Trade Protectionism (Edexcel A-Level Economics A): Revision Notes

Trade Protectionism

Introduction to restrictions on free trade

International trade brings many potential benefits to countries and consumers. Trade allows countries to access goods that cannot be produced domestically, gives producers access to larger markets, and can enable economies of scale. From the perspective of a country, export-led growth becomes possible. Some countries, particularly in South East Asia including China, have benefited significantly from international trade opportunities.

Exposure to competition from overseas firms can provide incentives for domestic firms to become more efficient. This can improve the quality of goods and the efficiency of production processes. As a result, consumers may benefit from a wider variety of available products, improved quality, and lower prices.

However, despite these potential gains from trade, countries have often been reluctant to open their economies fully to international competition. Instead, governments have frequently intervened in various ways to protect their domestic producers from foreign competition. This practice is known as protectionism.

Protectionism refers to measures taken by a country to restrict international trade and protect domestic industries from foreign competition.

Reasons for protectionism

Many arguments have been put forward to justify protectionist measures. Not all of these reasons have a strong grounding in economic analysis, and some are primarily political rather than economic in nature.

Political and strategic reasons

Governments may want to protect certain domestic industries for political or strategic reasons. A common argument concerns food security. Countries may wish to maintain a strong agricultural sector to ensure they are not overly dependent on imported foodstuffs. This could prove disastrous during times of war or international conflict when supply chains might be disrupted. Such strategic arguments were used historically when setting up the Common Agricultural Policy in Europe.

More recently, similar national security arguments have been employed to justify trade restrictions.

Sunset industries

Some economists and policymakers argue that domestic industries should be protected because of the impact of high unemployment among workers displaced from declining sectors. These are known as sunset industries.

Sunset industry refers to an industry in decline that needs protection for its displaced workers.

This argument is really about managing the period of transition towards more open trade. Workers released from declining sectors could, in time, be redeployed to sectors that have comparative advantage and are more efficient. However, this transitional process can be painful for firms that need to close down or move into new markets, and for workers who may need to undergo retraining before they are ready for employment in newly expanding parts of the economy.

Infant industries

A common line of argument centres on the need to protect so-called infant industries. This may be especially important for developing countries wanting to develop their manufacturing sectors.

Infant industry refers to an industry that needs protection from international competition in the short run so that it can learn to become competitive.

The argument is that protecting a domestic industry from international competition will allow new activities to become familiar with the market. In the longer term, they should then be able to compete effectively.

There have been some exceptions to this pattern. For example, South Korea protected its manufacturing sector during its initial drive to achieve economic growth in the 1960s. This was facilitated by high subsidies for firms and tariff barriers. The South Korean economy went through a period of rapid economic growth during this time. However, industries that have been protected to allow rapid economic growth sometimes do so at the expense of potential competing nations.

Anti-dumping measures

A contentious issue concerns whether a country is justified in taking steps to protect domestic economic activity from dumping by firms in other countries. Dumping occurs when a country or large firm sells its product in another country at a price below cost in order to gain a foothold in the economy.

This may be seen as unfair competition, designed to force domestic producers out of business. WTO rules allow countries to implement countervailing duties to combat such unfair practices. In other words, if a country subsidises its exports in order to be competitive, the importing country is entitled to impose restrictions in defence.

Prices might be raised in the future once domestic firms are forced out of business. As with predatory pricing, consumers may gain from low prices in the short run, but may suffer in the longer run if domestic firms are eliminated.

The debate on free trade

David Ricardo's theory of comparative advantage, developed in the early nineteenth century, formed the basis of arguments for free trade. This theory still has resonance today, suggesting that countries can benefit from specialising in goods where they have the lowest opportunity cost of production.

However, the idea of free trade is not without its critics among economists, such as Ha-Joon Chang.

Historical criticisms

One line of criticism is historically based. During the Industrial Revolution, Britain led the world in the development of manufacturing industry. But was this based on the principles of free trade?

Factor mobility

A second line of argument notes that Ricardo's analysis rested on the assumption that capital and other factors of production were immobile. This provided support for local specialisation, as factors of production would remain in the country. When factors of production are more mobile, as they are in today's globalised world, this argument becomes less compelling.

International institution advice

There has been a tendency for institutions such as the World Bank and the International Monetary Fund to provide policy advice for developing countries based on becoming more open to international trade and promoting exports of goods in which developing countries may hold a comparative advantage. This advice has not always produced the expected results. This is partly because these countries are not in a position to take full advantage of trading opportunities in a hostile global market environment.

