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A Review of the Theory
Trade between nations has always been an intriguing issue. Some argue that there should be a complete allowance of trade between countries and on the other hand some say that this would be disastrous for many countries that would lose from such a decision. In understanding why would a country seek trading with other countries and whether free trade should be introduced in the world, we have to take into account some basic theories from the past.
Adam Smith, was the first person to attempt to give a reason for this in the late 18th century. In his book, “Wealth of Nations”, he tried to give a good reason to promote free trade, through his “absolute advantage theory”. In his theory he first used a comparison between nations and households. The concept of this example was simple. The master of a family would never choose to produce something at home that is going to cost less by buying it. And this is a fact because doing so, he would gain more time to produce something else. This is the same case as for countries. A country would prefer to buy a product, if the cost of producing it, would be higher than buying it. This country would gain the opportunity cost of using the spare time from not producing that good, to produce something else. In order to show this, he used the term of “absolute advantage” of one country over another in producing a good. A country is supposed to have an absolute advantage in producing a good if a worker of that country is able to produce higher amounts of this good than a worker of the same industry in another country. To define and measure this advantage he used labor productivity and production cost and compared them between countries. Thus, Adam Smith explained the benefits of free trade, and showed that trade helps every single country to make the most of its absolute advantage in constructing some products. Generally, the overall level of wages in countries is determined by absolute advantage, and trade patterns are determined by comparative advantage. To sum up with, a country is more affluent with trade, without being an disbursement to the other country. This theory was something very important for that period because it introduced the free trade idea to many governments. On the other hand, it had a big imperfection. In a case in which a country would have absolute advantage in all products over another country (and the world was following his  theory thoroughly), no trade would occur between these two countries, because of no absolute advantage existence.
This is when David Ricardo introduced his own “theory of comparative advantage”, to give an answer and solution to this imperfection. In his theory, he entails that a country doesn’t need to have absolute advantage over another country in order to trade a good. He combined the theories of comparative advantage and opportunity cost, to prove that “a country will export the goods and services that it can produce at a low opportunity cost and import the goods and services that it would otherwise produce at a high opportunity cost” (Pugel, 2009). According to comparative advantage theory, the living standards of these countries are going to boost because of trading, because the resulting world pattern of production faces higher efficiency instead of each country producing only for its own market. If this theory is accurate, globalization is beneficial for every society, to the extent that living standards are higher and prices for goods are lower. In conclusion, Ricardo proved that advantageous trade can arise even if one country is less productive at producing all products, on condition that, these countries will have different relative advantage or disadvantage on the production of different goods.
An alternative to Ricardo’s model came up in the early 19th century. Heckscher-Olin theory, which predicts, that “a country exports the product(s) that use its relatively abundant factor(s) intensively and imports the product(s) using its relatively scarce factor(s) intensively. The H-O theory focuses on another important source of production-side differences. There exist some basic assumptions that have to hold in order for two countries to trade goods with each other, according to H-O theory. First of all, there has to be a condition in which major factors of production are not found in the same amount in both countries and that these two goods being produced, will require either relatively more labor or relatively more capital. When a country has a relatively higher amount of capital, it specializes in producing capital-intensive goods, while on the other hand, the country with the relatively higher amount of labor, is going to specialize in the production of labor-intensive goods. Furthermore, another condition that has to stand is that there will be no movements of labor and capital between the two countries. In addition, these countries will have to be in a market environment in which, transporting goods between countries has no associated costs. The final assumption required, is that the citizens of these two nations have the same wants. To conclude with, the prediction that comes out of Heckscher-Olin theory is that a country exports products that use the country’s relatively abundant factors more intensively. They exchange these products for imports of products that have an intensive usage of the country’s relatively limited factors”. Specialization in production and trade generates a higher standard-of-living for the countries involved, according to the H-O theory. The problem arising from this theory is that it is not taking the trade of capital goods into consideration. Moreover, capital and labor are fixed components endowed to each country.
