Wednesday, August 09, 2006

Fallacious arguments for low levels of tariff protection

The argument that Nicholas Gruen has propounded, and which John Quiggin seems to have supported, that low levels of tariff protection are justified by the existence of market power in export markets, is just wrong.

I think they have in mind a simple two good model where the Lerner symmetry condition implies that it doesn't matter whether you levy an export tax on goods in not perfectly elastic supply or instead levy equivalent tariffs on imports. In this simple two good model it doesn't matter which traded good you tax in order, for example, to exploit the optimal tariff argument. The argument here suggests that restricting output in export markets will raise price sufficiently to increase a nation's advantage. Specifically levying a tariff on imports in a two good world will drag resources away from the export sector, reducing output there and potentially advantaging the economy from an optimal tariff viewpoint.

But in a model that even broadly captures the features of the Australian economy this argument breaks down completely. For example if you have market power only in wool exports and you put an import tariff on car imports, then in general, that tariff will draw resources away from all sectors, not just the wool sector. Lerner symmetry disintegrates and doesn't help design policy.

And given the vastly different production technologies in play here in the Australiuan economy a tariff on car imports may not draw any resources at all from the wool sector - instead it will draw resources away from industries with no exporting market power at all. In this case the economy will be worse off with any non-zero tariff on car imports since the tariff will be distortionary.

In general you can't draw any conclusion about a case for low level tariffs without paying attention to the nature of complementarities and substitutabilities in the use of inputs in the economy as a whole. To suggest there is some general argument for low tariffs is an erroneous conclusion.

And to present the rejection of this fallacious argument as a kneejerk rejection of any argument against free trade is unfair. The optimal tariff type of argument can only ever be a very specialised argument that will only ever work in the most restricted circumstances. The difficulty with such fallacious arguments is that they create the impression - on the basis of an inapplicable 2*2 trade model - that there is a general argument for low levels of tariff protection in any economy with some market power in exporting. Since this would apply to almost any economy it suggests a general case against free trade.

There is no such general case and, in particular given the lack of input substitutability between the car industry and those industries where Australia does have market power, there is no specific argument for low levels of import tariff protection in this particular setting.

There is a well-known argument that cutting low tariffs to still lower levels will confer almost no national advantage in terms of output gains. This argument is correct but it has nothing to do with the fallacious argument that optimal tariff arguments on the basis of claimed monopoly power in exporting creates a general case for low level tariff protection of industries such as the car industry.

10 comments:

Bring Back EP at LP said...

Yes, this is what I thought.
It is good to have a micro-economic specialist spell it out in detail.

Thanks

whyisitso said...

Harry you hear a lot from critics of free trade that reducing tariffs is only advantageous to a country where trading partners reciprocate. I'd always believed that cutting out tariffs benefits the importing country regardless of the lack of reciprocracy. Would you argue something similar?

Also I've heard the argument that if we unilaterally remove all trade barriers (other than for GENUINE quarantining reasons) we have nothing left to negotiate with in bi-lateral FTAs. What's your approach to this?

I'm not an economics graduate, merely a member of the public who finds economics interesting but without the technical background.

Damien Eldridge said...

Hi Harry,

It seems that some of the CGE models used to assess trade policy employ an Armington specification. This means that they assume that domestic and foreign versions of the same good are not perfect substitutes. This tends to imply that the domestic country has some degree of market power with respect to each of the traded goods in the model. As such, some level of protection may well be optimal in those models. The PC is investigating this issue at present (see http://www.pc.gov.au/researchproject/2005/050902.html). They have already released some related work on the Armington assumptionb and the Armington elasticities that are currently employed (see http://www.pc.gov.au/research/swp/armingtonelasticities/index.html and http://www.pc.gov.au/research/swp/armingtonelasticities/index.html).

Regards,

Damien.

hc said...

Whether or not we have monopoly power in export markets is a separate issue from whether we should tax imports. There is no obviously link unless there is an equivalrence between import tariffs and export taxes and the point of my comment is that outside a 2*2 world this is unlikely - The Lerner symmetry condition breaks down.

By the way how much mischief has been done in Australian academic economics by appeals to 'optimal tariff' arguments? If monopolists control the export of goods where we do have some pricing power then an export tax is irrelevant since we are already extracting the rents. And what is the extent of pricing power in markets for wool or wheat? My guess is very low.

Damien Eldridge said...

Just a brief clarification on the last paragraph of my previous post. according to the descriptions on the PC website, the two recent PC publications that were mentioned look at the Armington model and its implications for terms of trade effects, rather than discussing the Armington elasticities that are currently used. The description on their website of the current project that was mentioned in the previous post will involve a comparison of the Armington model with a traditional trade model.

Regards,

Damien.

Damien Eldridge said...

I suspect that the arguments for protection would rely on the domestic industry being competitive but the domestic good being an imperfect substitute for the foreign good. As such, each domestic firm would be a price taker and would not be able to exert market power by itself. In this situation, a protectionist policy could enable the domestic country to exert some market power.

Regards,

Damien.

Anonymous said...

"And what is the extent of pricing power in markets for wool or wheat? My guess is very low."

It's probably quite high in coal and iron ore, where we have significant shares of world markets.

Whether or not there is sufficient substitution in inputs between cars and other sectors to justify an optimal tariff on cars - if there is no retaliation - is a question that only can be answered emprically with a CGE model. No one knows the answer a priori.

Just because the it's not a 2X2 world, doesn't mean in itself that the policy implications from a 2X2 model are necessarily wrong.

After all, the policy implications of a 2X2 trade model with the small country assumption thrown in are routinely used to justify free trade.

But if you are intent on making an a priori case against optimal tariffs why not simply argue that even if the elasticities are such that an optimal tariff will raise welfare, this is only true if there is no retaliation.

Andrew Leigh said...

Trackback: http://andrewleigh.com/?p=281

Nicholas Gruen said...

I'm with Anonymous. The point on retaliation, is also fair enough, although the traffic is not all one way on that argument.

1) the argument that John Quiggin and I put to the PC in various inquiries - myself in the auto inquiry and John in the inquiry on cutting 5% tariffs to zero was in opposition to cutting existing tariffs, rather than raising existing levels of tariffs. It's hard to see much scope for retalition here.

2) particularly in this context and generally the argument against this is that higher tariffs here give us more 'negotiating coin'.

I don't argue 2) much because I think, especially for a small country it's a weak argument - based as much on wish fullfilment as anything else, but in this context it seems to me it is at least as strong as the idea that there'd be trade retaliation. (I say this because WTO disciplines make it difficult for countries to retaliate against us (providing we haven't done anything contrary to WTO disciplines ourselves, like increase our tariffs beyond their bound rate))

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