FEDERAL RESERVE OF ST. LOUtS JANUARY/FEBRUARY 1988

Protectionist Policies: A Survey of Theory, Evidence and Rationale

Cletus C. Coughlin, K. Alec Chrystal and Geoffrey E. Wood

ROTECTIONIST pm-essures have been mounting THE GAINS FRONt won-idwide during the 1980s. These pn-essmmres are due to various economic problems incltnding the lam-ge and The most famous demonstration of the gains fn-om persistent balance of tn’ade deficits in the United tnade appear-ed in 1817 in ’s Principles of States; the har’d times expenienced by seven-al indus- and Ta,vation. We use his example tries; and tire show growth of many foreign countn-ies.’ inm’olm’ing tn-ade between England and Portugal to dem— Pn-oponents of protectionist trade policies amgue that onstnate how both countries can gain fn-om tnade.. The has contributed substantially to two countnies pn-oduce the same two , and these problems and that protectionist tmade policies cloth, and the only pn-oduction costs an’e labor- costs. will head to improved n’esults. Professional economists The figures below list the amount of lahior leg.. in the , however-, generally agree that won-ker-daysi requin-ed in each country to pn-oduce one tmade restn-ictions such as tariffs and quotas substan- bottle (if wnne on- one hiolt of cloth. tially reduce a nation’s economic well~being.2 Wine Cloth This article surveys the theory, evidence and na- tionale concen-ning protectionist trade policies. The England 3 first section illustrates the gains from fm-ce tn-ade using Portugal 1 the concept of compan-ative advantage. Recent dem’el- opments in international trade theorm’ that emphasize Since both goods ar-c tiione costly to produce in En- other reasons for- are also reviewed. gland than in Por-tugal, England is ahisolmrtely less The theoretical discussion is followed hiy an exami- efficient at producinig both goods than its prospective nation of recent empirical studies that demonstm-ate trading partner. Portugal has an in the large costs of protectionist trade policies. Then, hioth wine and cloth. At fin-st glance, this appear-s to the rationale for restricting trade is presented. The r-ule. (iut mutual gains fn-om trade; howem’e,n-, as we concluding section summarizes the paper’s main demonstrate below, absolute advantage is irrelevant in arguments. discerniing whether tn’ade can hienefit both countn-ies. The natio of the pr-oductioni costs fon’ the two goods is diffen’ent in the two countries. hn England. a bottle (if Cletus C. Coughlin is a senior economist at the Federal Reserve Bank wine will exchange for 3/7 of abolt (if cloth becamnse the of St Louis. K. Alec Chnystal is the National Westminster Bank Profes- sor ofPersonal Finance at City University, London. Geoffrey E Woodis labor content of the wine is 3/7 of that for (:10th. In a professor of economics at City University, London. This article was Por’tmtgal, a bottle of winieivill exchanige for 1/5 of a bolt written while Chrystal was a professor ofeconomics at the University of of cloth. Thus, wine is relatively cheaper in Portugal Sheffield, Sheffield, England. Thomas A. Pollmann provided research assistance. than in Englanid and, conm’ersels’, cirith is relativehs’ cheaper in England than in Portmngal. ‘the example ‘See Page (1987) for a detailed examination of trade since 1974. indicates that Pom-tugal has a compam-atim’e adm’amitage in

2 This consensus was found in a survey published in the late 1970s mvimie pr-oduction and England has a comiipar’ative ad- (Keart et at., 1979). Recent developments in international trade vantage in cloth pn’ocluction. theory, which can be used to justify governmental intervention in trade policy, have not altered the consensus (Krugman, 1987). 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. The labor was the only resource used to produce the two gains arise from both exchange and specialization. goods in the example above; yet, labor is really only one of many resources used to prodmnce goods. The The gains from exchange can be highlighted in the example also assumed that the costs of producing following manner. If a Portn.mguese wine producer sells additional units of the goods ar-c constant. For exam- five bottles of wine at home, he receives one bolt of ple, in England, three units of labor an-c used to pro- cloth. If he in England, he receives more than duce one bottle of wine regardless of the level of wine two bolts of cloth. Hence, he can gain by expon-ting his pn-oduction. In reality, unit costs could mvine to England. English cloth-pn-oducen-s are willing either increase or- decrease as more is produced. A to trade in Portugal; for em’eny 3/7 of a bolt of cloth the thim-d assumption was that the goods an-c produced in sell there, they get just (iven’ twri bottles of wine. The per-fectlv competitive mat-kets. tn other- won-ds,an indi- English gain from exporting cloth to land imponting vidual firm has no effect on the price of the good that it wine fn-omi Por-tugal, and the Portuguese gain from pn’oduces. Some industries, however-, are dominated expon-tingwine to land importing cloth fromi England. by a small numhier of firms, each of which can affect Each country gains by expon-tinig the good in which it the manket pr-ice of the good iw altering its production has a compan-ative advantage and by impon-ting the decision. Sonic of these extensions at-c discnnssed in good in which it has a compam-ative disadm’antage. the appendix.

Gains fn-om specialization can be denionstrated in These theoretical developnients genem-atly have the follomming manner. tnitially, eachi country is pto- strengthened the case for an open rn-ading . ducing some of both goods. Suppose that, as an-esutt of They suggest thn-ee soun-ces of gains fi-om trade. First, tr-ade, 21 units of labor are shifted fnom mvine to cloth as the potentially served by firms expands pnoduction in England, while, in Portugal, 10 units of from a national to a market, then-c are gains labor- are shifted from cloth to wine production. ‘l’his associated with declining per’ unit pnoduction costs. A reallocation of labor- does not altet- the total amount of second sour-ce of gains results fn-om the reduction in labor’ used in the two countn-ies; howeven-, it causes the the monopoly power- of domestic firms. Domestic pn-oduction changes listed below. firms, facing more pressure from fon-eign competitors, are forced to produce the (iutput demanded by con- Bottles of Wine Bolts of Cloth sumers at the lowest possible cost”l’hird is the gain to consumers from increased product variety and lomver England —7 ±3 prices. Generally speaking, the gains fiomn tm-ade r-esult Portugal ±10 —9 from the increase in competitive pressures as the Net ±3 ±1 domestic economy becomes less insulated from the world economy. The shift of 21 rnnits of labor to the English cloth The gains fm’oni free trade can also he illustrated industr raises cloth production by three bolts, while reducing wine production by seven biotttes. In Pomtrn- gt-aphicallv. The shaded insert on pages 14 and 15 examines the gains fiom tt’ade in pemfectly competitim’e gal, the shift (if 10 units of labor from cloth to wine mar’kets using supply and demand analysis. The in- raises winie pm’oduction liv 10 bottles, while n-educing cloth pm-oduction by two liolts. This reallocation nif sert also analyzes the effects of tn-ade n-estn-ictions, a labor imicreases the total pnoduction of Iiothi goods topic that we discuss below. wine 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 wealth COSTS OF ‘TRADE PROTECTIONISM of both countries an’e incn-eased by the specializa— tion bm-ought about by trade based on compar-ative Protectionist trade policies can take numen’ous advantage. forms, some of which are discussed in the shaded insert on pages 16 amid 17. All forriis of lirotectioni an-e

