International_Economics_Tenth_Edition (1)

Foreign investment brings higher wages, and is a major source of technology transfer and managerial skills in host developing countries. This contributes to rising prosperity in the developing countries concerned, as well as enhancing demand for higher value-added exports from advanced economies. - OEeD Policy Brief, No.6, 1998

As investors search the globe for the highest return, they are often drawn to places endowed with bountiful natural resources but handicapped by weak or ineffective environmentallaws. Many people and communities are harmed as the environment that sustains them is damaged or destroyed-villagers are displaced by large construction projects, for example, and indigenous peoples watch their homelands disappear as timber companies level oldgrowth forests. Foreign investment-fed growth also promotes western-style consumerism, boosting car ownership, paper use, and Big Mac consumption rates toward the untenable levels found in the United States-with grave potential consequences for the health of the natural world, the stability of the earth's climate, and the security of food supplies. - Hilary French, "Capital Flows and the

Environment," Foreign Policy in Focus, August 1998

One of the requirements for economic development in a low-income economy is an increase in the nation's stockof capital. A developing nation may increasethe amount of capital in the domestic economy by encouraging foreign direct investment. Foreign direct investment occurs when foreign firms either locate production plants in the domestic economy or acquire a substantial ownership position in a domestic firm. This topic will be discussed further in Chapter 9.

Many developing economies have attempted to restrict foreign direct investment because of nationalist sentiment and concerns about foreign economic and political influence. One reason for this sentiment is that many developing countries have operated as colonies of more developed economies. This colonial experience has often resulted in a legacy of concern that foreign direct investment may serve as a modern form of economic colonialism in which foreign companies might exploit the resources of the host country.

In recent years, however, restrictions on foreign direct investment in many developing economies have been substantially reduced asa result of international treaties, external pressure

from the IMF or World Bank, or unilateral actions by governments that have come to believe that foreign direct investment will encourage economic growth in the host country. This has resulted in a rather dramatic expansion in the level of foreign direct investment in some developing economies.

Foreign direct investment may encourage economic growth in the short run by increasing aggregate demand in the host economy. In the long run, the increase in the stock of capital raises the productivity of labor and leads to higher incomes and further increases in aggregate demand. Another long-run impact, however, comes through the transfer of technological knowledge from industrial to developing economies. Many economists argue that this transfer of technology may be the primary benefit of foreign direct investment.

It is often argued, however, that it is necessary to restrict foreign direct investment in a given industry for national security purposes. This serves as a justification for prohibitions on investment in defense industries and in other industries that are deemed essential for national security. Most governments, for example, would be concerned if their weapons were produced by companies owned by firms in countries that might serve as future enemies.

Environmentalists are concerned that the growth of foreign direct investment in developing economies may lead to a deterioration in the global environment since investment is expanding more rapidly in countries that have relatively lax environmental standards. The absence of restrictive environmental standards, it is argued, is one of the reasons for the relatively high rate of return on capital investment in less-developed economies. Technology transfer from the developed economies, however, may also result in the adoption of more efficient and environmentally sound production techniques than would have been adopted in the absence of foreign investment.

Source: John Kane. Does Foreign Direct Investment Hinder or Help Economic Development? South-Western Policy Debate, 2004,

250 Trade Policies for the Developing Nations

Among the agreements that China made when it acceded to the WTO are:

•Reduce its average tariff for industrial goods to 8.9 percent and to 15 percent for agriculture by 2010.

•Limit subsidies for agricultural production to 8.5 percent of the value of farm output and not maintain export subsidies on agricultural exports.

•Grant full trade and distribution rights to foreign enterprises in China. Price controls will not be used to provide protection to Chinese firms.

•Fully open the banking system to foreign financial institutions. Joint ventures in insurance and telecommunication will be permitted.

•Protect the intellectual property of foreigners according to internationally agreed-upon standards.

