Argument against free trade

Today

We have learned why trade is good.
These models however uses various assumptions that may or may not be true.
When these assumptions are relaxed, some reason to NOT trade may emerges.
Today we learn two: small country & dynamic efficiency.
Leads to 3 insights: optimal tariff, infant industry, and current account management.

So far, we have explored gains from trade:
- difference in technology $\rightarrow$ specialization (comparative advantage)
- less constraint (i.e., as long as trade is balanced)
- difference in factor endowment
With large fixed cost & monopolistic, we get loves of variety & internal economies of scale efficiency.
Remember, as long as we can reach higher bundle with trade, then trade is better!

Gains of trade is not shared equally if factor movements and ownerships cannot switch fluidly.
- factor owners that stay in the import-competing industry loses.
- violates pareto optimality.
We showed that in this case, overall economic size increases, so in theory we can compensate those losers.
First policy lesson: we can redistribute losers as long as the pie is larger (and the government is efficient)

We use small country assumption so far.
That is, whatever happens in our country in question, it will not affect the world market.
In reality, various countries’ action affects world prices!
- OPEC capacity reduction increases oil price. US entered a recession because of this.
- Indonesian nickel ban $\rightarrow$ increased nickel ore price.

Remember, in international trade, we often use ToT (i.e., $\frac{P_X}{P_M}$ ) to measure welfare.
Since large countries can affect prices while its small partners cannot, large countries can alter their policy to affect ToT in their favor.
Basically kinda like a monopolist.
To see the mechanism, we have to understand the impact of tariff for small country first.

Import tariffs shift world price.
- $P_t - P_{tt}$ is the tariff rate.
- There’s ToT gain cuz $P_M$ goes down.
US tariffs always shakes the world. Also when China used tariff to punish Australia when Australia endorsed investigation on the origin of SARSCOV2.

DifferenceL import price changes $P_w \rightarrow P_{tt}$ , hence A,B,C and D gets smaller.
Government revenue = C+E
- C from CS
- E from TOT gain.
if B+D < E, then there’s a welfare gain from the tariff.
This tariff hurts small exporters. Globally, it reduces welfare.

Bottom line: for a large country, they can gain from import tariff (if big in terms of buyer) or export tariff (if big in terms of exporters)
If their partner is small, whatever they do won’t affect world price.
However, if their partner is large (or a combination of smaller countries like EU), then they can retaliate with their own tariff.
Large partners’ retaliation would reduce large country’s $P_X$ which led to initial ToT.

Large countries can only benefit from tariffs if:
- they are large enough (ensure B+D < E)
- Didn’t get retaliated a similarly sized partner(s).
The second part leads to a prisoner’s dilemma situation.
WTO and trade agreements exist to tackle this situation.
When a large country slap a unjustified tariff, small country can sue and other small countries can follow, combined creates large country effect.

Our model so far is static: cloth producer will always be a cloth producer.
In reality, a country’s industry structure changes: the Asian Tigers started as an agriculture economy.
Some firms may ask for a short-term tariff protection to build scale and expertise before they are able to compete against foreign producers.
That is, protection will lead to a short-term efficiency loss, but the promised long-run gain will make up for it.
This is called infant industry argument.

In the infant industry case, a case for tariff protection isn’t to avoid losses from import competition, but to create time for domestic industry.
Protection will lead to markups (which is bad for consumers), which then is used to innovate and grow.
Protection can be in the form of various policies: Tariffs, quota restrictions, Local Content Requirements (LCR), etc.
In designing policy with infant industry as its main argument, two things must be made clear:
- Measurement of the LEARNING of the industry & WHEN the policy will be revoked.

If an industry has a potency in the future, why capital market won’t finance their learning?
- Tech startups do not need the government: they simple get investors to fund their learning.
Instead of trade policy, why not use subsidy or fiscal incentives?
- trade policy looks free, but it is paid by the consumers through inefficiency / DWL.
- Non-tariff is even worse since its complicated and gains are unclear.
- Also, retaliations -> more loss, less scale.

What if the industry never grow up?
Instead of growing, more firms actually just consume the markups.
- SOEs, Steel, Automotive in Indonesia still not competitive.
What if international firms are also growing?
How to make sure the protected domestic firms can catch up? When a government should cut its losses?

Since infant industry mostly argued for import competing industry, it often dubbed Import Substitution Strategy (ISS).
Protection against good that a country is not comparatively good at will result in higher cost.
- India & Pakistan protects heavy-manufacturing goods (cars, steel), but their main exports are light-manufacturing goods (textiles)
Needs to ensure those industry exports BECAUSE of past protection.

Choosing ISI = choosing not to pursue export orientation growth:
- protection skews up prices for importing industries relative to exporting industries (e.g., $\frac{P_X}{P_M} \Downarrow$ ).
- Factor of production will move to these industries instead of exporting industries.
Again, this is bad for welfare, unless the ISI industries can catch up.

ISI most often ended up accompanied by increased FDI:
- Incoming FDI seeks market.
- This means, the domestic markups can be absorb by foreigners.
However, domestic firms can learn from foreigners.
Good examples are the rise of local champions: Toyota, Samsung, BYD, Foxconn.
- What’s Indonesia’s local champions?

Often bad for welfare amid naturally pursue a comparative disadvantage industry.
The forever infants: why grow if can reap markups?
Markups absorbed by foreigners.
Retaliations can be bad and actually reduce scale.
Hard to measure and evaluate.

If an industry has the potency to grow, theory says that a good capital market will comes in to finance that industry.
However, if this is not the case, then ISI may be useful.
In the presence of market failures, industrial policy that support ISI may be desirable:
- Imperfect capital market
- Coordination problem
Next week, we will discuss the new industrial policy from these exact problems.