Sophisticated Arguments for Activist Trade Policy
Nothing in the analytical framework developed in Chapters 9 and 10 rules out the desirability
of government intervention in trade. That framework does show that activist government
policy needs a specific kind of justification; namely, it must offset some preexisting domestic
market failure. The problem with many arguments for activist trade policy is precisely that
they do not link the case for government intervention to any particular failure of the assumptions
on which the case for laissez-faire rests.
The difficulty with market failure arguments for intervention is being able to recognize
a market failure when you see one. Economists studying industrial countries have identified
two kinds of market failure that seem to be present and relevant to the trade policies of
advanced countries. One of these is the inability of firms in high-technology industries to
capture the benefits of that part of their contribution to knowledge that spills over to other
firms. The other is the presence of monopoly profits in highly concentrated oligopolistic
industries.
Technology and Externalities
The discussion of the infant industry argument in Chapter 11 noted that there is a potential
market failure arising from difficulties of appropriating knowledge. If firms in an industry
generate knowledge that other firms can use without paying for it, the industry is in effect
producing some extra output—the marginal social benefit of the knowledge—that is not
reflected in the incentives of firms. Where such externalities (benefits that accrue to parties
other than the firms that produce them) can be shown to be important, there is a good
case for subsidizing the industry.
At an abstract level, this argument is the same for the infant industries of lessdeveloped
countries as it is for the established industries of the advanced countries. In
advanced countries, however, the argument has a special edge because in those countries,
there are important high-technology industries in which the generation of
knowledge is in many ways the central aspect of the enterprise. In high-technology
industries, firms devote a great deal of their resources to improving technology, either
by explicitly spending on research and development or by being willing to take initial
losses on new products and processes to gain experience. Because such activities take
place in nearly all industries, there is no sharp line between high-tech and the rest of
the economy. There are clear differences in degree, however, and it makes sense to
talk of a high-technology sector in which investment in knowledge is the key part of
the business.
The point for activist trade policy is that while firms can appropriate some of the
benefits of their own investment in knowledge (otherwise they would not be investing!),
they usually cannot appropriate them fully. Some of the benefits accrue to other firms
that can imitate the ideas and techniques of the leaders. In electronics, for example, it is
not uncommon for firms to “reverse engineer” their rivals’ designs, taking their products
apart to figure out how they work and how they were made. Because patent laws
provide only weak protection for innovators, one can reasonably presume that under
laissez-faire, high-technology firms do not receive as strong an incentive to innovate as
they should.
CHAPTER 12 Controversies in Trade Policy 273
The Case for Government Support of High-Technology Industries Should the U.S.
government subsidize high-technology industries? While there is a pretty good case for
such a subsidy, we need to exercise some caution. Two questions in particular arise: First,
can the government target the right industries or activities? Second, how important,
quantitatively, would the gains be from such targeting?
Although high-technology industries probably produce extra social benefits because of
the knowledge they generate, much of what goes on even in those industries has nothing to
do with generating knowledge. There is no reason to subsidize the employment of capital
or nontechnical workers in high-technology industries; on the other hand, innovation and
technological spillovers happen to some extent even in industries that are not at all hightech.
A general principle is that trade and industrial policy should be targeted specifically
on the activity in which the market failure occurs. Thus policy should seek to subsidize the
generation of knowledge that firms cannot appropriate. The problem, however, is that it is
not always easy to identify that knowledge generation; as we’ll see shortly, industry practitioners
often argue that focusing only on activities specifically labeled “research” is taking
far too narrow a view of the problem.
The Rise, Fall, and Rise of High-Tech Worries Arguments that the United States in
particular should have a deliberate policy of promoting high-technology industries and
helping them compete against foreign rivals have a curious history. Such arguments gained
widespread attention and popularity in the 1980s and early 1990s, then fell from favor,
only to experience a strong revival in recent years.
The high-technology discussions of the 1980s and early 1990s were driven in large part
by the rise of Japanese firms in some prominent high-tech sectors that had previously been
dominated by U.S. producers. Most notably, between 1978 and 1986 the U.S. share of world
production of dynamic random access memory chips—a key component of many electronic
devices—plunged from about 70 percent to 20 percent, while Japan’s share rose from under
30 percent to 75 percent. There was widespread concern that other high-technology products
might suffer the same fate. But as described in the box on page 278, the fear that Japan’s
dominance of the semiconductor memory market would translate into a broader dominance
of computers and related technologies proved to be unfounded. Furthermore, Japan’s overall
growth sputtered in the 1990s, while the United States surged into a renewed period of
technological dominance, taking the lead in Internet applications and other information
industries.
