1. The Free Trade Movement:
Part 1: Trade Theory
(chapters 1 & 2 in Delios)
World Trade

2. THE THEORY OF INTERNATIONAL TRADE:
EVOLUTION OF A CONCEPT
Theorists:
Adam Smith (1776)
David Ricardo (1817)
Eli Heckscher (1919) / Bertil Ohlin (1933)
Wassily Leontif (1953)
Raymond Vernon (1966)
Paul Krugman and others (1980s & 1990s)
Michael Porter (1990)
pre-18th century:
mercantilism

3. An Overview of Trade Theory
Free Trade policy prevails when a government does not attempt to influence (eg, through quotas or duties) what its citizens can buy from another country or what they can produce and sell to another country.
The Benefits of Trade allow a country to specialize in the production and export of products that can be made most efficiently in that country.

4. South Korea is often cited an exemplary case study of the benefits of trade.
--Balassa et. al. found continuous lowering of import barriers since late 1950s.
But these studies are controversial.
--Created incentives to export. Nationalized banks and directed large firms (chaebols) how to invest.
(HOWEVER, THIS REPRESENTS NOT FREE TRADE POLICY, BUT “STRATEGIC TRADE POLICY” …AS WILL BE ARGUED LATER.)

5. The Benefits of Trade in S. Korea
1950s: 77% of employment in agriculture. 2001: 10%.
Percentage of GNP in manufacturing went from 10% to over 30%.
1970 GNP/per capita: $
2002 GNP/per capita: $10,013
GNP Growth/year until Crisis: 9%
Shift from non-productive uses (agriculture) to comparative advantage uses (labor-intensive manufacturing).

6. Mercantilism: mid-16th century
Mercantilism: The theory and system of political economy prevailing in Europe after the decline of feudalism, based on national policies of accumulating bullion, establishing colonies and a merchant marine, and developing industry and mining to attain a favorable balance of trade.
Excerpted from American Heritage Dictionary.

7. Is the Mercantilist Theory Still Valid?
Pursuit of national economic interests seems to indicate: Yes.
It equates international status (political power) with economic power and economic power with a trade surplus.
The classic case of neo-
mercantilism: Japan (?)

8. Fallacy of Mercantilist theory identified by David Hume - 1752
Increased exports by Country A lead to increased money supply, hence inflation and higher prices.
Increased imports by Country B lead to lower prices.
Result: Country A sells less because of high prices and Country B sells more because of lower prices.
In the long run, no country can keep a trade surplus.

9. “Classic” theory justified free trade, discredited mercantilism.
ABSOLUTE ADVANTAGE - ADAM SMITH
Two countries - Two products
Each country can produce one product more efficiently than the other.
They should specialize and trade.
COMPARATIVE ADVANTAGE - RICARDO
One country can produce both products more efficiently than the other country.
Each should specialize in the product in which it has a comparative advantage and trade for the other product.

10. Comparative Trade Advantage
Product X
Point “B” shows the benefits from free trade.
China
Germany A B
exports
imports
imports B
exports A
Product Y

11. Factor Proportions Theory
Hecksher and Ohlin argued that comparative advantage arises from differences in national factor endowments.
Factors can now be seen as including:
RESOURCES, LABOR, CAPITAL;
ENTREPRENEURSHIP & TECHNOLOGY
The empirical test of H-O  “Leontif paradox”
Leontif’s study found that US imports capital-intensive goods and exports labor-intensive goods; yet has relatively more abundant capital and expensive labor.
An explanation:
US has special advantage in new product innovations.
These may be less capital intensive until mass-production state; in fact this is labor-intensive production.
It was clear that factor endowments were complex (basic, advanced).
Focus still is on comparative advantage.

12. INTERNATIONAL PRODUCT-LIFE CYCLE (IPLC) - RAYMOND VERNON
PRINCIPLE
Original innovation of a particular product generally occurs in a country with favorable demand conditions.
Both location of sales (trade) and location of production will shift depending on the stage of the PLC.

13. International Product Life Cycle
sales
time
InvestDC InvestLDC
PLC for innovator country

14. …..progress report on the evolution of the concept of free trade over 2 centuries:
From Adam Smith  Wassily Leontif, the original concept was refined and expanded, and it supported Free Trade Policy.
Most theories had attempted to answer the question,
“Why do countries trade?” However,
the real question is: “Why do companies trade?”
THEORIES ORIENTED ON FIRMS/INDUSTRIES:
New Trade Theory
National Competitive Advantage

15. NEW TRADE THEORY - PAUL KRUGMAN and others
PRINCIPLE
First Mover Advantages will create Barriers to Entry.
Productive efficiency may not be the result of initial factor endowments or stage of development, but instead be a result of a firm's first mover advantages that create a “barrier to entry” against competitors due to progressing along the Experience Curve.
(Experience curve: scale economies and learning curve)
 Rationale for governments to pursue Strategic Trade Policy:
(i.e. Some firms in specific industries are favored, nurtured, promoted and protected from free trade so they can catch up with the First Movers.)

