Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

24 June 2012

Selling Below Cost

[For comment on Mohamed Mursi’s election as President of Egypt, click here.]

Free trade helps avoid war
Tariffs are bad
So is selling below cost, and for similar reasons
Below-cost selling is hard to detect and identify

Free trade helps avoid war. In all the encomiums to free markets that pervade our culture, one important point often gets lost. Free markets can prevent war. At least they reduce the risk of repeating the last century’s wars.

The two great wars of the last century were part imperialistic and part economic. If you ignore the imperial and racist motivations, the economic part seems relatively simple.

Germany and Japan felt deprived. Neither had been a colonizing power. In fact, Japan itself had all but been colonized under the influence of Admiral Perry’s “Black Ships.” Both nations lacked access to developing markets and natural resources, principally oil. So once war started, Japan drove right for the oil and rubber fields of Indonesia and Malaysia and Germany for North African (and later Romanian) oil.

Now fast-forward to the present. No one threatens war over oil because it’s a globally-traded commodity. Whoever can pay the going price can get it.

That rule seems fair to everyone. More important, it’s economically efficient. The nation or firm that can use the oil more efficiently can afford to pay more for it, and (in a free market) can get it.

Anyway the most competent extractors and users of oil are no longer states. They are private companies. Free trade in free markets works because our species has organized its best productive efforts in huge private firms: oil companies and car companies. Not only are these companies multinational in scope and operations. Their ownership and staffing are multinational, too.

So in extracting and using oil and gas, we’ve now grown up as a species. Nations and nationalism no longer matter so much. What matters is competence, efficiency and technology. The only way oil now threatens war is when one country threatens to take the profits from what another country sees as its own resources, as China may be doing now with the Spratly Islands and in the South China Sea.

That’s one reason why free trade is so important. Not only is it economically efficient. Not only is it the international equivalent of free markets domestically, which virtually every nation in the world has adopted as the best economic system, except for North Korea, Venezuela and Bolivia. Even Iran has.

But because free trade is efficient and seems fair, it also avoids the kinds of disputes (“This oil field is mine!”) that often has no resolution short of war.

Tariffs are bad. The same reasoning shows why tariffs are so destructive. Not only are tariffs economically inefficient: they protect high-cost manufacturers who overuse scare resources. They also breed justifiable resentment and conflict that can lead to war.

“This market is mine!” differs little from “This oil field is mine!” But that’s what tariffs say. That kind of possessiveness can make people angry and lead to war.

Indeed, that’s precisely what colonialism was—an indirect way of saying “This (developing) market is mine!” And that’s why colonialism often led to war among major powers, quite apart from the understandable desire of colonized peoples to be free.

So free trade is good for a whole bunch of reasons, including reducing the risk of war. That means tariffs are bad, for just as many reasons. And that’s why all our international trade agreements, including the agreements organizing the World Trade Organization (WTO), outlaw tariffs.

So is selling below cost, and for similar reasons. But what about selling below cost. Is it like a tariff—a barrier to international trade—or is it just a legitimate part of global business?

In order to answer that question, you must first ask why anyone would sell anything at a price below the cost of producing it. Isn’t the function of business to generate a profit? And isn’t profit the prime mover of free markets and free trade and the motivator of economic efficiency? So if you sell each item at a loss, aren’t you not only losing money, but throwing sand in the global economy’s engine?

The answer is that no one sells below cost expecting to do so indefinitely. The purpose of selling below cost is to drive competitors out of the market and—once they’ve left—to raise prices and make a profit again.

So selling below cost is just a more subtle and riskier way of saying “This market is mine!” It requires some patience and perhaps the deep pockets of a wealthy angel. But it amounts to the same thing.

If a subsidy drives the selling price of anything below cost, it’s much the same as a tariff. Eventually, someone has to pay for the accumulated losses through the subsidy, just as domestic purchasers of goods protected by a tariff have to pay for the tariff, usually in increased prices for the imported goods. That “someone” may be taxpayers of the subsidizer, or later purchasers of the same products, who must endure higher prices after the subsidizer has killed honest competition.

For these reasons, we Yanks outlawed below-cost selling in our own country over a century ago. We outlawed it with our antitrust laws.

Back then, we used different terminology because the tactics were slightly different. Long before the Internet and cheap national transportation, product markets were geographically fragmented. A single firm might have a monopoly in one market (say, in the South) yet meet strong competition in another geographic market (say, in the West). So that firm might raise its prices in its monopoly markets to subsidize below-cost sales in contested markets.

