Chapter 06 - The Political Economy of International Trade

THE POLITICAL ECONOMY OF INTERNATIONAL TRADE

Introduction
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Free trade refers to a situation where a government does not attempt to restrict what its
citizens can buy from another country or what they can sell to another country.

Instruments of Trade Policy

The main instruments of trade policy are:
 tariffs
 subsidies
 import quotas
 voluntary export restraints
 local content requirements
 antidumping policies
 administrative policies

Tariffs

Tariffs are the oldest form of trade policy. The principal objective of most tariffs is to
protect domestic producers and employees against foreign competition. Tariffs also raise
revenue for the government. Domestic producers gain, because tariffs afford them some
protection against foreign competitors by increasing the cost of imported foreign goods.
Consumers lose because they must pay more for certain imports. Tariffs reduce the
overall efficiency of the world economy.

Subsidies
Subsidies take many forms (cash grants, low-interest loans, tax breaks, and government
equity participation in domestic firms). By lowering production costs, subsidies help
domestic producers in two ways: they help them compete against foreign imports and
they help them gain export markets. Subsidy revenues are generated from taxes.
Governments typically pay for subsidies by taxing individuals. Therefore, whether
subsidies generate national benefits that exceed their national costs is debatable.

Subsidies encourage over production, inefficiency and reduced trade. In practice, many
subsidies are not that successful at increasing the international competitiveness of
domestic producers. Rather, they tend to protect the inefficient and promote excess
production.

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Quotas and Voluntary Export Restraints

Quotas and Voluntary Export Restraints (VER) are direct restrictions on the quantity
of some good that may be imported into a country. The quota restriction is usually
enforced by issuing import licenses to a group of individuals or firms. A VER is a quota
on trade imposed by the exporting country, typically at the request of the importing
country’s government.

Local Content Requirements

Local content regulations have been widely used by developing countries to shift their
manufacturing base from the simple assembly of products whose parts are manufactured
elsewhere into the local manufacture of component parts. They have also been used in
developed countries to try to protect local jobs and industry from foreign competition.

From the point of view of a domestic producer of parts going into a final product, 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.

Administrative Policies
Governments sometimes use informal or administrative policies to restrict imports and
boost exports. Administrative trade policies are bureaucratic rules that are designed to
make it difficult for imports to enter a country.

Anti Dumping Policies

Dumping is defined as selling goods in a foreign market at below cost of production or at
below “fair” market value.

The Case for Government Intervention

There are two types of arguments for government intervention, political and economic.

Political Arguments for Intervention

Political arguments for government intervention include:
 protecting jobs
 protecting industries deemed important for national security
 retaliating to unfair foreign competition
 protecting consumers from “dangerous” products
 furthering the goals of foreign policy
 protecting the human rights of individuals in exporting countries

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Protecting Jobs and Industries

The most common political reason for trade restrictions is "protecting jobs and
industries."

Protecting 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 (e.g., aerospace, advanced electronics, semiconductors).

Retaliation
Government intervention in trade can be used as part of a "get tough" policy to open
foreign markets.

Protecting Consumers
Consumer protection can also be an argument for restricting imports. Since different countries do
have different health and safety standards, what may be acceptable in one country may be
unacceptable in others.

Furthering Policy Objectives

Sometimes, governments use trade policy to support their foreign policy objectives.

Protecting Human Rights

Governments sometimes use trade policy to create pressure for improvement of human
rights policies of trading partners. For years the most obvious example of this was the
annual debate in the United States over whether to grant most favored nation (MFN)
status to China. MFN status allows countries to export goods to the United Status under
favorable terms. Under MFN rules, the average tariff on Chinese goods imported into the
United States is 8 percent. If China’s MFN status were rescinded, tariffs would probably
rise to about 40 percent.

Economic Arguments for Intervention

Protecting infant industries and strategic trade policy are the main economic reasons for
trade restrictions.

The Infant Industry Argument

The infant industry argument has been considered a legitimate reason for
protectionism, especially in developing country contexts. Many economists criticize this
argument: protection of manufacturing from foreign competition does no good unless the
protection helps make the industry efficient. Brazil built up the world’s 10th largest auto
industry behind tariff barriers and quotas. Once those barriers were removed in the late
1980s, however, foreign imports soared and the industry was forced to face up to the fact
that after 30 years of protection, the Brazilian industry was one of the most inefficient in
the world.

