International_Economics_Tenth_Edition (1)

revenue to West African countries would increase by about $250 million. But in Mississippi, there is little sympathy for the removal of subsidies-e-cotton is king in Mississippi, and its growers don't want competition from WestAfrica'sfarmers. Simplyput, American cotton farmers maintain that they cannot survive without subsidies. However, West Africa's growers feel that life is unfair when they must compete against American farmers as well as the U.S. government.

American food-aid policies are another source of controversy. It is true that U.S. food donated to the developing world has saved millions of lives made destitute by the failure of their farms. But growers in developing countries complain that the U.S. government purchases surplus grain from American farmers and sends it halfway around the world, instead of first purchasing what foreigners grow. By law, the United States is bound to send its own homegrown food for assistance, instead of spending cash on foreign produce, in all but the most exceptional cases. It is a policy that supports American farmers, processors, and shippers, as well as the world's hungry. The complaints of farmers in West Africa do not get much sympathy in the United States, where farmers oppose the U.S. government's spending taxpayer money to purchase foreign crops.

Nevertheless, developing countries refer to the food-aid policy of the European Union as a better method. Under this system, Europe donates cash to buy as much food as possible in a poor country rather than always sending food. Although such local purchases can add more bureaucracy to the process, they provide greater flexibility, making it easier to style food packages to local tastes and nutritional needs rather than being linked to what is available because of European surpluses. Local purchases can also be cheaper. Analysts estimate that transport and handling costs from America to hungry recipients in Africa add about $200 to each ton of grain. The greatest benefit, however, is the economic stimulus it provides by placing cash in the hands of farmers in the developing world.

In 2004, the World Trade Organization issued an interim ruling that declared America's subsidies to its cotton farmers illegal. It remains to be seen whether this ruling results in a dismantling of

America's agricultural subsidies as well as the subsidies of other nations.

Aiding the Developing

Countries

Dissatisfied with their economic performance and convinced that many of their problems are due to shortcomings of the existing international trading system, developing nations have pressed collective demands on the advanced nations for institutions and policies that improve the climate for economic development in the international trading system. Among the institutions and policies that have been created to support developing countries are the World Bank, International Monetary Fund, and the generalized system of preferences.

World Bank

During the 1940s, two international institutions were established to ease the transition from a wartime to a peacetime environment and to help prevent a recurrence of the turbulent economic conditions of the Great Depression era. The World Bank and the International Monetary Fund were established at the United Nations Monetary and Financial Conference held at Bretton Woods, New Hampshire, in July 1944. Developing nations view these institutions as sources of funds to promote economic development and financial stability.

The World Bank is an international organization that provides loans to developing countries aimed toward poverty reduction and economic development. It lends money to member governments and their agencies and to private firms in the member nations. The World Bank is not a "bank" in the common sense. It is one of the United Nations' specialized agencies, made up of 184 member countries. These countries are jointly responsible for how the institution is financed and how its money is spent.

The "World Bank Group" is the name that has come to be used for five closely associated institutions. The International Bank for Reconstruction and Development and the International Development Association provide low-cost loans and

230 Trade Policies for the Developing Nations

grants to developing countries. The International Finance Corporation provides equity, long-term loans, loan guarantees, and advisory services to developing countries that would otherwise have limited access to capital. The Multilateral Investment Guarantee Agency encourages foreign investment in developing countries by providing guarantees to foreign investors against losses caused by war, civil disturbance, and the like. Finally, the International Center for Settlement of Investment disputes encourages foreign investment by providing international facilities for conciliation and arbitration of investment disputes, thus helping foster an atmosphere of mutual confidence between developing countries and foreign investors.

The World Bank makes loans to developing members that cannot obtain money from other sources at reasonable terms. These loans are for specific development projects such as hospitals, schools, highways, and dams. The World Bank is involved in projects as diverse as raising AIDS awareness in Guinea, supporting education of girls in Bangladesh, improving health-care delivery in Mexico, and helping India rebuild after a devastating earthquake. The World Bank provides lowinterest rate loans, and in some cases interest-free loans, to developing countries that have little or no capacity to borrow on market terms.

