Specialisation, free trade and protection

Last time

Before we start: last time, in Multinational companies, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Why countries trade

Pakistan exports textiles and rice, and imports oil and machinery. Why not make everything at home? Because countries, like workers, are better at some things than others. Trading lets each one specialise. In this lesson: the gains from trade, and why governments sometimes restrict it.

Specialisation by countries

A country specialises when it concentrates on producing the goods it can make at a relatively low cost, and imports the rest. Its advantage may come from natural resources, climate, skills, or capital. By specialising and trading, countries together can produce and consume more than if each made everything itself.

Advantages of specialisation

Higher output and lower costs, because resources are used where they are most productive. Economies of scale from producing for a world market, and a wider choice of goods for consumers. Export earnings that pay for imports.

Risks of specialisation

Over-dependence on a few products: if world demand or prices fall, the whole economy suffers. Structural unemployment, if demand for the main export collapses. And dependence on imports for essential goods, such as food or fuel.

Free trade

Free trade means international trade with no restrictions, such as tariffs or quotas. Consumers gain lower prices, more choice and better quality, because domestic firms face foreign competition. Exporters gain a larger market, so output, jobs and growth can rise.

Does free trade raise growth?

It may: exports rise, firms gain economies of scale, and competition makes them more efficient. It may not: cheap imports may force domestic firms to close, causing unemployment, and the current account may worsen. The result depends on how competitive a country's firms are.

Methods of protection

When governments do restrict trade, these are the tools they use.

Why protect?

To protect infant industries: new firms that cannot yet compete, until they grow big enough to gain economies of scale. To protect jobs in declining industries, and strategic industries such as food and defence. To prevent dumping: foreign firms selling below cost to win the market. And to raise revenue and reduce a current account deficit.

Why not protect?

Consumers pay higher prices and have less choice. Protected firms have less pressure to be efficient, and may never grow up. Other countries may retaliate with their own tariffs, so exports fall. Firms that use imported materials face higher costs.

Tariffs and output

A tariff makes imports dearer, so some demand switches to home-produced goods, and domestic output may rise. But if other countries retaliate, exports and the output of exporters fall. And if home firms rely on imported raw materials, their costs rise and output may fall. So the effect depends on retaliation and on imported inputs.

Protect every industry?

Protecting all industries would mean high prices, little choice and inefficient firms, and the loss of the gains from trade. Protection is easier to justify for a few industries: infant, strategic, or victims of dumping, and only for a time. That is the kind of conclusion examiners reward: a judgement with a reason.

Mistakes that lose marks

Mistake one: defining a tariff as a limit on imports. That is a quota. A tariff is a tax. Mistake two: giving only arguments for protection in a discuss question. Mistake three: forgetting retaliation when judging the effect of a tariff. The fix: precise method, both sides, and retaliation in the judgement.

The full-marks tip

The full-marks tip: name the method of protection precisely, and say who gains and who loses. In a discuss answer, weigh the gains from trade against the case for protection.

On one card

So, on one card: trade and protection. Keep it for revision.