International Trade Note 2

Theory of trade protection

Tariff s and non-tariff barriers

Countries use a variety of measures which come under the broad heading of ‘trade
protection’. The measures listed in this section may not be exhaustive, but it contains the
major instruments of trade policy.

Tariffs, or customs duties

A tariff is a tax imposed on the import or export of a good or service that crosses a
national boundary. Tariffs can take a number of forms. A specific tariff is imposed as a
fixed amount per unit of import or export: for example, £1 per bottle of wine, or £10 per
ton of coal imported. Tariffs which are specific are easy to collect. They depend only on
the number of items or the volume of a product. The disadvantage is that they do not
reflect the value of imports or exports. An ad valorem tariff relates to the total value of a
commodity imported or exported, say 10 per cent of its monetary value. For example, an
item valued at £100 could have 10 per cent, that is £10, levied as an import or export
duty. The value of an item is usually determined by an invoice or bill of lading. Finally,
compound tariffs are a combination of specific and ad valorem tariffs.
Successive rounds of GATT negotiations, culminating in the Uruguay Round and the
establishment of the WTO, have had a dramatic effect in lowering tariffs worldwide.
Average customs duties in the world economy are now very low. But there are still ‘tariff
peaks’ on so-called sensitive products. For industrialised countries, tariffs of 15 per cent
and above are generally recognised as tariff peaks.
Another tariff-related concept in trade policy is ‘tariff escalation’. Tariffs can be applied at
a low rate on raw materials, rising on semi-processed goods, and being highest of all on
finished products. Tariff escalation operates in the interests of domestic manufacturing.
Raw materials are allowed in with low or zero rates of protection. Intermediate goods
attract some protection, with the highest rates being reserved for the final goods. The
effect is to concentrate protection on the final stages of manufacturing. It has the effect
of discouraging value-added processing in the countries from which the raw materials
originate. Processed goods which are intended for export cannot compete once a tariff is
imposed. The result is to keep the raw materials exporter out of the market for
manufactured goods.

Non-tariff barriers
As tariffs have declined in importance in the real world, non-tariff barriers have increased.
They are now the main obstacles to free trade in the international economy.
Import quotas limit the number of units of a good or service that can enter an economy.
They can be imposed unilaterally (by one country) or multilaterally (by a number of
countries) and are imposed by the importing country to reduce supplies of foreign
products. Examples of import quotas can be found on a variety of products in the world
economy: coal, chemicals, iron and steel, fertilisers and plastic materials. Import quotas
are the most significant trade barrier in the world today.
Export quotas are imposed by an exporting country for one of two reasons. Either there is
a wish to manipulate the world price by restricting supply – OPEC oil exporters, for
example – or quotas are imposed to prevent exports of ‘strategic’ goods: for example,
military hardware, strategic raw materials such as uranium or technologically sensitive
material such as certain types of computer software.
Import and export quotas, like tariffs, are fairly transparent. It is straightforward enough
to learn of their existence, and their trade restricting intent is clear. Usually it is possible
to work out their effects on trade.
There are two other NTB’s (non-tariff barriers) which are less transparent: VER’s
(voluntary export restraints) and subsidies.
● Voluntary export restraints are quotas imposed by the exporting country. The word
‘voluntary’ is a misnomer because the true situation is one in which the exporter agrees
to curtail exports in order to forestall other trade restrictions. In 1981, for example, Japan
imposed a VER on her exports of cars to the US. Had Japan not set up a VER, the US
would have put a quota on imports of Japanese cars. The most famous VER of all was the
multinational MFA (multifibre arrangement). This limited exports of textiles from newly-
industrialising countries to the US and Europe. The Uruguay Round generally reduced
VERs, and abolished altogether the multifibre arrangement.
● An export subsidy is a government payment to a firm which sells its products abroad. It
can be specific (a fixed sum) or ad valorem (a proportion of the value of goods and
services exported). Subsidies affect income distribution and distort markets. Producers
receive large benefits at the expense of the taxpayers who fund the subsidy, and
consumers who bear the burden of higher prices. One of the best-known subsidy schemes
is the CAP (Common Agricultural Policy) of the European Union.

