INTERNATIONAL ECONOMICS FREE TRADE & PROTECTIONISM Economics – A Course Companion. Blink & Dorton,

What is free trade? Free trade is said to take place between countries when there are no barriers to trade put in place by governments or international organizations. Goods are able to move freely between countries.

Key Questions - Trade If international trade is so good for all the countries concerned, why is it that countries do not trade freely? Why do they often protect their economies from imports?

What is Protectionism? Any measured designed to give local producers of a good or service an advantage over a foreign competitor. The best examples of protectionism are tariffs, quotas and subsidies.

ARGUMENTS FOR PROTECTION There are many arguments for protecting local producers and industries. These include: Protecting Domestic Employment Protecting The Economy from Low-Cost Labour Protecting an infant (sunrise) Industry. To Avoid the Risks of Over-Specialization Strategic Reasons To Prevent Dumping

ARGUMENTS FOR PROTECTION Protecting Domestic Employment At any given time in an economy, there will be some industries that are in decline (sunset industries) because they cannot compete with foreign competition. If the industries are relatively large, this will lead to high levels of structural unemployment and governments often attempt to protect the industries in order to avoid the unemployment. The negative externalities of a rapidly declining major industry may so great, the government feels obligated to provide some protection.

ARGUMENTS FOR PROTECTION Protecting Domestic Employment Counter Argument for Free Trade The industry will continue to decline and protection will simply prolong the process. Although there will be short-run social costs, it could be better to let the resources employed in the industry more into another, expanding area of the economy.

ARGUMENTS FOR PROTECTION 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 that are produced in countries where the cost of labour is very low.

ARGUMENTS FOR PROTECTION Protecting the Economy from low-cost labour US Clothing Industry Example There have been demands in the US to protect the domestic clothing industry against cheap imports from Asia, where wages are much lower.

ARGUMENTS FOR PROTECTION Protecting the Economy from low-cost labour Manufacturing Industries While trade may create many benefits for an economy as a whole, the cost in terms of job looses may be concentrated in particular industries. There is much greater job insecurity among manufacturing workers in developed countries who fear they will lose their jobs to workers in emerging markets such as China & India. Workers and their trade unions may lobby vigorously for protection against imported goods.

ARGUMENTS FOR PROTECTION Protecting the Economy from low-cost labour South Korea – Shipbuilding Industry In 1998, the hourly wage for shipbuilding in the US was $19.19, but in South Korea it was $9.27. While cheaper labour is available in other Asian, countries, South Korean workers were well educated and could achieve high levels of productivity. Not surprisingly, 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 PROTECTION Protecting the Economy from low-cost labour Counter Argument for Free Trade If we protect the economy from low-cost labour, it will mean that consumers pay higher prices than they should. Production in a protected economy would take place at an inefficient level. The country wishing to export would lose trade and their economy would suffer.

Comparative Advantage Changes Over Time It should be realized that comparative advantage changes over time and that a country that has a comparative advantage in the production of a good at present may not have that in the future. For example, if it quite likely that the US did have a comparative advantage in shipbuilding at one time. As relative factor costs change in different countries, it is important that resources should move freely as possible form industries where comparative advantage is waning, into industries where it is growing.

ARGUMENTS FOR PROTECTION Protecting the Economy from low-cost labour Counter Argument: Government supports workers who lose jobs: There is some responsibility on governments to help those workers who have lost their jobs due to increasing competition, from low cost foreign labor. These supply side policies could include additional education and training so retrenched workers can enter new industries.

ARGUMENTS FOR PROTECTION Protecting an Infant (sunrise) industry Many governments argue that an industry that is just developing may not have the economies of scale advantages that larger industries in other countries may enjoy. The domestic industry will not be competitive against foreign imports until it can gain teh cost advantages of economies of scale. Because of this, it is argued that industry needs to be protected against imports, until it achieves size where it is able to compete on an equal footing.

ARGUMENTS FOR PROTECTION Protecting an Infant (sunrise) industry Counter Argument for Free Trade Most developed countries have highly efficient capital markets (well as least before the GFC!) which allows them access to large amounts of financial capital, even more so since the advent of globalization. Due to this fact, it can be argued that there is no basis for the idea that industries in developed countries will set up in a relatively small way. They could be able to benefit from economies of scale with relatively short period of time.

ARGUMENTS FOR PROTECTION Protecting an Infant (sunrise) industry Counter Argument Example The Saudi Arabian government has been diversifying into petrochemical production in recent years. It has undertaken a number of projects in partnership with large multinationals such as Chevron, BP and Exxon Mobil. The plants constructed have been among some of the largest in the world, gaining almost immediately from economies of scale.