TRADE THEORY SINCE HICARDO ‘A profit-maximizing firm produces its output at minimum cost. When Since 1817, numerous analyses have gener-ated in- firms are insulated from , costs are not necessarily being sights concerning the gains from tmade, ‘l’hiey chiefly minimized. This situation, which is catted X-etficiency, has been stressed by Leibenstein (1980). The increase in competitive pres- examine the consequences rif relaxing the assump- sures due to international trade reduces the probability that costs tions used in the pn-eceding example. For example, are not minimized. A Supply and Demand Analysis of the Gains from Free Trade and the Effects of a rliarjff

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mnili-rm,hith tim immmimllmm— liii inrn_ilmnmr nt ninrnnn,—stmr- ni’tntmmi rlmrrn—ns inn’ inrniilit him i-~rmni nir it c nirrtn—, iii 1 1 tin Iuinn—Ir;mn iiichmmii-ns I rn— ‘inn inn ,iinmmi— Iinm-rnnngii imrim cr11 rnninrrits —mimni,— lmnncii_znm niiiihnn,im’ nir~nm niiiimc i-it—s Iinnt nir,-n n—~sl hit,- lnm,nin, inrtii~i-lrim—rn— ml mini- trrn-,—n&~nm hnigiii-m nniris tmrrrln,-in i—mptrnts lii tim rninlictr,i mmniri,_,-I mnii,hnrm-l ,h,-m’nr-tst- tIn, pm I nihnn,tnmnmn rmn~ts nI citimmirsi ml Then-c have lieeni numerous studies of the costs of tim-iris mr srnmnii—iiiimm mn’sini,l Ilir- ,ic-n-I-—~s ri pr’otectionism. We begin by examining three recent rhmnri-n—— Iii liii- chrnmin,-stnr nmnriL,-t studies of pm-otectioriism in the United States, then The 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 of r-esour-ces to the protected industry. The goven’nment Costs qf Protectionism in the Crated imposing pr-otectioniist trade policies may also benefit, States for example, in the form of tan’iff revenue.

---. Recent studies by Tan and Morkre 119841, t-lickok 1 he expansiomi of doniestic pn-odnnctnon mni pr’otected — ------.- -- 1985) and Huliuauer et al. 11986) esttmated the costs of nndustiits is not costless it n quit is tddntnonal pi otcctnotusni in tin Unitc d St ntis I lit s studn s usc sources from other itidustrres. Consequently, output -.- ---. --.--,,.different estnmatnoni procedun’es, examine diffem-ent iii 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 mesults higher 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 the protected 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 and pr-otected good is n-educed because of the, associated sugar-. Their cost estinuate is a net measur-e in which rise in its price. Second, they consume less of other the losses of consumers are offset partially by the gains goods, 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-, and Domestic 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—income interests an-c also affected by tr’ade resti-ictions. The fànnilies. The impor’t r’estm’aints on clothing, sugar and pn’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 sun-char’ge that is, an additional Fermi Of Preticfio\nisrn

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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— ,‘trmnm ),’Iitimi 1

tax added to the normal income tax) for families with consumet losses associated with protection in car-hon incomes less than $10,000 in 1984 and a 3 percent steel $6.8 billion), automobiles $5.8 billion) and dairy income tax sin-charge fom families with incomes cx- products $5.5 billion). ceeding $60,000. The purpose of pr-otectionism is to IJm’otect jobs in

Hufbauer et al. 11986) examined 31 cases in which specific industries. A useful approach to gain some trade volumes exceeded $100 million arid the United penspective on consumer- losses is to express these 4 States imposed protectionist trade restrictions. They losses on a per-job-saved basis. In 18 of the 31 cases, generated estimates of the welfare consequences for the cost per-job-saved is $100,000 or more pen-year-; the each major- group afected see table 1). The figures in consumer losses per-job-saved in benzenoid chemni- the table indicate that annual consumer losses exceed cais, carbon steel )two separate periodsL specialty $100 million in all hut six of the cases. The largest steel, and bolts, nuts and screws exceeded $500,000 losses, $27 billion pen- year-, come fnom protecting the per year. textiles and apparel industry. There also ane lan-ge Table I also neveals that domestic producers were the primary beneficiaries of protectionist policies; however, there are some noteworthy cases where fom~ ~Whilethere were cases in which the industry adjusted to its new eign producers realized relatively lam-ge gains. For the competitive position and the protection was terminated, these cases US-Japanese voluntary export agn-eenient in automo- were more the exception than the rule. In far more cases, protection- isi policies were maintained indefinitely or removed because of biles, foreign producers gained 38 percent of what favorable demand changes. domestic consumers lost, while a similar computation FECfRAL RESERVE BANK OF sr. LOWS JANUARY/FEBRUARY lOSS

Table 1 Distribution of Costs and Benefits from Special Protection Producer - consumer Losses Gains eltare costs of Restraints Gamn to Efficiency Totals 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 29 Benzpr-ond clrernca~ 2 650 fl? 1 2 2h0 ceo 252 14 “:n-tnt:.rl 200 2Lno 000 1-30 meg 54 13 Rr,Lbe- tr,otwoa. 230 30 000 90 rreg 139 33 sc-am--; am:nrjen 9u 47.500 25 --cg 69 6 £erarm;clc-s 116 135000 oP ~ 55 11 Orarnge u-ce 525 240 oco 39O neq ‘29 150 Gannenlnna 9~ 7~.00Q 74 5 10 4 lax’nlr-s ond apoa’e Phase; 9.400 22 njOO 6700 ico 1 ‘56 lOU lexlnles ond appa’sl Phase ml 20 000 37000 8000 350 2’43 3 100 Texmnies and Hpnarci Phase UI oT 000 42000 22000 1 800 2.535 4850 Gareo-~steel- Pt-aspi 1.970 240.000 1 330 330 290 50 carbon steel rb-,~etn 4 3’0 62000(3 2 /70 940 a56 120 Carbon steel Phase lit 6 $00 750 000 ‘3 800 2.000 560 33cr Bail 004nnnus 43 90000 21 neq 18 -cc Snou only slee- 520 1 000 Xc cc so 32 30 Nr-nwbner trMnwea’ 700 55 000 250 220 lb Color leiev-snom-s 420 420 000 190 140 77 7 ~B aoo; 55 93.000 n4 nt-a 32 3 Bolts -Us arge svews ~10 550 000 50 nan P’etared ‘imnsnrcorns 3S 11/000 reg /5 r) 8 Autrynob-les 5.800 105 000 2.1-00 2200 /90 200 MolomnyL e~ 04 50 000 67 meg 117

St- rv.cos Mdr tnme nrousl’nes 3000 270 000 2 njOO req 10 1 000 Agr.cul~reard fnsbemnes Sugar 930 60 000 550 410 -, 130 690-acre Davy pmoduris 5 500 220 000 5 000 S0 3-4 I 370 800 ~ow

Pcanuis 1/0 • 000 dcrP 170 ‘nag 9 14 Meat - 800 150000 1 600 135 44 725 t-pao Fnsh 560 21-300 200 170 1// ‘5 M-nnrg Pelroneum 6 900 160 000 4 800 2 000 /0 3 000 Leacljr-Lzrnc 67 30000 41- 4 I:

