Topic 5: Trade and Factor Mobility on trade theories to guide policy

Theory development.

Laissez-Faire Versus Interventionist Theories of Trade Patterns

Approaches to Exports and Imports
After taking a look at theories dealing
Once countries set economic and with trade intervention, we examine
political objectives, officials enact those that help explain trade patterns
policies—including trade policies—to (how much countries depend on trade,
achieve desired results. This influences in what products, and with whom),
which countries can produce given including theories of country size, factor
products more efficiently and whether proportions, and country similarity. We
countries will permit imports to compete then consider theories dealing with the
against their domestically produced dynamics of countries’ trade
goods and services. Some nations take competitiveness for particular products,
a more laissez-faire approach, one that which include the product life cycle
allows market forces to determine theory and the diamond of national
trading relations. competitive advantage theory.

Free-trade theories TRADE THEORIES AND BUSINESS

Table 5.1 (reference from Daniels et al
(absolute advantage and comparative
2015) summarizes the major trade
advantage) take a complete laissez-faire
theories and their emphases. These
approach because they prescribe that
different theories expand our
governments should not intervene
understanding of how government trade
directly to affect trade. At the other
policies might affect business
extreme are mercantilism and
competitiveness. For instance, they
neomercantilism, which prescribe a
provide insights on favorable locales
great deal of government intervention in
and products for exports, thereby
trade. Whether taking a laissez-faire or
helping companies determine where to
interventionist approach, countries rely
locate their production facilities when
governments do or do not impose trade
restrictions.
FACTOR-MOBILITY THEORY
Because the stability and dynamics of
countries’ competitive positions depend
largely on the quantity and quality of
their production factors (land, labor,
capital, technology), we’ll conclude this
Topic with a discussion of factor
mobility.
Interventionist Theories
Let us begin with mercantilism because
it is the oldest trade theory, out of which
neomercantilism has more recently
emerged. These theories are based on
some of the reasons for governmental
intervention, but there are other reasons
as well that we discuss in the next
Topic.
MERCANTILISM
Mercantilism holds that a country’s
wealth is measured by its holdings of
“treasure,” which usually means its gold.
According to this theory, which formed
the foundation of economic thought from
about 1500 to 1800, countries should
export more than they import and, if
successful, receive gold from countries
that run deficits. Nation-states were
emerging during this period, and gold
empowered central governments to
raise armies and invest in national
institutions so as to solidify the people’s
primary allegiance to the new nations.
Governmental Policies
To export more than they imported,
governments restricted imports and
subsidized production that otherwise
could not compete in domestic or export
markets. Some countries used their
colonies to support this trade objective
by having the colonies supply
commodities that the colonial powers
would otherwise have to purchase from
non-associated countries and by
running trade surpluses as an additional
way to obtain gold.
The Concept of Balance of Trade
Some terminology of the mercantilist era
has endured. For example, a favorable
balance of trade (also called a trade
surplus) still indicates that a country is
exporting more than it imports. An
unfavorable balance of trade (also
known as a trade deficit) indicates the
opposite. Many of these terms are
misnomers. For example, the word
favorable implies “benefit,” and the word
unfavorable suggests “disadvantage.” In
fact, it is not necessarily beneficial to run
a trade surplus or detrimental to run a
trade deficit. A country with a favorable
balance of trade is, for the time being,
supplying people in foreign countries
with more than it receives from them.
NEOMERCANTILISM
The term neomercantilism describes the
approach of countries that try to run
favorable balances of trade in an
attempt to achieve some social or
political objective. A country may aim for
increased employment by setting
economic policies that encourage its
companies to produce in excess of the
demand at home and send the surplus
abroad. Or it may attempt to maintain
political influence in an area by sending
more merchandise there than it receives
from it, such as a government granting
aid or loans to a foreign government to
use to purchase the granting country’s
excess production.
Free-Trade Theories
Why do countries need to trade at all?
Why can’t countries be content with the
goods and services it produces? In fact,
many countries following mercantilist
policy tried to become as self-sufficient
as possible. In this section, we discuss
two theories supporting free trade:
absolute advantage and comparative
advantage.
Both theories hold that nations should
neither artificially limit imports nor
promote exports. The market will
determine which producers survive as
consumers buy those products that best
serve their needs. Both free trade
theories imply specialization. Just as
individuals and families produce some
things that they exchange for things that
others produce, national specialization
means producing some things for
domestic consumption and export while
using the export earnings to buy imports
of products and services produced
abroad.
 country specialize? Although Smith
believed the marketplace would make
THEORY OF ABSOLUTE
the determination, he thought that a
ADVANTAGE
country’s advantage would be either
In 1776, Adam Smith questioned the natural or acquired.
mercantilists’ assumptions by stating
that the real wealth of a country consists
of the goods and services available to Natural Advantage
its citizens rather than its holdings of
A country’s natural advantage in
gold. This theory of absolute advantage
creating a product or service comes
holds that different countries produce
from climatic conditions, access to
some goods more efficiently than
certain natural resources, or availability
others, and questions why the citizens
of certain labor forces. In the case of
of any country should have to buy
Costa Rica’s climate and soil support
domestically produced goods when they
the production of bananas, pineapples,
can buy them more cheaply from
and coffee, while its biodiversity
abroad. Through specialization, it could
supports a thriving ecotourism industry.
increase its efficiency for three reasons:
Costa Rica imports wheat. If it were to
1. Labor could become more increase its wheat production, for which
skilled by repeating the same tasks. its climate and terrain are less suited, it
would have to use land now devoted to
2. Labor would not lose time in
the cultivation of bananas, pineapples,
switching production from one kind of
and coffee, or convert some of its
product to another.
biodiverse national park areas to
3. Long production runs would agricultural production, thus reducing
provide incentives for developing more those earnings.
effective working methods.

The country could then use its excess

specialized production to buy more
imports than it otherwise could have
produced. But in what products should a

Acquired Advantage
Most of today’s world trade is of
manufactured goods rather
agricultural goods and
resources. Countries that
competitive in manufactured goods have
an acquired advantage, usually in either
product or process technology. An
advantage of product technology is that
it enables a country to produce a unique
product or one that is
distinguished from those of competitors.
For example, Denmark exports silver
tableware, not because there are rich
Danish silver mines but because Danish
companies have developed distinctive
products.
An advantage in process technology is
a country’s ability to efficiently produce a
homogeneous product (one not easily
distinguished from that of competitors).
Japan has exported steel despite having
to import iron and coal to produce it
because its steel mills
encompassed new labor- and material-
saving processes. Thus, countries that
develop distinctive or less expensive
products have acquired advantages, at
least until producers in another country
emulate them successfully.
How Does Resource Efficiency
Work? We can demonstrate absolute
trade advantage here by examining two
than countries and two commodities.
natural Because we are not yet considering the
are concepts of money and exchange rates,
we define the cost of production in terms
of the resources needed to produce
either commodity. This example is
realistic because real income depends
on the output of goods compared to the
easily resources used to produce them.
Say that Costa Rica and the United
States are the only two countries and
each has the same amount of resources
(land, labor, and capital) to produce
either coffee or wheat. Using Figure 5.2,
let’s say that 100 units of resources are
available in each country. In Costa Rica,
assume that it takes four units to
produce a ton of coffee and 10 units per
ton of wheat. The purple Costa Rican
production possibility line shows that
Costa Rica can produce 25 tons of
have coffee and no wheat, 10 tons of wheat
and no coffee, or some combination of
the two.
THEORY OF COMPARATIVE
ADVANTAGE
2. Production Possibility
We have just described absolute
Assume the United States is more
advantage, which is often confused with
efficient in producing coffee and wheat
comparative advantage. In 1817, David
than Costa Rica is, thus having an
Ricardo examined the question, “What
absolute advantage in the production of
happens when one country can produce
both.6 Take a look at Figure 5.3. As in
all products at an absolute advantage?”
our earlier example, it assumes that
His resulting theory of comparative
there are only two countries, each with a
advantage says that global efficiency
total of 100 units of resources available,
gains may still result from trade if a
and half of each used in each product. It
country specializes in what it can
takes Costa Rica 10 units of resources
produce most efficiently—regardless of
to produce either a ton of coffee or a ton
other countries’ absolute advantage.
of wheat, whereas it takes the United
1. Comparative Advantage by States only five units to produce a ton of
Analogy Although this theory may seem coffee and four for a ton of wheat.
initially incongruous, an analogy should
clarify its logic. Imagine that the best
physician in town also happens to be 3. Do not Confuse Comparative and

the best medical administrator. It would Absolute Advantage

not make economic sense for the Most economists accept the
physician to handle all the administrative comparative advantage theory and its
duties of the office, because of earning influence in promoting policies for freer
more money by concentrating on trade. Nevertheless, many government
medical duties, even though that means policymakers, journalists, managers,
having to employ a less-skilled office and workers confuse comparative
administrator. advantage with absolute advantage and
do not understand how a country can maximizing income. Yet there are a
simultaneously have a comparative number of reasons for choosing not to
advantage and absolute disadvantage in work full time at medical tasks, such as
the production of a given product. finding administrative work relaxing and
self-fulfilling, fearing that a hired
Theories of Specialization: Some
administrator would be unreliable, or
Assumptions and Limitations
wishing to maintain administrative skills
Both absolute and comparative in the somewhat unlikely event that
advantage theories are based on administrators will command higher
increasing output and trade through wages than physicians in the future.
specialization. However, these theories
3. Division of Gains
make assumptions, some of which are
not always valid. Although specialization brings potential
economic benefits to all trading
1. Full Employment
countries, the earlier discussion did not
The physician/administrator analogy we indicate how countries will divide
used earlier assumed that the physician increased output. In the case of our
could stay busy full time practicing wheat and coffee example, if both the
medicine. If not, the physician might United States and Costa Rica receive
perform the administrative work without some share of the higher output, both
sacrificing earnings from medical duties. will be better off economically through
The theories of absolute and specialization and trade.
comparative advantage both assume
4. Transport Costs
that resources are fully employed. When
countries have many unemployed or If it costs more to transport the goods
unused resources, they may seek to than is saved through specialization, the
restrict imports to employ or use idle advantages of trade are negated. In
resources. other words, in our two-country
scenario, some workers would need to
2. Economic Efficiency
forgo producing coffee or wheat in order
Our analogy also assumes that the to work in transporting the coffee and
physician is interested primarily in wheat abroad. However, as long as the
diversion reduces output by less than might conduct R&D in Country A, secure
what the two countries gain from components in Countries B and C,
specialization, there are still gains from assemble final products in Country D,
trade. manage finances in Country E, and
carry out call center services in Country
5. Statics and Dynamics
F. Although this type of development
The theories of absolute and adds complexity to the analysis, it fits
comparative advantage address well with the concept of advantages
countries statically—by looking at them through specialization.
at one point in time. However, the
8. Mobility
relative conditions that give countries
production advantages and These theories assume that resources
disadvantages change. can move domestically from the
production of one good to another—and
6. Services
at no cost. But this assumption is not
The theories of absolute and completely valid. For example,
comparative advantage deal with steelworkers might not move easily into
products rather than services. However, software development jobs because of
with a growing portion of world trade different skill needs. Even if they do,
made up of services, the theories apply they may be less productive than
because resources must also go into before. The theories also assume that
service production. For instance, the resources cannot move internationally.
United States sells an excess of such Increasingly, however, they do, and the
services as education to foreign movement affects countries’ production
countries (many foreign students attend capabilities.
U.S. universities).

7. Production Networks

Both theories deal with trading one

product for another. Increasingly,
however, portions of a product may be
made in different countries. A company
 on imports and exports more than
others. We will now examine theories
that help explain country differences.

