Investigating Macroeconomics 8th Edition PDF

Investigating Macroeconomics 8" edition Steven Kemp Publications  Investigating Macroeconomics 8th edition Part? Australia and the Global Economy 1 Australia's international trade alg 2 Free trade and protection...

Investigating Macroeconomics 8" edition Steven Kemp Publications  Investigating Macroeconomics 8th edition Part? Australia and the Global Economy 1 Australia's international trade alg 2 Free trade and protection 23 3 The balance of payments 55 4 The terms of trade 85 5 Exchange rates 101 6 Foreign investment 129 7 Macroeconomics and the business cycle 155 8 The aggregate expenditure model 181 9 Aggregate demand and aggregate supply 213 10 Fiscal policy 239 11 Monetary policy 267 12 Labour productivity 289  Chapter Contents Chapter Section Page Linkages between economies 2 The importance of international trade 4 1 The composition of Australia's trade 8 The direction of Australia's trade 12 Australia's trade policy 13 Introduction 24 The concept of absolute advantage 25 The concept of comparative advantage 27 2 Comparative advantage and the demand/supply model 33 Protection 37 Arguments for protection 42 The benefits of trade liberalisation 45 The structure of the balance of payments 56 3 Australia's balance of payments 60 Trends in the current account 67 The savings-investment gap 71 Introduction 86 The terms of trade index 86 4 Factors affecting the terms of trade 89 Effects of changes in the terms of trade 92 The foreign exchange market 102 The exchange rate 105 The equilibrium exchange rate 112 5 Effects of movements in the exchange rate 115 The balance of payments and the exchange rate 117 Recent trends in the Australian dollar 119 What is foreign investment? 130 Foreign direct and portfolio investment 132 6 Foreign investment and the balance of payments 137 The benefits and costs of foreign investment 138 Australia’s foreign liabilities and foreign assets 141 Chapter Section Page What is macroeconomics? 156 The business cycle 159 rf The business cycle - causes and turning points 165 Economic indicators 169 Australia’s macroeconomic performance 172 Aggregate expenditure 182 Factors affecting aggregate expenditure 185 8 The concept of macroeconomic equilibrium 192 The aggregate expenditure model 192 | The concept of the multiplier 200 | The impact of changes in aggregate expenditure 205 | The aggregate demand curve 214 The aggregate supply curves 219 | 9 Macroeconomic equilibrium 224 | Changes in aggregate demand and aggregate supply 225 | The AD/AS model and the business cycle 229 | The concept of fiscal policy 240 | The Government's policy objectives 242 Budget outcomes - balanced, surplus or deficit 246 | 10 Financing a budget deficit 249 Automatic stabilisers and discretionary fiscal policy 252 Expansionary and contractionary fiscal policy 254 Strengths and weaknesses of fiscal policy 259 Monetary policy and the cash rate 270 | The economic policy objectives of the RBA 271 Conventional and unconventional monetary policy 275 ua The transmission mechanism 277 Expansionary and contractionary monetary policy 279 Strengths and weaknesses of monetary policy 283 | The importance of long-run economic growth 290 The concept of labour productivity 292 The aggregate production function 295 12 The factors affecting labour productivity 297 Government policies to influence productivity 299 Labour productivity and the AD/AS model 301 Chapter 1 Australia’s International Trade Australia’s International Trade Key understandings Australia’s linkages between economies, including trade, investment, tourism and immigration * the extent and importance of trade for the Australian economy * the composition and direction of Australia’s trade * Australia’s trade policy, including regional and bilateral free trade agreements ISBN 978-1-875313-68-6 © Tactic Publications 2025  Investigating Macroeconomics Why is trade - both exports and imports - important forthe Australian economy? What does Australia export and import and who are Australia’s main trading partners? These are the main questions that we seek answers for in this chapter. Australia is an island continent situated in the southern hemisphere - relatively isolated from the major economic and population hubs of Europe, Asia and Being an island nation, North America. Being an island, Australia has no land borders with any other trade is vital to the country. Of the largest fifteen economies in the world (by GDP), only Japan Australian economy shares this same characteristic. But what makes Australia unique is that it is the only economy in the largest fifteen to be located in the southern hemisphere. It is for this reason that trade is so vital for Australia’s ongoing prosperity and economic development. The Covid pandemic of 2020-21 was a very timely reminder of how we all live in an increasingly internationalised world. Rapid advances in communications and transport have increased access to all corners of the globe. It is now cheaper and quicker to fly to every major city in the world. Computers and the Internet have enabled people to instantly access the world wide web for information, for downloading documents, for streaming music and movies and for purchasing goods and services. But an interconnected world can also mean that an economic shock such as a pandemic or a financial crisis can quickly spread from one country to another. Australian firms and households are constantly involved in economic transactions with other economies. Some examples include Australian firms exporting iron ore, coal and education services. Australian consumers purchase cars from Korea, computers from China, iPhones from the United States and coffee from Brazil. Australia has also been a major recipient of foreign investment. The world has effectively become a global market enabling the rapid movement of goods, services, people, information and finance. Linkages between economies When people think of global markets they tend to just think about international trade in goods and services - exports and imports. But economies are linked by more than just trade - there are movements in financial capital (foreign Exports contribute around investment) and movementsin people suchas tourists, workers and immigrants. 