Neo mneg: gnoie Unless o’herwnse sr-pc -fpc. t.ommro: ire oar wor-0r EsI marco eumncs colk.clecn on sn-n) mepanns on-fnrmeo -abroac i-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 tnmengr exporters 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 was value of . One r-ationale for this finding is that a 29 percent. reduction in the pun-chases of foreign goods reduces foreign incomes and, in turn, causes reduced foreign Finally, table 1 indicates that the efficiency losses purchases of domestic goods. ane small in compan-ison to the total losses bor’ne by consumers. These efficiency losses, which are defined While the reduction in impot-ts increases employ- precisely and illusu-ated in the fir-st shaded insert, mnent in industries that produce pn-oducts similar to result fr-on) the excess domestic production and the the previously imported goods, the reduction in cx- reduction in consumption caused lw pr-otectnonist por-ts decreases employment in the expor-t industries. trade policies. En laige cases such as textiles and In other words, while some jobs are saved, other-s ar-c apparel, petroleum, dairy pm-oducts and the maritime lost; however-, this economic n-ealitv may not be obvi- industries, these losses equal or exceed $1 billion. It is ous to businessmen, labon- union leaders, politicians likely that these estimates understate the actual costs and others. Luttrell 1978) has stressed that the jobs because they do not capture the secondary effects that saved by piotectionist legislation are more readily occur as pn-oduction and consumption changes in one obsen’ed than the jobs lost due to protectionist legis- industry affect other industries.~ In addition, restric- lation. In other words, the jobs that are protected in, tive trade policies generate additional costs because of say, the textiles industry by U.S. restrictions on hun-eaucn-atic enforcement costs and efforts by the foreign textiles are more readily apparent land publi- pi-ivate sector to influence these policies fon- their own cized) than the jobs in agriculture and high technol- gain as well as simply comply with administrative ogy industries that do riot materialize because of the r-egulations. impoi-t restrictions. These employment effects will net to appi-oximately zei-oY Costs o/’ Protectionism Throughout the t’he OECt) study also stresses that developing coun- ti-ies need exports to offset their debts. Thus, pr-otec- World tionist tn-ade policies by developed countries affect not In 1982, the for Economic Co— only the economic activity of the developing coun— opet-ation and Development OECD) began a pn-oject to tries, but the stability of the intet-natiorial financial analyze the costs and benefits of protectionist policies system as debtor nations find it increasingly difficult in manufacturing in OECD countnes. The DEC13 to their debts. 1983) highlighted a numbei- of ways that protectionist Not only does a free trade policy by developed policies have generated costs far in excess of benefits. countries benefit developing countries, hut a free Since protectionist policies increase pr-ices, the i-epon-t trade policy by developing countries benefits develop- concludes that the attainment of sustained non- ing countries. A recent World Bank study (1987) of 41 inflationary growth is hindered by such price— developing countr-ies compar-ed the perion-mance of increasing effects. Moreovei-, economic growth is po— countries following a fr-ce tr-ade policy with countries tentiallv reduced if the uncertainty created by varying following a restricted trade policy.’ Table 2 lists the tnace policies depnesses investment. Wood and Mudd 1978), and many others, have shown that impoi-ts do not cause higher unemploy- ment. Conversely, the OECD study stresses the fact that a r-eduction in via trade restr-ictions does eRecent evidence shows that protectionist legislation actually may not cause gn-eater employment. A reduction in the reduce employment. Denzau (1987) estimated that 35,600 manu- value of imports i-esults in a similar reduction in the facturing jobs were lost as a result of the September 1984 voluntary export restraints that limited the level of U.S. steel imports. Despite an increased employment for producers of steel (14000) and pro- ducers of inputs for steel producers (2,800), these increases were more 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 subject them to more foreign competition in the U.S. market. 5 Recent estimates of the costs of protectionist policies using general ‘The World Bank study divides trade strategies into two groups: equilibrium models suggest thai the secondary effects, to the limited outward oriented and inward oriented. An outward-oriented strat- extent they are measurable, are substantial. For example, Grais, de egy, which we call a free trade policy, is one in which trade and Melo and Urata (1986) estimate that the elimination of quotas in industrial policies do not discriminate between production for the Turkey in 1978 would have caused a 5.4 percent rise in gross domestic market and exports, nor between purchases of domestic domestic product, while Clarete and Whalley (1985) estimate that and foreign goods. An inward-oriented strategy, which we call a the elimination of tariffs, quotas and export in the Philippines in restricted trade policy, is one in which trade and industrial policies 1978 would have caused a 5.2 percent rise in gross national are biased toward production for the domestic market relative to the product. export market. FEDERAL RESERVE BANK OF ST. LOUIS JANUARY/FEBRUARY 1988

Table 2 Annual 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 34 6 0 Tha-and 49 Nngena 42 Burur-dn 3 2 l-ndonesna 46 Turrs:a 4 0 Arger-t na 3 costa Rnca 39 Kenya 3 9 Pakrstar 3 Malays.a 38 Phnlnppnnes 2 2 Tanzanna 27 Ivory coast 35 Bolnvna 20 Sm Lanka 2 3 co-orbna 33 Hondu’as 1 9 Erhnoona 1 9 Guaremaa 27 E Sa-vador 1 4 Chnle 1 7

~amerooi 01 Madagascar 1 1 Peru i N-caraoua 1 I Uruguay l 5 Senegal 0 6 7amb-a 1 2 Inc-na 1.1 Ghana 0 Bang:aoesh 4 Sudan 1.9 1973—55 Snngapore 65 Malaysn~ 4 1 Cameroon 56 Banglacesh 20 HongKong 63 Tnanlano SO lndorc-sna 40 mona 20 54 Tunrsna 29 S’n Lanka 33 Buruno 1 2 Braz-- 1 ~ Pa~nsnan 31 Domnnncan Repub.rc 05 Turkey 1 4 Yugoslavia 2 7 Efhnoona 0 4 Isree. 04 cola-tb-a 1 8 Sudan 0 4 Uruguay 0.4 Mexnco 1 3 Peru 1 chnne 0.1 Phnlnpp-nes 11 Tan?anna ‘ 6 Kcnya 0 3 Argenrnna 2 0 0 I Zamh,a 2 3 Senegan 05 Nnqerna 2 5 costa Rca 1 0 Bonnvna 31 Guatemala 1 0 Ghana 3 2 Ivory Coast 1 2 Madagascar 34 En Savaoo’ 35 Nncaragua 39

