Assignment 3Assignment 3 is due after you complete Lessons 9 t.docx

Assignment 3
Assignment 3 is due after you complete Lessons 9 to 11. It is
worth 20% of your final grade.
Prepare your responses to these assignment problems in a word
processing file; put financial data in a spreadsheet file. As you
complete the assignment problems for each lesson, add your
responses to these files.
Do not submit your answers for grading until you have
completed all parts of Assignment 3.
Note: In assignments, show all calculations to 4 decimal
places.
Lesson 9: Assignment Problems
9.1
The Constant-Growth-Rate Discounted Dividend Model, as
described equation 9.5 on page 247, says that:
P0 = D1 / (k – g)
A.
rearrange the terms to solve for:
i. g; and
ii. D1.
As an example, to solve for k, we would do the following:
1. Multiply both sides by (k – g) to get: P0 (k – g) = D1

2. Divide both sides by P0 by to get: (k – g) = D1 / P0
3. Add g to both sides: k = D1 / P0 + g
(8 marks)
9.2
Notation: Let
Pn = Price at time n
Dn = Dividend at time n
Yn = Earnings in period n
r = retention ratio = (Yn– Dn) / Yn = 1 – Dn/ Yn = 1 - dividend
payout ratio
En = Equity at the end of year n
k = discount rate
g = dividend growth rate = r x ROE
ROE = Yn / En-1 for all n>0.
We will further assume that k and ROE are constant, and that r
and g are constant after the first dividend is paid.
A.
Using the Discounted Dividend Model, calculate the price P0 if
D1 = 20, k = .15, g = r x ROE = .8 x .15 = .12, and Y1 = 100
per share
B.
What, then, will P5 be if:

D6 = 20, k = .15, and g = r x ROE = .8 x .15 = .12?
C.
If P5 = your result from part B, and assuming no dividends are
paid until D6, what would be P0? P1? P2?
D.
Again, assuming the facts from part B, what is the relationship
between P2 and P1 (i.e., P2/P1)? Explain why this is the result.
E.
If k = ROE, we can show that the price P0 doesn’t depend on r.
To see this, let
g = r x ROE, and ROE = Yn / En-1, and
since r = (Yn – Dn) / Yn , then D1 = (1 – r) x Y1 and
P0
=
D1 / (k – g)
P0
=
[(1 – r) x Y1] / (k – g)
P0
=
[(1 – r) x Y1] / (k – g), but, since k = ROE = Y1 / E0

P0
=
[(1 – r) x Y1] / (ROE – r x ROE)
P0
=
[(1 – r) x Y1] / (Y1 / E0 – r x Y1 / E0)
P0
=
[(1 – r) x Y1] / (1 – r) x Y1 / E0), and cancelling (1 – r)
P0
=
Y1 / (Y1/E0) = Y1 x (E0 / Y1) = E0
So, you see that r is not in the final expression for P0,
indicating that r (i.e., retention ration or, equivalently, dividend
policy) doesn’t matter if k = ROE.
Check that changing r from .8 to .6 does not change your answer
in part A of this question by re-calculating your result using r =
.6.
(10 marks)
9.3
You are considering an investment in the shares of Kirk's
Information Inc. The company is still in its growth phase, so it
won’t pay dividends for the next few years. Kirk’s accountant
has determined that their first year's earnings per share (EPS) is
expected to be $20. The company expects a return on equity
(ROE) of 25% in each of the next 5 years but in the sixth year
they expect to earn 20%. In the seventh year and forever into
the future, they expect to earn 15%. Also, at the end of the sixth
year and every year after that, they expect to pay dividends at a

rate of 70% of earnings, retaining the other 30% in the
company. Kirk's uses a discount rate of 15%.
A.
Fill in the missing items in the following table:
Year
EPS
ROE
Expected Dividend
(end of year)
Present Value Of Dividend
(at time 0)
0
n/a
n/a
n/a
n/a
1
20
25%
0
0
2
25 = 1.25 x 20
25%
0
0
3
?
25%
0
0
4
?

25%
0
0
5
?
25%
0
0
6
?
20%
?
?
7
?
15%
?
?
8
?
15%
?
?
B.
What would the dividend be in year 8?
C.
Calculate the value of all future dividends at the beginning
of year 8. (Hint: P7 depends on D8.)

D.
What is the present value of P7 at the beginning of year 1?
E.
What is the value of the company now, at time 0?
(10 marks)
9.4
You own one share in a company called Invest Co. Inc.
Examining the balance sheet, you have determined that the firm
has $100,000 cash, equipment worth $900,000, and 100,000
shares outstanding.
Calculate the price/value of each share in the firm, and explain
how your wealth is affected if:
A.
The firm pays out dividends of $1 per share.
B.
The firm buys back 10,000 shares for $10 cash each, and you
choose to sell your share back to the company.
C.
The firm buys back 10,000 shares for $10 cash each, and you
choose not to sell your share back to the company.

D.
The firm declares a 2-for-1 stock split.
E.
The firm declares a 10% stock dividend.
F.
The firm buys new equipment for $100,000, which will be used
to earn a return equal to the firm's discount rate.
(12 marks)
Do not submit these questions for grading until you have
completed all parts of Assignment 3, which is due after Lesson
11.
10.1
A.
Calculate the mean and standard deviation of the following
securities’ returns:
Year
Computroids Inc.
Blazers Inc.
1
10%
5%
2

5%
6%
3
–3%
7%
4
12%
8%
5
10%
9%
B.
Assuming these observations are drawn from a normally
distributed probability space, we know that about 68% of values
drawn from a normal distribution are within one standard
deviation away from the mean or expected return; about 95% of
the values are within two standard deviations; and about 99.7%
lie within three standard deviations.
Using your calculations from part A, calculate the 68%, 95%,
and 99% confidence intervals for the two stocks. To calculate
the 68%, you would calculate the top of the confidence interval
range by adding one standard deviation to the expected return,
and calculate the bottom of the confidence interval by
subtracting one standard deviation from the expected return. For
95%, use two standard deviations, and for 99%, use three.
Your answer should show three ranges from the bottom of the
confidence interval to the top of the confidence interval.

C.
For each security, would a return of 14% fall into the 68%
confidence interval range? If not, what confidence interval
range would it fall into, or would it be outside all three
confidence intervals?
[This is the same as asking whether a return of 14% has less
than a 68% probability of occuring by chance for that security.
If it’s not inside the 68% confidence interval, it’s unlikely to
occur, since it will only occur by chance 32% of the time. Of
course, the 99% confidence interval is much more likely to
include the observed return, simply by chance. Only 1% of the
time will it fall outside the 99% CI. Pretty rare.]
(14 marks)
10.2
Some Internet research may be required to answer this question,
although it’s not absolutely necessary.
What could you do to protect your bond portfolio against the
following kinds of risk?
A.
Risk of an increasing interest rate
B.
Risk of inflation increasing
C.
Risk of volatility in the markets
(6 marks)
10.3
You are starting a new business, and you want to open an office

in a local mall. You have been offered two alternative rental
arrangements. You can pay the landlord 10% of your sales
revenue, or you can pay a fixed fee of $1,000 per month.
Describe the circumstances in which each of these arrangements
would be your preferred choice.
(10 marks)
11.
11.1
In the northeast United States and in eastern Canada, many
people heat their houses with heating oil. Imagine you are one
of these people, and you are expecting a cold winter, so you are
planning your heating oil requirements for the season. The
current price is $2.25 per US gallon, but you think that in six
months, when you'll need the oil, the price could be $3.00, or it
could be $1.50.
A.
If you need 350 gallons to survive the winter, how much
difference does the potential price variance make to your
heating bills?
B.
If your friend Tom is running a heating oil business, and selling
100,000 gallons over the winter season, how does the price
variance affect Tom?

C.
Which one of you benefits from the price increase? Which of
you benefits from price decrease?
D.
What are two strategies you can use to reduce the risk you face?
Could you make an agreement with Tom to mitigate your risk?
E.
Assuming you are both risk-averse, does such an agreement
make you both better off?
(10 marks)
11.2
You have just received good news. You have a rich uncle in
France who has decided to give you a monthly annuity of
€2,000 per month. You are concerned that you will become
accustomed to having these funds, but if the currency exchange
rate moves against you, you may have to make do with less.
A.
If you are living in Canada, what does it mean for the currency
exchange rate to move against you?
B.

Would moving to France mitigate some of the risk? If so, how?
If not, why not?
C.
If you want to stay in Canada, and your grandparents, who have
retired to Provence, receive a Canadian pension of C$1100
each, what could you do to reduce the risk for all of you?
(9 marks)
11.3
You have learned about a number of ways of reducing risk,
specifically hedging, insuring, and diversifying. In the table
below, place an X in the cell for the technique being used to
reduce risk.
Hedging
Insuring
Diversifying
1
Placing an advance order with Amazon.ca, which agrees to
charge you the lower of the advance price, and the price at the
time your order is filled.
2
Purchasing a call option on a stock you think may go up in
price.
3
Selling 200 shares of IBM and buying a mutual fund that holds

the same stocks as the S&P index.
4
Selling a debt owed to you for $.50 per dollar owed.
5
Agreeing to a long-term contract with a supplier at a fixed
price.
6
Agreeing to a no-trade clause with the sports team that employs
you.
7
Buying a Mac and a PC.
8
Paying a clown to perform for your child's birthday party six
months before the birthday.
(16 marks)
11.4
Suppose you own 100 shares of Dell Inc. stock. Today it is

trading at $15 per share, but you're worried Michael Dell might
retire again, causing the price to go down. How would you
protect yourself against his retirement, assuming you don't want
to sell the shares today?
(5 marks)
When you have completed these questions, check to see that
Assignment 3 is complete and submit it for grading.
LEA
R
N
IN
G
O
B
J
E
C
T
IV
E
S After you have read this chapter you should be able to:
1 Identify the policy instruments used by governments to
influence international trade flows.

2 Understand why governments sometimes intervene in
international trade.
3 Summarize and explain the arguments against strategic trade
policy.
4 Describe the development of the world trading system and
the current trade issues.
5 Explain the implications for managers of developments in
the world trading system.
part 3 Cross-Border Trade and Investment
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opening case
O ver the past 25 years two facts have characterized
international trade. First, the volume of world trade has grown
every single year, creating an increasingly interdependent
global economy, and second, barriers to international trade have
been progressively
reduced. Between 1990 and 2007, international trade grew by 6
percent per annum compounded,
while import tariffs on goods fell from an average of 26 percent
in1986 to 8.8 percent in 2007. In
the wake of the global financial crisis that started in the United
States in 2008 and quickly spread
around the world, this has now changed. As global demand
slumped and financing for
international trade dried up in the wake of tight credit

conditions, so did the volume of
international trade. The volume of world trade fell by 2 percent
in 2008, the first decline since
1982, and a further 9 percent in 2009.
This contraction is alarming because, in the past, sharp
declines in trade have been fol-
lowed by calls for greater protectionism from foreign
competition as governments try to pro-
tect jobs at home in the wake of declining demand. This
occurred in the 1930s, when shrinking
trade was followed quickly by increases in trade barriers,
mostly in the form of higher tar-
iffs. This actually made the situation far worse and led to the
Great Depression.
Much has changed since the 1930s. Treaties now limit the
ability of national govern-
ments to raise trade barriers. Most notably, World Trade
Organization rules in theory
constrain the ability of countries to implement significant
increases in trade barriers.
But WTO rules are not perfect, and evidence shows that
countries are raising bar-
riers to international trade. Many developing countries have
latitude under WTO
rules to raise some tariffs, and, according to the World Bank, in
2008 and 2009
they were doing just that. For example, Ecuador raised duties on
600 goods,
Russia increased import tariffs on used cars, while India placed
them on
some steel imports.
The Global Financial Crisis and Protectionism
The Political Economy of
International Trade

6 c h a p t e r
2010/01:07:10/MHBR169:Slavin:VY
204 Part Three Cross-Border Trade and Investment
According to the World Bank, however, two-thirds of the
protectionist mea-
sures taken in 2008 and 2009 are various kinds of “nontariff”
barriers that are
designed to get around WTO rules. Indonesia, for example,
specified that cer-
tain kinds of goods, including clothes, shoes, and toys, can be
imported only
through five ports. Since these ports have limited capacity, this
constrains the
ability of foreign companies to sell into the Indonesian market.
Argentina has
imposed discretionary licensing requirements on a range of
goods including
car parts, textiles, and televisions. If you can’t get a license,
you can’t sell into
Argentina. China has stopped a wide range of imports of food
and drink
products from Europe, citing safety rules and environmental
concerns, while
India has banned imports of toys from China for safety reasons.
Developed nations have in general not taken similar actions,

but they have
sharply increased subsidies to troubled domestic producers,
which gives
them an advantage against unsubsidized international
competitors, and
therefore distorts trade. The key example of this in 2008 and
2009 was the
automobile industry. To protect national producers, hold on to
jobs, and stave
of bankruptcies, rich countries including the United States,
Great Britain,
Canada, France, Germany, Italy, and Sweden gave over $45
billion in
subsidies to car companies between mid-2008 and mid-2009.
Such subsidies
could cause production to switch from more-efficient plants to
less-efficient
plants that have an advantage due to state support. Although the
WTO has
rules against trade-distorting subsidies, its enforcement
mechanisms are
weaker than in the case of tariffs, and so far countries that have
been increasing
subsidies have not been challenged. •
Source: “The Nuts and Bolts Come Apart,” The Economist,
March 28, 2009, pp. 79–81; “Barriers to Entry,” The
Economist, December 20, 2008, p. 121; and “Beyond Doha,”
The Economist, October 11, 2008, pp. 30–33.
Introduction
Our review of the classical trade theories of Smith, Ricardo,
and Heckscher-Ohlin in
Chapter 5 showed us that in a world without trade barriers,
trade patterns are
determined by the relative productivity of different factors of
production in different

countries. Countries will specialize in products that they can
make most efficiently,
while importing products that they can produce less efficiently.
Chapter 5 also laid out
the intellectual case for free trade. Remember, free trade refers
to a situation in which
a government does not attempt to restrict what its citizens can
buy from or sell to
another country. As we saw in Chapter 5, the theories of Smith,
Ricardo, and
Heckscher-Ohlin predict that the consequences of free trade
include both static
economic gains (because free trade supports a higher level of
domestic consumption
and more efficient utilization of resources) and dynamic
economic gains (because free
trade stimulates economic growth and the creation of wealth).
Free Trade
The absence of
government barriers to
the free flow of goods
and services between
countries.
2010/01:07:10/MHBR169:Slavin:VY

Chapter Six The Political Economy of International Trade 205
In this chapter, we look at the political reality
of international trade. Although many nations
are nominally committed to free trade, they
tend to intervene in international trade to
protect the interests of politically important
groups or promote the interests of key domestic
producers. The opening case illustrates the
nature of such political realities. In the wake of
the global economic slowdown that followed
the financial crisis of 2008–2009, a wide range of
countries have been increasing tariffs and non-
tariff barriers to international trade in an
attempt to protect domestic producers, and
hold onto jobs. While such actions are under-
standable from a political perspective, interna-
tional trade theory teaches us that they are
self-defeating. Ultimately, protecting inefficient
producers raises the price of goods and services,
and results in lower economic growth.
In this chapter, we explore the political and economic
reasons that governments
have for intervening in international trade. When governments
intervene, they of-
ten do so by restricting imports of goods and services into their
nation, while
adopting policies that promote domestic production and exports.
As in 2008 and
2009, normally their motives are to protect domestic producers.
In recent years,
social issues have intruded into the decision-making calculus.
In the United States,
for example, a movement is growing to ban imports of goods
from countries that
do not abide by the same labor, health, and environmental

regulations as the United
States.
We start this chapter by describing the range of policy
instruments that govern-
ments use to intervene in international trade. This is followed
by a detailed review
of the various political and economic motives that governments
have for interven-
tion. In the third section of this chapter, we consider how the
case for free trade
stands up in view of the various justifications given for
government intervention in
international trade. Then we look at the emergence of the
modern international
trading system, which is based on the General Agreement on
Tariffs and Trade and
its successor, the WTO. The GATT and WTO are the creations
of a series of mul-
tinational treaties. The most recent was completed in 1995,
involved more than 120
countries, and resulted in the creation of the WTO. The purpose
of these treaties
has been to lower barriers to the free flow of goods and services
between nations.
Like the GATT before it, the WTO promotes free trade by
limiting the ability of
national governments to adopt policies that restrict imports into
their nations. In
the final section of this chapter, we discuss the implications of
this material for
management practice.
Instruments of Trade Policy
Trade policy uses seven main instruments: tariffs, subsidies,
import quotas, voluntary
export restraints, local content requirements, administrative

policies, and antidumping
duties. Tariffs are the oldest and simplest instrument of trade
policy. As we shall
see later in this chapter, they are also the instrument that the
GATT and WTO have
Another Per spect i ve
Rankings of the World Economic Forum (WEF)
The World Economic Forum (WEF) is an independent
economic organization whose mission is to improve the
state of the world. Based in Geneva, Switzerland, it hosts
meetings that serve as a forum for the collaboration of
international leaders. The WEF also conducts global
economic research and annually publishes country competi-
tive rankings. In the latest report (2009–2010), the top coun-
tries in competitiveness were Switzerland, the United States,
and Singapore, followed by Sweden, Denmark, Finland, and
Germany. If you review the report’s complete list of rankings,
you’ll note a strong correlation between a country’s ranking
and its political system. Visit www.weforum.org.
LEARNING OBJECTIVE 1
Identify the policy
instruments used by
governments to influence
international trade flows.
2010/01:07:10/MHBR169:Slavin:VY

been most successful in limiting. A fall in tariff barriers in
recent decades has been
accompanied by a rise in nontariff barriers, such as subsidies,
quotas, voluntary export
restraints, and antidumping duties.
TARIFFS A tariff is a tax levied on imports (or exports).
Tariffs fall into two
categories. Specific tariffs are levied as a fixed charge for each
unit of a good
imported (for example, $3 per barrel of oil). Ad valorem tariffs
are levied as a pro-
portion of the value of the imported good. In most cases, tariffs
are placed on
imports to protect domestic producers from foreign competition
by raising the price
of imported goods. However, tariffs also produce revenue for
the government. Until
the income tax was introduced, for example, the U.S.
government received most of
its revenues from tariffs.
The important thing to understand about an import tariff is
who suffers and who
gains. The government gains, because the tariff increases
government revenues.
Domestic producers gain, because the tariff affords them some
protection against
foreign competitors by increasing the cost of imported foreign
goods. Consumers
lose because they must pay more for certain imports. For
example, in 2002 the U.S.
government placed an ad valorem tariff of 8 percent to 30

percent on imports of
foreign steel. The idea was to protect domestic steel producers
from cheap imports
of foreign steel. The effect, however, was to raise the price of
steel products in the
United States between 30 and 50 percent. A number of U.S.
steel consumers, rang-
ing from appliance makers to automobile companies, objected
that the steel tariffs
would raise their costs of production and make it more difficult
for them to compete
in the global marketplace. Whether the gains to the government
and domestic pro-
ducers exceed the loss to consumers depends on various factors
such as the amount
of the tariff, the importance of the imported good to domestic
consumers, the num-
ber of jobs saved in the protected industry, and so on. In the
steel case, many argued
that the losses to steel consumers apparently outweighed the
gains to steel produc-
ers. In November 2003, the World Trade Organization declared
that the tariffs
represented a violation of the WTO treaty, and the United
States removed them in
December of that year.
In general, two conclusions can be derived from economic
analysis of the effect
of import tariffs. 1 First, tariffs are pro-producer and anti-
consumer. While they
protect producers from foreign competitors, this restriction of
supply also raises
domestic prices. For example, a study by Japanese economists
calculated that tariffs
on imports of foodstuffs, cosmetics, and chemi-

cals into Japan cost the average Japanese con-
sumer about $890 per year in the form of higher
prices. 2 Almost all studies find that import tariffs
impose significant costs on domestic consumers
in the form of higher prices. 3
Second, import tariffs reduce the overall effi-
ciency of the world economy. They reduce
efficiency because a protective tariff encourages
domestic firms to produce products at home that,
in theory, could be produced more efficiently
abroad. The consequence is an inefficient utiliza-
tion of resources. For example, tariffs on the im-
portation of rice into South Korea have led to an
increase in rice production in that country; how-
ever, rice farming is an unproductive use of land
in South Korea. It would make more sense for the
Tariff
A tax levied on imports.
U.S. Tariff Rates
Because the United States takes a free trade public posi-
tion, many people assume the U.S. government has few
tariffs. Information about U.S. trade is readily available
online.
For example, you can review the U.S. government’s
current tariffs at the U.S. Office of Tariff Affairs and Trade
Agreements site (www.usitc.gov/tata/index.htm). However,
with many schedules and fine distinctions made within
product groups, this site can be a challenge to browse. For
interesting statistics on imports and exports of the United
States, as well of as other nations, check out the World
Trade Organization Web site at www.wto.org.

Specific Tariff
A tariff levied as a fixed
charge for each unit of
good imported.
Ad Valorem Tariff
A tariff levied as a
proportion of the value of
an imported good.
2010/01:07:10/MHBR169:Slavin:VY
South Koreans to purchase their rice from lower-cost foreign
producers and to uti-
lize the land now employed in rice production in some other
way, such as growing
foodstuffs that cannot be produced more efficiently elsewhere
or for residential and
industrial purposes.
Sometimes tariffs are levied on exports of a product from a
country. Export tariffs
are far less common than import tariffs. In general, export
tariffs have two objectives:
first, to raise revenue for the government, and second, to reduce

exports from a sector,
often for political reasons. For example, in 2004 China
imposed a tariff on textile ex-
ports. The primary objective was to moderate the growth in
exports of textiles from
China, thereby alleviating tensions with other trading partners.
SUBSIDIES A subsidy is a government payment to a
domestic producer. Subsi-
dies take many forms, including cash grants, low-interest loans,
tax breaks, and gov-
ernment equity participation in domestic firms. By lowering
production costs,
subsidies help domestic producers in two ways: (1) competing
against foreign imports
and (2) gaining export markets. According to the World Trade
Organization, in the
mid-2000s countries spent some $300 billion on subsidies, $250
billion of which was
spent by 21 developed nations. 4 As noted in the opening case,
between mid-2008 and
mid-2009 some developed nations gave $45 billion in subsidies
to their automobile
makers. While the purpose of the subsidies was to help them
survive a very difficult
economic climate, one of the consequences was to give
subsidized companies an unfair
competitive advantage in the global auto industry.
Agriculture tends to be one of the largest beneficiaries of
subsidies in most coun-
tries. In the mid-2000s, the European Union was paying about
€44 billion annually
($55 billion) in farm subsidies. Not to be outdone, in May 2002
President George
W. Bush signed into law a bill that contained subsidies of more
than $180 billion

for U.S. farmers spread out over 10 years. This was followed in
2007 by a farm bill
that contained $286 billion in subsidies for the next 10 years.
The Japanese also
have a long history of supporting inefficient domestic producers
with farm subsi-
dies. The accompanying Country Focus looks at subsidies to
wheat producers in
Japan.
Nonagricultural subsidies are much lower, but they are still
significant. For
example, subsidies historically were given to Boeing and
Airbus to help them lower
the cost of developing new commercial jet aircraft. In Boeing’s
case, subsides came
in the form of tax credits for R&D spending or Pentagon money
that was used to
develop military technology, which then was transferred to civil
aviation projects.
In the case of Airbus, subsidies took the form of government
loans at below-market
interest rates.
The main gains from subsidies accrue to domestic producers,
whose international
competitiveness is increased as a result. Advocates of strategic
trade policy (which, as
you will recall from Chapter 5, is an outgrowth of the new trade
theory) favor subsi-
dies to help domestic firms achieve a dominant position in those
industries in which
economies of scale are important and the world market is not
large enough to profit-
ably support more than a few firms (aerospace and
semiconductors are two such in-
dustries). According to this argument, subsidies can help a firm
achieve a first-mover

advantage in an emerging industry (just as U.S. government
subsidies, in the form of
substantial R&D grants, allegedly helped Boeing). If this is
achieved, further gains to
the domestic economy arise from the employment and tax
revenues that a major
global company can generate. However, government subsidies
must be paid for, typi-
cally by taxing individuals and corporations.
Whether subsidies generate national benefits that exceed
their national costs
is debatable. In practice, many subsidies are not that successful
at increasing the
Subsidy
Government financial
assistance to a domestic
producer.
2010/01:07:10/MHBR169:Slavin:VY
international competitiveness of domestic producers. Rather,
they tend to protect the
inefficient and promote excess production. One study estimated
that if advanced
countries abandoned subsidies to farmers, global trade in
agricultural products would

be 50 percent higher and the world as a whole would be better
off by $160 billion. 5
Another study estimated that removing all barriers to trade in
agriculture (both subsi-
dies and tariffs) would raise world income by $182 billion. 6
This increase in wealth
arises from the more efficient use of agricultural land. For a
specific example, see the
Country Focus on wheat subsidies in Japan.
IMPORT QUOTAS AND VOLUNTARY EXPORT
RESTRAINTS An
import quota is a direct restriction on the quantity of some good
that may be
imported into a country. The restriction is usually enforced by
issuing import
licenses to a group of individuals or firms. For example, the
United States has a quota
on cheese imports. The only firms allowed to import cheese are
certain trading
companies, each of which is allocated the right to import a
maximum number of
Subsidized Wheat Production in Japan
Japan is not a particularly good environment for growing
wheat. Wheat produced on large fields in the dry climates
of North America, Australia, and Argentina is far cheaper
and of much higher quality than anything produced in
Japan, which imports some 80 percent of its wheat from
foreign producers. Yet tens of thousands of farmers in
Japan still grow wheat, usually on small fields where yields
are low and costs high, and production is rising. They do
this because government subsidies keep inefficient
Japanese wheat producers in business. In the mid-2000s,
Japanese farmers were selling their output at market

prices, which were running at $9 per bushel, but they
received an average of at least $35 per bushel for their
production! The difference—$26 a bushel—was govern-
ment subsidies paid to producers. The estimated costs of
these subsidies were more than $700 million a year.
To finance its production subsidy, Japan operates a tariff
rate quota on wheat imports in which a higher tariff rate is
imposed once wheat imports exceed the quota level. The
in-quota rate tariff is zero, while the over-quota tariff rate
for wheat is $500 a ton. The tariff raises the cost so much
that it deters over-quota imports, essentially restricting
supply and raising the price for wheat inside Japan. The
Japanese Ministry of Agriculture, Forestry and Fisheries
(MAFF) has the sole right to purchase wheat imports within
the quota (and since there are very few over-quota imports,
the MAFF is a monopoly buyer on wheat imports into
Japan). The MAFF buys wheat at world prices then resells
it to millers in Japan at the artificially high prices that arise
due to the restriction on supply engineered by the tariff
rate quota. Estimates suggest that in 2004, the world mar-
ket price for wheat was $5.96 per bushel, but within Japan
the average price for imported wheat was $10.23 a bushel.
The markup of $4.27 a bushel yielded the MAFF in excess of
$450 million in profit. This “profit” was then used to help
cover the $700 million cost of subsidies to inefficient wheat
farmers, with the rest of the funds coming from general
government tax revenues.
Thanks to these policies, the price of wheat in Japan can
be anything from 80 to 120 percent higher than the world
price, and Japanese wheat production, which exceeded
850,000 tons in 2004, is significantly greater than it would
be if a free market were allowed to operate. Indeed, under
free market conditions, there would be virtually no wheat
production in Japan since the costs of production are sim-
ply too high. The beneficiaries of this policy are the thou-

sands of small farmers in Japan who grow wheat. The
losers include Japanese consumers, who must pay more
for products containing wheat and who must finance
wheat subsidies through taxes, and foreign producers,
who are denied access to a chunk of the Japanese market
by the over-quota tariff rate. Why then does the Japanese
government continue to pursue this policy? It continues
because small farmers are an important constituency and
Japanese politicians want their votes.
Sources: J. Dyck and H. Fukuda, “Taxes on Imports Subsidize
Wheat
Production in Japan,” Amber Waves, February 2005, p. 2; and
H. Fukuda,
J. Dyck, and J. Stout, “Wheat and Barley Policies in Japan,”
U.S. Department
of Agriculture research report, WHS-04i-01, November 2004.
3 Country FOCUS
Import Quota
A direct restriction on
the quantity of some
good that may be
imported into a country.
2010/01:07:10/MHBR169:Slavin:VY

pounds of cheese each year. In some cases, the right to sell is
given directly to the
governments of exporting countries. Historically this is the case
for sugar and textile
imports in the United States. However, the international
agreement governing the
imposition of import quotas on textiles, the Multi-Fiber
Agreement, expired in
December 2004.
A common hybrid of a quota and a tariff is known as a tariff
rate quota. Under a
tariff rate quota, a lower tariff rate is applied to imports within
the quota than those
over the quota. For example, as illustrated in Figure 6.1, an ad
valorem tariff rate of 10
percent might be levied on rice imports into South Korea of 1
million tons, after
which an out-of-quota rate of 80 percent might be applied.
Thus, South Korea might
import 2 million tons of rice, 1 million at a 10 percent tariff rate
and another 1 million
at an 80 percent tariff. Tariff rate quotas are common in
agriculture, where their goal
is to limit imports over quota. For an example, see the Country
Focus that looks at
how Japan uses the combination of a tariff rate quota and
subsidies to protect ineffi-
cient Japanese wheat farmers from foreign competition.
A variant on the import quota is the voluntary export
restraint. A voluntary export
restraint (VER) is a quota on trade imposed by the exporting
country, typically at the
request of the importing country’s government. One of the most

famous historical
examples is the limitation on auto exports to the United States
enforced by Japanese
automobile producers in 1981. A response to direct pressure
from the U.S. govern-
ment, this VER limited Japanese imports to no more than 1.68
million vehicles per
year. The agreement was revised in 1984 to allow 1.85 million
Japanese vehicles per
year. The agreement was allowed to lapse in 1985, but the
Japanese government indi-
cated its intentions at that time to continue to restrict exports to
the United States to
1.85 million vehicles per year. 7 Foreign producers agree to
VERs because they fear
more damaging punitive tariffs or import quotas might follow if
they do not. Agreeing
to a VER is seen as a way to make the best of a bad situation by
appeasing protection-
ist pressures in a country.
As with tariffs and subsidies, both import quotas and VERs
benefit domestic pro-
ducers by limiting import competition. As with all restrictions
on trade, quotas do not
0
0 80 9010 20 30 40 50 60 70
Quota limit
2 million
1 million
Tariff rate (%)

To
ns
o
f r
ic
e
im
po
rte
d
Out of quota In quota
6.1 figure
Hypothetical Tariff Rate
Quota
Voluntary Export
Restraint (VER)
A quota on trade imposed
by the exporting country,
typically at the request of
the importing country’s
government.
Tariff Rate Quota
The process of applying
a lower tariff rate
to imports within the
quota than those over

the quota.
2010/01:07:10/MHBR169:Slavin:VY
benefit consumers. An import quota or VER always raises the
domestic price of an
imported good. When imports are limited to a low percentage of
the market by a
quota or VER, the price is bid up for that limited foreign
supply. The automobile
industry VER mentioned above increased the price of the
limited supply of Japanese
imports. According to a study by the U.S. Federal Trade
Commission, the automobile
VER cost U.S. consumers about $1 billion per year between
1981 and 1985. That
$1 billion per year went to Japanese producers in the form of
higher prices. 8 The extra
profit that producers make when supply is artificially limited by
an import quota is
referred to as a quota rent.
If a domestic industry lacks the capacity to meet demand, an
import quota can raise
prices for both the domestically produced and the imported
good. This happened in
the U.S. sugar industry, in which a tariff rate quota system has
long limited the amount

foreign producers can sell in the U.S. market. According to one
study, import quotas
have caused the price of sugar in the United States to be as
much as 40 percent greater
than the world price. 9 These higher prices have translated into
greater profits for U.S.
sugar producers, which have lobbied politicians to keep the
lucrative agreement. They
argue U.S. jobs in the sugar industry will be lost to foreign
producers if the quota sys-
tem is scrapped.
LOCAL CONTENT REQUIREMENTS A local content
requirement is a
requirement that some specific fraction of a good be produced
domestically. The re-
quirement can be expressed either in physical terms (e.g., 75
percent of component
parts for this product must be produced locally) or in value
terms (e.g., 75 percent of
the value of this product must be produced locally). Local
content regulations have
been widely used by developing countries to shift their
manufacturing base from the
simple assembly of products whose parts are manufactured
elsewhere into the local
manufacture of component parts. They have also been used in
developed countries to
try to protect local jobs and industry from foreign competition.
For example, a little-
known law in the United States, the Buy America Act, specifies
that government agen-
cies must give preference to American products when putting
contracts for equipment
out to bid unless the foreign products have a significant price
advantage. The law

specifies a product as “American” if 51 percent of the materials
by value are produced
domestically. This amounts to a local content requirement. If a
foreign company, or an
American one for that matter, wishes to win a contract from a
U.S. government agency
to provide some equipment, it must ensure that at least 51
percent of the product by
value is manufactured in the United States.
Local content regulations provide protection for a domestic
producer of parts in
the same way an import quota does: by limiting foreign
competition. The aggregate
economic effects are also the same; domestic producers benefit,
but the restrictions on
imports raise the prices of imported components. In turn, higher
prices for imported
components are passed on to consumers of the final product in
the form of higher
final prices. So as with all trade policies, local content
regulations tend to benefit pro-
ducers and not consumers.
ADMINISTRATIVE POLICIES In addition to the formal
instruments of
trade policy, governments of all types sometimes use informal
or administrative pol-
icies to restrict imports and boost exports. Administrative trade
policies are bu-
reaucratic rules designed to make it difficult for imports to
enter a country. It has
been argued that the Japanese are the masters of this trade
barrier. In recent decades,
Japan’s formal tariff and nontariff barriers have been among the
lowest in the world.

