FEDERAL RESERVE BANK OF ST. LOUtS JANUARY/FEBRUARY 1988

Protectionist Trade Policies: ASurvey of Theory, Evidence andRationaleCletus C. Coughlin, K. Alec Chrystal and Geoffrey E. Wood

ROTECTIONIST pm-essures have been mountingwon-idwide during the 1980s. These pn-essmmres are dueto various economic problems incltnding the lam-ge andpersistent balance of tn’ade deficits in the UnitedStates; the har’d times expenienced by seven-al indus-

tries; and tire show growth of many foreign countn-ies.’Pn-oponents of protectionist trade policies amgue thatinternational trade has contributed substantially tothese problems and that protectionist tmade policieswill head to improved n’esults. Professional economistsin the United States, however-, generally agree thattmade restn-ictions such as tariffs and quotas substan-tially reduce a nation’s economic well~being.2

This article surveys the theory, evidence and na-tionale concen-ning protectionist trade policies. Thefirst section illustrates the gains from fm-ce tn-ade usingthe concept of compan-ative advantage. Recent dem’el-opments in international trade theorm’ that emphasizeother reasons for- gains from trade are also reviewed.The theoretical discussion is followed hiy an exami-nation of recent empirical studies that demonstm-atethe large costs of protectionist trade policies. Then,the rationale for restricting trade is presented. Theconcluding section summarizes the paper’s mainarguments.

Cletus C. Coughlin is a senior economist at the Federal Reserve Bankof St Louis. K. Alec Chnystal is the National Westminster Bank Profes-sor ofPersonal Finance at City University, London. Geoffrey E Woodisa professor of economics at City University, London. This article waswritten while Chrystal was a professor ofeconomics at the University ofSheffield, Sheffield, England. Thomas A. Pollmann provided researchassistance.‘See Page (1987) for a detailed examination of trade protectionismsince 1974.

2 This consensus was found in a survey published in the late 1970s(Keart et at., 1979). Recent developments in international tradetheory, which can be used to justify governmental intervention intrade policy, have not altered the consensus (Krugman, 1987).

THE GAINS FRONt FREE TRADE

The most famous demonstration of the gains fn-omtnade appear-ed in 1817 in David Ricardo’s Principles ofPolitical Economy and Ta,vation. We use his exampleinm’olm’ing tn-ade between England and Portugal to dem—onstnate how both countries can gain fn-om tnade.. Thetwo countnies pn-oduce the same two goods, wine andcloth, and the only pn-oduction costs an’e labor- costs.

The figures below list the amount of lahior leg..won-ker-daysi requin-ed in each country to pn-oduce onebottle (if wnne on-one hiolt of cloth.

EnglandPortugal

Wine

31

Cloth

Since both goods ar-c tiione costly to produce in En-gland than in Por-tugal, England is ahisolmrtely lessefficient at producinig both goods than its prospective

trading partner. Portugal has an absolute advantage inhioth wine and cloth. At fin-st glance, this appear-s tor-ule. (iut mutual gains fn-om trade; howem’e,n-, as wedemonstrate below, absolute advantage is irrelevant indiscerniing whether tn’ade can hienefit both countn-ies.

The natio of the pr-oductioni costs fon’ the two goodsis diffen’ent in the two countries. hn England. a bottle (ifwine will exchange for 3/7 of abolt (if cloth becamnse thelabor content of the wine is 3/7 of that for (:10th. In

Por’tmtgal, a bottle of winie ivill exchanige for 1/5 of a boltof cloth. Thus, wine is relatively cheaper in Portugalthan in Englanid and, conm’ersels’, cirith is relativehs’cheaper in England than in Portmngal. ‘the exampleindicates that Pom-tugal has a compam-atim’e adm’amitage inmvimie pr-oduction and England has a comiipar’ative ad-vantage in cloth pn’ocluction.

The different relative pm-ices provide the basis fom

FEDERAL RESERVE SANK OF ST. LOUIS JANUARVIFEBRUARY lies

both countries to gain fn-omn iriternational tr’ade. Thegains arise from both exchange and specialization.

The gains from exchange can be highlighted in thefollowing manner. If a Portn.mguese wine producer sellsfive bottles of wine at home, he receives one bolt of

cloth. If he trades in England, he receives more thantwo bolts of cloth. Hence, he can gain by expon-ting hismvine to England. English cloth-pn-oducen-s are willingto trade in Portugal; for em’eny 3/7 of a bolt of cloth thesell there, they get just (iven’ twri bottles of wine. TheEnglish gain from exporting cloth to land impontingwine fn-omi Por-tugal, and the Portuguese gain fromexpon-tingwine to land importing cloth fromi England.Each country gains by expon-tinig the good in which ithas a compan-ative advantage and by impon-ting thegood in which it has a compam-ative disadm’antage.

Gains fn-om specialization can be denionstrated inthe follomming manner. tnitially, eachi country is pto-ducing some of both goods. Suppose that, as an-esutt oftr-ade, 21 units of labor are shifted fnom mvine to clothpnoduction in England, while, in Portugal, 10 units oflabor- are shifted from cloth to wine production. ‘l’hisreallocation of labor- does not altet- the total amount oflabor’ used in the two countn-ies; howeven-, it causes thepn-oduction changes listed below.

Bottles of Wine Bolts of Cloth

—7 ±3

The shift of 21 rnnits of labor to the English cloth

industr raises cloth production by three bolts, whilereducing wine production by seven biotttes. In Pomtrn-

gal, the shift (if 10 units of labor from cloth to wineraises winie pm’oduction liv 10 bottles, while n-educingcloth pm-oduction by two liolts. This reallocation niflabor imicreases the total pnoduction of Iiothi goodswine by thn-ee bottles and cloth hiy one bolt. This

increased output will be shared Iiy the two countries.Thus, the consumption of liothi goods and the wealthof both countries an’e incn-eased by the specializa—tion bm-ought about by trade based on compar-ativeadvantage.

TRADE THEORY SINCE HICARDO

Since 1817, numerous analyses have gener-ated in-sights concerning the gains from tmade, ‘l’hiey chieflyexamine the consequences rif relaxing the assump-tions used in the pn-eceding example. For example,

labor was the only resource used to produce the twogoods in the example above; yet, labor is really onlyone of many resources used to prodmnce goods. Theexample also assumed that the costs of producingadditional units of the goods ar-c constant. For exam-ple, in England, three units of labor an-c used to pro-duce one bottle of wine regardless of the level of winepn-oduction. In reality, unit production costs couldeither increase or- decrease as more is produced. Athim-d assumption was that the goods an-c produced inper-fectlv competitive mat-kets. tn other- won-ds, an indi-vidual firm has no effect on the price of the good that itpn’oduces. Some industries, however-, are dominatedby a small numhier of firms, each of which can affectthe manket pr-ice of the good iw altering its productiondecision. Sonic of these extensions at-c discnnssed inthe appendix.

These theoretical developnients genem-atly havestrengthened the case for an open rn-ading system.They suggest thn-ee soun-ces of gains fi-om trade. First,as the market potentially served by firms expandsfrom a national to a world market, then-c are gainsassociated with declining per’ unit pnoduction costs. Asecond sour-ce of gains results fn-om the reduction inthe monopoly power- of domestic firms. Domesticfirms, facing more pressure from fon-eign competitors,are forced to produce the (iutput demanded by con-sumers at the lowest possible cost”l’hird is the gain toconsumers from increased product variety and lomverprices. Generally speaking, the gains fiomn tm-ade r-esultfrom the increase in competitive pressures as thedomestic economy becomes less insulated from theworld economy.

The gains fm’oni free trade can also he illustratedgt-aphicallv. The shaded insert on pages 14 and 15examines the gains fiom tt’ade in pemfectly competitim’emar’kets using supply and demand analysis. The in-sert also analyzes the effects of tn-ade n-estn-ictions, atopic that we discuss below.

COSTS OF ‘TRADE PROTECTIONISM

Protectionist trade policies can take numen’ousforms, some of which are discussed in the shadedinsert on pages 16 amid 17. All forriis of lirotectioni an-e

‘A profit-maximizing firm produces its output at minimum cost. Whenfirms are insulated from competition, costs are not necessarily beingminimized. This situation, which is catted X-etficiency, has beenstressed by Leibenstein (1980). The increase in competitive pres-sures due to international trade reduces the probability that costsare not minimized.