SOURCE World Doveroomenn Reporl 1987 and l1987l

;rnirLnai nu-nar4n gn-uniii ni fl ii pin r.npil;r gnnnss Hr innustninenil •~einrrured mmmi- aiidiimrnn 1 1 Innun_nI pniniinirl tr’r-emr-k tnt line II rniinritnir—, tim 19mM 7% rnnnrnti ni-s luIInfl\nnlg a liii- 1mar11 pn i 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 a tii;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,ennltins finn 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-.r nil I inn nun,- Inn- lUh%-7% ~‘as U.U penlenni inn 1 1 nm-rnnnr)nunin--, sin-nmnnj.l~ inn triter Inn 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 9 iir run 0 I ni-er- nil ni-s nei-tn~n-Is 1 Inn- stnnnI~ )nn)n(mni-, Inn nrIrnitii~ Ii.- Iin.nlrr)nlmrmniimnnir- It j)nmntnrIirnnnn~.nnnis—,mnnnnstl~.~~in~i—. mnnrli-n-Iir,niisnnn sin 1 nr—,—,mnni mm liii LrruinrnI tinnninmnr_r \ Un\mnn nrnnrntnmnt ni nnn~\ ni’n\nsn’n~ I !ni’~snrtnnnln n-n—~nn—~~—~tint rnn.nlnnn nnr4nnnmninni’. 1 FEDERAL RESERVE BANK OF Si. LOUIS JAIIUARYIPEBRUARY INS for restricting tiade and provides explanations for the such a large producer- or consumer of a good that a existence of protectionist trade policies. change in its production or- consumption patterns influences world prices. For- example, by imposing a tarifL the countny can make tbr-eign goods cheaper. National he/ease Since a tariff reduces the demand for foreign goods, if The national defense argument says that impor-t the tariff-imposing country has some mar-ket power-, barrier-s are necessary to ensure the capacity to pro- the world price for the good will fall.’ The tariff- duce cr-ucial goods in anational emergency. While this imposing countr will gain because the pr-ice per unit ar-gument is especially appealing for weapons dun-ing of its imnports will have decreased. a war, then-c will likely be demands from other indus- There ar-c a number of obstacles that preclude the tn-ies that deem themselves essential. For- example, the widespread application of this ar-gnment. Few couri- footwear industry will demand protection because tries possess the necessary market power and, when militam personnel need combat boots.’ they do, only a small number of goods is cover-ed. The national defense ar-gument ignores the possibil- Secondly, in a won-Id of shifting supply and demand, ity of purchases from friendly countries dur-ing the calculating the optimum tan-iff and adjusting the rate emer-gency. The possibilities of storage and depletion to changing situations is difficult. Finally, the possibil- r-aise additional doubts about the general applicability ity of foreign retaliation to an act of economic warfare of the aigument. If crucial goods can be stored, for is likely. Such metaliation could leave both countries example, the least costly way to prepare for an erner- won-se off than they would have been in a fm-ce trade gency might be to buy the goods from foreigners at the environment - low 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 an Balancing the Balance o/’Trade erner-gency will cause a more rapid depletion of do- Many conntnies enact prDtectionist tnade policies in mestic r-eserves. Once again, stockpiling might be a far the hope of eliminating a deficit on less costly alternative. increasing a balance of tr-ade surplus. The desire to increase a balance of ti-ade surplus follows from the Income Redistribution mer-cantilist view that larger trade surpluses are bene- ficial from a national perspective. Since pr-otectionist tr-ade policies affect the distribu- This argument is suspect on a numben of grounds. tion of income, a might be defended First, there is nothing inherently undesir-able about a on the grounds that it fayors some disadvantaged tr-ade deficit or- desirable about a surplus” For exam- group. It is unlikely, however, that trade policy is the ple, faster economic growth in the United States than best tool for dealing with the perceived evils of income in the rest of the won-Id would tend to cause a trade inequality, because of its bluntness and adverse effects deficit. In this case, the trade deficit is a sign of a on the efficient allocation of resources. Attempting to healthy economy. Second, protectionist policies that equalize incomnes directly by tax and transfer pay- r-educe irnports will cause exports to decrease by a merits is likely less costly than rising trade policy. In comparable amount. Hence, an attempt to increase addition, as Hickok’s 19851 study indicates, trade re- exports permanently relative to imports will fail. tt is strictions on many items increase r-ather than de- doubtful that the trade deficit will be reduced even crease income inequality- tempor-ar-ily because imnpont quantities do not decline quickly in r-esponse to the higher- impor-t pr-ices and Optirnurn Tariff.zirgurnent the revenues of foreign producer-s might r-ise. The optimum tar-iff argument applies to situations in which a country has the economic po\\’el’ to alter won-Id prices. This power exists because the countr or a group of countries acting in consor-t like the Organization of Petroleum Exporting Countr-iesl is ‘If a country such as the United States has no market power, the world price is fixed. Consequently, the price faced by U.S. con- sumers and producers rises by the full amount of the tariff. In the optimum 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 the case because the world price falls and the amount of the tariff is the difference between the world price and the U.S. price. ‘See Pine (1984). “See Chrystal and Wood (1988) earlier in this issue. FEDERAL RESERVE BANK OF Si. LOUIS JANUARYIFEBRUARY INS

Protection of Jobs Public Choice Even though the aggregate effect is lange, the harm to each consumen- may be small. ‘this small cost, ofwhich The protection of jobs ar-gumenit is closely related to an individual may not even be awar-e, and the costs of the balance of trade argument. Sinceareduction in organizing consumers deter the formationi of a lobby imports via trade n-estr-ictions will result in a similar against the legislation. reduction in exports, the over-all employment effects, On the other hand, wor’ker-s arid other- n’esoun-ce as found in the OECD 1985) study and many others, owner-s are vex-v concer-ned about protectionist legisla— are negligible. While the overall effects are negligible. won-kens land r-esour-ce owners) in specific industries tiori for their industry. liieir benefits tend to be large individually and easy to identity. Their voting and ame affected differently. campaign contributions assist politicians who sup- A domestic industry faced with increased impomts thein positions and penalize those who do riot. fr-ore its foreign competition is under pressure to n-e- Thus, politiciarns are likely to respond to their de- duce production and lower- costs. Pn-oductive n-c- mnands for- pr-otectionist Iegislationiz sources mnust mnove fi-om this industry to other domes- tic industmies. Wor-ker-s must change jobs and, in some In/Cat .Industries cases, relocate to other cities. Since this change is forced upon these workers, these won-ken-s hear m-eal ‘Ehe preceding ar-gunient is couched in terms of costs that they are likely to resist. A similar statement protecting a domestic industry. A slightly different can be made about the owner-s of in the af- argument, the so-called infant industry case, is fected industry. couched in terms of promoting a domestic industry. Suppose an industry, alr’eady established in other’ Workers and other mesoinr-ce owner-s ~villllikely resist countm-ies, is being established in a specific coinntrv. these changes by lobbying for trade r-estr-ictions. The The country might riot he able to r’ealize its compar-a— pr-eviously cited studies on the costs of protectionism tive advantage in this industry because of the existing demonstt-ated that tr-ade restrictions entail substantial cost and other advantages of foreign fir-nis. Initially, neal costs as well. ‘l’hese costs likely exceed the adjust- owner-s of the fledgling firm must be willing to suffer mnent costs because the adjustment costs ar-c one-time losses until the firm develops its mar-ket and lower-s its costs, while the costs of protectionism continue as long as trade restrictions are maintained. production costs to the level of its fon-eign rivals. In on-den- to assist this entr-ant, tan-ill’ pn-otection can be An obvious question is why politicians supply the used to shield the fir-ni fn’omsome for-eign competition. protectionist legislation demanded by worker’s arid After this temnporan~period of protection, free trade otlier resource owner-s. A bm-anch of economics called should be n-estor-ed; howeven-, the removal of tariff public choice, which focuses on the interplay between individual pr-eferences and political outcomes, pro- protection frequently is resisted. As the industry de- velops, its political power- to thwan-t opposing legisla- vides an answer. The public choice liter-atur-e views the tion also increases. politician as an individual who offer-s voters a bundle of governmentally supplied goods in order to win Another- pr-oblennwith the infant industry arguniierit elections.’ Many argue that politicians gain by pr-ovid— is that a tariff is not the best way to intervene. A ing protectionist legislation. Even though the national production subsidy is super-ion- to a tariff if the goal is economic costs exceed the benefits, the politician to expand pn-oduction. A suhsidv will do ibis directly, faces different costs and benefits. while a tariff has the undesin-able side effect of r-educ— inig consumptioti. l’hose hat-med by a protectionist trade policy for a domestic industry, especially household consumen-s, In many cases, intervention might not be appr-opr’i— will incur a small individual cost that is difficult to ate at all. Ifthe infant industny is a good candidate for identify. For example, a consumer is unlikely to pon- being competitive inter-nationudly, borr-ouing from the der how much extra a shirt costs because of protec- tionist legislation for the textiles and apparel industry.

