CHAPTER SEVEN GOVERNMENTAL INFLUENCE ON TRADE

OBJECTIVES
To realize the rationales for government policies that enhance and restrict trade To interpret the effects of pressure groups on trade policies To understand the comparison of protectionist rationales used in high-income countries with those used in low-income countries economies To comprehend the potential and actual effects of governmental intervention on the free flow of trade To understand the major means by which trade is restricted and regulated To grasp the business uncertainties and business opportunities created by governmental trade policies

CHAPTER OVERVIEW
A governments political objectives are sometimes at odds with its economic proposals to improve a nations market efficiency and international competitiveness. Chapter Seven begins by discussing the reasons why and the ways in which governments intervene in the international trade process. It then examines the economic and the noneconomic effects of those actions upon participants in that process. Finally, the chapter considers the principle instruments of trade control, including both tariffs and nontariff barriers, and concludes with a discussion of ways in which firms can deal with adverse trading conditions both at home and abroad.

CHAPTER OUTLINE
OPENING CASE: TEXTILE AND CLOTHING TRADE [See Fig. 7.1.] The United States and Europe have a long history of protecting their domestic textile and garment manufacturing industries. Negotiated in response to political pressures from firms and workers in those countries, the Multifiber Arrangement (MFA) of 1974 permitted importing countries to (i) place tariffs on imported textiles and clothing and (ii) negotiate quotas with exporting countries. The arrangement included more than forty countries whose firms were heavily tied to the U.S. and European textile and garment markets. (Under the Arrangement tariffs were very complex, but in the United States, for example, tariffs averaged about 15 percent.) However, as the high-income countries became increasingly concerned about intellectual property rights and the protection of trade in services such as banking, they began to dismantle the MFA in exchange for concessions with respect to the curtailment of piracy and access to services markets. Thus, the origin of imports was dramatically altered as Chinese and Indian firms gained North American market share at the expense of both U.S. and Latin American competitors; similarly, 73

Chinese and Indian firms gained European market share at the expense of West European, East European, and Turkish competitors. In the first month following the end of the MFA in 2005, the United States lost 12,000 jobs in related industries; Latin America experienced the closing of 18 apparel factories very soon thereafter. TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Seven. I. INTRODUCTION In principle, no country permits a totally unregulated flow of goods and services across its borders. Likewise, governments may choose to enable the global competetiveness of their own domestic firms. Protectionism refers to those government restrictions and incentives that are specifically designed to help a countys domestic firms compete with foreign competitors at home and abroad. The rationale for such policies can be economic or noneconomic in nature. [See Fig. 7.2.] Whenever governments choose to impede the flow of imports and/or encourage the flow of exports, they simultaneously provide direct and/or indirect subsidies for their domestic firms.

II. CONFLICTING RESULTS OF TRADE POLICIES While governments intervene in trade in order to attain economic, social, and/or political objectives, they also pursue political rationality when they do so. Officials enact those trade policies they feel will best protect their nations and citizensand perhaps their personal political longevity. However, aiding struggling constituencies without penalizing those who are well off is often impossible. Thus, protectionist actions not only spark fierce debate among competing parties, but they can also lead to retaliation by affected stakeholders. [Note Fig. 7.1.] III. ECONOMIC RATIONALES FOR GOVERNMENTAL INTERVENTION Government intervention in the trade process may be either economic or noneconomic in nature. A. Unemployment Persistent unemployment pushes many groups to call for protectionism; one of the most effective is organized labor. By limiting imports, local jobs are retained as firms and consumers are forced to purchase domestically produced goods and services. As we can see from the case against new U.S economic policies included raising of prices in cuba for imported items made them to rely on domestic ones, they may result in a decline in export-related jobs because of (i) price increases for components or (ii) lower incomes abroad. Thus, governments must carefully balance the costs of higher prices with the costs of unemployment and the displaced production that would result from freer trade when enacting such measures. Infant-Industry Argument First presented by Alexander Hamilton in 1792, the infant-industry argument holds that a government should temporarily shield emerging industries in which the country may

