The nightmare of the Indian toy industry comes in the form of a pint-sized plastic doll. It’s made in China, sings a popular Hindi film song, and costs about 100 rupees ($2). Indian parents have snapped it up at markets across the country, leaving local toy companies petrified. Matching the speed, scale and technology involved in the doll’s production—resulting in its rock-bottom price—is beyond their abilities. . . . In areas such as toys and shoes, China has developed huge economies of scale while India has kept its producers artificially small.{750}
The economic problems of toy manufacturers in India under free trade are overshadowed by the far more serious problems created by previous import restrictions which forced hundreds of millions of people in a very poor country to pay needlessly inflated prices for a wide range of products because of policies protecting small-scale producers from the competition of larger producers at home and abroad. Fortunately, decades of such policies were finally ended in India in the last decade of the twentieth century.
INTERNATIONAL TRADE RESTRICTIONS
While there are many advantages to international trade for the world as a whole and for countries individually, like all forms of greater economic efficiency, whether at home or abroad, it displaces less efficient ways of doing things. Just as the advent of the automobile inflicted severe losses on the horse-and-buggy industry and the spread of giant supermarket chains drove many small neighborhood grocery stores out of business, so imports of things in which other countries have a comparative advantage create losses of revenue and jobs in the corresponding domestic industry.
Despite offsetting economic gains that typically far outweigh the losses, politically it is almost inevitable that there will be loud calls for government protection from foreign competition through various restrictions against imports. Many of the most long-lived fallacies in economics have grown out of attempts to justify these international trade restrictions. Although Adam Smith refuted most of these fallacies more than two centuries ago, as far as economists are concerned, such fallacies remain politically alive and potent today.
Some people argue, for example, that wealthy countries cannot compete with countries whose wages are much lower. Poorer countries, on the other hand, may say that they must protect their “infant industries” from competition with more developed industrial nations until the local industries acquire the experience and know-how to compete on even terms. In all countries, there are complaints that other nations are not being “fair” in their laws regarding imports and exports. A frequently heard complaint of unfairness, for example, is that some countries “dump” their goods on the international market at artificially low prices, losing money in the short run in order to gain a larger market share that they will later exploit by raising prices after they achieve a monopolistic position.
In the complexities of real life, seldom is any argument right 100 percent of the time or wrong 100 percent of the time. When it comes to arguments for international trade restrictions, however, most of the arguments are fallacious most of the time. Let us examine them one at a time, beginning with the high-wage fallacy.
The High-Wage Fallacy
In a prosperous country such as the United States, a fallacy that sounds very plausible is that American goods cannot compete with goods produced by low-wage workers in poorer countries, some of whom are paid a fraction of what American workers receive. But, plausible as this may sound, both history and economics refute it. Historically, high-wage countries have been exporting to low-wage countries for centuries. The Dutch Republic was a leader in international trade for nearly a century and a half—from the 1590s to the 1740s—while having some of the highest-paid workers in the world.{751} Britain was the world’s greatest exporter in the nineteenth century and its wage rates were much higher than the wage rates in many, if not most, of the countries to which it sold its goods.
Conversely, India has had far lower wage rates than those in more industrialized countries like Japan and the United States, but for many years India restricted imports of automobiles and other products made in Japan and the United States, because India’s domestic producers could not compete in price or quality with such imported products. After an easing of restrictions on international trade, even the leading Indian industrial firm, Tata, has had to be concerned about imports from China, despite the higher wages of Chinese workers compared to workers in India:
. . .the Tata group set up a special office to educate the different parts of its sprawling business empire on the possible fallout from the removal of import restrictions. Jiban Mukhopadhyay, economic adviser to the group’s chairman, heads the operation. In his desk drawer, he keeps a silk tie bought on a trip to China. Managers who attend the company’s WTO [World Trade Organization] workshops are asked to guess its price. “It’s only 85 rupees,” he points out. “A similar tie made in India would cost 400 rupees.”{752}
Economically, the key flaw in the high-wage argument is that it confuses wage rates with labor costs—and labor costs with total costs. Wage rates are measured per hour of work. Labor costs are measured per unit of output. Total costs include not only the cost of labor but also the cost of capital, raw materials, transportation, and other things needed to produce output and bring the finished product to market.
When workers in a prosperous country receive wages twice as high as workers in a poorer country and produce three times the output per hour, then it is the high-wage country which has the lower labor costs per unit of output. That is, it is cheaper to get a given amount of work done in the more prosperous country simply because it takes less labor, even though individual workers are paid more for their time. The higher-paid workers may be more efficiently organized and managed, or have more or better machinery to work with, or work in companies or industries with greater economies of scale. Often transportation costs are lower in the more developed country, so that total costs of delivering the product to market are less.
