There are different approaches to define small economies. Besides usual quantitative ways to measure country’s smallness by its population, territory, GDP and other criteria, there some qualitative factors that are used to define the economy’s scale. Some economists state that small economies are those that adopt “price taking” policies as they cannot dictate their rules in the market, neither significantly influence trade rules. This peculiarity of small economies mainly lies in the fact that such countries have limited resources. Hereby, small countries are more dependent on imports and are forced to accept trade agreements offered by large exporters. Limited domestic competition makes inner market highly sensitive to any tariffs and taxes imposed, as they reflect immediately on the prices and consumption level (Commonwealth Secretariat, 2008, p.22).
International trading occupies one of the key positions in the country’s economic development and welfare growth. Since the appearance of the cross border trade, each country uses a number of tolls to gain the maximum benefit from the trade as well as these measures are called to protect national producers and consumers from unfair market conditions. Protection policy was used since many centuries before. This policy grants a protection for business in small and less developed countries (LDC). The main reason for applying protection measures is that LDC firm cannot compete with their rivals from the developed countries. First of all, because these firms did not have that much time to improve their efficiency in production as their competitors had. Secondly, LDC companies have less knowledge on the production process and ways of its effective management. Thirdly, they cannot easily track and analyze key market trends. Subsequently, prices for the products of LDC firms are much lower compared to the prices of the developed firms. Hence, small companies will not be able to remain profitable in the market. Which is why an import tariff is used to protect these LDC firms (Suranovic, 2002, n.p.).
Chand (n.d.) defines the following 6 main reasons why a protection policy should be adopted: (1) Infant Industry; (2) Diversification of Industry; (3) Promotion of Employment; (4) Balance of Payments and Terms of Trade; (5) Pauper Labour; (6) Anti-Dumping. First of all, it is necessary to state that there is no single definition of what is an infant industry. In most sources this term is used to define either a new company in a developing country, or a business in a small country. Basically, an infant industry refers to a company or business which is less competitive in the market than an international company of the same industry. Secondly, protection policy held by the government has a great impact on the infant industry. Thus, imposing of the import tariffs will reflect on the aforementioned business (Nathan Associates, 2004,pp.1-3).
Protection policy is mainly important for the infant-industry business; although it also allows to diversify other industries of the country and prevent over-dependence of the country’s economy from one industry, which might be caused by an excessive specialization. Tariff impose is one of the most frequently used tools of the protection policy; hence, imposing tariffs may increase the employment, as most of money will flow in the local market thus boosting the national producing and creating new labour demand. Tariffs have been also advocated as the most effective tool, applied for a trade balance correction. They are also used as anti-dumping measure, which helps to stop any attempts of foreign companies to win with a help of dumping prices (Chand, n.d., n.p.).
Once there is an industry, which assumed to be nonprofitable in the domestic market due to heavy competition with foreign rivals, the government usually applies tariffs or subsidies to support it. On the one hand, it helps the business to benefit. Although, on the other hand, these actions may cause a situation when limited and expensive in creation products are overproduced and exported. Basically, a distortion in the market of goods was caused by the governmental intervention. Therefore, most small economies tend to support primarily developing industries.
Differences in prices for the factors may be even more challenging in terms of regulation. There is a number of rules that suppliers should follow while providing domestic industries with the resources required. Amongst them are licenses, taxes, law restrictions, etc. All of these criteria influence the business’ welfare; however, a distortion in the factor market can be controlled only once some systematic characteristics are observed. Perhaps, the most common factor distortion is the one in the labor market, which can be influenced by shifting the wage ratio. Hereby, tariffs as an intervention tool have only an indirect influence on regulating the distortion mentioned.
The equilibrium with the tariff imposed is a distorted equilibrium, which does not satisfy the optimum conditions of the economic model. Lipsey and Lancaster describe the theory of “the second best”, which is used to describe the equilibrium situation in case one of the conditions assumed for the optimal model is not satisfied. In case of the small economies, the optimal conditions would be if the principle laissez-faire is followed, which basically means that the market runs under a free trade policy. Such an optimal market equilibrium is called “the first best”. However, due to the before mentioned reasons, ideal market conditions in a small economy are almost impossible. The introduction of even one distortion into such economy will either increase or lower the level of a national welfare. Nonsensitive world pricing plays a role of such distortion. Thus, an equilibrium in the market with a horizontal export supply curve is called “the second best” (Schmitz, 2012, n.p.).
Export tariffs imposed by a small economy will not have any effect on the global trading, except of the country itself. Although, small countries have no effect on the world prices, they can change the import’s price in the local market. Thus, the exporter will supply the amount that is demanded in the market for the world price, while the burden of tariffs will be put on the local purchasers. Hereby, the higher the tariff is the lower demand for the imported goods is. Government actions are mostly oriented on reverting the economy to “the first best” equilibrium; however, the economy can only be improved but never can be put into the ideal market circumstances. Tariffs are usually used in such cases so that to influence the flow of goods and services between countries. Based on the Lipsey and Lancaster’s theory a number of “first best” and “second best” imperfection policies was suggested (Schmitz, 2012, n.p.). Some researchers state that directional tariff and transfer reforms may be considered are a first best trade policy as they tend to move the prices toward the world price vector, and also lead to proportional reductions, and reductions of extreme tariffs (Diewert, Woodland, and Turunen-Red, 1991, n.p.). The first best policy is called to improve the welfare level, while the second one is the policy, which has lower improvement economic effect. Since any policy adopted to correct the trade balance is used to eliminate distortions, it is considered to be the second best one (Schmitz, 2012, n.p.).
