The Regulation of International Trade

4th Edition

Robert Howse, Antonia Eliason

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781136291760
• Edition: 4
• Topic: Business
• Subtopic: Business General
• Index: Business

Drawing on a wide variety of classic and contemporary sources, respected authors Trebilcock, Howse and Eliason here provide a critical analysis of the institutions and agreements that have shaped international trade rules. In light of the growing debate over globalization, they include special sections with examinations of topics such as:

• agriculture
• services and Trade-Related Intellectual Property Rights
• labour rights
• the environment
• migration
• competition.

Drawing on previous highly praised editions, this comprehensive text is an invaluable guide to students of economics, law, politics and international relations. Now fully updated, this fourth edition includes full coverage of new developments including the Doha trade round, the proliferation of Preferential Trade Agreements, the debate on trade, climate change and green energy, the response of the trading system to the 2007--10 financial and economic crisis, the controversy over trade and exchange rate manipulation, and the growing body of WTO dispute resolution case law.

1 The evolution of international trade theory, policy and institutions

AN INTELLECTUAL HISTORY OF INTERNATIONAL TRADE THEORY AND POLICY¹

The central question that must be confronted at the outset of any study of international trade is: Why do we need a theory of international trade at all? Why is the analysis of the economic, political and social implications of exchange between traders in two national markets different from the analysis of the implications of exchange between traders within a single national market?

Early thinking on foreign trade

In a marvellously accessible and illuminating intellectual history of free trade, Against the Tide,² Douglas Irwin traces views on the virtues and vices of foreign trade back to early Greek and Roman writers. Their views generally reflected a high degree of ambivalence about trading with foreigners, mainly for non-economic reasons. First, merchants or traders of whatever origins were often regarded as of an inferior social class. This general hostility to merchants and commercial activity was accentuated in the case of foreign traders, where contact with strangers could disrupt domestic life by exposing citizens to the bad manners and corrupt morals of barbarians. On the other hand, some early writers (such as Plato) acknowledged the gains from specialization or division of labour, although they were reluctant to extend the implications of this acknowledgement explicitly to foreign trade.

Other writers (such as Plutarch) took the view that God created the sea, geographic separation and diversity in endowments in order to promote interactions through trade between the various peoples of the earth. This doctrine of universal economy was developed by philosophers and theologians in the first several centuries AD, although dominant strands in medieval scholastic thought (reflected, for example, in the writings of St Thomas Aquinas) continued to be suspicious about commercial activity and to worry that contact with foreigners would disrupt civil life. Natural law philosophers of the seventeenth and eighteenth centuries (such as Grotius) sought to resurrect the doctrine of universal economy, justifying a largely unconstrained freedom to trade on the basis of the law of nations (jus gentium).³

Mercantilism

However, none of these early views on international trade were primarily based on economic arguments, although (as we will see) they have continued to recur in one form or another even in contemporary debates over free trade. In the seventeenth and eighteenth centuries, a school of thought often referred to as mercantilism emerged in Britain and the Continent that was explicitly economic in its foundations. While not hostile to commercial activity generally or to international trade in principle, mercantilists argued for close government regulation of international trade for two principal reasons:

1 To maintain a favourable balance of trade, which argued for aggressive export but restrictive import policies – although how foreigners were to pay for imports without the ability to export was never adequately explained.

2 To promote the processing or manufacturing of raw materials at home, rather than importing manufactured goods, which would displace domestic production and employment – hence arguments for export taxes on exported raw materials and import duties on imported manufactured or luxury goods.

The origins of the economic case for free trade

These two central tenets of mercantilist theories of international trade were fundamentally attacked and undermined, at least as a matter of theory, if not as a matter of policy, in the second half of the eighteenth century. The first argument for restricting foreign trade reflected a concern that international trade may give rise to an inadequate supply of circulating monetary gold as a result of balance of payment deficits. Silver and gold were mainstays of national wealth and essential to vigorous commerce. Hence the appropriate policy goal was perceived to be the maintenance of a continuing surplus in the balance of payments, i.e. sell more to foreigners than one buys from them. Imperial rivalries also led to political concerns about the transfer of specie into foreign hands and in part explain colonization efforts in the eighteenth and nineteenth centuries where colonies were seen as a source of raw materials and an outlet for manufactured goods. However, David Hume, in 1752, demonstrated that, through the price–specie–flow mechanism, international trade was likely to maintain an equilibrium in the balance of payments. If a country found itself with surplus currency, domestic prices would tend to rise relative to prices of foreign commodities, and money would flow out of the country. If a country found itself with a shortage of currency, domestic prices would become depressed and would attract foreign currency until the shortage had disappeared.⁴

