Study Guide - Chapter 7 – Government Policy and International Trade

Brief chapter summary and most important points

Introduction and chapter coverage

The most important lesson to be taken away from the theories presented in chapter 6 is that ‘trade is
good!’. By adopting policies of free trade governments can allow their citizens to enjoy a wider variety
of goods at cheaper prices; and the world’s resources can be deployed most productively.

However, despite wide agreement on the above, there is even wider contravention of the policy of free
trade by governments around the world. Almost all governments have some intervention in trade, and
some have established very significant barriers to the free import and export of goods and services.
Such actions are viewed from a mercantilist perspective, although today we refer to such actions as
‘protectionism’.

This chapter looks at three things; firstly how governments intervene in trade, that is the so-called
‘instruments of trade policy’ which are used to limit imports; secondly it looks at why governments
intervene, suggesting there are a number of political and economic motivations for doing so; thirdly,
after a brief diversion on the history of world trade regulation, the chapter finishes with a look at the
current state of the WTO, the international body dedicated to the promotion of free trade.

How governments intervene in trade

Government intervention in international trade is probably just as old as trade itself as countries have
always sought to limit what and how many foreign goods can be brought into their country. However,
the form of protectionism has changed over the years and additional forms of intervention have been
developed. Although each of the measures below works differently, the basic function of the measures
is the same and the ‘winners and losers’ from the use of each method are also unchanged. Each
measure is designed to restrict imports or support exports and the winners are the local producers who
are ‘protected’ from international competition, the losers are the general public who are denied access
to imported products or have to pay more to purchase them.

The widely used instruments of trade policy are:

Tariffs: Historically the most common form of trade barrier were tariffs; these are a tax on
imported goods designed to protect local producers from foreign competition, they also
are used as a revenue source for governments. Tariffs come in various forms including
‘ad valorem’ tariffs which is a fixed tariff amount per item imported and ‘value-added’
tariffs which are calculated as a percentage of the value of the goods imported.

Subsidies: These work differently from the other measures in that the government makes
payments or provides some other form of benefit to local producers in order to allow
them to compete with imported products or allow them to have a lower cost base as a
result of which they can export more. As it’s the public who ultimately pay for these
subsidies, again they are paying the price for support to the local manufacturers.
 Subsidies are particularly common in agriculture where governments make payments to
domestic farmers and denying the ability of poorer countries with a comparative
advantage in farming to export their products.

Quotas: These are a numerical restriction on the import of a certain item. Sometimes these are
used together with tariffs to create a ‘tariff rate quota’ where a certain amount of a
product can be imported at a lower tariff rate, but any goods imported beyond this
amount are subject to a higher tariff. Sometimes countries agree to a ‘voluntary export
restraint’ that is an agreement made by the exporting country to place a quota on the
amount of a good that it will export to another country. Although such measures are
described as ‘voluntary’ in fact normally they are made only under duress from the
importing nation who are again trying to protect domestic firms.

The above instruments of trade policy are the traditional forms that protectionism has taken. However,
these traditional forms have been greatly reduced as countries have agrees to reduce their trade
barriers and bodies like the WTO have convinced all countries to multilaterally cut tariffs, reduce quotas
etc. Partially as a result of signed agreements to limit the use of the above methods some countries
have turned to ‘less visible’ forms of protectionism as outlined below.

Local content requirements: These are used by governments who demand that a certain percentage
of a product or a percentage of its value be produced by local companies rather than
100% imported from foreign suppliers. This again helps local companies but restricts
the range and quality of imported goods. This policy is often adopted by developing
countries who are keen to both limit imports and in order to gain access to foreign
technology.

Administrative policies: Here the importing country government does not explicitly ban or restrict
imports, they just make it exceedingly difficult for the exporter to comply with
administrative or regulatory requirements. Often the costs of gaining certification or
clearance to import the goods makes it an uneconomical proposition. Because these
slightly underhand methods don’t explicitly break tariff agreements they are
increasingly being used as a means of protectionism.

