Threat of Protectionism and Its Possible Effects on World GDP and Income Distribution - Term Paper Example

THREAT OF PROTECTIONISM AND ITS POSSIBLE EFFECTS ON WORLD GDP AND INCOME DISTRIBUTION Contents Contents 1. Introduction 2 2. Theoretical Review 2 3. Effects of Trade Protection Measures 4 3.1 Effect on Income Distribution 4 3.2 Effect on GDP 5 4. Conclusion 5 5. Reference 6 1. Introduction The ongoing financial crisis is showing its effects on a global scale. In an interesting trend, countries that were once the advocates of free trade and globalization are adopting diagonally opposite strategies today. There is a growing consensus among leaders that the only way for economies to protect themselves is by resorting to protection measures. As on date, more than 60 new measures to protect international trade have been formulated (Gamberoni E. and Newfarmer R., March 4, 2009). Economists, who believe that increased trade is the only optimum solution to this pandemonium, feel that countries might slip further if protectionism measures are actually implemented. BBC News Reporter James Melik in his report “The dangers of trade protectionism” discusses the consensus among global leaders about the evils of protectionism. The ‘Buy America’ clause propagated by US President Barrack Obama is sending wrong messages all over. Economists feel that this will create an atmosphere where countries will compete among themselves to introduce trade protection measures. It will further aggravate the grim conditions the world is already facing. Some quarters, however, believe that it is more of a political necessity than an economic one that is fuelling the drive for ‘Buy America’. British Prime Minister Gordon Brown has also initiated a slogan of British Jobs for British workers. In a way, these effects might not sound that alarming if considered in isolation. The images become devastating only when the domino effect of countries going into protectionist mode is considered. All this is capable of ultimately leading economies into autarky that seriously jeopardizes their growth prospects. International trade can actually help economies get out of this bleak phase. A memorable example of this can be the way in which the East Asian Tigers restored their economies after the East Asian Crisis in 1997 through increased exports. This realisation has perhaps lead to the agreement among finance ministers of G7 nations towards a systematic approach and joint efforts in working together to restore growth in employment and growth. (G7 Pledges to Avoid Protectionism, February 2009) 2. Theoretical Review The basic framework of international trade is derived from the factor price equalization theorem designed by Eli Heckscher and Bertil Ohlin. According to this theory a country will export those commodities which can be produced by the relatively abundant factor of production. An important finding of this model is the equalisation of factor prices as a result of free trade. Countries will also enjoy higher community welfare if they accept foreign trade rather than be in autarky. In fact, any government should restrict itself from obstructing the free flow of goods and services. The real world implications of factor price equalization are interesting. Since a considerable part of the population resided outside the industrialised nations, equalisation of factor prices would mean a fall in wages and rise in cost of capital in developed nations and a rise in wages in the developing nations. This seemed to tilt the balance of income distribution in favour of the owners of capital. Other gains from free trade will be due to the import of goods at a price less than the price of substitutes available at home. The availability of goods at a low price also increases the real income of all those who are not employed in import competing sector. The risk of unemployment of laborers due to imports is eradicated through their employment in export promoting industries. Protectionism refers to the designing of measures that prevents free trade. Tariffs form the most commonly used trade barriers. The effects of trade tariff get reflected through effects on production and consumption. This is understood by taking a two country model where one country exports and the other imports. When an importing country imposes tariff, the price of goods rises in the home country and falls elsewhere. Consumers of the home country will suffer a decrease in their consumer surplus on account of both high prices of imported goods as well as domestically available substitutes. Producers of the country will be better off as a result of the tariff. This is attributed to the increase in producer surplus due to increased prices. In addition to this, producers will also enjoy an increased output, increased employment, and increased profits. The tariff revenue goes to the government of the tariff imposing country. It is generally difficult to analyse how the increased revenue benefits because that depends on the avenues where the government spends it. Thus, the aggregate welfare to the residents of the country will be a summation of positive trade effect, negative production and consumption distortions. (Suranovic S. M., August 2004) In case of the exporting country, consumers will enjoy an increased welfare due to a decrease in price. Producers will suffer a loss of producer surplus. Imposition of tariff will result in lower prices, lower output, and lower employment. The government of the exporting country does not undergo a change in its position. The total welfare of the country will be a summation of three components; negative terms of trade effect, negative consumption distortion and negative production distortion. The effects of a tariff on global welfare will be equal to the sum of welfare of the importing