16. B A Experience curve Unit costs Accumulated output
(Economies of scope = spreading of costs across different types of activities.)
Accumulated output

17. Application of New Trade Theory to national economic policy
Lack of “free trade” began to be recognized in the 1970s, as Japan and other countries were seen to use highly successful export promotion strategies.
Typically, NTT applies to industries with high, fixed costs, where world demand will support few competitors. High returns from specialization where substantial economies of scale are present.
Competitors may dominate markets because “they got there first”.  first-mover advantage.
Thus: government intervention (strategic trade policy) is motivated to create this advantage.

18. Founded 1915 by William Boeing
A CASE STUDY OF FIRST MOVER ADVANTAGE
Founded 1915 by William Boeing
Largest commercial airplane manufacturer
Economies of scale may preclude new entrants.
9,000 commercial jetliners in service.
© McGraw Hill Companies, Inc.,2000

19. Established 1967 by governments of France, Germany, Great Britain
By 2001, Airbus had achieved parity with Boeing in commercial airplane orders.
There was an important role for governments.
© McGraw Hill Companies, Inc.,2000

20. What determines first mover advantage?
“Luck”... first mover may be simply lucky.
“Strategic Trade Policy”, or industrial policy
(i.e., Some firms in specific industries are favored, nurtured, promoted and protected from domestic and international competition. - eg. Korean government. – Chaebols)

21. The role of industrial policy in Asia
What is it? It refers to domestic policies to create new industry to compete internationally.
(Strategic Trade Policy)
INDUSTRIAL AND TRADE POLICY
AIMS TO BENEFIT THE HOME ECONOMY
THROUGH ADVANTAGEOUS TRADING PRACTICES
OR CREATING NEW INDUSTRY
WITHOUT RUNNING FOUL OF EXISTING
BI-LATERAL AND MULTI-LATERAL TRADE AGREEMENTS

22. A case of strategic trade policy:
Japan’s position in the world semiconductor industry
McGraw Hill Companies,2000

23. The concept of comparative advantage today: Porter’s Diamond
The Competitive Advantage of Nations, Michael Porter, 1990
Looked at 100 industries in 10 nations.
The Diamond incorporates and extends the logic of existing theories.
Question: “Why does a nation achieve international success in a particular industry?”

24. Determinants of national competitive advantage: Porter’s “Diamond”
Chance
Firm Strategy,
Structure and
Rivalry
Factor Endowments
Demand Conditions
Related and
Supporting
Industries
Government

25. Relationship of Basic to Advanced Factors
Factor Endowments
Basic factors:
natural resources,
climate,
location
Advanced factors:
infrastructure,
skilled labor,
technology
Relationship of Basic to Advanced Factors
Basic can provide an initial advantage.
Must be supported by advanced factors to maintain success.
No basics, then must invest in advanced factors.

26. Demand Conditions
Demand was seen as likely to create the capabilities of firms to satisfy the market with new products.
Countries with more sophisticated and demanding consumers
start the product life cycle.

27. Related and Supporting Industries
Firm Strategy,
Structure and Rivalry
Management ‘ideology’ can either help or hurt you. Japanese firms stressed market share, and competition based on cost.
Related and Supporting Industries
Creates clusters of supporting
industries that are internationally
competitive.

28. Determinants of National Competitive Advantage
Factor endowments:The factors of production must be considered in full complexity. ADVANCED factors result from investment by government, companies, and people, and are more likely to lead to competitive advantage.
Firm strategy, structure and rivalry:The conditions in the nation governing how companies are created, organized, managed, and the nature of domestic rivalry –all effect competitive vitality of the firms.
Demand conditions:The nature of demand --concentrated, sophisticated, demanding home customers push firms to be globally competitive.
Related and supporting industries:The presence or absence in a nation of supplier industries or related industries can create “clusters” with strong spillover effects, which makes firms internationally competitive.
Other determinants: Government, chance

31. Some implications of trade theory for practical business decisions
Company strategy: Managers can exploit national competitive advantages in their global strategy.
Location implications:It makes sense to establish a global web of production activities to countries where they can be performed most efficiently.
First-mover implications:It may pay to invest substantial financial resources in building a first-mover, or early-mover, advantage.

