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Chapter2:
2:Free
FreeTrade
Tradeand
andProtection
Protection 39
Chapter 2
Free Trade and Protection
(ii) If each country specialised in wheat production by devoting all of its resources to wheat production,
Country X could produce 800 tonnes of wheat, whereas Country Y could only produce 400 tonnes
of wheat. Therefore Country X has an absolute advantage in the production of wheat.
Since Country X has an absolute advantage in the production of both computers and wheat, there is no
basis for international trade between the two countries. David Ricardo, in his Principles of Economics
and Taxation (1817), refined Adam Smiths principle of absolute advantage. He argued that a country
could still engage in trade if it did not have an absolute advantage in production. By this he meant
that if a country was comparatively more efficient in the production of a good than another country, it
could engage in trade. David Ricardos principle of comparative advantage was based on the concept
of opportunity cost in production. If a country can produce a good with greater comparative efficiency
(as measured by a lower opportunity cost of production) it should specialise and engage in trade.
Comparative advantage refers to production at the lowest opportunity cost, and can be calculated in our
example by the opportunity cost of computer and wheat production in countries X and Y in Table 2.1,
to determine which country has a comparative advantage in the production of each good:
The opportunity cost of computer production in Country X is 800/300 = 2.6 wheat
The opportunity cost of computer production in Country Y is 400/200 = 2 wheat
The opportunity cost of wheat production in Country X is 300/800 = 0.3 of a computer
The opportunity cost of wheat production in Country Y is 200/400 = 0.5 of a computer
The opportunity cost co-efficients above are listed in Table 2.2. Country Y has a comparative advantage
in the production of computers since the opportunity cost is 2 wheat, whereas in Country X it is 2.6
wheat. Country X has a comparative advantage in wheat production since the opportunity cost is 0.3 of
a computer, whereas in Country Y it is 0.5 of a computer. Therefore Country Y should specialise in the
production of computers and Country X should specialise in the production of wheat. If each country
did this they could engage in international trade. Total computer output would be 20,000 (200 x 100
resources) and total wheat output would be 80,000 (800 x 100 resources). Therefore, according to
comparative advantage or specialisation, wheat output would increase by 20,000 tonnes, but computer
output would fall by 5,000 (i.e. compare the results for total output in Tables 2.1 and 2.2). This could
be overcome by Country X producing some computers but largely specialising in wheat production.
A reason for a country specialising in the production of goods in which it has a comparative advantage
(i.e. producing a good with greater comparative efficiency than another country) is that it may be able
to generate economies of scale in production. This means that with increasing output it may be able
to reduce the unit cost of production, and therefore sell its goods at a more competitive or lower price
in overseas markets. Economies of scale may result from the use of specialised labour, land, capital or
entrepreneurial resources in production. Different countries will have different factor endowments and
can utilise these according to their comparative advantage in different types of production. For example,
Australia has abundant land resources, including minerals and agriculture, which are important exports
in the balance of payments. Japan on the otherhand, has abundant capital and skilled labour resources,
which are used to manufacture and export high technology products such as cars to overseas markets.
Australia therefore exports natural resources to Japan and imports manufactured goods from Japan.
150
100 Country X
Country Y
0 Wheat
200 400
Since Country X has an absolute advantage in the production of both computers and wheat, there is
no basis for international specialisation and trade between the two countries. However according to
the principle of comparative advantage, Country X is more efficient in producing wheat than Country
Y, since the opportunity cost of wheat production is 0.3 computers in Country X, compared to 0.5
computers in Country Y. Therefore Country X should specialise in wheat production and trade its
surplus with Country Y. Country Y is more efficient in producing computers than Country X, since the
opportunity cost of computer production is 2 wheat in Country Y, compared to 2.6 wheat in Country
X. Therefore Country Y should specialise in computer production and trade its surplus with Country Y.
Table 2.3: Production after Specialisation based on Comparative Advantage
Production of computers and wheat after specialisation is illustrated in Table 2.3. Total production
after specialisation is 200 computers and 800 wheat. Computer production has fallen by 50 units
(from 250 to 200) but wheat production has risen by 200 units (from 600 to 800). Country X should
therefore produce some computers to make up the shortfall, but largely specialise in wheat production.
If country X produced 100 computers, computer production would rise by 100 to 300, and wheat
production would fall to 700. After trading their surplus output, both countries can consume more
computers and wheat (consumption gains) than by being self sufficient. This is illustrated in Table 2.4.