ARGUMENTS FOR PROTECTION Protecting an Infant (sunrise) industry It is likely that developing countries without access to sophisticated capital markets, can use the infant industry argument to justify protectionist policies. However, whether have the international political power to able to impose protectionist policies, without complaints and action from developed countries is debatable.

ARGUMENTS FOR PROTECTION To avoid the risks of over-specialization Governments may want to limit over- specialization, if it means the country could become over-dependent on the export sales of one or two products. Any change in the world markets for these products might have serious consequences for the country’s economy. For example, changes in technology could severely reduce the demand for a commodity, as the development of quartz crystal watches did for the Swiss wristwatch industry, harming the economy.

ARGUMENTS FOR PROTECTION To avoid the risks of over-specialization The introduction of new products or changes in the patterns of demand and supply can have serious effects on the economies of developing countries which tend to over specialize in the production of primary products without choice. For example, the over-supply of coffee on the world market, caused a fall in price, and had severe impact on countries like Ethiopia.

ARGUMENTS FOR PROTECTION To avoid the risks of over-specialization Counter Argument for Free Trade There are no real arguments against this view. It does not promote protectionism, it simply points out the problems that countries may face if they specialize to a great extent.

ARGUMENTS FOR PROTECTION Strategic Reasons It is sometimes argued that certain industries need to be protected in case they are needed at times of war, for example: agriculture, steel and power generation. Steel is needed for many defence items such as planes and tanks. The steel industry would argue that it must be protected in order to stay competitive.

ARGUMENTS FOR PROTECTION Strategic Reasons Counter Argument for Free Trade To certain extent, this argument may be a valid one, although it is often overstated. In many cases, it is unlikely that countries will go to war, if they do, it also unlikely that they will be cut off from all supplies. Most probably this argument is being used as an excuse for protectionism.

ARGUMENTS FOR PROTECTION To Prevent Dumping What is dumping? Dumping is the selling by a country of large quantities of a commodity, at a price lower than its production cost, in another country. For example, the EU may have a surplus of butter and sell this at a very low cost to a small developing country. Where countries can prove that their industries have been severely damaged by dumping, their governments are allowed under international trade rules to impose anti-dumping measures to reduce the damage. However, it is very difficult to prove whether or not a foreign industry is guilty of dumping.

ARGUMENTS FOR PROTECTION To Prevent Dumping Counter Argument For Free Trade A government that subsidizes a domestic industry may actually support dumping. For example, developing countries argue that when the EU exports subsidized sugar, it is actually a came of dumping because the price doesn’t reflect that actual cost of the EU sugar producers. Therefore if dumping does occur, it is more likely that there will be a need for talks between governments, rather than any form of protection.

ARGUMENTS FOR PROTECTION To Prevent Dumping Counter Argument For Free Trade There is always a danger that protectionism will invite retaliatory actions by foreign governments and this reduces the benefits that can be gained by all consumers and producers in all countries.

ARGUMENTS FOR PROTECTION To Protect Product Standards A country might which to impose safety, health or environmental standards on goods being imported into its domestic market in order to ensure that the imports match the standards of domestic producers. This is a valid argument, as long as the concern themselves are valid. For example, the EU has previously banned the importing of American Beef, because it have been treated with hormones.

ARGUMENTS FOR PROTECTION To Protect Product Standards Counter Argument for Free Trade Many of the reasons given for bans when standards are not reached are considered to be simply subtle means of protection. Where there is a dispute over product standards, a response by the exporting country might be use retaliatory policies. In the EU-US Beef dispute, the US retaliated against the EU in May 1999 by imposing trade sanctions of $117 million worth of imports from Europe.

ARGUMENTS FOR PROTECTION To raise government revenue In many developing countries it is difficult to collect taxes and so governments impose import taxes (tariffs) on products in order to raise revenue. The International Monetary Fund (IMF) estimated that, on average, import duties accounted for approximately 15% of total government revenue for the developing countries in 2002.

ARGUMENTS FOR PROTECTION To raise government revenue Counter Argument for Free Trade This is not so much an argument for protectionism, but more a means of raising revenue. In effect, the import duties are actually a tax on consumers in the country who are buying the imports.

ARGUMENTS FOR PROTECTION To correct a balance of payments deficit Governments sometimes impose protectionist measures to attempt to reduce import expenditure and thus improve a current account deficit. A current account deficit occurs when a country is spending more on its imports of goods and services, than it is earning for its exports of goods and services.

