Deadweight Loss from Tariffs are Probably Greater Than Models Predict

Yesterday, I quoted from Randy Holcombe and Russ Sobel’s paper Public Policy Toward Pecuniary Externalities. Elsewhere in the paper, they write:

In a comparative statics setting such as that developed by Bator (1958), monopolies are inefficient because they produce too little out put. In a dynamic setting, monopoly power can also result in inefficiencies because a single firm has an incentive to take account of the pecuniary externalities that innovation can have on the firm’s existing investments. Thus, the inefficiencies from monopoly are larger than the simple comparative statics model of monopoly suggests.

When government creates incentives for firms to take account of pecuniary externalities by either implicitly (via regulatory protection) or explicitly (via legal monopolies) giving them property rights in the value of their output, it gives them incentives to defend that value from said externalities. In the example quoted above, the monopolist can hold back innovation, prevent stores from opening, lobby against competition, etc.

With regard to protectionist tariffs, the situation is similar. Typically, the only deadweight loss from a tariff is the result of higher price paid and lower quantity achieved, as well as the encouragement of inefficient production techniques, by the domestic country. But those static models are incomplete for a few reasons: first, in the typical public choice framework, protectionist tariffs do not just arise out of nowhere and there are resources firms spend to lobby for protection. Secondly, and related to the point Holcombe and Sobel make above, the static model strips away the dynamic role of competition. Protectionist tariffs give domestic firms an implicit property right to the value of their output. Subsequently, this means firms could spend resources defending these values, either in the form of maintaining protectionist tariffs or in the form of preventing domestically produced pecuniary externalities.

“But wait, Jon you handsome devil,” one might object. “Did you not say that even the threat of competition can cause a firm to act in a perfectly-competitive manner? These domestic firms are still competing against one another and thus there would be no deadweight loss from protection of pecuniary externalities domestically!”

It is true that competition, either real or shadow, does cause a firm to innovate. But remember the goal of protectionist legislation is precisely to prevent such innovative competition from occurring at all. The domestic firms must be “protected” from foreign competition because it is impossible for domestic firms to meet their costs of production (for whatever reason). Thus, even then we will still get the deadweight loss because, even if domestic firms are competiting against each other, it is unlikely they will operate at the same price level that was achieved with free trade because 1) they are cut off from foreign (and potentially cheaper) sources of inputs and 2) they were unable (supposedly) to compete at that price level anyway without incurring pecuniary loss from their current position. If they were, they would not have called for the protectionist tariffs. Furthermore, if a new entrant enters the market with a cheaper production technique, given the implicit property rights awarded by the government, firms have an incentive to fight this domestic entrant. Likewise, they have interests in protecting their profits by not expanding their own production, as Sobel and Holcombe discuss. Thus, by removing (or, at least, reducing) this incentive to innovate, the deadweight loss of tariffs is likely worse than the static models predict.