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ultimately possess a comparative advantage from international competition until its firms are able to effectively compete in world markets. As we can see from the case that U.S has stopped trading with cuba because of Castros incite revolution which made them gain Eventual competitiveness in the world market Two basic problems associated with this argument are the assumptions that (i) governments can in fact identify those industries that have a high probability of success and (ii) firms within those industries should receive government assistance. Infant-industry protection requires some segment of the economy (typically local consumers) to incur the initial higher cost of inefficient local production. Ultimately, the validity of the argument rests on the expectation that the future benefits of an internationally competitive industry will exceed the costs of the associated protectionist measures. Industrialization Argument Many of todays emerging economies emulate historical practices and use protectionism to spur local industrialization. The industrialization argument purports that the development of national industrial output (and hence economic growth) should be supported, even though domestic prices may not be competitive on the world market. Reasons to support it are numerous. 1. Use of Surplus Workers. Surplus workers can more easily be used to increase manufacturing output than agricultural output. However, this shift may also lead to (i) increasing demand for social services because of the rural to urban migration and (ii) decreasing agricultural output. In this instance, improved agriculture practices may be a better means of achieving economic success. 2. Promoting Investment Inflows. Import restrictions encourage foreign direct investment by foreign firms that want to avoid the loss of a lucrative or potential market. FDI inflows in turn lead to increased local employment, an attractive outcome for policy makers. 3. Diversification. Price variations can wreak havoc on economies that rely on just a few commodities for job creation and export earnings. Contrary to expectations, however, unless a countrys industrial base is truly expanded, a move into manufacturing may simply shift that dependence from a reliance on the basic commodities to the downstream manufactured goods produced from them. 4. Greater Growth for Manufactured Products. Terms of trade refers to the quantity of imports that a given quantity of a countrys exports can buy. Many emerging nations have experienced declining terms of trade because the demand for and prices of raw materials and agricultural commodities have not risen as fast as the demand for and prices of finished goods. In addition, changes in technology have reduced the need for many raw materials. Cost savings realized from manufactured products go mainly to higher profits and wages, thus fueling the industrialization process.

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Import Substitution versus Export Promotion. Import substitution represents an economic development strategy that relies on the stimulation of domestic production for local consumption by erecting barriers to imported goods. If the protected industries do not become globally competitive, however, local customers will continually be penalized by high prices. On the other hand, export-led development, i.e., export promotion, encourages economic development by harnessing a country-specific advantage (e.g., low labor costs) and building a vibrant manufacturing sector through the stimulation of exports. In reality, when effectively crafted, import substitution policies eventually lead to the possibility of export promotion as well. 6. Nation Building. The industrialization process helps countries build infrastructure, advance rural development, enhance the quality of peoples lives, and boost the skills of the workforce. B. Economic Relationships with Other Countries Countries track their own performance as compared to other nations to deter-mine whether to impose trade restrictions as a means of improving their competitive positions. Primary motivations are four. 1. Balance of Payments Adjustments. The trade account (the current account) is a major part of the balance of payments for most countries. If balance-of-payments difficulties persist, a government may restrict imports and/or encourage exports in order to balance its trade account. If it chooses to devalue its currency, the value of all transactions will be affected. If, however, it wishes to target certain products, then protectionist measures (both tariffs and nontariff barriers) will be more effective. 2. Comparable Access or Fairness. The comparable access argument promotes the idea that a countrys firms are entitled to the same access to foreign markets as foreign firms have to its market. Economic theory reasons that producers operating in industries where increased production leads to economies of scale but which lack equal access to foreign competitors markets will struggle to become cost-competitive. However, restricting trade, even on the grounds of fairness, may lead to higher prices for domestic customers. 3. Restrictions as a Bargaining Tool. Import restrictions may be levied as a means to try to persuade other countries to lower their import barriers. The danger, however, is that each country will, in turn, retaliate by escalating its own restrictions. To successfully use restrictions as a bargaining tool requires that they be (i) believable and (ii) important to the targeted parties. 4. Price-Control Objectives. Countries may withhold products from international markets in an effort to raise world prices and thus improve export earnings and/or favor domestic customers. (Organization of Petroleum Exporting Companies (OPEC) is a case in point.) The practice of pricing exports below cost, or below their home-country prices, i.e., below their fair market value, is known as dumping. Most countries prohibit imports of dumped products, but enforcement usually occurs only if the product disrupts domestic production. The optimum-tariff theory claims that a foreign producer will