Besides affecting its domestic economy, China's accession to the WTO affects trade everywhere, as seen in Table 7.11. In particular, China's economic success will likely come at the expense of

workers and companies throughout the developing world that offer cheap labor but not much else. In India, for example, which has some of the world's lowest wages, low-tech industries cannot compete with the Chinese in productivity. India's products will increasingly become less attractive to consumers as Chinese-made goods surge into the world economy.

Does the u.s. economy gain from China's accession to the WTO? Many sectors of the u.s. economy will likely benefit from China's accession to the WTO as Beijing removes certain trade barriers: agriculture, beverages, chemicals, plastics, electronic equipment, and the like. However, trade liberalization will foster efficiency gains for China because of further investment in China's economy, thereby expanding production. Also, China will benefit from increased imports of capital goods, which would improve its productivity. Therefore, some u.s. industries will lose ground to imports of Chinese goods: footwear, wearing apparel, wood products, and other light manufacturers.

Southeast Asia

Taiwan

South Korea

Malaysia, Indonesia, Thailand, and the Philippines will lose foreign investment to China. Pressure will increase to upgrade industries and workforces.

Its trade surplus with China will decline. More production will shift to China, enhancing competitiveness of Taiwanese tech companies.

Exports of fabrics to China'sexpanding apparel industry could decrease, as could outflow of steel and industrial gear.

1.Developing nations tend to be characterized by relatively low levels of gross domestic product per capita, shorter life expectancies, and lower levels of adult literacy. Many developing countries believe that the current international trading system, based on the principle of comparative advantage, is irrelevant for them.

2.Among the alleged problems facing the developing nations are (a) unstable export markets,

(b)worsening terms of trade, and (c) limited market access.

3.Among the institutions and policies that have been created to support developing countries are the World Bank, International Monetary Fund, and the generalized system of preferences.

4.International commodity agreements have been formed to stabilize the prices and revenues of producers of primary products. The methods used to attain this stability are buffer stocks, export controls, and multilateral contracts. In practice, these methods have yielded modest success.

5.The OPEC oil cartel was established in 1960 in reaction to the control that the major international oil companies exercised over the posted price of oil. OPEC has used produc-

tion quotas to support prices and earnings above what could be achieved in more competitive conditions.

6.Besides seeking financial assistance from advanced nations, developing nations have promoted internal industrialization through policies of import substitution and export promotion. Countries emphasizing export promotion have tended to realize higher rates of economic growth than countries emphasizing import-substitution policies.

7.The East Asian economies have realized remarkable economic growth in recent decades. The foundation of such growth has included high rates of investment, the increasing endowments of an educated workforce, and the use of export-promotion policies.

8.By the 1990s, China had become a high performing Asian economy. Although China has dismantled much of its centrally planned economy and permitted free enterprise to replace it, political freedoms have not increased. Today, China describes itself as a socialist market economy. Being heavily endowed with labor, China specializes in many labor-intensive products. In 2001, China became a member of the WTO.

•Advanced nations

(page 218)

•Buffer stock (page 234)

•Cartel (page 236)

•Developing nations

(page 218)

•East Asian tigers (page 245)

•Export controls (page 233)

•Export-led growth

(page 242)

•Export-oriented policy

•Flying-geese pattern of economic growth (page 246)

•Generalized system of preferences (GSP)

(page 231)

•Import substitution

(page 240)

•International commodity agreements (ICAs)

(page 232)

•International Monetary Fund (IMF) (page 230)

•Multilateral contract

(page 235)

•Organization of Petroleum Exporting Countries (OPEC) (page 235)

•Primary products

(page 218)

•Production controls

(page 234)

•World Bank (page 229)

1.What are the major reasons for the skepticism of many developing nations regarding the com- parative-advantage principle and free trade?

2.Stabilizing commodity prices has been a major objective of many primary-product nations. What are the major methods used to achieve price stabilization?

3.What are some examples of international commodity agreements? Why have many of them broken down over time?

4.Why are the less-developed nations concerned with commodity-price stabilization?

