The International Business Environment Introduction and overview International trade theory and policy: three months in three hours

Schedule Classical and neoclassical trade theory Conclusions and institutional solutions –ITO, GATT, WTO Why its all wrong: modern trade theory Conclusions and institutional solutions –Airbus, MITI, regional integration, FDI

Technology differences Labor only factor of production Cross-country differences in technology (differences in labor requirements) Adam Smith 1776, absolute advantages provide possibilities for mutually beneficial trade David Ricardo 1815, comparative advantages sufficient to generate trade

Absolute advantages (labor requirements per unit of output)

Absolute advantages Relative price of cloth in England: 0.5 wine Relative price of cloth in Portugal: 2 wine => Better with international trade if England produces and exports cloth and Portugal exports wine, and the international price of cloth is 0.5 wine < cloth < 2 wine (or 0.5 cloth < wine < 2 cloth)

Comparative advantages

Relative price of cloth in England: 1.5 wine Relative price of cloth in Portugal: 2 wine => better with international trade if England exports cloths and Portugal exports wine, and the relative prices are 1.5 wine < cloth < 2 wine (or 0.5 cloth < wine < 0.67 cloth)

Comparative advantages There is a potential for profitable trade as soon as the relative prices differ Rule: focus on production and exports of the good with comparative advantages (i.e. the lowest opportunity cost)

Differences in factor abundance Rapid technology diffusion from mid- 1800s: are technology differences sufficient explanations for international trade? Heckscher-Ohlin model, 1920s: cross- country differences in relative factor abundance may result in differences in factor prices that explain differences in relative goods prices.

The H-O model Industries differ in factor intensity (the use of production factors) Capital abundant countries will have relatively cheap capital, and will therefore be well positioned to export goods from capital-intensive industries Still a very useful general equilibrium model

Conclusions More trade => more profits and more welfare Free trade better than protectionism => Reduce trade barriers and generate more international trade ITO, GATT, WTO

The principles of GATT Non-discrimination: The Most Favored Nation principle Transparency:All protection in the form of tariffs Liberalization: Tariff reductions = Fair Trade (and lots of trade) (+ Reciprocity: You scratch my back and Ill scratch yours)

The Uruguay round World Trade Organization Lower tariffs for industrial products Agriculture Textiles and clothing Services Intellectual Property Dispute settlement

World Trade Organization - WTO Permanent institution to perform GATT functions - first ministerial meeting in Singapore December 1996 Standing councils for goods, services, and TRIPS, with continuous negotiations on further liberalization More efficient dispute settlement

Tariff reductions Developed country tariffs reduced by a third within 5-10 years, to about 3% Tariff binding - national lists to include almost all products Eliminated tariffs –Pharmaceuticals –Paper –Steel –Construction machinery –Agricultural machinery –Medical equipment –Furniture –Toys –Beer & brown alcohol

Agriculture Tariffization of agricultural protection Tariff reductions –36% average reduction in first round Market access guarantees –imports at least 3% of domestic consumption Reductions in public subsidies –cuts by % of subsidy levels

Textiles and clothing Phasing out of MFA over ten-year period Integration of half of imports into GATT system during transition process Liberalization of remaining quotas during transition process

General Agreement on Trade in Services - GATS Framework of GATT-related rules –National treatment, MFN, transparency, progressive liberalization, dispute settlement Annexes with rules for specific sectors National schedules –liberalization commitments –exceptions from GATS principles Successful continuing negotiations on telecom and finance

TRIPS and TRIMS Protection of trade-related intellectual property (TRIPS) - copyrights, trade marks, patents Including trade-related investment measures (TRIMS) under GATT rules Clearer principles for use of safeguards

Problem areas High tariffs outside OECD Undisciplined use of contingent protection, + agressive unilateralism (EU and US) Gray zone of Non-Tariff Barriers (NTBs) that are not fully addressed by the GATT framework. Regional integration?

Whats contingent protection? Countervailing duties - if foreign exporter is subsidized by foreign government. Antidumping tariffs - if foreign exporter is dumping goods on our markets. Most common in the US and EU. More frequent since the early 1980s: lobbies growing smarter?

Aggressive unilateralism Not protectionism, but aggressive export promotion: open your markets for our exports, or else... Mainly found in US legislation: –Section 301: essentially GATT consistent, wait for GATT panel statement –Super 301: unilateral definitions of unfair trade, unilateral decisions to retaliate –Special 301: same for intellectual property rights issues

Modern trade theory Some of the assumptions in the H-O model are not realistic (perfect competition, identical preferences, constant returns to scale) Empirical findings have contradicted the predictions of the H-O model: lots of trade between similar countries, large amounts of intra-industry trade (exports and imports of the same goods)

Modern trade theory The Linder-hypothesis: birds of a feather Economies of scale and preferences for variation Reciprocal dumping Strategic trade policy

Economies of scale and competitive strategies Not fun to fight with bigger companies Alternative 1. Product differentiation: make something thats slightly different –specialization and intra-industry trade Alternative 2. Make sure that you grow large as soon as possible –government intervention - Boeing vs Airbus –regional integration - big home market

Conlusions for economic policy Free trade and GATT may be good for potato chips… …but other solutions look tempting for micro chips Trade conflicts between Japan and the USA Problem: how do you pick the winners?

More conclusions GATT not sufficient to guarantee free trade in strategic industries Individual European countries will rarely manage to compete with American and Japanese larger firms Regional integration necessary for Europe: competition with the USA and Japan requires larger market with fair rules Foreign direct investment sometimes more important that international trade?

Schedule What is regional integration? Effects of regional integration –static –dynamic A look around: whats happening on the RI front? RI and GATT: complements or substitutes?