These main theories give emphasis to differences in production conditions instead of tastes. Ricardo’s argument was that, because countries have different comparative advantages in producing different goods, trade is profitable. “The Heckscher-Ohlin theory agrees that comparative advantages in production are the basis for trade, but H-O explains comparative advantage in terms of underlying differences in factor endowments. Each country tends to export those goods that intensively use its relatively abundant factors of production” (Pugel, 2009). The evidence is that the H-O theory explains a fine part of the world’s actual trade patterns sensibly well, but that some significant aspects of trade patterns do not square easily with H-O (Pugel, 2009).
Most economists favor letting nations trade freely, with few tariffs or other barriers to trade. The striking consensus in favor of free trade is based primarily on a body of economic analysis demonstrating that there are usually net gains from free trade, both for nations and the world. Trade affects production and the quantity of consumption in a country. In the country importing a good, it is doing so, by raising consumption and by lowering the production of that single good. On the same time, it is raising production of that good in the exporting country, but we cannot be sure whether it is going to lower or raise the quantity of consumption of that single good. We can say that both countries gain from trade. That is because it makes, both the exporting as well as the importing nation, better off in the net national sense. “Each country’s net national gains are proportional to the change in its price from its no-trade value, so the country whose prices are disrupted more by trade, gains more” (Pugel, 2009). A further source of national gains from trade is that the variety of products that become available to consumers, increases through imports, because of the country’s opening to trade. The economic well-being of consumers increases when they are able to choose from a wider variety of goods. Another source of national gains, comes from international competition, which can lower the prices of domestic goods, bringing extra gains to home consumers.
It is quite interesting to have a look on who are the gainers and who are the losers, from opening trade. To do so, we need to make a distinction between the short run and long run effects of open trade. In the short run, we can say that those consuming the goods being imported and those producing exportable goods, are the main gainers. To find losers and gainers from trade, in the long run, we need to examine the findings of the Stolper-Samuelson theorem. This theorem shows that in long run, a person that is making his living by selling a factor that is more abundant in his country, in respect to other countries, is able to gain from trade. And this is a fact regardless of the goods he might be consuming, or the sector he might be working in. On the other hand, a person that makes his living by selling a factor that is relatively scarce in his country, can lose from trade. Again, this is a fact regardless of the goods he might be consuming, or the sector he might be working in.
But free trade is not accomplished due to trade policies and barriers that countries put up, according to their own benefits. Kinds of policies like these, with all their consequences are explained in the following section.
Trade Policies and The Role of the WTO
A tariff is a tax imposed by a country on the import of a good or service, which custom officials accumulate at the place of import. There are two major kinds of such taxes. A specific tariff is described as the total sum of money that should be given for each unit of import (dollars per ton of steel bars). “An ad valorem tariff, is a percentage of the estimated market value of the goods when they reach the importing country” (Pugel, 2009). In general, a tariff is going to be beneficial for domestic producers, competing against imports, but on the other hand, it is going to hurt all the domestic consumers that buy this imported good, forcing them to suffer from higher prices for the consumption of the same good. Furthermore the effect of a tariff that is not so high as to end the imports, for a government, is an increase on this government’s revenue. This government could use this extra revenue for projects that will benefit the nation’s wellbeing. Through years, several empirical effects of placing tariffs can be made. We can say that putting up a tariff reduces in almost every case the overall world’s, as well as, each nation’s welfare. Another impact of using a tariff is that it benefits those groups that produce goods or services that can be used as substitutes for the taxed import.
Another kind of trade policies is the nontariff barrier (NTB) and it is a policy that governments use in order to reduce number of imports. This is accomplished by several effects. For example, the cost of getting imports into a market is increased, and also it generates uncertainty over the conditions under which imports are going to be allowed. This is different than a usual import tariff. The most common nontariff barrier is “import quota”, with which, a government can restrict the import of a product into the country, above a specified limit of total quantity, during a period of time. The direct effect of NTB is on quantity. Protectionists and government officers might decide on putting up quotas instead of tariffs for many reasons. One of them is that a quota, guarantees that there is a strict limitation on the import’s quantity, quite the opposite to a tariff. A result of such a quota, is that government officials end up with greater power.