We called this practice “geographic price discrimination,” and we outlawed it. We did so first with the Sherman Act—the main source of out antitrust law—in 1890. When that law didn’t effectively eliminate the practice, we enacted a supplementary law in 1936.

Called the Robinson-Patman Amendments, the supplementary law explicitly prohibits price discrimination of all kinds. It outlaws geographic price discrimination, i.e., selling the same product at a high price in a dominated market to subsidize below-cost sales in a competitive market. But it also outlaws mere price discrimination: selling one product at a high price in a dominated market to subsidize below-cost sales of another product in a competitive market.

So the notion that selling below cost is unfair and economically harmful is nothing new. We’ve outlawed the practice in our own country for over a century, with specific prohibitions for 76 years.

What’s new is the context of international trade. In the bad old days, subsidies for below-cost sales came from big private firms that enjoyed local monopolies and wanted to expand them. Nowadays, subsidies for losses from below-cost selling come primarily from governments, not private firms operating in different geographic regions or selling different products.

The new international context raises all the old specters of imperialism, nationalism and even racism. But the economic questions are precisely the same. Why would anyone sell below cost? The most obvious reason is to drive out competition in order to dominate a market (which now may be global) and later to raise prices and profit.

Another reason—new in the international context—might be to dominate a market in order to gain a strategic advantage. This second reason is often why governments subsidize below-cost sales. It’s just another face of modern mercantilism.

Claims before the WTO have accused European governments of subsidizing Airbus, and China of subsidizing windmills, for precisely these reasons. Civilian aircraft comprise a strategic industry, with innumerable suppliers who create jobs and obvious spillovers into military aviation. And windmills promise to be a large part of our species’ clean-energy future. So, the claim goes, Europe and China, respectively, are subsidizing Airbus planes and Chinese windmills to get a leg up in these strategic industries.

What’s wrong with subsidies for selling below cost? Three things. First, they’re unfair: they tilt the playing field. And because they’re unfair, they raise all those old ghosts of nationalism, racism and war.

Second, selling below cost is inefficient. With non-market subsidies (typically from government) an inefficient firm can win. When an inefficient firm wins, the result is higher prices for everyone—higher than they would be from efficient firms, without the interference of subsidies.

Subsidized below-cost sales also create other inefficiencies, even in the short term. They make inefficient use of resources. The subsidized firm doesn’t have to conserve scarce inputs (such as oil or copper) or cut costs because it knows it can rely on government subsidies to take up the slack.

Below-cost sales also cause buyers to overuse the cheap product, which would cost more if not subsidized. In so doing, buyers overuse all the commodities and specialized labor used to make the subsidized product. Thus subsidized below-cost sales ripple through the entire economy, causing distortions and waste in the markets for all relevant materials, labor and even land.

Finally, selling below cost is just another way to avoid real competition, which is the driving force of free markets. Subsidizing below-cost sales says, in effect, “This market is mine! Don’t enter no matter how good you are, no matter how efficient your operations or how attractive your products. We will lower our prices by hook or by crook, and you can’t win.” That, of course, is not free-market economics.

Below-cost selling is hard to detect and identify. The economic theory under which we outlaw selling below cost is sound. So are the laws long on our books that outlaw the practice. So are the rules of the WTO. But identifying selling below cost is not easy.

Below-cost selling is not like a tariff. Tariffs are open charges applied to foreign goods but not to the same goods of domestic manufacture. Where they exist, governments advertise them, in part to discourage foreign competition.

But governments try to hide below-cost selling by their own firms and the subsidies that make it possible. They hide their subsidies in such things as tax relief, land concessions, or labor laws, i.e., concessions to workers.

Governments can can hide a subsidy in virtually anything that businesses rely on, from the price of electricity to insurance against fire and casualty. In socialist or formerly socialist systems like China, where state enterprises sell inputs like electric power, it’s easy to hide subsidies in non-market or special prices for such inputs. The state subsidizes below-cost production by charging below-cost rates for inputs used in production.

So it’s much harder to detect and identify selling below cost than to spot tariffs. Maybe that’s why the practice has been resurging lately. And that’s definitely why disputes about below-cost sales are often drawn-out affairs requiring lots of lawyering.

Two types of legal proceedings address below-cost selling. First, a private firm here at home can bring a case before the US International Trade Commission (USITC), claiming injury from that practice. In order to prevail, it must prove that some importer is selling goods in this country below cost. It must also prove that those sales are injuring a domestic industry in which it competes. Then the President, who governs foreign policy, must agree.

Only after all these hurdles are passed can the USITC impose so-called “countervailing duties” on the imported products. These duties neutralize the illegal subsidies and drive the products’ final prices above the cost of producing them.

