Free Trade & Protectionism

Ch 22 IB International Economics

Arguments for protectionism If international trade is so good why is it that countries

don’t all trade freely? Why do they often protect their economies from

imports? Here are some of the arguments (some of which are not

valid – evaluation!) Protecting Domestic employment At any given time in an economy there will be some

industries in decline (sunset industries) They cannot compete with foreign competition If the industry is large it will cause high levels of

structural unemployment Governments often attempt to protect the industry

to prevent the unemployment Evaluation – this argument is not very strong;

protecting the industry may just prolong the process of decline Even though there will be short run social costs, it

might be better to let the resources move to other industries expanding other areas of the economy

The negative externalities of a rapidly declining major industry may be so great that government feels it has to protect

Free Trade: no barriers to trade put in place by governments or international organisations

http://www.youtube.com/watch?v=Y2X3KPilAt0

Arguments for protectionism Protecting the economy from low cost labour It is often argued that the main reason for declining

domestic industries is the low cost of labour in exporting countries

The economy should be protected from imports produced in low cost labour countries

Demands in the US to protect domestic clothing against cheap Asian imports

There may be widespread benefits to the economy from but losses (particularly job losses) in particular industries

There is much more job insecurity in the manufacturing industries of developed countries who fear losing their jobs to workers in China and India

Workers and trade unions lobby for protectionism Evaluation

This argument goes against the whole concept of comparative advantage

If the industry is protected consumers will pay higher prices than they should and production will be inefficient

Example: In 1998 the hourly wage for shipbuilding in the US was $19.19 but $9.27 in South Korea. South Korea is now the largest shipbuilder in the world. In 2004 South Korea produced 14,768 large commercial ships whereas the US produced only 289

Arguments for protectionism Protecting the economy from low cost labour Comparative advantage will change over time The US may have had a comparative advantage in shipbuilding at one time As relative factor costs change resources should move freely Supply side policies that focus on labour markets emphasise the importance

of making labour flexible to adapt to changing economic circumstances If governments don’t help create a flexible workforce they will have to

financially help the unemployed caused by increased international competition

Important!!

Arguments for protectionism Protecting and infant (sunrise) industry Many governments argue that new developing

industries do not have the economies of scale advantages

Until it can gain EoS it can’t compete It needs to be protected until it achieves size Evaluation: this argument may not work

for developed countries They have access to capital markets to start

off big Saudi Arabian government recently

diversified into petrochemical production – worked with Chevron, BP and Exxon Mobil to build some of the largest plants in the world

This argument may be more applicable to developing countries but they may not have the international

political power to impose protectionist policies without complains and action from developed countries.

Arguments for protectionism To avoid the risks of over-

specialisation Governments may want to avoid

putting all their eggs in one basket The country could become

dependent on export sales of one or two products

If demand changes there will be serious consequences

The invention of synthetic rubber had a large negative effect on the rubber industry in Malaysia

The oversupply of coffee on the world market causing falling prices did the same for Ethiopia

Evaluation: there are no real arguments against this view!

Example: the development of the quartz crystal severely damaged the Swiss wristwatch industry damaging the economy

Exports of Swiss mechanical watches plummeted from 40 million in 1973 to only three million ten years later.

While some Swiss watch companies did manufacture quartz watches, Japan and Hong Kong dominated the quartz segment and decimated the Swiss industry.

