An analysis of Free Trade
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Published: Fri, 12 May 2017
UK can export 30 units of X for 30 units of Y from USA. Hence moving to point ‘E’. Similarly USA can export 30 Y units for 30 X units from UK, which leads to both countries moving to ‘E’. As a result both countries gain from economies of scale as both UK and USA gain 10 X units and 10 Y units, therefore reducing costs and increasing production.
Another benefit is that it leads to product differentiation. Product differentiation is when a product is produced in the same industry but are slightly differentiated. This leads to intra-industry trade, where countries or producers specialize in few varieties of products. Hence, this gives rise to an additional benefit from trade, which is economies of scale and also makes products more attractive since customers have a wider choice of products that suit their needs. Therefore in international trade, countries benefit more as they have a wider choice of goods. For example, France and Germany import and export cars of different models even though they are in the same industry. (Deardoff, 1998)
Arguments against free trade
Increased unemployment is created by unions supporting low skilled labor jobs, which are exported abroad leaving domestic workers unemployed. Wage inequalities are increasing due to removal of trade barriers. For example, the prices of textile goods fall in developed countries whereas prices of manufacturing products increase due to greater demand. Lower prices on imports puts downward pressure on wages paid to low skilled workers and higher prices on exports put upward pressure on high skilled workers. (Journeyman, TV) This has led to wide increase in wage inequality in developed countries. The inequality exists because of technological advances. However, overall economic welfare has been increased of a country.
Secondly, more and better capital needs to be employed. Increase in capital per worker at the same rate of increase in labor is needed. This is known as capital widening. This will increase investment through the use of capital, which is beneficial to the economy in the long run. Theory suggests that a country should export goods in which it is better at producing and import those goods in which other countries have absolute advantage. This means the number of units of output a worker can produce in one hour or in other words the number of hours it takes to produce one unit. (Barry University, 2009)
Even though practice makes workers perfect, it can lead to boredom. This means that there could be a decrease in marginal productivity and diseconomies of scale. This reduces overall standard of living or economic welfare of a country. The impact will be greater if an economy was closed to trade. So, specializing in one good is more cost efficient for the country.
Protectionism is when the government protects its domestic producers from competing with foreign producers. This is normally achieved by import quotas, tariffs or embargoes.
Graph -In the absence of tariff. (Powell, 2005)
In a domestic market, equilibrium will be at point X. At point X, consumers pay price P for the good whereas the quantity produced and sold is point Q. Consumers benefit from the given price, therefore consumer surplus/welfare is area a, PXZ. Producer surplus/welfare is area b+d, XPP1UN. (Nello, 2009) Consumer surplus is the difference between the price that a consumer is prepared to pay for a certain quantity of a product and the price that is effectively paid for that quantity. While, producer surplus is the difference between the total revenue and the total cost of the producer or the profits of the producer.
Imports are priced at P1, which is lower than P. Therefore the new equilibrium is at point V; domestic demand has increased from Q to Q1 and domestic supply decreased to Q2. The level of goods imported is between Q1 to Q2 whereas, the export level is P1Q2.
When trade takes place, consumer surplus increases from B+C points P1VXP but producer surplus falls from b+d to area b, points P1NXP.
Graph-tariff imposed (Nello, 2009)
Now, if a tariff is imposed on goods the price will increase from Pw to Pd. The price of a good in the importing country increases and falls in the exporting country. At price Pd demand falls from Qd to Q’d and domestic supply increases from Qs to Q’s. Therefore, Imports will fall to Q’d to Q’s. Consumers lose in the importing country and win in the exporting country. Whereas, producers win in the importing country and lose in the exporting country.
In a perfectly competitive market, producers and the government gain from tariff while the consumers are worse off. (Greenaway, 1979).
The effect of an import quota (Nello, 2009)
Here, the diagram shows the effect of quota on imports in a particular country. Now assume there is no quota on imports then a country’s imports would equal to Qd-Qs at price Pw (world price). By placing a quota, quantity of imports would be the area between Qd’ and Qs’, whereas the domestic price level would increase to Pd. This would mean that there would be excess demand, area d.
(Nello, 2009) argues, that quota will protect the domestic firms from international competition whereas placing tariff, domestic producers will not be able to raise the price level above Pw without losing market share as domestic consumers demand imports. In perfect competition the level of price, quantity demanded and produced stays same. Therefore the level of imports stays same.
The critique according to (Nello, 2009) is that quota is better than tariff as quota restricts imports whereas tariff just raises the price level. However, it all depends on demand and supply curves as they can shift regularly. Also it depends on the elasticity of demand. An inelastic product would not have a bigger effect of change in price than an elastic product.
(Greenaway, 1979) The only argument that can be agreed is the infant industry argument. Those industries that are in its early development needs to be protected, as they cannot compete internationally. They do not enjoy the same benefits as established industries, therefore temporary protection may help. As the industries develop, tariffs may be reduced so that they can compete internationally so comparative advantage can be gained later. This means comparative advantage can change over time and government intervention is required correct any market failures.
A lot of economies use import controls to control trade deficit but there are alternative methods that can be used. For example, the government could provide export subsidies to industries. This is a type of supply side policy. It will encourage producers to supply more goods, which would shift the aggregate supply curve to the right from AS to AS1, as shown in the figure below. Subsidies reduce costs therefore lower price level from P to P1, demand extends. This will boost exports that can lead to higher jobs in domestic country leading to economic growth in the long run. Also by opening up to trade will mean that economies face more competition. However, this encourages firms to find incentives to cut costs and increase efficiency. Therefore, consumers will benefit too from lower prices.
Aggregate supply and demand graph.
Protecting industries is not beneficial for the long term. Permanent protection is inadequate and leads to inefficiency. (Greenaway, 1979) It has helped poor countries to become richer.
(WTO, n.d), Ricardo’s theory is one of the most accepted by economists. Therefore, it could be said that all countries do benefit from comparative advantage. The definition itself says that countries benefit from trade. Research shows that both Smith and Ricardo supported free trade but did not believe that trade dominate society (Dunkley, 2004). However, Samuelson believed that free trade is better that no trade. So it could be agreed that comparative advantage does exist and it is one of the reasons why countries trade. (Greenaway, 1979 and Redding 1999) both agreed that economists view free trade as increasing welfare. Consequently, trading partners will be in a win-win situation and inequality could be prevented.
On the other hand, Heckscher-Ohlins theory looked at what determines comparative advantage, which Ricardo failed to do so it could be said that although comparative advantage benefits countries it, would depend on the factors.
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