International Trade

Trade

Advantages

Allows Countries to Specialise:

  • Become more efficient in the production of a specific good maximising their input factors
  • Access to economies of scale, this provides incentive to buy goods from a country who is “better” at producing them

Cheaper Products:

  • There is usually a gain in consumer surplus, assuming a free trade scenario the imported good would be below the domestic market equilibrium price.

Wider Market for Goods and Services:

  • A greater variety of goods and services will be available as a result of trade
  • This may allow countries to access products that would otherwise be unavailable

Creation of International Competition:

  • Through access to international markets firms are exposed to competition so there is a need to become more efficient, productive, or innovative.
  • In theory it should also crowd out bad products, as there is a readily available substitute which may be of a cheaper price and better quality.

Increase in Global Employment:

  • There is the entire logistics industry surrounding trade, thereby more trade greater need for logistics
  • Additionally, there is the shipping, rail, and aviation that is an integral factor in the movement of resources and goods providing another source of global employment

Builds International Markets & Political Ties:

  • This takes the form of trade agreements such as NAFTA, ASEAN, & APTA
  • Not only does this provide the structure for trade, but it also ensures a political consensus on the need for trade, and ensuring that it is kept fair.

Disadvantages

Interdependency:

  • Countries become dependent on each other for the supply of certain products or services; this can lead to serious economic stability issues if there are supply shocks.
  • Furthermore, overdependence can also be established meaning that an economy survives purely on exports of one product or good. An example of this is Cuba when the United States placed export sanctions and restrictions in the 1960s. The U.S. had been the biggest importer of Cuban sugar cane, and without their main importer the economy was left in a fragile state. The Soviet Union rescued the economy, by purchasing all excess Cuban sugar cane.

Over-Specialisation:

  • This can lead to certain areas of the economy being underdeveloped. An example common to most developing countries is that they are specialised in agricultural production and then are reliant on Western imports for technology.
  • Dutch Disease: this is where natural resources are exploited in favour of maintaining an agricultural and manufacturing industry. Through foreign countries buying the natural resource the currency strengthens and then other exports are no longer competitive. Thus, restricting the economy to be dependent on the natural resource export. In the case of the Netherlands, the discovery of the Groningen gas field in 1959 had led to other Dutch exports to lose any competitive edge.

Exhaust Resources:

  • Increasing global demand may lead to the exploitation of resources to the point where the law of diminishing returns is fully enacted, which may eventually cripple the domestic economy. Often the case with agricultural countries with the over-cultivation of land.

Trade Monopoly:

  • One country may specialise to the point where others cannot compete, creating a degree of monopoly power in international trade. This may force countries to import goods at an un-competitive price, giving the original producer the entire benefit of trade.
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Comparative Advantage

Figs and Peaches

Two fruits which until today I have rarely regarded important to my life, and more so important to understanding economics. But today I was humbled by the simplicity of fruit and trade. No I didn’t walk to a supermarket and compare the prices of what is ultimately the same fig or peach at varying price levels. I sat down in a classroom and considered the opportunity cost in the production of peaches or figs, within the scenario of being on an island which exclusively produces figs or peaches (i.e. a nation capable of trade).

The premise of what seemed like an amiable task, turned out to reveal the essence of trade and the benefit gained from engaging in trade. The simple definition of trade is the exchange of goods between two parties, but the real question to ask is what motivates us to trade?

Now as I am meandering my way into the topic of trade, and its benefits I must bring forward what has become an economic cliché of mentioning Adam Smith’s thoughts on the matter. Obviously, he was not the first to consider aspects of trade but it was his critique of Mercantilism alongside his development of what was to become the explanation for the need to trade. This extract summarises the basis of what was going to become the critique of mercantilism and the purpose of trade:

If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage. The general industry of the country, being always in proportion to the capital which employs it, will not thereby be diminished, no more than that of the above-mentioned artificers; but only left to find out the way in which it can be employed with the greatest advantage.”

