Chapter 6

Government Influence on Trade





!          Evaluate the rationale for government policies that enhance and restrict trade.

!          Examine the effects of pressure groups on trade policies.

!          Compare the protectionist rationales used in developed countries with those used in developing economies.

!          Study the potential and actual effects of government intervention on the free flow of trade.

!          Give an overview of the major means by which trade is restricted, regulated and liberalized.

!          Profile the GATT and the World Trade Organization.

!          Show that government trade policies create business uncertainties and business opportunities.



Chapter Overview


A government’s political objectives are often at odds with economic proposals to improve its market efficiency and international competitiveness. Chapter 6 first discusses the ways in which governments intervene in the international trade process, their reasons for doing so and the economic and non-economic effects of those actions upon participants in the process. It then examines the role of the General Agreement on Tariffs and Trade and the World Trade Organization in the international trade arena. The chapter concludes with a discussion of some ways in which firms can deal with adverse trading conditions.



Chapter Outline


OPENING CASE: European and U.S. Trade Relations

This case vividly describes government influence on trade among the European Union, the United States and the banana-producing countries of Latin America. In 1993, the EU adopted a trade policy that directly favored the small banana growers in various countries in Africa, the Caribbean and the Pacific. Following a nine-year “banana war” between the U.S. and the EU that finally played out before the World Trade Organization, a truce was declared and a new spirit of trade cooperation decreed. At the same time, however, the U.S. and the EU continued to disagree on other trade matters such as the importation of hormone-treated beef, the labeling and licensing of genetically modified foods, data protection and privacy, aerospace subsidies, standards for a new generation of cellular phones and agricultural subsidies. The situation reached a new extreme when President Bush moved to protect the U.S. steel industry through the imposition of tariff barriers. The European Union blasted the U.S. for violating basic free trade principles and WTO directives and retaliated by imposing trade sanctions on an assortment of politically-targeted U.S. products.


Teaching Tip: Carefully review the PowerPoint slides for Chapter 6. Also review in the text Table 6.3—GATT Milestones.


I.                   INTRODUCTION

In principle, no country allows an unregulated flow of goods and services across its borders. Likewise, governments may choose to enable the global competitiveness of their own domestic firms. The rationale for such policies may be economic or non-economic in nature. Protectionism refers to government measures designed to shield domestic industries from foreign competition. Such measures often provide direct or indirect subsidies intended to help domestic firms compete with foreign producers either at home or abroad.



While governments intervene in trade to attain economic, social and/or political objectives, they also pursue political rationality when they do so. However, aiding struggling constituencies without penalizing those who are well off is often impossible. In addition to conflicting goals, there also looms the ever-present threat of retaliation against protectionist actions.



A.                Unemployment

One of the most effective types of political pressure is organized labor’s efforts to preserve domestic jobs. By limiting imports, local jobs are retained as firms and consumers are forced to purchase domestically produced goods and services. However, unless the protectionist country is relatively small, such measures are usually ineffective with respect to limiting unemployment. Further, such measures are likely to lead to retaliation. Thus governments must carefully balance the costs of higher prices with the costs of unemployment and the displaced production that would result from free trade.

B.                 Infant-Industry Argument

First presented by Alexander Hamilton in 1792, the infant industry argument holds that a government should shield emerging industries in which the country may ultimately possess a comparative advantage from international competition until its firms are able to effectively compete in world markets. Eventual competitiveness is the result of movement along the learning curve plus the efficiency gains from achieving the economies of large-scale production. Nonetheless, infant-industry protection requires some segment of the economy (typically local consumers) to incur the initial higher cost of inefficient local production.

C.                Industrialization Argument

Emulating historical patterns, many of today’s emerging economies use trade protection to spur local industrialization.

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 decreasing agricultural output and increasing demand for social services. In this instance, improved agriculture practices may be a better means of achieving economic success.

2.                  Promoting Investment Inflows. Import restrictions may increase foreign direct investment if foreign firms want to avoid the loss of a lucrative or potential market. The fact that FDI inflows may lead to increased local employment is attractive to 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 country’s industrial base is 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 a given quantity of a country’s exports can buy. Many emerging nations have experienced declining terms of trade because the prices of raw materials and agricultural commodities have not risen as fast as the prices of finished goods. In addition, changes in technology have reduced the need for many raw materials. Further, cost savings realized from manufactured products go mainly to higher profits and wages, thus fueling the industrialization process.

