4.1.6 Restrictions on free trade – Edexcel Economics A notes

Contents

What are the reasons for restrictions on free trade?

Restrictions on free trade include measures such as tariffs (taxes on imports), as well as quotas and other types of trade barrier.

Examples of tariffs include US tariffs on steel and aluminium imports.

Why might governments impose restrictions on free trade?

• Protect domestic employers and jobs.
  • International trade leads to increased competition for domestic firms.
  • This may lead to domestic firms shutting down, leading to reduced employment.
  • Protectionist measures, such as tariffs, may protect domestic firms from international competition.
• Reduce the size of the current account deficit by reducing imports.
• Protect in particular infant industries and sunset industries.
  • Infant industries feature small firms where there are significant economies of scale. Governments may impose trade restrictions to give industries time to grow and compete internationally, without being undercut by established foreign competitors.
  • Sunset industries are declining sectors that may require protection. Protectionist policies allow workers and businesses to transition gradually to work in other sectors or produce other goods, minimising economic disruption.
• Protect strategic industries such as national defence and energy.
• Raise revenue for government.
  • Tariff revenue could be used to reinvest in infrastructure or other areas of government spending.
• Prevent dumping of goods
  • Dumping is when goods are sold at excessively low prices to force out competitors
• Disincentivise production of goods abroad that have poor working conditions or are produced using highly polluting production processes.
  • For example the EU is considering a “carbon border tariff”, taxing goods that produce a lot of emissions in their production.

The tariff diagram

On a supply and demand diagram for world trade, there is one demand curve and two types of supply curve.

There is domestic supply (upward-sloping) and world supply (horizontal).

This reflects the fact that domestic consumers can buy goods from domestic producers or import the goods from producers in the rest of the world.

The world supply is drawn as perfectly price-elastic. This means the world market can supply any amount at the world price.

A. Free trade diagram – no tariff

Without a tariff, the free market equilibrium with free trade is as follows:

• Domestic production is cheaper than world production up to q. So the domestic supply is q.
• Domestic demand is where world supply meets the demand curve. This occurs at quantity q1.
• As domestic demand exceeds domestic supply, the difference is imported from the rest of the world. So the level of imports is q1-q.

B. Basic tariff diagram

What happens when a tariff is imposed?

• The tariff increases the world price, so the world supply line shifts upwards on the diagram. The price rises from pw to pw+T.
• This leads to a higher price and a reduced quantity of imports. Imports fall from (q1-q) without the tariff to (q3-q2) with the tariff.

Welfare effects of a tariff

A tariff leads to a decrease in consumer surplus. This fall in consumer surplus is the area shaded in the diagram below:

However the tariff leads to an increase in domestic producer surplus and an increase in government revenue (GR). These areas are shown on the diagram below:

Overall there is a welfare loss from a tariff, shown by the two triangles in the diagram below:

There are two welfare loss areas in the diagram. They both represent loss in consumer surplus that is not transferred either to the government as tariff revenue, or to producers as producer surplus. Specifically:

• The right hand triangle is loss due to reduced consumption because of higher prices caused by the tariff. As the quantity demanded falls, these lost units are not facing tariffs and nor can the producers gain revenue from these units. In other words, the consumer surplus loss here is not replaced by producer surplus gain or government revenue gain.
• The left hand triangle is loss due to a switch to a less efficient producer. Previously, without the tariff, these units were produced by foreign producers and imported into the country. However with the tariff, the domestic producer produces these units instead. But at this point, the domestic producer has higher costs compared to the foreign producer, which get passed on to the consumers in higher prices. So the consumer loses out in terms of higher prices.

Quotas

Quotas are a limit on the quantity of imports.

Similarly to tariffs, quotas reduce the amount of imports and protect domestic industry from competition. However this creates a shortage of the good at the original price. This leads to a rise in price to ration away excess demand.

Quotas have an even larger negative effect on social welfare compared with tariffs. While with tariffs, the government gains some revenue from taxing imports, there is no direct revenue gain for the government from enforcing a quota.

In practice tariffs and quotas may be combined into a “tariff-rate quota”. In this case, a set number of imports are tariff free. Imports above that set amount face the tariff.

An example of a tariff rate quota is for imports of certain agricultural products into the UK from outside the EU, such as lamb and beef.

Subsidies to domestic producers

Subsidies to domestic producers are payments given by governments to firms based in the domestic (home) economy.

These payments allow domestic firms to reduce their production costs, so that prices fall.

This increases the price competitiveness of domestically produced goods relative to imports.

As a result, more goods are produced domestically but less is imported.

The drawback of the subsidy is the cost to the government. Government spending on the subsidy may come at an opportunity cost or increase the budget deficit, increasing the national debt and leading to higher debt interest payments.

An example of this is UK subsidies for farmers under the Environmental Land Management (ELM) schemes.

Other non-tariff barriers

These include regulations such as:

• Sanitary and phytosanitary (SPS) checks. These are health checks on imports of animal products such as meat from the EU into the UK.
• Customs declaration forms must be filled in for imports coming into the UK from the EU.
• Goods imported from the EU into the UK must meet “rules of origin” requirements. These make it more difficult to import goods with large amounts of non-EU content.