Adam Smith, The Wealth of Nations Book IV, Chapter II

Here, Smith notes the existence of a trade-off that benefits both parties involved. As the terms of trade are established in order to allow two nations who have specialised in the production of a given good to gain an advantage. The critique of mercantilism is clearer in David Hume’s use of the bullion example, which was in essence a supply of money issue. But Smith highlights the mercantilist’s inability to recognise absolute and comparative advantage. The final remark suggests that Smith was thinking in terms of what we would now consider a Production Possibility Frontier (PPF) in which trade will allow us to operate at a point outside of our original output.

Significantly, Smith had developed what was to become classical economics based on a Laissez-Fair approach, which encouraged free trade (removal of tariffs, and protectionism). However, it was not until the early 19th century when David Ricardo had begun to build up the theory of comparative advantage which facilitated the need for free trade and the benefits of trade even when a country has an absolute advantage in the products being traded.

Comparative Advantage:
“A country can produce a good at a lower opportunity cost than its direct competitor”

Absolute Advantage:
“A country is able to produce more of a good or service with the same amount of resources”

Now back to the figs and peaches, firstly it is important to establish why a country would be able to produce a product “better” than its competitor. This is where the factor of endowment comes into place; in accordance with this example it can take the form of an investment into human capital in order to educate the workforce so they know the correct growing conditions for peaches or figs.

Let’s assume that the islands are producing the following goods in the amounts stated, where they will specialise in the production of one good as they cannot maximise the production of both at the same time.

Picture1

Opportunity Cost:

If country A produces 300 peaches it gives up 600 figs, and if it produces 600 figs it gives up 300 peaches. Providing the ratios:

1 Fig – ½ Peach
1 Peach – 2 Figs

If country B produces 100 peaches it gives up 300 figs, and if it produces 300 figs it gives up 100 peaches. Providing the ratios:

1 Fig – ⅓ Peach
1 Peach – 3 Figs

So should there be trade?

Well, first who should export figs or peaches and who should import figs or peaches.

Country A has a lower opportunity cost in the production of peaches in comparison to country B, therefore, Country A should produces peaches as the only lose 2 figs per peach. So A has a comparative advantage in the production of peaches.

Country B has a lower opportunity cost in the production of figs in comparison to Country A, therefore Country B should produce figs as they only lose a 1/3 of a peach per fig. So B has a comparative advantage in the production of figs.

Terms of Trade:

Country A should trade 1 peach for between 2 figs & 3 figs. Below 2 figs they can produce it more effectively themselves, but above 3 country B can produce peaches themselves.

Country B should trade 1 fig for between ⅓ peach & ½ peach. Below ⅓ peach they can produce it more effectively themselves, but above ½ country A can produce figs themselves.

So the (approximate) terms will be:

1P: 2.5F for Country A
&
1F: 0.4P for Country B

This identifies the direct benefit of trade as the ability to go beyond the country’s original PPF, as now Country A can have approximately 150 more figs than before, and Country B can have approximately 20 more peaches. Even though Country A has an absolute advantage in the production of both peaches and figs, the differing comparative advantage means there is still a benefit to trade.

Is this the best model?

Well, not really. It is clear there are some major flaws in this ultimately very simply model of how trade occurs. Firstly, it can be noticed that once a third country is involved a different formulation is necessary, and the existence of a large range of goods makes it difficult to have a clear trade-off. Secondly, the model is based on the immobility of capital, of which we are living in a world where capital is increasingly mobile. Finally, the model would suggest that agrarian nations would remain agrarian thereby not developing but specialising in natural resource production, this would create a larger technological gap and also led to an increasing inequality gap between nations. One alternative is the competitive advantage model, but it fails to provide an outlook on the trade-off and opportunity cost, and has a greater dependence upon the assumption that labour and natural resources are abundant and don’t necessarily effect the economy.

