International Economics Topic 2 Free Trade & Protectionism Niels Brock Summer 2013 Course Advanced Diploma Management

Economists argue that international trade should be based on comparative advantage and free trade. Free trade is the flow of goods and services between countries without restrictions or special taxes Fair trade is the flow of goods and services with countries that do not have an ‘unfair’ competitive advantages (and is also willing to reduce trade barriers). There is an alternative definition of “fair trade” (i.e. non- exploitation of developing economies) which will be discussed in the next few weeks. Strategic trade is where governments facilitate certain sectors of the economy and industries that have export potential 2 Free trade, fair trade and strategic trade

Free trade helps to bring lower prices, greater choice for consumers and lower input prices for firms using imported factors. Higher spending power within the economy may also stimulate growth in other industries. But…moving towards free trade may have short-term adjustment problems. 3 Benefits of free trade

Provide consumers with lower prices Extra buying powers of consumers stimulates growth in other areas of the domestic economy (with the resulting increase in employment, investment etc.) Allows local industries to purchase raw materials and intermediate goods more cheaply, lowering the cost of production, thus making the end price of goods more competitive on the domestic and international market (lower input prices) Arguments for free trade

Puts local industries out of business as they cannot compete on price (higher labour costs) May reduce income of employees, or lead to job loss (with consequent impact on consumption, prices and employment) Arguments against free trade

6 Protectionism Protectionism uses restrictions to protect domestic producers from foreign competition, including Embargoes: laws that bar trade with another country. Tariffs: taxes on imports. Quotas: limits on the quantity of a good that may be imported (variation is voluntary export restraint)

Other forms of protectionism are export subsidies and product standard requirements Subsidies are grants or other funding given to firms or industries that compete with imported goods to allow them to keep input costs and prices down. Product standards provide restrictive rules on imported goods such as safety requirements, product features, and packaging requirements (which may increase input costs due to “red tape”) Protectionism reduces international trade More forms of protectionism

Protecting employment in industries affected by foreign competition To compete with countries that use anti-competitive “cheap labour” Protecting new or ‘infant’ (sunrise) industries, which have not yet grown to a size big enough to allow them to compete To avoid the risks of over-specialisation, so as not to be over-dependent on the export of one or two products Maintaining industries which are considered strategic, e.g. food supplies, defence supplies, energy supplies (sometimes called the “national security” argument) reducing imports in order to improve a weak balance-of payments position retaliating against those countries which protect their industries and markets To increase government revenue (increasing tariffs means increasing tax income for the government) Arguments for protectionism

preventing dumping; dumping is the selling of goods, by foreign producers, at prices below the cost of production; this may be done to gain a foothold in new markets or to get rid of surpluses helping the environment, e.g. banning the import of hardwoods from tropical rain forests; products from rare animals, e.g. rhino horn, furs. To protect product standards protecting consumers from harmful products, e.g. illegal drugs, dangerous animals, poor quality foods etc. exerting political pressure, e.g. the US embargo on Cuba, UN embargo on Iran These arguments are especially strong during times of economic decline (pressure on jobs and failing companies/industries etc. due to economic downturn) All of these arguments only receive weak support from economists as ANY intervention into the market creates inefficiency Arguments for protectionism

Supports industries that are not economically viable or efficient Less consumer choice Reduces competition Increases prices Distorts comparative advantage (reduces specialisation and thus world output) May result in “retaliation” from other countries (reducing export potential) Arguments against protectionism

Activity Student workpoint 22.1, p. 270 of textbook Article: EU imposes long-term tariffs on Asian shoes In groups, answer the following 1.Define dumping 2.Outline the arguments for and against the European imposition of tariffs on Chinese and Vietnamese shoes Present your findings to the class

Activity Student workpoint 22.2, p.271 of text RESEARCH – Environmental standards as a barrier Discuss in your groups then share with the class

Who is advantaged and who is disadvantaged by the introduction of the following protectionist measures: – Tariffs – Subsidies – Quotas – Embargoes – Product standard requirements Consider why each of these parties advantaged or disadvantaged Discussion

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EFFECT ON AGGREGATE SUPPLY AND DEMAND FROM PROTECTIONISM

Culbertson Article (HBR) Questions to consider 1.Why does Culbertson argue that international trade IS NOT governed by comparative advantage ? (p.124) Do you find this argument compelling? Why or why not? 2.Is cost-cutting possible to assist countries to compete internationally and does it produce efficiencies in the market? 3.How valid do you think his argument is for not allowing developing countries free access to the US market? 4.What are the key recommendations about US trade policy (for 1986 hence). Is this what you would recommend? Why or why not? 5.What is the key message from this article? 6.Are these arguments as valid today as in 1986? Why or why not?

