEBLINK: Ben Bernanke

Quotas

As mentioned above, quotas are limits on the quantity of a good that can be imported into a given country. In a static sense, quotas and tariffs have similar effects, except that tariffs provide tax revenue while quotas put more money per unit in the pocket of the foreign manufacturer. Both raise price, lower imports, help domestic producers at the expense of consumers, and cause market inefficiencies. Dynamically, however, quotas can be even more protectionist than tariffs—explaining why domestic industry favors them and the WTO rejects them. For example, if domestic demand goes up when a quota is in place, then the production gap has to be made up by domestic producers, which means even higher prices for consumers (and more profits for domestic producers). On the other hand, if a tariff is in place, then extra production can be provided through additional imports, which usually means that price goes up less quickly than with a quota in place.

 

VIDEO: Quotas Versus Tariffs

 

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