Free Trade & Protection

11.
Free Trade & Protection

The Rationale for World Trade
The countries of the world are endowed with various resources. This
resource endowment means that certain countries will always have an
advantage in the production of certain goods. We can think of countries
that are famous for the production of certain products. Brazil is famous
for the production of coffee and Ceylon is famous for the production of
tea. South Africa has always been the worlds largest producer of gold
and the !iddle "ast is the largest oil producer. When a country has an
advantage in the production of a good because of its resource endowment
it is said to have an absolute advantage.
"ven when one country has an absolute advantage over another country
in the production of two goods both countries can benefit from trade in
those two goods. This is called comparative advantage and can be shown
in the following e#ample.
Assume that two countries Australia and $ew %ealand both produce wine
and cheese. The following table shows the output per worker per day in
each country. &t is based on the following assumptions'
(. There are only two countries Australia and $ew %ealand.
). "ach country produces the same two goods.
*. +abour is the only input.
,. All labour is employed and can move between industries.
-. .roduction costs are constant in each country.
/. Transports costs are zero.
0. 1ree trade e#ists between the two countries.
Country Wine (litres) Cheese (Kg)
Australia 50 30
New Zealand 10 20
Australia has an absolute advantage in the production of both goods. &t
can produce more wine and cheese with one days labour. 2owever both
countries can still benefit from trade according to the principle of
comparative advantage. The principle of comparative advantage or
comparative costs states that each country will benefit from trade by
specializing in the production of those commodities which allows them to
make the most efficient use of their resources. This can be achieved by
minimizing the opportunity cost of production. Whenever a countrys
resources are used to produce a particular commodity the chance to use
(
those resources to produce another commodity is foregone. All
production creates an opportunity cost. According to the principle of
comparative advantage trade between the two countries is mutually
beneficial if they have different opportunity costs.
The opportunity cost of production can be calculated from the above
table. &n $ew %ealand the opportunity cost of producing one litre of wine
is ) kilograms of cheese and the opportunity cost of producing one
kilogram of cheese is 3.- litres of wine. &n Australia the opportunity cost
of producing one litre of wine is 3./ kilograms of cheese and the
opportunity cost of producing one kilogram of cheese is (.// litres of
wine.
$ew %ealand has a lower opportunity cost in cheese production and has a
comparative advantage in cheese. Australia has a lower opportunity cost
in wine production and has a comparative advantage in wine. Assuming
that both countries can switch their labour force between wine and cheese
they could both specialise4 trade with each other and be better off.
&f Australia produced all the wine and $ew %ealand produced all the
cheese then output between the two countries would increase and through
trade both countries could benefit from this e#tra production. The net gain
would be ,3 litres of wine but there is a loss of (3 kilograms of cheese.
Australia would trade wine for cheese and $ew %ealand would trade
cheese for wine.
Free Trade
1ree trade can be defined as a situation where there are no artificial
barriers to trade imposed by governments. .rotection includes all
measures to restrict trade.
Arguments for Free Trade
Increased Output' 1ree trade allows countries to benefit from
increased output as a result of specialization according to comparative
and absolute advantage. The principle of comparative advantage states
that even if one country can produce all goods more efficiently than
another country4 trade will still benefit both countries if they both
specialise in the production of the goods in which they are
comparatively more efficient. &ncreased output means higher per
capita incomes and an improved standard of living. Advocates of free
trade claim that higher growth rates will result in greater prosperity for
all countries.

