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 1. Home
 2. Trade Policy in Crisis


CHAPTER 3: TRADE AGREEMENTS AND ECONOMIC THEORY

In This Section

IN THIS SECTION

 * Chapter 1: U.S. Trade Policy in Crisis
 * Chapter 2: America’s Trade Agreements
 * Chapter 3: Trade Agreements and Economic Theory
 * Chapter 4: Trade Agreements and U.S. Commercial Interests
 * Chapter 5: Foreign Policy: The Other Driver
 * Chapter 6: Economic Development: A Missed Opportunity
 * Chapter 7: Uneasy Neighbors: Trade and the Environment
 * Chapter 8: The Labor Dilemma
 * Chapter 9: The Way Forward

Economists have had an enormous impact on trade policy, and they provide a
strong rationale for free trade and for removal of trade barriers.  Although the
objective of a trade agreement is to liberalize trade, the actual provisions are
heavily shaped by domestic and international political realities. The world has
changed enormously from the time when David Ricardo proposed the law of
comparative advantage, and in recent decades economists have modified their
theories to account for trade in factors of production, such as capital and
labor, the growth of supply chains that today dominate much of world trade, and
the success of neomercantilist countries in achieving rapid growth.

By William Krist

Almost all Western economists today believe in the desirability of free trade,
and this is the philosophy advocated by international institutions such as the
World Bank, the International Monetary Fund, and the World Trade Organization
(WTO).  And this was the view after World War II, when Western leaders launched
the General Agreement on Tariffs and Trade (GATT) in 1947.

However, economic theory has evolved substantially since the time of Adam Smith,
and it has evolved rapidly since the GATT was founded. To understand U.S. trade
agreements and how they should proceed in the future, it is important to review
economic theory and see how it has evolved and where it is today.

In the seventeenth and eighteenth centuries, the predominant thinking was that a
successful nation should export more than it imports and that the trade surplus
should be used to expand the nation’s treasure, primarily gold and silver. This
would allow the country to have a bigger and more powerful army and navy and
more colonies.

One of the better-known advocates of this philosophy, known as mercantilism, was
Thomas Mun, a director of the British East India Company.  In a letter written
in the 1630s to his son, he said: “The ordinary means therefore to increase our
wealth and treasure is by Foreign Trade, wherein wee must ever observe this
rule; to sell more to strangers yearly than wee consume of theirs in value…By
this order duly kept in our trading,…that part of our stock which is not
returned to us in wares must necessarily be brought home in treasure.”[1]

Mercantilists believed that governments should promote exports and that
governments should control economic activity and place restrictions on imports
if needed to ensure an export surplus. Obviously, not all nations could have an
export surplus, but mercantilists believed this was the goal and that successful
nations would gain at the expense of those less successful. Ideally, a nation
would export finished goods and import raw materials, under mercantilist theory,
thereby maximizing domestic employment.

Then Adam Smith challenged this prevailing thinking in The Wealth of Nations
published in 1776.[2] Smith argued that when one nation is more efficient than
another country in producing a product, while the other nation is more efficient
at producing another product, then both nations could benefit through trade.
This would enable each nation to specialize in producing the product where it
had an absolute advantage, and thereby increase total production over what it
would be without trade. This insight implied very different policies than
mercantilism. It implied less government involvement in the economy and a
reduction of barriers to trade.


THE THEORY OF COMPARATIVE ADVANTAGE

Thirty-one years after The Wealth of Nations was published, David Ricardo
introduced an extremely important modification to the theory in his On the
Principles of Political Economy and Taxation, published in 1817.[3] Ricardo
observed that trade will occur between nations even where one country has an
absolute advantage in producing all the products traded.

Ricardo showed that what was important was the comparative advantage of each
nation in production. The theory of comparative advantage holds that even if one
nation can produce all goods more cheaply than can another nation, both nations
can still trade under conditions where each benefits. Under this theory, what
matters is relative efficiency.

Economists sometimes compare this to the situation where even though a lawyer
might be more proficient at both law and typing than the secretary, it would
still pay the lawyer to have the secretary handle the typing to allow more time
for the higher-paying legal work. Similarly, if each country specializes in the
products where it is comparatively more efficient, total production will be
higher and consumers will have more goods to utilize.

Smith and Ricardo considered only labor as a “factor of production.”   In the
early 1900s, this theory was further developed by two Swedish economists, Bertil
Heckscher and Eli Ohlin, who considered several factors of production.[4] The
so-called Heckscher-Ohlin theory basically holds that a country will export
those commodities that are produced by the factor that it has in relative
abundance and that it will import products whose production requires factors of
production where it has relatively less abundance. This situation is often
portrayed in economics textbooks as a simplified model of two countries (England
and Portugal) and two products (textiles and wine). In this simplified
portrayal, England has relatively abundant capital and Portugal has relatively
abundant labor, and textiles are relatively capital intensive whereas wine is
relatively labor intensive. With these conditions, both nations would be better
off if they freely traded, and under such a situation of free trade, England
would export textiles and import wine. This would maximize efficiency, resulting
in more total production of textiles and wine and cheaper prices for consumers
than would be the case without trade. Through empirical studies and mathematical
models, economists almost universally believe that this model holds equally well
for multiple products and multiple countries.

In fact, economists consider this law of comparative advantage to be
fundamental. As Dominick Salvatore says in his basic economics textbook
International Economics, the law of comparative advantage remains “one of the
most important and still unchallenged laws of economics. …The law of comparative
advantage is the cornerstone of the pure theory of international trade.”[5]

The law of comparative advantage also holds equally well for many factors of
production. In addition to labor and capital, other factors of production
include natural resources such as land and technology, and these can be
subdivided. For example, land can be land for mining or land for farming, or
technology for making cars or computer chips, or skilled and unskilled labor.
Additionally, over time factor endowments may change. For example, natural
resources, such as coal reserves, may be used up, or a country’s educational
system may be improved, thereby providing a more highly skilled labor force.

Furthermore, some products do not utilize the same factors of production over
their life cycle.[6] For example, when computers were first introduced, they
were incredibly capital intensive and required highly skilled labor. Over time,
as volume increased, costs came down and computers could be mass produced.
Initially, the United States had a comparative advantage in production; but
today, when computers are mass produced by relatively unskilled labor, the
comparative advantage has shifted to countries with abundant cheap labor. And
still other products may use different factors of production in different
countries. For example, cotton production is highly mechanized in the United
States but is very labor intensive in Africa. The fact that factors of
production may change does not nullify the theory of comparative advantage; it
just means that the mix of products that a nation can produce relatively more
efficiently than its trade partners may change.