If successful, these USITC proceedings produce something that may look like a tariff. The countervailing duties increase the domestic prices of the imported items above their unfair imported prices.

But although countervailing duties act like tariffs, they are not tariffs. Their sole purpose is to counteract selling below cost. They seek not to protect inefficient domestic firms from global competition, but to protect efficient domestic firms from being driven out of business by unfair foreign subsidies.

Nevertheless, because countervailing duties resemble tariffs, they are legitimate causes for trading partners’ concern. If trading partners think countervailing duties themselves are improper or unfair, they can complain to a dispute-resolution panel in the World Trade Organization.

There the complaining party is an aggrieved state, not a private business. There the state can claim that the countervailing duty is in error and is really an illegal tariff in disguise. If it wins its case, the complaining state can gain the legal right to impose countervailing tariffs or other import restrictions of its own, in retaliation for the improper countervailing duties.

States aggrieved by unfair subsidies can also take action before the WTO, claiming the right to impose import barriers to domestic sales below cost. Those barriers can take the form of countervailing duties, quotas, or even exclusion of unfairly subsidized imports. In other words, a state (such as our own US) can seek the legal right, in proceedings before the WTO, to impose countervailing duties or other import barriers against below-cost sales, despite the WTO rules that outlaw tariffs generally.

The modern WTO is hardly an ancient body. Its existence dates to 1996, only sixteen years ago. Yet its laws and procedures, recognized in international treaties, reflect the current global consensus on free trade.

Free trade is good, the WTO Agreements say. Anything that undermines free trade is bad. And states that are victims of bad practices have the right—in special exceptions to the general rule of free trade—to retaliate with their own trade sanctions.

So below-cost selling is not only illegal in the United States, where it has been so for over a century. It is also illegal worldwide. A private firm can use USITC proceedings to make a case in the United States, using the leverage of our huge market to get foreign firms’ and foreign states’ attention. A foreign firm can contest the claim of below-cost selling before the USITC or, through its state as claimant, before the WTO. In both tribunals, cases turn on a basic factual question: were the sales of imports really below cost?

These are not easy cases for either party. They are especially hard when they involve sales emanating from states like Russia or China, which only recently adopted free-market economics. The claimant has to show that selling prices are below the seller’s costs, and the seller can show real (unsubsidized) costs that the claimant missed.

The claimant’s task is usually harder because the seller usually has all the information. As a result, the court or tribunal sometimes relies on “constructed” costs, or costs inferred from general market prices for materials, labor, etc. But however hard applying it may be, the prohibition against selling below cost remains vital for free markets in international trade.

Conclusion. Outlawing below-cost selling is not protectionism. If we can prove below-cost selling, the WTO Agreements, which 155 nations have signed, allow us to impose so-called countervailing duties on imported products in order to neutralize the effect of the unfair and economically inefficient subsidies.

Those duties may resemble tariffs in effect. But they are not tariffs in substance. They do not say, “Don’t bring your products in because we will tax them until they are uncompetitive.” Instead, they say, “Don’t bring in artificially cheap products, expecting to kill free-market competition here, because we’ll tax them just enough to neutralize the unfair price advantage of your subsidy.” The sole (and legitimate) purpose of these countervailing duties is to prevent unfair subsidies from distorting free markets at home and abroad.

In this country, that’s the same goal that antitrust law has had for more than a century. We Yanks believe the rule prohibiting selling below cost to be economically sound, and we obey it ourselves. So in applying that rule to products from China (or anywhere else), we are doing nothing more than following the Golden Rule, treating others as we treat ourselves.

Mohamed Mursi, Elected President of Egypt

Egypt’s election commission announced the results of its presidential election today. Mohamed Mursi, the Muslim Brotherhood’s candidate, won by 51.7 percent to 48.3 percent.

As far as anyone can tell from abroad, the election was free and fair. It certainly wasn’t manipulated by the Army, which put up its own token candidate after dissolving the Islamist-dominated Parliament, who lost.

So Mr. Mursi has the distinction of being the first truly democratic elected leader of one of the world’s oldest nations. In five millennia, he’s unique. That simple accomplishment ought to make everyone inside and outside of Egypt take a deep breath and cut him some slack.

There is no reason to suspect that the Army falsified the results. If it had, it would have cut down Mursi’s margin of victory. So Mursi self-evidently commanded the allegiance of a majority of Egyptian voters. How he uses their mandate only time will tell.

The future of Egypt’s new and fragile democracy is unclear. But one thing is certain. The word “Muslim” in the name of Mursi’s political party will produce an epidemic of Islamophobia among ignorant people in the US and EU.

