How Protectionism has been used as a major economic tool by both developed and developing countries.
This Nine-Page Graduate paper discusses how Protectionism has been used as a major economic tool by both developed and developing countries. The paper highlights the usual forms of protectionism employed and the consequent influence on the domestic
manufacturing sector.
Protectionism.
Protectionism is defined as the policy of protecting domestic industries from foreign competition by means of various barriers to trade, these include tariffs, quotas, subsidies, Voluntary Export Restrictions, stringent quality requirements and boycott or sanctions. We will look at each of these later in the paper.
Economic theory strongly disapproves of protectionism; the central argument in favour of free trade devoid of restrictions is the Theory of Comparative Advantage. This proposes that each country should produce that good which its particular combination of factors of production are most suited to, for example a country with surplus labour and shortage of capital should produce labour intensive goods and similarly a country with a surplus of capital and shortage of labour should produce capital intensive goods, this can be illustrated by a couple of simple examples:
We assume two countries, U.S, a capital intensive country and Pakistan a labour intensive country producing two goods, automobiles a capital intensive good, and cotton a labour intensive good. They use 50% of their resources to produce each good.
Automobiles Bales of Cotton
U.S 100 10
Pakistan 10 100
Total 110 110
Total production is 110 units of each commodity. Now suppose each country exclusively produces the good that it produces more efficiently.
Automobiles Bales of Cotton
U.S 200 0
Pakistan 0 200
Total 200 200
Specializing in more efficient areas has led to a gain of 90 units for each commodity. This is in a situation where each country had an absolute advantage, that is, each produced one good more efficiently than the other country. However, consider the following situation:
Automobiles Bales of Cotton
U.S 150 200
Pakistan 50 100
Total 200 300
Here, the U.S produces both goods more efficiently than Pakistan; however, the ratio in automobiles is 3:1 for the U.S and for cotton is 2:1. Here the U.S has absolute advantage in both goods (i.e. it produces them both more efficiently) but Pakistan has comparative advantage in cotton (i.e. it is comparatively more efficient in cotton) if it specializes in its comparative advantage gains from trade will result, in this case the country with absolute advantage in both goods (U.S) will shift half of its resources producing cotton into automobiles, Pakistan will specialize completely in the good that it has comparative advantage in:
Automobiles Bales of Cotton
U.S 225 100
Pakistan 0 200
Total 225 300
There is a gain of 25 automobiles in world production, while cotton production remains the same.
Despite this theoretical evidence of the gains from freer trade there are several arguments cited in favour of protectionism. Before we look at the arguments for and consequences of protectionism let us look at some of the main barriers to trade in use today.
) TARIFFS: A tariff can be thought of as a tax on the consumption of a good. Let us suppose imported good X is priced at Rs. 100. A tariff of 100% imposed on the good would mean that it would come into the market priced at Rs.200. Rs 100 the cost price, and Rs 100 more tariff revenue added on which would go to the government. This would have two effects. One would be to reduce quantity demanded for the imported good because of the higher price. It would also increase the demand for domestically produced goods. The reduction in imports improves the balance of trade.
Tariffs can be used to stimulate an industry that is in the middle of a recession or is not cost competitive for some other reason. In the previous example good X is priced at Rs.100 by the foreign producers. Suppose it costs Rs150 for domestic producers to make. In such a situation there will be no demand for the domestic product. However, the 100% tariff imposed means the foreign good is now priced at Rs 200. This makes the domestic good cheaper and demand for the good rises and domestic producers have an incentive to produce. If the ...
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Tariffs can be used to stimulate an industry that is in the middle of a recession or is not cost competitive for some other reason. In the previous example good X is priced at Rs.100 by the foreign producers. Suppose it costs Rs150 for domestic producers to make. In such a situation there will be no demand for the domestic product. However, the 100% tariff imposed means the foreign good is now priced at Rs 200. This makes the domestic good cheaper and demand for the good rises and domestic producers have an incentive to produce. If the objective of a barrier to trade is self sufficiency and a cut in imports then a tariff is the best because it is better to reduce consumption by increasing production and reducing consumption rather than reducing consumption alone.
2) QUOTAS: A quota is a physical restriction on the amount of a good imported. It is more effective in reducing imports then tariffs because a government cannot control how much of an imported good is consumed under a tariff regime. It will certainly be less than without the tariff, but there is no control on how much less.