Other policies in restraint of trade

Not all policies which turn out in practice to have protectionist effects are designed to be
in restraint of trade. They may have objectives such as health and safety, and their
protective effects may be unintended. Or health and safety might disguise an intention to
operate in restraint of trade. Barriers to trade related to health and safety issues are non-
transparent and are difficult to remove.
Other trade barriers which seem to be increasing in importance in the world economy are
government procurement and marketing and packaging standards.
● Government procurement. Governments purchase many of the goods and services
necessary for education, defence, health, infrastructure and so on. The GPA (Government
Procurement Agreement) was negotiated under GATT. It extends free trade principles of
non-discrimination and transparency to government procurement. Measures which go
against GPA include preferential prices, offsets (such as domestic content requirements)
and lack of competitive tendering. All of these measures discriminate in favour of
domestic firms.
● Marketing and packaging standards can also discriminate against imports. The
requirement, for example, that soft drinks be supplied in returnable, i.e. glass, bottles
discriminates against imports in favour of domestic suppliers. Similarly, customs
procedures can be turned into barriers which place great burdens on potential foreign
suppliers attempting to enter domestic markets. In the 1980s, France had customs
regulations which effectively restricted the paperwork for high-tech imports to a handful
of overworked regional customs houses.

In their analysis of trade policy, economists tend to overlook the huge variety of
protectionist measures which can be taken by governments. The tariff is the basis of the
analysis. This plays down the fact that post-Uruguay Round tariffs in developed countries
are low. They average less than 4 per cent (Table 4.1). Tariffs are relatively insignificant
in the modern world economy, at least in an empirical sense.
Exchange and capital controls as barriers to trade
Exchange controls refer to the restrictions placed on access to foreign exchange and the
uses to which it can be put.
A small number of countries in the world economy still maintain dual or multiple
exchange rates. There may be one rate for imports and another for exports. Different
types of imports, ‘necessities’ and ‘luxuries’ may attract different rates. There may also
be one rate for trade and another for capital account transactions.
Capital controls refer to restrictions placed on the free movement of financial capital
between countries. Nearly two-thirds of countries in the world economy have foreign
exchange restrictions associated with the capital account.
Sometimes there is outright prohibition of capital movements, or central banks might
discourage lending overseas by the commercial banks. Taxes can be imposed on short-
term capital flows in order to discourage speculative movements. Dual or multiple
exchange rates can be used to restrict capital flows.

Why do we regard exchange and capital controls as barriers to trade? It is because these
controls have the effect of increasing the transactions costs associated with foreign trade.
They also tend to encourage unproductive ‘rent-seeking’ behaviour on the part of
importers and exporters.

‘Old’ arguments for protection

In the classical theory of trade, two exceptions to free trade were recognised quite early
on: the optimum tariff argument and the infant industry argument. But they were
recognised as exceptional arguments. Economists who advocated protection as a general
rule – for example Hamilton in the United States and List in Germany – had only a limited
impact on attitudes towards protectionism.
In the 1930s protectionist ideas revived. The case for protection resurfaced as the
‘optimum tariff’ theory. There was also a new interest in promoting industrialisation
through tariff protection, a policy developed in the main by European scholars.
In this section we consider the two traditional arguments for protection which have
received serious attention from economists: the optimum tariff and the infant industry
arguments for protection.
The optimum tariff
As a large country raises its tariff (import duty) unilaterally, it has two advers effect on its
welfare: the terms of trade may improve and the volume of trade may decline. The first
one affects the welfare postitively and the latter does negatively.
The improvement in the terms of trade inially tends to more than ofsett the
accompanying reduction in the volume of trade and the community welfare is enhanced.
Beyond some point, however, it is likely that detrimetal effect of successive reductions in
the trade volume will begin to outweight the positive effect of further improvements in
terms of trade so that community welfare begins to fall. Somewhere in between there
must be a tariff which optimises a country’s welfare level under these conditions.
Thus the optimum tariff is the rate of tariff which maximises the net welfare increase.

