Wednesday, February 11, 2009

The Rise of Protectionism and It's Implications

By Christopher Espinal

Here, I made the case for free trade. I want to further extend the
argument eliminating the anti-left polemic.

Free trade on the global scene is the same as trade within a
market. There is a supply and a demand for goods. Nothing

When an economy opens up its borders, one of three events
will follow. The price of some good produced in the United
States may increase, stay the same or decrease. What does
each of the consequences mean?

If a domestic price increases after opening borders, there
must be an implication for the global market equilibrium.
Demand is probably greater, or supply is relatively scarce
for a resource in the global market than in the micro-
market, making the relative scarcity of the good in question
increase. This can also happen with a competitive market
comprising of firms that have higher cost production
functions or with global markets that are more centralized.

In the middle of the spectrum, the domestic price may remain
the same implying a lack of increase in demand for a good,
or competitive global market economy where firms have
similar marginal costs.

On the other end of the spectrum a price can decrease
suggesting a more competitive economy with a more efficient
production process on the global scene than in the domestic

Thus there are two components to the analysis – the
preferences of the global consumer and the comparative
advantage as illustrated in their production “functions” (or
the efficiency of their production process).

Now we can move into the policy aspect. Protectionist
policies artificially can artificially alter the demand or
the supply side of our global market through several
mechanisms. Politicians may utilize artificial price
manipulation through taxation, import or price caps,
creations of barriers to entry into the American economy
[for example], and outright trade restrictions. However, all
do one important thing – they alter the price clearing
condition of the market.

The obvious objective of these policies are to incentivize a
nationalistic motive (to some degree) to buy goods made in
the “homeland.” If people purchase more American goods, the
theory states, it will create more jobs at home causing a
rise in American production, all of which will contribute to
restoring confidence in the American economy.

However true this may be, there are side effects to these
sorts of policies. All goods that dropped in prices with
international trade will increase. All imported goods, that
now must incur taxation or supply caps, will face price
increases. These price increases will thus increase the
general price level of the American economy causing
aggregate demand to fall.

Taxing imports have other unintended side effects. A drop in
demand due to the protectionist country will cause a decline
in production from foreign companies and thus a decline in
profits. A decline in global production implies cutting
labor and capital input prices or firing workers and cutting
capital. Laying off workers and cutting capital happens more
often than cutting pay to keep high productivity workers and
capital inputs.

The potential for losses in profits for foreign companies
after protectionism creates an incentive for all those
affected by US protectionism to rally behind trade
restrictions for their own countries. Foreign companies and
workers will too demand price caps and other trade
restrictions for the same purposes of stimulating their own
economy. This creates even greater price increases, and thus
falls in aggregate demand for the American Economy and those
economies abroad.

One can make the argument that these restrictions, will
create American jobs and cause American firms to redevelop.
As shown, this argument ultimately ignores the additional
costs supplanted by foreign protectionism resulting from
American protectionism. It also ignores additional problems –
foreign investment in the American economy, and access to
global consumer demand after foreign protectionism.

When American products go abroad so does American cash. This
money supply of American dollars abroad creates an incentive
for foreigners to invest in American companies and US
government bonds. The real interest rate in the American
credit market will rise as a result of a decline in American
exports, and thus foreign investment in the American
economy. This means, that the supply side of the American
economy can also be affected by protectionism abroad. All in
all, the net affects of a decline in the demand and supply
side of the American economy can have drastic stagflationary

The issue that worries me the most with the idea of
restricting trade to the US in an effort to create jobs at
home, is that companies may experience a negative change in
profits after being pushed out the market from foreign
protectionism. Companies will have to limit their production
abroad and focus more on the domestic market – likely a
smaller market for most companies. Since firms will have to
reduce their size to accommodate only a domestic market, it
may imply net zero affects and possibly negative affects for
firms, and thus jobs at home.

Jobs at home from foreign protectionism, and jobs abroad
from domestic protection, can also be negatively affected
due to the neglect of comparative advantages. We just might
be better at producing something than someone else, but
that “someone else” might be better at producing something
else. In the end, we both lose out on maximizing our
efficiency and its related benefits.

All in all, consider the impact of our trade restrictions on
other countries, their resulting trade restrictions on us,
and the loss of efficiency from the implicit limits on
everyone's comparative advantages.

Christopher Espinal is a regular contributor to
and an economics student at the University of Chicago. He can be reached at

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