EnglandPortugal ±10

Net ±3

—9

±1

A Supply and Demand Analysis of the Gains from FreeTrade and the Effects of a rliarjff

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FEDERAL RESERVE SANK OF ST. LOUIS JANUARYIFEBRUARY ION

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Then-c have lieeni numerous studies of the costs ofpr’otectionism. We begin by examining three recent

studies of pm-otectioriism in the United States, thenThe specific goal of protectionist tn-ade policies is to proceed to studies examining developed and finally,

expand domestic pn-oductioni in the protected indus— developing countries.ti-ies, benefiting the owners, workers and suppliers ofr-esour-ces to the protected industry. The goven’nment Costs qfProtectionism in the Cratedimposing pr-otectioniist trade policies may also benefit, Statesfor example, in the form of tan’iff revenue.

- - - . Recent studies by Tan and Morkre 119841, t-lickok1 he expansiomi of doniestic pn-odnnctnon mni pr’otected — - - -

- - - . - - - 1985) and Huliuauer et al. 11986) esttmated the costs ofnndusti its is not costless it n quit is tddntnonal

pi otcctnotusni in tin Unitc d St ntis I lit s studn s uscsources from other itidustrres. Consequently, output - . - - - -.

- - . - - , , . different estnmatnoni procedun’es, examine diffem-entiii other domestic industm-ies is i-educed. these nndus— - .. - -

- - - . . protectnonnst policies arid cover dnfferent tnriie periods.trres also might be made less competrtnve hecanise ot - -Norn thiclcss thcv ptovnde consnstenit mesultshigher pt-ices for imported inputs. Since protectionist

tr-ade policies frequently incr-ease the price of the Tair and Mork,-e 11984) estimate annual costs to theprotected good, domestic consumers are liar-med. U.S. economy of 812.7 billion 1983 dollars) from all tan—l’hey lose in two ways. I-inst. their consuniption of the ifs and from quotas on automobiles, textiles, steel andpr-otected good is n-educed because of the, associated sugar-. Their cost estinuate is a net measur-e in whichrise in its price. Second, they consume less of other the losses of consumers are offset partially by the gainsgoods, as their output declines and pm-ices r-ise. of domestic producer’s and the U.S. gover’nment.

The preceding discussion highlights the domestic Estimates liv thickok 1985) indicate that tr-ade rt~—

winniers and losers due to pnotectionist trade policies. strictions on only three goods —— clothing, sugam-, andDomestic produrcers of the liiotected good and the automobiles caused increased consumer expenidi—government if tariffs an-c imposed) gain; domestic con- tunes of $14 billion in 1984. I-Iickok also shows that low—somers and otliei cloniestic pn’oducem-s lose. F’on-eigni income families am-c affected mom-c than high—incomeinterests an-c also affected by tr’ade resti-ictions. The fànnilies. The impor’t r’estm’aints on clothing, sugar andpn’otection of doniestic pn-oducers will harm some automobiles are calculated to be equivalent to a 23

for’eigni pm’oducers; oddly emiourgbi, other for’eign pmt— percent income tax sun-char’ge that is, an additional

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FEDERAL RESERVE BANK OF ST. LOUIS JANUARY/FEBRUARY ION

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mm m,tnm’I,ti inicb_t—Em—m is hi-imig strinsidi-,c-iI hm iii- rent ni esnhanngm’ rzntt’ tund him-mt—in - wiLt— ticnrnmn-sth- pmmn~timtpt,nmimjrnnm cttnt’mns in’s— ,‘trmnm1),’Iitimi

tax added to the normal income tax) for families withincomes less than $10,000 in 1984 and a 3 percentincome tax sin-charge fom families with incomes cx-ceeding $60,000.

Hufbauer et al. 11986) examined 31 cases in whichtrade volumes exceeded $100 million arid the UnitedStates imposed protectionist trade restrictions.4 Theygenerated estimates of the welfare consequences foreach major- group afected see table 1). The figures inthe table indicate that annual consumer losses exceed$100 million in all hut six of the cases. The largestlosses, $27 billion pen- year-, come fnom protecting thetextiles and apparel industry. There also ane lan-ge

~Whilethere were cases in which the industry adjusted to its newcompetitive position and the protection was terminated, these caseswere more the exception than the rule. In far more cases, protection-isi policies were maintained indefinitely or removed because offavorable demand changes.

consumet losses associated with protection in car-honsteel $6.8 billion), automobiles $5.8 billion) and dairyproducts $5.5 billion).

The purpose of pr-otectionism is to IJm’otect jobs in

specific industries. A useful approach to gain somepenspective on consumer- losses is to express theselosses on a per-job-saved basis. In 18 of the 31 cases,

the cost per-job-saved is $100,000 or more pen-year-; theconsumer losses per-job-saved in benzenoid chemni-cais, carbon steel )two separate periodsL specialtysteel, and bolts, nuts and screws exceeded $500,000per year.

Table I also neveals that domestic producers werethe primary beneficiaries of protectionist policies;however, there are some noteworthy cases where fom~eign producers realized relatively lam-ge gains. For theUS-Japanese voluntary export agn-eenient in automo-biles, foreign producers gained 38 percent of whatdomestic consumers lost, while a similar computation

FECfRAL RESERVE BANK OFsr. LOWS JANUARY/FEBRUARY lOSS

Table 1Distribution of Costs and Benefits from Special Protection

Producer- consumer Losses Gains eltare costs of Restraints

Gamn to Tariff EfficiencyTotals Per job Totals foreigners revenue loss(million saved’ (million (million (million (mmIlion

case dollars) (dollars) dollars) dollars) dollars) dollars)Murutaciun mg

St-OK r-na’naoclmnra S 500 5 ~00 000 S KTh n--c S 0 5 29Benzpr-ond clrernca~ 2 650 fl? 1 2 2h0 ceo 252 14

“:n-tnt:.rl

200 2Lno 000 1-30 meg 54 13Rr,Lbe- tr,otwoa. 230 30 000 90 rreg 139 33sc-am--; am:nrjen 9u 47.500 25 --cg 69 6£erarm;clc-s 116 135000 oP ~ 55 11Orarnge u-ce 525 240 oco 39O neq ‘29 150Gannenlnna 9~ 7~.00Q 74 5 10 4lax’nlr-s ond apoa’e Phase; 9.400 22 njOO 6700 ico 1 ‘56 lOUlexlnles ond appa’sl Phase ml 20 000 37000 8000 350 2’43 3 100Texmnies and Hpnarci Phase UI oT 000 42000 22000 1 800 2.535 4850Gareo-~steel- Pt-aspi 1.970 240.000 1 330 330 290 50carbon steel rb-,~etn 4 3’0 62000(3 2 /70 940 a56 120Carbon steel Phase lit 6 $00 750 000 ‘3 800 2.000 560 33crBail 004nnnus 43 90000 21 neq 18 -ccSnou only slee- 520 1 000 Xc cc so 32 30Nr-nwbner trMnwea’ 700 55 000 250 220 lbColor leiev-snom-s 420 420 000 190 140 77 7~B aoo; 55 93.000 n4 nt-a 32 3Bolts -Us arge svews ~10 550 000 50 nanP’etared ‘imnsnrcorns 3S 11/000 reg /5 r) 8Autrynob-les 5.800 105 000 2.1-00 2200 /90 200MolomnyLe~ 04 50 000 67 meg 1 1 7

St- rv.cosMdr tnme nrousl’nes 3000 270 000 2 njOO req 10 1 000

Agr.cul~reard fnsbemnesSugar 930 60 000 550 410 -, 130

690-acreDavy pmoduris 5 500 220 000 5 000 S0 3-4 I 370

800 ~owPcanuis 1/0 • 000 dcrP 170 ‘nag 9 14Meat - 800 150000 1 600 135 44

725 t-paoFnsh 560 21-300 200 170 1// ‘5

M-nnrgPelroneum 6 900 160 000 4 800 2 000 /0 3 000Leacljr-Lzrnc 67 30000 41- 4 I:

Neo mneg: gnoieUnless o’herwnse sr-pc -fpc. t.ommro: ire oar wor-0rEsI marco eumncs colk.clecn on sn-n) mepanns on-fnrmeo -abroaci-i Ions case becaLse of Ihe way tnt: ouctas were alnoratoni the ganrs to ‘iporir ms arc- Led ~Urjonnestnc metnno’s rati’t-r tar tnmengrexporters

SOURcE Irude Protpn Inorl nt-ne Umnn:ed blaIcs 31 Case Stuc-es

FEDERAL RESERVE BANK OF ST. LOWS JANUARY/FEBRUARY IS

for the latest phase of protection for carbon steel was29 percent.

