Overview of the Pros and Cons of Trade Barriers
As well as an indication of future topics for this newsletter
Trade barriers have always been a thorn in my side. I still remember way back in 2000 when I joined the fan club for the metal band Fozzy, and membership came with a free copy of their DVD titled Unleashed, Uncensored, Unknown. When it arrived to my door, I was shocked to find that because it was shipped from Florida, I had to pay Canada Post almost $20; their excuse was that Canada customs levied the 7% Goods and Services tax on the import, and then Canada Post added its own $9.95 “handling fee”. Remember: I paid nothing for it, and 7% of nothing is still nothing. It just felt wrong, but there was nothing I could do about it.
Now I know that some people will accuse me of being a whiner about “First World Problems”, and I admit that there are much bigger problems out there then me having to pay border fees for a DVD from a (then) parody band. And indeed, this example is meant to a silly way of introducing trade barriers. But to be serious for a moment, these barriers typically do harm many of the people they are meant to help, especially low-income people who cannot avoid their negative consequences.
Furthermore, trade barriers are very common in all countries around the world, even between countries that officially have “free trade agreements” between them, and even within countries themselves — such as Canada where trade barriers exist between provinces. Some of these trade barriers are “natural” in that they would exist even in the absence of human beings making them happen (such as geography), but there are many more that exist because governments create them for various reasons.
In the coming weeks, I will write a lot about trade barriers, and next week I will even offer a defense of trade barriers in the context of security threats created in the Western world by the Chinese government. But this week, I feel it is worthwhile to talk about the pros and cons of trade barriers more generally to demonstrate why most economists oppose them, but also why even an economist might defend them in certain (very) limited circumstances.
But before moving on, I invite you all to please consider a paid subscription to this newsletter, as it will help enable me to put more resources into my research. Reading and writing in my dark, cold basement while listening to “the metal” is one of the great joys of my life, and your generous support will help lower the opportunity costs of doing so.
Tariff Barriers to Trade
Import Tariffs
The most commonly-known barrier to trade is a tariff, which is an international tax that affects people in four ways:
The consumption of the imported good: consumers in the country where the tariff is levied will end up paying more for less of the product being imported. In some cases, such as my DVD example, the response could be “so what?” since it is not something I need (or so my mother told me at the time). But there are many other tariffs which are attached to necessities such as food and clothing, and the rise in price will also occur for domestically-produced substitutes for these imports, as I will demonstrate later.
Domestic production of goods that compete with these imports: tariffs will enable these producers to sell more of their products for higher prices, so it is clear why they are often the ones to lobby governments for these tariffs. But remember that the benefits to these producers are more than offset by the losses to the same country’s consumers, as I will show below.
Foreign production of the imported good: domestic producers can sell more of their product to domestic consumers because foreign production falls with the rising import costs. This is often the explicit purpose of trade barriers: to encourage consumers to “Buy Local” or “Buy America”. But again, the costs of these tariffs to the local economy are usually greater than the benefits.
The structure of the domestic economy: with less foreign competition, domestic producers become more monopolistic, which discourages innovation and other ways to keep prices low. Politicians like to complain about “skyrocketing” prices, such as the rising costs of food and energy, but they conveniently overlook the effects of their preferred trade policies on these prices.
However, this is a good time to demonstrate that I am not an ideologue when it comes to trade barriers, because there are times when governments have no reasonable alternatives, even from an economics perspective. This is because there are two categories of tariffs: revenue tariffs and protective tariffs. Protective tariffs are the ones we typically see in high-income countries like Canada and the U.S., because governments have lots of revenue sources without them, but they still choose to levy them because they want to protect domestic industry.
But revenue tariffs are the ones that can be most defensible economically, because they are levied in small low-income countries that cannot generate sufficient revenues without them. These are countries where the local tax collector does not have the resources to properly assess and collect taxes from its citizens, and perhaps where the tax collector is more vulnerable to bribery because their employer does not pay them enough to remain honourable. But since imported goods have to pass through customs, it is much easier to assess and collect taxes on them.
Some of what I argued above makes intuitive sense, but I want to go into a little more detail into a few points made. To me, it is easiest with some cool graphs with lots of coloured polygons, but based on my experience teaching this stuff, I imagine a lot of readers’ eyes will glaze over at the sight of these graphs, so I will avoid them here.