Poverty & Equity

Absolute Poverty:

“A condition characterized by severe deprivation of basic human needs, including food, safe drinking water, sanitation facilities, health, shelter, education and information. It depends not only on income but also on access to services”

For the consideration of poverty many countries adopt a national poverty line which considers the income needed to satisfy minimum needs. The World Bank consider extreme poverty to be living on less than $1.25 a day and moderate poverty as living on less than $2 a day.

Relative Poverty:

Relative poverty takes into consideration the income of an individual or household and compares it to the median income of that economy. In relation to the Lorenz curve if there was perfect income equality there would be no relative poverty. In this case they still have enough money to survive, and it is more based around the cultural environment.

Causes of Poverty

There are many causes of poverty; some apply more to certain countries than others

  • Low Wages/Income
  • Unemployment

The individual will have no income, and in countries where there is no welfare system they will struggle to survive.

  • Lack of Human Capital

This is where the individual lacks training or education to get a job, or if their health is at a state where they cannot be productive. This is the case in my countries in Africa as there is shortage of education and health.

  • Geography

Certain areas have less job opportunities, but the people cannot afford to move. There may only be low paying jobs which have adverse effects on health in the given area.

  • Age

In a country with no benefits and no welfare system anyone of old age will struggle to survive unless they have children supporting them

  • Shortage of Merit & Public Goods

This is a lack of education, no housing available, no healthcare, bad living conditions. Etc.

  • War

Has adverse effects on human capital, government, job opportunity, and geography

This can lead into a poverty cycle; it is extremely difficult to break out off. In most places where there is extreme poverty and absolute poverty it is a combination of causes which means that the entire system needs to be rebooted.

Consequences of Poverty

There are many consequences of poverty, as it affects many aspects of life.

  • Low living standards

This may mean that those suffering from poverty may not have access to suitable housing, clean water, or basic food items. This usually results in increased disease and infection

  • Lack of Access to Healthcare (high rates of preventable diseases)

Many people suffer as a result of low living standards and there may not be a healthcare system available. Any healthcare that is offered may come at a considerable expense which they cannot afford.

  • Lack of Access to Education

There are no available institutions for education, making it difficult to break out off the poverty cycle

  • Social Problems

Crime, Violence, Family Breakdown, etc.

  • High rates of infant mortality

The Role of Taxation in Promoting Equity

Direct Tax: Income, Corporation, Capital Gains, National Insurance, Inheritance, etc.

Indirect Tax: Excise (fuel, cigarettes, and alcohol), VAT (Value Added Tax), Sales Tax, Tariffs, etc.

Direct tax is usually a tool used in order to redistribute income, whereas indirect tax is usually used to solve negative externalities related with the consumption of certain products. Indirect taxes are avoidable as they are taxes on consumption.

Proportional Taxation:

This is taxation where it remains at a fixed rate, so it does not depend on income. Therefore it will not change if there an increase or decrease in income.

Progressive Taxation:

This is where the rate of taxation depends on a change in income. So if income were to increase of an individual so would the tax paid. If a tax system is very progressive then the equality in income distribution after taxes is greater. (Suits Index)

Regressive Taxation:

This is the case where the tax rate decreases as the amount subject to taxation increases. This type of tax is more of a burden with those on a lower income, as a result of income elasticity of demand of staple items.

Other Measures to Promote Equity

The provision of public and merit goods by the government, this is in order to supply these to people with a low income who otherwise would not be able to afford it.

The government would do this through the direct provision of these goods, or create subsidies which would make it more affordable for those on lower incomes.

For example this can be the provision of health care services, education institutions. This can also involve the provision of infrastructure that would enable suitable housing (e.g. council houses), clean water supply, access to food (food stamps), and general sanitation.

Without government provisions of these goods it would be under-consumed due to poverty and low income in a free market.