Finally, table 1 indicates that the efficiency losses

ane small in compan-ison to the total losses bor’ne byconsumers. These efficiency losses, which are definedprecisely and illusu-ated in the fir-st shaded insert,result fr-on) the excess domestic production and the

reduction in consumption caused lw pr-otectnonisttrade policies. En laige cases such as textiles and

apparel, petroleum, dairy pm-oducts and the maritimeindustries, these losses equal or exceed $1 billion. It islikely that these estimates understate the actual costsbecause they do not capture the secondary effects thatoccur as pn-oduction and consumption changes in one

industry affect other industries.~ In addition, restric-tive trade policies generate additional costs because ofhun-eaucn-atic enforcement costs and efforts by the

pi-ivate sector to influence these policies fon- their owngain as well as simply comply with administrativer-egulations.

Costs o/’ Protectionism Throughout theWorld

In 1982, the Organization for Economic Co—opet-ation and Development OECD) began a pn-oject toanalyze the costs and benefits of protectionist policiesin manufacturing in OECD countnes. The DEC131983) highlighted a numbei- of ways that protectionist

policies have generated costs far in excess of benefits.Since protectionist policies increase pr-ices, the i-epon-tconcludes that the attainment of sustained non-inflationary growth is hindered by such price—increasing effects. Moreovei-, economic growth is po—tentiallv reduced if the uncertainty created by varyingtnace policies depnesses investment.

Wood and Mudd 1978), and many others, haveshown that impoi-ts do not cause higher unemploy-ment. Conversely, the OECD study stresses the factthat a r-eduction in imports via trade restr-ictions doesnot cause gn-eater employment. A reduction in thevalue of imports i-esults in a similar reduction in the

5Recent estimates of the costs of protectionist policies using generalequilibrium models suggest thai the secondary effects, to the limitedextent they are measurable, are substantial. For example, Grais, deMelo and Urata (1986) estimate that the elimination of quotas inTurkey in 1978 would have caused a 5.4 percent rise in grossdomestic product, while Clarete and Whalley (1985) estimate thatthe elimination of tariffs, quotas and export taxes in the Philippines in1978 would have caused a 5.2 percent rise in gross nationalproduct.

value of exports. One r-ationale for this finding is that areduction in the pun-chases of foreign goods reduces

foreign incomes and, in turn, causes reduced foreignpurchases of domestic goods.

While the reduction in impot-ts increases employ-mnent in industries that produce pn-oducts similar tothe previously imported goods, the reduction in cx-por-ts decreases employment in the expor-t industries.In other words, while some jobs are saved, other-s ar-clost; however-, this economic n-ealitv may not be obvi-ous to businessmen, labon- union leaders, politiciansand others. Luttrell 1978) has stressed that the jobssaved by piotectionist legislation are more readilyobsen’ed than the jobs lost due to protectionist legis-lation. In other words, the jobs that are protected in,say, the textiles industry by U.S. import restrictions on

foreign textiles are more readily apparent land publi-cized) than the jobs in agriculture and high technol-ogy industries that do riot materialize because of theimpoi-t restrictions. These employment effects will net

to appi-oximately zei-oY

t’he OECt) study also stresses that developing coun-ti-ies need exports to offset their debts. Thus, pr-otec-tionist tn-ade policies by developed countries affect notonly the economic activity of the developing coun—tries, but the stability of the intet-natiorial financialsystem as debtor nations find it increasingly difficultto service their debts.

Not only does a free trade policy by developedcountries benefit developing countries, hut a freetrade policy by developing countries benefits develop-ing countries. A recent World Bank study (1987) of 41

developing countr-ies compar-ed the perion-mance ofcountries following a fr-ce tr-ade policy with countries

following a restricted trade policy.’ Table 2 lists the

eRecent evidence shows that protectionist legislation actually mayreduce employment. Denzau (1987) estimated that 35,600 manu-facturing jobs were lost as a result of the September 1984 voluntaryexport restraints that limited the level of U.S. steel imports. Despitean increased employment for producers of steel (14000) and pro-ducers of inputs for steel producers (2,800), these increases weremore than offset by the 52,400 job losses by steel-using firms.These losses are due to the higher steel prices that cause steel-using firms to be less competitive in export markets and subjectthem to more foreign competition in the U.S. market.‘The World Bank study divides trade strategies into two groups:outward oriented and inward oriented. An outward-oriented strat-egy, which we call a free trade policy, is one in which trade andindustrial policies do not discriminate between production for thedomestic market and exports, nor between purchases of domesticand foreign goods. An inward-oriented strategy, which we call arestricted trade policy, is one in which trade and industrial policiesare biased toward production for the domestic market relative to theexport market.

FEDERAL RESERVE BANK OF ST. LOUIS JANUARY/FEBRUARY 1988

Table 2Annual Average Growth of Per Capita Real Gross National Product

Free Trade Restricted Trade

Period Strongly Moderately Moderately Strongly

1963-73 S;ngapore 9 0-~ Braznl 55% Ynngoslav-a 49% Turkey a 5’--.Soutn Korea 7 1 lsrae- 5.4 Mexnco 43 Dornnr-cun Pc-publnc 34Hong Kong 6 0 Tha-and 4 9 Nngena 4 2 Burur-dn 3 2

l-ndonesna 4 6 Turrs:a 4 0 Arger-t na 3costa Rnca 3 9 Kenya 3 9 Pakrstar 3Malays.a 3 8 Phnlnppnnes 2 2 Tanzanna 2 7Ivory coast 3 5 Bolnvna 2 0 Sm Lanka 2 3co-orbna 33 Hondu’as 1 9 Erhnoona 1 9Guaremaa 27 E Sa-vador 1 4 Chnle 1 7~amerooi 01 Madagascar 1 1 Peru i

N-caraoua 1 I Uruguay l 5Senegal 0 6 7amb-a 1 2

Inc-na 1.1Ghana 0Bang:aoesh 4Sudan 1.9

1973—55 Snngapore 65 Malaysn~ 4 1 Cameroon 56 Banglacesh 20HongKong 63 Tnanlano SO lndorc-sna 40 mona 20South Korea 54 Tunrsna 29 S’n Lanka 33 Buruno 1 2

Braz-- 1 ~ Pa~nsnan 31 Domnnncan Repub.rc 05Turkey 1 4 Yugoslavia 2 7 Efhnoona 0 4Isree. 04 cola-tb-a 1 8 Sudan 0 4Uruguay 0.4 Mexnco 1 3 Peru 1chnne 0.1 Phnlnpp-nes 1 1 Tan?anna ‘ 6

Kcnya 0 3 Argenrnna 2 0Honduras 0 I Zamh,a 2 3Senegan 0 5 Nnqerna 2 5

costa Rca 1 0 Bonnvna 31Guatemala 1 0 Ghana 3 2Ivory Coast 1 2 Madagascar 3 4En Savaoo’ 35Nncaragua 39