More recently, however, concerns about the status of U.S. high-technology industries
have reemerged. A central factor in these concerns has been the decline in U.S. employment
in the so-called ICT—information, communication, technology—industries, which
are at the heart of the information technology revolution. As Figure 12-1 shows, the
United States has moved into a large trade deficit in ICT goods, while as Figure 12-2
shows, U.S. employment in the production of computers and related goods has plunged
since 2000, falling substantially faster than overall manufacturing employment.
Does this matter? The United States could, arguably, continue to be at the cutting edge
of innovation in information technology while outsourcing much of the actual production
of high-technology goods to factories overseas. However, as explained in the box on page
277, some influential voices warn that innovation can’t thrive unless the innovators are
close, physically and in business terms, to the people who turn those innovations into
physical goods.
It’s a difficult debate to settle, in large part because it’s not at all clear how to put
numbers to these concerns. It seems likely, however, that the debate over whether or not
high-technology industries need special consideration will grow increasingly intense in
the years ahead.
274 PART TWO International Trade Policy
0
–80.00
–60.00
–40.00
–20.00
–100.00
–120.00
–140.00
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
U.S. Trade balance
in ICT goods
($ billion)
Figure 12-1
The U.S. Trade Balance in Information Goods
Since 2000, the United States has developed a large trade deficit in ICT—information, communications,
technology—goods, which are widely seen as the cutting edge of innovation.
Source: National Science Foundation, Science and Engineering Indicators 2010.
Imperfect Competition and Strategic Trade Policy
During the 1980s a new argument for industrial targeting received substantial theoretical
attention. Originally proposed by economists Barbara Spencer and James Brander of the
University of British Columbia, this argument identifies the market failure that justifies
government intervention as the lack of perfect competition. In some industries, they point
out, there are only a few firms in effective competition. Because of the small number of
firms, the assumptions of perfect competition do not apply. In particular, there will typically
be excess returns; that is, firms will make profits above what equally risky investments
elsewhere in the economy can earn. There will thus be an international competition
over who gets these profits.
Spencer and Brander noticed that, in this case, it is possible in principle for a government
to alter the rules of the game to shift these excess returns from foreign to domestic
firms. In the simplest case, a subsidy to domestic firms, by deterring investment and production
by foreign competitors, can raise the profits of domestic firms by more than the
amount of the subsidy. Setting aside the effects on consumers—for example, when the
firms are selling only in foreign markets—this capture of profits from foreign competitors
would mean the subsidy raises national income at other countries’ expense.
The Brander-Spencer Analysis: An Example The Brander-Spencer analysis can be
illustrated with a simple example in which there are only two firms competing, each from
a different country. Bearing in mind that any resemblance to actual events may be
coincidental, let’s call the firms Boeing and Airbus, and the countries the United States
CHAPTER 12 Controversies in Trade Policy 275
Index of employment, 2000=100
70
60
65
75
80
85
95
105
2000 2001 2002 2003 2004 2005 2006
All manufacturing
Computers and related
2007 2005 2009
90
100
Figure 12-2
U.S. Manufacturing Employment
Since 2000, the number of workers producing computers and related goods in the United States
has fallen sharply, outpacing the general decline in manufacturing employment.
Source: Bureau of Labor Statistics.
and Europe. Suppose there is a new product, a superjumbo aircraft, that both firms are
capable of making. For simplicity, assume that each firm can make only a yes/no decision:
either to produce superjumbo aircraft or not.
Table 12-1 illustrates how the profits earned by the two firms might depend on their
decisions. (The setup is similar to the one we used to examine the interaction of different
countries’ trade policies in Chapter 10.) Each row corresponds to a particular decision by
Boeing, each column to a decision by Airbus. In each box are two entries: The entry on the
lower left represents the profits of Boeing, while that on the upper right represents the
profits of Airbus.
As set up, the table reflects the following assumption: Either firm alone could earn
profits making superjumbo aircraft, but if both firms try to produce them, both will incur
losses. Which firm will actually get the profits? This depends on who gets there first.
TABLE 12-1 Two-Firm Competition
Produce
–5 100
0 0
Boeing Produce
Don’t produce
Don’t produce
–5 0
100 0
Airbus
276 PART TWO International Trade Policy
Suppose Boeing is able to get a small head start and commits itself to produce superjumbo
aircraft before Airbus can get going. Airbus will find that it has no incentive to enter. The
outcome will be in the upper right of the table, with Boeing earning profits.
Now comes the Brander-Spencer point: The European government can reverse this situation.
Suppose the European government commits itself to pay its firm a subsidy of 25 if it
enters. The result will be to change the table of payoffs to that represented in Table 12-2. In this
case, it will be profitable for Airbus to produce superjumbo aircraft whatever Boeing does.
Let’s work through the implications of this shift. Boeing now knows that whatever it
does, it will have to compete with Airbus and will therefore lose money if it chooses to
produce. So now it is Boeing that will be deterred from entering. In effect, the government
subsidy has removed the advantage of a head start that we assumed was Boeing’s and has
conferred it on Airbus instead.