With respect to domestic consumers paying more for less, you might be wondering why they would pay more for domestically-produced goods when the tariff is only on the imported stuff. It is precisely because the domestic economy has become less competitive: now that domestic producers face less competition, they can raise their prices to be more consistent with the prices of imported goods. Unless businesses are designed to be either non-profit or not-for-profit, their primary goal is to maximize their profits, so that is what they do.
Then, by the Law of Demand, higher prices lead to less quantity demanded because consumers cannot afford to buy as much as they bought absent the tariffs.
As for why the losses to domestic consumers will more than offset the gains to domestic producers, it is due to two key distortions to the domestic economy relative to the free trade equilibrium:
Consumption distortion: too little is being consumed at too high a price.
Production distortion: too much is being produced domestically at too high a price. While you might wonder how a business can produce too much, it is because it could have been produced more efficiently if foreign competition was allowed.
Both of these distortions are also known as deadweight losses to the economy.
Now here is where I give more credit where credit is due and admit another potential benefit of tariffs: the benefit of the revenue earned by the government levying it. For a very (economically) small country, its imports mean practically nothing to the other countries involved; if that country says “we are lowering our imports from you guys”, the other country will say “OK” and go on with their business. Therefore, the revenues earned from the tariff will not outweigh the two distortions.
But take a much larger country like the U.S.: if it says to the rest of the world, “we are raising tariffs because we want our citizens to ‘Buy American’”, there is a good chance that foreign producers will lower their “world” price to lessen the pain of these tariffs. In other words, foreign producers will “eat” some of that tariff to avoid losing so much business. The lower world price will lead to lower economic distortions and higher tariff revenues for the U.S. government, such that (if large enough) the tariff revenues might even outweigh the distortions.
So that is a potential defense of tariffs (at least for the large country), but there is a caveat: this argument assumes the rest of the world just lies down and takes the beating from that large country. In reality, tariffs from one country can lead to a trade war, which leads to everyone being worse off. For example, when the Trump government levied steel tariffs on Canada a few years ago, Canada responded with its own retalitatory tariffs on the U.S. Fortunately, the trade war did not last long as the two sides got back to the bargaining table to work their issues out.
Other Tariff Barriers to Trade
An import tariff is not the only kind of tariff barrier to trade. Another one is an export subsidy, which is a negative tariff because instead of the government charging the importer for whatever is imported, it is paying a domestic business to export more of its product instead of selling it domestically. These subsidies have historically been used to benefit European agricultural producers, and are so distortionary that the WTO banned them.
The reason why they are especially distortionary can be explained by referring back to the effects of import tariffs: with these tariffs, the larger is the country, the more revenue that government can earn relative to the distortions created by the tariff. But with an export subsidy, the larger is the country, the more the government spends to provide the subsidy. There is no possible way the export subsidy can have a net benefit for the domestic economy.
Next, there is the case where the tax is on exports instead of imports. An example is the National Energy Program (NEP) which existed in Canada in the early 1980s, and which still angers many Western Canadians (especially Albertans) to this day. In that case, the federal government under Pierre Trudeau (Justin’s daddy) wanted Canadian energy producers to sell their energy to Canadians instead of non-Canadians, so he taxed exports of natural gas. Contrary to the effects of an import tax, the export tax hurts domestic producers because they give domestic consumers more bargaining power, so domestic consumers are able to demand lower prices for the gas. But the benefits to consumers are still outweighed by the losses to domestic producers for a small country due to two distortions relative to the free trade equilibrium:
Consumption distortion: too much is being consumed at too low a price.
Production distortion: too little is being produced domestically at too low a price.
For a large country, it is possible for the tax revenues to outweigh the distortions, but that again ignores the potential for retaliatory trade barriers.
Non-Tariff Barriers to Trade
There are also two reasons why a government might be hesitant to levy tariff barriers to trade: first, tariffs will likely not shut out foreign competition completely; and second, tariffs are a highly visible form of protectionism. If a government can block trade without making it obvious to consumers why their prices are rising, that is a good political move.
With respect to the first hesitation, a government might resort to import quotas, in which it explicitly limits how much of a good can be imported. While the method of limiting imports differs, the effects are basically the same except that the domestic government does not necessarily capture the revenues generated from the quota; those “quota rents” are earned by the businesses who are given import licenses. However, governments can capture at least some of these rents with license fees.