ARGUMENTS FOR PROTECTION To correct a balance of payments deficit Counter Argument for Free Trade This will only work in the short run. It does not actually address the actual problem, because it does not rectify the actual causes of deficit. Also, if countries do this, then it is likely that other countries will retaliate with protectionist measures of their own.

ARGUMENTS AGAINST PROTECTIONISM All the counter arguments previously covered are great arguments for free trade. The arguments against protection are really related to the reasons why countries trade, as previously studied.

ARGUMENTS AGAINST PROTECTIONISM Prices Protection may raise prices to consumers and producers of the imports they buy. Choice Protection would lead to less choice for consumers.

ARGUMENTS AGAINST PROTECTIONISM Competition Competition would diminish if foreign firms are kept out of a country, and so domestic firms may become inefficient without the incentive to minimize costs. Innovation may also be reduced for the same reason.

ARGUMENTS AGAINST PROTECTIONISM Comparative Advantage Protectionism distorts comparative advantage leading to the inefficient use of the world’s resources. Specialization is reduced and this would reduce the potential level of world’s output.

ARGUMENTS AGAINST PROTECTIONISM Economic Growth For all reasons listed previously, protection may hinder economic growth.

FREE TRADE EXAMPLE This graph shows a situation where free trade is taking place in a country where wheat is both produced domestically and locally. If there was no foreign trade, then domestic farmers would produce 0Q e tons of wheat at a price of P e per ton. If we now assume the market is open and foreign trade takes place, then the situation changes. Consumers find they can import wheat at the world price. If they are prepared to pay the world price, they can import as much wheat as they like. This means the supply curve faced by importers S (World) is perfectly elastic. S (World) must be below P e or there would be not point in trading. With free trade, the price of wheat in the country will be S (World). At this price, domestic farmers will only be prepared to supply 0Q 1 tons of wheat. However, the demand for wheat will be 0Q 2 and so the excess demand is satisfied by imported wheat. Foreign producers will supply Q 1 to Q 2 tons of wheat. Thus domestic consumers get to consume QeQ 2 more wheat at a lower price.

Tariffs A tariff is a tax that is charged on imported goods. As we know from microeconomics, any tax placed upon a good shifts the supply curve upwards by the amount of the tax In the case of a tariff, it will shift the world supply curve upwards, since it is placed on the foreign producers of the good and not the domestic producers.

THE EFFECT OF A TARIFF ON IMPORTED WHEAT Before the tariff, 0Q 2 tons of wheat were being consumed at a price of p w. Domestic production was 0Q1 and imports were Q 1 Q 2. When the tariff is imposed S (World) shifts up by the amount of tariff to S (World) + tariff and so the market price rises to P w + T. Total quantity demanded falls from 0Q 2 to 0Q 4 because the price has risen. Domestic producers increase production to 0Q 3 and so their revenue increases from g to g + a + b + c + h. Foreigner producers supply the rest, which is now Q 3 to Q 4. They receive P w + T, but they 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.

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

Tariffs & Prices Car Industry Example If the government introduced a tariff on car component parts, then this would raise the cost 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 reduces its international competitiveness.

Tariffs & Anti-Dumping Measures Tariffs are the most common type of anti- dumping measure. If a country has 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 advantages of the dumped imports.

DEAD WEIGHT LOSS OF WELFARE: Explanation 1 Q 4 Q 2 tons of wheat are no longer demanded. Consumers keep the amount of money k, that they would have spent on the wheat. As a consequence there is a loss of consumer surplus equivalent to f, because the wheat is not purchased. This is known as a dead-weight loss of welfare, because of the loss of consumer surplus.

DEAD WEIGHT LOSS OF WELFARE: Explanation 2 After the tariff, Q 1 Q 3 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 minimum reserve of h, whereas the domestic farmers need a minimum revenue of h+c. Thus c represents the inefficiency of the domestic producers and a loss of world efficiency, since more of the world resources are being used to produce the wheat than are necessary. This is another dead weight loss of welfare.

Subsidies A Subsidy is an amount of money paid by the government to a firm, per unit of output. In the case of protectionist policies, the government is giving a subsidy to domestic producers to make them more competitive. The effect of this policy will be to shift domestic supply curve downwards by the amount of the subsidy

Before the subsidy, 0Q 2 tons of wheat were being consumed at a price of P w. Domestic production was 0Q 1 and imports Q1Q2. When the subsidy is granted, S (Domestic) shifts downwards by the amount of the subsidy to S (Domestic) + subsidy. The market prices stays at P w and so demand remains at 0Q 2 However, domestic producers increase production to 0Q 3 because they are now receiving P w + subsidy per unit they produce. This means that their revenue increases from a to a+b+e+f+g. Foreign producers now supply the rest which is now Q 3 to Q 2. Thus 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. SUBSIDY ON DOMESTIC WHEAT PRODUCTION