There are, after all, reasons why one country is more prosperous than another, in the first place—and often that reason is that they are more efficient at producing and delivering output, for any of a number of reasons. In short, higher wage rates per unit of time are not the same as higher costs per unit of output. It may not even mean higher labor costs per unit of output—and of course labor costs are not the only costs.
An international consulting firm determined that the average labor productivity in the modern sectors in India is 15 percent of labor productivity in the United States.{753} In other words, if you hired an average Indian worker and paid him one-fifth of what you paid an average American worker, it would cost you more to get a given amount of work done in India than in the United States. Paying 20 percent of what an American worker makes to someone who produces only 15 percent of what an American worker produces would increase your labor costs.
None of this means that no low-wage country can ever gain jobs at the expense of a high-wage country. Where the difference in productivity is less than the difference in wage rates, as with India’s well-trained and English-speaking computer programmers, then much American computer programming will be done in India. All other forms of comparative advantage will also mean a shift of jobs to countries with particular advantages in doing particular things. But this does not imply a net loss of jobs in the economy as a whole, any more than other forms of greater efficiency, domestically or internationally, imply a net loss of jobs in the economy. The job losses are quite real to those who suffer them, whether due to domestic or international competition, but restrictions on either domestic or international markets usually cost jobs on net balance because such restrictions reduce the prosperity on which the demand for goods and labor depends.
Labor costs are only part of the story. The costs of capital and management are a considerable part of the cost of many products. In some cases, capital costs exceed labor costs, especially in industries with high fixed costs, such as electric utilities and railroads, both of which have huge investments
in infrastructure. A prosperous country usually has a greater abundance of capital and, because of supply and demand, capital tends to be cheaper there than in poorer countries where capital is more scarce and earns a correspondingly higher rate of return.
The history of the beginning of the industrialization of Russia under the czars illustrates how the supply of capital affects the cost of capital. When Russia began a large-scale industrialization program in the 1890s, foreign investors could earn a return of 17.5 percent per year on their investments—until so many invested in Russia that the rate of return declined over the years and fell below 5 percent by 1900.{754} Poorer countries with high capital costs would have difficulty competing with richer countries with lower capital costs, even if they had a real advantage in labor costs, which they often do not.
At any given time, it is undoubtedly true that some industries will be adversely affected by competing imported products, just as they are adversely affected by every other source of cheaper or better products, whether domestic or foreign. These other sources of greater efficiency are at work all the time, forcing industries to modernize, downsize or go out of business. Yet, when this happens because of foreigners, it can be depicted politically as a case of our country versus theirs, when in fact it is the old story of domestic special interests versus consumers.
Saving Jobs
During periods of high unemployment, politicians are especially likely to be under great pressure to come to the rescue of particular industries that are losing money and jobs, by restricting imports that compete with them. One of the most tragic examples of such restrictions occurred during the worldwide depression of the 1930s, when tariff barriers and other restrictions went up around the world. The net result was that world exports in 1933 were only one-third of what they had been in 1929.{755} Just as free trade provides economic benefits to all countries simultaneously, so trade restrictions reduce the efficiency of all countries simultaneously, lowering standards of living, without producing the increased employment that was hoped for.
These trade restrictions around the world were set off by passage of the Smoot-Hawley tariffs in the United States in 1930, which raised American tariffs on imports to record high levels. Other countries retaliated with severe restrictions on their imports of American products. Moreover, the same political pressures at work in the United States were at work elsewhere, since it seems plausible to many people to protect jobs at home by reducing imports from foreign countries. The net result was that severe international trade restrictions were applied by many countries to many other countries, not just to the United States. The net economic consequences were quite different from what was expected—but were precisely what had been predicted by more than a thousand economists who signed a public appeal against the tariff increases, directed to Senator Smoot, Congressman Hawley and President Herbert Hoover. Among other things, they said:
America is now facing the problem of unemployment. The proponents of higher tariffs claim that an increase in rates will give work to the idle. This is not true. We cannot increase employment by restricting trade.{756}
These thousand economists—including many leading professors of economics at Harvard, Columbia, and the University of Chicago—accurately predicted “retaliatory” tariffs against American goods by other countries.{757} They also predicted that “the vast majority” of American farmers, who were among the strongest supporters of tariffs, would lose out on net balance, as other countries restricted their imports of American farm products. All these predictions were fulfilled: Unemployment grew worse and U.S. farm exports plummeted, along with a general decline in America’s international trade.{758}
The unemployment rate in the United States was 6 percent in June 1930, when the Smoot-Hawley tariffs were passed—down from its peak of 9 percent in December 1929. A year later, unemployment was 15 percent, and a year after that it was 26 percent.{759} All of this need not be attributed to the tariffs. But the whole point of those tariffs was to reduce unemployment.{xxvii}
At any given time, a protective tariff or other import restriction may provide immediate relief to a particular industry and thus gain the political and financial support of corporations and labor unions in that industry. But, like many political benefits, it comes at the expense of others who may not be as organized, as visible, or as vocal.