Transfer Payments

This would be the direct redistribution of income to individuals by the government, it is to take money away from certain groups and bring it towards other groups.  This is done in the case of the elderly where they cannot work, so the income produced by those working goes to assisting people in need. In this example it would take the form of old age pension.

There are various other examples of this such as unemployment benefit, child allowances, war veteran benefits, student grants, disability benefits, maternity benefits, and housing benefits, and fuel allowances.

The Relationship between Equity and Efficiency

Government policies to promote equity may have positive and negative effects on the efficiency in the allocation of resources, and growth.

For example the pursuit of high income tax will disincentive high income earner to work, and may encourage them to save their money or to move their money out of the country.

Indirect taxes as a result of their regressive nature will have a negative effect on the distribution of income. But there is also the factor that they are placed to reduce negative externalities which conflicts with the allocation of resources in regards to benefitting the economy.

There can be a trade-off between income equity/equality and efficiency as you this involves direct intervention in the economy which may affect price mechanisms and market forces.

Government expenditure tends to be a restraint on the overall budget. But there is also the factor that government intervention even though the intention may be good may not result in greater equity, and only achieve allocative inefficiency and misallocation of resources.

When there is considerable income inequality it discourages labour as they may have to work harder to receive the same wage, and this leads to less productivity. Furthermore, transfer payments may reduce allocative efficiency as it may discourage people from seeking work. But there is also the argument the vulnerable groups’ still need protection.

Long Run Aggregate Supply

There are two theoretical outlooks on long run aggregate supply; there is the neo-classical/monetarist model and then the Keynesian model.

Neo-classical/Monetarist Model

Picture1

In the short run producers will respond to a change in price, but also higher demand by bringing in more inputs of production and utilising existing means of production. But in the long run in this model it can be note that supply is independent of price.

This makes the assumption that all prices are flexible, and if some prices go up others will go down. Furthermore, this displays that the potential of an economy to grow is based on four central factors land, labour, capital, and enterprise. There can also be an increase in productivity and efficiency which is the better utilisation of already existing factors of production.

An outward shift would be considered an increase in productive potential. This particular model also states that at that given point all resources are being employed and there is a point of full employment.

As a result of this model monetarists would argue that stimulating aggregate demand is artificial manner of promoting growth, and therefore shows that fiscal policy is ineffective.

Equilibrium Neo-classical/Monetarist Model

Picture3

This diagram determines that at the point aggregate demand meets long run aggregate supply that it is at the point of full employment of all resources including labour.  There can only be short term fluctuations as ultimately prices are completely flexible so there are no inflationary or recessionary gaps. The economy should always go back to the point of full employment level of output.

It also shows that increasing aggregate demand only invokes an inflationary response, rather than growth. This shows how supply side policies are extremely effective in regards to the monetarist model as an outward shift of LRAS would mean that there is great output at lower prices if it were to meet the same level of demand.

Keynesian model

Picture2

This model contains an element of the neo-classical model, but otherwise there are two significant differences. These differences are highlighted as this model can be separated into three different sections.

The first section is the horizontal line this is recognition that there are downward inflexible prices (sticky prices). This is because of factors such as labour contracts, unions, minimum wage, etc. At any point of alongside the horizontal line it is the recognition that some resources are not being employed and that there is production capacity which is not utilised.

Then there is the curve section which introduces the concept that there is still some response to price in the long run.  As the output increases so does the employment of resources, this causes prices to rise. To continue output firms must be able to continue increasing prices.

Finally there vertical section where there is the potential of full employment of resources. This is where prices can increase rapidly and GDP can’t increase as all aspects are being utilised.

Similar to the monetarist model, there can be an outward shift in long run aggregate supply. This is where the four main factors land, labour, capital, and enterprise are being utilised in a more efficient or productive manner. There may also be an introduction of new resources, which would cause the expansion. This particular model shows the benefits of using fiscal policy to stimulate aggregate demand as you achieve growth without an inflationary response.

