Economic integration and the terms of trade

1. Economic integration and the terms of trade

2. Economic Integration Economic integration refers to economic co-operation between countries and co-ordination of their economic policies, leading to increased economic links between them.

3. Preferential Trade Agreements Economic Integration is enhanced by Preferential Trade Agreements. A preferential trade agreement (PTA) is an agreement between two or more countries to lower trade barriers between each other on particular products.

4. A bilateral trade agreement is an agreement between two countries. A multilateral trade agreement involves an agreement between many countries. Regional trade agreements, involves agreements between a group of countries that are within a geographical region

5. Trading blocs A trading bloc is a group of countries that have agreed to reduce tariff and other barriers to trade for the purpose of encouraging free or freer trade and co- operation between them. Free Trade Area A free trade area (FTA) consists of a group of countries that agree to gradually eliminate trade barriers between themselves, and is the most common type of trading bloc. Each member country retains the right to pursue its own trade policy towards other non-member countries (i.e. to impose its own trade barriers). In trade relations between members, there may be free trade in some products, and some protection in other products. Customs Union Free Trade Area + a common policy towards all non-member countries. Each country in a customs union is no longer free to determine its own trade policy towards non-member countries, but must adopt the policy agreed upon by the customs union. Also, the member countries of the customs union act as a group in all trade negotiations and agreements with non-members.

6. Common Market Customs Union + any factors of production within the common market. The factors of production of importance are labour and capital, which in a common market are free to cross all borders and move, travel and find employment freely within all member countries.

7. Draw a table with the three headings Free Trade Area, Customs Union and Common Market and categorise the following trading blocs NAFTA ASEAN SACU SAARC CEFTA EEC CARICOM PARTA

8. Case Study In your groups, research one trading bloc and prepare 3 slides on the following. • Background (origin, history, member states) • Operations (Economic benefit/Impact) • Recent news of significance.

9. Advantages of Trading Blocs? Increased competition With low or no barriers, imports increase, forcing domestic producers to compete with lower cost producers from other countries. Trade barriers, on the other hand, protect inefficient domestic producers. Increased competition offers major advantages in terms of production by more efficient producers, lower prices for consumers and improved allocation of resources. Expansion into larger markets This is an obvious benefit arising from the ability of firms to sell beyond their national boundaries, increasing their exports and leading to greater economic growth.

10. Advantages of Trading Blocs Economies of Scale (HL Topic) When an economy opens itself up to free trade with other countries, its exports are likely to increase and as the size of the market expands, the firm can achieve lower costs of production on average (economies of scale), lower prices for consumers and greater export competitiveness. Economies of scale are one of the major benefits of free trade. Lower prices for consumers and greater consumer choice The elimination of trade barriers (along with increased competition and economies of scale) results in lower prices for consumers. In addition, increased imports mean a greater of variety of goods from which consumers can choose. Increased investment Enlarged markets often give rise to increased investment by firms that want to take advantage of the larger market size. This investment may be internal, that is, by firms originating from a country within the trading bloc, or external, originating from a country outside the bloc (by multinational corporations).

11. Advantages of Trading Blocs Better use of factors of production: improved resource allocationIf a trading bloc develops into a common market, which involves free movement of factors of production, this also results in better use of these within the bloc. As discussed above, unemployed workers in one country may seek a job elsewhere where there are more employment opportunities. Capital can also move freely in search of greater profits. Improved efficiency in production and greater economic growthThe elimination of trade barriers, leading to a better utilisation of resources and improved efficiency in production, allow for more rapid economic growth.

12. Advantages of Trading Blocs? Political advantages Greater economic integration is likely to result in a reduced likelihood of hostilities between countries whose economies become more interdependent through increased trade, investment, labour and financial flows.

13. Disadvantages of Trading Blocs Trading blocs may not be the best way to achieve trade liberalisation Many economists believe that while the establishment of trading blocs with free trade between members may be an improvement over trade protection, trading blocs are inferior to the WTO’s multilateral approach of reducing trade barriers towards all countries.