Antidumping policies: Dumping occurs when goods are sold in a foreign market at below their cost of
production. Firms engage in dumping in order to establish market share dominance and
force out local suppliers, often dumping can be supported by governments who provide
subsidies for their domestic firms. Anti-dumping measures if used correctly are
therefore not in themselves a bad thing. Dumping leads to the misallocation of
resources as more competitive local firms are ousted by less productive dumpers.
Unfortunately, antidumping measures are often not used correctly, and they are used as
a means of penalising producers from lower cost or more productive nations on the
pretext that ‘they must be dumping’. For example, the EU put anti-dumping penalties
on the import of Chinese TV’s, to protect local European manufacturers; these penalties
were later overturned by the WTO who ruled that no dumping had occurred.
Why governments intervene in trade

If governments know that the above types of trade barriers, all of which limit free trade, hurt consumers
at the expense of local producers, then why do they continue to put such barriers in place. The book
separates the reasons for implementation of barriers into ‘political’ and ‘economic’ reasons: in reality,
almost all of the time the reasons are political and almost all of the time the reason is just the first of the
listed political reasons - protecting jobs and industries. The remaining political and economic reasons
are often cited as the reasons for putting trade barriers in place; very often however they are simply
used as more acceptable excuses for the real purpose of protecting local jobs and companies,

Political factors

Political factors in this instance refers to actions that governments take in order to achieve political
goals, even if they acknowledge (or at least privately recognise) that implementing trade barriers is
harmful to the economy.

1. Protecting jobs and industries

As stated above this is the primary reason why trade barriers are used today. Governments are
concerned to ‘protect’ certain local producers or groups of local workers, even if by doing so they
harm the broader economy. Studies have repeatedly shown for example that tariffs placed on
protecting the jobs of American auto workers results only in higher prices for consumers and
businesses and ends up hurting far more people and businesses than they supposedly protect.

So why would governments still put these ‘protections’ in place? The answers are political; by being
seen to protect certain groups of workers the government of the day can count on the votes of
these workers come the next election. To auto workers, protection by tariffs on auto imports may
well be the major voting issue come election day, whereas to the rest of the population (who
collectively suffer from the tariffs) the issue may be marginal. In other cases, the companies and
industries who lobby hard for protection may be major contributors to re-election campaigns of
existing governments and the continued financial contributions are contingent on providing
protection from foreign competition.

2. Protecting national security

Governments argue that some industries are so vital to a nation’s security that it is vital that local
manufacturing is supported and the country does not become reliant on imports (especially from
strategic rivals). Countries may wish to retain control of their aerospace and defence industries for
example and may subsidise local firms to keep them operational. Another example of this would be
the U.S. refusal to allow imports of telecoms equipment from Huawei over concerns about
cybersecurity.

3. Retaliating

Economists can illustrate that putting barriers on goods from another country just because they put
barriers on goods you export to them does not really help your own country economically; it just
makes both countries less well off. However, governments like to project power and place barriers
 for retaliatory purposes.

4. Protecting consumers

A government has a responsibility to protect its citizens and it may make sense on occasion to ban
imports of products deemed unsafe (such as British beef during the mad cow disease). However,
often such safety concerns are highly dubious and seem aimed more at just keeping out imports.

5. Furthering foreign policy objectives

A country may choose to limit economic contact with another country if it wishes to weaken that
countries government. The U.S. penalises not only American firms, but any foreign firm that does
business with Iran.

6. Protecting Human rights

Related to the point above, countries may choose to restrict doing business with countries who are
considered to abuse the human rights of their citizens. Countries around the world for example put
a ‘trade embargo’ on South Africa, refusing to sell to or buy from that country until it changed its
apartheid policies which denied human rights to the majority black population.

Economic factors

Economic factors are much less common than political reasons for the imposition of trade barriers, but
they include:

1. The infant industry argument

Many developing countries claim that they are at a disadvantage to developed nations and that by
opening up their markets completely to free trade their country would become dominated by
MNC’s and small local competitors would be unable to compete and forced to close down.
Therefore, these countries argue for protection for certain industries for a limited time period,
enough for them to establish the size and competencies necessary to compete with foreign
competitors on a more equal footing.

2. Strategic Trade Policy

The previous chapter introduced new trade theory which suggested that in certain industries which
can only support a small number of competitors and where economies of experience are high, then
government support may lead to long term competitiveness. While there is some backing for this
viewpoint, others argue that the number of such industries is limited and use of strategic trade
policy only leads to damaging retaliation.

What can be done to stop governments intervening in trade?

So, if free trade is a good thing, but for domestic political purposes governments insist on putting trade
barriers in place, what can be done to stop them? The chapter concludes with an examination of the
bodies responsible for promoting free trade and resolving trade tensions, prior to that however it gives a
short historical overview of the global trading system.

