Chapter 65: Restrictions on free trade (3.1)

“When goods can’t cross borders, armies will.” Frédéric Bastiat

what is ‘free trade’?

  • Tariffs

From autarky to free trade to tariff

Assume an economy which goes through three stages; an initial stage of zero trade followed by perfectly free trade and finally a tariff. Figure65.1, diagrams I to III, illustrate what would happen to a fictitious economy producing and consuming oranges.

Figure 65.1 Autarky, free trade and tariff

  • In figure 65.1, diagram I, the country is consuming only what it produces, i.e. it is a closed economy and produces/consumes Q0 tonnes of oranges at P0 per tonne.
  • When the economy opens its doors to foreign competition, diagram II, it will face a horizontal world supply curve (we drop the assumption of “only two countries in the world” so world supply will to all intents and purposes be infinite) of Sworld. The world price of oranges, P1, is lower than the domestic price of P0 leading consumers to increase their quantity demanded to QD1 at a market equilibrium of Sworld = D. (Note that we are assuming that domestic and foreign oranges are perfectly substitutable.) Observe that the effect of an open economy on domesticoutput is negative; Sdom shows that domestic producers are competitive up to QS1 where after foreign producers are able to undercut domestic suppliers along the horizontal world supply curve Sworld. This open economy will now have domestic consumption at QD1 and domestic output at QS1. The difference is made up of imports of QS1QD1. This is the free trade equilibrium.
  • Now, if a tariff of P1P2is levied on imported oranges, shown by the arrow in diagram III, the world supply curve shifts from Sworld to Sworld + tariff, increasing the price on the domestic market from P1 to P2. This will have the effect of encouraging/enabling increased domestic production in a manner similar to that of a minimum price (see Chapter 15). Domestic producers replace QS1QS2tonnes of imported oranges with domestic, which shows how the tariff protects domestic producers by raising the price of imported oranges. The increase in the domestic price of oranges also has the effect of decreasing the quantity demanded from QD1 to QD2. The combination of a higher price level and lower demand achieves the purpose of lowering imports and raising domestic production.

effects of a tariff

Figure 65.2 The effects of a tariff on oranges

In our trade example, the domestic economy is made up of three players; consumers, domestic suppliers and government.

  • Area A: A loss to consumers which is offset by a gain to one of the other two players means that society is in fact equally well off. Thus area A shows how domestic firms benefit from selling more at a higher price: the increase in supplier surplus.
  • Area C: Area C is the gain to government from additional tax receipts of the tariff times imports; 200 tonnes at 20 cents per kg = €40,000.
  • Areas B and D: Areas B and D represent the net reduction in overall economic welfare; thenet societal loss.
  • Area B shows the cost to society of production being taken over by relatively inefficient producers; at all levels of output between 500 and 600 tonnes, foreign producers could have produced oranges at a lower cost. The triangle shows the extra resources used by society in producing domestically rather than importing from more efficient foreign producers at the world price. This can be labelled a ‘green’ loss since it is wasteful to allocate productive resources to areas best left to others.
  • Area D shows the net loss of consumer surplus, i.e. the loss of consumer surplus which has not been transferred to others in society (domestic firms and/or government).

Taken together, areas B and D constitute a pure allocative waste to society called a deadweight loss (which you will recognise from Chapter 8).

  • Quotas

To make the comparison with tariffs easier, assume that a quota of 200 tonnes is set.

Figure 65.3 The effects of a quota on oranges

Again there are societal transfers and net efficiency losses. Figure 65.3 above outlines these as previously demonstrated with tariffs. The main difference between tariffs and quotas is within the issue of which societal members will benefit from the difference between the import price of €1 and the new price of €1.2 resulting from protectionism. Area C does not go to government tax coffers as in the case of tariffs, but into the pockets of foreign suppliers. This unexpected increase in revenue is known as a windfall gain, and partially offsets the loss of revenue shown by areas F and G.

  • Subsidies

Any action by government which lowers the ratio of domestic prices to import prices (in other words raises the relative price of imports or lowers the relative price of domestic goods) will serve as a barrier to trade.

Figure 65.4 The effects of a subsidy on cotton T-shirts

Figure 65.4 shows how a subsidy going to domestic producers affects the market for cotton T-shirts in an economy. Initially the domestic economy is producing 200,000 T-shirts and importing 200,000 T-shirts, enabling domestic consumption of 400,000 T-shirts at a price of $10. When the government subsidises domestic production at $2 per T-shirt, domestic suppliers are able to increase supply from 200,000 to 300,000. This is shown by the shift of the domestic supply curve from Sdom to S+subsidy. (Note that the entire incidence of the subsidy goes to domestic suppliers and that there is still an efficiency loss triangle.) The subsidy allows domestic producers to capture market share from foreign producers who are now left with one quarter of the market rather than half.

