Macroeconomics (ECON 1211) Lecturer: Dr B. M. Nowbutsing Topic: International Trade and Commercial Policy

Exports as % of GDP

33.2 Destination of world exports, 1996 Source: Direction of Trade Statistics

33.3 The composition of world exports

33.4 Imports and Exports (Rs M) – Mauritius Imports Exports

33.5 Imports and Exports (Rs M) – Mauritius Imports Exports

33.6 Imports and Exports (% of GDP) – Mauritius Imports Exports

33.7 Openness: (Imports and Exports)/GDP

Some Important Issues n Raw materials prices – Less-developed countries (LDCs) have claimed exploitation by industrial countries n e.g. by buying raw materials cheaply & selling manufactures dear n Manufactured exports from LDCs – some LDCs have had success in exporting manufactures – leading to complaints that jobs are under threat in the industrial countries n Trade disputes between industrial countries – In some countries, established producers of certain goods are being undercut by efficient modern producers – especially from Japan & East Asia – should such exports be restricted?

Comparative Advantage n Trade offers benefits when there are international differences in the opportunity cost of goods. n Opportunity cost of a good – the quantity of other goods sacrificed to make one more unit of that good n The law of comparative advantage – states that countries should specialize in producing and exporting the goods that they produce at a lower relative cost than other countries.

Comparative Advantage n This concept is best understood in its classical form, the Ricardian theory of comparative advantage. n Main assumptions: -Markets are perfectly competitive. -There are two goods say cds and shirts that are produced under constant returns to scale. -There is a single factor which is mobile across sector but immobile across countries -There are two countries (UK and USA) each with a fixed endowment of labour

Comparative Advantage USAUK Unit Labour Requirement (hours per unit of output) Cds3060 Shirts56 Opportunity cost of Cds6 shirts10 shirts Shirts1/6 Cds1/10 Cds

Comparative Advantage n Absolute advantage: USA – 30 hours to produce a cd; 60 hours in UK n Similarly, a shirt is produced with 5 hours of labour in USA compared to 6 hours in UK n Thus, USA has absolute advantage in the production of both goods

Comparative Advantage n Opportunity cost table n It is cheaper to produce cds in USA (6<10) n It is cheaper to produce shirts in UK (1/10<1/6) n Ricardian model: requires that each country specialises completely in the activity in which it has comparative advantage

Comparative Advantage – Terms of Trade n Suppose terms of trade are 1 cd = 5 shirts (or 1 shirt = 1/5 cd) n USA exporter of cd: for each video it exports, USA can obtain 5 UK made shirts n However, it cost 6 shirts to produce cd in USA n Surely, it does not make sense to produce a cd at the domestic cost of 6 shirts and sell it to get 5 shirts. n The proposed TOT implies a loss to the USA n The TOT must lie in the range 1 cd = (6, 10) shirts

The Source of Comparative Advantage n An important difference between countries is in factor endowments n which will be reflected in different relative factor prices – e.g. if the UK has relatively abundant capital but relatively scarce labour as compared with India, – then the UK would tend to specialize in capital-intensive goods, – and India would tend to specialize in labour-intensive products n Comparative advantage may also reflect a relative advantage in technology

The Source of Comparative Advantage n According to the Heckscher-Ohlin model or Ricardian model, countries specialize in one production. Trade occurs only between industries: inter-industry trade. n Suppose now that the global cloth industry is described by the monopolistic competition model. Because of product differentiation, suppose that each country produces different types of cloth. n Because of economies of scale, large markets are desirable: the foreign country exports some cloth and the domestic country exports some cloth. Trade occurs within the cloth industry: intra-industry trade.

The Source of Comparative Advantage n Gains from inter-industry trade reflect comparative advantage. n Gains from intra-industry trade reflect economies of scale (lower costs) and wider consumer choices. n The monopolistic competition model does not predict in which country firms locate, but a comparative advantage in producing the differentiated good will likely cause a country to export more of that good than it imports.