Trade Pattern Theories

Theory of Country Size
The free trade theories demonstrate
Land area is an obvious way to measure
how economic growth occurs through
a country’s size and largely explains
specialization and trade; however, they
countries’ relative dependence on trade.
do not deal with trade patterns such as
The theory of country size holds that
how much a country trades, what
large countries usually depend less on
products it trades, or who will be its
trade than small ones. Countries with
trading partners when following a free
large land areas are apt to have varied
trade policy. In this section, we discuss
climates and an assortment of natural
the theories that help explain these
resources, making them more self-
patterns.
sufficient than smaller ones. Most large
countries (such as Brazil, China, India,

HOW MUCH DOES A COUNTRY the United States, and Russia) import

TRADE? much less of their consumption needs

and export much less of their production
Free-trade theories of specialization
output than do small nations (such as
neither propose nor imply that only one
Uruguay, Belgium, and Taiwan).
country should or will produce a given
product or service. Non-tradable goods
—products and services (haircuts, retail Size of the Economy
grocery distribution, etc.) that are
While land area helps explain the
seldom practical to export because of
relative dependence on trade, countries’
high transportation costs—are produced
economic size helps explain differences
in every country. However, among
in the absolute amount of trade. Nine of
tradable goods, some countries depend
the world’s top 10 exporters in 2012
were developed countries, and the only
exception was China, which is the
world’s second largest economy.
Similarly, developed countries account
for well over half of the world’s exports.
Simply put, they produce so much that
they have more to sell, both
domestically and internationally.
WHAT TYPES OF PRODUCTS DOES
A COUNTRY TRADE?
In our discussion of absolute advantage,
we indicated that this advantage might
be either natural or acquired. Here, we
discuss theories that help explain what
types of products result from these
natural and acquired advantages. We
will not delve again into those factors
we’ve already discussed (climate and
natural resources) that give a country a
natural advantage; however, we will
or capital endowments explain
differences in the cost of production
factors. For instance, if labor were
abundant in comparison to land and
capital, labor costs would be low relative
to land and capital costs; if scarce, the
costs would be high. These relative
factor costs would lead countries to
excel in the production and export of
products that used their abundant—and
therefore cheaper— production factors:
1. People and Land
Factor-proportions theory appears
logical. In countries that have many
people relative to the amount of land,
such as Hong Kong and the
Netherlands, land price is very high
because it is in such demand.
2. Manufacturing Locations
Casual observation of manufacturing

examine the factor endowment theory of locations also seems to substantiate the

trade. For acquired advantage, we theory. The most successful industries

discuss the importance of production in Hong Kong are those in which

and product technology. technology permits the use of a

minimum amount of land relative to the
Factor-Proportions Theory Eli
number of people employed.
Heckscher and Bertil Ohlin developed
the factor-proportions theory, 3. Capital, Labor Rates, and

maintaining that differences in countries’ Specialization

endowments of labor compared to land

In countries where little capital is
available for investment and the amount
of investment per worker is low,
managers might expect to find cheap
labor rates and export competitiveness
in products that need large amounts of
labor relative to capital.

4. Process Technology
With Whom Do Countries Trade?
Factor-proportions analysis becomes
more complicated when the same We have already noted that developed
product can be created by different countries account for the bulk of world
methods, such as with labor or capital trade. They also trade primarily with
each other, whereas developing
5. Product Technology
countries mainly export primary and
Manufacturing is by far the largest laborintensive products to developed
sector, with commercial services the countries in exchange for new and
fastest-growing sector. Manufacturing technologically advanced products.
competitiveness depends largely on Below, we discuss the roles that country
technology to develop new products and similarity and distance play in
processes. The technology depends, in determining trading partners.
turn, on a large number of highly
educated people. (especially scientists
and engineers) and a large amount of Country-Similarity Theory
capital to invest in R&D. Because
The theories explaining why trade takes
developed countries have an
place have focused so far on the
abundance of these features, they
differences among countries in terms of
originate most new products and
natural conditions and factor
account for most manufacturing output
endowment proportions. That most
and trade.
trade takes place among developed
countries can be further explained by
the country-similarity theory, which says
that companies create new products in
response to market conditions in their
home market
home, such as those that speak a
common language. Likewise, historic
colonial relationships explain much of
the trade between specific developed
and developing economies.

1. Specialization and Acquired

Advantage

However, in order to export, a company

must provide consumers abroad with an
advantage over what they could buy 4. The Effects of Political

from their domestic producers. Trade Relationships and Economic

occurs because countries’ producers Agreements

spend more on R&D in some sectors Political relationships and economic

than in others, thus leading to countries’ agreements among countries may
specialization and acquired advantage. discourage or encourage trade between

2. Product Differentiation them. Witness the political animosity

between the United States and Cuba
Trade also occurs because companies
that has diminished their mutual trade
differentiate products, thus creating two-
for about five decades.
way trade in seemingly similar products.
The United States is both a major 5. The Effects of Distance

exporter and a major importer of tourist Although no single factor fully explains

services, vehicles, and passenger specific pairs of trading partners, the

aircraft because different firms from geographic distance between two

different countries have developed countries is important. In essence,

product variations with different appeals. greater distances usually mean higher

3. The Effects of Cultural transportation costs; that’s why Intel’s

cost to ship semiconductors from Costa
Similarity Importers and exporters
Rica to the United States is lower than if
perceive greater ease in doing business
it had to bring them from, say,
in countries that are culturally similar to
Argentina. However, distance is more
important for homogeneous products countries develop, maintain, and lose
than for differentiated products in as their competitive advantages.
much as the former compete more on
the basis of price.
PRODUCT LIFE CYCLE (PLC)
6. Overcoming Distance
THEORY
Transport cost is not the only factor in
The international product life cycle
trade partner choice. New Zealand
(PLC) theory of trade states that the
competes with Chile, Argentina, and
production location of certain
South Africa for out-of-season sales of
manufactured products shifts as they go
apples to the Northern Hemisphere—but
through their life cycle. The cycle
with a disadvantage in freight costs to
consists of four stages: introduction,
the United States and Europe. It has
growth, maturity, and decline. Table 5.2
countered this disadvantage by boosting
(as cited by Daniels et al 2015)
yields, developing new premium
highlights these stages.
varieties, bypassing intermediaries to
sell directly to supermarkets abroad,
and consolidating efforts through a CHANGES OVER THE CYCLE
national marketing board.
Companies develop new products
primarily because they observe nearby

The Statics and Dynamics of Trade needs for them; thus a U.S. company is
most apt to create a new product for the
We have alluded to the fact that trading
U.S. market, a French company for the
patterns change due to such factors as
French market, and so on. At the same
political and economic relations among
time, almost all new technology that
countries and the development of new
results in new products and production
product capabilities. We now discuss
methods originates in developed
two theories—the product life cycle
countries, which have most of the
theory and the diamond of national
resources to develop new products and
advantage— that help explain how
most of the income to buy them.
1. INTRODUCTION Once a company occupied in developing unique product
has created a new product, theoretically variations for Japanese consumers.
it can manufacture it anywhere in the
c. Japanese costs may still be high
world. In practice, however, the early-
because of production start-up
production stage, called the introductory
problems.
stage, generally occurs in a domestic
location so the company can obtain Growth is characterized by:

rapid market feedback and save on a. Increases in exports by the innovating

transport costs, since most sales are country.
domestic. Any export sales are mainly to
b. More competition.
other developed countries because of
more affluent customers there. c. Increased capital intensity.

The introduction stage is marked by: d. Some foreign production

a. Innovation in response to observed 3. MATURITY

need.
b. Exporting by the innovative country.
c. Evolving product characteristics.
2. GROWTH Sales growth attracts
competitors to the market, particularly in
other developed countries. Let’s say the
innovator is in the United States and a
competitor puts a manufacturing unit in
Japan.
In the maturity stage, worldwide demand
begins to level off, although it may be
growing in some countries and declining
in others. Typically, there is a shakeout
of producers, more standardized
production, and increased importance of
price as a competitive weapon. Capital-
intensive production reduces per-unit
cost, thus creating even more demand
in developing economies. Because

The Japanese production is sold mainly markets and technologies are

in Japan for several reasons: widespread, the innovating country no

longer commands a production
a. The growing demand there does not
advantage.
allow for much attention to other
markets. b. Producers there stay Maturity is characterized by:
a. A decline in exports from the Decline is characterized by:
innovating country.
a. A concentration of production in
b. More product standardization. developing countries.

c. More capital intensity. b. An innovating country becoming a net

importer.
d. Increased competitiveness of price.

e. Production start-ups in emerging

economies.

4. DECLINE VERIFICATION AND LIMITATIONS OF

PLC THEORY
As a product moves into the decline
stage, those factors occurring during the The PLC theory holds that the location
maturity stage continue to evolve. The of production facilities that serve world
markets in developed countries decline markets shifts as products move
more rapidly than those in developing through their life cycle. Today, most
economies as affluent customers production has located in developing
demand ever newer products. By this countries, and prices have declined.
time, market and cost factors have Types of products abound for which
dictated that almost all production is in production locations usually do not shift.
developing economies that export to the Such exceptions include the following:
declining or small-niche markets in the
a. Products with high transport costs
developed world. In other words, the
that may have to be produced close to
country in which the innovation first
the market, thus never becoming
emerged—and was exported from—
significant exports.
then becomes the importer.
b. Products that, because of very rapid advantages? The diamond of national
innovation, have extremely short life competitive advantage is a theory
cycles, making it impossible to reduce showing four features as important for
costs by moving production from one competitive superiority: demand
country to another. Some fashion items conditions; factor conditions; related and
fit this category. supporting industries; and firm strategy,
structure, and rivalry. (see Figure 5.5
c. Luxury products for which cost is of
from Daniels et al 2015).
little concern to the consumer. In fact,
production in a developing country may
cause consumers to perceive the
product as less luxurious.

d. Products for which a company can

use a differentiation strategy, perhaps
through advertising, to maintain
consumer demand without competing
FACETS OF THE DIAMOND
on the basis of price.
Usually, all four conditions need to be
e. Products that require specialized
favorable for an industry within a country
technical personnel to be located near
to attain and maintain global supremacy.
production so as to move the products
into their next generation of models. 1. Demand Conditions
This seems to explain the long-term
Demand conditions are the first feature
U.S. dominance of medical equipment
in the theory. Both PLC theory and
production and German dominance in
country-similarity theory show that new
rotary printing presses.
products (or industries) usually arise
from companies’ observation of need or
demand, which has traditionally been in
THE DIAMOND OF NATIONAL
their home country, where they start up
COMPETITIVE ADVANTAGE
production.
Why have countries developed and
2. Factor Conditions
sustained different competitive
Continuing our example, the second advantage required favorable
feature—factor conditions (recall natural circumstances for the fourth feature: firm
advantage within the absolute strategy, structure, and rivalry.
advantage and factor-proportions
theories)— influenced both the choice of
tile to meet consumer demand and the Limitations of the Diamond of

choice of Italy as the production National Advantage Theory

location. Wood was expensive, and The existence of the four favorable
most production factors (skilled labor, conditions does not guarantee that an
capital, technology, and equipment) industry will develop in a given locale.
were available within Italy on favorable Entrepreneurs may face favorable
terms. conditions for many different lines of

3. Related and Supporting Industries business. In fact, comparative

The third feature—the existence of advantage theory holds that resource

nearby related and supporting industries limitations may cause a country’s firms

(enamels and glazes)—was also to avoid competing in some industries

favorable. Recall, for instance, the despite an absolute advantage.

importance of transport costs in the A second limitation concerns the growth

theory of country size, in assumptions of of globalization. The industries on which
specialization, and in the limiting factors this theory is premised grew when
of the PLC theory. companies’ access to competitive

4. Firm Strategy, Structure, and capabilities was much more

Rivalry domestically focused. We can see how

The combination of three features—
demand, factor conditions, and related
and supporting industries—influenced
globalization affects each of the four
conditions:
1. Observations of foreign or foreign-

companies’ decisions to initiate plus-domestic demand conditions have

production of ceramic tiles in postwar spurred much of the recent Asian export

Italy. The ability of the companies to growth. In fact, such Japanese

develop and sustain a competitive companies as Uniden and Fujitech

target their sales almost entirely to By expanding the diamond of national
foreign markets. advantage theory to include changes
brought about by globalization, we can
2. Companies and countries do not
see its validity for countries’ economic
depend entirely on domestic factor
policies. In our opening case, Costa
conditions. For example, capital and
Rica diversified its economy from
managers are now internationally
agricultural products to modern high-
mobile, and companies may depend on
tech products by satisfying the market
foreign locations for portions of their
entry conditions of the diamond. This
production.
transformation could not have occurred
3. If related and supporting industries had Costa Rican authorities looked only
are not available locally, materials and at what was available within their own
components are now more easily borders.
brought in from abroad because of
transportation advancements and
relaxed import restrictions. In fact, many
MNEs now assemble products with
parts supplied from a variety of
countries.