2 Special interests benefiting from trade will likely resist the forces for protectionist legislation. Destler and OdeIl (1987) identify exporters, industrial import users, retailers of imported products, “The role of pressure groups, acting in their economic self-interest, providing trade-related services, foreign exporters, and foreign gov- has been stressed by Stigler (1g71) and Peltzman (1976). For ernments as interest groups capable of exerting some anti- references, as well as an example of an international trade study protection pressure. Decisions about protectionist legislation result focused on the interaction of politicians and interest groups, see from the interaction of both pro-protection and anti-protection Coughlin (1985). forces. FEDERAL RESERVE BAtIK OF ST. I.OUiS JANUARYIFEBRUART INS pr-ivate capital markets can finance the expansion. petition to favor-domestic over’foreign firms and shift Investors are willing to ahsor-b losses temporarily if the the excess returns in monopolistic mar-kets from for- prospects for- future profits ar-c sufficiently good. eign to domestic fir-ms. Knugman 1987) illustrates an example of the angu- rnent. Assume that there is only one firm in the United Spillover Effects States, Boeing, and one multinational Iir-m in Europe Airbus, capable of producing a 150-seat passenger The justification for pn-otecting an industry, infant or aircraft. Assume also that the aim-cr-aft is pn-oduced only otherwise, frequently entails a suggestion that the for export, so that the returns to the firm can be industry generates spilloven’ benefits for other’ in— identified with the national inter’est. This export mar- dustrres ot’ individuals fon which the industry is not ket is pn-ofitable for either fin-nm if it is the only producer; compensated. Despite patent laws, one common sug- however, it is unprofitable for both fir-ms to pnodtice gestion is that cer-tain industn-ies are not fully compen- the plane. Finally, assume the following payoffs are sated for their- r-esear-ch arid development expendi- associated with the four combinations of production: tur-es. This argument is frequently clirected toward 1) if both Boeing and Airbus pr-oduce the aircr-aft, each technologically progressive industr’ies where some fir’m loses $5 million; 2) if neither Boeing non’ Ain’bus firms can capture the n’esults of other- finns’ n’esearch pn’oduces the aircn-aft, profits are zero; 3) if Boeing and development simply by dismantling a pr-oduct to pn-oduces the aircraft and Air-bus does not, Boeing see how it wor’ks. profits by $100 million and Air-bus has zero pr-oUts; and The application of this ar-gumnent, however-, enigeti- 4) if Air-bus produces the air-cr-aft and Boeing does not, den-s a niurnbem of pn-oblems. Spillovens of knowledge Airbuns profits by $100 million and Boeing has zero ane diffic,ult to measure. Since spilloven-s am-e not mar- pr’ofits - ket tr-ansactions, they do not leave an obvious tr-ail to Which finnn)s) will pr-oduce the air-craft? The exam- idemitifv their- heneficiar-ies. The lack of niar-ket tr-ansac- ple does not yield a unique outcome. A unique out- tions also complicates an assessment of the value of come can be genen-ated if one firm, say Boeing, has a these spillover’s. To determine the appr-optiate sub- head stant and begins production before Airbus. tn sidy, one must be able to place a dollar value on the this case, Boeing will n-cap pn-ofits of $100 million and spillovers genen-ated by a given reseamch and develop- will have deter-n-ed Airbus from emitening the niarket nient expenditure. Actually, the calculation requires because Air-bus will lose $5 million if it enter’s after munch mom-c than the aln’eady difficult task of r’econ- Boeing. stn-ucting the past. It r-equir-es complex estimates of the spilloven’s’ future worth as well. Since resources are Stnategic trade policy, however-, suggests that judi- moved fioni other’ industries to the targeted industry, cious gover-nmental intervention can alter the out- the goven-nment must tinder-stand the functioning of come. Ifthe Eun’opean governments agree to subsidize the entire economy. Air-bus’ production with $10 million no mnatter’ what Boeing does, then Airbus will produce the plane. Pro- Finally, then-c are political pr-ohlems. An aggressive duction by Air-bus will yield more profits than not application of this an-gumuent might lead to retaliation producing, no matter- what Boeing does. At the same and a mutually destructive tn-ade war’. In addition, as time, Boeing will be cleterred fi’om pn’oducing because inten’est gr’oups compete for the gover-nmental assis- it would lose money. Thus, Airhus will captur-e the tance, there is no guar-antee that the tight gr-oups emitim’e rnar-ket and reap profits of $110 mnillion, $100 will be assisted or’ that they will use the assistance mnillion of which can be viewed as a tnansfer of pr-ofits efficientl. from the United States. The criticismns of a strategic trade policy ar-c similar’ Strategic Trade Policy to the criticisms agaimist pr-otectimig a technologically pr-ogn-essive industry that gener-ates spilloverbenefils.’’ Recent theor-etical developments have identified Then-c ar’e major- infonmational pn-obleniis in applying a cases in which so-called stn-ategic tr-ade policy is supe- rior- to fl-ce trade. As we discussed earlier, decreasing unit production costs and market structures that con- tain monopoly elements ar-e conirnon hi industr-ies involved in inter-miational tmade. Mar-ket imperfections 3 immediately suggest the potential benefits of govern— ‘ A recent volume edited by (1986) examines the Øolicy implications of the new trade literature, See Grossman’s mental intervention. In the str-ategic tr’ade policy argu- article in that volume for a discussion of the information require- ment, gover-nmnent policy can alter the terms of com- ments. FEDERAL RESERVE BANK OF ST. LOUIS JANUARY/FEBRUARY 1988 strategic trade policy. The government must estimate ducers are relatively disadvantaged, the wisdom of a the potential payoff of each course of action. Eco- pn-otectionist response is doubtful. Again, the costs of nomic knowledge about the behavior of industnies pr-otectionismn exceed substantially the benefits froni a that have monopoly elements is limited. Firms mnay miatiorial perspective. behave competitively on- cooper-ativel~and may com- In an attempt to r’einfon-ce the ar-gument for fair’ pete by setting pm-ices on- outpr.rt. The behavior- of rival tnade, pr-oponents also an-gue that n-etaliatory thn-eats, govem-nments also must he amiticipated. l”oreign r’etalia- combined with changes in tariffs and mion—tam’iff barri- tiomi must be viewed as likely where substantial profits ers, allow for the simultaneous pr-otectiomi of domestic are at stake. In addition, many intem-est gr-oups will industries against unequal comnpetition and indunce compete for the govem-nmental assistance. Though mon-c open fom-eign mnar-kets. This mom-c flexible ap- only a small number’ of sector-s can be conisidered pr-oach is viewed as super-ior to a ‘‘one—sided’’ free poterrtiall~stmategic, many industries will make a case trade policy. ‘l’he suggestion that a fair tnade policy for assistance. produces a tnading environment with fewer- trade ne- strictions allows pmoponents to asser-t that such a policy serves to pn-omote both equity and efficiency. In Reciproci~vand the “Level Playing Field” other- words, not only will domestic and foreign pno- ducem-s in the same industry be treated equally. but the Bhagwati and Irwin 1987) note that U.S. tnade policy gains associated with a fn’eer tr-ading envir-onment will discussions in recent year-s have frequently stressed he n-ealized. the importance of “fair tr-ade.” The concept of , which is technically n-efen-red to as reciprocity, On the other- hand, critics of a fair trade policy argue means diffen-ent things to different people. that such a policy is simply disguised protectionisni

