ECO 6 International Trade
Trade policy matters to a global investor because it shapes the volume and value of cross-border trade, and through that the returns earned on capital. A shift in a government’s stance on imports or exports feeds straight into the demand a firm faces, the prices it can set, and therefore its profitability and growth. Economists have argued for decades over how far trade helps a national economy, so it is worth setting out the case on both sides.
The case for trade
The most persuasive arguments in favour of international trade are that countries gain from exchange and specialisation, that industries reach greater economies of scale, that households and firms enjoy wider product variety, that competition intensifies, and that resources end up allocated more efficiently.
Gains from exchange arise when trade lets a country sell its exports at a higher price (and larger profit) or buy imports at a lower price than it would pay to make the same goods at home less efficiently. This pushes each trading partner to produce more of the good it exports and less of the good it imports, which is a more efficient use of resources and lets both countries consume a larger bundle of goods. Overall welfare rises. That does not mean every single consumer and producer ends up better off. It means the winners could, in principle, compensate the losers and still come out ahead.
Trade also raises efficiency by encouraging specialisation according to comparative advantage. Traditional frameworks, the Ricardian model and the Heckscher-Ohlin model among them, trace that pattern to differences in technology and in factor endowments, respectively. Newer models shift the focus to gains that come from economies of scale, greater variety, and stronger competition. When an economy opens up, foreign rivals erode the monopoly power of domestic firms and force them to sharpen up. Industries with increasing returns to scale, such as automobiles and steel, benefit from a larger market because average cost falls as output grows.
Monopolistically competitive models help explain why two countries trade heavily inside the same industry, a pattern called intra-industry trade, in which one country both sells and buys goods that fall inside the same product category. Such an industry has many firms, each making a differentiated product, with free entry and exit and zero long-run economic profit. Even similar countries gain, because each specialises in a few varieties and imports the rest. The European Union, for instance, ships out and brings in various types of cars. Consumers get more variety and firms reach larger scale, lowering average cost.
Evidence suggests that trade liberalisation can lift real (inflation-adjusted) GDP, although the strength of that link is still debated. The channels include tighter resource allocation, learning by doing, stronger productivity, spillovers of knowledge, and trade-led shifts in policy and institutions that reward innovation. In industries that live by learning by doing, such as semiconductors, unit cost falls as cumulative output rises. Foreign research and development also lifts domestic productivity, and the effect strengthens the more open the economy is: some estimates put roughly a quarter of the benefit of research spending in a Group of Seven country as accruing to its trading partners. Logitech, the Swiss maker of computer mice, is a case in point. To win original equipment contracts from IBM and Apple it moved production to Taiwan Region in the late 1980s, drawn by skilled labour, capable parts suppliers, a fast-growing local computer industry, and low-cost space in a science park, and soon secured the Apple contract.
The costs and who bears them
Critics of free trade point to wider income inequality and job losses in developed economies exposed to import competition. As a country moves toward open trade, resources have to be reallocated: exporting industries expand while import-competing ones contract. Less efficient firms may be forced out, unemployment can rise, and displaced workers may need retraining before they find work in the growing industries. The rebuttal is that even where short-term and medium-term costs appear, those resources are likely to be put to better use elsewhere over the long run. Even so, the adjustment almost always imposes real costs on some groups.
Two countries each make the same pair of goods. Assume that, measured against lumber, cotton is cheaper to produce in Cottonland than in Lumberland.
Trade restrictions, also called trade protection, are government policies that limit how freely domestic households and firms can trade with other countries. The main instruments are tariffs, import quotas, voluntary export restraints, subsidies, embargoes, and domestic content rules. Tariffs are taxes levied on imported goods. Quotas cap the quantity of a good that may be imported over a period. A voluntary export restraint works like a quota, but the exporting country is the one that sets it. An export subsidy is a government payment to a firm for every subsidised unit it exports; it is meant to promote exports but reduces welfare because it encourages production and trade that run against comparative advantage. Domestic content provisions require some share of the value added or components to be of domestic origin.
