Chapter on Protectionism and International Trade

Protectionism and International Trade

 

Introduction

In this chapter we discuss the role of protectionism in international trade. There is tendency among nations to protect their market from free-trade. There are also many nations that are formally committed to free trade but in interest of their domestic markets, they tend to adopt a neo-mercantilist stance, protecting their home market from foreign competition if possible, while simultaneously trying to gain access to the markets of others for their "ports.

Classical and neo-classical economists have laid the foundation of free-trade and this was further elaborated by Ohlin theory. He elaborated that trade pattern will be determined by the relative productivity of different factors of production in different countries provided there are no trade- barriers. In the process no trade barriers, most of the countries will specialize in the production of products that they can produce most efficiently, while importing products that they can produce less efficiently.  This is the rationale for countries for entering into international trade because such pattern will provide positive sums to all participating countries.

But there is question, why there is need for government to intervene in international trade if it is free trade? There are economic as well as political reasons for government intervention in international trade. Government intervention is primarily by creating trade barriers, these barriers are through restricting imports of goods and services into their nation. Also by adopting exports promotion policies.  Normally their motives for intervention are to protect-domestic producers and jobs from foreign Competition, while at the same time increasing the foreign market for the products of domestic producers. 

Instruments of Trade Policy

There are six main instruments of trade policies. These are:

·         Tariffs,

·         Subsidies,

·         Import quotas,

·         Voluntary export restraints,

·         Local content requirements,

·         Administrative policies. 

Tariffs are the most effective instruments used primarily to regulate and restrict trade. These are the oldest and simplest instrument of trade policy. GATT was created to limit tariff through negotiations. GATT and further WTO were successful in limiting tariffs but with a fall of tariffs barriers there is a rise in nontariff barriers such as subsidies, quotas, and voluntary export restraints in recent decade

Tariffs                            

A tariff is a kind tax. These levied on imports.  There are two specific categories of tariffs in trade policy. These are known as Specific Tariffs and ad valorem tariffs.  Specific tariffs generally known as a fixed charge for each unit of a good imported (for example, Rs 100 per barrel of oil).  Ad valorem tariffs are levied in accordance of the value of the imported good or as a proportion of the value of the imported good.  An example of an ad valorem tariff is the 40 -percent tariff the Indian government placed on imported cars from USA

A tariff imposition either specific or ad valorem consequently raises the cost of imported products relative to domestic products.  Thus the 40 percent tariff on car imported into India increased the price of USA cars relative to Indian produced cars.  The prime objective of tariff imposition is to provide protection to Indian car industry. The principal objective of most tariffs is to protect domestic producers and employees against foreign competition; they also raise revenue for the government. There is also need to understand that in this process of tariffs imposition, who suffers and who gains.  There is gain for government, because the tariff increases government revenues. There are also some gains to domestic producers gain, because the tariff gives them some protection against foreign competitors by increasing the cost of imported foreign goods. But most suffers are consumers because they must pay more for certain imports.  The amount of tariffs decides the gains to the government and domestic producers. The gains to government and domestic producers  exceed the loss to consumers depends on various factors such as the amount of the tariff, the importance of the imported good to domestic consumers, the number of jobs survived in the protected industry and so on  A specific tariff is a certain amount of money per unit of import.  An ad Valero (on the value of tariff is a percentage of the estimated market value of the imports. As shown in Figure 1 and Effects of a Tariff

 

 

 

 

 

 

 

PriceRs/bikeBike)

 

 

                                                                

Figure No. 1

Price with Tariff

a

c

g

b

e

f

d

S0

S1

D1

D0

Qty

World Price

0

200

300

330

550

 

 

 

 

 

 

 

 

                                                          

	Before Tariff     Table No. 1	After Tariff
Consumer Surplus	a + b + c + d + e + f	a + b
Producer Surplus	G	c + g
Government Revenue	0	e
Total Social Gain Dead weight loss	a + b + c + d + e + f + g	a + b + c + e + g d + f

 

Table  No.  2

	Before Tariff	After Tariff
Domestic Price	300	330
Consumption	1.5	1.25
Domestic Production	0.5	0.75
Imports	1.0	0.5

 

The Effect of a Tariff on Consumers (Small country case)

Consumers lose area c + d + e + f That is equal to Rs 41.25 million a year.

Consumption (quantity consumed) goes down as consumers pay a higher price now for the bikes (Figure No. 1 & Table 1 & 2).

The Effect of a Tariff Producers (Small country case)

 

Producers gain area c. That is equal to Rs. 18.75 million a year.

 

Domestic production goes up as domestic price goes up.

 

Government Revenue

 

Government collects revenue equal to tariff rate times the amount of imports.  This is given b3, area e and equals Rs.15 million a year.

Net National loss from a tariff.

 

We will use the one rupee one vote yardstick in this analysis.

Every dollar loss or gain is worth the same no matter who bears the cost or benefit of it. (Figure No. 1 & Table 1 & 2).

 

Consumption Effect

Area f. This is a loss to consumers as they buy less number of bicycles at a higher price.  The country could have bought the bikes at $300 but pays $330.  The number of bikes bought goes down from 1.5 million to 1.25 million.  This area is a dead weight loss as no one less gains from it. (Figure No. 1 Table 1 & 2).

