Economics 244 International Trade 2023 Jafta PDF

2023 INTERNATIONAL ECONOMICS 244: TRADE A READER* *COMPILED BY PROF. RACHEL JAFTA© & IREEN SEMENYA FOREWORD Dear Students...

2023 INTERNATIONAL ECONOMICS 244: TRADE A READER* *COMPILED BY PROF. RACHEL JAFTA© & IREEN SEMENYA FOREWORD Dear Students, You are advised to use your module framework and the lecture Welcome to Economics 244 International presentations, together with the tutorials Trade! I am delighted to have you join and the online tutorial tests to work me in exploring the fascinating and systematically through the work. Test complex world of international trade. yourself regularly to make sure you have grasped everything. To this end, Textbooks are expensive and not always your module framework will provide key appropriate for students in emerging questions that you must complete by the economies. So, this eBook is written deadlines indicated. Your lecture slides especially for you. It contains the will provide key elements that must be in prescribed work that an Intermediate every answer and this eBook is your best International Trade student should go-to place to find them. know. It is aimed at helping you to: You will also see suggestions for further Understand the current economic reading and videos to watch to enhance conditions and the implications for your understanding. Just follow the economic growth prospects; icons: Gain insights from International Trade Theories that explain why video international trade matters; Understand why and how and to what effect governments intervene in reading international trade; Understand the multilateral global trading system and how it advances May you find your studies delightful and trade amongst countries; the success that follows from your hard Understand regional integration, work rewarding. its purpose and possibilities and obstacles; With best wishes, Use the insights from theory to understand how the confluence of freer trade under the World Trade Rachel Jafta Organisation’s Trade Facilitation Agreement, the African Continental Free Trade Agreement and the Fourth Industrial Revolution can propel Africa into economic prosperity. We thank Tessa Hubble for assistance in updating the eBook. Cover photo credit: The Economist 2 ECONOMICS 244: INTERNATIONAL TRADE  ECONOMICS 244: INTERNATIONAL TRADE A READER COMPILED BY PROF. RACHEL JAFTA & IREEN SEMENYA CONTENTS 5 Introduction: Is the Covid-19 pandemic the end of International Trade? 6 PART 1: Why does International Trade matter? 28 Part 2: Intervention and International Trade 40 Part 3: Reducing Barriers to Trade 58 Part 4: Africa and South Africa’s prospects for economic prosperity through Trade 81 Bibliography ECONOMICS 244: INTERNATIONAL TRADE 3 PART 1 WHY DOES INTERNATIONAL TRADE MATTER? “Trade is a force for good, and properly harnessed can help lift millions out of poverty and bring shared prosperity.” Dr Ngozi Okonjo-lweala, WTO Director General (first woman and the first African to be chosen as Director-General of the WTO). 4 ECONOMICS 244: INTERNATIONAL TRADE  INTRODUCTION: PART 1 WHY DOES INTERNATIONAL TRADE MATTER? PERSISTENT INFLATION, COVID, GENERATIVE AI AND OBSTINATE WAR: IS THIS THE END OF INTERNATIONAL TRADE? To answer this question, we need In Part II, we note that, although the to understand why trade matters theories we have learned suggest that free trade is the best policy choice to in the first place, how it works maximise economic welfare, the world and what it means for Africa’s around us is filled with barriers to development prospects and for you trade. Here we need to understand why and me, here in South Africa. governments intervene in free trade, how they do it and what the impact of Part 1 therefore, uses the theories of such interventions can be over time. International Trade that have evolved over many years to explain the gains from But, what if a concerted effort is made to trade and the transmission mechanisms reduce barriers to trade to capture the of those gains into economic growth. gains from trade? How can this be done, Remember that theories develop to and who will gain from these efforts? In explain observed phenomena. To Part III we discover that there are two formulate a theory, one has to abstract ways to reduce barriers to trade: from reality, i.e. we cannot include every little detail. Theorists do so by setting 1. Through the multilateral rules-based the theory in a number of assumptions. system of international trade regulation Over time, theories prove no longer under the auspices of the World Trade fully relevant to changed circumstances Organisation(WTO); and or new theories are advanced. In the timeline of the International Trade 2. Through cooperation amongst countries in theories, you will be able to observe how a process called regional integration. this process played out. It is important that we grasp how the insights from theories and research can help us improve the well-being of the people in our countries. In Part IV we will see that there are various exciting ways in which our continent, Africa, can benefit not only from the efforts to remove barriers to trade but also from the opportunities that new technologies, collectively known as the Fourth Industrial Revolution (FIR) can bring. Throughout we bear in mind the link between more and better trade and economic growth and the well-being of people, especially the youth and women, who remain most vulnerable. ECONOMICS 244: INTERNATIONAL TRADE 5  PART 1 WHY DOES INTERNATIONAL TRADE MATTER? THEORY OF INTERNATIONAL to build a prosperous and powerful TRADE TIMELINE: state. Mercantilists believed that the wealth of a nation is measured by how International trade is the exchange much gold and silver (the currency of capital, goods and services across at the time) they had in the national international borders or territories. treasury. From their perspective, International trade has led to significant exports were good, because foreign economic prosperity, although unevenly nations would pay for it, bringing an spread across the globe. Economic inflow of gold and silver. Imports, on prosperity through trade arises from: the other hand, meant that gold and silver would leave the country to pay for 1. the exploitation of comparative the imports and should, therefore, be advantage - Trading-partners reap limited. The Mercantilists were a very mutual gains when each nation powerful class and able to influence specialises in goods for which it holds government policies. Achieving their comparative advantage and then goals was accomplished by imposing engages in trade for other products, strict government controls and 2. gains from specialisation- higher regulations on trade, commerce and production volumes provide further economic activities. The restrictive cost benefits in terms of economies of economic policies imposed included scale, high tariffs, especially on manufactured 3. increased competition which lowers goods, export subsidies, limiting wages, world prices and promotes efficiency, exclusive trade with colonies, maximising 4. the breakdown of domestic the use of domestic resources, monopolies, and government support of new industries 5. the potential increase in the variety and through the provision of capital and quality of goods and services, as well as tax benefits, and the establishment of 6. employment, given that employment is monopolies over the local and colonial closely related to production. market. The government would also provide grant titles and pensions to But, this was not always understood successful producers (LaHaye, 2019). as such. Adam Smith, the father of Economics, spent much of the Wealth of Nations slaying the “Mercantilist dragon.’ These views are captured by the Who then, were the Mercantilists, and English mercantilist writer Thomas why did their thoughts and practices lead Mun, who in 1664 stated that Adam Smith to draw his literary sword? “the ordinary means therefore to increase our wealth and treasure is 1500-1700 by foreign trade, wherein we must ever observe this rule; to sell more MERCANTILISM to strangers yearly than we consume Mercantilism, the first theory of of theirs in value.” international trade, underlies the desire 6 ECONOMICS 244: INTERNATIONAL TRADE PART 1 WHY DOES INTERNATIONAL TRADE MATTER? Features of a mercantilist Economy: Three Assumptions of Mercantilism 1. Imports of certain goods were 1. There is a finite amount of wealth in prohibited through the imposition the world. of tariffs and other restrictions 2. A nation should have a positive introduced by the government. Balance of Trade by exporting more 2. The government prioritised export than it imports. industries through the provision of 3. A nation can only grow rich at the subsidies. expense of other nations; therefore, 3. Policies of nationalism were trade is a zero-sum game (Ahmad et imposed. al, 2014). 