Local Content
Requirement
A requirement that some
specific fraction of a
good be produced
domestically.
Administrative
Trade Policies
Bureaucratic rules
designed to make it
difficult for imports to
enter a country.
Quota Rent
The extra profit
producers make when
supply is artificially
limited by an import
quota.
2010/01:07:10/MHBR169:Slavin:VY

Dumping
selling goods in a foreign
market at below their
costs of production or
below their “fair” market
value.
Antidumping
Policies
Policies designed to
punish foreign firms that
engage in dumping and
thus protect domestic
producers from unfair
foreign competition.
Countervailing
Duties
Antidumping duties.
However, critics charge that the country’s informal
administrative barriers to im-
ports more than compensate for this. For example, at one point
the Netherlands
exported tulip bulbs to almost every country in the world
except Japan. In Japan,
customs inspectors insisted on checking every tulip bulb by
cutting it vertically
down the middle, and even Japanese ingenuity could not put
them back together.
Federal Express also initially had a tough time expanding its
global express shipping
services into Japan because Japanese customs inspectors insist
on opening a large

proportion of express packages to check for pornography, a
process that delayed an
“express” package for days. Japan is not the only country that
engages in such poli-
cies. France once required that all imported videotape recorders
arrive through a
small customs entry point that was both remote and poorly
staffed. The resulting
delays kept Japanese VCRs out of the French market until a
VER agreement was
negotiated. 10 As with all instruments of trade policy,
administrative instruments ben-
efit producers and hurt consumers, who are denied access to
possibly superior for-
eign products.
ANTIDUMPING POLICIES In the context of international
trade, dumping is
variously defined as selling goods in a foreign market at below
their costs of production
or as selling goods in a foreign market at below their “fair”
market value. There is a dif-
ference between these two definitions; the fair market value of a
good is normally
judged to be greater than the costs of producing that good
because the former includes
a “fair” profit margin. Dumping is viewed as a method by which
firms unload excess
production in foreign markets. Some dumping may be the result
of predatory behavior,
with producers using substantial profits from their home
markets to subsidize prices in
a foreign market with a view to driving indigenous competitors
out of that market.
Once this has been achieved, so the argument goes, the
predatory firm can raise prices

and earn substantial profits.
An alleged example of dumping occurred in 1997, when two
South Korean manu-
facturers of semiconductors, LG Semicon and Hyundai
Electronics, were accused of
selling dynamic random access memory chips (DRAMs) in the
U.S. market at below
their costs of production. This action occurred in the middle of
a worldwide glut of
chip-making capacity. It was alleged that the firms were trying
to unload their excess
production in the United States.
Antidumping policies are designed to punish foreign firms
that engage in dump-
ing. The ultimate objective is to protect domestic producers
from unfair foreign
competition. Although antidumping policies vary somewhat
from country to country,
the majority are similar to those used in the United States. If a
domestic producer
believes that a foreign firm is dumping production in the U.S.
market, it can file a
petition with two government agencies, the Commerce
Department and the Interna-
tional Trade Commission. In the Korean DRAM case, Micron
Technology, a U.S.
manufacturer of DRAMs, filed the petition. The government
agencies then investi-
gate the complaint. If a complaint has merit, the Commerce
Department may impose
an antidumping duty on the offending foreign imports
(antidumping duties are often
called countervailing duties). These duties, which represent a
special tariff, can be
fairly substantial and stay in place for up to five years. For
example, after reviewing

Micron’s complaint, the Commerce Department imposed 9
percent and 4 percent
countervailing duties on LG Semicon and Hyundai DRAM
chips, respectively. The
accompanying Management Focus discusses another example of
how a firm, U.S.
Magnesium, used antidumping legislation to gain protection
from unfair foreign
competitors.
2010/01:07:10/MHBR169:Slavin:VY
The Case for Government Intervention
Now that we have reviewed the various instruments of trade
policy that governments
can use, it is time to look at the case for government
intervention in international trade.
Arguments for government intervention take two paths: political
and economic. Politi-
cal arguments for intervention are concerned with protecting the
interests of certain
groups within a nation (normally producers), often at the
expense of other groups (nor-
mally consumers), or with achieving some political objective
that lies outside the sphere
of economic relationships, such as protecting the environment
or human rights. Eco-

nomic arguments for intervention are typically concerned with
boosting the overall
wealth of a nation (to the benefit of all, both producers and
consumers).
Understand why
governments sometimes
intervene in international
trade.
Management FOCUS
U.S. Magnesium Seeks Protection
In February 2004, U.S. Magnesium, the sole surviving U.S.
producer of magnesium, a metal that is primarily used in
the manufacture of certain automobile parts and aluminum
cans, filed a petition with the U.S. International Trade
Commission (ITC) contending that a surge in imports had
caused material damage to the U.S. industry’s employment,
sales, market share, and profitability. According to U.S.
Magnesium, Russian and Chinese producers had been
selling the metal at prices significantly below market value.
During 2002 and 2003, imports of magnesium into the United
States rose 70 percent, while prices fell by 40 percent and
the market share accounted for by imports jumped to 50
percent from 25 percent.
“The United States used to be the largest producer of
magnesium in the world,” a U.S. Magnesium spokesman
said at the time of the filing. “What’s really sad is that you
can be state of the art and have modern technology, and if
the Chinese, who pay people less than 90 cents an hour,
want to run you out of business, they can do it. And that’s
why we are seeking relief.”
During a yearlong investigation, the ITC solicited input

from various sides in the dispute. Foreign producers and
consumers of magnesium in the United States argued that
falling prices for magnesium during 2002 and 2003 simply
reflected an imbalance between supply and demand due
to additional capacity coming on stream not from Russia or
China but from a new Canadian plant that opened in 2001
and from a planned Australian plant. The Canadian plant
shut down in 2003, the Australian plant never came on
stream, and prices for magnesium rose again in 2004.
Magnesium consumers in the United States also argued
to the ITC that imposing antidumping duties on foreign
imports of magnesium would raise prices in the United
States significantly above world levels. A spokesman for
Alcoa, which mixes magnesium with aluminum to make
alloys for cans, predicted that if antidumping duties were
imposed, high magnesium prices in the United States would
force Alcoa to move some production out of the United
States. Alcoa also noted that in 2003, U.S. Magnesium was
unable to supply all of Alcoa’s needs, forcing the company
to turn to imports. Consumers of magnesium in the automo-
bile industry asserted that high prices in the United States
would drive engineers to design magnesium out of automo-
biles, or force manufacturing elsewhere, which would ulti-
mately hurt everyone.
The six members of the ITC were not convinced by these
arguments. In March 2005, the ITC ruled that both China and
Russia had been dumping magnesium in the United States.
The government decided to impose duties ranging from 50
percent to more than 140 percent on imports of magnesium
from China. Russian producers faced duties ranging from 19
percent to 22 percent. The duties were to be levied for five
years, after which the ITC will revisit the situation.
According to U.S. Magnesium, the favorable ruling would
allow the company to reap the benefits of nearly $50 million
in investments made in its manufacturing plant and enable

the company to boost its capacity by 28 percent by the end
of 2005. Commenting on the favorable ruling, a U.S. Magne-
sium spokesman noted, “Once unfair trade is removed
from the marketplace we’ll be able to compete with any-
one.” U.S. Magnesium’s customers and competitors, how-
ever, did not view the situation in the 2002–2003 period as one
of unfair trade. While the imposition of antidumping duties
no doubt will help to protect U.S. Magnesium and the 400
people it employs from foreign competition, magnesium
consumers in the United States are left wondering if they
will be the ultimate losers.
Sources: D. Anderton, “U.S. Magnesium Lands Ruling on
Unfair Imports,”
Deseret News, October 1, 2004, p. D10; “U.S. Magnesium and
Its Largest
Consumers Debate before U.S. ITC,” Platt’s Metals Week,
February 28,
2005, p. 2; and S. Oberbeck, “U.S. Magnesium Plans Big Utah
Production
Expansion,” Salt Lake Tribune, March 30, 2005.
2010/01:07:10/MHBR169:Slavin:VY
POLITICAL ARGUMENTS FOR INTERVENTION Political
arguments
for government intervention cover a range of issues, including

preserving jobs, pro-
tecting industries deemed important for national security,
retaliating against unfair
foreign competition, protecting consumers from “dangerous”
products, furthering the
goals of foreign policy, and advancing the human rights of
individuals in exporting
countries.
Protecting Jobs and Industries Perhaps the most common
political argument
for government intervention is that it is necessary for protecting
jobs and industries
from unfair foreign competition. The tariffs placed on imports
of foreign steel by
President George W. Bush in 2002 were designed to do this.
(Many steel producers
were located in states that Bush needed to win reelection in
2004.) A political motive
also underlay establishment of the Common Agricultural Policy
(CAP) by the Euro-
pean Union. The CAP was designed to protect the jobs of
Europe’s politically power-
ful farmers by restricting imports and guaranteeing prices.
However, the higher
prices that resulted from the CAP have cost Europe’s consumers
dearly. This is true
of many attempts to protect jobs and industries through
government intervention.
For example, the imposition of steel tariffs in 2002 raised steel
prices for American
consumers, such as automobile companies, making them less
competitive in the
global marketplace.
National Security Countries sometimes argue that it is

necessary to protect cer-
tain industries because they are important for national security.
Defense-related indus-
tries often get this kind of attention (e.g., aerospace, advanced
electronics,
semiconductors, etc.). Although not as common as it used to be,
this argument is still
made. Those in favor of protecting the U.S. semiconductor
industry from foreign
competition, for example, argue that semiconductors are now
such important compo-
nents of defense products that it would be dangerous to rely
primarily on foreign
producers for them. In 1986, this argument helped persuade the
federal government
to support Sematech, a consortium of 14 U.S. semiconductor
companies that ac-
counted for 90 percent of the U.S. industry’s revenues.
Sematech’s mission was to
conduct joint research into manufacturing techniques that can
be parceled out to
members. The government saw the venture as so critical that
Sematech was specially
protected from antitrust laws. Initially, the U.S. government
provided Sematech with
$100 million per year in subsidies. By the mid-1990s, however,
the U.S. semiconduc-
tor industry had regained its leading market position, largely
through the personal
computer boom and demand for microprocessor chips made by
Intel. In 1994, the
consortium’s board voted to seek an end to federal funding, and
since 1996 the consor-
tium has been funded entirely by private money. 11
Retaliation Some argue that governments should use the threat

to intervene in
trade policy as a bargaining tool to help open foreign markets
and force trading part-
ners to “play by the rules of the game.” The U.S. government
has used the threat of
punitive trade sanctions to try to get the Chinese government to
enforce its intellec-
tual property laws. Lax enforcement of these laws had given
rise to massive copyright
infringements in China that had been costing U.S. companies
such as Microsoft hun-
dreds of millions of dollars per year in lost sales revenues.
After the United States
threatened to impose 100 percent tariffs on a range of Chinese
imports, and after
harsh words between officials from the two countries, the
Chinese agreed to tighter
enforcement of intellectual property regulations. 12
If it works, such a politically motivated rationale for
government intervention
may liberalize trade and bring with it resulting economic gains.
It is a risky strategy,
2010/01:07:10/MHBR169:Slavin:VY
however. A country that is being pressured may not back down
and instead may re-

spond to the imposition of punitive tariffs by raising trade
barriers of its own. This
is exactly what the Chinese government threatened to do when
pressured by the
United States, although it ultimately did back down. If a
government does not back
down, however, the results could be higher trade barriers all
around and an eco-
nomic loss to all involved.
Protecting Consumers Many governments have long had
regulations to protect
consumers from unsafe products. The indirect effect of such
regulations often is to
limit or ban the importation of such products. For example, in
2003 several countries,
including Japan and South Korea, decided to ban imports of
American beef after a
single case of mad cow disease was found in Washington State.
The ban was motivated
to protect consumers from what was seen to be an unsafe
product. Together, Japan and
South Korea accounted for about $2 billion of U.S. beef sales,
so the ban had a sig-
nificant impact on U.S. beef producers. After two years, both
countries lifted the ban,
although they placed stringent requirements on U.S. beef
imports to reduce the risk of
importing beef that might be tainted by mad cow disease (for
example, Japan required
that all beef must come from cattle under 21 months of age). 13
The accompanying Country Focus describes how the European
Union banned
the sale and importation of hormone-treated beef. The ban was
motivated by a de-
sire to protect European consumers from the possible health

consequences of eating
meat from animals treated with growth hormones. The conflict
over the importa-
tion of hormone-treated beef into the EU may prove to be a
taste of things to come.
In addition to the use of hormones to promote animal growth
and meat production,
biotechnology has made it possible to genetically alter many
crops so that they resist
common herbicides, produce proteins that are natural
insecticides, grow dramati-
cally improved yields, or withstand inclement weather
conditions. A new breed of
A genetically engineered cotton seed that protects against three
common insects has been met with resistance in Europe
due to a fear that these genetically altered seeds could
potentially be harmful to humans.
2010/01:07:10/MHBR169:Slavin:VY
genetically modified tomatoes has an antifreeze gene inserted
into its genome and
can thus be grown in colder climates than hitherto possible.
Another example is a
genetically engineered cotton seed produced by Monsanto. The
seed has been engi-

neered to express a protein that protects against three common
insect pests: the
cotton bollworm, tobacco budworm, and pink bollworm. Use of
this seed reduces or
eliminates the need for traditional pesticide applications for
these pests.
As enticing as such innovations sound, they have met with
intense resistance from
consumer groups, particularly in Europe. The fear is that the
widespread use of
genetically altered seed corn could have unanticipated and
harmful effects on human
Trade in Hormone-Treated Beef
In the 1970s, scientists discovered how to synthesize cer-
tain hormones and use them to accelerate the growth rate
of livestock animals, reduce the fat content of meat, and
increase milk production. Bovine somatotropin (BST), a
growth hormone produced by cattle, was first synthesized
by the biotechnology firm Genentech. Injections of BST
could be used to supplement an animal’s own hormone
production and increase its growth rate. These hormones
soon became popular among farmers, who found that they
could cut costs and help satisfy consumer demands for
leaner meat. Although these hormones occurred naturally
in animals, consumer groups in several countries soon
raised concerns about the practice. They argued that the
use of hormone supplements was unnatural and that the
health consequences of consuming hormone-treated meat
were unknown but might include hormonal irregularities
and cancer.
The European Union responded to these concerns in
1989 by banning the use of growth-promoting hormones
in the production of livestock and the importation of
hormone-treated meat. The ban was controversial because

a reasonable consensus existed among scientists that the
hormones posed no health risk. Although the EU banned
hormone-treated meat, many other countries did not,
including big meat-producing countries such as Australia,
Canada, New Zealand, and the United States. The use of
hormones soon became widespread in these countries.
According to trade officials outside the EU, the European
ban constituted an unfair restraint on trade. As a result of
this ban, exports of meat to the EU fell. For example, U.S.
red meat exports to the EU declined from $231 million in
1988 to $98 million in 1994. The complaints of meat export-
ers were bolstered in 1995 when Codex Alimentarius, the
international food standards body of the UN’s Food and Ag-
riculture Organization and the World Health Organization,
approved the use of growth hormones. In making this deci-
sion, Codex reviewed the scientific literature and found no
evidence of a link between the consumption of hormone-
treated meat and human health problems, such as cancer.
Fortified by such decisions, in 1995 the United States
pressed the EU to drop the import ban on hormone-treated
beef. The EU refused, citing “consumer concerns about food
safety.” In response, both Canada and the United States in-
dependently filed formal complaints with the World Trade
Organization. The United States was joined in its complaint
by a number of other countries, including Australia and New
Zealand. The WTO created a trade panel of three indepen-
dent experts. After reviewing evidence and hearing from a
range of experts and representatives of both parties, the
panel in May 1997 ruled that the EU ban on hormone-treated
beef was illegal because it had no scientific justification.
The EU immediately indicated it would appeal the finding to
the WTO court of appeals. The WTO court heard the appeal
in November 1997 and in February 1998 agreed with the find-
ings of the trade panel that the EU had not presented any
scientific evidence to justify the hormone ban.

This ruling left the EU in a difficult position. Legally, the EU
had to lift the ban or face punitive sanctions, but the ban
had wide public support in Europe. The EU feared that lifting
the ban could produce a consumer backlash. Instead the
EU did nothing, so in February 1999 the United States asked
the WTO for permission to impose punitive sanctions on the
EU. The WTO responded by allowing the United States to
impose punitive tariffs valued at $120 million on EU exports
to the United States. The EU decided to accept these tariffs
rather than lift the ban on hormone-treated beef, and as of
2010, the ban and punitive tariffs were still in place.
Sources: C. Southey, “Hormones Fuel a Meaty EU Row,”
Financial Times,
September 7, 1995, p. 2; E. L. Andrews, “In Victory for U.S.,
European Ban on
Treated Beef Is Ruled Illegal,” The New York Times, May 9,
1997, p. A1;
F. Williams and G. de Jonquieres, “WTO’s Beef Rulings Give
Europe Food
for Thought,” Financial Times, February 13, 1998, p. 5; R.
Baily, “Food and
Trade: EU Fearmongers’ Lethal Harvest,” Los Angeles Times,
August 18, 2002,
p. M3; “The US-EU Dispute over Hormone-Treated Beef,” The
Kiplinger
Agricultural Letter, January 10, 2003; and Scott Miller, “EU
Trade Sanctions
Have Duel Edge,” The Wall Street Journal, February 26, 2004,
p. A3.
3 Country FOCUS

2010/01:07:10/MHBR169:Slavin:VY
health and may result in “genetic pollution.” (An example of
genetic pollution would be
when the widespread use of crops that produce natural
pesticides stimulates the evolu-
tion of “superbugs” that are resistant to those pesticides.) Such
concerns have led Austria
and Luxembourg to outlaw the importation, sale, or use of
genetically altered organ-
isms. Sentiment against genetically altered organisms also runs
strong in several other
European countries, most notably Germany and Switzerland. It
seems likely, therefore,
that the World Trade Organization will be drawn into the
conflict between those that
want to expand the global market for genetically altered
organisms, such as Monsanto,
and those that want to limit it, such as Austria and Luxembourg.
14
Furthering Foreign Policy Objectives Governments
sometimes use trade
policy to support their foreign policy objectives. 15 A
government may grant prefer-
ential trade terms to a country with which it wants to build
strong relations. Trade
policy has also been used several times to pressure or punish
“rogue states” that do
not abide by international law or norms. Iraq labored under

extensive trade sanc-
tions after the UN coalition defeated the country in the 1991
Gulf War until the
2003 invasion of Iraq by U.S.-led forces. The theory is that such
pressure might
persuade the rogue state to mend its ways, or it might hasten a
change of govern-
ment. In the case of Iraq, the sanctions were seen as a way of
forcing that country
to comply with several UN resolutions. The United States has
maintained long-
running trade sanctions against Cuba. Their principal function is
to impoverish Cuba
in the hope that the resulting economic hardship will lead to the
downfall of Cuba’s
Communist government and its replacement with a more
democratically inclined
(and pro-U.S.) regime. The United States also has had trade
sanctions in place
against Libya and Iran, both of which it accuses of supporting
terrorist action against
U.S. interests and building weapons of mass destruction. In late
2003, the sanctions
against Libya seemed to yield some returns when that country
announced it would
terminate a program to build nuclear weapons, and the U.S.
government responded
by relaxing those sanctions.
Other countries can undermine unilateral trade sanctions. The
U.S. sanctions
against Cuba, for example, have not stopped other Western
countries from trading
with Cuba. The U.S. sanctions have done little more than help
create a vacuum into
which other trading nations, such as Canada and Germany, have
stepped. In an attempt

to halt this and further tighten the screws on Cuba, in 1996 the
U.S. Congress passed
the Helms-Burton Act. This act allows Americans to sue foreign
firms that use prop-
erty in Cuba confiscated from them after the 1959 revolution.
Later in 1996, Congress
passed a similar law, the D’Amato Act, aimed at Libya and Iran.
The passage of Helms-Burton elicited protests from America’s
trading partners,
including the European Union, Canada, and Mexico, all of
which claim the law vio-
lates their sovereignty and is illegal under World Trade
Organization rules. For
example, Canadian companies that have been doing business in
Cuba for years see no
reason they should suddenly be sued in U.S. courts when
Canada does not restrict
trade with Cuba. They are not violating Canadian law, and they
are not U.S. compa-
nies, so why should they be subject to U.S. law? Despite such
protests, the law is still
on the books in the United States, although the U.S. government
has not enforced this
act—probably because it is unenforceable.
Protecting Human Rights Protecting and promoting human
rights in other
countries is an important element of foreign policy for many
democracies. Govern-
ments sometimes use trade policy to try to improve the human
rights policies of trad-
ing partners. For years, the most obvious example of this was
the annual debate in the
United States over whether to grant most favored nation (MFN)
status to China.

Helms-Burton Act
Act passed in 1996 that
allowed Americans to
sue foreign firms that
use Cuban property
confiscated from them
after the 1959 revolution.
D’Amato Act
Act passed in 1996,
similar to the Helms-
Burton Act, aimed at
Libya and Iran.
2010/01:07:10/MHBR169:Slavin:VY
MFN status allows countries to export goods to the
United States under favorable terms. Under MFN
rules, the average tariff on Chinese goods imported
into the United States was 8 percent. If China’s MFN
status were rescinded, tariffs could have risen to
about 40 percent. Trading partners who are signato-

ries of the World Trade Organization, as most are,
automatically receive MFN status. However, China
did not join the WTO until 2001, so historically the
decision of whether to grant MFN status to China
was a real one. The decision was made more difficult
by the perception that China had a poor human
rights record. As indications of the country’s disre-
gard for human rights, critics of China often point to
the 1989 Tiananmen Square massacre, China’s con-
tinuing subjugation of Tibet (which China occupied
in the 1950s), and the squashing of political dissent in China.
16 These critics argue that
it was wrong for the United States to grant MFN status to
China, and that instead, the
United States should withhold MFN status until China showed
measurable improve-
ment in its human rights record. The critics argue that trade
policy should be used as
a political weapon to force China to change its internal policies
toward human rights.
Others contend that limiting trade with such countries would
make matters worse,
not better. They argue that the best way to change the internal
human rights stance of a
country is to engage it through international trade. At its core,
the argument is simple:
Growing bilateral trade raises the income levels of both
countries, and as a state be-
comes richer, its people begin to demand, and generally receive,
better treatment with
regard to their human rights. This is a variant of the argument
in Chapter 2 that eco-
nomic progress begets political progress (if political progress is
measured by the adop-
tion of a democratic government that respects human rights).
This argument ultimately

won the day in 1999 when the Clinton administration blessed
China’s application to join
the WTO and announced that trade and human rights issues
should be decoupled.
Protecting the Environment Protecting the environment has
become an im-
portant policy objective of many nations. Increasingly,
environmental interest groups
such as Friends of the Earth and the Sierra Club have been
pressuring governments to
regulate international trade in a way the protects the
environment. The growing con-
cern over global warming has added an important dimension to
this debate.
One argument frequently made by environmental organizations
is that there is a
strong relationship between income levels and environmental
pollution and degra-
dation (i.e., industrial development leads to more pollution).
Thus, to the extent
that international trade leads to higher income levels, it can also
be expected to lead
to a decline in environmental quality. Organizations such as the
Sierra Club argue
that as a consequence, strong environmental safeguards need to
be part of any trade
agreements, and governments should be allowed to restrict trade
if doing so bene-
fits the environment.
As noted in Chapter 1, the empirical evidence suggests the
relationship between
income levels and pollution is not a linear one—rather it is an
inverted U-shaped rela-
tionship (see Figure 1.5). 17 To begin with, as countries start
to climb the ladder of

economic progress, pollution levels do increase, but past some
threshold, they start to
decline. The reason being that as societies get richer, citizens
lobby for environmental
protections, and governments tend to respond. We can see this
process starting to
unfold today in China. China has had an awful reputation for
pollution, but in the last
Beijing’s Tiananmen Square, a tangible reminder of China’s
history of
human rights abuses.
2010/01:07:10/MHBR169:Slavin:VY
few years the Chinese government has been working hard to
improve the air quality in
its major cities (although the country still has a considerable
way to go). In developed
nations such as the United States and United Kingdom, the air is
much cleaner that it
was half a century ago. This data suggests that international
trade, and the growth that
results from it, may not be damaging to the environment.
There is a very important exception to these trends, however,
and that is emissions
of carbon dioxide. Carbon dioxide emissions do rise with

income levels. Thus, the
country with the highest income per capita, the United States,
also produces the great-
est carbon dioxide emissions per capita. The reason is that
carbon dioxide emissions
are a by-product of energy use (i.e., oil, gas, or coal burning).
Richer societies are more
energy intensive, and to the extent that they use hydrocarbons to
produce that energy,
this leads to higher carbon dioxide emissions.
Carbon dioxide is the greenhouse gas at the center of concerns
over global warm-
ing. These concerns can be stated simply. 18 First, the burning
of fossil fuels to produce
energy also releases carbon dioxide into the atmosphere (and
atmospheric carbon
dioxide concentrations have steadily increased since
preindustrial times). Second, car-
bon dioxide absorbs heat radiated from the earth, warming the
atmosphere. Third, as
a consequence, average global temperatures will increase.
Indeed, estimates suggest
that average global temperatures increased by 0.7 degree
centigrade during the past
century, and they are forecasted to rise by between 1.1 and 6.4
degrees centigrade this
century. 19 Fourth, as global temperatures increase, there will
be environmental dislo-
cation, ice caps will melt and sea levels will rise, flooding low-
lying costal areas;
weather patterns will change; the frequency of violent storms
will increase; tropical
diseases (such as malaria) will move northward; species will go
extinct; and so on.
Of course, the global climate varies naturally due too, for
example, changes in solar

radiation connected with the well-known sun spot cycle,
volcanic activity (which can
inject large amounts of sulfur dioxide particles into the
atmosphere, temporarily cool-
ing it), changes in the circulation of ocean currents, and long-
term changes in the
orbit of the earth and the tilt of its axis. Human-induced global
warming is overlaid on
these natural variations. Thus, a natural cooling trend might be
moderated by greater
atmospheric carbon dioxide concentrations, and a natural
warming trend exacerbated
by them.
Although there is debate over the precise relationship between
carbon dioxide con-
centrations and the extent of future global warming, the vast
majority of climate scien-
tists have concluded that unless we take rapid action, we face a
rate of warming that in
unprecedented during the history of our civilization and may
cause major environ-
mental dislocation. 20 Given this, they advocate restricting
greenhouse gas emissions,
particularly carbon dioxide. The first international agreement to
limit global warming,
the Kyoto Protocol, was signed in 1997, although its impact was
reduced by the failure
of two of the world’s largest producers of carbon dioxide, the
United States and China,
to sign. A second international agreement was reached in
Copenhagen in 2009, this
time with the participation of the United States and China.
What does this have to do with international trade? So far,
there has been little
direct connection between the global warming debate and
international trade. How-

ever, looking forward, adherence to targets regarding carbon
emissions might start to
factor into trade agreements. Specifically, if countries do not
meet their targets for
reducing carbon emissions specified in international treaties,
they may find them-
selves the targets of retaliatory action. The EU, for example,
might respond to the
failure of the United States to meet its treaty commitments by
placing a carbon tariff
on the import of certain goods from the United States. Ten years
ago this was a re-
mote possibility. Ten years from now it may be a significant
factor in the international
trade environment.
2010/01:07:10/MHBR169:Slavin:VY
A second argument made with regard to environmental
regulations is that, to save
money, corporations will move production to countries where
environmental regu-
lations are lax. Thus, for example, if tight environmental
standards in the United
States raise costs, a manufacturing firm might move production
to a pollution haven
such as Mexico where environmental standards are weaker. To

protect against this
possibility, environmental organizations argue that governments
should place tariffs
or other limitations on goods imported from countries where
environmental regula-
tions are lax.
Economists have studied this issue but have found little
evidence that firms do
move production in response to changes in pollution
regulations. 21 Their findings
suggest that pollution abatement costs are a relatively small
component of the cost
structure of most enterprises, and that other factors, such as
labor productivity, access
to technological know-how, and transportation costs are far
more important in deter-
mining location decisions. It is also worth noting that
migrating to a pollution haven
would violate the ethical principles of many (but not all)
organizations (see Chapter 4
for details).
In sum, although environmental concerns have not figured
significantly in trade
treaties to date, there is a good chance that they will do so in
the future, particularly
with regard to the emission of carbon dioxide and other
greenhouse gases.
ECONOMIC ARGUMENTS FOR INTERVENTION With the
develop-
ment of the new trade theory and strategic trade policy (see
Chapter 5), the eco-
nomic arguments for government intervention have undergone a
renaissance in
recent years. Until the early 1980s, most economists saw little
benefit in government

intervention and strongly advocated a free trade policy. This
position has changed at
the margins with the development of strategic trade policy,
although as we will see
in the next section, there are still strong economic arguments
for sticking to a free
trade stance.
The Infant Industry Argument The infant industry argument
is by far the
oldest economic argument for government intervention.
Alexander Hamilton pro-
posed it in 1792. According to this argument, many developing
countries have a
potential comparative advantage in manufacturing, but new
manufacturing industries
cannot initially compete with established industries in
developed countries. To allow
manufacturing to get a toehold, the argument is that
governments should temporarily
support new industries (with tariffs, import quotas, and
subsidies) until they have
grown strong enough to meet international competition.
This argument has had substantial appeal for the governments
of developing
nations during the past 50 years, and the GATT has recognized
the infant industry
argument as a legitimate reason for protectionism. Nevertheless,
many economists
remain critical of this argument for two main reasons. First,
protection of manufactur-
ing from foreign competition does no good unless the protection
helps make the
industry efficient. In case after case, however, protection seems
to have done little
more than foster the development of inefficient industries that

have little hope of ever
competing in the world market. Brazil, for example, built the
world’s tenth-largest
auto industry behind tariff barriers and quotas. Once those
barriers were removed in
the late 1980s, however, foreign imports soared, and the
industry was forced to face up
to the fact that after 30 years of protection, the Brazilian
industry was one of the
world’s most inefficient. 22
Second, the infant industry argument relies on an assumption
that firms are unable
to make efficient long-term investments by borrowing money
from the domestic
or international capital market. Consequently, governments have
been required to
Infant Industry
Argument
New industries in
developing countries
must be temporarily
protected from
international competition
to help them reach a
position where they can
compete on world
markets with the firms of
developed nations.
2010/01:07:10/MHBR169:Slavin:VY

subsidize long-term investments. Given the development of
global capital markets
over the past 20 years, this assumption no longer looks as valid
as it once did. Today,
if a developing country has a potential comparative advantage
in a manufacturing
industry, firms in that country should be able to borrow money
from the capital mar-
kets to finance the required investments. Given financial
support, firms based in
countries with a potential comparative advantage have an
incentive to endure the
necessary initial losses in order to make long-run gains without
requiring govern-
ment protection. Many Taiwanese and South Korean firms did
this in industries such
as textiles, semiconductors, machine tools, steel, and shipping.
Thus, given efficient
global capital markets, the only industries that would require
government protection
would be those that are not worthwhile.
Strategic Trade Policy Some new trade theorists have
proposed the strategic
trade policy argument. 23 We reviewed the basic argument in
Chapter 5 when we con-
sidered the new trade theory. The new trade theory argues that
in industries in which
the existence of substantial economies of scale implies that the
world market will prof-
itably support only a few firms, countries may predominate in

the export of certain
products simply because they had firms that were able to
capture first-mover advan-
tages. The long-term dominance of Boeing in the commercial
aircraft industry has
been attributed to such factors.
The strategic trade policy argument has two components.
First, it is argued that
by appropriate actions, a government can help raise national
income if it can some-
how ensure that the firm or firms that gain first-mover
advantages in an industry are
domestic rather than foreign enterprises. Thus, according to the
strategic trade pol-
icy argument, a government should use subsidies to support
promising firms that
are active in newly emerging industries. Advocates of this
argument point out that
the substantial R&D grants that the U.S. government gave
Boeing in the 1950s
and 1960s probably helped tilt the field of competition in the
newly emerging mar-
ket for passenger jets in Boeing’s favor. (Boeing’s first
commercial jet airliner, the
707, was derived from a military plane.) Similar arguments have
been made with
regard to Japan’s dominance in the production of liquid crystal
display screens (used
in laptop computers). Although these screens were invented in
the United States,
the Japanese government, in cooperation with major electronics
companies, tar-
geted this industry for research support in the late 1970s and
early 1980s. The result
was that Japanese firms, not U.S. firms, subsequently captured
first-mover advan-

tages in this market.
The second component of the strategic trade policy argument
is that it might pay a
government to intervene in an industry by helping domestic
firms overcome the bar-
riers to entry created by foreign firms that have already reaped
first-mover advantages.
This argument underlies government support of Airbus,
Boeing’s major competitor.
Formed in 1966 as a consortium of four companies from Great
Britain, France,
Germany, and Spain, Airbus had less than 5 percent of the
world commercial aircraft
market when it began production in the mid-1970s. By 2009, it
had increased its share
to 45 percent, threatening Boeing’s long-term dominance of the
market. How did
Airbus achieve this? According to the U.S. government, the
answer is a $15 billion
subsidy from the governments of Great Britain, France,
Germany, and Spain. 24 With-
out this subsidy, Airbus would never have been able to break
into the world market.
If these arguments are correct, they support a rationale for
government interven-
tion in international trade. Governments should target
technologies that may be
important in the future and use subsidies to support
development work aimed at com-
mercializing those technologies. Furthermore, government
should provide export
subsidies until the domestic firms have established first-mover
advantages in the world
Strategic Trade
Policy