The end result is that the equilibrium shifts from the upper right of Table 12-1 to the lower
left of Table 12-2. Airbus ends up with profits of 125 instead of 0, profits that arise because
of a government subsidy of only 25. That is, the subsidy raises profits by more than the
amount of the subsidy itself, because of its deterrent effect on foreign competition. The subsidy
has this effect because it creates an advantage for Airbus comparable with the strategic
advantage Airbus would have had if it, not Boeing, had had a head start in the industry.
Problems with the Brander-Spencer Analysis This hypothetical example might seem
to indicate that this strategic trade policy argument provides a compelling case for
government activism. A subsidy by the European government sharply raises the profits of a
European firm at the expense of its foreign rivals. Leaving aside the interest of consumers,
this seems clearly to raise European welfare (and reduce U.S. welfare). Shouldn’t the U.S.
government put this argument into practice?
In fact, this strategic justification for trade policy, while it has attracted much interest,
has also received much criticism. Critics argue that making practical use of the theory
would require more information than is likely to be available, that such policies would risk
foreign retaliation, and that in any case, the domestic politics of trade and industrial policy
would prevent the use of such subtle analytical tools.
The problem of insufficient information has two aspects. The first is that even when looking
at an industry in isolation, it may be difficult to fill in the entries in a table like Table 12-1
with any confidence. And if the government gets it wrong, a subsidy policy may turn out to be
a costly misjudgment. Suppose, for example, that Boeing has some underlying advantage—
maybe a better technology—so that even if Airbus enters, Boeing will still find it profitable to
produce. Airbus, however, cannot produce profitably if Boeing enters.
In the absence of a subsidy, the outcome will be that Boeing produces and Airbus does
not. Now suppose that, as in the previous case, the European government provides a subsidy
TABLE 12-2 Effects of a Subsidy to Airbus
Produce
–5 100
0 0
Boeing Produce
Don’t produce
Don’t produce
20 0
125 0
Airbus
CHAPTER 12 Controversies in Trade Policy 277
sufficient to induce Airbus to produce. In this case, however, because of Boeing’s underlying
advantage, the subsidy won’t act as a deterrent to Boeing, and the profits of Airbus will fall
short of the subsidy’s value—in short, the policy will turn out to have been a costly mistake.
The point is that even though the two cases might look very similar, in one case a subsidy
looks like a good idea, while in the other case it looks like a terrible idea. It seems that
the desirability of strategic trade policies depends on an exact reading of the situation.
This leads some economists to ask whether we are ever likely to have enough information
to use the theory effectively.
The information requirement is complicated by the fact that we cannot consider industries
in isolation. If one industry is subsidized, it will draw resources from other industries
and lead to increases in their costs. Thus, even a policy that succeeds in giving U.S. firms a
strategic advantage in one industry will tend to cause strategic disadvantage elsewhere. To
ask whether the policy is justified, the U.S. government would need to weigh these offsetting
effects. Even if the government has a precise understanding of one industry, this is not
enough, because it also needs an equally precise understanding of those industries with
which that industry competes for resources.
If a proposed strategic trade policy can overcome these criticisms, it still faces the problem
of foreign retaliation, essentially the same problem faced when considering the use of a
tariff to improve the terms of trade (Chapter 10). Strategic policies are beggar-thy-neighbor
policies that increase our welfare at other countries’ expense. These policies therefore risk a
trade war that leaves everyone worse off. Few economists would advocate that the United
States be the initiator of such policies. Instead, the furthest that most economists are willing
to go is to argue that the United States should be prepared to retaliate when other countries
appear to be using strategic policies aggressively.
Finally, can theories like this ever be used in a political context? We discussed this issue
in Chapter 10, where the reasons for skepticism were placed in the context of a political
skeptic’s case for free trade.
A Warning from Intel’s Founder
When Andy Grove speaks about technology, people
listen. In 1968 he co-founded Intel, which invented
the microprocessor—the chip that drives your computer—
and dominated the semiconductor business
for decades.
So many people took notice in 2010 when Grove
issued a stark warning about the fate of U.S. high
technology: The erosion of manufacturing employment
in technology industries, he argued, undermines
the conditions for future innovation.* Grove wrote:
Startups are a wonderful thing, but they cannot
by themselves increase tech employment. Equally
important is what comes after that mythical moment
of creation in the garage, as technology goes
from prototype to mass production. This is the
phase where companies scale up. They work out
design details, figure out how to make things
affordably, build factories, and hire people by the
thousands. Scaling is hard work but necessary to
make innovation matter.
The scaling process is no longer happening in
the U.S. And as long as that’s the case, plowing
capital into young companies that build their
factories elsewhere will continue to yield a bad
return in terms of American jobs.
