International Trade, Protectionism and the Effects of Intervention in Markets - 031103

This Mind your Business article looks at International Trade, Protectionism and the Effects of Intervention in Markets.

Mind your Business - 03 November 2003

International Trade, Protectionism and the Effects of Intervention in Markets

The News

International Trade:
Any glance at the 'International Trade' section of a business or economics textbook will tell you that free trade has advantages for all - higher total output and higher standards of living being the broad benefits cited. The theory of comparative and absolute advantage with the oft-used examples of wheat and wine seem to clearly demonstrate such benefits so why do countries impose restrictions on trade? The answer is very simple; the primary reason is to protect domestic workers from competition from abroad. The basis for the decision is mainly political although there is some economic basis for protectionism.

In the United States, President George W. Bush applied this technique to offer support to workers in the steel industry in the Midwest of the USA. The Midwest includes the states of Michigan, Ohio, Illinois, Iowa and Wisconsin. The industry was complaining that foreign steel producers were 'dumping' cheap steel onto the US market rendering US steel producers uncompetitive. Textbook reasons for imposing some form of trade barrier often quote 'protecting an infant industry' as a reason and explain that such protection offers the industry an opportunity to be able to grow to be able to compete on an equal basis at which time the trade barrier is removed. Nice and convenient in theory but not quite so easy in practice.

Bush took the decision to impose a tariff on steel imports into the US amounting to 30%; his decision pleased the steel producers but has angered the steel users. Steel is used for a whole host of industrial applications from chemical manufacture to road building. Steel users in the US therefore faced a choice; continue buying from foreign suppliers and pay a higher price or buy from the US producers. On the face of it the second option looks to be the best but US steel producers took advantage of the protection they had been afforded to raise their prices.

Steel is used extensively in all industries

Steel is a product that is used in a wide variety of different industries for many different purposes.

So how do businesses react to this - they try to find a way round the problem. Some steel using businesses have done just that. They are rearranging their supply chain and rather than manufacturing component parts in the US they are transferring the work to Canada. The tariff does not affect steel imports landing in Canada and so getting a Canadian company to manufacture the component and then ship it to the US helps to keep costs low and avoids having to pay the tariff. The impact in manufacturing jobs in steel using businesses in the US though is evident; if the work is transferred to Canada there is no-longer a need for the workers in the US. An attempt to solve a problem in one sector by interfering in the market creates problems elsewhere. The question has to be what is the balance of the costs and benefits, not just in the short term but also in the long term, for all interested parties?

Theories

Absolute Advantage: A situation where a country can produce a good or service more efficiently than another.
Comparative Advantage: A theory developed by the Scottish economist David Ricardo (1772 - 1823) that states that there will be advantages to all parties in trading if countries specialise in producing goods in which they have a comparative advantage (the lowest opportunity cost). So even if one country possesses an absolute advantage in the production of a range of goods there can still be gains from trade provided the opportunity cost ratios are different. An example may serve to help:

Country Oranges Melons O/C Oranges O/C Melons
UK 120 80 0.6 1.5
Spain 180 90 0.5 2.0

The table shows the output per unit of resource in two products - oranges and melons. The table indicates that Spain has an absolute advantage in the production of both goods but is more efficient in the production of oranges as opposed to the production of melons. For the UK, moving one resource from orange production to melon production would result in a gain of 80 melons and a sacrifice of 120 oranges; the opportunity cost of producing one extra melon therefore would be 1.5 oranges sacrificed whereas the opportunity cost of moving one resource from melons to orange production would be 120 oranges gained but 80 melons sacrificed - an opportunity cost of 0.6. For Spain, moving a resource from melon production to orange production would lead to a gain of 180 oranges but at a sacrifice of 90 melons - an opportunity cost of 0.5 whereas a resource move from oranges to melons means sacrificing 180 oranges to gain 90 melons - an opportunity cost of 2.0 (one extra melon involves the sacrifice of two oranges that could have been produced by the same resource). If the two countries were to specialise in the resources in which they had a comparative advantage then total output could rise. Assume that the UK has 20 units of resource and Spain 16. Total output, given that the nations resources were divided equally to the production of both goods, would be as follows:

Before Trade:

Country Oranges Melons
UK 1200 800
Spain 1440 720
Total 2640 1520

Now assume that the two countries specialise and agree to trade - Spain will focus its output on oranges and the UK on melons. The situation now looks like this:

After Specialisation:

Country Oranges Melons
UK - 1600
Spain 2880 -

It is clear that total output of both melons and oranges have increased - trade could now be arranged between Spain and the UK at some mutually acceptable rate. For example, the UK could agree to sell 800 melons to Spain in exchange for 1300 oranges. Spain would be better off than before in terms of both oranges and melons and so would the UK.

