Introduction
In this chapter, we look at the political reality of international trade. While many nations are nominally committed to free trade, in practice nations tend to intervene in international trade. The nature of these political realities are amply illustrated in the case that opens this chapter. In this chapter, we explore the political and economic reasons for intervening in international trade. When governments intervene, they often do so by restricting imports of goods and services into their nation, while adopting policies that promote exports. Normally their motives for intervention are to protect domestic producers and jobs from foreign competition, while increasing the foreign market for domestic products. However, as the opening case illustrates, in recent years "social" issues have tended to intrude in the decision making.
Instruments of Trade Policy
Tariffs
A tariff is a tax levied on imports. The oldest form of trade policy, tariffs fall into two categories. Specific tariffs are levied as a fixed charge for each unit of a good imported. Ad valorem tariffs are levied as a proportion of the value of the imported good.
A tariff raises the cost of imported products relative to domestic products. While the principal objective of most tariffs is to protect domestic producers and employees against foreign competition, they also raise revenue for the government.
The important thing to understand about a tariff is who suffers and who gains. The government gains, because the tariff increases government revenues. Domestic producers gain, because the tariff gives them some protection against foreign competitors by increasing the cost of imported foreign goods. Consumers lose because they must pay more for certain imports. Whether the gains to the government and domestic producers exceed the loss to consumers depends on various factors such as the amount of the tariff, the importance of the imported good to domestic consumers, the number of jobs saved in the protected industry, and so on.
Although detailed consideration of these issues is beyond the scope of this book, two conclusions can be derived from a more advanced analysis. First, tariffs are unambiguously pro-producer and anti-consumer. While they protect producers from foreign competitors, this supply restriction also raises domestic prices. Thus, as noted
A second point worth emphasizing is that tariffs reduce the overall efficiency of the world economy. They reduce efficiency because a protective tariff encourages domestic firms to produce products at home that, in theory, could be produced more efficiently abroad. The consequence is inefficient utilization of resources
Subsidies
A subsidy is a government payment to a domestic producer. Subsidies take many forms including cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. By lowering costs, subsidies help domestic producers in two ways: they help them compete against low-cost foreign imports and they help them gain export markets.
But subsidies must be paid for. Governments typically pay for subsidies by taxing individuals. Therefore, whether subsidies generate national benefits that exceed their national costs is debatable. In practice, many subsidies are not that successful at increasing the international competitiveness of domestic producers. They tend to protect the inefficient, rather than promoting efficiency.
Import Quotas and Voluntary Export Restraints
An import quota is a direct restriction on the quantity of some good that may be imported into a country. The restriction is normally enforced by issuing import licenses to a group of individuals or firms. A variant on the import quota is the voluntary export restraint (VER). A voluntary export restraint is a quota on trade imposed by the exporting country, typically at the request of the importing country's government.
As with tariffs and subsidies, both import quotas and VERs benefit domestic producers by limiting import competition. Quotas do not benefit consumers. An import quota or VER always raises the domestic price of an imported good. When imports are limited to a low percentage of the market by a quota or VER, this bids the price up for that limited foreign supply.
Local Content Requirements
A local content requirement calls for some specific fraction of a good to be produced domestically. Local content regulations have been widely used by developing countries as a device for shifting their manufacturing base from the simple assembly of products whose parts are manufactured elsewhere, to the local manufacture of component parts. More recently, the issue of local content has been raised by several developed countries.
For a domestic producer of component parts, local content regulations provide protection in the same way an import quota does: by limiting foreign competition. The aggregate economic effects are also the same; domestic producers benefit, but the restrictions on imports raise the prices of imported components. In turn, higher prices for imported components are passed on to consumers of the final product in the form of higher prices. As with all trade policies, local content regulations tend to benefit producers and not consumers.
Antidumping Policies
In the context of international trade, dumping is variously defined as selling goods in a foreign market at below their costs of production, or as selling goods in a foreign market at below their "fair" market value. There is a difference between these two definitions, since the "fair" market value of a good is normally judged to be greater than the costs of producing that good. Dumping is viewed as a method by which firms unload excess production in foreign markets. Alternatively, some dumping may be the result of predatory behavior, with producers using substantial profits from their home markets to subsidize prices in a foreign market with a view to driving indigenous competitors out of that market. Once this has been achieved, so the argument goes, the predatory firm can raise prices and earn substantial profits.
Antidumping policies are policies designed to punish foreign firms that engage in dumping. The ultimate objective is to protect domestic producers from "unfair" foreign competition. Although antidumping policies vary somewhat from country to country, the majority are similar to the policies used in the United States.