SOURCE World Doveroomenn Reporl 1987 and The Economist l1987l

;rnirLnai nu-nar4n gn-uniii ni fl ii pin r.npil;r gnnnss Hr innustninenil •~einrrured mmmi- aiidiimrnn 1Innun_nI pniniinirl tr’r-emr-k tnt line II rniinritnir—, tim 19mM 7% rnnnrnti ni-s luIInfl\nnlg a liii- 1mar11 pn1i thur .1 ri

nd 97:; M_5 I hrrsr rrrtnmitniis hat did nut bias indi_ns— stnin-ni-d path- pnnIni-~ Ike n1.nsunn is that atii;tijinimdnmnlionilo~~rndrhrdrnnni-stnnmnnarknlim\ mum- nil’inlniiinnn-mit •nlinn~snr~mnrnlInn 11r\\ in, is mm—I hn~lnl~

mnslri-lnrnnms r~nn~\ri t_n’,lri natr-~tIn~nnn lutist- rlnnl nun \~rlineniIns’s ~~lniin a rvstnirlnl traIt- n-nn~innnninn,ennltinsfinn i-\mnnnpli- lInt n.m-n-ar_re amninnn.nl ginn~~tImn-atm iii n-n-rI linris n-r-nmnmnnnmnjr inremniiw—pt-n r-.r1nil I inn nun,- Inn- lUh%-7% ~‘as U.U penlenni innnm-rnnnr)nunin--, sin-nmnnj.l~ inn triter

1Inn rye Marie rrnrl

in lInt- et-n,nnrrnmies stnnninr_I~ nmnni-mnierl mm n_n

sIr jeir-mI p adi- I inn 1)7% 55 lines.’ r nfl tin n nit-s flint- i 9iir run 0 I ni-er-nil ni-s1nei-tn~n-Is

Inn- stnnnI~ )nn)n(mni-, Inn nrIrnitii~ Ii.- Iin.nlrr)nlmrmniimnnir- It j)nmntnrIirnnnn~.nnnis—,mnnnnstl~.~~in~i—.1mnnrli-n-Iir,niisnnn sin

nr—,—,mnni mm liii LrruinrnI tinnninmnr_r \ Un\mnn nrnnrntnmnt ni nnn~\ 1ni’n\nsn’n~ I !ni’~snrtnnnln n-n—~nn—~~—~tint rnn.nlnnn nnr4nnnmninni’.

FEDERAL RESERVE BANK OF Si. LOUIS JAIIUARYIPEBRUARY INS

for restricting tiade and provides explanations for theexistence of protectionist trade policies.

National he/ease

The national defense argument says that impor-tbarrier-s are necessary to ensure the capacity to pro-duce cr-ucial goods in anational emergency. While thisar-gument is especially appealing for weapons dun-inga war, then-c will likely be demands from other indus-tn-ies that deem themselves essential. For- example, thefootwear industry will demand protection becausemilitam personnel need combat boots.’

The national defense ar-gument ignores the possibil-ity of purchases from friendly countries dur-ing theemer-gency. The possibilities of storage and depletionr-aise additional doubts about the general applicability

of the aigument. If crucial goods can be stored, forexample, the least costly way to prepare for an erner-gency might be to buy the goods from foreigners at thelow world pr-ice befone an emer-gency and store them.Ifthe crucial goods ar-c depletable miner-al resour-ces,

such as oil, then the restriction of oil imports befon-e anerner-gency will cause a more rapid depletion of do-mestic r-eserves. Once again, stockpiling might be a farless costly alternative.

Income Redistribution

Since pr-otectionist tr-ade policies affect the distribu-tion of income, a trade restriction might be defendedon the grounds that it fayors some disadvantagedgroup. It is unlikely, however, that trade policy is the

best tool for dealing with the perceived evils of incomeinequality, because of its bluntness and adverse effectson the efficient allocation of resources. Attempting toequalize incomnes directly by tax and transfer pay-merits is likely less costly than rising trade policy. In

addition, as Hickok’s 19851 study indicates, trade re-strictions on many items increase r-ather than de-crease income inequality-

Optirnurn Tariff.zirgurnent

The optimum tar-iff argument applies to situationsin which a country has the economic po\\’el’ to alterwon-Id prices. This power exists because the countror a group of countries acting in consor-t like the

Organization of Petroleum Exporting Countr-iesl is

such a large producer- or consumer of a good that achange in its production or- consumption patternsinfluences world prices. For- example, by imposing atarifL the countny can make tbr-eign goods cheaper.Since a tariff reduces the demand for foreign goods, ifthe tariff-imposing country has some mar-ket power-,the world price for the good will fall.’ The tariff-imposing countr will gain because the pr-ice per unitof its imnports will have decreased.

There ar-c a number of obstacles that preclude the

widespread application of this ar-gnment. Few couri-tries possess the necessary market power and, whenthey do, only a small number of goods is cover-ed.Secondly, in a won-Id of shifting supply and demand,

calculating the optimum tan-iff and adjusting the rateto changing situations is difficult. Finally, the possibil-ity of foreign retaliation to an act of economic warfareis likely. Such metaliation could leave both countrieswon-se off than they would have been in a fm-ce trade

environment -

Balancing the Balance o/’Trade

Many conntnies enact prDtectionist tnade policies inthe hope of eliminating a balance of trade deficit onincreasing a balance of tr-ade surplus. The desire toincrease a balance of ti-ade surplus follows from themer-cantilist view that larger trade surpluses are bene-ficial from a national perspective.

This argument is suspect on a numben of grounds.First, there is nothing inherently undesir-able about atr-ade deficit or- desirable about a surplus” For exam-ple, faster economic growth in the United States than

in the rest of the won-Id would tend to cause a tradedeficit. In this case, the trade deficit is a sign of ahealthy economy. Second, protectionist policies thatr-educe irnports will cause exports to decrease by a

comparable amount. Hence, an attempt to increaseexports permanently relative to imports will fail. tt isdoubtful that the trade deficit will be reduced eventempor-ar-ily because imnpont quantities do not declinequickly in r-esponse to the higher- impor-t pr-ices andthe revenues of foreign producer-s might r-ise.

‘If a country such as the United States has no market power, theworld price is fixed. Consequently, the price faced by U.S. con-sumers and producers rises by the full amount of the tariff. In theoptimum tariff case, the price faced by U.S. consumers and pro-ducers rises, but not by the full amount of the tariff. This must be thecase because the world price falls and the amount of the tariff is thedifference between the world price and the U.S. price.

“See Chrystal and Wood (1988) earlier in this issue.‘See Pine (1984).

FEDERAL RESERVE BANK OF Si. LOUIS JANUARYIFEBRUARY INS

Protection of Jobs Public Choice

The protection of jobs ar-gumenit is closely related tothe balance of trade argument. Sinceareduction inimports via trade n-estr-ictions will result in a similarreduction in exports, the over-all employment effects,as found in the OECD 1985) study and many others,are negligible. While the overall effects are negligible.won-kens land r-esour-ce owners) in specific industries

ame affected differently.

A domestic industry faced with increased impomtsfr-ore its foreign competition is under pressure to n-e-duce production and lower- costs. Pn-oductive n-c-sources mnust mnove fi-om this industry to other domes-tic industmies. Wor-ker-s must change jobs and, in somecases, relocate to other cities. Since this change isforced upon these workers, these won-ken-s hear m-ealcosts that they are likely to resist. A similar statementcan be made about the owner-s of capital in the af-fected industry.

Workers and other mesoinr-ce owner-s ~villllikely resist

these changes by lobbying for trade r-estr-ictions. Thepr-eviously cited studies on the costs of protectionism

demonstt-ated that tr-ade restrictions entail substantialneal costs as well. ‘l’hese costs likely exceed the adjust-mnent costs because the adjustment costs ar-c one-timecosts, while the costs of protectionism continue aslong as trade restrictions are maintained.

An obvious question is why politicians supply theprotectionist legislation demanded by worker’s aridotlier resource owner-s. A bm-anch of economics calledpublic choice, which focuses on the interplay betweenindividual pr-eferences and political outcomes, pro-vides an answer. The public choice liter-atur-e views thepolitician as an individual who offer-s voters a bundleof governmentally supplied goods in order to winelections.’ Many argue that politicians gain by pr-ovid—ing protectionist legislation. Even though the nationaleconomic costs exceed the benefits, the politicianfaces different costs and benefits.

l’hose hat-med by a protectionist trade policy for a

domestic industry, especially household consumen-s,will incur a small individual cost that is difficult toidentify. For example, a consumer is unlikely to pon-der how much extra a shirt costs because of protec-

tionist legislation for the textiles and apparel industry.