5.The average person probably never heard of the Organization of Petroleum Exporting Countries until 1973 or 1974, when oil prices skyrocketed. In fact, OPEC was founded in 1960. Why is it that OPEC did not achieve worldwide prominence until the 1970s? What

7.1 The United Nations Conference on Trade and Development (UNGAD) helps developing nations compete successfullyin world markets. A description of UNCTAD's operations and a discussion of the problems of developing countries can be found by setting your browser to this URL:

http://www.unctad.org

7.2 For information on individual developing nations, the CIA'sannual The World Faetbook provides comprehensive information on most countries and territories, including geography, natural resources,

factors contributed to OPEC's problems in the 1980s?

6.Why is cheating a typical problem for cartels?

7.The generalized system of preferences is intended to help developing nations gain access to world markets. Explain.

8.How are import-substitution and exportpromotion policies used to aid in the industrialization of developing nations?

9.Describe the strategy that East Asia used from the 1970s to the 1990s to achieve high rates of economic growth. Can the Asian miracle continue in the new millennium?

10.How has China achieved the status of a highperforming Asian economy? Why has China's normal-trade-relation status been a source of controversy in the United States? What are the likely effects of China's entry into the WTO?

demographics, government, and economic statistics.The CIA'sHandbook of International Economic Statistics also contains much useful information on countries and regions. Set your browser to this URL:

http://www.odci.gov/cia/publications/

factbooklindex.html

7.3 To get a glimpse of U.S. foreign policy and U.S. relations with the countries in the Asia-Pacific region, log onto the Web sites of the Bureau of EastAsian and Pacific Affairs at this URL:

http://www.state.gov/p/eap

254 Regional Trading Arrangements

Although regional trading blocs can complement the multilateral trading system, by their very nature regional trading blocs are discriminatory; they are a departure from the principle of normal trading relations, a cornerstone of the wro system. Some analysts note that regional trading blocs that decrease the discretion of member nations to pursue trade liberalization with outsiders are likely to become stumbling blocks to multilateralism. For example, if Malaysia has already succeeded in finding a market in the United States, it would have only a limited interested in a free-trade pact with the United States. But its less successful rival, Argentina, would be eager to sign a regional free-trade agreement and thus capture Malaysia's share of the U.S. market-not by making a better or cheaper product, but by obtaining special treatment under U.S. trade law. Once Argentina gets its special privilege, what incentive would it have to go to wro meetings and sign a multilateral free-trade agreement that would eliminate those special privileges?

Two other factors suggest that the members of a regional trading arrangement may not be greatly interested in worldwide liberalization. First, trade-bloc members may not realize additional economies of scale from global trade liberalization, which often provides only modest opening of foreign markets. Regional trade blocs, which often provide more extensive trade liberalization, may allow domestic firms sufficient production runs to exhaust scale economies. Second, trade-bloc members may want to invest their time and energy in establishing strong regional linkages rather than investing them in global negotiations.

On the other hand, when structured according to principles of openness and inclusiveness, regional blocs can be building blocks rather than stumbling blocks for global free trade and investment. There are several ways in which regional blocs can foster global market opening. First, regional agreements may achieve deeper economic integration among members than do multilateral accords, because of greater commonality of interests and simpler negotiating processes. Second, a self-reinforcing process is set in place by the establishment of a regional free-trade area: As the market encompassed by a free-trade area enlarges, it becomes increasingly attractive for nonmembers to join to

receive the same trade preferences as member nations. Third, regional liberalization encourages partial adjustment of workers out of import-com- peting industries in which the nation's comparative disadvantage is strong and into exporting industries in which its comparative advantage is strong. As adjustment proceeds, the portion of the labor force that benefits from liberalized trade rises, and the portion that loses falls; this promotes political support for trade liberalization in a self-reinforcing process. For all of these reasons, when regional agreements are formed according to principles of openness, they may overlap and expand, thus promoting global free trade from the bottom up.

Let us next consider the various types of regional trading blocs and their economic effects.

