13.2: Free Trade and Protectionism

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    Definitions

     

    1. Free trade takes place between countries without any barriers (such as tariffs, quotas or subsidies) put in place by governments or government organizations. Goods and services are allowed to move freely between countries.
    2. Protectionism refers to policies that aim to restrict the flow of imports into a country and/or create an absolute advantage to exporting firms.
    3. Tariff is an import barrier that charges tax on imported goods in order to protect domestic industries from foreign competition and raise revenue for the government.
    4. Quota is an important barrier that sets a physical limit on the quantity or value of goods imported into a country.
    5. Subsidy is the amount of money paid by the government to a domestic producer, per unit of output, to encourage output and give the firm an advantage over foreign competition. The domestic supply curve shifts downward by the amount of subsidy.
    6. Dumping is the selling by large quantities of a good in another country, at a price lower than its production cost, or at a price significantly below the price in the domestic market.
    7. Anti-dumping tariffs/measures is a legislation that protects an economy against the importing of a good at a price below its unit cost of production. The aim of the tax is to equate the price of the good being dumped with the domestic price of the good.

     

    Arguments for protectionism

     

    1. Protecting domestic employment.

    • There will be some industries that are in decline because they can’t compete with foreign competition.
    • Large industries → High levels of structural unemployment → Government often attempt to protect the industries in order to avoid the unemployment.
    • This isn’t very strong, since the industry continue to decline and protectionism will make the process go even longer.
    • Negative externalities of a declining industry → Governments intervene and protect the declining markets.

     

    2. Protecting the economy from low-cost labor.

    • Low cost of labor in exporting countries + Economy protecting from imports that are produced in countries where cost of labor is very low.
    • Greater job insecurity among manufacturing workers in developing countries as workers fear they are going to lose jobs to workers in developed countries.
    • However, domestic consumers would have to pay products at a higher price and production in the protected economy would be inefficient.
    • A country with a comparative advantage in the present might not have comparative advantage in the future as it tends to change rapidly.

    3. Protecting an infant (sunrise) industry.

    • New industries doesn’t have the same economies of scale advantages compared to larger industries, particularly foreign industries.
    • Domestic industries won’t be as competitive against foreign imports until it can gain the cost advantages of economies of scale.
    • Governments product new domestic industries from foreign firms until they are able to compete with them equally.
    • However, this argument isn’t valid in highly developed countries as there’s no way small firms would benefit from economies of scale and high efficiencies due to access of large amounts of financial capital.
    • Developing countries use this argument to justify protectionist policies as they don’t have sophisticated capital markets.

    4. To avoid risks of over-specialization.

    • Governments may want to limit over-specialization as it leads to firms relying too much on one product that sells the most in an economy.
    • Any changes in specialized products would change the country’s economy severely.

    5. Strategic reasons.

    • Some industries are protected in case they are needed at times at war.
    • These industries include steel, agriculture and power generation.
    • It is unlikely that every country will go towards war, and if they do, they’ll be completely cut off from these supplies.

    6. To prevent dumping.

    • Dumping is selling by a country of large quantities at a price lower than its production cost in another country.
    • Governments impose anti-dumping tariffs to countries to eliminate or reduce the damage their economy had to go through because of dumping.
    • Difficult to blame foreign countries for dumping.
    • Governments that subsidizes a domestic industry could support dumping.
    • Danger that it might lead to retaliation.
    • Reduces consumer and producer benefits of lower costs in all countries.

    7. To protect product standards.

    • Countries might wish to impose safety, health or environment standards on goods being imported into domestic market in order to ensure quality of imports = quality of products in the domestic market.
    • Costs of trade barriers is very high and it’s time consuming.
    • Developing countries might have a hard time to obtain comparative advantage as the documentation for approval of the products takes up a long time.

    8. To raise government revenue.

    • Difficult to collect taxes, so governments impose tariffs on products in order to take revenue.
    • Import duties are on the consumers rather than the government as they are the ones buying the imports.

    9. To correct a balance of payments deficit.

    • Attempt to reduce import expenditure → Improves current account deficit.
    • This is only effective in the short run.
    • It doesn’t address the actual problem and it leads to retaliation from other countries.

     

    Arguments against protectionism

     

    1. Raise prices to consumers and producers of the exports that they buy.

    • Results in less consumers buying exported goods or services as higher prices leads to less spending by consumers as they wait for the prices to go lower.
    • Producers in exporting industries will have to produce less products as they have to spend more on the production of the product.