“The role of pressure groups, acting in their economic self-interest,has been stressed by Stigler (1g71) and Peltzman (1976). Forreferences, as well as an example of an international trade studyfocused on the interaction of politicians and interest groups, seeCoughlin (1985).

Even though the aggregate effect is lange, the harm to

each consumen- may be small. ‘this small cost, ofwhichan individual may not even be awar-e, and the costs oforganizing consumers deter the formationi of a lobbyagainst the legislation.

On the other hand, wor’ker-s arid other- n’esoun-ceowner-s are vex-v concer-ned about protectionist legisla—tiori for their industry. liieir benefits tend to be largeindividually and easy to identity. Their voting andcampaign contributions assist politicians who sup-port thein positions and penalize those who do riot.Thus, politiciarns are likely to respond to their de-mnands for- pr-otectionist Iegislationiz

In/Cat .Industries

‘Ehe preceding ar-gunient is couched in terms ofprotecting a domestic industry. A slightly differentargument, the so-called infant industry case, iscouched in terms of promoting a domestic industry.Suppose an industry, alr’eady established in other’countm-ies, is being established in a specific coinntrv.The country might riot he able to r’ealize its compar-a—tive advantage in this industry because of the existingcost and other advantages of foreign fir-nis. Initially,owner-s of the fledgling firm must be willing to sufferlosses until the firm develops its mar-ket and lower-s its

production costs to the level of its fon-eign rivals. Inon-den- to assist this entr-ant, tan-ill’ pn-otection can beused to shield the fir-ni fn’omsome for-eign competition.

After this temnporan~period of protection, free tradeshould be n-estor-ed; howeven-, the removal of tariff

protection frequently is resisted. As the industry de-velops, its political power- to thwan-t opposing legisla-tion also increases.

Another- pr-oblennwith the infant industry arguniieritis that a tariff is not the best way to intervene. A

production subsidy is super-ion- to a tariff if the goal isto expand pn-oduction. A suhsidv will do ibis directly,while a tariff has the undesin-able side effect of r-educ—inig consumptioti.

In many cases, intervention might not be appr-opr’i—ate at all. If the infant industny is a good candidate forbeing competitive inter-nationudly, borr-ouing from the

2Special interests benefiting from trade will likely resist the forces forprotectionist legislation. Destler and OdeIl (1987) identify exporters,industrial import users, retailers of imported products, businessesproviding trade-related services, foreign exporters, and foreign gov-ernments as interest groups capable of exerting some anti-protection pressure. Decisions about protectionist legislation resultfrom the interaction of both pro-protection and anti-protectionforces.

FEDERAL RESERVE BAtIK OF ST. I.OUiS JANUARYIFEBRUART INS

pr-ivate capital markets can finance the expansion.Investors are willing to ahsor-b losses temporarily if theprospects for- future profits ar-c sufficiently good.

Spillover Effects

The justification for pn-otecting an industry, infant orotherwise, frequently entails a suggestion that theindustry generates spilloven’ benefits for other’ in—dustrres ot’ individuals fon which the industry is not

compensated. Despite patent laws, one common sug-gestion is that cer-tain industn-ies are not fully compen-sated for their- r-esear-ch arid development expendi-tur-es. This argument is frequently clirected towardtechnologically progressive industr’ies where somefirms can capture the n’esults of other- finns’ n’esearchand development simply by dismantling a pr-oduct tosee how it wor’ks.

The application of this ar-gumnent, however-, enigeti-den-s a niurnbem of pn-oblems. Spillovens of knowledgeane diffic,ult to measure. Since spilloven-s am-e not mar-ket tr-ansactions, they do not leave an obvious tr-ail toidemitifv their- heneficiar-ies. The lack of niar-ket tr-ansac-tions also complicates an assessment of the value ofthese spillover’s. To determine the appr-optiate sub-sidy, one must be able to place a dollar value on the

spillovers genen-ated by a given reseamch and develop-nient expenditure. Actually, the calculation requiresmunch mom-c than the aln’eady difficult task of r’econ-stn-ucting the past. It r-equir-es complex estimates of thespilloven’s’ future worth as well. Since resources aremoved fioni other’ industries to the targeted industry,the goven-nment must tinder-stand the functioning ofthe entire economy.

Finally, then-c are political pr-ohlems. An aggressive

application of this an-gumuent might lead to retaliationand a mutually destructive tn-ade war’. In addition, asinten’est gr’oups compete for the gover-nmental assis-tance, there is no guar-antee that the tight gr-oupswill be assisted or’ that they will use the assistanceefficientl.

Strategic Trade Policy

Recent theor-etical developments have identifiedcases in which so-called stn-ategic tr-ade policy is supe-rior- to fl-ce trade. As we discussed earlier, decreasingunit production costs and market structures that con-tain monopoly elements ar-e conirnon hi industr-iesinvolved in inter-miational tmade. Mar-ket imperfectionsimmediately suggest the potential benefits of govern—mental intervention. In the str-ategic tr’ade policy argu-

ment, gover-nmnent policy can alter the terms of com-

petition to favor-domestic over’ foreign firms and shiftthe excess returns in monopolistic mar-kets from for-eign to domestic fir-ms.

Knugman 1987) illustrates an example of the angu-rnent. Assume that there is only one firm in the UnitedStates, Boeing, and one multinational Iir-m in EuropeAirbus, capable of producing a 150-seat passengeraircraft. Assume also that the aim-cr-aft is pn-oduced onlyfor export, so that the returns to the firm can beidentified with the national inter’est. This export mar-ket is pn-ofitable for either fin-nm if it is the only producer;however, it is unprofitable for both fir-ms to pnodticethe plane. Finally, assume the following payoffs areassociated with the four combinations of production:

1) if both Boeing and Airbus pr-oduce the aircr-aft, eachfir’m loses $5 million; 2) if neither Boeing non’ Ain’buspn’oduces the aircn-aft, profits are zero; 3) if Boeingpn-oduces the aircraft and Air-bus does not, Boeing

profits by $100 million and Air-bus has zero pr-oUts; and4) if Air-bus produces the air-cr-aft and Boeing does not,Airbuns profits by $100 million and Boeing has zeropr’ofits -

Which finnn)s) will pr-oduce the air-craft? The exam-

ple does not yield a unique outcome. A unique out-come can be genen-ated if one firm, say Boeing, has ahead stant and begins production before Airbus. tnthis case, Boeing will n-cap pn-ofits of $100 million and

will have deter-n-ed Airbus from emitening the niarketbecause Air-bus will lose $5 million if it enter’s afterBoeing.

Stnategic trade policy, however-, suggests that judi-cious gover-nmental intervention can alter the out-come. If the Eun’opean governments agree to subsidizeAir-bus’ production with $10 million no mnatter’ whatBoeing does, then Airbus will produce the plane. Pro-duction by Air-bus will yield more profits than not

producing, no matter- what Boeing does. At the sametime, Boeing will be cleterred fi’om pn’oducing becauseit would lose money. Thus, Airhus will captur-e theemitim’e rnar-ket and reap profits of $110 mnillion, $100mnillion of which can be viewed as a tnansfer of pr-ofitsfrom the United States.

The criticismns of a strategic trade policy ar-c similar’to the criticisms agaimist pr-otectimig a technologicallypr-ogn-essive industry that gener-ates spilloverbenefils.’’Then-c ar’e major- infonmational pn-obleniis in applying a

‘3A recent volume edited by Paul Krugman (1986) examines theØolicy implications of the new trade literature, See Grossman’sarticle in that volume for a discussion of the information require-ments.

FEDERAL RESERVE BANK OF ST. LOUIS JANUARY/FEBRUARY 1988

strategic trade policy. The government must estimatethe potential payoff of each course of action. Eco-nomic knowledge about the behavior of industniesthat have monopoly elements is limited. Firms mnaybehave competitively on- cooper-ativel~and may com-pete by setting pm-ices on- outpr.rt. The behavior- of rivalgovem-nments also must he amiticipated. l”oreign r’etalia-tiomi must be viewed as likely where substantial profitsare at stake. In addition, many intem-est gr-oups willcompete for the govem-nmental assistance. Thoughonly a small number’ of sector-s can be conisideredpoterrtiall~stmategic, many industries will make a casefor assistance.