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lower its prices if the destination country places a tariff on its products. So long as the foreign producer reduces its price by any amount, some shift in revenue goes to the importing country, and the tariff is deemed an optimum one. IV. NONECONOMIC RATIONALES FOR GOVERMENT INTERVENTION Governments may choose to intervene in the trade process for noneconomic reasons such as the maintenance of essential industries, the prevention of shipments to unfriendly nations, the maintenance or extension of spheres of influences, and/or the protection of national identity. A. Maintenance of Essential Industries The essential industry argument states that a government applies restrictions to protect essential domestic industries (particularly defense) so that the country is not dependent on foreign sources of supply. Protecting an inefficient industry, however, will lead to higher costs and possibly political consequences as well. B. Prevention of Shipments to Unfriendly Countries Groups concerned about security use national defense arguments to prevent the export, even to friendly countries, of strategic goods that might fall into the hands of potential enemies. Trade controls on non-defense goods may also be used as a foreign policy weapon to try to prevent another country from meetings its political objectives. However, retaliation often renders such protectionist measures ineffective. POINTCOUNTERPOINT: Should Countries Eliminate the Use of Trade Sanctions? POINT: Many argue against the use of sanctions on the grounds that they are ineffective. Further, even if sanctions are successful at weakening the targeted countries economies, the costs are borne not by government officials, but by innocent people. Finally, it appears that governments sometimes impose sanctions based on just a single issue, rather than on a countrys overall record, which is really counterproductive. COUNTERPOINT: Others argue that although not all trade sanctions are successful, many have at least been influential in achieving their objectives. Further, when a nation breaks an international agreement and/or acts in unacceptable ways, punitive actions such as removing diplomatic recognition, boycotting events, or eliminating foreign aid or loans may be ineffective without the addition of trade sanctions.

C. Maintenance or Extension of Spheres of Influence To maintain their spheres of influence, governments may give aid and credits to and encourage imports from countries that join a political alliance or vote a preferred way within international bodies. Further, trade restrictions may coerce governments to take certain political actions or punish firms whose governments do not comply. D. Protecting Activities that Help Preserve the National Identity

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Countries are partially held together though a unifying sense of cultural and national distinctiveness. To sustain this collective identity, governments may limit the presence of foreign products in certain sectors. V. INSTRUMENTS OF TRADE CONTROL Governments use many rationales and seek a range of outcomes when they try to influence the international trade process. The choice of instrument(s) is crucial because each type of control may incite different responses from both domestic and foreign groups. While some instruments directly limit the amount that can be traded, others indirectly affect the amount traded by directly influencing prices, i.e., while tariff barriers directly affect prices and subsequently the quantity demanded, nontariff barriers may directly affect price and/or quantity. [See Fig. 7.4.] A. Tariffs A tariff (also called a duty) is a tax levied on (internationally) traded products. Exports tariffs are levied by the country of origin on exported products; a transit tariff is levied by a country through which goods pass en route to their final destination; import tariffs are levied by the country of destination on imported products. A tariff increases the delivered price of a product, and, at the higher price, the quantity demanded will be less. A specific duty is a tariff that is assessed on a per unit basis; an ad valorem tariff is assessed as a percentage of the value of an item. If both a specific duty and an ad valorem tariff are assessed on the same product, it is known as a compound duty. A tariff controversy concerns the treatment of manufactured exports to industrialized nations. While raw materials frequently enter industrial countries tariff-free, when an ad valorem tariff is applied to manufactured goods, it is generally applied to the total value of the product. Critics argue that the effective tariff on the manufactured portion, i.e., the value-added portion, is higher than the published tariff. [Note: review the optimum tariff theory on p. 76 of this manual, p. 250 of the text, and/or slide 7-12.] B. Nontariff Barriers: Direct Price Influences Nontariff barriers (NTBs) represent administrative regulations, policies, and procedures, i.e., quantitative and qualitative barriers that directly or indirectly impede international trade. 1. Subsidies. Subsidies consist of direct or indirect financial assistance from governments to their domestic firms to help them overcome market imperfections and thus make them more competitive in the marketplace. From the standpoint of market efficiency, subsidies are more justifiable than tariffs because they seek to overcome, rather than create, market imperfections. However, many international frictions result from disagreements about the definition of a subsidy. 2. Aid and Loans. Governments may give aid and loans to other countries but require that the recipient spend the funds in the donor country; this is known as tied aid or tied loans. In this way some donor products that might otherwise be noncompetitive may find limited international markets. 3. Customs Valuation. Because of the temptation to declare a low invoice price in order to pay a lower ad valorem tariff, it is sometimes difficult to

