A discussion HW 300-350words

11 Globalization and Free Trade

Case Scenario: Expanding Double Z Beauty 315

Introduction: Business and Government in an Era of Globalization 316

Globalization and Neoliberalism 317

Theories of International Trade 319

Trade Protectionism 322

Regional Economic Integration 325

Economic Integration Among the Americas 330

Analytical Case: Sugar farmers and CAFTA-DR 333

Practical Skill: Selling overseas 334

Summary and Conclusion 335

CHAPTER CONTENTS

CASE 11 SCENARIO

Expanding Double Z Beauty

Zach’s grandparents had a 20-acre farm in a sunny southern canyon in a state where they could grow practically anything—avocados, oranges, tomatoes, you name it. Over the past several decades they developed a family business, Double Z Beauty, which produces and sells natural soaps and other organically grown skin- and hair- care products. Due to its natural ingredients and high-quality production, Double Z quickly gained a following and won several regional beauty product awards.

After graduating from college, Zach decided to join the family business. Recently, after talking with Zoey, he came up with ideas for a few organic pet products as well. Persuaded by Zach, the family made a critical decision to hire Tyler to design and help launch a business website to start selling all Double Z Beauty products online. At first, the website did not generate significant sales for the business, but the

scenario changed once the website was linked to Amazon.com and a few other commercial portals, a few tricks Tyler was getting good at applying. The excellent product reviews and customer service started to bring in a stream of retail and wholesale orders from all over the country. Last month, online sales even passed those of their family store and several local distributors and retailers combined. Zach’s grandparents, eager to spend more time traveling, began to think of increasing Zach’s company responsibilities.

In recent months, Zach has been receiving email inquiries from international customers and distributors interested in Double Z Beauty products. He took this as a very promising sign for expanding the business to a global market, but there is a long list of issues to overcome, such as shipping and distribution, payment and currency conversion, taxes and duties, advertising and marketing, products and packaging requirements, customer service, and so on. In addition, if the business sells to the international market, at some point Double Z will also need to consider expanding production. Currently the family farm produces just enough raw materials, now that there is also Zach’s pet product line. But once they go global, the family will need to purchase some supplies elsewhere. Zach did market research and found that several farms across the border in Mexico could become potential suppliers.

In college, Zach took a couple classes related to international business. His initial impression was that international trade was the business of large corporations. Now, however, he knows that many small businesses have substantial international business transactions and Zach is wondering how a family business like Double Z Beauty could expand its business overseas. He decides to call Zoey and Tyler and meet for coffee before he talks further to his grandparents.

Introduction: Business and Government in an Era of Globalization

When we expand our focus beyond local economic development, it is easy to recognize that we live in a global economy today. Goods and services produced in one region are easily available in others. Information flows quickly around the world and international communication is commonplace. Capital and labor travel rapidly and frequently across borders. Both business and government now operate in a global environment and need to respond to various global imperatives. Whereas firms gain access to more investment opportunities, cheaper labors, more appropriate operation cites, better suppliers and distributors, advanced technologies and innova - tions, and larger markets, they are under more intense competition with not only domestic competitors, but also adversaries from other countries. In addition to domestic political and economic forces, firms also need to understand and respond to various political, economic, social, and cultural imperatives of the countries in which they invest, operate, sell, or buy.

Governments today often find that their autonomous power has been over - shadowed by problems such as infectious diseases, terrorism, and climate change

316 Business–Government Relations in the Global Market

that can easily cross borders and demand international collaboration. They are facing increasingly difficult challenges, such as creating and retaining jobs, preventing tax evasion, and protecting the world’s deteriorating environment, all of which are a result of global competition.

The global context also instills new meaning to the relationship between business and government. Governments often play a dual, yet paradoxical, role on behalf of business—on one hand, governments are requested to maintain a stable monetary and fiscal system, negotiate trade agreements, and set up foreign policies on behalf of the country to facilitate free trade as well as to enhance the competitive advantage of domestic firms in the global market place; on the other hand, governments are needed to protect domestic firms and disadvantaged groups from the sharp edges of a global economy. More importantly, governments act as representatives for national interests in global trade and financial institutions, such as the World Trade Organization, the International Monetary Fund, and the World Bank, the de facto governing powers in the global marketplace.

Today, businesses often find that execution of a domestically oriented strategy in this fast-changing global environment may be unwise. Smart business students should learn how to take advantage of business opportunities overseas and how to interpret the global trends that directly affect business practices. It is critical for business to understand the trade regimes, foreign contexts, and global financial institutions in order to best capitalize on opportunities and avoid the problems related to lack of international business awareness.

Globalization and Neoliberalism

Globalization is an umbrella term for a complex series of economic, social, techno - logical, cultural, and political changes that are seen as increasing interdependence, integration, and interaction between people and companies in disparate locations.

The process of globalization has been observed in different historical times. Some scholars trace its historical origin to the age of European discovery and voyages to the New World. Others observe its presence from the late nineteenth century to the early twentieth century as the world’s economies became interconnected as a result of the industrial revolution.

The process has reached an unprecedented level since the 1980s, especially after the end of the Cold War. Distinguishing this current wave of globalization from earlier ones, Thomas Friedman, author of many thought-provoking books on globalization, says that today globalization enables “nation-states and corporations to reach farther, faster, cheaper, and deeper around the world than ever before” (Friedman 2005).

