Chapter 24: Free Trade and Protectionism

Free trade definition

said to take place when there are no barriers put in place by govs

What are the arguments in favour for free trade?

• Protecting domestic employment

  • Governments sometimes protect "sunset" industries, those in decline because they can't compete with foreign rivals, to avoid the high structural unemployment their collapse would cause. The argument is weak, though, because the industry will probably keep declining anyway, and protection only prolongs the process.

• Protecting the economy from lower cost labour

  • Low-cost imports can cause domestic industries to decline, leading to job losses and demands for protectionism from workers and unions. Although trade benefits the economy overall, these benefits are spread widely while job losses are concentrated in particular industries. However, protectionism raises consumer prices, maintains inefficient domestic production and reduces other countries’ export opportunities.

• Protecting an infant (sunrise) industry

  • New industries may initially have high costs because they lack economies of scale, making them unable to compete with established foreign industries. Governments may use protectionism, such as tariffs, to protect these industries until they become larger and more competitive. However, developed countries often have access to sufficient finance to start production at an efficient scale and achieve economies of scale quickly. The argument is therefore more relevant to developing countries, which may have less access to finance, although they may face international pressure from developed countries if they introduce protectionist policies.

• Avoid the risk of over-specialisation

  • Governments may want to avoid over-specialisation because relying on one or two exports makes an economy vulnerable to changes in global demand, supply and technology. Falling demand or prices can cause serious economic problems, particularly in developing countries that depend heavily on primary products. Although this highlights the risks of excessive specialisation rather than directly supporting protectionism, trade protection may help new industries develop and diversify the economy, reducing its vulnerability to external shocks.

• To correct balance of payments deficit

  • Governments may use protectionism to reduce imports and therefore improve a current account deficit. However, this is usually only a short-term solution because it does not address the underlying causes of the deficit. Other countries may retaliate by imposing their own protectionist measures. This can reduce international trade and harm both economies.

Reasons against protectionism

Linked to why countries trade (Chapter 23)

• Higher prices: Protectionism raises prices for consumers and producers buying imported goods.

• Less consumer choice: Fewer imports mean consumers have fewer products to choose from.

• Reduced competition: Domestic firms may become less efficient, innovate less and lose export competitiveness.

• Inefficient resource allocation: Protectionism distorts comparative advantage, reducing specialisation and potential global output.

• Retaliation and trade wars: Other countries may respond with tariffs, causing escalating trade restrictions.

• Lower economic growth: Reduced efficiency, competition and trade can hinder economic growth.

Free trade diagram (world has comparative advantage)

Free trade diagram: 

In the domestic market (without trade), the equilibrium will be where S_dom  and D_dom intersect.

If free trade occurred, the world suppliers are generally more efficient and therefore increases supply and becomes perfectly elastic.

This creates excess demand as domestic firms will have to leave the market as they cannot compete and demand increases as the price of the goods has fallen. The level of excess demand will be met through imports.

Free trade diagram (domestic has comparative advantage)

In the domestic market (without trade), the equilibrium will be where S_dom and D_dom intersect. If free trade occurs, the domestic suppliers are generally more efficient and therefore increases supply and becomes perfectly elastic. This creates excess supply as world firms will have to leave the market as they cannot compete and demand decreases as the price of the goods has fallen. The level of excess supply will be met through exports.

Protectionism diagram: taxes

A tariff will increase the price from P_w, to P_w + tariff.

S_w shifts left to S_w + tariff

This increase in price causes a contraction in demand Qd₀ to Qd₁ and an extension in supply Qs₀ to Qs₁. This indicates a higher level of quantity produced domestically, ‘protecting’ domestic industries. The level of imports falls from (Qs₀ - Qd₀) to (Qs₁ - Qd₁).

Protectionism diagram: Tariffs

Tariffs – effects on the market diagram

• Definition: A tariff is a tax on imported goods that raises their price.

• World supply curve: The tariff shifts the world supply curve upwards by the amount of the tax, from S_World to S_World+tariff.

• Price and quantity: The market price rises from P to P_+T, causing total quantity demanded to fall from OQ₁ to OQ₂.

• Domestic producers: Domestic production increases as local firms become more competitive. Their revenue rises from area g to g+a+b+c+h.

• Foreign producers: Imports fall from Q₁ x Q₂ to Q₃ x Q₄ (as shown in the diagram). Foreign producers' revenue falls from h+i+j+k to i+j, as they pay the tariff to the government.

• Government revenue: The government receives tariff revenue represented by areas d+e.

• Higher production costs: Importers pay more for foreign goods, passing higher costs on to businesses and consumers. For example, tariffs on car components raise car production costs, potentially reducing international competitiveness.

• Anti-dumping: Tariffs can raise the prices of goods sold below their normal value, reducing the price advantage of dumped imports.

Deadweight losses shown in the diagram

• Loss of consumer surplus (area f): Some consumers no longer buy wheat because the price rises. They retain the money they would have spent, but lose the benefit they would have gained from consuming it.

• Production inefficiency (area c): Domestic farmers produce wheat at a higher cost than more efficient foreign farmers. This wastes resources and reduces global efficiency.

• Overall impact: Although domestic producers and the government benefit, consumers lose, imports fall and the tariff creates deadweight welfare losses.

finish notes