In effect, Grove was arguing that technological
spillovers require more than researchers; they require
the presence of large numbers of workers putting new
ideas to work. If he’s right, his assertion constitutes a
strong argument for industrial targeting.
*Andy Grove, “How to Make an American Job Before It’s Too Late,” Bloomberg.com, July 1, 2010.
278 PART TWO International Trade Policy
Case Study
When the Chips Were Up
During the years when arguments about the effectiveness of strategic trade policy were at
their height, advocates of a more interventionist trade policy on the part of the United
States often claimed that Japan had prospered by deliberately promoting key industries.
By the early 1990s, one example in particular—that of semiconductor chips—had
become exhibit A in the case that promoting key industries “works.” Indeed, when author
James Fallows published a series of articles in 1994 attacking free trade ideology and
alleging the superiority of Japanese-style interventionism, he began with a piece titled
“The Parable of the Chips.” By the end of the 1990s, however, the example of semiconductors
had come to seem an object lesson in the pitfalls of activist trade policy.
A semiconductor chip is a small piece of silicon on which complex circuits have
been etched. As we saw on page 277, the industry began in the United States when the
U.S. firm Intel introduced the first microprocessor, the brains of a computer on a chip.
Since then the industry has experienced rapid yet peculiarly predictable technological
change: Roughly every 18 months, the number of circuits that can be etched on a chip
doubles, a rule known as Moore’s Law. This progress underlies much of the information
technology revolution of the last three decades.
Japan broke into the semiconductor market in the late 1970s. The industry was definitely
targeted by the Japanese government, which supported a research effort that helped
build domestic technological capacity. The sums involved in this subsidy, however, were
fairly small. The main component of Japan’s activist trade policy, according to U.S. critics,
was tacit protectionism. Although Japan had few formal tariffs or other barriers to imports,
U.S. firms found that once Japan was able to manufacture a given type of semiconductor
chip, few U.S. products were sold in that country. Critics alleged that there was a tacit
understanding by Japanese firms in such industries as consumer electronics, in which
Japan was already a leading producer, that they should buy domestic semiconductors, even
if the price was higher or the quality lower than that for competing U.S. products. Was this
assertion true? The facts of the case are in dispute to this day.
Observers also alleged that the protected Japanese market—if that was indeed what
it was—indirectly promoted Japan’s ability to export semiconductors. The argument
went like this: Semiconductor production is characterized by a steep learning curve
(recall the discussion of dynamic scale economies in Chapter 7). Guaranteed a large
domestic market, Japanese semiconductor producers were certain that they would be
able to work their way down the learning curve, which meant that they were willing to
invest in new plants that could also produce for export.
It remains unclear to what extent these policies led to Japan’s success in taking a
large share of the semiconductor market. Some features of the Japanese industrial
system may have given the country a “natural” comparative advantage in semiconductor
production, where quality control is a crucial concern. During the 1970s and
1980s, Japanese factories developed a new approach to manufacturing based on,
among other things, setting acceptable levels of defects much lower than those that
had been standard in the United States.
In any case, by the mid-1980s Japan had surpassed the United States in sales of
one type of semiconductor, which was widely regarded as crucial to industry success:
random access memories, or RAMs. The argument that RAM production was the key
to dominating the whole semiconductor industry rested on the belief that it would
yield both strong technological externalities and excess returns. RAMs were the
CHAPTER 12 Controversies in Trade Policy 279
largest-volume form of semiconductors; industry experts asserted that the know-how
acquired in RAM production was essential to a nation’s ability to keep up with
advancing technology in other semiconductors, such as microprocessors. So it was
widely predicted that Japan’s dominance in RAMs would soon translate into dominance
in the production of semiconductors generally—and that this supremacy, in
turn, would give Japan an advantage in the production of many other goods that used
semiconductors.
It was also widely believed that although the manufacture of RAMs had not been a
highly profitable business before 1990, it would eventually become an industry characterized
by excess returns. The reason was that the number of firms producing RAMs
had steadily fallen: In each successive generation of chips, some producers had exited
the sector, with no new entrants. Eventually, many observers thought, there would be
only two or three highly profitable RAM producers left.
During the decade of the 1990s, however, both justifications for targeting RAMs—
technological externalities and excess returns—apparently failed to materialize. On one
side, Japan’s lead in RAMs ultimately did not translate into an advantage in other types of
semiconductors: For example, American firms retained a secure lead in microprocessors.
On the other side, instead of continuing to shrink, the number of RAM producers began
to rise again, with the main new entrants from South Korea and other newly
industrializing economies. By the end of the 1990s, RAM production was regarded as a
“commodity” business: Many people could make RAMs, and there was nothing especially
strategic about the sector.
The important lesson seems to be how hard it is to select industries to promote. The
semiconductor industry appeared, on its face, to have all the attributes of a sector suitable
for activist trade policy. But in the end, it yielded neither strong externalities nor
excess returns.
