Trade

Trade and Exchange between Nations In this section we consider some of the theory of free trade and then analyse and evaluate the arguments for and against import protectionist policies. If there were an Economists Creed, it would surely contain the affirmations I believe in the Principle of Comparative Advantage and I believe in Free Trade. Paul Krugman, Professor of Economics at MIT, Cambridge The concept of comparative advantage First introduced by David Ricardo in 1817, comparative advantage exists when a country has a margin of superiority in the production of a good or service i.e. where the marginal cost of production is lower. Countries will usually specialise in and export products, which use intensively the factors inputs, which they are most abundantly endowed. If each country specialises where they have an advantage, then total output can be increased leading to an improvement in allocative efficiency and welfare. Trade allows each country to specialise in the production of those products that it can produce most efficiently (i.e. those where it has a comparative advantage). This is true even if one nation has an absolute advantage over another country. So for example the Canadian economy which is rich in low cost land is able to exploit this by specialising in agricultural production. The dynamic Asian economies including China have focused their resources in exporting low-cost manufactured goods which take advantage of much lower unit labour costs. In highly developed countries, the comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and highknowledge services. Comparative advantage for the UK Using trade data drawn from our balance of payments with other countries, the UKs comparative advantage now lies in the following areas: chemicals & pharmaceuticals, aerospace and medical technology, insurance, financial services, computer services & software, other business services, and entertainment and other creative industries. We have lost much if not all of our comparative advantage in textiles, steel, coal and many other areas of manufacturing industry. Worked example of comparative advantage Consider two countries producing two products digital cameras and vacuum cleaners. With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below.
PRE-SPECIALISATION UK United States Total DIGITAL CAMERAS 600 2400 3000 VACUUM CLEANERS 600 1000 1600

Working out the comparative advantage To identify which country should specialise in a particular product we consider the internal opportunity costs for each country. For example, were the UK to shift resources into supplying more vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television. For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners.

If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra camera is still one vacuum cleaner. But for the United States the opportunity cost is only 5/12ths of a vacuum cleaner. Thus the United States has a comparative advantage in producing digital cameras because its opportunity cost is lowest. Output after Specialisation
UK United States Total DIGITAL CAMERAS 0 (-600) 3360 (+960) 3000 3360 VACUUM CLEANERS 1200 (+600) 600 (-400) 1600 1800

o o o

The UK specializes totally in producing vacuum cleaners doubling its output to 1200 The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners As a result of specialisation according to the principle of comparative advantage, output of both products has increased - representing a gain in economic welfare.

For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. If the two countries trade at a rate of exchange of two digital cameras for one vacuum cleaner, the post-trade position will be as follows: o o The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras The USA exports 840 digital cameras and imports 420 vacuum cleaners

Post trade output / consumption

UK United States Total DIGITAL CAMERAS 840 2520 3360 VACUUM CLEANERS 780 1020 1800

Compared with the pre-specialisation output levels, consumers in both countries now have an increased supply of both goods to choose from. Assumptions behind trade theory This theory of the benefits from trade and exchange based on comparative advantage depends on a number of assumptions: 1. Occupational mobility of factors of production (land, labour, capital) -this means that switching factor resources from one industry to another involves no loss of efficiency and productivity. In reality we know that factors of production are not perfectly mobile labour immobility for example is a root cause of structural unemployment 2. Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the benefits from trade are reduced. Conversely increasing returns to scale means that specialisation brings even greater increases in output. 3. No externalities arising from production and/or consumption no discussion about the overall costs and benefits of specialisation and trade should ignore many of the environmental considerations arising from increased production and trade between countries.

What Determines Comparative Advantage? Comparative advantage is a dynamic concept meaning that it can and does change over time. For a country, the following factors are important in determining the relative costs of production: 1. The quantity and quality of factors of production available 2. Investment in research & development which can drive innovation and invention 3. Fluctuations in the real exchange rate, which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers. 4. Import controls such as tariffs, export subsidies and quotas and other forms of protectionism these can be used to create an artificial comparative advantage for a country's domestic producers. 5. The non-price competitiveness of producers - covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support. Comparative advantage is often a self-reinforcing process. Entrepreneurs in a country develop a new comparative advantage in a product either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets. Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on. The expansion of an industry leads to external economies of scale. Broader benefits of international trade One way of expressing the gains from trade in goods and services between countries is to distinguish between the static gains from trade (i.e. improvements in allocative and productive efficiency) and the dynamic gains (the gains in welfare that occur over time from improved product quality, increased choice and a faster pace of innovative behaviour) Some of the broader gains from free trade are outlined below: 1. Welfare gains: Neo-liberal economists who support the liberalisation of trade between countries believe that trade is a positive-sum game in other words, all counties engaged in open trade and exchange stand to gain. 2. Economies of scale - trade allows firms to exploit scale economies by operating leading to lower average costs of production that can be passed onto consumers. 3. Competition / market contestability trade promotes increased competition particularly for those domestic monopolies that would otherwise face little real competition. 4. Dynamic efficiency gains from innovation - trade enhances consumer choice and stimulates product and process innovations that generates better products for consumers and enhances the overall standard of living. 5. Access to new technology: trade, like investment, is also an important mechanism by which countries can have access to new technologies. 6. Rising living standards and a reduction in poverty - trade can be a powerful force in reducing poverty and raising living standards. A growing body of evidence shows that countries that are more open to trade grow faster over the long run than those that remain closed. And growth directly benefits the world's poor.

