Topic: Protection and comparative advantage (1 of 10), Conf: Governance-General From: Larry Willmore willmore@un.org Date: Wednesday, January 31, 2001 04:58 PM As Paul Krugman pointed out, Ricardo's theory of comparative advantage is a difficult idea. Another concept that people find equally difficult to comprehend is the idea that protection, via a tax on imports, is equivalent to a tax on exports. This is known as the Lerner Symmetry Theorem, after A.P. Lerner, who formalised the theorem in a 1936 Economica article. In the classroom, we typically rely on a geometric proof using a simple two-good model. Some years ago I was asked to give a series of talks on trade liberalisation to businessmen and government officials in Central America, and I found the customary blackboard demonstration to be much too abstract for an audience of practitioners. So, I introduced an exchange rate to illustrate the anti-export bias of import tariffs. A written version ended up in an article that I co-authored with an ELCAC colleague: _____________________________________________ If the State wants to eliminate anti-export bias for favoured goods (which may be termed "non-traditional")without granting explicit subsidies, it will have to effect a _compensated devaluation_ of its currency and impose export taxes on unfavoured products (which may be termed "traditional"). The implications of this option can be better understood with a hypothetical example. If the uniform, free exchange rate is 10 pesos per dollar and there exists a uniform tariff of 20% on imports, then there is an anti-export bias because a good that is worth 12 pesos in the local market is worth only 10 pesos when it is exported. If the currency is devalued to 12 pesos per dollar and the tariff is simultaneously lowered to zero, this compensated devaluation is not inflationary because the good that sold for 12 pesos in the local market will continue to sell for 12 pesos. But the same good will now be worth 12 pesos in export markets: the anti-export bias will have disappeared. If the State does not want exporters of traditional products (coffee, bananas, beef, etc.) to benefit from the devaluation, it need only collect a tax of 16.7% so that they continue to receive only 10 pesos for each dollar of exports. The export tax will also help to compensate for the loss of tax revenue that results from the elimination of the import tariff. L. Willmore and J. Mattar, "Industrial restructuring, trade liberalization and the role of the State in Central America," Cepal Review 44 (August 1991), p. 11. _____________________________________________ Fortunately, I did not give any lectures in Panama, for that country has no Central Bank! The didactic technique will soon fail as well in El Salvador, which recently began official dollarisation of its economy. Larry Willmore Topic: Protection and comparative advantage (2 of 10), Conf: Governance-General From: Henk-Jan Brinkman brinkman@un.org Date: Wednesday, January 31, 2001 06:31 PM Larry's argument about the Lerner symmetry only holds if the same good that is imported is exported as well. But who would do that? In general, the problem with the Lerner symmetry is its uni-dimensionality. The uni-dimensionality implies that it is impossible to have outward oriented policies combined with import protection. In other words, any bias in favour of import substitution means a bias against exports. This view, however, can be challenged. Liang (1992) showed that the bipolar interpretation is based on the traditional 2-goods model (exportables and importables) which yields one relative price and one dimension. When three sectors are introduced, by adding a non-tradable home good, two relative prices and two dimensions result. Hence, we have four combinations of (dis) incentives for export and/or import activities. This can of course be expanded to the real world with many more goods and services. There is also a logical error. The Lerner symmetry would lead to a conclusion that import protection and export promotion cancel each other out and would yield a neutral trade regime. Yet many countries in East Asia import substitution policies were often combined with export promotion strategies. Topic: Protection and comparative advantage (3 of 10), Conf: Governance-General From: Larry Willmore willmore@un.org Date: Thursday, February 01, 2001 11:51 AM In response to Henk-Jan's comment, I would like to point out that the Lerner Symmetry Theorem is based on two goods or sectors, not a single good. In other words, the good that is exported is not the same as the good that competes with imports. Max Corden, in his book _The Theory of Protection_ (Oxford University Press, 1971, pp. 119-122) generalised the Lerner Theorem to 'n' goods. Topic: Protection and comparative advantage (4 of 10), Conf: Governance-General From: Henk-Jan Brinkman brinkman@un.org Date: Thursday, February 08, 2001 06:20 PM I agree that the Lerner Symmetry is based on 2 goods. My point was that your example seems to suggest it is based on one good. Topic: Protection and comparative advantage (5 of 10), Conf: Governance-General From: Larry Willmore willmore@un.org Date: Thursday, February 08, 2001 06:36 PM The compensated devaluation approach worked well with Central American businessmen and government officials, who think of the real world rather than an abstract world with only one, two or three goods. I have never tested it on students, preferring to use the traditional two-sector blackboard diagram to explain the Lerner symmetry theorem. Topic: Protection and comparative advantage (6 of 10), Conf: Governance-General From: Larry Willmore willmore@un.org Date: Monday, February 12, 2001 11:45 AM I apologise for returning belatedly to this thread. Henk-Jan in his original post wrote: "Larry's argument about the Lerner symmetry only holds if the same good that is imported is exported as well. But who would do that?" I explained that I intended the 'compensated devaluation' approach