Free Trade,

Protection and
Welfare Dr. M. Ganeshamoorthy,
Department of Economics,
University of Colombo
 • Arguments for free trade:
• It increases production and
consumption.
• It increases total welfare of the society:
Recall welfare impact of exporting and
importing countries.
• It encourages the efficient use of
Free Trade, resources
• It enable high standard but cheap
Protection and commodies availble for consumers
• It helps transfer of technology,
Welfare manegerial and marketing skills across
the world
• It can lead to invention of new
technologies
• Is support economic growth,
employment creation and development
Read Seven Moral Arguments for Free
Trade:
https://www.cato.org/commentary/seven-
moral-arguments-free-trade
 • Arguments for Protection
• To create or protect employment at home
country
• To protect startup infant industries from
import competition
• As a solution to balance of payments
Free Trade, problem
• As a solution to terms of trade problem
Protection and • To retaliate a trading partner’s protection
policy
Welfare • To protect strategically important sectors
from foreign competition
• To respond to dumping (antidumping)
• To respond to export subsidies (counter
vailing)
• To control to unfair increase in imports
(import surge)
Free Trade, Protection and Welfare

Trade Protection Measures/Barriers/Restrictions

• Trade protection measures could be classified into two groups:
• (a) Tariff measures and (price measures)
• (b) non-tariff measures (quantitative measures)

Tariff barriers/measures
• Unit of specific tariff
According to the purpose:
• Advalorem tariff • Revenue Tariff
• Compound tariff • Protective Tariff
• Prohibitive Tariff
 Trade Protection Measures or Barriers

Free Trade, Non Tariff barriers/measures

• Quota or rationing
Protection •
•
Licenses
Subsidies and incentive to producers

and •
•
•
Foreign exchange controls
Local Content Requirements (LCR)
Voluntary Export Restraints (VER)
Welfare •
•
Imposing administrative and technical standards
Environmental and health regulations
• Government procurement policies
• Trade embargos
Local
Content
Requirement
Welfare impact of an
import tariff in a small
country

Free Trade,
Protection
and Welfare
Free Trade, Protection and Welfare
• Effective Rate of Protection
• The effective rate of protection is the percentage increase in value
added per unit of a good produced in a country in relation to the
value added under free trade.
• The effective rate of protection takes into account both the nominal
rate and any tariffs on intermediate inputs.
• Effective rate of protection shows the extent of real protection
available to local producers.
Free Trade and Protection
• Effective Trade of Protection: Two methods of calculation
(𝑉1−𝑉0)
1. ERP = × 100 where
𝑉0
• V1=Value added amount after tariff
• V0= Value added amount before tariff
• V= Total output – imported raw materials
(𝑛−𝑎𝑏)
2. ERP = × 100 where
1−𝑏
• 𝑛 = nominal tariff rate on the final product
• a= percentage of imported inputs contained in the final product
• b= nominal tariff rate on the imported inputs
Free Trade and Protection
• Effective Trade of Protection: Two methods of calculation
• Suppose imported special steel worth Rs. 10,000 is required for producing
domestically a machine.
• The free trade price of machine is Rs. 16,000.
• If 25 percent nominal tariff is imposed on each imported machine, its price
for domestic consumer will be Rs. 20,000.
• Out of this, (a) Rs. 10,000 represent imported steel, (b) Rs. 6,000 is the
domestic value added and (c) Rs. 4,000 is the tariff.
• Rs. 4,000 tariff obtained from each imported machine signifies a 25
percent nominal tariff rate because the nominal tariff is calculated on the
price of the final commodity [(4,000/16,000) × 100 = 25 Percent].
• The rate of effective tariff is, however, much larger as it is calculated on the
domestic value added. In this illustration, it amount to [(4,000/16,000) ×
100 = 66.7 Percent].
Free Trade and
Protection
• Effective Trade of
Protection: Two methods
of calculation
 • Definition: The price of a unit of a foreign currency
in number of local currency units
1. Nominal Exchange Rate (NER) the ratio of
Exchange exchnage between the two currencies (e.g. 1
USD = 194 LKR) or 1 LKR = 1/194 USD)
Rates: 2. Real Exchange Rate (RER) NER adjusted for
inflation differential between the two countries
involved
3. Nominal Effective Exchange Rate (NEER)
weighted average of nominal exchange rate of a
basket of trading partner and competitor
countries
4. Real Effective exchange Rate (REER) NEER
adjusted for inflation differencial with respect
to each country in the basket of partner aand
competitor countries
 • The ER is determined in the Foreign Exchange
(FOREX) market through the interaction of demand
and supply forces.
Exchange Rate • Here we consider the demand and supply of a foreign
Determination: currency. E.g., USD
➢ Demand for dollar arises in Sri Lanka because of
Imports, foreign travel, foreign education,
foreign investment,
repayments of loans or advancing loans to
foreigners etc
➢ Supply of dollar arise because of exports,
remittances, loans and
grants, foreign investment receipts, inbound
tourist arrivals etc.
Exchange rate
determination
Exchange rate determination
Exchange Rate
Determination:
• Exchange rate determination is influenced by
• Terms of trade
• Current account deficit or surplus
• Inflation
• Interest rate
• Public debt
• Political stability and economic performance
Exchange
Rate
Regimes
 Exchange Rate Regimes