Nothing in the analytical framework developed in Chapters 9 and 10 rules out the desirability
of government intervention in trade. That framework does show that activist government
policy needs a specific kind of justification; namely, it must offset some preexisting domestic
market failure. The problem with many arguments for activist trade policy is precisely that
they do not link the case for government intervention to any particular failure of the assumptions
on which the case for laissez-faire rests.
The difficulty with market failure arguments for intervention is being able to recognize
a market failure when you see one. Economists studying industrial countries have identified
two kinds of market failure that seem to be present and relevant to the trade policies of
advanced countries. One of these is the inability of firms in high-technology industries to
capture the benefits of that part of their contribution to knowledge that spills over to other
firms. The other is the presence of monopoly profits in highly concentrated oligopolistic
industries.
Technology and Externalities
The discussion of the infant industry argument in Chapter 11 noted that there is a potential
market failure arising from difficulties of appropriating knowledge. If firms in an industry
generate knowledge that other firms can use without paying for it, the industry is in effect
producing some extra output—the marginal social benefit of the knowledge—that is not
reflected in the incentives of firms. Where such externalities (benefits that accrue to parties
other than the firms that produce them) can be shown to be important, there is a good
case for subsidizing the industry.
At an abstract level, this argument is the same for the infant industries of lessdeveloped
countries as it is for the established industries of the advanced countries. In
advanced countries, however, the argument has a special edge because in those countries,
there are important high-technology industries in which the generation of
knowledge is in many ways the central aspect of the enterprise. In high-technology
industries, firms devote a great deal of their resources to improving technology, either
by explicitly spending on research and development or by being willing to take initial
losses on new products and processes to gain experience. Because such activities take
place in nearly all industries, there is no sharp line between high-tech and the rest of
the economy. There are clear differences in degree, however, and it makes sense to
talk of a high-technology sector in which investment in knowledge is the key part of
the business.
The point for activist trade policy is that while firms can appropriate some of the
benefits of their own investment in knowledge (otherwise they would not be investing!),
they usually cannot appropriate them fully. Some of the benefits accrue to other firms
that can imitate the ideas and techniques of the leaders. In electronics, for example, it is
not uncommon for firms to “reverse engineer” their rivals’ designs, taking their products
apart to figure out how they work and how they were made. Because patent laws
provide only weak protection for innovators, one can reasonably presume that under
laissez-faire, high-technology firms do not receive as strong an incentive to innovate as
they should.
CHAPTER 12 Controversies in Trade Policy 273
The Case for Government Support of High-Technology Industries Should the U.S.
government subsidize high-technology industries? While there is a pretty good case for
such a subsidy, we need to exercise some caution. Two questions in particular arise: First,
can the government target the right industries or activities? Second, how important,
quantitatively, would the gains be from such targeting?
Although high-technology industries probably produce extra social benefits because of
the knowledge they generate, much of what goes on even in those industries has nothing to
do with generating knowledge. There is no reason to subsidize the employment of capital
or nontechnical workers in high-technology industries; on the other hand, innovation and
technological spillovers happen to some extent even in industries that are not at all hightech.
A general principle is that trade and industrial policy should be targeted specifically
on the activity in which the market failure occurs. Thus policy should seek to subsidize the
generation of knowledge that firms cannot appropriate. The problem, however, is that it is
not always easy to identify that knowledge generation; as we’ll see shortly, industry practitioners
often argue that focusing only on activities specifically labeled “research” is taking
far too narrow a view of the problem.
The Rise, Fall, and Rise of High-Tech Worries Arguments that the United States in
particular should have a deliberate policy of promoting high-technology industries and
helping them compete against foreign rivals have a curious history. Such arguments gained
widespread attention and popularity in the 1980s and early 1990s, then fell from favor,
only to experience a strong revival in recent years.
The high-technology discussions of the 1980s and early 1990s were driven in large part
by the rise of Japanese firms in some prominent high-tech sectors that had previously been
dominated by U.S. producers. Most notably, between 1978 and 1986 the U.S. share of world
production of dynamic random access memory chips—a key component of many electronic
devices—plunged from about 70 percent to 20 percent, while Japan’s share rose from under
30 percent to 75 percent. There was widespread concern that other high-technology products
might suffer the same fate. But as described in the box on page 278, the fear that Japan’s
dominance of the semiconductor memory market would translate into a broader dominance
of computers and related technologies proved to be unfounded. Furthermore, Japan’s overall
growth sputtered in the 1990s, while the United States surged into a renewed period of
technological dominance, taking the lead in Internet applications and other information
industries.
More recently, however, concerns about the status of U.S. high-technology industries
have reemerged. A central factor in these concerns has been the decline in U.S. employment
in the so-called ICT—information, communication, technology—industries, which
are at the heart of the information technology revolution. As Figure 12-1 shows, the
United States has moved into a large trade deficit in ICT goods, while as Figure 12-2
shows, U.S. employment in the production of computers and related goods has plunged
since 2000, falling substantially faster than overall manufacturing employment.