Table 2.4: Consumption Gains from Specialisation based on Comparative Advantage
Newly established firms in infant industries will find it difficult to compete against more efficient
and established foreign firms. Infant industries will take longer to achieve the necessary economies
of scale to compete globally, and may go out of business before reaching an optimal scale of plant.
Under conditions of free trade, the most efficient and competitive producers will attract resources
away from less efficient and less competitive industries, causing some regions to lose key industries
and experience unemployment. Job displacement in uncompetitive industries can lead to structural
unemployment and more regional inequality. As a result, governments will need to provide job
retraining schemes and welfare assistance to the structurally unemployed in affected industries.
Free trade (with no government intervention) can lead to negative externalities if firms do not pay
for the unintended consequences of their production activities, such as higher levels of pollution,
the degradation of the environment, or the exploitation of labour in developing economies.
Countries pursuing free trade strategies may not be able to diversify their economic base because they
specialise in production according to comparative advantage. For example, countries specialising
in agricultural exports may not have a high level of industrialisation, and therefore be increasingly
dependent on imports of manufactured, energy and capital goods from other countries.
Free trade may lead to unfair price cutting, if countries which are efficient producers of agricultural
or manufactured goods, sell their exports at below factor cost in foreign markets.
This is known as the dumping of surplus output in export markets and may lead to higher
unemployment in import competing industries in other countries.
A country pursuing free trade can often experience a sustained or persistent current account deficit
in the balance of payments, if it is unable to finance its import expenditure with its export income.
This may occur if domestic import replacement industries are relatively inefficient compared to
export industries. This situation can lead to high levels of import penetration and a shortfall in
export income to finance import expenditure, resulting in a trade or current account deficit.
Since the formation of GATT in 1947 and the World Trade Organisation (WTO) in 1994, there has
been a tendency for the levels of global protection to fall as more countries pursue free trade. Many
developing countries have joined the WTO in seeking further reductions in the protection of agriculture,
textiles, clothing and footwear by advanced nations (through subsidies and tariffs). Negotiations in
reducing protection in the WTOs Doha Round began in 2001. There was however an upsurge in global
protection in 2008-09 in response to the Global Financial Crisis (GFC), with many countries using
protection to support employment in major industries such as agriculture, manufacturing and services.
However in a breakthrough in December 2015 in Nairobi, Kenya, the WTOs 163 members agreed to
abolish all government subsidies to farmers (including export subsidies) between 2015 and 2018.
REVIEW QUESTIONS
THE BASIS FOR FREE TRADE
1. Define free international trade and give an example of an international trade transaction.
2. Why do countries engage in international trade? What are the expected gains from international trade?
3. Using an example, explain what is meant by Adam Smiths principle of absolute advantage.
4. Refer to Table 2.1 and explain why Country X has an absolute advantage in both computer and
wheat production over Country Y.
5. What is the principle of comparative advantage? Refer to Table 2.2 and calculate the
opportunity cost of computer and wheat production for Country X and Country Y.
(a) Which country has an absolute advantage in iron ore and car production?
(b) Calculate the opportunity cost of iron ore and car production in Australia and Japan.
Which country has a comparative advantage in iron ore and car production?
(c) On what basis should Australia and Japan trade? What are the gains from free trade?
Source: Productivity Commission (2006), Trade and Assistance Review 2004-05, Melbourne.
For the Cairns Group of free trading agricultural exporters (including Australia), the major outcome of
the Uruguay Round was an agreement by the USA and EU to cut their agricultural subsidies by 2000:
An average cut in all agricultural tariffs of 36%;
Domestic support measures (i.e. subsidies) to be cut by 20%; and
Export subsidies to be cut by 36% in budgetary terms, and 21% in quantitative terms.
