9.4.1
Credit-Market Failures
If the worker in the above example wants to take the radio job because it would give her a higher PDV of income, she might need to take out a loan to smooth out her consumption due to the low income she will be receiving during the early stages of the job. Similarly, an entrepreneur wishing to enter a new industry may need to take out a loan to cover a few years of losses as learning by doing proceeds.
In both cases, if the loan is not available, we may have labor and capital stuck in the less remunerative sector. This is a consequence of credit-market failures and provides a possible rationale for infant-industry policies. If a tariff raises the domestic price of radios during the learning-by-doing period, that may alleviate the need for a loan, thus leading entrepreneurs and workers to enter the industry and profit from it. This creates a consumer distortion by distorting the prices consumers face, but since it corrects a production inef ficiency, it may be worth it.
Credit markets can fail for many reasons. One important one is often called .financial repression-regulations that keep interest rates for bank lending below market-clearing levels, and that keep banks' reserve requirements high, which have in the past been practiced by the governments of many medium- and low income countries (see McKinnon, 1973, for a classic account). Financial repression, naturally, can lead to the rationing of loans (analogously to the rationing of apartments in a standard rent-control model), and thus to a failure of the economy to develop learning-by-doing industries to an optimal degree. As a result, it can lead to a case for infant-industry protection. However, it must be emphasized that this is a second-best policy: If the credit market is mal functioning because of financial repression policies, the first-best strategy is to remove those policies rather than introduce a new distortion by imposing a tariff. A second reason credit markets may fail is asymmetric information (the argument pioneered by Stiglitz and Weiss, 1981). Asymmetric infomzation describes a situation in which one party to a transaction has information
SHOULD DEVELOPING-COUNTRY GOVERNMENTS USE TARIFFS?
relevant to the transaction that the other party does not have. It is extremely common in lending: A lender always wants to know that the borrower is able to pay back the loan, but the borrower always knows more about his or her creditworthiness, and the riskiness of the project financed by the loan, than the lender does. Given this, a lender may worry that a high interest rate will discourage more high-quality borrowers than low-quality borrowers (since if a borrower knows that he or she is unlikely to pay back the loan anyway, then he or she will not be bothered by a high interest rate). As a result, it is possible that there can be a ceiling for the interest rate above which a lender will be unwilling to lend; if this ceiling is not very high, it can result in an equilibrium with credit rationing quite similar to the outcome with financial repression. Therefore, asymmetric information in the credit market can lead to a coherent case for infant-industry protection.
This argument contains an important pitfall, however. Infant-industry protection is, by definition, temporary assistance to the industry. As a result, the entrepreneurs for whom it will make the most difference are those who do not expect to be around very long. It is possible that the policy can therefore make things worse by encouraging the entry of fly-by-night operators and thereby worsening the asymmetric information problem. 3
In sum, credit-market failures can provide a rationale for infant-industry protection, but the argument is far from ironclad.
9.4.2
Learning Spillovers
From here on in, we set aside the possibility of credit-market imperfections to discuss the other major market failure that is used to rationalize infant-industry protection: learning spillovers.
Now, suppose that the worker has accepted the radio job and proceeds down the learning curve month by month as described above, learning from her mistakes as she goes along. In addition, however, suppose that at lunch, during work breaks, and after hours, she also describes her experiences to her cow orkers, who thereby also learn from her mistakes. Similarly, she learns from the experiences of her coworkers, not only at her own firm, but through informal interactions with workers from radio assembly operations in the area. In this case, each radio worker confers a positive externality on the others: A portion of the learning achieved by each worker benefits other workers in the same industry. This phenomenon is called learning spillovers and is an important argument for infant-industry protection in its own right.
In the context of our model, we can stipulate that g is now a variable and is dependent on how many workers there are in the local radio manufacturing industry. The more local radio workers there are, the more abundant are the learning spillover opportunities and the higher is g.
This actually gives rise to a form of increasing returns to scale. Consider what happens if we double the number of radio workers in this location (along with other inputs, such as components, tools, and so on). For a fixed value of g, we would simply double the number of radios that can be assembled at each date, but given that g also increases, we will now more than double the output of radios at
3 This argument was made formally by Grossman and Hom (1988), strictly speaking not in the context
of a credit-market model, but the reasoning applies to credit markets. These adverse-selection effects are, unfortunately, difficult to test empirically.
9.4 Market-Failure Arguments for Infant-Industry Protection
each date (after the initial month). Doubling the input and more than doubling the output implies increasing returns to scale. Recalling Chapter 3, Section 3.2, as long as a portion of the learning spillovers is captured by workers in other firms, then this is a case of external increasing returns to scale. If the learning stays within the country, the increasing returns are external and national; if they spill out to other countries as well, the increasing returns are external and international.
This is an example of an important class of externalities called agglom eration externalities, or positive externalities from locating a particular eco nomic activity close to other firms or workers undertaking the same activity. Agglomeration externalities can take a number of forms. For example, the productivity of a manufacturer can be enhanced by the local presence of a wide range of other manufacturers. The reason is that with transport costs unnec essary, the local manufacturing sector provides a wide range of intermediate inputs available at a low price and at short notice. This type of agglomeration externality is emphasized by Krugman and Venables
(1995),
who show thatwith this type of agglomeration externality, trade can lead to a sharp rise in international income inequality, as manufacturing concentrates in clusters. Agglomeration can also make it possible for firms to become more specialized, facilitated by a large local market for industrial inputs that makes specialized local input producers viable (Holmes,
1999)
and by thicker markets thatalleviate various contracting costs (McLaren, 2000).
Workers sew shirts in a factory in China that makes apparel for Abercrombie and Fitch, J. Crew, and other leading American retailers.
Whatever their source, agglomeration externalities do appear to be important in practice, given the presence of industrial clusters in many areas, such as the famous Silicon Valley of California. Fallows (2007) describes the productivity benefits of a huge concentration of manufacturers in Shenzhen, China, the largest manufacturing center in the Pearl River Delta, which has become "the world's manufacturing center" (p. 50). Electronic inputs of every imag inable variety are available at a moment's notice, for example, at "the SEG
SHOULD DEVELOPING-COUNTRY GOVERNMENTS USE TARIFFS?