ECON102: Principles of Macroeconomics

When a government legislates policies to reduce or block international trade, it is engaging in protectionism. Protectionist policies often seek to shield domestic producers and domestic workers from foreign competition. Protectionism takes three main forms: tariffs, import quotas, and nontariff barriers.

Recall from International Trade that tariffs are taxes that governments impose on imported goods and services. This makes imports more expensive for consumers, discouraging imports. For example, in 2018, President Trump increased tariffs on Chinese-manufactured goods by 2–25%, including TVs, monitors, desktop PCs, smartwatches, and many other consumer goods.

The intention behind the policy was to shelter U.S. manufacturers from competition, helping companies that operate domestically. China responded with tariffs on American goods, launching a trade war. President Biden retained these tariffs and considered additional ones, but as of August 2022, the administration was considering changes designed to reduce inflation.

Another way to control trade is through import quotas, which are numerical limitations on the quantity of products that a country can import. For instance, during the early 1980s, the Reagan Administration imposed a quota on the import of Japanese automobiles. In the 1970s, many developed countries, including the United States, found themselves with declining textile industries. Textile production does not require highly skilled workers, so producers were able to set up lower-cost factories in developing countries.

In order to "manage" this loss of jobs and income, the developed countries established an international Multifiber Agreement that essentially divided the market for textile exports between importers and the remaining domestic producers. The agreement, which ran from 1974 to 2004, specified the exact quota of textile imports that each developed country would accept from each low-income country. A similar story exists for sugar imports into the United States, which are still governed by quotas.

Non-tariff barriers are all the other ways that a nation can draw up rules, regulations, inspections, and paperwork to make it more costly or difficult to import products. A rule requiring certain safety standards can limit imports just as effectively as high tariffs or low import quotas, for instance. There are also non-tariff barriers in the form of "rules-of-origin" regulations; these rules describe the "Made in Country X" label as the one in which the last substantial change in the product took place. A manufacturer wishing to evade import restrictions may try to change the production process so that the last big change in the product happens in their own country. For example, certain textiles are made in the United States, shipped to other countries, combined with textiles made in those other countries to make apparel – and then re-exported back to the United States for a final assembly to escape paying tariffs or to obtain a "Made in the USA" label.

Despite import quotas, tariffs, and nontariff barriers, the share of apparel sold in the United States that is imported rose from about half in 1999 to about three-quarters today. According to the U.S. Bureau of Labor Statistics (BLS), the number of U.S. jobs in textiles and apparel fell 44% from 2007 to 2014 and will fall by another 25% by 2024. Even more U.S. textile industry jobs would have been lost without tariffs. However, domestic jobs that are saved by import quotas come at a cost. Because textile and apparel protectionism adds to the costs of imports, consumers end up paying billions of dollars more for clothing each year.

When the United States eliminates trade barriers in one area, consumers spend the money they save on that product elsewhere in the economy. Thus, while eliminating trade barriers in one sector of the economy will likely result in some job loss in that sector, consumers will spend the resulting savings in other sectors of the economy and hence increase the number of jobs in those other sectors. Of course, workers in some of the poorest countries of the world who would otherwise have jobs producing textiles would gain considerably if the United States reduced its barriers to trade in textiles. That said, there are good reasons to be wary about reducing barriers to trade. The 2012 and 2013 Bangladeshi fires in textile factories, which resulted in a horrific loss of life, present complications that our simplified analysis in the chapter will not capture.

Realizing the compromises between nations that came about due to trade policy, many countries came together in 1947 to form the General Agreement on Tariffs and Trade (GATT). (We'll cover the GATT in more detail later in the chapter.) This agreement has since been superseded by the World Trade Organization (WTO), whose membership includes about 150 nations and most of the world's economies. It is the primary international mechanism through which nations negotiate their trade rules – including rules about tariffs, quotas, and non-tariff barriers. The next section examines the results of such protectionism and develops a simple model to show the impact of trade policy.

Demand and Supply Analysis of Protectionism

To the non-economist, restricting imports may appear to be nothing more than taking sales from foreign producers and giving them to domestic producers. Other factors are at work, however, because firms do not operate in a vacuum. Instead, firms sell their products either to consumers or to other firms (if they are business suppliers), who are also affected by the trade barriers. A demand and supply analysis of protectionism shows that it is not just a matter of domestic gains and foreign losses but a policy that imposes substantial domestic costs as well.

Consider two countries, Brazil and the United States, that produce sugar. Each country has a domestic supply and demand for sugar, as Table 21.1 details and Figure 21.2 illustrates. In Brazil, without trade, the equilibrium price of sugar is 12 cents per pound, and the equilibrium output is 30 tons. When there is no trade in the United States, the equilibrium price of sugar is 24 cents per pound, and the equilibrium quantity is 80 tons. We label these equilibrium points as point E in each part of the figure.

Figure 21.2 The Sugar Trade between Brazil and the United States Before trade, the equilibrium price of sugar in Brazil was 12 cents a pound, and it was 24 cents per pound in the United States. When trade is allowed, businesses will buy cheap sugar in Brazil and sell it in the United States. This will result in higher prices in Brazil and lower prices in the United States. Ignoring transaction costs, prices should converge to 16 cents per pound, with Brazil exporting 15 tons of sugar and the United States importing 15 tons of sugar. If trade is only partly open between the countries, it will lead to an outcome between the free-trade and no-trade possibilities.

