In the situation today (panel a), the average cost curve is AC and the industry would make losses at the world price of PW. A tariff increases the price from PW to PW+t , allowing the industry to produce at S2, with the net loss in welfare of (b+d).
But producing today allows the average cost curve to fall through learning. So in the future (panel b) the firm can produce and the price P* without tariff protection, and earns producer surplus of e.
Market Failure Justifications for Infant Industry Protection
If a developing country does not have a set of financial institutions that would allow savings from traditional sectors (such as agriculture) to be used to finance investment in new sectors (such as manufacturing), then growth of new industries will be restricted.
Appropriability argument: Pioneering firms in a new industry generate social benefits which they are not compensated, e.g., “start-up” costs of adapting technology to local circumstances or of opening new markets.
Example: The U.S. and Germany had high tariff rates on manufacturing in the 19th century, while Japan had extensive import controls until the 1970s.
A US success story: The case of U.S. tariff on imports of heavyweight motorcycles. Harley-Davidson was on the brink of bankruptcy in 1982-83. It applied to the International Trade Commission (ITC) for Section 201 protection. HD was able to secure a bank loan only after receiving protection. So the tariff may well have contributed to its continued survival.
Its near-bankrupt status was due to problems of poor management and lagging productivity, while its revival after 1983 was due to the introduction of improved products and production techniques.
It cannot be argued that this broad change in company practices was caused by the tariff, but it appears that the temporary tariff bought it some breathing room.
Its improved products later offered by Harley-Davidson (which were emulated by its Japanese rivals), the temporary tariff may well have contributed to long-run welfare gains for consumers.
Calculation of Deadweight LossThe deadweight loss relative to import value in 1983 is measured as
This table shows the effects of the tariff on imports of heavyweight motorcycles in the United States..