Adam Smith, in The Wealth of Nations (1776), mounted a broader assault on mercantilist theories, in particular the second or commodity composition argument for restricting trade, and argued that the case for gains from specialization in domestic economic activities applied equally to specialization in international trade:

What is prudence in the conduct of every private family can scarcely be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we can make, better buy it of them with some part of the produce of our own industry.⁵

Thus, to take some simple examples, if countries with tropical climates can produce bananas or pineapples more cheaply than countries with temperate climates, the latter should purchase these products from the former. Conversely, if countries with industrialized economies can produce hydroelectric plants or communications systems more cheaply and of better quality than those that could be produced by countries that enjoy a cost advantage in producing tropical goods, the latter should buy these products from the former. In domestic economic activities, most of us accept that it makes no sense for an individual to try to produce all his or her own food, clothing, medical services, dental services, home construction services, etc., but rather to specialize in producing some goods or services for others and perhaps for some limited subset of his or her own needs, while purchasing requirements to meet remaining needs from others who specialize in their production. It is equally easy to appreciate the force of this argument for free trade within nation states. For example, in a large federal state like the USA, Michigan specializes in producing automobiles (inter alia), Florida citrus fruit and tourism, Texas oil and beef, and California wine and high-technology products. If each state of the USA were to have attempted to become self-sufficient in these and all its own needs, the USA would today be immeasurably poorer. It equally follows, on Smith’s theory, that similar specialization is likely to generate mutual gains from trade in international exchanges – the division of labour is limited only by the extent of the market. It is important to note that, on Smith’s theory, unilateral trade liberalization would be an advantageous policy for a country to pursue, irrespective of the trade policies pursued by other countries.

THE THEORY OF COMPARATIVE ADVANTAGE

A central question left open by Smith’s theory of absolute advantage (as it came to be called) was: What if a country has no absolute advantage over any of its potential trading partners with respect to any products or services? Is international trade of no relevance or value to it? David Ricardo, in his book The Principles of Political Economy, published in 1817, answered this question with a shattering insight that continues to form the basis of conventional international trade theory today. His insight has come to be called the theory of comparative advantage. He advanced this theory by means of a simple arithmetic example. In his example, England could produce a given quantity of cloth with the labour of 100 men. It could also produce a given quantity of wine with the labour of 120 men. Portugal, in turn, could produce the same quantity of cloth with the labour of 90 men and the same quantity of wine with the labour of 80 men. Thus, Portugal enjoyed an absolute advantage over England with respect to the production of both cloth and wine, i.e. it could produce a given quantity of cloth or wine with fewer labour inputs than England. However, Ricardo argued that trade was still mutually advantageous, assuming full employment in both countries: when England exported to Portugal the cloth produced by the labour of 100 men in exchange for wine produced by 80 Portuguese, she imported wine that would have required the labour of 120 Englishmen to produce. As for Portugal, she gained by her 80 men’s labour cloth that it would have taken 90 of her labourers to produce. Both countries would be rendered better off through trade.

Another way of understanding the same intuition is to imagine the following simple domestic example.⁶ Suppose a lawyer is not only more efficient in the provision of legal services than her secretary, but also a more efficient secretary. It takes her secretary twice as long to type a document as it would if the lawyer typed it herself. Suppose, more specifically, that it takes the lawyer’s secretary two hours to type a document that the lawyer could type in one hour, and that the secretary’s hourly wage is $20 and the lawyer’s hourly rate to clients $200. It will pay the lawyer to hire the secretary and pay her $40 to type the document in two hours while the lawyer is able to sell for $200 the hour of her time that would otherwise have been committed to typing the document. In other words, both the lawyer and the secretary gain from this exchange. These examples, in an international trade context, generalize to the proposition that a country should specialize in producing and exporting goods in which its comparative advantage is greatest, or comparative disadvantage is smallest, and should import goods in which its comparative disadvantage is greatest.

An unfortunate semantic legacy of Ricardo’s demonstration of the gains from international trade, perpetuated in the terminology of much subsequent trade literature and debate, is that in international trade countries are trading with each other. This, of course, is rarely the case. As in purely domestic exchanges, private economic actors (albeit located in different countries) are trading with each other. In its most rudimentary form, all that international trade theory seeks to demonstrate is that free international trade dramatically broadens the contract opportunity set available to private economic actors and hence the mutual gains realizable from exchange as parties with different endowments of specialized resources or skills are able to reap the gains from their differential advantages and disadvantages through trade.