— it simply achieves the goals of specific intemest Under the Genen-al Agreement on ‘I’ariffs and ‘made, gn-otnps at the expense of the nation at lam-ge. In mnany negotiations to reduce trade ham-mien-s focus upon cases, fair tr-ader-s focus ori a specific pr-actice that can matching concessions. This form of reciprocity, be portr-ayed as pn-otectionist while ignon-imig the entine known as first-difference reciprocity, attempts to n-e- package of policies that are affecting a nation’s comn- duce -s by r-equiring a country to provide a petitive position. In these cases, the fon-eign coumitmv is tariff rtduction of value compan-able to one pr-ovided muon-c likely either not to respond or retaliate by in- by the other country. In this case, n’eciprocity is cr-easing r-athcr- than n-educing their tracle barriens. In defined in terms of matching changes. the latter- case, the escalation of trade han-mien-s causes Recent U.S. demands, exemplified by the Gephardt losses for- both nations, which is exactly opposite to amendment to the cur-rent tn-ade legislation, r-eyeal an the alleged efi’ects of an activist fair trade policy. approach that is called fbll reciprocity. This approach Critics of fain’ trade proposals ar-c especially both- seeks r-eciprocitv in terms of the level of pr-otection er-ed by the use of bilateral trade deficits as evidence of bilaterally and ovem a specific n-ange of goods. Beci- unfair’ trade. In aworld of many tn-ading countries, tlìe pn-ocitv n-equines equal access and this access can he trade between two countnies need not be balanced for’ deter-mined by bilatemal tnade balances. A tnade deficit the tr-ade of each to be in global balance. Diffemimig with a trading partner is claimed to be prima fade demands and pr-oductive capabilities across countries evidence of unequal access. Examples ahounnd. For will cause a specific coumitry to have trade deficits with example, U.S. constr’uction fin-mns have not had a major’ some countries and sur-pluses with other- counitmies. contract in since 1965, while Japanese con- These bilateral imbalances an-c a rionmual result of stm-uction fim-ms did $1.8 billion wonth ofbirsiness in the coumitmies tradimig on the basis of comnpar-ative advan- 4 United States in 1985 alone. Recent legislation liar-s tage.’ Thus, the focuns on the hilater-al tnade deficit can Japanese panticipation in U.S. public won-ks pnojects produce inappr-opriate conclusions about fain-ness until the Japanese offer r-ecipn-ocal pr-ivmleges. and, niiore impor-tantly, policies attempting to elimi- As the name suggests, the fundamental argument nate bilaten’al trade deficits ar-c likely to be very costly for fain- trade is one of equity. Domestic producens irm a becaunse they eliminate the gains from a multilateral fl-ce tnade country argue that foneign trade harrier-s am-c tn-ading system. unfair because it places them at a competitive disad- vantage. In an extreme yer-sion, it is asserted that this unfain’ competition will vir-tually eliminate [1.5. mnanu— factoring, leaving only jobs that consist primarily of flipping hamburgers at fast restaun-ants on-, as Bhag%%-ati and Inwin have said, rolling mice cakes at ‘~Bergstenand Cline (1985) estimate an equilibrium U.S-Japanese Japanese-owned sushi bar-s. While domestic pm-o- bilateral trade deficit of $20—$25 billion annually. FEDERAL RESERVE BANK Of ST. LOUIS JANUARY/FEBRUARY INS

CONCLUSION Interest gr-oup pressunes from industries expenienc- ing difficulty and the gener-al appeal of a “level playing The pr-olifer-ation of pnotectm()nist tr-ade policies in field’’ combine to make the reduction of trade hiar-riers recemit year-s pm-ovides an impetus to m-econsidem’ their’ especially difficult at the present timmic in the United wor-th. In the won-id of tr-aditionial trade theory, chan-ac— States. Nonetheless, national inten-ests will be served ter’ized by perfect competition, a definitive recoin— best by such an admittedly difficult political comm-se. Imi mendatiori in favor- of fl-ce trade can he made. The light of the cur-rent tJm’uguay Round negotiations un- gains fnonii initen-nationial trade result fm-om a m-ealloca— der- the General Agn-eement on Tan’iffs and Tm-ade, as tioni of pn-oducti~’em-esour-ces towam-d goods that cami he well as numerous bilateral discussions, this fact is lin’o(lumced less costly at home than abroad amid the especially timnely. exchange of some of these goods for’ goods that can he pm-odunced at less cost aljnoad than at home. Recent developments in inter-national tm-ade theory have examitied the consequences of international tr-ade in mar-kets when-c tliene ar-c nianket imperfec- REFERENCES tions, such as momiopoly and technological spillo\’er-s. Bergsten. C. Fred, and William R. Cline. The United States-Japan Do these imperfections justitv protectionist trade poli- Economic Problem (Institute for , October cies? The answer- continues to he no. While protec- 1985). tionist trade policies may offset monopoly power- over-— Bhagwati, Jagdish N., and Douglas A. Irwin, “The Return of the or advantageously use domestic moniopol~ Reciprocitarians — U.S. Trade Policy Today,” World Economy (June 1987), pp. 109—30. power, trade restrictions tend to reduce the competi- Brander, James A. “Intra-Industry Trade in Identical ,” tion faced by domestic producer’s, protecting domes- Journal of International Economics (February 1981), pp. 1—14. tic producer-s at the expense of domestic conisunIens. Brander, James A.. and Paul R. Krugman. “A ‘Reciprocal ’ ‘chic empirical evidence is clear-—cut. The costs of Model of International Trade,” Journal of International Economics (November 1983), pp. 313—21. pr-otectionist tr-ade policies far exceed the benefits. Chrystal, K. Alec, and Geoffrey E. Wood. “Are Trade Deficits a ‘the losses suffer-ed by consumer-s exceeml the gains Problem?” this Review(January/February 1988), pp. 5—i 3. reaped by domestic pr-oducen’s and government. Low- Clarete, Ramon L., and John Whalley. “interactions Between Trade inconiie consumer-s ar-c n’elatively more adversely af- Policies and Domestic Distortions,” Center for the Study of Inter- fected than high-income consumers. Not only are national Economic Relations Working Paper 8522C (London, On- then-c inefficiencies associated with excessive domes- tario: University of Western Ontario, 1985). tic production and restricted consumption, but then-c Coughlin, Cletus C. “Domestic Content Legislation: House Voting ane costs associated with the enfor-cemnent of the pm-o— and the Economic Theory of Regulation,” Economic Inquiry (July 1985), pp. 437—48. tectionist legislationm and attempts to influence trade Denzau, Arthur T. “How Import Restraints Reduce Employment,” policy. Washington UniversityCenterfor the Study of American , Formal Publication #80 (June 1987). The primam~reason for these costly protectionist Destler, I. M., and John S. Odell, Anti-Protection: Changing Forces policies relies on a public choice an-gumemit. The desire in United States Trade Politics (Institute for International Eco- to influence tr’ade policy arises froni the fact that trade nomics, 1987). policy changes benefit some gr-oups, while har-ming Dixit, Avinash K., and Victor D. Norman. Theory of International other’s. Consumer-s are ham-med by pr-otectionist legis- Trade (Cambridge University Press, 1980). lation; however-, ignor-ance, small individual costs, and Dixit. Avinash K., and Joseph E. Stiglit2. “Monopolistic Competition the high costs of or-ganizing consumers pr-event the and Optimum Product Diversity,” American Economic Review (June 1977), pp. 297—308. consumers from beirig an efl’ective for-ce. On the other 74 hand, wor-ken-s and other resour-ce owner-s in an indus- The Economist. July 4,1987, p. . tn-v ar-c mor-e likely to be effective politically because of Grais, Wafik, Jaime de Melo, and Shujiro Urata. “A General Equilib- their relative ease of om-ganizing and their- individually rium Estimation of the Effects of Reductions in Tariffs and Quanti- tative Restrictions in Turkey in 1978,” in T. N. Srinivasan and John large and easy-to-identify benefits. Politicians inter-- Whalley, eds. General Equilibrium Trade Policy Modeling (MIT ested in re—election will most likely respond to the Press, 1986). demands for- pmotectionist legislation of such an inter- Grossman, Gene M. “Strategic Export Promotion: A Critique,’ Stra- est group. tegic Trade Policy and the New International Economics in Paul R. Krugman, ed. (MIT Press, 1986), pp. 47—68. ‘I’he enmpimical evidence also suggests that the ad- Helpman, Elhanan. “International Trade in the Presence of Product ~‘er-seconsumer effects of pr-otectionist trade policies Differentiation, Economies of Scale and Monopolistic Competi- tion,” Journal of International Economics (August 1981), pp. 305— am’e riot shor-t-lived. These policies genem-ate lower’ eco- 40. nomic gn-owth n-ales than the rates associated with fr-ce Hickok, Susan. “The Consumer Cost of U.S. Trade Restraints,” trade policies. In turn, slow gr-owth contributes to Federal Reserve Bank of New York Quarterly Review (Summer additional pr-otectionist pressum-es. 1985), pp. 1—12. FEDERAL RESERVE BANK OF ST. LOWS JANUARY/FEBRUARY 1988