In analyzing the causes of this new wave of globalization, technological advance - ment has commonly been recognized as one principal driver. Advances in trans - portation and telecommunications infrastructure have dramatically transformed economic life. The development of the automobile, aviation, and nautical technol - ogies in the twentieth century has not only made international travel easy and affordable to individuals, but also enhanced corporations’ capability to ship materials and products around the world. Information and telecommunication technologies,

Globalization and Free Trade 317

318 Business–Government Relations in the Global Market

such as microchips, fiberoptics, satellites, and the Internet, have largely reduced the cost and time of long-distance communication and made it possible for companies to operate in multiple locations.

Increased global awareness has also propelled the globalization process. In 1968, when NASA astronauts sent back the first picture of Earth from deep space (Exhibit 11.1), the Gaia sentiment was shared by many people and a new perspective toward our mother planet was adopted. Gaia was the Greek Goddess of the Earth. The word was borrowed to describe the view that our planet is an organism, an interconnected living system of soil, oceans, biosphere, and atmosphere, which is delicate, fragile, and yearning for protection. The sentiment has not only drawn a strong following from environmentalists, ecologists, New Agers, feminists, and other fringe social groups, but also largely driven the global environmental and humanity movements. People around the world are increasingly concerned about the welfare of all human and nonhuman life, preservation of Earth as our home, the balance between development and sustainability, as well as the growing confrontation between the zeal of nationalism, patriotism, and diversity and the yearning for peace, harmony, and unity.

First picture of Earth from outer space

EXHIBIT 11.1

Source: http://www.nasa.gov/multimedia/imagegallery/image_feature_102.html.

Perhaps the most critical catalyst to the accelerated globalization process in the past three decades was the adoption of free market principles by a majority of the nation states around the world as a result of the triumph of capitalism over communism. This renewed interest toward free market economy has been referred to as neoliberalism, a term already much discussed in this text.

To review the term, neoliberalism was originally thought of as the combination of the classical economic liberalism of Smith and Ricardo, combined with the social awareness of John Stuart Mill that the state must play a humanitarian role, and the awareness of Keynes that the large administrative state was also expected to play an important series of economic roles, from monetary and interest-rate stabilization to counter-cyclical economic fiscal policy in order to mitigate the ravages of the business cycle. Today neoliberalism almost always refers to the advocacy of a smaller government role and a more robust role for the market.

Neoliberalism Policies

Generally speaking, neoliberalism advocates transferring control of the economy from the public to the private sector with the belief that it will lead to improved economic health as well as a more efficient government. Policies advanced by neoliberalism are often referred to as the “Washington Consensus,” a term coined to describe the policy package that gained consensus approval among the Washington (DC)-based economic organizations, such as the International Monetary Fund (IMF), World Bank (see Chapter 13), and the US Treasury Department. The package includes a list of policies such as:

• Free trade: removal of trade barriers, like tariffs, subsidies, and regulatory restrictions

• Privatization: transfer of previously public-owned enterprises, goods, and services to the private sector

• Competitive exchange rates: accepting market-determined exchange rates, as opposed to government-fixed exchange rates

• Undistorted market prices: refraining from policies that would alter market prices

• Limited intervention: with exception only for promoting exports, education, or infrastructural development

• Fiscal rectitude: cutting government expenditures and/or raising taxes to maintain a budget surplus.

Theories of International Trade

Free trade, advanced by neoliberalism, refers to a policy by which governments do not discriminate against imports or exports. It has long been a debatable topic. To its proponents, free trade maximizes the interest of consumers throughout the world by giving them a wider variety of goods from which to choose. Differences in the efficiency of land, labor, and capital make it profitable for nations to specialize in the production of goods and services in which their resource situation is the most

Globalization and Free Trade 319

advantageous, and exchange them for the goods and services of other nations with

different resource advantages. If there were no restraints placed on the movement

of goods and services from one region to another, or from one nation to another,

then in theory the welfare of consumers would be maximized.

The benefits of free trade were theoretically explored by many economists, such

as Adam Smith, David Ricardo, and others.

The theory of absolute advantage is generally attributed to Adam Smith. In his book The Wealth of Nations (1937), Smith pointed out that countries could not all become rich simultaneously by following mercantilism, but they could gain together

if they specialized in producing goods or services in which they had an absolute

advantage and traded freely with each other.1 Absolute advantage refers to the ability

of a party (being an individual, firm, or nation) to produce a certain service or goods

more efficiently than another one. The theory provides a basis for trade, in that if

one party has absolute advantage over the other, the latter should buy from the

former. Adam Smith described the theory by comparing labor productivity in the

context of international trade. The simple comparison of labor productivity pointed

to an intrinsic limitation of the theory—if a party has no absolute advantage in

anything, then trade is not beneficial and would never occur.

The benefits of trade were further explored by David Ricardo (1772–1823), a

British political economist. Ricardo’s most important legacy was the theory of

comparative advantage, a fundamental argument in favor of free trade among countries and of specialization among individuals. Ricardo argued that there is

mutual benefit from trade (or exchange), even if one party (e.g., resource-rich

country, highly skilled artisan) is more productive in every possible area than its

trading counterpart (e.g., resource-poor country, unskilled laborer), as long as each

concentrates on the activities in which it has relative productivity advantage

(Hollander 1979).

Comparative advantage holds that if one country has an advantage over another country in the production of several goods, it should produce the good in which it

has the greatest advantage and buy the good in which it has the least advantage

from the other country. Gains can also arise from specialization—a concentration of labors and other resources for producing a single product, a practice which can

lead to greater skill and productivity than would be achieved by the same number

of workers and resources being devoted to the production of a variety of goods and

services. Specialization due to trade based on comparative advantage provides

mutual benefits to trading parties.

