IGM Forum. (2012, March 13). Free Trade: IGM Economics Experts Forum. Retrieved March 10, 2018, from Chicago Booth IGM Forum, http://www.igmchicago.org/surveys/free-trade.
Economists nearly unanimously support open and free trade among nations.1 The arguments for free trade are not new, dating back at least to Adam Smith's famous book An Inquiry into the Nature and Causes of the Wealth of Nations in 1776 and David Hume's series of essays, On Commerce and On the Balance of Trade in 1752. Free trade increases wealth in a nation by promoting the division of labor, thereby increasing the quantity of goods and services in the economy. This increased division of labor benefits people in two main ways. First, it expands the range of goods and services available to people. For example, many spices that are not native to the United States would be unavailable without international trade. Second, it allows people in a nation to buy goods of a given quality that are made more cheaply—that is, produced with fewer or cheaper resources. In short, free trade allows people to minimize their own use of scarce resources to achieve their desired ends.
But even Adam Smith recognized a possible exception to free trade: using tariffs to support domestic industries that are vital to national defense. In the 21st century, are such tariffs for defense-relevant goods justified? My answer is: not likely. First, though, let's consider what's wrong with tariffs.
The Problem with Tariffs
Tariffs, by restricting trade, reduce the wealth of a nation's people. By artificially limiting foreign sources of resources, which are imported only because they are cheaper or better than what can be produced at home, tariffs encourage the wasteful use of resources and reduce the wealth of a nation.
For example: to buy a jacket made outside the United States, an average American worker need work for only 3 hours.2 That would mean he could use his income from working the other 37 hours of his 40-hour week for other goods and services. Now, imagine that a tariff is implemented that is high enough to make the imported jacket at least as expensive as a domestically produced jacket of the same quality. The worker now has to work 4 hours for the same-quality jacket from a domestic producer; his real income has been reduced. Maybe he forgoes an extra restaurant meal or a few cups of Starbucks' coffee. He might even forgo the new jacket altogether. In short, although he is by no means poor, the tariff makes him poorer.
The National Security Exception
There is one major exception to the case for free trade: national security can trump free trade concerns. Adam Smith carves out this exception in multiple places in The Wealth of Nations. For example, he writes:
If any particular manufacture was necessary, indeed, for the defence of the society, it might not always be prudent to depend upon our neighbours for the supply; and if such manufacture could not otherwise be supported at home, it might not be unreasonable that all the other branches of industry should be taxed in order to support it. The bounties upon the exportation of British-made sail-cloth and British-made gun-powder may, perhaps, both be vindicated upon this principle.3
The fear is, as Smith puts it, that certain items are necessary for national defense, and free trade may reduce the nation's capacity to produce those items, making them too scarce should a national emergency arise. Interestingly, this scarcity can arise due to the threat of price controls, something that economists from Adam Smith on have been quite firmly against. If the price system can work, when the government increases demand for national defense goods, the prices of such goods will rise. The higher prices, in turn, give manufacturers an incentive to produce more of the necessary goods and even to stockpile such goods if they anticipate a foreign policy crisis. However, governments tend to establish price controls in the face of political pressure and sentiments against "war profiteering." Firms are unlikely to invest as much in building wartime inventories or capacity as they would with tariffs since such potential for profits is reduced. Tariffs can encourage increased production capacity in the protected industry by limiting foreign competition and generating higher profits. These tariffs would potentially ensure a domestic industry able to meet ramped-up government demand even if price controls are implemented, as long as the price controls allow for some increase in price.4
For background on the long history of imposing tariffs on the sugar and steel industries, see Some Aspects of the Tariff Question, by Frank Taussig.
The national defense argument has been used to justify tariffs in many industries. Two examples are sugar5 and steel.6 The argument is simple: if we import some of our national defense goods from other nations and do not foster domestic production, then we become beholden to them. In the event of a war or embargo, we would have less ability to defend ourselves. Furthermore, the foreign nation could simply jack up the prices once they commanded a market monopoly, thus making us slightly poorer and somewhat reducing our ability to wage war. But how likely are these fears to be justified? Are they strong enough to justify tariffs in peacetime? The Trump Administration argues that they are, in particular for steel and aluminum.
U.S. Steel Production and National Defense
Steel and aluminum are important commodities for U.S. national defense. Ships, tanks, aircraft, and buildings all require steel or aluminum. But does that mean that the U.S. primary metals industries are incapable of handling production for national defense industry? It turns out that only about 3% of U.S. steel shipments go to servicing U.S. defense.7 This means that the current capacity is quite capable of handling national security demands and would still be able to even if the metal industries were to contract considerably.
"Most U.S. imports of steel come from solid allies."
