In this chapter, we discuss the development of national trade policies that protect domestic firms from foreign competition and help promote the country’s exports. We also explore the rationale for these policies and the means by which governments implement them.
This chapter’s learning objectives include the following:Presenting the major arguments in favor of and against governmental intervention in international trade. Identifying the advantages and disadvantages of adopting an industrial policy. Analyzing the role of domestic politics in formulating a country’s international trade policies.
Additional learning objectives include:Describing the major tools countries use to restrict trade.Specifying the techniques countries use to promote international trade.Explaining how countries protect themselves against unfair trade practices.
Politicians, economists, and businesspeople have been arguing for centuries over government policies regarding international trade. Two principal issues have shaped the debate:Whether a national government should intervene to protect the country’s domestic firms by taxing foreign imports or constructing other import barriers. Whether a national government should help domestic firms increase their foreign sales through export subsidies, government-to-government negotiations, and guaranteed loan programs.
In North America, the trade policy debate has recently focused on the issue of whether the government should promote “free” trade or “fair” trade. Free trade implies that the national government exerts minimal influence on the exporting and importing decisions of private firms and individuals. Fair trade is sometimes called managed trade. Advocates of fair trade assert that the national government should intervene to ensure (1) that domestic firms’ exports receive an equitable share of foreign markets and (2) that imports are controlled to minimize losses of domestic jobs and market share in specific industries. The outcome of the debate is critical to international managers. The policies that individual countries adopt affect the size and profitability of foreign markets and investments, as well as the impact of foreign imports in domestic markets. The debate also affects consumers in every country, influencing the prices they pay for thousands of goods.
The argument for free trade follows Adam Smith’s analysis as discussed in Chapter 6. In Smith’s view, a country and its citizens are better off when self-interested individuals, regardless of where they reside, exchange goods, services, and assets as they see fit. However, many businesspeople, politicians, and policy makers believe that, under certain circumstances, deviations from free trade are appropriate. This section reviews arguments against free trade and for government intervention. It also reviews strategictrade theories and policies that focus on the needs of individual industries.
National defense has often been used as a reason to support governmental protection of specific industries. Because world events can suddenly turn hostile to a country’s interests, the national defense argument holds that a country must be self-sufficient in critical raw materials, machinery, and technology. The national defense argument appeals to the general public, which is concerned that its country will be pushed around by other countries that control critical resources. Many special interest groups have used this argument to protect their industries from foreign competition.
Alexander Hamilton, the first U.S. Secretary of the Treasury, articulated the infant industry argument in 1791. He feared that the young nation’s manufacturers would not survive because of fierce competition from more mature European firms. Thus, he fought to impose tariffs on numerous imported goods to protect certain U.S. firms from foreign competition until they could fully establish themselves. His philosophy has been adopted by countries worldwide. Governmental nurturing of domestic industries that will ultimately have a comparative advantage can be a powerful economic development strategy. However, determining which industries deserve infant-industry protection is often done on a political rather than an economic basis. Moreover, once an industry is granted protection, it may be reluctant to give it up. In fact, many infant industries end up being protected well into their old age.
Well-established firms and their workers, particularly in high-wage countries, are often threatened by imports from low-wage countries. To maintain employment levels, firms and workers often petition their governments for relief from foreign competition. Government officials may provide assistance in the form of tariffs, quotas, or other barriers.
When firms and labor union officials plead for government intervention to help them compete internationally, economists claim that such intervention ultimately harms the economy. They base this claim on the classical trade theories of absolute advantage and comparative advantage. These trade theories, however, assume that firms operate in perfectly competitive markets of the sort that exist only in economics textbooks. In the early 1980s, new models of international trade (known collectively as strategic trade theory) were developed. These models provide a new theoretical justification for government trade intervention, thereby supporting firms’ requests for protection. Strategic trade theory applies to oligopolistic industries capable of supporting only a few firms worldwide, perhaps because of high product development costs or strong experience curve effects. This trade theory suggests that a national government can make its country better off if it adopts trade policies that improve the competitiveness of its domestic firms in such industries.