to illustrate the real world of multiple goods, not the abstract theory of two sectors or, much less, a single good. I would now like to answer Henk-Jan's question "who would do that?" In the real world we observe that countries _do_, in fact, import and export the same good. Canada, for example, imports crude oil from Venezuela by sea to the Atlantic port of Halifax and simultaneously exports crude oil by land from Alberta to the western USA. Why does Canada do that? To save transportation costs. As another example, the USA exports a lot of apples, primarily from Washington state, and also imports apples, primarily from Chile, South Africa and New Zealand. Why does the USA do this? In part because the varieties of apples exported differ somewhat from the varieties of apples imported, but the main reason is to save storage costs and give consumers access to fresher fruit. (The growing seasons in the north and the south are different, giving rise to gains from trade in fresh produce, even if exports and imports are otherwise identical products). Monopolistic competition and oligopolistic rivalry can also result in simultaneous import and export of identical goods. I discuss this, and illustrate the theory with examples of intra-CACM trade in cement and rubber tires, in "The Industrial Economics of Intra-Industry Trade and Specialisation," in _On the Economics of Intra-Industry Trade_, ed. Herbert Giersch (J.C.B. Mohr, Tübingen, Germany, 1979), pp. 185-205. (The CACM is the Central American Common Market.) Topic: Protection and comparative advantage (7 of 10), Conf: Governance-General From: Henk-Jan Brinkman brinkman@un.org Date: Monday, February 12, 2001 06:08 PM My question ("who would do that?") referred to the same good, not identical goods. Your examples of intra-industry trade are well taken but that's not what I meant. Even your case of oil and apples is not what I meant. Actually, we have to go back to your example, trying to explain the Lerner symmetry. It seems to me that you refered to a case of re-exporting the SAME good. Admittedly, some economies make a good business out of this (e.g. Hong Kong (China) and the Netherlands) but that's not what you were referring to or were you? Topic: Protection and comparative advantage (8 of 10), Conf: Governance-General From: Larry Willmore willmore@un.org Date: Tuesday, February 13, 2001 02:10 PM Henk-Jan, Regarding the Lerner Theorem, I think that I have identified the source of our misunderstanding. In my compensated devaluation approach, I assume that a country produces two types of goods: importables and exportables. Importables can be imported, of course, but they can also be exported. The anti-export (home) bias refers not to the bias against re- exported an imported good, but rather the bias against exporting an importable good, i.e. a good that is importable, but produced locally behind protective tariff walls. For simplicity, I abstracted from transportation costs. It is possible to export importables, even without removing import tariffs or quotas. But subsidies are required to offset the difference between the international price of a good and the protected, hence higher, home price. Or governments can provide subsidies indirectly. Mexico, for example, a few years ago stimulated exports of automobiles this way. Automobiles are clearly importables in Mexico, since protection is high, as are local costs of production. Imports in fact were prohibited (can't grant more protection than that), but the government decided to allow manufacturers to import one automobile for every three automobiles they exported (or something like that--I don't remember the exact details). The sale of the imported automobile at a huge profit in the local market more than compensated for the loss incurred in export sales. And governments everywhere routinely award exporters with cheap credit, or with access to duty-free imports of intermediate goods, all of which is a form of subsidisation of exports of 'importables'. Does this mean the Lerner Theorem is wrong? No, it just means that the implicit tax on exports produced by import tariffs and quotas can be offset by subsidies. I'll try to explain this again, with an example, as I believe it is important. Suppose that the exchange rate is 10 pesos per US dollar and that there is a uniform tariff of 20% on imports. This means that the domestic price of _any_ importable good would be 20% higher than the international price. In the case of an _imported_ good, the excess price goes to the government as tariff revenue. In the case of a locally produced good, the excess price goes to the producer. (Remember, we are abstracting from transportation costs). But the domestic price of any exportable good would be equal to its international price. It is _as if_ there were no import tariff, but the central bank set the price of a US dollar at 12 pesos for importables and at 10 pesos for exportables. If an importable worth, say 120 pesos in the domestic market were exported, it would be worth only 100 pesos in the international market. This is the home (or anti-export) bias. Now, suppose we remove the tariff and devalue the currency to 12 pesos per US dollar. In our example, the importable continues to sell for 120 pesos in the domestic market. But now it is also worth 120 pesos in international markets (because of the new exchange rate). More importantly, the price of exportables goes up in local currency, so exports that were formerly worth, say, 100 pesos are now worth 120 pesos. If the government wants to restore the previous implicit tax on exports it need only collect an explicit tax of 16.7% on all exports, so that the producer receives, not 120 pesos, but rather 83.3% of 120 pesos, or 100 pesos. What happens in practice with trade liberalisation is that goods which were previously 'importables' become transformed into 'exportables' because of the real devaluation of the exchange rate. In Chile, because of extremely high import tariffs, until