CHAPTER SEVEN

GOVERNMENTAL INFLUENCE ON TRADE

OBJECTIVES
• To realize the rationales for government policies that enhance and restrict trade
• To interpret the effects of pressure groups on trade policies
• To understand the comparison of protectionist rationales used in high-income
countries with those used in low-income countries’ economies
• To comprehend the potential and actual effects of governmental intervention on the
free flow of trade
• To understand the major means by which trade is restricted and regulated
• To grasp the business uncertainties and business opportunities created by
governmental trade policies

CHAPTER OVERVIEW
A government’s political objectives are sometimes at odds with its economic proposals to
improve a nation’s market efficiency and international competitiveness. Chapter Seven
begins by discussing the reasons why and the ways in which governments intervene in
the international trade process. It then examines the economic and the noneconomic
effects of those actions upon participants in that process. Finally, the chapter considers
the principle instruments of trade control, including both tariffs and nontariff barriers, and
concludes with a discussion of ways in which firms can deal with adverse trading
conditions both at home and abroad.

CHAPTER OUTLINE
OPENING CASE: TEXTILE AND CLOTHING TRADE [See Fig. 7.1.]
The United States and Europe have a long history of protecting their domestic textile and
garment manufacturing industries. Negotiated in response to political pressures from
firms and workers in those countries, the Multifiber Arrangement (MFA) of 1974
permitted importing countries to (i) place tariffs on imported textiles and clothing and (ii)
negotiate quotas with exporting countries. The arrangement included more than forty
countries whose firms were heavily tied to the U.S. and European textile and garment
markets. (Under the Arrangement tariffs were very complex, but in the United States, for
example, tariffs averaged about 15 percent.) However, as the high-income countries
became increasingly concerned about intellectual property rights and the protection of
trade in services such as banking, they began to dismantle the MFA in exchange for
concessions with respect to the curtailment of piracy and access to services markets.
Thus, the origin of imports was dramatically altered as Chinese and Indian firms gained
North American market share at the expense of both U.S. and Latin American

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competitors; similarly, Chinese and Indian firms gained European market share at the
expense of West European, East European, and Turkish competitors. In the first month
following the end of the MFA in 2005, the United States lost 12,000 jobs in related
industries; Latin America experienced the closing of 18 apparel factories very soon
thereafter.

TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Seven.

I. INTRODUCTION
In principle, no country permits a totally unregulated flow of goods and services
across its borders. Likewise, governments may choose to enable the global
competetiveness of their own domestic firms. Protectionism refers to those
government restrictions and incentives that are specifically designed to help a
county’s domestic firms compete with foreign competitors at home and abroad. The
rationale for such policies can be economic or noneconomic in nature. [See Fig.
7.2.] Whenever governments choose to impede the flow of imports and/or
encourage the flow of exports, they simultaneously provide direct and/or indirect
subsidies for their domestic firms.

II. CONFLICTING RESULTS OF TRADE POLICIES

While governments intervene in trade in order to attain economic, social, and/or
political objectives, they also pursue political rationality when they do so. Officials
enact those trade policies they feel will best protect their nations and citizens—and
perhaps their personal political longevity. However, aiding struggling constituencies
without penalizing those who are well off is often impossible. Thus, protectionist
actions not only spark fierce debate among competing parties, but they can also lead
to retaliation by affected stakeholders. [Note Fig. 7.1.]

III. ECONOMIC RATIONALES FOR GOVERNMENTAL INTERVENTION

Government intervention in the trade process may be either economic or
noneconomic in nature. [See Table 7.1.]
A. Unemployment
Persistent unemployment pushes many groups to call for protectionism; one of
the most effective is organized labor. By limiting imports, local jobs are
retained as firms and consumers are forced to purchase domestically produced
goods and services. However, unless the protectionist country is relatively
small, such measures usually do little to limit unemployment. On the other
hand, they may result in a decline in export-related jobs because of (i) price
increases for components or (ii) lower incomes abroad. Further, such measures
are likely to lead to retaliation unless either the protectionist or the affected
country is relatively small. Thus, governments must carefully balance the costs
of higher prices with the costs of unemployment and the displaced production
that would result from freer trade when enacting such measures.

