Infant Industry Protection, Dynamic Internal Economies and the Non-appropriability of Consumers’ and Producers’ Surpluses*

Z Economists would generally agree that the protection of an infarit

industry may be necessary if the infant industry generates external economies which it cannot charge for. As Kemp [4, p. 1871 aptly puts it, the infant industry argument has as its foundation ‘the possibility of external economies, albeit of a peculiar dynamic kind‘. The presence cf external economies is explicit or implicit in most models in which social intervention is claimed to be necessary. In particular, the model b:y Clemhout and Wan [l] implicitly assumes the existence of economies internal to each industry but external to the firms in each industry, since their h s maximize instantaneous profits, taking as given the technical progress index u,( 1 ) .l

So far, so good. But there are authors who push the non-appro- priability argument much further. For example, Negishi [5, pp. 57-81 argues that ‘there are cases in which . . . interference with the competi- tive allocation . . . is desirable even if no external effects are present The reason lies in the existence of dynamic internal economies . . .’. According to Negishi, ‘the common sense of this possibility may be: found in the increments to consumers’ surplus generated by the price: changes which result from the growth of an infant industry. These increments may be foreseen by private producers, but since they do not accrue to the producers the increments fail to induce private producers spontaneously to create the industry’ [5, p. 591. Negishi‘s proposition is supported by Ohyama [7]). Johnson [3, p. 741 refers approvingly to Negishi’s paper and presents a partial equilibrium, diagrammatic argument for protection on the ground of ‘uncaptured

* I wish to thank Professor L. R. Webb for having drawn my attention to this topic and Professor M. C. Kemp, F. Milne and E. Sieper for their comments. The responsibility for errors rests with me alone.

1 Clemhout and W a n [l] seems to be the first elaborate model with more than one learning industry. Their results are intuitively quite plausible. The possibility of permanent protection is not new and not surprising since they assume that the accumulation of output continues to lower costs (see, for example, Johnson [3, p. 751. Other ‘models of protection’ are possible, mainly because of the assumption that both industries learn.

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JUNE, 1975 INFANT INDUSTRY PROTECTION 25 7 increases in consumers’ and producers’ surpluses’.

The purposes of this paper are: ( a ) to re-affirm that, in a fully competitive world, protection is unnecessary if the learning process is internal to the firm;2 and (b) to point out that the case for intervention in the presence of dynamic internal economies can be upheld only if there are market imperfections, such as lack of foresight on the part of producers.

zz Johnson’s argument is based on a partial equilibrium model, with

diagrams portraying costs and gains resulting from the protection of an infant industry behaving as a monopolist in its country. Negishi’s paper [ 5 , p. 661 also gives, in an appendix, a ‘heuristic partial equili- brium version of the infant industry argument . . . in terms of consumers’ surplus’. Negishi presents the arguments in a general equili- brium framework, and analyses the cases of both a competitive and a monopolistic infant industry. Ohyama’s approach is similiar to Negishi’s, although he is mainly concerned with the case of a small country facing given prices of traded goods. We choose to argue using Negishi’s general equilibrium model since in Negishi’s own words, ‘partial equilibrium analysis gets a first approximation . . . by assuming that other things are equal . . . No one can deny its significance as a heuristic method. But there is the danger of a sweeping generalization if one forgets its basic assumption that other things are equal. The role of general equilibrium analysis is . . . to check the general applicability and relevance of the results obtained under the assumption that other things are equal’ [6, p. 21. In the present context, we only need point out that when demand and/or cost curves of the infant industry shift, other demand and cost curves cannot remain stationary. Notwithstanding our disagreement with Negishi’s argument for protection, we believe that Negishi’s approach-the use of a general equilibrium framework -is itself an important contribution to the infant industry debate.

We note that while Johnson and Ohyama seem to be mainly con- cerned with welfare comparisons from the point of view of a single country, Negishi looks at the infant industry problem from the point of view of the world’s welfare. However, as Negishi points out, his model ‘can be applied to the analysis from the point of view of a single country, provided the foreign offer curve is interpreted as a kind of input-output relation’ [5 , p. 601.

We adopt the following strategy. We first present a well-known, well-proven theorem which says that, even in the presence of dynamic internal economies, a competitive equilibrium is a Pareto optimum. This will be followed by a reexamination of Negishi’s crucial test 2. We shall show that this test, while useful and relevant for some purposes, does not demonstrate that a socially intervened equilibrium may be

*This position was widely accepted prior to the publication of [S] and 131. See, for example, Kemp [ 4, p. 1871.

258 THE ECONOMIC RECORD JUh E

‘superior’ to a competitive equilibrium. In fact, a competitive equilibrium can never be inferior.