Other measures in the Uruguay Round included reductions in beef and rice subsidies by the EU and
USA for exports to the Asian market over 1994-2000, and for Japan and South Korea to open their
domestic rice markets to imports. GATT also cut tariffs on trade in many industrial products.
of sovereign debt default in Europe such as Greece (SDR26.4b), Portugal (SDR23.7b) and Ireland
(SDR19.4b). Other countries in receipt of IMF financial assistance were Pakistan (SDR7.2b), Colombia
(SDR3.8b), Mexico (SDR47.2b) and the Ukraine (SDR4.7b). The IMFs five main responsibilities in
the global economy are the following:
1. Promoting international monetary co-operation and global monetary stability;
2. Facilitating the expansion of international trade;
3. Promoting exchange rate stability;
4. Supporting the multilateral payments system; and
5. Making resources available to members experiencing balance of payments difficulties.
During the Global Financial Crisis in 2008-09 the IMFs funds were insufficient to meet the demand
for credit by advanced, developing and emerging countries. At the Pittsburgh Summit in 2009 the G20
leaders committed to tripling the IMFs lending capacity to US$750b to deal with the Global Financial
Crisis. The IMF has played a major role with the European Central Bank in lending funds to Greece,
Ireland and Portugal during the height of the European Sovereign Debt Crisis between 2010 and 2012.
In mid 2015 Greece defaulted on its loan repayments to the IMF. The Greek government negotiated
with European leaders and the IMF over reforms to help Greece remain in the Euro Area.
Many developing countries are critical of the conditions imposed by the IMF and World Bank on
countries receiving financial assistance (i.e. the Conditionality Principle). These conditions may involve
a loss of autonomy over economic policy or directives on how assistance funds are spent. The IMF and
World Bank usually require governments in developing countries to implement structural reforms in
their economies to receive financial assistance. As the IMF and World Bank are controlled by advanced
countries, many developing countries interpret their policies as undermining their national sovereignty.
Source: World Bank (2015), World Development Indicators 2015, Washington DC.
The G8 leaders met in St Petersburg, Russia, in July 2006, and urged WTO negotiators in the Doha
Round to reach an agreement on a broad outline for liberalising world trade. G8 meetings in 2007
and 2008 discussed possible reductions in greenhouse gas emissions by 2050 and at the July meeting in
Japan in 2008 the G8 leaders adopted a 50% target for reducing greenhouse gas emissions by 2050. At
the G8 Summit in May 2012 at Camp David, Maryland, USA, leaders agreed to greater fiscal discipline
to prevent the European Sovereign Debt Crisis from undermining global growth. In June 2014 the G7
leaders met in Brussels instead of Sochi, Russia, as Russia was expelled from the G8 due to its violation
of Ukraines sovereignty with the invasion of the Crimean Peninsula. The G7 now replaces the G8 with
consideration for Russia to be readmitted in 2017 if there is no further violation of Ukraines sovereignty.
REVIEW QUESTIONS
INTERNATIONAL ORGANISATIONS AFFECTING TRADE
1. Discuss the guiding principles of the WTO. What were the results of the Uruguay Round of GATT
negotiations? How did Australia benefit from the outcomes at the Uruguay Round?
2. Discuss the agenda for the WTOs Doha Round of trade talks. How did the Doha Round
progress at the Ministerial Meeting in Nairobi in 2015?
3. Distinguish between the history and functions of the IMF and World Bank.
4. How did the IMF and World Bank try to assist countries in dealing with the Global Financial
Crisis in 2009? What role did the IMF play during the European Sovereign Debt crisis?
5. Why have the policies of the IMF and World Bank been criticised by developing countries?
6. Discuss the Sustainable Development Goals (SDGs) for 2030 set by the UN in Table 2.5.
7. Discuss the influence of the OECD, G7, G8 and G20 on the world economy and world trade.
A free trade area is where a group of member countries (e.g. the EU) abolish trade restrictions or
barriers between themselves but may retain restrictions against non member countries.
A customs union is where member countries not only abolish trade restrictions between themselves
but adopt a common set of trade restrictions against non member countries (e.g. the EU).
A common market involves the features of a customs union but also allows for the free mobility of
labour and capital between the common market countries (e.g. the EU).
A monetary union has the features of a common market plus the adoption of a common or single
currency and the co-ordination of monetary policy through a single central bank (e.g the EMU).
Fiscal, welfare and competition policies may also be co-ordinated between member countries.
The three types of free trade agreements (FTAs) are bilateral (i.e. between two countries such as the
US-Australia Free Trade Agreement); regional (i.e. between many countries in a region such as APEC,
NAFTA, ASEAN and the TPP); and multilateral (i.e. between many countries not necessarily in the
same geographic region such as the WTO). Examples of these three types of trade agreements are
contained in Figure 2.5. Multilateral trade agreements such as the WTO (rather than bilateral or
regional agreements) are considered to be the most effective way of achieving trade liberalisation on a
global basis, because they are non exclusive, and lead to trade creation rather than trade diversion.
