More econ homework. I’m not particularly fond of the text we are using in my courses. It’s Principles of Economics, by Harvard’s (and Mitt Romney’s) N. Gregory Mankiw. I have cast some minor vitriol on him a couple of times in these humble e-pages, but now I have to read his textbook, more or less in its entirety. As such, I’m pleased to be asked about my opinions of things in the book. To wit:
Do any of the arguments for restricting free trade mentioned in the book convince you? Which ones? Explain.
Discussion of trade in Principles of Economics, from principle #5 (of the “10 Principles” of chapter 1 [see below for those who haven’t had the pleasure of the 10 Principles]) to the “present” of Chapter 9, is framed in starkly binary terms, you either restrict trade or you have free trade. Such terms tell us how we should feel. We like freedom. We do not like restrictions…especially on freedom! Who wants to incur DEADWEIGHT LOSSES! It just sounds so awful. Yet why, then, do so many continue to dread this freedom? Can millions and millions of rational actors be wrong? Don’t they know what’s good for them?
If one values nothing beyond the lowest prices for raw materials and manufactured goods, it is easy to make a rock solid argument for totally unrestricted trade. However, looking beyond the areas of surplus in a supply and demand graph, many valid arguments against unfettered trade can be placed on the scales of consideration, opposite even a rather large triangle of the densest deadweight loss. To discuss just one such argument mentioned in the text (though I would happily make a case for numerous others), I bring you:
The Infant Industry Argument
The case for protecting less-developed domestic industries from their more mature counterparts in developed nations was first formulated in the early 19th century and the textbook’s “many economists” who are skeptical notwithstanding, a short list of economists and thinkers over the last 200 years who are not skeptical of this argument includes Alexander Hamilton (who first laid out the case in his 1790 Report on Manufactures), John Stuart Mill, Amartya Sen, Joseph Stiglitz, Ha-Joon Chang, Paul Krugman and many others. The straw man nature of the text’s explanation of this well-established concept seems an accurate reflection of the dimness of the author’s view of it.
Missing from the text entirely is the key element of the infant-industry argument: that the protection afforded to infant industries in developing economies has spillover learning effects for the economy as a whole. In other words, the protection of lower efficiency industries from more highly efficient competitors affords precious time for the improved implementation of technology, manufacturing logistics, personnel allocations, distribution networks and so on. These improvements will tend to disseminate through a domestic economy. Some basic improvement (think assembly lines or steam power or even simply improved record keeping and inventory systems) is readily spread to other industries in a domestic economy by the churn of employees, the involvement of outside suppliers and distributors, etc. The implementation of such improvements throughout an economy can lower the equilibrium price and raise the equilibrium quantity of thousands of goods over decades and beyond in exchange for the a higher price being held in place temporarily for a few key goods. These benefits are dynamic and diffuse in nature, and as such are harder to compare to static costs such as the deadweight loss measured by a supply and demand diagram.
After dispensing with the “pro” explanation for the infant-industry argument in two sentences, the author spends approximately seven times as much page space attacking it, but even this extended foray comes up short. Per Mankiw:
To apply protection successfully, the government would need to decide which industries will eventually be profitable and decide whether the benefits of establishing these industries exceed the costs of this protection to consumers. Yet “picking winners” is extraordinarily difficult.1
Still, in spite of such difficulties, we do it as a matter of course in virtually every interaction between the state and the private sector. Economics would seem to have many tools with which to measure such likelihoods and values to society. Indeed, one such test that has enjoyed some significant level of acceptance for nearly two centuries is the “Mill-Bastable test.”