Reciproci~vand the “Level Playing Field”

Bhagwati and Irwin 1987) note that U.S. tnade policydiscussions in recent year-s have frequently stressedthe importance of “fair tr-ade.” The concept of fairtrade, which is technically n-efen-red to as reciprocity,means diffen-ent things to different people.

Under the Genen-al Agreement on ‘I’ariffs and ‘made,negotiations to reduce trade ham-mien-s focus uponmatching concessions. This form of reciprocity,known as first-difference reciprocity, attempts to n-e-duce trade barrier-s by r-equiring a country to provide atariff rtduction of value compan-able to one pr-ovided

by the other country. In this case, n’eciprocity isdefined in terms of matching changes.

Recent U.S. demands, exemplified by the Gephardtamendment to the cur-rent tn-ade legislation, r-eyeal anapproach that is called fbll reciprocity. This approachseeks r-eciprocitv in terms of the level of pr-otectionbilaterally and ovem a specific n-ange of goods. Beci-pn-ocitv n-equines equal access and this access can hedeter-mined by bilatemal tnade balances. A tnade deficitwith a trading partner is claimed to be prima fadeevidence of unequal access. Examples ahounnd. Forexample, U.S. constr’uction fin-mns have not had a major’contract in Japan since 1965, while Japanese con-stm-uction fim-ms did $1.8 billion wonth ofbirsiness in theUnited States in 1985 alone. Recent legislation liar-sJapanese panticipation in U.S. public won-ks pnojectsuntil the Japanese offer r-ecipn-ocal pr-ivmleges.

As the name suggests, the fundamental argumentfor fain- trade is one of equity. Domestic producens irm afl-ce tnade country argue that foneign trade harrier-s am-cunfair because it places them at a competitive disad-vantage. In an extreme yer-sion, it is asserted that thisunfain’ competition will vir-tually eliminate [1.5. mnanu—factoring, leaving only jobs that consist primarily of

flipping hamburgers at fast food restaun-ants on-, asBhag%%-ati and Inwin have said, rolling mice cakes atJapanese-owned sushi bar-s. While domestic pm-o-

ducers are relatively disadvantaged, the wisdom of apn-otectionist response is doubtful. Again, the costs ofpr-otectionismnexceed substantially the benefits froni amiatiorial perspective.

In an attempt to r’einfon-ce the ar-gument for fair’tnade, pr-oponents also an-gue that n-etaliatory thn-eats,combined with changes in tariffs and mion—tam’iff barri-ers, allow for the simultaneous pr-otectiomi of domesticindustries against unequal comnpetition and induncemon-c open fom-eign mnar-kets. This mom-c flexible ap-pr-oach is viewed as super-ior to a ‘‘one—sided’’ freetrade policy. ‘l’he suggestion that a fair tnade policyproduces a tnading environment with fewer- trade ne-strictions allows pmoponents to asser-t that such apolicy serves to pn-omote both equity and efficiency. Inother- words, not only will domestic and foreign pno-ducem-s in the same industry be treated equally. but thegains associated with a fn’eer tr-ading envir-onment willhe n-ealized.

On the other- hand, critics of a fair trade policy argue

that such a policy is simply disguised protectionisni— it simply achieves the goals of specific intemestgn-otnps at the expense of the nation at lam-ge. In mnanycases, fair tr-ader-s focus ori a specific pr-actice that can

be portr-ayed as pn-otectionist while ignon-imig the entinepackage of policies that are affecting a nation’s comn-petitive position. In these cases, the fon-eign coumitmv ismuon-c likely either not to respond or retaliate by in-cr-easing r-athcr- than n-educing their tracle barriens. Inthe latter- case, the escalation of trade han-mien-s causeslosses for- both nations, which is exactly opposite tothe alleged efi’ects of an activist fair trade policy.

Critics of fain’ trade proposals ar-c especially both-er-ed by the use of bilateral trade deficits as evidence ofunfair’ trade. In aworld of many tn-ading countries, tlìetrade between two countnies need not be balanced for’the tr-ade of each to be in global balance. Diffemimigdemands and pr-oductive capabilities across countrieswill cause a specific coumitry to have trade deficits withsome countries and sur-pluses with other- counitmies.These bilateral imbalances an-c a rionmual result ofcoumitmies tradimig on the basis of comnpar-ative advan-tage.’4 Thus, the focuns on the hilater-al tnade deficit canproduce inappr-opriate conclusions about fain-nessand, niiore impor-tantly, policies attempting to elimi-nate bilaten’al trade deficits ar-c likely to be very costlybecaunse they eliminate the gains from a multilateraltn-ading system.

‘~Bergstenand Cline (1985) estimate an equilibrium U.S-Japanesebilateral trade deficit of $20—$25 billion annually.

FEDERAL RESERVE BANK Of ST. LOUIS JANUARY/FEBRUARY INS

CONCLUSION

The pr-olifer-ation of pnotectm()nist tr-ade policies inrecemit year-s pm-ovides an impetus to m-econsidem’ their’wor-th. In the won-id of tr-aditionial trade theory, chan-ac—

ter’ized by perfect competition, a definitive recoin—mendatiori in favor- of fl-ce trade can he made. Thegains fnonii initen-nationial trade result fm-om a m-ealloca—

tioni of pn-oducti~’em-esour-ces towam-d goods that cami he

lin’o(lumced less costly at home than abroad amid theexchange of some of these goods for’ goods that can hepm-odunced at less cost aljnoad than at home.

Recent developments in inter-national tm-ade theoryhave examitied the consequences of internationaltr-ade in mar-kets when-c tliene ar-c nianket imperfec-tions, such as momiopoly and technological spillo\’er-s.Do these imperfections justitv protectionist trade poli-cies? The answer- continues to he no. While protec-tionist trade policies may offset monopoly power- over-—seas or advantageously use domestic moniopol~power, trade restrictions tend to reduce the competi-tion faced by domestic producer’s, protecting domes-tic producer-s at the expense of domestic conisunIens.

‘chic empirical evidence is clear-—cut. The costs of

pr-otectionist tr-ade policies far exceed the benefits.‘the losses suffer-ed by consumer-s exceeml the gainsreaped by domestic pr-oducen’s and government. Low-inconiie consumer-s ar-c n’elatively more adversely af-fected than high-income consumers. Not only arethen-c inefficiencies associated with excessive domes-

tic production and restricted consumption, but then-cane costs associated with the enfor-cemnent of the pm-o—tectionist legislationm and attempts to influence trade

policy.

The primam~reason for these costly protectionist

policies relies on a public choice an-gumemit.The desireto influence tr’ade policy arises froni the fact that trade

policy changes benefit some gr-oups, while har-mingother’s. Consumer-s are ham-med by pr-otectionist legis-lation; however-, ignor-ance, small individual costs, and

the high costs of or-ganizing consumers pr-event theconsumers from beirig an efl’ective for-ce. On the otherhand, wor-ken-s and other resour-ce owner-s in an indus-tn-v ar-c mor-e likely to be effective politically because oftheir relative ease of om-ganizing and their- individuallylarge and easy-to-identify benefits. Politicians inter--ested in re—election will most likely respond to thedemands for- pmotectionist legislation of such an inter-est group.

‘I’he enmpimical evidence also suggests that the ad-~‘er-seconsumer effects of pr-otectionist trade policiesam’e riot shor-t-lived. These policies genem-ate lower’ eco-nomic gn-owth n-ales than the rates associated with fr-cetrade policies. In turn, slow gr-owth contributes to

additional pr-otectionist pressum-es.

Interest gr-oup pressunes from industries expenienc-ing difficulty and the gener-al appeal of a “level playingfield’’ combine to make the reduction of trade hiar-riersespecially difficult at the present timmic in the United

States. Nonetheless, national inten-ests will be servedbest by such an admittedly difficult political comm-se. Imilight of the cur-rent tJm’uguay Round negotiations un-der- the General Agn-eement on Tan’iffs and Tm-ade, aswell as numerous bilateral discussions, this fact isespecially timnely.

REFERENCES

Bergsten. C. Fred, and William R. Cline. The United States-JapanEconomic Problem (Institute for International Economics, October1985).