The disadvantages of monetary union in the EU include the loss of national currency sovereignty,
and macroeconomic policy autonomy, and political opposition that arises if the economic benefits of
monetary union are not realised in member countries. The main features of the European Union are:
Economic and political integration has led to common policies for member countries, who take
joint decisions on many economic and political matters. Examples include the Kyoto Protocol
(2004) to reduce greenhouse gas emissions; and the Treaty of Lisbon (2007) to promote democratic
and transparent government, and sustainable development in the EU.
The creation of a single European market through the removal of trade barriers has led to the free
movement of goods, services, people and capital between member countries.
The single currency of the euro managed by the European Central Bank has created an Economic
and Monetary Union (EMU) in the EU. In 2002 euro notes and coins replaced national currencies
in 12 of the 15 EU countries, and the official interest rate in the EU was set by the ECB.
The EU has a combined population of 508m and its total GDP is slightly larger than the USA. The EU
accounts for around 14% of world GDP and 20% of world trade, with trade between EU countries (i.e.
intra-regional trade) accounting for 66% of all EU trade. However the Global Financial Crisis in 2008-
09 led to negative economic growth, rising unemployment rates and current account deficits in the EU.
A sovereign debt crisis emerged in the Euro Area in 2010-11 because of the rising budget deficits and
sovereign debts of the governments of Portugal, Ireland, Greece and Spain. The crisis exposed flaws in
EMU fiscal governance with government debt reaching an average of 85.3% of GDP in 2013. The
crisis caused financial contagion in the Euro Area, with the ECB and the IMF providing a US$200b
loan to Greece. Europes finance ministers set up a comprehensive rescue package in May 2010 of
US$1,000b by creating a European Financial Stability Facility. IMF and ECB bailout packages to
governments in Greece, Ireland and Portugal in 2010-11, Spain in 2012, and Cyprus in 2013, were
conditional on cuts to government spending and higher taxes to reduce budget deficits and public debt.
APEC does not impose a formal rules based structure like the EU or NAFTA on its members, but
conducts a series of forums for ministers and leaders, who formulate policy and allow industry based
working groups to collaborate on matters of common interest and concern. APECs importance to
regional trade and economic development is its commitment to four major areas of reform:
1. Trade liberalisation within the region supplementary to, but consistent with WTO initiatives.
2. Trade facilitation in the region through the development of an Asia Pacific investment code; dispute
settlement procedures; macroeconomic policy co-ordination; mutual recognition of testing and
certification arrangements; and closer co-ordination of competition policy.
3. Technical co-operation to facilitate the development of physical and human capital resources
needed for future economic development in the region.
4. Institutionalisation of APECs role through regular annual leaders meetings and an enhanced role
for members economic ministers in guiding the APEC process.
The advantage of APECs approach to economic integration and trade liberalisation is that it is based on
open regionalism where reductions in trade barriers are based on non discrimination, by liberalising
trade between members, but not discriminating against non APEC members. APECs initiatives are
therefore consistent with the WTOs guiding principles for free trade. Between 1994 and 2009 APEC
economies reduced their tariffs from an average 8.2% to 5.4%, and annual trade increased by 7.1%.
At the APEC meeting in Lima, Peru in 2008, leaders reinforced their commitment to achieving the
Bogor Goals; promoting recovery from the global slowdown; and examining ways to create a future Free
Trade Area of the Asia Pacific (FTAAP). At the APEC meeting in 2009 in Singapore, leaders responded
to the Global Financial Crisis by strengthening trade and investment links within the APEC region (i.e.
regional economic integration) and opposing protectionism. The APEC meeting in Yokohama, Japan
in 2010, reaffirmed support for the Bogor Goals; concluding the Doha Round; the UN Framework
Convention on Climate Change (UNFCCC); taking steps to establish the FTAAP; and providing
continued economic and technical assistance to APEC members (ECOTECH). In 2011 in Honolulu
the APEC leaders declaration was based on moving Towards a Seamless Regional Economy.
