International Economics

International Economics

Topic 1Why Do Countries Trade?

Niels Brock Summer 2013

Course 17832 Advanced Diploma Management

HOUSEKEEPING

• Notes– Wikispace– http://

nielsbrockprogram.swsi.wikispaces.net/home

• Any issues?

2

Names

• Write names on folded piece of paper

Assessments

• ASSESSMENT 1 – IN-CLASS EXAM• WEEK 6• Method: Written

• Students will sit an in-class in Week 6 under the supervision of the class teacher.

• The exam will consist of 20 multiple choice questions, 5 short answer questions and 1 long answer.

• The exam will cover the topic areas from Chapters 21-23.

Assessments

• ASSESSMENT 2 – IN-CLASS ACTIVITIES• WEEKS 2, 4 & 5• Method: Oral• • Students will complete the in-class activities,

based around the assessments in the text-book.• Students will work individually and in groups to

complete the activities and present their analysis and findings to the class,

Topic 1

6

Why Do Countries Trade?

1. The gains from International Trade

2. Comparative Advantage Theory

3. The World Trade Organisation (WTO)

WHY DO COUNTRIES TRADE?Topic 1 (Ch 21)

What is trade?

• Trade might be defined as the buying and selling, or exchange, of goods, services or commodities between 2 or more interested parties.

• Trade can be domestic (within a country), OR international (between countries).

• International trade is the focus for your course in Australia

Exports and Imports

• What are exports?• What are imports?• What is “balance of trade” otherwise known

as?

Some definitions for trade• Imports – the goods and services one country brings in (i.e.

buys) from another country or countries• Exports – the goods and services one country sends out (i.e.

sells) from another country or countries• Imports and exports are usually measured in value – DKK,

USD, AUD etc. Comparative figures worldwide are often measured in USD (in the EU it is, of course, the Euro)

• The difference in value between imports and exports is a countries “balance of trade” or “net exports” (NX). We will discuss this later in the course when we look at the concept of “balance of payments”)

How does trade relate to other economic principles?

• Trade is a fundamental part of economics.

• Economics is (as you know) about the study of “how…resources are allocated to fulfil(l) the infinite needs of consumers” (Blink and Dorton, 2011, p.3)

• The way we get the resources and end product to consumers is by trading, both domestically and internationally.

Activity

• Why do countries trade?

Why trade then?

• Lower prices• Greater choices (consumption and investment)• Better resource allocation or ability to access

resources not available in the country• Specialisation and economies of scale• Increased competition• More efficient allocation of resources• Source of foreign exchange

Blink and Dorton 2011:260-261

14

TRADE

Australia’s 4 Biggest Customers1. Japan2. China3. U.S.A.4. New Zealand

Australia’s 4 Biggest Suppliers1. U.S.A.2. China3. Japan4. Germany

The Chinese Powerhouse• 1.3 Billion people• Economic growth rate 2 – 3 times more than

developed countries like Australia

Implications:– Huge Potential Market– Tough and efficient competitor– A source of materials and supplies– As a partner to take on the world

• Also INDIA; And in our region - Thailand, Malaysia, Vietnam, are expanding as their societies develop and become prosperous

Who does Australia trade with?

And now for some research!• In order to truly understand trade, you need to start looking

at what countries actually do in their trading and who they trade with.

• Research and answer the following questions:– Which countries are the top 5 trading partners for Denmark for

imports AND exports of goods (do both)?– What was the approximate value (in DKK) of all exports and imports

undertaken by Denmark for 2013? • What is the approximate proportion of this that the EU represents?

– What are the top 5 exports for Denmark?

• Please undertake your research in English • A useful website: www.statbank.dk

Student Workpoint 21.1

• Make a list of goods that you commonly use that are imported. – This can include food, clothing, electronics, etc. – If possible, identify the source of the good.

• Share / Discuss

Some quick revision

• What is opportunity cost?– Blink and Dorton define opportunity cost as “the next best

alternative foregone when an economic decision is made” (2011, p.3)

– What is the opportunity cost to you (or whoever funded it) of this trip to Australia? Tip: think about what the money might have been spent on if you hadn’t spent it on a trip to Australia.