    2. Less choice for consumers.

    • Consumers are limited to having products from foreign countries.
    • Might not get the best available product as the quality from the same product produced domestically might be low compared to foreign countries.

    3. Minimized competition.

    • There would be less competition as foreign firms are kept out of the country.
    • Domestic firms would become less efficient without the incentive to minimize costs as they barely have competition for their industry.
    • Innovation will be reduced for the same reason because domestic firms aren’t facing up to foreign firms for intense competition.

    4. Distorts comparative advantage.

    • This leads to inefficient use of the world’s resources.
    • Results in reduced specialization → Reduce potential level of the world’s output.

     

    5. Hinders economic growth.

    • Restrictions on foreign countries involved in a country would lead to lower economic growth as there won’t be a growth in sales and resources aren’t allocated properly.

     

    Types of protectionism

     

    1. Tariffs

    • Tax on imported goods.
    • Shifts world supply curve upwards.

    • Domestic producers: E → A + B + E + F
    • Foreign producers: F + G + H → G
    • Government: 0 → C
    • Loss of consumer surplus: D
    • Deadweight loss: B and D

    ●       Advantages of tariffs:

    • Domestic producers are able to sell more at a higher price → Increased profits → Increased employment in domestic industries.
    • Government revenue is increased → Decreased unemployment concerns → Spend more on merit goods and services that would benefit majority of the society.

    ●       Disadvantages of tariffs:

    • Foreign producers sell less at the same price → Decreased profits → Increased unemployment in foreign industries.
    • Consumers consume less at a higher price → Loss of consumer surplus.
    • Production shifts from efficient foreign producers to less efficient domestic producers → inefficient resource allocation.

     

    2. Subsidies

    • Amount of money paid by the government to a firm, per unit of output.
    • Shifts supply domestic curve to the right.

    • Domestic producers: D → A + B + C + D + E
    • Foreign producers: E + F → F
    • Government subsidy: A + B + C
    • Deadweight loss: C + E

    ●       Advantages of subsidies:

    • Domestic producers are able to sell more at a higher price → Increased profits → Increased employment in domestic industries.

    ●       Disadvantages of subsidies:

    • Foreign producers sell less at the same price → Decreased profits → Increased unemployment in foreign industries.
    • Governments have to increase their spending, which leads to less government revenue for the government when providing a subsidy.
    • Consumers are indirectly affected by subsidies by paying tax revenues to the government.

     

    3. Quotas

    • Physical limit on number/value of goods that can be imported into a country.
    • Harsher form of protectionism.

    • Domestic producers: J → A + D + E + K + L
    • Foreign producers: K + L + M → B + C + K
    • Government: None
    • Deadweight loss: J + K
    • Loss of consumer surplus: K

    ●       Advantages of quota:

    • Domestic producers are able to sell more at a higher price → Increased profits → Increased employment in domestic industries.

    ●       Disadvantages of quota:

    • Foreign producers sell less at the same price → Decreased profits → Increased unemployment in foreign industries.
    • Consumers consume less at a higher price → Loss of consumer surplus.
    • Production shifts from efficient foreign producers to less efficient domestic producers → inefficient resource allocation.
    • Government doesn’t earn revenue from a quota → Less spending on merit goods.

    4. Administrative barriers

    ●       Red Tape:

    • Lengthy and complicated process to producing imports → Restriction to the goods.
    • Lengthy paperwork and requiring large amount of legal work → Slow downs the process and raises the cost to the importer.
    • Countries may designate certain areas that are difficult to reach and more expensive → Border delays and raises costs.

    ●       Health, safety and environmental standards:

    • Restrictions may be placed on goods that are sold in the domestic market or the methods used to manufacture the goods.
    • Apply to imports and may restrict their entry.
    • It’s important for governments keeping out imports than protecting domestic workers.

    ●       Embargoes:

    • Extreme quota → Complete ban on imports.
    • Form of political punishment.

     

    5. Nationalistic campaigns

    • Governments run marketing campaigns to encourage consumers to spend on domestic products rather than foreign ones.
    • Increases demand for domestic goods and preserve domestic jobs.
    • Lead to moral suasion as government links consumption of imported goods to the creation of unemployment.

     

    Paper 3 Question

     

    1. Subsidies

    Below is the market for cooking oil in a country. The world price for cooking oil is $1 and the government provided a subsidy of $0.25.