The term free flow of goods and services is only theoretical in nature. In the real world, there are certain restrictions and agreements that work in favor of or against the free flow.

1.1.         Restrictions on Trade and Capital Flows

a.  A tariff is a tax levied by a government on imported goods. It is mainly intended to protect domestic industries within a country.
Tariffs mainly increase the welfare of the domestic country if

     i.  there is no retaliation and

    ii.  the deadweight loss is less than the benefit from improving trade.

b.  An import quota is a restriction on the quantity of a good that can be imported. It is controlled by import licenses.
Importers earn quota rents if they charge a higher price with a quota.

c.  A voluntary export restraint (VER) is a voluntary limit on goods exported to a specific country. It allows the exporter to earn quota rents.

d.  An export subsidy is a payment by a government to a firm when it exports a specified good. It encourages firms to shift to export goods, increases the domestic price.

e.  Embargoes are the economic weapons used to restrict trade or any commercial activities with a particular country.

f.  There are domestic content requirements that also restrict the trade.

g.  The restrictions are imposed on the free flow of trade in order to:

      i.  protect the established and new domestic industries within a country,

    ii.  protect domestic employment,

   iii.  for national security reasons,

   iv.  generate revenues, and

    v.  close trade deficits.

h.  Domestic content provisions are requirements that a specific portion of value-added or components be produced domestically.

i.  Capital restrictions are controls placed on ownership of assets, either of foreign assets or of ownership of domestic assets by foreign persons or firms. It limits the openness of the financial markets.

j.  The effect of restrictions on trade and capital depends on whether the country is a price taker or can affect the price:

     i.  A small country in the context of international trade is a price taker.

    ii.  A large country in this context can influence the price.

1.1.1.     Impact of Tariffs on the Economy

a.  The impact of tariffs on the economy can be analyzed with the help of the following diagram:

b.  We know that the opening up of the economy decreases the prices of a commodity and creates a demand-supply gap for it.

c.  So, when we raise the tariffs for the same, the price of the commodity increases to P_t, reducing the demand-supply gap.

d.  As a result of an increase in the tariffs:

     i.  There is a loss of surplus-value for the consumer which equals the area covered by A+B+C+D in the above diagram.

    ii.  There is a gain in the surplus-value to the producer, which equals the area A in the above diagram.

   iii.  There is revenue in form of the tariff to the government, which equals the area C in the above diagram.

   iv.  And, there is a deadweight loss equal to area B+D in the above diagram.

1.1.2.     Impact of Quotas on the Economy

a.  Quotas also have a similar impact on the economy.

The imposition of quota restrictions raises the prices of the product upwards to P_t, reducing the demand-supply

b.  As a result of quota restrictions:

     i.  There is a loss of surplus-value for the consumer which equals the area covered by A+B+C+D in the above diagram.

    ii.  There is a gain in the surplus-value to the producer, which equals the area A in the above diagram.

   iii.  There is a quota rent earned by the government, which equals the area C in the above diagram.

   iv.  And, there is a deadweight loss equal to area B+D in the above diagram if the quota rent is captured by the importing country.

    v.  However, if the quota rent is captured by the exporting country, then the deadweight loss equals B+C+D.

c.  Sometimes, the exporting country agrees to put a voluntary export restraint (VER), instead of importing country having to put the quota restrictions. In such a case, the effect is the same as that of quota restriction, but the exporter captures the quota rent.

1.1.3.     Export Subsidy

a.  The export subsidy is meant to encourage exports. It is a direct payment from the government to the producer.

b.  Due to the export subsidy, the producer shifts the sales to the export markets and gets the price plus the subsidy as the revenue.

c.  Also, the producer now has no incentive to sell in the domestic market for any price less than the original price plus the subsidy.

d.  Thus, resultantly if the exporter is a small country, i.e. the price taker which cannot influence the price, the producer receives a higher price which includes the subsidy and the consumer also end up paying a higher price.

e.  If however, the exporter is a large country, the exports will depress the world price, and:

     i.  the producer receives a lower price plus the subsidy,

    ii.  the consumer still pays the same original equilibrium price plus the subsidy.

In this case, some part of the subsidy is now transferred to the rest of the world.

1.1.4.     Summary of the effects

The restrictions on trade and capital have effects on producer surplus, consumer surplus, government revenue, and national welfare, as well as the price, consumption, and production of goods. A tariff, import quota, export subsidy, and voluntary export restraint would increase producer surplus, reduce consumer surplus, and result in higher prices and lower production. These restrictions affect government revenue differently and affect the national welfare depending on whether the country is a price taker (small country) or can affect prices (large country).