25% to Australia’s GDP Figure 1.1 shows some of Australia’s important links with the global economy. Exports contribute around 25 per cent of Australia’s GDP and around 25 per cent of Australian workers are directly involved in trade-related activities. Australia is a major exporter of resources to the world, including iron ore, coal, natural gas, gold, lithium and bauxite. At the same time, Australia imports large quantities of capital goods, such as machinery, as well as motor vehicles and consumer goods. Just think how dependent you are on other countries for many goods we take for granted - the ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 1 Australia’s International Trade Figure 1.1 Australia’s links with the global economy Imports Exports Foreign tourists Australian tourists Immigrants Emigrants Foreign investment Australian investment ee Imports/Income/Tourists/ Exports/Income/Tourists/ Investment flowing to Investment flowing from Australia Australia [Total Goods ae | $444 billion | __—_—‘$536 billion Income — | $145 billion | $204 billion | Ts $245 billion ee $142 billion ea Migrants (2023) 737,000 219,000 clothes you wear, your mobile phone, the coffee you drink, your TV set, your laptop and the family car. All of these are imported goods, some of which may have used Australian resources in their manufacture. Australia is also a multicultural nation. Immigration has been an important source of skilled labour and has helped to boost Australia’s population growth. Around 30 per cent of Australia’s population were born overseas. Traditionally, more people immigrate to, than emigrate from Australia each year. From 2006 to 2020, net overseas migration contributed more each year to Australia’s population growth than natural increase. Population growth is important for continued economic growth. In 2023, net migration to Australia was a record high of 518,000 which means that the population was boosted by over half a million people. International tourism has grown in importance due to improvements in transport and communications and ranks fourth (after fuels, chemicals and automotive products) in world exports. For Australia, tourism (known as personal travel) is Australia’s 6th largest export but is Australia’s largest import. This means that more Australians travel overseas (11 million in 2024) than overseas tourists visit Australia (8 million in 2024). ISBN 978-1-875313-68-6 © Tactic Publications 2025  Investigating Macroeconomics The Australian economy has throughout its history relied on net foreign investment to supplement its domestic savings to help fund its economic development. This means that inflows of foreign investment into the Australian economy normally exceed outflows. During 2024, for example, foreign investment into Australia was $245 billion, while Australian investment abroad was $142 billion - a difference of over $100 billion! Australia has a relatively small population and does not generate enough savings to fund its investment needs and therefore relies on the inflow of foreign investment. Much of the infrastructure, such as transportation systems and communication networks, to support industry is financed from overseas funds. The mining and resources sector would not have been developed without foreign investment. Australia is an outward-looking country that is strongly engaged with the rest ol the world. Australia has a number of globally significant industries: * agricultural products - 12th largest exporter in the world e international tourism - 11th largest exporter in the world ¢ fuels and mining - 4th largest exporter in the world « education services - 4th largest exporter in the world e financial services - 9th largest exporter in the world e investment fund assets - 3rd largest in the world The importance of international trade The Australian economy has always relied on the international sector ~ not just for the sale and purchase of goods and services, but also for funds for investment. Historically, Australia has been a significant exporter of primary commodities (minerals and agricultural products); an importer of manufactured goods; and an importer of financial capital. This has meant that trade and foreign investment have played a major role in the economic development of the Australian economy. ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 1 Australia’s International Trade Trade is vitally important to the Australian economy Trade (exports and imports) is a large part of the Australian economy, accounting for around 48 per cent of GDP. Trade has been an important driver of economic growth. Over the past 30 years, Australia's economy has doubled in size; exports have accounted for over a quarter of this growth. Trade liberalisation over the past 30 years has benefited the Australian economy, with both real GDP and real income being much higher than otherwise. Many Australian jobs rely on trade. Around one in five Australian workers are employed in a trade-related activity. This includes workers in export-focused industries like agriculture, minerals and energy, but also, in the many industries involved with the importation of goods and services. Consumers are big beneficiaries of trade. Trade means access to a wider variety of goods and services at more competitive prices, boosting living standards. The price of audio, visual and computing equipment has fallen over 50 per cent in the past five years. Imports reduce Australian production costs and increase employment. Over half of all Australian imports are essential inputs that businesses use to produce goods locally. Exposure to competition from overseas compels Australian firms to innovate and adopt more efficient production methods. More efficient resource use boosts economic growth. Source: Productivity Commission Traditionally, Australia has been described as a small open economy. The ‘small’ refers to the size of its economy in terms of both population and Gross Domestic Product. But Australia could no longer be described as a small economy. Australia’s