A quota on the hand directly imposes physical limits, so the government allows exactly as much of a good into the country as it wants and no more. This greater level of control
is a big reason that developed countries prefer quotas as an instrument of protectionism. Developing countries are more likely to use tariffs because of the revenue that the government can gain.
3) SUBSIDIES: Subsidies can be thought of as a negative tariff. For example if Japanese rice producers produce rice at Rs. 120 a kilo and India produces rice at Rs 100 a kilo, the Japanese government will pay their rice producers a subsidy of Rs 20, so that they too can sell their rice at Rs 100 and be competitive in the market. This type of protection is common place in Japan as well as Europe. It is generally given to agricultural producers in capital intensive countries, the reasoning is that foodstuff is an extremely important industry and European countries and Japan do not want to be dependent on other countries for their food, so they give their own farmers generous incentives to produce. If the objective of a barrier to trade is to increase domestic production then subsidy is the best choice since it leads to an increase in production without imposing any consumption costs (unlike tariffs).
Subsidies are an outward looking barrier to trade; they synchronize internal cost to external price while tariffs bring the internal price of a good close to internal costs.
4) Voluntary Export Restrictions (VER): As the name implies, a country deliberately restricts its exports following negotiations. The importing country's industry may be having difficulties competing with the imports as was American industry in the 1980's. It put a VER regime in place in 1981 with regard to Japanese automobile imports but then let it lapse in 1986. The exporting country would agree to the restrictions in exchange for some concessions for itself, in order to avoid spiralling protectionism on both sides if it did not agree to the restrictions. This method of restricting trade is usually used between developing countries.
5) Stringent quality rules: Often used by developed countries against developing countries. They deliberately set such quality standards which can only be realistically met by their own industry and therefore create a barrier to trade for the rest of the world.
6) Embargo or sanctions: Refusing to trade with a particular country. This is more of a political than an economic tool. Sanctions were instrumental in the end of apartheid in South Africa. Sanctions are in place against Libya and Iraq for terrorism and nuclear proliferation related activities.
There are several arguments in favour of imposing these types of restrictions, tariffs and quotas in particular.
) Firstly, there is the "infant industry" argument. This proposes that a new industry that is being set up in a developing country would have no hope of being more cost effective than established and developed firms already in the market. While this new industry is in its infancy it should be protected by the government and made competitive by means of erecting barriers to trade against foreign competitors. Once the industry gets over its teething troubles then protection will be removed and the industry can stand on its own feet. The phrase "learning by doing" is often used in this regard. On its own, it would not be worthwhile to even begin production in the industry because it is not cost competitive with the rest of the market. However, once production begins under government protection, workers would become more and more adept at the skills required in the industry and productivity would increase as they gained practice and expertise and once productivity was increased and cost decreased to market competitive levels the protection would be removed.
This is a reasonably valid argument and this model has been successfully used in some countries in South East Asia. The problem that often arises however is that protected industries become complacent, they have no incentive to become competitive since they are being propped up by the government and as the industries do not become competitive or profitable the government cannot remove the tariffs and this imposes a welfare cost on the consumers (they are getting poor quality goods, for a higher price than the market.).
2) A second important argument is the strategic industries argument. One example is the heavy protection that Japan gives to its rice farmers. The logic is that while in a purely competitive situation Japan would produce no rice; this would make it extremely dependent on whichever countries supplied rice to it. Since rice is a staple food for the Japanese, a threat to withhold rice supplies would put the island at the mercy of the rice suppliers. So, while technically it might be inefficient and against the comparative advantage principle, practically it is essential for Japan to be self sufficient in rice.
Many countries cite the same argument when building up a protected defence industry, if foreign suppliers withheld arms or spare parts the armed forces would fall into disrepair, therefore self sufficiency or at least substantial indigenous production of a country's defence needs is deemed to be important. While most thinkers believe this is a valid argument they stress that such protection should only be given to industries whose social benefits outweigh their social costs. This would certainly include industries that result in externalities. An example might be research and development of a new medicine that can quickly be copied by other manufacturers.
3) Countries seeking to improve their terms of trade also impose barriers to trade. A country's ratio of imports to exports can become more favourable when imports fall because of trade barriers while exports stay the same. The danger however, is that the countries which have had their goods tariffed will respond with retaliatory tariffs and exports will fall as well. The result will be the same level of consumption in all countries, merely at higher prices due to the tariffs.
4) Countries also believe that they can improve their balance of payments situations by imposing barriers to trade. Particularly tariffs. The high prices resulting from the tariffs reduce the demand for imports, and the revenue from the tariffs can be used to pay for imports that do take place, so the balance of payments deficit is either static or reduced but does not increase.
