SHOULD THE U.S. PROTECT DOMESTIC INDUSTRIES FROM FOREIGN COMPETITION?

Arguments for Protectionism:

1. Saves American jobs: by raising the price of imports via tariffs or quotas (discussed below), American industries are more competitive in the domestic market and therefore American workers' jobs will be spared and/or expanded.
2. Protects infant industries: When industries are just beginning, it makes sense to protect them from the perils of foreign competition at first, until the industry grows and matures. At that time the protection can be lifted and the mature company will be competitive. In other words, the entry costs are so high from foreign compeition that trade barriers are necessary to overcome those barriers.
3. Raises government revenue: Government revenues increase since the US government collects the tariff revenue.
4. Keeps firms in U.S.: This effect might occur for two reasons. First, firms will face less competition here and not feel the pressure to move to low-wage countries. Second, the firm who moves to another country must pay the higher import tax to sell the product in the US and thus may not be as willing to relocate.
5. Levels the playing field for those firms who adhere to stricter environmental and labor laws.: If firms in the U.S. must adhere to costly environmental regulation and give laborers certain rights and minimum working conditions, then U.S. firms are at a cost disadvantage as compared to firms in nations who do not have to adhere to such regulations. Therefore, trade protection makes the playing field a little more equal.
6. National security: Certain industries (i.e. defense, computer technology) are too technologically sensitive to export indiscriminately.
7. Political tit for tat: If my trading partner plays unfairly, why should I play by the rules? We accuse Japan of unfair trading practices quite often, hence we have a right to impose similar unfair trading practices to make the playing field level.
8. Human rights violations: Trade policy may give the U.S. political leverage in coercing another country to improve its human rights violations (as the US tried unsuccessfully with China).

Economic Theory of Protectionism: Tariffs & Quotas

Tariffs

A tariff is a tax on an import. The chart below depicts a simple scenario when a tariff is placed on an imported product. The supply curve in the import market shifts to the left because the importers now have to pay a tax to the U.S. government. Since the domestic good is a substitute (can be consumed in place of) for the import, demand for the domestic good shifts to the right. The domestic producer can charge a higher price and sell a larger quantity (point B).

Winners and Losers of Tariff Protection:

Winners	Losers
Domestic producers who compete with importers	U.S. consumers who pay a higher price for imports
Government via increased tax revenue	Importers to U.S.

This explains why demand for trade protection is strong. U.S. firms often lobby the government for special treatment in order to put ease the competition from foreign producers. (As an example, consider the debate over mini-vans' status as trucks. If mini-vans were classified as trucks instead of their current classification as cars, then foreign mini-vans would be much more expensive in the U.S.)

Import Quotas

Winners and losers from quota restrictions:

Winners	Losers
Domestic producers who compete with importers	U.S. consumers who pay a higher price for product
Foreign producers who get in under the quota	Importers who are shut out of the US market

The Economic Argument for Free-Trade

Trade is rarely a zero-sum game. When exchange is voluntary, both parties to the exchange perceive that they will be made better off after making the exchange. Otherwise, the exchange would not occur. Trade is generally a win-win scenario. My job is to teach others how economies operate. I produce that service and then trade those services for all my other needs like clothing, shelter, and food. By these exchanges, I am made better off. Trading with other countries is no different.

An example of gains from trade using the concept of comparative advantage works the following way:

Given a certain amount of resources, the US can produce 50 airplanes and 200 shirts. With the same resources, Mexico can produce 20 airplanes and 160 shirts. Notice that the US has an absolute advantage in producing both airplanes and shirts. Does this mean that the US should produce both and cut off trade with Mexico? The answer is no. The production possibilities frontier for each country is graphed below (assuming that the principle of increasing costs does not apply for simplicity).

Notice that the U.S. can make one plane for every four shirts it gives up. Mexico can make one plane for every eight shirts that it gives up. Since the opportunity cost for Mexico to make airplanes is twice that of the US, the US has a comparative advantage in making airplanes. But the reverse is also true. The US can make one shirt for every 1/4 plane that it gives up whereas Mexico can make one shirt for every 1/8 plane it gives up. Since the opportunity cost to make shirts in the US is twice that in Mexico, Mexico has a comparative advantage in making shirts. If the US specializes in airplanes while Mexico specializes in shirts, both countries can consume more than before and therefore each country will be better off than if they live in isolation. Suppose the world price of airplanes costs 6 shirts. The consumption possibilities frontier for both countries is graphed below in red. Notice that both countries are better off after trading.

Are There Ever Justifications for Protectionism?

Given the gains from trade, are there any good reasons for protectionism? Let's reexamine the reasons that we listed above.

