Pros & cons of free trade

1. International Business(International Economics and Trade Theory – Regional Economic Integration)ERASMUS programme IVLecturer Dr Pavlos Dimitratos pdimitr@aueb.gr

2. Pros & cons of free trade • Mini-case discussion • Countries that adopt a more open stance toward international trade enjoy higher long-term growth rates than those that close their economies to trade • Trade theories (can help a firm decide where to locate its production activities) • Mercantilism: A country must maintain a trade surplus • Trade is a zero-sum game • Adam Smith was the first to assert that trade can be a positive-sum game

3. Absolute & comparative advantage • According to Adam Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for goods produced by other countries • According to David Ricardo, a country should specialize and export those goods that it produces MOST efficiently and import the goods that it produces less efficiently, even if it can produce the imported goods more efficiently itself

4. Heckscher-Olin Theory • Comparative advantage arises from differences in national (relative) factor endowments • Countries will export those goods that make intensive use of factors that are locally abundant, while it imports those goods that make intensive use of factors that are locally scarce • The pattern of international trade is determined by differences in (relative) factor endowments rather than differences in productivity (of Ricardo’s theory)

5. Product-Life Theory • Trade patterns are influenced by where in the world a new product is introduced (and produced subsequently). • This theory predicted correctly international trade of countries between 1945 and 1975 in some industries (e.g. electronics) but has been less predictive nowadays

6. New Trade Theory • If the output required to realize significant scale economies represents a substantial proportion of total world demand for that product, the world market may be able to support only a limited number of firms based in a limited number of countries producing that product • E.g. the commercial aerospace example dominated by Airbus and Boeing • Economies of scale matter • First mover advantages can accrue to early entrants into an industry • New trade theory may be at variance with the Heckscher-Olin theory but not with Ricardo’s theory • Thus, there may be role for strategic trade policy (government intervention), which is at odds with free trade prescriptions

7. National competitive advantage • Porter argues that four attributes of a nation (along with chance and government) shape the local environment in which firms compete and may formulate the creation of competitive advantage internationally • Factor endowments • Demand conditions • Related and supporting industries • Firm strategy, structure and rivalry • This theory encompasses aspects of previous ones, yet it should receive greater empirical testing • Mini-case discussion

8. Instruments of trade policy • Tariffs: A tariff is a tax levied on imports (e.g. US tariff on European pasta or on Japanese cars) • Tariffs are pro-producer and anti-consumer, and reduce the overall efficiency of the world economy • Subsidies: Government payment to domestic producers (e.g. EU subsidies to farmers) • Governments typically pay for subsidies by taxing individuals • Subsidies are accepted by advocates of new trade theory

9. Instruments of trade policy (con’d) • Import quotas: A direct restriction on the quantity of some good that may be imported into a country (e.g. US quota on cheese, UK quota on TV sets, EU quota on textiles) • A variant of import quotas is the voluntary export restraint: This is a quota on trade imposed by the exporting country, typically on the request of the importing country’s government (e.g. VER on Japanese cars into the US) • Local content requirement: some specific fraction of a good should be produced domestically (e.g. 62.5% North American content on automobiles coming from NAFTA member countries)

10. Instruments of trade policy (con’d) • Administrative trade policy: Bureaucratic rules designed to make it difficult for imports to enter a country (e.g. Japanese inspections on imported goods) • Antidumping policy: take measures (e.g. countervailing duties) against dumping, which refers to selling goods in the foreign market below the production cost or below a ‘fair’ market value (e.g. US antidumping policy against Japanese car imports)

11. Instruments of trade policy (con’d) • Boycott: Absolute restriction against purchase/importation of foreign goods (e.g. boycott against Nestle products) • Monetary barriers: foreign exchange-control restrictions • Blocked currency (refusing to allow importers to exchange national currency for the sellers’ currency) • Differential exchange rate (the importer is required to varying amounts of domestic currency for foreign exchange with which to purchase products in different categories • Government approval to secure foreign exchange (importers must apply for exchange permits)

12. The Case for Government Intervention • Political arguments • Protecting jobs and industries • National security • Retaliation • Protecting consumers • Furthering foreign policy objectives • Protecting human rights • Economic arguments • The infant industry argument • Strategic trade policy

13. The revised case for free trade • In response to the strategic trade policy arguments … • Retaliation and trade wars may occur • Special interest domestic politics may distort effectiveness of government intervention • Thus, WTO can be an effective solution

14. WTO • It can take measures against countries which refuse to conform to what has been agreed • Has been criticized (e.g. Seattle events) by mainly • Environmentalists • Human rights activists • Labor unions

15. Regional economic integration • It refers to agreements among countries in a geographic region to reduce, and ultimately, remove tariff and non-tariff barriers to the free flow of goods, services, and factors of production between each other

16. Levels of economic integration • Free trade area (e.g. NAFTA): No barriers to trade among member countries while members maintain individual tariff schedules for external countries • Customs union (e.g. between France and Monaco, Italy and San Marino): No barriers to trade among member countries and a common external tariff schedule on products outside the union • Common market (e.g. EEC, Central American Common Market): No barriers to trade among member countries, a common external tariff schedule on products outside the union, and no restriction on free flow of capital and labor among member countries

17. Levels of economic integration (con’d) • Economic union (e.g. EU): No barriers to trade among member countries, a common external tariff schedule on products outside the union, no restriction on free flow of capital and labor among member countries, and a common currency, harmonization of members’ tax rates & a common monetary and fiscal policy (economic integration) • Political union (former COMECON): Involves economic and political integration

18. The case for and against regional integration • Apart from the straightforward economic case for regional integration, the potential for violent conflict between the member countries is reduced and political leverage against the rest of the world is increased • Impediments to regional integration may be interests of special groups in individual nations and concerns over national sovereignty • Regional integration should not result in trade diversion • Is ‘regionalization’ (e.g. EU fortress) an end to ‘globalization’?

19. Readings • Hill, chapters 4, 5 & 8 Recommended: • Porter M.E. (1990), The Competitive Advantage of Nations, New York: The Free Press. • Rugman A. (2000), The End of Globalisation, London: Random House.