5) Industrialization at any price is the mantra of many third world governments and they use barriers to trade to protect their new industries from the international market. There is little concern whether the industries will be efficient or not, industries are setup as a show of prestige and power and since no thought is being given to efficiency the industries naturally need to be protected to survive in the international market.
Protectionist policies have often been used in the developing world as part of a policy of import substitution. Goods that were imported previously are now produced indigenously, the new industries are given protection and the purpose of the exercise is to reduce imports and improve the trade situation, preserving foreign exchange. Early on, this works, as non-durable consumption goods begin to be produced, developing countries in an early stage of industrialization are naturally suited to these industries and a low level of protectionism is all that is needed.
When the country moves to the second stage of industrialization, which is necessary in order to sustain high growth rates, then problems begin to occur. Intermediate goods such as steel and producer durables require high rates of protection as they are subject to economies of scale. If output is low, then unit cost is high. A developing country is unlikely to be able to produce high volumes in a new industry, the high level of protection is required to compete globally with other producers who are enjoying economies of scale and have very low unit costs. These high rates of protection lead to a lot of inefficiency. Since resources are diverted towards this inefficient operation away from goods where the country does have comparative advantage, exchange rates are artificially high because exports are lower than they would be if the country were concentrating where its comparative advantage lay. Since the industry that was supposed to substitute for imports is also not profitable because of high unit costs, there is no compensating factor for the lower exports; hence terms of trade can actually deteriorate as a result of import substituting policies.
Import substitution skews income distribution in favour of urban areas, urban dwellers tend to have a higher marginal propensity to import and this worsens the balance of payments. Protection taxes agriculture as it raises the price of industrial goods with respect to agricultural goods. Also, the artificially high exchange rates make agricultural exports less attractive as the amount of foreign currency received for X number of agricultural goods goes down. Basically, agricultural goods are worth less because of the high exchange rates.
In general protectionist measures lead to complacency and inefficiency in domestic industry, competition is severely limited in a protectionist environment therefore consumers have less choice and variety of goods, and they consequently suffer a welfare loss as they get fewer goods of poorer quality for a higher price.
That being the case it might seem surprising that so many protectionist measures are still in place. In dictatorships policy decisions are often made in idiosyncratic fashion, but even in democracies there are still several reasons that tariffs may stay in place.
In principle policy decisions in a democracy are made with a simple majority vote in parliament. Reasons why this majority vote may go against reduction or abolition of tariffs are as follows:
) Those losing out in a tariff reduction, for example owners of large textile mills when tariffs are being reduced on the textile industry, may have a majority in parliament and they and their cohorts will vote against the reduction in tariffs for their own gain.
2) Prospective gains from a tariff reduction will be intangible and over the long term, the losers will lose money directly and will have more incentive to participate actively in the political process.
3) People losing out from a tariff reduction may not have overall majority support in the country, however they have a majority in parliament, supposing there are three voting districts and they have 51% support in two districts they need only 34% of the total vote to command a majority in parliament. If they have 51% in 13 of 25 districts they need only 27% of the total vote to get a majority.
4) Parliament might be fragmented but pro tariff groups might align themselves with each other. Group A very firmly wants tariff A in place, and is weakly in favour of tariff B, Group B very firmly wants tariff B in place and is weakly in favour of tariff A. If these two groups are unaligned then the free trade group is likely to get its way because both protection groups get played off against each other. But if they join, then they will be in majority.
5) Tariffs provide revenue for governments. Particularly in developing countries with poor tax structures tariffs can be an important source of revenue.
Pro tariff groups are those industries which benefit from tariffs, as well as their labour unions. Labour Unions strongly support protection for their industries because otherwise jobs would be lost.
Exporters tend to be against tariffs since they fear retaliatory tariffs by other countries, industrialists who depend on imports as raw materials for their own industries are against tariffs since they increase their costs, and consumers are against them as they have to make do with lower quality goods for higher prices.
Trade theory tells us that protectionism is certainly an incorrect and often harmful policy while barriers to trade have come down in general as a result of the General Agreement on Tariffs and Trade (GATT) talks, which were of course succeeded by the World Trade Organization (WTO) both developing and developed countries continue to practice protectionism as a result of various exigencies such as influence of pressure groups, vested interests and some conscious policy decisions, such as the need to promote strategic industries.
BIBLIOGRAPHY
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