Economics

1. International Trade Why trade? Economics

2. Why do countries trade? There will be much discussion of the pros and cons of trade in the rest of this topic. Before we go down that road, it is important to understand the fundamental reason why countries trade • Differences in their resources • More competition and choice • Economies of scale

3. Differences in their resources • Each country has a different allocation of natural and human resources. A given country will be well suited to the production of some goods (or the provision of certain services) and totally unsuited to the production of others. Particularly in the field of agriculture, the differences in climate can be immense; it is simply impossible to grow certain agricultural products in certain countries. • The consequence of this is that some countries will go without some essential goods unless they trade with other countries.

4. More competition and choice • Perfect competition is considered to be the most efficient market structure because it is the most competitive. Competition puts pressure on firms to keep their prices, and therefore their costs, down. • In the same way, the more open to foreign imports a country is, the more competition the home producers will face and the more efficient they will have to be. This is not only good in an economic sense (greater efficiency) but domestic consumers enjoy lower prices and, therefore, increased consumer surplus. • Given what we said earlier about the unequal distribution of the world's resources, it is likely that countries will not be able to produce all the goods that consumers will desire. By definition, therefore, consumers will have a greater choice if the country trades internationally.

5. Economies of scale • Once a firm in a given product market is subject to international competition, often the only way to survive is through growth and economies of scale. The resulting reduction in their cost per unit produced will enable them to become more price competitive in the global marketplace. Obviously this will be good for consumers.

6. The case for free tradeSome definitions Before we plough into the case for free trade, it is important that we define a few terms. • Absolute advantage • A country has an absolute advantage over another country in the production of a certain good if, for a given amount of resources, it can produce more of the good than its competitor. Another way of looking at it is that the country with the absolute advantage can make the same amount of the good with fewer resources. Basically, it is when one country is better at making a given good than another country. See the next Learn-It for a numerical example.

7. Comparative advantage • The theory of comparative advantage takes absolute advantage a stage further. Even if a country is so bad at using a given set of resources that it is worse at making all goods than another country, it will still have a comparative advantage in the production of at least one good. This means that there will be at least one product where it is relatively better at producing, even though in absolute terms it is the worst at making everything. This might sound confusing, but all will be revealed with a numerical example

8. The terms of trade • Put simply, the terms of trade are the 'terms' (or price) agreed when two countries trade. You will see that it is important to understand this concept when we look at numerical example of trade between countries below.

9. Trade barriers • It should be obvious that when an economist refers to free trade he is referring to international trade without trade barriers (i.e. trade 'free' of barriers). We will see later the most prominent barriers that are used and the reason why they are used.

10. Question • Why is free trade a good thing?

11. The World Trade Organisation (WTO) • The WTO is the world policeman for matters associated with trade. It used to be called the General Agreement on Tariffs and Trade (GATT). The major industrialised countries signed this agreement straight after the war. Its purpose, in particular, was to reduce the use of tariffs around the world. Their ultimate objective was the elimination of all tariffs resulting in free trade around the world. It was very successful, reducing tariffs (on average) from around 40% after the war to fewer than 5% in the 1990s. • GATT consisted of a number of 'rounds' where ministers and civil servants from all the important countries got together and thrashed out deals on tariff reduction. The final round (the Uruguay round) that finished in 1993 (these rounds could take a number of years to complete) was not only ambitious in terms of the elimination of tariff and non-tariff barriers, it also created a new body (the WTO) to take over from the occasional policeman that was the GATT. The WTO was to be on going. Not only would it carry on the job of setting up 'rounds' of discussions for further reductions in barriers (the attempted introduction of the 'Seattle' round at the end of 1999 was not so successful), but it would act as the adjudicator when countries had a trade dispute.

12. The World Trade Organisation (WTO) • A good recent example of one such 'dispute' was between the USA and the EU (most of them are between these two huge economies) over the relatively humble banana. The EU gave preferential treatment to banana growers in African and Caribbean countries, partly due to historical colonial links, but also because they are at a huge cost disadvantage compared with the large, American owned, banana plants in Latin America. It would be no good for the EU if the poorer banana growers went bust. • The USA complained to the WTO in 1996. The WTO agreed with the USA and the EU was asked to change their banana regime. The proposed changes were not enough to satisfy the USA. It was at this point, towards the end of 1998, that the USA threatened to impose 100% tariffs on randomly selected EU products (Scottish Whiskey and French cheese to name but two). Again the WTO agreed and allowed the USA to go ahead with almost $200 million worth of retaliation. The EU finally backed down in 1999 with changes that the USA accepted. • The long running nature of the dispute does highlight the difficulty in reaching agreement and the trouble that the WTO has in getting countries to comply with their judgements. It is a better system than the old GATT, though, which had to rely on voluntary compliance by quarrelling member countries. At least the WTO has a formal disputes procedure and can impose penalties on countries that are judged to be in the wrong

13. The case for free trade -absolute advantage • We are now going to look at a numerical example that shows why it makes sense for two countries to trade when each has an absolute advantage in one of the two goods being traded. • The method used below is one based on the final output of the goods in question assuming each country has the same resources and that they are distributed evenly to the production of each good. Some textbooks prefer to illustrate the same concept by comparing the relative costs in terms of resources required to make one unit of the good in question. The first method has been chosen mainly because a diagram can be used to illustrate what is going on (in terms of a production possibility frontier, or PPF) as well as some numerical analysis.