Does this matter? The United States could, arguably, continue to be at the cutting edge
of innovation in information technology while outsourcing much of the actual production
of high-technology goods to factories overseas. However, as explained in the box on page
277, some influential voices warn that innovation can’t thrive unless the innovators are
close, physically and in business terms, to the people who turn those innovations into
physical goods.
It’s a difficult debate to settle, in large part because it’s not at all clear how to put
numbers to these concerns. It seems likely, however, that the debate over whether or not
high-technology industries need special consideration will grow increasingly intense in
the years ahead.
274 PART TWO International Trade Policy
0
–80.00
–60.00
–40.00
–20.00
–100.00
–120.00
–140.00
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
U.S. Trade balance
in ICT goods
($ billion)
Figure 12-1
The U.S. Trade Balance in Information Goods
Since 2000, the United States has developed a large trade deficit in ICT—information, communications,
technology—goods, which are widely seen as the cutting edge of innovation.
Source: National Science Foundation, Science and Engineering Indicators 2010.
Imperfect Competition and Strategic Trade Policy
During the 1980s a new argument for industrial targeting received substantial theoretical
attention. Originally proposed by economists Barbara Spencer and James Brander of the
University of British Columbia, this argument identifies the market failure that justifies
government intervention as the lack of perfect competition. In some industries, they point
out, there are only a few firms in effective competition. Because of the small number of
firms, the assumptions of perfect competition do not apply. In particular, there will typically
be excess returns; that is, firms will make profits above what equally risky investments
elsewhere in the economy can earn. There will thus be an international competition
over who gets these profits.
Spencer and Brander noticed that, in this case, it is possible in principle for a government
to alter the rules of the game to shift these excess returns from foreign to domestic
firms. In the simplest case, a subsidy to domestic firms, by deterring investment and production
by foreign competitors, can raise the profits of domestic firms by more than the
amount of the subsidy. Setting aside the effects on consumers—for example, when the
firms are selling only in foreign markets—this capture of profits from foreign competitors
would mean the subsidy raises national income at other countries’ expense.
The Brander-Spencer Analysis: An Example The Brander-Spencer analysis can be
illustrated with a simple example in which there are only two firms competing, each from
a different country. Bearing in mind that any resemblance to actual events may be
coincidental, let’s call the firms Boeing and Airbus, and the countries the United States
CHAPTER 12 Controversies in Trade Policy 275
Index of employment, 2000=100
70
60
65
75
80
85
95
105
2000 2001 2002 2003 2004 2005 2006
All manufacturing
Computers and related
2007 2005 2009
90
100
Figure 12-2
U.S. Manufacturing Employment
Since 2000, the number of workers producing computers and related goods in the United States
has fallen sharply, outpacing the general decline in manufacturing employment.
Source: Bureau of Labor Statistics.
and Europe. Suppose there is a new product, a superjumbo aircraft, that both firms are
capable of making. For simplicity, assume that each firm can make only a yes/no decision:
either to produce superjumbo aircraft or not.
Table 12-1 illustrates how the profits earned by the two firms might depend on their
decisions. (The setup is similar to the one we used to examine the interaction of different
countries’ trade policies in Chapter 10.) Each row corresponds to a particular decision by
Boeing, each column to a decision by Airbus. In each box are two entries: The entry on the
lower left represents the profits of Boeing, while that on the upper right represents the
profits of Airbus.
As set up, the table reflects the following assumption: Either firm alone could earn
profits making superjumbo aircraft, but if both firms try to produce them, both will incur
losses. Which firm will actually get the profits? This depends on who gets there first.
TABLE 12-1 Two-Firm Competition
Produce
–5 100
0 0
Boeing Produce
Don’t produce
Don’t produce
–5 0
100 0
Airbus
276 PART TWO International Trade Policy
Suppose Boeing is able to get a small head start and commits itself to produce superjumbo
aircraft before Airbus can get going. Airbus will find that it has no incentive to enter. The
outcome will be in the upper right of the table, with Boeing earning profits.
Now comes the Brander-Spencer point: The European government can reverse this situation.
Suppose the European government commits itself to pay its firm a subsidy of 25 if it
enters. The result will be to change the table of payoffs to that represented in Table 12-2. In this
case, it will be profitable for Airbus to produce superjumbo aircraft whatever Boeing does.
Let’s work through the implications of this shift. Boeing now knows that whatever it
does, it will have to compete with Airbus and will therefore lose money if it chooses to
produce. So now it is Boeing that will be deterred from entering. In effect, the government
subsidy has removed the advantage of a head start that we assumed was Boeing’s and has
conferred it on Airbus instead.