14. Disadvantages of Trading Blocs Trading blocs may create obstacles to the achievement of free trade on a global scale Some economists believe that the break-up of the world trading system into many blocs can create trade conflicts between different blocs that may slow down the process of global trade liberalisation. Trading blocs may enjoy free trade and all its benefits within the bloc, but trade barriers on non-members may result in limiting rather than increasing trade on a global scale. This would lead to a worse global allocation of resources, lower global output, a weakened role for the WTO, and a risk of breaking up the global economy into many regional trading blocs.

15. Disadvantages of Trading Blocs Unequal distribution of gains andpossible losses Countries forming a trading bloc are unlikely to gain equally from the operation of the trading bloc, and this creates the potential for conflicts between the members and makes it difficult to reach agreements. It is also possible for some countries to gain while others become worse off in some respects. The same applies to gains and losses within the member countries, as some stakeholders are likely to gain while others lose.

16. Trade Creation (HL) As opposed to the consequences covered previously, the following two effects are short term in nature. Trade creation refers to the situation where higher cost products (imported or domestically produced) are replaced by lower cost imports after the formation of a trading bloc. • Country A and B have tariffs. • They both have a bilateral agreement and tariffs is reduced. • They both import more from each other and products which are more expensively produced domestically are replaced by the cheaper imported goods. • Higher efficiency in production leads to greater allocative efficiency as more is being consumed.

17. Trade Creation (HL) Trade diversion refers to the situation where lower cost imports are replaced by higher cost imports from a member after the formation of the trading bloc. • A is the lowest cost producer of the three, followed by B, and then by C, which is the highest cost producer. • Initially, C imposes a tariff on all imports of cotton, regardless of country of origin. Since A is the lowest cost producer, C imports from A and not from B (A’s cotton price plus the tariff is lower than B’s price plus the tariff). C then decides to form a trading bloc with B. • It therefore eliminates the tariff on cotton from B, and maintains the tariff on cotton from A. • The result is that it now becomes cheaper for C to import cotton from B rather than A. C’s imports have shifted from a lower cost producer, A, to a higher cost producer, B; this is therefore a case of trade diversion.

18. Trade Creation (HL) The possibility of trade diversion resultingfrom a trading bloc is an additional argument against trading blocs, and in favourof multilateral (WTO) trade liberalisation. The reason is that trade diversion cannot occur with multilateral reduction or elimination of trade barriers. Trade diversion occurs when an importing country is forced to import from a higher cost producer within a trading bloc, whereas before it joined the trading bloc it was importing from a lower cost producer elsewhere. This difference is very important!

19. Trade Creation (HL) Trade creation has the effect of increasing social welfare, while trade diversion reduces it. Therefore, whereas a trading bloc creates free trade for the members, it may or may not improve the allocation of resources. Resource allocation will improve only if trade creation effects are larger than trade diversion effects. It is generally believed that the long-term benefits for the members of trading blocs are more important than the short-term effects. The long-term effects may be five or six times more important than the short-term ones. Why do you think this is so? Anticipate a Paper 2 d) question asking you to weigh up the long term and short term consequences of trading blocs.

20. South American nations form Unasur Do Real World Focus on Page 419 for homework (Important).

21. 8 7 6 5 4 3 2 1

24. Monetary Union Monetary union involves a far greater degree of integration than a common market, and occurs when the member countries of a common market adopt a common currency and a common central bank responsible for monetary policy. European Union Do a background research (why, who what, when, how, why) of the European Union. You can find this on page 419.

25. European Union Advantages of Monetary Union A single currency eliminates exchangerate risk and uncertainty. Exchange rate fluctuations create risks and uncertainties for traders and investors, who do not know what the future exchange rates will be. A single currency eliminates transaction costs. Whenever there is a conversion of one currency into another, banks (or others) charge a fee for the conversion; this is a type of transaction cost. savings from the elimination of transaction costs of currency conversions within the euro zone countries amounts to about 1% of the combined GDPs of the countries involved.

26. European Union A single currency encourages price transparency. Price transparency refers to the ability of consumers and firms to compare prices in all the countries that have adopted a common currency without having to make exchange rate calculations and conversions. Find the two remaining advantages

27. European Union Disadvantages A single currency involves loss of exchange rates as a mechanism for adjustment. If a member country has a trade deficit with another member country, it no longer has its own national currency that could depreciate (in a flexible exchange rate system) or devalue (in a fixed exchange rate system) to correct the imbalance.