Production Effect

This is the area d. The producers use more resources and produce at a higher cost to society.  This a dead weight loss as the country could buy the bikes at $300 but uses resources worth $330 instead to produce it at home. This is due to relatively inefficient production (Figure No. 1).

Redistribution Effect

The are a c. The transfer of consumer surplus to producer surplus.  This is a transfer so society as a whole does not gain or lose anything (Figure No. 1 Table 1 & 2).

Revenue Effect

Area e. The transfer of consumer surplus to the government as revenue.  There is no loss to society as it a transfer (Figure No. 1 & Table 1 & 2).

Figure No. 2

Terms of Trade effect and a Nationally Optimal Tariff (Large country case).

                                                              

e

f

b+a

Foreign supply

U. S Demand

Imports

Price

 

 

 

 

 

 

 

The country gains area e and loses b+d. The optimal tariff rate depends on the elasticity of supply of the foreign producers (Figure No.2).

Figure No. 3

Quantity

Sd+Q

Price

330

300

 

s

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

                                                                

A tariff raises the cost of imported products relative to domestic products. While the principal objective of most tariffs is to protect domestic producers and employees against foreign competition, they also raise revenue for the government. (Figure No.3).

The General Agreement on Tariff and Trade was negotiated among nations for reducing tariffs in 1945 and signed in 1947.  It was felt that promoting international trade by reducing tariff barriers would facilitate consumer welfare. Therefore the main objective of GATT was to reduce trade barriers such as tariffs in order to bring about free trade in the world. GATT was successful in reducing high tariff barriers but simultaneously non-tariff barriers also increased substantially which have affected free- trade to a larger extent. The agreement main objective were to encourage:-

 

(1)          Liberalized trade

 

(2)          Nondiscrimination

 

(3)          No unfair encouragement of exports.

 

Since 1947 there has been many rounds of GATT negotiations were taken place. These negotiations have resulted finally in the creation of new international trading institution popularly known as the as the World Trade Organization (WTO). 

Non Tariff Barriers

Instead of tariff, there are also considerable non- tariff barriers which countries impose to protect their markets. Major Non-tariff barriers are as:

 

- Antidumping

 

-Import Quota

 

-VER s (Voluntary Export Restriction)

 

-Quality Standards

 

- Domestic Content Requirements

 

 Anti dumping

 

 

Dumping happens when exporters sell their goods in foreign market at a price below than at what they are sold in the home market or below the cost of production. Therefore in these situations dumping can be established. An importing country in case of dumping has rights to levy anti-dumping duties to protect their home industries.  It has been that most of countries levy anti-dumping duties when they have substantial evidence that exporters are selling their goods in their market at a price below than at what they are sold in the home market (price discrimination) or below the cost of production (normal value). Price discrimination, when practiced with the intention to distort foreign markets is considered to be unfair and such practices lead to distortions of trade. The ant-dumping duties are primarily imposed to offset the distortion and injurious effect of the dumping margin in the importing country. Another important test in favour of dumping is to assess the nature and design of sale done by exporter in the importing country market.  “ When sales are made below cost in the domestic market they are not considered to be sold at ‘ normal value’, and a calculation is made of what the selling price would normally be in the domestic market, based on the producer’s costs of production”. This is then compared with the export price to determine if there is a dumping margin. The various situations in which this may arise are as follows:

 Suppliers may have rational reasons to want to sell to sell below cost. For example, they have invested at a certain point in time and the prices in the market may have dropped below the original estimate.

Dumping is also a marketing strategy of firms those have a dominant position of monopoly or oligopoly position in international markets. By dumping their products at lower price and these monopolists and oligopolists firms wish to undermine its competitors by sales below cost. They can only do this if they have substantial cash flows with them. In this scenario, price is reduced below variable cost. Most of the new competitors find very difficult even to recover their variable cost because to meet the competition they have to reduce prices.  The objective of monopolist or a near monopolist is drive out competitors. When the monopolists or oligopolists are successful in their objectives they further raise the price.  In international marketing such kind of pricing practice is known as predatory pricing.

 The argument has also been made that when a single firm sells below costs in order to increase market share, this is reasonable and normal. It will do so if, by increasing production, it can recover its costs through economies of scale. A typical example of sales below cost arises where a firm’s production at home has reached the point that it has covered its fixed costs. It will then be in a position to sell additional production at a much lower price that covers only its variable costs and a profit.

Quota

Quota is another form non-tariff barrier imposed to protect the home market by the importing country. Quota is a form of quantitative restriction because quota is imposed to limit on the amount of imports that can come into a country in a year. There are several kinds of quota currently used by various countries to protect their home markets. Most commonly used quota in trade policies are :-

(a)          Tariff Quota

(b)          Unilateral quota

(c)           Bilateral quota

(d)          Mixing quota

(e)      Import licensing

 

Tariff Quota is one of the most popularly used trade policy instrument to protect the home markets. In case of tariff quota specific volume of import is permitted in the importing country at specifically low rate of duty or without duty. This is form of quantitative restriction because import quantity at lower duty or duty free have been fixed. In case of free-trade means without any tariff quota, there is no restriction imposed on the imported quantity. In tariff quota,if in case In case the import goes above the specified 'volume the increased import duty is levied.