14. The 'pre-specialisation' situation • Assume that two countries, Germany and France, with similar amounts of resources (which is more or less true in the real world) both produce only two goods, beer and wine (not so true in the real world!). The table below gives the production possibilities for a given year assuming that they each split their resources evenly between the production of beer and wine.

15. The 'pre-specialisation' situation This information can be illustrated on two PPFs, one for each country

17. Assumptions • As the resources have been split equally between the productions of the two goods, we see that each country is producing at the mid-point on their respective PPFs (points A and B). Germany, for example, could produce 600 million bottles of beer if it concentrated all of its resources on the production of beer.

18. Assumptions • You can probably see that we have to make a number of assumptions for this model to be valid. First, each country is on rather than within its PPF. We assume, therefore, that each country is using all of their resources and in the most efficient way.

19. Assumptions • Secondly, the PPFs are straight lines. This means we are assuming that all resources used are equally good at making beer or wine (a bit dubious - most PPFs are convex to the origin). The straight line PPF also means that we are assuming that returns to scale are constant. If Germany does decide to concentrate on the production of beer, they do not experience economies of scale (they probably would in the real world).

20. Specialise and Trade • Looking back at the table, we have a situation here where France has an absolute advantage in the production of wine and Germany has an absolute advantage in the production of beer. In this situation, it makes sense for each country to specialise and produce the good that they are best at making, and then trade. So, Germany concentrates on beer production and France concentrates on wine production.

21. The situation after specialisation

22. The Result • France is now producing at point C on its PPF and Germany is producing at point D on its PPF. Notice that total production of both goods has now risen because each country is concentrating on the production of the good in which they have an absolute advantage. The question now is what will be the terms of trade? • If France was still a closed economy, it could produce an extra bottle of beer at the cost of exactly one bottle of wine. Hence, France will not want to trade a bottle of wine for anything less than one bottle of beer. The domestic trade off is one bottle of beer for one bottle of wine, so France would hope to do better than that.

23. Similarly, if Germany was still a closed economy, it could produce an extra bottle of beer at the cost of only half a bottle of wine. Germany would hope to get at least half a bottle of wine (from now on, W) for each bottle of beer (from now on, B) that it trades with France. • So the terms of trade (or the price) will be somewhere between 1B for W (or 2B for 1W) and 1B for 1W. France will hope the agreed price will be nearer to 2B for 1W and Germany will hope that the price is nearer 1B for 1W. • Let's say that they agree on 1½B for 1W, and decide to trade 255 million bottles of beer for 170 million bottles of wine.

24. The situation after specialisation and trade The final, post-trade, table will look like this:

25. The Result • Both countries now have more beer and wine than they had before they specialised and traded. Germany has 20 million more bottles of wine and 45 million more bottles of beer. France has 30 million more bottles of wine and 55 million more bottles of beer. In a sense, their PPFs have moved out as a result of specialisation and trade.

26. The case for free trade - comparative advantage • In the numerical example in the last Learn-It, it was fairly obvious what the two countries should do. One was better at making wine, the other was better at making beer, so they each specialised, overall production rose and they were both better off after trading. • What should happen, though, if one of the two countries is best at making both the goods in question?

27. The 'pre-specialisation' situation • Assume that two countries, Germany and France, with similar amounts of resources (which is more or less true in the real world) both produce only two goods, wine and cheese (not so true in the real world!). The table below gives the production possibilities for a given year assuming that they each split their resources evenly between the production of wine and cheese.

28. The Table In this example, where we assume that both countries produce only wine and cheese, France has an absolute advantage in the production of both wine and cheese. It is better at making both goods. Here are the relevant PPFs.

30. As you can see, France's PPF is further to the right than Germany's. They are better at making both goods, so why bother trade with Germany?This is where the theory of comparative advantage comes in. This theory states that in the situation above, both countries can still benefit from specialisation and trade. Germany must specialise in the good at which it is 'least bad' at making, and France should specialise in the product at which it is best (or 'most good') at making. We find out who should specialise in what by finding, for each country, the opportunity cost of making each good in terms of the other good. This is where the PPFs come in handy. It is easier to see what the opportunity costs are using a diagram.

