Domestic production costs aren’t fixed. Tariffs can spur investment, competition, and falling prices.
Sometimes, I feel I’m put in the strange position of defending markets from free traders. That seems to be happening in this ongoing debate with John Puri about the effect of tariffs.
Puri grants more than his headline suggests. He agrees that the aim of a tariff is more domestic production, and that if the tariff works, prices “should eventually fall as supply rises.” What he doesn’t grant is that it can fall to below where he started. Puri writes:
But tariffs cannot reduce the price of a good below its pre-tariff level. Prices may rise and then fall, but they won’t fall lower than where they used to be.
He offers two reasons. First, that New American supply only replaces foreign supply the tariff turned away. And if an American firm wasn’t willing to make something for $8 before the tariff, it won’t be willing after because “the relatively higher domestic production costs that made the tariff ‘necessary’ in the first place remain constant.”
Remain constant? I would assume that a free trader would be the last person to make such an argument.
We learned from Hayek the principle of market dynamics, with “Competition as a Discovery Procedure.” Costs and production methods aren’t known in advance, they are discovered through competition. Puri’s argument assumes the opposite, American production costs are a fixed fact, and no amount of firm entry, scale, or experimentation will change it. This was the argument Hayek rejected, and now it is deployed to defend free trade. My argument is that market participants change their behavior.
The development tradition from Hamilton and List argues alongside most economics that unit costs fall with scale, accumulated experience, and supplier clusters. A producer who couldn’t profitably supply at $8 with a small plant and no supply chain might be able to do just that or better with a larger one and a more mature supplier base. Reka Juhász’s work on the Napoleonic blockade showed that French regions shielded from British cotton built mechanized spinning capacity that were productive after the blockade ended.
In many cases, an import priced at $8 shouldn’t be treated as a free-market baseline. The item might be subsidized or a product of Chinese overcapacity. A statement that “prices can’t fall below where they were” is using an absent benchmark. Also an $8 price that relies on a foreign state’s industrial policy carries what we might also call a risk premium. Chinese-supplied rare earths were cheap until a political decision was made.
Puri’s case is strangely market-pessimistic. He says that “at best Americans gain access to only as much productive capacity as they lost.” Nothing actually caps domestic capacity at the level of the imports it displaces. If domestic producers make business or technical improvements — which is what research on past re-orderings of global trade suggests — as they learn, compete, and scale up, then they can keep extending beyond that point, lowering prices below what was originally offered and eventually exporting to compete internationally. That’s exactly what happened to Korean steel and Korean ships. The productive capacity that they built with industrial policy and from behind protection far outgrew the home market. Now, people cite Korean industry to tell Americans what was told to the Koreans in the 1960s and 1970s: You’re never going to get good at this, incumbents have an advantage, it is uneconomic.
There are important caveats to this. The policy has to settle, and it has to be durable, otherwise investment is discouraged by simply uncertainty. In real life, Trump has more often decided to simply make policy uncertainty in order to create leverage for doing his favorite thing: negotiating and announcing and promoting “deals.”
A policy shift may have predictable effects, but they aren’t static. It is not from benevolence of the chip maker, the ship builder, or the aerospace engineer that we expect our technological mastery, but from their regard to their own interest. We cannot repeal the effects of supply and demand with a tariff. We should expect people to respond to the changed incentives dynamically.
Yes, tariffs can, over time, bring prices below where they started. It doesn’t work by decree, but by drawing in new entrants, new competition, new investment, and new technology. We do not need to wait for every other government on earth to become free-trading and low-regulation, or accept into our market the deranging effect of every other capital’s industrial policy, before we can enjoy the market’s dynamic power to lower prices.