Protectionis Trade Policies

Is There Any Role For Protectionist Trade Policies? - Economics Essay

Paul Krugman (1987) once declared that "if there was an Economist's Creed, it would surely contain the affirmations, "I believe in the Principle of Comparative Advantage," and "I believe in free trade." In theory, free trade is seen as a positive sum game that maximises world output and consumers' choices, fosters peace and harmony among nations, and spurs domestic efficiency (Friedman, 1988). As its corollary, protectionism is regarded as a zero or negative sum game that should play no part in world affairs, a view strongly supported by the World Trade Organisation. Nevertheless, protectionist trade policies are still adopted in both highly developed countries like the USA and in developing countries like India. This phenomenon hints that there could be justification for protectionist trade policies, a view that is echoed by Corden's (1974) declaration that "theory does not say that trade is best ... it says that trade is best under certain conditions". However, this essay will argue that while free trade may not be ideal, adopting protectionist trade policies can lead to more problems especially when interventionism goes astray. Hence, while free trade may not be optimal under all circumstances due to market imperfections, it is still a better rule of thumb to avoid protectionism in a world whose politics are as imperfect as markets.

Theoretical gains from free trade

First of all, it is important for us to establish what the theoretical gains from free trade are, and we will do so by taking a closer look at the principle of comparative advantage. According to Ricardo, a country has a comparative advantage in the production of a certain good or service when its opportunity cost of producing that particular good or service is lower than in other countries. Hence, if countries all concentrate their productive efforts in activities that they possess comparative advantages in and trade, the total world output of these goods and services will necessarily increase and all countries will become better off through trade as their consumption possibilities will be expanded. Furthermore, participating in international trade exposes domestic producers to more competitive pressure than faced internally, and this could lead to greater efficiency of domestic firms through reorganisations and innovations. Technological diffusion between trading partners can also contribute to the innovative process, and in turn boost economic growth of the countries that are open to free trade. This might explain why some of the most open economies in the world like Finland and Sweden have been the source of some of the most innovative and successful firms in the world (i.e. Nokia from Finland, Ikea from Sweden).

Besides promoting economic gains, Milton Friedman also argued that free trade also gives rise to political gains by improving international relations between countries and fostering peace and harmony. Indeed, as countries rely more on one another for goods and services, they are more likely to settle international disputes through negotiation rather than hostility. A good example is the significant reduction in tensions amongst Western European countries after the adoption of internal free trade policies post World War II. Furthermore, regular communications amongst countries allow more opportunities for cultural exchange and learning, and this can be highly beneficial in promoting greater understanding between disparate nations with historical feuds. Conversely, restricting free trade will only lead to beggar-thy-neighbour policies that lead to retaliation between nations and more protection. Such a phenomenon occurred during the 1930s depression, and it caused many countries to take a very long time to recover from the economic stagnation.

Why free trade may not be optimal - arguments for protection

Nevertheless, one must be aware that the law of comparative advantage makes many unrealistic and over-simplified assumptions like the existence of perfect competition and constant returns to scale. If certain conditions are not fulfilled, there is a possibility that restricted trade via protectionist trade policies can prove to be more optimal than free trade. But although we will entertain this possibility in the next section by examining the various arguments for protectionism, we will show that each of the arguments have flaws that make protectionism worse than sub-optimal free trade. Let us begin with an increasingly popular argument known as strategic trade policy.

(1) Strategic trade policy

The strategic trade policy argument states that imperfect competition exists in the world, therefore governments should intervene to tilt the terms of oligopolistic competition and shift excess returns from foreign to domestic firms. For instance, it is argued that a protective government policy such as the provision of an export subsidy to a domestic firm will cause a rival firm to contract its own output. A popular example of how this can work is the Airbus-Boeing example used by Brander and Spencer (1985), and this is illustrated in the game theoretic matrix below.

Airbus versus Boeing: no export subsidy

Airbus

Produce Not produce

Boeing Produce -5, -5 100, 0

Not produce 0, 100 0, 0

Assume there are two firms, A (Airbus) and B (Boeing), and that B has some form of head start that enables it to commit to production before A's decisions. In the absence of government intervention, the outcome will be the upper right hand corner (100, 0) such that B earns large profits and deter A's entry. A's government would obviously like to change such an outcome, and STP says that if A's government can credibly commit itself to subsidising A (regardless of what B does), then this result can reverse the game's outcome, as seen below:

Airbus versus Boeing: with export subsidy

Airbus

Produce Not produce

Boeing Produce -5, 20 100, 0

Not produce 0, 125 0, 0

The hypothetical pay-off matrix above, after a subsidy of 25 to A, means that B now knows that it will make losses if it produces. So B will be induced to cease production and thus a subsidy of 25 raises A's profit by 100, since the outcome shifts from (100, 0) to (0, 125). Note that Boeing and Airbus are often used as examples by economists because the wide-body