5.                  Import Substitution vs. Export Promotion. Import substitution represents an economic development strategy that relies on the stimulation of domestic manufacturing 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. Export promotion, on the other hand, 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 may 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.

D.                Economic Relationships with Other Countries

Countries track their own performance as compared to other countries and then decide if they should impose trade restrictions as a means of improving their competitive positions.

1.                  Balance of Payments Adjustments. The trade 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.

2.                  Comparable Access, or “Fairness.” Economic theory supports the idea that a given country’s firms are entitled to the same access to foreign markets as foreign firms have to their market. However, restricting trade, even on the grounds of “fairness,” may lead to higher prices for domestic customers.

3.                  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. (OPEC is a good case in point.) The practice of pricing exports below cost, or below their home-country prices, 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 a foreign producer will lower its prices if the destination country places a tariff on its products. So long as the foreign producer lowers its price by any amount, some shift in revenue goes to the importing country and the tariff is deemed an optimum one.



A.                Maintaining Essential Industries

The essential industry argument states a government will apply trade restrictions to protect essential domestic industries so the country is not dependent on foreign sources of supply. Protecting an inefficient industry, however, will inevitably lead to higher costs.

B.                 Dealing with “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.

C.                Maintaining 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.                       

D.                Preserving Cultures and National Identity

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 [See Figure 6.3]

Governments use many rationales and seek a range of outcomes when they try to influence the international trade process. The choice of the instrument(s) of trade control is crucial because each type 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 or quantity.

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 may be 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; at the higher price the quantity demanded will be lower. 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. Tariffs generate revenues for the assessing government or body.

B.                 Nontariff Barriers: Direct Price Influences

Nontariff barriers (NTBs) represent administrative regulations, policies and procedures, i.e., quantitative and qualitative barriers, which 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.

2.                  Aid and Loans. Governments may give aid and loans to other countries but require the recipient to spend the funds in the donor country; this is known as tied aid or tied loans. In this way some products that might otherwise be noncompetitive may in fact find international markets.

3.                  Customs Valuation. Sometimes it is difficult to 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.

4.                  Other Direct Price Influences. Other means 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

Quantity controls limit the supply of a product; the resulting shift in the supply curve means 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) represent a negotiated limitation 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, i.e., it’s an economic means for achieving a political goal. (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 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. 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. Import and export licenses require 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.

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 foreign suppliers to accept products in lieu of money. Barter, i.e., the direct exchange of products between two parties, and offset, 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 17).

7.                  Restrictions on Services. Countries restrict trade in services for reasons of essentiality and the maintenance of standards.

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 public transportation, banking, utilities, security and communications sectors.

b.                  Professional 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 an organization, whether domestic or foreign, to demonstrate the skills needed for a particular job are not available locally before hiring a foreigner.



Governments actively cooperate with each other to reduce or remove trade barriers through the auspices of the GATT and the WTO.

A.                The General Agreement on Tariffs and Trade (GATT)

The General Agreement on Tariffs and Trade (GATT) was established by 23 signator nations in 1947 as a multilateral agreement with the objective to liberalize world trade. The fundamental principle of “trade without discrimination” was embedded in the most-favored-nation clause, i.e., the principle that each member nation must open its markets equally to every other member nation. Eight major rounds of negotiations from 1947 to 1994 (see Table 6.3) led to a wide variety of multilateral reductions in both tariff and nontariff barriers. At the conclusion of the Uruguay Round, the World Trade Organization was created for the purpose of institutionalizing the GATT.

B.                 The World Trade Organization (WTO)

The World Trade Organization (WTO) was founded in 1995 as a permanent world trade body for the purpose of facilitating the development of a free and open international trading system according to the GATT and for the adjudication of trade disputes between or amongst member nations. The WTO adopted the principles and agreements reached under the auspices of the GATT but expanded its mission to include trade in services, investment, intellectual property, sanitary measures, plant health, agriculture, textile and technical barriers to trade. Currently the 140 member countries of the WTO collectively account for more than 90 percent of world trade.