The end result is that the equilibrium shifts from the upper right of Table 12-1 to the lower
left of Table 12-2. Airbus ends up with profits of 125 instead of 0, profits that arise because
of a government subsidy of only 25. That is, the subsidy raises profits by more than the
amount of the subsidy itself, because of its deterrent effect on foreign competition. The subsidy
has this effect because it creates an advantage for Airbus comparable with the strategic
advantage Airbus would have had if it, not Boeing, had had a head start in the industry.
Problems with the Brander-Spencer Analysis This hypothetical example might seem
to indicate that this strategic trade policy argument provides a compelling case for
government activism. A subsidy by the European government sharply raises the profits of a
European firm at the expense of its foreign rivals. Leaving aside the interest of consumers,
this seems clearly to raise European welfare (and reduce U.S. welfare). Shouldn’t the U.S.
government put this argument into practice?
In fact, this strategic justification for trade policy, while it has attracted much interest,
has also received much criticism. Critics argue that making practical use of the theory
would require more information than is likely to be available, that such policies would risk
foreign retaliation, and that in any case, the domestic politics of trade and industrial policy
would prevent the use of such subtle analytical tools.
The problem of insufficient information has two aspects. The first is that even when looking
at an industry in isolation, it may be difficult to fill in the entries in a table like Table 12-1
with any confidence. And if the government gets it wrong, a subsidy policy may turn out to be
a costly misjudgment. Suppose, for example, that Boeing has some underlying advantage—
maybe a better technology—so that even if Airbus enters, Boeing will still find it profitable to
produce. Airbus, however, cannot produce profitably if Boeing enters.
In the absence of a subsidy, the outcome will be that Boeing produces and Airbus does
not. Now suppose that, as in the previous case, the European government provides a subsidy
TABLE 12-2 Effects of a Subsidy to Airbus
Produce
–5 100
0 0
Boeing Produce
Don’t produce
Don’t produce
20 0
125 0
Airbus
CHAPTER 12 Controversies in Trade Policy 277
sufficient to induce Airbus to produce. In this case, however, because of Boeing’s underlying
advantage, the subsidy won’t act as a deterrent to Boeing, and the profits of Airbus will fall
short of the subsidy’s value—in short, the policy will turn out to have been a costly mistake.
The point is that even though the two cases might look very similar, in one case a subsidy
looks like a good idea, while in the other case it looks like a terrible idea. It seems that
the desirability of strategic trade policies depends on an exact reading of the situation.
This leads some economists to ask whether we are ever likely to have enough information
to use the theory effectively.
The information requirement is complicated by the fact that we cannot consider industries
in isolation. If one industry is subsidized, it will draw resources from other industries
and lead to increases in their costs. Thus, even a policy that succeeds in giving U.S. firms a
strategic advantage in one industry will tend to cause strategic disadvantage elsewhere. To
ask whether the policy is justified, the U.S. government would need to weigh these offsetting
effects. Even if the government has a precise understanding of one industry, this is not
enough, because it also needs an equally precise understanding of those industries with
which that industry competes for resources.
If a proposed strategic trade policy can overcome these criticisms, it still faces the problem
of foreign retaliation, essentially the same problem faced when considering the use of a
tariff to improve the terms of trade (Chapter 10). Strategic policies are beggar-thy-neighbor
policies that increase our welfare at other countries’ expense. These policies therefore risk a
trade war that leaves everyone worse off. Few economists would advocate that the United
States be the initiator of such policies. Instead, the furthest that most economists are willing
to go is to argue that the United States should be prepared to retaliate when other countries
appear to be using strategic policies aggressively.
Finally, can theories like this ever be used in a political context? We discussed this issue
in Chapter 10, where the reasons for skepticism were placed in the context of a political
skeptic’s case for free trade.
A Warning from Intel’s Founder
When Andy Grove speaks about technology, people
listen. In 1968 he co-founded Intel, which invented
the microprocessor—the chip that drives your computer—
and dominated the semiconductor business
for decades.
So many people took notice in 2010 when Grove
issued a stark warning about the fate of U.S. high
technology: The erosion of manufacturing employment
in technology industries, he argued, undermines
the conditions for future innovation.* Grove wrote:
Startups are a wonderful thing, but they cannot
by themselves increase tech employment. Equally
important is what comes after that mythical moment
of creation in the garage, as technology goes
from prototype to mass production. This is the
phase where companies scale up. They work out
design details, figure out how to make things
affordably, build factories, and hire people by the
thousands. Scaling is hard work but necessary to
make innovation matter.
The scaling process is no longer happening in
the U.S. And as long as that’s the case, plowing
capital into young companies that build their
factories elsewhere will continue to yield a bad
return in terms of American jobs.