In recent years, the World Bank has financed debt-refinancing activities of some of the heavily indebted developing nations. The bank encourages private investment in member countries. In 2003, the World Bank lent about $18.5 billion to developing countries, as seen in Table 7.6. The World Bank receives its funds from contributions of wealthy developed countries.

Some 10,000 development professionals from nearly every country in the world work in the World Bank's Washington, DC, headquarters or in its 109 country offices. They provide many technical assistance services for members.

International Monetary Fund

Another source of aid to developing countries (as well as advanced countries) is the International Monetary Fund (IMF), which is headquartered in Washington, DC. Consisting of 184 nations, the IMF can be thought of as a bank for the central

World Bank Lending by Sector, 2003 (Millions of Dollars)

Source: World Bank, Annual Report. 20G3, http://www.worldbank.org.

banks of member nations. Over a given time period, some nations will face balance-of-payments surpluses, and others will face deficits. A nation with a deficit initially draws on its stock of foreign currencies, such as the dollar, that are accepted in payment by other nations. However, the deficit nation will sometimes have insufficient amounts of currency. That is when other nations, via the IMF, can provide assistance. By making available currencies to the IMF, the surplus nations channel funds to nations with temporary deficits. Over the long run, deficits must be corrected, and the IMF attempts to ensure that this adjustment will be as prompt and orderly as possible.

The funds of the IMF come from two major sources: quotas and loans. Quotas (or subscriptions), which are pooled funds of member nations, generate most of the IMP's funds. The size of a member's quota depends on its economic and financial importance in the world; nations with larger economic importance have larger quotas. The quotas are increased periodically as a means of boosting the IMF's resources. The IMF also obtains funds through loans from member nations. The IMF has lines of credit with major industrial nations as well as with Saudi Arabia.

All IMF loans are subject to some degree of conditionality. This means that to obtain a loan, a deficit nation must agree to implement econom-

ic and financial policies as stipulated by the IME These policies are intended to correct the member's balance-of-payments deficit and promote noninflationary economic growth. However, the conditionality attachment to IMF lending has often met strong resistance among deficit nations. The IMF has sometimes demanded that deficit nations undergo austerity programs including severe reductions in public spending, private consumption, and imports in order to live within their means.

Critics of the IMF note that its bailouts may contribute to the so-called moral-hazard problem, whereby nations realize the benefits of their decisions when things go well but are protected when things go poorly. If nations do not suffer the costs of bad decisions, won't they be encouraged to make other bad decisions in the future? A second area of concern is the contractionary effect of the IMF's restrictive monetary and fiscal policy conditions. Won't such conditions cause business and bank failures, induce a deeper recession, and limit government spending to help the poor? Many analysts feel the answer is yes.

Generalized System of

Preferences

Given inadequate access to markets of industrial countries, developingcountries have pressed industrial countries to reduce their tariff walls. To help developing nations strengthen their international competitiveness and expand their industrial base, many industrialized nations have extended nonreciprocal tariff preferences to exports of developing nations. Under this generalized system of preferences (GSP), major industrial nations temporarily reduce tariffs on designated manufactured imports from developing nations below the levels applied to imports from other industrial nations. The GSP is not a uniform system, however, because it consists of many individual schemes that differ in the types of products covered and extent of tariff reduction. Simply put, the GSP attempts to promote economic development in developing countries through increased trade, rather than foreign aid.

Trade preferences granted by industrial countries are voluntary. They are not WTO obligations. Donor countries determine eligibility

criteria, product coverage, the size of preference margins, and the duration of the preference. In practice, industrial-country governments rarely grant deep preferences in sectors where developing countries have a large export potential. Thus, developing countries often obtain only limited preferences in sectors where they have a comparative advantage. The main reason for limited preferences is that in some sectors there is strong domestic opposition to liberalization in industrial countries.