Furthermore, there are some other nontariff barriers. One of them is the voluntary export restraint (VER), which is a case in which an importing country government pressurizes with many ways the foreign exporting country to restrict its exports to this country. Just like an NTB, the direct effect of VER is on quantity. Voluntary export restraint results in the form of a cartel among the foreign producers, who agree not to export a good to the importing country that negotiated the VER. This leads to an increase of the foreign country’s price for this specific good, as well as a decrease for the revenue of the importing government because it suffers from the cut of a tariff for this imported good. To sum up with, VERs have negative effects on the welfare of both the importing and exporting nations, who suffer from higher prices and lower variety of the goods being cut from exports and imports.
Another nontariff barrier, is a tariff-quota. This kind of a barrier, allows imports with a low or zero tariff into the country, but up to a specified quantity, and imposes a higher tariff on imports above this quantity. In this way it manages to have a direct effect on quantity of imports, because, by placing a very high tariff, it makes the import above the specified quantity unaffordable. A further nontariff barrier, is the Government procurement. This is a case, when a government that buys a quantity of a good, is placing law and government rules that favor local products. This barrier has direct effects on the quantity and the cost of importing this good. Moreover, another NTB is the, Local content and mixing requirements. With this barrier governments succeed a direct effect on the quantity of an import, by requiring a specified use of local labor, materials, or other products. An additional NTB is, Import Licensing ,which, by requiring from importers to apply for approvals for intended imports accomplishes direct effects on the cost of the import and also it creates uncertainty on whether this import is going to be made.
Protectionism against import competition for a product has several results. First of all, it is clearly beneficial for domestic producers, by increasing the domestic production of a product. In addition, it harms domestic consumers on the purchase of this product, who suffer from higher prices. Furthermore because of protectionism, this product faces a decrease on its domestic consumption. It is probably harmful for the importing nation as a whole and furthermore, it is almost surely harmful for the world as a whole. On the other hand protectionism results in increasing government revenues and, in addition, the distribution of income or well-being in the country is being altered.
Evidence (that associate trade with economic growth and jobs) [1,500]
These are some of the reasons for the creation of the “World Trade Organization (WTO)”. The WTO espouses three major principles: first of all, reductions of barriers to trade, furthermore, nondiscrimination principle (MFN), and finally, reduction of unfair encouragement for exports.
The General Agreement on Tariffs and Trade (GATT)
The General Agreement on Tariffs and Trade (GATT) was signed in 1947 by 23 countries and focused directly on international trade issues. From 1948 to 1994, the GATT was putting up the rules on which world trade was accomplished. GATT was provisional with a limited field of action, but in its over 47 years of existence it succeeded promoting and securing the liberalization of much of world trade. With continuous reductions in tariffs it resulted in very high rates of world trade growth. During the Uruguay Round, the rush of new members confirmed that the multilateral trading system was recognized as an instrument for development and economic and trade improvement.
Under the GATT, eight rounds of multilateral trade negotiations were pursued by the member countries, with the purpose of lowering barriers. In the first five rounds they based their discussions on reductions of tariff rates, using item-by-item negotiations, where there was an agreement that the largest trading countries would reduce tariffs, extend them to all members, keeping the MFN nondiscrimination principle in mind. This means that GATT did not address other areas of trade, for example agriculture and services, even though they represented a considerable share in world trade. Through years, GATT was facing more and more problems because of its structure. Globalization of the world economy was ongoing, GATT rules were not covering trade-in services, which was becoming more and more interesting for countries, and international investment had expanded. World merchandise trade was further increasing and this was tied up closely to the expansion of services. These and other reasons were convincing enough for GATT members to attempt to reinforce and extend the multilateral system. That effort resulted in the Uruguay Round, the Marrakesh Declaration, and the creation of the WTO (World Trade Organization).
