4.

Free Trade and Protectionism Arguments against protectionism- the costs of protection
Local industries and firms receiving protection gain in the short term because they are able to raise prices, increase output and maintain or increase their market share. The effects on the economy are felt in the medium to long term as protective measures such as tariffs and quotas impact on resource allocation and income distribution.

Inefficiency of resource allocation

Economic growth is retarded by protection because resources are not being used efficiently in protected industries. Capital and labor may not be utilized intensively, if output is geared only to the small domestic market where it is difficult to reap economies of scale in production. International experience shows that the management and labor forces of protected industries often use outdated work practices and fail to achieve high levels of productivity. Furthermore, their willingness to innovate by adopting the latest technology is minimal because they are not exposed to the competitive forces of the international market place. The culture of protection tends to breed inefficient and inward looking industry structures not willing to adapt to changes in consumer preferences and technology. Example: in Australia, resources have been misallocated because they are directed away from efficient and competitive industries such as agriculture and mining and into inefficient and uncompetitive industries such as motor vehicles and the traditional textiles, clothing and footwear industries. The impact was worsened by the tendency for the owners of firms in the Australian car and textile industries to engage in rent seeking behavior by lobbying the Australian government for the maintenance and even increases to the levels of protection they were being given.

Increased prices of goods and services to consumers

Protectionism leads to higher prices being paid by domestic consumers for the goods and services they consume. In the case of tariffs importers will tack the import tax they pay onto the price they charge domestic consumers. As the price increase takes effect, some consumers will be squeezed out of the market as they are either unwilling or unable to purchase the higher priced consumer goods. Those that choose to purchase the imported goods will experience a loss of real income as they have less money to spend on other goods once they have purchased the higher priced imports. In this way, protection not only leads to a loss of consumer surplus but also a loss of producer surplus on the

part of producers in non protected industries. This latter group of firms, experience a loss of potential sales due to the income effect of the tariff. Example: In countries such as those of the European Union and Japan the high levels of protection used to assist their agricultural industries has imposed substantial costs on domestic consumers through higher prices paid for food items such as meat and cereal products. It has been estimated that these higher prices imposed a total cost of around $15 million to the consumers of the European Union and $58 million to Japanese consumers in 1995.

The cost effect of protected imports on export competitiveness

Industries which rely on the outputs of protected industries as inputs in their production process will pay a higher price for them because of the imposition of tariffs. In the case of tariffs on manufactured goods, efficient export industries such as mining and agriculture are penalized by having to pay higher prices for capital equipment. Since exporters cannot easily pass on these costs in world markets, their competitiveness may subsequently be reduced. This effect is known as negative protection. Export earnings are also likely to be lower than optimal since protected industries tend not to seek overseas markets because they may be inward looking and abnormally risk averse. Furthermore, the imposition of tariffs and quotas may lead to a loss of export markets through the retaliation of trading partners who respond by imposing similar restraints on the exports of the protectionist country.

Costs of long- run reliance on protectionist methods Generally speaking, protection measures increase domestic production and
employment at the cost of greater inefficiency and higher prices. In addition to welfare and efficiency effects, protectionist measures have long run costs of slower innovation and increased rent seeking on the part of domestic firms. Economists use the term rent seeking to describe behavior where firms use resources to capture more income without actually producing a good or service. It is often easier for a firm to lobby a government for protection than it is to become more competitive hence firms will resort to rent seeking tactics. One of the main problems with protection is that employment and production grow in inefficient industries that are supplying only the domestic market and not exporting to the global market. Capital resources are also wasted, and the returns to all the factors of production will necessarily be lower than they would be if allocated to their most efficient uses in the economy. There are three main types of loss associated with protection: Consumption Loss: Compared to the free trade scenario, protection

leads to a reduced level of consumption by domestic consumers coupled with a higher price being paid for imported goods. This implies a loss of utility and sovereignty on the part of consumers. Production Loss: This is a measure of the value of production lost to society through the inefficient allocation of resources encouraged by industry protection. Deadweight Loss: This refers to the reduction in the total level of welfare (or real incomes) across society arising due to protective measures. Refer to the article Analysis of the effects of a tariff and the featured diagram for a more detailed explanation of losses associated with protectionist measures. In the following case study we will explore the estimated costs of protection in the European Union, Japan and the USA.