The theory can be better illustrated with the following example. Suppose that

both the United States and Mexico produce wheat and avocados. With one unit of

input (i.e., labor, capital, land, etc.), the US can produce eight units of wheat and

four units of avocados, respectively, whereas Mexico can only produce one unit of

wheat and two units of avocados, as Mexico is less productive than the US in general

due to a variety of factors such as land, climate, technology, skill, etc. Therefore,

the US has absolute advantage over Mexico in producing both products. Based on

the theory of absolute advantage, trade between the two nations would never occur,

as Mexico does not have any incentive.

320 Business–Government Relations in the Global Market

Globalization and Free Trade 321

However, comparing the advantages of the US over Mexico in the two products (Exhibit 11.2), the ratio of eight units of wheat over one is better than that of four units of avocados over two for the US; and vice versa, the comparison ratio of avocados is better for Mexico than that of wheat. Based on the theory of comparative advantage, the US in this example has a comparative advantage in producing wheat and should specialize in producing wheat, whereas Mexico has a comparative advantage in producing avocados and should therefore specialize in avocados. If the US devotes its one unit of resources that used to produce avocados to producing wheat, the US should gain eight units of wheat; and if the country trades the eight units of wheat with Mexico for avocados, it will gain 16 units of avocados, which is better than the original four units produced domestically. Similarly, if Mexico devotes the one unit of input for wheat to producing avocados, it will gain two units of avocados; if it trades with the US for wheat, it will gain four units of wheat, which is better than the original one unit of wheat produced with the same amount of resources. Through specialization and exchange, both parties gain.

Government Policies in Promoting Trade

Trade can contribute to economic growth in multiple ways. As the market potentially served expands from a national to world market, there are gains with declining per-unit production costs (greater efficiency), gains resulting from the reduction in

An example of comparative advantage

EXHIBIT 11.2

United States 8 4 -

Wheat 811

Mexico 1 2 Avocado

Specialization United States wheat Exchange United States Export wheaW

r Y Import avocado Mexico avocado Mexico ~xport avocado1

Import wheat

Gains from Trade Un~ted States 8 16

Mexico 4 2

II

II

II

II

II

the monopoly power of domestic firms (less market distortion), and consumer gains

through increased product variety and lower costs (consumer focus).

Governments of all levels in the United States promote trade, especially export.

In 1934, Congress passed the Reciprocal Trade Agreement Act, delegating to the

President the authority to negotiate trade agreements. The Office of the US Trade

Representative (USTR), under the direction of the White House, serves as the

President’s representative in trade negotiation. Under the Department of Commerce

(DoC), the International Trade Administration (ITA) promotes exports of non-

agricultural US services and goods. ITA provides information assistance to

Americans in selecting markets and products, ensures access to international markets

by domestic firms, and safeguards Americans from unfair competition from dumped

and subsidized imports. Agencies like the Export–Import Bank (EximBank) promote

exports by making direct loans to exporters and by insuring and guaranteeing loans

made by private lenders. The Overseas Private Investment Corporation (OPIC)

provides insurance, such as loan guarantees and political risk insurance, for US direct

investment in less-developed countries.

State governments promote trade through economic development agencies and

trade commissions. A state government often offers a variety of subsidies or tax

policies to promote trade.

Local government can create Free Trade Zones (FTZs) to attract companies. For

example, Miami allows goods to be brought into the city FTZ tariff free. Firms will

not pay a tariff until the product is assembled and leaves the zone. Such a policy

will largely benefit firms that import and assemble goods with components from

multiple foreign suppliers.

Trade Protectionism

Despite the potential gains backed by economic theories and government’s efforts

in promoting trade, free trade is not without opposition. Ironically, the biggest

obstacle to free trade results from government’s trade protection policies. Trade

protection, or protectionism, refers to the economic policies that restrain trade between nations in an attempt to protect domestic industries from foreign takeover

or competition.

The policy of trade protection takes its root from mercantilism (see Chapter 1).

To mercantilists, in order to accumulate wealth, a nation should always maintain a

positive trade balance by keeping the value of exports greater than that of imports.

During colonial times, the British required that all colonial trade be conducted on

British ships manned by British sailors (Sawers 1992). To protect British steel

producers, the country also restricted the development of manufacturing industries.

American colonies could only export raw materials at a lower value, but had to

import manufactured products from the British at a higher value. In doing so, the

British maintained a positive trade balance with their colonies. The British would

even go to war against competing countries to protect this balance.

Protectionism has been also practiced extensively by nation states in this era of

globalization. Generally speaking, there are two types of protectionism—one set

322 Business–Government Relations in the Global Market

of policies seeks to protect domestic markets, such as tariffs, import quotas, and

regulatory barriers; the other unfairly promotes domestic goods in foreign markets,

such as export subsidies, exchange control, and dumping. See Exhibit 11.3 for

protectionist arguments.

Tariffs

Tariffs are taxes imposed on incoming goods. It is the most common device used to restrict foreign trade. The rates of tariff may vary based on the type of goods

imported. The Tariff Act of 1789 was the first trade protection Act passed in the

United States. The Act was intended to levy duties on incoming goods, wares, and

merchandise in order to support government, and encourage and protect domestic

manufacturers. For example, the Act established tonnage rates favorable to American

vessels by charging them lower cargo fees than those imposed on foreign boats

importing similar goods (Miller 1960).

Quota

Import quotas place limits on the amount of a product. The economic impact of an import quota is similar to that of a tariff, except that the tax revenue gain from a

tariff will instead be distributed to those who receive import licenses. The United

States places strict tariffs on the import of sugar. The country is not only one of the

largest sugar producers, but also one of the largest consumers of sugar in the world.