After Trade:

Country Oranges Melons
UK 1300 800
Spain 1580 800

Tariffs operate as a tax. The exporter pays the tax as the goods enter a country. In the example, steel exporters from, say the UK, would have to pay 30p in tax to the US government for every extra £1 of steel entering the US; this effectively raises the cost of production and so it raises its price to the buyer in the US to cover the cost of the tax. The supply curve shifts to the left by the amount of the tax leading to a rise in the price of steel in the US and a reduction in the amount bought and sold.The domestic producer can then fill the reduction in the amount of steel imported. See the PowerPoint presentation to illustrate what happens. A static view of the impact is also shown below.

A graph showing the impact of a tariff on steel

Questions

  1. Apart from moving production elsewhere as mentioned in the 'News' above, what other strategies could a business employ to cope with the changes in costs created by the tariff? (8 Marks)
  2. What factors are likely to limit the extent to which the principle of comparative advantage can be adopted in real world situations? (10 Marks)
  3. Explain how the imposition of trade barriers leads to greater inequality between developed and less developed countries. (10 Marks)
  4. Assess the extent to which the WTO has been successful in reducing barriers to trade and reducing inequality between trading nations. (12 Marks)

Total 40 Marks

Related Web sites for research

Mark Scheme

Question 1

This is a question that could have its context changed considerably and still have a similar answer. The fact that it is a tariff that has caused costs to increase is largely irrelevant - the basic question here is 'how do firms cope with increases in costs?' The answer in each case is simple - there are only two broad things they can do - find a way of impacting on costs or find some way to increase revenue. This would involve cutting other costs to maintain competitiveness, increasing prices, finding ways to market products more effectively and therefore maintain or increase sales or find ways of increasing productivity. The trick to the answer is how well you are able to relate your answer to the steel industry and to consider how easy or effective the strategies you come up with will be. Simply saying - 'increase prices' is not enough; you will have to consider the impact on the business if they do increase prices - elasticity will be relevant here! How easy will it be to reduce costs further? Will they have to make staff redundant and what effects might this have? How easy would it be to increase productivity further? and so on! 1 mark for identifying each strategy plus a further two for the explanation and 1 mark for discussing the likely impact (the evaluation part).

Question 2

Comparative advantage is a theory; it has had a significant impact on thinking but does make many assumptions. It assumes that the political and economic conditions are right for free trade; it assumes countries adopt a global view on welfare; it assumes factors can be moved from one use to another relatively easily and it assumes that countries are somehow in a position to direct resources to differing uses. What you must do in this answer is to explore some of these assumptions and how they might impact on the application of the theory to the real world. You should deal with at least 3 factors and offer an explanation of each (3 marks each) with the final mark reserved for your overall conclusion as a result of your analysis.

Question 3

This answer is a traditional critique of the problems caused by trade barriers and extends the analysis from a country base to the effect that powerful trading countries can have on their less developed neighbours. Essentially the effect is that LDCs tend to produce products that have lower value added and tend to rely on them for the bulk of their export earnings which in turn can be used to help fund growth and expansion of their economies. Barriers to trade prevent them from being able to sell their products (which are often cheaper than the home grown competitors - e.g. the textile industry in the UK) hence they are unable to generate wealth and end up remaining in a cycle of poverty and debt. Meanwhile, the rich countries get richer although by restricting trade they are not giving the LDCs the funds to be able to buy their products in the future! Two points with clear development of each and the use of relevant examples will earn 5 marks each. The focus should be on developing a coherent argument in each case showing your understanding of the process by which trade barriers will lead to greater inequality.

Question 4

For this question you will need to do a bit of extra research - additional links have been given to help you in this respect. This is an evaluation question and is asking you to make a judgement about the extent of the success of the trade negotiations between the world's nations. Remember that it is never likely that the negotiations are going to be neat, tidy and quick; many of these things take some time so you need to assess the success over the period of the negotiations - these have been going on in some form or another for many years. The quality of your research and your skill in making informed and supported judgements is going to determine the extent of the marks you get here. Remember to deal equally with BOTH parts of the question and try to avoid merely reproducing your own subjective views here - informed and balanced judgement is the order of the day.