Unilateral quota- Tariff quota also has a form of unilateral quota. This is also most commonly used instrument of trade policy to protect the home market. Unilateral quota used to protect the market when only one country unilaterally   specified a limit of the commodity’s quantity to be imported during a stipulated or a specified period. This is also a form of quantitative restrictions. WTO agreements have taken several steps to reduce quantitative restrictions in international trade in recent years.

 

Bilateral quota- Bilateral Quota is one of the most popularly used trade policy instrument to protect the home markets. It has been seen that bilateral quota in terms of quantities to be imported and exported is fixed through negotiation between the importing country and exporting country.

Mixing quota - Mixing quota is another form of non-tariff barriers. It has been seen that this kind of quota is mixed with the import of raw material and export of finished products. There are regulations in various countries by linking the utilization of certain proportion of domestic raw materials in the production of specified finished product. There mixing quota is imposed to import certain amount of finished product or raw material but it is also linked with export of finished products or raw material  Most of the time in mixing quota  proportion of domestic raw materials in the production of specified finished product is decided.  These regulations, sometimes referred to as ‘linked usage’ regulations, have a quota effect in that they serve to limit imports to a more or less fixed ratio of particular domestic production.

Import Licensing

Further to avoid various complexities in administrating quota allotment the mechanism of import licensing has been introduced by various countries. This is also another form of non-tariff barrier used to limit imports by importing countries. The objective of import licensing is to ensure even distribution of quotas as between different suppliers is ensured without in anyway disrupting market.

Effects of a Quota

The immediate effect of quota is the restriction in imports from importing countries. The quantity of imports reduces by imposing various types of quotas by countries in the international. These are effective non-tariffs barriers used to distort free-international trade. Another effect of quota is increase in the domestic price above the world price therefore there is loss of consumer. In other words it can be said that quotas are similar to import tariff.

Reasons for imposing Quotas:

Protecting domestic industries or infant industries from foreign competition is the main argument provided by most of government. Major reasons which were provided in favour of imposing quotas are as:-

·         Quotas are imposed to protect domestic industries from competition and curtailing imports spending, a balance in balance of payment is insured

·         Greater administrative flexibility and power (in giving out licenses).

Quota Vs.  Tariff

Under competition:

The effects are exactly the same except for the revenue effect.  The Government may or may not collect any money from the quota licenses.

 

Quota proceeds may go to:-

 

(1)          The government through license fees.

 

2)            To importer

 

(3)          To exporter

 

Ways to allocate quotas

 

(1)          Competitive auctions (the best and rarest way)

 

(2)          Fixed favoritism (most arbitrary way)

 

(3)          Resource-using application procedures (most inefficient way)

 

Voluntary Export Restraint

Voluntary export restraint (VER) is another form of non-tariff barrier. This is also a variant on the import quota. In case of voluntary export restraint, exporting country typically at the request of the importing country’s government imposes voluntary restrictions on exports. The exporting country agrees for imposing VERs to avoid any damaging punitive tariffs or import quota from the importing country. Agreeing to a VER, therefore, is seen as a way of making the best of a bad situation by appeasing protectionist pressure in a country.

As discussed by imposing tariffs, quotas and VERs, there are gains to domestic producers and government by limiting import competition but there are losses to consumers in terms and high prices and lesser choices for goods. An import quota or VER always raises the domestic price of an imported good. When imports are limited to a low percentage of the market by a quota or VER, the effect is to bid the price up for that limited foreign supply.

Subsidies

Subsidies have also been considered worst form of non-tariff barrier in international trade. Subsidies primarily are responsible for distorting free trade.   In case of subsidies, there is open or hidden payment by the government to producer. Through these payments or support from Government, producer can market their products at below price in international market.  There are various means by which government support to producers. Most commonly means are                             

cash grants, low-interest loans, tax breaks, and government equity participation in domestic firms. Subsidies facilitate local producer to access in international trade by two ways; they help them compete against low-cost foreign imports and they help them gain export markets.  

Most of the governments provide subsidies to their producers.  According to various studies as well as from official sources, it has been noted that in case of most industrialized countries level of subsidies amounted to between 2 percent and 3.5 percent of the value of industrial output. (These figures exclude subsidies to agriculture and public services.) It was also recorded that the average rate of subsidy in the United States was 0.5 percent; in Japan it was I percent; and in Europe it ranged from just below 2 percent in Great Britain and West Germany to as much as 6 to 7 percent in Sweden and Ireland. In these figures only cash grants have been included therefore these figures certainly underestimate the true value of subsidies. The true value of subsidies would definitely be much higher if we include other kind of subsidies like equity participation or low-interest loans etc.

There are various studies conducted on the quantum of subsidies provided by the various governments. According to a study conducted by the European Union(EU) commission to assess the subsidies provided  to manufacturing enterprises  ranged from a low of 2 percent of total valued added in Great Britain to a high of 14.6 percent in Greece.  Among the four largest EU countries, Italy was the worst offender; its subsidies are three times those of Great Britain, twice those of Germany, and 1.5 times those of France.

Although developed countries after signing the WTO treaty have also managed to wriggle out of subsidy reduction commitments. They have manipulated different “Boxes” of subsidies commitment. It has also been noticed that even after WTO agreements, OECD –countries combined spending on account of support to agriculture stood at $ 327 billion during 2006.