)
Allocation of Resources' 1ree trade creates an efficient allocation of
resources. Those countries that are more efficient at producing the
product are able to increase their production. Those countries that are
inefficient in the production of certain goods will stop producing those
goods. This will free up resources in all countries which will move to
the more efficient industries that are e#panding. &n this way the worlds
scarce resources will be used more efficiently creating less opportunity
cost.
Economies of Scale' 1ree trade increases specialisation and the scale
of operations and thus results in increased economies of scale. +arge
scale firms will be able to gain from all the factors that create
economies of scale. With free trade the size of a countrys efficient
industries will e#pand resulting in economies of scale.
Innoation' 1ree trade and international competition encourages
innovation and promotes the introduction of new technology. 1ree
trade e#poses e#isting firms to competition from firms anywhere in
the world. 1irms will have to adopt worlds best practice if they want
to survive.
Arguments against Free Trade
!nemplo"ment' Structural unemployment will result in the short term
as inefficient industries are closed. The assumption of perfect labour
mobility is unrealistic and in reality unemployment is often the end
result of any structural change. +ack of occupational mobility may
mean that many people remain unemployed in the long term.
#oss of Infant Industries' $ew industries and firms will have
difficulty starting up if they receive no protection from international
competition. &nfant industries are usually inefficient and will never be
able to compete with much larger international competitors. This
means that once an industry is lost it will probably never be regained
Trade $ependence' &ncreased specialisation means that a country
becomes less self sufficient and more dependent on trade. We have to
trade to gain the goods that we need. This places to country at a
disadvantage during times of trade disruption like during war or civil
unrest. &t may not be a good idea to lose self sufficiency in food or
weapons.
Reciprocal Agreement' 1ree trade re5uires reciprocal policies in
other countries or free trade agreements between two countries. &f this
does not occur and free trade policies are introduced by one country
only then that economy could be significantly disadvantaged.
$umping' 6umping is an unfair trade practice where imports are sold
at less than the cost of production thus reducing competition in the
*
local market. &ncreased specialisation and improved productivity can
easily general surplus output which is often dumped in other countries.
&t will be difficult to take action against dumping if you have a free
trade agreement with the country of origin.
!n%alanced econom"' 6evelopment theory often refers to the need
for manufacturing and agriculture to interact if a country wants to
develop and become an advanced economy. 1ree trade may create an
unbalanced economy to restricts this interaction and restricts
development.
Trade diersion' &f you have a free trade agreement with one country
but not another then goods may be sources from the second country
into the first and then enter Australia under the free trade agreement.
This trade diversion is a way around tariffs and other restrictions.
Standardi&ation of policies' free trade agreements each have to own
policies and regulations. &t is easy for these regulations and standards
to become inconsistent between one agreement and another.
What is protection'
.rotection is defined as any type of government action that has the effect
of giving domestic producers an artificial advantage over foreign
competitors.
(ethods of Protection
Tariff
A tariff is a ta# on imported goods.
Tariffs increase the price of imported goods in local currency which
makes them less attractive to Australian consumers.
After the tariff is introduced local producers increase their market
share.
!ore resources move into these import substitute industries as they
increase production to meet the e#tra demand. This creates structural
change of the Australian economy.
)uotas
A 5uota is a restriction on the amount of a good that can enter a
country.
An importer is a person who brings overseas made goods into
Australia to be resold.
"ach importer is given an import license. The government earns
revenue from selling these import licenses.
,
"ach import license has a 5uota or limit attached.
&f an importer e#ceeds their 5uota then they either pay penalty tariffs
7tariff 5uotas8 or they have the e#tra imports confiscated and
destroyed.
9uotas allow local producers to increase their market share.
Su%sidies
Subsidies involve financial assistance to domestic producers4 which
enables them to reduce their selling price.
Subsidies enable local producers to compete more easily with overseas
producers and remove the disadvantage of higher wage or transport
costs.
*oluntar" E+port Restraints
An agreement to restrict the amount of e#ports to a country.
A reciprocal arrangement with another country to limit e#ports.
#ocal ,ontent Rule
&f locally made goods are to 5ualify for local protection then there is a
re5uirement that they include a percentage of locally made parts.
+ocal content rules re5uire manufacturers to purchase locally made
components which creates a boost for local producers.
E+port Incenties