4. Companies react not only to domestic

rivals but also to foreign-based rivals
they compete with at home and abroad.
Thus, the prior domestic absence of any
of the four conditions from the diamond
may not inhibit companies
industries from gaining these conditions
and becoming globally competitive.
Factor-Mobility Theory
As both the quantity and quality of
countries’ factor conditions change, their
relative capabilities change as well,
and
possibly because of internal
circumstances. For instance, if savings
rates increase, countries have more
capital relative to their factors of land

Using the Diamond for and labor. If they spend relatively more

Transformation
on education, they improve the quality of They find information on interest-rate
the labor factor. differences readily available, and they
can transfer capital by wire
Concomitantly, nine countries are
instantaneously at a low cost. Short-
expected to account for half of the
term capital is more mobile than long-
world’s population increase, with India,
term capital, such as direct investment,
Pakistan, and Nigeria leading the pack.
because there are more active markets
These changes, of course, are important
to buy foreign holdings and sell them if
in understanding and predicting
investors want to transfer capital back
changes in export production and import
home or to another country.
market locations. At the same time, the
mobility of capital, technology, and People
people affect trade and relative
People are less mobile than capital.
competitive positions. Here we address
Some, of course, travel to other
the factor-mobility theory, which
countries as tourists, students, and
focuses on why production factors
retirees; however, this does not affect
move, the effects of that movement on
factor endowments because these
transforming factor endowments, and
travelers do not work in the destination
the impact of international factor mobility
countries. Unlike funds that can be
(especially people) on world trade.
cheaply transferred by wire, people
usually must incur high transportation
costs to work abroad.

In many cases, workers leave their

WHY PRODUCTION FACTORS MOVE
families behind in the hopes of returning
Capital home after saving enough money

Capital, especially short-term capital, is working in the foreign country. Some

the most internationally mobile move legally, others illegally

production factor. Companies and (undocumented); they lack government

private individuals primarily transfer permission to enter or work.

capital because of differences in 1. Economic Motives

expected return (accounting for risk).
People work in another country largely
for economic reasons, such
Indonesian laborers working in Malaysia
to earn more than at home.
2. Political Motives
People also move for political reasons—
for example, because of persecution or
war dangers, in which case they are
known as refugees and usually become
part of the labor pool where they live. It
is not surprising that most refugees
emanate from war-torn countries and go
to a neighboring country; the largest
recent movement has been
Afghanistan to Pakistan.
Effects of Factor Movements
Neither international capital
population mobility is a new occurrence.
For example, had it not been for
historical mass immigration, Australia,
Canada, and the United States would
have greatly reduced populations today.
Further, many immigrants brought
human capital with them, thus adding to
the base of skills that enabled those
countries to be newly competitive in an
array of products they might otherwise
have imported. Finally, these same
countries received foreign capital to
develop infrastructure and natural
resources, which further altered their
as competitive structures and international
trade.
What Happens When People Move?
Recent evidence is largely anecdotal.
Nevertheless, we have indicated that
immigration is substantial for many
countries and insignificant for others.
A controversial issue is the effect of
outward migration on countries. On the
one hand, countries lose potentially
productive resources when educated
people leave—a situation known as a
from brain drain. On the other hand, they
may receive money from those people.
Developing countries have lost people
with substantial work skills. However,
nor many of these people are now sending
remittances back.
Topic 6: Trade Protectionism
Introduction
At some point, you may work for or own
stock in a company whose performance,
or even survival, depends on
governmental trade policies. These
policies may affect the ability of foreign
producers to compete in your home forced consumers in those same areas
market. They may limit or enhance your to pay higher prices. In general,
company’s ability to sell abroad or governments would also like to help
acquire needed foreign supplies. their struggling companies and
Collectively, governmental restrictions industries without penalizing those that
and support to influence international are doing well. This goal is often
trade competitiveness are known as impossible, however, especially if other
protectionism. countries retaliate by limiting their own
imports.

All countries seek to influence trade,

and each has economic, social, and THE ROLE OF STAKEHOLDERS
political objectives: Proposals on trade regulations often
spark fierce debate among people and
1. Conflicting objectives
groups that believe they will be affected
2. Interest groups —the so-called stakeholders.

Conflicting Results of Trade Policies The Role of Consumers

Despite free-trade benefits,
In contrast, consumers (who are also
governments intervene in trade to attain
stakeholders) typically buy the best
economic, social, or political objectives.
product they can find for the price, often
Officials apply trade policies that they
without knowing or caring about its
reason will have the best chance to
origin. They often don’t realize how
benefit their nation and its citizens—
much retail prices rise in aggregate
and, in some cases, their personal
because of import restrictions. Nor do
political longevity. Determining whether
they take much notice, since consumer
and how to influence trade is
costs are typically spread out among
complicated by uncertain and conflicting
many people over time and entail a
policy outcomes. For example, catfish
small price increase for individual
importing was restricted to help workers
purchases.
in depressed areas, but the restrictions
 expected. Even if successful, the
potentially high costs must be borne by
Economic Rationales for
someone. Import restrictions to create
Governmental Intervention
domestic employment:
Governmental trade intervention may be
1. May lead to retaliation by other
classified as either economic or
countries.
noneconomic, as shown in Table 6.1
(cited from Daniels et al 2015). Let us 2. Are less likely retaliated against
begin by analyzing some leading effectively by small economies.
economic rationales.
3. Are less likely to be met with
retaliation if implemented by small
economies.
FIGHTING UNEMPLOYMENT
4. May decrease export jobs because of
There is probably no more effective
price increases for components.
pressure group than the unemployed;
no other group has more time and 5. May decrease export jobs because of
incentive to protest publicly and contact lower incomes abroad.
government representatives. Workers
displaced because of imports are often
the least able to find alternative work, The Prospect of Retaliation

such as the fairly unskilled catfish One difficulty with restricting imports to
workers in depressed regions. create jobs is that other countries,
whose production may typically drop as
a result, normally retaliate with their own
What’s Wrong with Full Employment
restrictions. Cited from Daniel et al
as an Economic Objective?
2015, the table shows the rationale why
Although every country desire full government intervene.
employment, using trade policy to
Even if no country retaliates, the
achieve it is problematic. From a
restricting country may gain jobs in one
practical standpoint, gaining jobs by
sector only to lose them elsewhere.
limiting imports may not fully work as
Why? Consider three factors:
1. Fewer imports of a product mean
fewer import-handling jobs, such as
those in the container-shipping industry.
2. Given the global complexity of
production, import restrictions on one
industry will likely cause lower sales in
other industries because they must incur
higher costs for inputs and components.
For example, U.S. import restrictions on
steel raise automobile and
equipment manufacturing costs.
3. Imports stimulate exports, though less
directly, by increasing foreign income
and foreign exchange earnings, which
foreign consumers then spend partially
on new imports. Thus, restricting
earnings abroad has some negative
effect on domestic earnings
employment.
Analyzing Trade-Offs
In deciding whether to restrict imports to
create jobs, governments must face the
difficult task of comparing the costs of
limiting imports with the costs
unemployment from freer trade. It is
hard to put a price on the distress
suffered by people who lose their jobs
due to import competition. It is also
difficult for working people to understand
that they may be better off financially
because of lower prices even if they
must pay higher taxes to support
unemployment or welfare benefits for
those who do lose their jobs.
farm Protecting “Infant Industries” One of the
oldest arguments for protectionism, the
infant-industry argument, holds that a
government should shield an emerging
industry from foreign competition by
guaranteeing it a large share of the
domestic market until it can compete on
its own. Many developing countries use
this argument to justify their protectionist
and
policies, especially if entry barriers are
high and foreign competition is
formidable.
PROTECTING “INFANT INDUSTRIES”
One of the oldest arguments for
protectionism, the infant-industry
argument, holds that a government
of should shield an emerging industry from
foreign competition by guaranteeing it a
large share of the domestic market until
it can compete on its own. Many internationally competitive products.
developing countries use this argument This risk poses two problems.
to justify their protectionist policies,
1. Determining Probability of Success
especially if entry barriers are high and
First, governments must identify those
foreign competition is formidable.
industries that have a high probability of
success. Some industries grow to be
competitive because of governmental
Underlying Assumptions
protection; automobile production in
The infant-industry argument presumes Brazil is a good example.
that the initial operating costs for an
industry in a given country may be so
high as to make its output 2. Who Should Bear the Cost?
noncompetitive in world markets.
Second, even if policymakers can
Eventual competitiveness is the result of
determine those infant industries likely
the efficiency gains that take time.
to succeed, it does not necessarily
Therefore, the industry’s government
follow that those companies therein
needs to protect it long enough for its
should receive government assistance.
fledgling companies to gain economies
Some segment of the economy must
of scale and their employees to translate
incur the higher cost when local
experience into higher productivity,
production is still inefficient, such as
enabling efficient production and
consumers paying higher prices for the
international competitiveness. The
protected products or taxpayers paying
government can then recoup the costs
for subsidies.
of trade protection through benefits like
higher domestic employment, lower
social costs, and higher tax revenues. DEVELOPING AN INDUSTRIAL BASE
Risks in Designating Industries Countries with a large manufacturing

Although it’s reasonable to expect base generally have higher per capita

production costs to decrease over time, GDPs than those that do not. Some,

they may never fall enough to create such as the United States and Japan,
developed an industrial base while
largely restricting imports. Many output. Consequently, many can move
developing countries try to emulate this into the industrial sector without
strategy, using trade protection to spur significantly reducing agricultural output.
local industrialization. Specifically, they Like the infant-industry argument, the
operate under the following set of industrialization argument presumes
assumptions: that the unregulated importation of lower
priced manufactures prevents the
1. Surplus workers can increase
development of a domestic industry.
manufacturing output more easily than
agricultural output. Shifting people out of agriculture,
however, can create at least two
2. Inflows of foreign investment in the
problems:
industrial sector promote sustainable
growth. 1. In rural areas, the underemployed
may lose the safety net of their
3. Prices and sales of agricultural
extended families, while many migrating
products and raw materials fluctuate
to urban areas cannot find enough
widely, which is a detriment to
suitable jobs, housing, and social
economies that depend heavily on just
services. For example, although millions
one or a few commodities.
of Chinese have moved to cities to find
4. Markets for industrial products grow jobs, many have not prospered through
faster than markets for commodities. the move.

5. Industrial growth reduces imports 2. Improved agriculture practices may

and/or promotes exports. be a better means of achieving

6. Industrial activity helps the nation- economic success than a drastic shift to

building process. industry. Many developed countries

continue to profit from exports of
Surplus Workers
agricultural products and maintain high
Disguised unemployment is high in per capita income with a mix of industry
many developing countries’ rural areas, and efficient agricultural production.
where people are effectively contributing
little, if anything, to the agricultural
Investment Inflows —say, how many bananas Country A
must sell to Country B to purchase one
Import restrictions, applied to spur
refrigerator from Country B—is referred
industrialization, also may increase FDI,
to as terms of trade. Historically, the
which provides capital, technology, and
prices of raw materials and agricultural
jobs. Barred from exporting to an
commodities have not risen as fast as
attractive foreign market, foreign
those of finished products, although they
companies may transfer manufacturing
have risen faster during short periods.
to that country to avoid the loss of a
Over time, therefore, it takes more low-
lucrative or potential market.
priced primary products to buy the same
amount of high-priced manufactured
Diversification goods.