Case Study - Estimating the Costs of Protection in the USA, Japan and the European Union Table 1: Estimated Effects of Protection in the EU, Japan and the USA (1995)
Country/region Tariff Quota & Revenue Rents* industry US$ mil US$ mil grouping European Union A B Agriculture 3,001 341 Clothing 1,450 2,239 Textiles 1,490 1,716 Japan Agriculture 1,085 6,906 Clothing 386 2,673 Textiles 772 142 United States Agriculture 176 646 Clothing 3,545 5,411 Textiles 632 713 Deadweigh t Losses~ US$ mil National Welfare loss# US$ mil Cost to Consumers^ US$ mil

C
4,879 1,461 571 7,186 1,701 14 350 2,301 181

B+C
5,219 3,161 2,288 14,096 4,375 156 996 7,712 894

E
15,130 7,735 7,096 58,058 879 166 2,947 21,158 3,275

Notes: Quota rents*(B) = the increase in prices charged by foreign suppliers due to quotas. Deadweight Losses~(C) = the total consumption and production loss from protection. National Welfare Loss# (B +C) = the net reduction in national welfare from the direct effects of tariffs and quotas. Cost to Consumers ^ (E) = total estimated cost to consumers of tariffs and quotas enforced. This is equal to the sum of columns A, B, C plus the producer surplus(not shown in table).

Source: Gerber (2007)

This table shows that in the European Union and Japan, the largest national losses occur in agriculture, while in the United States, national losses in agriculture are relatively smaller but in clothing they are much higher. European losses in agriculture are mostly efficiency losses that result from keeping relatively less efficient producers in operation, whereas in Japan they are efficiency losses plus large quota rents paid to foreign suppliers. This means that despite its desire to protect its agricultural producers, Japan is still one of the worlds largest food importers. Similarly, the United States imports large quantities of clothing and its commercial policy creates large net national losses from quotas. If there is a standout economy in Table1, it would have to be Japan with its huge costs arising from tariffs and quotas placed on imported agricultural products. At an estimated annual cost to consumers of $US 58 billion in 1995, one would have to question the economic validity of this type of industry policy. This would appear even more paradoxical when you consider the relatively small land mass of the Japanese islands. The obvious question arises as to why such a small country in terms of physical size with a very high population density would continue to place such a priority on agricultural production. The industries featured in the table; agriculture, clothing and textiles, tend to be the most highly protected sectors of industrial countries. The difficulty in penetrating these markets poses a particular problem to developing countries usually reliant on agricultural exports in their quest for higher levels of economic growth. Studies conducted of the costs of protection in the United States and the European Union, also uncover disturbing trends. According to a study by Hufblaur and Elliot (1995),voluntary export restraints imposed by the United States on Japanese automobiles in the 1980s, cost US consumers well over $100,000 per year for each job that was saved in the US car industry. Similarly, a study by Messerlin (2001), found that in the European Union, the cost per job saved of their trade barriers was estimated at over 550,000 euros per year in the 1990s.

Activity 1 After having a good look at table 1, go over your effects of a tariff diagram and reread the accompanying notes explaining deadweight loss. Answer the questions below before attempting the past IB question provided.
Table 1 shows estimations of the financial benefits earned through tariffs and quotas (columns A and B). Compare these figures to the cost to consumers figures shown for each of the three countries (column E). a) What do you notice about the magnitude of the tariff revenue and quota rents compared to size of the cost to consumers? _________________________________________________________

_________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ b) Who really bears the burden and incurs the true cost of protection in our economies? Back up your argument by citing data from Table 1. _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________ _________________________________________________________

Past IB Question. How do tariffs affect economic welfare? (M89.5)

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