International Trade Policy Free Trade Protectionism

Free Trade Free trade is the absence of government intervention of any kind in international trade, therefore there are no restrictions between countries. According to the law of comparative advantage, free trade is the pathway to increased output and efficient allocation of resources

Protectionism Protectionism is the imposition of barriers to trade to prevent the free entry of imports into a country in order to protect the domestic producers from foreign competition. The debate between free trade and protectionism has been raging for hundreds of years and remains a controversial subject

To import or to export..? If a country is producing a particular product but not engaging in international trade, how will the domestic price be determined? Now let’s assume this country decides to adopt a free trade policy. How will this country decide whether to import more of the good from the world supply, or export their production of this good?

Suppose the domestic price of the good is $10, but the world price is $12. What situation do we have in the domestic market at the $12 price? What would be the wise trading decision to make?

Does the country have a comparative advantage in this product? The decision to export Because this country has an excess supply of the product at the world price of $12, it has a surplus that can be sold abroad. The wise move to make would be to export the good and pocket the profits. So when the world price is above the domestic price, the good should be exported Does the country have a comparative advantage in this product?

Suppose the domestic price of the good is $10, but the world price is only $8. What situation do we have in the domestic market at the $8 price? What would be the wise trading decision to make?

Does the country have a comparative advantage in this product? The decision to import Because this country has excess demand of the product at the world price of $8, the shortage can be resolved with foreign purchases. The wise move to make would be to import the good. So when the world price is below the domestic price, the good should be imported Does the country have a comparative advantage in this product?

Protectionist policies Which of the two scenarios typically lead to protectionist policies by government? Why would the government choose this policy?

Tariffs Tariffs, (aka customs duties), are taxes on imported goods and are the most common form of trade restriction. Can you identify the two reasons tariffs are sometimes used as economic policy?

Protect domestic producers Tariffs can… Protect domestic producers Be a source of revenue

Effects of Tariff

Impacts of a tariff As you saw on the graph, the tariff raises the price of the good from the world price to the world price plus the tariff. Let’s see how different stakeholders fare in this situation

Stakeholders Domestic consumers are worse off. They now pay a higher price and they buy less quantity Domestic producers are better off. They sell more quantity and receive a higher price.

Stakeholders What effects does a tariff have on domestic employment? What happens to government revenue? How do tariffs effect income distribution? What is the effect on domestic society? What effect does the tariff have on foreign countries? What happens to the global allocation of resources?

Consumer and Producer Surplus The imposition of a tariff changes the consumer and producer surplus. As we will see on the next slide, consumers, producers and the government will all see their surpluses change after a tariff is put in place

Let’s take a closer look…

Consumer and Producer Surplus Before the tariff, consumer surplus was (a + b + c + d + e + f) Before the tariff, producer surplus was (g) So the total surplus to society was equal to (a + b + c + d + e + f + g) before the tariff was placed

Consumer and Producer Surplus After the tariff, consumer surplus is (a + b), so consumers are worse off After the tariff, producer surplus is (c + g), so producers are better off The government gains area (e) Total surplus to all of the above is equal to (a + b + c + g + e) Deadweight loss exists at (f + d)

Consumers are worse off, producers and government is better off. Final word on tariffs Consumers lose some of their surplus to producers and some to government. Consumers are worse off, producers and government is better off. The deadweight loss demonstrates that the social losses are greater than the gains, due to inefficient firms producing too much of the good

Ready for Import Quotas? An import quota is a legal limit to the quantity of a good that can be imported over a particular time period. It has a similar effect as a tariff, but may or may not create revenue for government

Yikes!

Effects of Import Quotas Domestic production increases because there is a limit on imports, but domestic consumption falls and so does the quantity of imports. Domestic consumers are worse off, they pay a higher price and buy less quantity Domestic producers are better off, they receive a higher price and sell more quantity

Effects of Import Quotas Domestic employment increases Quota revenues go to either government or importers, depending on government policy Domestic income distribution worsens, as the quota has the effect of a regressive tax Domestic society is worse off, as less is consumed and inefficient domestic producers overproduce Exporting countries are worse off as they sell less quantity Global misallocation of resources results

Consumer and Producer Surplus Import Quotas result in deadweight loss due to inefficiencies in production. Government has picked up a small piece, at the expense of consumers. Very similar effects to that of tariffs

Subsidies

Two types of Subsidies Production subsidies These are payments by government to domestic producers competing with cheap imported goods Export subsidies These are payments by government to domestic producers who export certain goods

Production subsidies

Production Subsidies As we can see from the previous slide, the world price is way below the domestic price, therefore domestic suppliers produce only Q1 output, while imports capture a much greater part of the market (Q1-Q3). A government subsidy will shift the domestic supply curve to the right, allowing domestic suppliers to increase quantity to Q2

Results of production subsidies Imports fall from Q1-Q3 to Q2-Q3 Consumption of the good is unchanged. Consumers simply buy a greater quantity of domestic output and less foreign output Price is unchanged Taxpayers are worse off, because their money goes to subsidizing producers and not to more beneficial purchases by government

Results of production subsidies Domestic producers are better off as they sell more quantity Domestic jobs are created Domestic society is worse off (too much produced by inefficient producers) but at least consumption doesn’t fall Exporting countries are worse off Global misallocation of resources is seen

Maybe we should draw a graph…. What if…… Government gave an enormous subsidy to domestic producers? Could they create a situation where the country could actually become an exporter of a good that it has a comparative disadvantage in? Maybe we should draw a graph….

Voluntary Export restraints

Voluntary export restraints Another form of protectionism. Essentially, a country that is being hurt by too many imports coming into their country threatens the exporting country with harsher treatment if they do not “voluntarily” restrict their exports. So it’s not as voluntary as the name suggests, and again the WTO is opposed to these deals.

Voluntary export restraints They have almost identical effects as import quotas, the only exception being that exporting countries receive additional revenue from the higher resulting price. Most stakeholders are worse off after VERs are imposed.

Other trade disruptions Governments may require a great deal of paperwork to make selling imported goods inconvenient Regulations requiring certain health, safety and environmental standards may restrict the amount of imported goods coming into a country

Last words on protectionism Domestic producers and workers are the main beneficiaries Consumers typically lose Inefficiencies in production result Income distribution worsens Foreign producers suffer Society suffers (misallocation of resources) Trade wars may result

Wake up! It’s Over!