The World Trade Organization
An international agreement in the early 1990s led to the establishment of the World Trade Organization (WTO) in January 1995. The WTO took the place of GATT as its physical expand and since then it is the organization that supervises the worldwide rules of policies being kept by several countries towards international trade. It provides the round-table for negotiating global agreements to improve these rules. The governments that had signed GATT were known as GATT contracting parties. Since they signed the new WTO agreements, they officially became known as, WTO members (World Trade Organization).Today the WTO has 153 member countries and an overall budget of 189 million Swiss francs for 2009. The WTO’s headquarters are in Geneva, Switzerland.
The WTO is making decisions in some quite unusual processes. There are two primary models of decision-making: decision by consensus and decision by voting. For general decision-making, WTO kept on acting like GATT, in making decisions by consensus. “In consensus decision-making, the minority will normally go along with the majority unless it has a serious objection” (Matsushita, M., et al). Then the majority will not make decisions using voting but it will discuss the objections of the minority. This decision-making process is always taking a great deal of time. In the WTO, only when a decision cannot be taken by consensus there is usage of voting decision- making. “In the Ministerial Conference and the General Council, decisions are taken by a majority of the votes cast, unless otherwise specified in the relevant WTO agreement” (Matsushita, M., et al).
There are several ways of looking at the WTO. It’s an organization that seeks the liberalization of trade. It is a forum where governments can negotiate trade agreements. Fundamentally, it is a place where member countries try to sort out some trade problems they might be facing with each other. The first step is to discuss. The organization was born out of negotiations, and everything it does is offering the table on which, optimal solutions can be made. It’s a place for governments to settle trade disputes. Regularly, incompatible interests are involved within trade relations. Agreements, including those thoroughly negotiated in the WTO, often need interpreting. The most harmonious way to settle these differences is through some neutral procedure based on an agreed legal foundation (World Trade Organization). That is the purpose behind the dispute settlement process written into the WTO agreements (World Trade Organization). It operates a system of trade rules. The WTO agreements, which are negotiated and signed by the world’s trading countries, provide the legal essentials for international trade. They are fundamental contracts, that bind governments on keeping their trade policies within settled limits. Although the negotiations are being discussed and signed by governments, the main goal is to help exporters and importers as well as producers of goods and services, carry out their business. And all this, while governments will be able to meet social and environmental principles. The whole system has an overriding purpose to help trade flow without restraints, whenever possible, because this is something crucial for economic development and well-being. That partially means removing barriers. It also means ensuring that individuals, companies and governments know what the trade rules are around the world, and giving them the confidence that there will be no sudden changes of policy (World Trade Organization). In other words, the rules have to be “clear” and unsurprising.
World Trade Organization is running under certain trade principles. According to these principles, the trading system should meet some requirements, such as, trade without discrimination, freer trade, predictability on trade issues by the governments, promotion of fair competition and encouragement of development and economic reform. Under the WTO agreements, countries are not allowed to discriminate between their trading associates. This principle is known as most-favoured nation (MFN) treatment (World Trade Organization). This principle suggests special treatment, but in fact it means non-discrimination. “Imported and locally-produced goods should be treated equally – at least after the foreign goods have entered the market.” (World Trade Organization). Free trade is another aim of the WTO. This aim suggests lowering trade barriers through negotiation. This is one of the most clear ways to encourage trade.
“The multilateral trading system is an attempt by countries to make the business environment stable and predictable” (World Trade Organization).WTO tries to improve predictability and stability through binding and transparency. With these factors stable, investment is encouraged, jobs are created and consumers can fully enjoy the benefits of competition. The organization also seeks on promoting fair competition while discouraging “unjust” practices such as export subsidies. The final principle under which the organization is running, is that trade should be more beneficial for less developed countries. The WTO is paying extra attention on the least-developed countries. “All the agreements recognize that they must benefit from the greatest possible flexibility, and better-off members must make extra efforts to lower import barriers on least-developed countries’ exports” (World Trade Organization).