Table 21.1 The Sugar Trade between Brazil and the United States

Suppose international trade between Brazil and the United States now becomes possible. In that case, profit-seeking firms will spot an opportunity: buy sugar cheaply in Brazil and sell it at a higher price in the United States. As sugar is shipped from Brazil to the United States, the quantity of sugar produced in Brazil will be greater than Brazilian consumption (with the extra production exported), and the amount produced in the United States will be less than the amount of U.S. consumption (with the extra consumption imported).

Exports to the United States will reduce the sugar supply in Brazil, raising its price. Imports into the United States will increase the sugar supply, lowering its price. When the sugar price is the same in both countries, there is no incentive to trade further. As Figure 21.2 shows, the equilibrium with trade occurs at a price of 16 cents per pound. At that price, the sugar farmers of Brazil supply a quantity of 40 tons, while the consumers of Brazil buy only 25 tons.

The extra 15 tons of sugar production, shown by the horizontal gap between the demand curve and the supply curve in Brazil, is exported to the United States. In the United States, at a price of 16 cents, the farmers produce a quantity of 72 tons, and consumers demand a quantity of 87 tons. The excess demand of 15 tons by American consumers, shown by the horizontal gap between demand and domestic supply at the price of 16 cents, is supplied by imported sugar.

Free trade typically results in income distribution effects, but the key is to recognize the overall gains from trade, as Figure 21.3 shows. Building on the concepts that we outlined in Demand and Supply and Demand, Supply, and Efficiency in terms of consumer and producer surplus, Figure 21.3 (a) shows that producers in Brazil gain by selling more sugar at a higher price, while Figure 21.3 (b) shows consumers in the United States benefit from the lower price and greater availability of sugar.

Consumers in Brazil are worse off (compare their no-trade consumer surplus with the free-trade consumer surplus), and U.S. producers of sugar are worse off. There are gains from trade – an increase in social surplus in each country. That is, both the United States and Brazil are better off than they would be without trade. The following Clear It Up feature explains how trade policy can influence low-income countries.

Figure 21.3 Free Trade of Sugar Free trade results in gains from trade. Total surplus increases in both countries, as the two blue-shaded areas show. However, there are clear income distribution effects. Producers gain in the exporting country, while consumers lose, and in the importing country, consumers gain and producers lose.

Now, let's look at what happens with protectionism. U.S. sugar farmers are likely to argue that if only they could be protected from sugar imported from Brazil, the United States would have higher domestic sugar production, more jobs in the sugar industry, and American sugar farmers would receive a higher price. If the United States government sets a high enough tariff on imported sugar or sets an import quota at zero, the result will be that the quantity of sugar traded between countries could be reduced to zero, and the prices in each country will return to the levels before trade was allowed.

Blocking only some trade is also possible. Suppose that the United States passed a sugar import quota of seven tons. The United States will import no more than seven tons of sugar, which means that Brazil can export no more than seven tons of sugar to the United States. As a result, the price of sugar in the United States will be 20 cents, which is the price where the quantity demanded is seven tons greater than the domestic quantity supplied. Conversely, suppose Brazil can export only seven tons of sugar. In that case, the price of sugar in Brazil will be 14 cents per pound, which is the price where the domestic quantity supplied in Brazil is seven tons greater than domestic demand.

In general, when a country sets a low or medium tariff or import quota, the equilibrium price and quantity will be somewhere between those that prevail with no trade and those with completely free trade. The following Work It Out explores the impact of these trade barriers.

Who Benefits and Who Pays?

Using the demand and supply model, consider the impact of protectionism on producers and consumers in each of the two countries. For protected producers like U.S. sugar farmers, restricting imports is clearly positive. Without a need to face imported products, these producers are able to sell more at a higher price.

For consumers in the country with protected goods, in this case, U.S. sugar consumers, restricting imports is clearly negative. They end up buying a lower quantity of the good and paying a higher price for what they do buy, compared to the equilibrium price and quantity with trade. The following Clear It Up feature considers why a country might outsource jobs even for a domestic product.

The fact that protectionism pushes up prices for consumers in the country enacting such protectionism is not always acknowledged openly, but it is not disputed. After all, if protectionism did not benefit domestic producers, there would not be much point in enacting such policies in the first place. Protectionism is simply a method of requiring consumers to subsidize producers.

The subsidy is indirect since consumers pay for it through higher prices rather than a direct government subsidy paid with money collected from taxpayers. However, protectionism works like a subsidy, nonetheless. The American satirist Ambrose Bierce defined "tariff" this way in his 1911 book, The Devil's Dictionary: "Tariff, n. A scale of taxes on imports, designed to protect the domestic producer against the greed of his consumer."

The effect of protectionism on producers and consumers in a foreign country is complex. When a government uses an import quota to impose partial protectionism, Brazilian sugar producers receive a lower price for the sugar they sell in Brazil – but a higher price for the sugar they are allowed to export to the United States. Notice that some of the burden of protectionism, paid by domestic consumers, ends up in the hands of foreign producers in this case.

Brazilian sugar consumers seem to benefit from U.S. protectionism because it reduces the price of sugar that they pay (compared to the free-trade situation). On the other hand, at least some of these Brazilian sugar consumers also work as sugar farmers, so protectionism reduces their incomes and jobs. Moreover, if trade between the countries vanishes, Brazilian consumers would miss out on better prices for imported goods – which do not appear in our single-market example of sugar protectionism.

The effects of protectionism on foreign countries notwithstanding, protectionism requires domestic consumers of a product (consumers may include either households or other firms) to pay higher prices to benefit domestic producers of that product. In addition, when a country enacts protectionism, it loses the economic gains it would have been able to achieve through a combination of comparative advantage, specialized learning, and economies of scale, concepts that we discuss in International Trade.