If the tariff rate is rised extremely, the trade volume decrease to zero. This is a prohibitive
tariff. In this situation, the country reaches to autarchy position. At this point, gains from
foreign trade decrease to zero.
The optimum tariff for a country therefore lies somewhere between the free-trade
position (no tariff) and the prohibitive tariff.

Retaliation
When the large country imposes optimum tariff on imported goods, it increases its
welfare at the expense of decrease in its trade partners. This is why the optimum tariff is
often described as a ‘beggar-my-neighbour’ policy, which is likely to provoke
retaliation and result in a wider violation of the principles of free trade. If an optimum
tariff policy by country A triggers a tariff war, then the end result is likely to be a
reduced volume of trade. All countries will end up worse off and the gains from trade
will evaporate.

The infant industry

The infant industry argument for protection is deceptively simple. It was first used by
Alexander Hamilton in the USA (1790), and later by Friedrich List (1841) to support
protection for German manufacturing against British industry. In the 1940s and 1950s the
argument was revived to support economic development via industrialisation, in newly
independent developing countries.
The idea is to introduce a tariff on a temporary basis. The infant industry can grow up
behind this tariff wall. As the infant industry gains experience (‘learning by doing’) its
costs will fall. Eventually it will have a comparative advantage and will be able to
compete in the international economy without the need for tariff protection. Everyone will
gain, so the argument goes. In the long run, all countries will benefit from the falling costs
encouraged by infant industry protection.
The argument for infant industry protection needs to be constructed with great care if it is
to have validity in terms of orthodox market-based economics. The argument cannot be
allowed to depend on the realisation of the firm’s internal economies of scale. This is
because a firm should be able to anticipate future cost reductions and allow for them in
present investment decisions. The firm should be able to borrow against future profits.
Borrowing will tide it over the early years when losses may be made. If capital markets
are imperfect and do not allow the smoothing of gains and losses, the government may
need to intervene by underwriting loans, but not by imposing tariffs which distort
international markets.
However, suppose future benefits are external to the firm, and cannot be reaped by the
individual firm. For example, the firm may be training a specialised labour force, which
will benefit all firms within the industry. Workers often leave the firm which trained them
to go and work for competitors. Or new knowledge may be acquired which cannot be kept
secret but must be shared with all firms in the industry. In these cases, social benefit may
outweigh private benefit. Even here, however, the preferable policy for the infant industry
is a direct subsidy rather than a tariff. A subsidy can be used to compensate firms in the
industry directly for the training of labour. Or a subsidy could be aimed towards the
‘learning process’ involved in new production methods. It should be noted, however, that
subsidies are rarely carefully thought out and targeted. Rather than stimulating an infant
industry, they often go to line the pockets of directors and shareholders. Private
profitability may be enhanced, but costs, employment and output will be unaffected.

Non-economic arguments
‘Optimum tariff’ and ‘infant industry’ are two of the traditional arguments for protection,
which have recognisable economic foundations. There are, in addition, traditional non-
economic arguments which have held sway from time to time.
● Distribution of income. A tariff might be justified on the grounds that it favours what
would otherwise be a disadvantaged group. It might be workers in a particular industry,
people living in certain regions, farmers, the poor and so on. Economists respond by
pointing out that the distribution of income can be managed better by taxes and transfer
payments. Tariffs distort markets and may well reduce the volume of trade and national
income. Then everyone, including the disadvantaged groups, loses out.
● Security and defence. Even the free trader Adam Smith was prepared to sanction the
Navigation Acts which imposed tariffs on the use of foreign ships and shipping services.
The idea was to maintain a navy for use in war. The national defence argument for
protection was a key justification among mercantilist thinkers. In more recent times, in
the 1950s and 1960s, the US imposed restrictions on oil imports on the grounds that a
thriving domestic oil industry was a strategic necessity.