The APEC leaders meeting in Vladivostok, Russia, in 2012 was held under the theme of Integrate to
Grow, Innovate to Prosper and discussed policies to strengthen the regions prosperity and leadership in
the global economy. The APEC leaders met in Bali in October 2013 under the theme, Resilient Asia-
Pacific, Engine of Growth, reaffirming their commitment to achieving the Bogor Goals by 2020. In 2014
in Beijing the APEC leaders met under the theme of Integrated, Innovative and Interconnected Asia. The
theme of the APEC leaders meeting in Manila, in November 2015, was Building Inclusive Economies,
Building a Better World, where there was a renewed commitment to achieving the Bogor Goals.
avoid tariffs and other barriers imposed by the USA and Canada on imports. In 1993 NAFTA was
endorsed by the US Congress, with proponents arguing that the benefits to the US economy would
be substantial. Rules of origin were established to avoid the problem of trade diversion. The rules of
origin are used to determine if imported goods are entitled to tariff free treatment through the extent
of value adding activity of products in a NAFTA member country, according to the following criteria:
If they are wholly produced in the region;
If they are produced from materials that originate in the region according to the rules of origin
governing regional content;
If the non originating materials used in their production have been subjected to special tariff
provisions that treat them as finished goods (e.g. finished goods are subject to higher tariffs than
intermediate goods); and
If they satisfy a regional content requirement, which is usually a percentage of the total value added
in the production of a good.
Major industries benefiting from NAFTAs elimination of trade barriers include agriculture, automobiles,
energy, petrochemicals, financial services, transport and intellectual property. NAFTA is now the worlds
largest trade bloc in terms of GDP in PPP terms which was estimated by the IMF at US$19,951b
in 2013. Merchandise trade between the NAFTA partners was estimated to have tripled, reaching
US$946b in 2008. In 2001 governments from 34 nations in North, Central and South America agreed
to work towards the formation of a Free Trade Area of the Americas (FTAA) which would expand the
scope of NAFTA. The FTAA is still under negotiation, but could provide the member countries with
greater market access for their exports, and far exceed the EU as a major global trade bloc.
Overall NAFTA has led to significant specialisation and trade creation between the USA, Canada and
Mexico, with increased manufacturing in Mexico and increased raw material exports from the USA
and Canada. However there is evidence of some de-industrialisation in both the Canadian and US
manufacturing sectors through the relocation of some industries to Mexico and a consequent loss of
employment. A North American Agreement on Labour Co-operation (NAALC) was signed to address
this problem. Also the North American Agreement on Environmental Co-operation (NAAEC) was
signed in 1994 to address public concerns over NAFTAs impact on environmental sustainability.
In 2007 in Singapore ASEAN leaders adopted the Cebu Declaration to establish an ASEAN Economic
Community (AEC) by 2015 through further reductions in tariff and non tariff barriers. This would
transform ASEAN into a region with the free movement of goods, services, skilled labour and more
capital mobility between member countries. ASEAN leaders at the 27th ASEAN Summit in Kuala
Lumpur in November 2015, adopted the AEC Blueprint: a highly integrated and cohesive economy;
a competitive, innovative and dynamic ASEAN; enhanced connectivity and sectoral co-operation; a
resilient, inclusive, people oriented and people centred ASEAN; and a global ASEAN.
ASEAN is a major free trade area or region, and in 2014 had a combined population of 622m, an annual
GDP of US$2,570b, annual trade of US$2,500b, and annual foreign direct investment of US$136b.
ASEAN was the third largest economy in Asia and seventh largest in the world in 2014.
REVIEW QUESTIONS
TRADING BLOCS, MONETARY UNIONS AND FREE TRADE
AGREEMENTS
1. What is meant by economic integration? Refer to Table 2.6 and distinguish between a free trade
area, customs union, common market and a monetary union.
3. Discuss the formation of the European Community and its evolution to the European Union under
the Maastricht Treaty. What are the benefits and costs of the EU and EMU? Discuss the impact
of the European sovereign debt crisis and the Brexit vote in 2016 on the EU and EMU.
4. How does APEC attempt to liberalise trade? Explain the significance of the Bogor Declaration in
1994. How is APEC a different form of regional economic integration to the EU and NAFTA?
5. Explain how NAFTA was formed. What advantages and disadvantages does NAFTA provide
for the USA, Canada and Mexico? How might the formation of the FTAA affect world trade?
6. Explain the importance of ASEAN and the formation of the AEC in liberalising Asian trade.
debt, and could use protective devices to reduce import spending and switch import expenditure
to domestically produced goods. This policy could have adverse effects, because specialisation is
not encouraged according to comparative advantage and resources may be diverted to less efficient
industries. Also, export and import competing industries and consumers may face higher prices for
imported inputs and outputs, reducing competitiveness and living standards in the economy.
