Free Trade: Start Looking

Free trade
Free trade is trade that occurs between countries

without any barriers or hindrances. This means that firms are able to sell directly into a
country as easily as the firms within that country are able to trade. The firm exporting into the
country should not face any additional barriers, taxes, regulations or any other obstacles that
prevent them selling their goods/services.
Free trade at an international level means that this freedom is true for trade between all
countries. In this way, countries gain the benefits from competition that exist where the
national markets are free from barriers and restrictions. Economic theory tells us clearly that
this is likely to deliver significant benefits, but it is far from being universally true. Countries
protect against free trade in a variety of ways and for a variety of reasons and in the next
section, we start to look at these. Click on the right arrow at the top or bottom of the page to
start looking.
Types of protectionism
Protectionism (protecting against imports) has arisen in various forms. These include:
Tariffs
A tariff is a tax on imports, which can either be specific (so much per unit of sale) or ad
valorem (a percentage of the price of the product). Tariffs reduce supply and raise the price of
imports. This gives domestic equivalents a comparative advantage. As such, tariffs are
distorting the market forces and may prevent consumers from gaining the benefit of all the
advantages of international specialisation and trade. The impact of a tariff is shown in Figure
1 below.
Figure 1 Impact of a tariff

The tariff has the effect of shifting the world supply curve vertically upwards by the amount
of the tariff. The level of imports will fall from QaQd to QbQc. The government will also
raise revenue, shown by the blue shaded area. The level of domestic production will increase
from 0Qa to 0Qb.
Quotas
Quotas have the effect of restricting the maximum amount of imports allowed into an
economy. Once again, they reduce the amount of imports entering an economy and increase
the equilibrium price within the market. The government receives no revenue from a quota,
as it does with a tariff, unless it can set up a system of licences.
Exchange controls
The government could limit the amount of foreign currency available for paying for imports.
These are not allowed amongst member states of the European Union (EU), for example, and
have become more difficult to sustain in a world of highly mobile capital.
Export subsidies
Export subsidies allow exporters to supply the market with more product than the natural
equilibrium would have allowed. Foreign consumers will enjoy increased economic welfare
as the price of their purchases fall. Domestic employees might enjoy more wages and job
security. But taxpayers are footing the bill for this. Domestic firms might divert trade into
exports and ignore the home market. This could lead to increases in domestic prices.
The impact of a subsidy is shown in Figure 2. The supply curve is shifted vertically
downwards by the amount of the subsidy and this leads to a lower equilibrium price and a
higher quantity being traded.
Figure 2 The effect of a subsidy

These 'expenditure-switching' polices are normally not allowed under membership conditions
of both the WTO and EU.
Voluntary export restraints (VER's)
Some quotas are voluntarily agreed between countries. This happened on a significant
number of occasions with Japanese firms (e.g. cars, televisions, videos) during the 1990s.
Where the quotas have been agreed, they are known as Voluntary Export Restraints (VER's).
In fact over 200 VER's were in force in the early 1990s. So why did the firms agree to these
restrictions voluntarily? Well, the answers to this are varied. Often it may have been because
they felt it would help avoid more punitive restrictions, but sometimes it was in their
interests. Where the Japanese firms had a significant cost advantage over the domestic
producers, the voluntary quotas meant that they could charge significantly higher prices. The
higher margins they earned more than made up for the restricted number they sold and
profitability was maintained or improved.
Other protectionist measures
Countries can also use a range of other protectionist measures to restrict imports. These might
include:
Administrative obstacles - countries can set administrative

hurdles. For example, they may require significant levels of paperwork
and then deal with these processes slowly making it difficult for
importers to compete on a level playing field with other firms.
Health and safety standards - countries may set onerously high

health and safety standards for goods that are imported, once again
making life difficult for importers.
Environmental standards - countries can set high environmental

standards that they know only domestic firms are likely to be able to
achieve, once again making life difficult for importers.
the impact of a tariff on the level of imports, domestic production, government

tax revenue and welfare losses, drag the tariff line in the following diagram up
and down.
the impact of a tariff on the level of imports, domestic production, government
tax revenue and welfare losses, drag the tariff line in the following diagram up
and down.
Arguments for protectionism

