Trade Policy: Free Trade and Protection
The foreign trade policy is concerned with whether a country should adopt the policy of free
trade or of protection. If the policy of protection for domestic industries is adopted, the
question which is faced whether protection should be achieved through imposing tariffs on
imports or through the fixation of quota or through licensing of imports. The foreign trade
policy has been the subject of heated discussion since the time of Adam Smith who
advocated for free trade and recommended that tariffs should be removed to avail of the
advantages of free trade. Even today, economists are divided over this question of foreign
trade policy. Various arguments have been given for and against free trade and protection.
Free trade is the simpler of the two theories: a laissez-faire approach, with no restrictions on
trade. The main idea is that supply and demand factors, operating on a global scale, will
ensure that production happens efficiently. Therefore, nothing needs to be done to protect or
promote trade and growth, because market forces will do so automatically.
In contrast, protectionism holds that regulation of international trade is important to ensure
that markets function properly. Advocates of this theory believe that market inefficiencies
may hamper the benefits of international trade, and they aim to guide the market accordingly.
Protectionism exists in many different forms, but the most common are tariffs, subsidies, and
quotas. These strategies attempt to correct any inefficiency in the international market.
Case for Free Trade:
1. Gains in Output and Well-being from Specialization: The case for free trade is
fundamentally based on the gain in output and well-being a country obtains from specializing
in the production of those goods in which it is relatively more efficient and therefore export a
part of them and in exchange gets those goods from other countries in production of which
they are comparatively more efficient. Specialization and trading in this way would achieve a
more efficient allocation of resources and a higher level of output and well-being.
2. Gains from Economies of Scale: An important gain from trade is that it enables the trading
countries to benefit from the economies of scale. If a country does not trade with others, its
firms will produce goods to meet the domestic demand for a product. If domestic demand for
a product is small, each of them will produce at a higher cost since they would not be able to
enjoy the benefits of the economies of large scale production. Accordingly, the production of
goods will be inefficient. Trade allows a country to export goods with the result that level of
output of goods in a country will exceed domestic demand within a country. Thus trade
expands the market for goods and enables the producers to take advantage of the economies
of scale.
3. Raising rate of saving and investment: Increase in national product or real national income
of a country obtained through trade above the level that prevails in autarky leads to a higher
level of saving. The higher level of saving ensures a higher rate of investment and capital
formation which stimulates growth.
4.Import of capital goods: Besides trade permits a country to import capital goods in
exchange for exports of consumer goods or surplus raw materials, and thereby accelerates
industrial growth. Imports of capital goods adds to the capital stock in a country and raises its
productive capacity more than it would have been possible without trade. Free trade also
often enables a country to borrow from other countries to finance import of capital goods.
5.Transfer of technology: If different countries worked in isolation the new technology
developed in one country would remain confined locally. Through trade technological
progress tends to feed on each other. A technology discovered by one is improved by another
, and so technology goes on being improved successively. Imagine if every country had to
invent a wheel, a steam engine, electricity operating in an isolated manner, how slow would
have been the progress in technology. The trade increases international diffusion of
technology and in this way transfer of technology from the developed countries to the
developing countries have been possible.
6. Promotes Competition and Prevents Monopoly: The case for free trade also rests on the
fact that it promotes competition and prevents the emergence of monopolies in the domestic
economy. In the absence of trade and therefore without facing any competition from foreign
firms, domestic firms tend to become inefficient which causes rise in cost per unit of output
and therefore higher prices of goods. When trade is free, increased competition by foreign
firms forces domestic firms to adopt measures to increase their efficiency and make efforts to
reduce cost by employing lowest cost production techniques. Free trade also compels them to
be innovative and to improve the quality of their products.
7. Political Gains from Free Trade: Free trade increases well-being or standard of living of
the trading countries and this mutual welfare gains from trade make different nations
economically dependent on each other. The economic interdependence raises the likelihood
of reduced hostility between countries. Economic interdependence provides powerful
incentives for peaceful solution of disputes. Trade between economically interdependent
countries increases the potential losses from war and thus reduces the likelihood of armed
conflict.
Despite the above gains from free trade, countries have put up various barriers to free trade.
Case for Protection: (Against free trade)
Despite gains from free trade, many arguments have been given against free trade and in
favour of protection.
1. Nationalism: First argument for protection has been that nationalistic feeling or patriotism
requires that people of a country should buy products of their domestic industries rather than
foreign products. In India recent campaign of ‘Swadeshi’ appeals to the patriotic feeling of
the Indian people that we should protect our indigenous industries and impose barriers on
imports of foreign goods or provide subsidies to our industries.
2.Employment Argument: An important argument for protection is that it will lead to
increase in domestic employment or at least preserves present domestic employment. It is
often believed that imports of goods from abroad reduce domestic employment. Therefore, if
instead of imports we produce those goods at home, employment in the country will increase.
3. Infant Industry Argument: A powerful argument given in support of protection, especially
in the context of developing countries is infant industries should be provided protection from
the competition of low-priced imports of the mature and well-established industries of the
developed industrialized countries. As a result, over a period of time, their cost per unit will
go down and will therefore be in a position to compete with the foreign imports. Therefore,
for some time they should be protected otherwise they would be destroyed by foreign
competition.
