Key Terms
Protectionism: Policies designed to shelter firms from overseas competition.
Tariff: A tax on imports, which can be used to restrict imports and raise revenue for the government.
Tariff: A tax on imports, which can be used to restrict imports and raise revenue for the government.
Theory
Methods of Protectionism
1) Tariffs
Without international trade domestic price and quantity = P & Q
If a country opens up to world supply price falls (P1) and quantity increases (Q2)
Domestic producers share falls (Q1) and imports dominate (Q1 – Q2)
Tariff shifts world supply up, new price (P2) and new Global quantity (Q3)
Domestic producers share of the market rise (Q4) and imports fall (Q4 to Q3)
2) Quotas
- Physical limits placed on level of imports.3) Subsidies
Government payments to firms to encourage domestic consumption.4) Embargoes
total ban on imported goods.5) Voluntary Export Restraint Agreements
Agreements between countries that limit trade in certain products to a specific quota.6) Administrative Barriers
Being deliberately bureaucratic e.g. safety checks and long hold ups in customs.Advantages of Protectionism
1) Infant Industry argument
Certain industries possess potential comparative advantage, these industries may not yet be able to compete because they have not been able to fully exploit economies of scale. Short-term protection will allow the infant industry to grow, once the industry is competitive, controls can be removed.
However it’s hard to judge when an economy is an infant. Economies don’t want to ‘grow up’, as they want to keep protectionist policies.
In the 1980s the infant industry argument developed into strategic trade theory. The theory argues that the government must create competitive advantage by nurturing strategically selected industries, therefore justifying the use of protectionism.
2) Prevents dumping
Dumping refers to the sale of a good below its cost of production. Persistent under cutting of domestic prices will force domestic firms out of business. Without domestic competition, a foreign firm may establish itself as a monopoly.
3) Internalises negative externalities
Negative externalities are produced by certain goods e.g. tobacco, protectionism can safe guard society from the importation of these goods.
Furthermore, international trade carries negative externalities of its own e.g. environmental pollution. High protectionist measures will reduce imports thus reducing transport and in turn pollution.
4) Sunset Industries / Prevention of structural unemployment
Some Keynsian economists justify the supply-side use of selective import controls to protect older industries. Protection in this case prevents unnecessary deindustrialisation and allows for an orderly change in the structure of the economy.
5) Decreasing Returns to Scale
The theory of comparative advantage assumes that constant returns to scale exists. However it's possible that firms could over-specialise and therefore experience decreasing returns to scale.
For example a country that has comparative advantage in agriculture could specialise to the extent where they experience mono-culture and land degredation.
6) Short-term economic growth
Protectionist policies should in theory decrease imports, thus increasing aggregate demand.
Certain industries possess potential comparative advantage, these industries may not yet be able to compete because they have not been able to fully exploit economies of scale. Short-term protection will allow the infant industry to grow, once the industry is competitive, controls can be removed.
However it’s hard to judge when an economy is an infant. Economies don’t want to ‘grow up’, as they want to keep protectionist policies.
In the 1980s the infant industry argument developed into strategic trade theory. The theory argues that the government must create competitive advantage by nurturing strategically selected industries, therefore justifying the use of protectionism.
2) Prevents dumping
Dumping refers to the sale of a good below its cost of production. Persistent under cutting of domestic prices will force domestic firms out of business. Without domestic competition, a foreign firm may establish itself as a monopoly.
3) Internalises negative externalities
Negative externalities are produced by certain goods e.g. tobacco, protectionism can safe guard society from the importation of these goods.
Furthermore, international trade carries negative externalities of its own e.g. environmental pollution. High protectionist measures will reduce imports thus reducing transport and in turn pollution.
4) Sunset Industries / Prevention of structural unemployment
Some Keynsian economists justify the supply-side use of selective import controls to protect older industries. Protection in this case prevents unnecessary deindustrialisation and allows for an orderly change in the structure of the economy.
5) Decreasing Returns to Scale
The theory of comparative advantage assumes that constant returns to scale exists. However it's possible that firms could over-specialise and therefore experience decreasing returns to scale.
For example a country that has comparative advantage in agriculture could specialise to the extent where they experience mono-culture and land degredation.
6) Short-term economic growth
Protectionist policies should in theory decrease imports, thus increasing aggregate demand.
Disadvantages of Protectionism
1) Most agents loose out
Consumers
Economic welfare is reduced through higher prices and restricted consumer choice
This also has a regressive effect as tariffs fall hardest on lower income families.
Producers
Higher prices for foreign goods will reduce profits for foreign firms due to lower levels of consumption.
Reduced profits will therefore offset economies of scale.
Higher prices for imports such as commodities used in the production process will also lead to cost-push inflation.
2) Retaliation
Countries who feel their domestic industries will be harmed by protection are likely to retaliate. In recent news, China threatened to retaliate to levies on solar panel imports from the E.U.
Retaliation creates animosity between nations which prevents new ideas and technological innovations from being shared thus preventing potential growth.
3) Offset supply-side benefits of imports
Some imports are critical to a countries production of goods. If goods in foreign countries (imports) improve in their quality, then protected countries will miss out on supply-side benefits of imports.
This point entirely depends on what types of imports are being protected against.
4) Restricts consumer choice
By restricting imports, consumer choice is limited. Consumer choice is important as it is associated with economic efficiency. Reduced consumer choice means reduced economic efficiency.
5) Protection redistributes income in favour of the protected
If one trade partner is protected and the other is free market, the free market trader will suffer increasing current account deficits and demand-deficient unemployment.
Consumers
Economic welfare is reduced through higher prices and restricted consumer choice
This also has a regressive effect as tariffs fall hardest on lower income families.
Producers
Higher prices for foreign goods will reduce profits for foreign firms due to lower levels of consumption.
Reduced profits will therefore offset economies of scale.
Higher prices for imports such as commodities used in the production process will also lead to cost-push inflation.
2) Retaliation
Countries who feel their domestic industries will be harmed by protection are likely to retaliate. In recent news, China threatened to retaliate to levies on solar panel imports from the E.U.
Retaliation creates animosity between nations which prevents new ideas and technological innovations from being shared thus preventing potential growth.
3) Offset supply-side benefits of imports
Some imports are critical to a countries production of goods. If goods in foreign countries (imports) improve in their quality, then protected countries will miss out on supply-side benefits of imports.
This point entirely depends on what types of imports are being protected against.
4) Restricts consumer choice
By restricting imports, consumer choice is limited. Consumer choice is important as it is associated with economic efficiency. Reduced consumer choice means reduced economic efficiency.
5) Protection redistributes income in favour of the protected
If one trade partner is protected and the other is free market, the free market trader will suffer increasing current account deficits and demand-deficient unemployment.
Evaluation
Paul Krugman, professor of economics at the University of Princeton, was awarded a nobel prize in economics in 2008 for his work in developing strategic trade theory.
Strategic trade theory argue's in favour of the use of protectionism in some circumstances. Krugman agued that present day rich developed countries benefitted from protectionism while they established their wealth.
Strategic trade theory argue's in favour of the use of protectionism in some circumstances. Krugman agued that present day rich developed countries benefitted from protectionism while they established their wealth.