The US sugar industry has enjoyed trade protection ever since 1789 when Congress

enacted the first tariff against foreign-produced sugar. Today, the US government

strictly controls sugar imports by means of Tariff-Rate Quotas (TRQs), which

specify the amount of sugar that can enter the country from abroad at a low or zero

duty. Additional sugar imports above TRQ levels will be imposed over-quota

tariffs, which will be too high for firms to make a profit. For example, in 2012, the

US allocated an import quota of 155,634 tons of raw cane sugar to Brazil, which

had to pay an import duty not to exceed US$1.4606 cents per kilogram.

Regulatory Barriers

Regulatory barriers come in various forms. There are various administrative rules

that may introduce barriers to imports. Such rules may concern food safety,

environmental standards, intellectual property rights, employment-based immi -

gration requirements, and so on. For example, after the Mattel toy scandal in 2007

(when toys manufactured in China used lead-based paint in excess of amounts

allowable in the US), the United States passed the Consumer Product Safe Improve -

ment Act, imposing the toughest toy-making standards in the world. As a result of

the regulations, the import of toys from China, Mattel’s major manufacturer, was

largely restricted, forcing the Chinese government to improve its product regulation.

Some countries are accused of intentionally making trade-related regulations vague

or undisclosed to hinder imports.

Globalization and Free Trade 323

324 Business–Government Relations in the Global Market

Export Subsidies

Government subsidies in the form of tax credits, lump-sum payments, loans, or free resources (such as water, public land, etc.) may be given to domestic firms to encourage exports. Agricultural subsidies are commonly paid by governments to farmers and agriculture businesses to influence the price and supply of agricultural products. Through various farm bills, the United States pays over $20 billion in subsidies to farms and agribusiness. At their peak in 2000, subsidies made up 47 percent of total farm income in the United States.2 Agricultural subsidies often are a common stumbling block in trade negotiations. For example, the WTO trade negotiations were stalled in 2006, because the US refused to cut subsidies to a level where other countries’ non-subsidized exports could be more competitive.

Exchange Control

Currency values can be manipulated to affect the trading relationship. Keeping the value of money low against other currencies can encourage lower imports and higher exports. Government, often through the national central bank, can practice exchange control by selling its currency in the foreign exchange market. Despite the benefit of improved trade balance, this policy can only be effective in the short run and it often leads to inflation in the country. China has been accused of manipulating exchange control over a long period of time.3

Dumping

Dumping refers to the selling of a product in another country at a cost lower than its production cost, which is often made up by government subsidy. Dumping may lead to conditions where one firm has a monopoly in a certain product or industry. For example, if a foreign firm wants to compete with a domestic firm that sells identical products, it prices its product far below the cost of producing it. To compete with the foreign firm, the domestic company has to lower its prices. Without equivalent protection from the foreign government, the domestic firm may lose money and exit the market. Thus, the foreign company gets the market share and may eventually monopolize the market. Dumping drives countries like the United States to develop antidumping laws to forbid predatory dumping.

Economists generally agree that protectionism is harmful, primarily because its costs outweigh the benefits and it impedes economic growth. For example, one study found that consumers were paying an average of $139,000 for each job protected in 1990 in the apparel industry, while in that same period of time the average pay of a production worker was less than $15,000 (Hufbauer and Elliott 1994). Protection requires additional resources from other industries, and therefore it will reduce the output in other domestic industries. Protection often raises the prices of materials and goods and requires scarce government resources be diverted to them. In addition, consumers are harmed by reduced consumption of protected items, both because the protected item is more expensive and less will be bought, and because fewer are able to consume other items as well, owing to the greater price of pro tected goods.

Regional Economic Integration

There have been two evolving trends in the world economic environment. We have been observing the progress of globalization as largely driven by technology innovation, which has resulted in not only a globalized market for goods and

Globalization and Free Trade 325

EXHIBIT 11.3

Protectionist arguments

There are a variety of arguments for trade protection. The national defense argument states that government should retain

minimum production capacity and restrict trade, especially in key areas such as armaments. Free traders often argue that protection has been overused in such areas, and that there should be a very limited number of industries that qualify for protection.

The income distribution argument refers to the claim that government should help select disadvantaged groups, such as sugar farmers, in the trade games. Free traders warn that it tampers with the market and is unfair to other groups.

Protectionists claim that government policies should help improve the balance of trade, especially by reducing the trade deficit through limiting imports. Since government policies may distort the market, free traders think it should only be used sparingly and in the short-term.

Probably the most popular protection argument is associated with the protection of jobs. Many interest groups, especially those whose jobs are affected, care more than do general consumers, and advocate that government should protect select industries, such as agriculture, clothing, manufacturing, etc. Free traders would argue that even though there is pain for those involved, instead of protecting select industries, government should assist these workers in migrating to more efficient industries.

The infant industry argument states that government should help infant industry and give the industry time to mature, or build critical mass. Opponents of this claim point out that it is extremely difficult to wean industries off infant industry subsidies. They argue that the policy has been overused and it needs to be extremely limited.

There are also arguments associated with the spillover effects of certain industries, such as those engaging in research and development, and that those industries that provide social usefulness should be protected. The free traders debate that it is the market, and not the government, that will promote such industries.

Finally, the strategic trade policy argument states that we should design select trade policies by reason rather than the market, especially when the market is limited or imperfect. Those against trade protection argue that it too easily leads to market distortion and political manipulation.

