FT MBA Ch. 4 W. Solutions - The World Economy - Fall 2022

The World Economy
WHU FT MBA
Chapter 4: Trade Restrictions and the Global Trading System
Excellence in
Management
Education
Professor Dr. Michael Frenkel

Chair of Macroeconomics and International Economics
WHU – Otto Beisheim School of Management
Burgplatz 2, 56179 Vallendar, Germany
www.whu.edu
Professor Dr. Michael Frenkel Fall 2022 1
© WHU – Otto Beisheim School of Management
Learning Goals of Chapter 4
This chapter will enable you to
 Distinguish various forms of trade restrictions
 Explain who benefits and who loses from trade barriers
 Outline how businesses respond to trade policy
 Describe the role and limitations of the WTO
 Understand the role of regional integration

Trade Barriers
 Tariffs (specific or ad valorem) Tariff barrier

 Import quotas
 Voluntary export restraints (VER)
 Subsidies
 Local content requirements Non-tariff barriers

 Specific permission requirements
 False antidumping measures
 Administrative policies

Who Benefits and Who Loses from a Trade Barrier?
Examine the effects of a trade barrier (example: a tariff)
 Price effects
 Quantity effects
 Welfare effects (i.e., who is better off?)
 Who in the economy benefits from a trade barrier?
 Who in the economy loses from a trade barrier?
 What can we say about the overall effects?

The Welfare Concept of the Consumer Surplus
Price
= Consumer surplus
p1
Quantity

The Welfare Concept of the Producer Surplus
Price
= Producer surplus
p2
Quantity

Different Scenarios after the Market is Opened up
Price (P) We assume that the home country is a small country.
When the world market price is

higher than the autarky
equilibrium price at home
Dh Sh
Pw1
A
When the world market price is
Pw2=PA the same as the autarky
C F When the world market price is

Pw3   lower than the autarky
Q1 Q4 Quantity (Q)

What are the Effects of a Tariff?
Price effect: Pw → Pw+t
Question:
Quantity effects: consumption: Q4→Q3
Price (P)
production: Q1→Q2
imports: Q4-Q1 → Q3-Q2
Welfare effects:
consumer surplus: - (I + II + III + IV)
Dh Sh producer surplus: +I
government budget: + III
Total welfare effect: - (II + IV)
A Hence, the tariff leads to a welfare loss
PA “deadweight loss”
Can you imagine a tariff at which the

B G government is not able to collect any
Pw+t tariff revenue?
I III F This happens, when the tariff is
C II D E IV
Pw   prohibitive.
Welfare effect?
The deadweight loss is at a maximum:
the entire area of the triangle ACF.
Q1 Q2 Q3 Q4 Quantity (Q)

What are Indirect Effects of a Tariff?
Indirect effects = effects additional to the ones on supply and demand of the protected
product)
 In case the protected good is an intermediate product for other domestic producers: higher
costs for processing industries
 Administrative costs of monitoring trade policies and their enforcement
 Costs of encouraged lobbying

 Long-term costs resulting from disincentives to search for most efficient production
processes
 Long-term costs resulting from the decline in incentives for innovations
 Danger of retaliation

Overall Effects of Trade Barriers
 Trade barriers
… can take different forms.
… drive a wedge between world market prices and domestic prices/costs.
 Welfare effects:
 Consumers are the losers.
 The protected industry can be a winner.
 Other industries are likely to be losers.
 The government can be among the losers or among the winners.
 Indirect effects
 Several indirect effects, notably on other industries, on innovation and on public administration
 Retaliation and trade war
 Trade balance effects

 Protectionism typically reduces imports in some areas and increases imports in other areas.
 To the extent that it makes material more expensive for domestic other producers, they will lose
price competitiveness leading to lower domestic turnover and exports.

Arguments Used for Government Intervention
Popular Arguments Brought Forward in Favor of Trade Policies
Economic arguments Political arguments
 Protecting jobs and industries  National security/interest
 Infant industry argument  Protecting consumers
 Strategic trade theory argument (first  Protecting human rights

mover advantage)
 Supporting foreign policy objectives
 Even industrial countries developed
with protectionist structures in the past  Retaliation against unfair action of
competitor countries

Forms of Trade Liberalization
Global trade liberalization

 All countries willing to follow the agreed-upon rules can participate.
Bilateral trade liberalization

 Trade agreement between two countries
 Simplest to agree Regional trade agreements
Multilateral trade liberalization

 Trade agreement between at least three countries
 More difficult to conclude than bilateral trade agreements

Global Trade Agreements
Average Tariff Participating

Date Event
Cuts Countries
1947 Geneva Round (23 countries sign the GATT) 19% 23
1949 Annecy Round of tariff negotiations 2% 13
1950-51 Torquay Round of tariff negotiations 3% 38
Geneva Round, fourth round of multilateral trade
1956 2% 26
negotiations
1960-62 Dillon Round 7% 26
1964-67 Kennedy Round 35% 62
1973-79 Tokyo Round 34% 102
1986-94 Uruguay Round 40% 123
1995 GATT superseded by the WTO
2001 China joins WTO

Since 2001 Doha Development Agenda (DDA) 141

The World Trade Organization (WTO)
 Focus: The only international organization
dealing with the global rules of trade
between countries
 Main objective: Ensure that trade flows as smoothly,

predictably and freely as possible
 Location: Geneva, Switzerland; established:

January 1, 1995
 Created by: Uruguay Round negotiations (1986-94)
 Budget: 197 million Swiss francs for 2018
 Head: Ngozi Okonjo-Iweala, Nigeria (Director-General),

since March 1, 2021 (she is in her first 4-year term)
 Staff: 625
 Website: www.wto.org (with excellent data!)

