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Protectionism and industry policy

By John Freebairn - posted Thursday, 22 September 2011

While special assistance to selected industries in the form of tariffs and direct subsidies benefit the assisted industry and its owners and employees, the selective assistance distorts the most productive allocation of scarce resources and reduces national living standards.

Reducing tariffs and subsidies to industry in Australia over the 1980s and 1990s was a major component of the microeconomic reform agenda. Over this period, the rate of productivity growth was way above average and the vast majority achieved higher living standards.

There are at least three ways in which special assistance to selected industries, but not others, reduce national productivity and living standards.


First, limited labour, capital and in some cases natural resources are reallocated from more productive to less productive industries. Suppose there are just two industries: A for automobiles and E for education. A tariff or direct subsidy to industry A provides an artificial increase in industry profitability. The higher profits enable it to attract more labour and capital and to increase production.

But, with a limited labour and capital, the expansion of A comes at the expense of less labour and capital for the rest of the economy, including industry E. Industry E is hurt by a combination of having to pay more for inputs purchasing from A in the case of a tariff, or by having to pay a higher price for resources receiving a subsidy in industry A employment. Importantly, the artificial increase to industry A profitability transfers limited resources from more productive use by industry E to less productive use in industry A, and a loss of national productivity. 

Second, general experience is that industries propped up with tariffs and direct subsidies lose some of the incentives and the drive to adopt new technology, better management and work practices, and to better understand and develop products sought by consumers.

Third, and allied, lobbying for the continuation of, or even increasing, the special assistance measures, often takes priority over investing in productivity improvements. Limited resources are reallocated from opportunities to increase productivity and living standards to what is, in effect, zero sum game rent seeking. A major benefit of increased competition fostered by the microeconomic reforms of the 1980s and 1990s was the stimulus it gave to improving management and work practices, the adoption of new technology, and closer attention to buyer needs.

Structural changes involving some industries expanding and others contracting and change in methods of production are inevitable characteristics of modern economies which deliver rising standards of living. A host of reasons lie behind the need for structural changes. These include changes in tastes, higher incomes, new technology, changes in relative input costs and changes in countries with whom we trade. In turn, the structural changes involve what Schumpeter termed “creative destruction” of jobs and industries.

Special assistance to selected industries in the form of tariffs and direct subsidies act to slow down and hinder structural change. At the same time, in most cases the special industry assistance only slows down or delays inevitable long-term structural change. Unfortunately, in the process of protecting some industries from the need to change, the opportunities for, and ability of, new and more productive industries and employment to expand are slowed down. Such a sclerotic economy turns out to be a less productive economy.


Rather than selective industry assistance via higher tariffs and special subsidies, there is another set of government policy initiatives to facilitate productivity enhancing structural changes. Improving the flexibility of labour to adapt to structural changes is enhanced by education and other measures to raise worker skills, and an industrial relations system supporting productivity growth for higher real wages. Open competitive capital markets and a close to neutral taxation system across different investment options support the redeployment of funds for investment in buildings, machinery, research and development, from less productive to more productive uses.

Other policy initiatives include removing conveyance duty on property transfers, perhaps with a less distorting system of land taxation, and a simpler and more rational regulatory system that does not unnecessarily block new initiatives.

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About the Author

John Freebairn is the Ritchie professor of economics in the Department of Economics at the University of Melbourne.

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