Other arguments used to justify protection may be based on non economic grounds, and seek
to promote political, social or cultural goals. These include the military self-sufficiency or defence
argument (where national defence industries are protected to ensure war-time supply); and the national
spending argument such as the buy Australia campaign which encourages expenditure switching from
imports to domestic goods, irrespective of prices and quality. Associated with this argument is the desire
to protect national sovereignty and Australias cultural identity such as subsidising local films, television
and the entertainment industry. Other arguments for protection include the diversification of industry;
using protection as a strategic industry policy to pick winners since the world trading environment is
not considered to be a level playing field because it is dominated by MNCs and trading blocs; and to
increase government revenue through the imposition of higher tariffs on imports.
OWOT a b
tariff
OW
c d
S D
0 Q
Q1 Q3 Q Q4 Q2
Protection Consumption
effect effect
1. The price of the traded good rises from OW to OWOT, causing inflation and a loss in consumers
real incomes, as higher prices are paid for both imports and domestic goods (i.e. the price effect).
2. The quantity of imports falls, and is displaced by locally produced goods which may or may not be
of the same quality or preferred to imports by consumers, since they are more expensive (i.e. the
consumption and protection effects).
3. The government receives tariff revenue equivalent to the shaded rectangle abcd, which is equal to
the tariff of OWOT-OW multiplied by the quantity of imports of Q3Q4 (i.e. the revenue effect).
4. There is a redistribution of income away from importers and consumers to the government and
local producers. Resources are reallocated from importers to local producers, who improve their
welfare at the expense of consumers and importers (i.e. the redistribution effect).
Subsidies are cash payments made to local producers to increase supply in the face of import competition.
The effects of a subsidy are illustrated in Figure 2.7. Curves DD and SS represent domestic demand
and supply respectively, with the equilibrium price at OP, and the equilibrium quantity at OQ. Price
OP1 is the world or free trade price for the traded good. At this price domestic producers supply OQ1
but domestic demand is OQ2. The shortage in the market of Q1Q2 at price OP1 is made up by imports.
If a subsidy equivalent to AB is paid to local producers, they will be able to increase supply from SS to
S1S1, and be willing to charge the lower world price of OP1, and supply more goods at OQ2, thereby
eliminating the need for imports. Subsidies are preferable to tariffs because they are paid for from
progressive taxation, are more subject to regular review, and lead to lower prices. However they distort
resource allocation and redistribute income away from taxpayers to a small sector of the economy.
Continuation of subsidies may also raise government expenditure and increase the taxation burden.
Subsidisation of inefficient industries causes a misallocation of resources, since inefficient industries
are favoured over efficient industries that are competitive in the market without government subsidies.
Bounties are similar to subsidies since they are cash payments to producers, but are paid on a per unit
basis. For example, farmers may receive a bounty of $50 for each tonne of wheat produced.
Quotas are a quantitative restriction on certain categories of imported goods. The larger (smaller)
the import quota the greater (lesser) the quantity of goods that may be imported and the less (more)
the protection effect. Importers usually apply for an import licence to receive a quota and may lobby
the government for the quota to be increased if local demand is high, whereas domestic competing
industries would lobby the government for a reduction in the import quota to gain more protection.
A increase in supply
P Subsidy
P1
B
S
S1 D
0 Q
Q1 Q Q2
The effects of a quota are shown in Figure 2.8. Curve DD is domestic demand for the imported good
and S is the import quota or the supply curve. The price of the good is OP and if the quota is reduced
(i.e. the movement from S to S2) the quantity of imports will fall from Q to Q2 and the price of the
imported good will rise to OP2 leading to greater protection for domestic industry. Increased protection
through quota reductions has a similar effect to the imposition of a tariff. If the quota is increased (e.g.
the movement from S to S1), the price of the imported good will fall to OP1, leading to lower levels of
protection for the domestic industry. Tariff quotas combine the effects of a quota and a tariff. Quotas
are imposed on imports up to a certain quantity and then a tariff is also levied, further raising the price
of the import. Another protective device similar to a quota is a voluntary export restraint (VER), where
a country (e.g. Japan) agrees to limit its exports to another country (e.g. the USA), to reduce its trade
surplus with that country. VERs have been used by the USA to limit the export of Japanese motor
vehicles and electronic goods to the US market to protect US manufacturing firms and employment.
