International Trade
1) Importing goods that we could not produce ourselves
2) Importing goods that other countries could produce more efficiently (inter-industry)
3) Importing varieties of goods that other countries produce better (intra-industry)
Benefits of Specialization:
1) Makes use of natural endowments
2) Reaps economies of scale- provides adequate demand for countries with small domestic markets
3) Time factor, production becomes better as more of it is done. “Learn by Doing”
4) Enjoy a greater variety of goods for consumption (inter-industry) and greater product differentiation within a category of goods (intra-industry)
5) *Increased competition puts more pressure on firms to be efficient
Absolute Advantage: A country has an absolute advantage over another in the production of a good if it can produce it with fewer resources than the other country”
It may be reflected in a larger output for a given quantity of inputs or fewer inputs for a given output. Only a small amount of world trade is based on absolute advantage including the diamond trade in South Africa or Saudi Arabia’s Oil.
Comparative Advantage: “A country has a comparative advantage over another country if the production of a good it can produce it at a lower opportunity cost.
Assumptions: 2 countries, 2 products, constant returns (i.e. PPC is a straight line), no transport costs, no government restrictions
Example: Australia has 125 Workers, China has 500 Workers
In Australia 1 worker can produce 4 kilos of rice or 8 bottles of wine a day
In China 1 worker can produce 2 kilos of rice or 1 bottle of wine a day
Australia / 250 / + / 500
China / 500 / + / 250
World Output / 750 / + / 750
Rice (kg) / Bottles of Wine
Australia / 0 / + / 1000
China / 1000 / + / 0
World Output / 1000 / + / 1000
Gain from trade is 250 kg of Rice and 250 Bottles of wine. The Rate of exchange for rice against wine must lie somewhere between the opp. cost ratio of the two countries. i.e. 1 wine to 0.5 to 2 kilos of rice. If we assume 1 wine trades for 1kg of rice, then the gain is split equally. However, if the richer and more powerful country may negotiate a more advantageous rate of exchange
Limitations to Theory:
1) Theory assumes constant returns, i.e. PPC is a straight line. In the real world most countries face increasing costs (diminishing returns) i.e. PPC will curve outward. This limits the degree of specialization but does not underminet he principle
2) Transport costs may wipe out any potential gain from trade
3) Instead of trading goods, factors may move between countries (globalization)
4) Theory is static, ignoring the dynamic element. Countries may decide what goods they want to acquire advantages in, rather than focusing on what they currently do best, e.g. China deciding to go into key sectors. This is an important criticism. CA is a theory of supply, but ignores the demand side.
5) Governments may restrict trade
Terms of Trade:
ToT is the amount of exports that must be given up to acquire a given quantity of imports. Usually expressed in monetary terms, being the ratio of export prices to import prices.
ToT = Index of Export Prices/Index of Import Prices * 100
Increases in ToT are improvements in the Tot and when ToT decreases it is known to have worsened.
ToT will alter if there are changes in the :
1) Relative price in imports and exports
2) Forex Rate – appreciation causes the ToT to improve, and vice versa
Impacts:
i. Improvement is good if the world’s demand for your exports is growing and export prices are rising, especially if world demand for your exports is inelastic.
ii. Improvement is bad if domestic Aggregate Supply is falling, i.e. high inflation, and if demand for exports is elastic.
iii. Worsening is good if it arises from an increase in Aggregate Supply, based on increased efficiency and productivity, especially if demand for exports is elastic.
iv. Worsening is bad if it arises from a lack of demand for your exports, especially if demand for those exports is inelastic .e.g Zambia Copper Piping
*Developed countries have been able to dictate favourable ToT so that gains from trade flow in their direction. ToT may have actually worsened for developing countries as they specialize in primary products (commodities), and have a low Y-ed. Supply grows with improved technology and in some cases they are replaced with synthetics, so their relative price falls. Moreover, developed countries tend to also protect their own agricultural sectors
Other Gains from Trade:
1) Decreasing Costs and ability to capitalize on EOS (esp for small domestic markets), MES
2) Differences in Tastes – greater variety in the domestic market
3) Increased Competition AND 4) Non Economic Advantages – Social, Cultural, Political.