Since its origin in 1976, the U.S. GSP program has extended duty-free treatment to about 3,000 items. Criteria for eligibility include not aiding international terrorists and complying with international environmental, labor, and intellectual property laws. The U.S. program grants complete tariff-free and quota-free access to eligible products from eligible countries. Beneficiaries of the U.S. program include some 150 developing nations and their dependent territories. Like the GSP programs of other industrial nations, the U.S. program excludes certain import-sensitive products from preferential tariff treatment. Textiles and apparel, footwear, and many agricultural products are not eligible for the GSP. Also, a country's GSP eligibility for a given product may be removed if annual exports of that product reach $100 million or if there is significant damage to domestic industry. Table 7.7 on page 232 provides examples of imported products from developing countries that are generally eligible for GSP treatment by the United States.

Although the GSP program provides preferential access to industrial countries' markets, several factors erode its effectiveness in reducing trade barriers faced by poor countries. First, preferences mainly apply to products that already face relatively low tariffs. Too, tariff preferences can also be eroded by non tariff measures, such as antidumping duties and safeguards. Moreover, products and countries have been removed from GSP eligibility because of lobbying by domestic interest groups in importing countries. Finally, preferences do little to assist the majority of the world's poor. Most of these living on less than $1 per day live in countries like India and Pakistan, which receive limited preferences in products in

232 Trade Policies for the Developing Nations

which they have a comparative advantage. As a result, developing countries have been frustrated about limited access to the markets of industrial countries.

Imports from Developing Countries that Are

Generally Eligible for GSP Treatment by the

United States, 2003

'Thefollowing products receive duty-free access to the U.S. market:

Operation of the Trade Agreements Program. 2003 (Washington. DC: U.S. Government Printing Office).

International Commodity Agreements

Stabilizing Primary-

Product Prices

Although developing countries have been gaining ground in exports of manufactured goods, agriculture and natural resource products remain a main source of employment. As we have learned, the export prices and revenues for these products can be quite volatile.

In an attempt to stabilize export prices and revenues of primary products, developing nations have attempted to implement international commodity agreements (ICAs). ICAs are agreements between leading producing and consuming nations of commodities about matters such as stabilizing prices, assuring adequate supplies to consumers, and promoting the economic development of producers. Table 7.8 gives examples of lCAs. To promote stability in commodity markets, ICAs have relied on production and export controls, buffer stocks, and multilateral contracts.

Production and

Export Controls

If an lCA accounts for a large share of total world output (or exports) of a commodity, its members

may agree on export controls to stabilize export revenues. The idea behind such measures is to offset a decrease in the market demand for the primary commodity by assigning cutbacks in the market supply. If successful, the rise in price due to the curtailment in supply will be sufficient to compensate for the reduction in demand, so that total export earnings will remain at the original level.

Figure 7.3 illustrates the process by which export receipts can be maintained at target levels for members of the International Coffee Agreement. Assume initial market equilibrium at point E. With the equilibrium price at $1 per pound and sales of 60 million pounds, the association's export receipts total $60 million. Let this figure be the target that the association wishes to maintain.

export revenues would now fall below the target level. To prevent this from occurring, the coffee producers could artificially hold back the supply of coffee to 51' Market equilibrium would be at point F, where 40 million pounds of coffee would be sold at a price of $1.50 per pound. Total export receipts would again be at $60 million, the association's target figure. This stabilization technique is contrary to what we might expect because it is based on efforts to increase prices during eras of worsening demand conditions.

In their efforts to stabilize export receipts, producers' associations have adopted export quotas to

234 Trade Policies for the Developing Nations

regulate market supply. Over the longer nm, however, export quotas must be accompanied by production controls to be effective. If production is not controlled, expanding surpluses of the member nations will lead to a greater likelihood that prices will be cut and that the association will eventually fail.

Buffer Stocks

Another technique for limiting commodity price swings is the buffer stock, in which a producers' association (or international agency) is prepared to buy and sell a commodity in large amounts. The buffer stock consists of supplies of a commodity financed and held by the producers' association. The buffer stock manager buys from the market when supplies are abundant and prices are falling below acceptable levels, and sells from the buffer stock when supplies are tight and prices are high.