As with a tariff, Q 1 Q 3 tons of wheat are 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 revenues of b+g. Thus g represents the inefficiency of domestic producers and misallocation of the world’s resources since more of the world’s resources are being used to produce the wheat than are necessary. This another dead weight loss of welfare. SUBSIDY ON DOMESTIC WHEAT PRODUCTION Dead-weight loss of welfare

There is No Loss of Consumer Surplus with Tariffs and Subsidies There is no loss of consumer surplus because the price of wheat does not change. However, consumers are indirectly affected as governments will use tax revenue to fund the subsidies. This may mean higher tax payments and also involves an opportunity costs in terms of reduced government spending on other things.

Quotas A quota is a physical limit on the numbers or values of goods that can be imported into a country. For example, the EU imposes import quotas on Chinese garlic and mushrooms. The imposition of a quota has peculiar effect on the free trade diagram.

S (Domestic) S (Domestic + Quota S (World) QUOTAS Before the quota is imposed 0Q 2 of wheat is purchased at price of p w. Domestic supply is 0Q 1 and imports are Q 1 Q 2. Let us now assume that the government imposes a quota of Q 1 -Q 3 tons of wheat. Domestic producers supply 0Q 1 at a price of Pw and the importers produce their quota of Q 1 -Q 3. However, once this has happened there is an excess of demand of Q3-Q2 at the price of 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. 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 P w. Eventually the price settles at price settles at P quota, where demand now equals supply again and the total quantity of wheat demanded falls to Q 4. Domestic producers now supply 0Q 1 and Q 3 -Q 4 tons of wheat at a price of P Quota. Their revenue rises from a to a + c + d + f +i + j. Foreign producers now supply their quota of Q 1 Q 3 and also receive a price of P quota. Thus their income changes from b+c+d+e to b+g+h.

S (Domestic) S (Domestic + Quota S (World) QUOTAS – DEAD-WEIGHT LOSS OF WELFARE Q 4 Q 2 tons of wheat are now demanded. Consumers keep the amount e they would have spent on the wheat, but there is a loss of consumer surplus equivalent to k, because the wheat is not now purchased. This is a dead-weight loss of welfare, because of the loss of consumer surplus After the quota, Q3Q4, tons of wheat are now produced by relatively inefficient domestic farmers, as opposed to more efficient foreign farmers. The foreign farmers would produce the quantity for a minimum revenue of c+d whereas the domestic producers need a minimum revenue of c+d+j. Thus j represents the inefficiency of the domestic producer and a loss of world efficiency, 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.

Voluntary Export Restraints (VERs) Voluntary export restraints are agreements between exporting and importing countries in which the exporting country agrees to limit the quantity of exports of 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. For example, China has agreed to limit its export of textiles to South Africa.

Administrative Barriers When goods are being imported, there are usually administrative processes that have to be undertaken. This may known as a “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 the country will slow down imports.

Administrative Barriers 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, Safety, & 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, it important that government are legitimately keeping out unsafe imports, rather than simply protecting their own country’s workers.

Health, Safety, & Environmental Standards Challenges for Developing Countries While the maintenance of product standards is extremely important, developing country exporters may find it is 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 if difficult for such countries to successfully exploit their comparative advantage.

Embargos In effect, an embargo is an extreme quota. It is complete ban on imports and is usually put in place as form of political punishment. For example, the US has a trade embargo on all products from Cuba. Complete embargoes are rare.

Economic Sanctions Countries may put in place a set of economic sanctions against an offending country. Unlike an embargo, these limit the exports or imports of one or a few key products and are also used as a form of political punishment or to achieve a desired political objective.

Nationalistic Campaigns Governments will sometimes run marketing campaigns to encourage people to buy domestic goods instead of foreign ones in order to generate more demand for domestic goods and preserve domestic jobs. Such campaigns have happened in countries, such as the UK, Australia and the US. This may be described as “moral suasion” where the government links consumption of imported goods to the creation of unemployment.

THE WORLD TRADE ORGANIZATION (WTO) The WTO is an international organization that sets the rules for global trading and resolves disputes between its member countries. The WTO was established on 1 st January It has 149 members. It replaced the General Agreement on Tariffs and Trade (GATT) which has been set up after WWII.

THE WORLD TRADE ORGANIZATION (WTO) The WTO along with is predecessor the GATT, is largely credited with average decline in world tariffs of 40% to 4% for manufactured goods.