Consider the potential market for a new nuclear power plant design, one that could safely and cheaply supply electrical energy. Assume that because of economies of scale, the market will be extremely profitable if one—and only one—firm decides to enter it. Further assume that only two firms, France’s Areva and Japan’s Toshiba, have the engineering talent and financial resources to develop the new plant design and that both are equally capable of successfully completing the project. This figure shows the payoff matrix for the two firms. If Toshiba decides to develop the plant design and Areva decides not to (see the lower left-hand corner), Toshiba profits by $10 billion, while Areva makes nothing. If Areva decides to develop the plant design and Toshiba does not, Areva profits by $10 billion, while Toshiba makes nothing (see the upper right-hand corner). If neither firm chooses to develop the design, they both make nothing (see the lower right-hand corner). If both decide to develop the design, both will lose $1 billion because the market is too small to be profitable for both of them. In this situation, neither firm has a strategy that it should follow regardless of what its rival does.
Now suppose the French government learns of the large profits that Areva could earn if it became the sole developer of the new plant design. If France offered Areva a subsidy of $2 billion to develop the new nuclear technology, the payoff matrix would change to you see in this figure. Because of the subsidy, Areva’s payoff is increased by $2 billion if and only if it develops the technology (see the first row). With the subsidy, Areva will develop the technology regardless of what Toshiba does because Areva makes more money by developing than by not developing. If Toshiba chooses to develop, Areva makes nothing if it does not develop and $1 billion if it does develop. If Toshiba does not develop, Areva makes nothing if it does not develop and $12 billion if it does develop. Thus, Areva will always choose to develop. If Toshiba knows that Areva will always choose to develop, however, the best strategy for Toshiba is not to develop.What has the French government accomplished with its $2 billion subsidy?It has induced Areva to develop the new nuclear power plant technology.It has induced the Japanese firm to stay out of the market.It has succeeded in allowing a French firm to make a $12 billion profit at a cost to French taxpayers of only $2 billion.By adopting a strategic trade policy in a market where monopoly profits are available, the French government has made French residents as a group better off by $10 billion ($12 billion in profits minus $2 billion in subsidies).
This section focused on the Rationale for Trade Intervention. After an introduction to the trade policy debate, the discussion included arguments against free trade and reviewed strategic trade theory. The next section will review the Advantages and Disadvantages of Adopting an Industrial Policy.
A national government may also develop trade policies by taking an economy-wide perspective. After assessing the needs of the national economy, the government then adopts industry-by-industry policies to promote the country’s overall economic agenda.
An important policy goal of many governments, particularly those of developing countries, is economic development. International commerce can play a major role in economic development programs. Some countries, such as Singapore, South Korea, and Taiwan, based their post–World War II economic development on exports. According to this export promotion strategy, a country encourages firms to compete in foreign markets by harnessing some advantage the country possesses, such as low labor costs. Other countries, such as Australia, Argentina, India, and Brazil, adopted an import substitution strategy after World War II; such a strategy encourages the growth of domestic manufacturing by erecting high barriers to imported goods. Many multinational enterprises (MNEs) responded by locating production facilities within these countries to avoid the costs resulting from the high barriers.
Industrial policy identifies domestic industries that are critical to the country’s future economic growth and then formulates programs to make them more competitive. Ideally, industrial policy assists a country’s firms in capturing larger shares of important, growing global markets.Many experts, however, do not view industrial policy as a panacea for improving the global competitiveness of a country’s firms. They argue that government bureaucrats cannot perfectly identify the right industries to favor under such a policy. Opponents of industrial policy also fear that the choice of industries to receive government aid will depend on the domestic political clout of those industries, rather than on their potential international competitiveness.