Government policy aimed
at improving the
competitive position of a
domestic industry or
domestic firm in the
world market.
2010/01:07:10/MHBR169:Slavin:VY
market. Government support may also be justified if it can help
domestic firms over-
come the first-mover advantages enjoyed by foreign competitors
and emerge as viable
competitors in the world market (as in the Airbus and
semiconductor examples). In
this case, a combination of home-market protection and export-
promoting subsidies
may be needed.
The Revised Case for Free Trade
The strategic trade policy arguments of the new trade theorists
suggest an economic
justification for government intervention in international trade.
This justification chal-

lenges the rationale for unrestricted free trade found in the work
of classic trade theorists
such as Adam Smith and David Ricardo. In response to this
challenge to economic ortho-
doxy, a number of economists—including some of those
responsible for the development
of the new trade theory, such as Paul Krugman—point out that
although strategic trade
policy looks appealing in theory, in practice it may be
unworkable. This response to the
strategic trade policy argument constitutes the revised case for
free trade. 25
RETALIATION AND TRADE WAR Krugman argues that a
strategic trade
policy aimed at establishing domestic firms in a dominant
position in a global industry
is a beggar-thy-neighbor policy that boosts national income at
the expense of other
countries. A country that attempts to use such policies will
probably provoke retalia-
tion. In many cases, the resulting trade war between two or
more interventionist gov-
ernments will leave all countries involved worse off than if a
hands-off approach had
been adopted in the first place. If the U.S. government were to
respond to the Airbus
subsidy by increasing its own subsidies to Boeing, for example,
the result might be that
the subsidies would cancel each other out. In the process, both
European and U.S.
taxpayers would end up supporting an expensive and pointless
trade war, and both
Europe and the United States would be worse off.
Krugman may be right about the danger of a strategic trade
policy leading to a trade

war. The problem, however, is how to respond when one’s
competitors are already being
supported by government subsidies; that is, how should Boeing
and the United States
respond to the subsidization of Airbus? According to Krugman,
the answer is pro-
bably not to engage in retaliatory action but to help establish
rules of the game that
minimize the use of trade-distorting subsidies. This is what the
World Trade Organiza-
tion seeks to do.
DOMESTIC POLICIES Governments do not always act in the
national interest
when they intervene in the economy; politically important
interest groups often influ-
ence them. The European Union’s support for the Common
Agricultural Policy
(CAP), which arose because of the political power of French
and German farmers, is
an example. The CAP benefited inefficient farmers and the
politicians who relied on
the farm vote, but not consumers in the EU, who end up paying
more for their food-
stuffs. Thus, a further reason for not embracing strategic trade
policy, according to
Krugman, is that such a policy is almost certain to be captured
by special-interest
groups within the economy, who will distort it to their own
ends. Krugman concludes
that in the United States,
To ask the Commerce Department to ignore special-interest
politics while for-
mulating detailed policy for many industries is not realistic: To
establish a blan-

ket policy of free trade, with exceptions granted only under
extreme pressure,
may not be the optimal policy according to the theory but may
be the best policy
that the country is likely to get. 26
Summarize and explain the
arguments against strategic
trade policy.
2010/01:07:10/MHBR169:Slavin:VY
Development of the World Trading System
Strong economic arguments support unrestricted free trade.
While many govern-
ments have recognized the value of these arguments, they have
been unwilling to uni-
laterally lower their trade barriers for fear that other nations
might not follow suit.
Consider the problem that two neighboring countries, say,
Brazil and Argentina, face
when deciding whether to lower trade barriers between them. In
principle, the gov-
ernment of Brazil might favor lowering trade barriers, but it
might be unwilling to do

so for fear that Argentina will not do the same. Instead, the
government might fear
that the Argentineans will take advantage of Brazil’s low
barriers to enter the Brazilian
market, while at the same time continuing to shut Brazilian
products out of their mar-
ket through high trade barriers. The Argentinean government
might believe that it
faces the same dilemma. The essence of the problem is a lack of
trust. Both govern-
ments recognize that their respective nations will benefit from
lower trade barriers
between them, but neither government is willing to lower
barriers for fear that the
other might not follow. 27
Such a deadlock can be resolved if both countries negotiate a
set of rules to govern
cross-border trade and lower trade barriers. But who is to
monitor the governments to
make sure they are playing by the trade rules? And who is to
impose sanctions on a
government that cheats? Both governments could set up an
independent body to act
as a referee. This referee could monitor trade between the
countries, make sure that
no side cheats, and impose sanctions on a country if it does
cheat in the trade game.
While it might sound unlikely that any government would
compromise its national
sovereignty by submitting to such an arrangement, since World
War II an international
trading framework has evolved that has exactly these features.
For its first 50 years,
this framework was known as the General Agreement on Tariffs
and Trade. Since
1995, it has been known as the World Trade Organization. Here

we look at the evolu-
tion and workings of the GATT and WTO.
FROM SMITH TO THE GREAT DEPRESSION As noted in
Chapter 5,
the theoretical case for free trade dates to the late eighteenth
century and the work of
Adam Smith and David Ricardo. Free trade as a government
policy was first officially
embraced by Great Britain in 1846, when the British Parliament
repealed the Corn
Laws. The Corn Laws placed a high tariff on imports of foreign
corn. The objectives
of the Corn Laws tariff were to raise government revenues and
to protect British corn
producers. There had been annual motions in Parliament in
favor of free trade since
the 1820s when David Ricardo was a member. However,
agricultural protection was
withdrawn only as a result of a protracted debate when the
effects of a harvest failure
in Great Britain were compounded by the imminent threat of
famine in Ireland. Faced
with considerable hardship and suffering among the populace,
Parliament narrowly
reversed its long-held position.
During the next 80 years or so, Great Britain, as one of the
world’s dominant trad-
ing powers, pushed the case for trade liberalization; but the
British government was a
voice in the wilderness. Its major trading partners did not
reciprocate the British pol-
icy of unilateral free trade. The only reason Britain kept this
policy for so long was
that as the world’s largest exporting nation, it had far more to
lose from a trade war

than did any other country.
By the 1930s, the British attempt to stimulate free trade was
buried under the eco-
nomic rubble of the Great Depression. The Great Depression
had roots in the failure
of the world economy to mount a sustained economic recovery
after the end of World
War I in 1918. Things got worse in 1929 with the U.S. stock
market collapse and the
subsequent run on the U.S. banking system. Economic problems
were compounded
Describe the development
of the world trading system
and the current trade
issues.
2010/01:07:10/MHBR169:Slavin:VY
in 1930 when the U.S. Congress passed the Smoot-Hawley
tariff. Aimed at avoiding
rising unemployment by protecting domestic industries and
diverting consumer de-
mand away from foreign products, the Smoot-Hawley Act
erected an enormous wall
of tariff barriers. Almost every industry was rewarded with its

“made-to-order” tariff.
A particularly odd aspect of the Smoot-Hawley tariff-raising
binge was that the
United States was running a balance-of-payment surplus at the
time and it was the
world’s largest creditor nation. The Smoot-Hawley Act had a
damaging effect on
employment abroad. Other countries reacted to the U.S. action
by raising their own
tariff barriers. U.S. exports tumbled in response, and the world
slid further into the
Great Depression. 28
1947–1979: GATT, TRADE LIBERALIZATION, AND
ECONOMIC
GROWTH Economic damage caused by the beggar-thy-
neighbor trade policies
that the Smoot-Hawley Act ushered in exerted a profound
influence on the economic
institutions and ideology of the post–World War II world. The
United States emerged
from the war both victorious and economically dominant. After
the debacle of the
Great Depression, opinion in the U.S. Congress had swung
strongly in favor of free
trade. Under U.S. leadership, the GATT was established in
1947.
The GATT was a multilateral agreement whose objective was
to liberalize trade by
eliminating tariffs, subsidies, import quotas, and the like. From
its foundation in 1947
until it was superseded by the WTO, the GATT’s membership
grew from 19 to more
than 120 nations. The GATT did not attempt to liberalize trade
restrictions in one fell
swoop; that would have been impossible. Rather, tariff

reduction was spread over eight
rounds. The last, the Uruguay Round, was launched in 1986 and
completed in
December 1993. In these rounds, mutual tariff reductions were
negotiated among all
members, who then committed themselves not to raise import
tariffs above negotiated
rates. GATT regulations were enforced by a mutual monitoring
mechanism. If a
country believed that one of its trading partners was violating a
GATT regulation, it
could ask the Geneva-based bureaucracy that administered the
GATT to investigate.
If GATT investigators found the complaints to be valid, member
countries could be
asked to pressure the offending party to change its policies. In
general, such pressure
was sufficient to get an offending country to change its policies.
If it were not, the
offending country could be expelled from the GATT.
In its early years, the GATT was by most measures very
successful. For example,
the average tariff declined by nearly 92 percent in the United
States between the
Geneva Round of 1947 and the Tokyo Round of 1973–79.
Consistent with the the-
oretical arguments first advanced by Ricardo and reviewed in
Chapter 5, the move
toward free trade under the GATT appeared to stimulate
economic growth. From
1953 to 1963, world trade grew at an annual rate of 6.1 percent,
and world income
grew at an annual rate of 4.3 percent. Performance from 1963 to
1973 was even
better; world trade grew at 8.9 percent annually, and world
income grew at 5.1 per-

cent annually. 29
1980–1993: PROTECTIONIST TRENDS During the 1980s
and early
1990s, the world trading system erected by the GATT came
under strain as pres-
sures for greater protectionism increased around the world.
Three reasons caused
the rise in such pressures during the 1980s. First, the economic
success of Japan
strained the world trading system. Japan was in ruins when the
GATT was created.
By the early 1980s, however, it had become the world’s second-
largest economy and
its largest exporter. Japan’s success in such industries as
automobiles and semicon-
ductors might have been enough to strain the world trading
system. Things were
made worse by the widespread perception in the West that
despite low tariff rates
Smoot-Hawley Act
Enacted in 1930 by the
U.S. Congress, this tariff
erected a wall of barriers
against imports into the
United States.
2010/01:07:10/MHBR169:Slavin:VY

and subsidies, Japanese markets were closed to imports and
foreign investment by
administrative trade barriers.
Second, the world trading system was strained by the
persistent trade deficit in
the world’s largest economy, the United States. Although the
deficit peaked in 1987
at more than $170 billion, by the end of 1992 the annual rate
was still running about
$80 billion. From a political perspective, the matter was
worsened in 1992 by the
$45 billion U.S. trade deficit with Japan, a country perceived as
not playing by the
rules. The consequences of the U.S. deficit included painful
adjustments in indus-
tries such as automobiles, machine tools, semiconductors, steel,
and textiles, where
domestic producers steadily lost market share to foreign
competitors. The resulting
unemployment gave rise to renewed demands in the U.S.
Congress for protection
against imports.
A third reason for the trend toward greater protectionism was
that many countries
found ways to get around GATT regulations. Bilateral voluntary
export restraints, or
VERs, circumvent GATT agreements, because neither the
importing country nor the
exporting country complain to the GATT bureaucracy in
Geneva—and without a com-
plaint, the GATT bureaucracy can do nothing. Exporting
countries agree to VERs to
avoid more damaging punitive tariffs. One of the best-known

examples is the automo-
bile VER between Japan and the United States, under which
Japanese producers
promised to limit their auto imports into the United States as a
way of defusing grow-
ing trade tensions. According to a World Bank study, 13 percent
of the imports of
industrialized countries in 1981 were subjected to nontariff
trade barriers such as
VERs. By 1986, this figure had increased to 16 percent. The
most rapid rise was in the
United States, where the value of imports affected by nontariff
barriers (primarily
VERs) increased by 23 percent between 1981 and 1986. 30
THE URUGUAY ROUND AND THE WORLD TRADE
ORGANIZATION
Against the background of rising pressures for protectionism, in
1986 GATT mem-
bers embarked on their eighth round of negotiations to reduce
tariffs, the Uruguay
Round (so named because it occurred in Uruguay). This was the
most difficult round
of negotiations yet, primarily because it was also the most
ambitious. Until then,
GATT rules had applied only to trade in manufactured goods
and commodities. In the
Uruguay Round, member countries sought to extend GATT rules
to cover trade in
services. They also sought to write rules governing the
protection of intellectual prop-
erty, to reduce agricultural subsidies, and to strengthen the
GATT’s monitoring and
enforcement mechanisms.
The Uruguay Round dragged on for seven years before an
agreement was reached

December 15, 1993. It went into effect July 1, 1995. The
Uruguay Round contained
the following provisions:
1. Tariffs on industrial goods were to be reduced by more
than one-third, and tariffs
were to be scrapped on more than 40 percent of manufactured
goods.
2. Average tariff rates imposed by developed nations on
manufactured goods were to
be reduced to less than 4 percent of value, the lowest level in
modern history.
3. Agricultural subsidies were to be substantially reduced.
4. GATT fair trade and market access rules were to be
extended to cover a wide
range of services.
5. GATT rules also were to be extended to provide enhanced
protection for patents,
copyrights, and trademarks (intellectual property).
6. Barriers on trade in textiles were to be significantly
reduced over 10 years.
7. The World Trade Organization was to be created to
implement the GATT
agreement.
2010/01:07:10/MHBR169:Slavin:VY

Services and Intellectual Property In the long run, the
extension of GATT
rules to cover services and intellectual property may be
particularly significant. Until
1995, GATT rules applied only to industrial goods (i.e.,
manufactured goods and com-
modities). In 2007, world trade in services amounted to $3.260
billion (compared to
world trade in goods of $13,570 billion). 31 Ultimately,
extension of GATT rules to this
important trading arena could significantly increase both the
total share of world trade
accounted for by services and the overall volume of world trade.
The extension of
GATT rules to cover intellectual property will make it much
easier for high- technology
companies to do business in developing nations where
intellectual property rules his-
torically have been poorly enforced (see Chapter 2 for details).
The World Trade Organization The clarification and
strengthening of GATT
rules and the creation of the World Trade Organization also
hold out the promise of
more effective policing and enforcement of GATT rules. The
WTO acts as an um-
brella organization that encompasses the GATT along with two
new sister bodies, one
on services and the other on intellectual property. The WTO’s
General Agreement on
Trade in Services (GATS) has taken the lead to extending free

trade agreements to
services. The WTO’s Agreement on Trade-Related Aspects of
Intellectual Property
Rights (TRIPS) is an attempt to narrow the gaps in the way
intellectual property
rights are protected around the world and to bring them under
common international
rules. WTO has taken over responsibility for arbitrating trade
disputes and monitor-
ing the trade policies of member countries. While the WTO
operates on the basis of
consensus as the GATT did, in the area of dispute settlement,
member countries are
no longer able to block adoption of arbitration reports.
Arbitration panel reports on
trade disputes between member countries are automatically
adopted by the WTO un-
less there is a consensus to reject them. Countries that have
been found by the arbitra-
tion panel to violate GATT rules may appeal to a permanent
appellate body, but its
verdict is binding. If offenders fail to comply with the
recommendations of the arbitra-
tion panel, trading partners have the right to compensation or,
in the last resort, to
impose (commensurate) trade sanctions. Every stage of the
procedure is subject to
strict time limits. Thus, the WTO has something that the GATT
never had—teeth. 32
WTO: Experience to Date By 2010, the WTO had 153
members, including
China, which joined at the end of 2001, who collectively
account for 97 percent of
world trade. Another 25 countries, including the Russian
Federation, were negotiating

for membership. Since its formation, the WTO has remained at
the forefront of efforts
to promote global free trade. Its creators expressed the hope that
the enforcement
mechanisms granted to the WTO would make it more effective
than the GATT had
been at policing global trade rules. The great hope was that the
WTO might emerge as
an effective advocate and facilitator of future trade deals,
particularly in areas such as
services. The experience so far has been encouraging, although
the collapse of WTO
talks in Seattle in late 1999, slow progress with the next round
of trade talks (the Doha
Round), and a shift back toward some limited protectionism in
2008–2009 have raised
a number of questions about the future direction of the WTO.
WTO as Global Police The first decade in the life of the WTO
suggests that its
policing and enforcement mechanisms are having a positive
effect. 33 Between 1995 and
early 2010 more than 400 trade disputes between member
countries were brought to
the WTO. 34 This record compares with a total of 196 cases
handled by the GATT over
almost half a century. Of the cases brought to the WTO, three-
fourths had been
resolved by informal consultations between the disputing
countries. Resolving the
remainder has involved more formal procedures, but these have
been largely successful.

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In general, countries involved have adopted the WTO’s
recommendations. The fact
that countries are using the WTO represents an important vote
of confidence in the
organization’s dispute resolution procedures.
Expanding Trade Agreements As explained above, the
Uruguay Round of
GATT negotiations extended global trading rules to cover trade
in services. The
WTO was given the role of brokering future agreements to open
global trade in ser-
vices. The WTO was also encouraged to extend its reach to
encompass regulations
governing foreign direct investment, something the GATT had
never done. Two of
the first industries targeted for reform were the global
telecommunication and finan-
cial services industries.
In February 1997, the WTO brokered a deal to get countries to
agree to open
their telecommunication markets to competition, allowing
foreign operators to pur-
chase ownership stakes in domestic telecommunication
providers and establishing a
set of common rules for fair competition. Under the pact, 68
countries accounting for
more than 90 percent of world telecommunication revenues

pledged to start opening
their markets to foreign competition and to abide by common
rules for fair competi-
tion in telecommunications. Most of the world’s biggest
markets, including the
United States, European Union, and Japan, were fully
liberalized by January 1, 1998,
when the pact went into effect. All forms of basic
telecommunication service are cov-
ered, including voice telephony, data and fax transmissions, and
satellite and radio
communications. Many telecommunication companies
responded positively to the
deal, pointing out that it would give them a much greater ability
to offer their busi-
ness customers one-stop shopping—a global, seamless service
for all their corporate
needs and a single bill. 35
This was followed in December 1997 with an agreement to
liberalize cross-border
trade in financial services. 36 The deal covers more than 95
percent of the world’s
financial services market. Under the agreement, which took
effect at the beginning of
March 1999, 102 countries pledged to open to varying degrees
their banking, securi-
ties, and insurance sectors to foreign competition. In common
with the telecommuni-
cation deal, the accord covers not just cross-border trade but
also foreign direct
investment. Seventy countries agreed to dramatically lower or
eradicate barriers to
foreign direct investment in their financial services sector. The
United States and the
European Union, with minor exceptions, are fully open to
inward investment by for-

eign banks, insurance, and securities companies. As part of the
deal, many Asian coun-
tries made important concessions that allow
significant foreign participation in their financial ser-
vices sectors for the first time.
The WTO in Seattle: A Watershed? At the
end of November 1999, representatives from the
WTO’s member states met in Seattle, Washington.
The goal of the meeting was to launch a new round
of talks—dubbed “the millennium round”—aimed at
further reducing barriers to cross-border trade and
investment. Prominent on the agenda was an attempt
to get the assembled countries to agree to work to-
ward the reduction of barriers to cross-border trade
in agricultural products and trade and investment in
services.
These expectations were dashed on the rocks of
a hard and unexpected reality. The talks ended
WTO protesters gather in front of the Niketown store at Fifth
Avenue and
Pike Street in downtown Seattle before the opening of the WTO
session
in 1999.
2010/01:07:10/MHBR169:Slavin:VY

December 3, 1999, without any agreement being reached.
Inside the meeting rooms,
the problem was an inability to reach consensus on the primary
goals for the next
round of talks. A major stumbling block was friction between
the United States and
the European Union over whether to endorse the aim of
ultimately eliminating subsi-
dies to agricultural exporters. The United States wanted the
elimination of such sub-
sidies to be a priority. The EU, with its politically powerful
farm lobby and long
history of farm subsidies, was unwilling to take this step.
Another stumbling block was
related to efforts by the United States to write “basic labor
rights” into the law of the
world trading system. The United States wanted the WTO to
allow governments to
impose tariffs on goods imported from countries that did not
abide by what the United
States saw as fair labor practices. Representatives from
developing nations reacted an-
grily to this proposal, suggesting it was simply an attempt by
the United States to find
a legal way of restricting imports from poorer nations.
While the disputes inside the meeting rooms were
acrimonious, it was events out-
side that captured the attention of the world press. The WTO
talks proved to be a
lightning rod for a diverse collection of organizations from
environmentalists and
human rights groups to labor unions. For various reasons, these
groups oppose free

trade. All these organizations argued that the WTO is an
undemocratic institution
that was usurping the national sovereignty of member states and
making decisions of
great importance behind closed doors. They took advantage of
the Seattle meetings to
voice their opposition, which the world press recorded.
Environmentalists expressed concern about the impact that
free trade in agricul-
tural products might have on the rate of global deforestation.
They argued that lower
tariffs on imports of lumber from developing nations will
stimulate demand and
accelerate the rate at which virgin forests are logged,
particularly in nations such as
Malaysia and Indonesia. They also pointed to the adverse
impact that some WTO
rulings have had on environmental policies. For example, the
WTO had blocked a
U.S. rule that ordered shrimp nets be equipped with a device
that allows endangered
sea turtles to escape. The WTO found the rule discriminated
against foreign import-
ers who lacked such nets. 37 Environmentalists argued that the
rule was necessary to
protect the turtles from extinction.
Human rights activists see WTO rules as outlawing the ability
of nations to stop
imports from countries where child labor is used or working
conditions are hazardous.
Similarly, labor unions oppose trade laws that allow imports
from low-wage countries
and result in a loss of jobs in high-wage countries. They
buttress their position by
arguing that American workers are losing their jobs to imports
from developing

nations that do not have adequate labor standards.
Supporters of the WTO and free trade dismiss these concerns.
They have repeat-
edly pointed out that the WTO exists to serve the interests of its
member states, not
subvert them. The WTO lacks the ability to force any member
nation to take an
action to which it is opposed. The WTO can allow member
nations to impose retalia-
tory tariffs on countries that do not abide by WTO rules, but
that is the limit of its
power. Furthermore, supporters argue, it is rich countries that
pass strict environmen-
tal laws and laws governing labor standards, not poor ones. In
their view, free trade, by
raising living standards in developing nations, will be followed
by the passage of such
laws in these nations. Using trade regulations to try to impose
such practices on devel-
oping nations, they believe, will produce a self-defeating
backlash.
Many representatives from developing nations, which make up
about 70 percent
of the WTO’s members, also reject the position taken by
environmentalists and advo-
cates of human and labor rights. Poor countries, which depend
on exports to boost
their economic growth rates and work their way out of poverty,
fear that rich coun-
tries will use environmental concerns, human rights, and labor-
related issues to erect

2010/01:07:10/MHBR169:Slavin:VY
barriers to the products of the developing world. They believe
that attempts to incor-
porate language about the environment or labor standards in
future trade agreements
will amount to little more than trade barriers by another name.
38 If this were to oc-
cur, they argue that the effect would be to trap the developing
nations of the world in
a grinding cycle of poverty and debt.
These pro-trade arguments fell on deaf ears. As the WTO
representatives gathered
in Seattle, environmentalists, human rights activists, and labor
unions marched in the
streets. Some of the more radical elements in these
organizations, together with
groups of anarchists who were philosophically opposed to
“global capitalism” and “the
rape of the world by multinationals,” succeeded not only in
shutting down the opening
ceremonies of the WTO but also in sparking violence in the
normally peaceful streets
of Seattle. A number of demonstrators damaged property and
looted; and the police
responded with tear gas, rubber bullets, pepper spray, and baton
charges. When it was
over, 600 demonstrators had been arrested, millions of dollars
in property had been
damaged in downtown Seattle, and the global news media had
their headline: “WTO

Talks Collapse amid Violent Demonstrations.”
What happened in Seattle is notable because it may have been
a watershed of sorts.
In the past, previous trade talks were pursued in relative
obscurity with only interested
economists, politicians, and businesspeople paying much
attention. Seattle demon-
strated that the issues surrounding the global trend toward free
trade have moved to
center stage in the popular consciousness, and they have
remained there since. The
debate on the merits of free trade and globalization has become
mainstream. Whether
further liberalization occurs, therefore, may depend on the
importance that popular
opinion in countries such as the United States attaches to issues
such as human rights
and labor standards, job security, environmental policies, and
national sovereignty. It
will also depend on the ability of advocates of free trade to
articulate in a clear and
compelling manner the argument that, in the long run, free trade
is the best way of
promoting adequate labor standards, of providing more jobs,
and of protecting the
environment.
THE FUTURE OF THE WTO: UNRESOLVED ISSUES AND
THE
DOHA ROUND Much remains to be done on the international
trade front. Four
issues at the forefront of the current agenda of the WTO are the
increase in anti-
dumping policies, the high level of protectionism in agriculture,
the lack of strong
protection for intellectual property rights in many nations, and

continued high tariff
rates on nonagricultural goods and services in many nations. We
shall look at each in
turn before discussing the latest round of talks between WTO
members aimed at
reducing trade barriers, the Doha Round, which began in 2001
and were still ongoing
as of 2010.
Antidumping Actions Antidumping actions proliferated during
the 1990s. WTO
rules allow countries to impose antidumping duties on foreign
goods that are being
sold cheaper than at home, or below their cost of production,
when domestic produc-
ers can show that they are being harmed. Unfortunately, the
rather vague definition of
what constitutes “dumping” has proved to be a loophole that
many countries are ex-
ploiting to pursue protectionism.
Between 1995 and 2008, WTO members had reported
implementation of some
3,427 antidumping actions to the WTO. India initiated the
largest number of anti-
dumping actions, some 564; the EU initiated 391 over the same
period, and the United
States 418 (see Figure 6.2). Antidumping actions seem to be
concentrated in certain
sectors of the economy such as basic metal industries (e.g.,
aluminum and steel),
chemicals, plastics, and machinery and electrical equipment. 39
These sectors account

2010/01:07:10/MHBR169:Slavin:VY
for some 70 percent of all antidumping actions reported to the
WTO. These four sec-
tors since 1995 have been characterized by periods of intense
competition and excess
productive capacity, which have led to low prices and profits
(or losses) for firms in
those industries. It is not unreasonable, therefore, to
hypothesize that the high level of
antidumping actions in these industries represents an attempt by
beleaguered manu-
facturers to use the political process in their nations to seek
protection from foreign
competitors, who they claim are engaging in unfair competition.
While some of these
claims may have merit, the process can become very politicized
as representatives of
businesses and their employees lobby government officials to
“protect domestic jobs
from unfair foreign competition,” and government officials,
mindful of the need to get
votes in future elections, oblige by pushing for antidumping
actions. The WTO is
clearly worried by this trend, suggesting that it reflects
persistent protectionist ten-
dencies and pushing members to strengthen the regulations
governing the imposition
of antidumping duties.
Figure 6.2 suggests that antidumping actions peaked in the

1999-2001 time period
and declined thereafter. However, the WTO reported a rise in
antidumping actions in
2008 and 2009 as the global financial crisis took hold (the 2009
data are not included
in Figure 6.2, since at the time of writing the data had not been
finalized). Many of
these actions seem to have been a direct response to the decline
in global demand that
followed the financial crisis and suggest that countries were
using antidumping actions
as a means of protecting domestic producers. The most frequent
target of these ac-
tions was China.
Protectionism in Agriculture Another recent focus of the
WTO has been the
high level of tariffs and subsidies in the agricultural sector of
many economies. Tariff
rates on agricultural products are generally much higher than
tariff rates on manufac-
tured products or services. For example, in the mid-2000s the
average tariff rates on
nonagricultural products were 4.2 percent for Canada, 3.8
percent for the European
Union, 3.9 percent for Japan, and 4.4 percent for the United
States. On agricultural
products, however, the average tariff rates were 21.2 percent for
Canada, 15.9 percent
for the European Union, 18.6 percent for Japan, and 10.3
percent for the United
400
50

100
150
200
250
300
350
0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
20062005 2007 2008
Rest of the WorldUnited StatesIndiaEuropean Community
N
um
be
r o
f a
gr
ee
m
en
ts
6.2 figure

Antidumping Actions,
1995–2008
Source: Constructed by author from
WTO data.
2010/01:07:10/MHBR169:Slavin:VY
States. 40 The implication is that consumers in these
countries are paying significantly higher prices
than necessary for agricultural products imported
from abroad, which leaves them with less money to
spend on other goods and services.
The historically high tariff rates on agricultural
products reflect a desire to protect domestic agri-
culture and traditional farming communities from
foreign competition. In addition to high tariffs, ag-
ricultural producers also benefit from substantial
subsidies. According to estimates from the Organi-
zation for Economic Cooperation and Develop-
ment (OECD), government subsidies on average
account for some 17 percent of the cost of agricul-
tural production in Canada, 21 percent in the
United States, 35 percent in the European Union,
and 59 percent in Japan. 41 In total, OECD coun-
tries spend more than $300 billion a year in subsi-

dies to agricultural producers.
Not surprising, the combination of high tariff
barriers and significant subsidies introduces sig-
nificant distortions into the production of agricultural products
and international
trade of those products. The net effect is to raise prices to
consumers, reduce the
volume of agricultural trade, and encourage the overproduction
of products that are
heavily subsidized (with the government typically buying the
surplus). Because global
trade in agriculture currently amounts to 10.5 percent of total
merchandized trade,
or about $750 billion per year, the WTO argues that removing
tariff barriers and
subsidies could significantly boost the overall level of trade,
lower prices to consum-
ers, and raise global economic growth by freeing consumption
and investment re-
sources for more productive uses. According to estimates from
the International
Monetary Fund, removal of tariffs and subsidies on agricultural
products would raise
global economic welfare by $128 billion annually. 42 Others
suggest gains as high as
$182 billion. 43
The biggest defenders of the existing system have been the
advanced nations of the
world, which want to protect their agricultural sectors from
competition by low-cost
producers in developing nations. In contrast, developing nations
have been pushing
hard for reforms that would allow their producers greater access
to the protected mar-

kets of the developed nations. Estimates suggest that removing
all subsidies on agri-
cultural production alone in OECD countries could return to the
developing nations
of the world three times more than all the foreign aid they
currently receive from the
OECD nations. 44 In other words, free trade in agriculture
could help to jump-start
economic growth among the world’s poorer nations and
alleviate global poverty.
Protecting Intellectual Property Another issue that has
become increasingly
important to the WTO has been protecting intellectual property.
The 1995 Uru-
guay agreement that established the WTO also contained an
agreement to protect
intellectual property (the Trade-Related Aspects of Intellectual
Property Rights, or
TRIPS, agreement). The TRIPS regulations oblige WTO
members to grant and
enforce patents lasting at least 20 years and copyrights lasting
50 years. Rich coun-
tries had to comply with the rules within a year. Poor countries,
in which such pro-
tection generally was much weaker, had five years’ grace, and
the very poorest had
Brazil Wins against U.S. Cotton
The United States is known for aggressively protecting its
agriculture from overseas competition, but this time it may
carry a cost.
Claiming for years U.S. subsidies drove down cotton
prices worldwide, Brazil recently won its suit against the