Bhagwati, Jagdish N., and Douglas A. Irwin, “The Return of theReciprocitarians — U.S. Trade Policy Today,” World Economy(June 1987), pp. 109—30.

Brander, James A. “Intra-Industry Trade in Identical Commodities,”Journal of International Economics (February 1981), pp. 1—14.

Brander, James A.. and Paul R. Krugman. “A ‘Reciprocal Dumping’Model of International Trade,” Journal of International Economics(November 1983), pp. 313—21.

Chrystal, K. Alec, and Geoffrey E. Wood. “Are Trade Deficits aProblem?” this Review (January/February 1988), pp. 5—i 3.

Clarete, Ramon L., and John Whalley. “interactions Between TradePolicies and Domestic Distortions,” Center for the Study of Inter-national Economic Relations Working Paper 8522C (London, On-tario: University of Western Ontario, 1985).

Coughlin, Cletus C. “Domestic Content Legislation: House Votingand the Economic Theory of Regulation,” Economic Inquiry (July1985), pp. 437—48.

Denzau, Arthur T. “How Import Restraints Reduce Employment,”Washington UniversityCenterfor the Study of American Business,Formal Publication #80 (June 1987).

Destler, I. M., and John S. Odell, Anti-Protection: Changing Forcesin United States Trade Politics (Institute for International Eco-nomics, 1987).

Dixit, Avinash K., and Victor D. Norman. Theory of InternationalTrade (Cambridge University Press, 1980).

Dixit. Avinash K., and Joseph E. Stiglit2. “Monopolistic Competitionand Optimum Product Diversity,” American Economic Review(June 1977), pp. 297—308.

The Economist. July 4,1987, p.74.

Grais, Wafik, Jaime de Melo, and Shujiro Urata. “A General Equilib-rium Estimation of the Effects of Reductions in Tariffs and Quanti-tative Restrictions in Turkey in 1978,” in T. N. Srinivasan and JohnWhalley, eds. General Equilibrium Trade Policy Modeling (MITPress, 1986).

Grossman, Gene M. “Strategic Export Promotion: A Critique,’ Stra-tegic Trade Policy and the New International Economics in Paul R.Krugman, ed. (MIT Press, 1986), pp. 47—68.

Helpman, Elhanan. “International Trade in the Presence of ProductDifferentiation, Economies of Scale and Monopolistic Competi-tion,” Journal of International Economics (August 1981), pp. 305—40.

Hickok, Susan. “The Consumer Cost of U.S. Trade Restraints,”Federal Reserve Bank of New York Quarterly Review (Summer1985), pp. 1—12.

FEDERAL RESERVE BANK OF ST. LOWS

Hufbauer, Gary Clyde, Diane T. Berliner, and Kimberly Ann Ellioti,Trade Protection in the United States: 31 Case Studies (Institute forInternational Economics, 1986).

Kearl, James R., Clayne L. Pope, Gordon C. Whiting, and Larry T.Wimmer, “A Confusion of Economists?” American EconomicReview, Papers and Proceedings (May 1979), pp. 28—37.

Kierzkowski, Henry K. “Recent Advances in International TradeTheory: A Selective Survey,” Oxford Review of Economic Policy(Spring 1987), pp. i—i9.

Krugman, Paul R. “Is Free Trade Passé?” Journal of EconomicPerspectives (Fall 1987), pp. 131-44.

Strategic Trade Policy and the New International Eco-nomics (MIT Press, 1986).

Lancaster, Kelvin. “Intra-Industry Trade Under Perfect MonopolisticCompetition,” Journal of International Economics (May 1980), pp.151—75.

Variety, Equity, and Efficiency (Columbia UniversityPress, 1979).

Leibenstein, Harvey. Beyond Economic Man (Harvard UniversityPress, 1980).

Luttrell, Clifton B. “Imports and Jobs — The Observed and theUnobserved,” this Review (June 1978), pp. 2—10.

Mill, John Stuart. Principles of Political Economy, W. J. Ashley, ed,(Longman, 1909).

Morici, Peter, and Laura L. Megna. U.S. Economic Policies AffectingIndustrial Trade: A Quantitative Assessment (National PlanningAssociation, 1983).

Munger, Michael C. “The Costs of Protectionism: Estimates of theHidden Tax of Trade Restraint,” Washington University Center for

JANUARY/FEBRUARY 1988

the Study of American Business, Working Paper #80 (July 1983).Organization for Economic Co-Operation and Development

(OECD). Costs and Benefits ofProtection (1985).

Page, Sheila. “The Rise in Protection Since 1974,” Oxford Reviewof Economic Policy (Spring 1987), pp. 37—Si.

Peltzman, Sam, “Toward a More General Theory of Regulation,”Journal ot Law and Economics (August 1976), pp. 211-40.

Pine, Art. “Footwear Industry Tells Congress ‘Shoe Gap’ ThreatensU.S. Defense,” Wall Street Journal, August 24, 1984.

Ricardo, David. The Principles of Political Economy and Taxation(Penguin, 1971).

Stigler, George J. “The Theory of Economic Regulation,” Bell Jour-nal of Economics and Management Science (Spring 1971), pp. 3—21.

Stolper, Wolfgang, and Paul A. Samuelson, “Protection and RealWages,” Review of Economic Studies (November 1941), pp. 58—73.

Tarr, David G., and Morris E. Morkre. Aggregate Costs to the UnitedStates of Tariffs and Quotas on Imports: General Tariff Cuts andRemoval of Quotas on Automobiles, Steel, Sugar, and Textiles,Bureau of Economics Staff Report to the Federal Trade Commis-sion (December 1984).

Venables, Anthony, and Alasdair Smith, “Trade and Industrial Pol-icy Under Imperfect Competition,” Economic Policy (October1986), pp.621—72.

Wood, Geoffrey E., and Douglas R. Mudd. “The Recent U.S. TradeDeficit—No Cause for Panic,” this Review (April 1978), pp. 2—7.

World Bank. World Development Report 1987 (Oxford UniversityPress, 1987).

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AppendixDevelopments in International Trade Theory and theGains from Trade

Since 1817, numerous developments have taken

place in inter-national tr’ade theory. The consequencesof mone than one factor of pn-oduction, increasing amiddecn-easing unit pn-oduction costs, amid imper-fectlycompetitive markets are examined mi this appemmdix.Special attention is focused on developments in inten’-natiomial tm-ade theory in the last decade.

Increasing the Number ofFactors ofProduction

Assume that, in the United States, two r’esoun-ces,labor- arid capital (e.g., machinesi, ar-c used in thepr-oduction of two goods, automobiles amid air-planes.

The pn’ices of these resources will be affected differ-—ently by tr-ade. As trade develops, demnanid for- theexported good that is, the good in which the UnitedStates has a comparative advantage) will incn’ease amid

demand for U.S. pr-oductiomi of the imported good willfall. ‘h’his demand shift causes the price of the ex-

ported good to rise n’elative to the pr-ice of the ire—ported good. Similar-h’, the shiff may also pn-oducechanges imm the pr-ices of r-esoun-ces: however-, thesepm-ice changes an-c not always obvious.

Initially, assumne that the r’esoum-ces cannot be tm-ans—ferr’ed across industn’ies. For examnple, the labor- andcapital used to pr-oduce automobiles, the good im—ported into the United States, cannot he used to pro-duce aimplamies, the expon-ted good. Consequently, asthe pr-ice of airphanes n-ises imi the United States, thecompensation for- lahor and capital in the air-planeindustry will rise; meanwhile, the decline in automo-bile pr-ices causes a decline in compensation for- laborand capital in the industry. It would riot be surpn-isingif labor and owners of capital in the imidustrv would

mesist such changes by asking for- tn-ade pm-otection.

While resources may not be easily transfer-n-edacr-oss industries imi the shon’t n-un, worker-s can changejobs and capital cart be moved as time passes. hfresources are mobile, then the longer-—run conse-

quences for- labom- and owmien’s of capital an-c differentfrom those described above. Even if lahor and capital

are perfectly mnobihe, however, one set of m’esour’ceowner-s may benefit while another- gn-oup is har-mned bytrade.’