Nowadays, most of the WTO’s members are developing countries. Because of their number, because they are gaining more importance in the global economy, and because they increasingly seek to trade as a crucial tool in their development efforts, they play an increasingly significant and vital role in the WTO. Developing countries are a group with very different concerns and views. The organization deals with the different needs of developing countries in several ways. First of all, the WTO agreements enclose special provisions on developing countries, providing them with special rights and “special treatment” than other members. For example, there might be some provisions, which allow developing countries to be treated more favourably by the developed countries, than the rest WTO members. In addition, the organization offers extra time for developing countries to accomplish their obligations. Moreover, it makes agreements that offer provisions, designed to increase trading opportunities for such countries, through greater market access.
*Rounds of negotiations (2000)
Through the years of their existence, GATT and WTO have started several rounds of negotiations to achieve the liberalization of trade and further reduction of tariffs and other policies standing against trade. These rounds are often lengthy, with an example being the Uruguay Round which lasted seven and a half years. Trade rounds can provide an important advantage. Instead of negotiating on a single issue, they offer a package approach to trade negotiations, which can sometimes turn to be more fruitful. This is a case, because the size of the package can imply more benefits for participants who can seek advantages across a wide range of issues. It can be easier for an agreement to be achieved, through trade-offs . This has political as well as economic implications. Developing countries and other less powerful participants, face a greater chance to influence the multilateral system in a trade round than in bilateral relationships with major trading nations (World Trade Organization).
In December 1945, 15 countries had already started negotiations to decrease and bind customs tariffs. Considerable tariff reductions were accomplished in the first round, which took place in Geneva. This round, started on April 1947 and lasted for 7 months. By the time the deal was signed on 30 October 1947, the number of member countries had increased to 23. These negotiations achieved the signing of GATT and in addition, it resulted in 45,000 tariff concessions, affecting $10 billion of trade (World Trade Organization). For almost half a century, the GATT’s basic legal principles remained much as they were in 1948 and efforts to reduce tariffs continued (World Trade Organization). This was achieved through the “trade rounds”, which were a series of multilateral negotiations. The leading steps forward in the liberalization of international trade, were achieved because of these rounds which were held under GATT’s support.
The next round, Annecy, started on April 1949 and finished 5 months later. 13 countries participated in these negotiations, which resulted in the exchange of some 5,000 tariff concessions by the countries (World Trade Organization). Negotiations continued in the Torquay round. They started on September 1950 and finished 8 months later. In Torquay, the result was that countries exchanged some 8,700 tariff concessions, cutting the 1948 tariff levels by 25% (World Trade Organization). 26 Countries continued negotiations in Geneva, on January 1956. The major subjects that were covered in this round were not only tariffs, but also the admission of Japan. Geneva II round of negotiations, achieved new reductions in tariffs of $2.5 billion (World Trade Organization). As did the Dillon Round in September 1960, from which, further tariff concessions that were worth $4.9 billion of world trade, were achieved (World Trade Organization). To achieve more extensive tariff reductions, the Kennedy Round (1963-1967), covered subjects not only on tariffs but also on “anti-dumping”. The 62 countries that participated in this round for 37 months, made the agreements so that the industrialized countries would use a formula to decrease all nonagricultural tariffs. The results from these agreements were substantial. They achieved tariff compromises worth $40 billion of world trade (World Trade Organization). In addition, the average tariff was decreased by 38 percent for non-agricultural imports into industrialized countries (World Trade Organization). The Tokyo Round started on September 1973 and lasted for 74 months. It included negotiations over tariffs, non-tariff measures and “framework” agreements. It achieved tariff reductions worth more than 300 billion dollars (World Trade Organization).
