A country currently imports automobiles at $8,000 each. Its government believes

Question

A country currently imports automobiles at $8,000 each. Its government believes that, given time, domestic producers could manufacture autos for only $6,000 but that there would be an initial shakedown period during which autos would cost $10,000 to produce domestically. a. Suppose each firm that tries to produce autos must go through the shakedown period of high costs on its own. Under what circumstances would the existence of the initial high costs justify infant industry protection? b. Now suppose, on the contrary, that once one firm has borne the costs of learning to produce autos at $6,000 each, other firms can imitate it and do the same. Explain how this can prevent development of a domestic industry and how infant industry protection can help.

Explanation / Answer

At best, infant-industry protection would be a third-best policy. Assuming that the government is correct, a subsidy to domestic producers would be more efficient than a tariff (either would be more efficient than a quota). A subsidy would be an appropriate policy given two market failures: capital markets fail to fund sound investments; or the initial producer cannot appropriate a significant portion of the benefits it creates. (For example, it trains workers, who then leave to take jobs in other emerging companies.)

If the shake-down period is short enough, and capital markets are efficient, then private investors would undertake this project. If they cannot, then the best solution would be to create a more efficient capital market. If this is not possible, a subsidy may improve overall efficiency, if its deadweight loss is not too large. If a country cannot implement a subsidy (and this problem cannot be fixed directly), then the third-best solution might be a tariff, although it imposes even larger deadweight losses.

When an investment will create large in appropriable benefits, but is not privately feasible, it is most efficient to compensate the investors for their intangible contributions. As we have learned before, the most efficient way to correct a market failure is to address it directly. If the external benefits are generated in the production, then the best solution may be a production subsidy. This will improve welfare provided that the deadweight loss from the subsidy is smaller than the external benefits from the extra production. As above, if this is not possible, a tariff may (or may not) yield net benefits.

Patent laws may be used to reward those who develop more efficient processes. Of course, these generate monopoly deadweight losses. However, the gains from innovation probably greatly exceed those deadweight losses

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