SYNOPSIS:

A hypothetical scenario may be useful for understanding what the costs of protection are, and why they are more modest than many people seem to think.

Let's imagine that most of the world's market economies were to group themselves into three trading blocs -- one centered on the United States, one centered on the European Economic Community and one centered on Japan. And let's suppose that each of these trading blocs becomes highly protectionist, imposing a 100-percent tariff against goods from outside the bloc, which we suppose leads to a fall in imports of 50 percent. So we are imagining a trade war that cuts the volume of world trade in half. What would be the costs of this trade war?

One immediate response would be that each bloc would lose jobs in the industries that formerly exported to the others. This is true; but each bloc would correspondingly gain a roughly equal number of jobs producing goods it formerly imported. There is no reason to expect that even such a major fragmentation of the world market would cause extra unemployment.

The cost would come instead from reduced efficiency. Each bloc would produce goods for itself that it could have imported more cheaply. With a 100-percent tariff, a maximum estimate, some goods would be produced domestically even though they could have been imported at half the price. For these goods, there is thus a waste of resources equal to the value of the original imports. But this would be true only of goods that would have been imported in the absence of tariffs.

However, even under free trade, our three hypothetical trading blocs would import only about 10 percent of the goods and services they use. A trade war that cut international trade in half (to 5 percent of GNP on average) and which caused an average cost of wasted resources for the displaced production of, say, 50 percent, would therefore cost the world economy only 2.5 percent of its income (50 percent x 5 percent = 2.5 percent).

This is not a trivial sum -- but it is a long way from a depression. It is roughly the cost of a 1 percent increase in the unemployment rate. And it is the result of an extreme scenario, in which protectionism has a devastating effect on world trade.

If the trade conflict were milder, the costs would be much less. Suppose that the tariff rates were only 50 percent, leading to a 30-percent fall in world trade. Then 3 percent of the goods originally used would be replaced with domestic substitutes, costing at most 50 percent more. If the typical domestic substitute costs 25 percent more, then the cost of the trade conflict is only 0.75 percent of world income.

Originally published, 3.25.90