Free trade can be defined as the situation whereby governments impose no artificial barriers to trade that restrict the free exchange of goods and services between countries with the aim of protecting domestic producers from foreign competitors.
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The argument for free trade is based on the economic concept of comparative advantage. Comparative advantage is the economic principle that nations should specialize in the areas of production in which they have the lowest opportunity cost and trade with other nations, so as to maximize both nations’ standards of living.
|Advantages |Disadvantages | |Free trade allows countries to obtain goods and services that the |An increase in short term unemployment may occur as some domestic | |cannot produce themselves, or in sufficient quantities to satisfy |businesses may find it hard to compete with imports. However, the short| |domestic demand. |term rise in unemployment should correct itself in the long term, as | | |the domestic economy redirects its resources to areas of production in | | |which it has a comparative advantage. | |Free trade allows countries to specialize in the production of the |Free trade can create barriers that make it more difficult for new | |goods and services in which they are most efficient. This leads to a |businesses and new industries to emerge as they are not protected from | |better allocation of resources and increased production within |larger foreign companies. | |countries, and throughout the world. | | |Free trade encourages the efficient allocation of resources.
Resources |A process called ‘dumping’ may occur wherein production surpluses from | |will be used more efficiently because countries are producing the goods|some countries are sold at unrealistically low prices on the domestic | |in which they have a comparative advantage. |market, pricing efficient domestic industries out of the market and | | |harming them. | |A greater tendency for specialization leads to economies of scale, |Free trade may produce negative externalities i.e. child labor. | |which will lower average costs of production and increase efficiency | | |and productivity even further. |Free trade may encourage environmentally irresponsible production | | |methods because some producers in some nations may produce goods at a | | |lowest cost due to weaker environmental protections and environmentally| | |damaging practices within that nation. | |International competitiveness will improve as domestic businesses face
|Allocation of resources will tend to move to the more efficient and | |greater competitive pressures from foreign producers, and governments |competitive producers. | |will encourage domestic industrial efficiency. | | |Free trade encourages innovation and the spread of new technology and | | |production processes throughout the world. | | |The opening up of global markets leads to higher rates of economic | | |growth and increased real incomes. Hence, free trade leads to higher | | |living standards. This is a result of lower prices, increased | | |production of goods and services and increased consumer choice as | | |countries have access to goods that a lack of natural resources may |
| |otherwise prevent. | |
REASONS FOR PROTECTION
Protection refers to government policies that give domestic producers an artificial advantage over foreign competitors.
New industries generally face many difficulties and risks in their early years. They usually start out on a small scale, with costs that are proportionately and relatively higher than the more established films competing in the international arena due to economies of scale. Hence, it is argued that these ‘infant industries’ require protection in the short run to enable them to expand their scale and reduce their costs of production so that they may compete with the rest of the world.
For this argument to be valid, protection should only be temporary, otherwise there would be no real incentive for industries to reach a certain level of efficiency so that they can compete viably without protection.
Historically, industries that have received assistant as infant industries have continued to rely of this assistance for many years. The infant industries argument has been used as a pretext referring to industries that would never have survived otherwise, hence economists do not generally accept the infant industry argument as an argument in favor of protection. When governments provide help to new industries now, this tends to involve direct assistance and lasts for a very limited time.
Prevention of Dumping
The process of dumping may be used to dispose of large production surpluses or to establish a market position in another country. These low prices are usually only of a temporary nature however they can harm domestic producers as they cannot compete, forcing them out of business, hence causing a loss in a country’s productive capacity and resulting in higher unemployment.
The only gain from dumping is that consumers will benefit from lower prices in the short term, but is is only temporary as producers will put up their prices again once the local competition is eliminated. Under such circumstances, it is generally into economy’s best interest to impose restrictions on such imports. Using protectionist methods to prevent dumping is considered to be the only reason for protection that is widely accepted by economists. Despite this, in recent years the WTO has questioned whether countries might be abusing their entitlement to prevent dumping and falsely accusing efficient low-cost foreign producers of dumping as an excuse to give domestic producers an artificial advantage.
Protection of Domestic Employment
One of the most popular arguments in favor of protection is that it saves local jobs. If local producers are protected from competition with cheaper foreign imports, the demand for local goods will be greater – labour as a derived demand of the demand for goods and services, will be in higher demand, hence creating more domestic employment.
