Question

Infant Industry protection is a key solution for the growth of industrialization of developing countries. Discuss your answer by using the graph below and any other graph(s) that you can deem appropriate

Answer 1

The Infant industry argument claims that protection is warranted for small new firms, especially in less-developed countries. New firms have little chance of competing head-to-head with the established firms located in the developed countries. Developed country firms have been in business longer and over time have been able to improve their efficiency in production. They have better information and knowledge about the production process, about market characteristics, about their own labor market, and so on. As a result, they are able to offer their product at a lower price in international markets and still remain profitable.

Let us understand with the help of example below:

Consider the market for a manufactured good such as textiles in a small, less-developed country.

Suppose that the supply and demand curves in the country are as shown in Figure 1 "An Infant Industry in a Small Importing Country". Suppose initially free trade prevails and the world price of the good is P₁. At that price, consumers would demand D₁, but the domestic supply curve is too high to warrant any production. This is the case, then, where domestic producers simply could not produce the product cheaply enough to compete with firms in the rest of the world. Thus the free trade level of imports would be given by the blue line segment, which is equal to domestic demand, D₁.

Figure 1 :

Suppose that the infant industry argument is used to justify protection for this currently nonexistent domestic industry. Let a specific tariff be implemented that raises the domestic price to P₂. In this case, the tariff would equal the difference between P₂ and P₁—that is, t = P₂ − P₁. Notice that the increase in domestic price is sufficient to stimulate domestic production of S₂. Demand would fall to D₂ and imports would fall to D₂ − S₂ (the red line segment).

The static (i.e., one-period) welfare effects of the import tariff are shown in Table 1 below "Static Welfare Effects of a Tariff".

Table 1: Static Welfare Effects of a Tariff

	Importing Country
Consumer Surplus	− (A + B + C + D)
Producer Surplus	+ A
Govt. Revenue	+ C
National Welfare	− B − D

Consumers of textiles are harmed because of the higher domestic price of the good. Producers gain in terms of producer surplus. In addition, employment is created in an industry that did not even exist before the tariff. Finally, the government earns tariff revenue, which benefits some other segment of the population.

The net national welfare effect of the import tariff is negative. Although some segments of the population benefit, two deadweight losses to the economy remain. Area B represents a production efficiency loss, while area D represents a consumption efficiency loss.

An Infant Industry in a Small Importing Country

• An import tariff that stimulates infant industry production sufficiently can raise national welfare over time, even for a small importing country.
• An import tariff is a second-best policy to correct for an infant industry production externality imperfection.
• A production subsidy is superior to an import tariff as a policy to correct for an infant industry production externality imperfection.
• In the presence of an infant industry production externality imperfection, a domestic policy is first best, while the best trade policy is second best.

Dynamic Effects of Infant Industry Protection

Now suppose that the infant industry argument is valid and that by stimulating domestic production with a temporary import tariff, the domestic industry improves its own productive efficiency. We can represent this as a downward shift in the domestic industry supply curve. In actuality, this shift would probably occur gradually over time as the learning effects are incorporated in the production process. For analytical simplicity, we will assume that the effect occurs as follows. First, imagine that the domestic industry enjoys one period of protection in the form of a tariff. In the second period, we will assume that the tariff is removed entirely but that the industry experiences an instantaneous improvement in efficiency such that it can maintain production at its period one level but at the original free trade price. This efficiency improvement is shown as a supply curve shift from S to S′ in Figure 2 "Efficiency Improvement in a Small Importing Country".

Figure 2 Efficiency Improvement in a Small Importing Country

This means that in the second period, free trade again prevails. The domestic price returns to the free trade price of P₁, while domestic demand rises to D₁. Because of the efficiency improvement, domestic supply in free trade is given by S₂ and the level of imports is D₁ − S₂ (the blue segment).

The static (one-period) welfare effects of the tariff removal and efficiency improvement are summarized in Table 2 below "Static Welfare Effects of Tariff Removal and Efficiency Improvement". Note that these effects are calculated relative to the original equilibrium before the original tariff was implemented. We do this because we want to identify the welfare effects in each period relative to what would have occurred had the infant industry protection not been provided.

Table 2 : Static Welfare Effects of Tariff Removal and Efficiency Improvement

	Importing Country
Consumer Surplus	0
Producer Surplus	+ E
Govt. Revenue	0
National Welfare	+ E

Consumers again face the same free trade price that they would have faced if no protection had been offered. Thus they experience no loss or gain. Producers, however, face a new supply curve that generates a producer surplus of + E at the original free trade price. The government tariff is removed, so the government receives no tariff revenue. The net national welfare effect for the second period then is simply the gain in producer surplus.

The overall welfare impact over the two periods relative to no infant industry protection over two periods is simply the sum of each period’s welfare effects. This corresponds to the sum of areas (+ E − B − D), which could be positive or negative. If the second-period producer surplus gain exceeds the first-period deadweight losses, then the protection has a positive two-period effect on national welfare.

In summary, it is shown that the protection of an infant industry may be beneficial for an economy. At the heart of the argument is the assumption that production experience generates efficiency improvements either directly in the protected industry or indirectly in other industries as a learning spillover ensues. The infant industry argument relies on a dynamic view of the world rather than the static description used in classical trade models. Although protection may be detrimental to national welfare in the short run, it is conceivable that the positive dynamic long-run effects will more than outweigh the short-run (or static) effects.