"#port assistance programs give e#porters assistance in the form of
advice4 loans and marketing support.
Such support can reduce marketing costs and increase e#port sales.
Reasons for Protection
There are many reasons for why countries use protective measures. These
reasons include'
Infant industr" argument- $ew industries are always going to be
inefficient initially. As they grow and become more e#perienced they
also become more efficient. &t has been argued for many years that
such new industries need to be protected against foreign competition
until they become established.
$omestic emplo"ment- The most inefficient industries in a country
are often those with the highest number of employees. Wage costs
make firms inefficient. 1ree trade means that many inefficient
industries are lost and workers in those industries become
unemployed.
-
$umping- 6umping occurs when overseas producers sell products in
the local market at below cost. This eliminates the local producer.
:nce there is no competition then the foreign producer increases
prices and make higher profits.
$efense & self sufficienc"- !a;or countries may want to keep their
defense and food industries so that they are able to defend and feed
themselves at times of war.
,heap la%our- Some countries overseas have workers who are
prepared to work for much lower wages. The products they produce
are much cheaper than locally produced products4 which are made
with higher paid local workers. Some governments feel ;ustified in
protecting local industries affected by cheap overseas labour to protect
;obs and ensure that workers receive fair pay.
$iersit" & multifunctionalit"- As economies ad;ust to free trade
they become more specialised and trade dependent. Some countries
prefer to have greater diversity believing that this means that their
economy will have better internal dynamic and be less dependent on
trade. Cultural factors and rural development may also be advanced by
such policies.
Enironment & foreign affairs- Countries may restrict trade with
other countries for a variety of political4 environmental or social
issues. Trade has become highly politicised.
Reasons for Protection in Australia
Australia has been one of the most protected countries in the world for
the following reasons.
Small $omestic (ar.et' Australia has a small population 7)3
million8 which means that the level of demand in many industries is
very limited. This makes domestic producers small and inefficient
because they lack economies of scale.
Transport ,osts' Australia is a long way from northern markets and
this means that Australian producers face higher transport costs.
2igher transport costs make Australian e#ports less competitive in the
ma;or northern hemisphere markets of "urope and America.
/arro0 E+port 1ase' Australia has a narrow e#port base and
protection has been used to broaden the industrial and occupational
distribution to generate domestic employment.
Recent Polic" ,hanges in Australia- Tops $o0n Approach
Australia has adopted a policy of reducing the level of tariff protection
and promoting free trade.
/
Australias protection policy is called the <Tops 6own Approach=
because the assistance for the most heavily protected industries has
been reduced the most.
The average level of tariff protection in Australia has fallen from */>
in (?/@A/? to ,.,> in )33(.
This policy aims to make domestic industries more competitive by
increasing the level of international competition.
This policy will encourage to flow of resources to more competitive
industries and structural change based on comparative advantage.
Australia has long advocated the removal of agricultural protection in
both the BATT and WT: forums. BATT is the Beneral Agreement on
Tariffs and Trade and is a multilateral agreement which aimed to
reduce the level of protection in the world. BATT eventually became
the WT:. The World Trade :rganisation WT: deals with trade
disputes between countries and also aims to reduce the use of
protection.
The Australian government has recently signed free trade agreements
with several countries including the Cnited States4 Thailand4
Singapore and $ew %ealand. The government is currently having free
trade talks with !alaysia and China.
Implications of a reduction in protection leels for the
Australian Econom"
The change to Australias protection policy has caused significant
structural change to the economy.
Effects on firms
Profits & (ar.et Share' 1irms in import substitute industries will
e#perience lower profits and reduced market share unless they can
become more competitive.
Industr" ,losure' Some industries or sectors of the economy may die
out altogether because they are unable to compete with overseas
producers.
Some Industries are #ess ,ompetitie' +abour intensive industries
with high wage costs will be unable to compete with low labour cost
countries.
Restructuring' 1irms will need to restructure. This may involve'
Csing a single plant that is more efficient.
"liminating less profitable production lines.
0
1inding e#port opportunities to compensate for reduced domestic
sales.
Adopting new production technologies.
Deducing staffing levels to reduce wage costs and increasing
labour productivity to ;ustify higher wage levels.
/eed for Innoation' 6omestic producers will have to be more
innovative and efficient if they are going to compete.
#o0er Imported Input ,osts' 1irms that depend upon imported