Despite this, there is little support amongst economists for this argument. Protection tends to distort the allocation of resources in an economy away from more efficient production towards areas of less efficient production. In the long run, this is likely to lead to higher levels of unemployment and lower growth rates. On the other hand, by phasing out protection it is is hoped that better and more lasting jobs will be created in sectors that are more internationally competitive. Furthermore, if a country protects its industries, it is possible that other countries could retaliate and adopt similar protectionist policies. The net result could be that the economy would maintain employment in less efficient protected industries but lose employment in more efficient export industries.
Defense and Self-Sufficiency
Defense: so that they can be confident that in a time of war that they would still be able to produce defense equipment.
Self-sufficiency of food supplies. Historical reasons… When a country adopts this approach it must accept that it may gain self sufficiency at the expense of higher living standards that would be achieved from specialization and free trade.
Trade unions often argue that producers should be protected from competition with countries that produce using low-cost labour. This is seen as a means to protect the better living standards of workers in high income economies. It is related to another argument that it is unethical to buy products from countries that may use unethical practices I.e. child slavery, because it would further encourage the exploitation of these people.
Countries may sometimes block trade in goods because of environmental factors, such as the environmental harm involved in the production of certain goods. Overseas producers may be able to produce some items cheaply because the producers are environmentally irresponsible and do not have to comply with the tougher environmental standards that apply in advanced economies.
Eg: 2011 Live Cattle Export Crisis
Australian export restrictions of live cattle were imposed in 2011 because of the deemed unethical treatment that Indonesia treated the live cattle with. Offended by Australian criticisms of its animal welfare standards, Indonesia announced that it would reduce the number of import permits issued for Australian cattle by around 2/3rds, and buy more live cattle from other countries instead.
METHODS OF PROTECTION
A tariff is a government imposed tax on imports. It has the effect of raising the price of the imported goods, making the domestic producer more competitive domestically.
Figure 2.2 reveals the following:
The curves SS and DD represent domestic supply and demand.
P is the price of imported goods if there was no tariff applied. At this price consumers demand Q1 domestic producers supply Q1 and the quantity imported would be QQ1 If a tariff of PP1 is imposed, all of which is passed to the consumer, demand will contract to Q3, domestic supply will expand to Q2, and imports will fall to Q2Q3 Following the imposition of the tariff the government will raise revenue of ABCD
|Economic Effects of a Tariff | |Domestic producers supply a greater quantity of the good. Tree fore the tariff stimulates domestic production and employment | |More domestic resources are attracted to the protected industry. This leads to a reallocation of resources towards less efficient producers | |Consumers pay a higher price and receive fewer goods. This redistributes income away from consumers to domestic producers. | |Tariff raises government revenue | |Retaliation effect can be experienced. In that case any increased production and employment gains for the import-competing industries would be | |offset by losses in the nation’s export industries. |
An import quota controls the volume of a good that is allowed to be imported over a given period of time. The quota guarantees domestic producers a share of the market.
Figure 2.3 reveals the effect of an import quota:
The curves SS and DD represent domestic supply and domestic demand P is the price at which the imported goods would sell if there was no quota imposed. At this price consumers demand Q1, domestic producers would supply Q, and the quantity imported would be QQ1 If the government imposed a quota restricting the imports to Q2Q3, this would have the effect of raising the price of imported goods to P1. This price would allow domestic supply to expand to Q2
|Economic Effects of a Quota | |Domestic producers supply a greater quota of the good. Therefore the quota stimulates domestic production and employment | |More resources in the economy are attracted to the protected industry. Therefore there will be a reallocation of resources from other sectors | |of the economy | |Consumers pay a higher price and receive fewer goods.
This redistributes income away from consumers to domestic producers in the protected | |industry, and results in lower overall levels of economic growth. | |Quotas do not generate revenue, however govt can raise a small amount of revenue by administering the quota through selling import licenses | |allowing firms to import a limited number of goods | |As with tariffs, the imposition of a quota on imports can invite retaliation from the country whose exports may be reduced because of the | |quota. This can result in lower exports for the country that initiated the import quota. |
Countries may also use tariff quotas. Goods imported up to the quota pay the standard tariff rate, whereas goods imported above the quota pay a higher rate.
Subsidies involve financial assistance to domestic producers, which enables them to reduce their selling price and compete more easily with imported goods.