28. European Union A single currency involves loss of monetary policy as an instrument of economic policy. For all euro zone countries, monetary policy isthe responsibility of the European Central Bank, the objective being price stability for the region as a whole. Each individual country, whatever its particular circumstances (higher or lower inflation, unemployment, etc., than the average of the euro zone countries), is unable to carry out its own monetary policy to influence the rate of interest and hence the level of economic activity within its boundaries.

29. European Union Fiscal policy is constrained by the convergence requirements. Whereas each member country retains the ability to carry out its own fiscal policy, total public debt cannot be greater than 60% of GDP and the budget deficit of any given year cannot be greater than 3% of GDP. This limits the government’s ability to borrow according to domestic needs and priorities. “How 'magic' made Greek debt disappear before it joined the euro” http://www.bbc.com/news/world-europe-16834815

30. European Union Monetary policy pursued by the single central bank impacts differently on each member country, depending on its own particular circumstances. Since countries are likely to differ from each other with respect to degrees of inflation, unemployment, etc., or generally where they are in the business cycle, the single monetary policy pursued by the single central bank is unlikely to suit every country’s needs and may be inappropriate. For example, if some countries face unemployment and others face inflation, an expansionary monetary policy would suit the needs of the first group but would make the inflation worse in the second group.

31. Optimum Currency Areas Thought by Nobel Prize Winner Robert Mundell, an optimum currency area (OCA) refers to an area in which all members have fixed exchange rates with each other, but flexible exchange rates with outsiders. Likely to be successful when: • There is greater mobility of capital and labour resources • There is close co-operation or co-ordination of fiscal policies, or there is an OCA-wide fiscal authority determining fiscal policy • There is greater synchronisation of the phases of the business cycle among members (members experience the phases of the business cycle roughly together).

32. Optimum Currency Areas Why? Labourand capital mobility should work toward evening out the differences between economically more and less advanced regions. If a country or region is depressed, labour will migrate to wealthier regions, or capital could flow into the poorer ones to take advantage of lower costs. Similarly, fiscal co-ordination or a common fiscal policy would allow for tax-financed investments to be made in depressed areas, or transfer payments to be paid to vulnerable groups in depressed areas if the phases of the business cycle occur roughly at the same time everywhere, then the common monetary policy will be well suited to everyone. Does not happen in EU.

33. Greece, EMU and the sovereign debt crisis Do Real World Focus on page 421 and do the questions on page 423. This is a very important piece and I strongly recommend you to go through it very thoroughly.

34. Terms of Trade (HL) Terms of Trade = Average Price of Exports x 100 Average Price of Imports The prices that a country receives for its exports to the prices it pays for its imports Note that prices of exports and imports are both measured in terms of the domestic currency (alternatively, in terms of a foreign currency; in other words, both are measured in terms of the same currency).

35. Terms of Trade (HL) Improvement in the terms of trade- an increase in the value of the ratio of average export prices to average import prices. It involves a fall in the opportunity cost of imports. Price of Exports ↑ or Price of Imports↓ Deterioration in the terms of trade, a decrease in the value of the ratio of average export prices to average import prices. It involves an increase in the opportunity cost of imports. Price of Exports ↓ or Price of Imports ↑

36. Terms of Trade (HL) Terms of Trade = Average Price of Exports x 100 Average Price of Imports For example if the base year is 2000, the terms of trade for the year 2000 is 100. Suppose that in 2002 the index of export prices is 103 and the index of import prices is 105. Terms of Trade = 103 x 100 = 98.1 105 Suppose in 2004 the index of export prices was 115 and index of import prices was 104. The terms of trade for 2004 are:

37. Terms of Trade (HL) An increase in the ratio of the index of average export prices to the index of average import prices shows an improvement in the terms of trade. A decrease in that ratio shows a deterioration in the terms of trade.

38. Changes in Terms of Trade Short Term Changes in global demand Increases in the global demand for a product cause its price to increase; decreases in global demand cause its price to fall. Some changes in demand may occur over relatively short periods of time for a variety of reasons. Changes in consumer tastes, for example in favour of textiles made of cotton, give rise to an increase in the global demand for cotton, and therefore an increase in its global price.

39. Changes in Terms of Trade Short Term Changes in global supply Prices of internationally traded products also change in response to changes in supply, which can occur over short periods of time due to a number of factors. For example, restrictions in the availability of an important input in production, such as oil, can have major impacts on supply over very short periods of time, causing its price to increase.