Local content rules refer to government procurement policies and industry plans, where a certain
percentage of inputs or outputs must be manufactured within Australia. Examples include local content
rules under the former Button Car Plan and local content specifications for government contracts.
Technical discrimination is when a government imposes certain minimum technical standards on
imported goods. Importers must comply with safety, health, quality and packaging standards before
the imported goods can be offered for sale in the domestic market. Quarantine regulations are another
means by which the government may restrict imports by enforcing health and agricultural regulations
on importers of food, vegetable, plant and animal products into Australia. Embargoes are the complete
prohibition of the import or export of certain goods. Examples of prohibited imports into Australia
include firearms and illegal drugs. Australia also used to ban the export of Merino rams, as their sale to
overseas producers was seen as a threat to the Australian wool industry through increased competition.
Export and tax incentives such as export subsidies in the US and EU or the Export Market Development
Grant Scheme (EMDG) used in Australia, attempt to reduce the costs of production for exporters by
allowing a tax deduction for expenditure incurred in developing export markets. The USA and EU
both use domestic and export subsidies effectively to reduce the prices of their agricultural exports.
This has led to US and EU farmers gaining a larger share of the world wheat and sugar markets, at the
expense of efficient producers like Australia and other Cairns Group countries which do not subsidise
their agricultural exports. Agricultural subsidies depress world farm prices and reduce market access.
P decrease S2 S S1
in quota increase in quota
P2
P1
D
0 Q
Q2 Q Q1
P P
S S1
D S
Loss of revenue
Global Subsidy
P a A B
D
P1 D1
C D
b
S D
S1 S
0 Q 0 Q
Q Q1 Q 4 Q3
The effect of wheat subsidies through the EUs Common Agricultural Policy (CAP) and the USAs
Export Enhancement Programme (EEP) on Australian wheat farmers is illustrated in Figure 2.9. As
a perfect competitor in the world wheat market, Australia has to accept the market price for wheat
determined by world demand (DD) and supply (SS) i.e. price OP in Panel A of Figure 2.9. The effect
of a wheat export subsidy of ab is to increase world wheat supplies from SS to S1S1, causing the world
wheat price to fall from OP to OP1 as shown in Panel A of Figure 2.9. This reduces the supply of
Australian wheat on the world wheat market from Q3 to Q4 and the total revenue (i.e. price x quantity)
to Australian wheat farmers falls from rectangle OABQ3 to rectangle OCDQ4 in Panel B of Figure 2.9.
The Uruguay Round of GATT negotiations was held between 1986 and 1994 and resulted in an
agreement by the EU and the US to cut their agricultural subsidies by up to 36%. The Doha Round of
WTO trade talks which began in 2001 has the main agenda item (supported by the Cairns Group and
developing countries), of further reductions or even the total elimination of agricultural subsidies in the
EU and USA. The WTOs 162 members voted to end all farm subsidies in Kenya in December 2015.
The Australian Department of Foreign Affairs and Trade (DFAT) noted in 2003 that despite fifty years
of trade reforms, remaining global trade barriers still impose considerable costs on both developing and
advanced economies. International trade barriers hinder developing economies from specialising in
production and exporting products in which they have a comparative advantage, and from reaping the
maximum gains from free trade. The two main categories of developing countries exports which face
the highest tariffs imposed by rich industrial countries include agriculture and textiles.
The trade policies of advanced economies like those of the EU, the United States, South Korea and Japan
finance huge agricultural production and export subsidy schemes that depress world agricultural prices
by an estimated 12% (US Department of Agriculture, 2001). These subsidies significantly undermine
the agricultural export income of developing countries. Developing countries trade policies also damage
each other through the use of protection. Eventhough their markets are smaller, developing countries
on average impose up to three times higher trade barriers than advanced economies.
The World Bank (2002) estimated that developing economies could increase their welfare by over
US$65b if they liberalised their trade regimes. The OECD (2001) has estimated that agricultural
policies in OECD economies cost consumers and taxpayers around US$300b every year. Furthermore
the World Bank (2002) has suggested that advanced economies would gain even more than developing
economies from reducing their own trade barriers. The removal of agricultural protection would
generate US$111b per year in additional welfare for advanced economies, due to consumers being able
to buy lower cost agricultural products and increasing their spending on other products.