Why do national governments adopt public policies that hinder international business and hurt their own citizenry overall, even though they may benefit small groups within their societies? According to public choice analysis, special-interest groups are willing to work harder to promote their interests than the general public is willing to work to defeat policies unfavorable to its interests. As a result, domestic trade policies don’t stem from a vision of a country’s international responsibilities; rather, they are shaped by the mundane interaction of politicians trying to get elected.
Our discussion of the Advantages and Disadvantages of Adopting an Industrial Policy focused on economic development, industrial policy, and public choice analysis. The next section will review the Barriers to International Trade.
We have seen that domestic politics can cause countries to try to protect their firms from foreign competitors by erecting barriers to trade. Such forms of government intervention can be divided into two categories: tariffs and nontariff barriers.
Historically, tariffs have been imposed for two reasons: to raise national government revenue and to act as a trade barrier to foreign goods. A tariff is a tax placed on a good that is traded internationally. An export tariff islevied on goods as they leave the country.A transit tariff is levied on goods as they pass through one country bound for another. The most common are import tariffs collected on imported goods.
There are three types of tariffs on imports:An ad valorem tariff is assessed as a percentage of the market value of the imported good. For example, this table drawn from the existing U.S. tariff code shows that a 2.1 percent ad valorem tariff is levied against imported pineapples preserved by sugar. A specific tariff is assessed as a specific dollar amount per unit of weight or other standard measure. This table shows that a tariff of 6 cents per kilogram is levied on imported citrus fruit preserved by sugar. A compound tariff has both an ad valorem component and a specific component. Imported cherries preserved in sugar are levied a 6.4 percent ad valorem tariff and a 9.9 cents per kilogram specific tariff. In practice, most tariffs imposed by developed countries are ad valorem. The tariff applies to the product’s value, which is typically the sales price at which the product enters the country.
Historically, tariffs have been imposed for two reasons: to raise revenue for the national government and to act as a barrier to trade. Tariffs affect both domestic and foreign special-interest groups. For example, suppose the U.S. government imposes a $2,000 specific tariff on imported SUVs. Foreign producers of SUVs will be forced to raise their U.S. prices, thereby reducing their U.S. sales. However, foreign-made SUVs and U.S.-made SUVs are substitute goods. Thus, the higher prices of foreign SUVs will increase the demand for SUVs made in the USA. This is shown in this graph by the shift in the demand for U.S.-made SUVs from D to D1, resulting in more domestic vehicles being sold at higher prices. The $2,000 specific tariff creates both gainers and losers. Gainers include GM, Ford, and Chrysler dealerships selling domestic SUVs; suppliers to domestic producers; workers at domestic GM, Ford, and Chrysler SUV assembly plants; and the communities in which domestic SUV factories are located. Domestic consumers are losers because they pay higher prices for both domestic and foreign SUVs. Foreign producers also lose, as do people and firms that depend on them, including Toyota and Mazda dealerships in the United States, workers and suppliers in Japan, and communities in Japan in which the SUVs are manufactured.
The second category of governmental controls on international trade includes nontariff barriers (NTBs).These barriers include any government regulation, policy, or procedure (other than a tariff) that impedes international trade. The following slides cover three kinds of NTBs: quotas, numerical export controls, and other nontariff barriers.
Countries may restrain international trade by imposing numericalquotas. A quota is a numerical limit on the quantity of a good that may be imported into a country during some time period, such as a year. Quotas have traditionally been used to protect politically powerful industries, such as agriculture, automobiles, and textiles, from the threat of competition.Many countries have replaced quotas with tariff rate quotas. A tariff rate quota (TRQ) imposes a low tariff rate on a limited amount of imports of a specific good; above that threshold, a TRQ imposes a prohibitively high tariff rate on the good. The graph on this slide depicts this situation. In this example, the first 100,000 widgets imported into a country are subjected to a low tariff rate, TL; all widgets after the first 100,000 are subjected to the high tariff rate, TH. In the short run, such high tariffs have the same effect as a quota. They normally limit imports of a good to the threshold level. However, at least in concept, exporters are allowed to increase their sales to the country, as long as they are willing to pay the high tariff. And because tariffs are more visible than quotas, most experts believe that converting quotas to TRQs makes it easier to eliminate this type of trade barrier over time through trade negotiations.
