International Trade Theories (Revised)

Political Economy of International

Trade

Introduction

• While many nations are nominally committed to free trade, • they tend to intervene in international trade – to protect the interests of politically important groups

Let’s ban the import of hormone-treated beef for the

reason that it might have potential health effect to our

citizens.

European Union—1989

• In the 1970’s US scientist discovered a synthesize certain hormones and use them to promote growth of livestock of animals, reduce fat content of meat, and increase milk production. Bovine Somatotropin (BST), a growth hormone produced by beef cattle which is to be injected to supplement an animal’s own hormone production and increase its growth rate.

Introduction

• Examine the political reality of international trade

– The political, economic reasons for government intervention– The range of policy instruments– The emergence of the modern international trading system.

• 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 increase the foreign market of domestic products.

The political, economic reason for government intervention

The decision of the EU to ban import of hormone treated beef was a political response to social concern about the health consequences.

Example

The range of policy

• This is followed by a detailed review of the political and economic motives that government have for intervention.

The emergence of the modern international trade

• The General Agreement of Tariffs and Trade (GATT) and its successor the World Trade Organization (WTO).

• The GATT and WTO are the creations of a series of treaties of multinational treaties. •The purpose of this treaties has been to lower barriers to the free flow of goods and services between nations.

Are you still ok?

Does Current Account Deficit matter ?

• A current account deficit– Money flows to other countries– These countries can use the money to purchase assets in the deficit

country.

• The US runs a trade deficit with China – The Chinese use the money – To purchase US assets– Stocks, bonds, real estate, whole corporations

• A deficit on the current account– Financed by selling assets to other countries

Does Current Account Deficit matter ?

• The persistent US current account deficit– Financed by a steady sale of US assets to other countries– Net debtor

– The US must deliver a stream of interest payments to • foreign bondholders• Rents to foreign landowners• Dividends to foreign stockholders

• Drain resources from a country and limit the funds available for investments within the country ?

Implications of trade deficits ?

• Investment within a country– Necessary to stimulate economic growth

• A persistent current account deficit can– Choke off a country’s future economic growth ?

• Opposite argument– Current account deficit is not that bad after all ?

Is Current Account Deficit that bad ?

• In global capital markets– Money is efficiently directed toward its highest value uses– Over the last quarter of a century– Many of the highest value uses of capital

• Have been in the US.

• Capital is flowing out of the US – In the form of payments to foreigners – Much of that capital comes back to the US– To fund productive investments in the US

• NOT clear whether the current account deficit chokes off US economic growth.

The US economic growth and FDI in the US

• For the last 25 years– The US had grown at impressive rate– Because

– Foreigners reinvest much of the income earned from the US assets– From exports to the US, right back into the US

• What if foreign investors lose appetite for US assets ?– Instead of reinvesting earning from the US– Sell dollars for another currency– Invest in euro-, yen- denominated assets.

• A fall in the value of the dollar on foreign exchange markets– Increase in the price of imports,– Lower the price of US exports

• Making them more competitive

– Reduce the overall level of the current account deficit.

Instruments of Trade Policy Question: How do governments intervene in international

trade?

• There are seven main instruments of trade policy 1. Tariffs 2. Subsidies3. Import quotas4. Voluntary export restraints5. Local content requirements 6. Antidumping policies 7. Administrative policies

Tariffs

• A tariff is – a tax levied on imports – raises the cost of imported products – relative to domestic products

– Specific tariffs• a fixed charge for each unit of a good imported

– Ad valorem tariffs• a proportion of the value of the imported good

Tariffs

Question: Why do governments impose tariffs?

• Tariffs – increase government revenues– provide protection to

• domestic producers against foreign competitors • by increasing the cost of imported foreign goods

– force consumers to pay more for certain imports

• So, tariffs are unambiguously – pro-producer and anti-consumer, – reduce the overall efficiency of the world economy

Who gain and who lose from Tariff policy ?