  • Administrative barriers

However…it is notably easy to implement intentional administrative barriers; a classic example of such was when France decreed in 1982 that all imported (e.g. Japanese) videocassette recorders had to clear customs at a tiny customs house in Poitiers – far from any and all major ports and points of entry to the country. This backlogged the imported VCRs (not ‘Very Cunning Restrictions’ but ‘Video Cassette Recorders’) tremendously and limited the imports to a trickle – giving domestic producers time to ‘catch up’.

  • Health and safety regulations

There are literally thousands of sets of standards which countries impose on products in the interest of public health and safety, which all serve to increase costs to importers and/or limit the physical access to the market. Here are a few examples of such standards: Moped manufacturers in the EU will face varying speed limits and the engines will have to be accordingly modified to reduce top speeds; legislation on content labelling will vary greatly in different countries and force manufacturers to print a variety of different labels; certain food additives, colouring and preservatives will be outlawed in some countries; bans on advertising goods such as alcohol and tobacco are increasingly common; and fireworks will face numerous safety regulations as to size and to whom they may be sold.[1]

misuse of health and safety concerns?

Perhaps the most (in-) famous example of health standards which limit trade is the EU ban on all beef containing growth hormones which was implemented in 1989. This has had the effect of a de facto ban on American beef, since virtually all US cattle are treated with growth hormones. Successive American administrations have all claimed that the EU policy is clearly in violation of WTO rules of free trade, since no conclusive evidence exists that growth hormones in any way endanger the health of beef eaters. The WTO, which is the mediator in such disputes, ruled in favour of the US in 2003 yet the EU has as yet not complied. The Americans retaliated with tariffs on $US100 million worth of EU agricultural goods and the ensuing tit-for-tat retaliatory ‘tariff game’ between the worlds’ two major traders came close to escalating to a trade war.

In March, 2008, the WTO again criticised the EU ban on beef from hormone-treated cattle as scientifically unjustified. US Trade Representative Susan Schwab applauded the WTO re-statement; “The findings confirm the principle that measures imposed for health reasons must be based on science.”[2] Another, perhaps equally famous, example of the EU – US trade conflict is the EU restriction on imports of genetically modified (GM) produce such as soybeans and corn. This issue, like that of beef, has yet to be resolved.

  • Environmental standards

Increasingly in our ever-integrating world, environmental standards are set not so much to meet domestic demands but to set global standards for environmentally acceptable production. This has arisen in partial response to increasing developed nation outsourcing of production to developing countries where environmental standards can be noticeably lacking. This is the ‘race to the bottom’ argument, which argues that negative externalities such as pollution, diminishing forests and encroachment of wildlife are “exported”, in a manner of speaking, to poorer countries in order that firms in rich countries might avoid increased costs of strict domestic environmental policies. To countermand this, a number of countries have implemented environmental standards which limit – or ban – imports of goods which do not meet certain criteria.

The debate about environmental standards in trade

The issue of using environmental arguments in trade is highly contentious (= controversial), as it is incredibly difficult to distinguish between commendable environmentalism and contrived trade barriers. The WTO has a number of articles which specifically allow for measures which are ‘necessary to protect human, animal or plant life or health’…provided the measures do not constitute “an arbitrary or unjustifiable discrimination between countries where the same conditions prevail or a disguised restriction on international trade”.[3] For example, the US imposed a ban on tuna fish imports caught using methods known to kill a large number of dolphins and another ban on shrimp from several Asian countries that used nets which also trapped turtles; the WTO ruled both bans illegal to general outrage amongst environmental groups.

  • Other forms of protectionism (some very interesting ones!)

If you think I was ranting above, baby you ain’t seen nothing yet![4] While my poor editor is desperately trying to get me to cut down on pages, I simply cannot avoid mentioning a few additional forms of protectionism. It’s what economics authors do for entertainment.[5]

  • Currencies and exchange rates

Currencies and exchange rates: Exchange rate fluctuations will create uncertainty for exporters and importers, leading perhaps to less trade. Commissions (service charges) on foreign exchange transactions also create barriers. Many countries also have strict controls on the amount of currency which can be traded – and by whom. A country can also devalue its currency (i.e. lower the exchange rate, which is the “price” of the domestic currency) thereby making imports more expensive and domestic goods cheaper relative to imports.

  • Government favouritism in procurement and nationalism

Government favouritism in procurement: Government agencies will frequently be required to favour domestic industries. Look closely at the brand of cars you see used for official functions in countries which have domestic auto production.

Nationalism: Persuasive advertising slogans and campaigns such as ‘Buy American/French/Italian…’ can skew demand away from imports which might be both better and cheaper.