population has now grown to over 26 million and Australia’s annual GDP exceeds $2.5 trillion. Australia has in fact become the world’s 12th largest economy. It would be more correct to refer to Australia as a medium size open economy. The ‘open’ means that the movement of goods, services and capital is generally unrestricted, that is, they can move freely between Australia and the rest of the world. Protectionist policies such as the use of tariffs, subsidies and quotas hamper the free movement of goods and services, and Australia has reduced its level of protection to domestic industry to historically low levels. Trade is important because it can expand a nation’s consumption possibilities by providing access to other countries’ production through imports. Exporting increases a nation’s production, while importing increases consumption. A country gains when it exports goods and services it can produce at a relatively low cost. But equally a country also gains when it imports goods and services it produces at a relatively high cost. Exporting enables Australian firms to reach a potential market of over 8 billion people. Importing allows Australian ISBN 978-1-875313-68-6 © Tactic Publications 2025  Investigating Macroeconomics households to consume goods and services that are either not produced in Australia or are too costly to produce. Engaging in trade permits increased specialisation, economies of scale, increased productivity and higher real incomes. There is a strong link between trade and economic growth. The countries that have experienced the fastest growth rates in trade have also achieved high rates of per capita income growth. Trade has been an important ‘engine of growth’ for many countries. This has certainly been the case for explaining the rapid growth of the East Asian region - economies such as Japan, South Korea, Singapore and China. International trade has become more important to the Australian economy over time. In 1990, total trade (exports plus imports) accounted for 30 per cent of Australia’s GDP. By 2024, total trade had increased to nearly 50 per cent of GDP. On the world stage, Australia is a relatively small exporter - accounting for just 1.5 per cent of global exports, compared with around 11.5 per cent for China, the world’s leading exporter (refer to figure 1.2). Australia is ranked 21 as a world exporter of goods and services and yet is the 12th largest economy. Does this mean that Australia is lagging in the trade stakes? No, not necessarily. Notice that of the countries shown, Australia is the only economy located in the southern hemisphere. Remember that most of the world’s major economies are located in the northern hemisphere. So in a way, Australia is probably ‘punching above its weight’ Figure 1.2 Australia’s rank in world exports 1. China 2. United States 3. Germany 4, United Kingdom 5. France 6. Netherlands 7. Japan 8. Singapore 9. Italy 10. India 21. Australia 0.00 4.00 8.00 12.00 Per cent of world exports ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 1 Australia’s International Trade 7 A country’s level of exports will be determined by a number of factors: the size and structure of the economy, its relative competitiveness and its location. Australia is an island continent, relatively isolated from the rest of the world. Remember that most of the world’s population lives in the northern hemisphere - Asia, Europe, North America. This means that global output and economic activity is concentrated in the northern half of the globe. If Australia was located in Europe, or shared a border with the United States (like Canada), then its ranking in world exports would be Trade to GDP ratio much higher. In fact, on a per capita basis, Australia’s export Australia performance could be considered quite remarkable. A useful Brazil way to measure the importance of international trade is to Canada calculate the share of trade in its Gross Domestic Product China (GDP). This trade-to-GDP ratio is often called the ‘trade France openness ratio’ or the ‘trade intensity ratio: It is a measure of Germany the sum of exports and imports (of both goods and services) Italy as a percentage of GDP. The ratio can be expressed as: Japan Netherlands Trade intensity = (X + M)/GDP] x 100 United Kingdom European economies, for example, tend to have a relatively United States high trade intensity because of the ease of trading within the World Euro zone. For the countries shown in the sidebar, only the Source: World Bank USA, China, Brazil and Japan have lower trade to GDP ratios than Australia. This is explained by the size of their domestic economies, which enables them to reap the advantages of economies of scale. Large economies such as the United States and China do not need to rely on trade as much as a Australia’s trade smaller economy such as Australia because their domestic markets are so large. intensity has increased Australia’s relatively low trade intensity can be partly explained by its geographic over time — from 34 per cent of GDP in 1992 to isolation. A notable Australian author, Geoffrey Blainey, referred to the problem over 48 per cent in 2023. of Australia’s isolation as its ‘tyranny of distance: Australia has also not had the opportunity of being part of a major regional trading bloc such as the European Union (EU). The purpose of economic growth is to enable a high level of consumption and a high standard of living. Exports add to national income, which can then be used to consume imports. Given that Australia has a small economic base in terms of labour and capital, producing for the world market is a rational strategy to promote economic growth and higher living standards. Review 1. Descibe four linkages between Australia and the global economy. Outline three benefits of positive net migration for the Australian economy. WN Why does Australia rely on the inflow of foreign investment? Explain how consumers benefit from international trade. Wik Provide a reason for Australia’s relatively low rank in world exports. ISBN 978-1-875313-68-6 © Tactic Publications 2025  Investigating Macroeconomics The composition of Australia’s trade