and exporting country. The positive trade effect of the importer is offset by the negative trade effect of the exporter. The global welfare thus consists of four components: negative consumption effect of importer and exporter, and negative production effect of importer and exporter. Since all the components are negative, the global welfare will decrease through inefficiencies in production and consumption as a result of tariff imposition. (Deardorff A.V., Stern M.R. and Baru S.R., 1994) The post-GATT era saw an increase in non tariff barriers (NTB) to trade. By definition, NTB is “any measure that reduces imports and leaves domestic producers unaffected” (Hill A. T., n.d.). An import quota is a major component of NTB. It limits the physical amount of any commodity that might be imported over a specific time period. Technically, quota results in the shift of economic welfare from consumer surplus to producer surplus through redistribution effect. The protection effect is felt through loss of welfare due to inefficient production of goods in domestic country. The loss to the consumer as an effect of quota arises due purchasing at higher prices. Mathematically, the revenue effect of quota is calculated by the product of the amount of quota and the rise in price. The revenue effect can either accrue to domestic producers acting as middlemen or to foreign suppliers; it might also go to the government if import licenses are auctioned off. (Hill A. T., n.d.) Voluntary export restraint (VER) is another form of NTB that originated in 1980. It is an agreement between the exporting and importing country where the former restricts the amount of goods it can export to the importing country. The VER is similar in its effect to the quota; only difference being that exporters will enjoy the revenue effect as increased profits. Often, implementation of VER has a political implementation and is viewed as a trade victory of the home country over the exporting country. 3. Effects of Trade Protection Measures 3.1 Effect on Income Distribution For the purpose of analysis, we consider a country with two factors of production, capital and labor. Trade liberalization opens up national boundaries and allows free movement of labor. This implies that there will be more jobs available in countries which are rich in labor. With trade protection, the production levels will come down due to decreased demand of catering only to the home market. This will generate unemployment due to decrease in demand for labor. As a consequence, wages will fall since producers will have an increased bargaining power. Protection will also restrict the flow of capital through controlled foreign investments. This will increase the cost of capital in the country, considering it to be a capital scarce and labor rich country. Overall, the cost of production will rise, wages will fall and owners of capital will demand higher returns. Globalization also gives rise to outsourcing of activities. This will be hit in case of protection. As a result, employment activities in the services sector will decline. Since the income will fall, the ability to spend also falls, resulting in decreased production. This cycle continues spirally with aggravating negative effects on the income of the factors of production. 3.2 Effect on GDP Trade protection measures will be detrimental to the global economy from the demand side. A decrease in demand of goods and services decreases the production which in turn decreases the income to labour. Since household provides the supply of labour, household income falls. The cumulative household income, in simple terms, can be taken as the GDP of that country. It is quite evident that GDP will fall if an economy resorts to protectionist measure and pulls itself in isolation. For instance, in US, decrease in exports by 23.6% during October-December 2008 was accompanied by a 6.2% fall in GDP. (The G-20 Summit and Global Trade: Restore Credit and Resist Protectionism, March 14, 2009) 4. Conclusion The economic turmoil has hit economies all around the world. However, the effects seem more pronounced for the developed countries than the developing countries. As a policy measure economies around the world seemed to be hesitant to jump into a protectionist mode; it appears that they are aware of the negative effects of The Smoot-Hawley Tariffs Act of 1930 which is supposed to aggravate the Great Depression of 1930. Although global trade is seeing a steady decline, the world leaders at meeting at regular intervals to coordinate a joint effort in preventing countries from going into the protectionist mode in a desperate attempt to save themselves from the heat of the meltdown. 5. Reference Deardorff A.V., Stern M.R. and Baru S.R., 1994, The Stolper-Samuelson Theorem: A Golden Jubilee, Published by University of Michigan Press, 1994ISBN 0472105337, 9780472105335. Gamberoni E. and Newfarmer R., March 4, 2009, Trade protection: Incipient but worrisome trends, [Online], Available: http://www.voxeu.org/index.php?q=node/3183 [1st April. 2009] G7 Pledges to Avoid Protectionism, February 2009, BBC News, [Online], Available: http://news.bbc.co.uk/go/pr/fr/-/1/hi/business/7889222.stm [1st April 2009] Hill A. T., No Date, NonTariff Barriers to Trade, Economics340: International Economics [Online], Available: http://www.udel.edu/Economics/ahill/ECON340/Notes01W/notes801.pdf [1st April. 2009] Suranovic S. M., August 2004, International Trade Theory and Policy, The International Economics Study Center [Online], Available: http://internationalecon.com/Trade/Tch90/T90-8.php [1st April. 2009] The G-20 Summit and Global Trade: Restore Credit and Resist Protectionism, March 14, 2009 [Online], Available: http://www.brookings.edu/opinions/2009/0314_g20_trade_panagariya.aspx [1st April 2009] Read More