Week Six Class Notes

Trade Theory and Policy

    Prof. Laurence Moss, editor of the American Journal of Economics and Sociology, has argued "A person's right to trade with others is an important, if not sacred, human right. Governments and others have a correlative right duty not to interfere, except to prevent the most egregious forms of behavior". That is, support for free trade is a "moral duty". Yet, for centuries, economists have argued about the legitimate role of governments in trade. To be sure, nations do not trade - buyers and sellers do. So, to begin, understanding trade theory is about answering questions like: why is there trade rather than complete self-sufficiency? Is free trade good? An unambiguous good? Because governments have political objective, trade issues become political ones. We ask - how should governments treat trade?  Trade theory offers both descriptive (what is happening) and normative (what SHOULD be happening) views.

Trade theory back ground

First, what is trade? An exchange between parties that is a) voluntary and b) believed to be mutually beneficial. Why trade? It is not a zero sum game: it always makes us better off (i.e., we give what we value less for that which we value more - therefore, we are better off than before the trade).  This is not always clearly recognized. The oldest theory of trade - mercantilism - is a normative approach that encourages exports and restricts imports (i.e., maintain a trade surplus).  Why? Historically, when metals were the only currency, rulers wanted to keep them at home (to pay for this war or that).  Today, think about what is said about our own balance of trade. Here trade is seen as a zero-sum game. In order to achieve these outcomes, exports are subsidized (which makes them cheaper to foreign buyers) and/or imports face restrictions and tariffs (which makes them more expensive for domestic buyers)

What is wrong with this approach? First, it is not dynamic and doesn't account for changes to the money supply in trading nations. What should happen to prices when the money supply increases? For example, suppose everyone's wealth doubled instantly. What happens to prices?  They would rise to reflect new income levels. In fact, they would double. Conversely, if the money supply shrinks, sellers cut prices to stimulate demand. Thus, if Country A ran a trade surplus and B a deficit, prices for A's exports would rise and make them less attractive (even with subsidies) while prices for B products would fall and make them more attractive, even with tariffs. Second, if everyone adopts a mercantilist position, no one trades and the game is undone. Third, per Adam Smith, it turns a society's aspirations upside down: national well being is based on ability to consume products (even such as clean air). Exports give us a way to pay for these but, strictly speaking, are not desirable in themselves. Think about how life would be under a perpetual trade surplus - lots of cash but few goods! Thankfully, this old, discredited theory doesn't apply today, right?


Absolute and Comparative Advantage

Adam Smith is famous for developing the first truly strong counter argument here in his advocacy of trade and the notion of absolute advantage. He saw that trade can expand the consumption possibility frontier - the mass of commodities that can be consumed. Under conditions of autarky, nations will not trade. Therefore, what each nation consumes will be limited by what they produce. This means that the possible combinations of consumption (the consumption possibilities frontier) will look exactly like the Production Possibilities Frontier (PPF). This makes sense - if each country is completely self-sufficient, it can consume only what it makes.

Smith's argument for trade sprang from the effects of specialization - "never attempt to make at home what it would cost him more to make than to buy" and this  applies across nations as well as local buyers and sellers. Specialized producers differ in what they can most efficiently produce (a matter of choices!) and when they are better at it than a trading partner, they have an absolute advantage. That is, an absolute advantage means it is less costly for one producer to produce a particular commodity than for another. The first part of the paper topic for this week covers how absolute advantage works.

David Ricardo made an important extension to this through the notion of comparative advantage. That is, in our simple two commodity example, even if a country has an absolute advantage in both commodities, it still makes sense to trade. This is one of the more counter-intuitive outcomes and well worth going through the math (in the paper assignment for this week) to see how it happens.

Ricardo's made a number of simplifying assumptions:  
·         The only relevant resource is labor and there are no price differences in input resources (production factors)
·         Constant returns to scale in production
·         Production resources can move freely between different production possibilities within but not across borders
·         Resource stocks are fixed
Are these incorrect or incomplete? Does comparative advantage stand up?

With respect to the first claim, the Hecksher-Ohlin theory argues that nations are heterogeneously endowed with factors of production and these can lead to the differing patterns of trade. That is, the differences do not necessarily arise from superior labor productivity but from factor costs. Specifically, countries will export goods that use locally abundant resources (because the cost is relatively low) and import goods that would use locally rare resources (assuming that some other nation has those resources in abundance)

For example, the US used to have a strong textile industry but now most textiles come from China (especially since import quotas were lifted in January 2005) and southeast Asia. Why? Textiles are labor intensive and the new producers have an abundance of low cost labor. Parenthetically, this difference in factor costs explains a lot about imperialism as the pursuit of resource control.