Many small- to medium-sized watch companies in Switzerland closed their doors by the end of the 1970s. The number of workers in the industry plunged from nearly 90,000 in 1970 to 47,000 by 1980

Arguments for protectionism

Strategic reasons It is sometimes argued that

certain industries need to be protected in case they are needed in times of war

E.g. agriculture, steel, power generation

Evaluation: A good excuse for protectionism?! In many cases it is unlikely that countries will go to war and that they will be completely cut off from all supplies

Arguments for protectionism To prevent dumping Dumping can ruin domestic producers Where countries can prove that their

industries have been severely damaged their governments are allowed under international trade rules to impose anti-dumping measures to reduce the damage

Evaluation: it is very difficult to prove Countries argue that when the EU

exports subsidized sugar it is actually dumping because the price doesn’t reflect the actual costs of the EU sugar producers

If dumping happens it is more likely that there will be a need for talks between governments rather than protectionism

Protectionism may invite retaliation reducing the benefits gained by consumers and producers

Dumping: the practice of selling a good in international markets at a price that is below the cost of producing it

Read case study & Answer Q’s P270

Arguments for protectionism To protect product standards A country might wish to impose safety,

health or environmental standards on goods being imported into its domestic market

This will ensure that products match the standards of domestic goods

The EU banned the importing of American beef because it has been treated with hormones

Evaluation: This is a valid argument if the concerns are valid The US don’t believe the EU has a valid

reason as they have no proof that the hormones are bad for consumers

They say it is an excuse for protectionism

The US retaliated in 1999 by imposing trade sanctions on $117m worth of European imports

Arguments for protectionism To raise government revenue In developing countries where it is difficult

to collect tax governments impose import taxes (tariffs) to raise revenue

The IMF estimated that import duties account for approximately 15% of total government revenue in developing countries

Evaluation: This is not so much an argument for protectionism but a reason why it happens

To correct a balance of payments deficit Governments sometimes impose

protectionist methods to reduce import expenditure and improve the current account deficit

Evaluation: This will only work in the short run and does not fix the actual cause of the deficitOther countries may also retaliate

Arguments against protectionism These arguments are really related to the

reasons why countries trade In brief these are

Protectionism raises prices to the consumers and producers of the imports

Leads to less choice for consumersCompetition would diminish and

domestic firms would become inefficient (innovation may also be reduced)

Comparative advantage is distorted leading to inefficient use of world resources

Economic growth will be reduced

Types of Protectionism Before we look at the types of

protectionism we are going to look at how we illustrate a country that has free trade (we will use wheat as an example)

If there is no foreign trade the domestic farmers would produce Qe tons of wheat and the price will be Pe

If we then introduce foreign trade and the world price is Pw which lower than Pe the situation changes

Consumers can now import as much wheat as they like at the lower price

The world supply curve is perfectly elastic because there are so many suppliers (it doesn’t really matter how much demand there is it will not affect the price)

Sworld has to be lower than Pe otherwise there would be no point in trading

Types of Protectionism With free trade the price of what

will be Sworld At this price domestic farmers will

only be prepared to supply Q1 tons but the demand will be Q2

Imports will satisfy the surplus demand

Q1Q2 tons of wheat will be supplied by foreign suppliers

Consumers get to consume QeQ2 more at the lower price

Lets now apply some different types of protectionism

Insert fig 24.1

Types of Protectionism - Tariff A tariff is a tax that is charged on an imported

good Any tax will cause suppliers to supply less (less

profit to be made) The world supply curve will shift upwards (the tax

is not applied to the domestic producers) We can see that the price goes up to Pw+t At this price domestic suppliers will only supply

Q3 This is more than before but there is still excess

demand (just less than before) Foreign suppliers will supply Q3Q4 which is less

than before Domestic producers revenue increases from go to

g+a+b+c+h Foreign producers receive Pw+T but they have to

pay the tariff to the government so their revenue falls from h+i+j+k to only i+j

The government receives revenue of d+e One of the issues is that importers pay a higher

price for the wheat They sell the more expensive wheat onto millers

and the flour is used to make cereals etc This may cause food inflation

Types of Protectionism - Tariff

Two more things happen Firstly because some

wheat is not purchased there is a dead-weight loss of welfare

Q4Q2 tons of wheat are not now demanded

Consumers keep the amount k that they would have spent on wheat

There is a loss of consumer surplus equivalent to f

This is dead weight loss

Types of Protectionism - Tariff Secondly, after the tariff, the wheat

is produced by relatively inefficient farmers (compared to the foreign farmers) Foreign farmers would produce

this quantity for a minimum revenue of h

Domestic producers need a minimum revenue of h+c

c represents the inefficiency of the domestic producers and a loss of world efficiency (more of the world’s resources are being used to produce the wheat than necessary)

