Protectionism, what is it and how does it impact trade?

With the topic once again in the media lime light, its seems appropriate to discuss protectionism in this post. However, this rather advanced economic concept is best understood if we take a few steps back first.

Before looking at the ins and outs of protectionism, we first have to understand the concept of trade. The idea of trade, and why we don't just all make everything we need ourselves, goes back to an economic theory called "comparative advantage". Developed by economist David Ricardo in 1817 it sets up a scenario in which two people make two products and need different amounts of time to make them. While I could write out the example and go through it step by step, it probably makes more sense for you to go here and watch the video, or go here for the super in depth Wikipedia explanation.

Now that we understand the underpinnings of why we trade, we take a look at how comparative advantage applies to the real world. We see that, like most economic theories, it does hold true; Singapore is known as the banking hub of Southeast Asia, but you won't find it ranked highly on the list of the largest grain producers in the world. Nevertheless, we can't give Mr. Ricardo too much credit, because if you look closely, some flaws start to emerge in his theory. Why is it, for example, that the USA both exports and imports coal? Surely if ole' Dave was right then it would be one or the other? Well, as is so often true, economic theories are just that, theories. They make sweeping generalizations and an abundant use of assumptions, ultimately taking some of the real world aspects out of the equation.

So where does that leave us on trade and protectionism? Well, if you need to know one thing about economists it's that they never pass up the chance to build a new and improved theory or model that attempts to revolutionize the way of thinking on a given topic. Cue Eli Heckscher and Bertil Ohlin. These guys did just that, they took the concept of comparative advantage and built on it. And yes, you guessed it, they named the outcome the Heckscher-Ohlin model (the second thing to know about economists is that they have huge egos). Often abbreviated to just the H-O model (bet they hate that), it tackles the real world applicability of David Ricardo's rather simple example. Though there is a ton of math involved (click

for a video that goes pretty in depth), essentially the model introduces the idea of something called "factors of production" which are nothing more than: land, labor, and capital (sometimes entrepreneurship is included too, but lets keep it simple).

Eli and Bertil go on to state that any economy will produce, and consequently export, goods and services that utilize the factors of production that the economy has in the most abundance. Woah, what on earth does that mean? Well, going back to our previous example, Singapore is an island nation of only 276 square miles (716 square km) which works out to roughly half the size of Los Angeles, but has lots of capital in the form of office buildings and top-notch software. The H-O model would take a look at this and come to a clear conclusion: it makes the most sense for Singapore to focus on things such as banking or tech startups because those need a lot of capital, what Singapore definitely should not focus on is anything that requires land. Aha, that makes sense...but unfortunately as you may have gathered, even the H-O model has its limitations. For example, the US is well known for its (in)famous investment banks, but is also home to huge farms that span miles and miles.

So now that we have a pretty solid understanding of economic trade theories, lets get back on track. Protectionism is of course the idea that trade is not good for your economy and you wish to suppress it. This can be done a number of different ways.

1) Taxes (also called tariffs): If you make Japanese manufactures pay a 45% tax on exporting their motorcycles, do you think they will keep 'em rolling? Probably not since your domestically produced motorcycle now looks much cheaper in comparison (this was actually a real thing back in the 80's).

2) Quotas: The less popular brother of tax, a quota is just a set number of a specific good that is allowed to be imported in a given time frame (usually a year). If there is a quota that your economy will only allow 5,000 Swiss wheels of cheese each year, after those are devoured by the end of January, that's it, no more until next year

3) Embargoes: The US until recently had an embargo on Cuban cigars. This meant that, legally, not a single Cuban cigar was allowed to be exported. This most extreme form of protectionism is rarely seen in today's world, and when it is, the reason is usually economic punishment (such as Iranian oil sanctions) to the recipient of the embargo rather than utilizing it as a form of protectionism.

4) Domestic subsidies: This is a tricky one. If two economies make the same $1 product that costs $0.50 to make and the government of economy A decides to institute a domestic subsidy of $0.15 per unit, then the producers in economy A could either lower the price of the product or make more of the product at the same cost (or a bit of both). Either way, the producers in economy A would be able to sell more, leaving the non-subsidy-receiving producers in economy B with the short end of the stick.

Now, all of these measures essentially do the same thing, they stem the flow of trade between economies. While it may be good for Joe, the ailing car laborer that the factory he works for isn't being moved to China (where his job would be filled by someone being paid a quarter of his salary) because it would mean paying a tariff on the car when it is imported into the country, an economist would argue that this is wrong. In the greater-picture, Joe should lose his job, retrain as a robotics engineer and found a company that automates the process of car manufacturing. This would be making use of abundant factors of production and create efficiency. Then again, Joe probably doesn't want to hear that, he wants to keep his job, and so he is in favor of protectionism.

There are more arguments to be made on either side, but honestly, you could probably write a book on the subject (oh wait, somebody already did). Each debate whether to implement protectionism or reduce it has its own nuances. One thing though is certain, it is always better to be well informed about a topic, especially when everyone and their grandmother are talking about it. So next time someone asks you about what you think about protectionist measures your local politician is suggesting, introduce them to your three new friends Ricardo, Heckscher, and Ohlin, and given them background knowledge so that they too can partake in the great joy that is the field of economic trade theories!

Happy trading!