From a long history of mercantilist policies, the major trading nations of the world, influenced by the
theories of Smith and Ricardo, began to open their borders to trade in the mid-19 th Century. As a result
of declining trade barriers, the volume of world trade flourished and some refer to this period (1850-
1910 or so) as the first wave of globalisation. Although interrupted by the first world war trade quickly
expanded again after that and throughout the 1920’s.

A major beneficiary of trade growth at that time was the United States (many European countries had
been devastated by the war) and the American economy boomed during the ‘roaring 20’s’ as a result of
trade expansion. Unfortunately, the boom led to the creation of a stock-market bubble that reached a
climax with the ‘wall street crash’ of October 1929. As a result of the crash many Americans lost their
savings, many banks and companies which had taken on debt to extend went bankrupt and this resulted
in unemployment. The American response to this was the Smoot-Hawley act (1930) which significantly
increased tariffs on foreign goods in the hope of protecting American jobs. Unfortunately, the act led to
retaliation by other countries and trade plummeted worldwide, unemployment rose and thus started
the great depression of the 1930’s.

Nationalist leaders in Europe flourished at this time, due to the poor economic conditions, leading to the
advent of the Second World War. After the devastation of this war countries resolved to not only form
bodies to prevent countries from ever engaging in such a war again (the United Nations) but also to
ensuring that retaliatory trade barriers (which some saw as an indirect cause of the war) were
discouraged. This led to the creation of the General Agreement on Tariffs and Trade (GATT) signed by all
the major trading nations of the world, an agreement that called on countries to commit to a more open
trade policy and negotiate the joint removal of trade barriers.

Once again, the volume of trade expanded post war and worldwide growth soared through the
following decades, largely as a result of trade liberalization under GATT. However, by the 1980’s
protectionist trends started to emerge once more. A range of political and economic factors, alongside
the emergence of new international competitors (Japan) led to this trend, countries started to abuse the
agreements to lower trade barriers they had signed by making increasing use of the less visible forms of
trade barriers (administrative barriers etc,)

A problem with GATT was that when countries flouted the agreement, there was no effective
enforcement mechanism to force countries to correct their behaviours or punish those who failed to do
so. As a result of this the decision was made to establish the World Trade Organisation (WTO) a more
powerful body who had the power to enforce GATT rules and punish offenders. The WTO employed
judges to adjudicate on trade disputes, set timelines for such disputes to be resolved and the WTO was
seen as an effective ‘policeman’ at least in the early years of its existence.

However, for much of its recent existence, through to the present day the WTO has faced difficulties. As
the organisation expanded and took on more members, a clear split between developed and developing
countries emerged. The developed countries wanted more trade barrier reductions in advanced
manufactured goods and services, the developing countries argued that it was more important to
remove long established barriers that prevented them from exporting commodities and agricultural
goods. Protests at annual gatherings of the WTO became common-place and gathered in intensity after
the financial crisis of 2008-10 as many blamed the multinational free trade system for the problems that
had occurred.

To this day, the WTO is beset by problems, it has achieved little in the way of enhanced free trade for
the past 15 years or so and even its role of adjudicator of disputes has been hampered by the
unwillingness of Trump’s U.S. to approve the appointment of new judges to the body. Free trade is thus
at a crossroads with fears of greater protectionism and trade wars to come.

Conclusions and Implications for international managers

Understanding the types of trade barriers and knowledge of how governments intervene in trade is
important for all MNC’s. Disputes over trade have become such an integral part of the international
business environment that businesses need to know how to navigate the landscape filled with differing
gradients of resistance to free trade. Firstly they need to know what barriers are in place that will keep
them from exporting their products to or from certain countries: the recent U.S. -China trade wars have
led to the advent of ‘re-shoring’ by foreign multinationals, pulling manufacturing back home as the
additional costs of new tariffs more than offset the lower production in China. Secondly, firms can
influence governments, either to help them remove barriers in other countries or to ask their own
government to raise barriers to foreign imports to ‘protect’ their own markets; such government
‘lobbying’ accounts for many millions of dollars spent by companies each year. In general businesses
who do much of their business overseas lobby in favour of free trade agreements and lower barriers,
those who are more domestically oriented lobby for greater local protection.

