No Such Thing as a Free Lunch: Principles of Economics (Part 177)

For the only way in which a durable peace can be created is by world-wide restoration of economic activity and international trade.

James Forrestal

International Trade, Comparative Advantage, and Protectionism

(Part D)

by

Charles Lamson

Free Trade or Protection?

One of the great economic debates of all time revolves around the free-trade-versus-protection controversy. In the next two posts, we briefly summarize the arguments in favor of each.

The Case for Free Trade

In one sense, Ricardo's theory of comparative advantage is the case for free trade. Trade has potential benefits for all nations. A good is not important unless its net price to buyers is below the net price of the domestically-produced alternative.

Tariffs, export subsidies, and quotas, which interfere with the free movement of goods and services around the world, reduce or eliminate the gains of comparative advantage.

We can use supply and demand curves to illustrate this. Suppose Figure 4 shows domestic supply and demand for textiles. In the absence of free trade, the market clears at a price of $4.20. At equilibrium, 450 million yards of textiles are produced and consumed.

Assume now that textiles are available at a world price of $2. This is the price of dollars that Americans must pay for textiles from foreign sources. If we assume an unlimited amount of textiles is available at $2 and there is no difference in quality between domestic and foreign textiles, no domestic producer will be able to charge more than $2. In the absence of trade barriers, the world price sets the price in the United States. As the price in the United States falls from $4.20 to $2.00, the quantity demanded by consumers increases from 450 million yards to 700 million yards, but the quantity supplied by domestic producers drops from 450 million yards to 200 million yards. The difference, 500 million yards, is the quantity of textiles imported.

The argument for free trade is that each country should specialize in producing the goods and services in which it enjoys a comparative advantage. If foreign producers can produce textiles at a much lower price than domestic producers, they have a comparative advantage. As the world price of textiles falls to $2, domestic (U.S.) supply drops and resources are transferred to other sectors. These other sectors, which may be export industries or domestic industries, are not shown in Figure 4(a). It is clear that the allocation of resources is more efficient at a price of $2. Why should the United States use domestic resources to produce what foreign producers can produce at a lower cost? U.S. resources should move into the production of the things it produces best.

Now consider what happens to the domestic price of textiles when a trade barrier is imposed. Figure 4(b) shows the effect of a set tariff of $1 per yard imposed on imported textiles. the tariff raises the domestic price of textiles to $2 + $1 = $3. The result is that some of the gains from trade are lost. First, consumers are forced to pay a higher price for the same good; the quantity of textiles demanded drops from 700 million yards under free trade to 600 million yards because some consumers are not willing to pay the higher price.

At the same time, the higher price of textiles draws some marginal domestic producers who could not make a profit at $2 into textile production. (Recall, domestic producers do not pay a tariff.) As the price rises to $3, the quantity supplied by producers rises from 200 million yards to 300 million yards. The result is a decrease in imports from 500 million yards to 300 million yards.

Finally, the imposition of the tariff means the government collects revenue equal to the shaded grey area in figure 4(b). This shaded area is equal to the tariff rate per unit ($1) times the number of units imported after the tariff is in place (300 million yards). Thus, receipts from the tariff are $300 million.

What is the final result of the tariff? Domestic producers receiving revenues of only $2 per unit before the tariff was imposed now receive a higher price and earn higher profits. However, these higher profits are achieved at a loss of efficiency.

Trade barriers preventing nations from reaping the benefits of specialization, push it to adopt relatively inefficient production techniques, and force consumers to pay higher prices for protected products than they would otherwise pay. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 679-680*

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