In Figure 2.4 this is shown by a rightward shift of the domestic industry’s supply curve from SS to S1S1, which results in a lower market price P1. Businesses will be able to sell a higher quantity of their product on both domestic and global markets. The quantity produced increases from Q –> Q1 The size of the subsidy in per unit terms is the vertical distance between
the S and the S1 curves
|Economic Effects of a Subsidy | |Domestic producers supply a greater quantity of the good. Therefore, the subsidy stimulates domestic production and employment in the protected| |industry. | |More resources in that economy are attracted to the protected industry, leading to a reallocation of resources from other sectors of the | |economy where production and employment will fall. | |Consumers pay a lower price and receive more goods, however they pay indirectly whether they buy it or not through higher taxes. | |Subsidies impose direct costs on government budgets. This means that governments have fewer resources to allocate to other priorities | |i.e.education and health care | |While economists are generally opposed to protectionist policies, they often prefer a subsidy over a tariff because subsidies tend to be | |abolished more quickly since they impose costs on the budget, rather than generating revenue. |
Local Content Rules specify that goods must contain a minimum percentage of locally made parts. The return is that the imported component does not attract a tariff. AUS used this to protect its motor vehicle industry in the past.
Export Incentive Programs give domestic producers assistance such as: Grants
Technical advice (marketing, legal info)
Encourage businesses to penetrate global markets or expand their market share
The popularity of such programs has grown considerably in recent years as nations have moved to a greater focus on capturing foreign markets, rather than protecting import-competing businesses, as a strategy to achieve higher rates of economic growth and employment.
Technically, export incentives do not protect businesses from foreign competition in the domestic market, but they are nevertheless artificial barrier to free trade.
|Overall Economic Effects of Protectionism ($$) | |In addition to the effects that protectionist policies have on domestic economies, they can also have overall impacts on the global economy. | |Global protectionist policies have the overall effect of reducing trade between nations. The WTO has cited research estimating that a | |far-reaching Doha agreement would remove protectionist policies that are currently costing the global economy between $US 180billion to $US | |520billion in exports every year. | |Overall, protectionist policies reduce living standards and reduce global economic growth by shielding inefficient producers.
The Institute for| |International Economics in Washington DC has estimated that protectionism is reducing gross world product by between $US 300billion and $US | |700billion each year. | |Protectionist policies make it more difficult for individual economies to specialize in production in which they are most efficient. Businesses| |are less able to achieve economies of scale and therefore have lower profits and lower dividends. With less competitive pressures, prices for | |goods and services in individual economies are higher. | |The negative economic impact of the protectionist policies of trading blocs tends to be greatest for developing economies, which are excluded | |from access to the markets of advanced economies. |
Doha agreement: an agreement that is aimed at achieving major reform of the international trading system through the introduction of lower trade barriers and revised trade rules. A trading bloc occurs when a number of countries join together in a formal preferential trading arrangement to the exclusion of other countries.
Different countries have different factor endowments and intensities. Nations engage in international trade as a means of specializing in production, increasing the productivity of their resources and realizing a larger output and economies of scale than by pursuing self sufficiency or autarky. Free trade occurs when there is an absence of protective barriers such as tariffs, quotas, subsidies and voluntary export restraints, which tend to divert trade, rather than create trade or new trade flows.
[economic independence or self sufficiency].
A reason for a country specializing in the production of goods in which it has a comparative advantage–the economic principle that states that even if one country can produce all goods more efficiently than another, trade will benefit both countries if each specializes in areas of production that have the lowest opportunity cost and trade with other nations–is that overall standards of living will be maximized for the nations in which trade is occurring between.
Figure 1 shows this. Country X has an absolute advantage in the production of both computers and wheat. According to the principle of comparative advantage, Country X is more efficient in producing computers than Country Y since the opportunity cost of wheat production is 1 unit of wheat in Country X, compared to 2 units of wheat in Country Y. Hence Country X has a comparative advantage in computers. However, Country Y has the comparative advantage in wheat, with an opportunity cost of 0.5 computers per unit of wheat, while Country X has an opportunity cost of 1 computer.
Through specialization, Country X can produce 100 computers and Country Y 80 units of wheat, or 90 computers and 10 units of wheat for an overall 90 computers and 90 units of wheat within the hypothetical economy, 20 more than the aggregated 70 computers and 90 units of wheat if each country was to produce with half their resources for one good and half on the other.