Hufbauer, Gary Clyde, Diane T. Berliner, and Kimberly Ann Ellioti, the Study of American Business, Working Paper #80 (July 1983). Trade Protection in the United States: 31 Case Studies (Institute for International Economics, 1986). Organization for Economic Co-Operation and Development (OECD). Costs and Benefits ofProtection (1985). Kearl, James R., Clayne L. Pope, Gordon C. Whiting, and Larry T. Page, Sheila. “The Rise in Protection Since 1974,” Oxford Review Wimmer, “A Confusion of Economists?” American Economic Review, Papers and Proceedings (May 1979), pp. 28—37. of (Spring 1987), pp. 37—Si. Kierzkowski, Henry K. “Recent Advances in International Trade Peltzman, Sam, “Toward a More General Theory of Regulation,” Journal ot Law and Economics (August 1976), pp. 211-40. Theory: A Selective Survey,” Oxford Review of Economic Policy (Spring 1987), pp. i—i9. Pine, Art. “Footwear Industry Tells Congress ‘Shoe Gap’ Threatens Krugman, Paul R. “Is Free Trade Passé?” Journal of Economic U.S. Defense,” Wall Street Journal, August 24, 1984. Perspectives (Fall 1987), pp. 131-44. Ricardo, David. The Principles of Political Economy and Taxation Strategic Trade Policy and the New International Eco- (Penguin, 1971). nomics (MIT Press, 1986). Stigler, George J. “The Theory of Economic Regulation,” Bell Jour- nal of Economics and Science (Spring 1971), pp. 3— Lancaster, Kelvin. “Intra-Industry Trade Under Perfect Monopolistic Competition,” Journal of International Economics (May 1980), pp. 21. 151—75. Stolper, Wolfgang, and Paul A. Samuelson, “Protection and Real Variety, Equity, and Efficiency (Columbia University Wages,” Review of Economic Studies (November 1941), pp. 58— 73. Press, 1979). Tarr, David G., and Morris E. Morkre. Aggregate Costs to the United Leibenstein, Harvey. Beyond Economic Man (Harvard University States of Tariffs and Quotas on Imports: General Tariff Cuts and Press, 1980). Removal of Quotas on Automobiles, Steel, Sugar, and Textiles, Luttrell, Clifton B. “Imports and Jobs — The Observed and the Bureau of Economics Staff Report to the Federal Trade Commis- Unobserved,” this Review (June 1978), pp. 2—10. sion (December 1984). Mill, John Stuart. Principles of Political Economy, W. J. Ashley, ed, Venables, Anthony, and Alasdair Smith, “Trade and Industrial Pol- (Longman, 1909). icy Under Imperfect Competition,” Economic Policy (October Morici, Peter, and Laura L. Megna. U.S. Economic Policies Affecting 1986), pp.621—72. Industrial Trade: A Quantitative Assessment (National Planning Wood, Geoffrey E., and Douglas R. Mudd. “The Recent U.S. Trade Association, 1983). Deficit—No Cause for Panic,” this Review (April 1978), pp. 2—7. Munger, Michael C. “The Costs of Protectionism: Estimates of the World Bank. World Development Report 1987 (Oxford University Hidden Tax of Trade Restraint,” Washington University Center for Press, 1987). FEDERAl. RESERVE BANK OF ST. LOUIS JANUARYIFEBRUARY INS

