Free Trade and Protection

Free Trade

This is defined as the absence of government intervention of any kind in international trade, so that trade takes place without any restrictions or barriers between individuals or firms in different countries.

There is a general agreement among economists that free trade and reductions of trade barriers have a positive effect, they also may have negative effects.

Australia’s Significance of Trade

• World’s Largest Exporter of iron ore, coal and wool
• 2nd largest exporter of Aluminium ores and beef
• 3rd largest exporter of copper ores
• 4th largest exporter of wine, sugar and cotton
• 5th largest exporter of pearls
• 6th largest exporter of gold

Trade is extremely important to the Australian economy.

• As a proportion of growth:
  • Trade represents 46 percent of GDP for Australia.
• Driver of growth
  • Over the last 30 years Australia’s economy has doubled, with exports accounting for over a quarter of this growth.
• Liberalisation (trade)
  • Over past 30 years contributing to higher real GDP (income)
• Employment
  • 1 in 5 Australians are employed in a trade related activity.
    • In Export related industries (e.g. agriculture, minerals and energy) and also sectors related to the importation of goods and services.
• Consumer Welfare
  • Access to wider variety of goods and services at more competitive prices.
  • Improves standard of living due to affordability.
  • Prices of Aud. Vis. and computing equipment fallen over 50 percent in the last 5 years.
    • Imports: Reduces cost of production due to lower or removal of tariffs. Increases employment. Over half of imports are essential inputs to produce goods locally.
• Competition
  • From overseas markets compels Australian firms to innovate and adopt more efficient methods. Improved efficiency boosts economic growth.

Specialisation

Specialisation occurs when an individual, firm or country concentrates production on one or a few goods and services.

• This refers to specialisation by a country in the production of a range of goods or services that it can produce efficiently (at a low cost)

A country has to consume all goods and services that are produced if it does not trade, and therefore cannot specialise.

However, if it uses its resources to specialise in the production of those goods and services it can produce more efficiently (with lower costs of production), it can produce more of these, and trade some of them for other goods produced more efficiently in other countries.

This way an economy is able to produce a greater quantity of output because it does not ‘waste’ its scarce resources on producing goods and services at a relatively high cost.

It can also increase consumption of goods and services, because by exporting part of its larger domestic output in exchange for other output produced more cheaply elsewhere, it can acquire a larger overall quantity of goods and services.

This is basically the theory of comparative advantage.

International specialization is possible due to the uneven distribution and quality of resources between nations.

• Australia has a lot of natural resources
• And for example, Japan lacks these natural resources but has a very large workforce and highly developed industrial base
  • Hence why Japan has developed an expertise in producing high quality manufactured goods like motor vehicles and electronic equipment

Benefits:

• Differences in the distribution of resources in terms of quantity and quality will affect the cost of supplying goods and services.
• If production costs differ then countries will benefit by:
  • Specializing in the goods and services in which they are most efficient
    • Exporting surplus production and importing those goods and services in which they are less efficient at producing domestically

Absolute and Comparative Advantage

Example Table:

	Good 1	Good 2
China	100 (1/2)	50 (2)
Australia	400 (1/4)	100 (4)

4 key assumptions:

• Two Countries
• Two Goods
• Perfectly Mobile (Transport is not an issue)
• The two countries have same resources

Absolute Advantage: You can make more of a good with the same amount of resources

We trade based on the concept of opportunity cost, where we trade the good with the lower opportunity cost.

When we export, we operate on world price not domestic price. The supply curve is all the suppliers in the world that produce the same good.

You cannot produce beyond the PPF, but you can consumer beyond your PPF by trading!

Comparative Advantage is the argument for trade, so that we can specialise in a good which we have a lower opportunity cost in.

• Trading allows us to consume more

Stepped Out Example

We can see in this table, that there are two different countries; Australia and China. Furthermore, there are two goods which are bread and cheese. We are assuming there are no more countries to trade with, and no more goods that these countries can produce and trade.