components will have lower costs as a result of the reforms. This will
reduce their costs and make them more internationally competitive.
Increased E+ports' "fficient industries in areas in which Australia
has a comparative advantage will benefit from increased trade.
World Integration' As Australia has become increasingly integrated
in the world economy manufacturing output has increased and the
manufacturing base has e#panded.
2lo%al Firms' Successful firms will be able to e#pand internationally.
Effects on indiiduals
!nemplo"ment' Workers in import substitute industries will face
unemployment. This type of unemployment is structural in nature
because the unemployed lack the skills for the ;obs that are available.
Retraining' 6isplaced workers from industries that are contracting
will need to retrain for new ;obs in e#panding industries.
#ong term !nemplo"ment' +ong term unemployment is possible if
individuals lack fle#ibility in their work skills and are unable to
retrain.
Ine3ualit" & $iscrimination' 6isadvantaged groups like migrants or
unskilled workers may find it especially difficult to find fullAtime
employment.
S.illed Wor.ers & 4uman ,apital' &ndividuals with the right
educational 5ualifications and skills for the new industries will be
advantaged by increased employment opportunities.
#o0er Prices' Consumers benefit from lower prices and better 5uality
products that are available on the international market.
Improed Product )ualit"' Consumers have benefited from
international alliances in terms of better 5uality products and services.
Effects on goernments
#o0er Tariff Reenue' +ower tariffs will generate less government
revenue. Tariffs revenue is now only a minor source of revenue for the
Australian 1ederal government.
@
Increased E+penditure' Bovernment e#penditure may need to
increase. Bovernment will need to finance education and training for
restructuring.
Social Welfare' Bovernments may also need to increase social
security payments for those who are displaced from inefficient
industries.
The impact of international protection on Australia
Changes to the level of protection in other countries affect demand
incomes and profits for Australian industries that sell similar products.
Australia is a ma;or agricultural producer and has been badly affected
by the agricultural policies of other countries. eg the Common
Agricultural .olicy of the "uropean Cnion4 which is a protectionist
policy shared by all the "uropean countries.
The future of Australian industr" in the glo%al econom"
Australia is e#pected to e#perience fast growth in industries like
tourism4 education4 financial and business services.
Communications and biotechnology are also increasingly important
industries.
Small e#port orientated manufacturing industries are becoming
increasingly important and Australia is an important part of the world
car industry.
Australias agricultural sector is very efficient by world standards and
should benefit from increased world specialisation.
"#am 9uestions
!ultiple Choice 9uestions
(. A reason for tariff reductions includes'
a8 Deducing input costs for domestic firms.
b8 &mproving the standard of living of Australian consumers.
c8 Deducing the level of imported inflation.
d8 All of the above.
). 1irms in Australia need tariff protection because'
a8 The Australian domestic market is very small.
b8 Australian firms are disadvantaged by high transport costs.
c8 Australian firms lack economies of scale.
d8 All of the above.
*. A reduction in the level of tariff protection would'
?
a8 &ncrease government ta# revenue.
b8 Stimulate import substitute industries.
c8 &ncrease employment in Australia.
d8 Deduce domestic inflation rates.
Short Answer 9uestions
(. 6efine the following terms' resource endowment4 absolute
advantage4 dumping4 voluntary e#port restraints4 local content rule4
e#port incentives4 BATT4 WT: E Common Agricultural .olicy.
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). "#plain the principle of comparative advantage.
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*. What are the arguments for free tradeG
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,. What are the arguments against free tradeG
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-. "#plain the various methods of protection.
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/. 2ow has Australias policy on protection changed in recent yearsG
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0. What has been the effect a reduction in the level of protection in
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"#tended Desponse
Outline the impact of tariff reductions on the Australian econom"'
Dule (' 6efine the terms in the 5uestion' Tariff4 tariff reduction.
Dule )' &dentify E define related concepts' unemployment4 import
substitute industry4 cost of living4 input costs.
Dule *' +ink introduced terms to the 5uestion' Tariff reduction will
reduce the cost of living for Australian consumers because the price of
imported goods will fall.
Dule 0' Cse e#amples to communicate additional meaning' 1or e#ample
Australian consumers will be able to purchase cheaper electrical goods
like 6H6 players and plasma televisions.
Dule ,' 6raw logical conclusions' Tariff reductions will affect Australian
consumers and firms.
(,

Free Trade & Protection

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11.

Free Trade & Protection

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