FIGURE 7.4

Buffer Stock: Price Ceiling and Price Support

(a) Offsetting a Price Increase

Figure 7.4 illustrates the hypothetical pricestabilization efforts of the International Tin Agreement. Assume that the association sets a price range, with a floor of $3.27 per pound and a ceiling of $4.02 per pound to guide the stabilization operations of the buffer-stock manager. Starting at equilibrium point A in Figure 7.4(a), suppose the buffer-stock manager sees the demand for tin rising from Do to D I- To defend the ceiling price of $4.02, the manager must be prepared to sell 20,000 pounds of tin to offset the excess demand for tin at the ceiling price. Conversely, starting at equilibrium point E in Figure 7.4(b), suppose the supply of tin rises from 50 to 51'To defend the floor price of $3.27, the buffer-stock manager must purchase the 20,000-pound excess supply that exists at that price.

(b) Offsetting 0 Price Decrease

Proponents of buffer stocks contend that the scheme offers the primary producing nations several advantages. A well-run buffer stock can promote economic efficiency because primary producers can plan investment and expansion if they know that prices will not gyrate. It is also argued that soaring commodity prices invariably ratchet industrial prices upward, whereas commodity price decreases exert no comparable downward pressure. By stabilizing commodity prices, buffer stocks can moderate the price inflation of the industrialized nations. Buffer stocks in this context are viewed as a means of providing primary producers more stability than is allowed by the free market.

Setting up and administering a buffer-stock program is not without costs and problems. The basic difficulty in stabilizing prices with buffer stocks is agreeing on a target price that reflects long-term market trends. If the target price is set too low, the buffer stocks will become depleted as the stock manager sells the commodity on the open market in an attempt to hold market prices in line with the target price. If the target price is set too high, the stock manager must purchase large quantities of the commodity in an effort to support market prices. The costs of holding the stocks tend to be high, for they include transportation expenses, insurance, and labor costs. In their choice of price targets, buffer-stock officials have often made poor decisions. Rather than conduct massive stabilization operations, buffer-stock officials will periodically revise target prices should they fall out of line with long-term price trends.

Multilateral Contracts

Multilateral contracts are another method of stabilizing commodity prices. Such contracts generally stipulate a minimum price at which importers will purchase guaranteed quantities from the producing nations and a maximum price at which producing nations will sell guaranteed amounts to the importers. Such purchases and sales are designed to hold prices within a target range. Trading under a multilateral contract has often occurred among several exporters and several importing nations, as in the case of the International Sugar Agreement and the International Wheat Agreement.

One possible advantage of the multilateral contract as a price-stabilization device is that, in comparison with buffer stocks or export controls, it results in less distortion of the market mechanism and the allocation of resources. This result is because the typical multilateral contract does not involve output restraints and thus does not check the development of more efficient low-cost producers. If target prices are not set near the long-term equilibrium price, however, discrepancies will occur between supply and demand. Excess demand would indicate a ceiling too low, whereas excess supply would suggest a floor too high. Multilateral contracts also tend to furnish only limited market stability, given the relative ease of withdrawal and entry by participating members.

I The OPEC Oil Cartel

Instead of forming international commodity agreements to stabilize export prices and revenues, some nations have formed cartels. Unlike commodity agreements, cartels involve unilateral attempts by exporting nations to increase the price of a product and export revenue by exerting their collective power. One of the most successful cartels in recent history has been the Organization of Petroleum Exporting Countries.

The Organization of Petroleum Exporting Countries (OPEC) is a group of nations that sells petroleum on the world market. The OPEC nations attempt to support prices higher than would exist under more competitive conditions to maximize member-nation profits. After operating in obscurity throughout the 1960s, OPEC was able to capture control of petroleum pricing in 1973 and 1974, when the price of oil rose from approximately $3 to $12 per barrel. Triggered by the Iranian revolution in 1979, oil prices doubled from early 1979 to early 1980. By 1981, the price of oil averaged almost $36 per barrel. OPEC's market power stemmed from a strong and inelastic demand for oil combined with its control of about half of world oil production and two-thirds of world oil reserves. Largely because of world recession and falling demand, oil prices fell to $11 per barrel in 1986, only to rebound thereafter.