Remember: This table shows an “either or” situation, where each country can either choose to use all their resources in one good, sacrificing the production of the other good.

• So in this case, Australia can choose to produce either 1000 loaves of bread or 100 kilograms of cheese. China can choose to produce either 800 loaves of bread or 200 kilograms of cheese.

Australia has the absolute advantage in bread in this economy, while China has the absolute advantage in cheese in the economy. This is because they can produce more of that good that they have an absolute advantage in with the same amount of resources. (Remember we assume that each country have the same amount of resources at their disposal but we know this is not true in the real economy)

There is also an opportunity cost when producing either goods. We can give a value to each good for each country the could produce it.

Opportunity Cost for Australia:

• To produce 1 loaf of bread, they give up producing 1/10th of a kilogram of cheese. (Cheese quantity divided by bread quantity)
• To produce 1 kilogram of cheese, they give up producing 10 loaves of bread. (Bread quantity over cheese quantity)

Opportunity Cost for China:

• To produce 1 loaf of bread, they give up producing 1/4 of a kilogram of cheese. (Cheese quantity divided by bread quantity)
• To produce 1 kilogram of cheese, they give up producing 4 loaves of bread. (Bread quantity over cheese quantity)

I have added it to the table below, where the opportunity cost of producing one of the good is in brackets in it’s corresponding box:

So who has the comparative advantage? Well in this case, Australia and China have the same comparative advantage as their absolute advantages, but these can be different in some instances. Australia and China have a lower opportunity cost in producing bread and cheese respectively.

Trade. Does Australia want to trade with China and vice versa? It depends on the price of trade. This can be agreed upon with an agreement (wow!), but for our purposes let’s give them both the same benefits.

Bread Side of Things:

• Australia has the comparative advantage in bread so they choose to trade bread in exchange for cheese.
• Without trading, they would have to give up 1/10th of a kilogram of cheese to produce 1 loaf of bread.
• This means that Australia will accept anything above 1/10th of a kilogram of cheese in exchange for 1 load of bread.
  • E.g. 1/9th, 1/5th, 1, 10 million
• On the other hand, China would have to give up 1/4 of a kilogram of cheese to produce 1 loaf of bread without trading.
• This means that China will accept giving anything below 1/4 of a kilogram of cheese in exchange for 1 loaf of bread.
  • E.g. 1/5th, 1/9th, 1/1 million
• If we meet in the middle, where both parties have equal benefits, we can reach 1/7th of a kilogram of cheese in exchange 1 loaf of bread.

Cheese Side of Things:

• China has the comparative advantage in cheese so they choose to trade cheese in exchange for bread.
• Without trading, they would have to give up 4 loaves of bread in exchange for 1 kilogram of cheese.
• This means that China will accept anything above 4 loaves of bread in exchange for 1 kilogram of cheese.
  • E.g. 5, 10, 420, 14 billion
• On the other hand, Australia would have to give up 10 loaves of bread in exchange for 1 kilogram of cheese without trading.
• This means that Australia will accept giving anything below 10 loaves of bread in exchange for 1 kilogram of cheese.
  • E.g. 9, 7, 1/3
• If we meet in the middle, where both parties have equal benefits, we can reach 7 loaves of bread in exchange for 1 kilogram of cheese.

As you can see, the ratio of bread to cheese is the same, and hence we can use this as a theoretical price that these countries will trade at:

• 7 loaves of bread in exchange for 1 kilogram of cheese
• Which is equal to 1 loaf of bread in exchange for 1/7th of a kilogram of cheese

Note: This is a theoretical price - a possible price of many prices. They do not have to agree on this price. They could agree on a more lopsided price which is in favour of one of the countries, but still benefit both parties.

Consumption PPF

So Australia and China agree to trade at this price. Let’s say Australia wants to trade 700 loaves of bread with China. Since China is specialising in cheese, they are not producing any bread, and want bread. So, China will receive the 700 loaves of bread in exchange for 100kg of cheese because the price of 1kg of cheese is 7 loaves of bread. These are the final amounts that each country has after trading.

