Globalisation, free trade and protection | IGCSE Class 10 Economics Notes

This note covers the meaning of globalisation, the role of multinational companies (MNCs) and the costs and benefits they bring to host and home countries, the benefits of free trade for consumers, producers and the economy, the methods of protection (tariffs, import quotas, subsidies and embargoes), the reasons governments protect industries (infant industry, declining industry, strategic industry and avoidance of dumping), and the consequences of protection for the home country and its trading partners.

What is globalisation?

Globalisation is the process by which countries become more closely linked through trade in goods, trade in services, flows of investment, movement of capital and, to a lesser extent, the movement of people. It is the rapid integration of national economies into one interconnected world economy.

Definition: Globalisation. The process of increasing economic interdependence between countries through growing trade, investment and the activities of multinational companies, so that events in one part of the world increasingly affect production, prices and jobs elsewhere.

Two features sit at the heart of globalisation: the integration of production, where a single good is manufactured in stages spread across several countries, and the integration of markets, where the same goods are bought and sold in many countries so that similar products compete against each other wherever they are made.

A garment company, for example, may source cotton fibre in one country, have the cloth woven in a second, cut and stitch it in a third and sell the finished shirt under a single brand in many markets at once.

Several factors have made this possible: much faster and cheaper transport (so that containers can be loaded straight onto ships, trains, lorries and aircraft, cutting handling costs and delivery times); huge improvements in telecommunications and the internet, which let a firm design a product in one country, manufacture it in a second and run its customer service from a third; and the liberalisation of trade and investment policy, discussed later in this note, which removed many of the barriers that used to stop goods, money and firms crossing borders freely.

What is the role of multinational companies (MNCs)?

A multinational company (MNC) is a firm that owns or controls production of goods or services in more than one country.

MNCs are the main driving force behind the globalisation of production: they look for locations where labour and other resources are cheap, where they are close to large markets, and where government policy is favourable, and then set up offices and factories there.

Definition: Multinational company (MNC). A company that owns or controls production of goods or services in two or more countries, often spreading different stages of manufacture across several locations to reduce costs.

MNCs interlink production across countries in several distinct ways.

1. They set up their own new factories or offices in a country where conditions are favourable for production.
2. They enter joint production arrangements with local companies, bringing investment and newer technology while the local partner provides existing plant and market knowledge.
3. They buy up existing local companies, which is the most common route, and then expand the production the local firm already carries out.
4. They place orders for production with independent small producers, such as garment, footwear or sports goods makers, and then sell the finished output worldwide under their own brand name, controlling price, quality and delivery conditions.

Whichever route an MNC takes, it gains tight control over production at the distant location while bearing little of the direct cost of building capacity from scratch, and the local economy gains new investment, technology and employment, though usually on terms set largely by the MNC.

What are the benefits and costs of MNCs to host countries?

Advantages for a host country

A host country is the country in which an MNC sets up production, away from its own home base.

Benefits to the host country include new investment in land, buildings and machinery; the transfer of modern technology and management skill; new jobs, both in the MNC's own plant and in local firms that supply it with raw materials and components; and, where the MNC's products are exported, extra foreign exchange earnings for the host economy.

For example, when a foreign car maker builds a plant in a developing country in partnership with a local vehicle manufacturer, the plant creates jobs directly and among local component suppliers, sells cars in the host market, and may also export cars and engines to other countries, bringing in foreign exchange for the host economy.

The host country also often gains from the knock-on growth of its own firms, some of which eventually become multinationals themselves once they have built skills and capital through supplying or competing with MNCs.

Limitations for a host country

Costs to the host country include the pressure placed on small local producers who cannot match the lower prices or wider designs offered by MNC brands or by cheap imports, forcing many small units to shrink or close.

For example, when a large foreign MNC buys a local company that has built a well-known brand and its own production plants, it gains the local firm's marketing network and capacity; output and jobs may continue under the new owner, but the local company no longer operates independently.

Workers can also lose out: to keep costs low, employers increasingly hire staff only on a temporary basis, without the job security, insurance or paid leave that permanent workers once had, so the gains of growth are shared unevenly between well-off consumers and skilled staff on one side and small producers and insecure workers on the other.

A host government may also feel pressure to relax labour or environmental rules, or to offer long tax holidays, in order to attract or retain foreign investment, which can reduce its own tax revenue and bargaining power.

