The infant industry argument - valid or not?

OUTLINE

I. Outline

II. List of figures

III. List of abbreviations
1. Introduction
2. Scientific discussion of the IIA
2.1 The IIA - general concept
2.2 Rationales in favour of the IIA
2.3 Refutations of the IIA
3. The IIA in praxis - empirical cases
4. Conclusion

IV. Bibliography

II. LIST OF FIGURES

FIGURE 1: AN INFANT INDUSTRY IN A SMALL IMPORTING COUNTRY

FIGURE 2: EFFICIENCY IMPROVEMENT IN A SMALL IMPORTING COUNTRY

III. LIST OF ABBREVIATIONS

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1. INTRODUCTION

“Even if a domestic industry will, within some years, have a cost advantage over its foreign competitors, when the industry is young its costs will invariably be higher … [and it must therefore] be protected from lower-cost foreign competition” (Egger, 2006, p.9).

The infant industry argument (IIA), initially devised by Alexander Hamilton (in 1791) and Friedrich List (in 1841) (Hoekman, 2001, p. 23), is a widely-used concept to justify the protection of young start-up companies against international competition. By invoking the IIA - which is even recognized by the WTO as a legitimate reason for restricting trade - countries apply protective regulations in favour of their domestic industries through various measures such as tariffs, import quotas and subsidies (Hill, 2009, p. 218). But just like every trade barrier, the argument is intensively discussed and contradicted in economic science. Adversaries of the concept show the danger of abuse, and question its validity in general, referring to the scientifically proven advantages of free trade.

By analyzing its pros and cons and showing successful examples as well as downsides of the concept, this paper will therefore examine whether the IIA can be considered to be valid, and if so, under which circumstances it should be applied.

2. SCIENTIFIC DISCUSSION OF THE IIA

2.1 THE IIA - GENERAL CONCEPT

The IIA states that - in their early stages - new enterprises have to be protected against competition in order to be able to mature and become competitive. This is said to be necessary, as young industries have to tackle various technical, managerial and commercial problems when starting their business, and cannot profit from economies of scale like their matured worldwide competitors do (Wood, 2003, p. 2).

The argument supposes that while growing under reasonable, temporary protection, the respective industry will gradually reduce costs through learning-by-doing production improvements and will therefore be able to become efficient and compete autonomously on the global marketplace at the end (Krueger; Tuncer, 1982, p.3).

If executed through tariffs or import quotas, the initial effects of the IIA can be illustrated as follows:

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FIGURE 1: An infant industry in a small importing country; Source: Suranovic, 2012

The model acts on the assumption that the country - with respect to the specific industry - is a relatively small importing country, as this is normally the case when a country is applying IIA measures.

The tariff (the difference between P2 and P1) raises the domestic price to P2, which reduces the overall domestic demand from D1 to D2 and limits the amount of imports from D1 to D2-S2, thereby enabling domestic supply (S2).

Overall, there is a welfare loss, as consumers lose rent (A+B+C+D), whereas producers get an additional rent of A (Suranovic, 2012). The amount of the welfare loss depends on the measure, in case of a tariff, the governments collects revenue the size of C, which means that the net welfare loss amounts to B+D (production and consumption distortions), in case of a quota, there is no governmental rent and C is lost, too, to foreign producers.

Subsidies work with comparable mechanisms, they increase consumer rents by shifting the supply curve downwards (the supported producers offer their product to cheaper prices), but also lead to government spending and create welfare losses through distortion.

Supporting the arguments for free trade, the model shows that the application of the IIA has negative consequences for the respective nation. But proponents of the IIA argue that, after the starting period has been overcome, protectionist measures can be gradually reduced and the situation will shift to the following:

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FIGURE 2: Efficiency improvement in a small importing country; Source: Suranovic, 2012

Figure 2 assumes that the protected industry has lowered its costs and has become efficient, it can now offer its goods at the original world market price, which is demonstrated by the downward shift of the supply curve (S → S’). Therefore, the demand rises to D1 again, and the consumer rent losses vanish, but suppliers now gain the additional rent E, which is also the overall welfare gain for the country (Suranovic, 2012).

Whether these economic theories actually work in reality, and whether the later welfare gains - if they occur - outweigh the initial welfare losses, rests contested.

2.2 RATIONALES IN FAVOUR OF THE IIA

The IIA ignores the arguments for free trade, but some economists claim that “free trade works well only in the fantasy theoretical world of perfect competition” (Elliott, 2005).

John Stuart Mill, himself a supporter of free trade, acknowledges that there are circumstances under which the IIA is reasonable. "[P]rotecting duties can be defensible … when they are imposed temporarily (especially in a young and rising nation) in hopes of naturalizing a foreign industry, in itself perfectly suitable to the circumstances of the country” (Taussig, 1915). This argumentation is based on the thought that the production pre-eminence of one country often results from its longer experience in this field which leads to superior skills without necessarily having a natural competitive advantage concerning the employed production factors. This means that a start-up company which does have such advantages may well be able to beat the existing market players if given the opportunity to acquire the necessary competences (idem).

Following this argumentation, protective measures support expedient restructuring procedures, particularly in developing economies, as “the transfer of the productive powers of a nation from one field of employment to another is subject to difficulties and hazards which do not always speak in favour of 'free trade,' but very often in favour of national protection” (List, 1885, p. 349).

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