The domestic producers gain if there are subsidies provided to them by their respective government. They gain because their international competitiveness is increased as a result of them.  There is also thought among the proponents of strategic trade policy that government should intervene in international trade to facilitate firms to acquire competitive advantages in the international market. They also favored the use of subsidies to help domestic firms achieve a dominant position in those industries where economies of scale are important and the world market is not large enough to profitably support more than a few firms. In this case successful examples of aerospace and semiconductors may be cited. As we are aware that US government subsidies in the form of substantial R& D grants helped Boeing to achieve a first-mover advantage in an emerging industry. Further if companies are able to compete globally with the support of subsidies then there are further gains to the domestic economy in the form of employment generation and tax revenues.

On the other hand, subsidies must he paid for.  Typically government’s raises revenue by taxing peoples for generating money for making payments for subsidies.  Therefore, again whether subsidies generate national benefits that exceed their national costs is debatable. However it has been seen that argument to increase competitiveness by providing subsidies may be a good example in some specific cases but in practice many subsidies are not that successful at increasing the international competitiveness of domestic producers.  Rather, they tend to protect the inefficient firms instead of promoting efficiency. The argument in favour of subsidies to increase international competitiveness is not valid in most of the cases.

Arguments in Favors of Subsidy

There is not only strategic trade policy argument in favour of subsidies but there are several arguments were advanced in favour of subsidies. Most of these arguments are based to promote development for acquiring competitiveness. It was also argued in favor of subsidy that there is always needs to motivate  domestic producer therefore a government could pay a certain amount of the production cost per unit produced as a means of encouraging production. Most of the arguments in favour of subsidies are summarized below:-

 

·         The infant industry Argument 

·         The Infant Government (Public Revenue) Argument

·         National Pride.

·         Income Redistribution

·         National Defense or Self-Sufficiency.

 

Preference for the developing countries – There are various instruments of trade policy which are normally used by various countries. The uses of these instruments depend on various circumstances. However, it is also equally important to understand prevailing problems, which are faced by an individual country. The choice of using these instruments depends to a great extent on the pattern of its import and export trade flow, the institutional setup and responsiveness of its economy to use of a particular measure. It has also been observed that most of the developed countries with advanced industrial system are sensitive to price changes and they can correct their balance of payments disequilibrium by costing to exchange rate adjustments of tariffs.  In these circumstances, however, where the import trends are deep rooted and speculative tendencies and rampant instruments of trade policy separating through price mechanism, such as, tariffs and exchange rate adjustments may not prove quite effective.  Under such circumstances when those developed countries with sophisticated monetary and capital market mechanism may have to resort to more restrictive measures as direct trade central and other restrictive measures. But for export promotion measure these countries normally depending upon indirect assistance mainly in the sphere of marketing, may have to go for providing direct subsidies to push export effects specified areas.  The developing countries howsoever, have to depend upon these instruments of trade policy, which can export direct effect on their import and export trade flows.  The quantitative restrictions to a lateral or country allocated unilateral quota or import licensing and exchange control, may, have to be resorted to the taking sure of their balance of payments problems.  Special facilities given to developing countries under article XVIII of GATT for restoring to more restrictive trade techniques or under the GATT code on 'Subsidies and Countervailing Measures' their right to subsidies their exports can be quoted as suitable illustrations of the need for such devices in these countries.  It should however not be construed that exchange rule adjustments and customs tariffs are not suitable for developing countries.  There are situations when -along with other instruments of trade policy, which can exert direct effect on the import and export trade flows, the tariffs and exchange rate adjustments may be applied as supplementary measures.

Global picture of the subsidies

There are various studies conducted to assess the total quantum of subsidies at global level. According to the study conducted by Moor/Calamai, the volume of subsidies is presently around USD 250bn in OECD countries, and around USD 150-200bn in developing countries but this study was focused on the energy sector.

A particularly interesting finding is that the developed world. “The more environmentally- damaging a fuel, the big-bigger the subsidy, coal is far in the forefront, followed by oil, then nuclear power and finally natural gas- (32) Reform  in the shape of rising energy prices would, he argues, bolster rather than stunt economic growth.  The social costs are also less problematic than hitherto supposed, since numerous subsidies (such as for electricity or petrol) are already of little benefit to the poorest sections of society”.

 It has also been noticed that most of EU members also providing huge subsidy to energy sector . The quantum of energy subsidy have estimated to the tune of USD 18.3bn,with the EU itself contributing another 1.3bn.  Report estimated that Western Europe spends USD 1.5bn on subsidies for renewable energy and 3.2bn on assistance for energy, efficiency, and USD 10.2bn are  spent on subsidizing fossil fuels and 4.7bn on nuclear energy,.  The county--specific reports are highly- revealing.  Direct subsidies are tracked in detail, with subsidies for R& D and for primary energy sources singled out.  In Denmark, for instance, 17 percent of all subsidies go into programmes for the promotion of renewable energy and as much as 57 percent in Finland - but only 2 percent in Germany.  If one looks at the absolute figures, the picture changes somewhat (e.g. USD 6.l mio in Denmark, compared with USD 112.3 mio in Germany.  But the fact remains that the structure of subsidies In several countries creates all the, wrong incentives.