 Membership: 164 countries (Latest member: Afghanistan, July 29, 2016) representing
98 percent of world trade. More than 20 countries are currently seeking to
join the WTO.
 Important feature: Most favored nations clause (MFN)
Working party on the accession of Belarus, May 15, 2018 Working party on the accession of the Comores, March 28, 2018

The Main Functions of the WTO
 Administering WTO trade agreements
 Forum for trade negotiations
 Handling trade disputes
 Monitoring national trade policies
 Technical assistance and training for developing countries
 Cooperation with other international organizations
The 8 most important countries that are not members of the WTO
▪ Iran ▪ Algeria ▪ Sudan ▪ Belarus
▪ Serbia ▪ Turkmenistan ▪ Azerbaijan ▪ Bosnia and Herzegovina

Trade Disputes: How Long to Settle a Dispute under the WTO?
Average Settlement of Trade Disputes

60 days consultations, mediation, etc.*
45 days panel set up and panelists appointment*
6 months final panel report to parties*
3 weeks final panel report to WTO members*
60 days Dispute Settlement Body adopts report (if no appeal)*
Total = 1 year (without appeal)**
60-90 days appeals report*

30 days Dispute Settlement Body adopts appeals report*
Total = 1y 3m (with appeal)**

Source: WTO (2017), https://www.wto.org/english/thewto_e/whatis_e/tif_e/disp1_e.htm
* Approximate periods for each stage of a dispute settlement procedure (target figures) — the agreement is flexible. In addition, the countries
can settle their dispute themselves at any stage.
** Totals are also approximate.
A Short Case Study: Sugar Conflict: Mexico vs. USA
The Sugar Conflict:
 March 16th 2004: The U.S. filed a case in the WTO regarding Mexico's 20 percent import
tax on sugar, imposed in January 2002.
 Reproach: The tax is inconsistent with Mexico's obligations in the WTO and the NAFTA
and protects Mexican sugar producers from competition.
 The import tax made it cost prohibitive for Mexican soft drink makers to continue using
U.S. sugar and increased the demand for domestically produced cane sugar.
 Mexico's soft drink bottlers would be expected to switch back to U.S. sugar quickly if
Mexico were to eliminate the tax.
 About 89 percent of Mexico's exports go to the U.S. and 62 percent of Mexico's imported
goods come from the U.S.

Effects of the Mexican Import Tax
 U.S. Sugar exports to Mexico have been drastically reduced.
 1997: U.S. sugar exports to Mexico were 193,519 metric tons (worth $63 million).
 2003: U.S. sugar exports were 4,111 metric tons, (valued at $1.5 million).
 U.S. industry representatives estimated the cost of this trade barrier to the U.S.
is about $1 billion.
400
350
in thsd. metric tons
300
250
200
150
100
50
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
U.S. sugar-exports (in thsd. metric tons) years
Mexico`s Sugar Imports (in thsd. metric tons)

Source: United States International Trade Commission (2004),
WTO Negotiations
 On June 10, 2004, the U.S. requested the establishment of a panel.
 On August 18, 2004, the panel was composed. The Chairman of the panel informed the
parties that it expected to complete its work in August 2005.
 On October 7, 2005, the WTO declares that the tax is inconsistent with Mexico's
obligations in the WTO.
 Mexico announced to eliminate the sugar tax from January 2006 on.
 Under the NAFTA, Mexico agreed to eliminate tariffs on all remaining industrial and most
agricultural products imported from the U.S.; remaining tariffs and non-tariff restrictions on
sugar were phased out by January 2008.
Source: U.S. Trade Policy Agenda (2004), WTO (2005), WTO (2010)
Limitations of the WTO
 The WTO cannot levy fines.
 The only instrument it has is to grant the permission to impose punitive tariffs.
 Given that it has no powerful instruments, the question is: do the WTO rules deter
countries from adopting protectionist measures? In other words: is the WTO a
“shark without teeth”?
 The ruling of the WTO is currently made impossible by the U.S. administration
blocking all new appointments of WTO judges (there are currently less judges in
office than required for a decision).
 The WTO is only as powerful as the shareholders allowed it to be, when they
designed the institution

Levels of Regional Economic Integration
No Tariffs Common Elimination of Unified Common Examples
Between External Tariff Non-Tariff Monetary and Government
Member Barriers Exchange with Federal
Countries (Includ. Free Rate Policies Fiscal Policies
Movement of
Factors of
Production)
Free Trade NAFTA