Traditional economic theories expounded by Ricardo and Heckscher-Ohlin are based
on a number of important assumptions, such as perfect competition with no
artificial barriers imposed by governments. A second assumption is that
production occurs under diminishing or constant returns to scale, that is, the
costs of producing each additional unit are the same or higher as production
increases. For example, to increase his wheat crop, a farmer may be forced to
use less-fertile land or pay more for laborers to harvest the wheat, thereby
increasing the cost of each additional unit produced.

Another key assumption of traditional economic theory is that basic factors of
production—such as land, labor, and capital—are not traded across borders.
Although Ohlin believed that such basic factors of production were not traded,
he argued that the relative returns to factors of production between countries
would tend to be equalized as goods are traded between the countries.
Subsequently, Samuelson argued that factor prices would in fact be equalized
under free trade conditions, and this is known in economics as the factor price
equalization theorem.[7] This might mean, for example, that international trade
would cause wage rates for unskilled workers to fall in the high-wage country in
relation to the rents available from capital and to the same level as wages in
the low wage country, and for wages to rise in relation to the rents available
from capital in the low-wage country and equal to the level of the country where
labor was less abundant. (The implications of this are important and are
explored further in chapter 8.)

In static terms, the law of comparative advantage holds that all nations can
benefit from free trade because of the increased output available for consumers
as a result of more efficient production. James Jackson of the Congressional
Research Service describes the benefits as follows: Trade liberalization, “by
reducing foreign barriers to U.S. exports and by removing U.S. barriers to
foreign goods and services, helps to strengthen those industries that are the
most competitive and productive and to reinforce the shifting of labor and
capital from less productive endeavors to more productive economic
activities.”[8]

Many economists, however, believe that the dynamic benefits of free trade may be
greater than the static benefits. Dynamic benefits, for example, include the
pressure on companies to be more efficient to meet foreign competition, the
transfer of skills and knowledge, the introduction of new products, and the
potential positive impact of the greater adoption of commercial law. Thus trade
can affect both what is produced (static effects) and how it is produced
(dynamic effects).


TERMS OF TRADE

Another important concept in international trade theory is the concept of “terms
of trade.” This refers to the amount of exports needed to obtain a given amount
of imports, with the fewer amount of exports needed the better for the country.
The terms of trade can shift, either benefiting a country or reducing its
welfare.

Assume that the United States exports aircraft to Japan and imports televisions,
and that one airplane can purchase 1,000 televisions. If one airplane now can
purchase 2,000 televisions, the United States will be better off; alternatively,
its welfare is diminished if it can only purchase 500 televisions with a single
airplane.

A number of factors can affect the terms of trade, including changes in demand
or supply, or government policy. In the example given just above, if Japanese
demand for aircraft increases, the terms of trade will shift in the United
States’ favor because it can demand more televisions for each airplane. 
Alternatively, if the Japanese begin producing aircraft, the terms of trade will
shift in Japan’s favor, because the supply of aircraft will now be larger and
the Japanese will have alternative sources of supply.

Under certain conditions, improvements in a country’s productivity can worsen
its terms of trade. For example, if Japanese manufacturers of televisions become
more efficient and reduce sale prices, Japan’s terms of trade will worsen as it
will take more televisions to exchange for the airplane.

A country can also adopt a beggar-thy-neighbor stance by deliberately turning
the terms of trade in its favor through the imposition of an optimum tariff or
through currency manipulation. In his economics textbook, Dominick Salvatore
defines an optimum tariff as

that rate of tariff that maximizes the net benefit resulting from the
improvement in the nation’s terms of trade against the negative effect resulting
from reduction in the volume of trade. . . . As the terms of trade of the nation
imposing the tariff improve, those of the trade partner deteriorate, since they
are the inverse. . . . Facing both a lower volume of trade and deteriorating
terms of trade, the trade partner’s welfare definitely declines. As a result,
the trade partner is likely to retaliate. . . . Note that even when the trade
partner does not retaliate when one nation imposes the optimum tariff, the gains
of the tariff-imposing nation are less than the losses of the trade partner, so
that the world as a whole is worse off than under free trade. It is in this
sense that free trade maximizes world welfare.[9]

If both countries play this game, both will be worse off. However, if only one
country pursues this strategy, it can gain at its partner’s expense.


THE ECONOMIC EFFECTS OF TRADE LIBERALIZATION

The objective of reducing barriers to trade, of course, is to increase the level
of trade, which is expected to improve economic well-being. Economists often
measure economic well-being in terms of the share of total output of goods and
services (i.e., gross domestic product, GDP) that the country produces per
person on average. GDP is the best measurement of economic well-being available,
but it has significant conceptual difficulties. As Joseph Stiglitz notes, the
measurement of GDP fails “to capture some of the factors that make a difference
in people’s lives and contribute to their happiness, such as security, leisure,
income distribution and a clean environment—including the kinds of factors which
growth itself needs to be sustainable.”[10]  Moreover, GDP does not distinguish
between “good growth” and “bad growth”; for example, if a company dumps waste in
a river as a by-product of its manufacturing, both the manufacturing and the
subsequent cleaning up of the river contribute to the measurement of GDP.

As the result of a multilateral round of trade negotiations under the GATT/WTO,
tariffs are reduced during a transition period but are not completely
eliminated. In the United States’ bilateral or regional free trade agreements
(FTAs), however, parties to the agreement completely eliminate almost all
tariffs on trade with each other, generally over a transition period, which may
be five to ten years.

Although reducing barriers to trade generally represents a move toward free
trade, there are situations when reducing a tariff can actually increase the
effective rate of protection for a domestic industry. Jacob Viner gives an
example: “Let us suppose that there are import duties both on wool and on woolen
cloth, but that no wool is produced at home despite the duty. Removing the duty
on wool while leaving the duty unchanged on the woolen cloth results in
increased protection for the cloth industry while having no significance for
wool-raising.”[11]

This happens for some products as a result of multilateral trade negotiations. 
For example, a country often reduces tariffs on products that are not import
sensitive—often because they are not produced in that country—to a greater
extent than it reduces tariffs on import sensitive products. In an FTA, where
the end result is zero tariffs, this would not be an effect when the agreement
is fully implemented. However, during the transition period it could well be
relevant for some products. Other than this exception, however, reducing tariffs
or other barriers to trade increases trade in the product, and this is the
intent of the trade agreement.

The benefits to an economy from expanded exports as a trade partner improves
market access are clear and indisputable. If the United States’ trade partner
reduces barriers as a result of a trade agreement, U.S. exports will likely
increase, which expands U.S. production and GDP. And suppliers to a firm that
gains additional sales through exports will likely also increase their sales to
that firm, thereby increasing GDP further.