United States before the World Trade Organization (WTO).
Not only does the WTO ruling permit Brazil to retaliate
against the United States, but it also apparently gives Brazil
the right to breach U.S. patents. Accordingly, Brazil said it
would impose higher tariffs on U.S. goods totaling nearly
$830 million per year, with about $240 million targeting intel-
lectual property. That’s likely to hit America where it lives.
(“Brazil Takes on Washington,” Forbes, March 26, 2010,
www.forbes.com; “Brazil, U.S.: An Intellectual Property
Precedent,” Stratfor.com, February 11, 2010, www.stratfor.
com; and Steve LeVine, “Brazil Bests U.S. in Cotton Battle,”
BusinessWeek, August 31, 2009, www.businessweek.com)
2010/01:07:10/MHBR169:Slavin:VY
10 years. The basis for this agreement was a strong belief
among signatory nations
that the protection of intellectual property through patents,
trademarks, and copy-
rights must be an essential element of the international trading
system. Inadequate
protections for intellectual property reduce the incentive for
innovation. Because
innovation is a central engine of economic growth and rising
living standards, the
argument has been that a multilateral agreement is needed to
protect intellectual

property.
Without such an agreement it is feared that producers in a
country, let’s say India,
might market imitations of patented innovations pioneered in a
different country, say
the United States. This can affect international trade in two
ways. First, it reduces the
export opportunities in India for the original innovator in the
United States. Second,
to the extent that the Indian producer is able to export its
pirated imitation to addi-
tional countries, it also reduces the export opportunities in those
countries for the U.S.
inventor. Also, one can argue that because the size of the total
world market for the
innovator is reduced, its incentive to pursue risky and expensive
innovations is also
reduced. The net effect would be less innovation in the world
economy and less eco-
nomic growth.
Something very similar to this has been occurring in the
pharmaceutical industry,
with Indian drug companies making copies of patented drugs
discovered elsewhere. In
1970, the Indian government stopped recognizing product
patents on drugs, but it
elected to continue respecting process patents. This permitted
Indian companies to
reverse-engineer Western pharmaceuticals without paying
licensing fees. As a result,
foreigners’ share of the Indian drug market fell from 75 percent
in 1970 to 30 percent
in 2000. For example, an Indian company sells a version of
Bayer’s patented antibiotic
Cipro for $0.12 a pill, versus the $5.50 it costs in the United
States. Under the WTO

TRIPS agreement, India agreed to adopt and enforce the
international drug patent
regime by 2005. 45
As noted in Chapter 2, intellectual property rights violation is
also an endemic
problem in several other industries, most notably computer
software and music. The
WTO believes that reducing piracy rates in areas such as drugs,
software, and music
recordings would have a significant impact on the volume of
world trade and increase
the incentive for producers to invest in the creation of
intellectual property. A world
without piracy would have more new drugs, computer software,
and music recordings
produced every year. In turn, this would boost economic and
social welfare, and
global economic growth rates. It is thus in the interests of WTO
members to make
sure that intellectual property rights are respected and enforced.
While the 1995
Uruguay agreement that created the WTO did make headway
with the TRIPS agree-
ment, some believe these requirements do not go far enough and
further commit-
ments are necessary.
Market Access for Nonagricultural Goods and Services
Although the
WTO and the GATT have made big strides in reducing the tariff
rates on nonagricul-
tural products, much work remains. Although most developed
nations have brought
their tariff rates on industrial products down to an average of
3.8 percent of value,
exceptions still remain. In particular, while average tariffs are

low, high tariff rates per-
sist on certain imports into developed nations, which limit
market access and eco-
nomic growth. For example, Australia and South Korea, both
OECD countries, still
have bound tariff rates of 15.1 percent and 24.6 percent,
respectively, on imports of
transportation equipment (bound tariff rates are the highest rate
that can be charged,
which is often, but not always, the rate that is charged). In
contrast, the bound tariff
rates on imports of transportation equipment into the United
States, EU, and Japan
2010/01:07:10/MHBR169:Slavin:VY
are 2.7 percent, 4.7 percent, and 0 percent, respectively (see
Table 6.1). A particular
area for concern is high tariff rates on imports of selected goods
from developing na-
tions into developed nations.
In addition, tariffs on services remain higher than on industrial
goods. The average
tariff on business and financial services imported into United
States, for example, is
8.2 percent, into the EU it is 8.5 percent, and into Japan it is
19.7 percent. 46 Given the

rising value of cross-border trade in services, reducing these
figures can be expected to
yield substantial gains.
The WTO would like to bring down tariff rates still further and
reduce the scope
for the selective use of high tariff rates. The ultimate aim is to
reduce tariff rates to
zero. Although this might sound ambitious, 40 nations have
already moved to zero
tariffs on information technology goods, so a precedent exists.
Empirical work sug-
gests that further reductions in average tariff rates toward zero
would yield substantial
gains. One estimate by economists at the World Bank suggests
that a broad global
trade agreement coming out of the current Doha negotiations
could increase world
income by $263 billion annually, of which $109 billion would
go to poor countries. 47
Another estimate from the OECD suggests a figure closer to
$300 billion annually. 48
See the accompanying Country Focus for estimates of the
benefits to the American
economy from free trade.
Looking further out, the WTO would like to bring down tariff
rates on imports of
nonagricultural goods into developing nations. Many of these
nations use the infant
industry argument to justify the continued imposition of high
tariff rates; however,
ultimately these rates need to come down for these nations to
reap the full benefits of
international trade. For example, the bound tariff rates of 53.9
transportation equipment into India and 33.6 percent on imports
into Brazil, by rais-

ing domestic prices, help to protect inefficient domestic
producers and limit economic
growth by reducing the real income of consumers who must pay
more for transporta-
tion equipment and related services.
A New Round of Talks: Doha Antidumping actions, trade
in agricultural
products, better enforcement of intellectual property laws, and
expanded market
access were four of the issues the WTO wanted to tackle at the
1999 meetings in
Seattle, but those meetings were derailed. In late 2001, the
WTO tried again to
launch a new round of talks between member states aimed at
further liberalizing
the global trade and investment framework. For this meeting, it
picked the remote
location of Doha in the Persian Gulf state of Qatar, no doubt
with an eye on the
Canada 2.8% 6.8% 5.2%
United States 1.8 2.7 2.1
Brazil 33.4 33.6 31.9
Mexico 34.7 35.8 34.1
European Union 1.6 4.7 3.3
Australia 4.5 15.1 13.3
Japan 0.9 0.0 0.2
South Korea 7.7 24.6 16.1

Country Metals Transportation Equipment Electric
Machinerytable 6.1
Bound Tariffs on Select
Industrial Products
(simple averages)
Source: WTO.
2010/01:07:10/MHBR169:Slavin:VY
difficulties that antiglobalization protesters would have in
getting there. Unlike the
Seattle meetings, at Doha, the member states of the WTO agreed
to launch a new
round of talks and staked out an agenda. The talks were
originally scheduled to last
three years, although they have already gone on longer and may
not be concluded
for a while.
The agenda includes cutting tariffs on industrial goods and
services, phasing out
subsidies to agricultural producers, reducing barriers to cross-
border investment,
and limiting the use of antidumping laws. Some difficult

compromises were made
to reach agreement on this agenda. The EU and Japan had to
give significant
ground on the issue of agricultural subsidies, which are used
extensively by both
entities to support politically powerful farmers. The United
States bowed to pres-
sure from virtually every other nation to negotiate revisions of
antidumping rules,
which the United States has used extensively to protect its steel
producers from
foreign competition. Europe had to scale back its efforts to
include environmental
policy in the trade talks, primarily because of pressure from
developing nations that
see environmental protection policies as trade barriers by
another name. Excluded
from the agenda was any language pertaining to attempts to tie
trade to labor stan-
dards in a country.
Countries with big pharmaceutical sectors acquiesced to
demands from African,
Asian, and Latin American nations on the issue of drug patents.
Specifically, the lan-
guage in the agreement declares that WTO regulation on
intellectual property “does
not and should not prevent members from taking measures to
protect public health.”
This language was meant to assure the world’s poorer nations
that they can make or
buy generic equivalents to fight such killers as AIDS and
malaria.
Estimating the Gains from Trade for America
A study published by the Institute for International Eco-

nomics tried to estimate the gains to the American econ-
omy from free trade. According to the study, due to
reductions in tariff barriers under the GATT and WTO since
1947, by 2003 the GDP of the United States was 7.3 percent
higher than would otherwise be the case. The benefits of
that amount to roughly $1 trillion a year, or $9,000 extra
income for each American household per year.
The same study tried to estimate what would happen if
America reached free trade deals with all its trading part-
ners, reducing tariff barriers on all goods and services to
zero. Using several methods to estimate the impact, the
study concluded that additional annual gains of between
$450 billion and $1.3 trillion could be realized. This final
march to free trade, according to the authors of the study,
could safely be expected to raise incomes of the average
American household by an additional $4,500 per year.
The authors also tried to estimate the scale and cost of
employment disruption that would be caused by a move to
universal free trade. Jobs would be lost in certain sectors
and gained in others if the country abolished all tariff
barriers. Using historical data as a guide, they estimated
that 226,000 jobs would be lost every year due to expanded
trade, although some two-thirds of those losing jobs would
find reemployment after a year. Reemployment, however,
would be at a wage that was 13 to 14 percent lower. The
study concluded that the disruption costs would total some
$54 billion annually, primarily in the form of lower lifetime
wages to those whose jobs were disrupted as a result of
free trade. Offset against this, however, must be the higher
economic growth resulting from free trade, which creates
many new jobs and raises household incomes, creating
another $450 billion to $1.3 trillion annually in net gains to
the economy. In other words, the estimated annual gains
from trade are far greater than the estimated annual costs
associated with job disruption, and more people benefit

than lose as result of shift to a universal free trade regime.
Source: S. C. Bradford, P. L. E. Grieco, and G. C. Hufbauer,
“The Payoff to
America from Global Integration,” in The United States and the
World
Economy: Foreign Policy for the Next Decade, ed. C. F.
Bergsten
(Washington, DC: Institute for International Economics, 2005).
3 Country FOCUS
2010/01:07:10/MHBR169:Slavin:VY
Focus on Managerial Implications
What are the implications of all this for business practice? Why
should the interna-
tional manager care about the political economy of free trade or
about the relative
merits of arguments for free trade and protectionism? There are
two answers to this
question. The first concerns the impact of trade barriers on a
firm’s strategy. The
second concerns the role that business firms can play in
promoting free trade or
trade barriers.

Trade Barriers and Firm Strategy
To understand how trade barriers affect a firm’s strategy,
consider first the material in
Chapter 5. Drawing on the theories of international trade, we
discussed how it makes
sense for the firm to disperse its various production activities to
those countries around
the globe where they can be performed most efficiently. Thus, it
may make sense for a
Clearly, it is one thing to agree to an agenda and quite another
to reach a consensus
on a new treaty. Nevertheless, if an agreement is reached there
are some clear poten-
tial winners. These include low-cost agricultural producers in
the developing world
and developed nations such as Australia and the United States.
If the talks are success-
ful, agricultural producers in these nations will ultimately see
the global markets for
their goods expand. Developing nations also gain from the lack
of language on labor
standards, which many saw as an attempt by rich nations to
erect trade barriers. The
sick and poor of the world also benefit from guaranteed access
to cheaper medicines.
There are also clear losers in this agreement, including EU and
Japanese farmers, U.S.
steelmakers, environmental activists, and pharmaceutical firms
in the developed world.
These losers can be expected to lobby their governments hard
during the ensuing
years to make sure that the final agreement is more in their
favor. 49 In general, though,
if ultimately successful, the Doha Round of negotiations could

significantly raise
global economic welfare. As noted above, estimates suggest that
a successful Doha
Round would raise global incomes by as much as $300 billion
annually, with 60 per-
cent of the gain going to the world’s poorer nations, which
would help to pull 150
million people out of poverty. 50
The talks are currently ongoing, and as seems normal in these
cases, they are
characterized by halting progress punctuated by significant
setbacks and missed
deadlines. A September 2003 meeting in Cancun, Mexico, broke
down, primarily
because there was no agreement on how to proceed with
reducing agricultural sub-
sidies and tariffs; the EU, United States, and India, among
others, proved less than
willing to reduce tariffs and subsidies to their politically
important farmers, while
countries such as Brazil and certain West African nations
wanted free trade as
quickly as possible. In 2004, both the United States and the EU
made a determined
push to start the talks again. However, since then little progress
has been made and
the talks are in deadlock, primarily because of disagreements
over how deep the cuts
in subsidies to agricultural produces should be. As of early
2010, the goal was to
reduce tariffs for manufactured and agricultural goods by 60 to
70 percent, and to
cut subsidies to half of their current level, but getting nations to
agree to these goals
was proving exceedingly difficult.

Explain the implications for
managers of developments
in the world trading system.
2010/01:07:10/MHBR169:Slavin:VY
firm to design and engineer its product in one country, to
manufacture components in
another, to perform final assembly operations in yet another
country, and then export
the finished product to the rest of the world.
Clearly, trade barriers constrain a firm’s ability to disperse its
productive activi-
ties in such a manner. First and most obvious, tariff barriers
raise the costs of ex-
porting products to a country (or of exporting partly finished
products between
countries). This may put the firm at a competitive disadvantage
to indigenous com-
petitors in that country. In response, the firm may then find it
economical to locate
production facilities in that country so that it can compete on an
even footing. Sec-
ond, quotas may limit a firm’s ability to serve a country from
locations outside of
that country. Again, the response by the firm might be to set up

production facilities
in that country—even though it may result in higher production
costs. Such reason-
ing was one of the factors behind the rapid expansion of
Japanese automaking
capacity in the United States during the 1980s and 1990s. This
followed the estab-
lishment of a VER agreement between the United States and
Japan that limited
U.S. imports of Japanese automobiles.
Third, to conform to local content regulations, a firm may have
to locate more
production activities in a given market than it would otherwise.
Again, from the firm’s
perspective, the consequence might be to raise costs above the
level that could be
achieved if each production activity was dispersed to the
optimal location for that
activity. And finally, even when trade barriers do not exist, the
firm may still want to
locate some production activities in a given country to reduce
the threat of trade bar-
riers being imposed in the future.
All these effects are likely to raise the firm’s costs above the
level that could be
achieved in a world without trade barriers. The higher costs that
result need not
translate into a significant competitive disadvantage relative to
other foreign firms,
however, if the countries imposing trade barriers do so to the
imported products of
all foreign firms, irrespective of their national origin. But when
trade barriers are
targeted at exports from a particular nation, firms based in that
nation are at a com-
petitive disadvantage to firms of other nations. The firm may

deal with such targeted
trade barriers by moving production into the country imposing
barriers. Another
strategy may be to move production to countries whose exports
are not targeted by
the specific trade barrier.
Finally, the threat of antidumping action limits the ability of a
firm to use ag-
gressive pricing to gain market share in a country. Firms in a
country also can make
strategic use of antidumping measures to limit aggressive
competition from low-
cost foreign producers. For example, the U.S. steel industry has
been very aggres-
sive in bringing antidumping actions against foreign
steelmakers, particularly in
times of weak global demand for steel and excess capacity. In
1998 and 1999, the
United States faced a surge in low-cost steel imports as a severe
recession in Asia
left producers there with excess capacity. The U.S. producers
filed several com-
plaints with the International Trade Commission. One argued
that Japanese pro-
ducers of hot rolled steel were selling it at below cost in the
United States. The
ITC agreed and levied tariffs ranging from 18 percent to 67
certain steel products from Japan (these tariffs are separate from
the steel tariffs
discussed earlier).51
Policy Implications
As noted in Chapter 5, business firms are major players on the
international trade
scene. Because of their pivotal role in international trade, firms

can and do exert a
strong influence on government policy toward trade. This
influence can encourage
protectionism or it can encourage the government to support the
WTO and push for
2010/01:07:10/MHBR169:Slavin:VY
free trade, p. 204
tariff, p. 206
specific tariff, p. 206
ad valorem tariff, p. 206
subsidy, p. 207
import quota, p. 208
tariff rate quota, p. 209
voluntary export restraint
(VER) , p. 209
quota rent, p. 210
local content requirement, p. 210
administrative trade policies, p. 210
dumping, p. 211
antidumping policies, p. 211
countervailing duties, p. 211
Helms-Burton Act, p. 216
D’Amato Act, p. 216

infant industry argument, p. 219
strategic trade policy, p. 220
Smoot-Hawley Act, p. 223
Key Terms
open markets and freer trade among all nations. Government
policies with regard to
international trade can have a direct impact on business.
Consistent with strategic trade policy, examples can be found
of government in-
tervention in the form of tariffs, quotas, antidumping actions,
and subsidies helping
firms and industries establish a competitive advantage in the
world economy. In
general, however, the arguments contained in this chapter and in
Chapter 5 suggest
that government intervention has three drawbacks. Intervention
can be self-defeating
because it tends to protect the inefficient rather than help firms
become efficient
global competitors. Intervention is dangerous; it may invite
retaliation and trigger a
trade war. Finally, intervention is unlikely to be well executed,
given the opportunity
for such a policy to be captured by special-interest groups. Does
this mean that
business should simply encourage government to adopt a
laissez-faire free trade
policy?
Most economists would probably argue that the best interests
of international busi-
ness are served by a free trade stance, but not a laissez-faire
stance. It is probably in the
best long-run interests of the business community to encourage
the government to

aggressively promote greater free trade by, for example,
strengthening the WTO.
Business probably has much more to gain from government
efforts to open protected
markets to imports and foreign direct investment than from
government efforts to
support certain domestic industries in a manner consistent with
the recommendations
of strategic trade policy.
This conclusion is reinforced by a phenomenon we touched on
in Chapter 1—the
increasing integration of the world economy and
internationalization of produc-
tion that has occurred over the past two decades. We live in a
world where many
firms of all national origins increasingly depend for their
competitive advantage on
globally dispersed production systems. Such systems are the
result of freer trade.
Freer trade has brought great advantages to firms that have
exploited it and to con-
sumers who benefit from the resulting lower prices. Given the
danger of retaliatory
action, business firms that lobby their governments to engage in
protectionism
must realize that by doing so they may be denying themselves
the opportunity to
build a competitive advantage by constructing a globally
dispersed production sys-
tem. By encouraging their governments to engage in
protectionism, their own ac-
tivities and sales overseas may be jeopardized if other
governments retaliate. This
does not mean a firm should never seek protection in the form
of antidumping ac-
tions and the like, but it should review its options carefully and

think through the
larger consequences.
2010/01:07:10/MHBR169:Slavin:VY
Summary
The goal of this chapter was to describe how the
reality of international trade deviates from the theo-
retical ideal of unrestricted free trade reviewed in
Chapter 5. In this chapter, we have reported the
various instruments of trade policy, reviewed the
political and economic arguments for government
intervention in international trade, reexamined the
economic case for free trade in light of the strategic
trade policy argument, and looked at the evolution
of the world trading framework. While a policy of
free trade may not always be the theoretically opti-
mal policy (given the arguments of the new trade
theorists), in practice it is probably the best policy
for a government to pursue. In particular, the long-
run interests of business and consumers may be best
served by strengthening international institutions
such as the WTO. Given the danger that isolated
protectionism might escalate into a trade war, busi-
ness probably has far more to gain from government
efforts to open protected markets to imports and
foreign direct investment (through the WTO) than

from government efforts to protect domestic indus-
tries from foreign competition. The chapter made
the following points:
1. Trade policies, such as tariffs, subsidies,
antidumping regulations, and local content
requirements tend to be pro-producer and
anti-consumer. Gains accrue to producers
(who are protected from foreign competitors),
but consumers lose because they must pay
more for imports.
2. There are two types of arguments for
government intervention in international trade:
political and economic. Political arguments for
intervention are concerned with protecting the
interests of certain groups, often at the expense
of other groups, or with promoting goals with
regard to foreign policy, human rights,
consumer protection, and the like. Economic
arguments for intervention are about boosting
the overall wealth of a nation.
3. A common political argument for intervention
is that it is necessary to protect jobs. However,
political intervention often hurts consumers
and it can be self-defeating. Countries
sometimes argue that it is important to protect
certain industries for reasons of national
security. Some argue that government should
use the threat to intervene in trade policy as a
bargaining tool to open foreign markets. This
can be a risky policy; if it fails, the result can be
higher trade barriers.

4. The infant industry argument for government
intervention contends that to let manufacturing
get a toehold, governments should temporarily
support new industries. In practice, however,
governments often end up protecting the
inefficient.
5. Strategic trade policy suggests that with
subsidies, government can help domestic firms
gain first-mover advantages in global industries
where economies of scale are important.
Government subsidies may also help domestic
firms overcome barriers to entry into such
industries.
6. The problems with strategic trade policy are
twofold: (a) such a policy may invite retaliation,
in which case all will lose, and (b) strategic
trade policy may be captured by special-
interest groups, which will distort it to their
own ends.
7. The GATT was a product of the postwar free
trade movement. The GATT was successful in
lowering trade barriers on manufactured goods
and commodities. The move toward greater
free trade under the GATT appeared to
stimulate economic growth.
8. The completion of the Uruguay Round of
GATT talks and the establishment of the
World Trade Organization have strengthened
the world trading system by extending GATT
rules to services, increasing protection for
intellectual property, reducing agricultural
subsidies, and enhancing monitoring and

enforcement mechanisms.
9. Trade barriers act as a constraint on a firm’s
ability to disperse its various production
activities to optimal locations around the globe.
One response to trade barriers is to establish
more production activities in the protected
country.
10. Business may have more to gain from
government efforts to open protected markets
to imports and foreign direct investment than
from government efforts to protect domestic
industries from foreign competition.
2010/01:07:10/MHBR169:Slavin:VY
Why Did Global Food Prices Rise?
For a quarter of a century, global food prices had been falling,
driven by the increased productivity and output of the farm
sector worldwide. In 2007, this came to an abrupt end as global
food prices soared. By September 2007, the world price of
wheat rose to more than $400 a ton—the highest ever recorded
and up from $200 a ton in May. The price of corn (maize)
surged
to $175 a ton, some 60 percent above its average for 2006. An

index of food prices, which The Economist magazine has kept
since 1845 and is adjusted for inflation, hit its highest level
ever
in December 2007!
One explanation for rising food prices has been increased
demand. The increased demand has been driven by greater
food consumption in rapidly developing nations, most notably
China and India. Rising consumption of meat, in particular,
closing case
Critical Thinking and Discussion Questions
1. Do you think governments should consider
human rights when granting preferential trading
rights to countries? What are the arguments for
and against taking such a position?
2. Whose interests should be the paramount
concern of government trade policy—the
interests of producers (businesses and their
employees) or those of consumers?
3. Given the arguments relating to the new trade
theory and strategic trade policy, what kind of
trade policy should business be pressuring
government to adopt?
4. You are an employee of a U.S. firm that produces
personal computers in Thailand and then
exports them to the United States and other
countries for sale. The personal computers were
originally produced in Thailand to take
advantage of relatively low labor costs and a

skilled workforce. Other possible locations
considered at the time were Malaysia and Hong
Kong. The U.S. government decides to impose
punitive 100 percent ad valorem tariffs on
imports of computers from Thailand to punish
the country for administrative trade barriers that
restrict U.S. exports to Thailand. How should
your firm respond? What does this tell you
about the use of targeted trade barriers?
5. Reread the Management Focus “U.S.
Magnesium Seeks Protection.” Who gains most
from the antidumping duties levied by the
United States on imports of magnesium from
China and Russia? Who are the losers? Are
these duties in the best national interests of the
United States?
Use the globalEDGE Resource Desk (http://
globalEDGE.msu.edu/resourcedesk/) to complete
the following exercises:
1. Your company is considering exporting its
pharmaceutical products to Japan, but
management’s current knowledge of the
country’s trade policies and barriers for this
sector is limited. Conduct the appropriate level
of research in a trade barriers database to identify
any information on Japan’s current standards and
technical requirements for pharmaceutical
products. Prepare an executive summary of your
findings.
2. You work for a national chain of clothing stores
that is considering importing textiles from India

into the United States. You want to determine
whether the goods are subject to import quotas.
Using information provided by the U.S. Customs
and Border Protections, prepare a report
highlighting the elements that determine
whether a shipment is subject to this type of
trade restriction.
Research Task http://globalEDGE.msu.edu
2010/01:07:10/MHBR169:Slavin:VY
has driven up demand for grains; it takes eight kilograms of
cereals to produce one kilogram of beef, so as demand for
meat rises, consumption of grains by cattle surges. Farmers
now feed 200 million to 250 million more tons of grain to their
animals than they did 20 years ago, driving up grain prices.
Then there is the issue of biofuel subsidies. Both the United
States and the European Union have adopted policies to
increase production of ethanol and biodiesel to slow global
warming (both products are argued to produce fewer CO2 emis-
sions, although how effective they are at doing this is actively
debated). In 2000, about 15 million tons of American corn was
turned into ethanol; in 2007 the figure reached 85 million tons.
To
promote increased production, governments have given subsi-
dies to farmers. In the United States, subsidies amount to

between $0.29 and $0.36 per liter of ethanol. In Europe, the
sub-
sidies are as high as $1 a liter. Not surprisingly, the subsidies
have created an incentive for farmers to plant more crops that
can be turned into biofuels (primarily corn and soybeans). This
has diverted land away from production of corn and soy for
food
and reduced the supply of land devoted to growing crops that
don’t receive biofuel subsidies, such as wheat. This highly sub-
sidized source of demand seems to be having a dramatic effect
on demand for corn and soybeans. In 2007, for example, the
U.S.
increase in demand for corn-based ethanol accounted for more
than half of the global increase in demand for corn.
Complicating the situation are the high tariffs that shut
producers of alternative products that can be turned into bio-
fuels, most notably sugar cane, out of the American and EU
markets. Brazil, the world’s most efficient producer of sugar
cane, confronts import tariffs of at least 25 percent by value in
the United States and 50 percent in the EU, raising the price
of imported sugar cane and making it uncompetitive with
subsidized corn and soybeans. This is unfortunate because
sugar cane is widely seen as a more environmentally friendly
raw material for biofuels than either corn or soy. Sugar cane
uses less fertilizer than corn or soy and produces a higher
yield per hectare, in terms of its energy content. Ethanol is
also produced from what used to be considered a waste
product—the fiber removed from the cane during processing.
If policy makers have their way, however, the situation
may get even worse. Plans in both the United States and EU
call for an increase in the production of biofuels, but neither
political entity has agreed to reduce tariff barriers on sugar
cane, nor remove the trade-distorting subsidies given to
those who produce corn and soy for biofuels. Brazil is not sit-
ting on the sidelines; in 2007 it asked the World Trade Organi-

zation to probe U.S. subsidies to corn farmers for ethanol
production.
Sources: “Cheap No More: Food Prices,” The Economist,
December
8, 2007, p. 84; “Brazil Seeks WTO Probe of U.S. Farm
Subsidies,”
Journal of Commerce, September 13, 2007, p. 1; M. Wolf,
“Biofuels:
An Everyday Story of Special Interests and Subsidies,”
Financial
Times, October 31, 2007, p. 11; and J. Von Braun and R. K.
Pachauri,
The Promises and Challenges of Biofuels for the Poor in
Developing
Countries: IFPRI 2005–2006 Annual Report Essay (Washington,
DC:
International Food Policy Research Institute, 2007).
Case Discussion Questions
1. Who benefits from government policies to (a) promote
production of ethanol and (b) place tariff barriers on
imports of sugar cane? Who suffers from these policies?
2. One estimate suggests that if food prices rise by one-
third, they will reduce living standards in rich countries
by about 3 percent, but in very poor ones by about
20 percent. According to the International Food Policy
Research Institute, unless there is a change in policies,
cereal prices will rise by 10 to 20 percent by 2015, and
the expansion of biofuel production could reduce
calorie intake by 2 to 8 percent by 2020 in many of the
world’s poorest nations. Should rich countries do
anything about this? If so, what?

3. The argument for giving subsidies to ethanol producers
rests upon the assumption that ethanol results in lower
CO2 emissions than gasoline and therefore benefits the
environment. If we accept that global warming is a
serious problem, should we not be encouraging
governments to increase such subsidies? What are the
arguments for and against doing so? On balance, what
do you think is the best policy?
2010/01:07:10/MHBR169:Slavin:VY
part 3 Cross-Border Trade and Investment
L
E
A
R
N
IN
G
O
B
J

E
C
T
IV
E
S
After you have read this chapter you should be able to:
1
Understand why nations trade with each other.
2
Summarize the different theories explaining trade flows
between
nations.
3
Recognize why many economists believe that unrestricted free
trade
between nations will raise the economic welfare of countries
that
participate in a free trade system.
4
Explain the arguments of those who maintain that government
can play
a proactive role in promoting national competitive advantage in

certain
industries.
5
Understand the important implications that international trade
theory holds for
business practice.
2010/01:07:10/MHBR169:Slavin:VY
opening case
B
angladesh, one of the world’s poorest countries, has long
depended heavily upon exports
of textile products to generate income, employment, and
economic growth. Most of these
exports are low-cost finished garments sold to Western mass-
market retailers, such as
Walmart. For decades, Bangladesh was able to take advantage
of a quota system for textile
exports that gave it, and other poor countries, preferential
access to rich markets such as the
United States and the European Union. On January 1, 2005,
however, that system was scrapped
in favor of one that was based on free trade principles. From

that point on, exporters in
Bangladesh would have to compete for business against
producers from other nations such as
China and Indonesia. Many analysts predicted the quick
collapse of Bangladesh’s textile
industry. They predicted a sharp jump in unemployment, a
decline in the country’s balance of
payments accounts, and a negative impact upon economic
growth.
The collapse didn’t happen. On the contrary, Bangladesh’s
exports of textiles continued to
grow, even as the rest of the world plunged into an economic
crisis in 2008. Bangladesh’s
exports of garments rose to $10.7 billion in 2008, up from $9.3
billion in 2007 and $8.9 billion
in 2006. Apparently, Bangladesh has a comparative advantage
in the production of textiles—
it is one of the world’s low-cost producers—and this is allowing
the country to grow its
share of world markets. Indeed, as a deep economic recession
took hold in developed
nations during 2008–09, big importers such as Walmart
increased their purchases of
inexpensive garments from Bangladesh to better serve their
customers, who were
looking for low prices. Obviously this benefits producers in
Bangladesh, but it also
benefits consumers in developed nations who can use money
saved on garment
purchases to buy other goods and services.
Bangladesh’s advantage is based on a number of factors. First,
labor costs
are low, in part due to low hourly wage rates, and in part due to
textile
manufacturers’ investments in productivity-boosting
technology during the

previous decade. Today, wage rates in Bangladesh’s textile
industry are
Bangladesh’s Textile Trade
International Trade Theory
5 c h a p t e r
2010/01:07:10/MHBR169:Slavin:VY
about $40 to $50 a month, barely half the minimum wage in
China. While
this pay rate seems dismally low by Western standards, in a
country where
the gross national income per capita is only $470 a year, the
textile industry
provides a living wage and a source of employment for some 2.5
million
people, 85 percent of whom are women with few alternative
employment
opportunities.
Another source of advantage for Bangladesh is that it has a
vibrant
network of supporting industries that supply inputs to its
garment manufac-
turers. Some three-quarters of all inputs are made locally. This

saves gar-
ment manufacturers transport and storage costs, import duties,
and the long
lead times that come with the imported woven fabrics used to
make shirts
and trousers. In other words, the local supporting industries
help to boost
the productivity of Bangladesh’s garment manufacturers, giving
them a cost
advantage that goes beyond low wage rates.
A third advantage for Bangladesh is that it is not China! Many
importers in
the West have grown cautious about becoming too dependent
upon China
for imports of specific goods for fear that a disruption,
economic or other,
would decimate their supply chains unless they had an
alternative source.
Thus, Bangladesh has benefitted from the trend by Western
importers to
diversify their supply sources. •
Source: K. Bradsher, “Jobs Vanish as Exports Fall in Asia,”
The New York Times, January 22, 2009, p. B1;
“Knitting Pretty,” The Economist, July 18, 2008, p. 54; and K.
Bradsher, “Competition Means Learning to Offer
More Than Just Low Wages,” The New York Times, December
14, 2004, p. C1.
Introduction
The growth of the garment industry in Bangladesh is a striking
example of the bene-
fits of free trade and globalization. Low barriers to trade have
enabled Bangladesh to
exploit its comparative advantage in the production of garments
and enabled the
country to grow its exports, even during a global economic

downturn. This benefits
Bangladesh, one of the world’s poorest nations, whose strong
garment exports help
support 2.5 million jobs and may help the country to attain
sustainable economic
growth. It also benefits consumers in developed nations, who
can save on their gar-
ment purchases and, as a consequence, have more money
available for spending on
other goods and services, thereby helping to improve their
living standards. The losers
in this process are higher-cost garment producers in more
developed nations, who
have lost business to enterprises from Bangladesh.
In the world of international trade, there are always winners
and losers, but as
economists have long argued, the benefits to the winners
outweigh the costs born by
the losers, resulting in a net gain to society. Economists argue
that in the long-run,
free trade stimulates economic growth and raises living
standards across the board.
The economic arguments surrounding the benefits and costs of
free trade in goods
and services are not abstract academic ones. International trade
theory has shaped the
2010/01:07:10/MHBR169:Slavin:VY

Chapter Five International Trade Theory 163
economic policy of many nations for the past 50 years. It was
the driver behind the
formation of the World Trade Organization and regional trade
blocs such as the
European Union and the North American Free Trade Agreement
(NAFTA). The 1990s,
in particular, saw a global move toward greater free trade.
Therefore, it is crucially
important to understand these theories and why they have been
so successful in shap-
ing the economic policy of so many nations and the competitive
environment in
which international businesses compete.
This chapter has two goals that go to the heart of the debate
over the benefits and
costs of free trade. The first is to review a number of theories
that explain why it is
beneficial for a country to engage in international trade. The
second goal is to explain
the pattern of international trade that we observe in the world
economy. With regard
to the pattern of trade, we will be primarily concerned with
explaining the pattern of
exports and imports of goods and services between countries.
The pattern of foreign
direct investment between countries is discussed in Chapter 7.
An Overview of Trade Theory
We open this chapter with a discussion of mercantilism.
Propagated in the sixteenth
and seventeenth centuries, mercantilism advocated that
countries should simultaneously
encourage exports and discourage imports. Although
mercantilism is an old and

largely discredited doctrine, its echoes remain in modern
political debate and in the
trade policies of many countries. Next, we will look at Adam
Smith’s theory of absolute
advantage. Proposed in 1776, Smith’s theory was the first to
explain why unrestricted
free trade is beneficial to a country. Free trade refers to a
situation where a govern-
ment does not attempt to influence through quotas or duties
what its citizens can buy
from another country, or what they can produce and sell to
another country. Smith
argued that the invisible hand of the market mechanism, rather
than government pol-
icy, should determine what a country imports and what it
exports. His arguments im-
ply that such a laissez-faire stance toward trade was in the best
interests of a country.
Building on Smith’s work are two additional theories that we
shall review. One is the
theory of comparative advantage, advanced by the nineteenth
century English econo-
mist David Ricardo. This theory is the intellectual basis of the
modern argument for
unrestricted free trade. In the twentieth century, Ricardo’s work
was refined by two
Swedish economists, Eli Heckscher and Bertil Ohlin, whose
theory is known as the
Heckscher-Ohlin theory.
THE BENEFITS OF TRADE The great strength of the
theories of Smith,
Ricardo, and Heckscher-Ohlin is that they identify with
precision the specific bene-
fits of international trade. Common sense suggests that some
international trade

is beneficial. For example, nobody would suggest that Iceland
should grow its own
oranges. Iceland can benefit from trade by exchanging some of
the products that it can
produce at a low cost (fish) for some products that it cannot
produce at all (oranges).
Thus, by engaging in international trade, Icelanders are able to
add oranges to their
diet of fish.
The theories of Smith, Ricardo, and Heckscher-Ohlin go
beyond this common-
sense notion, however, to show why it is beneficial for a
country to engage in in-
ternational trade even for products it is able to produce for
itself. This is a difficult
concept for people to grasp. For example, many people in the
United States be-
lieve that American consumers should buy products made in the
United States by
American companies whenever possible to help save American
jobs from foreign
competition. The same kind of nationalistic sentiments can be
observed in many
other countries.
Understand why nations
trade with each other.
Free Trade
The absence of
government barriers to
the free flow of goods
and services between
countries.