  • Pirates of the Carib…that’s Malacca in Indonesia

I thought the Mexicans were masters of protectionist policies…and then I moved to Indonesia. The Indonesians make the Mexican trade barriers look like something Donald Duck invented when Goofy got bored. Here are three incredible examples of trade barriers erected by the Indonesian government.[6]

cabotage laws…or “sabotage” laws?[7]

In the early 2000s, Indonesian ship owners lobbied fiercely for government protection against foreign owned transport vessels operating in Indonesian waters. Foreign cargo ships carried about half the goods transported in Indonesia. Why didn’t more Indonesian ships compete with the foreign ships you say? Well, it seems that the Indonesian ship builders had previously campaigned hard to get protection against foreign ship builders…which raised the price of ships…so Indonesian shipping companies couldn’t afford to buy more ships. It gets better! The Indonesian governments response was, yes, you guessed it; more protectionism. This time in legislation passed during 2008 which basically will ban foreign owned vessels from transporting goods within Indonesia’s 18,000 islands. I’m not done yet! To make sure that foreign ships don’t offload in ports where there are logistical benefits in getting Indonesian flagged carriers to the final Indonesian destination, a new law is looking to pass in 2012 limiting all foreign ships to just two ports.[8]

Maybe the Indonesians should ask the Hawaiians and Alaskans what they think. The Jones Act from 1920 does exactly what the Indonesian government has done; all goods and services to and from Hawaii and Alaska from any other US states must be transported on US flagged ships. Guess which are two the most expensive states in the USA? I’ll give you two guesses but you’ll only need one.[9]

self medication

Along with a decree in 2010 forcing importers to renew their import licenses – an effective short run ban for many of the companies due to the horrendous inefficiency and corruption of Indonesian customs – the government took special pains to limit the importation of pharmaceuticals. Yes, you read correctly. One of the poorest nations in the world with some 120 million people living in poverty, has passed legislation whereby any foreign company making medicines must open a manufacturing plant in Indonesia within two years.

When the health minister was asked to comment on the legislation his response was “If they [the foreign companies] want go away, go ahead.”[10] This in a country where fake drugs constitute around 25% of all drugs sold and which the government admits poses a serious threat to public health.[11] Who do you think this hits the hardest, the low income groups or the high? Well, let’s just say that everyone I know in Indonesia goes to Singapore for any type of medical service. Do you think my maid can send her kids to Singapore to get cheap generic drugs?

“pay me or i shoot the package!”

The bald-faced corruption in Indonesia involving any type of goods shipped in to the country is legendary – and a bit scary. I actually took the time to get hold of the complete list of tariff rules translated into English. Scary reading! It turns out that any good coming into the country can be subject to import tax if the good is valued at over USD50. But if you read the fine print, it is also the case that no matter what it says on the shipping label in terms of declared value, the customs officials in charge get to assess the value themselves!

Basically goods are held hostage at the post office or customs office at the port of entry. Why not read them the law? Well, one colleague tried just that. He got a translator and a copy of the law and asked the duty officer for an explanation and an official paper outlining why he was supposed to pay a USD100 “tax” for his own (used) computer he had sent from his address abroad. He got no explanation…but he did get his laptop. It had a big boot print on it and was smashed to pieces. My lady Bell had the same thing happen – for an old iPod she forgot in Australia and had sent to our home here. They wanted USD45 for “duties” – but forgot to get paid before delivery to our door! I cannot put in print my letter to the customs officer in charge. Finally, the winner; Katie at school is an IB examiner and was presented with a USD40 “customs invoice” for a pack of…wait for it…IB exam papers! Since there is zero fiscal value of exam papers and the declared value was exactly that, the cunning bandits put the tax on the weight of the package!!! When our fabulous Indonesian admin staff called them and challenged them about the fee, they said “Oh never mind!” and dropped the issue. No, I am not making this up. I mean, you can’t make this stuff up.

  • Reasons for protectionism

Standard economic theory states that protectionism generally creates losers amongst foreign import firms and domestic consumers; winners amongst domestic firms; possible gains to government in the form of tax receipts; and overall allocative losses for society.

  • Protection of industries and employment

The employment protection argument is probably the most controversial argument for protection. It is certainly the most divisive amongst economists, where views range from ‘partially viable’ to ‘absolutely erroneous’. The basic argument in implementing trade barriers in reference to unemployment is that traditional/large industries which are subjected to increased foreign competition will cause structural unemployment. When comparative advantage ratios shift as foreign competitors become increasingly proficient in certain industries, governments often resort to protectionist measures in order to preserve jobs – or at least delay a decline in what becomes a ‘sunset industry’. A large proportion of the trade barriers of the past 20 years fall within this argument; steel, cars and cotton in the US; sugar, wine and ship building in the EU; and agricultural goods and textiles – to some extent – in all developed countries.[12]

pro and con in employment argument

The employment argument has limited validity at best and is seriously flawed and fallacious at worst: