Trade Policy: Free Trade and Protection

What should be the appropriate trade policy or commercial policy of a country? The issue was first raised by the classical authors.

How­ever, they were the champions of free trade. About two hundred years ago, the giant ad­vocates of free trade—Adam Smith and David Ricardo—argued that free flow of goods and services, i.e., unrestricted trade, would be ben­eficial.

As a result of free trade, each country specialises in the production in which it has a comparative advantage. This will enable each country to reap the gains from trade.

After the World War II (1939-1945), commercial policy underwent a change when the wave of pro­tectionism swept all over the world. It was argued at that time that though some trade is better than no trade, there is no reason to sup­pose that free trade is the best.

A new question, thus, arose: Can protected trade cause a gain from trade? LDCs, by imposing tariff and duties, made an attempt to secure maximum benefits from interna­tional exchange of commodities. But the last quarter of the 20th century saw the revival of free trade all over the globe as protection failed to provide enough gains which the countries required.

Actually speaking, a strong wind was then blowing in favour of free trade. In­ternational Monetary Fund (IMF) and the World Bank also pampered the free trade phi­losophy.

I. Free Trade:

International trade that takes place without barriers such as tariff, quotas and foreign ex­change controls is called free trade. Thus, un­der free trade, goods and services flow be­tween countries freely. In other words, free trade implies absence of governmental inter­vention on international exchange among different countries of the world.

There are many arguments for free trade:

1. Arguments for Free Trade:

(i) Advantages of specialisation:

Firstly, free trade secures all the advantages of inter­national division of labour. Each country will specialise in the production of those goods in which it has a comparative advantage over its trading partners. This will lead to the optimum and efficient utilisation of resources and, hence, economy in production.

(ii) All-round prosperity:

Secondly, because of unrestricted trade, global output increases since specialisation, efficiency, etc. make pro­duction large scale. Free trade enables coun­tries to obtain goods at a cheaper price. This leads to a rise in the standard of living of peo­ple of the world. Thus, free trade leads to higher production, higher consumption and higher all-round international prosperity.

(iii) Competitive spirit prevails:

Thirdly, free trade keeps the spirit of competition of the economy. As there exists the possibility of intense foreign competition under free trade, domestic producers do not want to lose their grounds. Competition enhances efficiency. Moreover, it tends to prevent domestic mo­nopolies and free the consumers from exploi­tation.

(iv) Accessibility of domestically unavail­able goods and raw materials:

Fourthly, free trade enables each country to get commodi­ties which it cannot produce at all or can only produce inefficiently. Commodities and raw materials unavailable domestically can be pro­cured through free movement even at a low price.

(v) Greater international cooperation:

Fifthly, free trade safeguards against discrimi­nation. Under free trade, there is no scope for cornering raw materials or commodities by any country. Free trade can, thus, promote in­ternational peace and stability through eco­nomic and political cooperation.

(vi) Free from interference:

Finally, free trade is free from bureaucratic interferences. Bu­reaucracy and corruption are very much as­sociated with unrestricted trade.

In brief, restricted trade prevents a nation from reaping the benefits of specialisation, forces it to adopt less efficient production tech­niques and forces consumers to pay higher prices for the products of protected industries.

2. Arguments against Free Trade:

Despite these virtues, several people jus­tify trade restrictions.

Following arguments are often cited against free trade:

(i) Advantageous not for LDCs:

Firstly, free trade may be advantageous to advanced coun­tries and not to backward economies. Free trade has brought enough misery to the poor, less developed countries, if past experience is any guide. India was a classic example of co­lonial dependence of UK’s imperialistic power prior to 1947. Free trade principles have brought colonial imperialism in its wake.

(ii) Destruction of home industries/prod­ucts:

Secondly, it may ruin domestic industries. Because of free trade, imported goods become available at a cheaper price. Thus, an unfair and cut-throat competition develops between domestic and foreign industries. In the proc­ess, domestic industries are wiped out. Indian handicrafts industries suffered tremendously during the British regime.

(iii) Inefficient industries remain perpetu­ally inefficient:

Thirdly, free trade cannot bring all-round development of industries. Comparative cost principle states that a coun­try specialises in the production of a few com­modities. On the other hand, inefficient indus­tries remain neglected. Thus, under free trade, an all-round development is ruled out.

(iv) Danger of overdependence:

Fourthly, free trade brings in the danger of dependence. A country may face economic depression if its international trading partner suffers from it. The Great Depression that sparked off in 1929-30 in the US economy swept all over the world and all countries suffered badly even if their economies were not caught in the grip of depression. Such overdependence following free trade becomes also catastrophic during war.

(v) Penetration of harmful foreign com­modities:

Finally, a country may have to change its consumption habits. Because of free trade, even harmful commodities (like drugs, etc.) enter the domestic market. To prevent such, restrictions on trade are required to be imposed.

In view of all these arguments against free trade, governments of less developed coun­tries in the post-Second World War period were encouraged to resort to some kind of trade restrictions to safeguard national inter­est.

II. Protection:

By protection we mean restricted trade. For­eign trade of a country may be free or re­stricted. Free trade eliminates tariff while pro­tective trade imposes tariff or duty. When tar­iffs, duties and quotas are imposed to restrict the inflow of imports then we have protected trade. This means that government intervenes in trading activities.

Thus, protection is the anti-thesis of free trade or unrestricted trade. Government imposes tariffs on ad valorem basis or imposes quota on the volume of goods to be imported. Sometimes, export taxes and subsidies are given to domestic goods to pro­tect them from foreign competition. These are the various forms of protection used by mod­ern governments to restrict trade.

Now an important question arises what forces the government to protect trade? What are the chief arguments for protection? Can protection deliver all the goods that a nation needs?

Arguments for Protection:

The concept of protection is not a post-Second World War development. Its origin can be traced to the days of mercantilism (i.e., 16th century). Since then various arguments have been made in favour of protection.

The case for protection for the developing countries received a strong support from Argentine economist R. D. Prebisch and Hans Singer in the 1950s.

All these arguments can be summed up under three heads:

(i) Fallacious or dubious arguments;

(ii) Economic arguments; and

(iii) Non-economic arguments.

(i) Fallacious Arguments:

Fallacious arguments do not stand after scrutiny. These arguments are dubious in na­ture in the sense that both are true. ‘To keep money at home’ is one such fallacious argu­ment. By restricting trade, a country need not spend money to buy imported articles. If every nation pursues this goal, ultimately global trade will squeeze.

(ii) Economic Arguments:

(a) Infant industry argument:

Perhaps the oldest as well as the cogent argument for pro­tection is the infant industry argument. When the industry is first established its costs will be higher. It is too immature to reap econo­mies of scale at its infancy. Workers are not only inexperienced but also less efficient. If this infant industry is allowed to grow inde­pendently, surely it will be unable to compete effectively with the already established indus­tries of other countries.

Thus, an infant indus­try needs protection of a temporary nature and over time will experience some sort of ‘learn­ing effect’. Given time to develop an indus­try, it is quite likely that in the near future it will be able to develop a comparative advan­tage, withstand foreign competition and sur­vive without protection.

It is something like the dictum: Nurse the baby, protect the child, and free the adult. Once an embryonic indus­try gets matured it can withstand competition. Competition improves efficiency. Once efficiency is attained, protection may be with­drawn. Thus, an underdeveloped country at­tempting to have rapid industrialisation needs protection of certain industries.

However, in actual practice, the infant in­dustry argument, even in LDCs, loses some strength. Some economists suggest production subsidy rather than protection of certain in­fant industries. Protection, once granted to an industry, continues for a long time. On the other hand, subsidy is a temporary measure since continuance of it in the next year requires approval of the legislature.

Above all, expendi­ture on subsidy is subject to financial audit. Thus, protection is something like a “gift”. Secondly, protection saps the self-sufficiency outlook of the protected industries. Once pro­tection is granted, it becomes difficult to with­draw it even after attaining maturity. That means infant industries, even after maturity, get ‘old age pension’.

In other words, infant industries become too much dependent on tariffs and other countries. Thirdly, it is diffi­cult to identify potential comparative advan­tage industries. A time period of 5 to 10 years may be required by an industry to achieve maturity or self-sufficiency. Under the circum­stances, infant industry argument loses force.

In view of these criticisms, it is said by ex­perts that the argument “boils down to a case for the removal of obstacles to the growth of the infants. It does not demonstrate that a tariff is the most efficient means of attaining the objective.”

These counter-arguments, however, do not deter us to support the growth of infant in­dustries in less developed countries by means of tariff, rather than subsidies.

(b) Diversification argument:

As free trade increases specialisation, so protected trade brings in diversified industrial structure. By setting up newer and variety of industries through protective means, a country mini­mises the risk in production. Comparative ad­vantage principle dictates narrow specialisa­tion in production.

This sort of specialisation is not only undesirable from the viewpoint of economic development, but also a risky propo­sition. Efficiency in production in some prod­ucts by some countries (e.g., coffee of Brazil, milk product of New Zealand, oil of Middle East countries) results in overdependence on these products.

If war breaks out, or if politi­cal relations between countries change, or if recessionary demand condition for the prod­uct grows up abroad, the economies of these industries will be greatly injured. Above all, this sort of unbalanced industrial growth goes against the spirit of national self-sufficiency. Protection is the answer to this problem. A government encourages diverse industries to develop through protective means.

However, a counter-argument runs. Poli­tics, rather than economics, may be the crite­rion for the selection of industries to be pro­tected in order to produce diversification at a reasonable cost. But, one must not ignore eco­nomics of protection.

(c) Employment argument:

Protection can raise the level of employment. Tariffs may re­duce import and, in the process, import-com­peting industries flourish. In addition, import- substituting industries—the substitution of domestic production for imports of manufac­tures—develop. The strategy of import-sub­stituting industrialisation promotes domestic industry at the expense of foreign industries.

Thus, employment potential under protective regime is quite favourable. In brief, tariff stimulates investment in import-competing and import substitution industries. Such investment produces favourable employment multiplier.

But cut in imports following import sub­stituting industrialisation strategy may ulti­mately cause our exports to decline.

(d) Balance of payments argument:

A defi­cit in the balance of payments can be cured by curtailing imports. However, imports will decline following a rise in tariff rate provided other trading partners do not retaliate by im­posing tariff on a country’s export. However, import restrictions through tariff may be un­called for if the balance of payments crisis be­comes serious and chronic. In view of this and other associated problems of tariff, it is said that tariff is a second best policy.

(e) Anti-dumping argument:

Usually, we hear about unfair competition from firms of low-cost countries. One particular form of un­fair competition is dumping which is outlawed by international trade pacts, such as WTO. Dumping is a form of price discrimination that occurs in trade. Dumping occurs when a coun­try sells a product abroad at a low price because of competition and at a high price in the home market because of monopoly power.

In other words, dumping is a kind of subsidy given to export goods. This unfair practice can be pre­vented by imposing tariff. Otherwise, workers and firms competing with the dumped prod­ucts will be hit hard.

(f) Strategic trade advantage argument:

It is argued that tariffs and other import restric­tions create a strategic advantage in produc­ing some new products having potential for generating some net profit. There are some large firms who prevent entry of new firms because of the economies of large scale pro­duction. Thus, these large firms reap pure profits over the long run during which new firms may not dare enough to compete with these established large firms. Thus, the large scale economies themselves prevent entry of new firms.

But as far as new products are concerned, a new firm may develop and market these products and reap substantial profit. Ulti­mately, successful new firms producing new products become one of the few established firms in the industry. New firms showing po­tential for the future must be protected. “If protection in the domestic market can increase the chance that one of the protected domestic firms will become one of the established firms in the international market, the protection may pay off.”

(iii) Non-Economic Arguments:

(a) National defense argument:

There are some industries which may be inefficient by birth or high cost due to many reasons and must be protected. This logic may apply to the production of national defence goods or nec­essary food items. Whatever the cost may be, there is no question of compromise for the defence industry since ‘defence is more im­portant than opulence’. Dependence on for­eign countries regarding supply of basic food items as well as defence products is absolutely unwise.

However, objections against this argument may be cited here. It is difficult to identify a particular item as a defence industry item be­cause we have seen that many industries— from garlic to clothespin—applied for protec­tion on defence grounds. Candlestick-maker (for emergency lighting) and toothpick-maker (to have good dental hygiene for the troops) demanded protection at different times at dif­ferent places. A nation which builds up its military strength through tariff protection does not sound convincing. Thus, tariff is a second-best solution.

(b) Miscellaneous arguments against protec­tion:

There are some good ‘side effects’ or ‘spillover effects’ of protection. This means that it produces some undesirable effects on the economy and the basic objective of pro­tection can be attained rather in a costless manner by other direct means other than pro­tection. That is, protection is never more than a second-best solution.

Firstly, protection distorts the com­parative advantage in production. This means that specialisation in production may be lost if a country imposes tariff. All these lead to squeezing of trade. Secondly, it im­poses a cost on the society since consumers buy goods at a high price. Thirdly, often weak declining industries having no potential fu­ture stay on the economy under the protec­tive umbrella. Fourthly, international tension often escalates, particularly when tariff war begins.

Usually, a foreign country retaliates by imposing tariff on its imports from the tariff-imposing country. Once the retaliatory attitude (i.e., ‘beggar-my-neighbour policy’) develops, benefits from protection will be lost. Finally, protection encourages bureauc­racy. Increase in trade restrictions means expansion of governmental activity and, hence, rise in administrative cost. Bureauc­racy ultimately leads to corruption.

III. Conclusion:

The classical golden age of free trade no longer exists in the world. But, free trade concept has not been abandoned since the case for free trade is strongest in the long run. Protection is a short term measure. Thus, the issue for public policy is the best rec­onciliation of these two perspectives so that gains from trade (may be free or restricted) become the greatest.

In recent times (July 2008), most of the countries (153) are members of the World Trade Organisation (WTO) which favour more free trade than restricted trade. This phi­losophy gathered momentum in the Dunkel Draft and General Agreement on Tariffs and Trade (GATT) negotiations. The aims of both the GATT (abolished in 1995) and now the WTO are trade liberalisation rather than trade restrictions.