2010/01:07:10/MHBR169:Slavin:VY
However, the theories of Smith, Ricardo, and
Heckscher-Ohlin tell us that a country’s economy
may gain if its citizens buy certain products from
other nations that could be produced at home.
The gains arise because international trade allows
a country to specialize in the manufacture and ex-
port of products that can be produced most effi-
ciently in that country, while importing products
that can be produced more efficiently in other
countries. Thus, it may make sense for the United
States to specialize in the production and export
of commercial jet aircraft, since the efficient pro-
duction of commercial jet aircraft requires re-
sources that are abundant in the United States,
such as a highly skilled labor force and cutting-
edge technological know-how. On the other
hand, it may make sense for the United States to
import textiles from China since the efficient
production of textiles requires a relatively cheap
labor force—and cheap labor is not abundant in
the United States.
Of course, this economic argument is often difficult for
segments of a country’s

population to accept. With their future threatened by imports,
U.S. textile companies
and their employees have tried hard to persuade the government
to limit the importa-
tion of textiles by demanding quotas and tariffs. Although such
import controls may
benefit particular groups, such as textile businesses and their
employees, the theories
of Smith, Ricardo, and Heckscher-Ohlin suggest that the
economy as a whole is hurt
by such action. Limits on imports are often in the interests of
domestic producers, but
not domestic consumers.
THE PATTERN OF INTERNATIONAL TRADE The theories
of Smith,
Ricardo, and Heckscher-Ohlin help to explain the pattern of
international trade that
we observe in the world economy. Some aspects of the pattern
are easy to understand.
Climate and natural resource endowments explain why Ghana
exports cocoa, Brazil
exports coffee, Saudi Arabia exports oil, and China exports
crawfish. However, much
of the observed pattern of international trade is more difficult to
explain. For exam-
ple, why does Japan export automobiles, consumer electronics,
and machine tools?
Why does Switzerland export chemicals, pharmaceuticals,
watches, and jewelry? Why
does Bangladesh export garments? David Ricardo’s theory of
comparative advantage
offers an explanation in terms of international differences in
labor productivity. The
more sophisticated Heckscher-Ohlin theory emphasizes the
interplay between the

proportions in which the factors of production (such as land,
labor, and capital) are avail-
able in different countries and the proportions in which they are
needed for produc-
ing particular goods. This explanation rests on the assumption
that countries have
varying endowments of the various factors of production. Tests
of this theory, how-
ever, suggest that it is a less powerful explanation of real-world
trade patterns than
once thought.
One early response to the failure of the Heckscher-Ohlin
theory to explain the
observed pattern of international trade was the product life-
cycle theory. Proposed by
Raymond Vernon, this theory suggests that early in their life
cycle, most new products
are produced in and exported from the country in which they
were developed. As a
new product becomes widely accepted internationally, however,
production starts in
A n o t h e r P e r s p e c t i v e
Outsourcing: Putting Jobs into Growing Markets
Another way of looking at the hollowing out of the Ameri-
can knowledge-based economy through outsourcing is to
see the process from the perspective of developing na-
tions. To them, outsourcing brings with it the benefits of
trade. It is one of the positive outcomes of globalization.
Multinational corporations doing some business in their
markets can locate their production in the very markets
into which they are selling. As India, the Philippines, and
China develop a knowledge-based labor supply, compa-
nies such as Intel and EMC that are selling into these mar-
kets may want to locate some of their research and

development and other knowledge-based activities in
these markets as a commitment to a local presence, as a
way to learn more about the customer, and as a way to
establish sustained and sustaining relationships. Yes, there
are cost savings, especially on labor, but long term, such
cost savings may be secondary.
2010/01:07:10/MHBR169:Slavin:VY
other countries. As a result, the theory suggests, the product
may ultimately be
exported back to the country of its original innovation.
In a similar vein, during the 1980s economists such as Nobel
Prize winner Paul
Krugman developed what has come to be known as the new
trade theory . New trade
theory (for which Krugman won the Nobel Prize in 2008)
stresses that in some cases
countries specialize in the production and export of particular
products not because
of underlying differences in factor endowments, but because in
certain industries
the world market can support only a limited number of firms.
(This is argued to be
the case for the commercial aircraft industry.) In such
industries, firms that enter the
market first are able to build a competitive advantage that is

subsequently difficult to
challenge. Thus, the observed pattern of trade between nations
may be due in part to
the ability of firms within a given nation to capture first-mover
advantages. The
United States is a major exporter of commercial jet aircraft
because American firms
such as Boeing were first movers in the world market. Boeing
built a competitive
advantage that has subsequently been difficult for firms from
countries with equally
favorable factor endowments to challenge (although Europe’s
Airbus Industries has
succeeded in doing that). In a work related to the new trade
theory, Michael Porter
developed a theory, referred to as the theory of national
competitive advantage. This
attempts to explain why particular nations achieve international
success in particular
industries. In addition to factor endowments, Porter points out
the importance of
country factors such as domestic demand and domestic rivalry
in explaining a nation’s
dominance in the production and export of particular products.
TRADE THEORY AND GOVERNMENT POLICY Although
all these the-
ories agree that international trade is beneficial to a country,
they lack agreement in
their recommendations for government policy. Mercantilism
makes a crude case for
government involvement in promoting exports and limiting
imports. The theories of
Smith, Ricardo, and Heckscher-Ohlin form part of the case for
unrestricted free trade.
The argument for unrestricted free trade is that both import

controls and export in-
centives (such as subsidies) are self-defeating and result in
wasted resources. Both the
new trade theory and Porter’s theory of national competitive
advantage can be inter-
preted as justifying some limited government intervention to
support the develop-
ment of certain export-oriented industries. We will discuss the
pros and cons of this
argument, known as strategic trade policy, as well as the pros
and cons of the argument
for unrestricted free trade, in Chapter 6.
Mercantilism
The first theory of international trade, mercantilism, emerged
in England in the mid-
sixteenth century. The principle assertion of mercantilism was
that gold and silver
were the mainstays of national wealth and essential to vigorous
commerce. At that
time, gold and silver were the currency of trade between
countries; a country could
earn gold and silver by exporting goods. Conversely, importing
goods from other
countries would result in an outflow of gold and silver to those
countries. The main
tenet of mercantilism was that it was in a country’s best
interests to maintain a trade
surplus, to export more than it imported. By doing so, a country
would accumulate
gold and silver and, consequently, increase its national wealth,
prestige, and power. As
the English mercantilist writer Thomas Mun put it in 1630:
The ordinary means therefore to increase our wealth and
treasure is by foreign

trade, wherein we must ever observe this rule: to sell more to
strangers yearly
than we consume of theirs in value. 1
New Trade Theory
Theory that sometimes
countries specialize in
the production and
export of particular
products not because of
underlying differences in
factor endowments, but
because in certain
industries the world
market can support only
a limited number of firms.
Mercantilism
An economic philosophy
advocating that countries
should simultaneously
encourage exports and
discourage imports.
Summarize the different
theories explaining trade
flows between nations.
2010/01:07:10/MHBR169:Slavin:VY

Consistent with this belief, the mercantilist doctrine
advocated government interven-
tion to achieve a surplus in the balance of trade. The
mercantilists saw no virtue in a
large volume of trade. Rather, they recommended policies to
maximize exports and
minimize imports. To achieve this, imports were limited by
tariffs and quotas, while
exports were subsidized.
The classical economist David Hume pointed out an inherent
inconsistency in the
mercantilist doctrine in 1752. According to Hume, if England
had a balance-of-trade
surplus with France (it exported more than it imported) the
resulting inflow of gold
and silver would swell the domestic money supply and generate
inflation in England.
In France, however, the outflow of gold and silver would have
the opposite effect.
France’s money supply would contract, and its prices would
fall. This change in rela-
tive prices between France and England would encourage the
French to buy fewer
English goods (because they were becoming more expensive)
and the English to buy
more French goods (because they were becoming cheaper). The
result would be a
deterioration in the English balance of trade and an
improvement in France’s trade
balance, until the English surplus was eliminated. Hence,
according to Hume, in the

Is China a Neo-mercantilist Nation?
China’s rapid rise in economic power has been built on
export-led growth. The country, using its cheap labor, has
converted raw material imports into products that it sells to
developed nations. For years, the country’s exports have
been growing faster than its imports, leading some critics
to claim that China is pursuing a neo-mercantilist policy,
trying to amass record trade surpluses and foreign
currency that will give it economic power over developed
nations. This rhetoric reached new heights in 2008 when
China’s trade surplus hit a record $280 billion and its foreign
exchange reserves exceeded $1.95 trillion, some 70 per-
cent of which are held in U.S. dollars. Observers worry
that if China ever decides to sell its holdings of U.S. cur-
rency, this could depress the value of the dollar against
other currencies and increase the price of imports into
America.
Throughout 2005–2008, China’s exports grew much
faster than its imports, leading some to argue that China
was limiting imports by pursuing an import substitution
policy, encouraging domestic investment in the produc-
tion of products such as steel, aluminum, and paper,
which it had historically imported from other nations. The
trade deficit with the United States has been a particular
cause for concern. In 2008, this reached $260 billion, the
largest deficit ever recorded with a single country. At the
same time, China has long resisted attempts to let its
currency float freely against the U.S. dollar. Many claim
that China’s currency is too cheap, and that this keeps the
prices of China’s goods artificially low, which fuels the
country’s exports.
So is China a neo-mercantilist nation that is deliberately
discouraging imports and encouraging exports in order to

grow its trade surplus and accumulate foreign exchange
reserves, which might give it economic power? The jury is
out on this issue. Skeptics suggest that the slowdown in
imports to China is temporary and that the country will
have no choice but to increase imports of commodities that
it lacks, such as oil. They also note that China did start
allowing the value of the renminbi (China’s currency) to
appreciate against the dollar in July 2005, and between then
and January 2010 it appreciated 17 percent in value. More-
over, although China’s overall trade surplus was up sharply
in 2008, import growth exceeded export growth for 2008,
and exports slowed sharply toward the end of the year as
the global economic crisis took hold. In 2009, China’s trade
surplus contracted somewhat, and its deficit with America
appears to have shrunk by some $100 billion, as the global
economic crisis of 2008–2009 hit Chinese exporters hard.
While this suggests that China’s trade surplus may have
peaked for now, it is still significant.
Source: A. Browne, “China’s Wild Swings Can Roil the Global
Economy,”
The Wall Street Journal , October 24, 2005, p. A2; S. H.
Hanke, “Stop the
Mercantilists,” Forbes , June 20, 2005, p. 164; G. Dyer and A.
Balls, “Dollar
Threat as China Signals Shift,” Financial Times , January 6,
2006, p. 1;
Tim Annett, “Righting the Balance,” The Wall Street Journal ,
January 10,
2007, p. 15; “China’s Trade Surplus Peaks,” Financial Times ,
January 12,
2008, p. 1; and W. Chong, “China’s Trade Surplus to U.S. to
Narrow,”
China Daily , December 7, 2009.
3 C o u n t r y F O C U S

2010/01:07:10/MHBR169:Slavin:VY
long run no country could sustain a surplus on the balance of
trade and so accumulate
gold and silver as the mercantilists had envisaged.
The flaw with mercantilism was that it viewed trade as a
zero-sum game. (A zero-
sum game is one in which a gain by one country results in a
loss by another.) It was
left to Adam Smith and David Ricardo to show the
shortsightedness of this approach
and to demonstrate that trade is a positive-sum game, or a
situation in which all coun-
tries can benefit. Unfortunately, the mercantilist doctrine is by
no means dead. Neo-
mercantilists equate political power with economic power and
economic power with a
balance-of-trade surplus. Critics argue that many nations have
adopted a neo-mercantilist
strategy that is designed to simultaneously boost exports and
limit imports. 2 For exam-
ple, critics charge that China is pursuing a neo-mercantilist
policy, deliberately keeping
its currency value low against the U.S. dollar in order to sell
more goods to the United
States, and thus amass a trade surplus and foreign exchange

reserves (see the accompa-
nying Country Focus).
Absolute Advantage
In his 1776 landmark book The Wealth of Nations, Adam
Smith attacked the mercan-
tilist assumption that trade is a zero-sum game. Smith argued
that countries differ
in their ability to produce goods efficiently. In his time, the
English, by virtue of
their superior manufacturing processes, were the world’s most
efficient textile man-
ufacturers. Due to the combination of favorable climate, good
soils, and accumu-
lated expertise, the French had the world’s most efficient wine
industry. The
English had an absolute advantage in the production of
textiles, while the French had
an absolute advantage in the production of wine. Thus, a
country has an absolute
advantage in the production of a product when it is more
efficient than any other
country in producing it.
According to Smith, countries should specialize in the
production of goods for
which they have an absolute advantage and then trade these for
goods produced by
other countries. In Smith’s time, this suggested that the English
should specialize in
the production of textiles while the French should specialize in
the production of
wine. England could get all the wine it needed by selling its
textiles to France and
buying wine in exchange. Similarly, France could get all the
textiles it needed by
selling wine to England and buying textiles in exchange.

Smith’s basic argument,
therefore, is that a country should never produce goods at home
that it can buy at a
lower cost from other countries. Smith demonstrates that, by
specializing in the
production of goods in which each has an absolute advantage,
both countries benefit
by engaging in trade.
Consider the effects of trade between two countries, Ghana
and South Korea.
The production of any good (output) requires resources (inputs)
such as land, labor,
and capital. Assume that Ghana and South Korea both have the
same amount of
resources and that these resources can be used to produce either
rice or cocoa. As-
sume further that 200 units of resources are available in each
country. Imagine that
in Ghana it takes 10 resources to produce one ton of cocoa and
20 resources to
produce one ton of rice. Thus, Ghana could produce 20 tons of
cocoa and no rice,
10 tons of rice and no cocoa, or some combination of rice and
cocoa between these
two extremes. The different combinations that Ghana could
produce are repre-
sented by the line GG’ in Figure 5.1. This is referred to as
Ghana’s production pos-
sibility frontier (PPF). Similarly, imagine that in South Korea
it takes 40 resources to
produce one ton of cocoa and 10 resources to produce one ton of
rice. Thus, South
Korea could produce 5 tons of cocoa and no rice, 20 tons of rice
and no cocoa, or
Zero-Sum Game

A situation in which an
economic gain by one
country results in an
economic loss by
another.
Absolute Advantage
A country has an
absolute advantage
in the production of a
product when it is more
efficient than any other
country in producing it.
2010/01:07:10/MHBR169:Slavin:VY
some combination between these two extremes. The different
combinations avail-
able to South Korea are represented by the line KK’ in Figure
5.1, which is South
Korea’s PPF. Clearly, Ghana has an absolute advantage in the

production of cocoa.
(More resources are needed to produce a ton of cocoa in South
Korea than in
Ghana.) By the same token, South Korea has an absolute
advantage in the produc-
tion of rice.
Now consider a situation in which neither country trades with
any other. Each coun-
try devotes half of its resources to the production of rice and
half to the production of
cocoa. Each country must also consume what it produces. Ghana
would be able to
produce 10 tons of cocoa and 5 tons of rice (point A in Figure
5.1), while South Korea
would be able to produce 10 tons of rice and 2.5 tons of cocoa
(point B in Figure 5.1).
Without trade, the combined production of both countries would
be 12.5 tons of
cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15
tons of rice (5 tons in
Ghana and 10 tons in South Korea). If each country were to
specialize in producing
the good for which it had an absolute advantage and then trade
with the other for the
good it lacks, Ghana could produce 20 tons of cocoa, and South
Korea could produce
20 tons of rice. Thus, by specializing, the production of both
goods could be increased.
Production of cocoa would increase from 12.5 tons to 20 tons,
while production of
rice would increase from 15 tons to 20 tons. The increase in
production that would
result from specialization is therefore 7.5 tons of cocoa and 5
tons of rice. Table 5.1
summarizes these figures.
By engaging in trade and swapping one ton of cocoa for one

ton of rice, producers
in both countries could consume more of both cocoa and rice.
Imagine that Ghana
and South Korea swap cocoa and rice on a one-to-one basis; that
is, the price of one
ton of cocoa is equal to the price of one ton of rice. If Ghana
decided to export 6 tons
of cocoa to South Korea and import 6 tons of rice in return, its
final consumption after
trade would be 14 tons of cocoa and 6 tons of rice. This is 4
tons more cocoa than it
could have consumed before specialization and trade and 1 ton
more rice. Similarly,
South Korea’s final consumption after trade would be 6 tons of
cocoa and 14 tons of
rice. This is 3.5 tons more cocoa than it could have consumed
before specialization
and trade and 4 tons more rice. Thus, as a result of
specialization and trade, output of
both cocoa and rice would be increased, and consumers in both
nations would be able
to consume more. Thus, we can see that trade is a positive-sum
game; it produces net
gains for all involved.
figure 5.1
The Theory of Absolute
Advantage
5 10 15 200
Rice
K

G20
15
10
A
G'
B
K'
Co
co
a
5
2.5
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Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice

Ghana 10 20
South Korea 40 10
Production and Consumption without Trade
Cocoa Rice
Ghana 10.0 5.0
South Korea 2.5 10.0
Total production 12.5 15.0
Production with Specialization
Cocoa Rice
Ghana 20.0 0.0
Consumption after Ghana Trades 6 Tons of Cocoa for 6 Tons
of South Korean Rice
Cocoa Rice
Ghana 14.0 6.0
Increase in Consumption as a Result of Specialization and Trade

Cocoa Rice
Ghana 4.0 1.0
South Korea 3.5 4.0
Comparative Advantage
David Ricardo took Adam Smith’s theory one step further by
exploring what might
happen when one country has an absolute advantage in the
production of all goods. 3
Smith’s theory of absolute advantage suggests that such a
country might derive no
benefits from international trade. In his 1817 book Principles
of Political Economy,
Ricardo showed that this was not the case. According to
Ricardo’s theory of comparative
advantage, it makes sense for a country to specialize in the
production of those goods
that it produces most efficiently and to buy the goods that it
produces less efficiently
from other countries, even if this means buying goods from
other countries that it
could produce more efficiently itself. 4 While this may seem
counterintuitive, the logic
can be explained with a simple example.
5.1 table
Absolute Advantage

and the Gains
from Trade
2010/01:07:10/MHBR169:Slavin:VY
Assume that Ghana is more efficient in the production of
both cocoa and rice;
that is, Ghana has an absolute advantage in the production of
both products. In
Ghana it takes 10 resources to produce one ton of cocoa and
131/3 resources to
produce one ton of rice. Thus, given its 200 units of resources,
Ghana can produce
20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or
any combination in
between on its PPF (the line GG’ in Figure 5.2). In South Korea
it takes 40 re-
sources to produce one ton of cocoa and 20 resources to produce
one ton of rice.
Thus, South Korea can produce 5 tons of cocoa and no rice, 10
tons of rice and no
cocoa, or any combination on its PPF (the line KK’ in Figure
5.2). Again assume that
without trade, each country uses half of its resources to produce
rice and half to pro-
duce cocoa. Thus, without trade, Ghana will produce 10 tons of
cocoa and 7.5 tons

of rice (point A in Figure 5.2), while South Korea will produce
2.5 tons of cocoa and
5 tons of rice (point B in Figure 5.2).
In light of Ghana’s absolute advantage in the production of
both goods, why should it
trade with South Korea? Although Ghana has an absolute
advantage in the production
of both cocoa and rice, it has a comparative advantage only in
the production of cocoa:
Ghana can produce 4 times as much cocoa as South Korea, but
only 1.5 times as much
rice. Ghana is comparatively more efficient at producing cocoa
than it is at producing rice.
Without trade the combined production of cocoa will be 12.5
tons (10 tons in
Ghana and 2.5 in South Korea), and the combined production of
rice will also be
12.5 tons (7.5 tons in Ghana and 5 tons in South Korea).
Without trade each country
must consume what it produces. By engaging in trade, the two
countries can increase
their combined production of rice and cocoa, and consumers in
both nations can con-
sume more of both goods.
THE GAINS FROM TRADE Imagine that Ghana exploits its
comparative
advantage in the production of cocoa to increase its output
from 10 tons to 15 tons. This
uses 150 units of resources, leaving the remaining 50 units of
resources to use in pro-
ducing 3.75 tons of rice (point C in Figure 5.2). Meanwhile,
South Korea specializes
in the production of rice, producing 10 tons. The combined
output of both cocoa and
rice has now increased. Before specialization, the combined

output was 12.5 tons of
cocoa and 12.5 tons of rice. Now it is 15 tons of cocoa and
13.75 tons of rice (3.75 tons
in Ghana and 10 tons in South Korea). The source of the
increase in production is
summarized in Table 5.2.
figure 5.2
The Theory of
Comparative Advantage
K
G
A
G'
B
K'
C
5 7.53.75 10 15 200
Rice
20
15
10Co
co

a
5
2.5
2010/01:07:10/MHBR169:Slavin:VY
Not only is output higher, but both countries also can now
benefit from trade. If
Ghana and South Korea swap cocoa and rice on a one-to-one
basis, with both countries
choosing to exchange 4 tons of their export for 4 tons of the
import, both countries are
able to consume more cocoa and rice than they could before
specialization and trade
(see Table 5.2). Thus, if Ghana exchanges 4 tons of cocoa with
South Korea for 4 tons
of rice, it is still left with 11 tons of cocoa, which is 1 ton more
than it had before trade.
The 4 tons of rice it gets from South Korea in exchange for its 4
tons of cocoa, when
added to the 3.75 tons it now produces domestically, leaves it
with a total of 7.75 tons
of rice, which is .25 of a ton more than it had before
specialization. Similarly, after

swapping 4 tons of rice with Ghana, South Korea still ends up
with 6 tons of rice, which
is more than it had before specialization. In addition, the 4 tons
of cocoa it receives in
exchange is 1.5 tons more than it produced before trade. Thus,
consumption of cocoa
and rice can increase in both countries as a result of
specialization and trade.
Resources Required to Produce 1 Ton of Cocoa and Rice
Cocoa Rice
Ghana 10 13.33
South Korea 40 20
Production and Consumption without Trade
Cocoa Rice
Ghana 10.0 7.5
South Korea 2.5 5.0
Production with Specialization
Cocoa Rice
Ghana 15.0 3.75

Consumption after Ghana Trades 4 Tons of Cocoa for 4 Tons
of South Korean Rice
Cocoa Rice
Ghana 11.0 7.75
South Korea 4.0 6.0
Increase in Consumption as a Result of Specialization and Trade
Cocoa Rice
Ghana 1.0 0.25
South Korea 1.5 1.0
5.2 table
Comparative
Advantage and the
Gains from Trade
2010/01:07:10/MHBR169:Slavin:VY
The basic message of the theory of comparative advantage is

that potential world
production is greater with unrestricted free trade than it is with
restricted trade. Ricardo’s
theory suggests that consumers in all nations can consume more
if there are no re-
strictions on trade. This occurs even in countries that lack an
absolute advantage in the
production of any good. In other words, to an even greater
degree than the theory of
absolute advantage, the theory of comparative advantage
suggests that trade is a positive-sum
game in which all countries that participate realize economic
gains. As such, this theory pro-
vides a strong rationale for encouraging free trade. So powerful
is Ricardo’s theory
that it remains a major intellectual weapon for those who argue
for free trade.
QUALIFICATIONS AND ASSUMPTIONS The conclusion
that free trade
is universally beneficial is a rather bold one to draw from such
a simple model. Our
simple model includes many unrealistic assumptions:
1. We have assumed a simple world in which there are only
two countries and two
goods. In the real world, there are many countries and many
goods.
2. We have assumed away transportation costs between
countries.
3. We have assumed away differences in the prices of
resources in different countries.
We have said nothing about exchange rates, simply assuming
that cocoa and rice

could be swapped on a one-to-one basis.
4. We have assumed that resources can move freely from the
production of one good
to another within a country. In reality, this is not always the
case.
5. We have assumed constant returns to scale; that is, that
specialization by Ghana or
South Korea has no effect on the amount of resources required
to produce one
ton of cocoa or rice. In reality, both diminishing and increasing
returns to
specialization exist. The amount of resources required to
produce a good might
decrease or increase as a nation specializes in production of that
good.
6. We have assumed that each country has a fixed stock of
resources and that free
trade does not change the efficiency with which a country uses
its resources. This
static assumption makes no allowances for the dynamic changes
in a country’s
stock of resources and in the efficiency with which the country
uses its resources
that might result from free trade.
7. We have assumed away the effects of trade on income
distribution within a
country.
Given these assumptions, can the conclusion that free trade is
mutually beneficial
be extended to the real world of many countries, many goods,
positive transportation

costs, volatile exchange rates, immobile domestic resources,
non-constant returns to
specialization, and dynamic changes? Although a detailed
extension of the theory of
comparative advantage is beyond the scope of this book,
economists have shown that
the basic result derived from our simple model can be
generalized to a world com-
posed of many countries producing many different goods. 5
Despite the shortcomings
of the Ricardian model, research suggests that the basic
proposition that countries will
export the goods that they are most efficient at producing is
borne out by the data. 6
However, once all the assumptions are dropped, the case for
unrestricted free trade,
while still positive, has been argued by some economists
associated with the “new
trade theory” to lose some of its strength. 7 We return to this
issue later in this chapter
and in the next when we discuss the new trade theory.
Moreover, in a recent and
widely discussed analysis, the Nobel Prize winning economist
Paul Samuelson argued
that contrary to the standard interpretation, in certain
circumstances the theory of
comparative advantage predicts that a rich country might
actually be worse off by
switching to a free trade regime with a poor nation. 8 We will
consider Samuelson’s
critique in the next section.
Recognize why many
economists believe that
unrestricted free trade

between nations will raise
the economic welfare of
countries that participate in
a free trade system.
2010/01:07:10/MHBR169:Slavin:VY
EXTENSIONS OF THE RICARDIAN MODEL Let us explore
the effect of
relaxing three of the assumptions identified above in the simple
comparative advan-
tage model. Below we relax the assumptions that resources
move freely from the pro-
duction of one good to another within a country, that there are
constant returns to
scale, and that trade does not change a country’s stock of
resources or the efficiency
with which those resources are utilized.
Immobile Resources In our simple comparative model of
Ghana and South
Korea, we assumed that producers (farmers) could easily
convert land from the pro-
duction of cocoa to rice, and vice versa. While this assumption
may hold for some
agricultural products, resources do not always shift quite so
easily from producing

one good to another. A certain amount of friction is involved.
For example, embrac-
ing a free trade regime for an advanced economy such as the
United States often
implies that the country will produce less of some labor-
intensive goods, such as tex-
tiles, and more of some knowledge-intensive goods, such as
computer software or
biotechnology products. Although the country as a whole will
gain from such a shift,
textile producers will lose. A textile worker in South Carolina is
probably not quali-
fied to write software for Microsoft. Thus, the shift to free trade
may mean that she
becomes unemployed or has to accept another less attractive
job, such as working at
a fast-food restaurant.
Resources do not always move easily from one economic
activity to another. The
process creates friction and human suffering too. While the
theory predicts that the
benefits of free trade outweigh the costs by a significant
margin, this is of cold comfort
to those who bear the costs. Accordingly, political opposition to
the adoption of a free
trade regime typically comes from those whose jobs are most at
risk. In the United
States, for example, textile workers and their unions have long
opposed the move
toward free trade precisely because this group has much to lose
from free trade. Govern-
ments often ease the transition toward free trade by helping to
retrain those who lose
their jobs as a result. The pain caused by the movement toward
a free trade regime is
a short-term phenomenon, while the gains from trade once the

transition has been
made are both significant and enduring.
Diminishing Returns The simple comparative advantage
model developed above
assumes constant returns to specialization. By constant returns
to specialization we
mean the units of resources required to produce a good (cocoa
or rice) are assumed to
remain constant no matter where one is on a country’s
production possibility frontier
(PPF). Thus, we assumed that it always took Ghana 10 units of
resources to produce
one ton of cocoa. However, it is more realistic to assume
diminishing returns to special-
ization. Diminishing returns to specialization occurs when more
units of resources are
required to produce each additional unit. While 10 units of
resources may be sufficient
to increase Ghana’s output of cocoa from 12 tons to 13 tons, 11
units of resources may
be needed to increase output from 13 to 14 tons, 12 units of
resources to increase out-
put from 14 tons to 15 tons, and so on. Diminishing returns
implies a convex PPF for
Ghana (see Figure 5.3), rather than the straight line depicted in
Figure 5.2.
It is more realistic to assume diminishing returns for two
reasons. First, not all
resources are of the same quality. As a country tries to increase
its output of a certain
good, it is increasingly likely to draw on more marginal
resources whose productivity
is not as great as those initially employed. The result is that it
requires ever more
resources to produce an equal increase in output. For example,

some land is more pro-
ductive than other land. As Ghana tries to expand its output of
cocoa, it might have to
utilize increasingly marginal land that is less fertile than the
land it originally used. As
yields per acre decline, Ghana must use more land to produce
one ton of cocoa.
Constant Returns
to Specialization
The units of resources
required to produce a
good are assumed to
remain constant no
matter where one is on
a country’s production
possibility frontier.
2010/01:07:10/MHBR169:Slavin:VY
A second reason for diminishing returns is that different goods
use resources in dif-
ferent proportions. For example, imagine that growing cocoa
uses more land and less
labor than growing rice, and that Ghana tries to transfer
resources from rice produc-
tion to cocoa production. The rice industry will release

proportionately too much
labor and too little land for efficient cocoa production. To
absorb the additional
resources of labor and land, the cocoa industry will have to
shift toward more labor-
intensive methods of production. The effect is that the
efficiency with which the cocoa
industry uses labor will decline, and returns will diminish.
Diminishing returns show that it is not feasible for a country
to specialize to the
degree suggested by the simple Ricardian model outlined
earlier. Diminishing returns
to specialization suggest that the gains from specialization are
likely to be exhausted
before specialization is complete. In reality, most countries do
not specialize, but in-
stead, produce a range of goods. However, the theory predicts
that it is worthwhile to
specialize until that point where the resulting gains from trade
are outweighed by di-
minishing returns. Thus, the basic conclusion that unrestricted
free trade is beneficial
still holds, although because of diminishing returns, the gains
may not be as great as
suggested in the constant returns case.
Dynamic Effects and Economic Growth The simple
comparative advantage
model assumed that trade does not change a country’s stock of
resources or the effi-
ciency with which it utilizes those resources. This static
assumption makes no allow-
ances for the dynamic changes that might result from trade. If
we relax this
assumption, it becomes apparent that opening an economy to
trade is likely to gener-

ate dynamic gains of two sorts. 9 First, free trade might
increase a country’s stock of
resources as increased supplies of labor and capital from abroad
become available for
use within the country. For example, this has been occurring in
Eastern Europe since
the early 1990s, with many Western businesses investing
significant capital in the
former Communist countries.
Second, free trade might also increase the efficiency with
which a country uses its
resources. Gains in the efficiency of resource utilization could
arise from a number of fac-
tors. For example, economies of large-scale production might
become available as trade
expands the size of the total market available to domestic firms.
Trade might make better
technology from abroad available to domestic firms; better
technology can increase labor
G
G'
Co
co
a
Rice0
figure 5.3
Ghana’s PPF under
Diminishing Returns