Free trade has several other advantages:
Free trade allows countries to obtain goods and services that they cannot produce themselves, or in sufficient quantities to meet domestic demand due to a lack of adequate resources.
Free trade allows countries to specialize in the production of goods and services in which they have a comparative advantage. This leads to a better allocation of resources and increased production within countries, and throughout the world.
Free trade encourages the efficient allocation of resources. Resources will be used more efficiently because they are being used in the production of goods in which they have a comparative advantage.
Free trade leads to a greater tendency for specialization, which should result in economies of scale as seen in Figure 2 wherein average costs decrease with an increase in output.
International competitiveness will generally improve due to free trade as domestic businesses face greater competitive pressures from foreign producers, and because of governments encouraging domestic industrial efficiency.
Free trade encourages innovation and the spread of new technology and production processes throughout the world because of increased competition.
Free trade typically leads to higher rates of economic growth and increased real incomes, leading to higher living standards; this is a result of low prices, increased production of goods and services and increased consumer choice.
Although free trade has clear benefits in theoretical terms, it can lead to a number of disadvantages.
The imposition of free trade tends to result in a short term increase in unemployment as some domestic producers may find it hard to compete with imports. However, this generally corrects itself in the long term as the domestic economy redirects its resources to areas of production in which it has a comparative advantage.
Free trade may make it more difficult to establish new businesses and new industries if they are not protected from larger foreign competitors as new businesses and industries generally have higher costs in the starting phases because of a lack of scale, hence they would find it harder to compete.
Free trade may result in ‘dumping’ wherein foreign countries may sell goods in the domestic market for unrealistically low prices to sell off their production surpluses or to establish a market position, hurting efficient domestic industries.
Free trade may encourage environmentally or ethically irresponsible production processes because producers in some nations are able to produce goods at a lower cost due to weaker regulations or enforceability of these deemed irresponsible production practices.
Alternatively to free trade is protection. Protection refers to any artificial advantage given by governments to domestic industries to protect them from international competition.
Free trade relies upon the interplay of market forces to secure the benefits that derive from it[efficient resource allocation, higher living standards and greater competition from international specialization and exchange]. However, in reality, historically most countries have tended to impose at least some forms of protection to assist local producers in the face of foreign competition.
This is primarily for these reasons:
‘Infant Industries’ arguably need temporary protection to expand their scale and reduce their costs of production so that they can compete viably in the global market as they usually start on a small scale with higher costs (see Figure 2). In theory this argument is plausible, however in practice, industries have tended to rely on this assistance for many years without a real incentive to reach a level of efficiency so that they are able to compete without protection. For this reason, governments tend to involve direct assistance when helping infant industries that lasts for a very limited time.
Protection is used to prevent dumping that may harm domestic producers, potentially forcing them out of business and causing a loss in a country’s productive capacity and higher unemployment. Using protectionist methods to prevent dumping is considered to be the only reason for protection that is widely accepted by economists. Despite this, in recent years the WTO has questioned whether countries might be abusing their entitlement to prevent dumping as an excuse to give domestic producers an artificial advantage.
One of the most popular arguments for protection is that it saves local jobs. This is on the premise that if domestic producers are protected from foreign competition, the demand for local goods will be greater and hence, labour as a derived demand of the demand for goods and services, will be demanded at a higher level. Despite this, protection tends to distort the allocation of resources in an economy away from efficient production towards area of less efficient production and in the long run, this is likely to lead to higher levels of unemployment and lower growth rates. Furthermore, other countries may retaliate with similar protectionist methods.
Some arguments used to justify protection may not be solely based on economic grounds. For example, major powers generally want to retain their own defense industries so that they can be confident during times of war that they would still be able to produce defense equipment. Similarly, protection may be used for self-sufficiency of food supplies – for example, Japan experienced famine twice in the 20th Century due to wartime blockades that prevented imports of food supplies.
Trade unions in advanced economies often argue that producers should be protected from competition with countries that produce using low-cost labour. This is to protect the better living standards of workers in high income economies and to not endorse unethical practices that exploit people in less developed nations. Countries sometimes block trade of goods because of environmental factors, such as the environmental harm involved in the production of certain goods in some foreign nations. Environmental regulations across countries are not universal, hence protection is arguably better for the global environment overall.
Main protectionist policies include: tariffs, quotas, subsidies, local content rules and export incentives.
A tariff is a government-imposed tax on imports, making domestic producers relatively more competitive. [pic]