31. Finding the value of the opportunity costs • Let's look at France first. France is initially at point A on its PPF, producing 200 million bottles of wine (from now on, W) and 200 million kilograms of cheese (from now on, C). If France was to make one more kilogram of cheese, you can see from the diagram that a bottle of wine would have to be sacrificed. So the opportunity cost of making 1C is 1W. If France were to make one more bottle of wine, it would have to sacrifice a kilogram of cheese. The opportunity cost of making 1W is 1C. The gradient of the PPF (which is -1) determines the size of the opportunity cost.

32. France • The calculation is a little more complicated for Germany, currently at point B on its PPF. To make one more kilogram of cheese you can see from the steeper slope of the PPF that Germany will have to give up more than one bottle of wine. To be exact, the opportunity cost of 1C is 1½W. Again the gradient of the PPF (which is -1½) holds the key. To make one more bottle of wine, you can see that Germany will be giving up less than one kilogram of cheese. To be exact, the opportunity cost of 1W is 2C/3.

33. The table above has been reproduced below, but the opportunity costs of making an extra unit of each product has been added in the relevant boxes.

34. The Result • Now that we have the opportunity costs of production, we can see which country is relatively better at making each good. In other words, we can see which country has a comparative advantage in producing which good. Let's look at wine first. France can make 1W at a cost of 1C, but Germany can make wine relatively more cheaply. It can make 1W for only 2C/3. Germany has a comparative advantage in the production of wine. With cheese, France can make 1C at a cost of 1W, but it is more costly in Germany, where 1C costs 1½W. France has a comparative advantage in the production of cheese.

35. The situation after specialisation So, Germany will specialise in wine and France will specialise in cheese. This gives the following table:

36. Notice that, although overall production has risen (700 units is bigger than 650 units), the extra 100 million kilograms of cheese have been produced with a loss of 50 million bottles of wine. This may seem like a bad deal if you particularly like wine! It is for this reason that the two countries in this situation are unlikely to specialise 100% in the product for which they have a comparative advantage.

37. The table below gives a more sensible degree of specialisation which results in higher overall production of both goods.

38. Both wine and cheese lovers should be happy now! The two countries together now produce 20 million more bottles of wine and 30 million more kilograms of cheese. So now its time to trade. What will the terms of trade be? • If France was still a closed economy, it could produce an extra kilogram of cheese at the cost of exactly one bottle of wine. Hence, France will not want to trade a kilogram of cheese for anything less than one bottle of wine. The domestic trade off is one kilogram of cheese for one bottle of wine, so France would hope to do better than that. • Similarly, if Germany was still a closed economy, it could produce an extra bottle of wine at the cost of only two-thirds of a kilogram of cheese. Germany would hope to get at least two-thirds of a kilogram of cheese for each bottle of wine that it trades with France. 1W for 2C/3 is the same as 1C for 1½W.

39. The Terms of Trade • So the 'price' will be somewhere between 1C for 1W and 1C for 1½W. France would rather the price was as close as possible to 1C for 1½W and Germany will hope that the price is as close as possible to 1C for 1W. • Let's say that the two countries agree on a price of 1C for 1¼W, and decide to trade 112 million kilograms of cheese for 140 million bottles of wine.

40. The situation after specialisation and trading The final, post-trade, table will look like this:

41. Summary • Both countries now have more cheese and wine than they had before they specialised and traded. Germany has 10 million more bottles of wine and 12 million more kilograms of cheese. France has 10 million more bottles of wine and 18 million more kilograms of cheese. In a sense, their PPFs have moved out as a result of specialisation and trade. • As with the absolute advantage example, it should be noted that we have assumed that there are no transport costs for the delivery of the exports of each product. Also, we have assumed that there are no negative externalities in the production process, or from the consumption of wine and cheese (which is definitely not the case in the real world!).

42. The lawyer and his secretary • If the numerical example above doesn't make much sense, think of the concept of comparative advantage in terms of a lawyer and his secretary. • Assume that a lawyer can charge his services out at 100 pounds an hour (it is probably more nowadays!). Also assume that he/she happens to be a very quick typist, and can type 80 words a minute. His secretary is fairly good, typing 60 words a minute. The secretary is paid 12 pounds an hour. • The lawyer has an absolute advantage in being a lawyer and being a secretary! But he is much better at being a lawyer and only a little bit better at typing. He has a comparative advantage in the law and the secretary has a comparative advantage at typing.

43. The lawyer • If the lawyer decides to type a letter, or a report, because he is a bit quicker than the secretary, he would lose out overall. Let's say that it takes him 15 minutes to type a report. The secretary types 25% slower, so it would take him/her 20 minutes. It costs the lawyer four pounds to hire the secretary for 20 minutes, but if he types the report, he has wasted 15 minutes for which he could have earned 25 pounds being a lawyer!