Recognize why many
countries that participate
in a free trade system.
2010/01:07:10/MHBR169:Slavin:VY
productivity or the productivity of land. (The so-called green
revolution had this effect
on agricultural outputs in developing countries.) Also, opening
an economy to foreign
competition might stimulate domestic producers to look for
ways to increase their effi-
ciency. Again, this phenomenon has arguably been occurring in
the once-protected mar-
kets of Eastern Europe, where many former state monopolies
have had to increase the
efficiency of their operations to survive in the competitive
world market.
Dynamic gains in both the stock of a country’s resources and
the efficiency with which
resources are utilized will cause a country’s PPF to shift
outward. This is illustrated in
Figure 5.4, where the shift from PPF 1 to PPF 2 results from

the dynamic gains that arise
from free trade. As a consequence of this outward shift, the
country in Figure 5.4 can
produce more of both goods than it did before introduction of
free trade. The theory
suggests that opening an economy to free trade not only results
in static gains of the type
discussed earlier, but also results in dynamic gains that
stimulate economic growth. If this
is so, then one might think that the case for free trade becomes
stronger still, and in gen-
eral it does. However, as noted above, in a recent article one of
the leading economic
theorists of the twentieth century, Paul Samuelson, argued that
in some circumstances,
dynamic gains can lead to an outcome that is not so beneficial.
The Samuelson Critique Paul Samuelson’s critique looks at
what happens
when a rich country—the United States—enters into a free trade
agreement with a
poor country—China—that rapidly improves its productivity
after the introduction of
a free trade regime (i.e., there is a dynamic gain in the
efficiency with which resources
are used in the poor country). Samuelson’s model suggests that
in such cases, the lower
prices that U.S. consumers pay for goods imported from China
following the intro-
duction of a free trade regime may not be enough to produce a
net gain to for the U.S.
economy if the dynamic effect of free trade is to lower real
wage rates in the United
States. As he stated in a New York Times interview, “Being
able to purchase groceries
20 percent cheaper at Walmart (due to international trade) does

not necessarily make
up for the wage losses (in America).” 10
Samuelson goes on to note that he is particularly concerned
about the ability to off-
shore service jobs that traditionally were not internationally
mobile, such as software
debugging, call center jobs, accounting jobs, and even medical
diagnosis of MRI scans
(see the accompanying Country Focus for details). Recent
advances in communications
Co
co
a
Rice0
PPF2
PPF1
5.4 figure
The Influence of Free
Trade on the PPF
2010/01:07:10/MHBR169:Slavin:VY

technology have made this possible, effectively expanding the
labor market for these jobs
to include educated people in places such as India, the
Philippines, and China. When
coupled with rapid advances in the productivity of foreign labor
due to better education,
the effect on middle-class wages in the United States, according
to Samuelson, may be
similar to mass inward migration into the United States—it will
lower the market clear-
ing wage rate, perhaps by enough to outweigh the positive
benefits of international trade.
Having said this, it should be noted that Samuelson concedes
that free trade has
historically benefited rich counties (as data discussed below
seem to confirm). More-
over, he notes that introducing protectionist measures (e.g.,
trade barriers) to guard
against the theoretical possibility that free trade may harm the
United States in the
future may produce a situation that is worse than the disease the
measures are trying
to prevent. To quote Samuelson: “Free trade may turn out
pragmatically to be still best
Moving U.S. White-Collar Jobs Offshore
Economists have long argued that free trade produces
gains for all countries that participate in a free trading sys-
tem, but as the next wave of globalization sweeps through
the U.S. economy, many people are wondering if this is true,
particularly those who stand to lose their jobs because of
this wave of globalization. In the popular imagination for
much of the past quarter century, free trade was associated

with the movement of low-skill, blue-collar manufacturing
jobs out of rich countries such as the United States and to-
ward low-wage countries—textiles to Costa Rica, athletic
shoes to the Philippines, steel to Brazil, electronic products
to Malaysia, and so on. While many observers bemoaned
the “hollowing out” of U.S. manufacturing, economists
stated that high-skilled and high-wage white-collar jobs
associated with the knowledge-based economy would stay
in the United States. Computers might be assembled in
Malaysia, so the argument went, but they would continue to
be designed in Silicon Valley by high-skilled U.S. engineers.
Recent developments have some people questioning this
assumption. As the global economy slowed after 2000
and corporate profits fell, many American companies
responded by moving white-collar “knowledge-based” jobs
to developing nations where they could be performed for a
fraction of the cost. During the long economic boom of the
1990s, Bank of America had to compete with other organi-
zations for the scarce talents of information technology
specialists, driving annual salaries to more than $100,000.
However, with business under pressure, the bank cut
nearly 5,000 jobs from its 25,000-strong U.S.-based IT work-
force. Some of these jobs were transferred to India, where
work that costs $100 an hour in the United States can be
done for $20 an hour.
One beneficiary of Bank of America’s downsizing is
Infosys Technologies Ltd., a Bangalore, India, information
technology firm where 250 engineers now develop IT
applications for the bank. Other Infosys employees are
busy processing home loan applications for Greenpoint
Mortgage of Novato, California. Nearby in the offices of
another Indian firm, Wipro Ltd., five radiologists interpret
30 CT scans a day for Massachusetts General Hospital
that are sent over the Internet. At yet another Bangalore
business, engineers earn $10,000 a year designing leading-

edge semiconductor chips for Texas Instruments. Nor is
India the only beneficiary of these changes. Accenture, a
large U.S. management consulting and information tech-
nology firm, moved 5,000 jobs in software development
and accounting to the Philippines. Also in the Philippines,
Procter & Gamble employs 650 professionals who prepare
the company’s global tax returns. The work used to be
done in the United States, but now it is done in Manila,
with just final submission to local tax authorities in the
United States and other countries handled locally.
Some architectural work also is being outsourced to
lower-cost locations. Fluor Corp., a Texas-based construc-
tion company, employs some 1,200 engineers and drafts-
men in the Philippines, Poland, and India to turn layouts of
industrial facilities into detailed specifications. For a Saudi
Arabian chemical plant Fluor is designing, 200 young engi-
neers based in the Philippines earning less than $3,000 a
year collaborate in real time over the Internet with elite
U.S. and British engineers who make up to $90,000 a year.
Why does Fluor do this? According to the company, the
answer is simple. Doing so reduces the prices of a project by
15 percent, giving the company a cost-based competitive
advantage in the global market for construction design.
Sources: P. Engardio, A. Bernstein, and M. Kripalani, “Is Your
Job Next?”
BusinessWeek, February 3, 2003, pp. 50–60; “America’s Pain,
India’s Gain,”
The Economist, January 11, 2003, p. 57; and M. Schroeder and
T. Aeppel,
“Skilled Workers Mount Opposition to Free Trade, Swaying
Politicians,”
The Wall Street Journal , October 10, 2003, pp. A1, A11.
3 C o u n t r y F O C U S

2010/01:07:10/MHBR169:Slavin:VY
for each region in comparison to lobbyist-induced tariffs and
quotas which involve
both a perversion of democracy and non-subtle deadweight
distortion losses.” 11
Some economists have been quick to dismiss Samuelson’s
fears. 12 While not ques-
tioning his analysis, they note that developing nations are
unlikely to be able to up-
grade the skill level of their workforce rapidly enough to give
rise to the situation in
Samuelson’s model. In other words, the countries will quickly
run into diminishing
returns. To quote one such rebuttal: “The notion that India and
China will quickly
educate 300 million of their citizens to acquire sophisticated
and complex skills at
stake borders on the ludicrous. The educational sectors in these
countries face enor-
mous difficulties.” 13 Notwithstanding such rebuttals,
however, Samuelson’s stature is
such that his work will undoubtedly be debated for some time.
Evidence for the Link between Trade and Growth Many
economic studies
have looked at the relationship between trade and economic

growth. 14 In general,
these studies suggest that, as predicted by the standard theory of
comparative advan-
tage, countries that adopt a more open stance toward
international trade enjoy higher
growth rates than those that close their economies to trade (the
opening case provides
evidence of the link between trade and growth). Jeffrey Sachs
and Andrew Warner cre-
ated a measure of how “open” to international trade an economy
was and then looked
at the relationship between “openness” and economic growth for
a sample of more
than 100 countries from 1970 to 1990. 15 Among other
findings, they reported:
We find a strong association between openness and growth,
both within the
group of developing and the group of developed countries.
Within the group of
developing countries, the open economies grew at 4.49 percent
per year, and the
closed economies grew at 0.69 percent per year. Within the
group of developed
economies, the open economies grew at 2.29 percent per year,
and the closed
economies grew at 0.74 percent per year. 16
A study by Wacziarg and Welch updated the Sachs and Warner
data through the late
1990s. They found that from 1950 to 1998, countries that
liberalized their trade re-
gimes experienced, on average, increases in their annual growth
rates of 1.5 percent
compared to preliberalization times. 17
The message of these studies seems clear: Adopt an open

economy and embrace
free trade, and your nation will be rewarded with higher
economic growth rates.
Higher growth will raise income levels and living standards.
This last point has been
confirmed by a study that looked at the relationship between
trade and growth in
incomes. The study, undertaken by Jeffrey Frankel and David
Romer, found that on
average, a one percentage point increase in the ratio of a
country’s trade to its gross
domestic product increases income per person by at least one-
half percent. 18 For every
10 percent increase in the importance of international trade in
an economy, average
income levels will rise by at least 5 percent. Despite the short-
term adjustment costs
associated with adopting a free trade regime, trade would seem
to produce greater
economic growth and higher living standards in the long run,
just as the theory of
Ricardo would lead us to expect. 19
Heckscher-Ohlin Theory
Ricardo’s theory stresses that comparative advantage arises
from differences in pro-
ductivity. Thus, whether Ghana is more efficient than South
Korea in the production
of cocoa depends on how productively it uses its resources.
Ricardo stressed labor
productivity and argued that differences in labor productivity
between nations under-
lie the notion of comparative advantage. Swedish economists
Eli Heckscher (in 1919)

Recognize why many
2010/01:07:10/MHBR169:Slavin:VY
and Bertil Ohlin (in 1933) put forward a different explanation
of comparative advan-
tage. They argued that comparative advantage arises from
differences in national fac-
tor endowments. 20 By factor endowments they meant the
extent to which a country
is endowed with such resources as land, labor, and capital.
Nations have varying fac-

tor endowments, and different factor endowments explain
differences in factor costs;
specifically, the more abundant a factor, the lower its cost. The
Heckscher-Ohlin
theory predicts that countries will export those goods that make
intensive use of
factors that are locally abundant, while importing goods that
make intensive use of fac-
tors that are locally scarce. Thus, the Heckscher-Ohlin theory
attempts to explain the
pattern of international trade that we observe in the world
economy. Like Ricardo’s
theory, the Heckscher-Ohlin theory argues that free trade is
beneficial. Unlike
Ricardo’s theory, however, the Heckscher-Ohlin theory argues
that the pattern of
international trade is determined by differences in factor
endowments, rather than
differences in productivity.
The Heckscher-Ohlin theory has commonsense appeal. For
example, the United
States has long been a substantial exporter of agricultural
goods, reflecting in part its
unusual abundance of arable land. In contrast, China excels in
the export of goods
produced in labor-intensive manufacturing industries, such as
textiles and footwear.
This reflects China’s relative abundance of low-cost labor. The
United States, which
lacks abundant low-cost labor, has been a primary importer of
these goods. Note that
it is relative, not absolute, endowments that are important; a
country may have larger
absolute amounts of land and labor than another country, but be
relatively abundant in
one of them.

THE LEONTIEF PARADOX The Heckscher-Ohlin theory has
been one of the
most influential theoretical ideas in international economics.
Most economists prefer
the Heckscher-Ohlin theory to Ricardo’s theory because it
makes fewer simplifying
assumptions. Because of its influence, the theory has been
subjected to many empirical
tests. Beginning with a famous study published in 1953 by
Wassily Leontief (winner
of the Nobel Prize in economics in 1973), many of these tests
have raised questions
about the validity of the Heckscher-Ohlin theory. 21 Using
the Heckscher-Ohlin theory,
Leontief postulated that since the United States was relatively
abundant in capital com-
pared to other nations, the United States would be an exporter
of capital-intensive goods
and an importer of labor-intensive goods. To his surprise,
however, he found that U.S.
exports were less capital intensive than U.S. imports. Since this
result was at variance
with the predictions of the theory, it has become known as the
Leontief paradox.
No one is quite sure why we observe the Leontief paradox.
One possible explana-
tion is that the United States has a special advantage in
producing new products or
goods made with innovative technologies. Such products may be
less capital inten-
sive than products whose technology has had time to mature and
become suitable
for mass production. Thus, the United States may be exporting
goods that heavily
use skilled labor and innovative entrepreneurship, such as

computer software, while
importing heavy manufacturing products that use large amounts
of capital. Some
empirical studies tend to confirm this. 22 Still, tests of the
Heckscher-Ohlin theory
using data for a large number of countries tend to confirm the
existence of the
Leontief paradox. 23
This leaves economists with a difficult dilemma. They prefer
the Heckscher-Ohlin
theory on theoretical grounds, but it is a relatively poor
predictor of real-world inter-
national trade patterns. On the other hand, the theory they
regard as being too lim-
ited, Ricardo’s theory of comparative advantage, actually
predicts trade patterns with
greater accuracy. The best solution to this dilemma may be to
return to the Ricardian
idea that trade patterns are largely driven by international
differences in productivity.
Factor
Endowments
The extent to which a
country is endowed with
such resources as land,
labor, and capital.
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Thus, one might argue that the United States exports
commercial aircraft and imports
textiles not because its factor endowments are especially suited
to aircraft manufacture
and not suited to textile manufacture, but because the United
States is relatively more
efficient at producing aircraft than textiles. A key assumption in
the Heckscher-Ohlin
theory is that technologies are the same across countries. This
may not be the case.
Differences in technology may lead to differences in
productivity, which in turn, drives
international trade patterns. 24 Thus, Japan’s success in
exporting automobiles since the
1970s has been not just because of the relative abundance of
capital, but also because
of its development of innovative manufacturing technology that
enabled it to achieve
higher productivity levels in automobile production than other
countries that also had
abundant capital. More recent empirical work suggests that this
theoretical explana-
tion may be correct. 25 The new research shows that once
differences in technology
across countries are controlled for, countries do indeed export
those goods that make
intensive use of factors that are locally abundant, while
importing goods that make
intensive use of factors that are locally scarce. In other words,
once the impact of dif-
ferences of technology on productivity is controlled for, the

Heckscher-Ohlin theory
seems to gain predictive power.
The Product Life-Cycle Theory
Raymond Vernon initially proposed the product life-cycle
theory in the mid-1960s. 26
Vernon’s theory was based on the observation that for most of
the twentieth century a
very large proportion of the world’s new products had been
developed by U.S. firms
and sold first in the U.S. market (e.g., mass-produced
automobiles, televisions, instant
cameras, photocopiers, personal computers, and semiconductor
chips). To explain this,
Vernon argued that the wealth and size of the U.S. market gave
U.S. firms a strong
incentive to develop new consumer products. In addition, the
high cost of U.S. labor
gave U.S. firms an incentive to develop cost-saving process
innovations.
Just because a new product is developed by a U.S. firm and
first sold in the U.S.
market, it does not follow that the product must be produced in
the United States. It
could be produced abroad at some low-cost location and then
exported back into the
United States. However, Vernon argued that most new products
were initially pro-
duced in America. Apparently, the pioneering firms believed it
was better to keep pro-
duction facilities close to the market and to the firm’s center of
decision making, given
the uncertainty and risks inherent in introducing new products.
Also, the demand for
most new products tends to be based on non-price factors.
Consequently, firms can

charge relatively high prices for new products, which obviates
the need to look for
low-cost production sites in other countries.
Vernon went on to argue that early in the life cycle of a
typical new product, while
demand is starting to grow rapidly in the United States, demand
in other advanced
countries is limited to high-income groups. The limited initial
demand in other
advanced countries does not make it worthwhile for firms in
those countries to start
producing the new product, but it does necessitate some exports
from the United
States to those countries.
Over time, demand for the new product starts to grow in
other advanced countries
(e.g., Great Britain, France, Germany, and Japan). As it does, it
becomes worthwhile
for foreign producers to begin producing for their home
markets. In addition, U.S.
firms might set up production facilities in those advanced
countries where demand is
growing. Consequently, production within other advanced
countries begins to limit
the potential for exports from the United States.
As the market in the United States and other advanced
nations matures, the prod-
uct becomes more standardized, and price becomes the main
competitive weapon. As

2010/01:07:10/MHBR169:Slavin:VY
this occurs, cost considerations start to play a greater role in the
competitive process.
Producers based in advanced countries where labor costs are
lower than in the United
States (e.g., Italy, Spain) might now be able to export to the
United States. If cost
pressures become intense, the process might not stop there. The
cycle by which the
United States lost its advantage to other advanced countries
might be repeated once
more, as developing countries (e.g., Thailand) begin to acquire
a production advan-
tage over advanced countries. Thus, the locus of global
production initially switches
from the United States to other advanced nations and then from
those nations to
developing countries.
The consequence of these trends for the pattern of world
trade is that over time the
United States switches from being an exporter of the product to
an importer of the
product as production becomes concentrated in lower-cost
foreign locations. Figure 5.5
shows the growth of production and consumption over time in
the United States, other

advanced countries, and developing countries.
EVALUATING THE PRODUCT LIFE-CYCLE THEORY
Historically, the
product life-cycle theory seems to be an accurate explanation of
international trade
patterns. Consider photocopiers; the product was first developed
in the early 1960s
by Xerox in the United States and sold initially to U.S. users.
Originally Xerox
exported photocopiers from the United States, primarily to
Japan and the advanced
countries of Western Europe. As demand began to grow in those
countries, Xerox
entered into joint ventures to set up production in Japan (Fuji-
Xerox) and Great
Britain (Rank-Xerox). In addition, once Xerox’s patents on the
photocopier process
expired, other foreign competitors began to enter the market
(e.g., Canon in Japan,
Olivetti in Italy). As a consequence, exports from the United
States declined, and U.S.
users began to buy some of their photocopiers from lower-cost
foreign sources, par-
ticularly Japan. More recently, Japanese companies have found
that manufacturing
costs are too high in their own country, so they have begun to
switch production to
developing countries such as Singapore and Thailand. Thus,
initially the United
States and now other advanced countries (e.g., Japan and Great
Britain) have switched
from being exporters of photocopiers to importers. This
evolution in the pattern of
international trade in photocopiers is consistent with the
predictions of the product

life-cycle theory that mature industries tend to go out of the
United States and into
low-cost assembly locations.
However, the product life-cycle theory is not without
weaknesses. Viewed from
an Asian or European perspective, Vernon’s argument that most
new products are
developed and introduced in the United States seems
ethnocentric and increasingly
dated. Although it may be true that during U.S. dominance of
the global economy
(from 1945 to 1975), most new products were introduced in the
United States, there
have always been important exceptions. These exceptions
appear to have become
more common in recent years. Many new products are now first
introduced in Japan
(e.g., videogame consoles) or Europe (new wireless phones).
Moreover, with the in-
creased globalization and integration of the world economy
discussed in Chapter 1,
a growing number of new products (e.g., laptop computers,
compact disks, and digi-
tal cameras) are now introduced simultaneously in the United
States, Japan, and the
advanced European nations. This may be accompanied by
globally dispersed pro-
duction, with particular components of a new product being
produced in those loca-
tions around the globe where the mix of factor costs and skills
is most favorable (as
predicted by the theory of comparative advantage). In sum,
although Vernon’s the-
ory may be useful for explaining the pattern of international
trade during the brief
period of American global dominance, its relevance in the

modern world seems
more limited.
2010/01:07:10/MHBR169:Slavin:VY
160
140
120
100
80
60
40
20
0
160
140

120
100
80
60
40
20
0
160
140
120
100
80
60
40
20
0
A. United States
B. Other advanced countries

C. Developing countries
Exports
Production
Consumption
Production
Consumption
Production
Consumption
Maturing
product
New
product
Standardized
product
Stages of product development
Exports
Imports
Expo
rts
Imp
orts

Imp
orts
5.5 figure
The Product Life Cycle
Theory
Source: Adapted from R. Vernon
and L. T. Wells, The Economic
Environment of International
Business. 4th ed., © 1986.
Reprinted by permission of
Pearson Education, Inc. Upper
Saddle River, N.J.
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New Trade Theory
The new trade theory began to emerge in the 1970s when a
number of economists

pointed out that the ability of firms to attain economies of scale
might have impor-
tant implications for international trade. 27 Economies of
scale are unit cost reduc-
tions associated with a large scale of output. Economies of scale
have a number of
sources, including the ability to spread fixed costs over a large
volume, and the abil-
ity of large-volume producers to utilize specialized employees
and equipment that
are more productive than less-specialized employees and
equipment. Economies of
scale are a major source of cost reductions in many industries,
from computer soft-
ware to automobiles, and from pharmaceuticals to aerospace.
For example, Micro-
soft realizes economies of scale by spreading the fixed costs of
developing new
versions of its Windows operating system, which runs to about
$5 billion, over the
250 million or so personal computers upon which each new
system is ultimately
installed. Similarly, automobile companies realize economies of
scale by producing
a high volume of automobiles from an assembly line where each
employee has a
specialized task.
New trade theory makes two important points: First, through
its impact on econo-
mies of scale, trade can increase the variety of goods available
to consumers and de-
crease the average costs of those goods. Second, in those
industries where the output
required to attain economies of scale represents a significant
proportion of total world
demand, the global market may be able to support only a small

number of enterprises.
Thus, world trade in certain products may be dominated by
countries whose firms
were first movers in their production.
INCREASING PRODUCT VARIETY AND REDUCING
COSTS Imagine
first a world without trade. In industries where economies of
scale are important, both
the variety of goods that a country can produce and the scale of
production are limited
by the size of the market. If a national market is small, there
may not be enough de-
mand to enable producers to realize economies of scale for
certain products. Accord-
ingly, those products may not be produced, thereby limiting the
variety of products
available to consumers. Alternatively, they may be produced,
but at such low volumes
that unit costs and prices are considerably higher than they
might be if economies of
scale could be realized.
Now consider what happens when nations trade with each
other. Individual na-
tional markets are combined into a larger world market. As the
size of the market ex-
pands due to trade, individual firms may be able to better attain
economies of scale.
The implication, according to new trade theory, is that each
nation may be able to
specialize in producing a narrower range of products than it
would in the absence of
trade, yet by buying goods that it does not make from other
countries, each nation can
simultaneously increase the variety of goods available to its
consumers and lower the

costs of those goods—thus trade offers an opportunity for
mutual gain even when
countries do not differ in their resource endowments or
technology.
Suppose there are two countries, each with an annual market
for 1 million auto-
mobiles. By trading with each other, these countries can create
a combined market
for 2 million cars. In this combined market, due to the ability to
better realize econo-
mies of scale, more varieties (models) of cars can be produced,
and cars can be pro-
duced at a lower average cost, than in either market alone. For
example, demand for
a sports car may be limited to 55,000 units in each national
market, while a total out-
put of at least 100,000 per year may be required to realize
significant scale economies.
Similarly, demand for a minivan may be 80,000 units in each
national market, and
again a total output of at least 100,000 per year may be required
to realize significant
Recognize why many

Economies of Scale
Cost advantages
associated with large-
scale production.
2010/01:07:10/MHBR169:Slavin:VY
scale economies. Faced with limited domestic market demand,
firms in each nation
may decide not to produce a sports car, since the costs of doing
so at such low volume
are too great. Although they may produce minivans, the cost of
doing so will be higher,
as will prices, than if significant economies of scale had been
attained. Once the two
countries decide to trade, however, a firm in one nation may
specialize in producing
sports cars, while a firm in the other nation may produce
minivans. The combined
demand for 110,000 sports cars and 160,000 minivans allows
each firm to realize scale
economies. Consumers in this case benefit from having access
to a product (sports
cars) that was not available before international trade and from
the lower price for a

product (minivans) that could not be produced at the most
efficient scale before inter-
national trade. Trade is thus mutually beneficial because it
allows for the specialization
of production, the realization of scale economies, the
production of a greater variety of
products, and lower prices.
ECONOMIES OF SCALE, FIRST MOVER ADVANTAGES
AND THE
PATTERN OF TRADE A second theme in new trade theory is
that the pattern
of trade we observe in the world economy may be the result of
economies of scale and
first-mover advantages. First-mover advantages are the
economic and strategic ad-
vantages that accrue to early entrants into an industry. 28 The
ability to capture scale
economies ahead of later entrants, and thus benefit from a lower
cost structure, is an
important first-mover advantage. New trade theory argues that
for those products
where economies of scale are significant and represent a
substantial proportion of
world demand, the first movers in an industry can gain a scale-
based cost advantage
that later entrants find almost impossible to match. Thus, the
pattern of trade that we
observe for such products may reflect first-mover advantages.
Countries may domi-
nate in the export of certain goods because economies of scale
are important in their
production and because firms located in those countries were
the first to capture scale
economies, giving them a first-mover advantage.
For example, consider the commercial aerospace industry,

where substantial
scale economies come from the ability to spread the fixed costs
of developing a new
jet aircraft over a large number of sales. It has cost Airbus some
$15 billion to
develop its new super-jumbo jet, the 550-seat A380. To recoup
those costs and
break even, Airbus will have to sell at least 250 A380 planes. If
Airbus can sell over
350 A380 planes, it will apparently be a profitable venture.
Total demand over the
next 20 years for this class of aircraft is estimated to be
somewhere between 400
and 600 units. Thus, the global market can probably profitably
support only one
producer of jet aircraft in the super-jumbo category. It follows
that the European
Union might come to dominate in the export of very large jet
aircraft, primarily
because a European-based firm, Airbus, was the first to produce
a super-jumbo jet
and realize scale economies. Other potential producers, such as
Boeing, might be
shut out of the market because they will lack the scale
economies that Airbus will
enjoy. By pioneering this market category, Airbus may have
captured a first-mover
advantage based on scale economies that will be difficult for
rivals to match, and
that will result in the European Union becoming the leading
exporter of very large
jet aircraft. (Boeing does not believe the market to be large
enough to profitably
support even one producer, hence its decision not to build a
similar aircraft, and
instead focus on its super- efficient 787.)

IMPLICATIONS OF NEW TRADE THEORY New trade
theory has impor-
tant implications. The theory suggests that nations may benefit
from trade even when
they do not differ in resource endowments or technology. Trade
allows a nation to spe-
cialize in the production of certain products, attaining scale
economies and lowering
First-Mover
Advantages
Advantages accruing to
the first to enter a
market.
Recognize why many
2010/01:07:10/MHBR169:Slavin:VY

the costs of producing those products, while buying products
that it does not produce
from other nations that specialize in the production of those
products. By this mecha-
nism, the variety of products available to consumers in each
nation is increased, while
the average costs of those products should fall, as should their
price, freeing resources
to produce other goods and services.
The theory also suggests that a country may predominate in
the export of a good
simply because it was lucky enough to have one or more firms
among the first to pro-
duce that good. Because they are able to gain economies of
scale, the first movers in an
industry may get a lock on the world market that discourages
subsequent entry. First
movers’ ability to benefit from increasing returns creates a
barrier to entry. In the
commercial aircraft industry, the fact that Boeing and Airbus
are already in the indus-
try and have the benefits of economies of scale discourages new
entry and reinforces
the dominance of America and Europe in the trade of midsized
and large jet aircraft.
This dominance is further reinforced because global demand
may not be sufficient to
profitably support another producer of midsized and large jet
aircraft in the industry.
So although Japanese firms might be able to compete in the
market, they have decided
not to enter the industry but to ally themselves as major
subcontractors with primary

producers (e.g., Mitsubishi Heavy Industries is a major
subcontractor for Boeing on
the 777 and 787 programs).
New trade theory is at variance with the Heckscher-Ohlin
theory, which suggests
that a country will predominate in the export of a product when
it is particularly well
endowed with those factors used intensively in its manufacture.
New trade theorists
argue that the United States is a major exporter of commercial
jet aircraft not because
it is better endowed with the factors of production required to
manufacture aircraft,
but because one of the first movers in the industry, Boeing, was
a U.S. firm. The new
trade theory is not at variance with the theory of comparative
advantage. Economies
of scale increase productivity. Thus, the new trade theory
identifies an important
source of comparative advantage.
This theory is quite useful in explaining trade patterns.
Empirical studies seem to sup-
port the predictions of the theory that trade increases the
specialization of production
The European Union may come to dominate in the export of
super-jumbo jets primarily because Airbus, a European-based
firm, was the first to produce a 550-seat aircraft and realize
economies of scale.
2010/01:07:10/MHBR169:Slavin:VY

within an industry, increases the variety of products available to
consumers, and results in
lower average prices. 29 With regard to first-mover
advantages and international trade, a
study by Harvard business historian Alfred Chandler suggests
the existence of first-mover
advantages is an important factor in explaining the dominance
of firms from certain na-
tions in specific industries. 30 The number of firms is very
limited in many global indus-
tries, including the chemical industry, the heavy construction-
equipment industry, the
heavy truck industry, the tire industry, the consumer electronics
industry, the jet engine
industry, and the computer software industry.
Perhaps the most contentious implication of the new trade
theory is the argu-
ment that it generates for government intervention and strategic
trade policy. 31 New
trade theorists stress the role of luck, entrepreneurship, and
innovation in giving a
firm first-mover advantages. According to this argument, the
reason Boeing was the
first mover in commercial jet aircraft manufacture—rather than
firms such as Great
Britain’s DeHavilland and Hawker Siddeley, or Holland’s
Fokker, all of which could
have been—was that Boeing was both lucky and innovative.
One way Boeing was
lucky is that DeHavilland’s Comet jet airliner, introduced two
years earlier than

Boeing’s first jet airliner, the 707, was found to be full of
serious technological flaws.
Had DeHavilland not made serious technological mistakes,
Great Britain might
have become the world’s leading exporter of commercial jet
aircraft. Boeing’s inno-
vativeness was demonstrated by its independent development of
the technological
know-how required to build a commercial jet airliner. Several
new trade theorists
have pointed out, however, that Boeing’s R&D was largely paid
for by the U.S. gov-
ernment; the 707 was a spin-off from a government-funded
military program (the
entry of Airbus into the industry was also supported by
significant government sub-
sidies). Herein is a rationale for government intervention; by
the sophisticated and
judicious use of subsidies, could a government increase the
chances of its domestic
firms becoming first movers in newly emerging industries, as
the U.S. government
apparently did with Boeing (and the European Union did with
Airbus)? If this is
possible, and the new trade theory suggests it might be, we have
an economic ratio-
nale for a proactive trade policy that is at variance with the free
trade prescriptions
of the trade theories we have reviewed so far. We will consider
the policy implica-
tions of this issue in Chapter 6.
National Competitive Advantage:
Porter’s Diamond
In 1990 Michael Porter of the Harvard Business School

published the results of an
intensive research effort that attempted to determine why some
nations succeed and
others fail in international competition. 32 Porter and his
team looked at 100 indus-
tries in 10 nations. Like the work of the new trade theorists,
Porter’s work was driven
by a belief that existing theories of international trade told only
part of the story. For
Porter, the essential task was to explain why a nation achieves
international success in
a particular industry. Why does Japan do so well in the
automobile industry? Why
does Switzerland excel in the production and export of precision
instruments and
pharmaceuticals? Why do Germany and the United States do so
well in the chemical
industry? These questions cannot be answered easily by the
Heckscher-Ohlin theory,
and the theory of comparative advantage offers only a partial
explanation. The theory
of comparative advantage would say that Switzerland excels in
the production and
export of precision instruments because it uses its resources
very productively in
these industries. Although this may be correct, this does not
explain why Switzerland
Explain the arguments of
those who maintain that
government can play a
proactive role in promoting
national competitive

advantage in certain
industries.
2010/01:07:10/MHBR169:Slavin:VY
is more productive in this industry than Great Britain, Germany,
or Spain. Porter
tries to solve this puzzle.
Porter theorizes that four broad attributes of a nation shape
the environment in
which local firms compete, and these attributes promote or
impede the creation of
competitive advantage (see Figure 5.6). These attributes are
• Factor endowments —a nation’s position in factors of
production such as skilled
labor or the infrastructure necessary to compete in a given
industry.
• Demand conditions —the nature of home demand for the

industry’s product or
service.
• Relating and supporting industries —the presence or
absence of supplier industries
and related industries that are internationally competitive.
• Firm strategy, structure, and rivalry —the conditions
governing how companies are
created, organized, and managed and the nature of domestic
rivalry.
Porter speaks of these four attributes as constituting the
diamond. He argues that firms
are most likely to succeed in industries or industry segments
where the diamond is most
favorable. He also argues that the diamond is a mutu-
ally reinforcing system. The effect of one attribute
is contingent on the state of others. For example,
Porter argues favorable demand conditions will not
result in competitive advantage unless the state of
rivalry is sufficient to cause firms to respond to them.
Porter maintains that two additional variables
can influence the national diamond in important
ways: chance and government. Chance events, such
as major innovations, can reshape industry struc-
ture and provide the opportunity for one nation’s
firms to supplant another’s. Government, by its
choice of policies, can detract from or improve na-
tional advantage. For example, regulation can alter
home demand conditions, antitrust policies can in-
fluence the intensity of rivalry within an industry,
and government investments in education can
change factor endowments.