1Il Negishi [ 5 ] considers a two-period model of the world econ0m.y.

Let x and x* denote the world consumption vector of cornmoditits in the first period (the present) and the second period (the future) respectively, the asterisk denoting variables in the second period. The initial resources are c and c*. Consumers maximize intertemporal utility by choosing ( x , x * ) , subject to their intertemporal budget constraints. Indifference surfaces are convex. For the moment, we need not specify whether individual indifference maps are identical and whether Engel curves are straight lines through the origin, although both these assump- tions are explicitly stated in Section VIII of Negishi’s paper [ 5 ] . The input-output vector for all industries, except the infant industry, is ( y , y * ) . The set of all technologically feasible (y, y * ) is Y, which is closed and convex. The infant industry produces the first commodity, and its input-output vector is ( q , q * ) . Of course q1 3 0 and ql* 2 0, where the subscript 1 denotes the first commodity. The set of possible q is Q and that of possible q* is Q* ( q l ) , implying the learning-by-doing possibility. The set of possible (q , q * ) need not be convex. It is assumed that ‘external effects, static or dynamic, do not exist at all. Therefore, there is no need to distinguish the infant industry and the firm’ [ 5 , p. 611.

Negishi’s approach is to perform welfare comparisons between alternative social states, using (equilibrium) price and quantity data.3 Given the present framework, these social states must, of course, be equilibrium states. Equilibria are thus assumed to exist.

A close inspection reveals that Negishi’s model is just a special case of Debreu [2]. Dynamic internal economies are allowed for in Debreu’s concept of the production set,q where commodities at different dates are differentiated.

The well-known theorem of welfare economics that, in the absence of externalities, a laissez-faire competitive equilibrium is a Pareto opti- mum, is precisely stated and proved in Debreu [2], with a minimurri number of assumptions.6 These are convexity of preferences, non- satiation, a t the equilibrium, and convex consumption sets (which represent non-economic restraints on consumers’ choice). Debreu’s definition of a competitive equilibrium of course involves the assumption that producers know their production sets and maximize intertemporal profits (properly discounted). The theorem contradicts Negishi’s asser-

3 The technique is well-known. See, for example, Samuelson’s 1950 paper 181. 4 Debreu [Z] does not assume everywhere that production sets are convex. I n

particular, the convexity of production sets is not assumed for the theorem we shall invoke. Admittedly, an equilibrium may not exist due to the lack of con- vexity. But for a meaningful comparison between social states, equilibria must of course be assumed.

5 See Debreu [Section 6.3, p. 941.

1975 INFANT INDUSTRY PROTECTION 259

tions such as that ‘the competitive allocation of resources may be imperfect even though the learning process is internal to the Em’ [5, p. 591 and that ‘the protective tarif€, though not optimal, turns out to be better than laissez-faire’ [ 5 . p. 651-unless the term ‘competitive allocation’ used by Negishi is not to be understood in its usual sense and his assumption of perfect foresight [ 5 , p. 591 is dropped. For example, if firms are myopic, a ‘myopic competitive allocation’-a concept as yet not well defined-may be inferior to an equilibrium with protection.

It is interesting to note that the theorem of welfare economics we have just invoked can be used to derive Negishi’s valid test 1 (which is arrived at by Negishi using a different approach). For the purpose of test 1, Negishi postulates a (hypothetical) competitive equilibrium, supposing the infant industry does not exist. This competitive equilibrium is characterized by ( p , p * ) , ( x , x*) and ( y , y*). Perfect foresight is of course assumed here. If there is rw technologically feasible (q, q * ) such

that, at the price (i, p * ) , the infant industry’s profit @q + p*’u*) is positive, then the infant industry should not be protected. This is Negishi’s test 1 [5, p. 611, which can be derived straightforwardly by noting that if there is no (q, q * ) such that $q + j*’i* > 0, then (i p), ( x , x * ) , ( y , y * ) with (4, q * ) = (0, 0) constitute a laissez- faire competitive equilibrium at which the infant industry’s competitive output is (0, 0) since it cannot do any better. By virtue of the theorem we invoked, this equilibrium is a Pareto optimum and there is no need for any social intervention.

zv In the preceding section, the argument for infant industry protection

based on dynamic internal economies alone was shown to be contradicted by a well-known theorem in welfare economics. We now take a closer look at Negishi’s test 2 which supposedly provides a sufficient condition for the superiority of an intervened equilibrium over a competitive allo- cation. If the term ‘competitive allocation’ is understood in its usual sense (so that E m s know their production sets and maximize profits over time), this test (and hence its variants, tests 3 and 4) will be shown to be invalid. The test, however, can be useful for making welfare comparisons between a socially intervened situation and any other allocation that is not a competitive equilibrium (in its usual sense).