Commodities - either rural or mining - have always dominated Australia’s exports while manufactured goods have been our most important import category. For the past two decades the mining sector has been the ‘king’ of Australia’s exports. Commodities such as iron ore, coal, natural gas and gold account for just over half of Australia’s exports. That is an amazing fact! There would be very few economies that have such a concentration of exports in just a handful of goods. Prior to the mining boom, Australia was said to ‘ride on the sheep’s back’ - signifying the importance of the agricultural sector. But today it Australia is a major exporter of commodities could be said that Australia ‘rides in the back of the iron ore truck’! and an importer of The composition of a country’s trade will reflect its relative advantages in terms manufactured goods. of its resource endowment. Traditionally Australia has been a major exporter of primary commodities. This is not surprising given Australia’s large natural resources to population ratio and its substantial wealth in mining, energy and rural resources. Australia has historically enjoyed a relative cost advantage in the production of primary commodities - specifically rural and mining. Australia has been a leading world producer in wool, wheat and beef and a significant producer of iron ore, coal, natural gas, gold and bauxite. Prior to the 1980s, agriculture (wool wheat and meat) was the mainstay of Australia’s exports. But over the past few decades agriculture has declined in importance while the mining sector has exploded! The table below reveals the changes in Australia’s key categories of exports since the 1990s. Commodity exports have increased from just over half of all exports in 1990 to 71 per cent in 2024. What is interesting is that the share of rural commodities has halved over the same period from 22 per cent 1990s | 2000s | 2024 to just 11 per cent, while the share of Commodities % % % mining has doubled from 31 per cent Rural 22 16 11 to 60 per cent. Mining (incl gold) 31 41 60 What has driven this change? Total 53 57 71 th : dj Non-commodities cing eae heen a ciel China. In fact, China is the answer to Manufactures 24 21 11 : ? - Sai most questions regarding Australia’s ervices 23 22 18 economy! Total 47 43 29 The rapid growth of China from 2000 onwards fuelled a major resources boom in Australia lasting for over 20 years. China emerged as the world’s biggest factory supplying clothing, electrical appliances, cars and technology products to the rest of the world. China required vast amounts of iron ore, coal and more recently, natural gas to feed its hungry industrial sector and Australia became its number one supplier of these essential resources. ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 1 Australia’s International Trade The growth of the mining sector in Australia meant that resources were diverted away from the manufacturing sector. Exports of manufactured goods as a share of the total declined dramatically from 24 per cent in 1990 to just 11 per cent in 2024. The share of services exports has also declined relative to mining, but it is not as significant. Normally services account for between 20 and 25 per cent of total exports. The current figure of 18 per cent is low due to the impact of the Covid pandemic which decimated the exports of both education and tourism - Australia’s two most important service exports. The major changes in the composition of Australia’s exports have been: e adramatic decline in rural exports ¢ asignificant increase in mining sector (minerals & energy) exports e a significant decline in manufacturing exports * services exports have become larger than either rural or manufactured exports. The broad composition of Australia’s trade is illustrated in figure 1.3. The dominance of the mining and rural sector in exports is evident (71%), comprising mainly three commodities - iron ore, coal and natural gas. For imports the largest category is intermediate goods (33 per cent), consisting of refined fuels and processed industrial goods. Notice that most imported goods are manufactured goods - either in the form of consumer goods or capital goods (e.g. machinery for Australian industry). In contrast to exports, there are very few imported primary goods. The composition of our trade is a reflection of the structure of the economy. Australia has a very efficient and internationally competitive commodities sector - both mining and rural, while our manufacturing sector is smaller and relatively less efficient. Australia has a strong advantage in exploiting its natural mineral wealth and using its vast landmass for extensive agriculture. Figure 1.3 Australia’s composition of trade 2024 IMPORTS - % share 2024 71 Consumption Goods 25 11 Motor vehicles 7 28 Clothing & footwear 4 27 Capital Goods 18 5 Machinery 6 11 Intermediate goods 33 18 Fuels (petrol) 10 8 Services 24 3 Tourism 11 ISBN 978-1-875313-68-6 © Tactic Publications 2025  10 Investigating Macroeconomics What are Australia’s main exports and imports? Figure 1.4 provides a ranking of the top ten exports and imports in 2024, It is not surprising to see that iron ore, coal and natural gas are at the top of the export table. These three exports account for nearly half of Australia’s exports. Notice that eight of the top ten exports are primary commodities. Two of the top 10 are service exports - education, ranked fourth and personal travel (overseas tourists), ranked sixth. Many people would be surprised to see education services ranked higher Figure 1.4 Australia’s main exports and imports EXPORTS Per cent of total exports 0 3 6 9 12 15 18 21 lron ore Coal Natural gas Iron ore, coal and natural gas account Education for half of all exports Gold Personal travel Beef Crude petroleum Aluminium ores Wheat IMPORTS Per cent of total imports i) 2 4 6 8 10 12 Personal travel Refined petroleum Passenger motor vehicles Manufactured Goods vehicles goods dominate Australia’s imports Telecom equipment Freight services Professional services Computers Passenger transport services Medicaments ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 