The Case Against Free Trade

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The Case Against Free Trade

In the Learn-It called 'The case for free trade - comparative advantage', you can see a fairly convincing economic argument in favour of international trade without barriers based on the theory of comparative advantage. It is certainly true that the world economy as a whole benefits from free trade, but who are the winners and losers? Some industries within economies will lose out under a free trade regime. Governments may seek to help these industries through 'protectionism'.

To start with, we need to look at the methods of protection in some detail. Then we shall look at some of the economic reasons given by those who defend protectionism. Finally, we shall briefly look at some of the counter arguments of those who reject protectionism.

...Or, to put it another way, trade barriers. The most famous of the lot is the tariff. Although its use has been much reduced through the sterling work of the GATT and the WTO, it is still the first port of call when a government is thinking of a way to deter foreign competition.

Tariffs

A tariff is, quite simply, a tax levied by the government on imported goods. This forces the price of the good up and so makes it relatively expensive in the home market. This benefits the domestic industry as its product now appears relatively cheaper to home consumers. The home industry has, in effect, been 'protected' from the foreign competition.

It should be noted that the foreign firm could absorb the tax by reducing its price until the overall price (including the tariff) is the same as it was before the imposition on the tax. The firm is unlikely to be able to do this forever, though, and the tariff imposing country could always raise the tax again.

The diagram below shows the effect of introducing a tariff on a good in a previously unprotected market. This diagram is very popular with examiners for multiple-choice questions. It is important that you understand fully what is going on in this diagram.

Tariffs

This diagram is an extension of the one used in the Learn-It called 'The case for free trade'. Again, the world supply curve is assumed to be horizontal (SW). The domestic supply curve above point G no longer exists given that the world price (PW) now dominates. The effective supply curve, therefore, is the line JGSW. The demand at price PW is OQ4, of which OQ1 is supplied domestically. This means that the rest is imported (Q3 − Q4). Notice that consumer surplus is represented by the large triangle ACPW and that producer surplus is represented by the much smaller triangle GJPW.

If the government now decides to protect the home industry be imposing a tariff (equal to PWPW+T) on world imports, the world supply curve will shift up to SW+T and the new price will be PW+T. At this higher price, demand falls back to OQ3, of which OQ2 is supplied domestically (more than before). Imports, therefore, have now been reduced to Q3 − Q2.

The higher price has reduced consumer surplus from ACPW to ABPW+T. Some of this welfare loss has been transferred to other parties. The black shaded trapezium (PWPW+THG) is now extra producer surplus (or profit for the domestic producers). The green rectangle (BEFH) is now government revenue from the tax on imports (number of imports times the tax per unit). The two red triangles represent losses to society.

The first red triangle (FGH) represents the loss due to the fact the quantity between Q1 and Q2 used to be imported at a total cost in terms of resources used of FGQ1Q2 (number of units supplied times cost per unit), but is now produced domestically at a higher cost (HGQ1Q2). The upward sloping domestic supply curve shows that the cost per unit is rising for the domestic firms, whereas this cost per unit is constant for foreign producers.

The second red triangle (BCE) is simply the loss of consumer surplus due to the fact that consumers used to be able to buy the quantity between Q3 and Q4 at price PW and now they don't, because at the higher price the demand is only Q3.

Non-tariff barriers

Due to the fact that the tariff has always been the main method used for protection (although that is not so true nowadays), textbooks often lump all the other methods of protection into one group called 'non-tariff barriers'. Here is a quick look at these other forms of protection.

  1. Quotas. A quota is a physical limit on the number of units of the product that can be imported into a country. The restriction in supply has a similar effect to the tariff in that the price will rise, demand will fall and there will be a welfare loss to society. The difference is that at least with the tariff the domestic government receives some tariff revenue; with the quota, the benefit of the increased price goes to the foreign firms who provide the imports. Voluntary Export Restraints (VER) are very like quotas, but the two countries involved agree on the restriction. It might seem odd for the exporter to agree on a quota, but as discussed above, the revenue per unit sold increases. Until recently, Japan and the EU had such an agreement for the importing of Japanese cars.
  2. Subsidies. A subsidy is a grant paid by the government to a firm producing a certain good. It may be paid to promote the production of the good in question or, in this context, as a 'helping hand' to domestic producers to help them compete with the foreign competition. A good example is the agriculture industry. The EU gives farmers across Europe billions of pounds. The USA also subsidises their farmers (a sort of retaliation).
  3. Exchange controls. Some countries still control the amount of foreign currency that is available so that the amount of imports that can be bought (with foreign currency) is reduced. Thatcher's first Conservative government abolished exchange controls in the UK in 1979. She believed in free markets and this included the free flow of capital between countries.
  4. Other bureaucratic restrictions. Countries often impose certain safety standards that are unnecessary, but put off foreign imports. In the past there have also been some ridiculous time-wasting regulations. There are many examples of countries that will only allow certain goods to be imported through a certain port or checkpoint. There have also been examples of countries that take weeks to process the administration involved in admitting an import.

There are a number of reasons why some people think that it is justified to use trade barriers. Many of them, some would say, are a little old fashioned in today's global economy. The first is probably the one that is normally used by politicians in the heat of an election campaign, especially in the USA.