Demand
conditions
Factor
endowments
Related and
supporting
industries
Firm strategy,
structure, and
rivalry
figure 5.6
Determinants of
National Competitive
Advantage: Porter’s
Diamond
Source: Reprinted by permission of
the Harvard Business Review . “The
Competitive Advantage of Nations”
by Michael E. Porter, March–April
1990, p. 77. Copyright © 1990 by
The President and Fellows of

Harvard College; all rights reserved.
North Dakota: Oil Capital of the Plains?
When you think “North Dakota,” what comes to mind? Per-
haps you think endless fields of winter wheat, the Minot Air
Force Base, or the Coen brothers’ award-winning film,
Fargo . You’re probably unlikely to think oil—but if you did,
you’d be right. Thanks to recent technology improvements,
oil has become North Dakota’s fastest-growing industry and
an important new factor endowment for the state. In 2009, oil
production doubled in North Dakota, rendering it the fourth-
largest oil producer in the United States. If estimates are
accurate, some observers believe North Dakota could out-
perform Alaska in oil production by 2019. (Ben Castleman,
“Oil Industry Booms—in North Dakota,” The Wall Street
Journal, February 26, 2010, http://online.wsj.com)
2010/01:07:10/MHBR169:Slavin:VY
FACTOR E N DOWM E NTS Factor en-
dowments lie at the center of the Heckscher-
Ohlin theory. While Porter does not propose
anything radically new, he does analyze the char-
acteristics of factors of production. He recog-
nizes hierarchies among factors, distinguishing

between basic factors (e.g., natural resources, cli-
mate, location, and demographics) and advanced
factors (e.g., communication infrastructure, so-
phisticated and skilled labor, research facilities,
and technological know-how). He argues that
advanced factors are the most significant for
competitive advantage. Unlike the naturally en-
dowed basic factors, advanced factors are a prod-
uct of investment by individuals, companies, and
governments. Thus, government investments in
basic and higher education, by improving the
general skill and knowledge level of the popula-
tion and by stimulating advanced research at
higher education institutions, can upgrade a
nation’s advanced factors.
The relationship between advanced and basic factors is
complex. Basic factors can
provide an initial advantage that is subsequently reinforced and
extended by invest-
ment in advanced factors. Conversely, disadvantages in basic
factors can create pres-
sures to invest in advanced factors. An obvious example of this
phenomenon is Japan,
a country that lacks arable land and mineral deposits and yet
through investment has
built a substantial endowment of advanced factors. Porter notes
that Japan’s large pool
of engineers (reflecting a much higher number of engineering
graduates per capita
than almost any other nation) has been vital to Japan’s success
in many manufacturing
industries.
DEMAND CONDITIONS Porter emphasizes the role home
demand plays in
upgrading competitive advantage. Firms are typically most

sensitive to the needs of
their closest customers. Thus, the characteristics of home
demand are particularly im-
portant in shaping the attributes of domestically made products
and in creating pres-
sures for innovation and quality. Porter argues that a nation’s
firms gain competitive
advantage if their domestic consumers are sophisticated and
demanding. Such con-
sumers pressure local firms to meet high standards of product
quality and to produce
innovative products. Porter notes that Japan’s sophisticated and
knowledgeable buyers
of cameras helped stimulate the Japanese camera industry to
improve product quality
and to introduce innovative models. A similar example can be
found in the wireless
telephone equipment industry, where sophisticated and
demanding local customers in
Scandinavia helped push Nokia of Finland and Ericsson of
Sweden to invest in cellular
phone technology long before demand for cellular phones took
off in other developed
nations. The case of Nokia is reviewed in more depth in the
accompanying Manage-
ment Focus.
RELATED AND SUPPORTING INDUSTRIES The third
broad attribute
of national advantage in an industry is the presence of suppliers
or related industries
that are internationally competitive. The benefits of investments
in advanced factors
of production by related and supporting industries can spill over
into an industry,

Factor Endowments: A Quiz
One of the most significant factor endowments is educa-
tion, with important measures being literacy rate and the
literacy rate gap between the genders. Which of the fol-
lowing countries do you think has the largest literacy gap
between males and females? (a) Iraq, (b) Rwanda,
(c) Chile, (d) India.
The answer may surprise you. It’s not Iraq, although in
nearly all countries of the Middle East, men are more likely
than women to be literate. With 74 percent literacy overall,
Iraq has a nearly 20-point gap between males and females.
Nor is it Rwanda, with a 12-point gap and a 70 percent lit-
eracy rate overall. And it certainly isn’t Chile, with its
96 percent literacy rate and less than a 1-point gap be-
tween the sexes. It is India, with an overall adult literacy
rate of 61 percent and a gap of nearly 26 points between
males and females. (U.S. Central Intelligence Agency,
World Factbook 2010, www.cia.gov)
2010/01:07:10/MHBR169:Slavin:VY
thereby helping it achieve a strong competitive position
internationally. Swedish
strength in fabricated steel products (e.g., ball bearings and
cutting tools) has drawn

on strengths in Sweden’s specialty steel industry. Technological
leadership in the U.S.
semiconductor industry provided the basis for U.S. success in
personal computers and
several other technically advanced electronic products.
Similarly, Switzerland’s success
in pharmaceuticals is closely related to its previous
international success in the techno-
logically related dye industry.
M a n a g e m e n t F O C U S
The Rise of Finland’s Nokia
The wireless phone market is one of the great growth sto-
ries of the last decade. Starting from a very low base in
1990, annual global sales of wireless phones surged to
reach about 1.2 billion units in 2009. By the end of 2009, the
number of wireless subscriber accounts worldwide was
around 4.5 billion, up from less than 10 million in 1990.
Nokia is one of the dominant players in the world market
for mobile phones with a 37 percent share of the market in
2008. Nokia’s roots are in Finland, not normally a country
that comes to mind when one talks about leading-edge
technology companies. In the 1980s, Nokia was a rambling
Finnish conglomerate with activities that embraced tire
manufacturing, paper production, consumer electronics,
and telecommunications equipment. By the early 2000s it
had transformed itself into a focused telecommunications
equipment manufacturer with a global reach. How has this
former conglomerate emerged to take a global leadership
position in wireless telecommunications equipment? Much
of the answer lies in the history, geography, and political
economy of Finland and its Nordic neighbors.
In 1981 the Nordic nations cooperated to create the
world’s first international wireless telephone network.

They had good reason to become pioneers: It cost far too
much to lay a traditional wire-line telephone service in
those sparsely populated and inhospitably cold countries.
The same features made telecommunications all the more
valuable: People driving through the Arctic winter and
owners of remote northern houses needed a telephone to
summon help if things went wrong. As a result, Sweden,
Norway, and Finland became the first nations in the world
to take wireless telecommunications seriously. They found,
for example, that although it cost up to $800 per subscriber
to bring a traditional wire-line service to remote locations,
the same locations could be linked by wireless cellular for
only $500 per person. As a consequence, 12 percent of
people in Scandinavia owned cellular phones by 1994,
compared with less than 6 percent in the United States, the
world’s second most developed market. This lead contin-
ued over the next decade. By 2008, 90 percent of the popu-
lation in Finland owned a wireless phone, compared with
70 percent in the United States.
Nokia, a longtime telecommunications equipment sup-
plier, was well positioned to take advantage of this devel-
opment from the start, but other forces were also at work
to help Nokia develop its competitive edge. Unlike virtually
every other developed nation, Finland has never had a
national telephone monopoly. Instead, the country’s tele-
phone services have long been provided by about
50 autonomous local telephone companies whose elected
boards set prices by referendum (which naturally means
low prices). This army of independent and cost-conscious
telephone service providers prevented Nokia from taking
anything for granted in its home country. With typical
Finnish pragmatism, its customers were willing to buy from
the lowest-cost supplier, whether that was Nokia, Ericsson,
Motorola, or some other company. This situation con-
trasted sharply with that prevailing in most developed na-

tions until the late 1980s and early 1990s, where domestic
telephone monopolies typically purchased equipment from
a dominant local supplier or made it themselves. Nokia re-
sponded to this competitive pressure by doing everything
possible to drive down its manufacturing costs while stay-
ing at the leading edge of wireless technology.
The consequences of these forces are clear. Nokia is
now a leader in digital wireless technology. Many now re-
gard Finland as one of the lead markets for wireless tele-
phone services. If you want to see the future of wireless, you
don’t go to New York or San Francisco; you go to Helsinki,
where Finns use their wireless handsets not just to talk to
each other or browse the Web, but also to control house-
hold heating and lighting systems, or purchase Coke from a
wireless-enabled vending machine. Nokia has gained this
lead because Scandinavia started switching to digital
technology five years before the rest of the world.
Sources: “Lessons from the Frozen North,” The Economist ,
October 8, 1994,
pp. 76–77; “A Finnish Fable,” The Economist , October 14,
2000; D. O’Shea
and K. Fitchard, “The First 3 Billion Is Always the Hardest,”
Wireless
Review 22 (September 2005), pp. 25–31; P. Taylor, “Big
Names Dominate in
Mobile Phones,” Financial Times , September 29, 2006, p. 26;
and Nokia
Web site at www.nokia.com.
2010/01:07:10/MHBR169:Slavin:VY

One consequence of this process is that successful industries
within a country tend
to be grouped into clusters of related industries. This was one of
the most pervasive
findings of Porter’s study. One such cluster Porter identified
was in the German textile
and apparel sector, which included high-quality cotton, wool,
synthetic fibers, sewing
machine needles, and a wide range of textile machinery. Such
clusters are important
because valuable knowledge can flow between the firms within
a geographic cluster,
benefiting all within that cluster. Knowledge flows occur when
employees move be-
tween firms within a region and when national industry
associations bring employees
from different companies together for regular conferences or
workshops. 33
FIRM STRATEGY, STRUCTURE, AND RIVALRY The
fourth broad attri-
bute of national competitive advantage in Porter’s model is the
strategy, structure, and
rivalry of firms within a nation. Porter makes two important
points here. First, differ-
ent nations are characterized by different management
ideologies, which either help
them or do not help them to build national competitive
advantage. For example,
Porter noted the predominance of engineers in top management
at German and

Japanese firms. He attributed this to these firms’ emphasis on
improving manufactur-
ing processes and product design. In contrast, Porter noted a
predominance of people
with finance backgrounds leading many U.S. firms. He linked
this to U.S. firms’ lack
of attention to improving manufacturing processes and product
design. He argued
that the dominance of finance led to an overemphasis on
maximizing short-term
financial returns. According to Porter, one consequence of
these different manage-
ment ideologies was a relative loss of U.S. competitiveness in
those engineering-based
industries where manufacturing processes and product design
issues are all-important
(e.g., the automobile industry).
Porter’s second point is that there is a strong association
between vigorous do-
mestic rivalry and the creation and persistence of competitive
advantage in an in-
dustry. Vigorous domestic rivalry induces firms to look for
ways to improve
efficiency, which makes them better international competitors.
Domestic rivalry
creates pressures to innovate, to improve quality, to reduce
costs, and to invest in
upgrading advanced factors. All this helps to create world-class
competitors. Porter
cites the case of Japan:
Nowhere is the role of domestic rivalry more evident than in
Japan, where it is
all-out warfare in which many companies fail to achieve
profitability. With goals
that stress market share, Japanese companies engage in a

continuing struggle to
outdo each other. Shares fluctuate markedly. The process is
prominently covered
in the business press. Elaborate rankings measure which
companies are most
popular with university graduates. The rate of new product and
process develop-
ment is breathtaking. 34
A similar point about the stimulating effects of strong
domestic competition can be
made with regard to the rise of Nokia of Finland to global
preeminence in the market
for cellular telephone equipment. For details, see the
Management Focus.
EVALUATING PORTER’S THEORY Porter contends that the
degree to
which a nation is likely to achieve international success in a
certain industry is a
function of the combined impact of factor endowments,
domestic demand condi-
tions, related and supporting industries, and domestic rivalry.
He argues that the
presence of all four components is usually required for this
diamond to boost com-
petitive performance (although there are exceptions). Porter
also contends that gov-
ernment can influence each of the four components of the
diamond—either
Explain the arguments of
those who maintain that
government can play a

proactive role in promoting
national competitive
advantage in certain
industries.
2010/01:07:10/MHBR169:Slavin:VY
positively or negatively. Factor endowments can be affected by
subsidies, policies
toward capital markets, policies toward education, and so on.
Government can shape
domestic demand through local product standards or with
regulations that mandate
or influence buyer needs. Government policy can influence
supporting and related
industries through regulation and influence firm rivalry through
such devices as
capital market regulation, tax policy, and antitrust laws.
If Porter is correct, we would expect his model to predict the
pattern of interna-
tional trade that we observe in the real world. Countries should
be exporting products
from those industries where all four components of the diamond
are favorable, while
importing in those areas where the components are not

favorable. Is he correct? We
simply do not know. Porter’s theory has not been subjected to
detailed empirical test-
ing. Much about the theory rings true, but the same can be said
for the new trade
theory, the theory of comparative advantage, and the Heckscher-
Ohlin theory. It may
be that each of these theories, which complement each other,
explains something
about the pattern of international trade.
Focus on Managerial Implications
Why does all this matter for business? There are at least three
main implications for
international businesses of the material discussed in this
chapter: location implica-
tions, first-mover implications, and policy implications.
Location
Underlying most of the theories we have discussed is the notion
that different coun-
tries have particular advantages in different productive
activities. Thus, from a profit
perspective, it makes sense for a firm to disperse its productive
activities to those
countries where, according to the theory of international trade,
they can be per-
formed most efficiently. If design can be performed most
efficiently in France, that is
where design facilities should be located; if the manufacture of
basic components can
be performed most efficiently in Singapore, that is where they
should be manufac-
tured; and if final assembly can be performed most efficiently
in China, that is where

final assembly should be performed. The result is a global web
of productive activi-
ties, with different activities being performed in different
locations around the globe
depending on considerations of comparative advantage, factor
endowments, and the
like. If the firm does not do this, it may find itself at a
competitive disadvantage rela-
tive to firms that do.
Consider the production of a laptop computer, a process with
four major stages:
(1) basic research and development of the product design, (2)
manufacture of standard
electronic components (e.g., memory chips), (3) manufacture of
advanced components
(e.g., flat-top color display screens and microprocessors), and
(4) final assembly. Basic
R&D requires a pool of highly skilled and educated workers
with good backgrounds
in microelectronics. The two countries with a comparative
advantage in basic micro-
electronics R&D and design are Japan and the United States, so
most producers of
laptop computers locate their R&D facilities in one, or both, of
these countries.
(Apple, IBM, Motorola, Texas Instruments, Toshiba, and Sony
all have major R&D
facilities in both Japan and the United States.)
Understand the important
implications that
international trade theory
holds for business practice.

2010/01:07:10/MHBR169:Slavin:VY
The manufacture of standard electronic components is a
capital-intensive process
requiring semiskilled labor, and cost pressures are intense. The
best locations for such
activities today are places such as Taiwan, Malaysia, and South
Korea. These coun-
tries have pools of relatively skilled, moderate-cost labor. Thus,
many producers of
laptop computers have standard components, such as memory
chips, produced at
these locations.
The manufacture of advanced components such as
microprocessors is a capital-
intensive process requiring skilled labor. Because cost pressures
are not so intense at
this stage, these components can be—and are—manufactured in
countries with
high labor costs that also have pools of highly skilled labor
(e.g. Japan and the
United States).
Finally, assembly is a relatively labor-intensive process
requiring only low-skilled
labor, and cost pressures are intense. As a result, final assembly
may be carried out in
a country such as Mexico, which has an abundance of low-cost,
low-skilled labor. A

laptop computer produced by a U.S. manufacturer may be
designed in California,
have its standard components produced in Taiwan and
Singapore, its advanced com-
ponents produced in Japan and the United States, its final
assembly in Mexico, and be
sold in the United States or elsewhere in the world. By
dispersing production activi-
ties to different locations around the globe, the U.S.
manufacturer is taking advan-
tage of the differences between countries identified by the
various theories of
international trade.
First-Mover Advantages
According to the new trade theory, firms that establish a first-
mover advantage with
regard to the production of a particular new product may
subsequently dominate
global trade in that product. This is particularly true in
industries where the global
market can profitably support only a limited number of firms,
such as the aerospace
market, but early commitments also seem to be important in less
concentrated indus-
tries such as the market for cellular telephone equipment (see
the Management Focus
on Nokia). For the individual firm, the clear message is that it
pays to invest substan-
tial financial resources in trying to build a first-mover, or early-
mover, advantage, even
if that means several years of losses before a new venture
becomes profitable. The idea
is to preempt the available demand, gain cost advantages related
to volume, build an
enduring brand ahead of later competitors, and, consequently,

establish a long-term
sustainable competitive advantage. Although the details of how
to achieve this are be-
yond the scope of this book, many publications offer strategies
for exploiting first-
mover advantages, and for avoiding the traps associated with
pioneering a market
(first-mover disadvantages). 35
Government Policy
The theories of international trade also matter to international
businesses because
firms are major players on the international trade scene.
Business firms produce ex-
ports, and business firms import the products of other countries.
Because of their
pivotal role in international trade, businesses can exert a strong
influence on govern-
ment trade policy, lobbying to promote free trade or trade
restrictions. The theories of
international trade claim that promoting free trade is generally
in the best interests of
a country, although it may not always be in the best interest of
an individual firm.
Many firms recognize this and lobby for open markets.
For example, when the U.S. government announced its
intention to place a tariff on
Japanese imports of liquid-crystal display (LCD) screens in the
1990s, IBM and Apple
Computer protested strongly. Both IBM and Apple pointed out
that (1) Japan was the
lowest-cost source of LCD screens, (2) they used these screens
in their own laptop

2010/01:07:10/MHBR169:Slavin:VY
computers, and (3) the proposed tariff, by increasing the cost of
LCD screens, would
increase the cost of laptop computers produced by IBM and
Apple, thus making them
less competitive in the world market. In other words, the tariff,
designed to protect
U.S. firms, would be self-defeating. In response to these
pressures, the U.S. govern-
ment reversed its posture.
Unlike IBM and Apple, however, businesses do not always
lobby for free trade. In
the United States, for example, restrictions on imports of steel
are the result of direct
pressure by U.S. firms on the government. In some cases, the
government has re-
sponded to pressure by getting foreign companies to agree to
“voluntary” restrictions
on their imports, using the implicit threat of more
comprehensive formal trade barri-
ers to get them to adhere to these agreements (historically, this
has occurred in the
automobile industry). In other cases, the government used what
are called “antidump-
ing” actions to justify tariffs on imports from other nations
(these mechanisms will be
discussed in detail in the next chapter).
As predicted by international trade theory, many of these

agreements have been
self-defeating, such as the voluntary restriction on machine tool
imports agreed to in
1985. Due to limited import competition from more efficient
foreign suppliers, the
prices of machine tools in the United States rose to higher
levels than would have
prevailed under free trade. Because machine tools are used
throughout the manufac-
turing industry, the result was to increase the costs of U.S.
manufacturing in general,
creating a corresponding loss in world market competitiveness.
Shielded from interna-
tional competition by import barriers, the U.S. machine tool
industry had no incentive
to increase its efficiency. Consequently, it lost many of its
export markets to more ef-
ficient foreign competitors. Because of this misguided action,
the U.S. machine tool
industry shrunk during the period when the agreement was in
force. For anyone
schooled in international trade theory, this was not surprising.
36 A similar scenario
unfolded in the U.S. steel industry, where tariff barriers erected
by the government in
2001 raised the cost of steel to important U.S. users, such as
automobile companies
and appliance makers, making their products more
uncompetitive.
Finally, Porter’s theory of national competitive advantage also
contains policy im-
plications. Porter’s theory suggests that it is in the best interest
of business for a firm
to invest in upgrading advanced factors of production; for
example, to invest in bet-
ter training for its employees and to increase its commitment to

research and devel-
opment. It is also in the best interests of business to lobby the
government to adopt
policies that have a favorable impact on each component of the
national diamond.
Thus, according to Porter, businesses should urge government to
increase invest-
ment in education, infrastructure, and basic research (since all
these enhance ad-
vanced factors) and to adopt policies that promote strong
competition within
domestic markets (since this makes firms stronger international
competitors, ac-
cording to Porter’s findings).
free trade, p. 163
new trade theory, p. 165
mercantilism, p. 165
zero-sum game, p. 167
absolute advantage, p. 167
constant returns to specialization,
p. 173
factor endowments, p. 178
economies of scale, p. 182
first-mover advantages, p. 183
Key Terms
2010/01:07:10/MHBR169:Slavin:VY

Summary
This chapter has reviewed a number of theories that
explain why it is beneficial for a country to engage in
international trade and has explained the pattern of
international trade observed in the world economy.
We have seen how the theories of Smith, Ricardo,
and Heckscher-Ohlin all make strong cases for un-
restricted free trade. In contrast, the mercantilist
doctrine and, to a lesser extent, the new trade theory
can be interpreted to support government interven-
tion to promote exports through subsidies and to
limit imports through tariffs and quotas.
In explaining the pattern of international trade,
the second objective of this chapter, we have seen
that with the exception of mercantilism, which is
silent on this issue, the different theories offer largely
complementary explanations. Although no one the-
ory may explain the apparent pattern of international
trade, taken together, the theory of comparative
advantage, the Heckscher-Ohlin theory, the product
life-cycle theory, the new trade theory, and Porter’s
theory of national competitive advantage do suggest
which factors are important. Comparative advantage
tells us that productivity differences are important;
Heckscher-Ohlin tells us that factor endowments
matter; the product life-cycle theory tells us that
where a new product is introduced is important; the
new trade theory tells us that increasing returns to
specialization and first-mover advantages matter; and
Porter tells us that all these factors may be important

insofar as they impact the four components of the
national diamond. The chapter made these major
points:
1. Mercantilists argued that it was in a country’s
best interests to run a balance-of-trade surplus.
They viewed trade as a zero-sum game, in
which one country’s gains cause losses for other
countries.
2. The theory of absolute advantage suggests that
countries differ in their ability to produce
goods efficiently. The theory suggests that a
country should specialize in producing goods
in areas where it has an absolute advantage and
import goods in areas where other countries
have absolute advantages.
3. The theory of comparative advantage suggests
that it makes sense for a country to specialize in
producing those goods that it can produce
most efficiently, while buying goods that it can
produce relatively less efficiently from other
countries—even if that means buying goods
from other countries that it could produce
more efficiently itself.
4. The theory of comparative advantage suggests
that unrestricted free trade brings about
increased world production; that is, that trade
is a positive-sum game.
5. The theory of comparative advantage also
suggests that opening a country to free trade
stimulates economic growth, which creates

dynamic gains from trade. The empirical
evidence seems to be consistent with this claim.
6. The Heckscher-Ohlin theory argues that the
pattern of international trade is determined by
differences in factor endowments. It predicts
that countries will export those goods that
make intensive use of locally abundant factors
and will import goods that make intensive use
of factors that are locally scarce.
7. The product life-cycle theory suggests that
trade patterns are influenced by where a new
product is introduced. In an increasingly
integrated global economy, the product life-
cycle theory seems to be less predictive than it
once was.
8. New trade theory states that trade allows a
nation to specialize in the production of certain
goods, attaining scale economies and lowering
the costs of producing those goods, while
buying goods that it does not produce from
other nations that are similarly specialized. By
this mechanism, the variety of goods available
to consumers in each nation is increased, while
the average costs of those goods should fall.
9. New trade theory also states that in those
industries where substantial economies of scale
imply that the world market will profitably
support only a few firms, countries may
predominate in the export of certain products
simply because they had a firm that was a first
mover in that industry.

10. Some new trade theorists have promoted the
idea of strategic trade policy. The argument is
that government, by the sophisticated and
judicious use of subsidies, might be able to
increase the chances of domestic firms becoming
first movers in newly emerging industries.
2010/01:07:10/MHBR169:Slavin:VY
11. Porter’s theory of national competitive advantage
suggests that the pattern of trade is influenced
by four attributes of a nation: (a) factor
endowments, (b) domestic demand conditions,
(c) relating and supporting industries, and
(d) firm strategy, structure, and rivalry.
12. Theories of international trade are important
to an individual business firm primarily because
they can help the firm decide where to locate
its various production activities.
13. Firms involved in international trade can and
do exert a strong influence on government
policy toward trade. By lobbying government,
business firms can promote free trade or trade
restrictions.

Critical Thinking and Discussion Questions
1. Mercantilism is a bankrupt theory that has no
place in the modern world. Discuss.
2. Is free trade fair? Discuss.
3. Unions in developed nations often oppose
imports from low-wage countries and advocate
trade barriers to protect jobs from what they
often characterize as “unfair” import
competition. Is such competition “unfair”? Do
you think that this argument is in the best
interests of ( a ) the unions, ( b ) the people they
represent, and/or ( c ) the country as a whole?
4. What are the potential costs of adopting a free
trade regime? Do you think governments should
do anything to reduce these costs? What?
5. Reread the Country Focus “Is China a Neo-
mercantilist Nation?”
a. Do you think China is pursing an economic
policy that can be characterized as neo-
mercantilist?
b. What should the United States, and other
countries, do about this?
6. Reread the Country Focus “Moving U.S. White-
Collar Jobs Offshore.”
a. Who benefits from the outsourcing of skilled
white-collar jobs to developing nations? Who

are the losers?
b. Will developing nations like the United States
suffer from the loss of high-skilled and high-
paying jobs?
c. Is there a difference between the transference
of high-paying white-collar jobs, such as
computer programming and accounting, to
developing nations and low-paying blue-collar
jobs? If so, what is the difference, and should
government do anything to stop the flow of
white-collar jobs out of the country to
countries such as India?
7. Drawing upon the new trade theory and Porter’s
theory of national competitive advantage, outline
the case for government policies that would
build national competitive advantage in
biotechnology. What kinds of policies would you
recommend that the government adopt? Are
these policies at variance with the basic free
trade philosophy?
8. The world’s poorest countries are at a
competitive disadvantage in every sector of their
economies. They have little to export. They have
no capital; their land is of poor quality; they
often have too many people given available work
opportunities; and they are poorly educated.
Free trade cannot possibly be in the interests of
such nations! Discuss.
Use the globalEDGE Resource Desk (http://
globalEDGE.msu.edu/resourcedesk/) to complete
the following exercises:

1. You work for a telecommunications company
and your current project is to determine the five
African countries that, in your estimation, should
have an advantage in telecommunications
infrastructure. Use a resource that tracks statistics
on economic factors such as Internet use of each
country. Develop a list and brief report on the
top five African countries in telecommunications
infrastructure. Were you surprised by any
countries listed? Why (or, why not)?
Research Task http://globalEDGE.msu.edu
2010/01:07:10/MHBR169:Slavin:VY
2. Your coffee firm is seeking new locations to
source coffee from to sustain its growth as it
internationalizes. Currently, your company only
purchases green coffee beans from South
America and is hoping to begin purchasing
coffee from the Central American countries of
Costa Rica, El Salvador, Guatemala, Honduras,
and Panama. Applying the most current
information from FAOSTAT, a UN agency Web

site that gathers data on food and agricultural
trade flows, determine which three countries
have the highest export value of green coffee as
well as growth of export value over the most
recent year of data available.
Logitech
Best known as one of the world’s largest producers of com-
puter mice, Logitech is in many ways the epitome of the mod-
ern global corporation. Founded in 1981 in Apples, Switzerland,
by two Italians and a Swiss, the company now generates
annual sales of more than $2.2 billion, most from products
such as mice, keyboards and low-cost video-cams. Logitech
made its name as a technological innovator in the highly
competitive business of personal computer peripherals. It
was the first company to introduce a mouse that used infrared
tracking, rather than a tracking ball, and the first to introduce
the wireless mouse and keyboard. Logitech is differentiated
from competitors by its continuing innovation, its high brand
recognition, and strong retail presence. Less obvious to con-
sumers, but equally important, has been the way the company
has configured its global value chain to lower production
costs while maintaining the value of those assets that lead to
differentiation.
Logitech still undertakes basic R&D work (primarily soft-
ware programming) in Switzerland where it has several hun-
dred employees. The company is still legally Swiss, but most
of the corporate functions are run out of offices in Fremont,
California, close to many of America’s high-technology enter-
prises, where it has more than 500 employees. Some R&D
work (again, primarily software programming) is also carried
out in Fremont. Most significantly though, Fremont is the
headquarters for the company’s global marketing, finance,
and logistics operations. The ergonomic design of Logitech’s
products—their look and feel—is done in Ireland by an out-

side design firm. Most of Logitech’s products are manufac-
tured in Asia.
Logitech’s expansion into Asian manufacturing began in
the late 1980s when it opened a factory in Taiwan. At the time,
most of its mice were produced in the United States. Logitech
was trying to win two of the most prestigious OEM customers—
Apple Computer and IBM. Both bought their mice from Alps,
a large Japanese firm that supplied Microsoft. To attract
discerning customers such as Apple, Logitech not only
needed the capacity to produce at high volume and low cost,
bit it also had to offer a better-designed product. The solution:
manufacture in Taiwan. Cost was a factor in the decision, but
it was not as significant as might be expected, since direct
labor accounted for only 7 percent of the cost of Logitech’s
mouse. Taiwan offered a well-developed supply base for
parts, qualified people, and a rapidly expanding local com-
puter industry. As an inducement to fledgling innovators,
Taiwan provided space in its Hsinchu Science and Industrial
Park for the modest fee of $200,000. Sizing this up as a deal
that was too good to pass up, Logitech signed the lease. Soon
afterward, Logitech won the OEM contract with Apple. The
Taiwanese factory was soon outproducing Logitech’s U.S.
facility. After the Apple contract, Logitech’s other OEM busi-
ness started being served from Taiwan; the plant’s total
capacity increased to 10 million mice per year.
By the late 1990s, Logitech needed more production ca-
pacity. This time it turned to China. A wide variety of the com-
pany’s retail products are now made there. Take one of
Logitech’s biggest sellers, a wireless infrared mouse called
Wanda. The mouse itself is assembled in Suzhou, China, in a
factory that Logitech owns. The factory employs 4,000 people,
mostly young women such as Wang Yan, an 18-year-old em-
ployee from the impoverished rural province of Anhui. She is
paid $75 a month to sit all day at a conveyer belt plugging
three tiny bits of metal into circuit boards. She does this about

2,000 times each day. The mouse Wang Yan helps assemble
sells to American consumers for about $40. Of this, Logitech
takes about $8, which is used to fund R&D, marketing, and
corporate overhead. What remains from the $8 is the profit
attributable to Logitech’s shareholders. Distributors and re-
tailers around the world take a further $15. Another $14 goes
to the suppliers that make Wanda’s parts. For example, a
Motorola plant in Malaysia makes the mouse’s chips and
another American company, Agilent Technologies, supplies
closing case
2010/01:07:10/MHBR169:Slavin:VY
the optical sensors from a plant in the Philippines. That leaves
just $3 for the Chinese factory, which is used to cover wages,
power, transport, and other overhead costs.
Logitech is not alone in exploiting China to manufacture
products. According to China’s Ministry of Commerce, foreign
companies account for three-quarters of China’s high-tech
exports. China’s top 10 exporters include American compa-
nies with Chinese operations, such as Motorola and Seagate
Technology, a maker of disk drives for computers. Intel now
produces some 50 million chips a year in China, the majority
of which end up in computers and other goods that are ex-
ported to other parts of Asia, or back to the United States. Yet
Intel’s plant in Shanghai doesn’t really make chips; it tests

and assembles chips from silicon wafers made in Intel plants
abroad, mostly in the United States. China adds less than
5 percent of the value. The U.S. operations of Intel generate
the bulk of the value and profits.
Sources: V. K. Jolly and K. A. Bechler, “Logitech: The Mouse
that
Roared,” Planning Review 20, no. 6 (1992), pp. 20–34; K.
Guerrino,
“Lord of the Mice,” Chief Executive , July 2003, pp. 42–44; A.
Higgins,
“As China Surges, It Also Proves a Buttress to American
Strength,”
The Wall Street Journal , January 30, 2004, pp. A1, A8; J. Fox,
“Where
Is Your Job Going?” Fortune , November 24, 2003, pp. 84–88;
and
R. Wray, “Logitech Cuts 500 Jobs and Abandons Targets,”
The Guardian , January 7, 2009, p. 28.
Case Discussion Questions
1. In a world without trade, what would happen to the costs
that American consumers would have to pay for
Logitech’s products?
2. Explain how trade lowers the costs of making computer
peripherals such as mice and keyboards.
3. Use the theory of comparative advantage to explain the
way in which Logitech has configured its global
operations. Why does the company manufacture in China
and Taiwan, undertake basic R&D in California and
Switzerland, design products in Ireland, and coordinate
marketing and operations from California?

