This analysis shows that the policy of free trade is potentially superior to a policy of import protection where welfare is concerned. It also means that there is always an optimal free trade point on the optimal trading line, FPF`, at which everyone is made better off than being at some particular trade-distorted consumption point. According to the Scitovsky condition, the collection of goods at the new tariff point C` is always insufficient to make everyone as well off as they are at the free trade point (R Baldwin, 1992, p806).
In today’s society, fair trade and harmonisation of domestic policies and institutions amongst trading partners are required for free trade to occur. The reason for this harmonisation is to counter the arguments for protection. Industries are likely to be given the protection if they can prove that the foreign country is gaining from unfair trade advantage such as low wages (the paper-labour argument). A good example of this is where Mexico agreed at a NAFTA meeting to increase its minimum wage to bring up its labour cost.
Without harmonisation before free trade occurs there is the fear that trade may cease to become mutually beneficial, however economic analysis has proved that harmonisation is not always necessary. According to Bhagwati “diversity of domestic policies, institutions, and standards is generally compatible with gainful free trade.” Unfortunately the popular assumption is that if your rival abroad has lower labour standards that amounts to ‘social dumping’ in your market. As a result of this dumping that you earn the right to impose import duties. If a country were engaging in free trade it needs to make sure that it doesn’t go down the route of dumping, as it would give the protectionists ample ammunition to cite more reasons for countervailing duties.
Another challenge to free trade is the fear of the income-distributional effect of trade with the South (the South being developing countries, as most developed countries are in the North). It used to be a different story, when the South were weary of trade with the North thinking they couldn’t industrialise without protection schemes. Advocates of protectionism utilise the idea of Factor Price Equalisation (FPE) and the Stolper-Samuelson (SS) theory to show the adverse impact of free trade on the factor of production that is scarce in the country relative to abroad in the country’s trading partners. In this case unskilled labour in the North vis-à-vis unskilled labour in the South, relative to other factors of production such as capital. The presumption is that rich country imports (unskilled) labour-intensive goods and exporting (human and physical) capital intensive goods and that the terms of trade improve when trade is freed. In this 2x2 SS model, the real wage of unskilled labour falls. Nevertheless, Helpman & Krugman (1985) disproved this using the scale economies argument. They concluded that scale economies invalidated this proposal and both factors’ real wages rose.
Having looked at arguments for and against free trade, we now turn our attention to the major trade-policy intervention, namely terms of trade or optimum tariff argument.
The Terms-of-Trade Argument for Protection
Countries can influence to a certain extent the international price of traded commodities by restricting its demand for or the supply of commodities through various policy measures. Under these conditions we find that the Pareto-optimal condition that marginal revenue equals marginal cost is not satisfied for that country. In this case, free trade is not the welfare maximising policy for the country. If an import duty or export tax were imposed everyone in the country would be better off. A clear example of an export tax is the tax on oil by Saudi Arabia and other oil producing countries. One cannot argue that Saudi Arabia would have been better off under free trade. This is the best-known traditional argument against free trade.
Imposing an Optimum Tariff
The curve oF in Figure 2 represents the foreign offer curve with points along oCC`F indicating the amounts of commodity Y foreigners will offer for commodity X at various prices of X in terms of Y. We find that the optimal welfare position for the country is at the community indifference curve at point C. To determine production and trade in the home country, the individual would set the international price of X which equals the slope of oC and produce at the point o, where the marginal social cost of producing X equals the marginal revenue from trading X. If the market is perfectly competitive both domestically and internationally, the optimum point C can be attained through the government imposing an import duty on Y or an export tax on X which raises the domestic price of Y above its international price and brings production to the point o on the production possibilities curve. In the case where a monopolist controls Y, the government can impose a subsidy on Y to offset the monopolist’s mark-up on domestic sales and achieve Pareto-optimal for the country as a whole. If under variable production conditions, the offer curve a country faces is not completely elastic, foreign trade policies are taken as fixed, and there are no domestic distortions, an optimum tariff or export-tax policy is better than a free trade policy for a country. No matter what the free trade collection of goods, there is some attainable collection of goods reached with an optimum tariff where there are more of all goods and thus the welfare of consumers could be increased compared to their free trade welfare position. This does not imply that the collection of goods is superior to that of welfare under free trade. There doesn’t need to be more goods at the optimal tariff position than at the free trade point and it may not be possible by redistributing the optimum tariff bundle of goods to make everyone better off than they are with the free trade bundle. There is a theoretical case for intervention when Pareto optimal conditions are not satisfied for the country because of either an international or domestic economic distortion. In this case the distortion is international, because free trade and perfect competition, the country’s marginal revenue from trading will not equal marginal cost of production and marginal rate of substitution in consumption.
