Jophisticated Arguments for Activist Trade Policy

Nothing in the analytical framework developed in Chapters 8 and 9 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 problem with market failure arguments for intervention is how to know 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 10 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 also 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 less-developed 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 explicit spending on research and development or by being willing to take initial losses on new products and processes to gain experience. Such activities take place in nearly all industries, of course, so that 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, there is a reasonable presumption that under laissez-faire high-technology firms do not receive as strong an incentive to innovate as they should.

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, the ability of government policy to target the right thing; second, the quantitative importance of the argument.

Although high-technology industries probably produce extra social benefits because of the knowledge they generate, much of what goes on even in a high-technology industry 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 mostly not at all high-tech. 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. A general subsidy for a set of industries in which this kind of knowledge generation is believed to go on is a pretty blunt instrument for the purpose.

Perhaps, instead, government should subsidize research and development wherever it occurs. The problem here is one of definition. How do we know when a firm is engaged in creating knowledge? A loose definition could lend itself to abuse: Who is to say whether paper clips and company cars were really supporting the development of knowledge or were placed in the research department's budget to inflate the subsidy? A strict definition, on the other hand, would risk favoring large, bureaucratic forms of research where the allocation of funds can be strictly documented over the smaller, informal organizations that are widely believed to be the key to the most original thinking.

The United States does in effect subsidize research and development (R&D), at least as compared with other kinds of investment. Research and development can be claimed by firms as a current expense and thus counts as an immediate deduction against the corporate profit tax. By contrast, investment in plant and equipment cannot be claimed as an immediate expense and can be written off only through gradual depreciation. This effective favorable treatment for knowledge is an accident of tax history rather than an explicit policy, but we should note it before concluding that the United States spends too little on R&D or that the high-technology sector needs further encouragement. To reach such a conclusion we would need to know how much subsidy is justified.

How Important Are Externalities? The question of the appropriate level of subsidy for high technology depends on the answer to a difficult empirical problem; How important, quantitatively, is the technological spillover argument for targeting high-technology industries? Is the optimal subsidy 10, 20, or 100 percent? The honest answer is that no one has a good idea. It is in the nature of externalities, benefits that do not carry a market price, that they are hard to measure.

Further, even if the externalities generated by high-technology industries could be shown to be large, there may be only a limited incentive for any one country to support these industries. The reason is that many of the benefits of knowledge created in one country may in fact accrue to firms in other countries. Thus if, say, a Belgian firm develops a new technique for making steel, most of the firms that can imitate this technique will be in other European countries, the United States, and Japan rather than in Belgium. A world government might find it worthwhile to subsidize this innovation; the Belgian government might not. Such problems of appropriability at the level of the nation (as opposed to the firm) are less severe but still important even for a nation as large as the United States,

Despite the criticism, the technological spillover argument is probably the best case one can make intellectually for an active industrial policy. In contrast to many simplistic criteria for choosing "desirable" industries, which can be strongly rejected, the case for or against targeting "knowledge-intensive" industries is a judgment call.

Imperfect Competition and Strategic Trade Policy

During the 1980s a new argument for industrial targeting received substantial theoretical attention. Originally proposed by the economists Barbara Spencer and James Brander of the University of British Columbia, this argument locates the market failure that justifies govern* ment intervention in 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 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. 1

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 and Europe. Suppose there is a new product, 150-seat aircraft, that both firms are capable of making. For simplicity, assume each firm can make only a yes/no decision: either to produce 150-seat aircraft or not.

Table 11 -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 9.) 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 150-seat aircraft, but if both firms try to produce them, both will make losses. Which firm will actually get the profits'? This depends on who gets there first. Suppose Boeing is able to get a small head start and commits itself to produce 150-seat 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 11 -2. It is now profitable for Airbus to produce 150-seat aircraft whatever Boeing does.

Table I I-I


Don 7 produce

Two-Firm Competition

Table I I-I

Two-Firm Competition

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