The Terms of Trade The terms of trade measures the rate of exchange of one good or service for another when two countries trade with each other. For trade to be mutually beneficial, the terms of trade must lay within the opportunity cost ratios for both countries. We calculate the terms of trade as an index number using the following formula: Terms of Trade Index (ToT) = 100 x Average export price index / Average import price index

If export prices are rising faster than import prices, the terms of trade index will improve. This means that fewer exports have to be given up in exchange for a given volume of imports. If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services. The terms of trade fluctuate in line with changes in export and import prices. Clearly the exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade. What determines the international competitiveness of a country? Competitiveness has been defined as the ability of an economy to compete fairly and successfully in markets for internationally traded goods and services that allows for rising standards of living over time. There are two main aspects of competitiveness: Cost competitiveness differences in unit costs between producers reflected in prices Non-price competitiveness encompasses technical factors such as product quality and performance, choice, after-sales services, marketing, branding and replacement parts In highly competitive markets where prices have often converged, non-price factors can become crucial Drivers of international competitiveness Goldman Sachs Growth Environment Scores (used to build the BRIC hypothesis) use these indicators 1. Macroeconomic Stability (GDP growth, inflation, interest rates) 2. Human Capital the quality of the labour force especially in knowledge industries 3. Political stability e.g. strength of political institutions, rule of law, protection of property rights 4. Technological capabilities ability of people and businesses to innovate, adopt, adapt and exploit new technologies Other indicators might include o o o o Research and development spending and success in being awarded patents Investment in fixed capital including essential infrastructure Productivity growth and unit labour costs Movements in the exchange rate which affects the relative prices of exports and imports

The Pattern of UK Trade In an age of globalisation, it is inevitable that, over time, the pattern of trade in goods and services changes, reflecting shifts in comparative advantage and movements in prices of traded products in international markets. The pattern of trade is also affected by the growth and development of particular countries or regions and by foreign investment decisions of UK and overseas companies. The rapid growth of many emerging market countries is causing pivotal changes in the patterns of global trade and investment; the UK economy is deeply affected by this. Key trade data for the UK (2008) Trade to GDP ratio (2005-2007) 57.6% Share of world exports of goods 3.1% Share of world exports of services 8.3% Pattern of exports of goods * Agricultural products 6.3% * Fuels and mining products 14.8% * Manufactures 74.1% Main export markets: * European Union 57% * United States: 15% * Switzerland: 2% * China: 2% * Japan: 2% Main source of imports: * European Union 55% * USA: 9% * China: 8% * Norway: 5% * Japan: 3% Source: Trade Profile for the UK, World Trade Organisation The majority of UK trade is with twenty-six partner countries in the European Union. There has been a long-term shift in our trade with EU since the UK joined in 1973. The enlargement of the Single Market that has led to trade creation and trade diversion effects has encouraged the growth of trade. The share of UK trade with North American countries has declined, but the United States remains the largest single export market accounting for 15% of UK exports. Trade with oil exporting countries has fallen in relative importance over the last fifteen years In 1979, 10% of UK exports went to oil exporting countries, this has now declined to just over 3% as has the share of imports from these countries. The other significant change in the geographical pattern of trade for the UK is an increasing share of trade with emerging economies in Asia including China, Singapore, Malaysia, South Korea, Taiwan and Thailand and also now with fast-growing countries in the Indian Sub-Continent.

Trade agreements in the international economy o o Trade agreements can involve two countries reducing tariffs on each others goods, or perhaps reducing bureaucracy by simplifying import/export procedures. Trade liberalisation might involve creating free-trade areas. This creates larger markets, greater access to raw materials, and more competition. The happy ending should be lower unit costs, since firms are able to gain economies of scale. From the consumers point of view, lower prices and greater choice should make them happy too.

Growth of Regional Trade Agreements Some of these agreements are simply free-trade agreements that involve a reduction in current tariff and non-tariff import controls so as to liberalise trade in goods and services between countries. The most sophisticated RTAs go beyond traditional trade policy mechanisms, to include regional rules on flows of investment, co-ordination of competition policies, agreements on environmental policies and the free movement of labour. Examples of Regional Trade Agreements: o o o o o o o The European Union (EU) a customs union, a single market and now with a single currency The European Free Trade Area (EFTA) The North American Free Trade Agreement (NAFTA) created in 1994 Mercosur - a customs union between Brazil, Argentina, Uruguay, Paraguay and Venezuela The Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA) The Common Market of Eastern and Southern Africa (COMESA) The South Asian Free Trade Area (SAFTA) created in January 2006 and containing countries such as India and Pakistan