1.                  Normal Trade Relations. The WTO replaced the most-favored-nation clause with the concept of normal trade relations, which prohibits any sort of trade discrimination. With the following exceptions, it restricts this privilege to official members:

a.                   Under the Generalized System of Preferences (GSP), emerging economies’ manufactured goods are given preferential treatment (lower barriers) over those from industrial countries in member markets.

b.                  Concessions granted to members of economic blocs, such as the EU or NAFTA, are not extended to countries outside the blocs. (See Chapter 7)

c.                   Exceptions can be made in times of war or international tension.

2.                  Settlement of Disputes. Under the WTO there exists a clearly defined mechanism for the settlement of disputes. Countries may bring charges of unfair trade practices to a WTO panel; accused countries may appeal; WTO rulings are binding.



Although each option has associated risks and costs, 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. Chances of success in securing protectionism will be enhanced if companies enlist pertinent stakeholders to share in the necessary lobbying efforts.



Do Trade Sanctions Work?

Countries wrestle with the basic question of whether to use trade policy to try to change objectionable policies in other nations. The principal dilemma is the issue of relativism versus normativism. Overall, trade sanctions aimed at changing policies in foreign countries seldom work as intended; in fact, they can even cause job and other economic losses in the sanctioning country. Some argue, however, that the ultimate purpose of sanctions is to make a meaningful social or moral declaration. Other arguments against sanctions include the costs to innocent people, the inability of sanctions to induce a change in leadership, the unevenness with which policies are applied across countries, and the lack of agreement about the cause(s) being protested.



The Prospects for Freer Trade

Countries usually prefer to exercise their sovereignty. However, they may cede authority on trade issues by agreeing to the binding provisions of the WTO or by becoming members of a regional economic bloc in order to capture the general advantages associated with doing so. Groups that feel they are adversely affected by imports and/or unfair trade practices will try to slow foreign trade liberalization. At the same time, consumers (and therefore firms) want to buy high-quality products at cost-competitive prices. Thus, stakeholders must reason together as the world continues to move toward freer markets and countries strive for the growth and development of their own economies.




Teaching Tip: Visit for additional information and links relating to the topics presented in Chapter 6. Be sure to refer your students to the on-line study guide, as well as the Internet exercises for Chapter 6.



CLOSING CASE: U.S.-Cuban Trade [See Map 6.1, Figure 6.4]


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 U.S. can do. However, given the consensus that Cuba consistently violates human rights, the continuance of U.S. trade sanctions against Cuba is consistent with U.S. policy. In addition, Cuba’s 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 argument that if the Cuban economy can be further weakened, Castro may 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 U.S. (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 U.S. against Iran, Iraq, Libya and North Korea. Economically, it is argued that because of the U.S. government posture, 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 U.S. 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.


3.         Assume you are Fidel Castro. What kind of trade relationship with the U.S. 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 welcome 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.


4.                  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. While recently diminished, the pro-embargo viewpoint is supported by key people in key positions throughout the government.


Additional Exercises: Government Influence on Trade


Exercise 6.1. Ask students to debate the use of embargoes as a means to accomplish political objectives. Can an embargo by a single nation against another be truly effective, or must it be a multilateral, if not a unilateral, action? Should the use of an embargo ever be subject to the scrutiny of the World Trade Organization? Why or why not?


Exercise 6.2. From a global perspective one can observe excess capacity in the steel, automobile and airline industries in both industrialized and developing countries. Ask students to discuss the logic of (rationale for) this from the standpoint of the Infant Industry Argument. Then ask them to debate whether the argument should be applied only in the case of developing countries or in the case of all countries.


Exercise 6.3. In 1998 the World Trade Organization issued a ruling in which it said the U.S. was wrong to prohibit shrimp imports from countries that failed to protect sea turtles from entrapment in the nets of shrimp boats. The basic position of the WTO was that while environmental considerations are important, the primary aim of international trade agreements is the promotion of economic development through unfettered free trade. Ask students to debate the position of the WTO in decoupling trade and environmental policy.