Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

International Trade
References
Anderton, Alain. Economics Fifth Edition. Pearson Education, Edinburgh Gate, Harlow, Essex, 2008. Chapter 89 page 613 Blink, Jocelyn and Ian Dorton. Economics l Course Companion. Oxford: Oxford University Press, 2007. Chapter 23 McGee, Matt. Economics - In Terms of the good, the Bad and the Economist. Victoria: IBID Press, 2004. Chapter 4 page 462 Sloman, John. Essentials of Economics. Harlow: Pearson Education Limited, 2001. Chapter 11 & 12 page 395

Why do countries trade?

International trade: Exchange of goods and services between countries I. Gains from trade: 1. Lower prices Main goal of trade: ability to buy goods & services at a lower price than the domestic ones o Consumers buy less expensive products o Producers purchase less expensive raw materials and semimanufactured goods Causes of lower price: o Access to natural resources o Differences in the quality of the labor forces o Differences in the quality of capital o Levels of technology o Mainly determined by the concept of comparative advantage 2. Greater choice / variety: Consumers have greater choice and have access not just to domestically produced products 3. Differences in resources: Some countries lack of some resources To imports commodities they lack, they will need to export goods or services o Earn foreign currency and so buy the required resources Singapore has to import water

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Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

4. Economies of scale: Producing for international market + domestic market = size of market & demand will INCREASE o Increased level of production scope for economies of scale to be achieved & production become more efficient o Larger production units Specialization Division of labor Countries specialize in the production of certain commodities (chemicals) cost benefits to be gained from acquiring experience & expertise o Moving down the learning curve (long-run average cost curve) International trade a countrys export industries to become more efficient in the LONG RUN o Producers: more competitive o Reduction in LONG RUN average costs 5. Increased competition: Domestic firms compete with foreign firms o Greater efficiency o Consumers: offered less expensive goods & services o Quality and variety of goods increase 6. Specialization: Individual or firm or country concentrates production on one or a few goods and services Production of goods efficiently (at a low cost) A country specializes in producing something and thus can produce more of these, and exchange (trade) some of them for other goods produced more efficiently in another country Factor endowments: o factors of production that a country is endowed with or possesses o countries can take advantages of differences in factor endowments Each country has different: Quantities of resources Quality of resources Geographical locations types and level of technology Greece shipping services Switzerland high quality of watches and clocks

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Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

7. Interconnected countries Advantages: o Eliminate possibility of future wars EEC (European Economic Community) in 1957 EU Disadvantages: o If countries become too dependent, any problems that a country faces might as well affect the other country within the connections 8. Major contribution to the countrys economic growth specialization, economies of scale, greater efficiencies, acquisition of needed resources, increased competition, technological advances and expanding markets domestic output economic growth export import (raw materials and capital equipment) = economic growth

Absolute & Comparative Advantages

1. Absolute advantages (Adam Smith) a. Produce goods using fewer resources than another country Country Indonesia France Total Wine 14 France 8 2 Indonesia 1 0 1 5 12 20 Wine Rice 2 12 8 5 10 17

b. Indonesia: absolute advantage in rice specialization maximize c. France: absolute advantage in wine specialization maximize i. With trading and specialization: Country Indonesia France Total Wine 1 14 15 Rice 20 1 21

d. Reciprocal absolute advantage = Each country has an absolute advantage in the production of one product

Rice

Before free trade, France produces at and Indonesia at After specialization, France & Indonesia: Both countries trade and specialize: new PPC

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Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

2. Comparative advantage (David Ricardo) a. Produce the goods / services at a lower opportunity cost than another country (sacrifice less) i. Country A has to give up fewer units of other goods to produce the good in question than does country B 1. David Ricardo Coals OC of coals Oil OC of oil Arabia 1 2 of oils 3 of coals Australia 3 4 4 Calculation: Arabia: OC coals = =2 OC oils Coals 4 = =

