The Effects of Terrorism on Trade: A Factor Supply Approach

T his article reconsiders the effects of terrorism on trade. The conventional wisdom is that trade with a nation affected by terrorism involves higher risks. The consequent rise in the transaction costs is akin to a rise in transportation costs, which tend to reduce trade. Based on such an argument, Nitsch and Schumacher (2004) and Blomberg and Hess (2006) find evidence that terrorism indeed tends to depress a nation’s trade. However, terrorism not only affects transaction costs for a trading nation, but also can deplete a nation’s supply of scarce productive factors. This depletion may result from terrorist groups drawing the nation’s radicalized elements into terrorism activities or terrorist groups directing attacks on the nation’s people or productive capital. Negative impacts on the economy may also stem from foreign investors being dissuaded from investing because of potential terrorist activities. The literature in this area has already documented these effects,1 but there has been no analysis of how these factor supply effects may influence the pattern of trade. This is an important gap because once factor supply effects are considered, the predictions of how terrorism may affect trade may be reversed.2 When terrorism affects a nation’s factor supplies, its production possibility frontier will shift and The conventional view of terrorism is that it raises risks and, as a result, reduces trade. The authors use a factor supply approach to show that this hypothesis is not necessarily correct. They use a twogood, two-factor, small open economy model to show that terrorism can either reduce or raise trade depending on critical factors, such as the impact of terrorism on the intensive factor of the export or the import sector. They then extend the analysis to models with several goods and factors and identify conditions under which trade may rise or fall with a greater incidence of terrorism. Finally, they provide an analysis of the effects of terrorism on trade in the presence of an optimal counterterrorism policy. The authors find that a nation’s adjustment of its counterterrorism level in response to a greater terrorist threat may moderate the impact of terrorism on trade. (JEL F11, F52, H56)