Types of Regional Trading

Arrangements

Since the mid-1950s, the term economic integration has become part of the vocabulary of economists. Economic integration is a process of eliminating restrictions on international trade, payments, and factor mobility. Economic integration thus results in the uniting of two or more national economies in a regional trading arrangement. Before proceeding, let us distinguish the types of regional trading arrangements.

A free-trade area is an association of trading nations whose members agree to remove all tariff and nontariff barriers among themselves. Each member, however, maintains its own set of trade restrictions against outsiders. An example of this stage of integration is the North American Free Trade Agreement (NAFTA), consisting of Canada, Mexico, and the United States. The United States also has free-trade agreements with Israel and Chile. Another free-trade agreement occurred in 1999 when the European Union and Mexico reached a deal that will end all tariffs on their bilateral trade in industrial goods by 2007.

Like a free-trade association, a customs union is an agreement among two or more trading partners to remove all tariff and nontariff trade barriers among themselves. In addition, however, each member nation imposes identical trade restrictions

against nonparticipants. The effect of the common external trade policy is to permit free trade within the customs union, whereas all trade restrictions imposed against outsiders are equalized. A wellknown example is Benelux (Belgium, the Netherlands, and Luxembourg), formed in 1948.

A common market is a group of trading nations that permits (1) the free movement of goods and services among member nations, (2) the initiation of common external trade restrictions against nonmembers, and (3) the free movement of factors of production across national borders within the economic bloc. The common market thus represents a more complete stage of integration than a free-trade area or a customs union. The European Union (EU)t achieved the status of a common market in 1992.

Beyond these stages, economic integration could evolve to the stage of economic union, in which national, social, taxation, and fiscal policies are harmonized and administered by a supranational institution. Belgium and Luxembourg formed an economic union during the 1920s. The task of creating an economic union is much more ambitious than achieving the other forms of integration. This is because a free-trade area, customs union, or common market results primarily from the abolition of existing trade barriers, but an economic union requires an agreement to transfer economic sovereignty to a supranational authority. The ultimate degree of economic union would be the unification of national monetary policies and the acceptance of a common currency administered by a supranational monetary authority. The economic union would thus include the dimension of a monetary union.

The United States serves as an example of a monetary union. Fifty states are linked together in a complete monetary union with a common currency, implying completely fixed exchange rates among the 50 states. Also, the Federal Reserve serves as the single central bank for the nation; it

'Founded in 1957, the European Community was a collective name for three organizations: the European Economic Communitv, the European Coal and Steel Community. and the European Atomic Energy Commission. In 1994, the European Community was replaced

by the European Union following ratification of the Maastricht Treaty

by the 12 member countries of the European Community. For sim-

plicity, the name European Union is used throughout this chapter in

discussing events that occurred before and after 1994.

issues currency and conducts the nation's monetary policy. Trade is free among the states, and both labor and capital move freely in pursuit of maximum returns. The federal government conducts the nation's fiscal policy and deals in matters concerning retirement and health programs, national defense, international affairs, and the like. Other programs, such as police protection and education, are conducted by state and local governments so that states can keep their identity within the union.

IImpetus for Regionalism

Regional trading arrangements are pursued for a variety of reasons. A motivation of virtually every regional trading arrangement has been the prospect of enhanced economic growth. An expanded regional market can allow economies of large-scale production, foster specialization and learning-by-doing, and attract foreign investment. Regional initiatives can also foster a variety of noneconomic objectives, such as managing immigration flows and promoting regional security. Moreover, regionalism may enhance and solidify domestic economic reforms. East European nations, for example, have viewed their regional initiatives with the European Union as a means of locking in their domestic policy shifts toward privatization and market-oriented reform.

Smaller nations may seek safe-haven trading arrangements with larger nations when future access to the larger nations' markets appears uncertain. This was an apparent motivation for the formation of NAFTA. In North America, Mexico was motivated to join NAFTA partially by fear of changes in U.S. trade policy toward a more managed or strategic trade orientation. Canada's pursuit of a free-trade agreement was significantly motivated by a desire to discipline the use of countervailing duties and antidumping duties by the United States.