A country also may impose quantitative barriers to trade in the form of numerical limits on the amount of a good it will export. A voluntary export restraint (VER) is a promise by a country to limit its exports of a good to another country to a pre-specified amount or percentage of the affected market. Often this is done to resolve or avoid trade conflicts with an otherwise friendly trade partner.Export controls may also be adopted to punish a country’s political enemies. An embargo is an absolute ban on the exporting (and/or importing) of goods to a particular destination. This ban is adopted by a country or international governmental authority to discipline another country. Numerical export controls may also be used to promote a country’s industrial policy or the competitiveness of its other industries.
Countries use various other NTBs to protect themselves from foreign competition. Non-quantitative NTBs have now become major impediments to the growth of international trade. The most common non-quantitative NTBs are as follows:Product and testing standards are a common NTB. Foreign firms often claim that these standards discriminate against their products.Restricted access to distribution networks limitforeign suppliers’ access to the normal channels of distribution.Public-sector procurement policiesgive preferential treatment to domestic firms.Local-purchase requirementshinder foreign firms from exporting to or operating in a host country by requiring them to purchase goods or services from local suppliers. Regulatory controlsaffect the ability of international businesses to compete in host markets. Currency controls allow exporters of goods to exchange foreign currency at favorable rates; however, importers are forced to purchase foreign exchange from the central bank at unfavorable rates. Investment controls on foreign ownership are common. Such controls can make it hard for foreign firms to develop an effective market presence.
Our discussion of the Barriers to International Trade defined tariffs and explored why they are used. Then, typical nontariff barriers were introduced, along with a number of other nontariff barriers. The next section will examine the Promotion of International Trade.
This section discusses government policies that promote international business; such as subsidies, establishment of foreign trade zones, and export financing programs. Typically, these programs are designed to create jobs in the export sector or attract investment to economically depressed areas.
Countries often seek to stimulate exports by offering subsidies designed to reduce firms’ costs of doing business. National, state, and local governments often provide economic development incentives to entice firms to locate or expand facilities in their communities to provide jobs and increase local tax bases. Because subsidies reduce the cost of doing business, they may affect international trade by artificially improving a firm’s competitiveness in export markets or by helping domestic firms fight off foreign imports. Subsidies, however, can grow so large as to disrupt the normal pattern of international trade. The shipbuilding, wheat, and butter industries are notorious examples of markets in which trade is distorted because of the high level of subsidies. The big losers in the subsidy wars are efficient producers in countries that lack large-scale subsidies.
A foreign trade zone (FTZ) is a geographic area where imported or exported goods receive preferential tariff treatment. Governments all over the globe use FTZs to spur regional economic development. An FTZ may be as small as a warehouse or a factory site,or as large as an entire city. Through utilization of an FTZ, a firm typically can reduce, delay, or sometimes totally eliminate customs duties. For example, a firm can import a component into an FTZ, process it further, and then export the processed good abroad and avoid paying customs duties on the value of the imported component.
For big-ticket items such as aircraft or offshore drilling rigs, success or failure in exporting depends on a firm’s producing a high-quality product, providing reliable repair service after the sale, and offering an attractive financing package. Because of the importance of the financing package, most major trading countries have created government-owned agencies to assist their domestic firms in financing export sales. The Export-Import Bank of the United States (Eximbank) provides financing for U.S. exports through direct loans and loan guarantees; in 2010 it supplied financing for more than 3,500 export transactions worth $24.5 billion. The U.S. government also sponsors the Overseas Private Investment Corporation (OPIC), which provides political-risk insurance. If a foreign country confiscates an insured firm’s goods or assets, OPIC will compensate the firm for its losses. Most major trading countries have similar organizations that provide export financing, commercial insurance, and political-risk insurance.
