SUMMARY OF CHAP 7 Government Policies in International Business

Learning Objectives

 1: Identify the policy instruments used by governments to influence international trade flows.

 2: Understand why governments sometimes intervene in international trade.

 3: Summarize and explain the arguments against strategic trade policy.

 4: Describe the development of the world trading system and the current trade issue.

 5: Explain the implications for managers of developments in the world trading system.

Introduction
This chapter focuses on the political systems and tools of trade policy. The major objective of this chapter is to
describe how political realities shape the international trading system.

With an introduction to tariffs, subsidies, and the development of the world trading system, the chapter
describes the evolution of the World Trade Organization and its impact on the global business environment.

What Is the Political Reality of Free Trade?

Free trade refers to a situation in which a government does not attempt to restrict what its citizens can buy
from another country or what they can sell to another country.

Instruments of Trade Policy

The main instruments of trade policy are:
 tariffs
 subsidies
 import quotas
 voluntary export restraints
 local content requirements
 antidumping policies
 administrative policies

Tariffs
Tariffs are the oldest form of trade policy. The principal objective of most tariffs is to protect domestic
producers and employees against foreign competition. Tariffs also raise revenue for the government. Domestic
producers gain, because tariffs afford them some protection against foreign competitors by increasing the cost
of imported foreign goods. Consumers lose because they must pay more for certain imports. Tariffs reduce the
overall efficiency of the world economy.

There are two main categories of tariffs: Specific tariffs are levied as a fixed charge for each unit of a good
imported (e.g., $3 per barrel of oil), while ad valorem tariffs are levied as a proportion of the value of the
imported good.

Subsidies
Subsidies take many forms (cash grants, low-interest loans, tax breaks, and government equity participation in
domestic firms). By lowering production costs, subsidies help domestic producers in two ways: they help them
compete against foreign imports and they help them gain export markets. Subsidy revenues are generated from
taxes. Governments typically pay for subsidies by taxing individuals. Therefore, whether subsidies generate
national benefits that exceed their national costs is debatable.
Subsidies encourage overproduction, inefficiency, and reduced trade. In practice, many subsidies are not very
successful at increasing the international competitiveness of domestic producers. Rather, they tend to protect
the inefficient and promote excess production.

Import Quotas and Voluntary Export Restraints

Import quotas and voluntary export restraints (VER) are direct restrictions on the quantity of some good
that may be imported into a country. The quota restriction is usually enforced by issuing import licenses to a
group of individuals or firms. A VER is a quota on trade imposed by the exporting country, typically at the
request of the importing country’s government. A common hybrid of a quota and a tariff is known as a tariff
rate quota. Under a tariff rate quota, a lower tariff rate is applied to imports within the quota than those over
the quota.

Export Tariffs and Bans

Export tariffs are taxes placed on the export of a good with the goal of discouraging exporting to ensure that
there is a sufficient supply of a good within a country. An export ban partially or entirely restricts the export
of a good.

Local Content Requirements

Local content requirements (LCR) have been widely used by developing countries to shift their
manufacturing base from the simple assembly of products whose parts are manufactured elsewhere into the
local manufacture of component parts. They have also been used in developed countries to try to protect local
jobs and industry from foreign competition.

From the point of view of a domestic producer of parts going into a final product, local content regulations
provide protection in the same way an import quota does: by limiting foreign competition. The aggregate
economic effects are also the same; domestic producers benefit, but the restrictions on imports raise the
prices of imported components.

Administrative Policies
Governments sometimes use informal or administrative policies to restrict imports and boost exports.
Administrative trade policies are bureaucratic rules that are designed to make it difficult for imports to enter
a country.

Anti dumping Policies

Dumping is defined as selling goods in a foreign market at below cost of production or at below “fair” market
value. Anti dumping policies are designed to punish foreign firms that engage in dumping and protect
domestic producers from unfair competition. The Commerce Department may impose an antidumping duty on
the offending foreign imports (called countervailing duties).

The Case for Government Intervention

There are two types of arguments for government intervention—political and economic.

Political Arguments for Intervention

Political arguments for government intervention include:
 protecting jobs
 protecting industries deemed important for national security
  retaliating for unfair foreign competition
 protecting consumers from “dangerous” products
 furthering the goals of foreign policy
 protecting the human rights of individuals in exporting countries

The most common political reason for trade restrictions is “protecting jobs and industries.”

Countries sometimes argue that it is necessary to protect certain industries because they are important for
national security. Defense-related industries often get this kind of attention (e.g., aerospace, advanced
electronics, semiconductors).

Government intervention in trade can be used as part of a "get tough" policy to open foreign markets.

Consumer protection can also be an argument for restricting imports. Since different countries do have
different health and safety standards, what may be acceptable in one country may be unacceptable in others.

Sometimes, governments use trade policy to support their foreign policy objectives.

Governments sometimes use trade policy to create pressure for improving the human rights policies of trading
partners. For years the most obvious example of this was the annual debate in the United States over whether
to grant most favored nation (MFN) status to China. MFN status allows countries to export goods to the United
Status under favorable terms. Under MFN rules, the average tariff on Chinese goods imported into the United
States is 8 percent. If China’s MFN status were rescinded, tariffs would probably rise to about 40 percent.

Economic Arguments for Intervention

Protecting infant industries and strategic trade policy are the main economic reasons for trade restrictions.

The infant industry argument has been considered a legitimate reason for protectionism, especially in
developing countries. Many economists criticize this argument: protection of manufacturing from foreign
competition does no good unless the protection helps make the industry efficient. Brazil built up the world’s
10th largest auto industry behind tariff barriers and quotas. Once those barriers were removed in the late 1980s,
however, foreign imports soared and the industry was forced to face up to the fact that after 30 years of
protection, the Brazilian industry was one of the most inefficient in the world.

