Is free trade the best economic policy that countries can adopt or is protectionism ever justified?

Protectionism versus Free Trade Policy.

It has been vehemently argued that the comparative advantage theory that had been put into place by Ricardo, is in fact a classical economic theory, however, its application to the modern day world is illogical and impractical. It is stated that theory initially aimed to encompass the movement of capital and products that were immobile between nations, and cannot be therefore extended to the application of free trade of goods across nations[1]. The movement of capital as was the initial encompassing intention will invariably flow to the nation where the costs are lowest in comparison in order to achieve an absolute advantage. A successful example of such a notion is the shifting of production plants to Mexico by various American companies including Hershey Chocolate[2].

Strategic Trade Policy.

A comparatively new idea to the notion of protectionism, strategic trade policy argues that in imperfect market globally, certain industries may be earning a higher return on investment then their initial cost that have been employed on resources. Where economies of scale are sufficiently larger in an industry and allows only the operation of one more entrant that may gain profit, where two entrants will penetrate the market, both will not only incur the initial losses but only one firm that has been able to establish itself within the industry will be able to earn a normal amount of return on investment. Brander and Spencer, 1985, state that in order to restrict foreign firms for competing within a lucrative market, the government must put into place subsidised approach to exports and restrictions on imports[3]. The term strategic trade policy entails the strategic placement of polices by the government to serve a form of oligopolistic competition.

Furthermore, by adopting this strategic position the government can support their own local firms in an era of international competition and therefore such a position would result in the enhancement of the particular nation’s welfare but on the expense of the foreign industry[4]. One way of achieving this strategic position is the imposition of subsidies; this would result in the protection of a market that is capable of producing good quality products, thereby enhancing the profits of the domestic market and reducing the profits of the foreign industry. In some instances, where both the local and international firms may enter the same market segment, through the application of subsidized exports, foreign market entry can be prevented and the domestic market can then be allowed to gain benefit from the excess return[5].

Also, it has been argued by various economists that such an approach to trade would invariably lead to encouragement of exports resulting in higher foreign exchange and an increase in the national income of the country. However, on the other hand, it is also argued by various economists, despite the attraction of the strategic policy, that it forms the basis of an actual intervention.

External Economies.

The concept of external economies is old in the theory deviating from the application of free trade and promulgates the notion that positive external economies can be achieved through encouraging activities that yield the same. The notion of positive external economies is a component of the traditional trade policy. Empirically, it seems that the best source for a positive external economy is through the inability of an innovative firm to fully appropriate the knowledge that they have created themselves[6]. This is most apparent in the case of extreme technological advancement, where the companies are constantly looking and examining the products of rival companies to decipher how a certain product was manufactured and currently operates. The emphasis placed on external economies has its basis on the same reasoning as the strategic trade policy, whereby the government should target particular sector, however, one strong distinguishing factor between the two theories is that emphasis on one particular industry sector that results in external economies does not affect other countries adversely. The positive or negative effect on other countries is dependent upon the externality sector being national or international. There is a constant struggle between nations as to who specifically will recognize these externalities.

Moreover, an externality can become the source of a conflict of interest internationally, however, various changes in the trade pattern have been identified which has resulted in the aforementioned struggle by nations for recognition of the externalities[7]. Such an argument results in doubting the current approach which requires deviation from the free trade policy because it requires a substantially respectable rationale for such an encumbering deviation.