The firms gaining sales through this may well hire more workers and possibly
increase dividends to stockholders. This money is distributed through the
economy a number of times as a result of what economists call the money
multiplier effect, which states that for every $1 an individual receives as
income, a portion of it will be spent (i.e., consumption) and a portion will be
saved. If individuals save 10 percent of their income, for every $1 earned as
income, 90 cents will be spent and 10 cents will be saved. The 90 cents that is
spent then becomes income for another individual, and once again 90 percent of
this will be spent on consumption.  This continues until there is nothing left
from the original $1 amount.

In fact, expanded exports increase a nation’s GDP by definition. One equation
economists use for determining GDP is GDP = Domestic Consumption (C) + Domestic
gross investment (In) + Government spending (G) + [Exports (E)—Imports (I )],
or GDP = C + In + G + (E—I)

The impact of trade on GDP, therefore, is the net amount that exports exceed or
are less than imports. However, this is a static measure.  As noted above,
expanded exports also have a dynamic effect as companies become more efficient
as sales increase.

The economic impact of increased imports is different. By the economists’
definition of GDP, of course, increased imports reduce GDP. A way of looking at
this is that if a U.S. firm produces a product that suddenly loses out to
increased imports, it will reduce its production and employment, and
consequently its suppliers will also reduce production and employment, thereby
reducing economic output.

This would suggest that the mercantilists were right, that a nation would be
well advised to restrict imports. However, almost all economists today would
reject that conclusion, and in fact many economists believe that reducing its
trade barriers benefits a country whether or not the country’s trade partners
also reduce their barriers. Adam Smith and many economists after him argue that
the objective of production is to produce goods for consumption. Stephen Cohen
and his colleagues express this argument as follows: “The theories of
comparative advantage (both classical and neoclassical) imply that liberalizing
trade is always beneficial to consumers in any country, regardless of whether
the country’s trading partners reciprocate by reducing their own trade
barriers.  From this perspective, the emphasis on the reciprocal lowering of
trade barriers in most actual trade liberalization efforts . . . is
misplaced.”[12]

The benefits of unilateral elimination of trade barriers are particularly
obvious in those cases where the country does not produce the product; in these
cases, eliminating trade barriers expands consumer choice. (As noted above,
however, an exception to this occurs in situations where reducing a trade
barrier on a raw material or component that is not produced by the country
increases the effective rate of protection for the finished product.)

Even where the country does produce the product, increased competition from
trade liberalization will likely lead to lower prices by the domestic firms. In
this event, some of the consumer’s savings will then be spent consuming other
products. The amount spent consuming other products will have positive
production effects, which will somewhat mitigate the loss in production by the
firm competing with the imports.

Increased import competition also has dynamic benefits by forcing domestic
producers to become more efficient in order to compete in the lower price
environment. Lower prices also may have a positive impact on monetary policy;
because import competition reduces the threat of inflation, central banks can
pursue a more liberal monetary policy of lower interest rates than otherwise
would be the case. These lower rates benefit investment, housing, and other
productive sectors.


ECONOMIC MODELS

Economists have developed a number of sophisticated models designed to simulate
the changes in economic conditions that could be expected from a trade
agreement. These models, which are based on modern economic theories of trade,
are helpful where the barriers to trade are quantifiable, although the results
are highly sensitive to the assumptions used in establishing the parameters of
the model.

One type of model used extensively by economists to estimate the economy-wide
effects of trade policy changes, such as the results of a multilateral trade
round, is the Applied General Equilibrium Model, also called the Computable
General Equilibrium (CGE) Model.[13] James

Jackson of the Congressional Research Service notes: “These models incorporate
assumptions about consumer behavior, market structure and organization,
production technology, investment, and capital flows in the form of foreign
direct investment.”[14]

CGE models may be used to estimate the impact of a trade agreement on trade
flows, labor, production, economic welfare, or even the environment.  They may
consider the effects of the agreement on all countries involved, and are ex
ante; that is, they attempt to forecast changes that would result from a trade
agreement. General equilibrium models are based on input-output models, which
track how the output of one industry is an input to other industries. General
equilibrium models use enormous data inputs that reflect all the elements to be
considered.[15]

One of the great strengths of these models is that they can show how the effects
on industries flow through the entire economy. One of their disadvantages is
that because of their complexity, the assumptions behind their projections are
not always transparent. Economic models are useful to give a sense of what might
happen as a result of a trade agreement.  They give the appearance of being
authoritative, but users need to be aware that economic models are not
predictive of what will actually happen and that they have significant
weaknesses.

First, the results of any model depend on the assumptions underlying it, such as
the degree to which imported products and domestically produced products can be
substituted for one another, or whether or not there is perfect or imperfect
competition. Differing assumptions can produce a wide range of results, not only
in magnitude but also sometimes even in the direction of projected changes.

Second, the economic data needed are often weak, not only for developing
countries but even for the United States and other developed nations.  For
example, trade and economic data between countries, and even within countries,
are not readily compatible. In the United States, the North American Industry
Classification System (NAICS), which is used to collect statistical data
describing the U.S. economy, is based on industries with similar processes to
produce goods or services. In contrast, data on international trade in goods are
collected on a commodity basis.[16] The United States’ NAFTA partners, Canada
and Mexico, also use NAICS, but the European Union uses a system called
Nomenclature of Economic Activities. Although there are concordances between
these differing systems, these are far from exact.

Nontariff barriers—such as import quotas, subsidies, standards, and
regulations—must be converted to their tariff equivalents, and this is often
difficult and unreliable. For new areas covered in trade negotiations —such as
services, investment, and intellectual property—efforts to measure the impact of
barriers is even more difficult.

Although measuring the impact of tariffs is more accurate than measuring
nontariff barriers or services, it is not as straightforward as it would seem.
For example, often economists use a weighted tariff by considering the
proportion of imports entering under that tariff line. A problem with this
approach is that a very high duty will completely block imports, resulting in
the false conclusion that that tariff line is given no weight.

In view of the problems with trade models, some economists dismiss their
usefulness. For example, Bhagwati says: “I consider many of the estimates of
trade expansion and of gains from trade—produced at great expense by
number-crunching at institutions such as the World Bank with the aid of huge
computable models…as little more than flights of fancy in contrived flying
machines.”[17] Many economists would consider this criticism extreme, but
nonetheless trade models do need to be viewed with a large degree of caution.


THE ECONOMIC THEORY OF TRADE BLOCS

The drafters of the GATT believed that reducing barriers to trade should be on a
multilateral basis to get the greatest benefits of expanded production based on
comparative advantage. As noted above, they enshrined this concept in Article I
of the GATT (most-favored-nation, MFN, treatment), which requires members to
give equal treatment with regard to trade barriers to all GATT members.