An outward shift would mean an increase in productive potential, as the economy can utilise more resources in order to produce more. In this model however there are inflationary and deflationary gaps, as a result of the price sensitivity.

Equilibrium Keynesian model

Picture4

As shown in the diagram it can be noted that the economy can be at equilibrium at a variety of points where the economy is not at the point of full employment level of output. For AD1 it can be noted that there is not the full utilisation of resources.

Then the following point of AD2 it reaches the beginning of the section which is considered the deflationary gap. In this model the economy can stay at this gap. This is shown at the equilibrium with AD3. The economy can remain at this point because the model argues that without intervention the economy will not tend towards the point of full employment of output.

AD4 in contrast is presiding in the inflationary gap, where any increase in demand results in inflation rather than growth. At the turning point between the curve and the vertical line it can be considered the maximum potential output in the long run as it is the point that coincides with the greatest value of real output.

It is important to look at the point between AD1 and AD2 as this is the justification for the use of fiscal policy to increase aggregate demand. It can be seen that there is only an increase in real output between the two points, and not an inflationary response. This is because while shifting alongside this point the economy is simply using already existing spare capacity. The only point where there is a price increase is the deflationary and inflationary segments.

Evaluation

It is clear that there are strong arguments proposed for both models, the question to apply in the scenario is which one is more relevant to our current economic state. This however leads to a obvious split in decision making in regards to which model is followed, in brief terms Keynes’ model suggest that you must spend to save, whereas the monetarist model argues that there is the cyclical nature and any changes we make are artificial.

The main downfall of the monetarist model in regards to solving recessionary crisis or promoting growth is the extent to which it requires long-term planing. The Keynesian model creates a short-term effect as well as long-term which can make it seem more favorable for economic policy. However to apply the Keynesian model to today’s economic situation in Britain there is a curious result. In regards to aggregate demand there is expansionary monetary policy (low interest rates, increasing money supply i.e. QE) but there is an environment of deficit control which could be counteracting any effects on AD. But in regards to aggregate supply, in the current scenario I would support the Keynesian model as there is currently clear unfulfilled capacity.

 

Monetary Transmission Mechanism

I am going to consider and evaluate the money transmission mechanism in regards to the use of a contractionary monetary policy. This will be in form of a hypothetical increase in the base interest rate set by a central bank, and the no change in money supply. This has a considerable effect on the value of currency, output of the economy, price level, and the factors that establish output.

The increase in the base rate of interest by a central bank does not directly affect the consumer, as it does not lend to individuals. However, the change in base rate does influence the interest rate at which retail banks will lend money, and may vary the cost of long term borrowing such as mortgages.

First there will be a direct effect on consumer spending as a result of the increase in the base rate, due to the influence on retail banks. In a sense the cost of borrowing money has increased, and therefore this will decrease demand for borrowing as people will not be able to afford it. This will considerable effect on households with mortgages, as the consumer will now have more of their income paying off the loan, thereby decreasing their disposable income. This does not only apply to mortgages but also those with short term loans, and even credit cards. The cost of money for the consumer has increased and this restricts their effective demand. In a large scale this would cause a contraction in aggregate demand, as consumer spending will decrease.

This monetary policy will also induce a fiscal effect. Higher interest rates would encourage people to save more of their money rather than to spend it. Fiscally this would be seen as a withdrawal which again would affect the level of aggregate demand. This would “cool-down” the economy and can be noted as part of a policy that would have both monetary and fiscal elements.

Furthermore, the manipulation of interest rates will have a direct consequence on the strength of the currency in regards to foreign exchange. The currency will strengthen as a result of increasing the interest rates, as money will enter the system for the purpose of saving at a lucrative interest rate. An example of this was seen in Australia where interest rates were high and as a result the currency continued to strengthen.

