Free Trade. Vs Protection

Dr. Mrutyunjay Dash

Free TradeIt refers to a condition of international trade, when all kinds of artificial controls on international trade, such as tariffs, quotas, etc. are absent.

Under free trade, the distinction between domestic trade and international trade disappears.Arguments in Favour of Free Trade:Optimum allocation of ResourcesUnder free trade, every country specialises only in the production of those goods in which it has comparative advantage. This leads to proper and most efficient use of productive resources of the world.Technical Reasoning: To avoid misutilisation of resources on the production of those items over which the country has comparative disadvantage.

Optimisation of Consumption• Free trade helps the trading countries to secure the optimisation

of consumption. In the absence of international trade, a country’s domestic consumption is limited to its production possibilities.

• But through international trade, the consumption possibilities can expand beyond its production possibilities.

• Benefits to Consumers: Free trade also benefits the consumers by enabling them to enjoy the large variety of foreign goods which their own country cannot produce.

• Economic Development : Encourages specialisation and division of labour Stimulates healthy competition Increases skills, technical know-how Makes available necessary raw materials, machinery and

foreign capital.

Figure 1 : The Production Possibilities Frontier

ProductionPossibilitiesFrontier

B

D

A

Quantity ofCars Produced

2,200

600

1,000

3000 700

2,000

3,000

1,000

Quantity ofComputers

Produced

C

E

M

F

Basic Qs: Trade off

The only way of getting more of one good is to get less of the other Opportunity costs

The cost of something is what you give up to get it. At point E: Frontier is steep

Resources best suited to make cars are already in the car industry An additional car: Transfer of best technicians of Comp. Industry to Car IndustryThe opportunity cost of a car is high

At point F: Frontier is flat Resources best suited to car is utilised in comp. The opportunity cost of car is low. As the production of comp. will not be affected much. Is there any possibility to resolve such trade offs, if so, HOW ?

Figure 2 :A Shift in the Production Possibilities Frontier

Quantity of

Cars Produced

2,200

600

2,300

6500

4,000

3,000

1,000

Quantity ofComputers

Produced

A

G

Check on monopolies:• It promotes competition and prevents monopolistic tendencies.• The fear of foreign competition does not permit the producers

at home to form monopolies and exploit the consumers by raising the prices of their products.

Arguments against Free trade:• Unrealistic policy: Assumption of laisseez-faire /govt. non-intervention/• Perfect competition-Free entry and exit• Non-cooperation of countries:import restriction/gain by some while loss

by other.• Economic Dependence: For essential commodities.• Unbalanced development:Sectors developed over which the country has

comparative advantage.• Dumping

Protection• It refers to the policy of encouraging the home industries by giving

subsidies to the home producers and by imposing duties on the foreign goods by raising their prices relative to those of domestically produced goods.

• Economic Arguments:Infant Industry Argument:

• The operational cost of the infant industries are very high./ SOL: Imposition of Tariff on imports• Protection ,how long?”• A baby is to be nursed,a child is to be protected;and the grown up

young one is to be left free.” (List) • Infant industry argument may not be against free trade policy

fully./It favors free trade based on potential(or long run), and not present, comparative advantage.

• Based on the realistic conditions of unrealised internal and external economies of scale.

Internal Economies:Firms can grow upto optimum level External Economy: It helps to reduce costs of all firms by creating a trained labour force or by spreading knowledge of production tecniques.

Is there any scope to generalise ‘infant industry argument ‘ to ‘infant country argument’?

Industrialisation: sound infrastructure/growth of sizeable labour force with the requisite attitude of skills, thus enabling the infant developing country to industrialise itself.

Negative Implications: Protection may lead to political corruption: Industries whether economically justified or not start claiming for protecting. Develop an attitude of dependence on Govt.assistance.

Employment Argument:Expansion of employment occurs in two ways:

Imports form a leakage in the domestic income stream.Income and employment are increased by a multiple of reduced expenditure in imports.

Overall increase in employment and income in other sectors/more capital/investment in capital goods stimulate investment, income and employment.