The concern about relying on foreign sources of war materials is that they could be unreliable or disrupted. In a world of shifting alliances, geographical concerns, and logistical issues, as in the 18th century Britain of Adam Smith, this fear might be justified. However, in 21st century America, it is less plausible. Most U.S. imports of steel come from solid allies such as Canada (17% of imports, which is 5.9% of total domestic consumption), Brazil (14% of imports, or 4.7% of consumption), South Korea (10% of imports, or 3.4% of consumption) and Mexico (9% of imports, or 3.2% of consumption).8 Russia and China, potentially antagonistic countries, account for only 9% and 2% of U.S. imports respectively (3% and 0.7% of consumption, respectively). Moreover, these are primarily "long steel products," which are used in construction. Disruptions of steel imports from these nations would not adversely affect U.S. national defense needs. Furthermore, the United States' main steel trading partners are located primarily along land trade routes; even if the United States were blockaded, the government would still be able to get steel.
One last point on the national defense argument. If China, a national security threat and military threat for influence in the region according to President Trump's economic advisor Peter Navarro9 were dumping steel in the U.S. market to gain some military advantage, the logical thing for the U.S. government to do would be not to encourage U.S. exports but, rather, to encourage Chinese imports. Since steel is a scarce resource, sending it abroad (i.e., encouraging exports) necessarily reduces the stock of steel in the United States, whereas imports increase it. If China is dumping, then it means that the product is being sent to the United States rather than being used in Chinese markets; for every unit of steel sent to the United States, that is one less unit that could be used for a Chinese war machine and one more for a U.S. war machine. The logical action for the U.S. government would be to purchase a lot of low-cost steel from China and simply stockpile it, thus depriving China of war materials while maximizing U.S. steel stockpiles. In the event of war, the United States would have a large stockpile from which to draw, while China's would be reduced.
Predatory Pricing and Trade
Predatory pricing is a strategy by a well-financed entity to enter a market, sell below cost to drive out other competitors, and use the newfound market power to subsequently raise prices to monopolistic levels once competition is reduced.
If a foreign firm were to engage in predatory pricing with a defense-oriented good like steel, then the worry would be that a country's national defense could be put at risk.
The predatory pricing argument is neither new nor unique to international trade. The argument has been used in the United States since at least the 1800s as a reason for going after "robber barons." Currently, Chinese steel production accounts for approximately 50% of global steel output, whereas the United States', Japan's, and Europe's shares of production have fallen. This has caused consternation among governments and steel producers in the West. A major fear is that China will use a predatory pricing strategy to seize market share and use its newly found monopoly power to charge higher prices.10 If this strategy is used for items that are important for national security, it could put that security at risk.
There are several important problems with the logic of predatory pricing. For a monopoly to persist, there must be high barriers to entry: something that prevents firms from entering the marketplace. The mere fact the potential monopolist initially faces competition indicates that the barriers to entry are already low enough to allow for competition. Therefore, if the monopolist raises prices, new entrants would be attracted by the extra-normal profits, causing the monopolist to reduce his price.
But what if the monopolist can maintain its power with the mere threat of lower prices? Even this does not suggest permanently high prices or that the putative monopolist will be able to take advantage of consumers. Here, the Second Law of Demand becomes relevant:
[T]he longer the time allowed to adjust amount demand in response to a price change, the greater is the change in amount demanded, that is, the greater the elasticity.... For example, if the price of water were doubled, consumption would immediately decrease some—but would decrease by a great deal more within a few months, after people had more economically made adjustment to their water-using equipment[.]11
In other words, people initially make little adjustments to a rise in prices, but the longer prices stay high, the bigger their adjustments become. Take the water example in the above quote: if the price of water spikes quickly, people may water their lawn less or wash their car less. If the price of water stays high, people may rip out their lawns and go for rock gardens, may move to disposable plates rather than washable dishware, etc. As people adjust their usage, the extra-normal profits of the monopolist start to disappear.
There are also economic and legal problems with predatory pricing. A predatory pricing firm needs to have a large market share to have pricing power in the market (in other words, the firm is a price maker). This indicates that, when the predatory firm attempts to cut prices in the market below cost to drive out other firms, the firm takes considerable losses. To earn those losses back, the predatory firm will need to raise its prices not just above cost, but also above the prices it was charging before it engaged in predation. But, as mentioned above, new entrants would be attracted by the profits and enter the market. They may even enter the market at a lower cost level by buying the original firms' resources at fire sale prices, reducing the price in the market and preventing the predatory firm from ever making back its losses.