32. PART 2: THE POLITICAL ECONOMY OF TRADE
History of the free trade movement
origins: end of “mercantilism” in Europe
post WWII: under the auspices of GATT
GATT (GENERAL AGREEMENT ON TARIFFS AND TRADE)
created in 1948
one of the 3 major institutions created to guide the “free” economies
purpose: multilateral negotiating forum to achieve free trade
GATT championed TRADE LIBERALIZATION and a 16-fold increase in world trade in 50 years.
World Trade

33. GATT PRINCIPLES Non-discrimination – MFN (“normal” trade status)
MFN - If country A gives country B "most-favored nation” concessions, must give the same to all member countries.
Reciprocity -- Countries should engage in mutual exchange of concessions on the principle of membership-wide participation.
 If free trade is undermined by one country then another country(s) may be entitled to RETALIATE.
Exceptions to GATT rules:
Regional Blocs and bilateral deals
EU, NAFTA, etc. - exempt from giving regional concessions to non-member countries.
Less-developed countries (LDCs) generally did not participate and were not expected to reciprocate for concessions offered by developed countries.
This policy is being abandoned now, under WTO.

34. Retaliation: US Trade Sanctions
Partial List
Afghanistan Italy
Burma Libya
Canada Nigeria
China N. Korea
Cuba Pakistan
India Saudi Arabia
Iran Sudan
Iraq Syria
Yugoslavia 98
McGraw-Hill Companies,2000

35. GATT NEGOTIATION ROUNDS
Date name outcome
1947 Geneva tariffs (45000 tariff concessions)
1949 Annecy tariffs
Torquay tariffs
Geneva tariffs
Dillon tariffs
Kennedy 35% tariff reduction; anti-dumping
Tokyo 34% tariff reduction; NTB* codes
Uruguay complex international business package
Doha ?
* NTB: non-tariff barrier, i.e. everything else.
e.g. subsidies, quotas, administrative policies

36. WORLD TRADE ORGANIZATION – WTO WTO inaugurated on 1/1/1995 Currently, 148 members (@ 2004)
Initiated a new “round” in Doha on 15/11/2001, scheduled to finish by the end of 2004
decision-making based on consensus; highly politicized
unfinished business from Uruguay Round~
agriculture
tariffs on industrial goods
other possible issues

37. complex agenda now being negotiated:
agriculture is most important, to help poor countries
tariffs on industrial goods gradually reduced to zero
and include goods exported by the poor countries
“Singapore issues”: (mostly non-trade issues)
foreign investment (national treatment)
transparency in government purchasing
trade facilitation (efficient customs clearance)
competition policies (monopoly; price fixing)
other possible issues:
protect intellectual property rights from abuse
From pirates
From patent-holders
regional and bilateral negotiations
e-commerce
labor standards, human rights, environment

38. Impact of GATT / WTO
154 Rue de Lausanne, Geneva
Tariff reduction in advanced countries from 40% to 4%.
Uruguay Round opened new frontiers for liberalization; the final round under GATT.
Created the World Trade Organization.
90% of disputes satisfactorily settled.
104 disputes brought to WTO in first three years.
196 handled by GATT during its entire history.

39. Average Tariff Rates on Manufactures
1950
1990
2000
France 18
5.9
3.9
Germany 26
Italy 25
Japan --
5.3
Holland 11
Sweden 9
4.4
Britain 23
USA

40. Instruments of Trade Policy (1)
Tariff - oldest form of trade policy
Subsidy - payment to domestic producer
e.g.: cash grants, low-interest loans, tax breaks,
government equity participation in the company
Local content requirement
Import Quota:
Restriction on quantity of some good imported into a country
Voluntary Export Restraint (VER):
Quota on trade imposed by exporting country, typically at the request of the importing country

41. Instruments of Trade Policy(2)
Antidumping policies
Defined variously as:
Selling goods in a foreign market below production costs.
Selling goods in a foreign market below fair market value.
Result of:
Unloading excess production.
Predatory behavior.
Remedy: seek imposition of tariffs.
Administrative policies
Japanese are accused
Tulip bulbs
Federal Express

42. Instruments of Trade Policy (3)
Local content requirement
Requires some specific fraction of a good to be produced domestically.
Percent of component parts or of the value of the good
Initially used by developing countries to help shift from assembly to production of goods. Developed countries (US) beginning to implement.
For component part manufacturer, LCR acts the same as an import quota.

43. Results of Japanese VERs
“Voluntary” Export Restraints limit exports
Japan limited to 1.85 mm vehicle exports/year. Restraints finally dropped by US in early 1990s.
Cost to US consumers: $1B/year
Money went to Japanese producers
in the form of higher prices.
Today US auto manufacturers losing market share to Japanese cars made in USA.
See
VERs for semiconductors
(see: “The Rise … of the Japanese Semiconductor Industry”)
In 1986, Japan agreed to VERs and promote US market share in Japan. The agreement for changed from enforcement to monitoring.
The intended results were indeed achieved, but probably due to market forces.

