Restrictions on Free Trade

Although free trade ensures that global output is maximised as countries produce the goods and services where they enjoy comparative advantage, all countries operate some kinds of protectionism, aimed at either reducing imports or increasing exports. The main protectionist measures are as follows:

Quotas

A __quota __is a physical restriction on the quantity of imports. The effect of a quota can also be shown with reference to Fig 1.

Suppose a quota is introduced restricting imports to a maximum of BC. The diagram shows that the market quantity will again be OC, as the foreign producers will be able to sell all they are allowed to export at price OL. Once again, domestic producers will now be willing to sell OB.

The effects of the quota are therefore exactly the same as a tariff, with one very important exception:

The foreign producers receive the whole of the market price for their exports, as there is no tariff. Spending on imports is therefore equal to area BFHC __rather than __BGIC. It therefore follows that from the importing country’s point of view, a tariff is preferable to a quota, as it reduces the import bill by more than a quota. From the exporting country’s point of view, a quota is preferable. Under WTO rules, tariffs are preferred to quotas, as the former is more transparent, but many countries have introduced quotas as tariffs have been gradually reduced through WTO negotiation rounds. A quota may result from an informal agreement between countries, with the threat of a tariff being levied if the exporting country doesn’t agree to it. It may therefore be a hidden form of protectionism.

Subsidies

A direct subsidy is a payment to a domestic producer by the government, which enables it to sell its products at a lower price. For instance, a country may pay its farmers £x for every tonne of wheat produced (see notes on 1.2.9). The subsidy may lead to lower imports and/or higher exports. An indirect subsidy (sometimes called a hidden subsidy), such as tax breaks or cheap energy prices are often used as they are less transparent. There has been a long running dispute between the USA and the EU over claims of hidden subsidies to their respective aircraft manufacturers (Boeing and Airbus).

Administrative and Product Regulation Barriers

A country can restrict imports through regulations that are difficult for foreign producers to satisfy or which may increase their costs. Imports may be subject to stringent product safety standards, for instance, which can be changed at short notice, or imports may be subject to delays at customs posts. Some countries have restricted certain imports on the grounds of protecting the environment, or to protect endangered species. For instance the USA imposed a rule that imported tuna has to be caught using ‘dolphin friendly’ nets.

Tariffs

A _tariff __is a tax on an imported good. It can be an _ad valorem or specific tax (see notes on 1.2.9). Manufactured goods, such as cars are usually subject to ad valorem tariffs, whilst commodities, such as agricultural products and minerals are subject to specific tariffs.

A tariff reduces imports by raising their price. This is shown in Fig 1 below:

In fig 1, the effect of a specific tariff is shown. Suppose the good in question is wheat, and the government wants to protect domestic farmers by reducing imports.

Dd represents the level of domestic demand for wheat, and Sd represents supply from domestic producers.

Sw represents the supply of imports from the rest of the world. An assumption is made that the ountry can import as much wheat as it likes at the world market price, which is OK per unit. The world supply is therefore perfectly elastic (a horizontal straight line) at the world market price.

Before the tariff is introduced, we can see that:

The market price of wheat is OK per unit
The equilibrium market quantity (also the quantity demanded) is OD
The quantity of imports is AD
Spending on imports is equal to area AEJD
The quantity supplied by domestic farmers is OA

If a tariff of KL per unit is introduced, the supply of imports moves upwards to Swt. This leads to the following changes:

The market price rises to OL per unit
The equilibrium market quantity (also the quantity demanded) falls to OC
The quantity of imports falls to BC
Spending on imports falls to BGIC
The quantity supplied by domestic farmers increases to OB
There is a loss of consumer surplus equal to area KLHJ
There is an increase in producer surplus equal to area KLFE
The government receives tax revenue equal to area GFHI
There is a deadweight loss of welfare comprising:

(a) a consumption cost equal to area HJI (consumption is below the socially optimal level of OD)

(b) a production cost equal to area__ EFG __(as higher cost domestic output replaces lower cost imports)

Exchange Rate Manipulation

A government may deliberately try to push down the exchange rate of its currency (see notes on 4.1.8) in order to gain a competitive advantage for its exports and to make domestically produced goods more competitive against imports. It can achieve this through a combination of low interest rates, increasing the domestic money supply and selling its own currency in exchange for foreign currency. It is not always easy to prove that a currency is being deliberately held below its market value, but a country can make a complaint to the WTO that it is a victim of exchange rate manipulation and if the complaint is upheld, it is able to take retaliatory measures.

Reasons for Protectionist Policies

There is a number of reasons why a government may introduce protectionist policies:

It is the victim of unfair competition – A country might argue that it is the victim of any of the following practices, which could be considered unfair competition and a distortion of comparative advantage:

(a) Dumping - This is defined as selling goods below the cost of production. It is a clear distortion of comparative advantage, but it is often difficult to prove. A clear example is the European Union’s practice of selling surplus agricultural produce on the world market, whilst compensating farmers with export subsidies. This has now stopped. More recently, China has been accused of dumping its surplus steel on overseas markets, including the USA, which has imposed a steep tariff to protect domestic steel producers. Sometimes the ‘victim’ country may fear that dumping is being used as a strategy for driving its own producers out of the market altogether, and then being able to raise prices.