Forms of protectionism

When recession began to threaten in 2008, there was strong lobbying in several countries in favour of introducing protectionist measures. In the lead-up to the G20 Summit in April 2009, the World Bank reported that 17 members of that group had taken a total of 47 trade-restricting steps in the previous months.

However, the drive towards globalisation had created a more integrated global economy, in which many firms relied on global supply chains. With production processes fragmented between different parts of the world, the dangers of protectionism became more severe, and the possibilities of rapid contagion from a crisis became acute.

Tariffs

A policy instrument commonly used in the past to give protection to domestic producers is the imposition of a tariff.

Tariff is a tax imposed on imported goods.

Tariff rates in developed countries have been considerably reduced since the Second World War, but they are nonetheless still in place.

The operation of a tariff

The diagram above shows how a tariff is expected to operate. The curve labelled D represents the domestic demand for a commodity, and Sdom shows how much domestic producers are prepared to supply at any given price.

The price at which the good can be imported from world markets is given by Pw (the world price). When dealing with a global market, it is reasonable to assume that the supply at the world price is perfectly elastic. This is especially true for a small economy that is unable to influence the world price. Another way of thinking about this is that supply is perfectly elastic in the sense that the country can import as much as it wishes at the going world price.

In the absence of a tariff, domestic demand is given by D0, of which S0 is supplied by domestic producers within the economy, and the remainder (D0 − S0) is imported.

By imposing a tariff, the domestic price rises to Pw + T, where T is the amount of the tariff. This has two key effects:

• It reduces demand for the good from D0 to D1
• It encourages domestic producers to expand their output from S0 to S1

As a consequence, imports fall substantially, to (D1 − S1). On the face of it, the policy has achieved its objective of protecting the domestic industry. Furthermore, the government has been able to raise some tax revenue, shown by area C in the diagram.

Negative effects of a tariff

However, not all the effects of the tariff are favourable for the economy. Consumers are certainly worse off, as they have to pay a higher price for the good. They therefore consume less, and there is a loss of consumer surplus. This is represented in the diagram by the sum of areas A + B + C + E.

Some of what was formerly consumer surplus has been redistributed to others in society:

• The government has gained the tariff revenue (area C)
• Producers gain producer surplus, shown by area A

There is also a deadweight loss to society, represented by areas B and E. These areas were formerly part of consumer surplus, but are now lost.

Effectively, the government is subsidising inefficient local producers, and forcing domestic consumers to pay a price that is above that of similar goods imported from abroad.

Justification and criticism of tariffs

Some would defend this policy on the grounds that it allows the country to protect an industry, thus saving jobs that would otherwise be lost. However, this goes against the principle of comparative advantage. In the longer term, it may delay structural change that is necessary for the economy to remain competitive.

For an economy to develop new specialisations and new sources of comparative advantage, there needs to be a transitional process in which old industries contract and new ones emerge. Although this process may be painful, it is necessary in the long run if the economy is to remain competitive.

Furthermore, the protection which firms enjoy as a result of the tariff may foster complacency and an inward-looking attitude. This is likely to lead to X-inefficiency, where firms fail to minimise costs and become unable to compete effectively in the global market.

Trade wars and retaliation

Even worse is the situation that develops where nations respond to tariffs raised by competitors by putting up tariffs of their own. This has the effect of further reducing trade between countries, and everyone ends up worse off as the gains from trade are sacrificed.

The table above illustrates this prisoner's dilemma situation using a game theory pay-off matrix. It shows hypothetical gains that two countries could make under different tariff rates. The matrix demonstrates how individual countries pursuing their own interests can lead to a collectively worse outcome, as both countries end up imposing high tariffs that reduce overall welfare.

Quotas

An alternative policy that a country may adopt is to limit the imports of a commodity to a given volume.

Quota is an agreement by a country to limit its exports to another country to a given quantity or quota.

For example, a country may come to an agreement with another country that only a certain quantity of imports will be accepted by the importing country. Such arrangements are known as voluntary export restraints (VERs) or more commonly as quotas.

The effects of a quota

The diagram above illustrates the effects of a quota. D represents the domestic demand for a commodity, and Sdom is the quantity that domestic producers are prepared to supply at any given price.

Suppose that without any agreement, producers from country X would be prepared to supply any amount of the product at a price P2. If the product is sold at this price, D1 represents domestic demand, of which S0 is supplied by domestic producers and the remainder (D0 − S0) is imported from country X.