4. Wealth was measured in gold and silver in the national treasury, and The view of trade as a zero-sum game private accumulation, use or export not only encouraged the adoption of of precious metals was prohibited. complex government trade restrictions, 5. Promotion of one-way trade which raised prices and stunted the with colonies and importation of growth and freedom of businesses, but it precious metals from a trading also ignited the conflict between trading partner (Ahmad et al, 2014). parties and colonies in some instances. Whilst the decline of mercantilism can be linked to the rise of the laissez-faire doctrine of free-market economics, it is the publication of Adam Smith’s Did You Know? “The Wealth of Nations” that was generally thought to mark the end of the South African students would Mercantilist era. Adam Smith coined the find it interesting that Mun term “mercantile system” to describe the was the director of the East system of political economy that sought India Company at whose to enrich the country by restraining insistence Jan Van Riebeeck imports and encouraging exports. established the Dutch settlement at the Cape of “It is the maxim of every prudent Good Hope in the 1650s. master of a family, never to attempt to make at home what it will cost him more to make than to buy...What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom”. The Wealth of Nations, Book IV Chapter II, pp. 456-7, paras. 11-12. Photo credit: VOC Ships; https://www.sahistory.org.za/article/ dutch-east-india-company-deicvoc ECONOMICS 244: INTERNATIONAL TRADE 7  PART 1 WHY DOES INTERNATIONAL TRADE MATTER? 1776 ADAM SMITH ADAM SMITH’S ABSOLUTE AND THE DIVISION OF LABOUR ADVANTAGE We must remember that Adam Adam Smith’s “An Inquiry into the Smith wrote in the 1770s, at the Nature and Causes of the Wealth beginning of the first Industrial of Nations” installed him as one of Revolution. Factory processes that the most influential figures in the to us are well known were a novelty development of economic theory. in his day. One day he visited a pin Smith challenged the mercantilist idea factory and what he saw there led that national wealth was reflected in a him to formulate the concepts of country’s holdings of precious metals by division of labour and specialisation convincingly arguing that national wealth that have stood the test of time for was reflected in a nation’s productive more than 200 years. Here is his capacity rather than the stock of gold excited account: and silver (money). Moreover, growth in productive capacity was fostered best in ‘One man draws out the wire, an environment where individuals are another straights it, a third cuts it, free to pursue their self-interest. Self- a fourth points it, a fifth grinds it interest, in-turn, would lead individuals at the top for receiving the head; to specialise in and exchange of goods to make the head requires two and services based on their special or three distinct operations; to abilities. Thus, gains are acquired put it on, is a peculiar business, through division and specialisation of to whiten the pins is another; it is labour (see Box). even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands’. He goes on to explain how breaking a process up into smaller steps and learning to execute those steps very well through learning, practice and specialisation boosts productivity. It is indisputable how this still TIP Think how Adam Smith’s insight on applies today. The Apple products, division of labour and specialisation will for example, are designed, help developing country firms become manufactured, assembled, and competitive in the 21st century. marketed in many different places. 8 ECONOMICS 244: INTERNATIONAL TRADE PART 1 WHY DOES INTERNATIONAL TRADE MATTER? Smith advocated laissez-faire as he saw 3. Labour is homogenous and mobile little need for government control. He within a country but immobile vehemently objected to the mercantilist between countries. system that enabled powerful 4. Free Trade, i.e. no restrictions on merchants to enrich themselves imports or exports through government favour in the form 5. Perfect competition of monopoly concessions and other 6. The labour theory of value holds privileges, while contributing nothing 7. No transport costs to the general welfare of society (Ingham, 2004:11). Smith pointed out The economic principle of absolute that government policies that favour advantage implies that a country should one industry take away resources from specialise in and produce commodities another industry where they might it is most efficient at making and which have been more gainfully employed in turn will ensure that the price of (Wang, 2004). In sum, Smith applied that commodity is competitive for all the principles of division of labour and consumers. This makes trade mutually specialisation to international trade beneficial for all trading countries, thus where he explains that in a setting a positive-sum game as every country where individuals can pursue their self- will export the commodities it has an interests, countries would specialise in absolute advantage over and import and export goods in which they have the commodities it has an absolute an absolute advantage. disadvantage over. The pivot from the mercantilist view of trade as a zero- Absolute advantage theory sum game to Smith’s view of trade as a positive-sum game set the foundation Adam Smith described absolute for free trade and the elimination of advantage as a particular country’s government-imposed protectionist capability to produce more of a measures. commodity at a lower cost (that is, with less input) than its competitors Examples of Absolute Advantage (AA): could. Absolute advantage is achieved through low-cost production. In Adam 1. A simple example of AA Smith’s theory, the efficiency that leads to lower costs is linked to the division There are two countries, the US and of labour and specialisation. China, both producing two goods, computers and shoes. The output per The theory is based on the following worker in one year: assumptions: 1. A two-country and two-commodity model is applied. 2. Labour is the only factor of production thus only input or US 5 3 production cost is taken into account. China 2 10 ECONOMICS 244: INTERNATIONAL TRADE 9 PART 1 WHY DOES INTERNATIONAL TRADE MATTER? In this example, 3. Absolute advantage in everything The US has an absolute advantage in producing computers (5 to 2) There are two countries, the US and China has the absolute advantage in South Africa, both producing two goods, producing shoes (10 to 3) clothes and cars. The output per worker in one year: 2. Absolute advantage and labour costs There are two countries, South Africa and Brazil, both producing two goods, wine and cloth. The hours of labour required to produce one unit: US 5 10 South Africa 3 1 In the above scenario, the US has an absolute advantage in producing clothes (5 to 3) and has an absolute advantage in South Africa 60 110 producing cars (10 to 1). Brazil 120 50 According to Adam Smith, there would be no reason for the US to engage In this example, the absolute advantage in trade with South Africa, because it is illustrated differently. Rather than produces both goods at a lower cost. showing the output, the hours of labour Absolutely, yes, said David Ricardo as he required are shown. This reflects the introduced the notion of comparative effective cost of production. advantage. In the scenario above, South Africa has “It will appear then, that a country an absolute advantage in producing wine possessing very considerable (only requires 60 hours compared to 120 Brazil’s 120 hours). advantages in machinery and skill, and which may, therefore, be Brazil has an absolute advantage in enabled to manufacture commodities producing cloth (only requires 50 hours with much less labour than her compared to 110 hours in South Africa). neighbours, may in return for such commodities import a portion of the However, what if one country had the absolute advantage in everything, corn required for its consumption, would there still be reason to trade? even if its land were more fertile and corn could be grown with less labour than in the country from which it was imported”. David Ricardo, Principles of Political Economy and Taxation, 1817: 83. 10 ECONOMICS 244: INTERNATIONAL TRADE PART 1 WHY DOES INTERNATIONAL TRADE MATTER? 