When the number of jobs in the American steel industry fell from 340,000 to 125,000 during the decade of the 1980s, {760}it had a devastating impact and was big economic and political news. It also led to a variety of laws and regulations designed to reduce the amount of steel imported into the country that competed with domestically produced steel. Of course, this reduction in supply led to higher steel prices within the United States and therefore higher costs for all other American industries that were manufacturing products made of steel, which range from automobiles to oil rigs.
All these products made of steel were now at a disadvantage in competing with similar foreign-made products, both within the United States and in international markets. It has been estimated that the steel tariffs produced $240 million in additional profits to the steel companies and saved 5,000 jobs in the steel industry. At the same time, those American industries that manufacture products made from this artificially more expensive steel lost an estimated $600 million in profits and 26,000 jobs as a result of the steel tariffs.{761} In other words, both American industry and American workers as a whole were worse off, on net balance, as a result of the import restrictions on steel.
Similarly, a study of restrictions on the importation of sugar into the United States indicated that, while it saved jobs in the sugar industry, it cost three times as many jobs in the confection industry, because of the high cost of the sugar used in making confections.{762} Some American firms relocated to Canada and Mexico because sugar costs were lower in both these countries. In 2013 the Wall Street Journal reported, “Atkinson Candy Co. has moved 80% of its peppermint-candy production to a factory in Guatemala that opened in 2010.” From 2000 to 2012, the average price of sugar in the United States was more than double its price in the world market, according to the Wall Street Journal.{763}
International trade restrictions provide yet another example of the fallacy of composition, the belief that what is true of a part is true of the whole. There is no question that a particular industry or occupation can be benefitted by international trade restrictions. The fallacy is in believing that this means the economy as a whole is benefitted, whether as regards jobs or profits.
“Infant Industries”
One of the arguments for international trade restrictions that economists have long recognized as valid, in theory at least, is that of protecting “infant industries” temporarily until they can develop the skills and experience necessary to compete with long-established foreign competitors. Once this point is reached, the protection (whether tariffs, import quotas, or whatever) can be taken away and the industry allowed to stand or fall in the competition of the marketplace.
In practice, however, a new industry in its infancy seldom has enough political muscle—employees’ votes, employers’ campaign contributions, local governments dependent on their taxes—to get protection from foreign competition. On the other hand, an old, inefficient industry that has seen better days may well have some political muscle left and obtain enough protectionist legislation or subsidies from the government to preserve itself from extinction—at the expense of the consumers, the taxpayers, or both.
National Defense
Even the greatest advocates of free trade are unlikely to want to depend on imports of military equipment and supplies from nations that could turn out at some future time to be enemy nations. Therefore domestic supplies of munitions and weapons of war have long been supported in one way or another, in order to assure that those suppliers will be available in the event that they are needed to provide whatever is required for national defense.
One of the rare cases in history where a people d
id depend on potential enemies for military supplies occurred in colonial America, where the indigenous American Indians obtained guns and ammunition from the European settlers. When warfare broke out between them, the Indians could win most of the battles and yet lose the war when they began to run out of bullets, which were available only from the white settlers. Since guns and bullets were products of European civilization, the Indians had no choice but to rely on that source. But countries that do have a choice almost invariably prefer having their own domestic suppliers of the things that are essential to their own national survival.
Unfortunately, the term “essential to national defense” can be—and has been—stretched to include products only remotely, tangentially, or fictitiously, related to military defense. Such products can acquire protection from international competition under a national defense label for purely self-serving reasons. In short, while the argument for international trade restrictions for the sake of national defense can be valid, whether it is or is not valid for a particular industry in a particular country at a particular time depends on the actual circumstances of that industry, that country, and that time.
Different foreign countries can represent different probabilities of becoming future enemies, so that the dangers of relying on foreign suppliers of military equipment vary with the particular countries involved. In 2004, for example, Canada was the largest foreign recipient of Pentagon contracts—$601 million worth—followed by Britain and Israel, {764}none of these three countries being likely to be at war with the United States.
Basic Economics Page 56