The Source of Comparative Advantage n The relative importance of intra-industry trade depends on how similar countries are. n Countries with similar relative amounts of factors of production are predicted to have intra-industry trade. n Countries with different relative amounts of factors of production are predicted to have inter- industry trade

Gainers and Losers n Countries may gain from specialization and trade – but not all countries may gain equally n Commercial policy – is government policy that influences international trade through taxes or subsidies n e.g. tariffs – or through direct restrictions on imports and exports.

The Effect of a Tariff n A specific tariff is levied as a fixed charge for each unit of imported goods, For example, Rs. 10 per kg of cheese n An ad valorem tariff is levied as a fraction of the value of imported goods. For example, 125% tariff on the value of imported cars.

The Effect of a Tariff DD SS Quantity Price DD and SS show the domestic demand and supply for a good. PwPw If the world price is P w, and there is free trade, QsQs domestic firms supply Q s QdQd domestic demand is Q d A tariff can stimulate domestic supply and restrict imports P w + T At a domestic price P w + T, where T is the size of the tariff Qs'Qs' Qd'Qd' Domestic demand falls to Q d ', domestic supply rises to Q s ' and the difference is imported. and imports fall.

33.22 The government raises revenue – i.e. there is a transfer to the government There is a social cost from production inefficiency, given that the good could be imported at P w. There is also a loss of consumer surplus. and there is a transfer in the form of extra profits to producers 5.The Effect of a Tariff – Welfare Effect DD SS Quantity Price PwPw QsQs QdQd P w + T Qs'Qs' Qd'Qd' The tariff leads both to transfers and net social losses.

The Effect of a Tariff n The deadweight burden of a tariff suggests that society suffers from this method of restricting trade. n This is the case for free trade. n Tariffs have fallen substantially under the GATT/WTO – General Agreement on Tariffs and Trade

The Case for Tariffs – Good Arguments n Optimal tariff – a first-best argument – only valid where the importing country is large enough to affect the world price n This policy fulfils the principle of targeting – which says that the most efficient way to attain a given objective is to use a policy that influences that activity directly. – Policies that attain the objective, but also influence other activities are second-best, because they distort those other activities.

The Case for Tariffs – Second- Best arguments n Way of life – an attempt to preserve ‘traditional’ ways – a production subsidy would be better n Suppressing luxuries – an attempt to curb consumption patterns of the rich in a poor society – better achieved by a consumption tax n Infant industries – an attempt to nurture new activities via learning by doing – a temporary production subsidy probably better n Revenue – tariffs raise government revenue – but there are better ways n Cheap foreign labour – a non-argument – denies benefits of comparative advantage

Other Tariffs Schedule n Preferential Duties: Tariffs applied to imports from particular group of countries; Countries are charged a lower tariff than countries outside the group. n Generalized System of Preferences: Developing countries charge a lower tariffs for specific imports from developing countries; It depends on a list chosen by developed countries (textiles and clothing not included) n Most Favoured Nation Treatment : WTO principles ; A country must give all countries who are part of the WTO the same tariff treatment as the most favoured nation with which the country is trading.

Other commercial policies n Although tariff rates have fallen under GATT, there has been a proliferation of other trade restrictions – quotas – non-tariff barriers n administrative regulations that discriminate against foreign goods – export subsidies

33.28 Social costs arise from production inefficiency and consumer surplus. 10.An Export Subsidy DD S Quantity Price PwPw World price Under free trade, with the world price at P w, QdQd consumers demand Q d QsQs production is Q s exports are GE. G E Subsidy With a subsidy, producers supply Q d ' to the domestic market and produce Q s '. P w + s Qd'Qd' Q `s ' Exports are now AB. A B

Other Non Tariffs Barriers n Import Quota: a restriction on the quantity of a good that may be imported. This restriction is usually enforced by issuing licenses to domestic firms that import, or in some cases to foreign governments of exporting countries. n Voluntary Export Restrictions: Bilateral agreements negotiated between an exporting and an importing country under which the exporting country agrees to limit its exports of particular products to the importing country to a fixed amount or share of the market. A relatively new form of barrier to trade