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B. Infant-Industry Argument
First presented by Alexander Hamilton in 1792, the infant-industry argument
holds that a government should temporarily shield emerging industries in which
the country may ultimately possess a comparative advantage from international
competition until its firms are able to effectively compete in world markets.
Eventual competitiveness will result from movement along the learning curve
plus the efficiency gains from achieving the economies of large-scale
production. Two basic problems associated with this argument are the
assumptions that (i) governments can in fact identify those industries that have a
high probability of success and (ii) firms within those industries should receive
government assistance. Infant-industry protection requires some segment of the
economy (typically local consumers) to incur the initial higher cost of inefficient
local production. Ultimately, the validity of the argument rests on the
expectation that the future benefits of an internationally competitive industry
will exceed the costs of the associated protectionist measures.
C. Industrialization Argument
Many of today’s emerging economies emulate historical practices and use
protectionism to spur local industrialization. The industrialization argument
purports that the development of national industrial output (and hence economic
growth) should be supported, even though domestic prices may not be
competitive on the world market. Reasons to support it are numerous.
1. Use of Surplus Workers. Surplus workers can more easily be used to
increase manufacturing output than agricultural output. However, this shift
may also lead to (i) increasing demand for social services because of the
rural to urban migration and (ii) decreasing agricultural output. In this
instance, improved agriculture practices may be a better means of achieving
economic success.
2. Promoting Investment Inflows. Import restrictions encourage foreign
direct investment by foreign firms that want to avoid the loss of a lucrative
or potential market. FDI inflows in turn lead to increased local
employment, an attractive outcome for policy makers.
3. Diversification. Price variations can wreak havoc on economies that
rely on just a few commodities for job creation and export earnings.
Contrary to expectations, however, unless a country’s industrial base is
truly expanded, a move into manufacturing may simply shift that
dependence from a reliance on the basic commodities to the downstream
manufactured goods produced from them.
4. Greater Growth for Manufactured Products. Terms of trade
refers to the quantity of imports that a given quantity of a country’s exports
can buy. Many emerging nations have experienced declining terms of trade
because the demand for and prices of raw materials and agricultural
commodities have not risen as fast as the demand for and prices of finished
goods. In addition, changes in technology have reduced the need for many
raw materials. Cost savings realized from manufactured products go mainly
to higher profits and wages, thus fueling the industrialization process.

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 5. Import Substitution versus Export Promotion. Import
substitution represents an economic development strategy that relies on the
stimulation of domestic production for local consumption by erecting
barriers to imported goods. If the protected industries do not become
globally competitive, however, local customers will continually be
penalized by high prices. On the other hand, export-led development, i.e.,
export promotion, encourages economic development by harnessing a
country-specific advantage (e.g., low labor costs) and building a vibrant
manufacturing sector through the stimulation of exports. In reality, when
effectively crafted, import substitution policies eventually lead to the
possibility of export promotion as well.
6. Nation Building. The industrialization process helps countries build
infrastructure, advance rural development, enhance the quality of peoples’
lives, and boost the skills of the workforce.
D. Economic Relationships with Other Countries
Countries track their own performance as compared to other nations to deter-
mine whether to impose trade restrictions as a means of improving their
competitive positions. Primary motivations are four.
1. Balance of Payments Adjustments. The trade account (the
current account) is a major part of the balance of payments for most
countries. If balance-of-payments difficulties persist, a government may
restrict imports and/or encourage exports in order to balance its trade
account. If it chooses to devalue its currency, the value of all transactions
will be affected. If, however, it wishes to target certain products, then
protectionist measures (both tariffs and nontariff barriers) will be more
effective.
2. Comparable Access or “Fairness.” The comparable access
argument promotes the idea that a country’s firms are entitled to the same
access to foreign markets as foreign firms have to its market. Economic
theory reasons that producers operating in industries where increased
production leads to economies of scale but which lack equal access to
foreign competitors’ markets will struggle to become cost-competitive.
However, restricting trade, even on the grounds of “fairness,” may lead to
higher prices for domestic customers.
3. Restrictions as a Bargaining Tool. Import restrictions may be levied
as a means to try to persuade other countries to lower their import barriers.
The danger, however, is that each country will, in turn, retaliate by
escalating its own restrictions. To successfully use restrictions as a
bargaining tool requires that they be (i) believable and (ii) important to the
targeted parties.
4. Price-Control Objectives. Countries may withhold products from
international markets in an effort to raise world prices and thus improve
export earnings and/or favor domestic customers. (Organization of
Petroleum Exporting Companies (OPEC) is a case in point.) The practice
of pricing exports below cost, or below their home-country prices, i.e.,
below their “fair market value,” is known as dumping. Most countries