This has adverse effects on the balance of trade, as a result of a strong currency exports will decrease because domestic products are more expensive abroad, and imports will increase because foreign products are “cheaper”. Referring back to the example of Australia the government announced that it wanted to reduce the interest rate as the economy was becoming too dependent on imports and it also sought to increase exports.

In regards to aggregate demand, there would be a considerable contraction if this were to continue for a long period of time. As there is a decrease in consumer spending, and imports would exceed exports. However, the final factor could be seen in a decreasing level of firm investment.

The increase in interest rates will decrease a firm’s ability to borrow money, and so this will decrease the firms’ ability to invest in development, or research. This would mean that firm’s would not seek to increase production, or invest in new technologies to achieve greater productivity or efficiency. It could also possibly involve the freezing of employees wage rates.

 

However as a result of increasing national independence some of these effects may be magnified or reduced by the monetary policy of other countries. The most recent example is that of the United States and China as each is accusing the other of direct currency manipulation it order to ensure economic goals are met by possibly affecting other economies. It is possible that if one central bank in a major economic country such as Britain would raise the base rate, it might signal the European Central Bank to increase their base rate. There is to a degree a large scale of speculation, in regards to what international effect there may be. Australia is a rare example where government announcement was met with direct action as money began to flow out of savings and was reinvested into the stock markets in the U.S. and U.K. identified in the rise of the central indexes of the S&P 500, Dow Jones, and FTSE 100.

Previously mentioned was also the actions of firm, and the question must be raised to what degree would they decrease investment. There is still the entire complex of competition amongst firms, so as a result of this no firm within a given industry may reduce levels of spending as a there is a need to maintain competiveness and market share. It is also a different market in regards to loans for large corporations or small business, the increase in the cost of borrowing for a corporation or conglomerate  may be insignificant, but for a small business it may depend on cheap borrowing to maintain a the entrepreneurial plan for creating a new firm.

In regards to the use of credit cards and other types of short term loans, there may not be such a drastic decline in their use. In many cases consumers are dependent on the use of credit cards to maintain their lifestyle. This brings along the point that even though interest rates are higher so saving is more lucrative, there could be the case that people cannot afford to save. This takes into account the marginal propensity to save. This is the change in savings in regards to a change in income; the change in income would be a result of the increased cost of borrowing. So in a sense marginal propensity to save will decrease as individuals have less income and must use it so live.

The effect on individuals with mortgages may have a time delay, as a result of there being different types of mortgages. Those with variable rate mortgages would suffer immediately as now a greater portion of their income will be taken up with monthly payments, but those that have fixed rate mortgages for a given time period may benefit as their monthly payments have not changed. However, to analyse this it would be necessary to take into account how many people have fixed rate mortgages, and this would establish the aggregate effect on consumer spending.

Finally, there is also the factor of how quick the change in the base rate is. For example in Europe following the financial crisis the central bank quickly dropped the base rate, but in Japan during the 90s the change in the base rate was gradual. In Europe to avert full scale crisis dropping the base rate quickly had arguably aided in ensuring that demand was not completely wiped out as a result of crisis. Although, it is still questionable as times of crisis are unique situations as their causes and consequences differ. This is where there is a greater link between monetary policy and fiscal policy, and the most recent example of this can be seen in European austerity.

Currently in Europe the ECB’s base rate is at 0.5%, simply this means that the cost of borrowing is “cheap” and this falls in line with expansionary monetary policy aimed at achieving economic growth. However, at the same time there is a restriction on government spending and increased taxes to deal with debt, and this can be seen as a reduction in injection and an increase in withdrawals forming contractionary fiscal policy. This forms an obstruction in the money transmission mechanism in regards to trying to pursue growth, but keep inflation down, and reduce government debt.

The money transmission mechanism is a good example of the expected response in changes to monetary policy. However the current economic climate is a fine example of how it may not work as a result of other policies pursued. In the evaluation of the changes it could be noted that it is difficult to consider it on a whole market level as it has different effects for those on high or low incomes, and small or big businesses.