Free Trade and Protectionism
Protectionism – “situations where countries are trying to protect their domestic industries from competition from overseas, it has expanded to cover any restriction on imports”
1) Tariffs: Customs Duties (ad valorem taxes) on imported goods, designed to raise the price of imports and thus discouraging them and encouraging domestic production. Success of this strategy still depends on P-Ed.
2) Quotas: Limit a quantity of a specific good allowed into the country, restricting entry of goods with an inelastic demand. E.g. Voluntary Export Restrictions. E.g. Japanese Cars in 1980s. This may result in more expensive cars flowing into the US (or any other) market
3) Non-Tariff Barriers: anything that make it difficult for goods to flow into the country. Licenses, Quotas, VERs, Embargoes, Standards, Local Content Requirements, Health Regulations. E.g. French Ski’s, British vs German Beer, Poitiers VCRs.
4) Exchange Controls: a country may limit the amount of foreign currency that can be purchased
5) Subsidies: Import subsidies makes domestic goods cheaper, or on exported goods. The latter may be seen as “dumping(selling goods at below cost)”, with a view to wipe out foreign producer before raising prices.
6) Procurement Policies: Governments may choose to only buy from domestic suppliers
7) Others: Import Licencing, Embargoes, Export Taxes, Import Deposit Schemes
Fallacious Arguments:
1) Cheap Foreign Labour – China can produce anything cheaper than the US. Not true because US has a comparative advantage in capital intensive or skill intensive goods.
2) Reduce Unemployment – might maintain jobs in what you could have imported cheaper, at the expense of destroying jobs in those goods you should be exporting. Competitive devaluations
3) Imports are a leakage – by buying foreign goods we create the income for them to buy what we are good at producing
Not So Fallacious Arguments:
1) Infant Industry – import substitution as new industries in developing countries may need some support before they can become internationally competitive. OR – senile industries, which may need protection to die gracefully. OR – ailing industries which can recover
2) Anti-Dumping – self explanatory. But how to differentiate between price differentiation and dumping?
3) Balance of Payments – tariff may be used to correct a BoP deficit
4) Revenue – Tariffs may generate revenue
5) Diversification – Tariffs may allow a country to avoid “putting all its eggs in one basket”
6) Demerit Goods
7) Optimum tariffs – If you have a monopsony in buying from the world (US), then applying a tariff may achieve social efficiency, ensuring MSC = MSB, improve efficiency of resource allocation by eliminating welfare loss.
8) Strategic Trade Theory – Lester Thurow, managed trade is preferable to free trade, as if other countries are cheating, there may be winner takes all gains.
9) Self Sufficiency – Agriculture, Steel, Power, Arms
10) Politics – sanctions
11) Traditional Way of Life – Japanese Rice Farmers
12) Human Rights – protecting fair trade and labour
Burden on Tariff:
Harberger Triangles – Welfare Loss Triangles
Other Costs of Protectionism:
1) Second Best – are tariffs the best way of addressing the issue, or are there better alternatives? E.g. retraining for declining industries
2) Retaliation – imposing tariffs on your country’s exports
3) Protects inefficiency
4) Bureaucracy and Corruption – DUP activity and waste of resources.
Economic Cooperation:
1) Free Trade Area – Countries have no tariffs between members. E.g. NAFTA or proposed AFTA.
2) Customs Union – this is a free trade union but involves harmonization of economic policies such as a Common External Tariff. E.g. EU before Maastricht Treaty in 1992
3) Common Market/Economic Union – harmonisation goes much further, similar taxes, employment regulation, free movement of labour and capital, a common currency.
Trade Creation – arises where a country joins a union and trades in goods with a partner, previously these goods were not traded at all, this is good as it presumably leads to production shifting to a lower cost producer.
Trade Diversion – this arises when a country joins a union and now buys from another member of the union instead of a country that is not part of the union. This is bad as it diverts trade from the lower cost producer to the higher cost producer inside the union.