236 Trade Policies for the Developing Nations

Prior to OPEC, oil-producing nations behaved like individual competitive sellers. Each nation by itself was so unimportant relative to the overall market that changes in its export levels did not significantly affect international prices over a sustained period of time. By agreeing to restrict competition among themselves via production quotas, the oil-exporting nations found that they could exercise considerable control over world oil prices, as seen in the price hikes of the 1970s.

Maximizing Cartel Profits

A cartel attempts to support prices higher than they would be under more competitive conditions, thus increasing the profits of its members. Let us consider some of the difficulties encountered by a cartel in its quest for increased profits.

Assume that there are 10 suppliers of oil, of equal size, in the world oil market and that oil is a standardized product. As a result of previous

Maximizing OPEC Profits

(a) Cartel

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(5

e-

'"u 20

d:

o 1,000 1,5001,800

OiIIBarrels/Day)

price wars, each supplier charges a price equal to minimum average cost. Each supplier is afraid to raise its price because it fears that the others will not do so and all of its sales will be lost.

Rather than engage in cutthroat price competition, suppose these suppliers decide to collude and form a cartel. How will a cartel go about maximizing the collective profits of its members? The answer is, by behaving like a profit-maximizing monopolist: Restrict output and drive up price. Figure7.5 illustratesthe demand and cost conditions of the ten oil suppliers as a group [Figure 7.5(a)] and the group's average supplier [Figure 7.5(b)]. Before the cartel is organized, the market price of oil under competition is $20 per barrel. Because each supplier is able to achieve a price that just covers its minimum average cost, economic profit equals zero. Each supplier in the market produces 150 barrels per day. Total industry output equals 1,500 barrels per day (150 X 10 = 1,500).

Suppose the oil suppliers form a cartel whose objective is to maximize the collective profits of its members. To accomplish this objective, the cartel must first establish the profit-maximizing level of output; this output is where marginal revenue equals marginal cost. The cartel then divides up the cartel output among its members by setting up production quotas for each supplier.

In Figure 7.5(a), the cartel will maximize group profits by restricting output from 1,500 barrels per day to 1,000 barrels per day. This means that each member of the cartel must decrease its output from 150 barrels to 100 barrels per day, as shown in Figure 7.5(b). This production quota results in a rise in the market price of a barrel of oil from $20 to $30. Each member realizes a profit of $8 per barrel ($30 - $22 = $8) and a total profit of $800 on the 100 barrels of oil produced (area a).

The next step is to ensure that no cartel member sells more than its quota. This is a difficult task, because each supplier has the incentive to sell more than its assigned quota at the cartel price. But if all cartel members sell more than their quotas, the cartel price will fall toward the competitive level, and profits will vanish. Cartels thus attempt to establish penalties for sellers that cheat on their assigned quotas.

In Figure 7.5(b), each cartel member realizes economic profits of $800 by selling at the assigned quota of 100 barrels per day. However, an individ- ual supplier knows that it can increase its profits if it sells more than this amount at the cartel price. Each individual supplier has the incentive to increase output to the level at which the cartel price, $30, equals the supplier's marginal cost; this occurs at 180 barrels per day. At this output level, the supplier would realize economic profits of $1,440, represented by area a + b. By cheating on its agreed-upon production quota, the supplier is able to realize an increase in profits of $640 ($1,440 - $800 = $640), denoted by area b. Note that this increase in profits occurs if the price of oil does not decrease as the supplier expands outputthat is, if the supplier's extra output is a negligible portion of the industry supply.

A single supplier may be able to get away with producing more than its quota without sig-

nificantly decreasing the market price of oil. But if each member of the cartel increases its output to 180 barrels per day to earn more profits, total output will be 1,800 barrels (180 X 10 = 1,800). To maintain the price at $30, however, industry output must be held to only 1,000 barrels per day. The excess output of 800 barrels puts downward pressure on price, which causes economic profits to decline. If economic profits fall back to zero (the competitive level), the cartel will likely break up.