China:

• Bread - 700 loaves
• Cheese - 100kg

Australia:

• Bread - 300 loaves
• Cheese - 100kg

We can plot these on the PPF, to compare the benefits of trading.

The blue line represents the original PPF, while the red dotted line represents the new consumption PPF curve after trading. REMEMBER: this is the consumption PPF, and hence you can NEVER ever produce more than the PPF, you can only consume beyond the PPF.

Now, if Australia trades all their bread for cheese with China, they will get 143kg of cheese which is more than the 100kg without trading. If China trades all their cheese for bread with Australia, they will get 1400 loaves of bread which is more than the 800 if they didn’t trade.

Gains from Trade using D&S Model

1. The demand and supply model may be used to determine the relative price of a good which is the same as opportunity cost.
2. By comparing the domestic price of a good with the world price we can determine whether a country has a comparative advantage.
3. If the domestic price is lower than the world price, then the country must be relatively more efficient at producing this good
4. Hence, it has a lower opportunity cost - comparative advantage - and it will benefit by exporting this good to the rest of the world.

Exports

After Trade, producers gain by selling more and receiving a higher price.

Consumers in Australia however will lose because they consume less and pay a higher price.

Economic Welfare will increase as a result of exports.

Imports

After trade, consumers gain by receiving more and buying at a lower price.

Producers in Australia however will lose because they produce less and sell at a lower price

Economic welfare will increase as a result of imports

Protection (Tariffs Subsidies Quotas)

Free Trade refers to the absence of government intervention. Government intervention leads to an inefficiency, and this includes protection.

Trade protection involves government intervention in international trade. Imposition of trade restrictions.

• Focus on domestic benefits and restricts imports

Three Types of Protection

Tariffs:

• A tax on imported products
• Increase the domestic price of a foreign product

Subsidies:

• Provide domestic producers with a cost advantage

Quotas:

• Impose quantitative restrictions on imports

Protection seeks to increase domestic production in the industries and decrease the consumption of imported goods and services.

Those that benefit from the protection include owners and workers in the protected industries.

Protection does however impose a cost or burden on the economy.

• The industries that are given protection will expand production and consumer more resources that other industries could have used.

Costs of Protection

• Production in non-protected industries will fall
• These industries may also have to pay higher prices for imported inputs which will reduce their competitiveness
• Protection, while decreasing import will also decrease exports
• All forms of protection result in a welfare loss in the economy

Tariffs:

• Consumers get less of the product and also have to pay a higher price.
• Consumers’ loss is more than offsets the gains to producers and the government.
• Whole welfare of total surplus of society as a whole is reduced whenever a tariff is imposed
• Deadweight loss may seem small, but it can affect other industries who buy the product that is getting tariffed, so it may also result in lower exports.
• Results in a net decrease in employment. (Benefits the protected industry as more are employed but it’s a net decrease)
• As tariff rate was increased, would government revenue increase?
  • No, since if it were increased to the equilibrium price, imports would fall to 0 and government revenue would be 0

Subsidies:

• Subsidies are grants or payments made by the government to domestic producers
• They are paid for out from general taxation revenue and directly lower a producer’s cost of production
• Increase the world price closer to the domestic price so that they can compete at a higher price
• There are no direct costs to consumers but there are indirect opportunity costs
  • Cost of the subsidy has been paid out of taxation revenue
• Resource allocation is affected due to inefficient producers being rewarded at the expense of efficient producers.
• There is a DWL even if consumer surplus does not change an producer surplus increases.
• Cost of subsidy is greater than gain in producer surplus

Arguments for Protection

Why should we implements tariffs, subsidies, or quotas?

Explain the argument then explain why its invalid.