44. Political and economic factors affecting national trade and industrial policy
Justification: (generally rejected by classical economists)
protecting jobs and industries
infant industry (emerging industries)
Oldest argument - Alexander Hamilton, 1792
Protected under the GATT / WTO.
national security
retaliation
protecting consumers
enhance national competitive advantage
strategic trade policy
(also called “industrial policy”)

45. INSTRUMENTS OF NATIONAL TRADE POLICY – examples
PROMOTING EXPORTS
Fiscal incentives to export producers
Export credits & export guarantees
Operation of overseas export promotion agencies (JETRO -Japanese External Trade Organization)
Export Processing Zones and Free Trade Zones

46. Japan The industrial policy of MITI (and other ministries):
Indicative planning (and vision)
Directed lending
Targeting new industries
Phasing out old industries
The purpose of government: to promote national competitiveness (not politics).

47. The traditional government-business relationship in Japan
Bureaucrats
Politicians
Business world

48. Disturbing Trends
US current account deficit sustained since 1970s; today 5-6% of GDP
Trade deficit has been mirrored by Japan’s surplus, famously in cars.
now, China’s trade surplus bigger!
US deficit grew even with weaker $.
GATT/WTO encounters resistance; countries now increasingly resort to regional and bilateral agreements.

49. THE POLITICAL ECONOMY OF REGIONAL TRADE
A key issue: Does integration result in “trade creation”
or “trade diversion” and create a “fortress”
or otherwise impair global free trade?

50. Regional economic integration
Agreements among countries in a geographic region to reduce, and ultimately remove, tariff and nontariff barriers to the free flow of goods, services and factors of production among each other
Additional gains from free trade beyond international agreements such as GATT / WTO
Political case for regional integration
Economic interdependence creates incentives for political cooperation and reduces potential for violent confrontation.
Together, the countries have more political and economic clout to enhance trade and other negotiations with other countries or regional blocs.
A key issue: Does integration result in a “fortress” or otherwise impair global free trade?

52. Stages of Regional Integration
Level of Integration
Political Union
Economic Union
NAFTA
Common Market
Customs Union
Free Trade Area
EU 1992
McGraw-Hill Companies,2000

53. Stages of Regional Integration
ASEAN (only a Preferential Trade Area)
No barriers to goods and services
Free Trade Area
(FTA)
EFTA, NAFTA, AFTA (prospective) ?
APEC – free and open trade and investment by 2010
ASEAN: Association of Southeast Asian Nations
AFTA: ASEAN Free Trade Area
APEC: Asia-Pacific Economic Co-operation
EC: European Community
EU: European Union
EFTA: European Free Trade Area
NAFTA: North American Free Trade Area
Customs Union
Common external trade policy
EC – Treaty of Rome
Common Market
Free factor movements
EU – Single European Act
Harmonization of
macro-economic policies;
Common currency
Economic Union
EU – Maastricht Treaty
EU – Maastricht Treaty
Political Union
Common administration

54. Bilateral and regional trade agreements  additional gains from free trade beyond GATT / WTOEU
NAFTA
ASEAN+3
MERCOSUR
Definition - agreement 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 among each other

55. Number of Regional and Bilateral Agreements
It is being pursued very actively today,
especially after the setback to the Doha Round
in Cancun in September 2003.
Number of Regional and Bilateral Agreements
280
125
GATT 1948~1994
WTO ~2003

56.                                                                                 EU

57. NAFTA
McGraw-Hill Companies,2000

58. APEC
McGraw-Hill Companies,2000

59. ASEAN
McGraw-Hill Companies,2000

60. Major Asia-Pacific Regional Groupings
APEC (1989)
21 countries including Asia-Pacific, North America, others
$18 trillion GDP; 47% of global trade (2000)
The policy concept of “open regionalism” implies nondiscrimination with the rest of the world.
ASEAN (1967) / AFTA (1992)
10 Southeast Asian countries
Sub-regional economic zones (SREZs), for example:
ASEAN-China FTA
Hong Kong – Macau – Taiwan – Guangdong – Fujian
Singapore – Johor (Malaysia) – Riau (Indonesia)
Japan Sea and Yellow Sea coastal areas
Other less formal subregional and bilateral arrangements

61. APEC since the Bogor Declaration
The new model of “open regionalism”
To be distinguished from “Fortress Europe” or “Fortress North America”
Liberalization supplemented by “facilitation” and economic and technical cooperation
Reflects member differences in stages of development
Unilateral rather than reciprocal concessions
Philosophy of consensus and voluntarism

62. Association of Southeast Asian Nations
McGraw-Hill Companies,2000

63. Who are the trading nations of East Asia
Who are the trading nations of East Asia? TRADE % OF GDP = ((Exports + Imports) / GDP (x100) Indicates a country’s dependence on trade

64. Asian Trade Flows ASEAN EU Chinese economies Aus/NZ
Destination of Exports
Aus/NZ
Source of Imports %
McGraw-Hill Companies,2000

65. Source: UN Comtrade and WTO