Besides the problem of cheating, there are several other obstacles to forming a cartel:

Number of Sellers

Generally speaking, the larger the number of sellers, the more difficult it is to form a cartel. Coordination of price and output policies among three sellers that dominate the market is more easily achieved than when there are 10 sellers each having 10 percent of the market.

Cost and Demand Differences

When cartel members' costs and product demands differ, it is more difficult to agree on price. Such differences result in a different profit-maximizing price for each member, so there is no single price that can be agreed upon by all members.

Potential Competition

The increased profits that may occur under a cartel may attract new competitors. Their entry into the market triggers an increase in product supply, which leads to falling prices and profits. A successful cartel thus depends on its ability to block the market entry of new competitors.

Economic Downturn

Economic downturn is generally problematic for cartels. As market sales dwindle in a weakening economy, profits fall. Cartel members may conclude that they can escape serious decreases in profits by reducing prices, in expectation of gaining sales at the expense of other cartel members.

Substitute Goods

The price-making ability of a cartel is weakened when buyers can substitute other goods (coal and natural gas) for the good that it produces (oil).

A U.S, presidential task force composed of apparel industry representatives, unions, and human rights activists recently agreed to codes of conduct for labor practices by multinational corporations. In responseto negative publicity, Nike, the athletic shoe and apparel company, hired former u.s. ambassador Andrew Young to conduct an independent investigation of its labor practices. Moreover, the Federation of International Football Associations announced it would not purchase soccerballs made with child labor. These events point to a growing concern about labor standards in the developing world.

High unemployment rates in Western Europe and stagnant wages of unskilled workers in the United States have contributed to a new ambivalence in the industrial countries about the benefits of trade with developing countries. Labor unions and human rights activists in industrial countries fear that industrial-eountry wages and benefits are being forced down by unfair competition from countries with much lower labor costs-so- called "social dumping." They also maintain that market access in the industrial countries should be conditioned on raising labor standards in developing countries to prevent a "race to the bottom" in wages and benefits, Trade sanctions imposed in response to violations of labor standards are sometimes referred to as a "social clause."

There are two main arguments for the international harmonization of labor standards. The economic argument suggeststhat low wages and labor standards in developing countries threaten the living standards of workers in developed countries. The moral argument asserts that low wages and labor standards violate the human rights of workers in the developing countries. Human rights activists believe that raising labor standards in developing countries will benefit workers in these countries and that some labor practices are morally intolerable, such asthe exploitation of working children and discrimination based on gender.

Proponents of the international harmonization of labor standards will not usually admit openly to any protectionist intent. However, developing countries remain deeply suspicious that disguised

protectionism motivates many of the calls for compliance with labor standards of industrial countries, especially if the latter are to be enforced with trade sanctions. Some unions and human rights groups in the United Statescontinue to insist that conditions on wages and benefits should be attached to agreements on labor standards.

That fairness should be observed in international competition seems indisputable. What constitutes fairness is not so obvious. Does the abundance of cheap labor in China render it an unfair competitor in the production of goods requiring relatively large amounts of unskilled labor? If so, do the plentiful coconut trees in the Philippines render it an unfair competitor in the production of coconut oil?

Another question concernsthe implementation of international labor standards. Most industrialcounty labor standards are not feasible for many developing countries. Concerning child labor, for example, it is indeed disturbing that young children in developing countries toil under harsh conditions for low pay. But the earnings of these children may be important to their families'-and their own-survival. Moreover, setting strict standards in a developing country'sregulated sector may consign children to even more degrading, less remunerative work in the unregulated sector. Moreover, if the goal is to enhance the welfare of developing countries, perhaps a more effective way would be to allow free international migration from lowto high-standard countries, an argument rarely made by proponents of harmonization of labor standards.

Nonobservance of international labor standards may impair, rather than enhance, overall competitiveness. To be sure, exploitative child labor and forced labor may suppress wage rates, but such practices also prevent those victimized from shifting readily into activities that best match their skills and goals, and thus reduce their productivity.

Source: Stephen Golub. "Are International Labor Standards Needed to Prevent Social Dumping?" Finance and Development. December 1997. pp.20-23.