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Strategic trade policy, where the existence of substantial scale economies suggests that
the world market will profitably support only a few firms, and may justify government
intervention in industries with possibly large economies of scale. Such intervention
reduces the competitive effect of existing first-mover advantage held by a foreign
company.

Revised Case for Free Trade

While strategic trade policy identifies conditions where restrictions on trade may provide
economic benefits, there are two problems that may make restrictions inappropriate:
retaliation and politics.

Retaliation and Trade War

Krugman argues that strategic trade policies 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.

Domestic Policies
Special interest groups may influence governments.

Development of the World Trading System

How has today’s world trade system evolved?

From Smith to the Great Depression

Up until the Great Depression of the 1930s, most countries had some degree of
protectionism. Great Britain, as a major trading nation, was one of the strongest
supporters of free trade.

Although the world was already in a depression, in 1930 the U.S. enacted the Smoot-
Hawley tariff, which created significant import tariffs on foreign goods. As other nations
took similar steps and the depression deepened, world trade fell further.

GATT, Trade Liberalization, and Economic Growth

After WWII, the U.S. and other nations realized the value of freer trade, and established
the General Agreement on Tariffs and Trade (GATT).

The approach of GATT (a multilateral agreement to liberalize trade) was to gradually

eliminate barriers to trade. Over 100 countries became members of GATT, and worked
together to further liberalize trade.

1980-1993: Protectionist Trends

Calls for protectionism were motivated by 3 factors:
1. Japan’s success in such industries as automobiles and semiconductors coupled with the
sense that Japanese markets were closed to imports and foreign investment by
administrative trade barriers.

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2. The world’s largest economy, the United States, was plagued by a persistent deficit.
The loss of market share to foreign competitors in industries such as automobiles,
machine tools, semiconductors, steel, and textiles, and the resulting unemployment gave
rise to renewed demands in the U.S. Congress for protection against imports.

3. Many countries found ways to get around GATT regulations.

The WTO: Experience to Date

In addition to the impasse at the meetings over agricultural subsidies, the Seattle round
was a lightning rod for a diverse collection of organizations from environmentalists and
human rights groups to labor unions that opposed free trade. All these organizations
argued that the WTO is an undemocratic institution that was usurping the national
sovereignty of member states and making decisions of great importance behind closed
doors. They took advantage of the Seattle meetings to voice their opposition.

The Future of the WTO: Unresolved Issues and the Doha Round
The Doha Round had several initiatives:
Cutting tariffs on industrial goods and services. In 2000, for example, the average tariff
rates on non-agricultural products were 4.4% for Canada, 4.5% for the European Union,
4.0% for Japan, and 4.7% for the United States. On agricultural products, however, the
average tariffs rates were 22.9% for Canada, 17.3% for the European Union, 18.2% for
Japan, and 11% for the United States.

Phasing out subsidies. Subsidies introduce significant distortions into the production of
agricultural products. The net effect is to raise prices to consumers, reduce the volume of
agricultural trade, and encourage the overproduction of products that are heavily
subsidized (with the government typically buying up the surplus).

Reducing antidumping laws. WTO rules allow countries to impose antidumping duties
on foreign goods that are being sold cheaper than at home, or below their cost of
production, when domestic producers can show that they are being harmed.

WTO on intellectual property should allow for health protection in poorer nations. Rich
countries have to comply with the rules within a year. Poor countries, in which such
protection generally was much weaker, have 5 years’ grace, and the very poorest have 10
years.

Implications for Managers

Managers need to consider how trade barriers affect the strategy of the firm and the
implications of government policy on the firm.

Trade Barriers and Firm Strategy

Trade barriers are a constraint upon a firm’s ability to disperse its productive activities.

Policy Implications

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International firms have an incentive to lobby for free trade, and keep protectionist
pressures from causing them to have to change strategy.

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QUESTION 1: Do you think that governments should consider human rights when
granting preferential trading rights to countries? What are the arguments for and against
taking such a position?