Administrative Policies        

 Along with various restriction of trade policy, governments of all types sometimes use a range of informal or administrative policies to restrict imports and boost exports.  Administrative trade policies are decided by bureaucracy. These are rules and procedures that are designed in such fashion  to make it difficult for imports to enter a country. For example, it has been said that maximum numbers of such policies have been designed by Japan in recent past to restrict the imports. This is another kind of trade barrier. It has also been noticed that Japan’s formal tariff and nontariff barriers have been among the lowest in the world but restrictions on imports have been exercised through administrative policies. One example is that of tulip bulbs; the Netherlands exports tulip bulbs to almost every country in the world except Japan.  Japanese customs inspectors insist on checking every tulip bulb by cutting it vertically down the middle, and even Japanese ingenuity cannot put them back together again!  Another example concerns the U.S. express mail operator Federal Express.  Federal Express has had a tough time expanding its global express services into Japan, primarily because Japanese customs inspectors insist on opening a large portion of express packages to check for pomography-a process that can delay an "express" package for days.  Japan is not the only country that engages in such policies but it has been noticed that European countries are also resorting to administrative measures to restrict free trade. It has been seen that in France for all imported videotape recorders there is a small customs entry point that was both remote and poorly staffed. The entry of imported videotapes tapes from small custom entry point is mandatory through administrative orders. Because of small custom entry point there is a continuous delay and this delay is keeping specifically Japanese VCRs out of the French market until a VER agreement was negotiated. As with all instruments of trade policy, administrative instruments benefit producers and hurt consumers, who are denied access to possibly superior foreign products.

THE CASE FOR GOVERNMENT INTERVENTION                           

We have assessed the various instruments of trade policy that governments can employ to restrict free trade. But there are various strong not only political arguments but economic arguments as well in support of government intervention in free trade. The government interventions in case of developing and underdeveloped countries have also been supported on the ground of development argument itself. There is need of more detailed analysis at the case for government intervention in international trade.  In general, there are two types of argument for government intervention-political and economic.  Political arguments for intervention are concerned with protecting the interests of certain groups within a nation (normally producers), often at the expense of other groups (normally consumers).  Economic arguments for intervention are typically concerned with boosting the overall wealth of a nation (to the benefit of all, both producers and consumers).Economic argument is also concerned with development also.

Political Arguments for Intervention        

 

 

The basis of political argument is primarily the nature and content of government philosophy. The nature of government may be supportive to free market, socialist or mixed. In case of socialist as well as in mixed, in the economic philosophy itself, there is more emphasis on self-reliance and curb on free trade. But it has been noticed that contrary to their philosophy free-market and free- trade, there is tendency among the proponents of free-trade to intervene politically in free-trade by imposing by controls in the forms of import restrictions or through providing huge subsidies. Trade war between US and Japan are the best examples of political intervention.

Politically, there are various issues for government intervention in free trade. These cover a range of issues including protecting jobs, protecting industries deemed important for national security, and retaliating to unfair foreign competition.  Political arguments for government intervention are not always based on careful economic reasoning.  Thus they tend to be relatively easy for economists to refute.

Protecting jobs and industries

Perhaps the most common political argument for government intervention is that it is necessary for protecting jobs and industries from foreign competition.  This argument has been repeated cited by various governments in favor of political intervention. It has also observed that in most developed nations specifically US and western European countries protect their jobs by imposing strict visa restrictions. This is a kind of administrative measures to control immigration from rest of the world.  President Barack Obama of USA has proposed giving tax breaks to U.S. manufacturers that produce domestically or bring back jobs. These steps were taken by US to protect their jobs outsourced to India and other emerging economies

Further, we also witnessed that to protect U.S. automobile, machine tool, and steel industries during the 1980s, the voluntary export restraints (VERS) measures were adopted by US government therefore it can be concluded that instead of free-market or socialist economies , it is nation interest that is the paramount cause of government intervention. Similarly in case of Japan’s also quotas imposed on imports of rice are aimed at protecting jobs in that country's agricultural sector.  In case of European Union (EU) also the establishment of the Common Agricultural Policy (CAP) is to protect agriculture sector.  “The CAP was designed to protect the jobs of Europe's politically powerful farmer by restricting imports and guaranteeing prices”.  However, the higher prices that resulted from the CAP have cost Europe's consumers dearly.  This is true of most market attempts to protect jobs and industries through government intervention.The VER in the automobile industry succeeded in raising the price of Japanese imports, at a cost of $1 billion per year to U.S. consumers.

In some cases, it is not only the international competitiveness that has adversely affected by the various kinds of trade controls but sometimes it also hurt the very producers they are intended to protect.   For example, VER agreement in the U.S. machine tool industry has been self-defeating. The U.S. manufacturers have to buy machine tools above prevailing in the world market price because there were trade controls in the form of voluntary export constrains were imposed by US Government on Japanese and Taiwanese machine tool imports .  In turn, this raised the capital costs of the U.S. manufacturing industry in general, thereby decreasing its international competitiveness.