1. Saves American jobs: By imposing trade protection, the price of foreign and domestic goods rise. In return, certain American jobs are preserved. However, it is often estimated that the cost to American consumers to save one job through protectionism is $100,000 to $150,000. The reason for the high cost is that all the consumers of a particular product pay a higher price than they otherwise would. This is a very inefficient way to save certain jobs. We would do better to pay the affected worker $50,000 in unemployment compensation per year than to impose tariffs.
2. Protects infant industries: This sounds reasonable at first glance. But why not lend the firm money instead? If the industry is so promising, why won't financial markets back up the firm and carry it through the early years? It could be that financial markets don't work well (though that certainly isn't true in the US). But even under this scenario, why not grant government subsidies? Also, the infant industry tends not to grow up because the protection rarely ends due to political lobbying.
3. Raises government revenue: It is true that tariffs raise revenue for the government (though quotas do not directly), but this is a very inefficient way to raise revenue because consumers end up paying for this tax by higher consumer prices. The government could raise an equivalent amount of revenue by raising corporate or personal income taxes.
4. Keeps firms in U.S.: The fallacy of this argument is in assuming that the lost jobs from firms moving overseas will not be replaced. By allowing production to shift internationally, we can specialize in our comparative advantage and replace the lost jobs with higher skilled, higher paying jobs on average. We can do better as a nation, for example, by allowing clothing production to be done in other countries, while we focus on software production.
5. Levels the playing field for those firms who adhere to stricter environmental and labor laws.: This argument is harder to dismiss. It is true that many other nations have environmental and labor laws that are much less stringent, and hence it is less costly to produce in those nations. We must be careful, however, to correctly isolate the cost advantages from differing labor and environmental laws. Usually, they are much less costly than we initially believe.

   The rights to form unions, engage in collective bargaining, and guarantee minimum wages and working conditions were hard-fought battles that unions slowly won in U.S. history. These rights, other things equal, increase the cost of labor in the U.S. Many people look to Mexico and note that average wages are about one-fifth of what they are in the U.S. It is tempting to attribute the difference to labor laws. If fact, most of the disparity comes from differences in labor productivity. Workers in the U.S. have higher average wages because we can produce more goods and services per hour than can the average worker in Mexico. We have the technology and capital to make us more productive. We must not confuse this real productivity difference with differences in labor laws. Labor laws do contribute to wage differentials, but they are secondary to average productivity.

   Environmental laws raise the cost of business as well. But meeting environmental regulations are also only one portion of a firm's overall costs. We must avoid attributing too much importance to differences in production costs due to these regulations.

   Having addressed these issues, there may be some justification for trade protection if comparative advantage is distorted by labor and environmental regulations. There are at least two ways to approach the problem. One is to erect protective barriers. The other is to encourage our trading partners to improve their labor and environmental laws. The second strategy is a longer-term approach that gives the U.S. less control over the outcome. But if free trade raises incomes in a poorer nation, then over time labor and environmental laws may improve.

6. National security: National security may indeed be a good reason to limit trade. Usually the scope of this limitation, however, is very narrow and focused. National security concerns will not widely disrupt free trade.
7. Political tit for tat: Adopting protective measures because our trading parterns are not playing fair may force our trading partners to open their economies up. There may be times when this policy is justified. However, it should be used as a last resort. Moreover, the end goal of these times of measures is to have more free trade, not less.
8. Human rights violations: As with political tit for tat measures, using trade policies as leverage for improving human rights may sometimes be justified. There is always an on-going discussion, however, of the advantages of engaging in trade with a nation rather than taking a more comabative approach and erecting trade barriers. One can make a case for either approach. If we engage in more trade with a country, we become mutually dependent on one another. So we may be able to influence that country more than if we reduce our economic presence in that country. However, the threat of sanctions may induce a nation to improve its human rights abuses more quickly and directly.

In sum, there may be some non-economic justifications for protectionist policies, but economic arguments are difficult to justify.

NAFTA

The North American Free Trade Agreement was a pact implemented in 1994 between the US, Mexico, and Canada which eliminated or will eliminate most of the tariffs and other trade restrictions between the countries.

Impacts of NAFTA

The initial impacts of NAFTA will be to lower the prices of goods and services that sell across the countries' borders. Since Mexico had far higher tariffs than the US, the prices of US goods sold in Mexico will fall farther than Mexican products sold in the US. At least two groups benefit: consumers in all three countries benefit from lower prices, and exporters benefit from an increased demand (due to lower prices) abroad.

Then Why All the Fuss?

Many people were also concerned about the lax labor and environmental laws that Mexico has in comparison to those in the U.S. To win passage of NAFTA, the final legislation included "side agreements" that attempted to address these issues. In particular, the Clinton administration negotiated the North American Agreement on Labor Cooperation and the North American Agreement on Environmental Cooperation. The goal of the environmental cooperation is to assist both countries in designing and financing environmental infrastructure projects in the border region. The labor side agreement established a federal government level office in each country called the National Administrative Office (NAO). One of its functions is to receive public complaints about lack of enforcemtn of labor laws in the home country. Many people viewed these side agreements as insufficient, and hence their opposition to NAFTA remained.

Recent studies of the impact of NAFTA on the U.S. economy have confirmed what many economists were predicting from the outset. Namely, that the benefits and costs from NAFTA are small. In other words, some jobs have been lost and some gained, but not many as a percentage of our labor force. To date, the disruption from NAFTA has been much quieter than the loud debate over passage of the trade pact itself.

NAFTA Links

Notes on NAFTA: The Masters of Mankind, by Noam Chomsky.

The NAFTA Trade Pact

NaftaNet

Summary

Most of the reasons people give to justify protectionist policies boil down to the fact that some U.S. firms and workers are threatened by international competition, and protectionism at least delays those negative consequences. Other things equal, free trade results in a higher material standard of living. Therefore, we want to be very careful in inhibiting free trade, and make sure that we are erecting trade barriers for worthy reasons.