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determine the true value of traded products. First, customs officials should use the declared invoice price. If there is none, or if the authenticity of the value is in doubt, then customs agents may assess the shipment on the basis of the value of identical (preferable) or similar (acceptable) goods arriving at about the same time. Further, because countries often impose different import barriers on products sourced from different countries, customs officials must also determine a products true origin. 4. Other Direct Price Influences. Other means that countries may use to affect prices include establishing special fees for consular and customs clearance and documentation, requirements that customs deposits be made in advance of shipment, and minimum price levels at which products can be sold after they receive customs clearance. C. Nontariff Barriers: Quantity Controls Governments use a variety of nontariff barriers to directly affect the quantity of imports and exports. When the quantity of imports is limited, the resulting shift in the supply curve means that the equilibrium price will then be higher. 1. Quotas. A quota represents a numerical limit on the quantity of a product that may be imported or exported in a given period of time. (Because of the increase in the equilibrium price, quotas may increase per unit revenues for firms that participate in the market.) Voluntary export restraints (VERs) are negotiated limitations of exports from one country to another and, as in the case of a quota, may result in higher prices to customers. An embargo represents an outright ban on imports from or exports to a particular country. (A commodity cartel seeks higher, more stable prices for its goods by assigning production quotas to individual countries and thus limiting overall output.) 2. Buy Local Legislation. Buy local legislation represents laws that are intended to favor the purchase of domestically sourced products over imported products, particularly with respect to government procurement. Local content requirements, i.e., costs incurred within the local country (usually measured as a percentage of total costs), fall within this category. 3. Standards and Labels. The professed purpose of standards is to protect the safety or health of the domestic population. However, countries may also devise classification, labeling, and testing standards that facilitate the sale of domestic products but obstruct the sale of foreign-sourced products. 4. Specific Permission Requirements. An import (and export) license requires that firms secure permission from government authorities before conducting trade transactions. Such procedures directly restrict trade when permission is denied and indirectly restrict trade because of the cost, time, and uncertainty involved in the process. A foreign exchange control requires an importer of a given product to apply to a government agency to secure the foreign currency to pay for the product.

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5. Administrative Delays. Intentional administrative delays create uncertainty and increase the cost of carrying inventory. However, competitive pressures can motivate countries to improve inefficient administrative systems. 6. Reciprocal Requirements. Governments may require that foreign suppliers accept products in lieu of money. Barter, i.e., the direct exchange of products between two parties, and offsets, i.e., the agreement by a foreign firm to purchase products with a specified percentage of the proceeds from an original sale within the importing country, both represent forms of countertrade (see Chapter 13). 7. Restrictions on Services. Countries restrict trade in services such as transportation, insurance, advertising, consulting, and banking for reasons of essentiality, the maintenance of standards, and employment. a. Essentiality. Countries consider certain services industries to be essential because they serve strategic purposes or provide social assistance to citizens. Private companies of any sort may be prohibited, and in other cases, price controls may be imposed by the government; government-owned operations are often subsidized. Essential services can include the transportation, postal, banking, utilities, security, and communications sectors. b. Standards. Governments may limit foreign entry into particular service professions in order to assure that practitioners are qualified. Licensing standards vary by country and extend to a wide variety of occupations. Prerequisites for taking certification examinations may be lengthy. c. Immigration. Government regulations often require that an organization, whether domestic or foreign, demonstrate that the skills needed for a particular job are not available locally before hiring a foreigner. VI. DEALING WITH GOVERNMENT TRADE INFLUENCES Although there are risks and costs associated with each option, firms can deal with trade restrictions by (a) moving operations to a lower-cost country, (b) concentrating on market niches that attract less international competition, (c) adopting internal innovations that lead to greater efficiency or superior products, or (d) trying to get government protection. Whether a firm benefits more from protectionism or more from some other means for countering international competition depends upon its own international strategy. However, chances of securing protectionist measures will be enhanced if companies enlist pertinent stakeholders to share in the necessary lobbying efforts.