1 Australia’s International Trade 11 than more traditional exports such as gold and beef. Figure 1.5 illustrates the growth in Australia’s export categories since 2000. The graph clearly shows the increasing dominance of the mining resources sector. Australia’s most important imports are personal travel (Australian tourists travelling overseas), refined petroleum and passenger motor vehicles. Notice that five of these imports are services and five are manufactured goods. The most important import category is manufactured goods including motor vehicles, refined petroleum and telecom equipment. Australia is fortunate to be located on the doorstep of the fastest developing region of the world with a massive appetite for our natural resource wealth. The bulk of Australia’s exports will continue to be in the mining sector given the strong demand for our resources from the fast growing economies of China, Korea and India. But the future of trade is likely to be services. As incomes and living standards rise, the demand for services such as travel (tourism), health and education will increase significantly. Figure 1.5 Australia’s export categories over time 120000 ,- Resources 100000 - $ Y Services 20000 + Rural res 0 ' T T T T Jun-2000 Jun-2004 Jun-2008 Jun-2012 Jun-2016 Jun-2020 Jun-2024 Review 1, Identify Australia’s most important export category and most important import category. 2. Outline the main reason for the growth in Australia’s commodity exports. 3. State Australia’s two largest exports and two /argest imports in 2024. 4, Identify Australia’s largest service export. ISBN 978-1-875313-68-6 © Tactic Publications 2025 12 Investigating Macroeconomics The direction of trade There has been a significant shift in the direction of Australia’s trade over time. This shift in direction has been primarily from Europe to the Pacific Asian region, comprising East Asia, North America and Oceania. This region has become the dominant trading group for Australia, accounting for over 80 per cent of Australia’s exports and 70 per cent of imports. Figure 1.5 shows Australia’s ten leading trading partners. China has become Australia’s largest trading partner - for both exports (33% share) and imports (20% share). It is important not to underestimate the significance of China’s relationship to the Australian economy. Prior to 2000, a favourite saying amongst economists was that if the United States sneezed, Australia would catch a cold, This has now changed to: “If China sneezes, Australia would catch pneumonia!” The top four countries - China, Japan, United States and South Korea account for over 50 per cent of Australia’s total two-way trade. Notice that all nine countries shown in the graph are in the Asia-Pacific region. Japan is Australia’s second most important export destination (13% share) while the United States is Australia’s second most important import source (12% share). Since 2000, the share of Australia’s exports to Asia has increased from 56 per cent to 80 per cent, while the share of imports from Asia has increased from 43 per cent to 56 per cent. The ascent of Asia in Australia’s trade has meant that Europe has become less important - this is especially the case for Australia’s exports. Since 2000, the share of Australia’s exports to Europe has decreased from 15 per cent to just 7 per cent, while the share of imports from Europe has decreased from Figure 1.5 The direction of Australia’s trade 35 MExports mlmports ah oe New _ Thailand European | China Japan United South Singapore India Malaysia States Korea Zealand Union ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 1 Australia’s International Trade 13 24 per cent to 20 per cent - a much smaller change. Notice that in figure 1.5, the European Union is second to China as an import source. e e ne There are a number of reasons for the change in direction of Australia’s trade. Australia’s trade by Geographically, Australia is part of the Asia-Pacific region but historically region 2023 Australia has had strong ties with the United Kingdom and Europe. When the (per cent share) United Kingdom joined the European Union Australia was forced to establish new markets. The Asia-Pacific region had the advantage of much lower transport Africa 1 costs for Australia compared to Europe and the region has the advantage of Fea ae a large and growing population that is very near to Australia’s shores - Asia America 7 accounts for two-thirds of the global population. Since East Asia has a limited Europe | 7 supply of raw materials relative to its population, Australia provides an obvious Oceania 4 complement in terms of its very small population and its rich endowment of natural resources. Australia is indeed a lucky country in terms of its vast wealth Source: DFAT of mineral and energy resources. The fast growing economies of East Asia require long term supplies of cheap energy such as coal and natural gas as well as minerals including iron ore, aluminium and lithium. Australia’s trade policy Australia is a member of many international organisations such as the World Trade Organization (WTO), the G20, Asia-Pacific Economic Cooperation (APEC) and the Organisation for Economic Co-operation and Development (OECD). The purpose of participating in these organisations is to increase both trade and investment in order to promote Australia’s long term economic growth and prosperity. Arguably the most important of these is the WTO, which was established in 1995 with the overall objective of helping member countries to use trade as a means to raise living standards. Some of the key principles of the WTO include: e Non-discrimination - a country should not discriminate between its trading partners, and it should not discriminate between its own and foreign products or services. e Opening trade - Lowering trade barriers to encourage trade; these barriers include tariffs) and measures such as import bans or quotas. e Fair competition - Discouraging “unfair” practices, such as export subsidies and dumping products at below normal cost to gain market share. e Protection of the environment - The WTO permit members to take measures to protect not