Globalisation in the short run....

Globalisation may be good in the long run, but what about the short run? What measures should be taken to compensate local firms whose products cannot compete with developed economies?

In relation to the firm, absolutely nothing! For four good reasons.

1) Firms face all sorts of uncertainties. They may become uncompetitive because of
- Failure to adapt to changing tastes
- Failure to adopt new technology
- Increased domestic competition
- Increased foreign competition
- etc

Facing these risks and trying to remain profitable despite them is what being in business is all about. What is so special about the risk of foreign competition? If we’re going to help out firms by erecting trade barriers when they cannot compete, why not ban new technology to protect firms that fail to adopt that? In both cases, protection is costly for society.

2) “Moral Hazard.” If you have insurance against a fire, you’re less likely to take measures to prevent fires. In the case of fire insurance, such moral hazard is unavoidable. In our context, we can think of governments protecting firms as a form of insurance. If firms believe that the government will protect them, they have less incentive to adapt to changing tastes, adopt new technology, stay competitive, etc. As a result, they’re more likely to need the insurance! But ultimately their failure to try to minimize risks is inefficient.

3) Hysteresis. This term is usually used in economics in relation to unemployment: if the unemployment rate increases, then it may become very difficult to reduce it in future. The same idea applies here. Once a Government has taken steps to protect firms that ‘might’ have gone bankrupt without protection, in future the firm will come to depend on that protection. The firm most likely ‘will’ go bankrupt if that protection is ever removed! So once protection is put in place, it is very difficult to ever remove it. Given that you already agree that globalization is good in the long run, you must agree that protection is bad in the long run….. with hysteresis, it will also be bad in the short run!

4) Creative Destruction. As callous as it sounds, it is good for the economy if firms that cannot make a profit go bankrupt. A firm that cannot return a profit is actually destroying economic wealth by staying in operation. The total value of the inputs they use in production exceed the total value the market places on their output. Society is worse off the longer a wealth-destroying firm stays in operation! This argument applies to both the short and the long run.

Firms should be away of all the risks that they take, and take steps themselves to mitigate them- for example, by diversifying and adapting rapidly to the changing market place. This is efficient. But if the Government really wants to get involved, it should encourage such adjustment- by ensuring a flexible labour market, and maybe providing support for workers who find their skills no longer demanded by an evolving market place to retrain.

Imagine if the Hong Kong Government had decided to try to protect local manufacturers of mass produced goods from competition in Guangdong…..