It may be argued that in international exchanges, in contrast to domestic exchanges, part of the gains from exchange are realized by foreigners, and that a country would be advantaged by capturing all the gains from exchange for itself. However, this raises the question of whether the domestic gains foregone by foreign trade are greater or less than the additional gains from purely domestic exchange. As a matter of simple economic theory, the gains to domestic consumers from foreign trade will almost always be greater than the additional gains to domestic producers from purely domestic trade. This is so because higher domestic than foreign prices will entail a transfer of resources from domestic consumers to domestic producers (arguably creating matching decreases and increases in welfare), but, in addition, some domestic consumers will be priced out of the market by the higher domestic prices and will be forced to allocate their resources to less preferred consumption choices, entailing a deadweight social loss. An alternative way in which to conceive of the net domestic loss from foregone foreign exchange opportunities is to ask what compensation domestic producers would need to offer domestic consumers to render them indifferent to these foregone opportunities. Presumably only domestic prices that matched foreign producers’ prices would achieve this end.

The factor proportions hypothesis

While Ricardo’s theory of comparative advantage still constitutes the underpinnings of conventional international trade theory, his theory has been refined in various ways by subsequent analysis. Ricardo’s theory, for example, assumed constant costs at all levels of production, which led to the conclusion that a country would specialize completely in the goods where its comparative advantage was greatest (wine in the case of Portugal) or its comparative disadvantage smallest (cloth in the case of England), but this hypothesis rarely seemed to fit the facts. For example, Portugal produced both wine and some cloth. Ricardo’s theory was thus modified to take account of increasing opportunity costs. For example, by releasing resources from cloth-making it would not necessarily follow that the addition of these labour inputs to wine-making would continue to increase wine production in constant proportions, especially if the factor proportions in the two activities were different, for example, cloth-making is labour-intensive while wine-making is land-intensive. In other words, once more than one factor of production was taken into account, it became obvious that combining land and labour at ever-increasing levels of output would not necessarily entail similar costs, since the land brought into production at higher levels of output may well (and typically would) be less productive and require more intensive use of labour. On the other hand, the opposite phenomenon may sometimes be true: that is, decreasing costs may be associated with increased scale of operations or levels of output, and may lead to complete international specialization.

Recognition of these considerations led to a reformulation of Ricardo’s theory of comparative advantage – often referred to as the factor proportions hypothesis (or the Heckscher–Ohlin theorem, after two Swedish economists who formulated the theorem in the 1920s). According to this hypothesis, countries will tend to enjoy comparative advantages in producing goods that use their more abundant factors more intensively, and each country will end up exporting its abundant factor goods in exchange for imported goods that use its scarce factors more intensively.

While the factor proportions hypothesis seems to provide an adequate explanation of patterns of international specialization in many activities, particularly agriculture and natural resources, it tends to be less satisfactory with regard to patterns of specialization in manufacturing activities in modern industrialized economies, where it is common to observe countries specializing in different segments of the same or closely analogous product markets, and simultaneously exporting and importing products in these sectors. Intra-industry trade has accounted for a very high percentage of the total increase in international trade in recent decades.⁷ The factor proportions hypothesis assumes that all countries have access to identical technologies of production and that the list of goods that are traded is somehow exogenously given and unaltered by economic activity. However, patterns of specialization and comparative advantage are not exclusively exogenously determined, but are likely to turn in part on a number of endogenous variables, such as savings and capital accumulation rates in different countries; the levels and patterns of investment in specialized human capital, reflecting the country’s commitment to investments in education, research and development; and public infrastructure such as transportation and communication systems, which again reflect patterns of collective investments. On this view, comparative advantage is a much more dynamic notion than the static notion implicit in the original formulation of the factor proportions hypothesis, and moreover recognizes the role that governments can play, through a variety of public policies, in shaping comparative advantage over time.

It is also important to note that classical trade theory, as described above, assumed that physical output from production was (subject to transportation costs) mobile across nations but that factors of production, while in most cases mobile within countries, were immobile across nations. While this obviously remains true of land, it has become dramatically less true of financial capital, technology, human capital, and even people, in large part because of advances in communication and transportation technologies. Thus, trade theory has historically focused on international trade in goods (a focus reflected in the initial preoccupations of the General Agreement on Tariffs and Trade (GATT)), and not international mobility of services, capital or people. This focus has been increasingly challenged, as reflected in a rapidly changing trade policy agenda.

THE PRODUCT CYCLE THEORY

Largely reflecting the less static and more dynamic conception of comparative advantage noted above, in the 1960s, Raymond Vernon of the Harvard Business School formulated a product cycle theory of trade in manufactured goods to explain patterns of international specialization in manufacturing.⁸ According to this theory, the USA and other highly developed and industrialized economies, reflecting their superior access to large amounts of financial capital and highly specialized for...