• Winners– Domestic producers : protection– Increased cost for foreign producers

• Losers– Consumers– Pay more for import goods

• US – ad valorem tariff of 8%-30% on foreign steel. – To protect domestic steel producers– Raised the price of steel products in the US by 30-35%– Carmakers, appliance makers lost

• Their costs of production increased • Less competitive• Led to job loss in these industries

Effective tariff policy ? March 2002

• In the steel case,– The losses to steel consumers outweighed– The gains to steel producers

– The gain vs. the loss depends on

• the amount of the tariff• The importance of the imported good to domestic consumers• The number of jobs saved in the protected industry• The number of jobs lost in other industries.

• The WTO declared the US tariff policy for steel industry– A violation of the WTO treaty– The US removed them in December.

Japanese economist calculated

• Tariffs on import of food stuffs, cosmetics, chemicals– Cost the average Japanese consumer about– $890 per year in the form of higher prices. – Impose significant costs on domestic consumers– Higher prices

• Tariffs reduce overall efficiency of the world economy– encourage domestic firms – To produce products at home– Could be produced more efficiently elsewhere.– Inefficient utilization of resources

Korea’s rice policy

• Tariffs on the importation of rice– an increase in rice production – Rice farming is an unproductive use of land– Make more sense to purchase rice from lower cost foreign producers– To utilize the land in other ways– Produce foodstuffs that can not be produced more efficiently elsewhere– Or use for residential and industrial purposes.

Export Tariff

• To raise revenue for government• To reduce export from a sector for

political reasons.

• In 2004, China imposed tariff on textile exports– to moderate the growth in exports of

textiles from China. – Alleviate tensions with other trading

nations.

Subsidies• A subsidy is

• a government payment to a domestic producer

• Cash grants, low interest loans, tax breaks

• Government equity participation in domestic firms

• Subsidies help domestic producers • Lower production costs• compete against low-cost foreign imports• gain export markets • Increase international competitiveness

• Consumers typically absorb the costs of subsidies

WTO estimates

• In the mid-2000s– Countries spent $300 billion on subsidies – $250 billion of which spent by 21 developed nations.

• Agriculture – One of the largest beneficiaries of subsidies– The EU was paying around euro 44 billion annually to farm subsidies.– May 2002, the president Bush signed a bill

• $180 billion payment for US farmers over 10 years. • In 2007, a farm bill contained $286 billion payment for next 10 years

– Japan paid to farmers substantial subsidies for many years

Agricultural subsidies

• Allow inefficient farmers to stay in business• Encourage countries to overproduce heavily subsidized products• Encourage countries to produce products that could be grown more

efficiently elsewhere and imported.• Reduce international trade in agricultural products

• If abandoned subsidies to farmers– Global trade in agriculture– 50% higher– The world as a whole would be better off by $160 billion.

Other sectors

• Subsidies given to Boeing and Airbus– To lower the cost of developing new commercial

jet aircraft.

• Boeing– In the form of tax credits for R&D spending– Or Pentagon money was used to develop

military technology– Then transferred to civil aviation projects.

• Airbus– Subsidies in the form of – Government loans at below-market interest rates.

Import Quotas and Voluntary Export Restraints

• An import quota – a direct restriction on the quantity of some good – Issue import licenses to firms

– The US has a quota on cheese imports– The only firms allowed to import cheese –certain trading companies– Allocated quota share

– In the US– Sugar, textile imports are under quota management.

• Tariff rate quotas are – a hybrid of a quota and a tariff – where a lower tariff is applied to imports – within the quota than to those over the quota

Tariff rate quota (TRQ)

• Rice import in South Korea– 10% ad valorem tariff on rice import of 1 million tons– Beyond this import

• 80% of out of quota rate is applied.

– If import 2 million rice to Korea• 1 million tons of rice at a 10 % tariff rate• Another 1 million tons of rice at an 80% tariff.

• TRQ is common in agriculture– To limit imports over quota.

• Japan applied TRQ to wheat imports– To protect inefficient Japanese wheat farmers from foreign

competition.

Voluntary Export Restraints

• Voluntary export restraints are – quotas on trade imposed by the exporting country, – typically at the request of the importing country’s

government

– Foreign producers agree to VERs because• They fear more damaging punitive tariffs or import quotas

• A quota rent is – the extra profit that producers make – when supply is artificially limited by an import

quota

– The US Sugar industry • A TRQ limited the amount foreign suppliers can sell to the

US market. • Raised the price of sugar in the US up to 40% greater than

the world price. • Higher price transferred to US sugar producers as greater

profits.