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 prohibit imports of “dumped” products, but enforcement usually occurs
only if the product disrupts domestic production. The optimum-tariff
theory claims that a foreign producer will lower its prices if the destination
country places a tariff on its products. So long as the foreign producer
reduces its price by any amount, some shift in revenue goes to the importing
country, and the tariff is deemed an optimum one.
IV. NONECONOMIC RATIONALES FOR GOVERMENT INTERVENTION
Governments may choose to intervene in the trade process for noneconomic reasons
such as the maintenance of essential industries, the prevention of shipments to
unfriendly nations, the maintenance or extension of spheres of influences, and/or the
protection of national identity.
A. Maintenance of Essential Industries
The essential industry argument states that a government applies restrictions
to protect essential domestic industries (particularly defense) so that the country
is not dependent on foreign sources of supply. Protecting an inefficient industry,
however, will lead to higher costs and possibly political consequences as well.
B. Prevention of Shipments to “Unfriendly” Countries
Groups concerned about security use national defense arguments to prevent the
export, even to friendly countries, of strategic goods that might fall into the
hands of potential enemies. Trade controls on non-defense goods may also be
used as a foreign policy weapon to try to prevent another country from meetings
its political objectives. However, retaliation often renders such protectionist
measures ineffective.

POINT—COUNTERPOINT:
Should Countries Eliminate the Use of Trade Sanctions?

POINT: Many argue against the use of sanctions on the grounds that they are ineffective.
Further, even if sanctions are successful at weakening the targeted countries’ economies,
the costs are borne not by government officials, but by innocent people. Finally, it
appears that governments sometimes impose sanctions based on just a single issue, rather
than on a country’s overall record, which is really counterproductive.

COUNTERPOINT: Others argue that although not all trade sanctions are successful,
many have at least been influential in achieving their objectives. Further, when a nation
breaks an international agreement and/or acts in unacceptable ways, punitive actions such
as removing diplomatic recognition, boycotting events, or eliminating foreign aid or
loans may be ineffective without the addition of trade sanctions.

C. Maintenance or Extension of Spheres of Influence

To maintain their spheres of influence, governments may give aid and credits to
and encourage imports from countries that join a political alliance or vote a
preferred way within international bodies. Further, trade restrictions may coerce

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 governments to take certain political actions or punish firms whose governments
do not comply.
D. Protecting Activities that Help Preserve the National Identity
Countries are partially held together though a unifying sense of cultural and
national distinctiveness. To sustain this collective identity, governments may
limit the presence of foreign products in certain sectors.

V. INSTRUMENTS OF TRADE CONTROL

Governments use many rationales and seek a range of outcomes when they try to
influence the international trade process. The choice of instrument(s) is crucial
because each type of control may incite different responses from both domestic and
foreign groups. While some instruments directly limit the amount that can be traded,
others indirectly affect the amount traded by directly influencing prices, i.e., while
tariff barriers directly affect prices and subsequently the quantity demanded,
nontariff barriers may directly affect price and/or quantity. [See Fig. 7.4.]
A. Tariffs
A tariff (also called a duty) is a tax levied on (internationally) traded products.
Exports tariffs are levied by the country of origin on exported products; a
transit tariff is levied by a country through which goods pass en route to their
final destination; import tariffs are levied by the country of destination on
imported products. A tariff increases the delivered price of a product, and, at the
higher price, the quantity demanded will be less.
A specific duty is a tariff that is assessed on a per unit basis; an ad valorem
tariff is assessed as a percentage of the value of an item. If both a specific duty
and an ad valorem tariff are assessed on the same product, it is known as a
compound duty. A tariff controversy concerns the treatment of manufactured
exports to industrialized nations. While raw materials frequently enter industrial
countries tariff-free, when an ad valorem tariff is applied to manufactured
goods, it is generally applied to the total value of the product. Critics argue that
the effective tariff on the manufactured portion, i.e., the value-added portion, is
higher than the published tariff. [Note: review the optimum tariff theory on p.
76 of this manual, p. 250 of the text, and/or slide 7-12.]
B. Nontariff Barriers: Direct Price Influences
Nontariff barriers (NTBs) represent administrative regulations, policies, and
procedures, i.e., quantitative and qualitative barriers that directly or indirectly
impede international trade.
1. Subsidies. Subsidies consist of direct or indirect financial assistance from
governments to their domestic firms to help them overcome market
imperfections and thus make them more competitive in the marketplace.
From the standpoint of market efficiency, subsidies are more justifiable than
tariffs because they seek to overcome, rather than create, market
imperfections. However, many international frictions result from
disagreements about the definition of a subsidy.
2. Aid and Loans. Governments may give aid and loans to other countries
but require that the recipient spend the funds in the donor country; this is