326 Business–Government Relations in the Global Market

services, but also a financial market in that the pool of savings is worldwide and financial intermediaries know no international boundaries. Meanwhile, it is also notable that countries around the world have been increasingly moving toward regional economic integration. Regional economic integration refers to agreements among countries, often in a geographically approximate region, to reduce, and ultimately remove, tariff as well as non-tariff barriers to the free flow of goods, services, and factors of production between each other.

The term integration in economics means the combination of business firms through contractual agreements, with the intention of reducing prices for distributors and consumers and increasing the combined economic productivity of the members. Economic integration aims to stimulate trade based on the economic theory of the second best, by which the best option is free trade and economic integration is treated as the second best for global trade where barriers to full free trade exist.4

The degree of economic integration can be categorized into several levels (Exhibit 11.4). From least integrated to most integrated, they are the preferential trade area, free trade area, customs union, common market, economic union, and finally, the political union.

Levels of economic integration

EXHIBIT 11.4

Political Union

Economic Union

Common Market

Customs Union

Free Trade Area

Preferential Trade Area

H ig

h L

e ve

l o f In

te g

ra tio

n

L o

w

Preferential Trade Area (PTA)

A preferential trade area is a trading bloc that gives trade preferences for certain products to a set of trading partners covered in an agreement. A PTA attempts to reduce tariffs among participants, but does not completely abolish them. The line between a PTA and an FTA may be blurred, as almost any PTA has the main goal of eventually becoming an FTA.

Free Trade Area (FTA)

A free trade area is essentially a PTA with increased depth and scope of reduction in trade barriers. An FTA aims at the removal of tariffs and other trade barriers among members; however, each country may establish its own trade policies with non-member countries. FTA is the most popular form of regional economic integration.

One of the longest lasting FTAs in the world is the European Free Trade Associ - ation (EFTA), which was established in 1960 by seven European countries— Austria, Denmark, Norway, Portugal, Sweden, Switzerland, and the United Kingdom—who were either unable or unwilling to join the European Community (the forerunner of the European Union; see Chapter 12). Those seven countries were often referred to as the Outer Seven as opposed to the Inner Six (Belgium, France, West Germany, Italy, Luxembourg, and Netherlands), which founded the European Community during that time. Today, EFTA has four members—Iceland, Liechten - stein, Norway, and Switzerland—who continue to expand and liberalize trade relationships among themselves and with the rest of the world.

Other significant FTAs include the North American Free Trade Area (NAFTA), which will be covered in depth later in the chapter, the ASEAN Free Trade Area (AFTA), the Central European Free Trade Area (CEFTA), and the Greater Arab Free Trade Area (GAFTA). AFTA is a trade bloc established in 1992 by the Associ ation of Southeast Asian Nations (ASEAN). AFTA seeks to increase ASEAN’s competitive edge as a production base in the world market through the elimination of tariffs and non-tariff barriers within the ASEAN and to attract more foreign direct investment (FDI) to the ASEAN. CEFTA is a trade agreement estab - lished among non-EU countries in southeast Europe after the Cold War in hopes of mobilizing efforts to integrate into western European political and economic systems, thereby consolidating democracy and free market economics. GAFTA is a pan-Arab free trade zone founded in 1997 by Arabian states. It is the most significant trade agreement for Arabian countries, and covers almost all of the internal Arab trade.

Customs Union (CU)

A customs union is an FTA that goes beyond removing trade barriers among themselves, and attempts to set a common level of trade barriers against outsiders as well. Purposes for establishing a customs union normally include increasing economic efficiency and establishing closer political and social ties between the

Globalization and Free Trade 327

member states in order to move toward greater economic integration down the road. For example, the EU started as a customs union and has moved beyond this level. The oldest existing customs union is the Southern African Customs Union (SACU) established in 1910 among southern African countries. The union aims to maintain the free interchange of goods between member countries by levying a common external tariff and a common excise tariff to this common customs area. All customs and excise collected in the common customs area are paid into the National Revenue Fund run by South Africa, the custodian of the pool. The revenue, which constitutes a substantial share of the state revenue of the member countries, is shared among members according to a revenue-sharing formula as described in the agreement.

Common Market (CM)

At a higher level of integration, a common market removes trade barriers between members, sets up common external trade policy, and allows not only the free exchange of goods and services, but also the free movement of other factors of production (i.e., labor and capital) among members. Common markets facilitate the freedom of movement of all factors of production, which become more efficiently allocated, thereby further enhancing productivity. Transition from a national market to a common market can be very difficult, demanding a significant level of cooperation on not only trade policies, but also monetary, fiscal, and labor policies among member states. For years, the European Union had operated as a common market before it achieved a higher level of integration. In 2012, the Customs Union of Belarus, Kazakhstan, and Russia became a single market—the Common Economic Space. These countries continue to strive for a higher level of integration to create the Eurasian Economic Union.

Economic Union

An economic union requires even higher economic integration, which involves the creation of common national economic policies. An economic union not only facilitates a single market among members, but also requires a common currency, coordinated tax rates, and harmonized monetary and fiscal policies. Very few nation states have formed an economic union, as it demands a high level coord - ination of policy-making and bureaucracy among members and the sacrifice of sovereign power of nation states to that of a supranational governing system. Despite some members not adopting the common currency of the euro, the European Union is a highly integrated economic union. Other economic unions include the Caribbean Single Market and Economy (CSME), established in 1989, which strives to deepen economic integration beyond a common market, expand the economic mass of the Caribbean Community, and progressively integrate the region within the global trading and economic system.