VER example

• The limitation on auto exports to the US by Japan in 1981– A response to direct pressure from the US government– Limited Japanese imports to no more than 1.68 million car per year.

• VER costs US consumers about $1 billion per year for 1981-1985• In the form of higher price

– Agreement revised in 1984 • To allow 1.85 million Japanese car per year

• Import quota and VER – Benefit domestic producers by limiting import competition. – Don’t benefit consumers– Raise the domestic price due to limited foreign supply.

Local Content Requirements

• A local content requirement – demands that some specific fraction of a good be produced

domestically

– The requirement can be • in physical terms or in value terms

• Local content requirements benefit – domestic producers and jobs, – but consumers face higher prices

LC example

• The Buy America Act– Government must give preference to American products – When putting contracts for equipment out to bid– Unless foreign producers have significant price advantages.

– A product as “American” – If 51% of the materials by value are produced domestically.– This needs to be ensured to have preference from the US government.

Administrative Policies

• Administrative trade policies are – bureaucratic rules – designed to make it difficult for imports to enter a country

• These polices hurt – consumers by denying access to possibly superior foreign

products.

Administrative Policies example

• Japan regulations on tulip bulbs– Customs inspectors check on every tulip bulb – By cutting it vertically down the middle– So could not put them back together. – Netherland, the world largest tulip bulb exporter, sold it to everywhere else except Japan

at one point of time.

• Federal Express had tough time in Japan initially– Japanese customs inspectors insist on – Opening a large proportion of express parcels to check for pornography– Delayed an ‘express’ package for days.

Administrative Policies• Dumping is

– selling goods in a foreign market • below their cost of production, or

– selling goods in a foreign market at • below their “fair” market value

– It can be a way for firms to • unload excess production in foreign markets

– Some dumping may be 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, • later raising prices and earning substantial profits

Administrative Policies• Antidumping policies

– to punish foreign firms that engage in dumping

• The goal is – to protect domestic producers from “unfair” foreign competition

• U.S. firms that believe – a foreign firm is dumping – can file a complaint with the government

• If the complaint has merit, – antidumping duties, – or countervailing duties may be imposed

Antidumping case

• 1997, Korean semiconductor manufacturers– LG Semicon– Hyundai Electronics

• Accused of DRAMs in the US at below production costs. • The world market – oversupplied at that time.• Alleged the firms were trying to unload excess production in the US.

• US manufacturer-Micron Technology filed the petition to – The Commerce Department– The International Trade Commission– Impose an antidumping duty (countervailing duty) of 9% on the offending foreign

imports (LG and Hyundai)• Special tariff.

Are you sure you’re ok?

The Case for Government Intervention

Question: Why do governments intervene in trade?• There are two types of arguments

– Political arguments are concerned with • protecting the interests of certain groups • within a nation (normally producers), • often at the expense of other groups (normally consumers)

– Economic arguments are typically concerned with • boosting the overall wealth of a nation • (to the benefit of all, both producers and consumers)

Political Arguments for Intervention

• Political arguments for government intervention include1. protecting jobs2. protecting industries deemed important for national

security3. retaliating to unfair foreign competition4. protecting consumers from “dangerous” products5. furthering the goals of foreign policy6. protecting the human rights of individuals in exporting

countries

Political Arguments for Intervention

1. Protecting jobs and industries

• the most common political reason for trade restrictions

• the result of political pressures – by unions or industries that are "threatened" by more

efficient foreign producers, – have more political clout than the consumers who will

eventually pay the costs

Political Arguments for Intervention

2. National Security

• Governments sometimes protect certain industries – such as aerospace or advanced electronics – because they are important for national security

• This argument is less common today than in the past

National Security example

• Federal funding for supporting Sematech– A consortium of 14 US semiconductor companies– Account for 90 % of the US industry’s revenues– To conduct joint research into manufacturing techniques

– US government considered it critical • Sematech was protected from antirust laws. • Provided $100 million in subsidies• Lasted until 1994.

