Chapter Introduction

In a recent survey of economists, 87% agreed with the statement “tariffs and import quotas usually reduce general economic welfare.”2 It is no exaggeration to say that this belief has been a guiding principle of the international institutions established to govern the world economy since World War II, especially the World Trade Organization. That belief is the message from the previous chapter, which showed that the application of tariffs and quotas will reduce welfare for a small country. We also found that although a large country might gain from the application of a tariff, that gain would come at the expense of its trading partners, so the world as a whole would still lose. So there is really no good economic argument for the use of tariffs or quotas.

Still, you might wonder if that is really the whole story. We gave several recent examples of tariffs and quotas in the previous chapter, and there are many more examples if we look to countries at earlier stages in their development. For example, during the 1800s the United States had average tariff rates that fluctuated between 10% and 50%. These tariff rates were at times even higher than the Smoot-Hawley tariff that was applied during the Great Depression and peaked at 25%. Likewise, countries that industrialized after World War II, like Japan, South Korea, and Taiwan, started with high tariffs and quotas that were eliminated only slowly and incompletely. More recently, China had very high tariffs before it joined the World Trade Organization in 2001, and it still enjoys tariffs in some industries that are well above those in the United States or Europe.

These observations can lead us to wonder if there are some arguments in favor of tariffs that are missing from our treatment in the previous chapter, which dealt with perfect competition. Do the effects of trade policies differ when markets are imperfectly competitive? We explore the answer to this question in this chapter and the next.

This question received a good deal of attention from trade economists in the 1980s, in a body of research that became known as strategic trade policy. The idea of strategic trade policy was that government trade policies could give a strategic advantage to Home firms in imperfectly competitive markets that would enable them to compete more effectively with Foreign firms. Initially, the economists writing in this area thought that their research would challenge the idea that free trade is best for a country. As more research was done, however, supporters of strategic trade policy theory realized that the new arguments were limited in their scope: in some cases, the use of tariffs or quotas would backfire and harm the Home country, and in other cases, their use would give results similar to the large country case we analyzed in the previous chapter. We will give examples of both outcomes.

When countries use strategic trade policies to try to give advantage to their own firms, other countries trading with them often regard these policies as “unfair” and may respond to these policies in some way. That is the idea behind the first quotation at the beginning of the chapter from President Barack Obama, who announced in 2012 that the United States would establish a special “Trade Enforcement Unit that will be charged with investigating unfair trading practices in countries like China.” In the previous chapter we already discussed one trade policy recently used by the United States against China: the tariff on imports of Chinese tires (in effect from September 2009 to September 2012). In this chapter we discuss other examples, including tariffs recently imposed by the United States against imports of solar panels from China. To explore strategic trade policy, we need to abandon the assumption that markets are perfectly competitive, an assumption that was central to the treatment of the tariff and quota in the previous chapter. Instead, we need to allow for imperfect competition, which we defined in Chapter 6 as the market conditions that exist when firms have influence over the price that they charge and can charge a price above marginal costs for their goods. Recall that imperfect competition can arise when there is a small number of producers, as in a monopoly or oligopoly, or if products are differentiated from one another, as we assumed in our model of monopolistic competition in Chapter 6. In this chapter, we use the extreme case of a single producer—a Home or Foreign monopoly—to see how tariffs and quotas affect prices, trade, and welfare. In practice, imperfectly competitive industries often have more than one firm, but focusing on the monopoly case will give us the clearest sense of how the effects of these policy tools differ from those under perfect competition.

In this chapter, we begin by analyzing the effects of tariffs and quotas under the assumption of a Home monopoly. In the perfectly competitive framework of the previous chapter, quotas and tariffs have an equivalent impact on Home prices. In imperfectly competitive markets, however, these two trade policy instruments have different effects on Home prices, so the choice of which, if any, trade policy to implement must take these different effects into account.

The second case we analyze is a Foreign monopoly that exports to the Home market. We analyze the effect of an import tariff applied by the Home country and find that the tariff has effects similar to those in the large-country case under perfect competition (described in the previous chapter) in which the Home country can potentially gain from the tariff. A specific example of a Foreign monopolist is the Foreign discriminating monopoly, which charges a lower price to Home than to firms in its own local market and is therefore dumping its product into the Home market. A tariff applied against the Foreign discriminating monopoly is called an antidumping duty. Because of the special way in which antidumping duties are applied, they are unlikely to result in gains for the Home country and instead result in losses.

The final case we analyze is an infant industry at Home, by which we mean an industry that is too young to have achieved its lowest costs. Often these industries comprise a small number of firms. In our analysis, we assume there is only one firm, so it is again a case of Home monopoly. The special feature of this Home firm is that it cannot compete effectively under free trade, because the world price is below its minimum cost of production today, so the firm makes a loss. But by increasing its output today, the firm will learn how to produce its output more efficiently, and therefore have lower costs in the future, so that it can compete profitably at the world price. One way to achieve this end is for the government to step in and offer assistance—such as with a tariff—that will help the firm to survive long enough to achieve lower, world-competitive costs. This policy is called an “infant industry tariff.”

Although we include the infant industry tariff argument in this chapter on strategic trade policy, it is actually a much older argument, dating back to the writings of John Stuart Mill (1806–1873). We will give several examples of infant industries, including the automobile industry in China, which imposed very high tariffs and quotas on foreign cars before it joined the WTO in 2001. We also use this argument to analyze the tariff used in the 1980s to protect Harley-Davidson motorcycles in the United States. The key policy question for an infant industry is whether a government should impose a temporary tariff today, to protect infant industry from competition, thereby keeping it in business long enough for it to learn how to achieve lower costs (and thus competitive prices) in the future.