Economic Integration between Countries A free trade area is a loose form of integration where countries simply agree to remove tariff and nontariff barriers between them to promote free trade in goods and services. The North American Free Trade Area (NAFTA) is a good example of this as is the European Free Trade Area (EFTA). ASEAN (Association of South East Nations), the Andean Pact, and Mercosur are other examples.
STAGE OF ECONOMIC INTEGRATION NO INTERNAL TRADE BARRIERS X X X X X X X X X X X X X X X COMMON EXTERNAL TARIFF FACTOR AND ASSET MOBILITY COMMON CURRENCY COMMON ECONOMIC POLICY

Free Trade Area Customs Union Single Market Monetary Union Economic Union

Customs Union The EU is a customs union. A customs union comprises two (or more) countries which agree to:

Abolish tariffs and quotas between member nations to encourage free movement of goods and services. Goods and services that originate in the EU circulate between Member States duty-free. However these products might be subject to excise duty and VAT. Adopt a common external tariff (CET) on imports from non-members countries. Thus, in the case of the EU, the tariff imposed on, say, imports of Japanese TV sets will be the same in the UK as in any other member country. Preferential tariff rates apply to preferential or free trade agreements that the EU has entered into with third countries or groupings of third countries.
AVERAGE TARIFF Per cent 56.9 32.6 29.1 23.2 11.5 11.2 6.5 6.5 5.8 4.6 4.2 2.0 1.7 0.9 0.0 Source: WTO web site, accessed August 2007

AVERAGE IMPORT TARIFFS IMPOSED BY THE EUROPEAN UNION Product groups Dairy products Sugars and confectionery Cereals & preparations Beverages & tobacco Clothing Fish & fish products Coffee, tea Textiles Oilseeds, fats & oils Chemicals Leather, footwear, etc. Petroleum Non-electrical machinery Wood, paper, etc. Cotton

The EU, as well as all its member states are a member of the World Trade Organisation and, officially at least, subscribes to its free trade ethos. The EU certainly argues in principle for more free trade, but mainly in areas where free trade is to the advantage of the EU! For example, the EU is ready to use the WTO appeals mechanism. A customs union shares the revenue from the CET in a pre-determined way in this case the revenue goes into the EU budget fund. The EU receives its revenues from customs duties from the common tariff, agricultural levies and countries paying 1% of their VAT base. Payments are also made through contributions made by member states based on their national incomes. Thus relatively poorer countries pay less into the EU and tend to be net recipients of EU finances. A single market represents a deeper form of integration than a customs union. It involves the free movement of goods and services, capital and labour and the concept are broadened to encompass economic policy harmonisation for example in the areas of health and safety legislation and monopoly & competition policy. Deeper economic and business ties requires some degree of political integration, which also requires shared aims and values between nations The economic effects of the creation and development of a customs union can be analysed both in the short term and the long term. We make an important distinction between trade creation and trade diversion effects Trade Creation This involves a shift in domestic consumer spending from a higher cost domestic source to a lower cost partner source within the EU, as a result of the abolition tariffs on intra-union trade. So for example UK households may switch their spending on car and home insurance away from a higherpriced UK supplier towards a French insurance company operating in the UK market.

Similarly, Western European car manufacturers may be able to find and then benefit from a cheaper source of glass or rubber for tyres from other countries within the customs union than if they were reliant on domestic supply sources with trade restrictions in place. Trade creation should stimulate an increase in intra-EU trade within the customs union and should, in theory, lead to an improvement in the efficient allocation of scarce resources and gains in consumer and producer welfare.
Price Domestic Supply

Trade creation access to cheaper supplies allows a lower price which benefits consumers P1

Supply price from non EU

Supply price from EU supply EUp Lower price leads to an expansion of demand and a rise in consumer surplus + a net improvement in economic welfare

Domestic Demand

Qs2

Qs1

Qd1

Qd2

Output (Q)

Trade Diversion Trade diversion is best described as a shift in domestic consumer spending from a lower cost world source to a higher cost partner source (e.g. from another country within the EU-15) as a result of the elimination of tariffs on imports from the partner. The common external tariff on many goods and services coming into the EU makes imports more expensive. This can lead to higher costs for producers and higher prices for consumers if previously they had access to a lower cost / lower price supply from a non-EU country. The diagram next illustrates the potential welfare consequences of imposing an import tariff on goods and services coming into the European Union. In general, protectionism in the forms of an import tariff results in a deadweight social loss of welfare. Only short term protectionist measures, like those to protect infant industries, can be defended robustly in terms of efficiency. The common external tariff will have resulted in some deadweight social loss if it has in total raised tariffs between EU countries and those outside the EU. The overall effect of a customs union on the economic welfare of citizens in a country depends on whether the customs union creates effects that are mainly trade creating or trade diverting.

Price

Domestic Supply

Revenue from Tariff

Deadweight loss of welfare from the tariff Pw + Tariff

Pw + T World Price Pw M

Domestic Demand

Qs

Qs2

Qd2

Qd

Output (Q)