Political Arguments for Intervention

3. Retaliation

• When governments take, or threaten to take, specific actions,– other countries may remove trade barriers

• This can be a risky strategy• If threatened governments don’t back down, – tensions can escalate and – new trade barriers may be enacted

Retaliation example

• The US government used the threat of punitive trade sanctions – To get Chinese government to enforce its intellectual property laws– In china, massive copyright infringements – Costing US companies, MS hundreds of millions of $ per year

– The threat : to impose 100% tariffs on a range of Chinese imports. – Chinese government agreed to tighter enforcement of IP regulations.

Political Arguments for Intervention

4. Protecting Consumers• Protecting consumers from unsafe products• This often involves – limiting or banning the import of certain products

Consumer protection example

• The US government in 1998– Permanently banned imports of 58 types of military style assault weapons.– To increase public safety

• The EU in 1989– Banned the sale and importation of hormone-treated beef – To protect European consumers from food safety risk. – Banned imports of GM foods and grains. – Monsanto- global food supplier wants to expand the global market for GM foods– Germany, Switzerland strongly against consumption of such products.

– WTO drawn into the conflict between these two parities.

Political Arguments for Intervention

5. Furthering Foreign Policy Objectives

• Trade policy can be used – to support foreign policy objectives

• Preferential trade terms can be granted to countries • a government wants to build strong relations with • Pressure or punish “Rogue states”

– that do not abide by international laws or norms

• it might cause • other countries to undermine unilateral trade sanctions

• US governments has trade sanctions against– Iraq, Cuba, Libya, Iran

Political Arguments for Intervention

6. Protecting Human Rights

• Governments can use trade policy – to improve the human rights policies of trading partners

• Unless a large number of countries choose to take such action, – however, it is unlikely to prove successful

• Some critics have argued that – the best way to change the internal human rights of a country is

• to engage it in international trade

– The decision to grant China MFN status in 1999 was • based on this philosophy

Human right issue

• The US grant Most Favored Nation (MFN) status to China – MFN are allowed to export goods to the US under favorable terms. – The average tariff on Chinese goods was 8%– Without the MFN status, tariffs would have been 40%.

• WTO members mostly receive MFN status. • China joined WTO in 2001

– China had a poor human rights record. – The 1989 Tiananmen square massacre– Subjugation of Tibet – Critics argue it is wrong for the US to grant MFN status to China.

Economic Arguments for Intervention

• Economic arguments for government intervention in international trade include

1. The infant industry argument

2. Strategic trade policy

Economic Arguments for Intervention

1. The infant industry argument

• an industry should be protected • until it can develop and be viable and

competitive internationally

– a justification for temporary trade restrictions under the WTO

• this argument has been criticized because – useless it makes the industry more efficient

• Protection – Foster the development of inefficient industries– Little hope of ever competing in the world market.– Given efficient global capital market, the only industries that

require government protections are• The ones that are not worthwhile.

Economic Arguments for Intervention

2. Strategic Trade Policy

• where there may be important first mover advantages, – governments can help firms from their

countries attain these advantages

• governments can help firms – overcome barriers to entry into

industries where foreign firms have an initial advantage

The Revised Case for Free Trade

• New trade theorists believe – government intervention in international trade is

justified

• Classic trade theorists disagree• Some new trade theorists believe

– while strategic trade theory is appealing in theory, – it may not be workable in practice – they suggest a revised case for free trade

• Two situations where restrictions on trade may be inappropriate

• Retaliation• Domestic Policies

Retaliation and War

• Krugman argues that – strategic trade policies aimed at – establishing domestic firms in a dominant position in a global industry – beggar-thy-neighbor policies

• boost national income at the expense of other countries

• A country that attempts to use such policies – probably provoke retaliation

• A trade war could leave both countries worse off

Beggar thy neighbor policy example

• The US government response to EU policy– EU provide Airbus subsidy – US provide subsidies to Boeing – The result : cancel each other out– Both European & American taxpayers support an expensive trade war– EU and the US worse off– The danger of a strategic trade policy

• Leading to a trade war.

– How to respond when one’s competitors are already being supported by government subsidies ?