Administrative Policies
In addition to the formal instruments of trade policy, governments of all types sometimes use a range of informal or administrative policies to restrict imports and boost exports. Administrative trade policies are bureaucratic rules designed to make it difficult for imports to enter a country. Some would argue that the Japanese are the masters of this kind of trade barrier.
The Case for Government Intervention
Political Arguments for Intervention .
Protecting Jobs and Industries
Perhaps the most common political argument for government intervention is that it is necessary for protecting jobs and industries from foreign competition. Antidumping policies are frequently justified on such grounds. The voluntary export restraints that offered some protection to the US automobile, machine tool, and steel industries during the 1980s were motivated by such considerations. Similarly, Japan's quotas on rice imports are aimed at protecting jobs in that country's agricultural sector.
In addition to trade controls hurting consumers, evidence also indicates they may sometimes hurt the producers they are intended to protect.
National Security
Countries sometimes argue that it is necessary to protect certain industries because they are important for national security. Defense-related industries often get this kind of attention .Although not as common as it used to be, this argument is still made. Those in favor of protecting the US semiconductor industry from foreign competition, for example, argue that semiconductors are now such important components of defense products that it would be dangerous to rely primarily on foreign producers for them.
Retaliation
Some argue that governments should use the threat to intervene in trade policy as a bargaining tool to help open foreign markets and force trading partners to "play by the rules of the game." Successive US governments have been among those that adopted this get-tough approach. If it works, such a politically motivated rationale for government intervention may liberalize trade and bring with it resulting economic gains. It is a risky strategy, however, because a country that is being pressured might not back down and instead may respond to the punitive tariffs by raising trade barriers of its own.
Protecting Consumers
The ban was motivated by a desire to protect European consumers from the possible health consequences of meat treated with growth hormones. It was motivated by concerns for the safety and health of consumers, as opposed to economic considerations. Many governments have long had regulations to protect consumers from "unsafe" products. Often, the indirect effect of such regulations is to limit or ban the importation of such products. The conflict over the importation of hormone-treated beef into the European Union may prove to be a taste of things to come. In addition to the use of hormones to promote animal growth and meat production, biotechnology has made it possible to genetically alter many crops so that they are resistant to common herbicides, produce proteins that are natural insecticides, have dramatically improved yields, or can withstand inclement weather
Furthering Foreign Policy Objectives
Governments will use trade policy to support their foreign policy objectives. A government may grant preferential trade terms to a country with which it wants to build strong relations. Trade policy has also been used several times as an instrument for pressuring or punishing "rogue states" that do not abide by international law or norms.
Protecting Human Rights
Protecting and promoting human rights in other countries is an important element of foreign policy for many democracies. Governments sometimes use trade policy to try to improve the human rights policies of trading partners.
On the other hand, some argue that limiting trade with countries such as China where human rights abuses are widespread makes matters worse, not better. The best way to change the internal human rights stance of a country is to engage it in international trade, they argue.
Economic Arguments for Intervention
The Infant Industry Argument
The infant industry argument is by far the oldest economic argument for government intervention. According to this argument, many developing countries have a potential comparative advantage in manufacturing, but new manufacturing industries there cannot initially compete with well-established industries in developed countries. To allow manufacturing to get a toehold, the argument is that governments should temporarily support new industries until they have grown strong enough to meet international competition.
Also, the infant industry argument has been recognized as a legitimate reason for protectionism by the WTO. Nevertheless, many economists remain very critical of this argument. They make two main points. First, protection from foreign competition does no good unless the protection helps make the industry efficient. In case after case, however, protection seems to have done little more than foster the development of inefficient industries that have little hope of ever competing in the world market. Brazil.
A second point is that the infant industry argument relies on an assumption that firms are unable to make efficient long-term investments by borrowing money from the domestic or international capital market. Consequently, governments have been required to subsidize long-term investments.
Strategic Trade Policy
The strategic trade policy argument has been proposed by the new trade theorists. There are two components to the strategic trade policy argument. First, a government can help raise national income if it can somehow ensure that the firm or firms to gain first-mover advantages in such an industry are domestic rather than foreign enterprises. Thus, according to the strategic trade policy argument, a government should use subsidies to support promising firms in emerging industries.