Export prices of many primary products,

such as oil and coffee, fluctuate Import Substitution and Export-Led
markedly. Price variations due to Development
uncontrollable factors—such as weather
Traditionally, developing countries
affecting supply or business cycles
promoted industrialization by restricting
abroad affecting demand—can wreak
imports in order to boost local
havoc on economies that depend on the
production and consumption of products
export of primary products. This is
they would otherwise import. However, if
especially true for many developing
the protected industries do not become
countries that must rely on only one or a
efficient—an all-too-frequent outcome—
few commodities.
local consumers may have to support
them by paying higher prices or taxes.
In contrast, some countries, such as
Taiwan and South Korea, have
achieved rapid economic growth by
Growth in Manufactured Goods promoting the development of industries
with export potential, an approach
The quantity of imports that a given
known as export-led development.
quantity of a country’s exports can buy
 BALANCE-OF-TRADE
ADJUSTMENTS
Nation Building
A trade deficit creates problems for
There may be a strong relationship
nations with low foreign exchange
between industrialization and aspects of
reserves—the funds that help finance
the nation-building process.
the purchase of priority foreign goods
Industrialization helps countries build
and maintain the trustworthiness of a
infrastructure, advance rural
currency. So, if balance-of-trade
development, and boost workforce
difficulties arise and persist, a
skills. Ecuador and Vietnam maintain
government may act to reduce imports
that industrialization has helped them
or encourage exports to balance its
move from feudal economies suffering
trade account. Two options that can
chronic food shortages to nations with
affect its competitive position broadly
improved food security and budding
are:
export competitiveness.
1. Depreciating or devaluing its
currency, which makes basically all of its
Noneconomic Rationales for products cheaper in relation to foreign
Government Intervention products.

Every nation monitors its absolute 2. Relying on fiscal and monetary policy
economic welfare, compares its to bring about lower price increases in
performance to that of other countries, general than those in other countries.
and enacts practices aimed at improving
its relative position. Among these many
practices, four stand out: making
balance-of-trade adjustments, gaining
comparable access to foreign markets,
using restrictions as a bargaining tool,
and controlling prices.

COMPARABLE ACCESS OR
“FAIRNESS”
Companies and industries often use the The threat or imposition of import
comparable access argument, which restrictions may be a retaliatory
holds that they are entitled to the same measure for persuading other countries
access to foreign markets as foreign to lower their import barriers. The
industries and companies have to theirs. danger is that each country then
Economic theory supports this idea for escalates its restrictions, creating, in
industries, such as semiconductors and effect, a trade war that has a negative
chemicals, with substantial production impact on all their economies. To use
cost decreases through economies of restrictions successfully as a bargaining
scale. Companies that lack equal tool, you need to be very careful in
access to a competitor’s market will targeting the products you threaten to
struggle to gain enough sales to be restrict. In particular, you need to
cost-competitive. There are, however, consider two criteria:
at least two practical reasons for
1. Believability: Either you have access
rejecting the idea of fairness:
to alternative sources for the product or
1. Tit-for-tat market access can lead to your consumers are willing to do without
restrictions that may deny one’s own it. The EU successfully retaliated
consumers lower prices. against U.S. import restrictions by
threatening to impose trade restrictions
2. Governments would find it impractical
on U.S.-grown soybeans when Brazil
to negotiate and monitor separate
had a surplus.
agreements for each of the many
thousands of different products and 2. Importance: Exports of the product
services that might be traded. you’re restricting are significant to
certain parties in the producer country—
parties influential enough to prompt
changes in their own country’s trade
policy. This consideration was
emphasized after the United States
RESTRICTIONS AS A BARGAINING
placed restrictions on the importation of
TOOL
steel. The EU threatened to restrict the
importation of apples from the state of
Washington and oranges from Florida.
Given the importance of these two
states in a close presidential election,
the United States soon removed the
steel import restrictions.
has limited cotton exports to increase
supplies for its textile industry, and the
United States is considering export
limitations on natural gas to assist its
chemical industry as new production
comes online.

There is also the fear that foreign

producers will price their exports so
PRICE-CONTROL OBJECTIVES
artificially low that they will drive
Countries sometimes withhold goods
producers out of business in the
from international markets in an effort to
importing country. If they succeed, there
raise prices abroad. This is most
are two potential adverse consequences
feasible when a few countries hold near-
for the importing economy:
monopoly control of certain resources
and can limit supply so consumers must 1. The foreign producers may be shifting
pay a higher price. However, this policy their countries’ unemployment abroad,
often encourages smuggling (such as but their own taxpayers are subsidizing
emeralds and diamonds), the the purchases by consumers abroad.
development of technology (such as
2. If there are high entry barriers,
synthetic rubber in place of natural
surviving foreign producers can charge
rubber), or different means to produce
exorbitant prices once their competitors
the same product (such as caviar from
go out of business. However,
farm-grown rather than wild sturgeons).
competition among producers from
A country may also limit exports of a different countries usually limits
product that is in short supply worldwide anyone’s ability to charge exorbitant
to favor domestic consumers. Typically, prices.
a greater supply drops local prices
beneath those in the intentionally
undersupplied world market. Russia and
Argentina have pursued this strategy by
limiting exports of food products; India
DUMPING

Companies sometimes export below OPTIMUM-TARIFF THEORY

cost or below their home-country price—
The optimum-tariff theory states that a
a practice called dumping. Most
foreign producer will lower its prices if
countries restrict imports of dumped
the importing country places a tax on its
products, but enforcement usually
products. If this occurs, benefits shift to
occurs only if the imported product
the importing country because the
disrupts domestic production. If there is
producer lowers its profits on the export
no domestic production, then host-
sales.
country consumers get the benefit of
lower prices. Let us examine a hypothetical situation.
Assume an exporter has costs of $500
Companies may dump products to
per unit and is selling abroad for $700
introduce them and build a market
per unit. With the imposition of a 10
abroad—essentially, a low price
percent tax on the imported price, the
encourages consumers to sample the
exporter may choose to lower its price to
foreign brand—after which they can
$636.36 per unit, which, with a 10
charge a high enough price to make a
percent tax of $63.64, would keep the
profit. However, the major motive from a
price at $700 in the foreign market. The
national standpoint is to increase
exporter may feel that a price higher
domestic employment.
than $700 would result in lost sales and
Import restrictions may: that a profit of $136.36 per unit instead
of the previous $200 is better than no
1. Prevent dumping from being used to
profit at all. Consequently, an amount of
put domestic producers out of business.
$63.64 per unit has shifted to the
2. Get foreign producers to lower their
importing country.
prices.
 United States [CFIUS].) This is called
the essential-industry argument.

In protecting essential industries,

NONECONOMIC RATIONALES FOR
countries must
GOVERNMENT INTERVENTION
Although noneconomic arguments are 1. Determine which ones are essential.
used to influence trade, many of these
2. Consider costs and alternatives.
also have economic undertones and
consequences. However, let us look at 3. Consider political and economic

the major noneconomic rationales: consequences.

1. Maintaining essential industries

(especially defense) Promoting Acceptable Practices

2. Promoting acceptable practices Abroad

abroad Governments use national defense

3. Maintaining or extending spheres of arguments to prevent the export, even

influence to friendly countries, of strategic goods

4. Preserving national culture
Maintaining Essential Industries
Governments apply trade restrictions to
protect essential domestic industries
during peace time, so the country is not
dependent on foreign supplies during
war. (In some cases, they also prevent
foreign companies from acquiring
companies needed for national security;
the United States does this through the
Committee on Foreign Investment in the
that might fall into the hands of potential
enemies. They also limit trade to
promote changes in a foreign country’s
policies or capabilities. The rationale is
to weaken the foreign country’s
economy by decreasing its earnings
from foreign sales or limiting its access
to needed products so that it amends
the externally unpopular policies.
Maintaining or Extending Spheres of
Influence
Governments also use trade to support
their spheres of influence—giving aid
and credits to, and encouraging imports
from, countries that join a political
alliance or vote a preferred way within Instruments of Trade Control
international bodies. The EU and the 77 Governments use many rationales and
members of the African, Caribbean, and seek a range of outcomes when they try
Pacific Group of States signed the to influence exports or imports. The
Cotonou Agreement to formalize choice of trade-control instrument is
preferential trade relationships that also crucial because each type may incite
strengthened political ties. Venezuela different responses from domestic and
has exported oil at low cost and with foreign groups. One way to understand
long-term financing to targeted Latin trade control instruments is by
American countries to gain influence in distinguishing between two types that
the region. differ in their effects:

1. Those that indirectly affect the

Preserving National Culture amount traded by directly influencing

4Countries are held together partly export or import prices.

through a unifying sense of identity that 2. Those that directly limit the amount of
sets their citizens apart from those in a good that can be traded.
other nations. To sustain this collective
identity, they prohibit exports of art and
historical items that they deem to be TARIFFS
part of their national heritage. In
Tariff barriers directly affect prices, and
addition, they limit imports of certain
nontariff barriers may affect either price
foreign products and services that may
or quantity. A tariff (also called a duty),
either conflict with their dominant
the most common type of trade control,
values, such as morality, or replace
is a tax levied on a good shipped
domestic sources of production that
internationally. That is, governments
uphold these traditional values.
charge a tariff on a good when it
crosses an official boundary—whether it production in direct competition if it
be that of a nation or a group of nations raises the price of some foreign
that have agreed to impose a common production in order to curtail overall
tariff on goods crossing the boundary of demand for imports.
their bloc. Tariffs collected by the
1. Tariffs as Sources of
exporting country are called
Revenue
export tariffs; if they are collected by a
Tariffs also serve as a source of
country through which the goods pass,
governmental revenue. Import tariffs are
they are transit tariffs;
of little importance to developed
if they are collected by importing countries, usually costing more to collect
countries, they are import tariffs. than they yield.
Because import tariffs are by far the
However, in many developing countries
most common, we discuss them in
they are a major source of revenue,
some detail.
potentially giving the governments more
Tariffs may be levied: control over determining the amounts
and types of goods crossing their
1. On goods entering, leaving, or
borders and collecting a tax on them
passing through a country.
than they have over determining and
2. For protection or revenue. collecting individual and corporate

3. On a per unit, a value basis, or both income taxes. Although revenue tariffs
are most commonly collected on
imports, some countries charge export
Import Tariffs tariffs on raw materials. Transit tariffs
were once a major source of countries’
Unless they are optimum tariffs
revenue, but governmental treaties have
(discussed earlier in the Topic), import
nearly abolished them.
tariffs raise the price of imported goods
by placing a tax on them, thereby giving 2. Criteria for Assessing Tariffs
domestically produced goods a relative
A government may assess a tariff on a
price advantage. A tariff may be
per unit basis (a specific duty), as a
protective despite no domestic
percentage of the item’s value (an ad
valorem duty), or on both (a compound
NONTARIFF BARRIERS: DIRECT
duty).
PRICE INFLUENCES
A tariff controversy concerns developed
Now that we’ve shown how tariffs raise
countries’ treatment of manufactured
prices and limit trade, let’s turn to a
exports from developing countries that
discussion of other ways that
seek to add manufactured value to their
governments alter product prices to limit
raw material exports. Raw materials
their trade.
frequently enter developed countries
free of duty (say, coffee beans);
however, if they are processed (instant Subsidies
coffee), developed countries then assign
Subsidies are a form of direct
an import tariff.
assistance to companies to boost
Because an ad valorem tariff is based competitiveness. Although this definition
on the total value of the product (say, $5 is straightforward, disagreement on
for a jar of instant coffee), meaning the what constitutes a subsidy causes trade
raw materials and the processing frictions. In essence, not everyone
combined ($2.50 for the coffee beans agrees that companies are being
and $2.50 for the processing), subsidized just because they lose
developing countries argue that the money, nor that all types of government
effective tariff on the manufactured loans or grants are subsidies.
portion turns out to be higher than the
1. Agricultural Subsidies The one area
published tariff rate. In other words, a
in which everyone agrees that subsidies
tariff rate of 10 percent is effectively 20
exist is agricultural products in
percent on the manufactured portion.
developed countries. The official reason
for granting subsidies to farmers is that
food supplies are too critical to be left to
chance. Although subsidies lead to
surplus production, surpluses are
argued to be preferable to the risk of to declare these wrongly on invoices to
food shortages. pay less duty. Generally, most countries
have agreed to use the invoice
information unless customs officers
2. Overcoming Market doubt its authenticity. Agents must then

Imperfections Another subsidization assess on the basis of the value of

area is less contentious. Most countries identical goods. If not possible, agents

offer potential exporters many business must assess on the basis of similar

developments services, such as market goods arriving at or about the same

information, trade expositions, and time. Valuation Problems The fact that

foreign contacts. so many different products are traded

creates valuation problems, especially
since new products are coming on the
Aid and Loans market all the time and must be
classified within existing tariff
Governments also give aid and loans to
categories. It is easy (by accident or
other countries. If the recipient is
intention) to misclassify a product and
required to spend the funds in the donor
its corresponding tariff.
country, which is known as tied aid or
tied loans, some products can compete
abroad that might otherwise be
Other Direct-Price Influences
noncompetitive. For instance, tied aid
helps win large contracts for Countries use other means to affect

infrastructure, such as prices, including special fees (such as

telecommunications, railways, and for consular and customs clearance and

electric power projects. documentation), requirements that

customs deposits be placed in advance
of shipment, and minimum price levels
Customs Valuation at which goods can be sold after they
have customs clearance.
Tariffs for imported merchandise
depend on the product, price, and origin
—which tempts exporters and importers
 quotas among countries, based on
political or market conditions.)