– How should Boeing and the US respond to the subsidization of Airbus ? • Not to engage in retaliatory action• to help establish rules of the game – minimize the use of trade distorting subsidies ( WTO

objectives)

Domestic Policies

• Governments can be influenced by special interest

• Consequently, a government’s decision to intervene in a market – may appease a certain group, – but not necessarily the support the interests of the country

as a whole

Domestic Policy example

• The EU support for the Common Agriculture Policy (CAP)– Due to the political power of French and German farmers– The CAP benefits

• Inefficient farmers• The politicians who relies on farmers’ vote• NOT consumers in the EU – pay more for their foodstuffs.

– Not a good strategic trade policy

Development of the World Trading System

• Since World War II, – an international trading framework has evolved to govern world trade

• In its first fifty years, – the framework was known as – the General Agreement on Tariffs and Trade (GATT)

• Since 1995, the framework has been known as – the World Trade Organization (WTO)

1947-1979: GATT, Trade Liberalization, and Economic Growth

• After WWII, the U.S. and other nations realized – the value of freer trade, and – established the GATT in 1947

• The approach of GATT (a multilateral agreement to liberalize trade) – was to gradually eliminate barriers to trade

– GATT’s membership • grew from 19 to more than 120 nations

– Tariff reduction was • spread over eight rounds of negotiation

– GATT regulations were enforce by • a mutual monitoring system

1980-1993: Protectionist Trends

• The world trading system came under strain – during the 1980s and early 1990s because

• Japan’s economic success strained – what had been more equal trading patterns

• Persistent trade deficits by the U.S – caused significant problems in some industries and political problems for the

government

– Many countries found that • although GATT limited the use of tariffs, • there were many other forms of intervention • had the same effect that did not technically violate GATT

The Uruguay Round and the World Trade Organization

• The Uruguay Round (1986) focused on

1. Services and Intellectual Property• Trade issues related to services and intellectual property and

agriculture were emphasized 2. The World Trade Organization

• The WTO was established as • a more effective policeman of the global trade rules

• The WTO encompassed – GATT and – the General Agreement on Trade in Services (GATS) – the Agreement on Trade Related Aspects of Intellectual Property Rights

(TRIPS)

WTO Experience to Date

• Since its establishment, the WTO has emerged as an effective advocate and facilitator of future trade deals, particularly in such areas as services – So far, most countries have adopted WTO

recommendations for trade disputes – The WTO has brokered negotiations to reform the global

telecommunications and financial services industries – The 1999 meeting of the WTO in Seattle demonstrated that

issues surrounding free trade have become mainstream, and dependent on popular opinion

The Future of the WTO: Unresolved Issues and the Doha Round

The WTO is currently focusing on 1. Anti-dumping policies• The WTO is encouraging members

– to strengthen the regulations governing – the imposition of antidumping duties

2. Protectionism in agriculture• The WTO is concerned with

– the high level of tariffs and subsidies – in the agricultural sector of many economies

3. Protecting intellectual property• Members believe that

– the protection of intellectual property rights is essential – to the international trading system

• TRIPS obliges WTO members – to grant and enforce patents lasting at least 20 years – copyrights lasting 50 years

The Future of the WTO: Unresolved Issues and the Doha Round

4. Market access for nonagricultural goods and services• The WTO would like to

– bring down tariff rates on nonagricultural goods and services, – reduce the scope for the selective use of high tariff rates

5. A new round of talks: Doha• The WTO launched a new round of talks in 2001 to focus on

– cutting tariffs on industrial goods and services– phasing out subsidies to agricultural producers– reducing barriers to cross-border investment– limiting the use of anti-dumping laws

Implications for Managers

Question: Why should international managers care about the political economy of free trade or about the relative merits of arguments for free trade and protectionism?

• Trade barriers impact firm strategy• Firms can play a role in promoting free trade or trade

barriers

Trade Barriers and Firm Strategy

• Trade theory suggests – why dispersing production activities globally can be beneficial

• However, trade barriers may – limit a firm’s ability to do so– Trade barriers

• raise the cost of exporting – Quotas

• limit exports– Firms may have to

• locate production activities within a country • to meet local content regulations

– The threat of future trade barriers can • influence firm strategy

• All of these can – raise costs above what they may have been in a world of free trade

Policy Implications

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

strategies

• While there may be short run benefits to – having government protection in some situations, – in the long run these can backfire– other governments can retaliate – making it more difficult to construct a globally dispersed production

system

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