The following table summarizes the effect of different types of trade restrictions on the economy:

1.2.         Regional Trading Agreements

a.  A trading bloc is an agreement among countries to work toward eliminating trade barriers and the movement of factors of production amongst members. Trading blocs may be regional (e.g., NAFTA, EU), yet there are different degrees of integration possible.

b.  Different types of trading blocs, depending upon the level of integration that takes place are:

     i.  Free Trade Agreements: In a free trade agreement (FTA) barriers to the flow of goods and services are eliminated amongst the agreeing members. However, each of the members is allowed to maintain its own policy to non-members.

    ii.  Customs Unions: In the customs unions along with the agreement for the free flow of goods and services amongst the members, unlike the FTA there is a common trade policy towards the non-members.

   iii.  Common Markets: In the common markets, along with the free flow of goods and services amongst the members, there is also a free flow of factors of production as well.

   iv.  Economic Union: In an economic union, along with the free flow of goods and services and the factors of production, there are also common economic institutions and coordination of economic policy.

    v.  Monetary Union: In the monetary the members along with common economic institutions and coordinated economic policy, also have a common currency.

c.  Regional integration is an easier and quicker method of attaining preferential treatment for its members as against the non-members than the WTO process.

d.  For example, suppose there is a group of five countries, i.e. A, B, C, D, and E. Of these, say D is the high-cost producer and E is a low-cost producer. Without any integration, in a situation of free-trade, E will supply the low-cost product to A, B, C, and D. This will reduce the price of the product in the world market.
On the other hand, A, B, C, and D form a cartel and puts a barrier on trade with country E, then D can continue to supply the goods to the countries within the cartel. There is a trade diversion due to the formation of the regional trading bloc. Now, the lower-cost imports from the non-members are replaced with the higher-cost imports from the member countries.
Also, if there were trade barriers amongst these countries before the formation of the trading bloc, which gets removed after this bloc is formed, then there will be a free flow of goods from country D to A, B, and C. This is a process of trade creation, due to which there is a replacement of higher-cost domestic production for the lower-cost imports from the member countries.

1.2.1.     Benefits of Trading Blocs

The trading blocs have many advantages intended to benefit the domestic economy. Some of them are:

a.  The increased competition results in lowers prices and increases quantity.

b.  The cost of production declines and it becomes easier to access natural resources and technology.

c.  There is increased access to technology and knowledge.

d.  There is increased specialization.

e.  There is a greater opportunity for economies of scale.

f.  There is increased employment.

g.  There is increased income.

h.  There is increased interdependence among members.

i.  There are fewer chances of conflicts.

1.2.2.     Costs of Trading Blocs

There is some of the adjustment cost, which results due to the formation of these blocs:

a.  In the short run, there is a loss of some of the production and employment in some countries.

b.  There is a contagion effect, due to which problems in one country might spread to the other countries.

1.2.3.     Challenges to Implementation of Regional Trading Agreements

a.  There may be cultural or historical differences due to which the integration of trade at the economic level might require some social and political integration.

b.  The higher levels of integration may result in the loss of independent economic controls of the countries. Hence it becomes difficult to control the relative prices and the level of imports. Therefore some countries may be less willing to enter into the agreement.

1.3.         Capital Restrictions

a.  Free flow of capital has many advantages for the participating countries, some of them are:

     i. The investment can occur at a rate higher than the domestic savings, which helps the economy in achieving a higher economic growth rate.

    ii.  FDI may bring new technology, skills, and processes to the economy which may help the domestic firms become more efficient.

b.  The free flow also has some disadvantages. For example, if the FDI is short-term in nature, that is the investment is only indirect (in stocks, bonds, etc., and not in the capital projects), then it may inflate the value of the local currency in the short run. And, when this capital leaves the country, i.e. when there is a capital flight, it actually creates a situation of value destruction, especially for the real estate and the equity markets.

c.  Therefore, there is a need for capital restrictions. This is mainly because it helps:

     i.  protect domestic industries,

     ii.  preserve domestic ownership,

    iii.  minimize the export of profits, and

    iv.  control currency value.

d.  If the economy has a fixed currency rate, in the form of a peg, the need for capital restrictions increases manifold. The limits on inflows and outflows make it easier to hold the peg because the inflows and outflows of foreign exchange push up and down the value of currency respectively. As a result of restriction, interest rates can be used to direct the economy instead of the exchange rates.

e.  Capital restrictions can be imposed in the form of:

     i.  prohibitions,

    ii.  taxes,

   iii.  price controls,

   iv.  quantity controls, etc.

f.  The main issue with the enforcement of capital restrictions is that:

     i.  They are costly to administer and monitor.

    ii.  They may have long-term costs in the form of isolation from global capital markets.