Free Trade and Protectionism

(4.2)

Free Trade

• Free trade is the total absence of any from of intrusions, or barrier in the flow of goods and services between countries which disadvantages foreign firms in favor of domestic firms.

• Free trade means that the only additional disadvantage experienced by a firm on a foreign market arises due to transaction cost such as foreign exchange costs, transportation costs and poorer market knowledge and closeness to foreign markets.

Cont.

• Protectionism can be widely regarded as any form of action taken by a country whereby the ratio of the price of domestic goods to imported goods goes down. – McGee Matt. “Ecomimics – In terms of The Good,

The Bad and The Economist.”

Types of Protectionism

• Tariff – A tax that is charged on imported goods.

• It can be a tax on the quantity of the product/service or a tax based on the volume of the product/service.

• Before the tariff, 0Q2 tons of wheat were being consumed at a price of PW.

• Domestic production was 0Q1 and imports were Q1Q2.

• When the tariff is imposed, S (World) shifts up by the amount of the tariff to S (World)+tariff and so the market price rises to P+T.

• Total quantity demanded falls from 0Q2 to 0Q4, because the price has risen.

• Domestic producers increase production to 0Q3 and so their revenue increases from g to g+a+b+c+h.

• Foreign producers supply the rest, which is now Q3Q4.

• They receive P+T, but have to pay the tariff to the government.

• Thus their revenue falls from h+i+j+k to only i+j.

• The government now receives tariff revenue of

• d+e.

• The importers must pay a higher price for the imported good. In the case of wheat, the higher price will be passed on to millers and eventually to the cereal companies or bakeries that buy the refined wheat.

• As another example, if a government introduced a tariff on automobile component parts, then this would raise the costs to car- makers and eventually lead consumers to have to pay higher prices for their cars.

• If the car-maker is an exporter, then the higher cost of imported components could reduce its international competitiveness.

• Tariffs are the most common type of anti-dumping measure.

• If a country has been able to prove that dumping has taken place, then it can place a tariff on the imported goods to raise their prices and eliminate the cost advantage of the dumped imports.

Subsidies

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

• In this case, the government is giving a subsidy to domestic producers to make them more competitive and so the effect will be to shift the domestic supply curve downwards by the amount of the subsidy.

• Before the subsidy, 0Q2 tons of wheat were being consumed at a price of PW

• Domestic production was 0Q1 and imports were Q1Q2.

• When the subsidy is granted, S (Domestic) shifts downwards by the amount of the subsidy to S (Domestic)+subsidy.

• The market price stays at P, and so demand remains at 0Q2.

• However, domestic producers increase production to 0Q3, because they are now receiving PW+subsidy per unit that they produce.

• This means that their revenue increases from a to a+b+e+f+g.

• Foreign producers supply the rest, which is now Q3Q2.

• So their revenue falls from b+c+d to only c+d.

• The government pays the subsidy, which is shown by the area e+f+g in total.

• As with a tariff, Q1Q3 tons of wheat are now produced by relatively inefficient domestic farmers, as opposed to more efficient foreign farmers.

• The foreign farmers would produce this quantity for a minimum revenue of b, whereas the domestic producers need minimum revenue of b+g.

• Thus g represents the inefficiency of the domestic producers and a misallocation of the world’s resources, since more of the world’s resources are being used to produce the wheat than are necessary.

• This is another dead-weight loss of welfare.

• There is no loss of consumer surplus, because the price of the wheat does not change.

• However, consumers are indirectly affected as governments will use tax revenues to fund the subsidies.

• This may mean higher tax payments and also involves an opportunity cost in terms of reduced government spending on other things.

Quotas

• A quota is a physical limit on the numbers or value of goods that can be imported into a country.

• The introduction of quotas will have an impact on free trade as shown in the diagram.

• Before the quota is imposed, 0Q2of wheat is purchased at a price of PW.

• Domestic supply is 0Q1 and imports are Q1Q2.

• Let us now assume that the government imposes a quota of Q1—Q3 tons of wheat.

• Domestic producers supply 0Q1 at a price of PW and the importers produce their quota of Q1

—Q3. • However, once this has

happened, there is an excess demand of Q3—Q2 at the price PW and so price begins to rise.

• As the price rises, importers are not allowed to supply more wheat, because they have filled their quota, and domestic producers begin to enter the market, attracted by the higher price of wheat.

• The domestic supply curve has, in effect, shifted to the right, above PW

• Eventually, the price settles at PQuota’ where demand now equals supply again and the total quantity of wheat demanded falls to Q4.

• Domestic producers now supply 0Q1 and Q3—Q4 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 tons of wheat and also receive a price of PQutoa

• Thus their income changes from b+c+d+e to b+g+h.

• This is usually a fall in income but, in theory, it does not have to be.

Loss

• Less wheat is demand, consumers spend less money on wheat. Also loss is the extra wheat that is available to the consumers.

• Wheat will also be produced more inefficiently by the local farmers when foreign farmers could produce it more efficiently.

Voluntary export restraints

• 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.

• This is usually to avoid the imposition of legal restrictions by the importing country.

• The agreement may be reached at either industry or government level.

Administrative barriers

• When goods are being imported, there are usually administrative processes that have to be undertaken.

• This may be known as ‘red tape”. • If these processes are lengthy and complicated,

then they can act as a restriction to imports. • For example, making importers go through

complicated paperwork, before they can get their goods into a country, will slow down imports

• In addition, if the paperwork requires a large amount of legal work, then it will slow the process down even more and raise the cost to the importer.

• Sometimes, countries may designate certain ports of entry that are difficult to reach and also more expensive.

• This may cause border delays and again raise costs.

Health and safety standards and environmental standards

• This is where various restrictions are placed upon the types of goods that can be sold in the domestic market, or on the methods used in the manufacture of certain goods.

• These regulations will apply to imports and may restrict their entry.

• While it is important that countries are able to guarantee the health and safety of their population by preventing the import of unhealthy or unsafe goods, it is extremely important that governments are legitimately keeping out imports rather than simply protecting their own country’s workers.

• While the maintenance of product standards is extremely important, developing country exporters face a particular difficulty in this regard as they may find it difficult or prohibitively expensive to carry out the necessary certification to prove that they meet the international standards.

• The costs involved in certification may make it difficult for such countries to successfully exploit their comparative advantage.