Import Tariffs May Be Helpful

Import tariffs may be helpful in markets for specialised intermediate goods, according to research by Emanuel Ornelas and John Turner, published in the March 2012 issue of the Economic Journal.

Their study shows how import tariffs can encourage a domestic supplier to make a stronger commitment to deliver tailored components to a domestic buyer, lowering its production costs and/or increasing the quality of its product.

This matters, the researchers conclude, since trade in customised intermediate inputs is increasingly important in today”s global economy and nearly every industry uses some customised inputs. They suggest that designers of trade policy should carefully consider the extent to which traded intermediate inputs are differentiated.

Economists typically think of import tariffs as being harmful. They conjure up images of politicians favouring particular companies or industries for political reasons and starting trade wars.

Tariffs are indeed harmful in markets for final goods because they artificially inflate the cost of foreign goods, driving buyers to purchase too few foreign goods and distorting the allocation of domestic resources toward inefficient but protected sectors.

For the same reason, import tariffs are also generally bad in markets for commoditised intermediate inputs like raw materials.

But in markets for specialised intermediate goods, tariffs may be helpful. The reason is that they may help firms overcome an important industrial phenomenon known as the ”hold-up problem”.

At its core, the hold-up problem is a commitment problem. Trade in intermediate goods often involves components tailored to a single buyer”s specifications. In such cases, it is often hard for the buyer to predict what the seller can feasibly make – or for the seller to predict what the buyer will want from the finished components.

As a result, sellers and buyers often pursue component and final product development without complete contractual protection for their investments – and they often do not finalise purchase prices and quantities until much of the work developing the components and final products is finished. So when they negotiate, one party may find itself in a weak bargaining position because it is locked into a specific use of the tailored components.

For example, if the buyer decides at the last minute to source from another seller, then the seller may recover little if any of its original investment. Fearing this situation, sellers may be hesitant to commit to invest resources in tailoring components to the buyer”s specifications in the first place.

How do tariffs help? Suppose a domestic buyer can source inputs from a domestic seller S, who makes customised components, but also from alternative suppliers elsewhere in the world who produce ”off the shelf” components that are useful but an imperfect fit for the buyer. A tariff applied to those generic imported inputs makes the customised components from S relatively more attractive to the buyer.

This, in turn, provides greater incentives for seller S to commit resources to tailoring its components to the buyer, because it knows that the buyer”s alternative source of supply is now more expensive. Or put differently, the tariff makes seller S less fearful of being ”held-up” by the buyer on the negotiating table, and this boosts its confidence to invest in the relationship.

When the seller makes a strong commitment, it will lower its production costs or increase its product”s quality. A tariff that achieves such a result may be better than no tariff at all.

The researchers acknowledge that as always, there are caveats. Since import tariffs discriminate in favour of domestic sellers, they will attenuate domestic hold-up problems but not help hold-up problems between buyers and sellers in different countries, unless the two countries have a free trade agreement between them.

And even when a tariff ameliorates domestic hold-up problems, it will still distort the allocation of resources – as economists are quick to point out – and it may also distort ownership decisions.

Still, Dr Ornelas and Dr Turner argue, their main point remains valid: when commitment is important for investment decisions about the customisation of inputs to a domestic partner, import tariffs can help.

”Protection and International Sourcing” by Emanuel Ornelas and John Turner is published in the March 2012 issue of the Economic Journal.

Emanuel Ornelas

Centre for Economic Performance at the London School of Economics | +44-20-7107-5175 | e.a.ornelas@lse.ac.uk

John Turner

University of Georgia