1800’s DAVID RICARDO’S Did You Know? COMPARATIVE ADVANTAGE that David Ricardo was a THEORY (RICARDIAN THEORY successful stockbroker to the OF TRADE) extent that he was wealthy enough to spend his time on In 1817 David Ricardo expanded upon economic theory development? Smith’s theory. While, in the context of For more on the lives of the great a two-country two-commodity model, economists, you can find Robert Adam Smith thought that a country Heilbroner’s delightful book, the with an absolute advantage in both Worldly Philosophers here free: commodities would derive no benefits from trade, in the “Principles of Political https://www.booksfree.org/the- worldly-philosophers-7th-edition-by- Economy and Taxation”, Ricardo argued robert-l-heilbroner-pdf-free-download/ that gains from trade go beyond those advocated by Adam Smith. The assumptions of the Ricardo showed that even in the Ricardian model: absence of a country’s absolute advantage in any of the two 1. A two-country and two-commodity commodities, trade can still be model is applied. favourable in a comparative advantage 2. Labour is the only factor of scenario. That is, in a two-commodity production, homogeneous and two-country model, even if one country mobile within a country but immobile is absolutely more cost-efficient at between countries. producing both products, both will still 3. Technology does not change (no gain from trade if each produces the innovation) good in which they have a comparative 4. There is full employment in both advantage (Saylor Academy, 2012). countries before and after the trade 5. Perfect competition prevails in all The Ricardian theory is based markets on comparative advantage and 6. Constant returns to scale specialisation. This classic model of 7. Free Trade: no restrictions on imports international trade attributes the basis or exports for trade to differences in technology 8. No transport costs across nations. The differences in technology give rise to differences David Ricardo predicts that a country in relative costs and are sources of will export goods in which it has the comparative advantage. Comparative comparative advantage, i.e where advantage refers to the ability of a productivity (output per worker) is country to produce a good or service higher, conversely, it will import the at a relatively (not absolutely) lower goods of its comparative disadvantage, cost than another country (Ulltveit- i.e where productivity is lower. Moe, 2010). ECONOMICS 244: INTERNATIONAL TRADE 11 PART 1 WHY DOES INTERNATIONAL TRADE MATTER? A NOTE ON OPPORTUNITY COST In this example, for the UK to produce 1 unit of cars, it has an opportunity cost of David Ricardo explained the concept 2/5= 0.4 textiles. of comparative cost advantage with a For India to produce 1 unit of cars, it has simple arithmetic example, comparing an opportunity cost of 10/2 = 5 textiles. the relative cost of wine and cloth- making in England and Portugal. At the Therefore, the UK has a comparative time, the value of a product was very advantage in producing cars because it much dependent on the amount of has a lower opportunity cost in cars. The labour it took to produce, i.e. based on opportunity cost of producing textiles: the labour theory of value. The problem was that this considered only one factor If the UK produces 1unit of textiles, of production. The advent of Neoclassical the opportunity cost is 5/2 = 2.5 cars economic theory and the ‘toolbox’ of foregone. economics, especially the introduction of If India produces 1unit of textiles, the opportunity cost by Gottfried Haberler opportunity cost if. 2/10 = 0.2 cars in 1933, made it easier to explain foregone, comparative advantage. Opportunity Therefore, India has a comparative cost is simply the quantity of one good advantage in producing textiles that must be given up to get one more of because it has a lower opportunity another (Ingham, 2004:15-16). cost in textiles. Examples of comparative advantage: Assuming that the international terms of trade (the price of cars in terms of A country has a comparative advantage textiles and vice versa) are better than the if it can produce a good at a lower domestic opportunity cost, trade will be opportunity cost than another country. mutually beneficial. Note that it is crucial A lower opportunity cost means a nation that what they can obtain through trade has to forego less of one good in order should be better than what they can to produce another. produce themselves; otherwise, there would be no incentive to trade. According 1. Example of output of two goods: to the theory of comparative advantage, if There are two countries, the UK and India, each country now specialises in producing both producing two goods, cars and one good, then assuming constant returns textiles. The output per worker in one year: to scale, the output will be double. The opportunity cost of producing cars: Output after specialisation: UK 5 2 UK 10 0 India 2 10 India 0 20 TOTAL 7 12 TOTAL 10 20 12 ECONOMICS 244: INTERNATIONAL TRADE  PART 1 WHY DOES INTERNATIONAL TRADE MATTER? Therefore, the output of both An economy that is operating on the goods has increased, illustrating the PPF is producing efficiently, meaning it is gains from trade from comparative impossible to produce more of one good advantage. without reducing the production of the Total output is now 10 cars and 20 other good. For example, if an economy Textiles, which is higher than the that is only producing computers and previous totals of 7 cars and 12 shoes is operating on the PPF, the textiles. production of computers would need Therefore, specialising in the good to be sacrificed to produce more shoes. where there is a comparative If production is efficient, the economy advantage has led to an increase in can choose between combinations overall economic welfare. (i.e. points) on the PPF, depending on society’s preference: A if computers are ! of interest, C if more shoes are needed, RECAP: UNDERSTANDING or B if an equal mix of computers and PRODUCTION POSSIBILITIES: shoes is required. The production possibility frontier (PPF) is a graph that shows all the Quantity of computers different combinations of the output of two commodities that can be produced using the total amount of available factors of production (resources) and technology. It shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology. The PPF captures the concept of scarcity, choice and Quantity of shoes tradeoffs. Source: PPF with increasing cost. https://justdan93.wordpress.com/2012/04/23/ The shape of the PPF depends on the production-possibilities-curve-and-law-of- cost structure. The usual PPF with increasing-opportunity-cost/ increasing cost is drawn outward (concave) from the origin. Conversely, If the economy is operating below A PPF with decreasing cost bows the curve (point X), it is operating inwards (convex) viewed from the inefficiently, because resources could origin and one with constant cost be reallocated to produce more of one is represented by a straight line. or both goods without decreasing the The slope of the PPF indicates the quantity of either. The point outside the opportunity cost of producing one curve (Y) is unattainable with existing commodity in terms of the other resources and technology. commodity. The opportunity cost can be compared to the opportunity cost of another producer to determine comparative advantage. ECONOMICS 244: INTERNATIONAL TRADE 13 PART 1 WHY DOES INTERNATIONAL TRADE MATTER? The PPF will shift outwards if more Single country gains from trade and inputs (such as capital or labour) become comparative advantage available or if technological progress makes it possible to produce more output with the same level of inputs. An outward shift means that more of one or both outputs can be produced without sacrificing the output of either good. Conversely, the PPF will shift inward if the labour force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital. In autarky (state of isolation without trade), each country consumes only what it produces. In this instance, the PPF is also the consumption possibility frontier. Trade enables consumption outside the PPF. The global PPF is made up of combining countries’ PPFs. When countries’ autarkic productions are added, the total quantity of each good produced and consumed is less than the global PPF under free trade (when nations specialise according to their comparative advantage). This shows that in a free trade system, the absolute quantity of goods available for consumption is higher than the quantity available under autarky (KhanAcademy & Lumencandela). Combining the notion of opportunity cost and the well-known Production Possibility Frontier (PPF) as well Source: EconomicsFun + edits https://www. as indifference curves, it becomes youtube.com/watch?v=V1Vh27kAPYc possible to illustrate the gains from trade clearly. You are familiar with We can now use a graphical illustration individual indifference curves from to explain the gains from trade. Microeconomics. If we assume that we Remember that comparative advantage can horizontally sum these individual is the advantage that one country has indifference curves, we can derive a over another if it can produce a product Community Indifference Curve (CIC). at lower opportunity cost than another The PPF then represents the supply country. Opportunity cost is the value of (production) side and the CIC the one product in terms of another, e.g. the demand (consumption) side of the quantity of food that must be sacrificed economy for a country. to produce one more unit of clothing. 