National security

 National security is another important argument in favour of government intervention in the free trade. It has been seen that protection are imposed because countries sometimes think that it is necessary to protect certain industries because they are important for national security. In most of such cases aerospace, advanced electronics, semiconductors, etc, which are  defense-related industries often get this kind of protection. Those in favor of protecting the U.S. semiconductor industry from foreign competition, for example, argue that semiconductors are now such important components of defense products that it would be dangerous to rely primarily on foreign producers for them.  In 1986 this argument helped persuade the federal government to support Sematech, a consortium of 14 U.S. semiconductor companies that accounts for 90 percent of the U.S. industry's revenues.  Sematech's mission is to conduct joint research into manufacturing techniques that can be parceled out to members.

Retaliation

It has also been said that governments should use the threat to intervene in trade policy as a bargaining tool to help open foreign markets and force trading partners to "play by the rules of the game." In case of US-Japan trade war U.S. governments have been among those that adopted this "get tough" approach. US government repeatedly used trade sanction as retaliatory measures not only for economic reasons but for political reasons also several occasions. On the demand of cellular telephone equipment owners the U.S. government used the threat of imposing trade sanctions on Japanese imports, including punitive tariffs, if Japanese markets are not open by Japan for American cellular telephone equipment. After WTO agreements, for the implementation of intellectual property rights in China, the U.S. government also successfully used the same threat of punitive trade sanctions to get the Chinese government to enforce its intellectual property laws.   These measures were taken by US to protect their industries as massive copyright infringements in China that had been costing U.S. companies such as Microsoft hundreds of millions of dollars per year in lost sales revenues.  After the United States threatened to impose 100 percent tariffs on a range of Chinese imports into the United States, and after harsh words between officials from the two countries, the Chinese backed down at the 11th hour and agreed to tighter enforcement of intellectual property regulations. If it works, such a politically motivated rationale for government intervention may liberalize trade and bring with it economic gains.  In recent years, retaliation has emerged as one of the important instrument to restrict trade but it has been argued that it is a risky strategy because instead of being pressured by retaliation country might not back down and instead might raise trade barriers of its own.  This is exactly what the Chinese government threatened to do when pressured by the United States, although it ultimately did back down.  If a government does not back down, however, the results could be higher trade barriers all around and an economic loss to all involved.

STRATEGIC TRADE POLICY

It also been argued in strategic trade policy that a government should use subsidies to support promising firms that are active in newly emerging industries. It was further stated that with the support of subsidies, industries would reap substantial scale economies. This implies that the world market will profitably support only a few firms, countries may predominate in the export of certain products simply because they had firms that were able to capture first-mover advantages.  The dominance of Boeing in the commercial aircraft industry is attributed to such factors.

Government by appropriate actions, can help raise national income if it can somehow ensure that the firm or firms to gain first-mover advantages in such an industry are domestic rather than foreign enterprises.  Thus, according to the strategic trade policy argument, a government should use subsidies to support promising firms that are active in newly emerging industries.  Advocates of this argument point out that the substantial R&D grants the U.S. government gave Boeing in the 1950s and 60s probably helped tilt the field of competition in the newly emerging market for jet passenger planes in Boeing's favor. (Boeing's 707 jet airliner was derived from a military plane.) Similar arguments are now made with regard to Japan's dominance in the production of liquid crystal display screens (used in laptop computers).  Although these screens were invented in the United States, the Japanese government, in cooperation with major electronics companies, targeted this industry for research support in the late 1970s and early 80s.  The result was that Japanese firms, not U.S. firms, subsequently captured the first-mover advantages in this market.

The second component of the strategic trade policy argument is that it might pay for a government to intervene in an industry if it helps domestic firms overcome the barriers to entry created by foreign firms that have already reaped first mover advantages.  This catch-up argument underlies government support of Airbus industries Boeing's major competitor.  Airbus is a consortium of four companies from Great Britain, France, Germany, and Spain formed in 1966.  When it began production in the mid-1970s it had less than 5 percent of the world commercial aircraft market.  By 1990 it had increased its share to over 30 percent and was beginning to threaten Boeing's dominance.  How has Airbus achieved this feat?  According to the U.S. government, the answer is a $13.5 billion subsidy from the governments of Great Britain, France, Germany, and Spain.12 Without this subsidy, Airbus would have never been able to break into the world market.  In another example, the rise to dominance of the Japanese semiconductor industry, despite the first-mover advantages enjoyed by U.S. firms, is attributed to intervention by the Japanese government.  In this case the government did not subsidize the costs of domestic manufacturers.  Rather, it protected the Japanese home market while pursuing policies that ensured Japanese companies got access to the necessary manufacturing and product know-how.

If these arguments are correct, they clearly suggest a rationale for government intervention in international trade.  Specifically, governments should target technologies that may be important in the future and use subsidies to support development work aimed at commercializing those technologies.  Furthermore, governments should provide export subsidies until the domestic firms have established first-mover advantages in the world market.  Government support may also be justified if it can help domestic firms overcome the first-mover advantages enjoyed by foreign comepetitors and emerge as viable competitors in the world market (as in the Airbus and semiconductor examples).  In this case, a combination of home-market protection and export-promoting subsidies may be called for.

THE REVISED CASE FOR FREE TRADE

As we have just seen, the strategic trade policy arguments of the new trade theorists suggest an economic justification for government intervention in international trade.  This justification challenges the rationale for unrestricted free trade found in the work of classic trade theorists such as Adam Smith and David Ricardo. In response to this challenge to economic orthodoxy, a number of economists-including some of those responsible for the development of the new trade theory, such as Paul Krugman of MIT-have been quick to point out that although strategic trade policy looks nice in theory, in practice it may be unworkable. This response to the strategic trade policy argument constitutes the revised case for free trade.