Regional integration now a global phenomenon Widening and deepening of European integration American alternatives: CUSFTA and NAFTA plus MERCOSUR (Argentina, Brasil, Paraguay, Uruguay) A larger ASEAN, emergence of AFTA and APEC? Indian Ocean FTA? Regional integration in Africa? Except Eastern Europe

What is regional integration? 1. Free Trade Area 2.Customs Union = 1 + common external tariff 3.Common market = 2 + harmonization + free factor mobility 4.Economic Union = 3 + fixed exchange rate + policy coordination 5.Economic and Monetary Union (EMU) = 4 + common currency and central bank + closer policy coordination

Why integrate? Offensive arguments –Regional Integration is a step toward free trade –RI promotes growth –Integrated countries dont start wars –RI cements positive policies, both at home and abroad Defensive arguments –RI is necessary because GATT/WTO doesnt work –We must practice RI because others do

Economic effects of integration Free Trade Areas and Customs Unions –trade creation and trade diversion Common Markets and Economic Integration –the costs of non-Europe

Static effects of integration Trade creation Before: Tariff protection allowed domestic firms to supply market After: Imports from RI-area replace less efficient domestic producers Trade diversion Before: Efficient foreign producers supplied market in spite of tariffs After: Relief from tariffs allows less efficient firms from RI-area to take over market shares from other foreigners

In addition, dynamic effects Trade creation increases production and income, and may also lead to –economies of scale –new entries and tougher competition –faster technology transfer But a Customs Union is usually not enough, because of various remaining NTBs

Gains from deeper integration Border controls Technical standards Scale economies Competition Public procurement

Border controls Administrative burden on firms –big problem for SMEs Delays at borders –administration & delays cost 2% of trade value in Europe; much more elsewhere Welfare losses of trade that doesnt occur –1 to 4 % of trade lost in Europe? Cost of maintaining border controls and customs administration

Differing technical standards Keeps small firms out of intl trade, and adds to production costs in large firms Top-down harmonization and mutual recognition the two replies in Europe –harmonization where health and safety matter –Cassis-de-Dijon general principle in most other areas

Scale economies Fragmentation of EU market obstacle for reaching MES in many industries Leading EU firms smaller than American and Japanese leaders although EU market is equally large or larger Costs saving from reaching MES in all industries estimated to 2 % of GDP

Lack of competition Fragmentation and trade barriers give market power in home country –leads to higher prices, smaller production volumes, and X-inefficiency Not only important for sectors with large firms, but also for growth in new sectors with many SMEs Contradiction between ambitions to increase competition and reach scale economies

Public procurement policies Public purchasing corresponds to about 15% of EUs GDP Only 2% of government contracts awarded to other EU nationals in mid-1980s, when imports in general reached 20% Liberalization should increase competition and bring lower prices

Estimated gains from the European Single Market Source of gainsBillion USD % of EU GDP Barriers to trade Barriers to production Economies of scale612.1 Increased competition461.6 Estimate EC

More dynamic gains? The Single Market leads to increases in productivity and output This will raise savings and investment The optimal long-run capital-output ratio will also be higher The gains from integration may be much higher when this effect is taken into account

Where is Europe? Treaty of Rome (1957) created Customs Union with ambitions Werner Plan (1970) failed attempt to introduce EMU EMS, ERM, and ECU (1978) steps towards EI from CU Single European Act (1987) creates CM EMU from 1999 Next step: taxes and welfare?

European Union Common Market with 15 member states - all of Western Europe except Switzerland, Norway, and Iceland - based on Treaty of Rome (1957) and Single European Act (1987) Enlarged several times, Eastern enlargement expected within the next decade Monetary Union from year 1999 Large impact on trade and investment

Chrystal ball: EU in 15 years? Widening versus deepening: –accession of EFTA countries made deepening harder but not impossible –accession of Central and Eastern Europe tougher question Federalism versus confederalism: –all power in Brussels or a Union of independent states? –deepening requires federalism, but EFTA accession probably strenthened con- federalism

NAFTA Free Trade Area including Canada, Mexico and the US, established 1994 Phasing in period of 10 years Rules of origin important Includes competition policy and environmental issues Significant impact, especially on Mexico

MERCOSUR Customs Union / Common Market including Argentina, Brazil, Paraguay, Urugua (associated member: Chile) Decided 1991 to be completed Customs Union from 1995 already covers 85% of trade Temporary exceptions for cars, telecom, computers (300 tariff lines per country) Marked effects on trade and investment

ASEAN Agreement from 1967 including Brunei, Indonesia, Laos (from 1998), Malaysia, Myanmar (from 1998) the Philippines, Singapore, Thailand, and Vietnam (from 1995) Preparations for Free Trade Area - AFTA - in progress, to be completed year 2003 Tensions because of Asian crisis

APEC Discussion club (?) with 18 members - ASEAN + NAFTA + Australia, New Zealand, China, Japan, Hong Kong, South Korea, Taiwan, PNG, and Chile Objective: Common Market by year 2020 Means: open (i.e. GATT-consistent) regionalism and voluntary liberalization Uncertain future - dominant if realized

Are GATT and regional integration compatible? Regional integration violates GATT´s MFN principles Article XXIV allows integration if –substantially all trade –not more restrictive GATT has accepted integration even in unclear cases

Regional integration is a step on the way to global free trade Easier to agree about reforms within geographically limited regions Easier to negotiate globally when there are fewer around the table Regional cooperation may cement political reforms Integration may stimulate growth and trade

Regional integration is an obstacle to global free trade A major motive for integration has been the slow progress of GATT Tariffs - i.e., what GATT can handle - are not the most serious trade restrictions Small interest groups - French peasants? - may yield too much power Big trading blocks may be less interested in global free trade