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 known as tied aid or tied loans. In this way some donor products that
might otherwise be noncompetitive may find limited international markets.
3. Customs Valuation. Because of the temptation to declare a low invoice
price in order to pay a lower ad valorem tariff, it is sometimes difficult to
determine the true value of traded products. First, customs officials should
use the declared invoice price. If there is none, or if the authenticity of the
value is in doubt, then customs agents may assess the shipment on the basis
of the value of identical (preferable) or similar (acceptable) goods arriving
at about the same time. Further, because countries often impose different
import barriers on products sourced from different countries, customs
officials must also determine a product’s true origin.
4. Other Direct Price Influences. Other means that countries may use to
affect prices include establishing special fees for consular and customs
clearance and documentation, requirements that customs deposits be made
in advance of shipment, and minimum price levels at which products can be
sold after they receive customs clearance.
C. Nontariff Barriers: Quantity Controls
Governments use a variety of nontariff barriers to directly affect the quantity of
imports and exports. When the quantity of imports is limited, the resulting shift
in the supply curve means that the equilibrium price will then be higher.
1. Quotas. A quota represents a numerical limit on the quantity of a product
that may be imported or exported in a given period of time. (Because of the
increase in the equilibrium price, quotas may increase per unit revenues for
firms that participate in the market.) Voluntary export restraints (VERs)
are negotiated limitations of exports from one country to another and, as in
the case of a quota, may result in higher prices to customers. An embargo
represents an outright ban on imports from or exports to a particular
country. (A commodity cartel seeks higher, more stable prices for its goods
by assigning production quotas to individual countries and thus limiting
overall output.)
2. “Buy Local” Legislation. Buy local legislation represents laws that are
intended to favor the purchase of domestically sourced products over
imported products, particularly with respect to government procurement.
Local content requirements, i.e., costs incurred within the local country
(usually measured as a percentage of total costs), fall within this category.
3. Standards and Labels. The professed purpose of standards is to protect
the safety or health of the domestic population. However, countries may
also devise classification, labeling, and testing standards that facilitate the
sale of domestic products but obstruct the sale of foreign-sourced products.
4. Specific Permission Requirements. An import (and export)
license requires that firms secure permission from government authorities
before conducting trade transactions. Such procedures directly restrict trade
when permission is denied and indirectly restrict trade because of the cost,
time, and uncertainty involved in the process. A foreign exchange control
requires an importer of a given product to apply to a government agency to
secure the foreign currency to pay for the product.

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 5. Administrative Delays. Intentional administrative delays create
uncertainty and increase the cost of carrying inventory. However,
competitive pressures can motivate countries to improve inefficient
administrative systems.
6. Reciprocal Requirements. Governments may require that foreign
suppliers accept products in lieu of money. Barter, i.e., the direct exchange
of products between two parties, and offsets, i.e., the agreement by a
foreign firm to purchase products with a specified percentage of the
proceeds from an original sale within the importing country, both represent
forms of countertrade (see Chapter 13).
7. Restrictions on Services. Countries restrict trade in services such
as transportation, insurance, advertising, consulting, and banking for
reasons of essentiality, the maintenance of standards, and employment.
a. Essentiality. Countries consider certain services industries to be
essential because they serve strategic purposes or provide social
assistance to citizens. Private companies of any sort may be prohibited,
and in other cases, price controls may be imposed by the government;
government-owned operations are often subsidized. Essential services
can include the transportation, postal, banking, utilities, security, and
communications sectors.
b. Standards. Governments may limit foreign entry into particular
service professions in order to assure that practitioners are qualified.
Licensing standards vary by country and extend to a wide variety of
occupations. Prerequisites for taking certification examinations may be
lengthy.
c. Immigration. Government regulations often require that an
organization, whether domestic or foreign, demonstrate that the skills
needed for a particular job are not available locally before hiring a
foreigner.