NONTARIFF BARRIERS: QUANTITY

CONTROLS Governments use other Voluntary Export Restraint
nontariff regulations and practices to
A variation of a quota is the so-called
affect the quantity of imports and
voluntary export restraint (VER).
exports directly. Let’s take a look at the
Essentially, Country A asks Country B to
various forms these typically take.
voluntarily reduce its companies’
Quotas exports to Country A. The term
voluntarily is somewhat misleading;
The quota is the most common type of
typically, either Country B volunteers to
quantitative import or export restriction,
reduce its exports or else Country A
limiting the quantity of a product that can
may impose tougher trade regulations.
be imported or exported in a given time
Procedurally, VERs have unique
frame, typically per year. Import quotas
advantages. They are much easier to
normally raise prices for two reasons:
switch off than an import quota, and the
1. To limit supply appearance of a “voluntary” choice by a

2. To provide little incentive to use price particular country to constrain its

competition to increase sales. A notable shipments can do less damage to

difference between tariffs and quotas is political relations than an import quota.

their effect on revenues. Tariffs

generate revenue for the government.

3. Quotas generate revenue only for

those companies that are able to obtain
and sell a portion of the intentionally
limited supply of the product.
(Sometimes governments allocate

Embargoes
A specific type of quota that prohibits all
trade is an embargo. As with quotas,
countries or groups of countries may
place embargoes on either imports or
exports, on whole categories of products
regardless of origin or destination, on
specific products with specific countries,
or on all products with given countries.
“Buy Local”
Legislation Another form of quantitative
trade control is so-called buy local
legislation. Government purchases are a
large part of total expenditures in many
countries; typically, governments favor
domestic producers. Sometimes they
specify a domestic content restriction—
that is, a certain percentage of the
product must be of local origin.
Standards and Labels
Countries can devise classification,
labeling, and testing standards to allow
the sale of domestic products but
obstruct foreign-made ones. Consider
product labels. The requirement that
companies indicate on a product where
it is made informs consumers who may
prefer to buy products from certain
nations.
Specific Permission Requirements
Some countries require that potential
importers or exporters secure
governmental permission (an import or
export license) before transacting trade.
A company may have to submit samples
to government authorities to obtain such
a license. The procedure can restrict
imports or exports directly by denying
permission or indirectly because of the
cost, time, and uncertainty involved.
A foreign-exchange control is similar.
It requires an importer to apply to a
government agency to secure the
foreign currency to pay for the product.
As with an import license, failure to
grant the exchange, not to mention the
time and expense of completing forms
and awaiting replies, obstructs foreign
trade.

Administrative Delays
Closely akin to specific permission
requirements are intentional
administrative customs delays or those
caused by inefficiency, which create
uncertainty and raise the cost
carrying inventory. Intentional delays
may occur not only to protect domestic
producers, but also for political reasons.
Japanese companies reported such
delays in China after Japan and China
clashed over ownership of islands in the
East China Sea.
Countertrade or offsets are government
requirements in the importing country
whereby the exporter, usually in sales
(especially military ones) to a foreign
government, must provide additional
economic benefits such as jobs or
technology as part of the transaction.
of When Lockheed Martin sold aircraft to
the Polish government it had to use a
number of Polish suppliers in its
production as well as transfer much
technology to Poland.
Restrictions on Services

Reciprocal Requirements Service is the fastest-growing sector in

international trade. In deciding whether
Because of government regulations in
to restrict service trade, countries
the importing countries, exporters
typically consider four factors:
sometimes must take merchandise or
essentiality, not-for-profit preference,
buy services in lieu of receiving cash
standards, and immigration.
payment. This requirement is common
in the aerospace and defense industries 1. Essentiality
—sometimes because the importer does
Countries judge certain service
not have enough foreign currency. For
industries to be essential because they
instance, Thailand has bought military
serve strategic purposes or provide
equipment from China and Russia in
social assistance to citizens.
exchange for dried fruit and frozen
Governments may prohibit private
chickens.
companies, foreign or domestic, in some
sectors because they feel the services
should not be sold for profit. In other
Countertrade
cases, they set price controls or hairstylists, lawyers, medical personnel,
subsidize government-owned service real estate brokers, and teachers.
organizations that create disincentives
for foreign private participation. Some
essential services in which foreign firms
might be excluded are media, 4. Immigration
communications, banking, utilities, and
Satisfying the standards of a particular
domestic transport. India has also
country is no guarantee that a foreigner
excluded foreign multi-brand retailers
can then work there. In addition,
because of the disruption they might
governmental regulations often require
cause to local retail establishments.
an organization—domestic or foreign—
2. Not-for-Profit to search extensively for qualified

Services Mail, education, and hospital personnel locally before it can even

health services are often not-forprofit apply for work permits for personnel it

sectors in which few foreign firms would like to bring in from abroad.

compete. When a government privatizes

these industries, it customarily prefers
Dealing with Governmental Trade
local ownership and control.
Influences
3. Standards
When companies face possible losses
Some services require face-to-face because of import competition, they
interaction between professionals and have several options, four of which
clients. At the same time, governments stand out: 1. Move operations to
limit entry into many service professions another country.
to ensure practice by qualified
2. Concentrate on market niches that
personnel. The licensing standards for
attract less international competition.
these personnel vary by country and
include such professionals as 3. Adopt internal innovations, such as
accountants, actuaries, architects, greater efficiency or superior products.
electricians, engineers, gemologists,
4. Try to get governmental protection.
 quickly copy their innovation. In such
situations, companies often ask their
Each option entails costs and risks.
governments to restrict imports or open
Nevertheless, companies undertake
export markets.
different ones. For example, competition
from Japanese imports spurred the U.S.
automobile industry to move some
CONVINCING DECISION MAKERS
production abroad (such as
subcontracting with foreign suppliers for Governments cannot try to help every

cheaper parts), developing niche company that faces tough international

markets through the sale of minivan and competition. Likewise, helping one

sport utility vehicles (SUVs) that initially industry may hurt another. Thus, as a

had less international competition, and manager, you may propose or oppose a

adopting innovations such as lean particular protectionist measure.

production techniques to improve Inevitably, the burden falls on you and

efficiency and product quality. General your company to convince officials that

Motors and Chrysler eventually received your situation warrants particular

substantial government funding to policies. You must identify the key

survive. decision makers and convince them by

using the economic and noneconomic
arguments presented in this Topic. In
TACTICS FOR DEALING WITH any situation, companies must convey
IMPORT COMPETITION to public officials that voters and
stakeholders support their position.
Granted, these methods are not realistic
for every industry or every business.
Companies may lack the managerial,
INVOLVING THE INDUSTRY AND
capital, or technological resources to
STAKEHOLDERS
shift their own production abroad, and
finding qualified foreign suppliers may A company improves the odds of

be problematic. They may not be able to success if it can ally most, if not all,

identify more profitable product niches. domestic companies in its industry.

Even if they do, foreign competitors may Otherwise, officials may feel that its
problems are due to its specific
inefficiencies rather than the general
import challenges or difficulty in gaining
export sales. Similarly, involving other
stakeholders can help, such as the
taxpayers and merchants in the
communities where it operates. Finally,
it can lobby decision makers and Topic 7: Economic Integration and
endorse the political candidates who are Cooperation
sympathetic to its situation.

Economic integration is a term used to

PREPARING FOR CHANGES IN THE describe the political and monetary
COMPETITIVE ENVIRONMENT agreements among nations and world
regions in which preference is given to
Companies can take different
member countries. There are three
approaches to deal with changes in the
major ways to approach such
international competitive environment.
agreements:
Frequently, their attitudes toward
protectionism are a function of the 1. Global integration—Countries from
investments they have made to all over the world decide to cooperate
implement their international strategy. through the World Trade Organization
Those that depend on freer trade and/or (WTO)
have integrated their production and
2. Bilateral integration—Two countries
supply chains among countries tend to
decide to cooperate more closely
oppose protectionism.
together, usually in the form of tariff
reductions.

3. Regional integration—A group of

countries located in the same
geographic proximity decide to
cooperate, as with the European Union.
Why do you need to understand the
nature of these agreements? Trade
groups, whether global, bilateral, or
regional, are an important influence on
MNE strategies. They can define the
size of the regional market and the rules
under which a company must operate.
In fact, an increase in market size is
their single most important reason for
existing. A company in the initial stages
of foreign expansion must be aware of
how the groups encompass countries
with good manufacturing locations or
market opportunities.
The World Trade Organization—
Global Integration Governments often
actively cooperate with each other to
remove trade barriers. The following
discussion focuses on the World Trade
Organization (WTO), the successor to
the General Agreement on Tariffs and
Trade (GATT) and the major multilateral
forum through which governments can
come to agreements and settle trade
disputes.
GATT: PREDECESSOR TO THE WTO
In 1947, 23 countries formed GATT
under the auspices of the United
Nations to abolish quotas and reduce
tariffs. By the time the WTO replaced
GATT in 1995, 125 nations had become
members. Many believe that GATT’s
contribution to trade liberalization
enabled the expansion of world trade in
the second half of the twentieth century.
Trade Without Discrimination
The fundamental principle of GATT was
that each member nation must open its
markets equally to every other member
nation. This principle of “trade without
discrimination” was embodied in GATT’s
most-favored-nation (MFN) clause—
once a country and its trading partners
had agreed to reduce a tariff, that tariff
cut was automatically extended to every
other member country, irrespective of
whether the country was a signatory to
the agreement.
WHAT DOES THE WTO DO?
The WTO adopted the principles and
trade agreements reached under the
auspices of GATT but expanded its
mission to include trade in services,
investment, intellectual property,
sanitary measures, plant health, treatment over those from industrial
agriculture, and textiles, as well as countries.
technical barriers to trade. Its 159
2. Concessions granted to members
members collectively account for more
within a regional trading alliance, such
than 97 percent of world trade and
as the EU, have not been extended to
include the BRIC countries (Brazil, India,
countries outside the alliance. (Recall
China, and Russia, which was finally
from our opening case, for instance, that
admitted to membership in 2012). The
although EU members can export and
entire membership makes significant
import cars from other EU nations
decisions by consensus. However, there
without limitations, Japanese carmakers
are provisions for a majority vote in the
must comply with strict import tariffs.)
event of a non-decision by member
countries. Agreements then must be 3. Countries can raise barriers against

ratified by the governments of the member countries who they feel are

member nations. trading unfairly. Exceptions are made in

times of war or international tension.
As of 2020, WTO organization has a
total of 164 members. 13
Dispute Settlement

Most Favored Nation One function of the WTO that is

garnering growing attention is the
The WTO continued the MFN clause of
organization’s dispute settlement
GATT, which implies that member
mechanism, in which countries may
countries should trade without
bring charges of unfair trade practices to
discrimination, basically giving foreign
a WTO panel, and accused countries
products “national treatment.” Although
may appeal. There are time limits on all
the WTO restricts this privilege to official
stages of deliberations, and the WTO’s
members, some exceptions are allowed,
rulings are binding. If an offending
as follows:
country fails to comply with the panel’s
1. Developing countries’ manufactured judgment, its trading partners have the
products have been given preferential right to compensation.
 intellectual property rights and trade in
services.
Doha Round