Whilst theoretically it seems appropriate to intervene in certain cases we need to consider other issues. For example, protectionism can result in retaliation from the countries affected through higher tariffs. The resulting trade war reduces the benefits from trade below those achieved by the country before its unilateral trade intervention. Under World Trade Organisation (WTO) rules, a country that increases tariffs above agreed levels must compensate major exporters affected by the ruling or risk retaliatory increases in duty. In the case of retaliation and counter-retaliation both countries may end up being worse off than under free trade. Most economists would argue for retaliation if an industrial country initiates a protectionist policy.
Developing nations have improved their terms of trade through effective use of protection. However, this has been carried out with the co-operation of developed countries to a certain extent, as it suited the developed country’s foreign policy. One of the problems with the infant industry argument is that it is hard to remove these tariffs as the concerned industries benefit from them. Infant industries do not have an incentive to be competitive as long as they are protected. Clear examples of this are in the US & Germany in the 19th century when they had high tariffs on manufacturing, Japan used tariffs in place until the 70s to bring its infant industries to the world level of competition.
The new theories of protection involve analysing the imperfect competitive conditions as opposed to the perfectly competitive paradigm traditionally assumed. The imperfect paradigm usually involves oligopolies and not monopolies. This usually leads to direct implications for government intervention. Protection in this market gives domestic firms a strategic advantage relative to their foreign rivals. Suppose there is no domestic production and as a domestic firm tries to enter into the market, the foreign firm sets its output at an entry deterring level. In this case the domestic economy gains from levying a tariff up to the point where the domestic firm will be able to enter the market. If the tariff goes above this level, there is the risk of reducing welfare.
Export subsidies can also be employed which pre-commits the firm sales to the foreign market. However the effect of protection in this market is sensitive to whether the markets are segmented, or if they are integrated and whether the number of firms in the industry is fixed or whether free entry exists.
It is clear that oligopoly is a better description of the world market, thus we would expect that economists advocate the use of protection for oligopolistic firms, but the empirical evidence does not support this. Strategic export policies sometimes lead to a lower national welfare as there are too many domestic firms.
In conclusion we have seen that protectionist policies are controversial as they can lead to lower welfare in the long run whilst trying to improve terms of trade. A clear example of free trade being better is the case of Canada, whose welfare is 8.6% better off than it was before the NAFTA agreement. There are larger gains to be materialised through trade liberalisation and not protection. Krugman argues “There is still a good case for free trade, and as a useful target in the practical world of politics”. Taxes on goods can lead to adverse effects, especially for the poor, so it is better to aim for the goal of free trade. With technological advancements and free mobility of financial capital, globalisation of the world economy has led to an increase of ‘freer’ trade, and an increase of GNP. Unfortunately Pareto optimality is very difficult to attain, as such there are many theoretical grounds for intervention, but the majority of times the welfare will be lower under intervention.
Bibliography
P Gray (1985) Free Trade or Protection – A pragmatic analysis
N Vousden (1990) The economics of trade protection
G Hufbauer (1986) Trade protection in the United States: 31 case studies
P Krugman & M Obstfeld (2000) International Economics Theory & Policy
R Baldwin (Jun. 1992) Journal of Economic Literature Vol. 30, Issue 2: Are Economists’ Traditional Trade Policy Views Still Valid?
J Bhagwati (Mar., 1994) The Economic Journal Vol. 104 Issue 423: Free Trade: Old and New Challenges
P Krugman (1987) Journal of Economic Perspectives Vol. I: Is Free Trade Passé
James Brander, Barbara Spencer, Paul Krugman are some of the pioneers of this “new” trade theory.
Free Trade or Protection, Peter Gray (1985)
Abba Lerner (1936) pointed out that these two policies are essentially the same. (Gray 1985)