As new regional trading arrangements are formed, or existing ones are expanded or deepened, the opportunity cost of remaining outside an arrangement increases. Nonmember exporters could realize costly decreases in market share if their sales are diverted to companies of the member nations. This prospect may be sufficient to tip the political balance in favor of becoming a member of

256 Regional Trading Arrangements

a regional trading arrangement, as exporting interests of a nonmember nation outweigh its importcompeting interests. The negotiations between the United States and Mexico to form a free-trade area appeared to have strongly influenced Canada's decision to join NAFTA, and thus not get left behind in the movement toward free trade in North America.

Effects of a Regional

Trading Arrangement

What are the possible welfare implications of regional trading arrangements? We can delineate the theoretical benefits and costs of such devices from two perspectives. First are the static effects of economic integration on productive efficiency and consumer welfare. Second are the dynamic effects of economic integration, which relate to member nations' long-run rates of growth. Because a small change in the growth rate can lead to a substantial cumulative effect on national output, the dynamic effects of trade-policy changes can yield substantially larger magnitudes than those based on static models. Combined, these static and dynamic effects determine the overall welfare gains or losses associated with the formation of a regional trading arrangement.

Static Effects

The static welfare effects of lowering tariff barriers among members of a trade bloc are illustrated in the following example. Assume a world composed of three countries: Luxembourg, Germany, and the United States. Suppose that Luxembourg and Germany decide to form a customs union, and the United States is a nonmember. The decision to form a customs union requires that Luxembourg and Germany abolish all tariff restrictions between themselves while maintaining a common tariff policy against the United States.

Referring to Figure 8.1, assume the supply and demand schedules of Luxembourg to be SL and DL. Assume also that Luxembourg is very small relative to Germany and to the United States. This means that Luxembourg cannot influence foreign prices, so that foreign supply schedules of grain are perfectly elastic. Let Germany's supply price be $3.25

per bushel and that of the United States, $3 per bushel. Note that the United States is assumed to be the more efficient supplier.

Before the formation of the customs union, Luxembourg finds that under conditions of free trade, it purchases all of its import requirements from the United States. Germany does not participate in the market because its supply price exceeds that of the United States. In free-trade equilibrium, Luxembourg's consumption equals 23 bushels, production equals 1 bushel, and imports equal 22 bushels. If Luxembourg levies a tariff equal to 50 cents on each bushel imported from the United States (or Germany), then imports will fall from 22 bushels to 10 bushels.

Suppose that, as part of a trade liberalization agreement, Luxembourg and Germany form a customs union. Luxembourg's import tariff against Germany is dropped, but it is still maintained on imports from the nonmember United States. This means that Germany now becomes the low-price supplier. Luxembourg now purchases all of its imports, totaling 16 bushels, from Germany at $3.25 per bushel, while importing nothing from the United States.

The movement toward freer trade under a customs union affects world welfare in two opposing ways: a welfare-increasing trade-creation effect and a welfare-reducing trade-diversion effect. The overall consequence of a customs union on the welfare of its members, as well as on the world as a whole, depends on the relative strengths of these two opposing forces.

Trade creation occurs when some domestic production of one customs-union member is replaced by another member's lower-cost imports. The welfare of the member countries is increased by trade creation because it leads to increased production specialization according to the principle of comparative advantage. The trade-creation effect consists of a consumption effect and a production effect.

Before the formation of the customs union and under its own tariff umbrella, Luxembourg imports from the United States at a price of $3.50 per bushel. Luxembourg's entry into the customs union results in its dropping all tariffs against Germany. Facing a lower import price of $3.25, Luxembourg increasesits consumption of grain by 3 bushels. The

welfare gain associated with this increase in consumption equals triangle b in Figure 8.l.