Countries impose these barriers for several reasons: to shield established domestic industries from foreign competition, to protect new industries until they mature (the infant industry argument), to defend or raise domestic employment, to safeguard strategic industries on national security grounds, to raise revenue from tariffs (which matters especially for developing countries), and to retaliate against barriers other countries have imposed. A separate category, capital restrictions, limits the ability of foreigners to own domestic assets or of residents to own foreign assets; unlike trade restrictions, which constrain goods markets, capital restrictions constrain financial markets.
Tariffs and their welfare effects
A tariff raises the price of an imported good above the free-trade price, which cuts demand for imports. How the effect plays out depends on whether the importing country is small or large. A small country is a price taker in world markets and cannot shift the world price, whatever its physical size: Brazil is a large economy but a price taker in the world car market. A large country imports enough of a good to influence the world price. When a large country sets a tariff, the exporter often lowers its price to hold on to market share. That price cut shifts the terms of trade and transfers income from the exporting to the importing country. In theory a large country can raise its own welfare with a tariff if its trading partner does not retaliate and the deadweight loss is smaller than the terms-of-trade gain, but global welfare still falls, because the large country gains only by imposing an even bigger loss on its partner.
Take the small-country case. At the world price the domestic price under a per-unit tariff is
Under free trade, domestic supply is Q1, domestic consumption is Q4, and imports fill the gap Q1Q4. Once the tariff raises the domestic price to Pt, domestic production rises to Q2, consumption falls to Q3, and imports shrink to Q2Q3.
The welfare pieces are as follows. Consumers lose surplus because the price rises, shown by areas A + B + C + D. Domestic producers gain surplus A from the higher price for their output. The government collects tariff revenue C on the imports Q2Q3. Summing the three effects, the loss to consumers exceeds the gain to producers plus government revenue, leaving a deadweight loss.
| Component | Effect |
|---|---|
| Consumer surplus | − (A + B + C + D) |
| Producer surplus | + A |
| Tariff revenue (or quota rents) | + C |
| National welfare | − B − D |
Netting the three components leaves the deadweight loss B + D:
The deadweight loss reflects inefficiencies on both sides of the market. Triangle B is a production distortion: instead of importing at the world price P*, the tariff draws in domestic producers whose costs exceed P*, wasting resources. Triangle D is a consumption distortion: buyers ready to pay above P* but below Pt are shut out of a trade that would have benefited both sides.
South Africa makes 110,000 tons of paper, while domestic demand runs to 200,000 tons. The world price of paper is USD 5.00 per ton, so at free-trade prices South Africa imports 90,000 tons. Suppose the government (a small country) puts a 20 percent tariff on paper imports, lifting the imported price to USD 6.00. Domestic production then rises to 130,000 tons and quantity demanded falls to 170,000 tons.
Quotas and voluntary export restraints
A quota caps the imported quantity, generally through import licences that state how much may enter. The European Union, for example, runs annual steel import quotas for producers outside the World Trade Organization. The key contrast with a tariff is who captures area C. Under a tariff the importing government collects it as revenue. Under a quota, foreign producers can often raise their price and pocket the difference as quota rents. If a quota is set to hold imports at Q2Q3, the equivalent tariff produces the same domestic price Pt, but area C now tends to flow to the foreign producer rather than to the domestic treasury. If foreigners keep the rent, the importing country’s welfare loss is B + D + C, which is larger than the tariff loss of B + D. If instead the government auctions the licences and captures the rent, the loss shrinks back to B + D, matching the tariff.
A voluntary export restraint (VER) is a barrier in which the exporting country agrees to cap its exports of a good at a set number of units. The difference from an import quota is who imposes it: the importer sets a quota, the exporter sets a VER. Under a VER the quota rents go to the exporter or exporting country, so the importing country always suffers a welfare loss. In 1981, for example, Japan placed VERs on the cars it exported to the United States.