A similar non-tariff barrier to trade is called a voluntary export restraint (VER), which is where the foreign government chooses to limit its exports to the domestic country. This is actually something that has happened, such as when the Japanese government agreed to export fewer automobiles to the U.S. in the 1980s. One reason why a government might voluntarily enter such an agreement is because they expect even worse retaliation otherwise. While the effects on the domestic economy of a VER is almost entirely the same as with an import quota, the main difference is that it is almost guaranteed the domestic government will not capture any of the quota rents, so there is no way the domestic economy can see any net-benefit from it.
Other non-tariff barriers to trade which can be natural or created by governments are:
Industrial policy: this involves an official strategic effort of a government to encourage the development and growth of the economy, such as in the case of Prime Minister Sir John A. Macdonald’s government after the birth of Canada in 1867. There are merits to this kind of policy, especially when related to national security concerns, and it will be the subject of a future issue of this newsletter.
Technical barriers to trade: these are barriers created unintentionally due to safety regulations, for example. These barriers are often unavoidable, but can be exploited by governments who want an excuse to limit trade.
Production subsidies: rather than subsidize exports, the government just subsidizes local production regardless of where it is sold. I will get into these subsidies in much more detail in next week’s post.
Government procurement: this involves rules surrounding how governments purchase goods and services, such as buying local.
Transportation costs: no matter how committed governments are to free trade, it will cost resources to move them from producer to consumer, as well as for producers to obtain inputs of production. There are ways to reduce these transport costs, but they will always exist as long as we do not have teleporters.
Common Arguments for Trade Barriers
There are several common arguments in favour of trade barriers:
Infant government: under this argument, the government does not have sufficient resources to collect revenues to cover its needs unless it resorts to tariffs. This is difficult to argue economically, but it certainly does not apply to “first-world” countries like Canada and the United States (even when they behave like infants).
National defence: it has been argued that certain industries, such as transportation and telecommunications, should be protected from foreign competition because we do not want to be left vulnerable to an invading country. This was a worry when Canada was a new country in the late 19th century and worries of a U.S. invasion were very real, but that worry is no longer relevant (despite what Tucker Carlson said). But in recent years there have been legitimate national security concerns in relation to the Chinese government (e.g., 5G and foreign election interference), so this will be the focus on next week’s issue of this newsletter.
Infant industries: similar to infant government, it is argued that new industries are too small to fend for themselves in the world of multinational corporations, so they need short-term protection to grow large enough to fly like big birds when they leave the nest. One counter-argument is that if they really do have the potential to survive on their own, then they should be willing to sustain short-term losses for long-term gains. Another one is that politicians are often loathe to take away protections once they are given. Furthermore, how can any government have the crystal balls to even foresee which businesses are winners and which ones are the losers? This will be a topic for another future issue of this newsletter.
Unfair competition: it is often argued it is “unfair” to force small domestic firms to compete with the foreign wolves. This argument can make economic sense when it is in the context of dumping, where a foreign business is purposely losing money to drive domestic competitors out of business (similar to the domestic offense of predation). In the absence of dumping, one counterargument to “unfairness” is that domestic consumers still benefit more than domestic producers lose. Once again, this will be the focus of a future issue of this newsletter.
Senile industry protection: here, the argument is that the industry will die on its own eventually, so we just want to help it die peacefully, so to speak. While this is a more defensible argument than infant industries, particularly since it is easier to identify senile ones, the question remains: how do we execute the plan?
Tariffs, trade, and jobs: it is argued here that tariffs creates jobs in the protected industries — sure, but it also reduces jobs in other industries because workers have to come from somewhere. Once again, this will be the subject of a future issue of this newsletter.
Protection as a bargaining chip: this is one I have heard in the context of cabotage, which involves restricting foreign competition in domestic transport industries such as airlines. I remember giving a talk on the subject at a conference 15-20 years ago, and a government employee told me: sure, it would be best to allow foreign competition but we need to keep our restrictions so that we can use them to get the other countries to lift their own restrictions. The problem with this argument is that it rarely works because no one want to be the first to lift their barriers. This is a topic that is near-and-dear to my heart given the work I did on the airline industry as an economist with the Canadian Competition Bureau, so this will definitely be a topic of at least one future issue of this newsletter.
Summary Remarks
International trade is one of my favourite fields of research, and I hope you are also excited to join me on this journey. As noted many (many) times above, I will be going deeper into several of these topics over the coming weeks.
A benefit of a paid subscription is that you will be able to comment on my posts, and I look forward to hearing any feedback (positive or negative) that you want to give me, as long as you are respectful about it — not just to me but also to anyone else.
Thank-you for reading to the end, and I hope to see you again next week.