This is another dead weight loss of welfare Complete student workpoint

22.3

Types of Protectionism - Subsidies

A subsidy is an amount of money paid by the government to a firm per unit of output

In this instance government is giving the subsidy to the firm to make it more competitive

The domestic supply curve will shift downwards reducing the price

This means that domestic producers will supply Q3 wheat to the market instead of Q1

foreign supply will decrease from Q1Q2 to Q3Q2

Domestic revenue increase from a to a+b+e+f+g

Foreign revenue decreases from b+c+d to c+d

Government has to pay out e+f+g

Types of Protectionism - Subsidies At this tariff Q1Q3 tons of what

are now produced by relatively inefficient farmers

Foreign farmers would produce for revenue b

Domestic farmers would produce for b+g

g represents the inefficiency (misallocation of world resources) – dead-weight loss of welfare

There is no loss of consumer surplus because price does not change

Consumers are indirectly affected as governments use tax revenues to fund the surplus

This could lead to higher taxes and is an opportunity cost – government could spend the taxes on other things

Complete student workpoint 22.4 P275

Types of Protectionism - Quotas Quotas are a physical limit on the

numbers or value of goods that can be imported into a country

The EU imposes quotas on Chinese garlic and mushrooms

This has a strange effect on the free trade diagram

Let us assume that the government imposes a quota of Q1Q3

Domestic producers supply Q1 Foreign suppliers produce Q1Q3 There is still excess demand of Q3Q2 at

the price Pw and so the price begins to rise

As the price rises importers are not allowed to supply more

Domestic producers begin to enter the market attracted by the high price of wheat

The domestic supply curve shifts to the right above Pw

Eventually the price settles at Pquota and the Quantity drops to Q4

Types of Protectionism - Quotas Domestic producers now supply Q1 and

Q3Q4 tons of wheat at a price of Pquota Their revenue rises from a to a+c+d+f+i+j Foreign producers now supply their quota

of Q1Q3 at Pquota Their income changes from b+d+c+e to

b+g+h This is a fall in income but in theory does

not have to be There are two areas of dead-weight loss

of welfare caused by the quota Consumer surplus loss of k because

wheat is not purchased Q3Q4 tons of wheat are now

produced by relatively inefficient foreign farmersForeign farmers would produce

for c+dDomestic farmers produce for

c+d+j J is the loss of world efficiency Complete student workpoint

24.4

Types of Protectionism – Voluntary export restraints (VERs)

VERs are agreements between exporting and importing countries in which the exporting country agrees to limit the quantity of exports of a specific good below a certain level

China has agreed to limit its export of textiles to South Africa

Types of Protectionism – Administrative barriers

When goods are imported there are always administrative processes e.g. paper work to be stamped etc

This is called red tape These can take time and make it

difficult for exporters It can also raise their costs Sometimes countries may

designate certain ports of entry that are difficult to reach and also more expensive

This is designed to put off the exporter

Complete workpoint 24.6 for homework

Types of protectionismHealth and safety standards and

environmental standards This is when restrictions are put on the

types of goods that can be sold in the domestic market or on the way they are manufactured

They may set quality or safety standards that are hard to meet

The certification may be very difficult and expensive to gain

It is important that government looks after its people but important that the country is behaving legitimately

Embargoes Complete ban on imports US has not traded with Cuba for 50

yearsNational campaigns Marketing campaigns to encourage

people to buy domestic goods

Time for you to do some work!!Complete the data response question on P280

HL Bit! Together we will work

through the example on P276

Time for you to do some work!!Complete the higher level paper 3 question on P279