Political Union

As economic integration drives beyond the economic union, it demands political integration to coordinate the governing system that ensures accountability to their

328 Business–Government Relations in the Global Market

Globalization and Free Trade 329

constituencies. A political union facilitates a central governing system that coordinates the economic, social, political, and foreign policies of the member states. A political union can be viewed as a highly integrated quasi-autonomous nation state that operates with a confederated system of governance. The early 13 colonies of the United States formed an example of a political union. In today’s world, the European Union has achieved partial political integration as demonstrated in its governing structure. Chapter 12 will have an in-depth discussion of the political structure of the European Union.

The major regional trading blocs today are:

• European Union (EU) • African Union (AU) • Union of South American Nations (UNASUR) • Caribbean Community (CARICOM) • Central American Integration System (SICA) • Arab League (AL) • European Free Trade Association (EFTA) • Eurasian Economic Community (EAEC) • Association of Southeast Asian Nations (ASEAN) • Central European Free Trade Agreement (CEFTA) • North American Free Trade Agreement (NAFTA) • South Asian Association for Regional Cooperation (SAARC) • Pacific Islands Forum (PIF).

The trading world looks like the illustration in Exhibit 11.5 below:

Major trading blocs

EXHIBIT 11.5

Source: en.wikipedia.org.

Economic Integration Among the Americas

Being one of the most important international traders, the United States has progressively pursued trade agreements with other countries. As of 2014, the US has free trade agreements in effect with 20 countries.5 These FTAs move beyond the foundation of the WTO Agreement, requiring more comprehensive and stronger disciplines. Many of the FTAs are bilateral agreements between two governments. But some, like the North American Free Trade Agreement and the Dominican Republic–Central America Free Trade Agreement, are multilateral agreements among several parties, which drive the regional economic integration among the Americas.

North American Free Trade Area

The North American Free Trade Area is a trading bloc consisting of the United States, Canada, and Mexico. It is an extension of the Canada–United States Free Trade Agreement, which was signed in 1988 and entered into force in 1989. NAFTA was negotiated in 1992, ratified in 1993, and finally entered into force on January 1, 1994.

The objectives of NAFTA are to:

• Eliminate barriers to trade in, and facilitate the cross-border movement of, goods and services between the territories of the Parties

• Promote conditions of fair competition in the free trade area • Increase substantially investment opportunities in the territories of the

Parties • Provide adequate and effective protection and enforcement of intellectual

property rights in each Party’s territory • Create effective procedures for the implementation and application of this

Agreement, for its joint administration and for the resolution of disputes • Establish a framework for further trilateral, regional, and multilateral

co operation to expand and enhance the benefits of this Agreement. Source: North American Free Trade Agreement,

Chapter One, Article 102 Objectives

NAFTA created the world’s largest free trade area, which accounts for over one third of the world’s Gross National Income (GNI) and 20 percent of world trade. Canada is the most important trading partner of the United States. US–Canada trade exceeds the entire amount of US–EU trade. Mexico is the third most important US trading partner after the EU.

NAFTA passed in Congress by a fairly small margin after weeks of acrimonious debate. Given that Mexico was a developing country, it was felt that America had little to gain by admitting Mexico into NAFTA. The policy debate of NAFTA became a notorious issue in the presidential campaign of 1992, when presidential candidate Ross Perot gained much political capital by saying that “the gigantic sucking sound you hear is the loss of American jobs to Mexico.”

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The early years of NAFTA were affected by the Mexican currency crisis of December, 1994. Mexico’s trade deficit increased in 1993 and 1994 to the point that it was losing its foreign financial reserves. The Clinton Administration provided a $40 billion assistance package to the Mexican government. The devaluation of the Mexican peso increased Mexican exports to the US and Canada and eventually led to the recovery of the Mexican economy.

Criticisms of NAFTA became rather subdued in the US, as later research indicates that NAFTA’s overall impact has been generally positive. Trade between the United States and its NAFTA partners has soared since the agreement entered into force, increasing at a more rapid rate than US trade with the EU. From 1993 to 2007, overall trade in goods among the three countries has grown from $297 billion to $930 billion, an increase of 213 percent, US exports to Canada and Mexico grew from $142 billion to $385.4 billion, an increase of 171 percent, and US imports from Canada and Mexico grew from $151 billion to $523.9 billion, an increase of 247 percent.6 All countries experienced strong productivity growth. While some argue that the United States has lost 110,000 jobs per year due to NAFTA, many

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EXHIBIT 11.6

The NAFTA debate

NAFTA was a very controversial policy issue during the Bush and Clinton years. When the agreement was initially proposed in 1988, there was much debate as to whether the agreement should be ratified.

Proponents of NAFTA argued that NAFTA should be seen as an opportunity to create an enlarged and more efficient production base for the entire North American region, and that while some lower-income jobs would move from the US and Canada to Mexico, new jobs would be created in the US and Canada as economic growth occurred in Mexico as a result of the job transfers.

In addition, the international competitiveness of US and Canadian firms that moved production to Mexico to take advantage of lower labor costs would be enhanced, enabling them to better compete against Asian and European rivals.

Those who opposed NAFTA claimed that US and Canadian citizens would lose their jobs in alarming numbers as low-income positions were moved to Mexico to take advantage of lower wage rates.

Environmentalists also voiced concerns about NAFTA. Because Mexico has more lenient environmental protection laws than either the US or Canada, there was concern that US and Canadian firms would relocate to Mexico to avoid the cost of protecting the environment.

Finally, there was opposition in Mexico to NAFTA from those who feared a loss of national sovereignty. Mexican critics feared that NAFTA would allow their country to be dominated by US and Canadian multinationals, and Mexico would be used as a low-cost assembly site, while keeping their higher-paying jobs in their own countries.

economists dispute this figure because more than two million US jobs were created each year during the same time period. Perhaps the most significant impact of NAFTA has not been economic, but political. While the United States entered into a war against terrorism in 2001, the increased political stability in Mexico as a result of NAFTA has helped create a safer backyard for US homeland security.