Legally, determining what constitutes predatory pricing versus healthy price competition is extremely difficult. Firms can sell below cost for any number of reasons (overstock, cancelled special orders, planning mistakes, etc). None of these constitutes predatory pricing, although they may appear to be a predatory pricing strategy. Furthermore, firms can engage in "loss-leader" strategies to encourage sales (for example, video game consoles are often sold at or below cost, while the games themselves are sold above cost). If legal action is taken against firms engaging in healthy price competition, then the resulting lawsuit can reduce economic well-being rather than enhance it.
To bring this back to China, if Chinese producers were to gain monopoly power and raise prices, even if they were to maintain their monopoly power with the mere threat of lower prices, it is unlikely that they would succeed in securing long-term monopoly prices. If the price of steel remains high, people will seek or develop alternatives, or other firms will enter the market. Perhaps someone will develop a super-lightweight but super-strong material that renders steel obsolete (like Kevlar for ships). Maybe steel consumers will shift to other options, such as iron or another alloy. While it's impossible to know what exactly what actions people will take, we do know that the Law of Demand says that people will adjust. Thus, it is highly improbable that anyone who gains monopoly power through predatory pricing will be able to maintain monopoly profits for a considerable period.
A counterpoint to the above argument is that predatory pricing would not work in the long run, but wars are fought in the short run. While wars are fought in the short run, this fact is not necessarily a strong enough basis for tariffs. As mentioned above, the United States' two main national rivals, China and Russia, account for very little steel used in the United States—steel that is used primarily for non-defense purposes. Furthermore, the United States during World War II provides evidence of how quickly a nation can retool in the event of a national emergency (In 1939, the United States produced approximately 3,000 aircraft per year. By the end of the war, production was around 300,000, or about 822 aircraft per day!12). To disrupt the U.S. war machine through economic means would be a monumental task.
National defense is often stated as a justified exception to a policy of free trade, and it may well be the most reasonable exception. Indeed, national defense is vital to economic prosperity. However, it is a plausible exception, not necessarily a probable one. Many of the tariff arguments presented under the "national defense" guise are flimsy. Given the negative impact of tariffs on wealth, when they are proposed, even under the national defense justification, they should be carefully examined to see if there is a true national defense issue or if domestic firms are merely justifying tariffs for protection from competition.
IGM Forum. (2012, March 13). Free Trade: IGM Economics Experts Forum. Retrieved March 10, 2018, from Chicago Booth IGM Forum, http://www.igmchicago.org/surveys/free-trade.
Assume that the worker's wage is $18/hr. and that a foreign-made jacket costs $54. He would need to work 3 hours ($54/$18 per hour = 3 hours) to make enough money to buy the jacket.
Smith, Adam (1981). An Inquiry into the Nature and Causes of the Wealth of Nations. Indianapolis: Liberty Fund, Inc. See Paragraph IV.5.36.
For an excellent discussion on this topic, see Benjamin Zycher, "Defense," in David R. Henderson, ed., The Concise Encyclopedia of Economics. Note, though, that Zycher used this reasoning as an argument in favor of relying on foreigners for defense-related goods, because a government cannot impose price controls on foreigners.
Tamny, John (2015, August 6). Marco Rubio's Big Sugar Embrace Flunks Basic Economics. Retrieved March 10, 2018, from Forbes: https://www.forbes.com/sites/johntamny/2015/08/06/marco-rubios-big-sugar-embrace-flunks-basic-economics.
Office of the President of the United States. (2018, March 8). Presidential Proclamation on Adjusting Imports of Steel into the United States. Retrieved March 10, 2018, from White House Official Website: https://www.whitehouse.gov/presidential-actions/presidential-proclamation-adjusting-imports-steel-united-states/.
American Iron and Steel Institute. (n.d.). Market Applications in Steel. Retrieved March 10, 2018, from SteelWorks: http://www.steel.org/about-aisi/statistics/market-applications-in-steel.aspx.
Author calculations derived from International Trade Administration. (2017, December). Steel Imports Report: United States. Retrieved March 10, 2018, from Global Steel Trade Monitor: https://www.trade.gov/steel/countries/pdfs/imports-us.pdf.
Navarro, Peter & Autry, Greg (2011). Death by China. Upper Saddle River, New Jersey: Prentice Hall.
Ibid., pp. 63-65.
Alchian, Armen A. & William R. Allen, (1983). Exchange and Production: Competition, Coordination, and Control. Belmont: Wadsworth Publishing Company.
Parker, Dana T. (2013). Building Victory: Aircraft Manufacturing in the Los Angeles Area in World War II. Cypress, CA.
*Jon Murphy is a Ph.D. economics student at George Mason University, specializing in Law & Economics and Smithian Political Economy. He previously was an economic consultant in New Hampshire.