What are the benefits and costs of MNCs to home countries?

The home country is the country in which an MNC is based and from which it originally grew, even though much of its production may now take place abroad.

The home country benefits because profits earned abroad are often repatriated to the parent company, strengthening its finances and allowing it to invest further at home; the company's exports of components, equipment or head-office services (such as design, finance and research) also continue to support jobs in the home country; and a strong global MNC adds to the economic weight and reputation of its home economy.

There are costs, too. When an MNC moves production abroad in search of cheaper labour, some jobs that used to be done in the home country disappear, particularly in manufacturing and, increasingly, in services that can be carried out remotely such as data entry, accounting or call-centre work.

Workers in the home country who are displaced in this way may need retraining to move into other work, and the home economy can become more dependent on a small number of very large firms whose decisions about where to locate production are made with the interests of shareholders worldwide in mind, not just the interests of any one country.

What are the benefits of free trade?

Free trade is trade between countries that takes place without tariffs, quotas or other government-imposed barriers, so that goods and services move across borders on the same terms as they move within a country.

Definition: Free trade. International trade conducted without tariffs, quotas, subsidies or other restrictions, so that buyers and sellers in different countries compete on equal terms.

Advantages of free trade for consumers, producers and the economy

For consumers, free trade widens the choice of goods available and tends to lower prices, because buyers are no longer limited to what domestic producers make.

When cheaper imported goods enter a market, buyers gain a wider range of designs and lower prices than before, and the standard of living of consumers who can take advantage of this choice rises.

For example, when foreign manufacturers begin exporting toys to a country at lower prices and in new designs, buyers there gain a wider choice between domestic and imported toys; shops may soon replace many domestic toys with the cheaper imports, and toys overall become cheaper. Free trade widens choice and lowers prices for consumers even while it reduces sales for domestic producers of the same good.

For producers, free trade opens up markets far beyond the domestic economy: a firm can sell its output not only at home but also compete for sales in other countries, which allows efficient producers to grow larger and benefit from economies of scale.

Facing competition from imports can also push domestic firms to raise quality, adopt better technology and cut costs, since firms that fail to do so lose sales to more efficient rivals.

For the wider economy, free trade connects markets across countries so that prices of similar goods in different countries move closer together, and resources tend to be used where they are most efficiently employed.

One country's efficient producers can supply a good to the whole world, while that country, in turn, imports goods that other countries make more efficiently, raising total output across the countries that trade.

The gains appear in very different kinds of country. A small, open economy such as Singapore relies on free trade both for most of the goods its people consume and for the markets its exporters serve. Developing economies such as Bangladesh and Vietnam have used open export markets to build garment and electronics industries that employ millions of workers. And consumers in high-income countries such as the United Kingdom pay less for clothing and electronics imported from lower-cost producers.

Free trade can also attract foreign investment and technology into a country, and can allow some domestic firms to grow strong enough to become multinationals in their own right, expanding their own exports and global presence.

However, free trade does not benefit everyone equally within a country. Competition from imports can be severe for small or older domestic producers who cannot match the price or scale of larger foreign rivals, so free trade usually has to be weighed against these losses, which is one reason some governments choose to protect selected industries rather than allow completely free trade in every sector.

What are the methods of protection?

Protectionism is the deliberate use of government measures to shield domestic producers from foreign competition, usually by making imports more expensive, scarcer or less attractive than domestically made goods.

Definition: Protectionism. Government policy that restricts or discourages imports in order to protect domestic producers from foreign competition, commonly through tariffs, quotas, subsidies or embargoes.

A tariff is a tax placed on imported goods. The tariff raises the price that buyers must pay for the imported good, so demand for it falls and domestic producers of the same good become more competitive by comparison.

An import quota is a physical limit on the quantity of a good that may be imported in a given period; once the quota is reached, no more units of that good may legally enter the country, whatever price buyers are willing to pay.

A subsidy is a payment made by the government to domestic producers, which lowers their costs and allows them to sell at a lower price than they otherwise could, so that they can compete with cheaper imports without raising their own prices.

An embargo is a complete government ban on trade, usually in a particular good or with a particular country, so that none of the good may be imported (or exported) at all.

Note: Protection in practice. If a government places a tax on imported toys, buyers of the imported toys must pay a higher price, so demand for the cheaper imports falls, imports of that good automatically reduce, and domestic toy makers who had been losing sales to the cheaper imports can prosper again.

