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The Free Trade Movement:
Part 1: Trade Theory
THE THEORY OF INTERNATIONAL TRADE:
EVOLUTION OF A CONCEPT
•
•
•
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•
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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
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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.
• 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.)
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:
$ 260
$10,013
» GNP Growth/year until Crisis: 9%
• Shift from non-productive uses (agriculture) to
comparative advantage uses (labor-intensive
manufacturing).
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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.
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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 neomercantilism: Japan (?)
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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.
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“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
Two countries - Two products
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.9
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
10
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.
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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.
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International Product Life Cycle
sales
time
InvestDC InvestLDC
PLC for innovator country
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…..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
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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.)
Experience curve
Unit
costs
B
A
Accumulated output
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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.
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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
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• 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
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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)
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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
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A case of strategic trade policy:
Japan’s position in the world semiconductor industry
60
50
40
Japan
USA
30
20
10
0
1974
76
78
80
82
84
86
88
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McGraw Hill Companies,2000
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?”
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Determinants of national competitive advantage:
Porter’s “Diamond”
Chance
Firm Strategy,
Structure and
Rivalry
Factor Endowments
Government
Demand Conditions
Related and
Supporting
Industries
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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.
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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.
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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.
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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
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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 firstmover, or early-mover, advantage.
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.
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GATT PRINCIPLES
1.
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.
2.
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.
3.
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.
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Retaliation:
US Trade Sanctions
Partial List
25
20
15
New
Sanctions
10
0
1993
95
97
98
5
Afghanistan Italy
Burma
Libya
Canada
Nigeria
China
N. Korea
Cuba
Pakistan
India
Saudi Arabia
Iran
Sudan
Iraq
Syria
Yugoslavia
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McGraw-Hill Companies,2000
GATT NEGOTIATION ROUNDS
•
Date
name
outcome
•
•
•
•
•
•
1947
1949
1950-1
1955-6
1960-1
1964-7
Geneva
Annecy
Torquay
Geneva
Dillon
Kennedy
tariffs (45000 tariff concessions)
tariffs
tariffs
tariffs
tariffs
35% tariff reduction; anti-dumping
Tokyo
Uruguay
Doha
34% tariff reduction; NTB* codes
• 1973-9
• 1986-94
• 2001-05
complex international business package
?
* NTB: non-tariff barrier, i.e. everything else.
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e.g. subsidies, quotas, administrative policies
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
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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
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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.
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Average Tariff Rates on Manufactures
France
Germany
Italy
Japan
Holland
Sweden
Britain
USA
1950
18
26
25
-11
9
23
18
1990
5.9
5.9
5.9
5.3
5.9
4.4
5.9
5.9
2000
3.9
3.9
3.9
3.9
3.9
3.9
3.9
3.9
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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
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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
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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.
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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 1981-85.
– 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 http://internationalecon.com/v1.0/ch10/10c071.html
• 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 19962001 changed from enforcement to monitoring.
– The intended results were indeed achieved, but
probably due to market forces.
43
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”)
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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
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• 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).
46
The traditional government-business relationship
in Japan
Bureaucrats
Politicians
Business world
47
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.
48
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?
49
• 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?
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51
Stages of Regional Integration
Political
Economic Union
NAFTA
Common Union
Free Customs Market
Union
Trade
Area
EU 1992
52
McGraw-Hill Companies,2000
Stages of Regional Integration
No barriers to goods and services
ASEAN (only a Preferential Trade Area)
Free Trade Area
(FTA)
?
Common external trade policy
EFTA, NAFTA, AFTA (prospective)
APEC – free and open trade and investment by 2010
ASEAN: Association of
Southeast Asian Nations
Customs Union
AFTA: ASEAN Free Trade
Area
EC – Treaty of Rome
Free factor movements
Common Market
APEC: Asia-Pacific
Economic Co-operation
EU – Single European Act EC: European Community
EU: European Union
Harmonization of
EFTA: European Free
Trade Area
Economic Union
macro-economic policies;
EU – Maastricht Treaty
NAFTA: North American
Free Trade Area
Common currency
EU – Maastricht Treaty
Common administration
Political Union
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Bilateral and regional trade agreements 
additional gains from free trade beyond GATT / WTO
WTO
EU
NAFTA
ASEAN+3
MERCOSUR
Definition - agreement among countries in a geographic
region to reduce, and ultimately remove, tariff and nontariff barriers to the free flow of goods, services and
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factors of production among each other
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
1995~2003
55
56
EU
57
NAFTA
McGraw-Hill Companies,2000
58
APEC
McGraw-Hill Companies,2000
59
ASEAN
McGraw-Hill Companies,2000
Major Asia-Pacific Regional Groupings
• APEC (1989)
– 21 countries including Asia-Pacific, North America, others
– $18 trillion GDP; 47% of global trade (2000)
– The policy concept of “open regionalism” implies
nondiscrimination with the rest of the world.