Most of the WTO’s agenda was

established by negotiations, or rounds, Regional Economic Integration
held by GATT— particularly the
Regional trade agreements are
Uruguay Round, which took place from
reciprocal pacts between two or more
1986 to 1994 and led up to the creation
partners that lie somewhat between
of the WTO. Perhaps the most complex
bilateral and global integration
issues the WTO currently faces,
agreements. According to the World
however, are those it is trying to address
Trade Organization, 354 RTAs were in
through the Doha Round, also called the
force as of mid-January 2013. Some of
Doha Ministerial Declaration, which
the best-known RTAs are the European
commenced in Doha, Qatar, in 2001
Union, the European Free Trade
with a focus on giving a boost to
Association (EFTA), the North American
developing countries on the world
Free Trade Agreement (NAFTA), the
scene.
Southern Common Market
(MERCOSUR), the ASEAN (Association
of Southeast Asian Nations) Free Trade
The Rise of Bilateral Agreement
Area (AFTA), and the Common Market
As the negotiations over the Doha of Eastern and Southern Africa
Round broke down, many countries (COMESA).10 As discussed below,
began to shift to bilateral (or however, other very significant regional
preferential) rather than multilateral free agreements are being negotiated,
trade agreements. In 2012, for example, especially in the Pacific Rim.
the U.S. signed free trade agreements
with Colombia and South Korea, both of
which reduced tariffs and other trade GEOGRAPHY MATTERS
barriers for industrial products and
It is logical that most trade groups
agricultural products while strengthening
contain countries in the same area of
the world. Neighboring nations tend to
ally for several reasons:
1. The distances that goods need to
travel are short.
2. Consumers’ tastes are likely to be
similar, and distribution channels can
easily be established.
From the standpoint of tariff reduction,
the two main types of agreements are
free trade agreements and customs
unions.
1. Free Trade Agreement (FTA)
The goal of an FTA is to abolish all
tariffs between member countries. It
usually begins modestly by eliminating
them on goods that already have low
tariffs, and there is usually
implementation period during which all
tariffs are eliminated on all products
included in the agreement. Moreover,
each member country maintains its own
external tariffs against non-FTA
countries. About 90 percent of the RTAs
identified by the WTO are free trade
agreements.
2. Customs Union
In addition to eliminating internal tariffs,
member countries levy a common
external tariff on goods being imported
from nonmembers in order to establish a
customs union. For example, when the
EU was organized in 1957, it began to
remove internal tariffs among member
states, but in 1967 it eliminated the
remaining internal tariffs and established
a common external tariff, meaning that
goods shipped into one member country
from abroad are free from tariffs in the
rest of the member countries.
Common Market (or Economic
Integration Agreement) Beyond the
reduction of tariffs and nontariff barriers,
countries can enhance their cooperation
in a variety of other ways. The EU also
allows free mobility of production factors
such as labor and capital. This means
an
that labor, for example, is generally free
to work in any country in the common
market without restriction. Adding free
mobility of production factors to a
customs union results in a common
market. In addition, the EU has
harmonized its monetary policies
through the creation of a common
currency, complete with a central bank.
THE EFFECTS OF INTEGRATION
Regional economic integration can
affect member countries in social,
cultural, political, and economic ways.
Initially, however, our focus is on its
economic rationale. As we noted in
Topic 6, the imposition of tariff and
nontariff barriers disrupts the free flow of
goods, affecting resource allocation.
Static and Dynamic Effects Regional
economic integration reduces or
eliminates those barriers for member
countries, producing both static and
dynamic effects. Static effects are the
shifting of resources from inefficient to
efficient companies as trade barriers fall.
Dynamic effects are the overall growth
in the market and the impact on a
company caused by expanding
production and by its ability to achieve
greater economies of scale. Figure 7.1
shows how RTAs result in static and
dynamic effects on trade and investment
flows.
Static effects may develop when either
of two conditions occurs:
1. Trade Creation: Production shifts to
more efficient producers for reasons of
comparative advantage, allowing
consumers access to more goods at
lower prices than would have been
possible without integration. Companies
protected in their domestic markets face
real problems when the barriers are
eliminated, and they attempt to compete
with more efficient producers. The
strategic implication is that companies
that were unable to export to another
country—even though they might be
more efficient than producers there—are
now able to export when the barriers
come down, creating more demand for
their products and less for the protected
ones.
2. Trade Diversion: Trade shifts to
countries in the group at the expense of
trade with other countries, even though
the nonmember companies might be
more efficient in the absence of trade
barriers.
ECONOMIES OF SCALE
Dynamic effects of integration occur
when trade barriers come down and
markets grow. Because of that growth,
companies can increase their
production, which will result in lower
costs per unit— a phenomenon we call
economies of scale. Companies can
produce more cheaply, which is good
because they must become more common market). Major trading groups
efficient to survive. This could result in exist in every region of the world, and it
more trade between the member is impossible to cover every group in
countries (trade creation) or an increase every region, so we’ll discuss a few of
in investment in the region by local or the major ones and examine the type of
foreign companies as the market grows. RTA they are.

INCREASED COMPETITION PREDECESSORS

Another important effect of an RTA is Because of the economic and human

greater efficiency due to increased destruction left by World War II,
competition. Many MNEs in Europe European political leaders realized that
have attempted to grow through greater cooperation among their
mergers and acquisitions to achieve the countries would help speed up recovery.
size necessary to compete in the larger Many organizations were formed,
market. Companies in Mexico were including the European Economic
forced to become more competitive with Community (EEC), which eventually
the passage of NAFTA due to emerged as the organization that would
competition from Canadian and U.S. bring together the countries of Europe
companies. This could result in into the most powerful trading bloc in the
investment shifting from less efficient to world. Several other countries, including
more efficient companies, or it could the United Kingdom, formed the
result in existing companies becoming European Free Trade Association
more efficient. (EFTA) with the limited goal of
eliminating internal tariffs.

Major Regional Trading Groups

ORGANIZATIONAL STRUCTURE
The two ways to look at different
regional trading groups are by location The EU encompasses many governing
(such as the European Union) and by bodies, among which are the European
type (such as an FTA, customs union or Commission, European Council,
European Parliament, European Court The EU has been very aggressive in
of Justice, and European Central Bank. enforcing antitrust laws in the high-tech
To be successful in Europe, MNEs need arena, where intellectual property is a
to understand the EU’s governance very sensitive issue as countries move
process, just as they need to to protect their own industries from
understand the governance process of possible violations by foreign
each individual European country in companies.
which they invest or do business. These
In 2009 Microsoft bowed to pressure
institutions set parameters within which
from European antitrust regulators,
companies must operate, so
agreeing to let European users of its
management needs to understand the
Windows software have the option to
institutions and how they make
choose which Web browsers they would
decisions that could affect corporate
like to use and be able to turn off
strategy.
Internet Explorer. Microsoft had already
paid the equivalent of $2.4 billion in
fines and penalties. Antitrust
Key Governing Bodies
investigations were also levied against
The European Commission provides the Google based on complaints of other
EU’s political leadership and direction. It companies, including Microsoft,
is composed of commissioners ironically, complaining that Google was
nominated by each member government using its market power to block
and approved by the European competing search engines. Google has
Parliament for five-year terms of office. an 82 percent market share in internet
The president of the commission is searching in Europe.
nominated by the member governments
and approved by the European
Parliament. THE SINGLE EUROPEAN ACT AND
THE LISBON TREATY

The passage of the Single European Act

ANTITRUST INVESTIGATIONS
of 1987 was designed to eliminate the
remaining barriers to a free market,
such as customs posts and different In order to facilitate the free flow of
certification procedures, rates of people from country to country within
valueadded tax, and excise duties. In the EU, the Schengen Agreement was
addition, the Act resulted in closer signed in 1990 with gradual
cooperation in trade (the EU has one implementation allowing citizens to
negotiator for the WTO who negotiates cross internal borders without having to
for all EU members), foreign policy, and go through border checks. Not all
the environment. members of the EU, such as the UK,
Ireland, Romania, and Bulgaria, have
The Lisbon Treaty, which went into
opted to be in the Schengen Area,
effect on December 1, 2009, amends
whereas some non-EU states, such as
the earlier treaties that led to the
Iceland, Norway, and Switzerland, are
creation of the EU. Some of the major
part of it.
objectives of the Lisbon Treaty are to
strengthen the EU’s governance
process and improve its ability to make
Expansion
and implement decisions.
One of the EU’s major challenges is
expansion. The May 2004 expansion
Monetary Union: The Euro In 1992, has been its largest and included
the members of the EU signed the Cyprus, the Czech Republic, Estonia,
Treaty of Maastricht in part to establish Hungary, Latvia, Lithuania, Malta,
a monetary union. The decision to move Poland, the Slovak Republic, and
to a common currency, the euro, in Slovenia. Bulgaria and Romania were
Europe has eliminated currency as a admitted at the beginning of 2007,
trade barrier for its adopters. As of 2013, bringing the total to 27 countries, and in
17 of the EU members had adopted the 2013, Croatia became the 28th member.
euro.

How to Do Business with the EU:

THE SCHENGEN AREA Implications for Corporate Strategy
The EU is a tremendous market in terms such as Ireland and Belgium, are
of both population and income—one experiencing unprecedented growth
that companies cannot ignore. It is also because their membership has
a good example of how geographic increased their attractiveness for FDI,
proximity and the removal of trade helped them develop global
barriers can influence trade. As noted perspectives, and sheltered them from
earlier, more than half the merchandise economic risks.
exports and imports of EU countries are
considered to be intrazonal trade. Doing
business in the EU can influence The North American Free Trade

corporate strategy, especially for outside Agreement (NAFTA)

MNEs, in three ways: Various forms of mutual economic

1. Determining where to produce. One cooperation have historically existed

strategy is to produce in a central between the United States and Canada,

location in Europe to minimize such as the Canada-U.S. Free Trade

transportation costs and the time it takes Agreement of 1989, which eliminated all

to move products from one country to tariffs on bilateral trade by 1998. In

another. However, the highest costs are February 1991, Mexico approached the

in central Europe. United States to establish a free trade

agreement. Canada was included in the
2. Determining whether to grow through
formal negotiations and the resulting
new investments, through expanding
North American Free Trade Agreement
existing investments, or through joint
(NAFTA) became effective on January
ventures and mergers.
1, 1994.
3. Balancing “common” denominators
Why NAFTA?
with national differences. There are
wider national differences in the EU than NAFTA has a logical rationale in terms

in various U.S. states, mostly due to of both graphic location and trading

language and history. But there are also importance. Although Canadian

widely different growth rates as Mexican trade was not significant when

mentioned above. Many smaller nations, the agreement was signed, the U.S. had
key trade relationships with each of
them. In fact, the one between the
United States and Canada is the largest
in the world, not including the 28-
member EU.
Static and Dynamic Effects
NAFTA provides the static and dynamic
effects of economic integration. For
example, Canadian and U.S. consumers
benefit from lower-cost agricultural
products from Mexico, a static effect of
economic liberalization. U.S. producers
also benefit from the large and growing
Mexican market, which has a huge
appetite for U.S. products—a dynamic
effect.
Trade Diversion
NAFTA is also a good example of trade
diversion. Prior to the agreement, many
U.S. and Canadian companies had
established manufacturing facilities in
Asia to take advantage of low-cost
labor. IBM, for example, was making
computer parts in Singapore. After
NAFTA, Mexico became a good option
for those companies, and in five years
IBM boosted exports from Mexico to the
United States from $350 million to $2
billion.
RULES OF ORIGIN AND REGIONAL
CONTENT
An important component of NAFTA is
the concept of rules of origin and
regional content. Because it is a free
trade agreement and not a customs
union, each country sets its own tariffs
to the rest of the world. That’s why a
product entering the United States from
Canada must have a commercial or
customs invoice that identifies the
product’s ultimate origin.
1. Rules of Origin “Rules of origin”
ensure that only goods that have been
the subject of substantial economic
activity within the free trade area are
eligible for the more liberal tariff
conditions created by NAFTA. This is a
major contrast with the EU, which is a
customs union rather than just an FTA.
When a product enters France, for
example, it can be shipped anywhere in
the EU without worrying about rules of
origin because tariffs are the same for
all member countries.
2. Regional Value
Requirement One aspect of rules of
origin in NAFTA refers to the Regional
Value Content requirement. According
to regional content rules, at least 50
percent of the net cost of components,
Content goods and services trade with NAFTA
totaled $1.6 trillion in 2009 (according to
the latest data available).
Immigration