3 a 2

Australia

Arabia 1 0 1 2 3 b 4 Oil

ii. Arabia has lower OC in oils and thus has to specialize in production of oil as Arabia sacrifice less 1. Leads to lower costs & more efficient 2. GLOBAL allocation of resources a. Production by less efficient production is and replaced by more efficient producers Comp. advantage for the more efficient producer (Australia) the greatest distant (a): coals production Comp. advantage for the less efficient producer (Arabia) the short distant (b): oil production The theory of comparative advantage will work for countries that have different opportunity costs

Limitations:
1. Perfect knowledge and aware of where the least expensive goods may be purchased 2. No transport cost. In reality, it is not true. The existence of transport cost erode a countrys comparative advantage not making international trade worthwhile eliminate competitiveness 3. Assumed that 2 economies producing 2 goods. 4. Assumed that costs do not change & returns to scale are constant 5. Goods being traded are identical (Toshiba Phillips) 6. Factors of production remained in the country 7. Free trade among countries 8. Perfect competition 9. Full employment 10. Imports and exports balance each other 11. Trade on the basis comparative advantage may lead to excessive specialization Page 4 of 10

Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

Free trade & Protectionism

Terms to know Free trade Protectionism Definition The absence of government intervention of any kind in international trade When government intervenes in international trade through the imposition of trade restrictions (barriers) to protect the domestic economy from foreign competition When a country become too dependent on factors beyond its control because the country overspecialize in certain goods/services Selling a good in international markets at a price that is below cost of producing it Customs duties are taxes on imported goods Payments per unit of output granted by the government to domestic firms that compete with imports Legal limit to the quantity of a good that can be imported over a particular time period (usually a year) Voluntary restrictions on exports by exporting countries that have been requested by importing countries (developed countries) Imports > exports The loss of total (consumer & producer) surplus due to a higher price or lower quantity than those that would be determined in a free, competitive market Change involving greater variety (goods & services) (developing countries) Example ASEAN , EU CAP (Common Agricultural Policy) in the EU; tariffs, subsidy and quota Middle East oil

Over-specialization

Dumping Tariffs Subsidy (production subsidy) Quota

US and China Indonesias tariffs on goods (rice) Subsidy to cotton industries in Indonesia, CAP in EU Quota on agricultural goods in Indonesia EU restricts imports of textiles, steel, electronics

Voluntary export restraints (VERs) Balance of payments deficit Dead-weight loss of payment

Outcomes of subsidy and other forms of protectionism Cuba sugar Ecuador bananas

Diversification

I. Arguments: a. FOR FREE TRADE (against protectionism) a. Protectionism may the price to consumers and producers b. Free trade leads to more variety of choices c. Without competition from foreign producers, domestic firms have no incentive to minimize cost or to innovate d. Protectionism distorts comparative advantage inefficient use of the resources e. If countries can specialize economies of scale efficiency lower cost

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Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

b. FOR PROTECTIONISM (against free trade)

Qualified arguments For Infant (sunrise) industry Hasnt had time to establish economies of scale Cannot compete with foreign countries more likely to go out of business Developing countries Qualification: gov. will take the tariff back once domestic firms are able to establish itself & reach economies of scale (temporary) Strategic trade policy (special case of infant industry) Common for HIGH-TECH industries Goods that are important for the future of the economy Japan semi-conductor Diversification Increasing the variety of products (opposite of specialization) Developing countries highly specialized in certain product employment, advanced tech, highly skilled labor National Defence Aircraft, weapons, chemicals should be protected

!
Against Too much tariffs protection firms will be less efficient

Hard to identify industries All countries do this distorts comparative advantage Fluctuations in global D&S Fall in export economic decline Can be used by industries that have Indirect use in defense

Arguments FOR PROTECTIONISM

Incorrect arguments Wage protection Questionable arguments For Source of gov revenue Developing countries that have larger portion of tariffs in gov revenue Tariffs = regressive type of tax Overcome balance of payments deficit Forcing domestic consumption Anti-dumping Selling lower than the cost (international market) Protection of domestic employment Unemployment falls Against Worsen the distribution of income

?
-

Retaliation worsening balance of payments Difficult to prove Retaliation

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Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