The formation of the customs union also yields a production effect that results in a more efficient use of world resources. Eliminating the tariff barrier against Germany means that Luxembourg producers must now compete against lower-cost, more efficient German producers. Inefficient domestic producers drop out of the market, resulting in a decline in home output of 3 bushels. The reduction in the cost of obtaining this output equals triangle a in the figure. This represents the favorable production effect. The overall trade-creation effect is given by the sum of triangles a + b.

Although a customs union may add to world welfare by way of trade creation, its trade-diversion effect generally implies a welfare loss. Trade diversion occurs when imports from a low-cost supplier outside the union are replaced by purchases from a higher-cost supplier within the union. This suggests that world production is reorganized less efficiently. In Figure 8.1, although the total volume of trade increases under the customs union, part of this trade (10 bushels) has been diverted from a low-cost supplier, the United States, to a high-cost. supplier, Germany. The increase in the cost of obtaining these 10 bushels of imported grain equals area c. This is the welfare loss to Luxembourg, as well as to the

258 Regional Trading Arrangements

In 1973, life in Britain changed. Prices of agricultural goods increased sharply. It cost families more to keep food on the table. It wasn'tan accident. A government decision pushed prices up. Britain turned away cheaper produce from its former colony, Australia. Instead, it increased farm output and purchased rural commodities from its more expensive European neighbors. But why was that decision made? Was there gain to offset the pain?

Britain'strading relationship with Australia was bound by the tradition of empire. The former colony had supplied food to the plates of Mother England. In 1950, a third of Australia's exports wound up in Britain. But in 1973, that tradition was broken. Britain signed an agreement to join its neighbors and enter the European Union (formerly the European Community). Although the British generally believed that it was the right thing to do, they had to accept the economic consequences.

Those economics hit Australian farmers hard. Their traditional trade with Britain ended almost overnight. In joining the EU, Britain had to comply with its common agriculture policy, which set common barriers against agricultural producers outside the EU.Tariffs and quotas increased the price of non-EU produce to British consumers. Therefore, Australia'spreferential access to the British market ended. It was shut out as Britain fell in line with other more costly European producers. Upon entering the EU, Britain'simports of Australian beef fell more than 75 percent, and the 800,000 tons of imported Australian wheat stopped almost instantly.

British consumers paid a high price for the change. Before joining the EU, British food bills

were the cheapest in Europe. Australia's beef, wheat, and other agricultural goods were efficiently produced and comparatively cheap. When Britain joined the EU, however, more expensive goods from Europe pushed its food prices up

25 percent on average; that increased its overall rate of inflation by 3 to 4 percent. Simply put, Britain lost because trade was diverted from a lowto high-cost producer; it had to pay more for agricultural goods.

But there'sanother side to this story. Trade in manufactured goods from Europe increased significantly as Britain entered the EU and thus abolished tariffs and quotas placed on imports of these goods from European nations. This allowed lower-priced imports from European trading partners to replace higher-priced British output, thus increasing welfare.

Evaluating whether entering the EU was good or bad for the British became an empirical question. Did the welfare-expanding effect of trade creation in manufactured goods more than offset the welfare-contracting effect of trade diversion in agricultural products? Many empirical studies have been conducted on the effects of Britain'sentrance into the EU. They generally support the conclusion that significant trade diversion occurred in agriculture and significant trade creation occurred in manufacturing. The overall effect between trade creation and trade diversion is still being debated.

Source: Richard Pomfret, Unequal Trade: The Economics of Discriminatory lntcrnational Trade Policies (New York: Blackwell Publishers, 1988).

world as a whole. Our static analysis concludes that the formation of a customs union will increase the welfare of its members, as well as the rest of the world, if the positive trade-creation effect more than offsets the negative trade-diversion effect. Referring to the figure, this occurs if a + b is greater than c.

This analysis illustrates that the success of a customs union depends on the factors contributing to trade creation and diversion. Several factors that bear on the relative size of these effects can be identified. One factor is the kinds of nations that tend to benefit from a customs union. Nations whose