Tariffs are unambiguously pro-consumer and anti-producer.

Global Business Today 6e

by Charles W.L. Hill

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6

The Political Economy of International Trade

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Introduction

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

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

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Instruments of Trade Policy

Question: How do governments intervene in international trade?

There are seven main instruments of trade policy

Tariffs

Subsidies

Import quotas

Voluntary export restraints

Local content requirements

Antidumping policies

Administrative policies

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Tariffs

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

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

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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, and tariffs reduce the overall efficiency of the world economy

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Classroom Performance System

A tariff levied as a fixed charge for each unit of a good imported is a(n)

Fixed tariff

Specific tariff

Ad valorem tariff

Transit tariff

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Classroom Performance System Answer: a

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Subsidies

A subsidy is a government payment to a domestic producer

Subsidies help domestic producers

compete against low-cost foreign imports

gain export markets

Consumers typically absorb the costs of subsidies

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Country Focus: Subsidized Wheat Production in Japan

Summary

This feature explores the subsidies Japan continues to pay its wheat farmers. Tens of thousands of Japanese farmers continue to grow wheat despite the fact that the wheat grown in North America, Argentina, and Australia is far cheaper and of superior quality. The Japanese farmers stay in business thanks to the hefty subsidies paid by the Japanese government. As a result, wheat prices in Japan are substantially higher than they would be if a free market were allowed to operate.

Suggested Discussion Questions

1. Who are the winners and who are the losers from Japanese wheat subsidies?

Discussion Points: Students will probably recognize that, as is usually the case with protectionist measures, the subsidies Japan pays its wheat farmers benefit the farmers, but cost the average consumer in the form of higher wheat prices. In fact, in 2004, Japanese consumers covered $700 million in subsidies! The subsidies also limit imports of wheat, which negatively affects foreign wheat farmers.

2. Why does Japan continue to subsidize its wheat farmers when cheaper wheat is readily available in international markets?

Discussion Points: Thanks to subsidies, wheat prices in Japan are between 80 and 120 percent higher than they are in world markets. In fact, if the subsidies were eliminated, Japanese wheat production would cease entirely. However, at least for now, because politicians count on the votes of the wheat farmers, there appears to be no plan to end the subsidies.

Teaching Tip: To extend this discussion, consider discussing Japan’s role in the production of rice. For more on this, go to {http://www.businessweek.com/globalbiz/content/may2008/gb20080522_132137.htm?chan=search}, and {http://www.businessweek.com/globalbiz/content/may2008/gb20080522_132137_page_2.htm}.

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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

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

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

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

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Import Quotas and

Voluntary Export Restraints

Question: Who benefits from import quotas and voluntary export restraints?

Import quotas and voluntary export restraints benefit domestic producers by limiting import competition, but they raise the prices of imported goods for consumers

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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

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Administrative Policies

Administrative trade polices are bureaucratic rules that are designed to make it difficult for imports to enter a country

These polices hurt consumers by denying access to possibly superior foreign products

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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, and later raising prices and earning substantial profits

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Administrative Policies

Antidumping polices are designed 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, also known as countervailing duties may be imposed

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Management Focus: U.S. Magnesium Seeks Protection

Summary

This feature explores the dumping charged levied by U.S. Magnesium against Chinese and Russian producers. According to U.S. Magnesium, the sole American producer of magnesium, Russian and Chinese producers were selling magnesium significantly below market value in an effort to drive U.S. Magnesium out of business. The company failed a complaint with the International Trade Commission (ITC) which ultimately ruled in favor of U.S. Magnesium.

Suggested Discussion Questions

1. What is dumping? Were Chinese and Russian producers guilty of dumping? How did U.S. Magnesium justify its claims against Russian and Chinese producers?

Discussion Points: Dumping is defined as selling goods in a foreign market below the cost of production, or below fair market value. In 2004, U.S. Magnesium claimed that China and Russia had been dumping magnesium in the United States. The company noted that in 2002 and 2003, magnesium imports rose, and prices fell. While the ITC ruled in favor of the American company, some students might question whether the fact that the Chinese could sell their product at low prices might simply reflect the country’s significantly lower wage rates.

2. What does the ITC’s ruling mean for American consumers of magnesium? In your opinion, was the ruling fair?

Discussion Points: The ITC ruled in favor of U.S. Magnesium finding that indeed China and Russia had been dumping their product in the United States. Fines ranging from 50 to 140 percent on imports were imposed against China, and 19 to 22 percent on Russian companies. Most students will note that while the ITC’s decision is a good one for U.S. Magnesium and its employees. for consumers, the ruling means magnesium prices that are significantly higher than those in world markets. Students will probably argue that this result is unfair, and should be revisited.

Teaching Tip: U.S. Magnesium’s web site is available at {http://www.usmagnesium.com/}.

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Classroom Performance System

A quota on trade imposed from the exporting country’s side is a(n)

Voluntary export restraint

Quota rent

Local content requirement

Administrative trade policy

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Classroom Performance System Answer: a

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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)

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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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Country Focus: Trade in Hormone-Treated Beef

Summary

This feature describes the trade battle between the United States and the European Union over beef from cattle that have been given growth hormones. It outlines the basic issues that led to the dispute, and shows how the World Trade Organization has treated the case.