This section focused on the Promotion of International Trade by reviewing government subsidies, foreign trade zones, and export financing programs. The next section will cover Controlling Unfair Trade Practices.
With governments around the world adopting programs to protect domestic industries from imports and promote their exports, international competitors often allege unfair trade practices. In response to these complaints, many countries have implemented laws to protect their domestic firms from unfair trade practices.
In the United States, complaints are first investigated by the International Trade Administration (ITA),a division of the U.S. Department of Commerce. The ITA determines whether an unfair trade practice has occurred. The Department of Commerce transfers confirmed cases of unfair trading to the U.S. International Trade Commission (ITC),an independent government agency. If a majority of the six ITC commissioners decide that U.S. producers have suffered “material injury,” the ITC will impose duties on the offending imports to counteract the unfair trade practice.
Most countries protect local firms from foreign competitors that benefit from subsidies granted by their home governments. A countervailing duty (CVD) is an ad valorem tariff on an imported good. It is imposed by the importing country to counter the impact of foreign subsidies. The CVD is calculated to just offset the advantage the exporter obtains from the subsidy. In this way, trade can still be driven by the competitive strengths of individual firms and the laws of comparative advantage, rather than by the subsidies that governments offer their firms.
Many countries are also concerned about their domestic firms being victimized by discriminatory or predatory pricing practices of foreign firms, such as dumping. There are two types of dumping. The first kind occurs when a firm sells its goods in a foreign market at a price below what it charges in its home market. This is a form of international price discrimination. The second type of dumping occurs when a firm sells its goods below cost in the foreign market. This is a form of predatory pricing. The concern with predatory pricing is that a foreign company may lower its prices in the host country, drive host country firms out of the market, and then charge monopoly prices to consumers once local competitors have been eliminated. Antidumping laws protect local industries from dumping by foreign firms. However, determining whether price discriminationhas actually occurred is not always easy. Furthermore, in predatory pricing,defining costs is complicated, particularly when dealing with a large, multidivisional MNE.
It may be surprising to learn that many economists argue for abolishing unfair trade practice laws. They in theory with the objectives of these laws. However, they assert that in practice these laws do more harm than good. Critics assert that the paperwork required by the U.S. International Trade Commission is onerous and that the Commission’s costing methods are flawed. As a result, they believe that enforcement of U.S. laws against unfair trade is based on politics and that the laws are nothing more than protectionist trade barriers. Some economists believe the laws harm consumers. These economists are skeptical of the predatory pricing argument, contending that decades of economic research have failed to find many real-world examples of such behavior. With regard to international price discrimination, they argue that if foreigners are kind enough (or dumb enough) to sell their goods to our country below cost, why should we complain?
International trade law also allows countries to protect themselves from sudden surges in imported goods, even if the goods were traded fairly, in order to allow them time to adjust to the changed economic environment. Such actions utilize “safeguard clauses” or “escape clauses.” For example, the Trade Act of 1974 permits the enactment of temporary trade barriers, if the International Trade Commission finds that American firms have been seriously harmed by a sudden increase in imported goods.
This section covered Controlling Unfair Trade Practices. It explored countervailing duties and antidumping regulations, along with the advantages and disadvantages of enforcing unfair trade practice laws. The discussion closed with an overview of the safeguards that countries use to counter unexpected import surges. This presentation will close with a review of the chapter’s learning objectives.
This concludes the PowerPoint presentation on Chapter 9, “Formulation of National Trade Policies.” During this presentation, we have accomplished the following learning objectives: Presented the major arguments in favor of and against governmental intervention in international trade. Identified the advantages and disadvantages of adopting an industrial policy. Analyzed the role of domestic politics in formulating a country’s international trade policies. Described the major tools countries use to restrict trade.Specified the techniques countries use to promote international trade.Explained how countries protect themselves against unfair trade practices.For more information about these topics, refer to Chapter 9 in International Business.