Dominican Republic–Central America Free Trade Area

On August 5, 2004, the US Senate approved the Dominican Republic–Central America–United States Free Trade Agreement (CAFTA-DR) with five Central American countries—Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua—and the Dominican Republic. It is the first agreement between the United States and a large number of developing countries. While the majority of the trade from Central America has enjoyed duty-free access to the US market, the agreement would benefit Central America through facilitating investment and intraregional trade and advancing regional integration. While these developing Central American countries often place high tariffs and other trade barriers on US exports, CAFTA-DR could not only reduce barriers to US goods and products, but also demand critical reform of their legal and business systems to promote transparency in rule-making, to improve and enforce the protection of intellectual property rights, and to provide clear guidance on customs issues.

Central America and the Dominican Republic represent the second largest US export market in Latin America, behind Mexico. US firms enjoy a 40 percent share of their import market. CAFTA-DR further enhances the trade relationship between the US and these countries. More than 80 percent of US exports of consumer and industrial goods became duty free in Central America and the Dominican Republic immediately upon implementation, with remaining tariffs phased out over ten years. The agreement establishes a secure, predictable legal framework for US investors in Central America and the Dominican Republic. In 2006, these six countries received $4.4 billion FDI from the United States. Since the Dominican Republic, the largest economy of the six developing countries, implemented CAFTA-DR in March of 2007, the US trade surplus with that country has increased 282 percent as of 2011.

Free Trade Area of the Americas

The Free Trade Area of the Americas (FTAA) was proposed in 1994 to reduce or eliminate the trade barriers among all American countries except Cuba. After several years, a goal was established to form the FTAA by 2005; however, that goal was not met. Negotiations have faltered between the developed nations as led by the United States, and the developing countries as led by Brazil. Developed nations attempt to expand trade in services and enforce intellectual property rights, whereas the developing states seek an end to agricultural subsidies and reduced barriers for agricultural goods. Hindered by these obstacles, support for the movement has waned, and the future of the proposed free trade area is in question.

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If the agreement can be achieved, the proposed market would involve more than 850 million people in the Americas.

In the meantime, two South American regional trading blocs have combined forces into the Union of South American Nations known as UNASUR (Unión de Naciones Suramericanas). This body was constituted relatively recently from the customs union Mercosur (Argentina, Brazil, Paraguay, Uruguay, Venezuela, and Bolivia) and the Andean Community of Nations (Colombia, Bolivia, Ecuador, and Peru). Given the growing importance of Brazil and its increased position as a regional power, and the long-time hostility between the US and Venezuela, this union may forestall the likelihood of a US-dominated Free Trade Area of the Americas for a long time.

The unprecedented development of technology, the increased global awareness, and especially the adoption of neoliberalism worldwide have driven the process of globalization. Under the trend of globalization, regions have increasingly moved toward economic integration. These trends present both opportunities and challenges to business. This chapter reviews the historical evolution of and policies advanced by neoliberalism, examines the debates surrounding free trade, and introduces government policies in relation to promoting or protecting trade. Business students are expected to gain insights into building effective connections with government in the face of the challenges of a growing global market.

ANALYTICAL CASE: SUGAR FARMERS AND CAFTA-DR*

Mark Olson was a sugar producer who owned 500 acres of sugar beets in Willmar, Minnesota. In 2004, when the Dominican Republic–Central American Free Trade Agreement (CAFTA-DR) was proposed, sugar farmers like Olson were very vocal in opposition to the trade agreement. CAFTA-DR, with the intention to liberalize trade with five Central American nations and the Dominican Republic, became a divider in the agricultural industry. Most American agricultural groups, such as corn and dairy farmers, were in full support of the agreement, anticipating that the larger market would promise an additional 44 million consumers outside the US access to their products. Others, particularly sugar farmers like Olson, however, believed that CAFTA-DR would spell disaster for them.

Agriculture has been traditionally subsidized by government. Unlike most US farmers, sugar farmers were not directly subsidized by the government. Instead, the United States sharply limited sugar imports, keeping sugar prices higher in the domestic market in the absence of overseas competition. Passing the CAFTA-DR agreement would result in falling trade barriers, and increased sugar imports from Central American countries.

According to Olson, other countries subsidized the production of their sugar. And under government subsidies, sugar farmers produced more than what their country needed and dumped their products onto the world market at a cost well below that of production. Olson claimed that the US sugar farmers were some of the most efficient sugar beet producers in the world, but they could not compete with other countries where farmers received government subsidies. Olson had invested half a million dollars in his business. In the US, 90 percent of the sugar was processed in

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farmer-owned co-ops like Olson’s southern Minnesota beet sugar cooperative. The industry employed some 140,000 Americans. Leaders of the co-ops were afraid that if CAFTA-DR passed, foreign producers would dump sugar on the US market and eventually drive people in the sugar industry out of their jobs.

The Bush Administration argued that the sugar producers were overstating their case. It estimated that CAFTA would allow less than 2 percent more sugar from Central America into this country. Free trade advocates, who proposed to stop protecting the sugar industry, pointed out that the price of sugar in the US market was twice that of outside prices, which led to higher profits for sugar farmers, but higher prices for consumers.

Olson, on the other hand, argued that the price of sugar in the US was less than almost any other developed country in the world and consumers were not paying too much for sugar. He pointed out that the only people who complained about the price of sugar were the big candy companies, and that if they bought sugar more cheaply, consumers would not see a reduction in the cost of their products at all.

