Protectionism

Free trade and protectionism

Free trade allows the free movement of goods and services, labour, capital, and the exchange of technology and information around the world.

Thanks to free trade, countries can engage in international trade without any restrictions. In theory, countries benefit from the specialisation, movement of resources, and increase in competition that free trade implies. Because of that, there are many advantages to free trade.

Despite the advantages of free trade, there are some who lose out from free trade.

The main way in which countries lose out from free trade is if their export sector isn’t competitive or loses its competitive advantage. This causes them to lose out from trading and selling their exports, and this has many negative effects on the wider economy. Because of that, many governments choose to implement protectionist policies.

Protectionist policies

As mentioned previously, there are many different protectionist policies a government can choose to implement. Let’s study the two main policies governments usually choose.

Tariffs

Tariffs are also known as customs duty or import tax.

Imposing tariffs makes imports more expensive than the domestic production of the same goods. Tariffs give domestic producers a chance to compete against foreign goods and services. For the government, tariffs help raise tax revenue. Figure 1 shows how trade tariffs work.

Fig. 1 - Trade tariffs

Figure 1 shows the demand and supply for coffee in Country A. The domestic demand for coffee in Country A is at Q4, while the domestic supply is at Q1. There is excess demand. Thus, to meet this demand, the country imports coffee from foreign countries (Q1 - Q4 is what is imported).

However, domestic firms lose out as they can’t compete with foreign countries that are able to meet the domestic demand for coffee. To help these firms out, Country A’s government imposes a tariff on coffee imports.

This tariff increases the price for imported coffee from P0 to P1. Because it is more expensive, domestic demand for coffee falls from Q4 to Q3, but domestic supply increases from Q1 to Q2. This is because domestic firms are now able to meet the demand for coffee. The imports for coffee fall from the distance of Q1 - Q4, to Q2 - Q3.

Consumer surplus has decreased from P0ZM to P1ZN as consumers now pay a higher price for coffee. Producer surplus increases from XP0R to XP1Q, as domestic firms are able to increase their supply and generate more profits. The government generates tax revenue from the imports of coffee and there is a net welfare loss in the global economy.

Quotas

Like tariffs, quotas also target imports. Although they do it in a different way.

The main difference between tariffs and quotas is that with quotas imports are limited instead of more expensive. Figure 2 shows the effects of imposing a quota on the economy overall and the global economy.

Fig. 2 - Trade Quotas

Sticking to the example of coffee in Country A, the domestic demand for coffee is Q4, while the domestic supply is Q1. Again, there is excess demand. And again, to meet this demand, the country imports coffee from foreign countries (Q1 - Q4 is what is imported).

Again, domestic firms lose out as they can’t compete with foreign countries that are able to meet the domestic demand for coffee. To help these firms out, Country A’s government imposes a quota on coffee imports.

The quota increases prices from P0 to P1 because there is a shortage of coffee in the country. The increase in price causes the demand for coffee to fall from Q4 to Q3. As Q1 - Q4 is no longer being imported, there is a gap between Q1 - Q3. To fill this gap and the shortage of coffee in the country, domestic firms increase their supply. Domestic firms supply put to Q1 and Q2 to Q3. Q2 - Q3 is, thus, the new amount that can be imported.

Consumer surplus falls from ZMP0 to ZNP1, and producer surplus rises from XP0R to XP1Q. There is a net welfare loss to the global economy due to world inefficiencies. Domestic firms in Country A produce coffee in a less efficient way than if foreign countries were to produce it.

Other policies and instruments

Although tariffs and quotas are the more commonly used protectionist policies, there are other policies that a country could use instead.

Embargoes

They are a restriction or a ban imposed on certain goods. These goods are usually those that are consequential in nature such as elephant ivory, drugs, weapons, etc. Embargoes are also typically politically motivated and less about protecting domestic industries.

Subsidies

They are a form of monetary assistance provided to either exporters, industries, or businesses. The assistance helps such firms or businesses to reduce costs and capture a larger market share and consumers, both at home or abroad. The subsidies paid to these businesses are paid from the tax revenues and while the taxpayers lose, the consumers benefit from the subsidies in the short run as well. However, in the long run, more efficient foreign firms could be rooted out and if the domestic producers raise prices, this would be a loss to the consumers.