Costs of trade
However, completely free trade may have a number of costs for some economies. These may
include:
Adjustment costs - changes in comparative advantage may require

adjustments in the structure of industry and these may take some time.
While they are taking place there may be employment costs from the
changeover.
Environmental costs - free trade may lead to firms relocating to where

environmental and other regulations are most lax. This could cause longterm environmental problems.
Arguments in favour of protectionism
So, why do some governments still protect trade? The main reasons include:
To safeguard domestic employment - as protectionist polices reduce

import penetration. In terms of the identity AD = C + I + G + (X-M), the
lower is M, the greater will be aggregate demand and thus the higher the
level of domestic output and employment.
To correct balance of payments disequilibrium - as demand for

imports is dampened and exports promoted. This makes the domestic
output appear to be more competitive.
To prevent labour exploitation in developing economies - this is

really a moral argument as it rests on making imports more accurately
reflect their true cost of production. However, it might also reduce imports
from some of the poorest economies in the world.
To prevent dumping - which is where economies sell goods in overseas

markets at a price below the cost of production. Domestic consumers pay
more than those buying overseas. Such low prices are part of a policy to
destroy rivals in export markets.
To safeguard infant industries - as shifts in comparative advantages

arise, so some countries become able to enter new markets. Their
fledgling industry needs some protection from the power of already
established competitors.
To enable a developing country to diversify - this is similar to the

infant industries argument. Many developing countries are heavily
dependent on exports of primary commodities. This can leave them very
exposed to changes in international commodity prices. If they want to
diversify and develop new export revenue streams, they may need to
protect these new industries from full exposure to international
competition for a while.
Source of government revenue - where protectionism takes the form of

a tariff, apart from reducing demand for imports via the impact of a higher
price, this will also raise revenue for the government, like any other tax.
The revenue raising function will be most successful where the demand for
imports is price inelastic.
Strategic arguments - a particular product or industry might be of

strategic importance to a country, e.g. agriculture or coal, and
protectionism may be justified on the grounds that it is keeping alive an
industry which plays a vital part in the economy, perhaps because of
social, political or military reasons.
Arguments against protectionism
Although protection is often seen as a convenient political solution for countries (and has
been extensively used even in recent years), it does also have a number of problems. This
means that it is not always the best solution for a country. These problems include:
Downward multiplier effects - if a country successfully protects against imports, this

will reduce the level of imports. However, one country's imports are another country's
exports and this reduction in exports will lead to a multiplied effect. This may even
reduce demand for exports from the country that raised the protectionist measures in
the first place, but will certainly reduce world output.
Retaliation - any protectionist measure tends to be instantly met with some form of
retaliation. This will tend to mean that any success in protecting against imports leads
to a fall in exports when the retaliation starts to bite.
Costs - tariffs (and other protectionist measures) tend to lead to a cost on society. If
we look at the tariff diagram in Figure 1 below, we can see that the tariff leads to a
reduction in imports. Some of the benefits from the reduced imports are passed to
domestic firms in the form of higher prices and the government in the form of
revenue, but the triangles either side of the blue shaded area represent a welfare cost
to society. Consumers will be paying higher prices for many of the goods and services
they consume.
Figure 1 The impact of a tariff
Inefficiency of resource allocation - the imposition of tariffs or other protection may

not be the best solution. Firms may be able to shelter behind the tariff wall and remain
inefficient. They may not have an incentive to reduce costs and become fully globally
competitive if they believe that the tariffs will continue. This will be true also where
infant industries are protected. If the tariffs remain in the long-term, the infant
industry may never 'grow-up'. Firms operating with higher costs may be unable to
achieve export competitiveness. In short, resources will not be allocated to their most
efficient uses.
Bureaucracy - many protectionist measures are very bureaucratic to enforce. This is

likely to reduce choice for domestic consumers and perhaps lead to possible
corruption and other administrative costs. These will not be beneficial for the
economy.

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Free trade

Free trade is trade that occurs between countries

Figure 1 Impact of a tariff

Figure 2 The effect of a subsidy

Voluntary export restraints (VER's)

Administrative obstacles - countries can set administrative

Health and safety standards - countries may set onerously high

Environmental standards - countries can set high environmental

the impact of a tariff on the level of imports, domestic production, government

Arguments for protectionism

Adjustment costs - changes in comparative advantage may require

Environmental costs - free trade may lead to firms relocating to where

Arguments in favour of protectionism

To safeguard domestic employment - as protectionist polices reduce

To correct balance of payments disequilibrium - as demand for

To prevent labour exploitation in developing economies - this is

To prevent dumping - which is where economies sell goods in overseas

To safeguard infant industries - as shifts in comparative advantages

To enable a developing country to diversify - this is similar to the

Source of government revenue - where protectionism takes the form of

Strategic arguments - a particular product or industry might be of

Arguments against protectionism

Downward multiplier effects - if a country successfully protects against imports, this

Figure 1 The impact of a tariff

Inefficiency of resource allocation - the imposition of tariffs or other protection may

Bureaucracy - many protectionist measures are very bureaucratic to enforce. This is

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