4. Anti-dumping Argument: The other important argument for protection is that foreign
producers compete unfairly by dumping the goods in another country. Dumping is a form of
price discrimination when producers of a country sell goods in another country at lower
prices than those charged at home. Of course, consumers in a country in which foreign goods
are dumped are beneficiaries, the industries of that country suffer as they are unable to
compete with the ‘dumped goods’. Besides, there is more harmful ‘predatory dumping’
The foreign trade policy is concerned with whether a country should adopt the policy of free
trade or of protection. If the policy of protection for domestic industries is adopted, the
question which is faced whether protection should be achieved through imposing tariffs on
imports or through the fixation of quota or through licensing of imports. The foreign trade
policy has been the subject of heated discussion since the time of Adam Smith who
advocated for free trade and recommended that tariffs should be removed to avail of the
advantages of free trade. Even today, economists are divided over this question of foreign
trade policy. Various arguments have been given for and against free trade and protection.
Free trade is the simpler of the two theories: a laissez-faire approach, with no restrictions on
trade. The main idea is that supply and demand factors, operating on a global scale, will
ensure that production happens efficiently. Therefore, nothing needs to be done to protect or
promote trade and growth, because market forces will do so automatically.
In contrast, protectionism holds that regulation of international trade is important to ensure
that markets function properly. Advocates of this theory believe that market inefficiencies
may hamper the benefits of international trade, and they aim to guide the market accordingly.
Protectionism exists in many different forms, but the most common are tariffs, subsidies, and
quotas. These strategies attempt to correct any inefficiency in the international market.
Case for Free Trade:
1. Gains in Output and Well-being from Specialization: The case for free trade is
fundamentally based on the gain in output and well-being a country obtains from specializing
in the production of those goods in which it is relatively more efficient and therefore export a
part of them and in exchange gets those goods from other countries in production of which
they are comparatively more efficient. Specialization and trading in this way would achieve a
more efficient allocation of resources and a higher level of output and well-being.
2. Gains from Economies of Scale: An important gain from trade is that it enables the trading
countries to benefit from the economies of scale. If a country does not trade with others, its
firms will produce goods to meet the domestic demand for a product. If domestic demand for
a product is small, each of them will produce at a higher cost since they would not be able to
enjoy the benefits of the economies of large scale production. Accordingly, the production of
goods will be inefficient. Trade allows a country to export goods with the result that level of
output of goods in a country will exceed domestic demand within a country. Thus trade
expands the market for goods and enables the producers to take advantage of the economies
of scale.
3. Raising rate of saving and investment: Increase in national product or real national income
of a country obtained through trade above the level that prevails in autarky leads to a higher
level of saving. The higher level of saving ensures a higher rate of investment and capital
formation which stimulates growth.
4.Import of capital goods: Besides trade permits a country to import capital goods in
exchange for exports of consumer goods or surplus raw materials, and thereby accelerates
industrial growth. Imports of capital goods adds to the capital stock in a country and raises its
productive capacity more than it would have been possible without trade. Free trade also
often enables a country to borrow from other countries to finance import of capital goods.
5.Transfer of technology: If different countries worked in isolation the new technology
developed in one country would remain confined locally. Through trade technological
progress tends to feed on each other. A technology discovered by one is improved by another
, and so technology goes on being improved successively. Imagine if every country had to
invent a wheel, a steam engine, electricity operating in an isolated manner, how slow would
have been the progress in technology. The trade increases international diffusion of
technology and in this way transfer of technology from the developed countries to the
developing countries have been possible.
6. Promotes Competition and Prevents Monopoly: The case for free trade also rests on the
fact that it promotes competition and prevents the emergence of monopolies in the domestic
economy. In the absence of trade and therefore without facing any competition from foreign
firms, domestic firms tend to become inefficient which causes rise in cost per unit of output
and therefore higher prices of goods. When trade is free, increased competition by foreign
firms forces domestic firms to adopt measures to increase their efficiency and make efforts to
reduce cost by employing lowest cost production techniques. Free trade also compels them to
be innovative and to improve the quality of their products.
7. Political Gains from Free Trade: Free trade increases well-being or standard of living of
the trading countries and this mutual welfare gains from trade make different nations
economically dependent on each other. The economic interdependence raises the likelihood
of reduced hostility between countries. Economic interdependence provides powerful
incentives for peaceful solution of disputes. Trade between economically interdependent
countries increases the potential losses from war and thus reduces the likelihood of armed
conflict.
Despite the above gains from free trade, countries have put up various barriers to free trade.
Case for Protection: (Against free trade)
Despite gains from free trade, many arguments have been given against free trade and in
favour of protection.
1. Nationalism: First argument for protection has been that nationalistic feeling or patriotism
requires that people of a country should buy products of their domestic industries rather than
foreign products. In India recent campaign of ‘Swadeshi’ appeals to the patriotic feeling of
the Indian people that we should protect our indigenous industries and impose barriers on
imports of foreign goods or provide subsidies to our industries.
2.Employment Argument: An important argument for protection is that it will lead to
increase in domestic employment or at least preserves present domestic employment. It is
often believed that imports of goods from abroad reduce domestic employment. Therefore, if
instead of imports we produce those goods at home, employment in the country will increase.
3. Infant Industry Argument: A powerful argument given in support of protection, especially
in the context of developing countries is infant industries should be provided protection from
the competition of low-priced imports of the mature and well-established industries of the
developed industrialized countries. As a result, over a period of time, their cost per unit will
go down and will therefore be in a position to compete with the foreign imports. Therefore,
for some time they should be protected otherwise they would be destroyed by foreign
competition.
4. Anti-dumping Argument: The other important argument for protection is that foreign
producers compete unfairly by dumping the goods in another country. Dumping is a form of
price discrimination when producers of a country sell goods in another country at lower
prices than those charged at home. Of course, consumers in a country in which foreign goods
are dumped are beneficiaries, the industries of that country suffer as they are unable to
compete with the ‘dumped goods’. Besides, there is more harmful ‘predatory dumping’