Anti-Dumping Argument

• Producer/nation produces and then dumps a product in another nation’s market - at a price that is lower than the cost of production
  • To drive the domestic producer out of business
  • Product is defective or getting rid of surplus
  • Illegal in the country
• Putting subsidies into exports is illegal and also an unfair practice
• Problem:
  • Generally does not happen - Normally the cost of production is just lower

Infant Industry Argument

• When an industry is first been developing (has not have had the time to establish itself) - higher cost structure
• Protect it because it can’t compete in the global scale - The idea is put protection in place for a short time
• They may have a comparative advantage, but not yet be visible, so it gives them time to mature
• You won’t protect every infant industry, only comparative advantageous infant industries.
• Problem:
  • Industries become dependent on the protection and cannot get to the point of competing in the global scale
  • May be difficult for the government to know which particular industries have the potential to become competitive on the global scale

Strategic Trade Policy (Similar to Infant Industry but don’t focus on this one)

• Protection of high technology industries to help them achieve economies of scale and create a comparative advantage.
• Protection in this case involves not just barriers to trade but also a variety of interventionist supply-side measures including tax advantages, low interest rates and government financing.
• Problem:
  • May be difficult for the government to know which particular industries have the potential to become competitive on the global scale
  • Hard to select appropriate protective policies.

Diversification Argument

• If you focus on specializing one good, and something happens then your economy may get destroyed
• Often applies to developing countries that are very highly specialized in producing and exporting one or a few primary commodities
• Problem:
  • Developed countries specialise in multiple industries
  • Governments may not know about which products or industries need protection

Nation Security (Defence) Argument

• Certain Industries are essential for national defence e.g. as aircraft, weapons, chemicals, certain minerals)
• Problem:
  • Some industries may have an indirect use in defence e.g. steel, and try to get protected

Increased Employment Argument (Protection of Domestic Jobs)

• Restrictions on imports are needed to protect domestic employment
• Import restrictions cause consumers to shift consumption away from imports and towards goods produced domestically.
• Problem:
  • Protection of these industries may be at the expense of employment in efficient export and import competing industries. 
    • It could lead to increased costs of production of industries who use imported goods in their productive processes.  Consumers will be faced with higher prices (income effect) and will have less to spend on the output of other industries (sectors).  Nations affected by the tariffs may retaliate with tariffs of their own, therefore reducing employment in export industries.  Reducing imports through tariffs may lead to an appreciation of the exchange rate, further reducing the competitiveness of export industries.

Cheap Foreign Labour Argument

• Domestic industries need to be protected from countries where wages are much lower
• Problem:
  • The level of wages is a function of productivity.  Australian workers can be payed higher wages as their productivity is higher.  Countries that have an abundance of labour relative to other resources will have a comparative advantage in labour intensive goods (think textiles), whereas countries that have high capital to labour ratios will be more competitive in industries that are capital intensive.

Favourable Balance of Trade Argument

• Trade balance is exports minus imports (X-M)
  • If Exports is greater: trade surplus
  • If Imports is greater: trade deficit
• Protection to decrease imports, create barriers of entry, so that we can get a trade surplus
• Problem:
  • Decreased imports would come at the expense of falling exports; there is a risk fo retaliation.

Benefits for Trade Liberalization

1. Economic Growth: Increases real incomes and living standards
   • Also openness to trade and investment is a major catalyst for economic growth
   • Discuss imports and exports for trade affecting GDP
   • Exports: Increased number of markets and larger markets
   • Imports: Lower cost of production

2. Efficiency: Increases efficiency through greater competition

3. Productivity: Increases productivity though efficient resource allocation

4. Consumer Gain: Consumer gain through lower prices and increased market access
   • Potentially higher quality as well
5. Domestic Producers: Domestic producers gain through lower input prices
   • Can sell at a lower price
6. Economies of Scale: Enables a greater specialization which allows economies of scales
   • More you produce, the more discounts you accumulate
   • Economies that produce much more will sell their products at a lower price because their cost of production are less