Free Trade & Protectionism

Question 1

What is free trade?

Answer 1

The economic policy of not discriminating against imports from and exports to foreign jurisdictions

Question 2

What are 3 benefits of free trade?

Answer 2

• consumers benefit from increased consumer surplus (as world price is always lower than domestic price), wider choice and increased firm competition
• being part of a large global market enables firms to gain more revenue and expand thus produce more and demand more labour
• countries can begin to specialize and stop being self sufficient which is allocatively inefficient

Question 3

What are 3 costs of free trade?

Answer 3

• previously protected domestic firms are exposed to a highly competitive global market, can lead to structural unemployment and regional inequality
• specialisation makes an economy vulnerable to supply side shocks
• not all countries trade on equal terms which can increase the current account deficit

Question 4

What does it mean to have a comparative advantage and an absolute advantage?

Answer 4

Comparative advantage = having a lower opportunity cost to produce something

Absolute advantage = being more productively efficient or cost efficient than another country

Question 5

What is protectionism?

Answer 5

Protectionism is an economic policy of restraining trade between countries through methods such as tariffs, quotas, etc

Question 6

What is a tariff?

Answer 6

A tariff is a tax placed on an imported good which is paid by the importing firm, thus becomes a cost of production which is passed onto consumers through a higher price

Question 7

Give 3 evaluation points for tariffs

Answer 7

• the imported good must be price elastic so that the increase in price leads to a proportional decrease in demand
• tariffs create cost-push inflation by increasing the cost of imported goods
• tariffs invite retaliatory action

Question 8

What are quotas?

Answer 8

Quotas are a limit on the volume of a good or service that can be imported. The exporting country has to pay for a quota license

Question 9

Give 3 evaluation points for quotas

Answer 9

• imported good must be price elastic and there must be domestically produced substitutes
• quotas do not bring in tax revenue like tariffs do and have a greater degree of dead weight loss
• danger of retaliatory action

Question 10

What are subsidies?

Answer 10

These are funds given to firms to lower production costs allowing them to sell at a lower price making domestic firms more price competitive

Question 11

Give 3 evaluation points of subsidies

Answer 11

• opportunity cost, the funding can be used elsewhere and could involve deficit spending
• incentivises productive inefficiency
• used by wealthy and powerful countries to gain an unfair advantage

Question 12

What is currency manipulation?

Answer 12

Imports can be made more expensive by depreciating the currency which incentivises consumers to switch to domestic alternatives

Depreciating the currency can be done by decreasing interest rates which reduces hot money flows. Also can be done by direct involvement by selling the currency and buying assets denominated in the currency of a key trading partner

Question 13

Give 3 evaluation points for currency manipulation

Answer 13

• only works if the Marshall Lerner condition applies: the combined PED of imports/ exports is greater than 1, doesn’t apply to the UK
• cannot be done if a country has declared it has a floating exchange rate
• depends on the central bank having sufficient resources to enter the FOREX market (foreign currency reserves)