Product standard regulations

These usually take the form of high safety standards or emission requirements. Foreign firms’ products that don’t comply with the standards can’t be imported, and this gives the opportunity to the domestic firms who comply with the standards to perform well.

Exchange control

This is when governments place a restriction on the amount of domestic currency that can be sold in the Forex market for the purchase of foreign currency. This helps place a limit on imports, investments, or travel abroad.

Economic and administrative burdens

Also known as ‘red tape’. It can discourage importers or foreign firms from doing business in the domestic market. Governments could do this deliberately to restrict foreign business activity. Product standards regulations such as safety standards are also sometimes used deliberately for the same purpose.

Voluntary Export Restraints (VER)

This is an agreement made between the two countries to restrict imports they make to one another. Governments can also manipulate exchange rates such as decreasing the exchange rate, to give domestic producers a competitive edge over foreign competition.

Protectionism examples

Some real-world protectionism examples are:

• EU Common Agricultural Policy (CAP). The EU imposes tariffs on many agricultural markets with the aim of protecting its domestic farmers.
• Tariffs on imports of tyres. The US has imposed tariffs on the imports of tyres from China. The tariffs levied were around 35%.
• Banana Wars. The EU imposed tariffs on the imports of Bananas from Latin American countries. These tariffs were reduced after an agreement was reached in the year 2012.
• Food tariffs. To protect local farmers in Argentina, the country increased tariffs on agricultural goods under the Mercosur Common External Tariff (CET).

The benefits of protectionism

Some benefits of protectionist policies are:

• Protection of industries: sometimes governments impose trade barriers to protect domestic industries, and this is especially the case for infant industries and for developing countries. Without any protection, infant industries most likely will find it difficult to compete with international companies or more competitive foreign industries and so protectionist policies might stay in place until those growing industries are big enough. However, with all the protection, these domestic industries could suffer from the curse of protectionism: not becoming competitive enough. Either they continue to have a lower quality of goods and/or services and/or higher prices.

• Protect jobs: losing infant industries and businesses to better and more competitive foreign companies, protectionist policies are also aimed at protecting jobs in the economy.

• Improves terms of trade: imposing barriers to trade means imports become expensive in a country. This is aimed at giving domestic production, goods, and services a chance to compete. With expensive imports, a country’s terms of trade will improve. However, this depends on the commodity in question and on its price elasticity of demand (PED).

• Ban goods: protectionist policies or instruments are sometimes also used by the governments to ban certain goods that are considered bad such as certain kinds of weapons or drugs.

• Anti-dumping: dumping is the deliberate practice of exporting goods/services at a price lower than its production cost to outcompete businesses. Sometimes, when governments face this practice by foreign companies or imports, they use protectionist policies to protect domestic businesses and producers from running out of business.

The disadvantages of protectionism

Like with every macroeconomic policy, there is always a good and bad side.

Some downsides to protectionist policies are:

• Reduce efficiency: protectionist policies lead to the global economy becoming less productive and to allocative efficiency. These policies divert resources away from their most efficient use in the economy. Additionally, with a lack of specialisation and competition, there is little incentive for the firms to be efficient. Thus, prices tend to be higher, which is bad both for the consumers and the producers.
• Higher prices: protectionist policies lead to higher prices which can be even more damaging, overall, if the goods in question are everyday goods. This could lead to high inequality as high prices impact the poorer factions of the economy harder than the richest ones.
• Harm domestic industries: domestic industries neither get the opportunity nor the incentive to grow, which means more and more dependence on protectionist policies for survival. Once these policies are in place, it could get difficult to remove them.
• Impact on international politics:the policies in question can also have an impact on international politics and not just on economics.

  Putting protectionist policies in place could trigger response and retaliation from countries that get affected by such policies. There is always a risk of a potential or an actual ‘trade war’, leading to other geopolitical problems while also disrupting international trade patterns.