Krugman argues that strategic trade policy aimed at establishing domestic firms in a Trade War dominant position in a global industry are beggar-thy-neighbor policies that boost national income at the expense of other countries. A country that attempts to use such policies will probably provoke retaliation. In many cases, the resulting trade war between two or more interventionist governments will leave all countries involved worse off than if a hands-off approach had been adopted in the first place. If the U.S., government were to respond to the Airbus subsidy by increasing its own subsidies to Boeing, for example, the result might be that the subsidies would cancel each other out. In the process, both European and U.S. taxpayers would end up sup-porting an expensive and pointless trade war, and both Europe and the United States would be worse off.

Krugman may be right about the danger of a strategic trade policy leading to a trade war. The problem, however, is how to respond when one's competitors are already being supported by government subsidies; that is, how should Boeing and the United States respond to the subsidization of Airbus? According to Krugman, the answer is probably not to engage in retaliatory action, but to help establish rules of the game that minimize the use of trade-distorting subsidies in the first place. This, of course, is what the GATT seeks to do.

Domestic Politics Governments do not always act in the national interest when they intervene in the economy. Instead they are influenced by politically important interest groups. The European Union's support for the common agricultural policy, which arose because of the political power of French and German farmers, is an example of this. The CAP benefited inefficient farmers and the politicians who relied on the farm vote, but no one else. Thus a further reason for not embracing strategic trade policy, according to Krugman, is that such a policy is almost certain to be captured by special interest groups within the economy, which will distort it to their own ends. Krugman concludes that with regard to the United States:

To ask the Commerce Department to ignore special-interest politics while formulating detailed policy for many industries is not realistic; to establish a blanket policy of free trade, with exceptions granted only under extreme pressure, may not be the optimal policy according to the theory but may be the best policy that the country is likely to get.

DEVELOPMENT OF THE WORLD TRADING SYSTEM

We have seen that there are strong economic arguments for supporting unrestricted free trade.  While many governments have recognized the value of these arguments, they have been unwilling to unilaterally lower their trade barriers for fear that other nations might not follow suit.  Consider the problem that two neighboring countries, say France and Italy, face when considering whether to lower barriers to trade between them.  In principle, the government of Italy might favor lowering trade barriers, but it might be unwilling to do so for fear that France would not do the same.  Instead, they might fear that the French will take advantage of Italy’s low barriers to enter the Italian market, while at the same time continuing to shut Italian products out of their market by high trade barriers.  The French government might believe it faces exactly the same dilemma.  The essence of the problem is a lack of trust between the governments of France and Italy.  Both governments recognize that their respective nations will benefit from lower trade barriers between them, but neither government is willing to lower barriers for fear that the other might not follow- How is such a deadlock to be resolved?  Both countries could negotiate a set of rules that would govern cross-border trade and lower trade barriers.  But who is to monitor the governments to make sure they are playing by the trade rules and not cheating?  And who is to impose sanctions on a government that cheats?  These are difficult questions, but they have an answer; both governments could set up an independent body whose function is to act as a referee.  This referee could monitor trade between the countries, make sure that no side cheats, and impose sanctions on a country if it does cheat.

 

While it might sound unlikely that any government would compromise its national sovereignty by submitting to such an arrangement, since World War 11 an international trading framework has evolved that has exactly these features.  For its first 50 years this framework was known as the General Agreement on Tariffs and Trade (the GATT).  Since 1995 it has been known as the World Trade Organization (WTO).  Here we look at the evolution and workings of the GATT and the WTO.  We begin, however, with a brief discussion of the pre-GATT history of world trade, since this helps set the scene.

From Smith to the Great Depression:  The intellectual case for free trade goes back to the late 18th century and the work of Adam Smith and David Ricardo.  Free trade as a government policy was first officially embraced by Great Britain in 1846, when the British Parliament repealed the Corn Laws.  The Corn Laws placed a high tariff on imports of foreign corn.  The objectives of the Corn Law tariff were to raise government revenues and to protect British corn producers.  There had been annual motions’ in Parliament in favor of free trade since the 1820s when David Ricardo was a Member of Parliament.  However, agricultural protection was withdrawn only as a result of a protracted debate when the effects of a harvest failure in Britain were compounded by the imminent threat of famine in Ireland.  Faced with considerable hardship and suffering among the populace, Parliament narrowly reversed its long-held position.  During the next 80 years or so, Great Britain, as one of the world's dominant trading powers, pushed the case for trade liberalization; but by and large the British government was a voice in the wilderness.  Its policy of unilateral free trade was not reciprocated by its major trading partners.  The only reason Britain was able to hold on to this policy for so long was that, as the world's largest exporting nation, it had far more to lose from a trade war than did any other country.