THE WORLD TRADE ORGANIZATION (WTO) Most Favoured Nation Status (MFN) All WTO members are required to grant “most favoured nation” status to one another. This usually means that trade concessions granted by a WTO country to another country must be granted to all WTO members. MFN status is one of the most important principles of the WTO.

Aims of the WTO The WTO aims to increase international trade by lowering trade barriers and providing a forum for negotiation.

Functions of the WTO Administer WTO trade agreements To be a forum for trade negotiations. To handle trade disputes among member countries. To monitor national trade policies To provide technical assistance and training for developing countries. To cooperate with other international organizations.

WTO Negotiating Rounds The WTO operates through a system of trade negotiations or rounds. The first rounds held under GATT addressed mainly the reduction of tariffs, but late negotiations included other areas such as anti- dumping legislation and non-tariff issues.

The DOHA Round of Trade Negotiations The current round of trade negotiations is called the Doha Round after the site of the meeting where negotiations were started in November The program called the Doha Development Agenda, covers a range of trade issues

Doha Development Agenda The Doha Development Agenda covers: agricultural tariffs. non-agricultural tariffs. trade and environment issues. anti-dumping issues. subsidies competition policy transparency in government procurement Intellectual property.

Outcomes from the DOHA Round Negotiations have been very contentious and no agreement has been reached. There were meetings in Cancun in 2003 and in Hong Kong in In July 2006, Doha round negotiations broke down and were ultimately suspended as a result of the inability to come to agreement on fundamental issues.

Agricultural Subsides at DOHA Round The EU and the US are being urged to reduce their agricultural subsidies to improve market access for developing country exports.

Is the WTO a success or failure? This is a very difficult, it not impossible, question to answer. There are many different views on the subject. Perhaps it is best to state the claims of the WTO and the arguments of their critics

The Benefits of the WTO according to the WTO The system helps to promote peace in the world. The more that countries trade freely, the less likely that they are to be in conflict. Disputes are now handled constructively and there is a forum for this to take place. Rules make like easier for everyone. Small countries have an equal say and gain form “collective bargaining” with larger countries.

The Benefits of the WTO according to the WTO Freer trade cuts the cost of living for the majority of consumers. Freer trade provides more choices of products and better quality products. Trade raises incomes and stimulates economic growth. The system encourages good government.

Criticism of the WTO Arguments against the WTO Unequal Power The WTO supposedly operates on a consensus basis, with equal decision-making power for all. In reality, many important decisions get made in informal negotiations between small groups of the wealthier nations. Thus many of the WTO’s developing country members are often excluded from decision making processes.

Criticism of the WTO Arguments against the WTO Undemocratic Many developing countries cannot afford to participate in all negotiations or even to have a permanent representative at the WTO. This means that their interests are not represented.

Criticism of the WTO Arguments against the WTO Privatisation Agenda The WTO’s General Agreement on Trade and Services, includes a long list of services that should be privatised. These include childcare, care for the aged, sewage, garbage disposal, park maintenance and postal services. It is argued that those least able to pay for vital services like low paid workers and poor communities will suffer from privatisation.

Criticism of the WTO Arguments against the WTO Free Trade Increases Inequality It is argued that free trade does not make life better for ordinary people, but only leads to rich people and rich nations becoming better off.

Criticism of the WTO Arguments against the WTO Bias towards Rich Countries Rich countries are being allowed to maintain high import duties and quotas in certain products, such as textiles, stopping imports from developing countries. The existence of highly protected agriculture in developed countries, while developing countries are being pressured to open up their markets.

Criticism of the WTO Arguments against the WTO Bias towards MNCs Intellectual property rights, banning developing countries from incorporating technology that originates from MNCs in developed countries. This especially applies to pharmaceuticals.

Criticism of the WTO Arguments against the WTO Health, Safety & Environmental Concerns It is claimed that in the quest for free trade, issues of health, safety at work and environmental protection are to often ignored. Animal rights lobbyists also argued that in an attempt to liberalize trade, the WTO rules contribute to the abuses of animal rights (eg: fur trade) or even towards the extinction of endangered species (eg: dolphins killed in the process of tuna fishing)

For & Against the WTO Conduct appropriate research to answer the following: “Evaluate the extent to which the WTO has been successful in improving the economic situation in developing countries”.

EXAMINATION QUESTIONS Short Response Questions (10 marks each) 1.Using a diagram, explain the likely effects of a tariff on imported bicycles? 2.Using a diagram, explain the likely effects of a quota on imported shoes?

EXAMINATION QUESTIONS Essay Question 1a.Explain the benefits of international free trade (10 marks) 1b.Evaluate the arguments used by governments when they erect barriers to free trade.