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Chapter 34

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ECON 110
Ian James Cromb

Chapter 34: Trade Policy Free Trade or Protection?  Today, most gov’ts accept that a relatively free flow of international trade is desirable for the health of their economies – however, heated debates still occur over trade policy o Trade Policy: A gov’ts policy involving restrictions placed on int. trade  Should countries have completely free trade, or sometimes protect domestic producers  If protection is desireable should it be achieved through tariffs or non-tariffs? o Tariffs are taxes designed to raise the price of imported goods o Non-tariffs are devices other than tariffs designed to reduce the flow of imports The Case for Free Trade  The Gains from trade were demonstrated in the previous chapter  In summary, each country should specialize in the prod which they have the lowest opportunity cost and trade for the rest – world production and consumption increases  Free trade makes the country as a whole better off, even though it may not make every individual in the country better off  If a country protects one of its industries, it is likely not to adopt new technologies and over time, the domestic industry will become less competitive in the international market o As the gap widens, the barrier will provide less and less protection for the domestic industry until finally it will succumb to foreign competition The Case for Protection  Two arguments – the first concerns objectives other than profit maximizing national income; the second concerns the desire to increase one’s national income Objectives Other than Maximizing National Income Advantages of Diversification  For a small country, specializing in the production of only a few products might involve risks that the country does not want to take o One risk is that a tech advancement may render the product obsolete o Another is that swings in world prices lead to large swings in national income  If the gov’t encourages a more diversified economy by protecting domestic industries they can better mitigate these risks Protection of Specific Groups  Although specialization maximizes average GPD, some groups may be able to earn a higher income under protection than in free trade  Trade restrictions can improve the earnings of one group (unskilled workers) whenever the restrictions increase the demand for that groups’ services  However, the overall national income and living standards will decrease  Social and distributional concerns may lead to the rational adoption of protectionism o The cost of this, is the country’s average living standards Maximizing National Income To Improve the Terms of Trade  Tariffs can be used to change the terms of trade in favour of a country that makes up a large fraction of the world demand for some product that it imports  By restricting its demand for the product through a tariff, it can force down the price that foreign exporters receive for that product  The price paid by domestic consumers will probably rise but as long as the increase is less than the tariff, foreign suppliers will receive less per unit  Not all countries can do this – need market power  large portion of total world demand  Large countries can sometimes improve their terms of trade by levying tariffs on some imported goods, small countries cannot Protect Infant Industries  Infant Industry Argument: The argument that new domestic industries with potential for economies of scale or learning by doing need to be protected from competition foreign producers so that they can grow large enough to achieve the same low costs o Once they are big enough, they will be able to compete without protection  One problem is that some “never grow up” – once they get used to this protected environment, they may resist having the protection disappear (even is E of S is achieved) To Earn Economic Profits in Foreign Markets  Trying to create an advantage in producing or marketing a prod that is expected to generate economic profits through sales to foreign consumers  If protection in the domestic market can increase the chance of the firm become established and thus earn high profits, the protection may pay off o Econ profit exceeds cost to domestic taxpayers – concept of strategic trade policy  However, if all countries try this, firms will try to enter industries where there is no room o Some people argue that a country should not do this – consumers could then buy cheaper imports, and firms could export at a higher price Fallacious Arguments for Protection Keep the Money at Home  This argument says that if I buy a foreign good, I have the good and the foreigner has the money – if I buy locally, I have the good and my country has the money  Common misconception – assumes that domestic money actually goes abroad physically when imports are purchased and that trade flows in only one direction o When you pay a foreign imported, you buy their currency & pay them, the money never leaves the country – Canadian money can only buy Canadian products, that’s why other people would want it  money would “come back” o If not, then the Bank of Canada could print off many millions of dollars and we could buy things easily Protect Against Low-Wage Foreign Labour  This argument says that the products of low-wage countries will drive Canadian products from the market, and the high Canadian standard of living will be dragged down  In actually, both parties gain – the producers gain because they are getting sales and the actual workers are getting an income o The buyers will gain by obtaining imports at a low cost in terms of the goods that must be exported in return  The cheaper our imports are, the better off we are in terms of the goods and services available for domestic consumption o Some ppl may be better off if didn’t happen, but overall average GDP is higher Exports are Good; Imports are Bad  Exports create domestic income; imports create income for foreigners o Surely it must be desirable to encourage exports and tax imports  Exports may raise GDP by adding to the value of domestic output and input, but they do not add to the value of domestic consumption o A country’s standard of living depends on the level of consumption, not income  If a country were to increase only exports, there would be a reduction in the standard of living since more goods are being sent abroad – country’s consumption would drop Create Domestic Jobs  Sometimes said if an economy has substantial unemployment, free trade should cease o This may be true for some industries, but it will also end up reducing the employment in other industries  Other countries can only buy Canadian goods with Canadian dollars and they can only earn these Canadian dollars if they sell their goods to Canada o Their decline in sales will decrease their Canadian purchases which will cause the past unemployment rate to be distributed among other industries  In the process, living standards will be reduced because employment expands in inefficient import-competing industries and contracts in efficient exporting industries  A country that imposes tariffs to create more domestic jobs may start a trade war leaving every country worse off as world output significantly falls Methods of Protection – Refer to Class Notes Tariffs  A tariff is a tax on imported goods – the immediate effect is to increase the domestic price of the good – has important implication for both domestic consumers and producers  It initially raises the price above the world price which causes imports to fall  As a result, foreign producers sell less and must transfer resources to other things  The price received on domestically produced units rises, as does the quantity produced o Domestic producers earn more – households consume less & pay more  DWL  Benefit for domestic producers and gov’t – costs on domestic consumers Quotas and Voluntary Export Restrictions (VERs)  Import Quota: A limit set on the quantity of a foreign commodity that may be imported  Voluntary Export Quota: An agreement by an exporting country to limit the amount of a good exported to another country  This restriction will have a similar effect as the tariff on domestic consumers & producers o Raises domestic prices, raises domestic production, lowers domestic consumption  However, a direct quantity restriction is actually worse than a tariff because the effect of the quantity restricted is to raise the price received by the foreign suppliers of the good o Leaves foreign suppliers uncha
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