14 ECONOMICS 244: INTERNATIONAL TRADE  PART 1 WHY DOES INTERNATIONAL TRADE MATTER? After trade: TIP You can follow the video explaining the Ricardian When markets open to trade, trading gains from trade here: countries will determine their https://www.youtube.com/watch?v=V1Vh27kAPYc comparative advantage using price ratios. On the graph, this means that we can draw a triangle under the We start with a situation where there is PPF to see the price ratio. If we have no trade at all because the country has no figures, we look at the distances a closed economy. Consider the graph instead. In our graph, it is clear that at the top and on page 14. Domestic our country has the comparative equilibrium is achieved at point E where advantage in product x. Our country the PPF and the nation’s IC are tangent will specialise in the production of to the domestic price line. good x in which it has a comparative advantage, given favourable Before trade (In autarky): international terms of trade (ITOT) indicated by the price line. The price Possibilities for economic growth line (now called the ITOT line) should in isolation are limited; the best a be better than the domestic price ratio country can do is to reach the PPF. (in autarky) to entice specialisation A point beyond the PPF is and trade, otherwise no trade will unattainable. occur. In autarky, consumption is equal to its The country will begin to shift production. resources to the production of good The most efficient point occurs x by moving along the PPF to produce where there is a tangency between the x2. PPF, the price line/ price ratio and the Specialisation splits the points highest possible country indifference of production and consumption. curves, ICi. An indifference curve is a Production now shifts to a point graph that shows a combination of lower down on the PPF, producing two goods that give a consumer equal more of x, the good of our CA and satisfaction and utility, thereby making less of y, the good of our comparative the consumer indifferent. Utility refers disadvantage. to the total satisfaction received If terms are favourable the ITOT line from consuming a good or service. will be steeper and tangent to a Higher indifference curves represent higher country indifference curve ICii. greater levels of utility than lower ones We can now export more of x and (Chappelow, 2020). import y in return. The difference between x3 and x2 is Now assume that international trade exported becomes an attractive option for this At the new price range, consumption country. of y increases to y3 because of imports. ECONOMICS 244: INTERNATIONAL TRADE 15  PART 1 WHY DOES INTERNATIONAL TRADE MATTER? Therefore, after trade : o The quantity consumed of good NB Note: y increases from y1 to y3 and the quantity consumed of good x Mercantilism, Adam Smith’s absolute increases from x1 to x3. advantage theory and David o The quantity produced of good Ricardo’s comparative advantage y decreases from y1 to y2, and constitute the classical economic the quantity produced of good x trade theories. Classical Economists increases from x1 to x2. simply accepted the fact that cost differences exist between countries; The increase in domestic production they made no concerted attempt and the ability of the country to to explain the origin of the cost operate on a higher indifference curve, differences. For many decades the indicating higher consumption of BOTH comparative advantage theory and products constitute the gains from its predictions for trade patterns international trade. were accepted and no-one thought to dig deeper into the basis for the relative cost differences crucial to the validity of the Ricardian theory… until Eli Heckscher and Bertil Ohlin. To get context of the lavish era TIP in which The Heckscher & Ohlin theory was written (and the start of our Department), watch the 2013 remake of “The Great Gatsby”, by cult filmmaker, Baz Luhrmann. https://www.rottentomatoes. com/m/the_great_gatsby_2013 16 ECONOMICS 244: INTERNATIONAL TRADE PART 1 WHY DOES INTERNATIONAL TRADE MATTER? 1900’s Bertil Ohlin was jointly awarded the 1977 Nobel Memorial Prize in HECKSCHER-OHLIN FACTOR Economic Sciences with the British ENDOWMENT THEORY economist James Meade “for their pathbreaking contribution to the theory of international trade and international “I started [in 1921] to write on the capital movements”. foundations of an approach to international trade theory that was The Heckscher-Ohlin (H-O) model can be summarized into their two key to some extent new and for which propositions and the predictions that flow I received the inspiration during a from those propositions, in the context of stroll on [the popular promenade] their assumptions outlined below. Unter den Linden in Berlin in 1920”. Assumptions of the Heckscher-Ohlin Bertil Gotthard Ohlin. Model 1. Two country and two commodity model applies 2. Two factors of production, capital(K) Did You Know and labour (L) that are mobile across that Bertil Ohlin said that sectors he in part was destined 3. Perfect competition prevails in all to become an economist, markets because at the age of five he 4. Free Trade: no restrictions on imports loved calculating the costs of or exports the cookies his Mom baked? 9. Constant returns to scale 5. Countries have identical production Source: https://www.jarofquotes. technologies com/author.php?tag=bertil%20ohlin 6. Consumer tastes are the same across countries, and preferences for commodities do not vary with a The Ricardian model with some country’s level of income. mathematical improvements Source (Fally, 2018) remained the accepted theory of comparative advantage through the 19th century into the early twentieth century. An explanation for the basis of relative cost differences across nations remained elusive until two TIP See the Heckscher- Ohlin model video here: Swedish economists, Eli Heckscher and his student, Bertil Ohlin provided https://www.youtube.com/watch?v=qOI2xoWhakQ an answer that was so self-evident that it remains a mistery why it was not articulated before. ECONOMICS 244: INTERNATIONAL TRADE 17  PART 1 WHY DOES INTERNATIONAL TRADE MATTER? Heckscher-Ohlin theorem Make sure that you understand the NOTE difference between inter-and intra- Having explained that the basis for industry trade, because this is crucial comparative advantage in their model for the understanding of the modern trade theories. would be relative cost differences based on relative availability of factors of production, the Heckscher-Ohlin theorem predicts that a capital-abundant country The Heckscher-Ohlin Propositions will export capital-intensive goods while the labour-abundant country will export 1. Relative availability (endowments) of labour-intensive goods. factors of production differs between countries. We can thus talk about The trade pattern that the H-O theory capital-abundant or capital-rich explains is one of inter -industry trade. A countries vs. labour-abundant or trade pattern represents the composition labour-rich countries. of imports and exports of nations, i.e. 2. Technology determines different who imports and exports what? Inter- combinations of factors of production industry trade occurs between different for different products. A product industries. At the time of Heckscher and could be produced in a capital- or Ohlin’s writing, for example, developed labour-intensive way (factor intensity). countries rich in capital would have Comparing the K/L ratios, we can exported manufactured goods and tell which production processes are developing countries with abundant labour (L) and which are capital (K) labour and natural resources would intensive. Hence, a process requiring have exported primary goods, such as relatively more labour would be agricultural and mining products. deemed labour-intensive and vice versa for capital. In conclusion, free trade depicted in the Heckscher-Ohlin Model produces winners Applying the usual micro-economic and losers. Owners of the abundant reasoning, we can illustrate the logic of factor will see an increase in real income this model. Assume a nation such as and the owners of the scarce factor will China (1.4bn) or India (1.3bn) has more see a decrease in their real income. Given labour than capital. With labour being this, it is hardly surprising that owners in abundant supply and capital scarce, of the relatively abundant resources are it follows that labour would be relatively usually pro-free trade, and owners of cheap and capital more expensive. relatively scarce resources are usually anti-free trade. Generally, however, The implication that we can derive is that a the number of winners is greater than country should specialise in the production the number of losers and international of the good that uses its abundant factor trade is considered a positive-sum game, most intensively, export that and import offering greater efficiencies and wealth. the good that uses its scarce factor of The question that emerges here is what production most intensively. to do about the losers. This is a key issue to think about so long TIP for our discussion on Africa in PART IV 18 ECONOMICS 244: INTERNATIONAL TRADE PART 1 WHY DOES INTERNATIONAL TRADE MATTER? THE INTRODUCTION OF ‘NEW’ TRADE THEORIES It is important to remember that comparative advantage does not NOTE become less relevant under the new Remember what we said in the trade theories. They simply explain new bases for comparative advantage. Introduction that theories sometimes become outdated or insuffiently useful, because the economic circumstances that they applied to have changed? Several new trade theories attempted Well, in the twentieth century it became to accomplish this task. It is important evident that some trade patterns to note that while the classical theories occurred that were not explained by the were complete, even elegant theories, traditional trade theories. For example, the new attempts were each tackling Germans were ardent beer producers the task of explaining the new bases and exporters, but also imported for comparative advantage underlying beer. South Africa produces cars, but modern trade patterns from a relatively also imports cars. These exchanges narrow perspective, for example by happening in the same industry, is called relaxing some of the assumptions of the intra-industry trade. classical theories. While Mercantilism, Adam Smith’s Whilst there exists a good crop of Absolute Advantage, David Ricardo’s modern trade theories, we will explore Comparative Advantage and Heckscher- three that an intermediate International Ohlin’s theories were still capably Economics should be familiar with: explaining inter-industry trade, it became clear that new explanations 1. Linder’s overlapping demand theory were required for intra-industry trade. 