the late 1970s copper was virtually the only export. Students of the Chilean economy often attributed this export failure to 'structural' rigidities in the economy. But when the economy was opened, the country began to export the most diverse products: wine, fresh fruit, cheese, kitchen stoves, even children's clothing. I trust this illustrates how taxes on imports act as a tax on exports. In the classroom, we do this more elegantly with relative prices, but I found 'compensated devaluation' to be a very useful didactic device for my audiences in Central America. I hope also that by now it is clear that Lerner symmetry is _not_ uni-dimensional, and that it is perfectly possible "to have outward oriented policies combined with import protection." Import tariffs or quotas alone of course do not produce such a result. What is needed is protection in the form of a production subsidy that, in the absence of import tariffs, leaves the producer indifferent between home and export markets. Or, export subsidies can be used to offset the anti-export bias of import protection. Or, exports can be _demanded_ of producers as a condition for continued import protection. There are many possibilities. The essential point is that it is necessary to offset the home bias to promote exports. I am not familiar with the work of Liang (1992) and have no idea where he or she is published. Yet I have no doubt that, by adding a third sector (nontradables) to importables and exportables, a clever theorist can discover policies that tax nontradables, and subsidize both importables and exportables, or policies that subsidize nontradables and tax both importables and exportables. The question is, is such a model relevant for the real world? I think not, but am open to evidence that might prove me wrong. Topic: Protection and comparative advantage (9 of 10) Conf: Governance-General From: Henk-Jan Brinkman brinkman@un.org Date: Friday, February 16, 2001 09:57 AM Larry's argument depends crucially on the assumption that a uniform tariff of 20% raises the price of ALL importables by 20%. Let's assume the tariff is on a final demand good. Whether the price of domestic goods are raised in response to a tariff depends on the market structure. If the goods are substitutes and direct competititors and the domestic firm has excess capacity, the firm will keep the price the same and enjoy a surge in demand and expand production. If the price of the imported good is set by a market leader, the domestic firm will follow the price increase. Moreover, pricing to market behaviour might lead to a cut in the price of the imported good in response to the tariff to keep the domestic price constant. In the case of a tariff on intermediate inputs it is much more likely that prices are increased by domestic firms because it is a costs increase. Firms are much more inclined to increase prices if costs increase (because they might go bankrupt otherwise), compared to the case when a competitor increases a price (or when demand increases). In any case, I found very little evidence that tarifss increase the domestic price level (see my book, Explaining prices in the global economy, Edward Elgar, 1999; Ch. 7 also discusses the above arguments). In sum, I go back to my original point. It is only absolute clear that exportables are taxed if the same good is first imported and charged with a tariff and then exported again. PS Liang (1992) was in J of Development Studies, 28(3). Topic: Protection and comparative advantage (10 of 10) Conf: Governance-General From: Larry Willmore willmore@un.org Date: Friday, February 16, 2001 01:12 PM Not just my argument, but the Lerner Symmetry Theorem itself depends crucially on the assumption that prices of domestically produced importables rise when imports are restricted with tariffs or quotas. If, as Henk-Jan alleges, exportables are taxed _only_ when "the same good is first imported and charged with a tariff and then exported again" or, more generally, when they embody imported inputs that are taxed, then the Lerner Symmetry Theorem is invalid and tariff protection has no indirect effect on exports. It is, of course, possible for exporters to absorb the import tax, keeping prices constant in the domestic market. And it is possible for domestic producers to choose to forgo an opportunity to sell their output at a higher price. In either case, the Lerner Symmetry Theorem would not hold. This is the difficulty with economic theory: almost anything is possible, depending on the assumptions that are made. That is why it is important to look at the real world. Are prices of automobiles higher in the USA because of 'voluntary export restraints' required of Japanese manufacturers? Most observers think so. Are US prices of clothing higher because of tariffs and quotas? Most observers think so, and Cline estimated the domestic US price to be 53% above world prices. Is the price of rice higher in Japan because of import restrictions? I understand that the domestic price of rice in Japan is approximately three times higher than the price of imported rice. Henk-Jan reports that he 'found very little evidence that tariffs increase the domestic price level'. If, by 'domestic price level', he means the relative price of importables, I find that difficult to believe. If he means the overall "purchasing power parity" price level, this is quite possible, but, so what? I have not read his book, so do not know whether he is referring to relative prices of importables or to a price index that includes exportables and nontradables as well as importables. I would like to thank Henk-Jan for supplying the Liang reference. The Cline reference is W.R. Cline, _The future of world trade in textiles and apparel_ (IIE, Washington, D.C., revised edition, 1990). This estimate of 53% higher prices (more than half due to quotas) may seem a bit dated, but the multi-fiber agreement is still in effect, so levels of protection haven't changed much in the last decade or so.