VI. DEALING WITH GOVERNMENT TRADE INFLUENCES

Although there are risks and costs associated with each option, firms can deal with
trade restrictions by (a) moving operations to a lower-cost country, (b) concentrating
on market niches that attract less international competition, (c) adopting internal
innovations that lead to greater efficiency or superior products, or (d) trying to get
government protection. Whether a firm benefits more from protectionism or more
from some other means for countering international competition depends upon its
own international strategy. However, chances of securing protectionist measures
will be enhanced if companies enlist pertinent stakeholders to share in the necessary
lobbying efforts.

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 LOOKING TO THE FUTURE: The Battle of Different Interests

Each time countries negotiate a trading agreement, new optimum production locations
emerge. Further, the international regulatory situation is in many ways becoming more
complex. While some groups and firms are pushing for freer trade, others clamor for
greater protection. Thus, it is likely that as barriers come down for some products in
some countries, they will go up for other products in other countries. Those who see
themselves as losers are not apt to accept their losses without a struggle. Support for
their positions may be garnered from alliances that cross national borders, as well as
within domestic countries, as economic positions continue to affect politics, and vice
versa.

CLOSING CASE: U.S.-Cuban Trade [See Fig. 7.5.]

Able to weather a variety of political leaders, economic events, and historical eras, the
U.S. embargo of Cuba is the longest and harshest embargo by one state against another in
modern history. Following Castro’s overthrow of the Batista government in 1959 and
threats to incite revolutions elsewhere in Latin America, the United States canceled its
trade agreement to buy Cuban sugar. Then, following a series of increasingly hostile
events, the United States severed diplomatic relations and initiated a full trade embargo
via the Trading with the Enemies Act in 1962. Trade between the United States and
Cuba stopped. Spurred by the collapse of communism more than thirty years later,
Congress passed the Cuban Democracy Act in 1992 and the Helms-Burton Act in 1996,
both of which tightened the noose for firms that attempted to do business with a Castro
government. It was not until 2000 that Congress passed the Trade Sanctions Reform and
Export Enhancement Act, which allowed for limited exports of U.S. agricultural, food
and medical products; Cuba quickly became the twenty-first largest agricultural market
for U.S. exports. Over time, sympathy for the U.S. role in Cuba has dwindled. Although
many countries had initially supported the embargo, by 2001 some 150 nations had
normal trade relations with Cuba. Further, the U.S. public has become increasingly
divided on the usefulness of the embargo. While many people feel that repealing the
embargo would help many U.S. industries and firms, others maintain that Cuban market
opportunities are extremely limited. Others feel that the Cuban embargo is an
unfortunate cold war relic and question the politics of U.S. policy.

Questions
1. Should the U.S. seek to tighten its economic grip on Cuba? If so, why?
From a practical standpoint, most would argue that without the cooperation of the
rest of the world, there is little left that the United States can do. Further, given that
China is now a member of the World Trade Organization (WTO) and nations like
Vietnam are trading with the United States, the Cuban embargo gives the appearance

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 of cold war relic that is no longer relevant in today’s world. However, given the
consensus that Cuba consistently violates human rights, the continuance of U.S.
trade sanctions against Cuba is consistent with U.S. policy. In addition, Cuba’s
expropriation of American property without compensation is internationally
recognized as unacceptable behavior; thus, retaliation can be seen as an appropriate
response. Finally, there is the continuing argument that if the Cuban economy can
be further weakened, Castro may at last be overthrown.