By the 1930s, however, the British attempt to stimulate free trade was buried under the economic rubble of the Great Depression.  The Great Depression had roots in the failure of the world economy to mount a sustained economic recovery after the end of World War I in 1918.  Things got worse in 1929 with the U.S. stock market collapse and the subsequent run on the U.S. banking system.  Economic problems were compounded in 1930 when the U.S. Congress passed the SmootHawley tariff.  Aimed at avoiding rising unemployment by protecting domestic industries and diverting consumer demand away from foreign products, the SmootHawley tariff erected an enormous wall of tariff barriers.  Almost every industry was rewarded with its "made to order" tariff.  A particularly odd aspect of the Smow Hawley tariff-raising binge was that the United States was running a balance-of payment surplus at the time and it was the world's largest creditor nation In any event, the Smoot-Hawley tariff had a damaging effect on employment abroad.  Other countries reacted to the U.S. action by raising their own tariff barriers.  U.S. exports tumbled in response, and the world slid further into the Great Depression. 1947-1979: GATT Trade Liberalization ,and Economic Growth The economic damage caused by the beggar-thy-neighbor trade policies that the Smoot-Hawley Act ushered in exerted a profound influence on the economic institutions and ideology of the post-World War 11 world.  The United States emerged from the war not only victorious but also economically dominant.  After the debacle of the Great Depression, opinion in the U.S. Congress had swung strongly in favor of free trade.  As a consequence, under U.S. leadership, the General Agreement on Tariffs and Trade (GATT) was established in 1947. The GATT is a multilateral agreement whose objective is to liberalize trade by eliminating tariffs, subsidies, import quotas, and the like.  Since its foundation in 1947, the GATT's membership has grown from 19 to more than 120 nations.  The GATT did not attempt to liberalize trade restrictions in one fell swoop; that would have been impossible.  Rather, tariff reduction has been spread over eight rounds.  The latest, the Uruguay Round, was launched in 1986 and completed in December 1993.  In these rounds mutual tariff reductions are negotiated among all members, who then commit themselves not to raise import tariffs above negotiated rates.  GATT regulations were enforced by a mutual monitoring mechanism.  If a country believed that one of its trading partners was violating a GATT regulation, it could ask the Geneva-based bureaucracy that administered the GATT to investigate.  If GATT investigators found the complaints to be valid, member countries could be asked to pressure the offending party to change its policies.  In general such pressure has always been sufficient to get an offending country to change its policies.  If It were not, the offending country could in theory have been expelled from the GATT.  In its early years the GATT was by most measures very successful.  In the United States, for example, the average tariff declined by nearly 92 percent over the 33 years spanning the Geneva Round of 1947 and the Tokyo Round of 1973-79.  Consistent with the theoretical arguments first advanced by Ricardo the move toward free trade under the GATT appeared to stimulate economic growth.  From 1953 to 1963 world trade grew at an annual rate of 6.1 percent, and world income grew at an annual rate of 4.3 percent.  Performance in the period 1963 to 1973 was even better; world trade grew at 8.9 percent per annum, and world income grew at 5.1 percent per annum.   1980-1993: Disturbing Trends   During the 1980s and early 1990s, the world trading system erected by the GATT began to come under strain as protectionist pressures rose around the world.  There were three main reasons for the rise in these pressures during the 1980s.  First, Japan's economic success strained the world trading system.  Japan was in ruins when the GATT was created.  By the early 1980s, however, it had become the world's second largest economy, i.e. its largest exporter. Japan’s success in such industries as automobiles and semiconductors by itself might have been enough to strain the world trading system.  Things were made worse, however, by the widespread perception in the West that despite low tariff rates and subsidies, Japanese markets were closed to imports and foreign investment by administrative trade barriers.

 

Second, the world trading system was further strained by the persistent trade deficit in the world's largest economy, the United States.  Although the deficit peaked in 1987 at over $170 billion, by the end of 1992 the annual rate was still running at about $80 billion.  From a political perspective, the matter was worsened in 1992 by the $45 billion deficit in U.S. trade with japan-a country perceived as not playing by the rules.  The consequences of the U.S. deficit included painful adjustments in industries such as automobiles, machine tools, semiconductors, steel, and textiles, where domestic producers steadily lost market share to foreign competitors.  The resulting unemployment gave rise to renewed protectionist pressures in the U.S. Congress.

A third reason for the trend toward greater protectionism was that many countries found ways to get around GATT regulations.  Bilateral voluntary export restraints (VERS) circumvent GATT agreements, because neither the importing country nor the exporting country complains to the GATT bureaucracy in Geneva-and without a complaint, the GATT bureaucracy can do nothing.  Exporting countries agreed to VERs to avoid far more damaging punitive tariffs.  One of the best-known examples is the VER between Japan and the United States, under which Japanese producers promised to limit their auto imports into the United States as a way of defusing growing trade tensions.  According to  World Bank study, 13 percent of the imports of industrialized countries in 1981 are Subjected to nontariff trade barriers such as VERS.  By 1986 this figure had increased to 16 percent.  The most rapid rise was is in the United States, where the  value of- imports affected by nontariff barriers (primarily VERS) increased by 23 percent  between 1981 and 1986. The Uruguay Round  and the World Trade Organization Against the background of rising protectionist pressures, in 1986 GATT members embarked on their eighth round of negotiations to reduce tariffs, the Uruguay  (so named because they occurred in Uruguay).  This was the most difficult round of negotiations yet, primarily because it was also the most ambitious.  Until now GATT rules had applied only to trade in manufactured goods and commodities.