The extent to which factor endowments explain trade is constantly challenged by research such as the Leontief paradox which showed that a capital intensive economy like the US ended up exporting more labor intensive products and importing capital intensive  - which makes little sense from an HO perspective. One explanation: the trade in complex goods is exceedingly difficult to disaggregate due to insufficient data and is subject to significant interpretation biases

The second assumption about freely moving resources implies that countries can choose without cost how to deploy resources and that they can be effectively used in alternate production. That is, in the tradeoffs between oil and amphorae, workers can as effectively do one as the other. Obviously, this is clearly not true of labor (because of training and/or geography) and also not true of capital (as it is often specialized and not easily re-deployed). This often gets governments involved because the dislocations are not quickly resolved. One major implication is that these inefficiencies or frictions slow the free trade process. Not all PPF are feasible, diminishing trade opportunities

The claim regarding resource stocks is more or less true for entities like land (and in Ricardo's time, this was the critical resource, in many ways) but not necessarily true elsewhere. What's usually missing is the innovation angle - innovation increase productivity in certain areas - which means resources are freed up to be used elsewhere. More to the point, resources can migrate. Capital can flow into a country (which is called FDI, a topic we'll explore later) and we also see skilled labor being more migratory and going where the opportunities are.


Strategic trade theory is a fairly recent movement that argues that new assumptions can justify more government intervention. First, governments can act to increase the market power of domestic producers. Market power creates the ability to command higher prices (like monopolies). This is usually taking advantage of a given state of nature. More "strategically", governments sometimes focus on industries where prospective Economies of Scale (EOS) (the unit average costs decline as output increases due to capital utilization) or learning curve effects (same argument as Economies of Scale except that it is labor that decreases) can create cost advantages vis a vis other countries. This means that nations (really, firms) that are early starters can claim early production and move down the cost curve. Later entrants are not competitive. Thus, it can be argued to be in national interest to support and protect industries that exhibit significant (i.e., global) EoS or LC on the premise that first movers are ultimate winners.  Finally, strategic trade theorists argue that potential positive externalities (actions that benefit society as a whole but are too costly for individual firms to undertake - i.e., a market failure has occurred) require government intervention. A classic example here is tariffs and subsidies that protect high tech industries in order to stimulate the requisite R&D investments.


Trade policies

If free trade is good, why then are there so many barriers to trade? What motivates governments to implement such barriers? What are the implications for firms and economies?

One fundamental reason for "trade instruments" such as tariffs, quotas, or subsidies is to protect particular industry sectors, i.e., protectionist policies. Why? There are several reasons. First, such polices can preserve (some) jobs and income. Recall that trade theory suggests win/win outcomes with both sides realizing overall gains. However, the economic response is evolutionary and not immediate and the relative employment position of sectors can degrade. When a sector weakens (such as automobiles in the 70s or steel over the past several decades), the job and income losses are very focused while the gains from trade dispersed. Plus, affected industries can speak with one voice whereas consumers or the economy cannot. Thus, affected industries are the squeaky wheel. Trade policies can benefit sub-groups at the expense of overall welfare. As Kenneth Ohmae (1991)  notes, "building a genuinely competitive economy often hurts".

A variation on this idea is the "infant industry" problem in that developing industries in nations often cannot compete with established competitors elsewhere (this is quite similar to Strategic Trade Theory).  Do learning curves or economies of scale come into play here? Obviously - the infants need the production volume to move down the cost curves. This is also called an import substitution policy. Note that many economists see this as self-defeating: without competition, protected industries often fail to become efficient enough to compete internationally.

Governments sometimes use trade instruments as a means of retaliating against the actions of trading partners. For example, in March, 2002, Pres. Bush, at the urging of the steel industry, imposed 20-30% tariffs on steel imports. This stimulated a quid pro quo (and more!) response from the EU, China and other steel exporters. Not only were responding tariffs placed on steel, but in other products as well (which are called "countervailing duties"). The EU drew up a "hit list" that included motorcycles, citrus, and textiles. Japan planned retaliatory tariffs on coal, chemicals, textiles, and electrical products. China had a similar list.