In his famous statement supporting the case for infant industry protection, John Stuart Mill alluded to one of the main prerequisites for such industries: the presence of dynamic learning effects that are external to firms. Mill recognized that certain additional conditions must also be met in order to justify protection. He specifically mentioned that protection must be temporary and that the infant industry must then mature and become viable without protection. Subsequently, Charles Francis Bastable added another condition requiring that the cumulative net benefits provided by the protected industry exceed the cumulative costs of protection. Together, these conditions are known as the Mill–Bastable Test. The economics literature has subsequently developed formal models with dynamic learning externalities demonstrating how protection can potentially raise welfare.2 (my bold)
Even less convincing is the author’s next counterargument:
In addition, many economists are skeptical about the infant-industry argument in principle. Suppose, for instance, that an industry is young and unable to compete profitably against foreign rivals, but there is reason to believe that the industry can be profitable in the long run. In this case, firm owners should be willing to incur temporary losses to obtain the eventual profits. Protection is not necessary for an infant industry to grow. History shows that start-up firms often incur temporary losses and succeed in the long run, even without protection from competition.3
This paragraph is, prima facie, nonsense. Its undefended assertions include the weirdly final statement that “Protection is not necessary for an infant industry to grow” (why go on any further then?). Next, it posits that the generic firm in a developing nation possesses an unspecified (perhaps unlimited?) capacity to absorb losses, as well as some sort of omniscience on the part of the holders of this unspecified but massive amount of capital (“incur temporary losses” for how long? Six months? Ten Years?). In reality, many firms in developing countries have zero or extremely limited access to credit and work with small overall capital in comparison with exponentially larger firms operating at economies of scale in developed countries. Many firms in countries with access to strong credit markets cannot weather losses beyond a reasonably short term; many ostensibly solvent firms regularly seek very short term funding in the commercial paper market on extremely short time horizons (a condition dramatically highlighted by the intervention of the Federal Reserve in the seizing commercial paper market in 20084), so the idea that “if you really believe in your industry, you should just stick it out and eat the losses until you can compete” seems, charitably, a bit simplistic. Furthermore, if even underdeveloped firms are this resilient to adverse business conditions, why all the hubbub today about the “uncertain business climate” in the US and job-killing legislation, etc? The average super firm described above seems invincible, to believe the author.
In terms of implementation, a good case can be made that quotas are the best of the three ways to implement such protection. A few advantages of a quota, versus tariffs, include a better chance that consumers of goods will realize some surplus gain from a quota (as even a restricted amount of lower priced imports will typically put some downward pressure on domestic prices). Unlike a tariff, a quota does not generate revenue to the government, a quality that may make it easier to eventually end since it is not a net loss to government revenue at that time. Using quotas, unlike both subsidies and tariffs, a period adjustment and phase out can occur automatically, rather than with the required tinkering as to decreasing amounts and effective dates required with tariffs and subsidies.
To explain further, a quota (in the amount n) of lower priced products coming into a market will theoretically become the first n sales in the market. Domestic producers will have to begin to realize at least modest productivity or other gains to regain some initially lost market share. Even by the time they do this, overall surplus will have increased relative to a closed market. However, the first n sales will continue to be lost until domestic producers can manage to increase technology and productivity, and can achieve economies of scale allowing competition on price terms. The incentive will remain these additional consumers of the imports until the free trade equilibrium price is reached. As they approach this ability (to compete directly on price and quality), the quota will approach a horizon where it is no longer binding. Eventually, it can become irrelevant or as it approaches irrelevance, it can be ended with little resistance from now-developed industries with little to lose.
The Infant Industry Argument is more than just an argument though, it has been used over centuries among most successful industrial nations. Nations as diverse as Germany, the United States, Japan, Korea, Taiwan, Sweden and now currently China have all heeded Hamilton’s advice and have subsequently managed to create highly advanced national industries and advanced productivity capabilities and massive human capital by employing a strategy of numerous tariffs, quotas and subsidies aimed at protecting their infant industries.
One of the early proponents of this strategy was the German economist Friedrich List. In 1841 he made an apt comparison regarding Britain preaching free trade to Germany after it had become (through a long period of protectionism) the preeminent industrial power on the earth.
“It is a very common clever device that when anyone has attained the summit of greatness, he kicks away the ladder by which he has climbed up, in order to deprive others of the means of climbing up after him. In this lies the secret of the cosmopolitical doctrine of Adam Smith, and of the cosmopolitical tendencies of his great contemporary William Pitt, and of all his successors in the British Government administrations.5
The US and many other countries would do well to consider this metaphor in our current age of free trade fervor. There are many kinds of welfare beyond the crude measures of consumer and producer surplus and striking and protecting a balance between efficiency and equality in the economy of a sovereign nation is a complex matter, one which defies the simple dictates of the supply and demand model (talking parrots notwithstanding)*.
* anyone needing clarification on this little chestnut, do a web search on “parrot supply demand economist”)
1 N. Gregory Mankiw, Principles of Economics (Mason, OH: South-Western Cengage Learning, 2009), 185.
3 Mankiw, Principles of Economics, 186.