Various forms of protectionism will shift the shift the supply curve You will see from the Blink and Dorton handout that there is: – a shift along the curve with tariffs (due to simple change in price) – A shift in the supply curves for subsidies and quotas The effect of protectionism

8-19 Costs and Benefits of Tariffs A tariff raises the price of a good in the importing country, making its consumer surplus decrease (making its consumers worse off) and making its producer surplus increase (making its producers better off). Also, government revenue will increase.

Costs and Benefits of Tariffs (cont.) 8-20

8-21 Costs and Benefits of Tariffs (cont.) For a “large” country that can affect foreign (world) prices, the welfare effect of a tariff is ambiguous. The triangles b and d represent the efficiency loss. – The tariff distorts production and consumption decisions: producers produce too much and consumers consume too little compared to the market outcome. The rectangle e represents the terms of trade gain. – The terms of trade increases because the tariff lowers foreign export (domestic import) prices.

8-22 Costs and Benefits of Tariffs (cont.) Government revenue from the tariff equals the tariff rate times the quantity of imports. – t = P T – P * T – Q T = D 2 – S 2 – Government revenue = t x Q T = c + e Part of government revenue (rectangle e) represents the terms of trade gain, and part (rectangle c) represents part of the value of lost consumer surplus. – The government gains at the expense of consumers and foreigners.

8-23 Costs and Benefits of Tariffs (cont.) If the terms of trade gain exceeds the efficiency loss, then national welfare will increase under a tariff, at the expense of foreign countries. – However, this analysis assumes that the terms of trade does not change due to tariff changes by foreign countries (i.e., due to retaliation).

Costs and Benefits of Tariffs (cont.) 8-24

Subsidies Where subsidies are paid to local firms to make them more competitive in the local market the domestic supply curve will shift downwards by the amount of the subsidy. (See Blink and Dorton summary for S+D curves)

8-26 Export Subsidy An export subsidy can also be specific or ad valorem – A specific subsidy is a payment per unit exported. – An ad valorem subsidy is a payment as a proportion of the value exported. An export subsidy raises the price of a good in the exporting country, making its consumer surplus decrease (making its consumers worse off) and making its producer surplus increase (making its producers better off). Also, government revenue will decrease.

8-27 Export Subsidy (cont.) An export subsidy raises the price of a good in the exporting country, while lowering it in foreign countries. In contrast to a tariff, an export subsidy worsens the terms of trade by lowering the price of domestic products in world markets.

Copyright © 2006 Pearson Addison- Wesley. All rights reserved Export Subsidy (cont.)

8-29 Import Quota An import quota is a restriction on the quantity of a good that may be imported. This restriction is usually enforced by issuing licenses to domestic firms that import, or in some cases to foreign governments of exporting countries. A binding import quota will push up the price of the import because the quantity demanded will exceed the quantity supplied by domestic producers and from imports.

8-30 Import Quota (cont.) When a quota instead of a tariff is used to restrict imports, the government receives no revenue. – Instead, the revenue from selling imports at high prices goes to quota license holders: either domestic firms or foreign governments. – These extra revenues are called quota rents.

Copyright © 2006 Pearson Addison- Wesley. All rights reserved US Import Quota on Sugar

8-32 Voluntary Export Restraint A voluntary export restraint works like an import quota, except that the quota is imposed by the exporting country rather than the importing country. However, these restraints are usually requested by the importing country. The profits or rents from this policy are earned by foreign governments or foreign producers. – Foreigners sell a restricted quantity at an increased price.

Homework for next week Read chapter 23 of Blink and Dorton (2011) Attempt the activities in the Chapter

Free trade agreements International trade organisations Next week

35 Thank You! Coming weeks – Topic 3, Ch 23: – Exchange Rates