Resources supplied and required and suggested reading

View the PowerPoint files of Chapter 7 available on Moodle

Read Chapter 7 from the assigned textbook

Keep yourself informed by reading and watching news reports of the ongoing trade disputes between
China and the U.S. and the actions that each side are taking

Participate in the class activities (this will be a rather interactive class)

Review the same class session made available as a recording

Watch the video uploaded on moodle. “China in the WTO”. This is a video that we normally watch in
class. It is a TVB documentary with Chinese subtitles from the time that China joined the WTO. The
video explains the changes that are expected to occur as a result of moving from a closed economy to
one open to free trade. The video compares the case of China to Mexico which went through a similar
transition twenty years previously. The video in fact illustrates many of the concepts explored in both
chapter 6 (namely the benefits of free trade) and chapter 7. (note: the video is in .dat format, you can
open it by right-clicking on it and choosing ‘open with’ and then choose your regular media player
software).
Answer the 10 multiple choice questions covering chapter 6 that have been prepared as a turnitin
assignment available on Moodle

Complete the written self-assessment questions that come at the end of this study guide which this
week are based upon the “China in the WTO” video described above.

In your groups: complete the following activities:

You should have already found and made use of international indexes when you completed the group
activity that accompanied lesson plan 5. In our class in a couple of weeks, the librarian will demonstrate to
you how to find appropriate indexes and share with you some additional sources that might be useful in
your project.

In the meantime, try to find appropriate indexes which help you to compare your countries on the following
criteria. Divide this task with one group member responsible for finding an index for one of the dimensions.

1. Average wage rates in each country (what kind of workers will you use?)
2. Overall corporate tax rates in each country
3. Strength of intellectual property protection in each country
4. Average literacy rate / educational attainment in each country
5. Country export volumes for the product you are producing.

Note that you might not use all these criteria in your final report / presentation; or you make the criteria
slightly different, or more specific to your product.

Please keep in mind that the purpose of the activity is to use indexes so that you have comparable
information. Do not use data from two different sources if you can avoid it.

Take a look at the following suggested articles also available on Moodle

‘Zero-sum economics: the destructive logic that threatens globalisation’ The Economist January 14th
2023

Subsidies, export controls and curbs on FDI are proliferating threatening the gains from
globalisation. Another article examines the use of subsidies by the U.S. for its technology firms.

‘Trade policy in America rinse and repeat’ The Economist February 13th 2021

A recent history of various trade barriers that have been imposed on the import of washing
machines t the U.S. How these barriers have generally failed to achieve their objectives and only
led to increased costs for American consumers.
‘Weapons of mass disruption’ The Economist June 3rd 2019

How changes to U.S. trade policy, that put new barriers in place, for example to firms like
Huawei and stops other firms from doing business with Chinese companies threatens world
trade and investment.

‘The Plaza Discord’ The Economist May 25th 2015

A historical perspective that views the current U.S. - China disputes in light of what happened to
Japan thirty years ago.

‘Trade war is China losing it’ The Economist 11th August 2018

Two articles discussing the impact of the trade war, from China's perspective and from the U.S.

‘The plan to save the WTO’ The Economist 21st July 2018

How Trump is threatening the global trade system and how it was weak already with the WTO
losing power and influence over the past 20 years. How the system needs to be reformed and
the hopes that it can be revitalised as a force for freer trade.

‘The threat to world trade’ The Economist March 10th 2018

How the actions by Donald Trump are much more serious than just a trade war between China
and the U.S.. The actions run contrary to established trade laws and threaten the future of the
WTO and global trade systems.
 Self-Assessment Questions

Chapter 7 - Government Policy and International Trade

Please note that these self-assessment questions are totally voluntary and for your own personal use
only. Please do NOT submit answers to these questions, additionally there is no ‘model answer’ for
these questions. Please note that although completing these questions may help you in your
preparation for the final exam, the inclusion of any question below does not imply that similar questions
either will or will not be on the final exam paper.

First watch the Moodle video ” China in the WTO”. Based on that video, please write down answers to
the following questions:

1. What will happen to China’s corn production following the entry to the World Trade
Organisation? Why?

2. What kinds of agricultural products will China be able to produce and compete successfully in
after WTO entry?

3. What economic theory (covered in chapter 6) explains your answers to questions 1 and 2?

4. An academic says ‘you cannot learn to swim on dry land’ what does he mean by this?

5. A worker says ‘Joining the WTO is good for the country, but bad for the masses’, what does
she mean by this?