ANSWER 1: China is frequently cited as a violator of human rights, and can form the
basis for a discussion of this question. While the answer to the first question clearly is a
matter of personal opinion, in stating their opinions, students should consider the
following points. Trade with the U.S. is very important to China, as China views the U.S.
as an important market. The U.S. is also an important source of certain products. Thus,
the U.S. has some leverage with trade when trying to influence China’s human rights
policies. For this policy to have much effect, however, other nations important to China
must adopt similar policies. Otherwise China will simply choose to work with other
countries, and U.S. consumers and producers may be more negatively impact than the
Chinese. Another concern with tying MFN status to human rights is that denying MFN
may make the human rights situation worse rather than better. By engaging in trade, the
income levels in China will increase, and with greater wealth the people will be able to
demand and receive better treatment.

QUESTION 3: Given the arguments relating to the new trade theory and strategic trade
policy, what kind of trade policy should business be pressuring government to adopt?

ANSWER 3: According to the textbook, businesses should urge governments to target

technologies that may be important in the future and use subsidies to support
development work aimed at commercializing those technologies. Government should
provide export subsidies until the domestic firms have established first mover advantages
in the world market. Government support may also be justified if it can help domestic
firms overcome the first-mover advantages enjoyed by foreign competitors and emerge as
viable competitors in the world market. In this case, a combination of home market
protection and export-promoting subsidies may be called for.
computers in sections and then assemble them in the U.S., depending on the legislation.
Or continue manufacture in Thailand and assemble them in Malaysia or HK. Such
targeted trade barriers can often be easily circumvented. Targeted trade barriers, like most
forms of government intervention, are usually ineffective.

CLOSING CASE: Trade in Textiles—Holding the Chinese Juggernaut in Check

Summary

The closing case explores the consequences of the expired Multi-Fiber Agreement
(MFA) on both developing and developed countries. The agreement, which had been in
place since 1974, involved a system of quotas designed to protect textile producers in
developed nations from foreign competition. When the decision was made to let the
agreement expire, many developing nations expected to benefit. However, China’s entry
into the WTO on 2001 changed everything. By 2003, China was making 17 percent of

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the world’s textiles, and that percentage was expected to continue to rise. Various groups
appealed to the WTO to stop the removal of the quotas, but were rejected. China
imposed its own limits on exports in 2004. Discussion of this case can revolve around
the following questions:

QUESTION 1: Was the removal of the Multi-Fiber Agreement a positive thing for the
world economy?

ANSWER 1: According to trade theory and the notion of specialization and free trade,
the removal of the Multi-Fiber Agreement made sense. In fact, if one considers the world
as a whole, the removal of the MFA should promote greater efficiency in the textile
industry that will be beneficial to consumers. However, if one considers the situation
from the perspective of some countries like Bangladesh, the removal of the quota system
spells disaster for the country’s fledgling textile industry. Other countries like Pakistan
see the removal of the MFA as an opportunity, believing that developed countries will
seek alternative sources to reduce dependency on China.

QUESTION 2: As a producer in a developing nation such as Bangladesh that benefited

from the MFA agreement, how should you respond to the expiration of the agreement?

ANSWER 2: This is a difficult question that will probably stir some debate. Thanks to
the agreement, Bangladesh has managed to build its textile industry. Indeed, the industry
employs some 2 million people. Some students will probably argue that Bangladesh
cannot possibly expect to compete with China, and therefore should throw in the towel
and move onto to something else. Other students however, might argue that Bangladesh
needs to identify a way to support its textile workers and help them continue to build the
industry. Students taking this perspective might suggest taking measures such as
focusing on niche markets, or teaming with other producers to cut costs.

QUESTION 3: Do you think China was right to place a tariff on exports of textiles from
China? Why? Does such action help or harm the world economy?

ANSWER 3: China’s move to place its own tariffs on its exports was probably simply a
defense mechanism. By taking the initiative, the country could head off potentially more
damaging protectionist measures from other nations. From the consumer’s perspective
however, the tariffs, though small, could have the effect of raising prices. For other
nations, the tariffs provide some breathing room, but could also foster a sense of
complacency.

The number of member nations of the World Trade Organization has increased
considerably in recent years. Additionally, some non-member countries have observer
status, which requires accession negotiations to begin within five years of attaining this
preliminary position. Identify the current total number of WTO members. Also, prepare
a list of current observer countries. Do you notice anything in particular about the
countries that have observer status?

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