Free trade on the global scene is the same as trade within a market. There is a supply and a demand for goods. Nothing complicated.
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 do 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 larger in the global market, or supply is relatively scarce for a resource in the global market than in the micro-market. An increase in demand from opening borders may make 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 a 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 market.
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 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 that will produce a net zero or negative effect. All goods that dropped in prices with international trade will face price increase. All imported goods, that now must incur taxation or supply caps, will face price increases as well. 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 their 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 additional drops 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 consequences.
Here is an issue that worries me the most with the idea of restricting a market's scope to the US in an effort to create jobs: companies may experience a negative change in profits after being pushed out the market from the resulting foreign protectionism. American 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. Firms that were able to take advantage of economies of scale in the global market will be badly hit.
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. This protectionism will end with the need of eliminating jobs at home.
All in all, one must consider the impact of our trade restrictions on other countries, their resulting trade restrictions on us, and the loss of efficiency from the implicit and consequential limits on comparative advantage.©2009 Jeff Peters, all rights reserved. You must have written permission from the author in order to republish this work.
Published: Wednesday, February 11, 2009
Last modified: Monday, May 4, 2009
The views expressed in this article are those of Jeff Peters only and do not represent the views of Nolan Chart, LLC or its affiliates. Jeff Peters is solely responsible for the contents of this article and is not an employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.
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