Extra paperwork for imports to come into the UK increase costs for firms in the EU trying to sell goods in the UK. This reduces competition for UK producers but also increases prices for UK based consumers.

What are the impacts of protectionist policies?

Some diagrams to show the effects of protectionism include:

• Tariff diagram (see earlier): higher producer surplus and more government revenue but lower consumer surplus. Welfare loss overall.
• AS-AD: AD shifts right as imports fall, so net trade increases. So AD shifts right.
• AS-AD: SRAS shifts left as firms face increased costs for importing inputs.

Here is a summary of advantages and disadvantages of protectionist policies such as tariffs (with explanations below):

What are the impacts of protectionist policies? A breakdown

• Consumers
  • Lower consumer surplus. Consumers are paying higher prices for imports and domestic goods as a result of the tariff.
  • The effect on consumer surplus is so large that tariffs can lead to a welfare loss. The fall in consumer surplus is larger than the gain to producer surplus and government revenue combined.
  • Reduced consumer choice and the potential for a reduction in quality due to a reduction in competition. In this sense, imports can be beneficial as they increase competition on choice, quality and prices, raising living standards.
• Producers
  • Higher producer surplus for domestic firms who face less competition from imports. This may protect employment in these industries.
  • The infant industry argument. New (“infant”) industries may benefit from temporary protection to enable growth to achieve economies of scale.
  • The sunset industry arguments. Old or declining (“sunset”) industries can be protected temporarily to slow their decline. This gives time for the industries to restructure and for workers to retrain. This ensures an easier adjustment process for workers and local communities, instead of leading to sudden collapse.
  • Prevent dumping – exporting goods at prices below cost of production to force out competing firms abroad.
  • Protectionism may encourage some businesses to “reshore” – bring back their production facilities to the domestic economy in order to avoid protectionist measures when selling to the home country.
  • However protectionism may lead to retaliation.
    • Other countries may impose their own tariffs in response to protectionist measures.
    • This results in less demand for exports, reducing profits of domestic producers.
  • Increased business costs for firms that use imports. In the US this includes car companies such as GM and Ford who rely on steel in their production process. This could reduce profits, investment and employment in these industries.
• Governments
  • Higher tax revenue due to the extra tariff revenue.
  • Higher profits for domestic producers may lead to higher government revenue from corporation tax.
  • Higher domestic employment in protected industries may boost tax receipts from income tax.
  • These increases in tax revenue could reduce the budget deficit, reducing the rate at which government debt and government debt interest payments grow. Extra government revenue could also be used to fund other government spending such as infrastructure or to cut other taxes.
  • However there may be increased government spending if domestic subsidies are being used instead of tariffs. This could increase the budget deficit.
• Living standards
  • Inflation may increase if there are tariffs. This follow from SRAS shifting left (increased cost of imported inputs) and AD shifting right (reduced imports).
  • Higher profits for domestic producers may lead to higher investment. However investment may fall from firms that rely on imported inputs.
  • There may be a greater demand for labour in industries with protection, raising wages and employment.
  • However there may be a reduced demand for labour in industries that rely on importing raw materials, reducing wages and employment.
  • Countries cannot fully exploit their comparative advantages when protectionist measures are present.The theory of comparative advantage assumes no protectionist measures including no tariffs. But tariff costs may eliminate any “gains from trade”, preventing specialisation and trade.
• Equality
  • Free trade has contributed to the loss of manufacturing jobs in some advanced economies like the US and UK. This reduces the incomes for workers in these industries. Meanwhile in the UK, financial service companies and their employees have benefitted from more cross border investment flows due to globalisation. Tariffs in theory could therefore reduce inequality, by reversing the effects of free trade.
  • Tariffs increase prices. Steel tariffs may lead to higher costs of production for cars, which may increase prices. Similarly if tariffs are applied directly to consumer goods, the cost of living for consumers increases. Direct increases in the prices of necessities are a greater proportion of the incomes of those on low income, hitting the poorest harder.

How to evaluate protectionist policies

The impacts of protectionist measures depend on:

• Whether other countries retaliate with their own protectionist measures. Retaliation may negate any benefits of protectionism for domestic producers, by reducing demand for exports.
• Which sectors are protected. There may be greater justification for temporary protection for infant industries rather than other sectors where the country is unlikely to have a comparative advantage, now or in the future.
• The price elasticities of supply and demand.
  • If the PED is inelastic, then a given tariff rise will lead to less of a fall in quantity demanded, reducing the extent of any welfare loss.
  • This could apply where the goods are necessities, for example to raw materials such as energy imports.
  • If the PES is inelastic, a tariff will lead to a smaller amount of cheaper imports being replaced with inefficient, costlier domestic production. This reduces the extent of welfare loss on the left hand side.
• Importance of imported inputs for firms, which may depend on the industry.
  • This dependence may also change over time, for example as firms gradually adapt to the tariff and reduce reliance on foreign imports.

Why is world supply drawn as perfectly price-elastic?

There are two ways to think about this:

• The importing country takes the world price as given. The country, being a small fraction of total demand for imports, cannot influence world prices by using its buying power. So the country becomes a price taker. This is known as the “small country” assumption for free trade and tariff diagrams.
• There are no limits on production capacity for world supply. In other words, there is so much spare capacity in the rest of the world that world supply is extremely responsive to price changes.

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