Limitations:I. Retaliation by affected countries.II. If the demand elasticity for imports is highly inelastic then ?Terms of trade Argument:Imposition of tariff/increased price of imports/less demand for imports/lower the price of exports to reduce the foreign supply to match the reduced demand in the imposing country.

But ifthe elasticity of demand for foreign good is greater than one & The elasticity of supply of foreign goods is less than one then a greater price rise in the importing country will occur. [Imported goods at a higher price would be available and it may also induce domestic producers to raise the price : over all result; HIGHER PRICEBalance of payment Argument:Anti-Dumping Argument:High tariff is imposed to counteract evil consequences of dumping.Conclusion:

Free trade on the basis of comparative advantage theory is not realistic commercial policy in the real world.

Permanent and blanket protection is neither desirable nor justified.

Protection is inferior to a more direct method; tariffs and quotas which protect the industries are inferior to subsidies which promote industries.

Specificity Rule• If an externality is present, government policy should

intervene as directly as possible on the specific source of the externality, to most enhance national economic efficiency.

• If a country has some other objective, government policy should intervene as directly as possible on the specific objective, to minimize the national economic cost of achieving the other objective (that is, to minimize the amount of economic inefficiency created).

• Key: Identify the specific problem clearly, then use a policy to attack the problem directly.

Figure 1.1 – The Infant Industry Argument

Infant Industry Argument Analysis:

• Domestic Supply curve Sdn is everywhere above the world price of $3,000

• Tariff imposed 33% Price becomes $4,000

• Domestic Supply 20,000

• Inefficiency

– Area ‘b’ – 20,000 COULD BE PRODUCED AT $3000

-- Area ‘d’ -- Consumers are deprived of 25,000 units

When the domestic supply curve shifts to Sdf for some reasons

Advanced Technology

Low costs

Tariff is removed

At $ 3,000-------- 50,000 units are supplied

Emergence of Producers’ Surplus –

’V’

IF WORLD PRICE by this time decreases then is there any possibility of P’s Surplus?

‘YES’ HOW?

If domestic production costs falls substantially

&

There is a substantial demand for the product in the international market

Then the P’s Surplus would be like an area ‘v’

Figure 1.2 – Two Ways to Promote Import-Competing Production: Tariff Vs Subsidy

ANALYSISTariff imposed of $30 on the initial price --$330

Inefficiency----Area ’b’—Producing the same at greater expense

----Area ’d’--- Discouraging purchases

MEB: Marginal External Benefits: Encourage to produce more at higher price. How to measure?

0.6 to 0.8 million---Area ’g’ –Extra gains to the nation

Net Outcome : Whether Area ’g’ is greater than both the Area ’b + Area ’d’

OPTION-II --- SUBSIDY

$30 on initial price -$300- Now- $330- Minimum Price required to produce

How much does consumer have to pay :$300

How much does govt. have to pay : $30

Annual production raised from 0.6 to 0.8 million

FOCAL THEME: Subsidy Vs Tariff : A critical Analysis Both cause domestic firms to produce 0.2 million extra. Both generate the same external social benefits [Area ‘g’] That both 0.2 million units are produced at a higher

direct cost than the price at which the nation could buy foreign bicycles.

In both the cases the extra cost is Area ’b’ YET !!!! No discouragement in terms of total consumption by

raising the price. Consumers pay only $300 per unit Consumers do not lose the additional Area ‘d’ In terms of Area gain is ‘g’ and loss is ‘b’ Why there is a loss Area ‘b’ [loss] is due to the subsidy borne by the Govt.

Table: Protection to Maintain Jobs, the United States

National Defense

• A country must have access to products to maintain the national defense, especially because imports may not be readily available during times of hostilities.

• Apply the specificity rule:• Some products can be kept in stockpiles. In this case,

imports during peacetime can be used to build the stockpiles.

• National production capabilities are needed for other products. Best to use a subsidy to building or maintaining national production capabilities.

Can an Import Barrier Be Better Than Doing Nothing, and Is It the Best Policy?

Diversification of Industries Argument:Excessive specialisation leads to too much dependence on foreign trade/risky and undesirable during war time.Economically dependence on a few industries may result in serious economic dislocation in times when such industries pass through adverse circumstances.

National self-sufficiency

Smooth and balanced growth of the economy