40. Changes in Terms of Trade Short Term Changes in the domestic rate of inflation relative to other countries Price level changes in a country, relative to other countries, have immediate effects on its terms of trade. A higher rate of domestic inflation meansthe country’s export prices increase relative to its import prices, resulting in an improvement in its terms of trade; at the same time this corresponds to a deterioration in the terms of trade of countries that import goods from the high inflation country.

41. Changes in Terms of Trade Long Term Changes in exchange rates Exchange rates fluctuate continuously over short periods of time, and affect prices of both exportsand imports, thus impacting on the terms oftrade. If a currency depreciates/devalues, prices of imports increase in terms of the domestic currency. Note, however, that the prices of exports remain unchanged in terms of the domestic currency (export prices fall for foreigners).

42. Changes in Terms of Trade Long Term Growth in incomes, affecting global demand Economic growth and increases in incomes are an important long-term cause of changing demand patterns, which affect terms of trade. As incomes increase, the demand for goods and services increases. Changes in productivity Productivity tends to increase over long periodsof time, and is an important factor influencing domestic supply.

43. Changes in Terms of Trade Long Term Technological advances Technological advances have a similar effect on the terms of trade as increases in productivity (they are often causes of productivity improvements), and are one of the more important factors influencing supply over the long term. A technological advance causes a rightward shift of the supply curve in industries using the new technology, leading to a lower price.

44. Changes in Terms of Trade Long Term Trade protection A small country that uses trade protection to restrict imports or expand exports cannot affect world import and export prices, and faces a perfectly elastic world supply curve. However, if a country has a large share in the world market for an import or export good, it may be able to affect the level of world prices.

45. Consequences of changes in the terms of trade on income distribution Lasting, or long-term improvements in the terms of trade redistribute global output and income towards the country experiencing the improvement. This follows from the principle that a country can purchase a larger quantity of imports with the same quantity of exports. The gain of extra output produced elsewhere corresponds to lost output for countries experiencing long-term deteriorating terms of trade. These countries suffer a transfer of output and income away from the domestic economy, because they are forced to export increasing quantities of exports in order to maintain a particular quantity of imports. Therefore, the result is a global redistribution of output and income.

46. The terms of trade and effects on the current account A change in the terms of trade leads to an improvement in the balance of trade (a smaller trade deficit or a larger trade surplus) if it causes an increase in the value of exports or a decrease in the value of imports. BOT = Value of X – Value of M BOT = PxQx- PmQm

47. Change in Demand When the terms of trade change due to a change in the global demand for a good, the terms of trade and the balance of trade change in the same direction: either they both improve or they both deteriorate. This applies to both exporting and importing countries. Can you observe it in the graph here?

48. Changes in global supply: the role of PED for exports and imports Inelastic Demand Wheat, being an agricultural commodity, has a relatively inelastic demand (PED<1). Since PEDx< 1, the increase in the quantity (S1 to S2) if its wheat exports is proportionately smaller than the fall in the export price, leading to a fall in the value of wheat exports. Flatland’s deterioration in its terms of trade causes a deterioration in its balance of trade

49. Changes in global supply: the role of PED for exports and imports Inelastic Demand (Export Perspective) Wheat, being an agricultural commodity, has a relatively inelastic demand (PED<1). Since PEDx< 1, the increase in the quantity (S1 to S2) if its wheat exports is proportionately smaller than the fall in the export price, leading to a fall in the value of wheat exports. Flatland’s deterioration in its terms of trade causes a deterioration in its balance of trade

50. Changes in global supply: the role of PED for exports and imports Inelastic Demand (Import Perspective) Suppose that Mountainland is a wheat importer. It faces a lower import price, and therefore improving terms of trade, and a larger quantity of wheat imports. Since Mountainland is a wheat importer, its PED for imports is relevant to analysing the effects of the terms of trade change on its trade balance. Since PEDm< 1, the increase in the quantity of wheat imports is proportionately smaller than the fall in the import price, leading to a fall in the value of wheat imports. Therefore, Mountainland’s improvement in its terms of trade leads to an improvement in its balance of trade (a smaller trade deficit or larger trade surplus).