Table 2.8: Post Uruguay Round Tariffs & Reductions in Selected Countries & Groups
European Union United States Poor Countries Rich Countries
Product Category Tariff Reduction Tariff Reduction Tariff Reduction Tariff Reduction
Source: UNDP (2003), Human Development Report, Oxford University Press, New York.
Table 2.8 shows the average tariff reductions for four product categories for the EU, United States, poor
countries and rich countries since the Uruguay Round of GATT was completed in 1994. Most rich
countries apply higher tariffs to agricultural goods and simple manufactures (e.g. textiles), which are the
types of goods that developing countries can produce and export cheaply to world markets.
In agriculture the tariffs of OECD countries are heavily biased against low priced farm products produced
by developing countries. Tariffs against developing countries manufactures also remain high. In the
1990s the average OECD tariff on manufactured goods from the developing world was 3.5%, more than
four times the average of 0.8% on OECD manufactures. Whilst there have been tariff reductions in
agriculture, textiles, metals and chemicals since the Uruguay Round, there remains greater scope for tariff
reductions in the EU and the United States for agricultural goods. This also applies to reductions in quotas
and export subsidies for agricultural goods in these countries. For developing countries a major aim in
the Doha Round is to achieve cuts in tariffs on other labour intensive exports such as textiles. Progress was
made in abolishing export subsidies by 2018 at the WTOs Ministerial Meeting in 2015 in Kenya.
REVIEW QUESTIONS
THE REASONS, METHODS AND EFFECTS OF PROTECTION
1. Define the term protection. Why do governments protect their domestic industries from import
competition?
2. Using examples, explain the five main economic arguments used to justify protection. Aside from
economic arguments, what other reasons are advanced for the protection of domestic industries?
3. Distinguish between tariff and non tariff barriers to free trade.
4. With the use of a diagram such as Figure 2.6 explain the main effects of the imposition of a tariff
on imports.
5. Use a diagram such as Figure 2.7 to explain the effects of a subsidy on domestic prices, output
and imports. What are the advantages and disadvantages of subsidies over tariffs?
6. Briefly discuss forms of protection other than tariffs and subsidies.
7. Discuss the main macroeconomic and microeconomic effects of protection on a national economy
like Australia. How do global wheat subsidies affect Australian wheat exports? Refer to Figure
2.9 in your answer.
8. Discuss the extent of global protection and the potential gains from global trade liberalisation.
Marks
3. According to the principle of comparative advantage, why should nations A and B trade? (2)
4. Explain THREE separate benefits that might result from nations A and B engaging
in international trade in computers and wheat. (3)
5. Explain the role of the World Trade Organisation in promoting free trade. (3)
Source: Productivity Commission (2006), Trade and Assistance Review 2004-05, Melbourne.
Source: Productivity Commission (2006), Trade and Assistance Review 2004-05, Melbourne.
iscuss the reasons for countries reducing their tariff barriers on a unilateral basis and analyse
D
the potential economic benefits for these countries and the global economy.
CHAPTER SUMMARY
FREE TRADE AND PROTECTION
1. International trade refers to the specialisation of production and the exchange of goods and
services between countries or across national boundaries.
2. The basis for international trade is the uneven distribution of world resources (or factor endowments)
and the use of different resource combinations to achieve the most efficient level of production.
3. A country has an absolute advantage in production if it can produce more output with a given level
of resources than another country. A country has a comparative advantage in production if it is
comparatively more efficient in production as measured by a lower opportunity cost.
4. The advantages of free trade include economies of scale in production leading to lower prices,
a greater quantity and quality of goods, and higher living standards for a nations residents.
5. The disadvantages of free trade are that infant industries cannot compete against more competitive
overseas producers and some structural unemployment may occur in uncompetitive local industries.
6. International organisations that promote free trade as a means of raising economic growth and
development and living standards include the following:
7. Global government economic forums that influence world trade and economic policy include:
The G7
The G8 (NB: Russia was expelled from the G8 in 2014 for violation of Ukraines sovereignty)
The G20
8. Some of the main forms of economic integration include a free trade area; a customs union;
a common market; and a monetary union. Examples of contemporary trade agreements include:
10. The main methods used to protect domestic industries from foreign competition include tariffs,
subsidies, quotas, embargoes, local content schemes and export incentives.
11. Protection may have negative effects on a nations economic performance including lower efficiency,
export earnings, employment and rate of economic growth.
12. Protection has a damaging effect on the global economy by restricting the growth in world trade,
living standards and levels of economic development in advanced and developing countries.