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LOOKING TO THE FUTURE: The Battle of Different Interests Each time countries negotiate a trading agreement, new optimum production locations emerge. Further, the international regulatory situation is in many ways becoming more complex. While some groups and firms are pushing for freer trade, others clamor for greater protection. Thus, it is likely that as barriers come down for some products in some countries, they will go up for other products in other countries. Those who see themselves as losers are not apt to accept their losses without a struggle. Support for their positions may be garnered from alliances that cross national borders, as well as within domestic countries, as economic positions continue to affect politics, and vice versa.

CLOSING CASE: U.S.-Cuban Trade [See Fig. 7.5.] Able to weather a variety of political leaders, economic events, and historical eras, the U.S. embargo of Cuba is the longest and harshest embargo by one state against another in modern history. Following Castros overthrow of the Batista government in 1959 and threats to incite revolutions elsewhere in Latin America, the United States canceled its trade agreement to buy Cuban sugar. Then, following a series of increasingly hostile events, the United States severed diplomatic relations and initiated a full trade embargo via the Trading with the Enemies Act in 1962. Trade between the United States and Cuba stopped. Spurred by the collapse of communism more than thirty years later, Congress passed the Cuban Democracy Act in 1992 and the Helms-Burton Act in 1996, both of which tightened the noose for firms that attempted to do business with a Castro government. It was not until 2000 that Congress passed the Trade Sanctions Reform and Export Enhancement Act, which allowed for limited exports of U.S. agricultural, food and medical products; Cuba quickly became the twenty-first largest agricultural market for U.S. exports. Over time, sympathy for the U.S. role in Cuba has dwindled. Although many countries had initially supported the embargo, by 2001 some 150 nations had normal trade relations with Cuba. Further, the U.S. public has become increasingly divided on the usefulness of the embargo. While many people feel that repealing the embargo would help many U.S. industries and firms, others maintain that Cuban market opportunities are extremely limited. Others feel that the Cuban embargo is an unfortunate cold war relic and question the politics of U.S. policy.

Questions
1. Should the U.S. seek to tighten its economic grip on Cuba? If so, why? From a practical standpoint, most would argue that without the cooperation of the rest of the world, there is little left that the United States can do. Further, given that China is now a member of the World Trade Organization (WTO) and nations like Vietnam are trading with the United States, the Cuban embargo gives the appearance of cold war relic that is no longer relevant in todays world. However, given the consensus