By imposing a quota of S1−D1, total supply is now given by Stotal, which is domestic supply plus the quota of imports allowed into the economy from country X. The market equilibrium price rises to P1 and demand falls to D1, of which S1 is supplied by domestic producers and the remainder is the agreed quota of imports.

Gainers and losers

Domestic producers gain by being able to sell at the higher price. They receive additional economic rent given by area A. Furthermore, the producers exporting from country X also gain, receiving the shaded area C.

This area represents the quota rent received by foreign producers. As in the case of the tariff, the two triangles (areas B and E) represent the deadweight loss of welfare suffered by the importing country.

Such an arrangement effectively subsidises the foreign producers by allowing them to charge a higher price than they would have been prepared to accept. Furthermore, although domestic producers are encouraged to produce more, the protection offered to them is likely to lead to X-inefficiency and weak attitudes towards competition.

Real-world example: textile industry

There have been many examples of quota agreements, especially in the textile industry. For example, the USA and China had long-standing agreements on quotas for a range of textile products. Ninety-one such quotas expired at the end of 2004 as part of China's accession to the WTO.

As you might expect, this led to extensive lobbying by producers in the USA, especially during the run-up to the 2004 presidential election. Notice that it could be argued that the removal of the quotas would allow domestic consumers to benefit from lower prices, and would allow American textile workers to be released for employment in higher-productivity sectors, where the USA maintains a competitive advantage.

Production subsidies

Another way in which a country may attempt to restrict trade is by subsidising domestic producers to enable them to compete more effectively with imports.

This approach shows domestic demand and supply for a product that can be imported at the world price Pw. Without intervention, demand is D0, of which S0 is supplied by domestic producers, with the remainder being imported.

Assume that the country is too small a producer to affect the world price. If the government decides to pay a subsidy of an amount Sub to domestic producers, this affects the supply curve such that it is horizontal at (Pw + Sub) up to S1.

This encourages domestic firms to increase production up to S1. Unlike the case of the tariff, domestic consumers are still able to buy the good at the world price, so there is not the same impact on consumer surplus. Imports fall to D0 − S1, so this measure has reduced the country's dependence on imported goods.

Producers gain from the subsidy, receiving the additional producer surplus given by area A. However, this needs to be covered by the government through taxation. The total cost to the government of providing the subsidy is thus the sum of areas A and B.

Furthermore, it is not clear that subsidising domestic production in this way provides any better incentives for efficiency than the tariff approach.

If governments wish to encourage firms to become more efficient in order to compete, a better approach might be to subsidise education and training or research and development to improve production techniques, thus tackling the problem more directly. Of course, this would depend on what was causing the inefficiency in the first place.

Non-tariff barriers

There are other ways in which trade can be hampered.

Non-tariff barriers are measures imposed by a government that have the effect of inhibiting international trade.

One example is the use of what are known as non-tariff barriers. These often comprise rules and regulations that control the standard of products that can be sold in a country.

Such rules and regulations may operate especially against producers in developing countries, who may find it especially difficult to meet demanding standards of production. This applies in particular where such countries are trying to develop new skills and specialisations to enable them to diversify their exports and engage more actively in international trade.

The impact of protectionist policies

Protectionist policies have a number of effects on economic agents in a country. These effects differ according to which policy is in operation, but the main impacts can be clearly illustrated with reference to the imposition of a tariff, which is the most common form of protectionist policy.

Effects on consumers

In general, consumers are likely to be worse off as a result of protectionist measures. In the case of a tariff, consumer surplus is lower after the tariff is imposed, as consumers must pay a higher price for the good and will consume less.

Effects on producers

Producers in the domestic economy will gain from protection. They will receive higher producer surplus at the expense of consumers. However, their incentives to produce efficiently will be low. In the long run they may never become able to compete effectively in world markets. The infant industry benefits are rarely delivered.

Effects on governments

When a government imposes a tariff, it gains revenue from the tax it raises. This may be valuable for the government of a developing country that faces problems with raising revenue through other forms of taxation, because of the lack of an administrative structure to collect taxes efficiently.

Effects on living standards

For society as a whole, the imposition of a tariff carries a deadweight welfare loss. Overall well-being is lower with a tariff in place compared to free trade.

Effects on equality

Protectionist measures entail a redistribution of resources from consumers to producers. There may therefore be an increase in inequality in the society, as income and wealth are transferred from one group to another.