Pattern of Trade:
World trade was virtually destroyed by the great depression, but has grown enormously since 1950s at around 7.5% p.a. in 1962 Tinbergen suggested a gravity model of trade, where trade is a function of the mass and distance between two countries.
Balance of Payments
A record of a country’s transactions with the rest of the world, inflows being recorded as credit and outflows being recorded as debit.
1. Current Account – Visible Trade, Invisible Trade (Services) [BoT] + Factor Incomes [Dividends, Interest, Profits] and Transfers
2. Capital Account – Direct Investment, Portfolio Investment, Financial Derivatives and Other Investment (loans)
3. Net Errors and Omissions
4. Overall Balance – Surplus or Deficit
5. Official Reserves – Addition as a negative figure, Subtraction as a positive figure
Balance of Payments must always balance, hence the Overall Balance and the Official Reserves must be zero.
BoP Deficit and Surpluses
Can be caused by a deficit/surplus in either the Current A/C or the Financial A/C or both, an overall surplus or deficit can only apply under a fixed exchange regime (as it will be eliminated by the appreciation/depreciation of any floating regime)
a) The Current A/C reflects current trends in demand and supply of goods and services between countries. A deficit implies a S>D whereas a surplus implies D>S. Affected by
- Terms of Trade (overall prices) due to supply or demand side factors
- Changes in the forex rates
- Rate of growth of domestic Income relative to the world’s rate of growth
- Trends in flows of investment income and transfers
b) The Financial Account can be split into Short Run and Long Run Flows
- In the short run, “hot money” flows according to current interest rates, changes in the i/r can cause an inflow or outflow (given that currency will remain stable, if it is likely to depreciate then no amount of i/r increase will attract hot money)
- In the long run, capital flows depend on political factors, government policy, global opinion and structural changes e.g. the cost of labour and availability of resources etc
Effects
Whether a surplus or deficit is negative or positive depends on the stage of development of a country and the cause of the surplus or deficit. (Typically developing countries will have a deficit on the Current A/C and a surplus on the Capital A/C, and the converse is true for developed countries)
Internal Effects:
a) Prices, output and employment: a surplus can create jobs to meet export orders and boost output, but may lead to inflation if it generates excess demand
b) Money supply: if there is a fixed exchange rate, then the MS will rise with a BoP surplus, and fall with a deficit, and hence,
c) A surplus will add to the foreign reserves and a deficit will run down reserves
External Effects:
a) A surplus/deficit may bring about a revaluation or devaluation, but this is asymmetric as additions to reserve can be built up indefinitely, but too many deficits and foreign reserves will be run down.
b) Terms of Trade – a surplus will cause the Terms of Trade to improve, whereas a deficit may cause it to worsen
Circular relationship between Forex rates, the ToT and the BoP. Each affects the other until equilibrium is restored.
E.g. If Forex rate rises above equilibrium, then the Terms of Trade will improve, and the BoP will produce a deficit
Policies
Note: External balance occurs when the inflow equals the outflow of currency at current exchange rates such that there is no change in reserves or exchange rate. Long term external imbalance is regarded as Fundamental Disequilibria. Deficits is a larger problem, and may lead to running down of reserves or a depreciation of the currency, which may undermine confidence in the economy. The following policies are designed to eliminate a deficit
Expenditure Dampening:
Excess Demand domestically may cause M>X, hence producing a deficits. Thus, either Monetary or Fiscal policy can be used to dampen domestic demand through deflationary policy.
a) It allows the government to maintain a fixed exchange rate
b) It avoids the use of import controls, thus avoiding international disapproval
c) It is not prone to retaliation
Domestic policy is hence directed to external policy, deflation might cause unemployment, fall in growth and bankruptcies, internal economy is subject to external balance
Expenditure Switching:
Focuses on increasing exports and reducing imports, there are two options:
a) Devaluation/depreciation under a fixed/floating exchange rates. This will improve BoP as long as the Marshall-Lerner Criterion is satisfied. (Price Elasticity of Demand for Imports and Exports together is greater than one). In the short run demand may be fairly inelastic and supply may not be able to adjust, so a J-curve may emerge before Current A/C gets better.