However, they also recognized a role for regional integration that would allow
the members of a trade bloc to eliminate barriers on trade among themselves,
while maintaining a discriminatory tariff on imports from nonmembers.[18]
Accordingly, Article XXIV of the GATT provides for a major exception to the MFN
principle that allows countries to form customs unions or free trade areas
(FTAs) that may discriminate against nonmembers of the bloc.[19]   In a customs
union, the members eliminate trade barriers among themselves but erect a common
customs tariff on imports from nonmembers. Members of a free trade area also
eliminate trade barriers among themselves, but they each retain their own
schedule of tariffs on imports from nonmembers.

Customs unions and free trade area agreements may expand trade and global
welfare or they may diminish welfare depending on whether they create new trade
patterns based on comparative advantage or simply divert trade from a more
competitive nonmember to a member of the trade bloc. In 1950, the economist
Jacob Viner defined trade creation as the situation where a member of a
preferential trading bloc has a comparative advantage in producing a product and
is now able to sell it to its free trade area partners because trade barriers
have been removed.

Trade creation benefits the exporters in the member of the trade bloc that has a
comparative advantage in producing a product and it benefits consumers in the
importing member who now can purchase the product at a lower price. Domestic
producers competing with the lower-cost imports from its partner country lose,
but their loss is less than the gains to the exporters and consumers. Trade
creation enhances global welfare through this greater efficiency.

In the case of trade diversion, however, a member gains its sales at the expense
of a more competitive producer in a country that is not a member of the bloc,
simply because its products enter its partner’s market duty free, while the more
competitive nonmember producer faces a discriminatory duty.[20] Nonmember
country exporters that would have a comparative advantage under equal
competitive conditions lose from trade diversion.

Additionally, under trade diversion, the importing country loses the tariff
revenue it had collected on those imports which now come in duty free from its
bloc partner. The consumer in the importing partner does gain, because the
imported good no longer has to bear the cost of the tariff; however, the
consumer’s gain is necessarily less than or equal to the lost customs revenue,
so the nation as a whole is less well off . Thus, trade diversion hurts both the
importing country and the rest of the world.  These loses are greater than the
gains to the bloc member that gains exports due to trade diversion.

If trade diversion is greater than trade creation, formation of the customs
union or FTA would diminish world welfare. If trade creation is greater, then
global welfare is enhanced.

In addition to trade diversion and trade creation, which are basically static
effects, participants in free trade areas and customs unions are also seeking
dynamic benefits, such as expanded production as firms take advantage of the
increased size of the market to increase output, and improved efficiency as
firms adapt to increased competition. Access to a larger market is particularly
important for small countries whose economy is too small to justify large-scale
production.

To minimize the potential adverse consequences of such trade blocs, GATT Article
XXIV requires that the members of a customs union or an FTA must eliminate trade
barriers on “substantially all” trade between them, and that all the members of
GATT have the opportunity to review the agreement. In the event that a GATT
member not a party to the customs union faces higher tariffs on some products as
a customs union is formed, Article XXIV requires that that member be compensated
for the lost trade. However, as noted in chapter 2, Article XXIV has proven to
be totally ineffective in restricting the growth of trade blocs; as a result,
trade patterns today are significantly distorted by these preferential schemes.


TRADE THEORY MEETS NEW REALITIES

From the time of Adam Smith in 1776 to the launching of the GATT in 1947,
economic theory of trade evolved fairly slowly. Since the GATT was launched in
1947, however, there have been a number of significant modifications to the
traditional Western economic theory of international trade. These modifications
largely update the basic theory of trade to reflect the new realities of
industry and commerce.

In the times of Smith, Ricardo, and Hecksher-Ohlin, companies were generally
small and most international trade was in agricultural or mineral products or
produced by small scale manufacturing. By 1947, however, large-scale
manufacturing had evolved, and a great deal of trade was in manufactured
products.

In 1979, the economist Paul Krugman noted that a great deal of trade was taking
place between developed countries that had similar factors of production. For
example, the United States and the nations of Europe have broadly similar
factors of production, yet conduct an enormous amount of trade generally within
the same industries. Thus, the United States will export automobiles and auto
parts to Europe and at the same time import autos and auto parts from Europe.

The Heckscher-Ohlin model, which is good at projecting likely trade patterns
between countries where factors of production are different, really did not
explain this trade pattern. Krugman’s theory is based on product differentiation
and economies of scale. For example, a Jeep and a Volkswagen are both
automobiles, but they are highly differentiated as seen by the consumer. And
both benefit from economies of scale; that is, the larger the production, the
more costs can be reduced within a broad range of volume. Unlike wheat, where
costs increase as volume is expanded, the cost of each additional automobile
produced declines as production is increased, although at a very large volume of
production costs would likely start to increase. Goods such as automobiles
require large, mechanized production runs and substantial capital investment,
and it may be extremely difficult for a new entrant to compete with an
established firm.

Under trade based on product differentiation and economies of scale, several
countries may produce the same product broadly defined and trade parts and
differentiated products with one another. Thus, the United States might
specialize in producing Jeeps, and Europe might specialize in producing
Volkswagens. Clearly, a great deal of production in modern developed country
economies is in industries that experience increasing returns to scale, and in
these industries returns to factors of production would not tend to equalize as
a result of international trade. In fact, returns to labor in a labor scarce
economy might well increase, rather than decrease, as would be predicted by the
factor price equalization theory.

Western economic theory has also changed in recent years to account for the fact
that world trade has increased so much more rapidly than overall economic growth
since the early 1970s. In 1973, the ratio of exports to GDP was 4.9 percent for
the United States, and by 2005 this had more than doubled to 10.2 percent. For
the world as a whole, this ratio was 10.5 percent in 1973, increasing to 20.5
percent in 2005.

What caused exports to increase more rapidly than production is that companies
evolved from being domestically oriented to becoming multinational, and now many
have evolved to become global. The first six rounds of GATT trade negotiations
had reduced developed-country tariffs on industrial goods from the average of 40
percent after World War II to less than half that level by the end of the
Kennedy Round in 1967.  Additionally, international communications and
transportation had improved enormously (the first commercial jet crossed the
Atlantic in 1958, and the first satellite for commercial telecommunications was
launched in 1965.)

As a result companies in some industries, such as electronics and chemicals,
became multinational corporations and increasingly began to purchase and produce
parts and materials in a number of countries.  Each time these parts and
materials cross a border, an international trade transaction has occurred; and
then, when the final good is exported, another international trade transaction
has occurred.

This trend has increased enormously during the past twenty-five years, and now
this cross-border trade occurs in virtually all industries.  Many products will
have parts and materials from many countries; for example, a new suit may have
cotton from West Africa that has been processed into fabric in Bangladesh, and
sewn into a suit in China, with buttons imported from India. And then the suit
may be exported to the United States. Another example is the first Airbus jumbo
jet 380, which had parts and components from more than 1,500 suppliers in twenty
seven countries. Many companies today have global supply chains, procuring parts
and materials worldwide. Each specific part or material in the value chain is
sourced from the country that can produce the part most cheaply, whether because
of its endowment of factors of production or because of special incentives, such
as tax holidays.