(b) Cheap labour and exploitative working conditions – A country may argue that its own producers are being driven out of the market by producers (usually from developing countries) that pay very low wages, or expose workers to dangerous conditions and long hours, or employ children. This may be considered unfair competition that justifies protectionism.

The problem here is that restricting imports from such countries may actually worsen the plight of these workers, who lose their incomes altogether. Cheap and plentiful (usually unskilled) labour is actually these countries’ source of comparative advantage. Richer countries may be better off exploiting their own comparative advantage in higher skilled industries, rather than protecting industries where comparative advantage now lies with other countries.

_To protect jobs __– This may be a legitimate concern where a country has serious structural unemployment resulting from a major shift in comparative advantage.(_see notes on 2.1.3). If a region is heavily dependent on a rapidly declining industry and is being overwhelemed by cheap imports, or is losing most of its exports, there is a case for temporary protective measures to allow time for the region to generate new industries and sources of employment.

The problem here is that once protectionism is introduced it can be politically difficult to remove, because the businesses that benefit from it, and their employees will strongly oppose it. This simply delays the necessary changes the economy needs as comparative advantage has changed.

To improve the terms of trade – In Fig 1 we assumed that the supply of imports is perfectly elastic (a horizontal straight line). This is only true where the importing country represents a very small proportion of the total demand for the good. For instance Iceland can probably increase its imports of sugar by ten times without driving up the price. But if China increased its imports of oil, it is likely to lead to higher oil prices, because it accounts for a large % of world demand.

In other words, the supply of imports will be upward sloping. The imposition of a tariff on its imports of oil will therefore lead to a reduction in the price paid to the exporting countries. The price paid by Chinese businesses and consumers will rise, but by less than the amount of the tariff (see notes on 1.2.9).

A fall in the price of its imports improves a country’s terms of trade (see notes on 4.1.4). But this is at the expense of the exporting countries, for whom the terms of trade have worsened. This could result in retaliation, leaving all countries worse off.

The optimal tariff argument – Where the supply of imports is upward sloping, the marginal cost to the economy (the social marginal cost) is higher than the private marginal cost to the importer (see notes on 1.3.2). This is shown in Fig 2 below:

The demand for imports is shown by demand curve D=msb, where msb is the marginal social benefit. S1=mpc is the supply curve of imports and also the marginal private cost curve to the importing firm.

But the marginal cost to the economy is higher than the marginal cost to the individual importing firm. This is because an extra import drives up the price not just for that firm, but for all other firms importing the good.

The marginal social cost of imports is shown by __MSC __on the diagram.

Without a tariff, the free market level of imports will be OQ1 __and the price __OP1.

The socially optimal of imports is at OQ2, since this is where msb = msc. There is therefore a welfare loss equal to area ABC. This can be corrected by introducing a tariff of AB __per unit. This will push the supply curve up to __S2, resulting in imports falling to__ Q2 and price rising to __P2. This tariff is called the optimal tariff.

At the same time, the price paid to the exporter falls to__ P3__, so the terms of trade will also improve.

The problem here is that it is difficult in practice to know what the socially and privately optimal level of imports are, so calculating the correct tariff is very difficult. Also, it might result in retaliation.

To protect an ‘infant industry’ – The USA and Japan are both countries that became economic super powers having developed world class manufacturing industries behind high tariff walls. Both countries had the skilled labour and technological expertise to succeed, but would have found it hard to compete with established European manufacturers because of the huge economies of scale they enjoyed. Protectionist measures can therefore give emerging, but small producers a chance to get established and build up scale before being exposed to international competition.

The problem here is that it is not always easy for a country to identify which new industries are likely to be successful in the long run. By protecting new industries, a country may end up backing ‘losers’ with no real future. This could retard rather than enable its economy to develop.

Impact of Protectionist Policies

Protectionism has the following consequences for:

Consumers – They are likely to face higher prices and less choice as a result of protectionism. Not only will the imported goods rise in price, so too will the prices of domestic equivalents. Protectionist measures also raise prices further down the supply chain. For instance, a tariff on imported steel will lead to higher prices of cars.

Producers__ __– Domestic producers may benefit in their home markets (if imports are subject to protectionist measures) or in export markets (if they receive subsidies). They may win a bigger market share and/or be able to raise prices. But producers who use imported goods in the production process may end up with higher costs if those imports are subject to protectionist measures.

Governments__ __– They may benefit from increased tax revenues if tariffs are introduced. Tax revenues may also increase from domestic firms that are now more profitable. But in the long run, protectionism may lead to a less efficient economy with lower growth, so that tax revenues may be lower.

Living standards – Workers who are protected from foreign competition may enjoy higher wages, but this is at the expense of consumers in general. Again, protectionism may result in slower long run growth, leading to a slower rise in living standards.

Equality – Protectionism may help to educe inequality between highly paid skilled workers and low paid unskilled workers. For instance if the U.S.A, imposes a tariff on textiles, this may raise the incomes of low paid textile workers in the U.S.A relative to highly skilled groups who are not exposed to foreign competition. But again, this may be at the expense of long run growth for the economy as a whole.

Explain and discuss the reasons why a country might introduce protectionist policies to reduce imports:: Your answer should include: dumping / job protection / infant industry / terms of trade / optimal tariff / cheap labour