– An understanding of opportunity cost is vital to the understanding of why countries trade because a country makes a decision about whether it should produce Good A rather than Good B (or C or D etc.) to trade (more about this soon).

• Increased employment

• Export industries will grow in size due the expansion of the world economy (although tempered by recessionary pressures). This encourages specialisation, mass production and economies of scale

• This allows companies to invest in the development of existing land, plant machinery, labour etc.

Why do we export goods?

• Goods are unavailable inside the country (might not have the resources or technology to produce)

• Goods can be produced but not in sufficient quantities to satisfy domestic demand

• Goods are cheaper from another country

• Import of intermediate goods may increase efficiency and variety of output/final production

• Import of intermediate goods may allow production to take place (may not be otherwise possible without the imported goods)

• Quantity and quality is enhanced, better satisfying the wants of consumers

Why import?

• Production possibilities

A bit more….

Production possibilities

• A production possibility curve (PPC) shows the maximum combinations of goods and services that can be produced by an economy in a given time period, if all the resources in the economy are being used fully and efficiently and the state of technology is fixed. It is said to show potential output.

• Any point inside the PPC is possible to achieve, but it means that not all of the factors of production in the economy are being used and/or some of the factors are being used inefficiently. In reality, of course, economies are always producing within their PPCs, since there are always unemployed factors of production. For the production possibility curve to shift. The quantity or quality of factors of production needs to increase (or decrease to shift the curve inwards)

• Blink and Dorton 2011

• Trade allows a country to consume goods & services in excess of its production possibilities frontier (PPF) (Layton et al 2012)

Trade and production possibilities

Absolute advantage

• Theory developed by Adam Smith in 1776

• Absolute advantage is the ability of a country to produce a good using fewer resources or inputs (land, labour, capital, enterprise) than another country.

• An example would be if there are two countries (the US and Japan) producing two goods (food and cars), using labour as the only input. All workers in a country are equally productive. Since Japan is more efficient in the production of cars and the US is more efficient in the production of food, Japan has an absolute advantage in the production of cars and the US has an absolute advantage in the production of food.

• Even if a country has an absolute advantage in producing both goods, this does not mean that there are no advantages to be gained from trade.

23

Absolute Advantage

• The table shows production outcomes where two countries are using the same quantities of resources to produce lamb and cloth

• Australia has an absolute advantage in producing lamb

• China has an absolute advantage in the production of cloth

Country Kilos of Lamb Metres of Cloth

Australia 6 1

China 4 3

TOTAL 10 4

Comparative Advantage• What if one of the countries in the table prior had absolute

advantage in both products?

• The economist, David Ricardo, in the early nineteenth century was the first to prove mathematically that trade could still be beneficial to both countries when one of the countries had an absolute advantage in producing all goods.

• This is by considering the opportunity cost of production and Ricardo uses this to explain the concept of Comparative Advantage

Comparative Advantage

• A country is said to have a comparative advantage in the production of a good if it can produce the good at a lower opportunity cost than another country

• In other words, Country A has to give up fewer units of other goods to produce the goods in question than does Country B

• This best shown by the table on the next slide

Comparative Advantage

• France has absolute advantage in production of both goods

• France needs to give up production of 4/3 kilos of cheese to produce 1 litre of wine, whilst Poland has to give up 3 kilos of cheese to produce 1 litre of wine

• So, France has a comparative advantage in the production of Wine

BUT…

Country Litres of WineOpportunity

Cost of 1 Litre of Wine

Kilos of CheeseOpportunity

Cost of 1 kilo of cheese

France 3 4/3 kilos of cheese 4 ¾ litre of wine

Poland 1 3 kilos of cheese 3 1/3 litre of wine

Comparative Advantage

• BUT Poland only has to give 1/3 litre of wine to produce 1 kilo of cheese, whilst France has to give up ¾ litre of wine to produce 1 kilo of cheese

• So, Poland has a comparative advantage in the production of Cheese

• The theory of Comparative Advantage tells us that France should specialise in the production of Wine and Poland should specialise in the production of cheese.

