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SUBMITTED TO: Prof. Dr. B. Swaminathan Indian Maritime University

Submitted By: SACHIN.M 11999051019

I-MBA (PSM) Question: Even though a few countries practice free trade, most economies favour free trade as a desirable policy. Why economists favour free trade policy? Whether these policy is the solution for Worlds current economic difficulties. Answer: Free trade means free and unrestricted movement of goods between countries. Free trade refers to a condition of international trade, when all kinds of artificial controls on international trade such as tariffs, quotas etc are absent. Under free trade, the distinction between domestic trade and international trade disappears. Under this policy, all barriers to the international movement of goods are removed and the trade between the countries are allowed to take its natural course. The Sea borne trade between 1950 and 2005 grew from 0.55 billion to 7.2 billion. This expansion was the result of the most fundamental redesign of worlds political and economic arrangements, since industrial revolution. The rapid economic growth and increasing consumer wealth drove these changes. Breton Woods Conference 1944 which established the economic foundations for a period of economic stability which allowed companies and investors to operate freely across the globe. The following 3 important developments helped:

1. The world was progressively opened to free trade. The European empires were dismantled in 1950s, removal of bilateral trade preferences, followed by break up of USSR in 1989 and the opening of diverse economy of China to free trade in mid 1990s. 2. Communication improved as telex, direct-dial telephone, fax, email and internet appeared in rapid succession, that process is taking another step forward with inter-regional broadband cabling. 3. Cheap transport. The falling cost of sea transport gave remote areas of the world access to world markets, making economic developments possible. With the associated improvements in inland transport infrastructure, the catchment area for free trade widened with each decade. Free trade v/s Protection: The effect of tariff


The simple model of demand and supply can be used to illustrate the economic effect of a tariff. By imposing import tax, govt. can raise the domestic price level of a product, stimulates the domestic production, reduces or eliminates imports and raises revenue. The model is drawn under the following assumptions. First, competition exists in domestic market. Secondly, the world supply of the product is perfectly elastic. Variations in demand from home country have no effect on price; it is too small an economy in the world scheme of things to have any impact. Under these assumptions, the world supply curve is given by WS, the domestic supply curve ST, and the domestic demand curve DD. In the absence of any government interference and in presence of free trade, the domestic market price must be the same as the world price, OW. Given market price is OW, market demand at that price is OQ4. This is met by producing OQ1 from domestic companies, because ST shows the amount that domestic firms are willing to supply at any market price. The quantity Q1Q4 will be supplied by imports, as the world supply schedule implies that overseas companies can supply any amount at that price. It is reflected in the vertical difference between the lines WS and RZ, which represents new price of the imported goods after the tariff has been levied. This raises market price, which generates three principal effects. First, market demand declines slightly, so total sales falls from OQ4 to OQ3. The precise size of this fall will depend on the slope of the demand curve, or the own price elasticity of demand. The second effect is that domestic supply is increased, as domestic producers are willing to supply more at a higher market price. Thirdly, the importers suffer a decline in business, as imports fall to Q2Q3.

Does this mean the economy better off being protected? The answer is no, two principle effects can be observed in the diagram. Firstly, consumers are worse off than they were in the free trade position. They have to pay higher prices and as consequence, they buy less of the product which is being protected. They are clearly worse off. Their precise loss is in fact measured by the triangle N which measures the loss of consumer surplus. To see this note that at odd price consumers bought OQ4. They also bought OQ4 when the price rose to OP2 from OP1. In the sense then, they were willing to pay OP2 even when the price was at OP1. This willingness to pay is measured by the vertical distance between the price actually paid and the demand curve, for each unit of output. The output range OQ3OQ4 generates the area shown by the triangle N as a result. It appears that producers are better off as they have expanded. In the sense they are, but this is a false impression. Remember that the comparative advantage model assumes full employment. This means that the resources that have been redeployed in the protected sector have been moved from elsewhere. It follows that the output in another part of the economy must have fallen as a result. These two effects can be shown to lead to the economy being worse off over all. This shows the difference between what it cost the economy to import the quantity Q1Q2 and what it now costs to produce the same amount in the domestic economy. Over all there is a loss to consumers and also an efficiency loss an the production side, as resources are redeployed in an efficient manner. These two aspects lead to the argument that free trade is superior to no trade.

Benefits of Free Trade Policy: The reasons for economists favour free trade policy are as follows: 1. The theory of Comparative advantage: This explains specialising in goods where countries have lower opportunity cost, there can be increase in economic welfare for all countries. 2. Reducing Tariffs barriers leads to trade creation: Trade creation occurs when consumption switches from high cost producers to low cost producers. The removal of tariffs leads to lower prices for consumer and an increase in the consumer surplus areas. 3. Increased exports: Lower tariffs enable higher quantity of exports and it will lead to economic development. 4. Economies of scale: If countries can specialise in certain goods, they can benefit from economies of scale and lower than average cost, this is especially true in industries with higher fixed costs or that require high levels of investments. The benefits of economies of scale will ultimately lead to lower prices for consumers. 5. Increased competition: Free trade helps to prevent monopoly. It provides space for competition. It removes the distinction between domestic trade and international trade. 6. Make use of surplus raw materials: The Middle East countries are blessed with fossil fuels. They export oil and petroleum to earn more revenue. It also helps the other countries in availing the raw materials.