Protect domestic jobs

It always looks good as a politician to be seen to care about domestic jobs at election time. Cheap imports may put domestic firms out of business creating unemployment. Perhaps barriers could be used to protect these jobs.

Free traders would argue that consumers suffer from higher prices and resources may well be misallocated if the market is distorted with barriers. The whole point of free trade is that whichever country is relatively better at making a certain good should be allowed to do so for the benefit of the world economy. Those in developed economies working in old fashioned manufacturing industries where the good can usually be made cheaper in a developing country must accept the fact that developed economies are moving away from the production of manufacturers towards the service sector. Trade barriers are a short-term solution, but long-term career prospects are best served in a newer, higher productivity industry.

Dumping

Dumping is where goods are sold (or 'dumped') in a foreign country at below cost price in order to kill off the competition and increase future market share. It is very similar to the concept of predatory pricing used in the topic called 'Market structure'.

Dumping is a widespread activity, so much so that countries that are being dumped upon are allowed, if approved by the WTO, to take retaliatory action. Some dumping is simply a short-term measure to get rid of excess stock that a company may have found difficult to sell in their domestic market. This is broadly acceptable. It is the predatory dumping that the WTO does not like.

Retaliatory duties do not officially count as tariffs. If they did, the average level of tariffs in the world would be much higher than the 5% figure given in the previous Learn-It. The number of complaints about dumping made to the WTO has been rising throughout the 90s.

Japan often gets accused of dumping. This is why you see many Japanese companies setting up factories in the country to which they normally export. These investments are often called 'screwdriver' plants (e.g. Nissan in Sunderland). All of the parts are taken to the new plant and then the parts are 'screwed together' to make the final car (in the case of Nissan). These cars now become UK domestically produced cars. These cars can then be exported around the EU barrier-free because the EU is a barrier-free customs union.

The infant industry argument

This is a rather old fashioned argument but countries do still protect infant industries if they can get away with it. If a country is planning to start up a new, but major, industry that is already established in many other countries, then they will start at a huge disadvantage. It will take time to develop experience economies and grow large enough to benefit from economies of scale. This is recognised by the WTO and some protection is allowed as these new industries find their feet.

The difficult question is when do you stop protecting this industry? Whilst it is harsh to face world competition straight away, it is also damaging for the firm to get used to this artificial short-term crutch. What if the industry is never strong enough to stand on its own two feet? Did the country in question choose the wrong industry (in which they did not, after all, have a comparative advantage)? This would be a horrendous waste of resources. If these infant industries face true competition from the start then only the fittest would survive and resources will have been allocated efficiently. What do you think?

The strategic industry argument

Some would say that this is also a slightly old fashioned argument given the unlikelihood of another World War. To be fair, though, it is always wise, as a country, to make sure that, in times of trouble, certain basic foodstuffs can be produced. As was said earlier, the EU spends most of its budget subsidising farmers through the Common Agricultural Policy (CAP). 'Strategic' industries can also refer to those linked to defence. The steel industry is an example of an industry that has been protected in the UK for this reason. Some would say that the UK coal industry held on for longer than made economic sense given the low cost imports on offer.

Multinationals v. the Third World

Most economists agree that free trade is a good thing. The theory of comparative advantage is, for most logical economists, an open and shut case. The arguments against free trade above are all valid, but overall, the world economy prospers with free trade. World trade (in terms of value of world exports) has grown by a factor of 20 since 1950, mainly due to the efforts of all countries to free up trade. This compares with world GDP that has only risen by a factor of six since 1950.

More recently, though, a growing number of bodies have emerged that are vehemently against free trade. Consumers International, a federation of 247 consumer groups in 111 countries, is one such huge body. Others include Oxfam and Friends of the Earth. They argue that, although the world economy does gain overall from free trade, nowadays nearly all that gain goes to multinationals owned by a tiny proportion of the world's population. The groups who lose out are consumers generally and poor countries in particular. The environment usually suffers too.

These feelings against free trade and the policeman of free trade, the WTO, were highlighted at the summit at Seattle, USA in November 1999. The summit was meant to be the first major meeting of government ministers to mark the beginning of a new 'round' of negotiations, the aim of which was to further reduce trade barriers.

Some final thoughts

Notice how nearly all of the arguments above come back to the first issue of saving domestic jobs. Dumping creates competition and might force domestic firms to close, resulting in job losses. Infant industries create new jobs. The government does not want the embarrassment of the resulting huge job losses if the industry does not succeed. Some would say protecting strategic industries if just an excuse to protect the jobs in these industries. It is cynical to say it, but governments do not like job losses because they translate into vote losses!

It should also be noted that any form of protection might result in retaliation, and, in the worst-case scenario, a full-blown trade war. This helps nobody and is very destructive. If two countries both put 20% tariffs on all imports, then all consumers simply pay higher prices for all imports. What's the point?

Finally, the main argument in favour of free trade is that countries produce what they are best at producing, so world resources are allocated efficiently. Any form of trade barriers distorts the free workings of these forces and leads to a misallocation of resources.

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