Kei-Mu Yi of the World Bank notes that standard economic models account very
well for the increase in world trade through the mid-1970s but cannot explain
the growth of trade since then.[21] However, a model that accounts for supply
chains does explain the growth in trade, and he believes that such vertical
specialization accounts for about 30 percent of world trade today.

Yi notes that tariff reductions have a far greater impact on these global supply
chains than they do on traditional trade. To take the suit example, assume that
China, Bangladesh, and the United States each reduces its tariffs by 1 percent
and that imported fabric and buttons account for half the cost of the suit made
in China; then the cost of producing the suit in China will be reduced by 0.5
percent. Coupled with the 1 percent U.S. tariff reduction, the cost to the U.S.
consumer would be reduced by 1.5 percent. If the suit had been wholly produced
in China, the cost to the consumer would have been reduced by just the U.S.
tariff reduction, or 1 percent.

The emergence of these extensive supply chains has enormous implications.  It
means that for many products the traditional concept of “country of origin” no
longer applies, because many products have many countries of origin. This in
turn means that standard trade statistics have limitations in how useful they
are for understanding what is really happening in world trade.[22] It has an
impact on how countries should approach economic development, because it means
that developing countries must become part of these global supply chains as a
way to increase the amount of value added in the parts and materials provided to
these supply chains. And it has an impact on how companies see themselves—a firm
selling globally and procuring its parts and materials globally sees itself as a
“global” firm rather than as a “national” firm.


TRADE IN FACTORS OF PRODUCTION AND SERVICES

Traditional economic theory assumed that goods are traded between countries, but
that factors of production (e.g., labor, capital, and technology) and services
are not traded from country to country. However, recently capital, technology,
and services have been increasingly flowing easily over national borders, and
even labor is moving from country to country more frequently. Accordingly, in
recent rounds of multilateral negotiations and in U.S. bilateral agreements,
negotiators have sought to develop rules governing investment, intellectual
property protection, services, and labor.

In economic theory, if factors of production are fully mobile, the costs of all
factors of production that could move across borders would result in equal costs
in all trading countries. This would mean that the basis of comparative
advantage for trade between countries would diminish and there would ultimately
be less international trade.

In reality, of course, there are reasons other than trade barriers why factors
of production such as capital or labor may not move across borders, even when
there are no barriers and higher returns could be gained in other markets.
Workers, for example, are reluctant to leave their homelands and family and
friends, and investors are reluctant to invest in other markets where they have
less familiarity. As a result, even eliminating all governmentally imposed
barriers to trade in capital and labor would not lead to the complete
equalization of costs between counties.

Like trade in investment and capital, post–World War II economists did not
conceive of trade in services. In fact, trade in services was almost considered
an oxymoron by early economists, such as Adam Smith and David Ricardo, who
assumed that services are not tradable. This was also the view of trade
negotiators for three or more decades after the GATT was launched.

Geza Feketukuty, the lead U.S. negotiator on services in the Uruguay Round,
gives a wonderful anecdote of early efforts to launch negotiations on trade in
services: “The Swiss delegate . . . dismissed trade in services by pointing out
how impossible it was for him to have his hair cut by a barber in another
country. The chairman of the committee . . . replied that every woman in Germany
had benefited enormously from French exports of hairdressing services, and she
was confident that the delegate’s wife would confirm the same was true in
Switzerland.”[23]

Not surprisingly, economic theory as it applies to services trade is still being
developed. In general, economists today assume that the basic theory of
comparative advantage as it applies to goods applies equally well to
cross-border trade in services. As Geza Feketekuty says, “The theory of
comparative advantage as a theoretical statement about economic relationships
should be equally valid whether the products encompassed by the theory are
tradable physical goods such as shoes and oranges, or tradable services such as
insurance and engineering.”[24]

Many types of services, such as telecommunications, are intimately
interconnected to other economic activity. Trade liberalization in these areas
can have far-reaching economic effects. For example, lowering the costs and
increasing the availability of telecommunications services can help
manufacturers compete in global markets, it can enable farmers to learn the
latest techniques, and it can help other services sectors, such as tourism, that
can now reach the world market through the Internet. Liberalization of
telecommunications services even facilitated the creation of a new form of
enterprise, namely, “off shoring,” where companies moved some of their basic
operations such as telemarketing call centers to low-cost locations in other
countries.

In contrast, liberalizing restrictions in some other sectors, such as tourism,
may affect revenues and employment for the providers and the country but will
have only a minimal impact on the competitiveness of other sectors within the
country. In other words, the liberalization of some services may have multiplier
effects throughout the economy, whereas in other sectors the benefits will
largely flow only to the affected sector.


CREATING COMPARATIVE ADVANTAGE

The classic Western model of trade was based on eighteenth-century economic
realities. Factors of production were relatively fixed: Land was immobile
(although its fertility or usage might change), and labor mobility was highly
restricted by political constraints. For most of the century, the movement of
capital across borders was limited by political barriers and a lack of knowledge
of other markets. (However, by the middle of the nineteenth century both capital
and labor were flowing more freely between Europe and the Americas.) Technology
in the eighteenth century was relatively simple by today’s standards and was
relatively similar in all countries. Additionally, the production of most
products at that time was subject to diminishing returns, which meant that as
production increased, the costs of producing each additional unit increased.

In this world, the classic Ricardian model of trade provided a good explanation
for trade patterns, such as which countries would produce what products. England
would produce textiles based on its wool production and capital availability,
and Portugal would produce wine based on its sunshine and fertile soil. If
Portugal chose to impose barriers to the importation of British textiles, its
own economy would be less well off, and it would still be in Britain’s interest
to allow the free importation of Portuguese wine.

However, the world economy began to change in the twentieth century, as some
products could be produced under conditions of increasing returns to scale. As a
company produced more steel, production could be automated and the costs of each
additional unit could be significantly reduced. And the same was true for
automobiles and a growing number of other more sophisticated products.

By the last twenty-five years of the twentieth century, the global economy was
significantly different. Land and labor were still relatively fixed, although
capital could again move more freely around the world. However, technology was
highly differentiated among countries, with the United States leading in many
areas.

An established company in an industry that required extensive capital investment
and knowledge had an enormous advantage over potential competitors. Its
production runs were large, enabling it to produce product at low marginal cost.
And the capital investment for a new competitor would be large.