Arguments against Free Trade Policy: The following are the reasons why free trade policy is not practiced by most of the countries: 1. Infant industry argument: New domestic industries would struggle against international competition. Therefore protection would allow them to progress and gain experience to enable them to competitive in future. 2. The senile industry argument: If industries are declining and inefficient, they may require large investment to make them efficient again. Protection for these industries would act as an incentive for firms to invest or reinvest themselves. 3. To diversify the economy: Many developing countries rely on producing primary products in which they have a competitive advantage. Relying on agricultural products has several disadvantages like a. Price can fluctuate due to environmental factors. b. Goods have a low income elasticity of demand. Therefore with economic growth and demand will only increase a little. 4. Raise revenue for the govt.: Import taxes can be used to raise money for the govt. 5. Help balance of payment 6. Protection against dumping: It is argued that free trade can harm the environment because; in free trade there is a huge need for resources. So it may exploit the natural resources and it can lead to imbalance in the environment.

Q. Why do economists favour free trade policy? Free trade is one of the most debated topics in economics of the 19th, 20th, and 21st century. Arguments over free trade can be divided into economic, moral, and socio-political arguments. The academic debate among economists is currently settled in favour of free trade, with a consensus having existed since at least the 1960s, based on theories dating to the 18th century. The debate among the public and politicians continues. Classical economic analysis shows that free trade increases the global level of output because free trade permits specialization among countries. Specialization allows nations to devote their scarce resources to the production of the particular goods and services for which that nation has a comparative advantage. The benefits of specialization, coupled with economies of scale, increase the global production possibility frontier. An increase in the global production possibility frontier indicates that the absolute quantity of goods and services produced is highest under free trade. Not only are the absolute quantity of goods and services higher, but the particular combination of goods and services actually produced will yield the highest possible utility to global consumers. 1. Increasing commerce makes war less likely War is made less likely as a function of economic interdependence, a key feature of Liberalismthe leading theory within the study of International Relations (IR). Liberalism suggests that states who share strong mutually-beneficial trading relationships will be far less likely to wage war with one another.

2. Free trade reduces poverty Conflating the "moral" and "economic" arguments are those campaigners who say that increased trade is the best way to relieve extreme poverty throughout the world. 3. Free trade enhances national security Free trade can enhance national security, on the condition that a nation does not trade with its enemies. Free trade increases a nation's relative power vis--vis its rivals, because free trade gives optimal economic advantages, which translates into more economic and military power and more technological innovation.

Q. Whether Free trade policy is the solution for Worlds current economic difficulties. Free trade policy is not a solution for Worlds current economic difficulties, due to the following reasons: 1. International trade requires more resources to distribute Delivering food produced on the other side of the world to a supermarket has an environmental impact because it requires the use of fossil fuel in delivery from overseas, as compared to local delivery. In a perfectly efficient market, the costs of the fossil fuel would include the externalities associated with their consumption. Thus the full impact of their transportation costs would be reflected in the market price of the good. In the real world, there are no perfectly efficient markets. Much of the true costs of transporting goods around the world and consuming fossil fuel must be paid in the future dealing with the health and environmental effects of pollution. It is also likely that economic

disruptions will be caused by future shortages of fossil fuel energy and spikes in fuel prices since it is a finite resource that is being depleted. 2. Free trade favours developed nations in certain areas Some services exported by developed nations are intangibles, such as medicinal formulae, trademarks, software, and entertainment. The value of this intellectual property is derived from legal protection against unauthorized reproduction. Some advocates of the poor claim that the reason IP-rights are strongly protected in International trade is the power developed nations have to protect the interests of intellectual property owners during trade negotiations. WTO-signatory nations renounce the right to produce generic copies of life-saving drugs, the only affordable treatment in developing nations. 3. Influence of foreign firms Within developing countries, the local populace often stages protests against multinational corporations. Protesters insist that once allowed free rein the corporations will use their superior resources and experience to sway the political establishment of a country in favour of excessive concessions (tax holidays, underpaying for property, etc.) and try to influence the political system to fulfil corporate interests, which may or may not be shared by the citizenry. The concessions sought by these multinational corporations in turn collide with the free trade idea that subsidies should not be used to prop up corporationsin other words, subsidizing local corporations invites accusations of Protectionism by free trade proponents, while concessions to foreign corporations are portrayed as mere rational incentives.

4. Free trade benefits only the wealthy within countries

The wealthy own more capital, which increases in value as companies are able to produce at the lowest cost in the world.

As the world's markets merge into a single global market the number of market-leading companies worldwide drops, with takeovers of smaller local corporations by larger multinational corporations. This process concentrates wealth in fewer corporations.

Free trade replaces low-skilled jobs often done by the poor more easily than high-skilled jobs.

5. Capital mobility and comparative advantage Some descriptions of comparative advantage rest on a necessary condition of capital immobility. If financial or labour resources can move between countries, then comparative advantage erodes, and absolute advantage dominates. For instance, the Heckscher-Ohlin model derives comparative advantage from differing relative abundances of capital and labour between countries. Capital mobility and the competitive drive for the highest return on investment would give all countries identical relative abundances for new investment, eliminating comparative advantage and trade.