Export subsidies
Under an export subsidy the government pays a firm for every unit it exports. The aim is to lift exports, but by interfering with the free market it can pull trade away from comparative advantage and so lowers welfare. Countervailing duties are charges the importing country levies against subsidised exports to offset them. Agricultural subsidies in developed economies, notably in the EU, have long irritated talks with emerging markets and with farm exporters like New Zealand and Australia. With a subsidy, exporters prefer to sell abroad because each exported unit earns the world price plus the per-unit subsidy, which lifts the home price by the size of the subsidy when the country is small. In the large-country case, the extra exports depress the world price, so part of the subsidy is effectively handed to the foreign country. The net welfare effect comes out negative either way, and more so for the large country.
| Tariff | Import quota | Export subsidy | VER | |
|---|---|---|---|---|
| Imposed by | Importer | Importer | Exporter | Importer |
| Producer surplus | Increases | Increases | Increases | Increases |
| Consumer surplus | Decreases | Decreases | Decreases | Decreases |
| Government revenue | Increases | Mixed | Falls (spending rises) | No change (rent to foreigners) |
| National welfare | Falls (small); may rise (large) | Falls (small); may rise (large) | Decreases | Decreases |
| Domestic price | Increases | Increases | Increases | Increases |
| Domestic production | Increases | Increases | Increases | Increases |
| Domestic consumption | Decreases | Decreases | Decreases | Decreases |
| Trade | Imports fall | Imports fall | Exports rise | Imports fall |
Government revenue under a quota is mixed: it rises if the importing country auctions licences, but not if exporters capture the rents.
Thailand, a small country, is deciding between a tariff and a quota on computer imports. You are weighing a stake in a domestic firm that is a leading computer importer.
The practical point for an analyst is that shifts in trade policy change the pattern and value of trade and can reshape an industry. They affect what a firm may import or export, the demand for its products, its pricing, and the delays created by extra paperwork, licences, and approvals. A rule that makes it harder to import a vital input, for example, can raise production costs and squeeze profitability.
Regional trading agreements (RTAs), or trading blocs, have multiplied in recent years. Well-known cases are the United States-Mexico-Canada Agreement (USMCA) and the European Union. A regional trading bloc is a set of countries that agree to lower, and over time abolish, barriers to trade and to factor movement among the members. A bloc may or may not maintain common barriers against non-members.
Types of trading blocs
Blocs differ by how deep the integration runs.
- Free trade area (FTA). Every barrier to the movement of goods and services between members is dropped, though each member keeps its own policy toward non-members. The USMCA, which links Canada, Mexico, and the United States, is an FTA.
- Customs union. Extends an FTA by adding a common trade policy against non-members. Belgium, the Netherlands, and Luxembourg (Benelux) formed a customs union in 1947 that joined the European Community in 1958.
- Common market. Covers all that a customs union does and, on top, lets factors of production move freely across member states. The Southern Cone Common Market (MERCOSUR), of Argentina, Brazil, Paraguay, and Uruguay, is an example.
- Economic union. Goes further still, requiring shared economic institutions and coordinated policy across members. In 1993 the European Community was renamed the European Union.
- Monetary union. If an economic union adopts a common currency, it is also a monetary union. With the euro, 19 EU member countries formed a monetary union.
Why regional integration is popular
Stripping away trade and investment barriers within a handful of countries is simpler, less politically charged, and quicker than multilateral bargaining at the World Trade Organization (WTO). This body is the venue where members set the rules of global trade and settle disputes. WTO rounds have taken on contentious issues important to developing countries, such as the cost of reforming trade policy, access to developed-country markets for their farm products, and access to affordable medicines. Progress on these has been limited despite decades of talks, which helps explain the renewed appetite for smaller-scale bilateral and multilateral deals. Coordinating and harmonising policy is simpler among fewer countries, so regional integration can be seen as a step toward freer trade.
Regional integration gives members preferential treatment over non-members and can reshape trade patterns. By lowering barriers against each other, members move toward freer trade and a more efficient use of resources. But integration can also move trade and output away from a cheaper non-member that still meets barriers toward a costlier member that meets none, which is less efficient and can reduce welfare. These two static effects of forming a customs union are called trade creation and trade diversion.