The following example describes how the tariffs implication can regulate the Infant industry in a small country.
Figure 1. An Infant Industry in a Small Country. (Schmitz, 2012, n.p.)
The free trade market conditions for an infant industry are revealed on the Figure 1. P1 on the figure shows the world price in the market. However, national producers are willing to sell their goods at a higher price, thus the supply curve is higher the D1, a preferred demand for a P1. This situation usually occurs due to lack of domestic resources, which makes producers to use more expensive raw materials, hence they cannot sell the product cheaper. The free trade supply and demand level will thus meet at a D1 point, as P1 is the lowest price offered in the market. However, the government is interested in protection of the national producer, which is why a tariff will be implemented in order to increase the market price to the P2 level and allow the infant industry to compete in the local market. The positive impact of this policy is that domestic supply may be stimulated to the S2 level, regardless the fact that demand will decrease to theD2 level, hence leading to the import failure (red line in the chart). The government and producers will benefit from the situation, section C and A in the chart respectively. Meanwhile, consumers will lose greatly, as the burden of price increase will fall on them. Even though some parties benefit from the situation and a short time welfare improvement was gained through this policy, the economy loss was in a production efficiency loss (B section), and consumption efficiency loss (D section) (Schmitz, 2012, n.p.).
Some researchers claim that increasing of tariffs mostly leads to the economy slowing down both in long and short terms, therefore differential tariffs are named to be the most effective for the welfare increase in a short time period(Pereira & Osang, 1996, n.p.). Lee states, that high import tariffs may generate only short term benefits but long run losses for the intervening country. Thus, he suggests that greater openness can lead to a higher growth, in case the government lowers the tariffs and supports national producers simultaneously (Lee, 2005, pp.93-95). The country can improve its welfare in case total trade results overcome the total deadweight losses.
Baldwin (1969, pp. 295-296) states that there are many factors that influence LDC economies, thus requiring to a market intervention by the government; however, he questions whether tariffs are the most appropriate tool to be used. He also claims that tariffs may cause an economic failure rather than bring benefits for the local business. Baldwin says in his article, that tariffs will not help the LDC firms to become stronger, if the only disadvantage they have against their rivals is lack of knowledge. The author also states that no one can be sure that a tariff imposed will definitely lead to a production increase. And constant overestimation of the risks may have an opposite effect by concentrating powers in a limited number of industries, as other will be considered as potentially nonprofitable. The other argument discussed in the article states that tariffs have temporary effects, while externalities may be either static or reversible.Therefore, and infant-industry argument appears to be no longer valid. (Baldwin, 1969, pp. 296-298)
Instead of tariffs some economists suggest to use subsidies as a supporting tool for local businesses. Subsidies will allow the national producers to increase the supply without the price change, hence they will be able to get higher profits. Levich (n.d., p.9) says, that tariffs are the second best option to be used after subsidies. However, subsidies require government’s expenses, while tariffs bring new income to the national budget. Which is why, tariffs are used more often.
Small economies are mostly limited in the resources available for any kind of production, or even services. Furthermore, most of small countries manage to use their limited resources to produce some rare and luxury goods, so that to be able to export them. Therefore, there is no pure import or export economies. Nevertheless, small countries are more interested in imports, as they have to support all consumers’ needs and demands at the lowest price. So, once the country allows free foreign trade in its market, consumers benefit from the lower prices, while local companies lose; in case the government decides to support local producers, consumers lose but companies benefit. The country’s welfare raises in case total benefits of the winners (either consumers or producers) are higher than the total loss of the ones who lose in the trade. (Gans et al, 2014, p. 198). If the country follows the same policy during a long period, there will always be those, who constantly loose, and those, who always benefit. Thus, in case producers will face losses for a long period, they may switch to other markets, or even relocate the business; while customers may go for substitutes to reduce their constant expenses. Therefore, the government should choose an optimal strategy so that to get the maximum benefits and to satisfy needs of all parties. The government should also consider the fact that too high tariffs may force importers to quit the market.
As a conclusion, it is important to state that international trade nowadays is an engine that boosts and defines a country’s economic growth in a long-term perspective. Tariff policy adopted by the national government has a direct impact on the small open economy’s growth. High import tariffs limit the access of the foreign gods and services into the local market, thus demand overcomes the supply, which in its turn stimulates national producers to enlarge their business. High incomes of the national producers increase the overall economic standards. Lowering the import tariffs will have the opposite effect on a small economy. Which means that national producers will face a strong competition in the market along with the oversupply of the goods, which will lead to the price reduction and economic losses.
Companies of the small countries, which are also named as an infant industry, are very important for the national welfare. However, they cannot compete in the international market due to their small resource base, as well as they cannot be equally strong players in the domestic market, when an import company suggests lower prices. Therefore, the government should use import tariffs as a tool of the protection trade policy so that to support national producers.
Import tariffs allow local producers to sell items for the price, which is higher than the world price suggested, and thus they can cover their expenses for raw materials. Meanwhile, increased prices force customers to spend more, hence they lose more to support the economy. Recent openness of the economics led to a tariff’s lowering. Many countries are now joined into different economic unions and free trade zones, which prohibits implementation of tariffs among its members. Imposing tariffs has its pros and cons, although small countries can get their welfare increased in case total benefits exceed total expenses after the tariff was imposed.
Tariffs are an effective tool to regulate the country’s trade balance, especially for a small country. However, in real economies, one regulating method is never used solely. In most cases, international trade policy is a complex set of financial tools, political agreements and specific restrictions, which allows the government to control, monitor and support the economic situation in the country.
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