2. Economies of scale (Krugman) 3. The Technology gap and product lifecycle theories ( Posner & Vernon) ECONOMICS 244: INTERNATIONAL TRADE 19 PART 1 WHY DOES INTERNATIONAL TRADE MATTER? 1961 2. Two trading countries are engaged in the trade of goods for which demand LINDER’S OVERLAPPING DEMAND exists within their domestic markets. THEORY 3. The domestic demand for goods is determined by the level of per capita Up to the H-O model, the explanation income. for the basis of comparative advantage 4. Similar levels of income influence was always sought on the production, the potential trade between the two thus the supply side with a direct countries. link to costs as the differentiator. A 5. Similar tastes and preferences in the Swedish economist, Staffan B. Linder trading partners. was the first to attempt to explain the pattern of international trade from To support his hypothesis, Linder the demand side, looking primarily at firstly, suggested that his theory was the factors that underlie the demand applicable only to trade in differentiated for the products in exchange. While manufactured goods in which consumer acknowledging that the traditional preferences and economies of scale theories still explained inter-industry were deemed important and complex trade, Linder limited his attention to and that the H-O theory still applies manufactured products in his quest to trade in primary products that are to explain modern trade patterns. determined by factor endowments He argued that manufactured goods (traditional theory). are initially produced to meet the domestic demand requirements. It Secondly, international trade is viewed as is only afterwards that the product is an extension of domestic trade with the exported to other countries, usually prime condition being that the countries neighbouring countries, such as those will trade in those manufactured goods bordering his home country, Sweden. for which domestic demand is large and Linder proposed that international active enough to allow for the exploitation trade in manufactured goods will take of economies of scale so that the resulting place largely between countries with lower costs would help penetrate foreign similar income levels and demand markets. Since consumer preferences patterns. The theory maintains that depend on income levels, the types of the countries with identical levels of products produced in a country are a income produce and consume similar function of per capita income. According quality goods and services and this to Linder, low-income countries will should lead them to trade with each produce low-quality products, and high- other, this is the Linder hypothesis, income countries will produce high- also known as the ‘demand-similarity’ quality products. hypothesis (Borkakoti, 1998). Given these patterns of production, Assumptions of Linder’s theory: international trade will occur in products that have overlapping 1. The potential trade of a country is demands, implying that consumers confined to goods that have domestic in different countries with similar per demand. capita incomes will consume similar 20 ECONOMICS 244: INTERNATIONAL TRADE PART 1 WHY DOES INTERNATIONAL TRADE MATTER? types of manufactured goods. Linder societies, rich and poor people reside in terms this ‘preference similarities the same country thus the possibility of hypothesis’ (Dhakal, Pradhan & overlapping demand in quality between Upadhyana 2009). countries with different income levels should not be ruled out. The more similar the demand structures of countries, the more “A good deal of trade now seems they will trade with one another. But, to arise because of the advantages how would trade make sense in this scenario? How do we link Linder’s of large-scale production, the hypothesis to a cost base. In this case, advantages of cumulative experience, Linder’s theory asserts that gains from and transitory advantages resulting trade derive not only from lower costs, from innovation. In industries where as emphasised by the conventional these factors are important, we are theory of comparative advantage but not going to see the kind of atomistic also from affording the market the choice of being able to consume the competition between small firms that precise quality, brand or variety of is necessary for ‘perfect’ competition” product demanded. This is thus an indirect route to comparative cost Paul Krugman, 1995 competitiveness, but comparative advantage still matters. Most certainly, Linder’s theory does 1979 not imply that no trade takes place PAUL KRUGMAN : ECONOMIES between low income and high-income OF SCALE countries. Given the prevalence of income inequality or disparities within Thinking about international trade within the Ricardian framework of comparative advantage meant doing so in the context of its strict assumptions, such as perfect competition, constant returns to News: scale and homogeneous labour. All I had the opportunity to interview these have become untenable in the Paul Krugman at the Global Internet modern economy where pure perfect Summit in Beijing, exclusively for competition was rare and increasing my economics 244 students. returns to scale powered many new You can see the video here: industries. Subsequently, modern economists began developing models of intra-industry trade based on the https://www.ekon.sun.ac.za/blog/2017-9-27-rachel- jafta-chats-to-paul-kru ECONOMICS 244: INTERNATIONAL TRADE 21  PART 1 WHY DOES INTERNATIONAL TRADE MATTER? relationship between economies of 4. Full employment scale and trade, but it wasn’t until Paul 5. The elasticity of demand rises as the Krugman’s paper titled “Increasing price of a good increases. Returns, Monopolistic Competition 6. There exist internal economies of and International Trade” that we had scale , i.e. a firm can reduce its own a simple formal model which gives rise average cost by expanding production to trade in the absence of the classical 7. Monopolistic competition – bases for comparative advantage. Internal economies of scale induced Instead, trade is driven by internal markets are imperfectly competitive; economies of scale, a key feature in therefore, there will be fewer firms, Krugman’s approach, and occurs when and each firm will produce more. a firm’s average cost per unit of output Firms will also have an incentive falls as total output increases. The to differentiate their product from simplest reason for internal economies those of their competitors -if there of scale is high fixed costs, where more are close or imperfect substitutes-, to output will allow the firm to spread compete for profits. In this case, the this fixed cost. Krugman shows that total number of firms depends on the trade and gains from trade will occur average cost and new entrants are between countries with identical only likely to enter the market if the preferences, technology and factor price of the product is higher than endowments. Thus, trade may simply the average cost. However, when the be a way of extending the market and price is equal to the average cost, allowing exploitation of economies of profits will not be high enough for scale. This model allows us to explain new firms to recover their fixed cost observed patterns of intra-industry investment and they are unlikely to trade. join the market. Assumptions of the model Economies of scale, imperfect competition and international trade 1. All individuals in the economy have the same utility function, i.e same Suppose two countries with a tastes monopolistically competitive market. 2. Countries have identical technology We assume that the countries have and factor endowments identical tastes, technologies and factors 3. Labour is the only factor of of endowment. According to traditional production theories, these countries will have no reason to trade with each other, and there are no potential gains from trade. According to Krugman, however, there will TIP Try to find some real world examples of economies be trade and gains from trade. of scale to improve your If free trade between the two countries understanding of the theory was suddenly allowed, given that the countries are identical, therefore they have 22 ECONOMICS 244: INTERNATIONAL TRADE PART 1 WHY DOES INTERNATIONAL TRADE MATTER? the same wage rate and the prices of the similarly endowed, then trade will tend goods produced are identical, it will be to be of the intra-industry type. As factor as though the market size of each firm is endowments become more unique, increased. So international trade increases the type of trade predicted by the the market size of both trading partners. Heckscher–Ohlin model will prevail. The internal economies of scale argument However, the total firms when trade Krugman formalised allow economists is allowed will be less than the total to explain aspects of international trade number of firms in autarky. Each that were previously not explainable surviving firm would produce more by Ricardian comparative advantage. If and exploit greater internal economies there are internal economies of scale — of scale, which lowers prices, but all firms are monopolistically competitive consumers in both countries would —, markets will be supplied by a certain be able to buy from a greater range quantity of firms (less than the number of firms. That is, along with reducing in perfectly competitive markets), each prices, the diversity of products also producing a greater amount of output increases. Thus, even in the absence than its perfectly competitive equivalent. of tradional comparative advantage, In these cases, even if there are no trade would still occur to exploit the differences in relative costs, tastes, or gains of internal economies of scale technology, there will be gains from and from the increased variety. Only, trade in the form of lower prices and economies of scale are now the basis greater product diversity. Whereas for trade. We can call this an acquired standard Ricardian theory applies when comparative advantage linked to the size there are differences between agents, of the combined market under trade. economies of scale explain trade when Further, under conditions of internal agents are similar (Finegold, 2014). economies of scale, countries will tend to export the good they produce more TECHNOLOGICAL GAP MODEL OF of. This is because domestic demand INTERNATIONAL TRADE for a product will induce firms with the greatest internal economies of scale to Until now, all the models discussed specialise in that product. In essence, the assumed that the techniques or country with the larger domestic market technologies of production for for a given good will be a net exporter countries were given or fixed. This of that good, because of economies of served to simplify the models; scale. Krugman argues that when there however, in the dynamic reality are barriers to trade, the specialisation we live in, there can be no place will be more limited because these costs for such an assumption. Technical reduce the profitability of exporting changes play a direct and significant (Krugman 1979; Finegold, 2014). role in production and trade. A technological change may manifest In summary, Krugman acknowledges the in new methods of producing existing type of trade between two countries has goods or in the production of new much to do with differences in factor varieties of goods. The last two endowments (the type of relatively prominent models discussed attempt abundant inputs). If two countries are to explain international trade based on technological changes: ECONOMICS 244: INTERNATIONAL TRADE 23 PART 1 WHY DOES INTERNATIONAL TRADE MATTER? 1. Technological Gap or imitation Gap 4. The cost of production (factor price) Model in the two countries are similar 2. Product Cycle Model. before trade 5. Countries have different production technologies 1961 TECHNOLOGICAL GAP OR Posner split the technological gap into three categories namely; IMITATION GAP MODEL 1. The demand lag – is the time taken by the domestic consumers to acquire a The technological gap theory was taste for the new product. developed by M.V. Posner, who argued 2. The foreign reaction lag- signifies that, even if countries have similar the time taken for the foreign firm to factor endowments and preferences, a imitate and produce the new product. technological change, such as continuous 3. The domestic reaction lag – refers to inventions and innovations can give the time required by the domestic rise to trade. According to this model, producers to keep innovating and a firm will first introduce a new product introducing new varieties to maintain in its domestic market. If the product the upper-hand in both the domestic is successful in the domestic market, and foreign market. efforts are made to introduce it in the foreign market. The new product will Posner referred to the combination grant the producing firm or exporting of the innovation and imitation lag as country a temporary monopoly position “dynamism”. According to him, a dynamic in world trade. Patents and copyrights country in international trade is one serve to protect this monopoly position. which innovates at a greater rate and As a result, the exporting country enjoys which imitates the foreign innovations at a comparative advantage over the rest a greater speed. A prosperous country of the world until the foreign producers is, therefore, the one that has a greater either imitate the new varieties of degree of dynamism than the other. The products or learn new processes absence of dynamism leads to erosion of of production. The lag between the markets and a consequent trade deficit introduction of the new product and the (import> export). introduction of the substitutes by the foreign market creates the technology Salvatore (2013:172) highlights three gap or imitation gap (Ingham, 2004: 31). shortcomings of the model: Assumptions of the model It does not explain the size of the gap; Nor the reason why it arose in the 1. There are two counties, A and B first place; 2. The factor endowments are similar in And precisely how it is eliminated the two countries over time. 3. Both countries have similar demand structures It is, nevertheless, important to note that the technology-gap is a direct reason for trade. This is a new basis for comparative advantage. 24 ECONOMICS 244: INTERNATIONAL TRADE PART 1 WHY DOES INTERNATIONAL TRADE MATTER? However, it could be temporary if the which prompts the turning out of the innovating country does not continue product for export. to innovate. With the introduction of changing technology, the static The simple argument in this model is comparative advantage of the traditional that the factor requirement of a product trade theory is extended to dynamic varies over its lifetime so that there comparative advantage. This has exists a cycle in its production. The particular relevance for our discussion innovation of the product includes risks of technological change and Africa’s that can be borne by relatively rich firms. prospects in PART IV. These risks can be decreased through adaptability on the production side that requires skilled labour and easy access 1966 to consumer insights. Vernon points out PRODUCT LIFE CYCLE THEORY that easy access to consumer insights is made possible by the proximity to the The product cycle model was originally market. In light of this, it is established developed by Raymond Vernon. that the production of new products is It is an extension of the technology likely to be concentrated in advanced gap model. According to Vernon, countries. It is only when the product every product has its life span and and manufacturing processes are goes through various stages, from standardised that other countries introduction to decline. Furthermore, can enter the market. This happens Vernon maintains that the innovating only if the other countries have a country that initially produced and cost advantage over the pioneering exported a good usually ends up being producers, e.g. their labour is cheaper. the importing country of the same Consequently, the pioneering country product or a differentiated variety of is overtaken by other developed or that product (Vernon, 1966). developing countries in the production of these goods. The assumptions of the model However, the pioneering firm could 1. The producers in capital-rich countries also set up production facilities in other initially introduce new products. countries to take advantage of the 2. The innovating firms have some real favourable factor prices. As a result, the or monopolistic advantage. country originally producing the good will 3. The need and opportunities of the experience a decline in their exports and domestic market stimulate the may even become an importer either of innovation of a new product. the same or an improved variety of the 4. The innovating firm has little product (Salvatore, 2013:172). information about the conditions existing in foreign markets. In the product lifecycle theory, Vernon 5. The domestic environment in the established four distinct phases that all advanced countries which initially products go through. Some products make the innovation is different from linger in one stage longer than others do, that in the other advanced countries. but they all eventually progress through 6. The market is competitive, and rival the cycle from start to finish. producers can enter the market, ECONOMICS 244: INTERNATIONAL TRADE 25 PART 1 WHY DOES INTERNATIONAL TRADE MATTER? Product life cycle theory summary Introduction stage: Product matures and Process becomes innovator establishes price starts to fall, low standardized enough a technological wage labor is used to be used by other breakthrough in and domestic market nations completing the production of a enters maturity stage. cycle. Technological manufactured good. Import competition breakthrough no longer Product has a high from foreign producers benefits the innovating price and thus high begins. Innovating nation only. The innovating returns. Market nation gradually loses its nation may even become expands to other comparative advantage an importer of the product foreign markets. and its export cycle as its monopoly position enters declining phase. is eliminated by foreign competition Make sure you can give examples of products that TIP Below, we elaborate on the stages that have gone through this cycle Vernon delineated. 