In this new world, the economic policies pursued by a nation could create a new
comparative advantage. A country could promote education and change its labor
force from unskilled to semiskilled or even highly skilled. Or it could provide
subsidies for research and development to create new technologies. Or it could
take policy actions to force transfer of technology or capital from another
country, such as allowing its companies to pirate technology from competitors or
imposing a requirement that foreign investors transfer technology.

Ralph Gomory and William Baumol describe this well:

The underlying reason for these significant departures from the original model
is that the modern free-trade world is so different from the original historical
setting of the free trade models. Today there is no one uniquely determined best
economic outcome based on natural national advantages. Today’s global economy
does not single out a single best outcome, arrived at by international
competition in which each country serves the world’s best interests by producing
just those goods that it can naturally turn out most efficiently. Rather, there
are many possible outcomes that depend on what countries actually choose to do,
what capabilities, natural or human-made, they actually develop.[25]

In the world of the late twentieth century, a country might be dominant in an
industry because of its innate comparative advantage, or it might be dominant
because of a strong boost from government policy, or it might be dominant
because of historical accident. For example, the U.S. dominance in aircraft was
probably due to a strong educational system that produced highly competent
engineers, a large domestic market with a dedicated customer (the U.S.
military), and the historical accident that the aircraft industries of the
United States’ major competitors—Japan, Germany, and England—had all been
destroyed in World War II.

Once such an industry becomes dominant, it is extremely difficult for other
countries’ industries to compete. The capital costs of entry may be very large,
and it is difficult for a new entrant to master the technology.  Additionally,
the industry normally has a web of suppliers that are critical to
competitiveness, such as steel companies and tire manufacturers. However, if
such an industry losses its dominance, it is equally difficult for it to reenter
the market.

A country with such a dominant industry benefits enormously economically. 
Because of its dominant position, such an industry may pay high wages and
provide a stable base of employment.

Access to other markets plays an important role in this economic model where
comparative advantage can be created. Without free trade, it becomes extremely
costly for a government to subsidize a new entrant because the subsidy must be
large enough both to overcome foreign trade barriers and to jump-start the
domestic producer. The WTO and the United States’ FTAs also play an important
role by setting out rules that govern what actions a country may take in many
areas to create comparative advantage; for example, the subsidies code limits
the type of subsidies that governments may grant.

Gomory and Baumol note that because countries can create a comparative advantage
in goods with decreasing costs of production, there are many possible outcomes
to trade patterns: “These outcomes vary in their consequences for the economic
well-being of the countries involved.  Some of these outcomes are good for one
country, some are good for the other, some are good for both. But it often is
true that the outcomes that are the very best for one country tend to be poor
outcomes for its trading partner.”[26]

Although country policies can lead to creation of a dominant industry, such an
industry may not be as efficient as if it had occurred in another country. An
example given by Gomory and Baumol is Japan’s steel industry. Japan has no
domestic energy supplies and high wages; by contrast, China “has low labor costs
and lots of coal.”[27] In theory, China would be the efficient producer of
steel, but in reality Japan is the dominant producer. (This example is less
valid today, as China has become a major steel producer.)

Although there are many areas where government policies can create comparative
advantage, there are still many areas where the classic assumptions of an
inherent comparative advantage still hold. The key is whether the industry is
subject to constant or increasing costs, such as wheat, or decreasing costs,
such as autos, aircraft, or semiconductors.


NEOMERCANTILISM

The economic theory based on Ricardo’s concept of comparative advantage
dominates current thinking in the West and formed the intellectual basis for
formation of the GATT/WTO. The doctrine of mercantilism, which dominated
thinking up to the end of the eighteenth century, is generally rejected by
Western economists today.

However, a number of countries—including Japan, South Korea, China, and some
other countries in the Far East—have pursued a neomercantilism model in which
they seek to grow through an aggressive expansion of exports, coupled with a
very measured reduction of import barriers. These countries seek to develop
powerful export industries by initially protecting their domestic industry from
foreign competition and providing subsidies and other support to stimulate
growth, often including currency manipulation.

The success of some countries pursuing a neomercantilist strategy does not
refute the law of comparative advantage. In fact, the reason these countries are
successful is that they focus on industries where they have or can create a
comparative advantage. Thus Japan first focused on industries such as steel and
autos, and later on electronics, where a policy of import protection and
domestic subsidies could enable their domestic firms to compete in world
markets, and particularly the U.S. market.

To succeed in a neomercantilist strategy, of course, a country needs access to
other markets, which the progressive liberalization of trade barriers under the
GATT/WTO provided.  Neomercantilists generally focus on key industries selected
by government, a strategy known as industrial policy. A successful industrial
policy requires a farsighted government. Japan had an extremely competent group
of government officials in the Ministry of Industry and Trade (MITI), which
oversaw its industrial policy and was basically immune from political pressures.
Although MITI had many successes, it also made some missteps. For example, in
their planning to develop a world-class auto industry in the 1950s, MITI
officials initially believed they had too many auto companies, and urged Honda
to merge with another company. Instead, Honda elected to invest in the United
States and went on to become a leading auto producer.

Countries pursuing the neomercantilist model have also generally promoted
education and high domestic savings to finance their growing export industries.
For example, the savings rate in Japan has often been more than 20 percent of
GDP, and it approaches 40 percent of China’s GDP today. (By contrast, the U.S.
savings rate has been only about 2 percent over the past decade and in some
years was actually negative.)

Many economists argue that a neomercantilist strategy may be successful for a
while but that over time such a strategy will not be effective. Basically this
argument is that the complexities for governments in picking potential winners
and identifying how to promote those industries are too great. For example,
Japan was very successful with its neomercantilist strategy until the mid-1990s.
However, since then the Japanese economy has been stagnating, and many
economists believe that Japan will need to change its approach to stimulating
domestic demand rather than focusing on export markets. During the past ten
years, South Korea and China have also pursued neomercantilist policies, and it
remains to be seen if these are effective over the long term.

Additionally, a number of economists argue that government intervention can be
effective in promoting a specific sector but that industrial policies are not
effective at the macro level of benefiting the economy as a whole. In any case,
Western economists and policymakers today almost universally reject the idea
that the United States should adopt an industrial policy that picks winners and
losers. Opponents of a possible U.S. industrial policy argue that under the U.S.
system, such a policy would be subject to political pressures that would ensure
failure.

