The Global Economy
2.2.2 Free trade and reasons for protection
The global economy
Free trade
Free trade: A situation in which goods and services coming into or going out of a country are not controlled or taxed.
With free trade, a government lets foreign goods into its markets with no limits or taxes, and encourages its own firms to sell abroad. More and more countries are opening up their markets, often by signing trade agreements with other countries.
Advantages of free trade
- Lower prices and increased choice for consumers: people can buy goods their own country cannot produce, e.g. tropical fruit in a country with a cold climate, and goods that other countries make more cheaply, e.g. cars and electronics. Cheaper goods mean people’s incomes go further, so living standards rise. Choice also widens because firms in different countries sell their own versions of the same product, e.g. smartphones.
- Lower input costs: firms can buy raw materials, parts and machinery from whichever country supplies them most cheaply, e.g. a chocolate maker can import cocoa beans from West Africa, where they grow well. Lower costs let firms sell their goods at lower prices.
- Wider markets for businesses: firms can sell to customers in many countries, not just at home, so their sales and revenue can grow. Producing more lets them gain economies of scale. Selling in several countries also spreads risk, because if sales fall in one country, sales elsewhere can make up for it.
Disadvantages of free trade
- Foreign competition harming domestic businesses: without trade barriers, domestic firms lose their protection from imports. If foreign firms have lower costs, e.g. lower wages, they can sell good-quality products at lower prices, so domestic firms lose sales and may struggle to survive. New industries that are not yet established may be forced to close.
- Increasing unemployment: when domestic firms lose sales to cheaper imports, they cut output and jobs. For example, the USA lost around 5 million manufacturing jobs between 2000 and 2014, partly because of competition from cheaper foreign goods. Countries that rely on a narrow range of exports are also at risk, as jobs go if demand for those goods falls.
Example: two neighbouring countries sign a free trade agreement
- Consumers: a television that cost $504 including a 20% tariff now costs $420, and shoppers can choose from more brands.
- Input costs: a furniture maker buys cheaper timber from across the border, so its costs fall.
- Wider markets: the furniture maker starts selling to 20 million customers in the neighbouring country.
- Domestic firms and jobs: a local shoe factory cannot match the price of imported shoes, loses sales and cuts 300 jobs.
Protectionism
Protectionism: approach used by governments to protect domestic producers.
Trade barriers: measures designed to restrict imports.
Most economists believe free trade is good for the world economy. Even so, governments sometimes decide it is in their country’s interest to restrict trade. They may put trade barriers on imports, e.g. tariffs and quotas, or give financial support to domestic producers and exporters, e.g. subsidies.
Reasons for protection
Dumping: A firm sells goods in another country below the cost of production.
Infant industry: A new industry that has yet to be established.
Seven reasons for protection:
- Prevent dumping: a foreign firm may sell goods at very low prices, sometimes helped by subsidies from its own government, to drive rival producers out of business. This is seen as unfair competition, and domestic firms cannot survive such low prices for long, so the government may restrict these imports.
- Protect employment: when cheap imports take sales from domestic firms, workers lose their jobs. Rising unemployment is unpopular, so governments may restrict imports to save jobs.
- Protecting infant industries: a new industry cannot yet compete with strong, established foreign rivals. Protection gives it time to grow and gain economies of scale. However, governments are not always good at picking which new industries will succeed.
- To gain tariff revenue: a tax on imports raises money for the government, which it can spend on public services or use to pay off government debt.
- Protect consumers from unsafe products: governments can ban or limit imports that may be harmful, e.g. food that does not meet safety standards.
- Reducing current account deficits: if a country spends far more on imports than it earns from exports, the deficit can grow out of control. Cutting imports means less money leaves the country, which helps to narrow the deficit.
- Retaliation: if another country dumps goods or puts trade barriers on a country’s exports, the country may hit back with barriers of its own. This can lead to a trade war, where each side adds more barriers, trade between them shrinks and both economies suffer.
Example: A foreign firm sells electric bikes in Country X for $300 each, although each one costs $450 to make. Country X’s own bike makers lose sales and 1 500 jobs are at risk, so the government puts a tariff on the imported bikes. The foreign country hits back with a tariff on Country X’s fruit exports.
