Chapter 18 International Trade.

Chapter 18 International Trade

Learning Objectives Discuss the importance of international trade to Australia. Understand the difference between comparative advantage and absolute advantage. Explain how countries gain from international trade. Discuss the sources of comparative advantage. Analyse the economic effects of government policies that restrict international trade. Evaluate the arguments for and against government policies that restrict international trade.

Motor vehicle tariffs reduce jobs
In Australia, the car industry was under heavy tariff protection in the past century. Those tariffs caused many other sections of the economy to suffer, including industries that extensively used motor vehicles as inputs (higher production costs) and consumers (less disposable income for other goods and services).

An overview of international trade
LEARNING OBJECTIVE 1 An overview of international trade International trade has grown enormously over the past 50 years. Exports: Goods and services produced domestically but sold to other countries. Imports: Goods and services bought domestically but produced in other countries. Tariff: A tax imposed by a government on imports.

Top 10 leading exporters in world merchandise trade and Australia, 2007: Figure 18.1a
Figure 18.1a: Top 10 leading exporters in world merchandise trade and Australia, 2007. Source: Derived from World Trade Organisation (2008), International Trade Statistics, 2008, viewed 26 March 2009, at < Germany was the leading exporting country in the world of merchandise, with a share of 9.5% of total world merchandise trade. It was closely followed by China (8.7%) and the USA (8.3%). Australia was ranked 27th in the world, exporting 1.0% of the world’s merchandise. Source: Derived from World Trade Organisation (2008), International Trade Statistics, 2008, viewed 26 March 2009, at < Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Top 10 leading exporters in world commercial services and Australia, 2007: Figure 18.1b
Figure 18.1b: Top 10 leading exporters in world commercial services and Australia, 2007. Source: Derived from World Trade Organisation (2008), International Trade Statistics, 2008, viewed 26 March 2009, at < The USA contributed the largest share of 13.9%, followed by the UK and Germany. Australia was ranked 24th in the world, with a 1.2% share of the world export of commercial services. Source: Derived from World Trade Organisation (2008), International Trade Statistics, 2008, viewed 26 March 2009, at < Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 1 An overview of international trade The importance of trade to the Australian economy. Exports and imports as a proportion of GDP have been increasing over time in Australia. In 2008, exports by sector as a proportion of total exports were: Mining: 49% Services: 22% Manufacturing: 16% Agriculture: 13% Source: Australian Bureau of Agricultural and Resource Economics (2008), Commodities, December quarter. Source: Australian Bureau of Agricultural and Resource Economics (2008), Commodities, December quarter.

Exports and imports as a percentage of GDP, Australia, 1960-2008: Figure 18.2
Figure 18.2: Exports and imports as a percentage of GDP, Australia, Source: Reserve Bank of Australia, Statistics (2009), ‘Gross domestic product—expenditure components’, Table G11, viewed 26 March 2009 at < In 1960 exports were a little over 12% of GDP and imports were 15% of GDP. By 2008 exports were just over 23.5% of GDP and imports were almost 24% of GDP. Source: Reserve Bank of Australia, Statistics (2009), ‘Gross domestic product—expenditure components’, Table G11, viewed 26 March 2009 at < Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 1 An overview of international trade Australian international trade in a world context. International trade as a proportion of GDP is less important to Australia than many European countries, but more important than in the USA or Japan. In 2008, Australia’s exports and imports were each approximately 24% of GDP. Open economy: An economy which exports a large proportion of its output and/or has few barriers to international trade.

International trade as a percentage of GDP: Figure 18.3
Figure 18.3: International trade as a percentage of GDP. Sources: World Bank (2008), ‘Integration with the global economy’, World Development Indicators, Table 6.1, viewed 11 April 2008 at <siteresources.worldbank.org>; Australian Bureau of Statistics (2007), Australian National Accounts: National Income, Expenditure and Product, Cat. No ; Department of Foreign Affairs and Trade (2008), Switzerland Country Brief, viewed 11 April 2008 at < International trade is much more important in some countries than for Australia. Sources: World Bank (2008), ‘Integration with the global economy’, World Development Indicators, Table 6.1, viewed 11 April 2008 at <siteresources.worldbank.org>; Australian Bureau of Statistics (2007), Australian National Accounts: National Income, Expenditure and Product, Cat. No ; Department of Foreign Affairs and Trade (2008), Switzerland Country Brief, viewed 11 April 2008 at < Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Has offshoring hurt the Australian economy?
MAKING THE CONNECTION 18.1 Has offshoring hurt the Australian economy? Some companies offshore technical support services to India. Despite the perception of the general public, offshoring, or outsourcing, is not a recent phenomenon. Relocation of production (manufacturing) capacities from the developed to developing countries became more visible since 1970s. With the advances in communication technology, offshoring of services became possible. Banks, communication, credit card and marketing companies relocated their software operations and call centres to India, where they can enjoy the lower costs of using English-speaking labour. In spite of a fear that offshoring will result in higher unemployment in Australia, there is no evidence to support this. Firstly, the number of jobs lost due to offshoring is small relative to the size of the Australian economy. Secondly, offshoring was largely beneficial to consumers and users of the outsourced services due to their lower cost. Thirdly, jobs lost to offshoring are often replaced by the jobs in other sectors of the economy. Offshoring is far more prevalent in the USA, where job losses due to offshoring are estimated to be substantially higher.

Comparative advantage in international trade
LEARNING OBJECTIVE 2 Comparative advantage in international trade Comparative advantage: The ability of an individual, business, or country to produce a good or service at a lower opportunity cost than other producers. Opportunity Cost: The highest-valued alternative that must be given up to engage in an activity. Absolute advantage: The ability to produce more of a good or service than competitors when using the same amount of resources.

An example of Japanese workers being more productive than Chinese workers: Table 18.1
OUTPUT PER HOUR OF WORK MOBILE PHONES MP3 PLAYERS JAPAN 12 6 CHINA 2 4 The opportunity costs of producing mobile phones and MP3 players: Table 18.2 Table 18.1: An example of Japanese workers being more productive than Chinese workers. Table 18.2: The opportunity costs of producing mobile phones and MP3 players. OPPORTUNITY COSTS MOBILE PHONES MP3 PLAYERS JAPAN 0.5 MP3 player 2 mobile phones CHINA 2 MP3 players 0.5 mobile phone Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

How countries gain from international trade
LEARNING OBJECTIVE 3 How countries gain from international trade Autarky: A situation in which a country does not trade with other countries. Production without trade: Table 18.3 PRODUCTION AND CONSUMPTION MOBILE PHONES MP3 PLAYERS JAPAN 9000 1500 CHINA 1000 Table 18.3: Production without trade.

LEARNING OBJECTIVE 3 How countries gain from international trade Increasing consumption through trade. Terms of Trade: The ratio at which a country can trade its exports for imports from other countries. Countries gain from specialising in producing and exporting goods in which they have a comparative advantage and importing goods in which other countries have a comparative advantage.

The gains from trade for Japan and China: Table 18.4
Table 18.4: The gains from trade for Japan and China. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 3 How countries gain from international trade Why don’t we see complete specialisation? Not all goods and services are traded internationally. Production of most goods involves increasing opportunity costs. Tastes for products differ.

LEARNING OBJECTIVE 3 How countries gain from international trade Does anyone lose as a result of international trade? Industries in which a country does not have a comparative advantage are reduced in size or cease to operate due to specialisation in other industries, leaving some entrepreneurs and workers unemployed. As will be shown later, then net effect on employment and output is positive due to specialisation and free trade.

Specialisation in household duties
LEARNING OBJECTIVE 3 Specialisation in household duties Ken and Sue have recently married and share a house together. They need to decide on the distribution of household chores but agreed to split jobs evenly between them. Assume there are only 2 jobs to be done: cooking dinners and cleaning the house. Ken usually spends one hour to cook a dinner and five hours to clean the house, whereas Sue is more efficient and spends just 30 minutes to cook a meal and four hours to clean the house. INSTRUCTOR NOTES -: This problem is intended to help students understand advantages of specialisation on simple household example.

Units of output per hour of labour
LEARNING OBJECTIVE 3 Specialisation in household duties Ken and Sue’s productivity table is presented as follows: Units of output per hour of labour Cooking Cleaning Ken 1 0.20 Sue 2 0.25

LEARNING OBJECTIVE 3 Specialisation in household duties Explain who has an absolute advantage in delivering each service. Explain who has a comparative advantage in delivering each service. Suppose that Ken and Sue decided to cook six dinners a week and eat one night out. Also, assume that they decided to clean the house once a week. Do you think that Ken and Sue should specialise or take turns in doing each job? Show how much time they would spend if they took turns in doing each job and if they specialised.

LEARNING OBJECTIVE 3 Specialisation in household duties STEP 1: Review the chapter material. This problem is about absolute and comparative advantage and the gains from specialisation, so you may want to review the section in the text book, ‘How countries gain from international trade’. STEP 2: Answer question 1 by determining who has an absolute advantage. Since Sue is capable of cooking more meals and doing more cleaning within given time frame, she has an absolute advantage in doing both chores.

LEARNING OBJECTIVE 3 Specialisation in household duties STEP 3: Answer question 2 by determining who has a comparative advantage. A person has a comparative advantage when he/she can deliver a service at a lower opportunity cost. Ken spends as much time cleaning the house as cooking five dinners. In contrast, Sue can cook eight dinners in the time spent cleaning. Therefore, the opportunity cost schedule for both of them would look as follows: Opportunity costs Cooking Cleaning Ken 0.20 of cleaning job 5 cooked meals Sue 0.125 of cleaning job 8 cooked meals

Time spent (hours) on chores per fortnight
LEARNING OBJECTIVE 3 Specialisation in household duties STEP 3 (cont.): Therefore, Ken has a comparative advantage in cleaning (he sacrifices 5 meals while Sue has to sacrifice 8 meals per cleaning job), but Sue has a comparative advantage in cooking. STEP 4: Answer question 3 by showing that Ken and Sue will spend less time on household chores if they decide to specialise. The following table presents the time Ken and Sue would spend on household chores if they decide to do them in turns. Time spent (hours) on chores per fortnight Cooking Cleaning Total Ken 6 5 11 Sue 3 4 7

Time spent (hours) on chores per fortnight
LEARNING OBJECTIVE 3 Specialisation in household duties STEP 4 (cont.): Since both Ken and Sue have a comparative advantage in doing one of the two chores, they will be better off specialising. If Ken does all the cleaning of the house and Sue cooks all the evening meals then the time they spent on the chores would be as follows: It is evident that both Ken and Sue would spend less time on household chores if they decide to specialise. Time spent (hours) on chores per fortnight Cooking Cleaning Total Ken 10 Sue 6

Where does comparative advantage come from?
LEARNING OBJECTIVE 4 Where does comparative advantage come from? Among the main sources of comparative advantage are the following: Climate and natural resources Relative abundance of labour and capital Technology External economies External economies: Reductions in a firm’s costs that result from an expansion in the size of an industry.

Government policies that restrict trade
LEARNING OBJECTIVE 5 Government policies that restrict trade Free trade: Trade between countries that is without government restrictions. Free trade can lead to cheaper imported production inputs, improved resource allocation and lower prices for domestic consumers. Lower production costs increase firms’ profitability, and lower prices increase consumers’ purchasing power. Both of these effects can increase domestic employment.

The Australian timber industry under autarky: Figure 18.4
Price (dollars per cubic metre) Consumer surplus Supply $30 Figure 18.4: The Australian timber industry under autarky. This figure shows the market for timber in Australia assuming autarky, where Australia does not trade with other countries. The equilibrium price of timber is $30 per cubic metre and the equilibrium quantity is cubic metres. The blue area represents consumer surplus and the red area represents producer surplus. Producer surplus Demand Quantity (cubic metres) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

The effect of imports on the Australian timber market: Figure 18.5
Under autarky With imports Consumer surplus A A+B+C+D Producer surplus B+E E Economic surplus A+B+E A+B+C+D+E Price (dollars per cubic metre) Australian Supply A F $30 B Figure 18.5: The effect of imports on the Australian timber market. When imports are allowed into Australia the price of timber falls from $30 to $20. Australian consumers increase their purchases from cubic metres to cubic metres. Equilibrium moves from point F to point G. Australian producers reduce the quantity of timber they supply from cubic metres to cubic metres. Imports equal cubic metres, which is the difference between Australian consumption and Australian production. Consumer surplus equals areas A, B, C and D. Producer surplus equals area E. C D G World price 20 E Imports Australian Demand Quantity (cubic metres) Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 5 Government policies that restrict trade Tariffs. Tariffs are the most common form of interference with free trade Like any other tax, a tariff will increase the cost of selling a good. Tariffs reduce consumer surplus and lead to a deadweight loss. Tariffs increase producer surplus and generate revenue for the government.

The effects of a tariff on timber: Figure 18.6
Loss of consumer surplus = Increase in producer surplus + Government tariff revenue Deadweight loss A+B+C+D A C B+D Australian Supply Price (dollars per cubic metre) Australian price = world price + tariff F $25 A Figure 18.6: The effects of a tariff on timber. Without a tariff on timber, Australian timber producers will sell cubic metres of timber, Australian consumers will purchase cubic metres and imports will be cubic metres. The Australian price will equal the world price of $20 per cubic metre. The $5 per cubic metre timber tariff raises the price of timber in Australia to $25 per cubic metre and Australian producers increase the quantity they supply to cubic metres. Australian consumers reduce their purchases to cubic metres. Equilibrium moves from point E to point F. The timber tariff causes a loss of consumer surplus equal to area A + B + C + D. Area A is the increase in producer surplus due to the higher price. Area C is the government’s tariff revenue. Areas B and D represent deadweight loss. B C D E World price 20 Australian Demand Quantity supplied by Australian firms Quantity (cubic metres) Australian timber consumption Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 5 Government policies that restrict trade Quotas. Quota: A numerical limit imposed by the government on the quantity of a good that can be imported into a country. Voluntary export restraint: An agreement negotiated between two countries that places a numerical limit on the quantity of a good that can be imported by one country from the other country. The effects of a quota are similar to that of a tariff.

The effect of the US sugar quota: Figure 18.7
Loss of consumer surplus = Gain by US sugar producers + Gain to foreign sugar producers Deadweight loss A+B+C+D A B C+D $2.24 billion $1.20 billion $0.35 billion $0.69 billion US Supply Price (dollars per pound) Sugar quota of 3.5 billion pounds $0.22 US price of sugar F A C B $0.12 World price of sugar Figure 18.7: The effect of the US sugar quota. Without a sugar quota US sugar producers would have sold 5.9 billion pounds of sugar, US consumers would have purchased 23.1 billion pounds of sugar and imports would have been 17.2 billion pounds. The US price would have equalled the world price of $0.12 per pound. Because the sugar quota limits imports to 3.5 billion pounds (the bracket in the graph), the price of sugar in the USA rises to $0.22 per pound and US producers increase the quantity of sugar they supply to 18 billion pounds. US consumers reduce their sugar purchases to 21.5 billion pounds. Equilibrium moves from point E to point F. The price of sugar in the USA is now $0.10 per pound higher than the world price. The sugar quota causes a loss of consumer surplus equal to areas A + B + C + D. Area A is the gain to US sugar producers. Area B is the gain to foreign sugar producers. Areas C and D represent deadweight loss. The total loss to US consumers in 2006 was $2.24 billion. D E US Demand 5.9 18.0 21.5 23.1 Quantity of sugar (billions of pounds) Quantity supplied by US firms US sugar consumption Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

LEARNING OBJECTIVE 5 Government policies that restrict trade Gains from unilateral elimination of tariffs and quotas. Countries gain from the reduction of their own tariffs and quotas even if other countries do not reduce their tariffs and quotas.

LEARNING OBJECTIVE 5 Government policies that restrict trade Domestic support policies. Price floor: A government-guaranteed minimum price for producers which is usually above the free-market equilibrium price. Price floors and other domestic subsidy policies increase domestic production and can lead to domestic surpluses, the surplus of which is often sold on international markets, driving world prices lower than they would otherwise be. This reduces trade opportunities for non-protected and developing countries.

LEARNING OBJECTIVE 5 Government policies that restrict trade Other barriers to trade. Health and safety requirements. If a government imposes stricter requirements on imported goods than on domestically produced goods, then this is a barrier to trade. Import restrictions on national security grounds.

The argument over trade policies and globalisation
LEARNING OBJECTIVE 6 The argument over trade policies and globalisation During the Great Depression of the 1930s, many countries raised tariffs in a mistaken attempt to protect domestic employment. This led to the collapse of international trade. World Trade Organisation (WTO): An international organisation that enforces international trade agreements. The WTO has over 130 member countries. WTO works towards reducing tariffs and increasing free trade.

LEARNING OBJECTIVE 6 The argument over trade policies and globalisation Why do some people oppose the World Trade Organization? Globalisation: The process of countries becoming more open to foreign trade and investment. Anti-globalisation: Some people believe that free trade and foreign investment destroy the distinctive cultures of many countries, create environmental and health problems, and can lead to the exploitation of workers.

The Unintended Consequences of Banning Goods Made with Child Labour
MAKING THE CONNECTION 18.2 The Unintended Consequences of Banning Goods Made with Child Labour Would eliminating child labour in developing countries be a good thing? In many developing countries, such as Indonesia, Thailand and Peru, the use of child labour has been a common practice. Assuming that children are forced to work at the expense of their education, many people supported banning and boycotting goods imported from the countries where child labour was used. Unfortunately, this assumption was not always valid, as very often there is no better alternatives to export-oriented work. Lack of teachers and resources mean that schools are not available within the reasonable distance or only run for a few months a year. Poor families are often unable to afford to send their children to school and rely on their income to obtain basic food stuff. As such, export-oriented jobs are usually less hazardous and better paid. Under a pressure from the public, soccer World Cup 1998 organisers in France banned the use of soccer balls hand stitched by Pakistani children and supplied by Baden Sports. As a result, the company moved its facilities to China, where they are machine-stitched. Unfortunately, a large proportion of the children who lost their jobs in Pakistan ended up begging or in prostitution.

LEARNING OBJECTIVE 6 The argument over trade policies and globalisation Why do some people oppose the World Trade Organization? ‘Old-fashioned’ protectionism. Protectionism: The use of trade barriers to shield domestic companies from foreign competition. Protectionism is usually justified on the basis of the following arguments: Saving jobs Protecting high wages Protecting infant industries Protecting national security

LEARNING OBJECTIVE 6 The argument over trade policies and globalisation Dumping: Selling a product for a price below its cost of production. Although controversial, the WTO will allow tariffs to be imposed to offset the effects of dumping.

LEARNING OBJECTIVE 6 The argument over trade policies and globalisation Radical environmentalism. Argument that trade restrictions should be put in place against countries who lack environmental protection laws. Poorer countries tend to lack these laws, therefore the WTO does not support this approach. WTO recommends maintaining trade, and wealthier countries offering financial and practical assistance to help improve production techniques and enforce environmental standards.

LEARNING OBJECTIVE 6 The argument over trade policies and globalisation Radical environmentalism. Argument that free trade increases carbon dioxide emissions due to the transportation of goods and services around the world. Transportation emissions are only part of total production emissions. Lower total emissions could occur if production occurred in efficient markets and trade took place. As with all economic activities, transport should occur up to the point where the marginal social benefit is equal to the marginal social cost.

LEARNING OBJECTIVE 6 The argument over trade policies and globalisation Positive versus normative analysis. All interferences with free trade make some people worse off (eg: consumers), some people better off (eg: some producers), and reduces total income and consumption. Positive analysis: The reduction in economic efficiency from a tariff or quota can be measured. Normative analysis: Whether a tariff or quota is bad public policy and should be eliminated is a normative decision.

An Inside Look Figure 1: The market for yogurt in Malaysia with and without the tariff on Australian yogurt. Insert Figure 1 from page 606: As large as possible while maintaining clarity. A free trade agreement with Malaysia is predicted to increase Australia’s GDP by $A1.9 billion over a 20-year period, and Malaysia’s GDP by $A6.5 billion over a 20-year period.

Key Terms Absolute advantage Opportunity cost Autarky Price floor
Comparative advantage Dumping Exports External economies Free Trade Globalisation Imports Open economy Opportunity cost Price floor Protectionism Quota Tariff Terms of trade Voluntary export restraint World Trade Organization (WTO)

Get Thinking! Australia has signed numerous free trade agreements (FTAs) in recent years. What kind of impact do you think these agreements have on the volume of trade between Australia and these countries? Is there an impact on Australia’s aggregate international trade? Do you think Australia and its FTA counterparts gain in terms of GDP growth? For details on Australia’s free trade agreements, follow the below link.

Check Your Knowledge Q1. Countries gain from specialising in producing goods in which they have a(n) ___________ advantage and trading for goods in which other countries have a(n) _____________ advantage. absolute; absolute absolute; comparative comparative; absolute comparative; comparative

Check Your Knowledge Q2. Refer to the figure below. Under autarky, which area represents consumer surplus? a. A b. A + B c. A + B + C d. C only.

Check Your Knowledge Q3. Refer to the figure below. Which area represents the net benefit from opening the economy to imports? a. Area A. b. Area B + C. c. Area C. d. Area D.

Check Your Knowledge Q4. In countries like the United States and Australia, the cost of trying to save jobs through trade barriers such as tariffs and quotas is: a. Very low in both countries. b. Very high in both countries. c. High for Australia but small for the United States. d. Low for Australia but high for the United States.

Chapter 18 International Trade.

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