What are the reasons for protection?

Governments give several justifications for protecting industries rather than leaving markets fully open to free trade.

The infant industry argument holds that a new industry, still establishing itself, cannot yet compete with large, experienced foreign producers, so it needs temporary protection while it grows large enough and gains enough experience to compete on equal terms.

Many newly independent developing countries gave their new industries this kind of protection in the 1950s and 1960s, because competition from established foreign producers at that early stage would not have let them become established at all; essential items such as machinery, fertilisers and petroleum were usually still allowed in, while many other new domestic industries were protected until they matured.

Definition: Infant industry argument. The case for temporarily protecting a new industry from foreign competition until it grows large and efficient enough to compete without help.

A declining industry may also be protected, where an established industry is losing out to cheaper foreign competitors and the government wishes to slow its contraction, giving workers and firms time to adjust, retrain or relocate rather than face sudden mass job losses.

A strategic industry, such as one supplying energy, food, defence equipment or other goods a country considers essential to its security or self-sufficiency, may be protected even if it is not the cheapest source, because a government does not wish to depend entirely on foreign suppliers for something so important.

Avoidance of dumping is another reason for protection. Dumping occurs when a producer, often supported by large government payments at home, sells surplus output in another country's market at a price below what it costs to produce, undercutting local producers who cannot survive at such low prices.

Farm producers that receive very large sums of support from their own government can sell their surplus output abroad at abnormally low prices, and this adversely affects farmers in the countries that receive those low-priced exports; protection against such dumping is intended to stop domestic producers being driven out of business by artificially cheap imports.

Definition: Dumping. Selling a good in a foreign market at a price below its cost of production, often made possible by government subsidies at home, which can drive local producers in the importing country out of business.

What are the consequences of protection?

Limitations of protection

Protection can be effective in the short term at shielding the industry it targets, but it carries costs both for the home country and for its trading partners.

In the home country, consumers usually face higher prices and less choice than they would under free trade, because the cheaper or more varied imports that protection restricts are no longer freely available; this is the mirror image of the earlier toy example, where a tax on imports let domestic toy makers prosper but reduced the choice and raised the prices faced by domestic buyers.

Protection can also reduce the pressure on domestic firms to become efficient, since they no longer have to match the price or quality of foreign rivals; industries that are protected for too long may fail to modernise, so when protection is eventually removed they can struggle badly against competition they are no longer used to facing.

This happened to small domestic producers who had grown used to supplying components under earlier import restrictions: once those restrictions were lifted as part of a trade agreement, many of their main customers switched to importing the same part at roughly half the price, and a number of the small producers saw their output fall by more than half and were forced to cut their workforce sharply.

For a country's trading partners, protection reduces the market available to their exporters, since the protecting country now buys less of the good from abroad.

This can provoke resentment or retaliation: exporting countries may argue that protection in their trading partner is unfair, especially where the protecting country itself demands that other countries remove their own barriers while retaining protection for its own producers, such as continuing to support its farmers heavily while asking other countries to stop supporting theirs.

Whether protection is ultimately effective for the home country as a whole, therefore, depends on how long it lasts, whether it is matched by genuine efforts to make the protected industry competitive, and how trading partners respond.

Going beyond the syllabus

Beyond the specific tools covered above, the World Trade Organization (WTO) is the international body most often involved in disputes over protection: founded with the aim of making trade freer by getting member countries to remove barriers, it is widely seen as applying this aim unevenly, since developing countries have often been pushed to remove their own barriers while some developed countries kept barriers of their own, for example continuing to support their farmers with large payments.

Some governments have also tried to attract more foreign investment directly, for instance by setting up special industrial zones with world-class infrastructure and tax holidays for the companies that locate there, and by allowing firms more flexibility over how they employ workers, though this last step can weaken the job security and benefits that workers in the formal sector previously enjoyed.

These wider debates sit alongside, rather than inside, the core syllabus points on globalisation, free trade and protection.