In Sections VI-VII of his paper [5], Negishi considers a situation in which world resources are optimally allocated under the restriction that the infant industry’s output of the first commodity in the first period, q1 is not less than a certain threshold level & > 0. He assumes that such a (conditionally) optimal situation is achieved by a competi- tive price system (p, p * ) at which the ‘profit’ of the infant industry,

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260 THE ECONOMIC RECORD JUVE

p’q 4- p*’q*, is maximized under the restriction that q1 > 41. Due to this restriction, the maximum profit achievable by the infant indusi:ry may well be negative.8 In this conditionally optimal situation, the profit of the other industries is maximized at ( y , y * ) and consumers’ chosen bundle is (n, x * ) .

Note that the ( x , x * ) and ( y , y * ) in this situation are not the same as those consumption and production vectors when the infant industry does not exist, and the ( q , q * ) in this situation need not be the sarne as that which maximizes profit at the price ( p , p * ) , in spite of the fact that Negishi uses the same notation.

Negishi then proposes to compare the socially intervened equili- brium with a competitive allocation with no infant industry. He de- notes ‘the consumption vector when there was no infant industry . . . by (2, ;*) and that available when the infant industry is allowed to grow by ( x , x * ) ’ [5, p. 631. For a meaningful welfare comparison between a laissez-faire situation and a socially intervened situation, one must interpret a situation in which ‘there were no infant industry’ [ 5 , p. 631 as one in which the infant industry was not competitively viable ra thx than as one in which the infant industry was somehow banned or not conceived of by private producers. This interpretation seems to be supported by the following quotation:

‘the competitive allocation of resources may be imperfect . . . The increments to consumers’ surplus . . . may be foreseen by private producers, but since they do not accrue to the producers the increments fail to induce private producers . . . to create the

With this interpretation in mind, we shall denote by ( p L , p , * ) the competitive price systems associated with (x, x*), (F,u*) and (c 1, (the latter is, by assumption, (0, 0) identically).

Let U be the set of consumption vectors preferred or indifferent to (x , x*) . Negishi observes that a sufficient condition for (X, E*) .$ U is p’x+p*’x* > p’X+p*’X* or equivalently,

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industry’ [5, p. 59].7 - -

p’(y-jj)+p*’(y*-jj*) > -p’q-p*’q*.

6 Although Negishi does not explicitly specify how the infant industry IS to be protected (if necessary), his assumption that all industries mayimize profils at the price ( p , p* ) is consistent with the following method of protection. T t e government instructs the infant industry to take market prices as given and to maximize its profit subject to the restriction qI 2 &. Any loss will be covered by a subsidy. See also [5 , p. 631 where it is stated: ‘since ( p , p * ) is a system of optimal prices, protection needs to be carried out in such a way that no price is changed by protection’.

7 Incidentally, this ‘common sense explanation’ can be quite misleading. We know, for example, that consumers’ surplus is not captured by firms in a COF- petitive equilibrium-with or without dynamic internal economies. Can we then conclude that, for this non-appropriability, any competitive equilibrium may be sub-optimal ?

8The subscript c is used-since this price system is not, or need not be, the same as the price system ( p , p * ) postulated by Negishi in [S, Section 1111.

1975 INFANT INDUSTRY PROTECTION 26 1 In other words, the ‘loss’ of the infant industry is more than compensated for by the ‘gain’ accrued to other industries. This is Negishi’s test 2 [5, p. 631. He concludes that ‘the infant industry should be promoted by protection if its loss is less than p’(y-J)+p*’(y*-J*)’ and that, even if the infant industry enjoys a monopolistic profit, ‘such an economic system is . . . superior to the system without the infant industry’ [5, p. 631.

We shall argue that Negishi’s test 2 is not valid for the purpose of establishing the superiority of a socially intervened equilibrium over a laissez-faire competitive allocation. It seems clear that Negishi assumes a consistent world indifference map for his Sections 111-VII [5, pp. 60-31 when he writes: ‘the world indifference m a p . . . is assumed to exist’ [5 , Section 111, p. 601. This assumption is explicitly stated later on [5 , Section VIII, p. 641. For the sake of completeness only, we shall show that Negishi’s test is not valid whether the Scitovsky world indifference surfaces intersect or not.