1. Introduction stage 2. Growth state The inventor’s country, usually in the At this stage, the demand for high income, capital-rich and advanced the product becomes so large part of the world with considerably that the foreign producers start rich firms, e.g. U. S, introduce a new manufacturing them or their close product in their domestic market. This substitutes. As a result, the shares of is because they are well equipped to do the manufacturers of the innovating R & D and manufacture the good. After country start declining, but they still they gain acceptance in the domestic supply meaningfully large quantities market, the new products are exported of the product. 2 to the other countries. The innovating producers enjoy a virtual monopoly in both the domestic and foreign market for some time. 26 ECONOMICS 244: INTERNATIONAL TRADE PART 1 WHY DOES INTERNATIONAL TRADE MATTER? 3. Maturity state 4. Decline stage The foreign country enjoys a greater Finally, the product is standardised, competitive advantage over the and foreign producers capture the manufacturers in the advanced markets of the originally innovating countries. Firstly, they enjoy the countries despite transport costs advantage of lower labour cost. and tariffs imposed by the advanced Secondly, they start enjoying the countries and the innovating advantages of economies of scale, countries become the net importers which were initially reaped only by the of the product. When this happens, advanced countries. the advanced countries have to 3 produce new varieties of products which are consumed by relatively well-off sections of consumers both at home and abroad. In conclusion, Vernon’s theory does not contradict the traditional theory 4 Now that you have a good grasp of the theories that explain international trade of comparative advantage and factor patterns and articulate the gains from endowment theory. However, it lends trade, we can take a closer look at the a dynamic element to CA, because the real world of trade in PART II. innovation of new products create the comparative advantage, backed by the relative abundance of scientific and technical skills in the capital- rich countries. Yet, this comparative advantage is not forever, the innovating country firms need to continue to produce and export new products at a relatively lower cost to remain competitive (Vernon 1979; Urhan, 2013). ECONOMICS 244: INTERNATIONAL TRADE 27  PART 2 INTERVENTION IN INTERNATIONAL TRADE “By means of glasses, hotbeds, and hotwalls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expense for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland?” The Wealth Of Nations, Book IV, Chapter II, p. 458, para. 15. 28 ECONOMICS 244: INTERNATIONAL TRADE  INTRODUCTION: PART 2 INTERVENTION IN INTERNATIONAL TRADE In PART I, we have seen that the policy Protectionism refers to trade and implications of all the international trade investment (subsidies) applied to theories we have learned, suggest that defend domestic markets and industries free trade is the superior contributor to (Chappelow, 2019). economic welfare. Globally, free trade implies the unrestricted flow of goods Protectionist measures include trade and services across national borders. tariffs, subsidies and other similar government practices. Free trade offers significant economic benefits, although unevenly spread A tariff is a tax imposed by the across the globe. Trade theories government on imported goods. Tariffs made it clear that restrictions impose have fallen over time, but remain high in efficiency costs and depresses economic some countries (Chatzky, 2019). growth (Ingham, 2004:45). Yet, we see governments erect trade barriers and Subsidies are financial or other intervene in other ways that restrict or resources that a government provides to alter free trade by applying protectionist a firm or group of firms. measures. Non-tariff trade barriers are government policies or measures that restrict trade without imposing a direct PART tariff or duty e.g. quotas. Quotas are government-imposed trade restrictions that limit the number or monetary value of goods that a country can import or export during a particular period (Barone, 2019). Protectionism versus free trade is one of the most enduring debates and warrants careful analysis to understand the why, how and for whom of the arguments. 2 ECONOMICS 244: INTERNATIONAL TRADE 29 PART 2 INTERVENTION IN INTERNATIONAL TRADE 1. WHY DO GOVERNMENTS from enjoying the gains possible from INTERVENE IN FREE TRADE? free trade. A further difficulty with the use of According to Knight (2015), governments trade barriers to bolster employment undertake intervention to achieve in a particular sector is that it can be several economic and non-economic an immensely expensive strategy. goals. Economic arguments are usually Estimates in the United States show that aimed at boosting overall economic an Obama-era tariff on Chinese tyres, welfare, whereas political and other for example, cost the economy more considerations are concerned with than US$900,000 per job temporarily protecting certain interest groups saved. Based on their empirical work, in a country (usually producers who Wendelbo and Robertson (2018) argue tend to be well-organised with power) that government could save taxpayers often at the expense of other groups (and consumers) money by giving each (usually consumers who happened to be displaced worker $100,000 to find and more dispersed and not organised for move to a new job. powerful impact). A. Economic reasons Find their paper here: https://theconversation.com/tariffs- wont-save-american-steel-jobs-but-we- Preventing unemployment can-still-help-steelworkers-93104 To maintain existing jobs threatened by foreign competition is a ubiquitous Protection of infant industries source of today’s protectionist policies. Some industries that at one time had Free trade creates a highly competitive a comparative advantage and did landscape which can be particularly not adapt to a changing competitive harsh for infant industries. The environment, struggle to stay afloat. government, therefore, argues that Resorting to cost cutting leads to layoffs, infant industries should be protected which lead to demands for protection. because they would not otherwise The government believes that imposing survive the rigours of competition from tariffs will divert demand to domestic producers in more advanced countries. firms, improve the firms’ profitability For instance, developing countries have and prevent plant closures, therefore, a potential comparative advantage securing employment (Wray, 2009). in manufacturing, however, new The model of international trade in manufacturing industries in developing perfect competition discussed before, countries cannot compete with well- suggests that trade will challenge some established manufacturing in developed industries. As countries specialize countries. As the infants mature and in activities in which they have a become more competitive, the protective comparative advantage, sectors in barriers could be lowered or eliminated. which they do not have this advantage The theory on infant protection will contract. Preserving those sectors articulates three requirements for through trade barriers prevents a nation protection to be successful: 30 ECONOMICS 244: INTERNATIONAL TRADE PART 2 INTERVENTION IN INTERNATIONAL TRADE The infant industry should have the A second argument is that it might pay potential to become competitive government to intervene in an industry if The protection should be temporary it helps its domestic firms overcome the The beneficiaries of such protection barriers to entry created by foreign firms should compensate the losers that have already reaped the first-mover (consumers who pay higher prices advantages. This has been the reasoning because of the restrictions) for their behind government support of Airbus sacrifice. This means that the benefits Industries (Ingham, 2004:58). from protection