Domestic and global economies

Globalisation refers to the process of increased integration between nations as traditional barriers separating economies are broken down, leading to the formation of a global economy. A key aspect of the move towards globalisation in recent decades has been reducing protectionism. Protection refers to any type of artificial advantage that a government gives to its domestic industries.

There are a number of different types of protection, including embargoes, subsidies, quotas, export incentives, voluntary export restraints and local content rules, although the most common form is the tariff (a government tax on an import). The removal of protection results in free trade, which occurs when there are no restrictions to the free movement of goods and services between economies. There are a variety of reasons for which nations reduce protection levels, mostly focused on achieving increased efficiency and productivity levels, and this can have a number of impacts on the domestic and global economy.

The main reason for reducing levels of protection ties in with David Ricardo's Law of Comparative Advantage. This law arises because of differences in factors of production (land, labour, capital, enterprise): as countries differ in both the quality and quantity of the resources at their disposal, a country may lack the appropriate factor endowment to produce desired goods. Free trade enables these goods to be obtained.

Ricardo's law of Comparative Advantage states that, even if one country has an absolute advantage in producing all goods over another, each country will gain from trade providing each specialises in the production of that good in which it has a comparative advantage, or lower opportunity cost, in producing. If a country produces to its comparative advantage, the LRASC (long run average supply curve) will move to the right. It will also lead to reduced costs of production as nations move towards economies of scale.

As illustrated above, reducing protection will increase the technical efficiency of an economy's industries, lowering average costs of production. It will also increase allocative efficiency as resources are allocated to more efficient producers. This will raise income levels and increase efficiency and productivity, and promote structural change. International competitiveness will improve as domestic businesses face greater competitive pressures from overseas producers. It encourages innovation and the spread of new technology and production processes around the world.

Reduced levels of protection will also lead to higher living standards and higher rates of economic growth as a result of lower prices, increased production of goods and services and greater consumer choice. Comparative advantage is still promoted by the World Trade Organisation (WTO) as the primary reason for all countries to embrace freer trade and international specialisation. 

A second reason for reducing protection levels is pressure from the global economy. The main institution encouraging free trade is the WTO, and economies face considerable pressure from the WTO to lower its trade barriers. Nations also face pressure from other economies, which may retaliate to high protection levels by implementing protectionist policies themselves, thereby restricting access to overseas markets.

Reduced levels of protection have a dramatic impact on the domestic economy, an effect which can be illustrated using the tariff diagram shown below. A tariff, the most common form of protection, is a government imposed tax on an import. It makes the import more expensive, giving domestic producers a greater market share. 

If a tariff of PWP1 is removed, it will have a number of impacts on the domestic economy. The government will lose revenue of abcd. The quantity of imports will increase from Q1Q2 to Q3Q4 while domestic supply will contract from OQ3 to OQ1, reducing domestic production and employment.

The price of the good will drop from P1 to PW, meaning inflationary effects are reduced. This forces domestic industries to become more competitive and provides them with incentive to innovate and use new technologies. Domestic demand will expand from OQ2 to OQ4. Consumers pay less, redistributing income aed from producers to consumers and raising the standard of living. Resources in the domestic economy are better allocated, moving away from inefficient industries towards more productive and competitive industries. Thus, the dynamic, technical and allocative efficiency of the domestic economy increases.