International Trade in Insurance Economic theory of trade –absolute versus comparative advantage –static welfare analysis of trade –dynamic welfare analysis of trade –common trade restrictions tariffs quotas subsidies government procurement

International Trade in Insurance Why restrict trade? 1. Foreign company will dominate the market economies of scale and scope greater financial resources infant industry 2. Insurance is “strategic business” national security national economic diversification

International Trade in Insurance Need to preserve foreign exchange reserves nature of insurance related trade flows import substitution the special case for insurance market development consumer protection concerns why insurance is special

International Trade in Insurance Fair trade concepts market access nondiscrimination transparency national treatment reciprocity some accounting issues in international trade

Mercantilist versus Smith Mercantilist view: If one country wins from trade the other country must lose Extending this view.. should Jalisco trade with Veracruz? Should Tlalpan trade with Copilco? Smith: Wealth of Nations is in the productive capacity of labor and capital and not in the gold reserves

Absolute versus comparative advantage The easiest way to see the notions of absolute and comparative advantage is by means of an example Suppose there are two countries each producing wine and wheat with the following cost structure CountryWheatWine England1530 Portugal1015

Comparative advantage opportunity cost of producing one unit of wine in England is two units of wheat oc in Portugal of one unit of wine is….. relative costs are different Portugal is relatively better at producing wine than England Portugal has a comparative advantage in wine production (England in wheat)

Comparative advantage Assume only input is labor assume England has 270 man hours and Portugal only has 180 before trade England can produce and consume 8 units of wheat and 5 units of wine Portugal can consume 9 wheat 6 wine total production 17 wheat 11 wine

Comparative advantage Is it possible for England to be better off and Portugal to be better off by not producing both wine and wheat? YES If specialize, total output 18 wheat 12 wine trade! …not a zero sum game What should be the terms of trade?

Some observations one country may have absolute advantage in producing everything but not a comparative advantage in production in all goods comparative advantage may be in other economic factors such as land, capital,… by how much each country gains depends on the terms of trade why is London the largest reinsurance market in the world?

Another example E and W produce two goods wine and cheese W requires 3 hours of work to produce 1 bottle of wine and E requires 1 W requires 7 hours of work to produce 1 kilo of cheese and E needs 5 What are relative costs of production in each country?

Terms of trade E can buy 1 kilo of cheese for five bottles of wine if they produce all by themselves But W can buy 1 kilo of cheese for 2.33 bottles of wine (or five bottles buys 2.15 kilos of cheese [2.15=5/2.33]) Thus, E can gain an extra 1.15 by selling in W W cheese producers can get more by selling in E

Common Misconceptions about gains from international trade Mexico is inefficient in producing everything, therefore, it will lose from trade –In our example E has an absolute advantage in producing both cheese and wine but they gain from trade. Why? Gains are due to relative efficiency and not absolute efficiency.

Common Misconceptions about gains from international trade “Giant sucking sound” argument of Ross Perrot –American domestic workers have to be protected against low wage Mexican workers. If it is cheaper to produce in one country, it should do so. For example, it does not make sense for the Australian garment industry to produce shirts at a cost twice that of China. We need to compare relative costs and relative productivities

Common Misconceptions about gains from international trade Trade exploits Mexico and makes it worse off (especially for goods that require lots of labor) –Value of production is not solely due to labor. It is possible that the gain for the US economy is larger than the gain for Mexico. However, both gain from trade. Singapore example: imports water, but exports refined petroleum!

Static welfare analysis of trade suppose a commodity has a domestic price of and a world price of 10 Clearly a possibility of import government is considering a tariff of 5 on import who will gain and who will lose? And by how much?