The second component of the strategic trade policy argument is that it might pay government to intervene in an industry if it helps domestic firms overcome the barriers to entry created by foreign firms that have already reaped first-mover advantages. This argument underlies government support of Airbus Industrie, Boeing's major competitor. If these arguments are correct, they clearly suggest a rationale for government intervention in international trade. Specifically, governments should target technologies that may be important in the future and use subsidies to support development work aimed at commercializing those technologies.
The Revised Case for Free Trade
Retaliation and Trade War
Krugman argues that strategic trade policy aimed at establishing domestic firms in a dominant position in a global industry are beggar-thy-neighbor policies that boost national income at the expense of other countries. A country that attempts to use such policies will probably provoke retaliation. In many cases, the resulting trade war between two or more interventionist governments will leave all countries involved worse off than if a hands-off approach had been adopted.
Domestic Politics
Governments do not always act in the national interest when they intervene in the economy. Instead, they are influenced by politically important interest groups. Thus, a further reason for not embracing strategic trade policy, is that such a policy is almost certain to be captured by special interest groups within the economy, who will distort it to their own ends.
Development of the World Trading System
From Smith to the Great Depression
The Corn Laws placed a high tariff on corn imports. The objectives of the Corn Law tariff were to raise government revenues and to protect British corn producers. There had been annual motions in Parliament in favor of free trade since the 1820s when David Ricardo was a member of Parliament. However, agricultural protection was withdrawn only after a protracted debate when the effects of a harvest failure in Britain were compounded by the imminent threat of famine in Ireland. Faced with considerable hardship and suffering, among the populace, Parliament narrowly reversed its long-held position.
The Uruguay Round and the World Trade Organization
Against the background of rising pressures for protectionism, in 1986 the members of the GATT embarked upon their eighth round of negotiations to reduce tariffs, the Uruguay Round (so named because they occurred in Uruguay). This was the most difficult round of negotiations yet, primarily because it was also the most ambitious. Until then, GATT rules had applied only to trade in manufactured goods and commodities. In the Uruguay Round, member countries sought to extend GATT rules to cover trade in services. They also sought to write rules governing the protection of intellectual property, to reduce agricultural subsidies, and to strengthen the GATT's monitoring and enforcement mechanisms.
Services and Intellectual Property
In the long run, the extension of GATT rules to cover services and intellectual property may be particularly significant. Extending GATT rules to this important trading arena could significantly increase both the total share of world trade accounted for by services and the overall volume of world trade. Having GATT rules cover intellectual property will make it much easier for high-technology companies to do business in developing nations where intellectual property rules have historically been poorly enforced High-technology companies will now have a mechanism to force countries to prohibit the piracy of intellectual property.
The World Trade Organization
The clarification and strengthening of GATT rules and the creation of the World Trade Organization also hold out the promise of more effective policing and enforcement of GATT rules in the future. This should have a beneficial effect on overall economic growth and development by promoting trade. The WTO will act as an umbrella organization that which will encompass the GATT along with two new sister bodies, one on services and the other on intellectual property. The WTO will take over responsibility for arbitrating trade disputes and monitoring the trade policies of member countries. While the WTO will operate as GATT now does--on the basis of consensus--in the area of dispute settlement, member countries will no longer be able to block adoption of arbitration reports. Arbitration panel reports on trade disputes between member countries will be automatically adopted by the WTO unless there is a consensus to reject them.
Implications of the Uruguay Round
The world is better off with a GATT deal than without it. Without the deal, the world might have slipped into increasingly dangerous trade wars, which might have triggered a recession. With a GATT deal concluded, the current world trading system looks secure, and there is a good possibility that the world economy will now grow faster than would otherwise have been the case. Estimates as to the overall impact of the GATT agreement, however, are not that dramatic.
WTO: Early Experience
WTO as a Global Policeman
Countries' use of the WTO represents an important vote of confidence in the organization's dispute resolution.
The backing of the leading trading powers has been crucial to the early success of the WTO. Initially, some feared that the United States might undermine the system by continuing to rely on unilateral measures when it suited or by refusing to accept WTO verdicts.
Encouraged perhaps by the tougher system, developing countries are also starting to use the settlement procedures more than they did under the GATT. So far the United States has proved willing to accept WTO rulings that go against it. The United States agreed to implement a WTO judgment that called for the country to remove discriminatory antipollution regulations that were applied to gasoline imports. In a dispute with India over textile imports, the United States rescinded quotas before a WTO panel could start work.