Tariffs
Customs duties = taxes on imported goods o Protective tariff = Protect domestic industries from foreign competition o Revenue tariff = raise revenue for government Sd = domestic supply Price Pd Pw + t Pw

a g

b c d h Q1 i Q2

e j

f k Q3 Q4

Pw + tariff World price = world supply curve Dd = domestic demand Quantity

Imports with tariff Imports without tariff In free trade: The country accepts the world price (Pw) supply Q1 Demand Q4 o Imports: Q4 Q1 Tariff is imposed: (Outcomes) Price rises to Pw + t o Supply Q2 o Demand Q3 o Imports Q3 Q2 Domestic producers revenue g g + a + b + c + h Foreign producers revenue h + i + l + k i + j Global Gov revenue = d + c Dead-weight loss of welfare Q1 Q2 produced by inefficient domestic producers Stakeholders Winner Loser Why? Prices increase Domestic consumers Less competition Domestic producers More jobs offered Domestic employment Less variety, high prices Domestic society High revenue Government Less demand, high cost of production Foreign producers Misallocation of resources (inefficiencies), dead-weight loss of welfare Example: Government put tariff on agricultural products to prevent excess imports (rice)

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Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

Subsidy
Payments per unit of output granted by the government to domestic firms that compete with imports 2 kinds of subsidy: o Production subsidy: domestic firms that compete with foreign industries o Export subsidy: domestic firms that exports

In free trade: Domestic supply curve is Sd Supply Q1 (intersection of s curve and world price) Demand Q2 o Imports: Q2 Q1 Subsidy is granted: (Outcomes) Lower down the cost downward shift of supply curve (Sd + subsidy) No price change consumption is still the same Domestic producers revenue a a + e + f + g + b Foreign producers revenue b + c + d = c + d Subsidy paid by gov.: e + f + g Foreign MINIMUM revenue box b domestic MINIMUM foreign b + g , and therefore g is the inefficiency (Dead-weight loss of welfare) Stakeholders Winner Loser Why? Expanding firms more employment Domestic employment More revenue production expand Domestic producers Part of tax is for inefficient producers Domestic consumers Encouraging inefficient domestic prod Domestic society Opportunity cost of granting subsidy Government Less export revenue Foreign producers Dead-weight loss of welfare Global Example: Common Agricultural Policy (CAP) in the EU (see presentation) Page 8 of 10

Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

Quota
Import quota: legal limit to the quantity of a good that can be imported over a particular time period (usually a year)

In free trade: Supply: Q1 Demand: Q4 Imports: Q4 Q1 Quota is imposed: (outcomes) Domestic production Q1 Q2 Imports Q4 Q1 Q3 Q2 Price Pw Pq ; Demand Q4 Q3 Gov. or importers gain quota revenue = ( Pw Pq ) x Q of imports o Gov issues import licenses Consumer surplus: o Before quota: a + b + c + d + e + f o After quota: a + b Producer surplus: o Before quota: g o After quota: g + c Quota revenue: e Dead weight loss of welfare: d (inefficiencies in production) and f (reduced consumption) Stakeholders Winner Loser Why? Firms expand more employment Domestic employment Receive higher revenue & produce Q Domestic producers Pay higher price & can only buy Q Domestic consumers consumption & inefficient producers Domestic society Receive quota revenue Government Less export = export revenue Foreign producers Global misallocation of resources Global Example: Government impose quota on imported rice from India Page 9 of 10

Economics HL Grade 11 International Trade

Jane Michelle Julius Submission date: 31st August 2011

Voluntary Export Restraints (VERs)

Restrictions on export by exporting countries that have been requested by importing countries o Threats: if the exporter do not restrict the quantity of their exports, the importing countries will impose stronger imports restrictions that will be more damaging than export restriction EU restricts imports of textiles, steel, electronics WTO bans VERs Same effects as quotas

Administrative Regulations
Increasing the amount of red-tape checks and procedures) time consuming and difficult Importing countries may impose requirements that the exporting countries do not fulfill (packaging, manual books, etc) reduce the imports quantities

Health, safety and environmental standards

Imposing requirements that involves health, safety, and environmental conditions Time consuming reduce the quantity of imports

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