Restrictions on Free Trade

This Topic Covers:

Advantages and disadvantages of free trade Specialisation leading to increased output Trade allows economies of scale (larger market to sell to) Lower price and increased choice Competition and innovation Risk – interdependence, over- reliance on trade, loss of control Unemployment (perhaps) Income inequality Environmental impact Culture

Welfare Gain From Trade S domestic P domestic A B C S world P world D domestic Q S domestic Q D domestic Imports Consumer surplus gain = A + B + C Producer surplus loss = A Total welfare gain = B + C

Trade Protection Options Tariffs: taxes on imports Quotas: quantity restrictions on imports Subsidies: given to domestic firms to help them compete in foreign markets Regulations: can make it very difficult or expensive for foreign products to comply

Tariffs A tax on imported goods (aka import duty/ customs duty) designed to raise the price to the level of, or above the existing domestic price. http://youtu.be/qiDE20UG0xE

Tariffs – A Loss of Welfare S domestic P tariff A B C D S world P world D domestic Q S1 free trade Q S2 with tariff Q D2 with tariff Q D1 free trade Lower Imports Consumer surplus reduced by A + B + C + D Producer surplus increased by A (domestic producers expand production at ↑ price) Gov’t tax revenue = C Total loss of welfare = B + D

From YouTube – Tariffs and Protectionism https://www.youtube.com/watch?v=dSQTbd2iJtY

We can draw a similar diagram for trade creation Trade creation from free trade within the trading bloc, ie a welfare gain for countries within the bloc Bigger market Economies of scale Jobs

Gains from trade creation S domestic P tariff S EU (France) + tariff A B C D P world = EU S EU (France) D domestic Q S2 FTA Q S1 with tariff Q D1 with tariff Q D2 FTA Higher Imports Eliminate tariffs, consumer surplus increased by A + B + C + D Producer surplus decreased by A, and government tax revenue falls by C Total welfare gain = B + D Imports have increased = trade is created

Trade diversion – loss in welfare And the loss in welfare from Trade Diversion…. Trade diversion – loss in welfare

Trade diversion (UK) S domestic P w+tariff S world + tariff (NZ) A B C P FTA S FTA (France) E P W S world (NZ) D domestic Q S2 FTA Q S1 with tariff Q D1 with tariff Q D2 FTA Starting point is where all countries have tariffs on all imports. Analyse impact on the UK Cheapest world supplier was not EU but say New Zealand, represented by Sworld + tariff so price is Pw + tariff Creation of FTA, we now buy at PFTA from eg France, so consumer surplus increases by A+B+C+D Producer surplus falls by A, and we lose C + E in revenue from the tariff So welfare gain is B + D - E, so if E is greater than B + D there is an overall loss in welfare The loss in revenue will be greater the greater the original difference in prices between France and NZ

Quotas A physical limit on the quantity of the good imported. Increases the share of the market available for domestic producers. Note a quota of zero is an embargo (“an official ban on trade or other commercial activity with a particular country”) Quota raises no money for the Government https://www.youtube.com/watch?v=EWvs1GCGAMk

Welfare loss from quota Quota amount decided, added to domestic production Loss in consumer surplus is A+B+C+D SD1 Price Gain in producer surplus is A Who receives C? Foreign exporters, so welfare loss to country is B+C+D Welfare loss to world is B+D PW +q A B C D PW SW So tariffs are better than quotas for the domestic economy D Note sometimes welfare loss is termed “deadweight loss” or “allocative inefficiency” QS1 QS2 QD2 QD1 Quantity

Subsidies Can be used to increase exports and reduce imports. Export examples: Airbus (to take on Boeing) Subsidies to reduce imports – generally in form of tax breaks or cheap loans (export credit guarantee [BAE systems], subsidies to rail firms to run unprofitable lines, airlines – no duty on fuel.

Other restrictions on free trade Administrative Barriers (protectionism by the back door) Quality standards add cost to foreign exporters (licensing regime for pharma firms, quality standards for phones (Samsung Galaxy Note 7), environmental standards, employment of very few customs officers) Bans due to perceived problem (BSE) Exchange Rate Manipulation Exchange controls (lowering currency value) to promote exports – China Sale of domestic currency to maintain competitiveness (Swiss Franc – policy abandoned Jan 2015 http://www.economist.com/blogs/economist- explains/2015/01/economist-explains-13

Reasons for restrictions on trade Infant Industry argument (fails on three counts: 1. Govt has to identify successful industries of the future 2. Firms protected by barriers fail on efficiency 3. better to use other policy tools such as subsidies) Job Protection: UK Steel industry – yes but consumers lose out Anti-Dumping: depends on duration; consumers benefit Protection from Cheap Labour: Deny an exporter a source of CA Terms of trade: If demand is elastic, raising import’s price a little will benefit current account (Total expenditure will fall) Other: Avoidance of vulnerability to supply, strategic industry (defence)

Impact of protectionist policies Consumers – pay higher prices. (Note other domestic industries – ie car makers - might pay more for say domestic tariffs on steel imports) Producers – may have protection at cost of retaliatory tariffs Workers – benefit in short term but welfare loss in long term Govts – gain in short term from tax revenue; longer term welfare loss Living standards – short term gain, lower economic growth long term