Instruments of policy

Tariffs are taxes imposed on imports. They can be specific (i.e., a fixed sum per unit) or ad valorem (to the value or a proportional tax). The effect of tariffs is to raise the relative price of imports and is intended to protect domestic producers. That is, if foreign products are more competitively priced, market analysis suggests that consumption will focus on them first. This damages domestic producers and, if there are issues such as EoS, they can fall further and further behind. Thus, tariffs are designed to make domestic and imported products at parity (theoretically) in a particular domestic market. Most economists argue that tariffs are clearly "anti-consumer" - and they are right. Aside from any external retaliation, consumers are subsidizing a (comparatively) poorly performing industry through higher prices. Moreover, where is the stimulus to improve? In other words, the benefits are focused and the drawbacks general.

Subsidies are allowances or grants by governments to domestic producers (such as tax breaks, low interest loans, etc.). For example, see Peng's  discussion of Airbus (p68) which illustrates Strategic Trade theory through the policy instrument of subsidies.  In general, subsidies are transfers from tax base to specific industries and firms. How are such transfers made? Why are they trade distorting? Who benefits?

Quotas are restrictions on quantities of goods that can be imported. These can be imposed by governments or adopted voluntarily by foreign producers (VER - voluntary export restriction) (why would they do that?). As with tariffs, consumers do not benefit.

Other polices that can affect trade less obviously include local content requirements, anti-dumping polices, and plain old bureaucratic processes. Local content requirements protect domestic industries by requiring (for certain kinds of projects) that certain kinds of goods have a minimum domestic value added. This is often used in developing countries to make sure that some industry there is stimulated. The recent economic stimulus packages passed by the governments of many nations (17 of the G2) contained requirements to source domestically!

Anti-dumping policies are intended to keep foreign firms from selling below cost (whatever that is and note that this is sometimes construed to be below a reasonable profit level). Sometimes this can be predatory because if they can dump enough, it will drive domestic producers out and the market will be open, leading to monopoly positions. The problems determining this are very well known, though:  is selling below domestic prices intrinsically predatory? How can we determine costs?

Bureaucratic processes and rules are informal means of retarding imports. One famous example is the Japanese and tulip bulb imports from the Netherlands - there is no formal tariff or quota in place, but Japanese customs inspectors are required to make certain that each bulb is healthy, and they do so by cutting them in half to check. What do you imagine is the effect on bulb imports?


Do these policies work?

Ohmae (1991) has argued that many of the questions that underlie a protectionist stance are greatly outdated. First, it is an increasingly meaningless question to ask what constitutes a domestic company. This is one reason that macro-economic indicators went from reporting GNP to GDP. Companies are less and less constrained to a nation. For example, what makes an American car America? It is not sensible to ask how government should "help" domestic companies, and therefore not sensible to support protectionist policies as they rest on spurious assumptions.

What is the effect of such policies? Broadly speaking, tariffs do save jobs in protected industries (for a while, anyway) but at a real cost in terms of higher domestic prices. In the longer term, Lawrence and Litan (1987) show that such polices almost all failed to save jobs within the industry (and most contracted), and had unintended consequences of eliminating jobs in other, linked, industrial sectors. Thus, from a macro perspective, these are almost always (if not always) sub-optimal. The losses to consumers generally outweigh the gains or benefits to a limited few.


References and further reading:
Buchanan, J. & Yoon, Y. (2002) Globalization as framed by the two logics of trade. Independent Review, Winter2002, Vol. 6 Issue 3, p399-406 (AN 5916242)

Lawrence, R. & Litan, R. (1987). Why protectionism doesn't pay. Harvard Business Review, May/Jun87, Vol. 65 Issue 3, p60 (AN 4126887)

Moss, L. (2001). Why the preaching must never stop: Henry George's and Paul Krugman's respective contributions to the free trade debate. The American Journal of Economics and Sociology. Vol. 60, Iss. 5; p. 137 (AN 5854752)

Ohmae, K. (1991). The boundaries of business: The perils of protectionism. Harvard Business Review, Jul/Aug91, Vol. 69 Issue 4, p128 (AN 9108261177)

Thurow, L. (2004). Do only economic illiterates argue that trade can destroy jobs and lower America's national income? Social Research, Summer2004, Vol. 71 Issue 2, p265-278 (AN 13986318)

Wolf Jr., C. (1994). The new mercantilism. Public Interest, Summer94, Issue 116, p96-106 (AN 9410043564)

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