• ASEAN (1967) / AFTA (1992)
– 10 Southeast Asian countries
• Sub-regional economic zones (SREZs), for example:
– ASEAN-China FTA
– Hong Kong – Macau – Taiwan – Guangdong – Fujian
– Singapore – Johor (Malaysia) – Riau (Indonesia)
– Japan Sea and Yellow Sea coastal areas
• Other less formal subregional and bilateral arrangements
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APEC since the Bogor Declaration
• The new model of “open regionalism”
– To be distinguished from “Fortress Europe” or
“Fortress North America”
• Liberalization supplemented by “facilitation”
and economic and technical cooperation
– Reflects member differences in stages of
development
• Unilateral rather than reciprocal concessions
– Philosophy of consensus and voluntarism
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Association of Southeast Asian
Nations
GDP Growth (%)
US Export to ASEAN
($billion)
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
45
40
35
30
25
20
15
10
5
0
62
McGraw-Hill Companies,2000
Who are the trading nations of East Asia?
TRADE % OF GDP = ((Exports + Imports) / GDP (x100)
Indicates a country’s dependence on trade
SINGAPORE
MALAYSIA
HONG KONG
TAIWAN
THAILAND
S. KOREA
INDONESIA
PHILIPPINES
CHINA
JAPAN
350
320
198
80
78
54
50
46
36
16
63
Asian Trade Flows
ASEAN
NAFTA
EU
Japan
Chinese economies
Destination of Exports
South Korea
Aus/NZ
Source of Imports
Rest of World
0
5
10
15
20
25
%
64
McGraw-Hill Companies,2000
INTER-REGIONAL TRADE
DIRECTION OF EXPORTS BY PERCENTAGE
TO
YEAR FROM
N. America
1980 N. America
33.5
1990
41.9
2001
39.5
1980 EU
1990
2001
EU
Europe E. Asia 1 L. America Africa
M. East S. Asia TOTAL
25.2
27.4
15.8
8.9
3.3
4.2
1.0
94.1
22.3
23.4
20.4
5.0
1.7
2.6
0.8
95.8
19.0
19.7
20.9
16.5
1.3
2.1 na
100.0
6.7
8.3
10.3
67.1
71.0
67.5
71.9
74.4
73.4
2.9
5.3
7.8
2.4
1.1
2.3
7.2
3.3
2.5
5.5
3.3
2.6 na
0.7
0.7
97.3
96.4
98.9
1980 Europe
1990
2001
6.3
8.2
4.2
63.7
70.6
55.2
72.7
74.5
81.8
2.7
5.2
6.6
2.3
1.1
2.1
6.9
3.3
1.0
5.5
3.3
2.8 na
0.7
0.7
97.1
96.3
98.5
1980 E. Asia
1990
2001 (Asia)
26.0
31.9
25.1
16.8
19.8
16.8
18.9
20.7
17.9
29.9
32.3
48.2
4.1
1.9
2.7
4.4
1.6
1.6
7.4
3.0
3.0 na
1.8
1.5
92.5
92.9
98.5
1980 L. America
1990
2001
27.9
22.9
60.8
26.5
25.3
12.1
35.1
27.6
13.0
5.4
10.3
6.3
16.6
14.0
17.0
2.7
2.1
1.2
1.9
2.4
1.2 na
0.5
0.4
90.1
79.7
99.5
1980 Africa
1990
2001
27.4
3.0
17.7
43.6
66.0
51.8
46.1
68.0
52.5
4.3
4.6
14.9
3.2
0.6
3.5
1.8
12.8
7.8
1.7
4.4
2.1 na
0.3
3.6
84.8
97.0
98.5
1980 M. East
11.5
40.3
41.5
28.7
5.0
1.5
4.1
2.5
Source: UN Comtrade and WTO
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94.8