only public, animal and plant health but also the environment. However, members must not use environmental protection measures as a means of introducing discriminatory trade barriers. ISBN 978-1-875313-68-6 © Tactic Publications 2025  14 Investigating Macroeconomics The WTO’s main activities are negotiating the reduction or elimination of barriers to trade (import tariffs) and agreeing on rules governing the conduct of international trade (e.g. anti-dumping, subsidies & product standards). In a perfect world there would be no barriers to trade. But in reality this is not the case. Many countries do impose barriers to trade, mainly for political reasons in order to ‘protect’ certain industries from foreign competition. But these barriers by reducing trade end up harming both economies. (Refer to chapter 2 for a more detailed analysis of trade barriers). Despite the efforts of the WTO in promoting the benefits of open and free trade, A free trade agreement it has been difficult getting all 166 member countries to reach consensus in is an international treaty between two or lowering trade barriers. For this reason many countries have opted to participate more economies that in free trade agreements (FTAs) - either regional or bilateral. A bilateral FTA is reduces or eliminates an agreement between two countries, while a regional FTA involves more than barriers to trade. two countries. FTAs are certainly favourable to increasing trade between the member countries by lowering or removing trade barriers. But at the same time, free trade agreements can be discriminatory and go against the ‘most favoured nation’ (MEN) principle of the WTO. This principle is based on the idea that countries should treat all their trade partners equally. For example, if a country lowers its tariffs for one country, it should do the same for all other countries. Free trade agreements can be attractive because it may be easier for a small group of neighbouring countries with similar concerns to agree on market opening in a particular area than to reach agreement in a wider forum such as the WTO. But free trade agreements also risk making it harder for countries outside the group to trade with those inside and may discourage further opening up of markets, ultimately limiting growth prospects for all. In this way a free trade agreement acts as a ‘trade bloc: Multilateral negotiations, on the other hand, deal with more countries and more sectors, and so offer greater potential for mutual gain than limited bilateral or regional deals. Apply economic reasoning - Australia negotiates FTA with the EU > In 2020 the Australian Government began negotiating a free trade agreement (FTA) = with the European Union (EU). The government believes it has the potential to open > = up a market for Australian goods and services of half a billion people and a GDP of 7) © USS23 trillion. As a bloc, the EU is Australia’s second largest trading partner and 7) fourth largest source of foreign investment. £ c hh e¢ Name four of the largest economies in the EU. o * — Explain how the EU acts as a trading bloc (research the term in google). ® _ ¢ Explain why the government is pursuing an FTA with the EU. ¢ Does Australia normally record a trade surplus or a trade deficit with the EU? Explain why. Chapter 1 Australia’s International Trade 15 A trade bloc is a group of countries that agree to reduce trade barriers between themselves but impose barriers on countries outside the ‘bloc: The most important trade blocs include the European Union (EU), the North American Free Trade Agreement (NAFTA) and the Association of South East Asian Nations (ASEAN). These three groups account for nearly 60 per cent of world trade. The European Union EU has become the most powerful trading bloc in the world with a GDP as large as that of the United States. The EU consists of 27 countries and has eliminated trade barriers between the member countries so they can trade freely with each other. A trade bloc typically applies a common external tariff on goods and services imported from countries outside the bloc. There is an important debate about whether free trade agreements are ‘trade creating’ or ‘trade diverting: Removing trade barriers will help to increase the volume of trade between members - this is trade creation. But FTAs are about establishing preferential trade between Australia’s FTAs specific countries. Often they will cause trade diversion, 1. New Zealand 1983 rather than trade creation. Trade diversion occurs when 2. Singapore 2003 trade is diverted from a low cost producer outside the 3. Thailand 2005 trade agreement, to a higher cost producer within the 4. United States 2005 group. Trade diversion is seen as a potential disadvantage 5. Chile 2009 of trade agreements. According to the Department of 6. ASEAN 2010 Foreign Affairs and Trade (DFAT) the research on free trade 7. Malaysia 2013 agreements suggests there has been little trade diversion 8. South Korea 2014 and that free trade agreements have been effective in 9. Japan 2015 encouraging wider trade liberalisation. 10. China 2015 11. Trans Pacific Partnership (TPP) 2018 DFAT points out that a practical advantage of free 12. Hong Kong 2020 trade agreements is that they are quicker and easier to 13. Peru 2020 negotiate than multilateral agreements because fewer parties are involved. Australia has currently 18 free trade 14. Indonesia 2020 agreements with 30 economies. Of these, 14 are bilateral 15. Pacific Agreement on Closer Economic Relations (PACER) 2020 agreements and four are regional involving three or more 16. Regional Comprehensive Economic economies. Three quarters of Australia’s trading markets Cooperation (RCEP) 2022 are now covered by free trade agreements, representing 17. India 2022 preferential access to 3.5 billion customers. Free trade 18. United Kingdom 2023 agreements result in increased economic activity and therefore greater employment opportunities. They make it easier for Australian businesses to access foreign markets and they provide Australian consumers better access to a wider range of goods and services. Under WTO rules FTAs must adhere to two key principles: ¢ eliminate tariffs and other trade restrictions on ‘substantially all the trade’ in goods between the member countries, and e eliminate substantially all discrimination against service suppliers from member countries. ISBN 978-1-875313-68-6 © Tactic Publications 2025  Investigating Macroeconomics 16 One of Australia’s recent FTAs - the Regional Comprehensive Economic Cooperation (RCEP) - came into force in 2022 and is the world’s largest trading bloc covering 30 per cent of the world’s population. The countries covered by this agreement include China, Japan, Korea, New Zealand and the ASEAN economies. Economists have estimated that the RCEP will boost intra-regional exports by over $US40 billion. In 2023, the Australia-United Kingdom free trade agreement entered into force, eliminating tariffs on over 99 per cent of Australian goods exports to the UK. Additionally, by 2028 all UK imports will enter Australia duty free, helping ease cost-of-living pressures for households and input costs for Australian business. Review 1. Identify Australia’s four main trading partners. Describe the change in the direction of Australia’s trade since 2000. wh Describe two key principles of the WTO trade framework. Outline the purpose of a free trade agreement (FTA). we Define the concepts of trade creation and trade diversion. Historic free trade deal with the United Kingdom The Australia-UK trade agreement (A-UKFTA) will deliver unprecedented benefits to Australian businesses and create new well-paying jobs. The agreement is a gold standard trade deal that delivers benefits for ail Australians — including manufacturers, workers, farmers, tradies, innovators, families, and students. The United Kingdom is one of Australia’s important trading partners, with exports worth $13 billion in 2023, and imports worth $18 billion. With the entry into force of this comprehensive agreement, there will be no tariffs on over 99 per cent of Australian goods exports to the UK, opening up new export opportunities, including for the agriculture sector. This includes Australian exports of wine, short- and medium-grain rice, honey, nuts, and manufactured products such as auto parts, electrical equipment, and cosmetic products. Savings of approximately $200 million a year will be made as tariffs on imports from the UK are eliminated. After five years, all UK imports will enter Australia duty free, helping ease cost-of-living pressures for households and input costs for Australian business. The FTA also provides a framework for professional bodies to agree to streamline processes fo facilitate the movement of qualified professionals between Australia and the UK. This outcome will help address the skills shortage in Australia. (DFAT May 2023) Questions Describe how each of the following groups will benefit from the A-UKFTA: 1. Australian exporters 2. Australian businesses 3. Australian consumers ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 1 Australia's International Trade 17 Chapter Summary + Australia has developed important linkages with the global economy through trade (exports and imports), foreign investment, immigration and tourism * Acountry’s trade intensity is measured by the ratio of total trade (X + M) to GDP * Australia’s trade to GDP ratio has increased from 30% in 1990 to nearly 50% in 2024 + Australia has a low rank in trade intensity due to its geographic isolation * Commodities dominate Australia’s exports - accounting for 71% of total exports * ron ore, coal and natural gas account for half of the value of exports + Manufactured goods dominate Australia’s imports - accounting for nearly half * Personal travel, refined petroleum and motor vehicles account for around 30% of total imports + Australia’s most important region for trade is Asia - accounting for 80% of exports i _ oy 56% of imports Le China is Australia’s most important trading partner with 27% of total trade, followed _ by Japan (10%) and the United States (8%) _* Australia adheres to the principles of the World Trade Organisation (WTO) including _ non-discrimination, open and fair trade tt Australia has 18 free trade agreements with 30 economies- 14 of these are bilateral FTAs and 4 are regional * Two important concepts concerning FTAs are trade creation and trade diversion ms See: Chapter Review Multiple Choice 1. The most important market in terms of value for Australian exports is a. China. b. Korea. c. Japan. d. the United States of America. 2. | The most important market in terms of value for Australian imports is a. the United Kingdom. b. the United States of America. c. Japan. d. China. 3. | Which export category has increased most rapidly since 2000? a. rural commodities. b. mining. c. manufactures. d. services. ISBN 978-1-875313-68-6 © Tactic Publications 2025 18 Investigating Macroeconomics When the Australian economy grows at a fast rate it tends to a. increase its spending on imports, especially capital equipment. b, increase its exports of rural products. c. export more manufactured goods and less primary goods. d. all the above. Which one of the following describes the long term trend in the composition of Australia’s exports? a. Services exports have become relatively less significant while manufactured exports have increased in importance. b. Mining exports have become more significant while rural exports have declined in importance. c. Primary exports have become relatively less significant while services and manufactured exports have increased in importance. d. The relative shares of all export groups have been increasing over time. Which of the following statements relating to Australia’s pattern of trade is correct? a. Australia is the largest agricultural exporter in the world. b. Clothing and footwear is the main import category. c. Australia’s major service export is education. d. The value of primary goods exports is less than manufactured goods exports Which of the following statements regarding Australia’s trade is correct? a. Australia is a major importer of manufactured products. b. Australia is a major importer of primary products. c. Australia is a major exporter of manufactured products. d. Australia is a major exporter of services. The main change in Australia’s direction of trade has been from a. the Asian region to the American region. b. the Indian Ocean region to the Pacific Ocean region. c. Europe to the Asia-Pacific region. d. the American region to the Asian region. Which of the following is not a reason for the shift in the direction of Australia’s trade? a. East Asia has a relatively limited supply of raw materials. b. Australia is geographically a part of the Asia-Pacific region. c. Australia is geographically a part of the European region. d. The Asia-Pacific region has lower transport costs compared with Europe. 