How Scale Economies Complicate the Case for Tariffs

New research suggests industrial subsidies outperform tariffs in high-tech sectors where bigger means cheaper

Smartphones, electric vehicles, and even solar energy are sitting in the center of the greatest economic conflict of our time. Over the past decade, the United States and China have been two rams in the fight to dominate the industries that will shape technology and growth. Recently, strategy has fluctuated from Trumpian tariff battles to planned subsidies and governmental policies in the Biden era. Contrasting ideas on how to manage a trade war with China raise an important question: What combination of strategies is the optimal way for these countries to compete in high-stakes markets?

A recent paper by Jiandong Ju (Tsinghua University), Hong Ma (Tsinghua University), Zi Wang (Hong Kong Baptist University), and Xiaodong Zhu (University of Hong Kong) finds that well designed industrial subsidies and government policies like technology share and education investments produce better outcomes for both the United States and China than strictly tariff based approaches. They argue that, because these high-tech industries become more efficient at scale, subsidizing these sectors will lead both countries to expand production, improving general welfare. By contrast, the authors suggest that tariffs instead raise prices and create only temporary, minimal, benefits, leading to less overall welfare increases.

The research is heavily based on the well documented phenomenon of “economies of scale,” the idea that, as an industry grows, production within the industry becomes cheaper and much more efficient. The researchers note that, if governments do nothing to support these economies of scale, their resources will be misallocated, meaning their resources are being spent inefficiently. Ju and his team argue that industrial subsidies can fix the problem of misallocation by helping a country’s industries reach a size where they can benefit from these economies of scale, meaning a company can produce more of a product at a smaller cost per unit, making the company more efficient. They argue that tariffs, in contrast, work by attempting to block foreign competition, but raise prices domestically and stifle efficiency.

To test the hypothesis that industrial subsidies support industry in a way that maximizes welfare for both countries, the research group built a simulation model based on a framework from an earlier paper by Caliendo and Parro¹. While the Caliendo and Parro model was useful, it failed to incorporate economies of scale. Instead, it assumed efficiency would remain constant as companies grew, which is unrealistic because of the high fixed costs required to become established in high-tech industries. Ju and his team developed a model that considered economies of scale using the 2017 OECD Inter-Country Input-Output database, a large data set that tracks how goods and services flow among countries and their industries. Using this model, they simulated how changes in tariffs and industrial subsidies would affect production, trade, and welfare across seven major economies. This approach allowed them to derive the optimal tariff and subsidy rates for each country and to compare the outcomes of tariff wars against industrial policy competition.

The simulations supported the argument that industrial subsidies perform better than tariffs in high-tech industries when accounting for economies of scale. Results showed that, when China subsidized its advanced manufacturing sectors, both the US and China experienced measurable gains in overall welfare because the price of intermediate goods for consumers went down. When tariffs were included in the simulation, global trade became more expensive and overall welfare fell for nearly everyone. The model showed that a mix of well-designed moderate subsidies and low tariffs produced a better outcome for the U.S. than relying solely on tariffs. In terms of global welfare, results showed that when countries coordinated industrial policy instead of hurling tariffs at each other, total global welfare improved the most.

Overall, the study suggests that trade wars do more harm than good in industries that exhibit economies of scale. Ju and his co-authors show that while tariffs can provide a temporary solution for domestic producers, they raise intermediate costs and reduce global welfare. They affirm that when countries apply well-designed industrial subsidies, production in the industries of scale exhibits much higher growth and can even benefit global welfare. Policy makers can use this research’s key finding that strategic investment in a country’s own industry results in greater welfare gains than protectionist trade policy does as a guide when considering whether to deploy tariffs or industrial policy.