WTO Telecommunications Agreement
As explained above, the Uruguay Round of GATT negotiations extended global trading rules to cover services. The WTO was given the role of brokering future agreements to open global trade in services. The WTO was also encouraged to extend its reach to encompass regulations governing foreign direct investment--something the GATT had never done. Two of the first industries targeted for reform were the global telecommunications and financial services industries. Given its importance in the global economy, the telecommunications services industry was a very important target for reform. The WTO's goal was to get countries to open their telecommunications markets to competition, allowing foreign operators to purchase ownership stakes in domestic telecommunications providers and establishing a set of common rules for fair competition in the telecommunications sector. Three benefits were cited.
First, advocates argued that inward investment and increased competition would stimulate the modernization of telephone networks around the world and lead to higher-quality service. Second, supporters maintained that the increased competition would benefit customers through lower prices.
WTO Financial Services Agreement
Fresh from its success in brokering a telecommunications agreement, in April 1997 the WTO embarked on negotiations to liberalize the global financial services industry. The financial services industry includes banking, securities businesses, insurance, asset management services, and the like.
Participants in the negotiations wanted to see more competition in the sector both to allow firms greater opportunities abroad and to encourage greater efficiency. Developing countries need the capital and financial infrastructure for their development. But governments also have to ensure that the system is sound and stable because of the economic shocks that can be caused by exchange rates, interest rates, or other market conditions fluctuating excessively. They also have to avoid economic crisis caused by bank failures. Therefore, government intervention in the interest of prudential safeguards is an important condition underpinning financial market liberalization.
The Future: Unresolved Issues
The 1994 GATT deal still leaves a lot to be done on the international trade front. Substantial trade barriers still remain in areas such as financial services and broadcast entertainment, although these seem likely to be reduced eventually. More significantly perhaps, WTO has yet to deal with the areas of environmentalism, worker rights, foreign direct investment, and dumping.
High on the list of the WTO's future concerns will be the interaction of environmental and trade policies and how best to promote sustainable development and ecological well-being without resorting to protectionism. The WTO will have to deal with environmentalists' claims that expanded international trade encourages companies to locate factories in areas of the world where they are freer to pollute and degrade the environment.
Paralleling environmental concerns are concerns that free trade encourages firms to shift their production to countries with low labor rates where worker rights are routinely violated.
Implications for Business
Trade Barriers and Firm Strategy
Trade barriers constrain a firm's ability to disperse its productive activities in such a manner. First, and most obviously, tariff barriers raise the costs of exporting products to a country. This may put the firm at a competitive disadvantage vis-à-vis indigenous competitors in that country. In response, the firm may then find it economical to locate production facilities in that country so it can compete on an even footing with indigenous competitors. Second, voluntary export restraints may limit a firm's ability to serve a country from locations outside of that country. The firm's response might be to set up production facilities in that country--even though it may result in higher production costs.
Third, to conform with local content regulations, a firm may have to locate more production activities in a given market than it would otherwise. From the firm's perspective, the consequence might be to raise costs above the level that could be achieved if each production activity was dispersed to the optimal location for that activity. And fourth, even when trade barriers do not exist, the firm may still want to locate some production activities in a given country to reduce the threat of trade barriers being imposed in the future.
All the above effects are likely to raise the firm's costs above the level that could be achieved in a world without trade barriers. The higher costs that result need not translate into a significant competitive disadvantage, however, if the countries imposing trade barriers do so to the imported products of all foreign firms, irrespective of their national origin.
Policy Implications
Government policies with regard to international trade also can have a direct impact on business.
In general, however, the arguments contained in this chapter suggest that a policy of government intervention has three drawbacks. Intervention can be self-defeating, since it tends to protect the inefficient rather than help firms become efficient global competitors. Intervention is dangerous because it may invite retaliation and trigger a trade war. Finally, intervention is unlikely to be well-executed, given the opportunity for such a policy to be captured by special interest groups. Most economists would probably argue that the best interests of international business are served by a free trade stance, but not a laissez-faire stance. It is probably in the best long-run interests of the business community to encourage the government to aggressively promote greater free trade by, for example, strengthening the WTO. Business probably has much more to gain from government efforts to open protected markets to imports and foreign direct investment than from government efforts to support certain domestic industries in a manner consistent with the recommendations of strategic trade policy.
This conclusion is reinforced by a phenomenon that we touched on in Chapter 1, the increasing integration of the world economy and internationalization of production that has occurred over the past two decades. We live in a world where many firms of all national origins increasingly depend for their competitive advantage on globally dispersed production systems. Such systems are the result of free trade. Free trade has brought great advantages to firms that have exploited it and to consumers who benefit from the resulting lower prices.
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