(i) Suppose that the Scitovsky world indifference surfaces may intersect. In this case (X, X*) 4 U does not imply that (X, Z*) is Pareto inferior to (x , x*).O The passing of test 2 thus does not mean that the protection situation is ‘superior’ to a laissez-faire competitive equilibrium, nor does it imply that ‘the competitive allocation of resources may be imperfect’.

(ii) Suppose that the world indifference map is consistent. In this case, if (X, X*) 4 U, then (X, X*) is Pareto inferior to ( x , x* ) , provided that compensation is paid. It will be demonstrated, however, that (X, X*) always belongs to U. Suppose that, on the contrary, (X, E*) $ U. This must imply that (X, X*) is on a lower indifference surface than (x , x*) , since we are considering the case of a consistent indifference map. Recall that (pc , pc*) is the competitive price system associated with (Z, X*), ( j j , J*) and (g, g*)[ = (0, O)]. Now (X, X*) is on a lower indifference surface only if pc‘Z+pc*’X* < pc‘x+pc*’x*. This cannot be true, however, since from the market clearing conditions1° we obtain jjc’X+pc*X* = p C ’ j +pc*’J* + p c q +pc*jq* +FC’C+jC*‘C*

jjc’x + pc * ’x* = pc’y + pc * ’y * + pc’q + pc *’q * + pc’c + jc* ’c* . But ( J , J*) and (q, q*) maximize profits at the price (pc, pc*). Hence (X, X*) 4 U implies a contradiction and cannot be true. Negishi’s test 2, if used to compare an intervened equilibrium with a competitive allocation, is therefore not valid, for it provides a sufficient condition for something that cannot be true. The same error is made by Ohyama.

9 For a precise statement of this well-known point, see [6, p.491. 10 These conditions are :

x - y - q - c = 0, x * - y* - q* - c* = 0

x - y - q - c = 0, x* - y* - 8 - c* = 0. - - - - - -

262 THE ECONOMIC RECORD JUNE, 1975 Let us turn our attention to Negishi’s comparison between a situa-

tion with a tariff protected infant industry and a laissez-faire competitive equilibrium [S, Section VIII]. Here Negishi explicity assumes a con- sistent world indifference map, and he considers the sufficient condition for (.?, ;*) 4 U (his test 4). Again, the test is not valid since it can be shown easily, by an argument similar to that used in the preceding paragraph,” that (i, i*) always belongs to U.

Finally, we wish to empasize once again that Negishi‘s test 2 can be useful for other purposes. More precisely, if ( x , x * ) and (y, y*: ) used in Negishi’s test 2 are consumption and production vectors o€ some arbitrary allocation (which is not a competitive equilibrium), then test 2 is meaningful. It provides, in this case, a useful sufficient condition for the superiority of a socially intervened situation over ii (non-competitive) allocation with no infant industry. After all, it i:; not totally unrealistic to assume that producers lack imagination and foresight, or that they may be local maximizers. In defending test 2! along these lines, we must not forget our basic conclusion that, in a world with perfect foresight, the line of argument based on dynamic: internal economies for interfering with competitive allocations is noi: tenable.

NGO VAN LQNG Australian National University Date of Receipt of Final Typescript: May 1974

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REFERENCES 111 Clemhout, S. and H. Wan, ‘Learning by Doing and Infant Industry Protec-

tion’, Rm‘ew of Economic Studies, Vol. XXXVII, January 1970, pp. 33-56. [2] Debreu, G., Theory of Value (Wiley, New York, 1959). [3] Johnson, H. G., ‘A New View of the Infant Industry Argument’, in R. H.

Snape and I. A. MacDougall (eds.), Studies in Infernational Economics: Monash Conference Papers ( North-Holland, Amsterdam, 1970).

[4] Kemp, M. C., The Pure Theory of International Trade (Prentice-Hall, Englc- wood Cliffs, N.J., 1964).

[5] Negishi, T., Protection of Infant Industry and Dynamic Internal Economies’, Economic Record, Vol. 44, March 1968, pp. 56-67.

[61 - General Equilibrium and International Trade (North-Holland, Amsterdhm, 1972).

[7] Ohyama, M., ‘Trade and Welfare in General Equilibrium’, Keio Economic Studies, Vol. 9, No; 2, 1972, pp. 37-73.

[8] Samuelson, P. A., Evaluation of Real National Income’, Oxford Economic Papers, Vol. 2, January 1950, pp. 1-29.

11 Formally, after a proper reinterpretation to incorporate commodity 0 (according to Negiszs tick), the -two equations in the preceding paragraph remain valid, since p’m = po*’m* = p.’m = pc*’m* = 0. (Note that, by definition, ma = -m1 etc. and the first two components of the price vector &, and of course Po*, are identical, reflecting free trade.)

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