Appendix Developments in International Trade Theory and the Gains from Trade

Since 1817, numerous developments have taken While resources may not be easily transfer-n-ed place in inter-national tr’ade theory. The consequences acr-oss industries imi the shon’t n-un, worker-s can change of mone than one factor of pn-oduction, increasing amid jobs and capital cart be moved as time passes. hf decn-easing unit pn-oduction costs, amid imper-fectly resources are mobile, then the longer-—run conse- competitive markets are examined mi this appemmdix. quences for- labom- and owmien’s of capital an-c different Special attention is focused on developments in inten’- from those described above. Even if lahor and capital natiomial tm-ade theory in the last decade. are perfectly mnobihe, however, one set of m’esour’ce owner-s may benefit while another- gn-oup is har-mned by Increasing the Number ofFactors of trade.’ Production The real world is more complicated than this dis- Assume that, in the United States, two r’esoun-ces, cussion has allowed. Them-c are mon-c thami two factor-s labor- arid capital (e.g., machinesi, ar-c used in the of pr-oduction amid vamyimig degrees of mobility for’ pr-oduction of two goods, automobiles amid air-planes. these factor-s. For example, the U.S. labor- for-ce con— The pn’ices of these resources will be affected differ-— taimis scientists and engirmeer’s as well as short—on-dem- ently by tr-ade. As trade develops, demnanid for- the cooks. Nonetheless, the underlying analysis does sug- exported good that is, the good in which the United gest somne generalizations. When trade occur-s, owner’s States has a ) will incn’ease amid of the resoun-ces that ar-c mor-e specialized imi the demand for U.S. pr-oductiomi of the imported good will pn-oduction of export goods will tend to become weal— fall. ‘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-oduce changes imm the pr-ices of r-esoun-ces: however-, these pm-ice changes an-c not always obvious. ‘Who wins and who loses? It depends on the U.S. endowment of capital to labor relative to other countries. If the United States has Initially, assumne that the r’esoum-ces cannot be tm-ans— relativelylargeramounts of capital to labor relative to othercountries, then owners of capital would benefit, while labor would be harmed. ferr’ed across industn’ies. For examnple, the labor- and This result follows from the Stolper-Samuelson Theorem (Stolper capital used to pr-oduce automobiles, the good im— and Samuelson, 1941). In the example. the United States is defined ported into the United States, cannot he used to pro- to be capital-abundant. The example also implicitly assumes that airplanes are produced by capital-intensive methods and automo- duce aimplamies, the expon-ted good. Consequently, as biles by labor-intensive methods, Thus, the production of airplanes the pr-ice of airphanes n-ises imi the United States, the requires the use of more capital relative to labor than automobiles, compensation for- lahor and capital in the air-plane Since the United States is relatively well-endowed with capital and the production of airplanes is capital intensive, the United States will industry will rise; meanwhile, the decline in automo- have a comparative advantage in the production of airplanes. With bile pr-ices causes a decline in compensation for- labor the elimination of trade barriers, the relative price of airplanes to and capital in the industry. It would riot be surpn-ising automobiles will increase. The Stolper-Samuelson Theorem shows that an increase in the relative price of the capital intensive good will if labor and owners of capital in the imidustrv would increase the return to capital relative to the prices of both goods and mesist such changes by asking for- tn-ade pm-otection. reduce the return to labor relative to the prices of both goods. FEDERAL RESERVE BANK OF ST. LOUIS JANUARY/FEBRUARY 1988 thier; those who own n-esoun-ces mon-c specialized in pontation costs. Each firm openates under what is the production of import-competing goods will tend termed a ‘‘Cournot comijectun-e,’’ meaning that each to lose wealth. People also gain or- lose, howeven’, firm assumnes its pmoduction decision ivill not affect its depending on what happens to the pr-ices of the goods rival’s pm’oduction decision. Before inter-national tnade, they buy. Individuals who chiefly consume imported each firm has a monopoly position in its home man-ket. goods will benefit, while those who pr-efer- consuming Aliowing for- fr-ce trade induces each fin-rn to emiter the the exported goods will lose. Thus, the net effect on othen br-ms niarket, because price exceeds mnamginal any individual depends on both the gains or losses cost in each coumitry. ‘Thus, the same good will flow to associated with the price changes on the goods that and fr-om each country. he consumes and the effect of tr’ade on his wealth (or- Kierzkowski l1987n has noted that the bulk of intn-a- income I. industry trade involves differentiated rather than ho- mogeneous goods. Two approaches, Lancaster’s (1979) chanacteristics approach and Dixit and Stighitz’s Increasing Unit Production Costs (1977) “hove of variety” appr-oach, have pr-ovided the A second assumption underlying the Rican’dian ex- foundation for- trade models involving differentiated ample of the gains fr-ore trade is that unit production goods. costs ar’e constant. If unit production costs rise as In the chanactenistics approach, individuals have more is produced, however, the gener’al conclusions pn-eferences for- the characteristics of goods m-ather about the gains fr-nm tr-ade remain essentially un- than for- collections of time goods themselves, A group changed. The major- difference is that rising unit pro- of goods is defined as goods possessing the sanre duction costs limit the extemit to which speciahizatiomi characteristics but in diffem-ent pn-oportions. A diversity occurs. in consumner pr-eferences causes different consumner-s to pr-efen different products (i.e., van’ieties) of a gr-oup of goods. Decreasing Unit Production Costs and Fleipman (1981) and Lancaster’)lSSD) used the char-- Imperfect Competition actem-istics appr’oach to show how intra-industry tnade results fn’om combining the demand for- variety with On the other hand, if unit production costs de- economies of scale, The change fr-om autan-chy to free crease as production increases, the extent to which actual trade patterns can be explained by comparative trade enlarges the mar-ket and causes output of the advantage becomes unclear. lt also fon’ces tr-ade theory existing varieties to increase and the production of to deal with nunmerous char-acteristics of international new varieties to begin. Consumers gain from the pro- trade in the real wor-hd. The market structure ofindus- ductiomm of more varieties and lowem pr-ices as econo- tries engaged in tn’ade is fr-equently highly concen- mies of scale are realized, tnated. In other words, the individual firms in an The sources of gains from tr-ade are identical using industry, contr’any to those in a perfectly competitive the love-of-variety and character-istics appr-oaches. In industry, can affect the manket price of their good by the love-of-variety approach, which is used by Dixit their productiomi and advertising decisions. In addi- and Norman )1980r, consumers have identical tastes tion, trade statistics show that intra-industny trade and prefen’ to consume as many types of the differenti- (i.e., the simultaneous export and import of the output ated product as possible. of the same industnz accounts for- incn-easinglv larger shames of won-Id trade. The introduction of imperfect competition and de- clining unit pm-oduction costs suggest three sources of In Ihe last decade, trade theorists have developed gain from free trade. As the market potentially served numnen-ous models to deal with these facts. An exhaus- by firms expands fi-om a national to a world market, tive r-eview of this rapidly expanding hitenature is be- there will be gains due to declining unit production yond the scope of this appendix; howeven, a few illus- costs. The second is the reduction in nmonopol~power trative articles are discussed in order to establish of firnms faced with foreign competitors. The thin-d is some key points. Brander (1981) and Br-ander and the gain to consumer-s fm-onn lower prices and in- Knugman (1983) developed models using a homogene- creased product variety. Gener-ally speaking. gains ous good to highlight how imperfect competition can from trade result from the increase in competitive cause intra-industry trade and how intna-industry pr-essures as the domestic econonmy becomes less tn-ade can arise in the absence of cost differences. insulated from the world economy. Nonetheless, time Assume two countries with one fir’m in each coun- numerous market structur-es and firm hehavion’s pos- try. The firms an-c pm’oducing a homogeneous good sible under imperfect competition preclude a defini- under identical cost situations and then-c am-c no trans- tive statement about the optimahity of fr-ce trade. FEDERAL RESERVE BANK OF ST. LOUIS JANUARYIFEBRUARY ISa

The demand curve is D,,and the marginal cost curve is MC,,~.(The mnarginah revenue curve associated with lJ,,~ Figure 3 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~’, price declines 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 the United States decline fr-om area P,,, RWM or i+j +kto area P, SXM or j +k+ 1. The domestic firm has one- Ttj~ TI half of the domestic market, so its profits an-c j with k + I going to the foreign firm. The domestic firm’s expon-ts P4 ICUS V w~x allow it to captune one-half of the foreign mar-ket. If the foreign mar-ket is identical to the domestic market, the firm’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 is D~512~ D~5 a h + I.

If the assumption of identically sized domestic and foreign mar-kets is dropped, then a different conclu- Sometimes the benefits of expanded consumption sion is possible. If the foreign market is smaller- than resulting from fl-ce trade an-c less than the costs associ- the domestic, the profits of the domestic firm in the ated with distorted pr-oduction. Venables and Smith foreign market will be less than k+ 1.Assuming zero

(1986) pn-ovide a graphical illustn-ation, duplicated in exports, the domestic gains fr-nm trade are h — k, and figure 3, of the pr’eceding point using the Br-ander- the domestic economy could lose from fnee trade. In Kr-ugman duopoly model. Assume the U.S. market and this case, consumer- gains can be mon-c than offset by the market in the rest of the won-Id for- a specific good the shifting of profits fi-onm the domestic to the fbreign are monopolies, the good is produced at a constant economy. ‘l’his shifting reflects the contraction of an marginal cost, and there are no tr-ansportation costs. activity that is already too little to an even smaller- level.