▪ Broadly speaking, the history of the past two centuries of exchange rate “regimes”— the institutions
that set exchange rates around the world—can be divided into three phases:
1. The era of the Gold Standard,
2. The era of the Bretton Woods System, and
3. The modern era of floating exchange rates.
▪ Figure 20.6, a graph of the exchange rate between the British pound and the U.S. dollar since 1791, plots
these three phases.
▪ Before World War I (1914–1918)—and especially in the half century leading up to the war—the
international financial system was to a great extent based on what is called the gold standard, under
which countries specified a fixed price at which they were willing to trade their currency for an ounce of
gold.
▪ For example, starting in 1834, the United States pegged the price of gold at just under $20.70 an ounce,
while the United Kingdom pegged its price at 4.25 pounds.
▪ This meant that effectively you could trade $1 for 1/20.7 ounces of gold, which could in turn be traded
for pounds at a price of 4.25 pounds per ounce.
Exchange Rate Regimes
▪ A quick glance at Figure 20.6
confirms that this was
indeed the exchange rate
between the pound and the
▪ The implied exchange rate was dollar for more than an
entire century.
 Exchange Rate Regimes

▪ The political, economic, and military havoc associated with World War I
led to the breakdown of the gold standard and a period of financial
instability.
▪ Then, in 1944, a blue- ribbon panel of financial economists met in Bretton
Woods, New Hampshire, to fashion a new regime for the international
monetary system.
▪ Under this regime—known as the Bretton Woods system—the United
States pegged the price of gold at $35 per ounce, and most other
economies specified a fixed exchange rate to the U.S. dollar.
▪ The Gold Standard was in essence replaced by a Dollar Standard.
 Exchange Rate Regimes

▪ Exchange rates were relatively stable after World War II until the early 1970s.
▪ The increase in inflation in the United States that had begun in the late 1960s put increasing
pressure on the international financial system.
▪ The United States wanted to devalue its currency by pegging to a higher price of gold; other
countries wanted the United States to raise interest rates and tighten monetary policy.
▪ In the early 1970s, this tension led the Bretton Woods system to collapse, as the United
States revalued its currency.
▪ Since then, floating exchange rates have prevailed among the major currencies in the
industrialized world.
▪ Monetary policies are not formally coordinated, and the value of the nominal exchange rate
is determined by supply and demand in the markets for foreign exchange.
▪ As illustrated in Figure 20.6, this period has been characterized by large, frequent
movements in exchange rates.