Free Trade vs. Protectionism Frederick University 2009

Free Trade vs. Protectionism “If there were an Economist’s Creed it would surely contain the affirmations: ‘I understand the principle of comparative advantage’ and ‘I advocate free trade’” Paul Krugman

Free Trade vs. Protectionism Trade Protection (Protectionism) - Policies that limit imports, usually with the goal of protecting domestic producers in import-competing industries from foreign competition

The Gains from trade Oz widget market P Q D S P o= 4 a b No trade: Oz price = 4; Q = 30 consumer surplus = a producer surplus = b Q o = 30 P w = 2 4 a c d e Trade: world price = 2; Q o = 16, Q imports = 28, Q = 44 Consumer surplus = a+d+e Producer surplus = c } Imports = 28 Q o =16Q = 44 Local consumer's extra gains = d+e Local producer’s extra gains = -d

The Gains from trade Zo widget market P Q D S P z = 1.5 Q z = 60 No trade: P = 1.5; Q = 60 Consumer surplus = f Producer surplus = g f g D S P = 2 } Exports = h i j Trade: P = 2; Q = 78 Consumer surplus = h = f – i Producer surplus = g + i + j g Zo consumer’s extra gain = -i Producer’s extra gains = i + j 1.5

The Gains from trade Oz consumers Oz producers Zo consumers Zo producers Surplus before trade ac + dh + ig Surplus after trade d + e + a chg + i + j Total: + e + j

Free Trade vs. Protectionism Showing that free trade is better than no trade is not the same thing as showing that free trade is better than sophisticated government intervention

Trade Restrictions Tariffs - taxes levied basically on imported goods. They are imposed as an attempt to raise foreign exchange revenue and increase the welfare at the expense of other nations. Nontariff barriers - all forms of trade restrictions other than tariffs.

Tariffs ad valorem import tariff - expressed as a percentage of the invoice value of the imported good specific tariff - a fixed sum levied on a physical unit of the good no matter what its invoice price is compound duty - a combination of ad valorem and specific duties variable levy - calculated daily official prices - a basis for ad valorem duty calculations

The Effect of a Tariff P Q D S Pd Pw Sd Dd } M } t Pt a a – producer gain c a + b + c + d – consumer loss St Dt b d c – government collection b + d – deadweight loss b – consumer loss due to the demand shift to domestic supply - production effect d – consumer loss due to the reduction in consumption consumption effect }

Nontariff barriers quantitative restrictions Quotas - numerical limits for a specific kind of good that a country will permit to be imported without restriction during a specified period Voluntary export restraints Tariff quotas -permit a stipulated amount to enter the country duty free or at a low rate, but when that quantity is reached, a much higher duty is charged for subsequent importations technical regulations administrative regulations other regulations of imports

The Import Quota P Q Sd Dd Pw } q Sq Pq Qsq Qs Qd Qdq a a – producer gain bcd a + b + c + d – consumer loss b + d – a loss to the country c – transfer from domestic consumers to someone else

Arguments for trade restrictions The need of protection of domestic labour markets against cheap foreign labour The desire to reduce domestic unemployment The need to counteract dumping in international trade The need to protect the infant industries Protect industries important for national defence Decrease the national balance of payments deficit Improve the nation’s terms of trade and welfare Strategic trade policies The scientific tariff The need to protect national health and safety standards

Strategic Trade Policies economies of scale justify the operation of just one firm in the world market as a whole lucky firms in the industry may be able generate returns higher than the opportunity costs of the resources they employ the country can raise its national income at other countries’ expense if it can somehow ensure that the lucky firm that gets to earn excess returns is domestic rather than foreign

Strategic Trade Policies – an example Assumptions: Two companies from two countries are capable of producing a good Neither country has any domestic demand for the good – the good is intended solely for export The producer surplus coincides with the national interest Each firm faces only a binary choice – either to produce or not to produce The market is profitable for either firm if it enters alone, unprofitable for both if both enter

Strategic Trade Policies – an example The good is a 150 – seat passenger aircraft The firms are Boeing and Airbus The countries are the U.S. and the EU The Payoff Matrix Airbus PN P -5 0 Boeing N 0 0

Strategic Trade Policies – an example Boeing has some kind of head start that allows it to commit itself to produce before Airbus’s decision Boeing earns 100 while deterring entry by Airbus The EU decides to subsidize Airbus at a point before Boeing is committed to produce The EU pays a subsidy of 10 to Airbus if it produces the plain, regardless of what Boeing does

Strategic Trade Policies – an example The Payoff Matrix after European Subsidy Airbus PN P 5 0 Boeing N 0 0