Let us make an in-depth study of the disadvantages of free trade in international environment.
The basic cause of trade can be found in differences in costs of production. India has cost advantage over Japan in the production of such products as cotton cloth and jewellery and we could expect Japan to buy such products from India.
Again, Japan has cost advantage over India in the production of calculators and cameras and so India is likely to buy these products from Japan.
International trade encourages producers in each nation to specialise in those items where the nation’s resources are most productively utilised. This way trade helps to utilise the world’s resources in the best possible way. Stated technically, trade allows each country to improve the efficiency of resource, use. David Ricardo is credited with demonstrating the result that the two countries can derive benefit from free trade if each country specialises in that line of production in which it has the greatest relative efficiency.
The gains from trade is a result of the improvement in the efficiency of resource use. But there are those who hold the view that efficiency gains from free trade is likely to be offset by other perverse effects of free trade. In fact, free trade doctrine ignores various factors that may go against the developing countries.
First, free trade may lead to deterioration in the balance of payments of developing countries.
There are at least two reasons for this:
(a) Developing countries are typically the exporters of agricultural goods and importers of manufactured goods
(b) Agricultural goods are highly income inelastic in the world market,and
(c) Manufactured goods which are exported by the developed countries are more elastic in demand than the agricultural goods.
Then, for a given growth of world income, the balance of payments of developing countries will automatically deteriorate over time. Let us elaborate on this point.
Assume that the income elasticity of demand for agricultural exports of developing countries is 0.5 and that the world income is growing at the rate of 4% per annum. Let the income elasticity of demand for manufactured exports of developed countries be 1.5. Given that the world is divided into developed and developing countries, it is obvious that the imports of developed countries are the exports of developing countries.
In such a situation, the exports of developing countries will grow at 2% (= 0.5 x 4%) per annum and imports will grow at 6% per annum. This will automatically lead to a deterioration in the trade balance of developing countries. Moreover, the home currency of the developing countries is likely to depreciate in the face of balance of payments crisis. This, in turn, will push the terms of trade against the developing countries.
Second, the export possibilities are severely limited for many agricultural products because these are susceptible to diminishing returns with limited scope for technical progress. By contrast the scope for technical progress is immense for manufactured products. It is quite perverse to suggest a trade policy based on activities which are subject to diminishing returns.
Third, the dependence on free trade on the criteria of comparative advantage may lead to excessive specialisation on a narrow range of products. This may expose the developing countries at the mercy of few developed nations.
Fourth, Comparative advantage may change over time because many industrial activities are subject to increasing returns to scale. This would mean that a developing country may have a comparative disadvantage in a particular product as present but due to increasing returns to scale, the same product can be produced at a lower comparative cost in future. Then the case for restricting trade is strengthened.
Fifth, development via specialisation in agricultural exports has little linkage effects on other productive activities. Manufacturing activities exerts strong forward and backward linkage effects. (Forward linkages are measured by the proportion of a sector’s output that is used as intermediate inputs by other sectors and backward linkages are given by the proportion of the value of a sector that represents purchases from other sectors). So free trade on the basis of specialisation in agricultural products will have relatively less secondary impact on employment and income generation in other sectors.
Finally, comparative cost doctrine of free trade is based on the notion of private costs. In developing countries private costs of a product to the producers very often deviates from actual or a social costs (i.e., the costs borne by the society). For example, real social costs of certain agricultural products may be higher than the private costs because fanners do not take into account the incidental costs such as soil erosion, deforestation while estimating their private costs.
As a result a developing country may have a relative cost advantage in the production of agricultural products. But if we take into account the true social costs, the relative cost advantage in the production of agricultural products may disappear.