Up to this point the achievement of all these negotiations is that they led to substantial reductions of tariffs, but on the other hand, they had let non-tariff barriers (NTBs) rise in importance. GATT members started discussing about NTBs in a more serious way. They tried to find ways of addressing these excluded sectors. This stood until the Uruguay Round successfully covered them. The Uruguay Round (1986-1994) kept on going, with usage of ways for cuts, with negotiated exceptions. It resulted on an agreement to allow full access for clothes and textiles from developing countries and intellectual property rights were extended. Furthermore governments agreed to limit their use of domestic content requirements. Industrialized countries’ nonagricultural tariffs fell by an average of 33 percent and 38 percent, respectively (World Trade Organization). The agreements also included new codes on customs, such as, import licensing and procedures, subsidies, safeguards and dumping. The last round of negotiations under the GATT was the most ambitious and most successful international economic negotiation since Bretton Woods (World Trade Organization).
The World Trade Organisation was launched in 1995, and since then, it has held five Ministerial conferences. The Doha Ministerial in 2001, was marked by the core concern, that the multilateral trading system should benefit the developing countries which constitute about two thirds of the WTO members. The entire package is called the Doha Development Agenda (DDA). Key elements of the striving agenda include significant liberalization on trade of agricultural products, drop of nonagricultural trade tariffs, reductions of nonagricultural goods tariffs, trade in services liberalization, provision of assured access on low-cost medicines for developing nations, and refinement of rules, governing various NTBs. The Doha declaration tried to help developing countries to obtain a share in the growth of world trade according to the needs of their economic development. It pledged that, through two key routes. First of all, by reducing import tariffs it tried to improve market access to the Northern markets for developing countries. Furthermore by phasing out domestic and export subsidies.
After failing to begin the new round at the WTO ministerial conference in Seattle in 1999, the next conference was in Doha, Qatar, in 2001. Developing countries were considering that the Uruguay Round was unfair for them. “They incurred substantial costs by accepting the mandatory NTB rules and the mandatory protections of intellectual property, but their benefits of greater access of export markets in the industrialized countries were limited by the slow end to the VERs on clothing and textiles and by the lack of actual liberalization of agricultural trade. Developing country governments pushed for a “development round” and vowed to be more active in the negotiations” (Pugel, 2009).
A special agreement led to the Information Technology Agreement of 1996. Each country involved in the agreement (initially 23 countries) was obligated to eliminate tariffs on imports of information technology goods and software. By 2007, 70 countries had embraced this agreement, so that 97 percent of international trade in these products is now free of tariff. Second, the developing countries that have joined the WTO since 1995 minimized their actual tariff rates as a condition for joining and accepted bound rates equal to, or very close to, their actual rates.
The Fifth Ministerial Conference in Cancún, in September 2003, was proposed as a stock-taking conference where members would come to an agreement on how to complete the rest of the negotiations. But the meeting was soured by discord on agricultural issues and ended in deadlock on the Singapore issues (World Trade Organization). “In 2003, member countries agreed to improve the rules on intellectual property to allow developing countries to import low-cost broad versions of patented drugs in health emergencies, however, there has been little progress. The major area of disagreement has been agriculture, for which, neither the United States nor the European Union has been willing to offer sufficient liberalization. The United States has resisted meaningful cuts in its subsidies to domestic agricultural production, and the European Union has been unwilling to offer sufficient cuts in tariffs and other barriers to agricultural imports. Without adequate progress on agriculture, the developing countries led by India and Brazil, have been unwilling to offer much in other areas of the agenda” (Pugel, 2009).
“Further progress in narrowing members’ differences was made at the Hong Kong Ministerial Conference in December 2005, but some gaps remained unbridgeable and Director-General Pascal Lamy suspended the negotiations in July 2006″ (World Trade Organization), though discussions continued at a less formal level. Efforts then focused on trying to achieve a breakthrough in early 2007” (World Trade Organization).
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