Instead, the real debate among economists and policymakers is whether the United
States should respond to foreign neomercantilist practices, and if so, how.
Stephen Cohen and his colleagues say:

Free trade advocates argue that imposing import barriers, even if other
countries do so, is tantamount to shooting oneself in the foot.  The
advisability of turning the other cheek to other countries’ trade barriers is
based on an economic argument traceable to Adam Smith in the eighteenth century:
Since consumption is the sole end of production, consumers’ interests come
before producers’ interests, especially those of relatively inefficient
producers. Carried to its logical conclusion, this strategy recommends that the
U.S. government take no action to offset the de facto subsidies provided to
domestic consumers when imports are sold at prices below fair value.[28]

Others argue that the objective of free trade is to promote competition based on
comparative advantage, which maximizes global efficiency.  Practices such as
subsidies or currency manipulation are a movement away from such competition and
can produce a result where the less efficient producer dominates trade, thereby
reducing total welfare. In these circumstances, taking an offsetting action,
such as imposing a countervailing duty, could restore “a level playing field”
where trade based on comparative advantage can occur.


UNBALANCED TRADE

The theory of comparative advantage assumes a world where trade between
countries is in balance or at least where countries have a trade surplus or
deficit that it is cyclical and temporary.[29] Relaxing the assumption “that
international trade among nations is balanced, could lead a nation with a trade
deficit to import some commodities in which it would have a comparative
advantage and it would in fact export with balanced trade,” says Dominic
Salvatore. However, he does not see this as a big problem “since most trade
imbalances are generally not very large in relation to GNP [gross national
product].”[30]

In analyzing the impact of a surplus or deficit, economists often consider
“trade” very broadly in definition. Generally, economists do not consider the
simple balance in merchandise trade as relevant as the “current account,” which
includes the balance of trade for goods and services, plus net international
income receipts (remitted profits from overseas investments, royalty payments,
interest, and dividends) and unilateral transfers (foreign aid and transfers
abroad by private citizens).  Except for unilateral transfers, all these
elements are covered in our trade agreements.

To give a real picture of how the nation is doing, the current account is often
measured as a percentage of GDP; as a country grows, a larger surplus or deficit
in the current account is not a source of concern because the economy can more
readily absorb the impact.

A surplus or deficit in the current account can be affected by the business
cycle. Thus, if our economy grows rapidly, the demand for imports will expand as
consumers can afford to buy more and businesses need parts and supplies for
expansion. Similarly, the United States’ exports are affected by economic growth
in its trade partners. If it grows more rapidly than its trade partners, in
short, that will have a negative impact on the U.S. current account balance.
Conversely, if the United States’ trade partners are growing more rapidly, that
will have a positive impact on its current account balance.

Economists are not concerned with such cyclical trade deficits or surpluses. 
Additionally, they are not concerned if a deficit occurs because the country is
borrowing heavily from abroad to finance investment that will be paid back
later. During the nineteenth century, in fact, the United States was in exactly
this position when it borrowed heavily to build railroads across the continent,
steel mills, and other long-term investments. However, that is not the United
States’ situation today. Today, it is borrowing heavily from other countries to
finance short-term consumption, such as the newest and largest HDTVs from Japan
or South Korea, and these purchases do not generate income to repay its debt in
the future.

A fundamental accounting concept in international economics is that a country’s
overall balance of payments, which consists of both the current account and the
capital account, has to be in balance. This means that if the current account is
in deficit, the country’s capital account has to be in surplus by an equal
amount. The capital account consists of purchases or sales of foreign exchange
by the central bank or by private citizens. This fundamental accounting
principal can be seen as:

Balance of Payments = Current Account + Capital Account = Zero

Two factors that may lead to a deficit or surplus in the current account balance
are the level of a nation’s savings and investment compared with consumption,
and the exchange rate between its currency and that of its trade partners. The
level of a country’s savings and investment compared with its consumption is
inversely related to its trade balance.  Joseph Stiglitz puts the matter as
follows: “Trade deficits and foreign borrowing are two sides of the same coin.
If borrowing from abroad goes up, so too will the trade deficit. This means that
if government borrowing goes up, unless private savings goes up commensurately
(or private investment decreases commensurately), the country will have to
borrow more abroad, and the trade deficit will increase…The reserve country can
be thought of as exporting T-bills” in exchange for the import of goods and
services.[31]

The second factor that can have an impact on a country’s current account balance
is the exchange rate. The exchange rate refers to the amount of foreign
currencies that can be purchased by a country’s own currency. According to
economic theory, if a nation is running a persistent trade deficit, its exchange
rate would be expected to fall in relation to its trade partners—for example, if
the United States runs a persistent deficit, the dollar should purchase less
foreign exchange such as euros or yen. This would mean that imported products
will cost more, because it would take more dollars for each unit of foreign
currency, and this would cause imports to decline. Additionally, the United
States’ exports should expand, as foreigners can buy more of its products for
each unit of their currency.

However, countries can prevent this mechanism from operating by aggressively
intervening in the foreign exchange markets. For example, under economic theory,
the value of the dollar should decline in relation to the renminbi because the
United States has enormous deficits while

China experiences comparable trade surpluses. However, China has pegged the
renminbi to the dollar and has prevented its exchange rate from rising and
thereby restoring a trade balance. China does this by using the dollars it
accumulates from its trade surplus to aggressively purchase U.S. currency in the
form of Treasury bills. The result has been an overvalued dollar and an
undervalued renminbi. (This is similar to what Japan did in the early 1980s when
the yen was undervalued and the dollar was overvalued.) In economic theory, an
“undervalued exchange rate is both an import tax and an export subsidy and is
hence the most mercantilist policy imaginable.”[32]


CONCLUSION

Most economists today consider the law of comparative advantage to be one of the
fundamental principles of economics. However, several very important caveats to
the law of comparative advantage are often overlooked or glossed over.

First, David Ricardo based his theory on the assumption that the costs of
production increase as production expands; in other words, each additional unit
produced costs more than the previous unit, and this is true for many products,
such as wheat. This assumption implies that countries have a comparative
advantage in certain goods because of their natural endowment. However, many
products today are produced under conditions of decreasing costs; for example,
the cost of producing each additional semiconductor or airplane decreases as
production expands.  The extremely important implication of this is that
countries can create comparative advantage.

A second extremely important caveat is the so-called factor price equalization
theorem, which holds that international trade will cause the relative returns to
factors of production, such as unskilled labor, to equalize between countries
under free trade conditions. This would mean that for a high-wage country such
as the United States, wages for unskilled workers would fall while wages in
labor abundant countries would rise. However, factor prices will not tend to
equalize in industries that have decreasing costs of production.

Third, Ricardo and other early economists based their theories on trade in
goods, and they did not consider trade in factors of production.  Today,
however, basic factors of production such as labor, capital, and technology are
traded. The implication of trade in factors of production is that factor
equalization will occur completely in a shorter time period than would occur
under trade in goods only.

Fourth, Western economic theory assumes that trade will be reasonably balanced
over time. Where this is not the case, it indicates that the deficit country
will be importing products where it would normally have a comparative advantage;
if these products are in areas that experience decreasing costs of production,
over time the industry may lose its ability to compete in global markets.