Trade creation versus trade diversion
Trade creation occurs when integration replaces higher-cost domestic production with lower-cost imports from a member. Trade diversion happens when cheaper imports from a non-member give way to dearer imports from a member, because the non-member still meets the external barrier. Both can happen at once inside an RTA. When trade creation exceeds trade diversion, the net welfare effect is positive, though there is no guarantee that it always will be.
Qualor produces 10 million shirts a year and imports 2 million shirts from Vulcan, the lower-cost producer, on which Qualor charges a 10 percent tariff. Qualor and Vulcan next set up a customs union. Afterwards Qualor cuts its own output to 7 million shirts and imports 11 million from Vulcan.
Benefits and costs of blocs
Blocs carry the same benefits attributed to free trade: sharper specialisation by comparative advantage, weaker monopoly power under foreign competition, economies of scale from a larger market, learning by doing, technology transfer, knowledge spillovers, more foreign investment, and better intermediate inputs at world prices. On top of that, deeper interdependence among members lowers the risk of conflict, and acting together gives members more bargaining power in the global economy.
Growth also spills across borders. Members of the Organisation for Economic Co-operation and Development, highly integrated as a group and within their regions, share in one another’s expansion, and strong growth in one RTA member can lift the others. One study asked what would have happened if Switzerland, landlocked but fully integrated with its neighbours and the world, had instead been subject to the weak spillovers seen for the Central African Republic. Under that scenario Switzerland’s 2000 GDP per capita would have come in 9.3 percent lower, a cumulative loss of USD 334 billion (in constant 2000 dollars), equal to 162 percent of Switzerland’s real GDP that year.
Integration also imposes costs on some groups. When the United States lowered barriers to labour-intensive imports from Mexico, there was real concern for low-skilled workers, and adjustment costs did arise as inefficient firms exited and their workers were at least temporarily unemployed. Yet surviving firms grew more productive and consumers gained from wider variety. One estimate found the range of products exported from Mexico to the United States grew about 2.2 percent a year across industries. Although the USMCA carried private costs of nearly USD 5.4 billion each year across the United States over 1994 to 2002, an average welfare gain of USD 5.5 billion a year from the extra variety more than covered them, and by 2003 the variety gain had reached USD 11 billion, far above the USD 5.4 billion in adjustment costs. Even so, workers displaced by integration can suffer lasting losses if they cannot find comparably paid work. Import competition was not the only cause of the sharp contraction in the US automobile industry, but its effect on employment there is likely permanent, and many former autoworkers, especially older ones, may never find comparable jobs. Concerns over national sovereignty, particularly where large and small nations share a bloc, have also slowed the formation of FTAs; a proposed South Asian bloc has faced questions over India’s role as one of the region’s biggest economies.
Challenges to deeper integration
Progressing from an FTA to a customs union, a common market, or an economic union meets at least two obstacles. First, cultural differences and historical grievances, including past wars and conflicts, complicate the social and political side of integration. Second, deep integration caps how far members can pursue their own economic and social agendas. Open trade plus mobile labour and capital blunt any policy that tries to steer relative prices or quantities inside one country, since balance-of-payments and fiscal-credibility pressures rein in diverging macroeconomic choices. This bites hardest in a monetary union, where monetary policy is out of national hands and neither devaluation nor revaluation is available to correct persistent imbalances. Such imbalances can build into a crisis that spreads. The Greek fiscal crisis of 2010 is the classic case: in May 2010 Standard and Poor’s cut Greece’s government rating from investment grade to junk and also downgraded Spain and Portugal, all suffering high deficits and slow growth. Fears of a Greek default spreading led the EU and the International Monetary Fund to agree a USD 145 billion (EUR 110 billion) bailout for Greece in May 2010, followed by a package of about USD 113 billion (EUR 85 billion) for Ireland that November.
Investment implications
For an investor, regional integration opens new opportunities for trade and investment. Doing business across a single large market is cheaper, and firms can exploit economies of scale. Two cautions remain. Gaps in tastes, culture, and competitive conditions persist across members and can limit the gains from investing within the bloc. And depending on the depth of integration and the safeguards in place, trouble in one member can spread quickly to the others.