Glossary

• Globalisation — the growing integration of national economies through trade, investment and the activities of multinational companies.
• Multinational company (MNC) — a firm that owns or controls production of goods or services in more than one country.
• Host country — the country in which a multinational company sets up production away from its own base.
• Home country — the country in which a multinational company originated and is based.
• Free trade — trade between countries without tariffs, quotas or other government-imposed barriers.
• Protectionism — government measures that restrict imports to shield domestic producers from foreign competition.
• Tariff — a tax placed on imported goods, raising their price to buyers.
• Import quota — a physical limit on the quantity of a good that may be imported in a given period.
• Subsidy — a government payment to domestic producers that lowers their costs of production.
• Embargo — a complete government ban on trade in a good or with a particular country.
• Infant industry — a newly established industry that has not yet grown large or efficient enough to compete with foreign producers.
• Declining industry — an established industry losing out to cheaper foreign competition, sometimes protected to slow its contraction.
• Strategic industry — an industry considered essential to national security or self-sufficiency, such as energy or defence.
• Dumping — selling a good abroad below its cost of production, often enabled by government support at home.
• Liberalisation — the removal of government restrictions on trade and investment between countries.

Common errors and misconceptions

• Misconception: an MNC's host country and home country are the same thing. Correct: the home country is where the company originated and is based; the host country is any other country in which it sets up production.
• Misconception: an import quota and a tariff do the same job in the same way. Correct: a tariff works by raising the price of an import through a tax, while a quota works by limiting the physical quantity that may enter, regardless of price.
• Misconception: free trade benefits every producer in every country equally. Correct: free trade tends to benefit efficient, competitive producers and consumers generally, but can seriously harm small or inefficient producers who cannot match foreign prices.
• Misconception: protection always helps the industry it protects in the long run. Correct: protection can let an industry avoid the pressure to modernise, so it may struggle once protection is removed, as happened when earlier import restrictions on certain components were lifted.
• Misconception: dumping just means exporting a lot of a good to another country. Correct: dumping specifically means selling that good abroad at a price below its cost of production, usually made possible by subsidies at home.
• Misconception: only developing countries protect their industries. Correct: developed countries also protect industries, for example by continuing to pay large subsidies to their own farmers while pressing other countries to remove their barriers.
• Misconception: a subsidy and a tariff are the same kind of trade barrier. Correct: a tariff taxes imports directly, whereas a subsidy supports domestic producers' costs so they can compete without the price of imports being taxed at all.

Exam-style questions with model answers

Q1. Define 'free trade'. [2 marks]

1. Trade between countries carried out without tariffs, quotas or other government-imposed barriers.
2. So that goods and services move across borders on broadly the same terms as domestic trade.

Q2. Identify two methods of protection other than tariffs. [2 marks]

1. Import quotas, which limit the physical quantity of a good that may be imported.
2. Subsidies to domestic producers, which lower their costs so they can compete with cheaper imports.

Q3. Country A's government has decided to place a tariff on imported furniture to protect its small domestic furniture makers from cheaper imports. Explain two likely effects of this tariff on consumers in Country A. [4 marks]

1. The price that consumers pay for imported furniture will rise, because the tariff adds to its cost.
2. Many consumers will switch to buying domestically made furniture instead of the now more expensive import.
3. Consumers will have less choice overall, since the range of imported designs previously available becomes more expensive to access.
4. Lower-income consumers who relied on cheap imported furniture will be worst affected, as they have less room in their budget to absorb the higher price.

Q4. Explain two reasons why a government might protect a declining domestic industry rather than allow it to shrink through free trade. [4 marks]

1. Protection can slow the loss of jobs in the industry, giving workers time to retrain or find alternative employment rather than losing jobs suddenly.
2. It can give firms in the industry time to restructure, modernise their equipment or find new products, rather than closing immediately under full foreign competition.
3. A government may be concerned about the wider social and regional effects of sudden job losses, such as rising local unemployment and falling local spending.
4. Keeping some domestic capacity in the industry may be seen as useful even in decline, for example to preserve some skills or supply in case foreign sources become unreliable.

Q5. Country B exports a large quantity of subsidised wheat, which is sold in Country C's market at a price below Country B's own cost of producing it. Analyse the effects of this on wheat farmers and wheat buyers in Country C. [6 marks]

1. This is an example of dumping, since the wheat is being sold below its cost of production because of the subsidy it receives.
2. Wheat buyers in Country C gain in the short term, because they can buy wheat at a lower price than domestic wheat farmers can profitably charge.
3. Domestic wheat farmers in Country C face falling sales, as buyers switch towards the cheaper imported wheat.
4. Falling sales reduce the income of domestic wheat farmers, and some may be forced to leave farming altogether if prices stay this low for long.
5. If enough domestic farmers exit the market, Country C could become more dependent on imported wheat in the future.
6. This dependence could leave Country C's wheat buyers exposed to higher prices later, if Country B's subsidy or exports are reduced once domestic competition has been eliminated.