In effect, Grove was arguing that technological
spillovers require more than researchers; they require
the presence of large numbers of workers putting new
ideas to work. If he’s right, his assertion constitutes a
strong argument for industrial targeting.
*Andy Grove, “How to Make an American Job Before It’s Too Late,” Bloomberg.com, July 1, 2010.
278 PART TWO International Trade Policy
Case Study
When the Chips Were Up
During the years when arguments about the effectiveness of strategic trade policy were at
their height, advocates of a more interventionist trade policy on the part of the United
States often claimed that Japan had prospered by deliberately promoting key industries.
By the early 1990s, one example in particular—that of semiconductor chips—had
become exhibit A in the case that promoting key industries “works.” Indeed, when author
James Fallows published a series of articles in 1994 attacking free trade ideology and
alleging the superiority of Japanese-style interventionism, he began with a piece titled
“The Parable of the Chips.” By the end of the 1990s, however, the example of semiconductors
had come to seem an object lesson in the pitfalls of activist trade policy.
A semiconductor chip is a small piece of silicon on which complex circuits have
been etched. As we saw on page 277, the industry began in the United States when the
U.S. firm Intel introduced the first microprocessor, the brains of a computer on a chip.
Since then the industry has experienced rapid yet peculiarly predictable technological
change: Roughly every 18 months, the number of circuits that can be etched on a chip
doubles, a rule known as Moore’s Law. This progress underlies much of the information
technology revolution of the last three decades.
Japan broke into the semiconductor market in the late 1970s. The industry was definitely
targeted by the Japanese government, which supported a research effort that helped
build domestic technological capacity. The sums involved in this subsidy, however, were
fairly small. The main component of Japan’s activist trade policy, according to U.S. critics,
was tacit protectionism. Although Japan had few formal tariffs or other barriers to imports,
U.S. firms found that once Japan was able to manufacture a given type of semiconductor
chip, few U.S. products were sold in that country. Critics alleged that there was a tacit
understanding by Japanese firms in such industries as consumer electronics, in which
Japan was already a leading producer, that they should buy domestic semiconductors, even
if the price was higher or the quality lower than that for competing U.S. products. Was this
assertion true? The facts of the case are in dispute to this day.
Observers also alleged that the protected Japanese market—if that was indeed what
it was—indirectly promoted Japan’s ability to export semiconductors. The argument
went like this: Semiconductor production is characterized by a steep learning curve
(recall the discussion of dynamic scale economies in Chapter 7). Guaranteed a large
domestic market, Japanese semiconductor producers were certain that they would be
able to work their way down the learning curve, which meant that they were willing to
invest in new plants that could also produce for export.
It remains unclear to what extent these policies led to Japan’s success in taking a
large share of the semiconductor market. Some features of the Japanese industrial
system may have given the country a “natural” comparative advantage in semiconductor
production, where quality control is a crucial concern. During the 1970s and
1980s, Japanese factories developed a new approach to manufacturing based on,
among other things, setting acceptable levels of defects much lower than those that
had been standard in the United States.
In any case, by the mid-1980s Japan had surpassed the United States in sales of
one type of semiconductor, which was widely regarded as crucial to industry success:
random access memories, or RAMs. The argument that RAM production was the key
to dominating the whole semiconductor industry rested on the belief that it would
yield both strong technological externalities and excess returns. RAMs were the
CHAPTER 12 Controversies in Trade Policy 279
largest-volume form of semiconductors; industry experts asserted that the know-how
acquired in RAM production was essential to a nation’s ability to keep up with
advancing technology in other semiconductors, such as microprocessors. So it was
widely predicted that Japan’s dominance in RAMs would soon translate into dominance
in the production of semiconductors generally—and that this supremacy, in
turn, would give Japan an advantage in the production of many other goods that used
semiconductors.
It was also widely believed that although the manufacture of RAMs had not been a
highly profitable business before 1990, it would eventually become an industry characterized
by excess returns. The reason was that the number of firms producing RAMs
had steadily fallen: In each successive generation of chips, some producers had exited
the sector, with no new entrants. Eventually, many observers thought, there would be
only two or three highly profitable RAM producers left.
During the decade of the 1990s, however, both justifications for targeting RAMs—
technological externalities and excess returns—apparently failed to materialize. On one
side, Japan’s lead in RAMs ultimately did not translate into an advantage in other types of
semiconductors: For example, American firms retained a secure lead in microprocessors.
On the other side, instead of continuing to shrink, the number of RAM producers began
to rise again, with the main new entrants from South Korea and other newly
industrializing economies. By the end of the 1990s, RAM production was regarded as a
“commodity” business: Many people could make RAMs, and there was nothing especially
strategic about the sector.
The important lesson seems to be how hard it is to select industries to promote. The
semiconductor industry appeared, on its face, to have all the attributes of a sector suitable
for activist trade policy. But in the end, it yielded neither strong externalities nor
excess returns.
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