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that Cuba consistently violates human rights, the continuance of U.S. trade sanctions against Cuba is consistent with U.S. policy. In addition, Cubas expropriation of American property without compensation is internationally recognized as unacceptable behavior; thus, retaliation can be seen as an appropriate response. Finally, there is the continuing argument that if the Cuban economy can be further weakened, Castro may at last be overthrown. 2. Should the U.S. normalize business relations with Cuba? If so, should the U.S. stipulate any conditions? There are both political and economic reasons for normalizing relations with Cuba. Cuba has long-since ceased to be a military threat, and there is hope that closer political relations with the United States (and the rest of the free world) will lead to greater democracy in Cuba. Further, Cuban trade sanctions are far tougher than those levied by the United States against Iran, Iraq, Libya, and North Korea. Economically, it is argued that because of the posture of the U.S. government, U.S. firms are losing out on opportunities to sell their products in Cuba to competitors from other countries. However, it is not likely that Cuba would trade with the United States as aggressively as in the past, even if it were possible. While progress in the area of human rights may be slow, experience in other countries suggests that imposing some human rights conditions may be effective in the long-run. In addition, the U.S. government may wish to facilitate the return to Cuba of U.S. companies whose properties were expropriated, even though any remaining assets are likely in a state of serious disrepair. Assume you are Fidel Castro. What kind of trade relationship with the United States would be in your best interest? What type would you be willing to accept? Castro would logically want a trade relationship that would permit him to save face politically while contributing to the economic development of the economy. Initial overtures from the U.S. government could help bolster his political position and thus would possibly be welcomed as a way to begin negotiations. Economic development assistance could come in the form of direct aid and, possibly, foreign direct investment, although there surely would be substantial controls on either form. How do the structure and relationships of the American political system influence the existence and specification of the trade embargo? The structure and relationships of the American political system serve to reinforce the existence and specification of the Cuban trade embargo. Pro-embargo supporters relentlessly lobby the U.S. Congress and presidential administration to tighten the embargo in order to spur the collapse of Cuban communism. Although recently diminished, the pro-embargo viewpoint is supported by key people in key positions throughout the government.

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WEB CONNECTION Teaching Tip: Visit www.prenhall.com/daniels for additional information and links relating to the topics presented in Chapter Seven. Be sure to refer your students to the online study guide, as well as the Internet exercises for Chapter Seven. _________________________ CHAPTER TERMINOLOGY: protectionism, p.239 retaliation, p.241 infant-industry argument, p.242 industrialization argument, p.244 terms of trade, p.245 export-led development, p.245 comparable access argument, p.246 dumping, p.24 optimum-tariff theory, p.248 essential industry argument, p.248 tariff (duty), p.251 export tariff, p.251 transit tariff, p.251 import tariff, p.251 specific duty, p.252 _________________________ ad valorem tariff, p.252 compound duty, p.252 effective tariff, p.252 nontariff barriers, p.253 subsidies, p.253 tied aid or loans, p.253 quota, p.254 voluntary export restraint (VER), p.254 embargo, p.255 buy local legislation, p.255 import license, p.256 foreign exchange control, p.256 countertrade, p.256 offsets, p.256

ADDITIONAL EXERCISES: Government Intervention in Trade Exercise 7.1. As a result of the many rounds of the General Agreement on Tariffs and Trade (GATT) and other trade negotiations, both tariff and nontariff barriers have been significantly reduced on a worldwide basis. However, given recent shifts in productive assets and employment from many industrialized countries to emerging economies such as India and China, cries for protectionist measures can be heard from many quarters. Ask students to debate the possibility that governments in industrialized countries will once again implement some form of protectionist measures in order to protect their markets and industries. Do the students expect that such measures would be in the form of tariffs or nontariff barriers? Exercise 7.2. From a global perspective one can observe excess capacity in the steel, automobile, and commercial airline industries in both industrialized and emerging nations. Ask students to discuss the logic of this from the standpoints of the Infant-Industry and the Industrialization Arguments. Then ask them to debate whether each of the arguments should be applied only in the case of emerging economies, or in the case of all countries.

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Exercise 7.3. Ask students to debate the issue of stakeholders in government trade policy, i.e., whose interests should be of paramount concernproducers, consumers, or the government. Can sanctions by a single nation against another be truly effective, or must it be a multilateral, if not a unilateral, action? Exercise 7.4. Former U.S. Secretary of State Lawrence Eagleburger claims that instead of an embargo, a more effective way to bring democracy to Cuba and other repressive nations would be to increase their exposure to the United States and other industrialized nations through trade and travel. Others claim, however, that governments that choose to violate human rights, expropriate private property, etc. must not be economically rewarded. Ask students to discuss the tension that frequently accompanies the use of economic means to achieve political ends.

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