Trade Liberalization
A case for protectionism

Despite widespread agreement that trade liberalization is beneficial, the speed of reform remains a controversial issue. In Discussion Paper No. 856, Research Fellow Larry Karp and Thierry Paul extend previous work which found that adjustment costs entailed as labour moves between sectors cannot justify gradualism and any case for policy intervention must be based on market failure. For an economy in initial disequilibrium, workers balance the discounted stream of the future wage differentials against current adjustment costs. Temporary congestion costs increase with the migration rate: if migration occurs too quickly, the first-best policy intervention is a labour tax/subsidy, but trade policies are often viewed as second-best alternatives. A tariff to protect the `dying' sector will raise its wage and slow migration at the cost of distorting both consumption and production.

Karp and Paul first assume that workers have rational expectations and that the government can commit over an infinite horizon to show that its optimal policy is to phase in and then phase out protectionism. If its `period of commitment' is finite, however, the optimal policy as this period approaches zero is immediate and complete liberalization. It is therefore optimal at least to <MI>begin<D> reform with liberalization under both extreme assumptions, which weakens the gradualist argument for continued protection.

Karp and Paul then relax the assumption that current wages have no first-order effect on the migration decision, to show that a positive initial tariff is then the optimal policy even if the government cannot commit to future policy. They emphasize that these contrasting results demonstrate the sensitivity of policy prescriptions to the nature of the migration decision and call for empirical work to determine whether this is affected by purely transitory variables, such as the current wage differential and, if so, whether their effects are of the same order of magnitude as those that proxy future streams of benefits from migration.

Phasing in and Phasing out Protectionism with Costly Adjustment of Labour
Larry Karp and Thierry Paul

Discussion Paper No. 856, November 1993 (IT)