Suggested Discussion Questions

1. Why is the European Union so concerned about beef from cattle that have been given growth hormones?

Discussion Points: Some students may argue that the European Union’s ban on growth hormones in cattle was little more than a thinly veiled form of protectionism. Australia, New Zealand, and Canada, which also use the hormones in their cattle industry, were also affected by the ban. The European Union claimed that it was merely protecting the health of its citizens, however studies showed that the hormones posed no health issues for people.

2. Why did the WTO rule against the European Union?

Discussion Points: The World Trade Organization ruled against the European Union stating that the European Union’s ban on imported hormone treated beef had no scientific justification. Even so, the European Union refused to lift the ban, which had strong public support, and in the end, the European Union was assessed punitive tariffs. The European Union held on to its principles though, and as of 2008, continued to maintain its restrictions on hormone treated beef despite the resulting punitive tariffs.

Teaching Tip: The WTO maintains a site for students. Go to {www.wto.org} and click on the students icon to search the site, research countries, and even see a list of internships that are available at the WTO.

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Political Arguments for Intervention

1. Protecting jobs and industries

This is the most common political reason for trade restrictions

This is typically the result of political pressures by unions or industries that are "threatened" by more efficient foreign producers, and have more political clout than the consumers who will eventually pay the costs

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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

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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

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Political Arguments for Intervention

4. Protecting Consumers

Protecting consumers from unsafe products is also be an argument for restricting imports

This often involves limiting or banning the import of certain products

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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 that a government wants to build strong relations with

Rogue states that do not abide by international laws or norms can be punished

However, it might cause other countries to undermine unilateral trade sanctions

Two acts, the Helms-Burton Act and the D’Amato Act, have been passed to protect American companies from such actions

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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

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Economic Arguments

for Intervention

Economic arguments for government intervention in international trade include

The infant industry argument

Strategic trade policy

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Economic Arguments

for Intervention

1. The infant industry argument

The infant industry argument suggests that an industry should be protected until it can develop and be viable and competitive internationally

This has been accepted as a justification for temporary trade restrictions under the WTO

However, this argument has been criticized because

it is useless unless it makes the industry more efficient

if a country has the potential to develop a viable competitive position, its firms should be capable of raising necessary funds

Critics argue that

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Economic Arguments

for Intervention

2. Strategic Trade Policy

Strategic trade policy suggests that in cases where there may be important first mover advantages, governments can help firms from their countries attain these advantages

Strategic trade policy also suggests that governments can help firms overcome barriers to entry into industries where foreign firms have an initial advantage

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Classroom Performance System

Which argument for government intervention suggests that an industry should be protected until it can develop and be viable and competitive internationally?

Strategic trade policy

National security

Retaliation

Infant industry

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Classroom Performance System Answer: d

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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 that 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

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Retaliation and 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

A country that attempts to use such policies will probably provoke retaliation

A trade war could leave both countries worse off

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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

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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)

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Country Focus: Estimating the Gains from Trade for America

Summary

This feature explores the results of a study by the Institute for International Economics. The study, which estimated the gains to the U.S. economy from free trade, found that the United States’ GDP was more than 7 percent higher as a result of reductions in trade barriers than it would have been if the barriers remained. The study also estimated that if tariffs were reduced to zero, significant gains would still result.

Suggested Discussion Questions

1. What does the Institute for International Economics suggest about the benefits of free trade?

Discussion Points: The Institute for International Economics found that thanks to reductions in trade restrictions, the United States’ GDP was up. The Institute also estimated that even greater gains in the country’s GDP would occur if protectionism was eliminated all together. Students should recognize that these findings follow the principles of Adam Smith and David Ricardo and suggest that free trade is beneficial.

2. According to the Institute for International Economics study, a move toward free trade would cause disruption in employment. Is it still worth pursuing free trade if it means that some people lose their jobs?

Discussion Points: This question should prompt a strong debate among students. Some students will probably suggest that the costs in terms of lost wages and benefits associated with free trade outweigh the benefits that would be gained. Other students however, will probably argue that since protectionism typically benefits only a few at the expense of others, while free trade generates greater economic growth and higher wages, a free trade policy should be followed.

Teaching Tip: The Web site for Institute for International Economics is available at {http://www.iie.com/}.

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From Smith to the Great Depression

Up until the Great Depression of the 1930s, most countries had some degree of protectionism

In 1930, the U.S. enacted the Smoot-Hawley Act, which created significant import tariffs on foreign goods

Other nations took similar steps and as the depression deepened, world trade fell further

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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 General Agreement on Tariffs and Trade 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

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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 that had the same effect that did not technically violate GATT

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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) and the Agreement on Trade Related Aspects of Intellectual Property Rights (TRIPS)

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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

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Internet Extra: The WTO site {http://www.wto.org} provides a wealth of information on current trade issues. Go to the site, and click on Trade Topics.

Browse down the menu to explore the current situation at the Doha Round, the status of talks on electronic commerce, or the WTO’s current efforts regarding trade and the environment.

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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 and copyrights lasting 50 years

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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, and 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

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Classroom Performance System

The main issues on the table at the Doha Round include all of the following except

Anti-dumping policies

Protectionism in agriculture

Intellectual property rights

Infant industry protection

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Classroom Performance System Answer: d

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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

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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

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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 and other governments can retaliate making it more difficult to construct a globally dispersed production system

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Critical Discussion Question

1. Do you think the U.S. government should consider human rights when granting preferential trading rights to countries? What are the arguments for and against taking such a position?

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