raw materials, and labor of most A major challenge to NAFTA is

products must come from the NAFTA immigration. As trade in agriculture
region to qualify for the FTA. increased with the advent of NAFTA,
more than a million farm jobs
disappeared in Mexico due to U.S.
SPECIAL PROVISIONS
competition. Many of these farmers
Because of U.S. labor unions’ and ended up as undocumented workers in
environmentalists’ strong objections, two the United States, sending home more
auxiliary agreements covering their money in wire transfers (see the
concerns were included in the NAFTA opening case in Topic 8) than Mexico
agreement. Opponents to the receives in FDI.
agreement worried about the potential
HOW TO DO BUSINESS WITH
loss of jobs in Canada and the United
NAFTA: IMPLICATIONS FOR
States to Mexico as a result of its
CORPORATE STRATEGY
cheaper wages, poor working
conditions, and lax environmental Although NAFTA has not expanded

enforcement. beyond the original three countries due

to political obstacles, each member has
entered into bilateral agreements with
The Impact of NAFTA other countries. However, when U.S.
companies invest in Mexico, for
There are pros and cons to any trade
example, they have an opportunity to
agreement, and NAFTA is no exception.
penetrate markets in countries where
It is obvious that trade and investment
Mexico has FTAs.
have increased significantly since the
agreement was signed in 1994. U.S.
RATIONALIZATION OF PRODUCTION REGIONAL ECONOMIC
INTEGRATION
One of the predictions made when
NAFTA was signed was that companies In the Americas if you look at Maps 7.2
would look at it as one big regional and 7.3 (please see book reference),
market, allowing them to rationalize you will see six major regional economic
production, products, financing, and the groups in the Americas, divided into
like. That has largely happened in a Central American and South American.
number of industries, especially in Central America (excluding Mexico) has
automotive products and electronics. the Caribbean Community (CARICOM),
Each NAFTA member ships more the Central American Common Market
automotive products, based on (CACM), and the Central American Free
specialized production, to the other two Trade Agreement (CAFTA-DR)—which
countries than any other manufactured includes the members of CACM but also
goods. Honduras and the Dominican Republic,
along with the United States. The two
major groups in South America are the
MEXICO AS A CONSUMER Andean Community (CAN) and the

Market An additional benefit is that Southern Common Market

Canadian and U.S. companies have (MERCOSUR). The Andean Community

realized that Mexico is a consumer is a customs union, whereas

market rather than just a production MERCOSUR is set up to be a common

location. Initially, the excitement over market.

the country for U.S. and Canadian firms

was the low wage environment.
ASSOCIATION OF SOUTHEAST
However, as Mexican income continues
ASIAN NATIONS (ASEAN)
to rise—which it must do as more
investment enters and more of its Organized in 1967, ASEAN is a
companies export production—demand comprehensive association that includes
is rising for foreign products. preferential trade as one of its many
goals. This preferential trade agreement
comprises Brunei Darussalam,
Cambodia, Indonesia, Laos, Malaysia, side, as noted above, primary products
Myanmar, the Philippines, Singapore, account for a significant portion of the
Thailand, and Vietnam. With a GDP and exports of many commodity-
combined GDP of $2.28 trillion and an producing countries.
estimated population of 622.5 million
people38—it is a significant
organization. CONSUMERS AND PRODUCERS

For many years, countries tried to band

Commodity Agreements
Commodities refer to raw materials or
primary products that enter into trade,
such as metals or agricultural products.
Primary commodity exports—such as
crude petroleum, natural gas, copper,
tobacco, coffee, cocoa, tea, and sugar—
are still important to developing
together as producer alliances or joint
producer/ consumer alliances to try to
stabilize commodity prices. However,
these efforts—with the exception of
OPEC, which we discuss below—have
not been very successful.
THE ORGANIZATION OF THE

countries. Out of 151 developing PETROLEUM EXPORTING

countries, 100, two-thirds of the total, COUNTRIES (OPEC) The Organization

derive more than 50 percent of their of the Petroleum Exporting Countries

export value from commodities. (OPEC) is an example of a producer

cartel that relies on quotas to influence
COMMODITIES AND THE WORLD
prices. It is a group of 12 oil-producing
ECONOMY Both long-term trends and
countries that have significant control
short-term fluctuations in commodity
over supply and band together to control
prices have important consequences for
output and price. Its members include
the world economy. On the demand
Algeria, Angola, Ecuador, Iran, Iraq,
side, commodity markets play an
Kuwait, Libya, Nigeria, Qatar, Saudi
important role in industrial countries,
Arabia, the United Arab Emirates, and
transmitting business cycle disturbances
Venezuela. Indonesia suspended its
to the rest of the economy and affecting
membership in January 2009, and
the growth rate of prices. On the supply
several of the largest oil exporting
countries, including the Russia, Norway,
Canada, the U.S., and Mexico, are not
members of OPEC.
Price Controls and Politics
OPEC controls prices by establishing
production quotas on member countries.
Saudi Arabia has historically performed
the role of the dominant supplier in
influencing supply and price.
Periodically OPEC oil ministers gather
together to determine the quota for each
country based on estimates of supply
and demand. Politics is also
important dimension of
deliberations. OPEC member countries
with large populations need large oil
revenues to fund government programs.
As a result, they are tempted to exceed
their export quotas to generate more
revenues.
Output and Exports
OPEC member countries produce about
33.6 percent of the world’s crude oil and
19 percent of its natural gas. However,
its oil exports represent about 60.4
percent of the oil traded
internationally.49 In addition, OPEC has
81 percent of the world’s oil reserves,
with the Middle East containing 66.4
percent of OPEC’s total reserves.
Therefore, OPEC can have a strong
influence on the oil market, especially if
it decides to reduce or increase its level
of production.
The Downside of High Prices
Keeping oil prices high has some
downside for OPEC. Competition from
non-OPEC countries rises because the
revenues accruing to the competitors
an are higher. Because some OPEC
the countries are putting up roadblocks to
production, major producers like BP,
ExxonMobil, and Shell are investing
heavily in areas like the Caspian Basin,
the Gulf of Mexico, and Angola and are
trying to enter areas like the Russian
Federation. Production in these areas is
expected to grow significantly.
Topic 8: Markets for Foreign
Exchange
What Is Foreign Exchange?
FOREIGN EXCHANGE is money reporting dealers, other financial
denominated in the currency of another institutions, and nonfinancial institutions.
nation or group of nations. The market
Reporting dealers, also known as
in which such transactions take place is
money center banks, are financial
the FOREIGN-EXCHANGE MARKET.
institutions that actively participate in
Foreign exchange can be in the form of local and global foreign exchange and
cash, funds available on credit and debit markets. Comprising mainly the large
cards, traveler’s checks, bank deposits, commercial and investment bank, they
or other short-term claims. are widely assumed to include the 10
largest banks and financial institutions in
An exchange rate is the price of a
terms of overall market share in foreign-
currency—specifically, the number of
exchange trading: Deutsche Bank,
units of one currency that buy one unit
Barclays Capital, UBS, Citi, JP
of another currency. The number can
Morgan, HSBC, RBS, Credit Suisse,
change daily. On May 1, 2013, €1 could
Goldman Sachs, and Morgan Stanley.
purchase US $1.3181 (or $1 could
purchase €0.7587). Exchange rates
make international price and cost
Money center banks engage in high
comparisons possible.
volume transactions and are often called
market makers and influencers of price-
setting. Example: HSBC
Players on the Foreign-Exchange
Market other financial institutions are not
classified as reporting dealers. They
The foreign-exchange market is made
include smaller commercial banks,
up of many different players. The Bank
investment banks and securities
for International Settlements (BIS), a
houses, hedge funds, pension funds,
central banking institution in Basel,
money market funds, currency funds,
Switzerland, owned and controlled by
mutual funds, specialized foreign-
60-member central banks, divides the
exchange trading companies, and so
market into three major categories:
forth. Western Union, whose current
activities are detailed in our opening
case, is a good example of a How to Trade Foreign Exchange
nonbanking financial institution that
Foreign exchange is traded using
deals in foreign exchange. As for
electronic methods (41.3 percent of all
nonfinancial customers, they comprise
trades), customer direct (24.3 percent),
any counterparty other than those
interbank direct (18.5 percent), or voice
described above and include any non-
broker (15.9 percent). Different kinds of
financial end user, such as governments
electronic methods are involved. One is
and companies (MNEs as well as small-
an electronic broking system in which
and medium-size corporations and
trades are matched up for foreign
firms).
exchange dealers using electronic
The other financial institutions are not systems such as EBS, Thomson
classified as reporting dealers. They Reuters, and Bloomberg. Another is an
include smaller commercial banks, electronic trading system that is
investment banks and securities executed on a single-bank proprietary
houses, hedge funds, pension funds, system or a multibank dealing system.
money market funds, currency funds, One example of this type of system is
mutual funds, specialized foreign- FXConnect, a Boston-based U.S.
exchange trading companies, and so company that provides trading and
forth. Western Union, whose current settlement options for its clients.
activities are detailed in our opening Customer direct refers to trades
case, is a good example of a between a reporting dealer and either a
nonbanking financial institution that non-reporting dealer or customer,
deals in foreign exchange. As for without a third party being involved.
nonfinancial customers, they comprise
any counterparty other than those
described above and include any non-
financial end user, such as governments
and companies (MNEs as well as small-
and medium-size corporations and
firms).
DEALERS CAN TRADE FOREIGN investment banks, and other financial
EXCHANGE institutions. The exchange-traded
market comprises securities
1. Directly with customers,
exchanges, such as the CME Group,
2. Through voice brokers, NASDAQ OMX, and NYSE Liffe, where

3. Through electronic brokerage certain types of foreign-exchange

systems, instruments, such as futures and

options, are traded.
4. Directly through interbank.

The electronic services provided for

customers by EBS, Thomson Reuters, GLOBAL OTC FOREIGN EXCHANGE

and Bloomberg also furnish a great deal INSTRUMENTS

of market data, news, quotes, and The phrase “global OTC foreign
statistics about different markets around exchange instruments” refers to spot
the world. It is not uncommon for a transactions, outright forwards, FX
trading room to have more than one swaps, currency swaps, currency
electronic service and for traders to options, and other foreign exchange
have different preferences within the products. These instruments are all
same office. Bloomberg and Reuters traded in the markets mentioned above.
provide market quotes from a large 1. Spot transactions involve the
number of banks, so their quotes are exchange of currency at an agreed-
close to the market consensus. upon rate for delivery within two
business days. For example, a bank
would quote an exchange rate for a
Some Aspects of the Foreign-
transaction on May 1, but the
Exchange Market
transaction would actually be settled two
The foreign-exchange market has two days later, on May 3. The rate at which
major segments: the over-the-counter the transaction is settled is the spot rate.
market (OTC) and the exchange-traded (Our opening case, which discusses
market. The OTC market is composed Western Union’s policies on currency
of commercial banks as just described, conversion, gives a good idea of how
individuals can trade foreign exchange forward rate. Although an FX swap is
on the spot market.) both a spot and a forward transaction, it
is counted as a single transaction.
2. Outright forward transactions
involve the exchange of currency on a 4. Currency swaps deal more with
future date beyond two business days. It interest-bearing financial instruments
is the single purchase or sale of a (such as a bond) and involve the
currency for future delivery. The rate at exchange of principal and interest
which the transaction is settled is the payments. Options are the right, but not
forward rate and is a contract rate the obligation, to trade foreign currency
between the two parties. The forward in the future.
transaction will be settled at the forward
5. A futures contract is an agreement
rate no matter what the actual spot rate
between two parties to buy or sell a
is at the time of settlement.
particular currency at a particular price
3. In an FX swap, one currency is on a particular future date, as specified
traded for another on one date and then in a standardized contract to all
swapped back later. Most often, the first participants in a currency futures
or short leg of an FX swap is a spot exchange rather than in the over-the
transaction and the second or long leg a counter market.
forward transaction. Let us say IBM
receives a dividend in British pounds
from its subsidiary in the United Using the U.S. Dollar on the Foreign-

Kingdom but has no use for British Exchange Market

pounds until it has to pay a U.K. supplier
in 30 days. It would rather have dollars
now than hold on to the pounds for a
month. IBM could enter into an FX swap
in which it sells the pounds for dollars to
a dealer in the spot market at the spot
rate and agrees to buy pounds for
dollars from the dealer in 30 days at the
The U.S. dollar is the most important
currency on the foreign-exchange
market; in 2013, it was one side (buy or
sell) of 87 percent of all foreign currency
transactions worldwide, as Table 8.1
shows (as cited by Daniels et al 2015).
(Numbers in the table are percentages
and add up to 200 percent because
there are two sides to each transaction.)
There are five major reasons why the
dollar is so widely traded:

1. It is an investment currency in many

capital markets. Frequently Traded Currency Pairs

2. It is a reserve currency held by many Another way to consider foreign

central banks. currency trades is to look at the most

frequently traded currency pairs. The
3. It is a transaction currency in many
top seven pairs in the 2013 BIS Survey
international commodity markets.
involved the U.S. dollar, with the top two
4. It is an invoice currency in many being euro/dollar (EUR/USD)—24.1
contracts. percent of the total—and dollar/yen
(USD/JPY). Because of the importance
5. It is an intervention currency
of the U.S. dollar in foreign-exchange
employed by monetary authorities in
trade, the exchange rate between two
market operations to influence their own
currencies other than the dollar—for
exchange rates.
example, the exchange rate between
Because of the ready availability of U.S. the Swiss franc and the Brazilian real—
dollars worldwide, this currency is is known as a cross rate.
important as a vehicle for foreign-
Carry trade is in effect when the
exchange transactions between two
interest rates being so low (for example
countries other than the United States.
in Japan), investors will borrow in yen
and invest the proceeds in other
countries, such as Brazil.

