August 11th, 2006

The fight over the economics of protection has been going on, with Harry Clarke at Kalimna saying

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 don’t think Harry’s argument actually proves his claims – he just shows that the simple version of this argument is too simple, which is true of all simple arguments, including simple arguments for free trade.

My view, for what it’s worth, is that any terms of trade benefit from protecting the industry is likely to be negligibly small and that the standard counterarguments about retaliation make it a bad idea to try to impose optimal tariffs to extract such benefits. But the allocative efficiency benefits of reducing small tariffs.

But if neither of these effects is significant what are we arguing about? A couple of things.

First, there’s a general question about the way in which economic modelling is used for policy purposes. As Nick Gruen points out here when the Productivity Commission applied its standard Computable General Equilibrium model to the proposal to cut car tariffs, the small terms of trade effect outweighed the even smaller allocative effect, so the proposal came out with negative net benefits. Rather than bite the bullet and go with the results, or admit that the effects were too small to form the basis of a policy decision, the PC put its thumb on the scales and threw in some ‘cold shower’ effects. This is really tennis with the net down – if you’re allowed to impute productivity benefits to policies you like you can justify anything, and there’s no point in doing any modelling. The whole process becomes an elaborate and extensive way of coming up with the number you first thought of. Via The Progressive Economics Forum there’s a nice piece at the Economist making this and other points I’ve been banging on about for years.

Second, not all economic policy decisions are best described in terms of triangles and rectangles. In this case, it seems clear that the industry is going to contract a bit further, though it no longer seems doomed as it did in the 1970s. So the problem is to make the adjustment path reasonably smooth, and to try and avoid unnecessary hardship. The Button Car Plan did a good job of managing the adjustment away from the huge tariffs of the 1980s, and it ought not to be beyond the wit of policymakers to manage the comparatively tractable problems present today.

  1. Uncle Milton
    August 11th, 2006 at 16:18 | #1

    The car industry, apart from Mitsubishi, is actually in pretty good shape. Toyota is extremely profitable, GMH is going well, and Ford is going OK.

    It used to be argued that the car components industry needs a critical mass of four assemblers to survive. If one went down, they would take down the entire components industry. Bu Mistsubishi now has only 6% market share, and that includes imported Pajeros and other Mitsublishis not made locally.

    It wouldn’t be nationally disastrous if Mitsublshi shut down, though it would be very disruptive in Adelaide.

    The policy of gradually reducing protection to the car industry has been a very good one, the two key words being “gradually” and “reducing”. Because the reductions have been gradual, the car industry has been given the opportunity to become more efficient, and it has.

  2. Hal9000
    August 11th, 2006 at 16:46 | #2

    “The whole process becomes an elaborate and extensive way”

    Should that be ‘elaborate and expensive’?

  3. rog
    August 11th, 2006 at 19:35 | #3

    Free trade is the principle to which we should aspire but in the mean time, with all these non-free traders around, we must be more business like.

  4. August 11th, 2006 at 20:46 | #4

    The car industry is weird. I recall from my MBA material that manufacturers are now competing on features, with most funds that are ploughed in turning into sunk costs and not earning any return unless each manufacturer keeps going just one more step in order to better the features of other products.

    But this turns straight into one of those counter-intuitive scenarios, the money auction. In that, each player bids for a sum, say $100, and the highest bid wins. But there’s a catch; every particpant has to pay over his last bid, whether he wins or not. What ends up making the difference is the increase in one’s bid, not the whole amount. Psychologists actually conducted tests and found bidders often went up to $200 or more.

    So we have a non-governmental externality here, at least in posse. Pigovian taxes seem to offer a patch, though myself I suspect that – apart from the transition costs, which would be inordinate – it would be better to have (i.e., to have had) a horizontally rather than vertically integrated car industry.

  5. August 12th, 2006 at 20:10 | #5

    John the last sentence in the second para after the quote doesn’t lead anywhere. It is a problem because the topic it starts with is the subject of my critique.

    My claim is that what is wrong in Nick’s argument is the contention that unrealised monopoly power in exporting that could provide a case for export taxes is being claimed to imply a case for low level tariffs on imports.

    This claim doesn’t hold outside a simple 2 country-2 good model where the Lerner theorem holds. In a 2*2 model a tariff on imports acts in exactly the same way as a tax on exports. It drags resources away from the export sector, decreasing output and potentially raising prices and returns from exports. Its a simple twist on the standard optimal tariff argument.

    There are not just two goods in the world. There are non-traded goods and goods we export where there is no monopoly power at all. Levying a small tariff on imports will not just drag resources away from industries with unrealised potential for extracting monopoly rents. In fact it may drag resources from other sectors where it will cause welfare losses.

    This is very likely in the case of the car industry which shares no obvious common input requirements with agricultural producers such as wool and wheat where we may have unrealised monopoly power. Resources will not be dragged from wool into motor car assembly by imposing a tariff on assembled car imports and that is what Nick’s argument requires.

    So I am not saying the ‘wrongness’ occurs in a simple model. The argument might work there but it won’t in models with any realism at all.

    To be clear I am not arguing against ‘optimal tariff’ arguments per se – I could they have very little practical value. Nor am I saying that cutting low tariffs to zero will produce big welfare gains. I am simply saying that such cuts are very unlikely to make us worse-off.

    Finally on the PC conclusions a better measure of welfare gains from trade liberalisation that captures both gains to producers and consumers is GDP. On this basis none of the PC results you cite support the contention that low level taxes on the auto industry make us better-off. Hardly surprising since the theory underlying this claim is so clearly flawed.

  6. August 12th, 2006 at 22:37 | #6

    Hi again John,

    Hope you’re going to this (Richard Heinberg & David Holmgren at The Brisbane Institute):-

    I’m going. I recommended Heinberg’s book to you a while ago, “The Party’s Over.”

    All the best, Kim

  7. August 12th, 2006 at 23:42 | #7

    Um, I’m not sure that Holden and Ford are doing all that well at the moment. They’ve been hit hard by the rising fuel costs.

  8. August 13th, 2006 at 01:36 | #8


    Why did the PC refer to consumption as the test of welfare (not GDP) – see p. 302 of its report.

  9. August 13th, 2006 at 13:21 | #9


    I’ve no idea.

  10. David Michie
    August 13th, 2006 at 14:41 | #10

    I agree with Robert. Holden spent a billion dollars developing the new Commodore based on oil price expectations of $25/barrel in 2006 (thank you ABARE!) If oil prices go any higher Holden and Ford will need to offer LPG or diesel alternatives to their thirsty six cylinder petrol engines.

    If you want a sneak preview of a world where petrol costs more than $2 a litre, go to Europe. The Europeans all drive Corolla-sized cars with ultra-efficient diesel engines. In some countries (like France) more than 70% of new cars have diesel engines.

Comments are closed.