should exceed the costs. B. Political and Other reasons These three requirements are known as To Prevent dumping the Mill-Bastable test. Dumping occurs when firms export goods at a price below the production cost or below the price charged in their More information here: domestic market. The low prices serve to https://www.investopedia.com/terms/i/ destroy rivals in the export market. The infantindustry.asp). World Trade Organisation (WTO) permits countries to impose anti-dumping duties where there is genuine “material” injury Strategic Trade Policy Argument to the competing domestic industry (WTO, 2020). For example, in the case Thanks to Economics Nobel Prize winner, of the USA, South Africans happen to Paul Krugman, a new version of the like different body parts of the chicken, infant industry argument has been used which is in low demand in the US, which in the past few years as technological gives US exporters an opportunity developments have spawned completely for market segmentation and price new industries and transformed differentiation. EU producers on the existing ones. The new version of the other hand, receive state aid enabling infant industry argument assumes an them to sell their chicken so cheaply imperfectly competitive market, based abroad. on Krugman’s new trade theory. The theory argues that if an industry has National-security economies of scale, the world market will support only a few firms profitably. National security is the security and Countries may lead in export of certain defence from military and non-military products simply because they had firms threats of a nation-state, including its who were able to capture first-mover citizens, economy and institutions which advantages. The dominance of Boeing is regarded as a duty of the government. in the commercial aircraft industry is It can often be argued by the attributed to such factors. government that protection of industries that serve to promote, both directly and According to the strategic trade policy indirectly, national securities should argument, government should use be protected through tariffs or other subsidies to support such firms. restrictive measures. These industries ECONOMICS 244: INTERNATIONAL TRADE 31 PART 2 INTERVENTION IN INTERNATIONAL TRADE would typically be those crucial for Generation of government revenue defence and related protection, such as aerospace and electronics. But, the Like any other tax, tariffs raise revenues argument may also be open to abuse or for the government. Many developing put politely, very broad interpretation. countries have depended on customs For example, on March 1st 2018, US and excise duties on imports to boost President Donald Trump announced the national budget. During the last his intention to impose special tariffs on few decades of trade liberalisation, steel and aluminium for the reason of governments have had to find other, national security (Diamond, 2018). more sustainable sources of government revenue (more on this in PART IV). Fairtrade versus free trade argument Free trade focuses on the reduction of barriers. Fairtrade, on the other hand focuses on working conditions. Governments tend to believe that tariffs or other restrictions can be imposed in the name of fairness. The rationale is that reducing competition and increasing prices, could improve working conditions and increase wages for workers (Gillikin, 2019). TIP If you are interested to explore reasons why protectionism may be problematic, Robert Lawrence and Robert Litan, provide sound arguments against protectionism in their Harvard Business Review article ‘Why Protectionism Doesn’t Pay’: https://hbr.org/1987/05/why-protectionism-doesnt-pay 32 ECONOMICS 244: INTERNATIONAL TRADE PART 2 INTERVENTION IN INTERNATIONAL TRADE 2. HOW DOES THE GOVERNMENT Since the creation of the World Trade INTERVENE IN FREE TRADE? Organisation and its predecessor, the General Agreement on Tariffs and Trade (GATT), the tariff burden has been Governments can use several different reduced steadily, but governments have measures to intervene in trade. It turned to other restrictive measures, is important to understand these collectively known as non-tariff different intervention measures, since barriers (NTB). These methods allow government has to make policy choices. governments to put up barriers to trade Although all interventions will distort overtly or covertly. We highlight some the economy, economists may be called examples of NTBs below and will explore upon to advise which measures may be more applied examples in PART III and ‘best’ in that they will be least distortive. PART IV. A. Tariffs b. Non-tariff barriers Tariffs are the most common measure Non-tariff barriers refer to any obstacle used to intervene in free trade. A tariff is to international trade that is not an a tax imposed on imported goods. Tariffs import or export duty (SADC, 2012). The influence trade patterns by making list below constitutes examples of non- products more expensive to consumers tariff barriers. and hampering the demand for imports. They also alter the relative price of products and can protect uncompetitive For more detailed information, read : TIP companies and their overpriced https://www.oecd.org/trade/topics/non-tariff-measures/. products. Examples of import tariffs are plenty: 1. Import quotas are restrictions on the amount of a product that may o Textile and Clothing is an industry be imported into a country (quantity that perennially attracts duties – limitation), e.g. on Chinese clothing depending on the fabric there are and food products like chicken. anything between 10-40% import tariffs applicable in South Africa. 2. Export quotas are restrictions on the o Tariffs have been imposed on amount of a product that may be importing chicken to SA for many exported within a given period. This years (more on this later). restraint is usually applied to prevent shortages or as a tool to moderate FUN domestic prices. Google ‘import tariff 3. Embargos are an official ban on trade or other commercial activity with ! examples’ and see how many hits you get. I had a particular country. For example in 1977 the UN ratified arms 6 270 000. embargos on SA after the Soweto uprisings. They can be political when Rachel Jafta linked to airspace and arms. ECONOMICS 244: INTERNATIONAL TRADE 33 PART 2 INTERVENTION IN INTERNATIONAL TRADE 4. Subsidies are financial or other 9. Government procurement: providing resources that a government specifications that favour domestic provides to a firm or group of firms. firms. 5. Sanctions constitute a threatened 10. Abuse of health and safety measures penalty for disobeying laws, rules or (sanitary and phyto-sanitary actions e.g. political sanctions, such as measures) President Trump’s sanctions on Russia. 11. Marketing and packaging standards: 6. Trade Levies: A tax, fee or fine e.g. The endorsement of the “Proudly (other than normal tariffs) that is South African” campaign* imposed on trade. The imposition of these levies and the safeguard 12. Abuse of customs procedures measures is established in the World Trade Organisation’s international 13. Exchange and capital controls agreement. The law addresses three types of trade levies: Figure 1 anti-dumping duty – a duty on dumped The Face of Protectionism in the 21st Century: imports that cause material injury to a Number of newly implemented protectionist domestic industry interventions by type, 2009 - 2017 countervailing duty – a duty on exports subsidised by a foreign government safeguard measures in the event of a sudden ‘surge’ in imports that threaten to destroy a sector or industry. They are imposed, inter alia, to protect the country’s balance of payments and its foreign currency reserves, to protect the agricultural industry and the country’s mined resources, or as an economic reciprocal action against a foreign country. 7. Import licenses: creating a need to be granted a trade license. Source: https://voxeu.org/article/global-trade-protection- Businesses need licences to import and-role-non-tariff-barriers goods, without it, trade is prohibited. 8. Voluntary export restraints or orderly marketing agreements are put in This was the situation before ? place to appease a trading partner, the Covid-19 pandemic, how did for example China agreeing to limit intervention change after and textile and clothing exports to South what impact has the Russian Africa or Japan limiting exports of invasion of Ukraine had? cars into the United States. 34 ECONOMICS 244: INTERNATIONAL TRADE PART 2 INTERVENTION IN INTERNATIONAL TRADE THE IMPACT OF THE WAR IN UKRAINE The war in Ukraine has caused an increase in protectionist measures which have a significant impact on Africa (WTO, 2023). Supplies of food, fertilisers and energy have been constrained since the outbreak of the war. Ukraine and the Russian Federation are major exporters of these goods, and the fear of shortages globally led many countries to limit exports of close substitutes. This drove up the prices of these goods leading to an increase in food insecurity in Africa and issues in food production due to rising inputs costs. Protectionist me