The real world is more complicated than this dis-

cussion has allowed. Them-c are mon-c thami two factor-sof pr-oduction amid vamyimig degrees of mobility for’these factor-s. For example, the U.S. labor- for-ce con—taimis scientists and engirmeer’s as well as short—on-dem-cooks. Nonetheless, the underlying analysis does sug-gest somne generalizations. When trade occur-s, owner’sof the resoun-ces that ar-c mor-e specialized imi the

pn-oduction of export goods will tend to become weal—

‘Who wins and who loses? It depends on the U.S. endowment ofcapital to labor relative to other countries. If the United States hasrelatively largeramounts of capital to labor relative to othercountries,then owners of capital would benefit, while labor would be harmed.This result follows from the Stolper-Samuelson Theorem (Stolperand Samuelson, 1941). In the example. the United States is definedto be capital-abundant. The example also implicitly assumes thatairplanes are produced by capital-intensive methods and automo-biles by labor-intensive methods, Thus, the production of airplanesrequires the use of more capital relative to labor than automobiles,Since the United States is relatively well-endowed with capital andthe production of airplanes is capital intensive, the United States willhave a comparative advantage in the production of airplanes. Withthe elimination of trade barriers, the relative price of airplanes toautomobiles will increase. The Stolper-Samuelson Theorem showsthat an increase in the relative price of the capital intensive good willincrease the return to capital relative to the prices of both goods andreduce the return to labor relative to the prices of both goods.

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thier; those who own n-esoun-ces mon-c specialized inthe production of import-competing goods will tendto lose wealth. People also gain or- lose, howeven’,depending on what happens to the pr-ices of the goodsthey buy. Individuals who chiefly consume importedgoods will benefit, while those who pr-efer- consumingthe exported goods will lose. Thus, the net effect onany individual depends on both the gains or losses

associated with the price changes on the goods thathe consumes and the effect of tr’ade on his wealth (or-income I.

Increasing Unit Production Costs

A second assumption underlying the Rican’dian ex-ample of the gains fr-ore trade is that unit productioncosts ar’e constant. If unit production costs rise asmore is produced, however, the gener’al conclusionsabout the gains fr-nm tr-ade remain essentially un-changed. The major- difference is that rising unit pro-duction costs limit the extemit to which speciahizatiomioccurs.

Decreasing Unit Production Costs andImperfect Competition

On the other hand, if unit production costs de-crease as production increases, the extent to whichactual trade patterns can be explained by comparativeadvantage becomes unclear. lt also fon’ces tr-ade theoryto deal with nunmerous char-acteristics of internationaltrade in the real wor-hd. The market structure ofindus-tries engaged in tn’ade is fr-equently highly concen-tnated. In other words, the individual firms in anindustry, contr’any to those in a perfectly competitiveindustry, can affect the manket price of their good bytheir productiomi and advertising decisions. In addi-tion, trade statistics show that intra-industny trade(i.e., the simultaneous export and import of the outputof the same industnz accounts for- incn-easinglv largershames of won-Id trade.

In Ihe last decade, trade theorists have developednumnen-ous models to deal with these facts. An exhaus-tive r-eview of this rapidly expanding hitenature is be-

yond the scope of this appendix; howeven, a few illus-trative articles are discussed in order to establishsome key points. Brander (1981) and Br-ander andKnugman (1983) developed models using a homogene-ous good to highlight how imperfect competition cancause intra-industry trade and how intna-industrytn-ade can arise in the absence of cost differences.

Assume two countries with one fir’m in each coun-try. The firms an-c pm’oducing a homogeneous goodunder identical cost situations and then-c am-c no trans-

pontation costs. Each firm openates under what istermed a ‘‘Cournot comijectun-e,’’ meaning that eachfirm assumnes its pmoduction decision ivill not affect itsrival’s pm’oduction decision. Before inter-national tnade,each firm has a monopoly position in its home man-ket.Aliowing for- fr-ce trade induces each fin-rn to emiter theothen br-ms niarket, because price exceeds mnamginalcost in each coumitry. ‘Thus, the same good will flow to

and fr-om each country.

Kierzkowski l1987n has noted that the bulk of intn-a-industry trade involves differentiated rather than ho-mogeneous goods. Two approaches, Lancaster’s(1979) chanacteristics approach and Dixit and Stighitz’s(1977) “hove of variety” appr-oach, have pr-ovided thefoundation for- trade models involving differentiatedgoods.

In the chanactenistics approach, individuals havepn-eferences for- the characteristics of goods m-atherthan for- collections of time goods themselves, A groupof goods is defined as goods possessing the sanrecharacteristics but in diffem-ent pn-oportions. A diversity

in consumner pr-eferences causes different consumner-sto pr-efen different products (i.e., van’ieties) of a gr-oup ofgoods.

Fleipman (1981) and Lancaster’)lSSD) used the char--actem-istics appr’oach to show how intra-industry tnaderesults fn’om combining the demand for- variety witheconomies of scale, The change fr-om autan-chy to freetrade enlarges the mar-ket and causes output of the

existing varieties to increase and the production ofnew varieties to begin. Consumers gain from the pro-ductiomm of more varieties and lowem pr-ices as econo-mies of scale are realized,

The sources of gains from tr-ade are identical usingthe love-of-variety and character-istics appr-oaches. Inthe love-of-variety approach, which is used by Dixitand Norman )1980r, consumers have identical tastesand prefen’ to consume as many types of the differenti-ated product as possible.

The introduction of imperfect competition and de-clining unit pm-oduction costs suggest three sources ofgain from free trade. As the market potentially servedby firms expands fi-om a national to a world market,

there will be gains due to declining unit productioncosts. The second is the reduction in nmonopol~powerof firnms faced with foreign competitors. The thin-d isthe gain to consumer-s fm-onn lower prices and in-creased product variety. Gener-ally speaking. gains

from trade result from the increase in competitivepr-essures as the domestic econonmy becomes lessinsulated from the world economy. Nonetheless, time

numerous market structur-es and firm hehavion’s pos-sible under imperfect competition preclude a defini-

tive statement about the optimahity of fr-ce trade.

FEDERAL RESERVE BANK OF ST. LOUIS JANUARYIFEBRUARY ISa

Figure 3

Ttj~

P4V

ICUS

D~512~ D~5 a

The demand curve is D,,and the marginal cost curve isMC,,~.(The mnarginah revenue curve associated with lJ,,~is omitted.) The monopoly pr-ice and output are P,~and Q~

The change from autarchy to free tnade tr’ansforms

the national monopolies into a world duopoly. As-suninng the firnis follow a Cournot str-ate~’, pricedeclines from P~to P,~, sales in the United States

incnease from Q,,, to Ii’,,,, and consumer’s gain an-ca P~ES P,, or h + i. Profits ignoring fixed costs) in theUnited States decline fr-om area P,,, RWM or i + j + k toarea P, SXM or j + k + 1. The domestic firm has one-half of the domestic market, so its profits an-c j with k +I going to the foreign firm. The domestic firm’s expon-tsallow it to captune one-half of the foreign mar-ket. If theforeign mar-ket is identical to the domestic market, thefirm’s profits on ibr-eign sales will equal k + I. There-fore, the net reduction in the domestic fin-rn’s profits is

— I and the overall welfare gain to the economy ish + I.

Sometimes the benefits of expanded consumptionresulting from fl-ce trade an-c less than the costs associ-ated with distorted pr-oduction. Venables and Smith(1986) pn-ovide a graphical illustn-ation, duplicated infigure 3, of the pr’eceding point using the Br-ander-Kr-ugman duopoly model. Assume the U.S. market and

the market in the rest of the won-Id for- a specific goodare monopolies, the good is produced at a constantmarginal cost, and there are no tr-ansportation costs.

If the assumption of identically sized domestic andforeign mar-kets is dropped, then a different conclu-

sion is possible. If the foreign market is smaller- thanthe domestic, the profits of the domestic firm in theforeign market will be less than k + 1. Assuming zeroexports, the domestic gains fr-nm trade are h — k, and

the domestic economy could lose from fnee trade. Inthis case, consumer- gains can be mon-c than offset by

the shifting of profits fi-onm the domestic to the fbreigneconomy. ‘l’his shifting reflects the contraction of anactivity that is already too little to an even smaller- level.

TI

w~x