Western powers cannot afford to indulge or even tolerate that outpouring of mindless fear and hate. If France, a Catholic nation, were emerging peacefully from decades or centuries of tyranny, should we quake to find its leading political party with the word “Christian” in its name? Should we fear Germany’s Christian Democratic Union, its leading center-right party?

Of course not. Just so, we should wait and see what the Muslim Brotherhood does with its long-awaited and legitimate electoral mandate. In particular, we should wait and see whether religion or much-needed economic progress becomes its chief practical goal. In the meantime, there are three very practical reasons to hope for and expect the best.

First, the secular and still powerful Egyptian Army stands ready to do everything and anything necessary to suppress extremism in domestic or foreign policy. The main risk now is not that it will do too little but that it may interfere too much. (The army may already have done too much, too soon, in dissolving the Egyptian parliament and commandeering constitutional reform.)

The precedent of Turkey is clear and compelling. A strong, secular and self-restrained army can moderate extremism. It can eventually allow Islam to take its appropriate place in a majority Islamic society while preserving democracy and minority rights.

The balance between military and civilian authority will be delicate and at times precarious, as it has been in Turkey since the death of its great leader Kemal Atatürk in 1938. But Turkey today works and works well. There is no reason that Egypt—the world’s most populous Arab nation—cannot work every bit as well. The world and Egypt’s people must provide the time, space and support that Egypt’s first-ever real democracy deserves.

The second reason why the world (and especially the US) should be supportive of the new regime is the Muslim Brotherhood’s history. That movement has indeed produced extremists, including Al Qaeda Central’s Ayman al-Zawahiri, the only surviving member of the late bin Laden’s original crew. These men made a career and political platform of blowing innocent people up.

But people who see the entire Brotherhood as a group of unredeemed terrorists are missing some important points of fact. Under the draconian Mubarak tyranny, all the bad terrorists long ago fled Egypt to carry their quixotic and doomed “armed struggle” against the West abroad. The few who remained were jailed or executed. The rest of the Brotherhood inside Egypt went underground to form a political party and work quietly for peaceful change.

When the Arab Spring came to Egypt, it took the Brotherhood by surprise. At first the Brotherhood was reluctant to accept it or participate in it, fearing a trap or a false dawn.

But the Brotherhood was the only thing in Egypt remotely resembling a political party. And so it eventually joined the Tahrir Square Revolution, as it had to do.

Once it joined, the Brotherhood’s initial success was foreordained. It had worked quietly to organize Egypt’s people against tyranny for decades, with its leaders constantly under threat of jail, torture and execution. So naturally it had a leg up in organization, leadership and popular support. But the Mubarak regime’s repression undoubtedly taught it caution and moderation.

How much of those lessons remain will be a key factor in the Brotherhood’s success in real politics. The party’s leaders, who are not stupid, must know that.

The third and final reason to respect Egyptians’ choice and work and hope for the best is Mursi himself. As usual, Western media seem to know little about him. They should learn fast. But they all describe him as a US-trained engineer.

That fact alone is important, maybe vital. Mursi is not an imam or religious leader. He’s an engineer, trained in our own country. By training and inclination he’s a builder and a practical man. Engineering didn’t choose him; he chose it. He won the election in part just by being the non-army candidate. But he also won in part by reaching out to the center, as any leader of a diverse society undergoing rapid change must do.

Mursi has a hard road ahead of him. He has to work with the army and convince it—and Egypt’s dissenting voters—that he’s not a fanatic. He has to push for new parliamentary elections and prepare his party for them while at the same time tolerating and even nurturing legitimate opposition parties and non-army candidates (unlike his octogenarian rival for the presidency, Shafik). He has to show the generals and skeptical secular Egyptians that he and his party are ready to govern all of Egypt for the benefit of all. And he has to do all this without alienating or disappointing his party’s members, who have waited decades for freedom and are now impatient. Most of all, he has to show all of Egypt’s people that the Revolution is real and can make their lives better.

None of this will be easy. But who can do it better than Mursi? Who is leader of the only organization resembling a genuine political party in Egypt’s long and tortured history? Who managed to prevail in a free and fair election in the aftermath of a popular revolution that was utterly disorganized and chaotic, but peaceful? Who is trained as a builder and maker, not an ivory-tower religious thinker?

No one can predict the future. But my money is on the engineer to succeed.

And succeed he must. Just think of F. W. de Klerk and Nelson Mandela in South Africa. Like apartheid South Africa, Egypt cannot afford to let Mursi fail. Nor can the world. For there is no guarantee nor any present prospect of a second chance.

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