4. Who creates more value for Logitech—the 650 people it
employs in California and Switzerland, or the 4,000
employees at its Chinese factory? What are the
implications of this observation for the argument that free
trade is beneficial?
5. Why do you think the company decided to shift its
corporate headquarters from Switzerland to Fremont?
6. To what extent can Porter’s diamond help explain the
choice of Taiwan as a major manufacturing site for
Logitech?
7. Why do you think China is now a favored location for so
much high-technology manufacturing activity? How will
China’s increasing involvement in global trade help that
country? How will it help the world’s developed
economies? What potential problems are associated with
moving work to China?
2010/01:07:10/MHBR169:Slavin:VY
Aa p p e n d i x
International trade involves the sale of goods and services to
residents in other coun-
tries (exports) and the purchase of goods and services from

residents in other countries
(imports). A country’s balance-of-payments accounts keep
track of the payments to
and receipts from other countries for a particular time period.
These include payments
to foreigners for imports of goods and service, and receipts
from foreigners for goods
and services exported to them. A summary copy of the U.S.
balance-of-payments
accounts for 2008 is given in Table A.1. Any transaction
resulting in a payment to
other countries is entered in the balance-of-payments accounts
as a debit and given a
negative (2) sign. Any transaction resulting in a receipt from
other countries is entered
as a credit and given a positive (1) sign. In this appendix we
briefly describe the form
of the balance-of-payments accounts, and we discuss whether a
current account defi-
cit, often a cause of much concern in the popular press, is
something to worry about.
Balance of Payments Accounts
Balance-of-payments accounts are divided into three main
sections: the current account,
the capital account, and the financial account (to confuse
matters, what is now called the
capital account was until recently part of the current account,
and the financial account
use to be called the capital account). The current account
records transactions that
pertain to three categories, all of which can be seen in Table
A.1. The first category, goods ,
refers to the export or import of physical goods (e.g.,
agricultural foodstuffs, autos, com-
puters, chemicals). The second category is the export or import

of services (e.g., intangi-
ble products such as banking and insurance services). The third
category, income receipts
and payments , refers to income from foreign investments and
payments that have to be
made to foreigners investing in a country. For example, if a
U.S. citizen owns a share of
a Finnish company and receives a dividend payment of $5, that
payment shows up on
the U.S. current account as the receipt of $5 of investment
income. Also included in the
current account are unilateral current transfers, such as U.S.
government grants to
foreigners (including foreign aid), and private payments to
foreigners (such as when a
foreign worker in the United States sends money to his or her
home country).
International Trade and the
Balance of Payments
Balance-of-
Payments Accounts
National accounts that
track both payments to
and receipts from
foreigners.
Current Account
In the balance of
payments, records
transactions involving the
export or import of goods
and services.

2010/01:07:10/MHBR169:Slavin:VY
A current account deficit occurs when a country imports
more goods, services,
and income than it exports. A current account surplus occurs
when a country exports
more goods, services, and income than it imports. Table A.1
shows that in 2008 the
United States ran a current account deficit of $706 billion. This
is often a headline-
grabbing figure and is widely reported in the news media. In
recent years the U.S.
current account deficit has been getting steadily larger,
primarily because America
imports far more physical goods than it exports (you will notice
that America actually
runs a surplus on trade in services and is close to balance on
income payments).
The 2006 current account deficit of $803 billion was the
largest on record and was
equivalent to about 6.5 percent of the country’s GDP. The
deficit shrank a little in
2007 and 2008, and provisional estimates suggested it would
fall to about $450 billion
in 2009. Many people find these figures disturbing, the common
assumption being
that high imports of goods displaces domestic production,

causes unemployment, and
reduces the growth of the U.S. economy. For example, The
New York Times responded
to the record current account deficit in 2006 by stating:
A growing trade deficit acts as a drag on overall economic
growth. Economists
said that they expect that, in light of the new numbers, the
government will have
to revise its estimate of the nation’s fourth quarter gross
domestic product to
show slightly slower expansion. 37
CURRENT ACCOUNT $ Millions
Exports of Goods, Services, and Income Receipts $
2,591,233
Goods 1,276,994
Services 549,602
Income Receipts 764,637
Imports of Goods, Services, and Income Payments
23,168,938
Goods 22,117,245
Services 2405,287
Income Payments 2646,406
Unilateral current transfers (net) 2128,363
Current Account Balance 2706,068

CAPITAL ACCOUNT
Capital Account Transactions (net) 953
FINANCIAL ACCOUNT
U.S.-Owned Assets Abroad, net 2106
U.S. Official Reserve Assets 24,848
U.S. Government Assets 2529,615
U.S. Private Assets 534,357
Foreign-Owned Assets in the United States 534,071
Foreign Official Assets in the United States 487,021
Other Foreign Assets in the United States 47,050
Statistical Discrepancy 200,055
Current Account
Deficit
Occurs when a country
imports more good,
services, and income
than it exports.
Current Account
Surplus
Occurs when a country

exports more goods,
services, and income
than it imports.
table A.1
U.S. Balance of
Payments Accounts,
2008 ($ millions)
Source: Bureau of Economic
Analysis
2010/01:07:10/MHBR169:Slavin:VY
However, the issue is somewhat more complex than implied
by statements like this.
Fully understanding the implications of a large and persistent
deficit requires that we
look at the rest of the balance-of-payments accounts.
The capital account records onetime changes in the stock of
assets. As noted
above, until recently this item was included in the current
account. The capital ac-

count includes capital transfers, such as debt forgiveness and
migrants’ transfers (the
goods and financial assets that accompany migrants as they
enter or leave the country).
In the big scheme of things, this is a relatively small figure
amounting to $953 million
in 2008.
The financial account (formally the capital account) records
transactions that
involve the purchase or sale of assets. Thus, when a German
firm purchases stock in
a U.S. company, or buys a U.S. bond, the transaction enters the
U.S. balance of pay-
ments as a credit on the capital account. This is because capital
is flowing into the
country. When capital flows out of the United States, it enters
the capital account as
a debit.
The financial account is comprised of a number of elements.
The net change in
U.S.-owned assets abroad includes the change in assets owned
by the U.S. government
(U.S. official reserve assets and U.S. government assets) and
the change in assets
owned by private individuals and corporations. As can be seen
from Table A.1, in 2008
there was a –$106 million reduction in U.S. assets owned
abroad, primarily due to a
$529 billion fall in the amount of foreign assets owned by the
U.S. government. In
other words, the government was selling foreign assets, such as
foreign bonds and cur-
rencies, during 2008. On the other hand, there was a $534
billion increase in the
amount of foreign assets owned by private entities, indicating
that U.S.-owned enter-

prises and private individuals were net buyers of foreign assets
in 2008, including for-
eign stocks, bonds, and real estate.
Also included in the financial account are foreign-owned
assets in the United States.
These are divided into assets owned by foreign governments
(foreign official assets)
and assets owed by other foreign entities such as corporations
and individuals (other
foreign assets in the United States). As can be seen, in 2008
foreigners increased their
holdings of U.S. assets, including treasury bills, corporate
stocks and bonds, and direct
investments in the United States, by $534 billion. Some $487
billion of this was due to
an increase in the holding of U.S. assets by foreign
governments, with the remainder
being due to investments by private corporations and
individuals in U.S. assets.
It is important at this point to understand that a basic principle
of balance-of-
payments accounting is double-entry bookkeeping. Every
international transaction
automatically enters the balance of payments twice—once as a
credit and once as a debit.
Imagine that you purchase a car produced in Japan by Toyota
for $20,000. Since your
purchase represents a payment to another country for goods, it
will enter the balance
of payments as a debit on the current account. Toyota now has
the $20,000 and must
do something with it. If Toyota deposits the money at a U.S.
bank, Toyota has pur-
chased a U.S. asset—a bank deposit worth $20,000—and the
transaction will show up
as a $20,000 credit on the financial account. Or Toyota might

deposit the cash in a
Japanese bank in return for Japanese yen. Now the Japanese
bank must decide what to
do with the $20,000. Any action that it takes will ultimately
result in a credit for the U.S.
balance of payments. For example, if the bank lends the $20,000
to a Japanese firm
that uses it to import personal computers from the United
States, then the $20,000
must be credited to the U.S. balance-of-payments current
account. Or the Japanese
bank might use the $20,000 to purchase U.S. government bonds,
in which case it will
show up as a credit on the U.S. balance-of-payments financial
account.
Thus, any international transaction automatically gives rise to
two offsetting entries
in the balance of payments. Because of this , the sum of the
current account balance, the
Capital Account
Records onetime
changes in the stock
of assets.
Financial Account
Records transactions
that involve the purchase
or sale of assets.
2010/01:07:10/MHBR169:Slavin:VY

capital account, and the financial account balance should always
add up to zero . In practice,
this does not always occur due to the existence of “statistical
discrepancies,” the source
of which need not concern us here (in 2008 the statistical
discrepancy amounted to
$200 billion).
Does the Current Account Deficit Matter?
As discussed above, there is some concern when a country is
running a deficit on
the current account of its balance of payments. 38 In recent
years a number of rich
countries, including most notably the United States, have run
persistent and grow-
ing current account deficits. When a country runs a current
account deficit, the
money that flows to other countries can then be used by those
countries to pur-
chase assets in the deficit country. Thus, when the United States
runs a trade deficit
with China, the Chinese use the money that they receive from
U.S. consumers to
purchase U.S. assets such as stocks, bonds, and the like. Put
another way, a deficit
on the current account is financed by selling assets to other
countries; that is, by a
surplus on the financial account. Thus, the persistent U.S.
current account deficit is
being financed by a steady sale of U.S. assets (stocks, bonds,
real estate, and whole

corporations) to other countries. In short, countries that run
current account defi-
cits become net debtors.
For example, as a result of financing its current account deficit
through asset sales,
the United States must deliver a stream of interest payments to
foreign bondholders,
rents to foreign landowners, and dividends to foreign
stockholders. One might argue
that such payments to foreigners drain resources from a country
and limit the funds
available for investment within the country. Since investment
within a country is nec-
essary to stimulate economic growth, a persistent current
account deficit can choke off
a country’s future economic growth. This is the basis of the
argument that persistent
deficits are bad for an economy.
However, things are not this simple. For one thing, in an era of
global capital mar-
kets money is efficiently directed toward its highest value uses,
and over the past quar-
ter of a century many of the highest value uses of capital have
been in the United
States. So even though capital is flowing out of the United
States in the form of pay-
ments to foreigners, much of that capital finds its way right
back into the country to
fund productive investments in the United States. In short, it is
not clear that the cur-
rent account deficit chokes off U.S. economic growth. In fact,
notwithstanding the
2008–2009 recession, the U.S. economy has grown at an
impressive rate over the past
25 years, despite running a persistent current account deficit,
and despite financing

that deficit by selling U.S. assets to foreigners. This is precisely
because foreigners
reinvest much of the income earned from U.S. assets, and from
exports to the United
States, right back into the United States. This revisionist view,
which has gained in
popularity in recent years, suggests that a persistent current
account deficit might not
be the drag on economic growth it was once thought to be. 39
Having said this, there is still a nagging fear that at some point
the appetite that
foreigners have for U.S. assets might decline. If foreigners
suddenly reduce their in-
vestments in the United States, what would happen? In short,
instead of reinvesting
the dollars that they earn from exports and investment in the
United States back into
the country, they would sell those dollars for another currency,
European euros,
Japanese yen, or Chinese yuan, for example, and invest in euro-
, yen- and yuan-
denominated assets instead. This would lead to a fall in the
value of the dollar on for-
eign exchange markets, and that in turn would increase the price
of imports, and lower
the price of U.S. exports making them more competitive, which
should reduce the
overall level of the current account deficit. Thus, in the long
run the persistent U.S.
2010/01:07:10/MHBR169:Slavin:VY

current account deficit could be corrected via a reduction in the
value of the U.S. dollar.
The concern is that such adjustments may not be smooth. Rather
than a controlled
decline in the value of the dollar, the dollar might suddenly lose
a significant amount
of its value in a very short time, precipitating a “dollar crisis.”
40 Since the U.S. dollar is
the world’s major reserve currency, and is held by many foreign
governments and
banks, any dollar crisis could deliver a body blow to the world
economy and at the very
least trigger a global economic slowdown. That would not be a
good thing.
balance-of-payments accounts, p. 197
current account, p. 197
current account deficit, p. 198
current account surplus, p. 198
capital account, p. 199
financial account, p. 199
Key Terms

2010/01:07:10/MHBR169:Slavin:VY
Assignment 2
places.
5.1
Assume you have $1 million now, and you have just retired
from your job. You expect to live for 20 years, and you want to
have the same level of consumption (i.e., purchasing power) for
each of these 20 years, after adjusting for inflation. You also
wish to leave the purchasing power equivalent of $100,000
today to your kids at the end of the 20 years as a bequest (or to
pay them to take care of you).
You expect inflation to be 3% per year for the next 20 years,
and nominal interest rates are expected to stay around 8% per
year.
A.
Calculate the actual amount of consumption, in nominal dollars,
using the stated assumptions.
i.

How much do you need for your kids?
ii.
If you plan to consume $1.03 in year 1, how much will you need
to have to keep the same real consumption in year 2? In year
10? In year 20?
iii.
How much, in nominal dollars, will $1 of retirement funds earn
in year 1? Year 2? Year 10? Year 20?
iv.
In an Excel spreadsheet (or in a manual table), calculate the
following:
a.
annual investment earnings for each year
b.
total savings after investment earnings for each year
c.
subtract annual consumption from total savings each year
d.

by trial and error, or with the Goal Seek command, determine
the amount of consumption that will give you exactly $100,000,
in today's purchasing power, at the end of 20 years
Hint: You will need to make your annual consumption column
dependent on the inflation rate, your investment earnings will
grow at the nominal rate, and the bequest of $100,000 will grow
at the inflation rate.
B.
Do the calculation again using real rates, and setting inflation to
equal 0. If you set up your Excel spreadsheet carefully, you
should be able to set the inflation rate to equal 0 and enter the
real rate of return as the investment earning rate.
Feel free to use the spreadsheet below to help you answer this
question.
5.1template.xls
i.
What is the amount of real consumption in year 1? In year 2? In
year 10? In year 20?
ii.
Show that this is consistent with your calculation using nominal
rates.
iii.
How much, in real dollars, does that leave for your kids?
iv.
Show that your bequest is consistent with the nominal rate

results above.
(30 marks)
5.2
A.
Linus is 18 years old now, and is thinking about taking a 5-year
university degree. The degree will cost him $25,000 each year.
After he's finished, he expects to make $50,000 per year for 10
years, $75,000 per year for another 10 years, and $100,000 per
year for the final 10 years of his working career. If Linus lives
to be 100, and if real interest rates stay at 5% per year
throughout his life, what is the equal annual consumption he
could enjoy until that date?
B.
Linus is also considering another option. If he takes a job at the
local grocery store, his starting wage will be $40,000 per year,
and he will get a 3% raise, in real terms, each year until he
retires at the age of 53. If Linus lives to be 100, what is the
equal annual consumption he could enjoy until that date?
C.
From strictly a financial point of view, is Linus better off
choosing option A or B?
(10 marks)
5.3
Are you better off playing the lottery or saving the money?
Assume you can buy one ticket for $5, draws are made monthly,
and a winning ticket correctly matches 6 different numbers of a
total of 49 possible numbers.
The probabilities: In order to win, you must pick all the
numbers correctly. Your number has a 1 in 49 chance of being
correct. Your second number, a 1 in 48 chance, and so on. There
are exactly 49 x 48 x 47 x 46 x 45 x 44 = 10,068,347,520 ways
to pick 6 numbers from 49 options.

But the order in which you pick them does not matter, so you
actually have a few more ways to win. You can pick 6 different
numbers in exactly 6 x 5 x 4 x 3 x 2 x 1 = 720 orders of choice.
Any one of those orders would still win the lottery.
Putting this all together, your ticket has 720/10,068,347,520 =
1/13,983,816 chance of winning. This equates to a .000000071
percentage chance.
If you played one ticket every month from age 18 to age 65, you
would have 47 x 12 = 564 plays. Your odds of not ever winning
would be calculated using a binomial distribution to be
.9999599568, meaning your chances of winning would be 1 –
.9999599568 = .0000400432.
So, if the lottery winnings averaged $10 million over this time
period, your expected return would be less than .0000400432 x
$10 million = $400.43.
(It's less than $400.43 because your 564 plays are spread out
over the next 47 years, so the present value of these future plays
would be significantly less than if you were able to play all 564
immediately. The $400.43 assumes you play all 564 plays today,
which makes it the highest possible expected value.)
REQUIRED:
A.
What would your $400.43 be worth if you invested it at 1% real
interest for 47 years?
B.
If, instead, you wrote down your 6 numbers on a piece of paper,
and deposited your $5 in a bank at 1% real interest, how much
would you have at the end of the first year?

C.
If you did this every year for 47 years, how much would you
have at age 65?
D.
If you earned 5% real interest on your deposits, how much
would you have at age 65?
E.
Which option would make you better off at age 65? How many
times better off?
(10 marks)
5.4
Use the Excel spreadsheet named “LeasevsBuyCCA.xls” to
answer the following question. You may choose to answer the
question without using the spreadsheet, but be very careful to
show all work, so your marker can follow your calculation and
award part marks as necessary.
You want to buy a new car, but you're not sure whether you
should lease it or buy it. You can buy it for $50,000, and you
expect that it will be worth $20,000 after you use it for 3 years.
Alternatively, you could lease it for payments of $650 per
month for the 3-year term, with the first payment due
immediately. The lease company did not tell you what interest
rate they're using to calculate the monthly payments, but you
know you could borrow money from your banker at an annual
percentage rate (APR) of 8%.
A.
Calculate the present value of the lease payments, assuming
monthly compounding at the given APR of 8%.
B.
Calculate the present value of the $20,000 salvage value, again

using monthly compounding and the given APR of 8%. Which
option do you prefer, lease or buy?
C.
Calculate the amount of the salvage value which would make
you indifferent between leasing and buying.
D.
If you were able to use this car 100% for business, rendering the
lease payments tax-deductible, or alternatively, allowing you to
deduct depreciation using straight-line depreciation (depreciated
to expected salvage value) and assuming your tax rate is 40%,
would you prefer to buy or lease the car?
(10 marks)
8.
You may find it helpful to use the Excel file named "Chapter 6
template.xls" to answer the following questions. You may
choose to answer the questions without using the spreadsheet,
but be very careful to show all work, so your marker can follow
your calculation and award part marks as necessary.
In order to ensure that you know how the spreadsheet works, it
is recommended that you replicate table 6.5 from page 182 of
your textbook before proceeding to answer the following
questions. (Note that a completed spreadsheet for Table 6.5 is
included with the Excel file as a separate worksheet, so you can
check your work.)
6.1

You and your friends are thinking about starting a motorcycle
company named Apple Valley Choppers. Your initial investment
would be $500,000 for depreciable equipment, which should last
5 years, and your tax rate would be 40%. You could sell a
chopper for $10,000, assuming your average variable cost per
chopper is $3000, and assuming fixed costs, such as rent,
utilities and salaries, would be $200,000 per year.
A.
Accounting breakeven: How many choppers would you have to
sell to break even, ignoring the costs of financing?
B.
Financial breakeven: How many choppers would you have to
sell to break even, if you required a 15% return? (Hint: Use the
15% as the discount rate and calculate net present value. In
Excel, you may want to use the Goal Seek command, or simply
use trial and error to find the correct amount.)
C.
Assuming you could sell 60 choppers per year, what would be
your IRR?
D.
Assuming you could sell 60 choppers per year, what would your
selling price have to be to generate a net present value of
$150,000 at a 15% discount rate?
E.
If you could sell 60 choppers in the first year, and your sales
volume increased by 5% each year until the end of year 5, what
would the net present value be at a 15% discount rate?
F.
If you need to invest working capital equal to 10% of the next
(coming) year‘s sales revenue, what would be the effect on the

net present value of the project? Do you think that working
capital investments always reduce the net present value of
projects? (Assume a 15% discount rate, and sales volume
increases by 5% each year.)
(20 marks)
6.2
Fill in the missing items in the following table. Assume that the
real interest rate is 3% per year, and inflation is expected to be
constant at 2% per year.
Year
Nominal cash flow
Real cash flow
0
–100,000
–100,000
1
+ 12,000
?
2
+22,000
?
3
+15,000
?
4
+10,000
?
Net present value
?
?
(10 marks)
8.

7.1
Find a Web site that shows exchange rates for all major
international currencies. At the time of writing, XE.com and
oanda.com are examples of such sites.
A.
is the British Pound shown? If not, why not? (You might have
to do some investigation online if you're not familiar with the
history of European currency.)
B.
What is the exchange rate between the Canadian dollar and the
US dollar?
C.
XE.com also allows you to see exchange rates for gold ounces
(under "more currencies available"). What does XE.com (or a
similar site) say 1 ounce of gold is worth in Canadian dollars?
In US dollars? What does this imply is the exchange rate
between Canadian dollars in US dollars? Is this the same as
your answer to part B.?
D.
If you saw that the US dollar price of gold was one dollar less
than the price shown, how could you use that information to
make an arbitrage profit?
(10 marks)
7.2
A.
Fill in the following table using XE.com or a similar foreign-
currency quote Web site. In each cell, record the number of
units of the currency stated in the first cell of the column that
would be required to buy one unit of currency as stated in
the row heading.

For example, if you sold US$1, how many European Euros
could you buy? Enter that amount in the third column, second
row. Continue until the table is filled completely.
sell/buy
US $1
European €1
Canadian $1
Japanese ¥1
US $1
1
European €1
1
Canadian $1
1
Japanese ¥1
1
B.
Why are the numbers in the Japanese ¥ column so much higher
than the numbers in the other rows?

(10 marks)
8.
8.1
A.
Look up the US Treasury yield curve online.
i.
What is the promised yield for a 1-month T-bill?
ii.
For a 6-month T-bill?
iii.
A 1-year T-bill?
iv.
A 5-year T-bond?
v.
A 10-year T-bond?
iv.
A 20-year T-bond?

iiv.
A 30-year T-bond?
iiiv.
On what date did you look up these yields?
ix.
On what Web site did you find these yields?
B.
Is this yield curve flat, rising, or inverted?
C.
Many introductory finance textbooks say, at the beginning of
bond valuation problems, "Assume the yield curve is flat."
Another way of putting this is "Assume the term structure of
interest rates is flat." How would this assumption make the
questions easier for students of introductory finance to solve?
(10 marks)
8.2
Fill in the missing items in the following table, using the Law
of One Price. Assume all these bonds have the same risk and
any coupon payments are paid annually.
Bond #
1
2
3
4
1-year
strip bond
2-year
strip bond

2-year 6% coupon bond
2-year 7% coupon bond
Time 0 cash flow (i.e., Purchase Price for the bond)
–950
?
?
?
Time 1 cash flow
+1000
0
+60
+70
Time 2 cash flow
0
+1000
+1060
+1070
Yield
?
?
5.50%
?
(10 marks)
8.3
A.
You are considering two investments from the bonds listed in
question 8.2. Show that the cash flows from the following two
investments would be identical.
i.
60 units of Bond #1 + 1060 units of Bond #2, and
ii.
1000 units of Bond #3.

B.
How many units of Bond #1 and #2 would you need to replicate
the cash flows of 1000 units of Bond #4?
C.
i.
If the yield of Bond #3 is 5.5%, what would it cost to buy 1000
units of Bond #3?
ii.
What would it cost to buy 60 units of Bond #1?
iii.
From part A. above, infer the value of 1060 units of Bond #2.
iv.
What is the value of one unit of Bond #2? Yield of Bond #2?
D.
What's the value of 1000 units of Bond #4? Yield?
E.
What have you learned about the Law of One Price from
questions 8.2 and 8.3?
(10 marks)
8.4
Assume the yield curve on "plain vanilla" default-free bonds is
flat at 5%, and you are thinking of buying a default-free bond.
Specifically, you're thinking of buying a bond issued by
Risklessco, a company considered to be default-free by all
major bond rating firms.

You will select one of the following three bonds, all identical
except for the special features listed:
Face Value
Maturity
Coupon Rate (Paid Annually)
Yield to Maturity
Special Features
Price
A
1000
20 years
5.5%
5%
None
?
B
1000
20 years
5.5%
5%
Callable
Par
C
1000
20 years
5.5%
3.5%
Callable and Convertible into Risklessco Stock
?
A.
Why is the yield on bonds A and B 5%? Why is the yield on

bond C different?
B.
What would be the price of Bond A?
C.
If bond C is considered identical to bond B except for the
conversion privilege, what is the value of the conversion
privilege? Does the conversion privilege benefit the issuer of
the bond or the purchaser? Is this consistent with the price you
calculated for bond C?
D.
Who does the callability provision benefit, the issuer or the
purchaser? Is this consistent with the price you calculated for
bond A?
(10 marks)
Assignment 1
places.
1.1
Households make four kinds of economic decisions (textbook,

pp. 4–5). Suppose you have two households with the same
income. Household A has one income earner and Household B
has two income earners.
How would the four types of economic decisions differ between
these two otherwise identical households?
(8 marks)
1.2
Three friends have just graduated, each with a B.Mgt. degree.
One wants to start a restaurant and another wants to work as a
subcontractor in a building trade. The third friend wants to put
together a firm with a couple of other graduates to provide
several kinds of complementary financial services including
insurance, financial planning, and bookkeeping.
What form of business organization (textbook, pp. 8–9) would
you suggest each of the three friends should use, and why?
(12 marks)
completed all parts of Assignment 1, due after Lesson 4.
2.1
Adam Smith is often called the father of economics. His famous
book, The Wealth of Nations,talks about an “invisible hand”
which automatically allocates goods to the persons most able to
put them to good use. The invisible hand operates through the
price mechanism for goods and services, so that individuals who
trade on the market, while seeking only their own good, are
actually efficiently allocating society’s resources.
His ideas, if applied to modern capital markets, imply that these
markets would efficiently allocate investment capital to the
firms that would use the capital most efficiently in producing
goods and services for society. But this would happen only if

markets were left to operate without state intervention.
Do you think modern governments should leave capital markets
unregulated? Why or why not?
(6 marks)
2.2
Consider a business firm, organized as a proprietorship, which
has $100,000 invested in assets—a bank loan of $80,000 and
$20,000 personal capital invested by the proprietor. If the firm
becomes insolvent, who is at risk? Why?
(6 marks)
2.3
In each of the following situations, moral hazard or adverse
selection may be present. Indicate which you think is present, if
any, and explain your choice.
(10 marks)
a.
An insurance company is thinking about issuing health
insurance to a firm’s employees.
b.
An insurance company has issued health insurance to a firm’s
employees on the basis of their medical histories.
c.
An investor is asking for a bank loan to support a new business
she wants to operate. She is unwilling to submit to a credit
check.
d.
An investor has purchased shares in a new software company.
He is just a shareholder, and is not going to be involved in the
daily operations of the firm.
e.

A grandfather has just given his grandson $100 as a birthday
present.
2.4
In each of the situations considered in question 2.3, what could
be done to overcome the problem?
(10 marks)
3.1
Use the information in the table below to calculate the
following ratios. Use the results to discuss and compare the
financial positions of the two firms.
(14 marks)
Ratios:
Total Shareholder Return
Return on Sales
Return on Assets
Return on Equity
Asset Turnover
Times Interest Earned
Debt Ratio (You’ll need to calculate the average debt during the
year.)
Spaling
Preston
EBIT (Earnings before Interest and Taxes)
300,000
190,000
Interest Expense
10,000
15,000
Net income

200,000
100,000
Dividend payout ratio
35%
40%
Retention ratio
65%
60%
Sales
3,000,000
2,000,000
Average assets during the year
2,500,000
1,500,000
Average shareholders’ equity during the year
1,800,000
1,000,000
Market price per share
Beginning of year
20
18
End of year
15
20
Number of shares outstanding
150,000
50,000
3.2
Assume you have put $1,000 in a savings account at 10%
annually compounded interest.

a.
How much could you take out each year and still have the
original $1,000 in the account?
b.
If you left half of the interest earnings in the account, at what
rate would the balance grow from year to year?
c.
If you took out 80% of the interest earnings in the account, at
what rate would the balance grow each year?
(6 marks)
3.3
Imagine a corporation with $1,000,000 of assets and a debt ratio
of 40%. ROE (return on equity) is expected to be 20% for the
foreseeable future. Assume the firm keeps the same amount of
debt indefinitely (as opposed to keeping the same debt ratio).
a.
What do you expect the firm’s earnings to be for the next 3
years if the firm doesn’t pay out any dividends or re-purchase
any shares?
b.
If the firm doesn’t pay any dividends or re-purchase any shares,
at what rate would the firm grow from year to year?
c.
If the firm pays 50% of its earnings as dividends, at what rate
would the firm grow from year to year?
d.
If the firm uses 80% of its earnings to re-purchase shares from
its shareholders, at what rate would the firm grow from year to
year?

e.
If the firm pays 50% of its earnings as dividends, and uses an
additional 20% of its earnings to re-purchase shares from its
shareholders, at what rate would the firm grow from year to
year?
f.
What does the term “Sustainable Growth Rate” mean? Would
the amounts you have calculated in parts b. to d. equal the
Sustainable Growth Rate for the firm?
(12 marks)
4.1
Assume that the correct discount rate for the following cash
flows is 8%. What is the present value of the following cash
flows?
a.
$50 at the end of 3 years
b.
$50 at the end of 100 years
c.
$50 received at the end of each year for 20 years
d.
$50 received at the beginning of each year, totaling 20
payments.
(8 marks)

4.2
Assuming an 8% discount rate, what is the future value of the
following cash flows?
a.
future value in 3 years of $50 received now
b.
future value in 100 years of $50 received now
c.
future value at the end of 20 years of $50 received each year at
the end of the year
d.
future value at the end of 20 years of $50 received each year at
the beginning of the year, again totaling 20 payments.
(8 marks)
4.3
Calculate the following values, assuming a discount rate of 8%:
a.
present value of a perpetuity (also called a perpetual annuity) of
$50 received each year at the end of each year
b.
present value of an annuity of $50 received at the end of each
year for 5 years
c.
present value of an annuity of $50 received at the end of each
year for 10 years, with the first payment to be received at the
end of the 6th year
d.
present value of a perpetuity of $50, with the first payment

received at the end of the 16th year.
(8 marks)
4.4
a.
Show (with a time line, for example) that the perpetuity in 4.3a.
is exactly the same as the sum of the annuities and perpetuities
in 4.3b. to 4.3d.
b.
Show that their present values add up to the same amount.
(6 marks)
4.5
a.
Jane is 20 years old today. Jane is going to put $1,000 into her
savings account on her 21st birthday and again on every
birthday for 20 payments (i.e., till her 40th birthday). She will
earn 5%, paid annually. How much money will be in the account
after she collects her interest and makes her 20th payment?
b.
Calculate how much money she could take out each year for the
20 years from her 41stbirthday till her 60th birthday, assuming
she still earns 5% and takes out the same amount each year,
leaving exactly $0 in the account after removing her
20th payment.
(6 marks)

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