The Euro

The euro is also in four of the top ten

currency pairs. Although the dollar is still
more popular in most emerging markets,
the euro is gaining ground, particularly
in Eastern European countries.
Moreover, it is slowly rising in
importance as a trading currency, even
outside of Europe. Given that the dollar DIRECT AND INDIRECT QUOTES
is clearly the most widely traded
Let us look at an example of how a bid
currency in the world, you would expect
and offer might work. Assume that the
the biggest market for foreign-exchange
rate a U.S.-based dealer quotes for the
trading to be in the United States.
British pound is $1.5556/58. This means
the dealer is willing to buy pounds at

Major Foreign-Exchange Markets $1.5556 each and sell them for $1.5558
each—i.e., buying low and selling high.
The Spot Market Foreign-exchange
In this example, the dealer quotes the
dealers are the ones who quote the
foreign currency as the number of U.S.
rates. The bid (buy) rate is the price at
dollars for one unit of that currency. This
which the dealer is willing to buy foreign
method of quoting exchange rates is
currency; the offer (sell) is the price at
called the direct quote, which is the
which the dealer is willing to sell foreign
number of units of the domestic
currency. In the spot market, the is the
currency (the U.S. dollar in this case) for
difference between the bid and offer
one unit of the foreign currency. It is
rates, as well as the dealer’s profit
also known as American terms.
margin. In our opening case spread, we
explain how Western Union quotes The other convention for quoting foreign

exchange rates for the purpose of exchange is known as the indirect

trading dollars for pesos. Its rates are quote, or European terms. It is the

often different from those quoted by number of units of the foreign currency

commercial banks, but some people for one unit of the domestic currency.

prefer to use Western Union, pay higher On May 1, 3013, the direct quote for the

fees, and get lower exchange rates. U.K. pound was $1.5556, and the

Why? In part, because of a lack of trust indirect quote was £0.6429.

in the banking system.

 approximations; exact quotes are
available through the dealers.

Base and Term Currencies

THE FORWARD MARKET
When dealers quote currencies to their
customers, they always quote the base As noted earlier, the spot market is for
currency (the denominator) first, foreign-exchange transactions that
followed by the term’s currency (the occur within two business days. But in
numerator). A quote for USD/JPY (also some transactions, a seller extends
shown as USDJPY = X) means the credit to the buyer for a period longer
dollar is the base currency and the yen than that. For example, a Japanese
is the terms currency (the number of exporter of consumer electronics might
Japanese yen for one U.S. dollar). If you sell television sets to a U.S. importer
know the dollar/yen quote, you can with immediate delivery but payment
divide that rate into 1 to get the due in 30 days. The U.S. importer is
yen/dollar quote. obligated to pay in yen in 30 days and
may enter into a contract with a
currency dealer to deliver the yen at a
Interbank Transactions forward rate—the rate quoted today for
The spot rates provided by The Wall future delivery.
Street Journal are the selling rates for
interbank transactions of $1 million and
Forward Discounts and Premiums
more. Retail transactions—those
between banks and companies or Building on what we said earlier, we
individuals—provide fewer foreign now can say that the difference between
currency units per dollar than interbank the spot and forward rates is either the
transactions. Similar quotes can be forward discount or the forward
found in other business publications and premium. In order to explain how to
online. However, these are only compute and interpret the premium or
discount, let’s use the direct rate The more likely the option is to benefit
between the U.S. dollar and the Swiss the company, the higher the fee. The
franc—in this case, the number of rate of ¥85 is called the strike price for
dollars per franc. If the forward rate for the option; the fee or cost is called the
the Swiss franc is greater than the spot premium.
rate, the franc would get more dollars in
the future, so it would be trading at a
premium. If the forward rate is less than
the spot rate, the franc would be selling Futures
at a discount since it would get you less
A foreign currency futures contract
dollars in the future. Using the May 1,
resembles a forward contract insofar as
2013 direct quote for the Swiss franc for
it specifies an exchange rate some time
a six-month forward contract, the
in advance of the actual exchange of
premium or discount would be
currency. However, a future is traded on
computed as follows:
an exchange, not OTC. Instead of
working with a bank or other financial

Options institution, companies work with

exchange brokers when purchasing
An option is the right, but not the
futures contracts. A forward contract is
obligation, to buy or sell a foreign
tailored to the amount and time frame
currency within a certain time period or
the company needs, whereas a futures
on a specific date at a specific exchange
contract is for a specific amount and
rate. It can be purchased OTC from a
maturity date. It is less valuable to a
commercial or investment bank or on an
company than a forward contract.
exchange. For example, a U.S.
However, it may be useful to
company purchases an OTC option
speculators and small companies that
from a commercial or investment bank
cannot enter into the latter.
to buy 1,000,000 Japanese yen at ¥85
per US $ ($0.011765 per yen)—or
$11,765. The writer of the option will The Foreign-Exchange Trading
charge the company a fee for writing it. Process
When a company sells goods or At one time, only the big money center
services to a foreign customer and banks could deal directly in foreign
receives foreign currency, it needs to exchange. Regional banks had to rely
convert it into the domestic currency. on them to execute trades on behalf of
When importing, the company needs to their clients. The emergence of
convert domestic to foreign currency to electronic trading has changed that.
pay the foreign supplier. This conversion Now even the regional banks can hook
usually takes place between the up to Bloomberg, Thomson Reuters, or
company and its bank. EBS and deal directly in the interbank
market or through brokers. Despite this,
Originally, the commercial banks
the greatest volume of foreign-exchange
provided foreign-exchange services for
activity takes place with the big money
their customers. Eventually, some in
center banks. Because of their reach
New York and other U.S. money
and volume, they are the ones that set
centers, such as Chicago and San
the prices in global trading of foreign
Francisco, began to look at foreign-
exchange.
exchange trading as a major business
activity instead of just a service. They
became intermediaries for smaller
Top Foreign-Exchange Dealers
banks by establishing correspondent
relationships with them. They also There is more to servicing customers in

became major dealers in foreign the foreign exchange market than size

exchange. The left side of Figure 8.6 alone. Each year, Euromoney magazine

shows what happens when U.S. surveys treasurers, traders, and

Company A needs to sell euros for investors worldwide to identify their

dollars. This situation could arise when favorite banks and the leading dealers in

A receives payment in euros from a the interbank market. In addition to

German importer. examining transaction volumes and

quality of services, the criteria for
selecting the top foreign-exchange
BANKS AND EXCHANGES dealers include:
1. Ranking of banks by corporations and
other banks in specific locations, such
as London, Singapore, and New York
2. Capability of handling major
currencies, such as the U.S. dollar and
the euro
3. Capability of handling major cross-
trades, such as those between the euro
and pound or the euro and yen
Companies enter the foreign-exchange
market to facilitate their regular business
transactions and/or to speculate. Their
treasury departments are responsible
for establishing policies for trading
currency and for managing banking
relationships to make the trades. From a
business standpoint, a company, first of
all, trades foreign exchange for
exports/imports and the buying or selling

4. Capability of handling specific of goods and services.

currencies BUSINESS PURPOSES (I): CASH

5. Capability of handling derivatives FLOW ASPECTS OF IMPORTS AND

(forwards, swaps, futures, and options) EXPORTS

6. Capability of engaging in research When a company must move money to

and analytics. pay for purchases, or receives money

from sales, it has options as to the
documents it can use, the currency of
Top Exchanges for Trading Foreign denomination, and the degree of
protection it can ask for.
Exchange In addition to the OTC
market, foreign-exchange instruments,
mostly options and futures, are traded
Commercial Bills of Exchange
on commodities exchanges. Three of
the best-known exchanges are the CME An individual or a company that pays a

Group, NASDAQ OMX, and NYSE Liffe. bill in a domestic setting can pay cash,
but checks are typically used—often
electronically transmitted. The check is
How Companies Use Foreign also known as a draft or a commercial
Exchange bill of exchange. A draft is an instrument
in which one party (the drawer) directs
another party (the drawee) to make a
payment. The drawee can be either a
company, like the importer, or a bank. In
the latter case, the draft would be
considered a bank draft.
Letters of Credit
With a bill of exchange, it is always
possible that the importer will not be
able to make payment to the exporter at
the agreed-upon time. A letter of credit
(L/C), however, obligates the buyer’s
bank in the importing country to honor a
draft presented to it, provided the draft is
accompanied by the prescribed
documents. Of course, the exporter still
needs to be sure the bank’s credit is
valid as well, since the L/C could be a
forgery issued by a nonexistent bank.
Confirmed Letter of Credit
A letter of credit transaction may include
a confirming bank in addition to the
parties mentioned previously. With a
confirmed letter of credit, the exporter
has the guarantee of an additional bank
—sometimes in the exporter’s home
country, sometimes in a third country. It
rarely happens that the exporter
establishes the confirming relationship.
Usually, the opening bank seeks the
confirmation of the L/C with a bank with
which it already has a credit
relationship. For an irrevocable L/C,
none of the conditions can be changed
unless all four parties agree in advance.
BUSINESS PURPOSES (II): OTHER
FINANCIAL FLOWS
Companies may have to deal in foreign
exchange for other reasons. For
example, if a U.S. company has a
subsidiary in the United Kingdom that
sends a dividend to the parent company
in British pounds, the parent company
has to enter into the foreign-exchange
market to convert pounds to dollars. If it
lends dollars to the British subsidiary,
the subsidiary has to convert them into
pounds. When paying principal and
interest back to the parent company, it
has to convert pounds into dollars.
Speculation
Companies sometimes deal in foreign
exchange for profit. This is especially
true for some banks and all hedge
funds. But sometimes corporate
treasury departments see their foreign-
exchange operations as profit centers
and also buy and sell foreign exchange
with the objective of earning profits.
discrepancy. For example, a dealer
might sell U.S. dollars for Swiss francs
in the United States, then Swiss francs
for British pounds in Switzerland, then
the British pounds for U.S. dollars back
in the United States, with the goal of
ending up with more dollars.

Investors can use foreign-exchange

transactions to speculate for profit or to
protect against risk. Speculation is the
buying or selling of a commodity—in this
case, foreign currency— that has both
Interest arbitrage is the investing in
an element of risk and a chance of great
debt instruments, such as bonds, in
profit. Assume that a hedge fund buys
different countries. A dealer might invest
euros in anticipation that the euro will
$1,000 in the United States for 90 days,
strengthen against other currencies. If it
or convert $1,000 into British pounds,
does, the investor earns a profit; if it
invest the money in the United Kingdom
weakens, the investor incurs a loss.
for 90 days, then convert the pounds
Speculators are important in the foreign-
back into dollars. The investor would try
exchange market because they spot
to pick the alternative that would yield
trends and try to take advantage of
the highest return at the end of 90 days.
them.

Arbitrage

One type of profit-seeking activity is

arbitrage, which is the purchase of
foreign currency on one market for
immediate resale on another market (in
a different country) to profit from a price