Q6. Discuss whether or not a government should use an import quota, rather than a tariff, to protect its domestic car industry from cheaper foreign cars. [8 marks]

1. A quota gives the government direct control over the exact physical quantity of foreign cars entering the market, which a tariff does not, since buyers can still import as many cars as they wish under a tariff provided they pay the tax.
2. This makes outcomes for domestic car producers more predictable under a quota, because foreign competition is capped once the quota limit is reached.
3. However, a quota does not raise any government revenue, whereas a tariff brings in tax revenue that the government can use elsewhere.
4. Once the quota limit is reached, the price of the remaining imported cars can rise sharply, since supply is fixed regardless of demand, which may hurt consumers more than a tariff would.
5. A tariff allows the market to adjust more smoothly, since demand and supply can still interact through the price mechanism, whereas a quota creates a hard cut-off.
6. Both tools reduce the competitive pressure on domestic car producers to improve quality or cut costs, which could weaken the industry's efficiency over time regardless of which tool is chosen.
7. Trading partners exporting cars to this country may object to either measure, but a strict quota that completely blocks additional imports once reached may provoke stronger retaliation than a tariff that still allows some trade to continue.
8. Overall, a quota may suit a government that wants certainty over the exact level of import penetration, but a tariff is likely to be the less disruptive and more flexible tool, and is generally preferable unless strict control over quantity is essential.

Q7. Explain two reasons why a newly established domestic industry might need protection from foreign competition. [4 marks]

1. A new industry has not yet built up the scale of production, skills or experience that established foreign competitors already have, so it cannot match their prices or quality straight away.
2. Without any protection, the new industry could be driven out of the market by established foreign producers before it has a chance to grow at all.
3. Temporary protection allows the new industry time to invest in better equipment and train its workforce, raising its efficiency towards the level of its foreign competitors.
4. Once the industry has matured and can compete on its own terms, protection can be withdrawn, having served its purpose of giving the industry a start.

Key takeaways

• Globalisation is the growing integration of national economies through trade, investment and the activities of multinational companies.
• Multinational companies interlink production across countries by setting up new plants, forming joint ventures, buying local firms, or placing orders with independent small producers.
• Host countries gain investment, technology and jobs from MNCs, but small local producers and insecure workers can lose out.
• Home countries benefit from repatriated profits and continuing exports, but can lose jobs when production moves abroad.
• Free trade widens consumer choice, lowers prices and lets efficient producers reach larger markets, but harms producers who cannot match foreign prices.
• Tariffs, import quotas, subsidies and embargoes are the main methods governments use to protect domestic producers.
• Protection is commonly justified by the infant industry argument, by the decline of an established industry, by the strategic importance of a good, or to prevent dumping.
• Protection can shield an industry in the short term but may reduce its incentive to become efficient, hurting consumers and trading partners alike.

Test yourself

What does it mean to say a company is multinational?

It owns or controls production of goods or services in more than one country, rather than operating only within its home country.

Why might a host country welcome MNC investment even though small local producers may suffer?

MNCs bring new investment, technology, skills and jobs, and can raise consumer choice and quality, which the government may judge to outweigh the harm to small producers.

How does a tariff differ from a subsidy as a method of protection?

A tariff taxes imports directly to raise their price, while a subsidy lowers domestic producers' own costs so they can compete without the imports being taxed.

Give one reason a government might protect a strategic industry even if it is not the cheapest source of the good.

It may not wish to depend entirely on foreign suppliers for a good it sees as essential to national security or self-sufficiency, such as food, energy or defence equipment.

What is dumping, and why is it harmful to producers in the importing country?

Dumping is selling a good abroad below its cost of production, often because of subsidies at home; it undercuts local producers who cannot survive at such low prices.

Name one cost that free trade can impose on an economy even though it generally widens choice and lowers prices.

Domestic producers who cannot match foreign prices or quality may lose sales, shrink or close, leading to job losses in the affected industry.

Why might protection make a domestic industry less efficient over time?

Because it reduces the competitive pressure to cut costs or improve quality, the protected industry may fail to modernise, struggling once protection is eventually removed.