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Free Trade.

Vs Protection

Dr. Mrutyunjay Dash


Free Trade
It 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.
Arguments in Favour of Free Trade:
Optimum allocation of Resources
Under free trade, every country specialises only in the
production of those goods in which it has comparative
advantage. This leads to proper and most efficient use of
productive resources of the world.
Technical Reasoning:
To avoid misutilisation of resources on the production of
those items over which the country has comparative
disadvantage.
Optimisation of Consumption
• Free trade helps the trading countries to secure the optimisation
of consumption. In the absence of international trade, a
country’s domestic consumption is limited to its production
possibilities.
• But through international trade, the consumption possibilities
can expand beyond its production possibilities.
• Benefits to Consumers:
Free trade also benefits the consumers by enabling them to
enjoy the large variety of foreign goods which their own
country cannot produce.
• Economic Development :
 Encourages specialisation and division of labour
 Stimulates healthy competition
 Increases skills, technical know-how
 Makes available necessary raw materials, machinery and
foreign capital.
Figure 1 : The Production Possibilities Frontier
Quantity of
Computers
Produced

3,000 F
C

A
2,200
2,000 B
Production
Possibilities
M Frontier
1,000 D

0 300 600 700 1,000 Quantity of


Cars Produced
Basic Qs:
 Trade off

The only way of getting more of one good is to get less of the other
 Opportunity costs

The cost of something is what you give up to get it.


 At point E: Frontier is steep
Resources best suited to make cars are already in the car industry
An additional car: Transfer of best technicians of Comp. Industry to Car
Industry
The opportunity cost of a car is high
 At point F: Frontier is flat
 Resources best suited to car is utilised in comp.
 The opportunity cost of car is low.
 As the production of comp. will not be affected much.
 Is there any possibility to resolve such trade offs, if so, HOW ?
Figure 2 :A Shift in the Production Possibilities
Quantity of
Frontier
Computers
Produced

4,000

3,000

2,300 G
2,200
A

0
600 650 1,000 Quantity of
Cars Produced
Check on monopolies:
• It promotes competition and prevents monopolistic tendencies.
• The fear of foreign competition does not permit the producers at home
to form monopolies and exploit the consumers by raising the prices of
their products.
Arguments against Free trade:
• Unrealistic policy: Assumption of laisseez-faire /govt. non-intervention/
• Perfect competition-Free entry and exit
• Non-cooperation of countries:import restriction/gain by some while loss by other.
• Economic Dependence: For essential commodities.
• Unbalanced development:Sectors developed over which the country has
comparative advantage.
• Dumping
Protection
• It refers to the policy of encouraging the home industries by giving subsidies to the home
producers and by imposing duties on the foreign goods by raising their prices relative to those
of domestically produced goods.
• Economic Arguments:
Infant Industry Argument:
• The operational cost of the infant industries are very high./
SOL: Imposition of Tariff on imports
• Protection ,how long?”
• A baby is to be nursed,a child is to be protected;and the grown up young one is to be
left free.” (List)
• Infant industry argument may not be against free trade policy fully./It favors free
trade based on potential(or long run), and not present, comparative advantage.
• Based on the realistic conditions of unrealised internal and external economies of
scale.
Internal Economies:Firms can grow upto
optimum level
External Economy: It helps to reduce costs of all
firms by creating a trained labour force or by
spreading knowledge of production tecniques.
Is there any scope to generalise ‘infant industry
argument ‘ to ‘infant country argument’?
Industrialisation: sound infrastructure/growth of sizeable
labour force with the requisite attitude of skills, thus
enabling the infant developing country to industrialise
itself.
Negative Implications:
 Protection may lead to political corruption:

Industries whether economically justified or not


start claiming for protecting.
 Develop an attitude of dependence on
Govt.assistance.
Employment Argument:
Expansion of employment occurs in two ways:
Imports form a leakage in the domestic income
stream.Income and employment are increased by a
multiple of reduced expenditure in imports.
Overall increase in employment and income in other
sectors/more capital/investment in capital goods
stimulate investment, income and employment.
Limitations:
I. Retaliation by affected countries.
II. If the demand elasticity for imports is highly inelastic
then ?
Terms of trade Argument:
Imposition of tariff/increased price of imports/less demand
for imports/lower the price of exports to reduce the foreign
supply to match the reduced demand in the imposing
country.
But if
the elasticity of demand for foreign good is greater than one &
The elasticity of supply of foreign goods is less than one then a greater
price rise in the importing country will occur. [Imported goods at a
higher price would be available and it may also induce domestic
producers to raise the price : over all result; HIGHER PRICE
Balance of payment Argument:
Anti-Dumping Argument:
High tariff is imposed to counteract evil consequences of dumping.
Conclusion:
Free trade on the basis of comparative advantage theory is not
realistic commercial policy in the real world.
Permanent and blanket protection is neither desirable nor
justified.
Protection is inferior to a more direct method; tariffs and quotas
which protect the industries are inferior to subsidies which promote
industries.
Specificity Rule
• If an externality is present, government policy should
intervene as directly as possible on the specific source
of the externality, to most enhance national economic
efficiency.
• If a country has some other objective, government
policy should intervene as directly as possible on the
specific objective, to minimize the national economic
cost of achieving the other objective (that is, to
minimize the amount of economic inefficiency
created).
• Key: Identify the specific problem clearly, then use a
policy to attack the problem directly.
Figure 1.1 – The Infant Industry Argument
Infant Industry Argument Analysis:

• Domestic Supply curve Sdn is everywhere above the world


price of $3,000
• Tariff imposed 33% Price becomes $4,000
• Domestic Supply 20,000
• Inefficiency
– Area ‘b’ – 20,000 COULD BE PRODUCED AT $3000
-- Area ‘d’ -- Consumers are deprived of 25,000 units
When the domestic supply curve shifts to Sdf for some reasons
Advanced Technology
Low costs
Tariff is removed
At $ 3,000-------- 50,000 units are supplied
Emergence of Producers’ Surplus –
’V’
IF WORLD PRICE by this time decreases then
is there any possibility of P’s Surplus?
‘YES’ HOW?
If domestic production costs falls substantially
&
There is a substantial demand for the product in the
international market
Then the P’s Surplus would be like an area ‘v’
Figure 1.2 – Two Ways to Promote Import-Competing
Production: Tariff Vs Subsidy
ANALYSIS
Tariff imposed of $30 on the initial price --$330
Inefficiency----Area ’b’—Producing the same at greater expense
----Area ’d’--- Discouraging purchases
MEB: Marginal External Benefits: Encourage to produce more
at higher price. How to measure?
0.6 to 0.8 million---Area ’g’ –Extra gains to the nation
Net Outcome : Whether Area ’g’ is greater than both the Area ’b
+ Area ’d’
OPTION-II --- SUBSIDY
$30 on initial price -$300- Now- $330- Minimum Price required to
produce
How much does consumer have to pay :$300
How much does govt. have to pay : $30
Annual production raised from 0.6 to 0.8 million
FOCAL THEME: Subsidy Vs Tariff : A critical Analysis
 Both cause domestic firms to produce 0.2 million extra.
 Both generate the same external social benefits [Area ‘g’]
 That both 0.2 million units are produced at a higher direct cost
than the price at which the nation could buy foreign bicycles.
 In both the cases the extra cost is Area ’b’

YET !!!!
 No discouragement in terms of total consumption by raising the
price.
 Consumers pay only $300 per unit
 Consumers do not lose the additional Area ‘d’
 In terms of Area gain is ‘g’ and loss is ‘b’
 Why there is a loss
 Area ‘b’ [loss] is due to the subsidy borne by the Govt.
Table: Protection to Maintain Jobs, the United States
National Defense
• A country must have access to products to maintain
the national defense, especially because imports may
not be readily available during times of hostilities.
• Apply the specificity rule:
• Some products can be kept in stockpiles. In this case,
imports during peacetime can be used to build the
stockpiles.
• National production capabilities are needed for other
products. Best to use a subsidy to building or
maintaining national production capabilities.
Can an Import Barrier Be Better Than Doing Nothing, and Is
It the Best Policy?
Diversification of Industries Argument:
Excessive specialisation leads to too
much dependence on foreign
trade/risky and undesirable during war
time.
Economically dependence on a few
industries may result in serious
economic dislocation in times when
such industries pass through adverse
circumstances.
National self-
sufficiency
Smooth and balanced
growth of the economy