Despite the debate, CAFTA-DR was narrowly passed by the US Congress (with a vote of 217 in favor and 215 against in the House of Representatives) in July 2005.

Questions for Discussion and Analysis

1. According to the theory of comparative advantage, should US farmers continue producing sugar?

2. According to Olson, other countries all subsidized sugar producers. In that case, should the US remove its import barriers to sugar or should the US subsidize American sugar producers?

3. What effect of CAFTA do you anticipate for American consumers? 4. If you were public policy-makers, how could government placate the different

interests among citizen groups for CAFTA?

*The case was developed based on the PBS NEWSHOUR Video Farmers Differ over CAFTA, July 20, 2005 at 12:00 AM EST.

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PRACTICAL SKILL

Selling overseas

Thanks to the Internet and globalization, small businesses like Double Z Beauty can easily tap into the international market for their goods or services. There are many government resources that you can explore. A convenient starting point can be www.export.gov. The website helps US companies that are interested in starting or expanding exports explore training and counseling programs, develop business plans, conduct market research, find foreign buyers, finance exports, and resolve trade problems.

SUMMARY AND CONCLUSION

1. The world entered into a new era of globalization. Three driving forces contributed to the process: technological advancement, increased global awareness, and most importantly, the acceptance of neoliberalism globally.

2. Neoliberalism, as a renewed version of classic economic liberalism, promotes a free market economy in which free trade is a key policy.

3. Classic international trade theories, such as the absolute advantage and comparative advantage, provide the economic rationale for free trade.

4. Governments at all levels promote trade, especially export.

5. Government uses tariffs, quotas, and regulatory barriers to protect domestic firms. It also uses subsidies, exchange control, and dumping to create unfair competitive advantage.

6. There has been an accelerated trend of regional economic integration. A number of levels of economic integration include a preferential trade area, a free trade area, a customs union, a common market, an economic union, and a political union in the order of increased integration.

7. Despite controversy, the North American Free Trade Agreement and the Dominican Republic–Central American Free Trade Agreement, as well as the ongoing Free Trade Agreement of Americas, drive the regional economic integration among American countries.

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Government agencies, such as the US Commerce Department (the International Trade Administration), the US Small Business Administration (US Export Assistance Centers) and the Export–Import Bank of the United States all offer help. In addition, many states operate agencies aimed at helping small businesses export their products. For example, the California Governor’s Office of Business and Economic Development (GO-Biz) (www.business.ca.gov) operates a California State Trade and Export Promotion (California STEP) project which leverages a statewide network of state, federal, private, and non-profit trade promotion organizations to facilitate export promotion and activities in targeted industries and to drive exports for small businesses.

Skill Exercise: Critical issues of international trade

Create a list of critical issues that Zach needs to deal with if Double Z Beauty decides to sell overseas, and highlight the issues that deal with government. Browse related government websites and advise Zach on how to deal with those issues.

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STUDY QUESTIONS

1. What are the driving forces to globalization and regional economic integration? To what extent do these two trends converge and diverge?

2. Discuss the theory of absolute advantage and comparative advantage, with examples.

3. What are the government policies in promoting and protecting trade? Discuss and critique them with examples.

4. What are the different levels of economic integration? How are they differentiated?

5. What are the debating arguments associated with NAFTA? If you were Adam Smith or David Ricardo, how would you respond to the debate?

6. What are the opportunities and challenges that US firms may face if the FTAA is approved? How should they respond to the trade policy?

Notes

1 Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations, the Glasgow edition of the works and correspondence of Adam Smith, edited by R. H. Campbell and A. S.

Skinner, 1981, Liberty Press.

2 Farm Subsidies over Time. Washington Post, 2 July 2006. URL: http://www.washington post.com/wp-dyn/content/graphic/2006/07/02/GR2006070200024.html.

3 Exchange Controls in China. The Canadian Trade Commissioner Service. Retrieved March 30, 2014, URL: http://www.tradecommissioner.gc.ca/eng/document.jsp?did=50775.

4 US Department of State. Benefits of US Free Trade Agreements. URL: http://www.state. gov/e/eb/tpp/bta/fta/c26474.htm.

5 The United States has established free trade agreements with 20 countries: Australia,

Bahrain, Canada, Chile, Colombia, Costa Rica, Dominican Republic, El Salvador, Guatemala,

Honduras, Israel, Jordan, Korea, Mexico, Morocco, Nicaragua, Oman, Panama, Peru, and

Singapore.

6 US Department of Commerce. Top US Export Markets: Free Trade Agreement and Country Facts Sheets. Summer 2008. URL: http://trade.gov/media/publications/pdf/tm_ 091208.pdf/.

Absolute advantage Common market Comparative advantage Customs union Dumping Economic union

Free trade Free trade area Globalization Neoliberalism Political union Protectionism

Quota Regional economic

integration Specialization Tariff

KEY TERMS

References

Friedman, T. (2005). The World Is Flat. New York: Farrar, Straus and Giroux. Hollander, S. (1979). The Economics of David Ricardo. Toronto: University of Toronto Press. Hufbauer, G. C., and Elliott, K. A. (1994). Measuring the Costs of Protection in the United States.

Washington, DC: Institute for International Economics.

Miller, J. C. (1960). The Federalists: 1789–1801. New York: Harper & Row. Sawers, L. (1992). The Navigation Acts Revisited. Economic History Review, 45(2):262–284. Smith, A. (1937). The Wealth of Nations. New York: The Modern Library.

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