Gains and losses There is benefit to the producer called producer surplus measured by ABCD and the amount is $37.50 Consumers suffer a loss an amount $87.50 measured by ABFG Government gains in the form of tax revenue EHFD equals $25

Gains and losses Note that the total loss to the consumers is not equal to what producers gain and what the government gets as revenue There is an additional loss to the society as a whole: CDE and FGH Since these losses are not gains of anybody in the society, they are called deadweight losses

Deadweight loss Clearly deadweight losses are bad for the economy What does the deadweight loss depend on? It depends on the elasticity of demand and the supply curves Consider demand elasticity: lower the demand elasticity, higher the deadweight loss

Deadweight loss What does the demand elasticity depend on? Goods with few substitutes will have lower elasticity of demand-necessities Goods with many substitutes will have higher elasticity of demand-luxuries How large are the costs of trade restrictions?

What do empirical studies show? Trade restriction has a cost of US$70b or 1.3% of GDP Is it worth it to have consumers pay more if it saves jobs? Cost to society $168,000 per job saved! Study of Kodak Australia: tax concessions, and other benefits given to stay in Australia

Then, why we see resistance? Job losses are concentrated in certain areas They may bring in votes They may have large political power Benefits to consumers are diffused Each consumer gains a little They do not have political clout It does not pay

DL S D price quantity A B DF G HC E

Dynamic welfare analysis Over time, there are further changes In Australia, tariff and quota on garment import has been reduced (from 100% to 5%) It has killed the usual garment manufacturing in Australia They are relocating factories to China, the Philippines, Indonesia etc.

Rent seeking People spend resources to engineer activities that lead to protectionism Lobbying for special interest groups Specific industries can get tax breaks, import quota imposed and other benefits Example: Luxury boat builders in the US

Tax on insurers Makes insurance more expensive transfer consumer surplus to domestic producers provides government with tax revenue create deadweight loss to society how about imposing a quota?

General equilibrium analysis There are spillover effects We have only studied the “partial equilibrium” or own market effects Higher insurance costs leads to higher product prices that needs insurance Effects are felt all over the economy

Common objections Foreign insurers will dominate the market –economies of scale and scope: larger, more efficient foreign companies will be able to drive the local companies out of the market –evidence shows that scale economies exist for small and medium sized companies but not for very large insurers (typically, they have diseconomies of scale) –dumping: who gains? Market share argument

Common objections For strategic reasons, insurance industry should remain national There will be great foreign exchange outflow Market development will be slowed down Consumers will not be protected

Dumping Goods sold abroad below the domestic price Japanese companies did that for many years for diverse sets of goods: cars, electronics, computers etc. What does that mean? Common argument: get into a foreign country, wipe out the competition and enjoy monopoly

Dumping To the country at the receiving end, dumping costs domestic jobs What prevents domestic producers from reentering the market? TVs, VCRs, etc. have become the biggest success of Japan in the rest of the world, and these industries were least helped by MITI and now they are produced elsewhere

MITI knows how to pick…losers In the 1960s, MITI wanted auto companies to produce just trucks Later it tried to keep the number of producers low, in particular keep Honda out of auto business MITI presumed that analog version of the HDTV will be the industry standard, wrong again!

Fair trade Market access –no country allows free access to insurance because of large potential for abuse –localization of ownership: majority shareholding local, subsidiary –localization of insurance: certain or all lines must be placed locally domiciled insurer –benefits to economy: needs test

Fair trade Nondiscrimination or MFN treatment –best possible market access Transparency –regulatory requirements should be clearly set and easily accessible National treatment –foreign products are treated no differently from domestic ones

Fair trade Reciprocity –concessions by a country matched by other –matching need not be for the same industry –retaliation can lead to escalating trade war –increasing tariff to reduce foreign threat to local export economy cannot last long because other countries retaliate and can lead to reduced welfare for both

Some implications of national income accounting Y=C+I+G+(X-M) where Y is the GDP Also, S=Y-C-G Therefore, S=I+CA where CA=X-M CA is called current account By this mechanism, a country can invest more than it saves Can it do that indefinitely?

Thailand’s saving and investment