2. Should the U.S. normalize business relations with Cuba? If so, should the U.S.
stipulate any conditions?
There are both political and economic reasons for normalizing relations with Cuba.
Cuba has long-since ceased to be a military threat, and there is hope that closer
political relations with the United States (and the rest of the free world) will lead to
greater democracy in Cuba. Further, Cuban trade sanctions are far tougher than
those levied by the United States against Iran, Iraq, Libya, and North Korea.
Economically, it is argued that because of the posture of the U.S. government, U.S.
firms are losing out on opportunities to sell their products in Cuba to competitors
from other countries. However, it is not likely that Cuba would trade with the United
States as aggressively as in the past, even if it were possible. While progress in the
area of human rights may be slow, experience in other countries suggests that
imposing some human rights conditions may be effective in the long-run. In
addition, the U.S. government may wish to facilitate the return to Cuba of U.S.
companies whose properties were expropriated, even though any remaining assets
are likely in a state of serious disrepair.

3. Assume you are Fidel Castro. What kind of trade relationship with the United States
would be in your best interest? What type would you be willing to accept?
Castro would logically want a trade relationship that would permit him to save face
politically while contributing to the economic development of the economy. Initial
overtures from the U.S. government could help bolster his political position and thus
would possibly be welcomed as a way to begin negotiations. Economic development
assistance could come in the form of direct aid and, possibly, foreign direct
investment, although there surely would be substantial controls on either form.

4. How do the structure and relationships of the American political system influence
the existence and specification of the trade embargo?
The structure and relationships of the American political system serve to reinforce
the existence and specification of the Cuban trade embargo. Pro-embargo supporters
relentlessly lobby the U.S. Congress and presidential administration to tighten the
embargo in order to spur the collapse of Cuban communism. Although recently
diminished, the pro-embargo viewpoint is supported by key people in key positions
throughout the government.

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WEB CONNECTION

Teaching Tip: Visit www.prenhall.com/daniels for additional information and links

relating to the topics presented in Chapter Seven. Be sure to refer your students to the
online study guide, as well as the Internet exercises for Chapter Seven.
_________________________

CHAPTER TERMINOLOGY:
protectionism, p.239 ad valorem tariff, p.252
retaliation, p.241 compound duty, p.252
infant-industry argument, p.242 effective tariff, p.252
industrialization argument, p.244 nontariff barriers, p.253
terms of trade, p.245 subsidies, p.253
export-led development, p.245 tied aid or loans, p.253
comparable access argument, p.246 quota, p.254
dumping, p.24 voluntary export restraint
optimum-tariff theory, p.248 (VER), p.254
essential industry argument, p.248 embargo, p.255
tariff (duty), p.251 buy local legislation, p.255
export tariff, p.251 import license, p.256
transit tariff, p.251 foreign exchange control, p.256
import tariff, p.251 countertrade, p.256
specific duty, p.252 offsets, p.256
_________________________

ADDITIONAL EXERCISES: Government Intervention in Trade

Exercise 7.1. As a result of the many rounds of the General Agreement on Tariffs
and Trade (GATT) and other trade negotiations, both tariff and nontariff barriers
have been significantly reduced on a worldwide basis. However, given recent shifts
in productive assets and employment from many industrialized countries to emerging
economies such as India and China, cries for protectionist measures can be heard
from many quarters. Ask students to debate the possibility that governments in
industrialized countries will once again implement some form of protectionist
measures in order to protect their markets and industries. Do the students expect that
such measures would be in the form of tariffs or nontariff barriers?

Exercise 7.2. From a global perspective one can observe excess capacity in the
steel, automobile, and commercial airline industries in both industrialized and
emerging nations. Ask students to discuss the logic of this from the standpoints of
the Infant-Industry and the Industrialization Arguments. Then ask them to debate
whether each of the arguments should be applied only in the case of emerging
economies, or in the case of all countries.

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Exercise 7.3. Ask students to debate the issue of stakeholders in government trade
policy, i.e., whose interests should be of paramount concern—producers, consumers,
or the government. Can sanctions by a single nation against another be truly
effective, or must it be a multilateral, if not a unilateral, action?

Exercise 7.4. Former U.S. Secretary of State Lawrence Eagleburger claims that
instead of an embargo, a more effective way to bring democracy to Cuba and other
repressive nations would be to increase their exposure to the United States and other
industrialized nations through trade and travel. Others claim, however, that
governments that choose to violate human rights, expropriate private property, etc.
must not be economically rewarded. Ask students to discuss the tension that
frequently accompanies the use of economic means to achieve political ends.

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