The world has changed since the time of Smith and Ricardo. Today, trade is no
longer mostly between small producers and farmers but giant global corporations
that buy parts and materials from around the world and sell globally. These
giant supply chains were made possible by trade liberalization and technology
changes, and they account for the fact that international trade has expanded far
more rapidly than global economic growth since 1970. These global supply chains
also have implications for strategies for developing countries in promoting
economic growth.

Clearly, the United States benefits when its trade partners reduce their trade
barriers, because its exports will increase, which generates expanded production
and employment. Most economists also believe that the United States benefits
from reducing its own trade barriers, as consumers gain from reduced costs and
producers are forced by international competition to improve efficiency.
However, import liberalization has an impact on domestic labor and production
that needs to be considered.

Multilateral trade liberalization, where all countries reduce their trade
barriers in parallel, best promotes trade based on comparative advantage. 
However, countries can abuse the system by adopting beggar-thy-neighbor poli

--------------------------------------------------------------------------------

[1] Thomas Mun, in a letter written to his son in the 1630s, available at
http://socserv.mcmaster.ca/econ/ugcm/3ll3/mun/treasure.txt.

[2] William Bernstein notes that Smith was not the first to advocate the
advantages of free trade. He says, “By far the most remarkable early free-trader
was Henry Martyn, whose Considerations upon the East India Trade preceded by
seventy-five years Adam Smith’s Wealth of Nations.” William J. Bernstein, A
Splendid Exchange: How Trade Shaped the World (New York: Grove Press, 2008),
258.

[3] David Ricardo, On the Principles of Political Economy and Taxation (London:
John Murray, 1821).

[4] Bertil Ohlin actually published this theory in 1933. A brief explanation of
the Heckscher-Ohlin theory is available at
http://nobelprize.org/educational_games/economics/trade/ohlin.html.

[5] Dominick Salvatore, International Economics, 8th ed. (Hoboken, N.J.: John
Wiley & Sons, 2004), 15.

[6] The concept of product life cycle was introduced by Raymond Vernon in 1966.

[7] A good explanation of this theorem, which shows a hypothetical trading
relationship between two countries, is available at
http://faculty.washington.edu/danby/bls324/trade/hos.html.

[8] James K. Jackson, Trade Agreements: Impact on the U.S. Economy (Washington,
D.C.: Congressional Research Service, 2006), 9.

[9] Salvatore, International Economics, 255.

[10] Stiglitz, Progress, What Progress, 27.

[11] Jacob Viner, The Customs Union Issue (New York: Carnegie Endowment for
International Peace, 1950), 48.

[12] Stephen D. Cohen, Robert A. Blecker, and Peter D. Whitney, Fundamentals of
U.S. Foreign Trade Policy: Economics, Politics, Laws, and Issues (Boulder,
Colo.: Westview Press, 2003), 57.

[13] A commonly used and publicly available CGE model and comprehensive database
is available from the Global Trade Analysis Project, which is housed in the
Department of Agricultural Economics at Purdue University. The GTAP model and
database are available at https://www.gtap.agecon.purdue.edu/default.asp.

[14] Jackson, Trade Agreements, 12.

[15] A second type of model commonly used is a gravity model, which assumes that
larger economies have a greater pull on trade flows than smaller economies, and
that proximity is an important factor affecting trade flows. And still another
common type is a partial equilibrium model, which estimates the impact of a
trade policy action on a specific sector, not the general economy. Partial
equilibrium models do not capture linkages with other sectors and accordingly
are useful when spillover effects are expected to be negligible. However,
partial equilibrium models are more transparent than CGE models and it is easier
to see the impact of changed assumptions.

[16] A good source for trade data and an explanation of the data systems used is
the Foreign Trade Statistics Web site at the Census Bureau,
http://www.census.gov/eos/www/naics/.

[17] Jagdish Bhagwati, In Defense of Globalization, Council on Foreign Relations
Report (New York:, Oxford University Press, 2004), 230.

[18] The drafters of the GATT probably were focused on the potential benefits of
a European customs union that would promote integration. Some historians argue
that the U.S. negotiators also envisioned a possible U.S.-Canadian free trade
agreement that would eliminate barriers to trade in North America.

[19] Another major exception to the MFN rule pertains to preferences for
developing countries. This exception is considered further in chapter 6.

[20] Viner notes a qualification to the rule that global welfare is diminished
if trade diversion is greater than trade creation and that is when unit costs
decrease in an industry as output expands. In such a case, a small country may
not have been able to develop an industry because its market size was too small
but is able to develop the industry within a customs union or free trade
arrangement.

[21] Kei-Mu Yi, Can Vertical Specialization Explain the Growth of World Trade?
(New York: Federal Reserve Bank of New York, 1999).

[22] WTO deputy director-general Alejandro Jara gave an interesting speech May
26, 2010, in which he outlined some of the implications of supply chains for how
we think about international trade. His speech is available at
www.wto.org/english/news_e/news10_e/devel_26may10_e.htm.

[23] Geza Feketekuty, International Trade in Services: An Overview and Blueprint
for Negotiations (Cambridge, Mass.: American Enterprise Institute /Ballinger,
1988), 2–3.

[24] Ibid., 100.

[25] Ralph Gomory and William Baumol, Global Trade and Confl icting National
Interests (Cambridge, Mass.: MIT Press, 2000), 5.

[26] Ibid., 5

[27] Ibid., 21.

[28] Cohen, Blecker, and Whitney. Fundamentals of U.S. Foreign Trade Policy,
8–9.

[29] See, e.g., ibid., 54: “The theory of comparative advantage assumes that
trade is balanced (i.e., exports equal imports in value) and that labor is fully
employed…If trade is not balanced, the surplus country must be exporting some
goods in which it does not have a ‘true’ comparative advantage.”

[30] Salvatore, International Economics, 167.

[31] Joseph E. Stiglitz, Making Globalization Work (New York: W. W. Norton,
2006), 252–53.

[32] Aaditya Mattoo and Arvind Subramanian. Currency Undervaluation and
Sovereign Wealth Funds: A New Role for the World Trade Organization (Washington,
D.C.: World Bank, 2008), 3.

Chapter Updates
 

Home

Chapter 1: U.S. Trade Policy in Crisis

Chapter 2: America's Trade Agreements

Chapter 3: Trade Agreements and Economic Theory

Chapter 4: Trade Agreements and U.S. Commercial Interests

Chapter 5: Foreign Policy: The Other Driver

Chapter 6: Economic Development: A Missed Opportunity

Chapter 7: Uneasy Neighbors: Trade and the Environment

Chapter 8: The Labor Dilemma

Chapter 9: The Way Forward

For more information or questions contact William Krist
at william.krist@wilsoncenter.org



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