• France can then consume the wine they wish, and then use the excess wine to exchange for cheese. In the same way, Poland will consume the cheese that it wants and use any extra cheese to exchange for Wine.

Country Litres of WineOpportunity

Cost of 1 Litre of Wine

Kilos of CheeseOpportunity

Cost of 1 kilo of cheese

France 3 4/3 kilos of cheese 4 ¾ litre of wine

Poland 1 3 kilos of cheese 3 1/3 litre of wine

REVISION

• Read over the section titled Comparative Advantage theory in the textbook – Ch 21 pp.261-263

Factor Endowments

• A country’s share of the factors of production is called its “factor endowment”

• Comparative advantage assumes that different countries have different opportunity costs (which is correct).

• Different countries have different opportunity costs because of the quantity and quality of factors of production

• A country will be the most efficient producer of a particular commodity if it makes intensive use of these abundant factors (which will be relatively cheaper)

• Thus the opportunity cost of foregoing production in the other goods will be lower than the opportunity cost of foregoing production of goods that makes intensive use of the abundant factors

Limitations of international trade theories

• The theory of comparative advantage has limitations by making the following assumptions:

– It assumes producers and consumers have perfect knowledge and are aware of where the cheapest goods may be purchased

– Assumes no transport costs– The basic theories assumes there are only two countries producing the goods (but

computer models can determine comparative advantage for multiple countries)– It assumes the costs do not change and the return to scale are constant i.e. that

there are no economies of scale.• Economies of scale would increase a countries comparative advantage as relative costs of

production fall even more– It usually assume the goods being traded are identical

• With commodities it is easier to determine, such as Barley, Cotton or Bananas• with an LG TV compared with a SONY TV it is much harder to compare.

– It is assumed that factors of production remain in the country• Labor may migrate• Some companies may not export finished goods, but export components and then

manufacture in the country– It is assumed that there is perfectly free trade among countries

The WTO

The World Trade Organisation (WTO) is an international organisation that sets the rules for global trading and resolves disputes between its member countries.

• WTO established on 1 January 1995 and now has 153 members and 30 observer countries, the majority of whom are seeking membership.

• It replaced the General Agreement on Tariffs and Trade (GATT) set up after the second World War

• The WTO, and its predecessor the GATT, is largely credited with the fact that, since 1947, average world tariffs for manufactured goods have declined approx. from 40% to 4%!!!– Allowing a system of closer to free trade, with better international competition,

improved resource utilisation and ultimately better outcomes for consumers

• All WTO member are required to grant “most favoured nation” status to one another, which means that, usually, trade concessions granted by a WTO country to another country must be granted to ALL WTO members.

The WTO

• The World Trade Organisation functions are:– Administer WTO trade agreements

• General Agreement on Tariffs and Trade GATT

– Be a forum of trade negotiations– Handle trade disputes among countries– Monitor national trade policies– Provide technical assistance and training for

developing countries– Cooperate with other international organisations

Sources

• Van Marrewijk, Charles (2009) The Princeton Encyclopedia of the World Economy vol. 1 p. 1

• Fraser I, Gionea G, and Fraser S (2005) Economics for Business McGraw Hill:North Ryde

It is time to participate in some free, voluntary trade!

• You are a country. Come up with a name for yourself!• Decide what you focus will be as a country i.e. your trade in

stock. Minerals, IP, IT/IS, consumer goods, labour, manufacturing steel components or auto parts.

• You will each select 3 x “goods” to trade with selected countries ( I will select the countries you will trade with)

• There will be 2 rounds of trade. I will explain each round to you before each round starts.

• We will have a discussion at the end of each round.

It is time to participate in some free, voluntary trade!

• At the end of the 2 rounds you will decide:– What you will consume domestically (i.e. keep for yourself)– What you continue to trade with other countries (i.e. swap with

someone else)– What you decide to grant as foreign aid to poorer countries (what you

give away because you feel sorry for your poor friends who were left with worthless “goods”)

Homework for next week

• Finish your internet research if you haven't already done so

• Read chapter 21 of Blink and Dorton (2011)

• Attempt the activities in the Chapter

46

Thank You!

• Coming weeks– Topic 2, Ch 22: – Free Trade and Protectionism