Area ASEAN
EU before
Customs
  1993
Union
MERCOSUR
Common
   EU after 1993
Market
Economic &
Monetary     EMU
Union
Individual
Political countries
    
Union (USA,
Germany)

Some Existing Regional Agreements
Example of not yet a Free Trade Area
 APEC: 21 is a forum established in 1989 which has worked to reduce tariffs; 21 members representing
somewhat more than half of world GDP and close to half of world trade
Examples of a Free Trade Area
 CARICOM: Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua
 ASEAN: a geo-political and economic association with 10 members (founding members: Indonesia,
Malaysia, Philippines, Singapore, Thailand; later: Brunei, Cambodia Laos, Myanmar, Vietnam)
 RCEP: ASEAN + China, Japan, S. Korea, Australia, and New Zealand
Examples of a Customs Union
 Andean Community: Bolivia, Ecuador, Peru, Colombia
 MERCOSUR: Argentina, Brazil, Paraguay, Uruguay, Venezuela (on paper a customs union, but with
many exceptions)
Example of a Common Market
 EU: European Union with 27 member countries
Example of a Monetary Union
 EMU: European Economic and Monetary Union: 19 countries share the same currency (euro)
 UEMOA: “Union économique et monétaire ouest-africaine” with 8 members (Benin, Burkina Faso, Cote
d'Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo) but with limited economic integration

Regional Trade Blocs Within the Broader Framework of Global
Integration
GATT / WTO
(1947) (1995)
*Single European Act.

Business Implications of Trade Policies
As businesses are important players in economies, they can exert a strong influence on
government policies. With respect to international trade policies, business needs to know that:
 Protectionist measures (i.e., trade barriers) help inefficient companies rather than help
companies to become more efficient; businesses that are protected by trade policies
typically do not succeed in the long run.
 Other market participants pay in one form or the other for such protection.
 Protectionism constrains businesses to take advantage of globalization and, thus, reduces
the ability of more efficient firms to be successful.
 Trade restrictions involve the risk of triggering a trade war.
 There are several possibilities for firms to respond to trade barriers or the threat of erecting
them:
 Locate production facilities inside the country that discriminates foreign businesses through trade
barriers
 Declare a VER as a second-best strategy in view of a credible threat of import restrictions of the
country to which the firm exports its products.
 Regional integration has developed dynamically over the past two decades.

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The World Economy

Chapter 4: Trade Restrictions and the Global Trading System

Professor Dr. Michael Frenkel

This chapter will enable you to

 Distinguish various forms of trade restrictions

 Explain who benefits and who loses from trade barriers

 Outline how businesses respond to trade policy

 Describe the role and limitations of the WTO

 Understand the role of regional integration

Professor Dr. Michael Frenkel Fall 2022 2

 Tariffs (specific or ad valorem) Tariff barrier

 Voluntary export restraints (VER)

 Local content requirements Non-tariff barriers

 False antidumping measures

Professor Dr. Michael Frenkel Fall 2022 3

Examine the effects of a trade barrier (example: a tariff)

 Welfare effects (i.e., who is better off?)

 Who in the economy benefits from a trade barrier?

 Who in the economy loses from a trade barrier?

 What can we say about the overall effects?

Professor Dr. Michael Frenkel Fall 2022 4

Professor Dr. Michael Frenkel Fall 2022 5

Professor Dr. Michael Frenkel Fall 2022 6

Price (P) We assume that the home country is a small country.

When the world market price is

C F When the world market price is

Professor Dr. Michael Frenkel Fall 2022 7

Can you imagine a tariff at which the

Professor Dr. Michael Frenkel Fall 2022 8

 Costs of encouraged lobbying

Professor Dr. Michael Frenkel Fall 2022 9

 Trade balance effects

Professor Dr. Michael Frenkel Fall 2022 10

Popular Arguments Brought Forward in Favor of Trade Policies

Economic arguments Political arguments

 Protecting jobs and industries  National security/interest

 Infant industry argument  Protecting consumers

 Strategic trade theory argument (first  Protecting human rights

Professor Dr. Michael Frenkel Fall 2022 11

Global trade liberalization

Bilateral trade liberalization

Multilateral trade liberalization

Professor Dr. Michael Frenkel Fall 2022 12

Average Tariff Participating

1995 GATT superseded by the WTO

2001 China joins WTO

Professor Dr. Michael Frenkel Fall 2022 13

 Main objective: Ensure that trade flows as smoothly,

 Location: Geneva, Switzerland; established:

 Created by: Uruguay Round negotiations (1986-94)

 Budget: 197 million Swiss francs for 2018

 Head: Ngozi Okonjo-Iweala, Nigeria (Director-General),

 Website: www.wto.org (with excellent data!)

 Important feature: Most favored nations clause (MFN)

Professor Dr. Michael Frenkel Fall 2022 15

The Main Functions of the WTO

 Administering WTO trade agreements

 Forum for trade negotiations

 Handling trade disputes