Strategic trade policy suggests that government intervention may be justified in an industry when the world
market will profitably support only a few firms because of the existence of substantial scale economies. Such
intervention reduces the competitive effect of existing first-mover advantages held by foreign companies.

The Revised Case for Free Trade

While strategic trade policy identifies conditions where restrictions on trade may provide economic benefits,
there are two problems that may make restrictions inappropriate: retaliation and politics.

Retaliation and Trade War

Paul Krugman argues that strategic trade policies aimed at establishing domestic firms in a dominant position
in a global industry are beggar-thy-neighbor policies that boost national income at the expense of other
countries.

Domestic Policies
Special interest groups may influence governments.
SUMMARY OF CHAP 8 Foreign Direct Investments

Learning Objectives

 1: Recognize current trends regarding foreign direct investment (FDI) in the world economy.

 2: Explain the different theories of FDI.

 3: Understand how political ideology shapes a government’s attitudes towards FDI.

 4: Describe the benefits and costs of FDI to home and host countries.

 5: Explain the range of policy instruments that governments use to influence FDI.

 6: Identify the implications for managers of the theory and government policies associated
with FDI.

INTRODUCTION
The focus of this chapter is foreign direct investment (FDI). The growth of foreign direct
investment in the last 25 years has been phenomenal. FDI can take the form of a foreign
firm buying a firm in a different country, or deciding to invest in a different country by
building operations there.

With FDI, a firm has a significant ownership in a foreign operation and the potential to
affect managerial decisions of the operation.

The goal of our coverage of FDI is to understand the pattern of FDI that occurs between
countries, and why firms undertake FDI and become multinational in their operations as
well as why firms undertake FDI rather than simply exporting products or licensing their
know-how.

What Is Foreign Direct Investment?

Foreign direct investment (FDI) occurs when a firm invests directly in new facilities to produce and/or market
in a foreign country. Once a firm undertakes FDI it becomes a multinational enterprise.

FDI can take the form of a greenfield investment, in which a wholly new operation is established in a foreign
country, or it can take place via acquisitions or mergers with existing firms in the foreign country.

Foreign Direct Investment in the World Economy

The flow of FDI refers to the amount of FDI undertaken over a given time period, while the stock of FDI
refers to the total accumulated value of foreign-owned assets at a given time. Outflows of FDI are the flows of
FDI out of a country, and inflows of FDI are the flows of FDI into a country.

Trends in FDI
There has been a marked increase in both the flow and stock of FDI in the world economy over the past 25
years.
The Direction of FDI
While the United States remains a top destination for FDI flows, South, East, and Southeast Asia, and
particularly China, are now seeing an increase of FDI inflows, and Latin America is also emerging as an
important region for FDI.

Theories of Foreign Direct Investment

There are three theories that approach the various phenomena of foreign direct investment from three
complementary perspectives.

Why Foreign Direct Investment?

Why do firms choose FDI instead of exporting or licensing? Internalization theory (also known as market
imperfections theory) suggests that licensing has three major drawbacks.

The Pattern of Foreign Direct Investment

Knickerbocker looked at the relationship between FDI and rivalry in oligopolistic industries (industries
composed of a limited number of large firms) and suggested that FDI flows are a reflection of strategic rivalry
between firms in the global marketplace.

Knickerbocker’s theory can be extended to embrace the concept of multipoint competition, which arises
when two or more enterprises encounter each other in different regional markets, national markets, or
industries.

Political Ideology and Foreign Direct Investment

Ideology toward FDI ranges from a radical stance that is hostile to all FDI to the non-interventionist
principle of free market economies. Between these two extremes is an approach that might be called
pragmatic nationalism.

The Radical View

The radical view argues that the MNE is an instrument of imperialist domination and a tool for
exploiting host countries to the exclusive benefit of their capitalist-imperialist home countries.

The Free Market View

According to the free market view, international production should be distributed among countries
according to the theory of comparative advantage.

Pragmatic Nationalism
Pragmatic nationalism suggests that FDI has both benefits, such as inflows of capital, technology, skills
and jobs, and costs, such as repatriation of profits to the home country and a negative balance of
payments effect.

Shifting Ideology
Recently, there has been a strong shift toward the free market stance creating:
 A surge in FDI worldwide.
 An increase in the volume of FDI in countries with newly liberalized regimes.

Benefits and Costs of FDI

Host-Country Benefits of FDI
Government policy is often shaped by a consideration of the costs and benefits of FDI.

There are four main benefits of inward FDI for host countries: resource transfer effects; employment
effects; balance of payments effects, and effects on competition and growth.
Host-Country Costs
There are three mains costs from inward FDI for the host country: the possible adverse effects of FDI on
competition within the host nation; adverse effects on the balance of payments; and the perceived loss
of national sovereignty and autonomy.

Home-Country Benefits
The benefits of FDI for the home country include: the effect on the capital account of the home country’s
balance of payments from the inward flow of foreign earnings; the employment effects that arise from
outward FDI; and the gains from learning valuable skills from foreign markets that can subsequently be
transferred back to the home country.

Home-Country Costs
The home country’s balance of payments can suffer from the initial capital outflow required to finance
the FDI; if the purpose of the FDI is to serve the home market from a low-cost labor location; and if the
FDI is a substitute for direct exports.

International Trade Theory and FDI

International trade theory suggests that home country concerns about the negative economic effects of
offshore production (FDI undertaken to serve the home market) may not be valid.