10. Primary commodities account for approximately what proportion of Australia’s exports? a. 30% b. 50% c. 70% d. 90% il. Services account for approximately what proportion of Australia’s exports? a. 20% b. 40% c. 60% d. 80% ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 1 Australia’s International Trade 19 AZ: The most important trading region for Australia is a. East Asia. b. South Asia. c. Europe. d. North America. 13. In 2024 Australia’s largest import by valuewas__——_saarnd largest export was a. refined petroleum; natural gas. b. personal travel; iron ore. c. crude petroleum; coal. d. passenger motor vehicles; education. 14. What would reduce the volume of international trade in the world economy? a. A German bank providing a loan to a Nigerian company. b. A Japanese car manufacturer establishing a factory in the Czech Republic. c. The Canadian government introducing quotas on Malaysian electronics products. d. The Swedish government granting aid to Somalia. 15. The main reason for Australia’s relatively low trade intensity [(exports + imports)/GDP] is a. its relatively high level of economic development (high GDP/capita). b. its relatively small population compared with the major developed economies c. its protectionist trade policy stance resulting in a closed economy. d. its geographic isolation from the large economies of the northern hemisphere. 16. Which of the following countries has the highest trade to GDP ratio? a. United States b. Japan c. China d. Australia 17: Which pair of sectors contribute most to Australia’s export income? a. Mining and Services b. Mining and Agriculture c. Services and Agriculture d. Services and Manufacturing 18. Which of the following is the situation in which a nation shifts its international trade from nations outside a regional trade bloc to nations within the bloc? a. Trade diversion b. Trade deflection c. Trade resilience d. Trade creation 19. What is a likely effect of Australia signing a multilateral free trade agreement? a. Anincrease in trade with non-member countries b. Anincrease in tariff revenue for the government c. Anincrease in long-run real gross domestic product d. Lower levels of short-term structural unemployment ISBN 978-1-875313-68-6 © Tactic Publications 2025 20 Investigating Macroeconomics Data Analysis Refer to the table below showing Australia’s trade with China. Australia’s trade with China 2023 Exports $ billion | % share Imports $ billion | % share Iron ore 115.5 67.1 | Telecom equipment 9.7 9.4 Natural gas 20.4... |Computers 7.0 Crude minerals 18.6.... | Passenger motor vehicles 6.3 Education 11.4... | Furniture, mattresses 3.8 Coal 9.2... | Toys, games, sporting goods| 3.34 Gold 6.4... | Electrical machinery 3.1 Total exports 218.8 100.0 | Totalimports _ 108.1 100.0 China is Australia’s largest trading partner in goods and services (valued at around $327 billion in 2023), our largest export destination ($219 billion), and our largest source of imports ($108 billion). China buys around one third of all Australian exports, and is the top overseas market for many Australian goods and services. Australia buys 20 per cent of its imports from China. The Australia-China economic relationship is extensive. The two economies are highly complementary and provide a broad range of opportunities for two-way trade and investment. Resources and energy make up the largest share of Australia’s exports to China, with iron ore and natural gas leading the way. China is also Australia’s largest services export market and is the largest market for agriculture. China is the largest source of tourism income and the largest source of overseas student enrolments. Questions 1. Calculate the size of Australia’s trade balance with China. 2. For both exports and imports, calculate the per cent share columns. 3. Describe the nature of Australia’s exports to China. 4. Describe the nature of Australia’s imports from China. Articles Australia becomes the world’s largest exporter of lithium Global demand for lithium has grown significantly in recent years. Lithium is a key component in the production of rechargeable batteries used in electric vehicles, renewable energy storage, and consumer devices such as mobile phones, laptops, and cameras. Australia is the world’s biggest exporter of lithium with most of it exported to China. Questions - refer to the graph showing Australia’s lithium exports 1. Why has global demand for lithium suddenly increased? 2. In which quarter did lithium exports first exceed $1 billion? 3. Calculate the total value of lithium exports for the 2023 calendar year. ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 1 Australia’s International Trade 21 Australia's Lithium Exports $ million Mar-2020 Mar-2021 Mar—2022 Mar-2023 Mar—2024 Free Trade Agreements Across the globe, there is an expanding network of free trade agreements (FTAs). High-quality, comprehensive free trade agreements can play an important role in supporting global trade liberalisation and are explicitly allowed for under the WTO rules. An FTA is an international treaty which removes barriers to trade and facilitates stronger trade and commercial ties, contributing to increased economic integration between participating countries. FTAs can cover entire regions with multiple participants or link just two economies. FTAs open up opportunities for Australian exporters and investors to expand their businesses into key overseas markets. FTAs can improve market access across all areas of trade and help to maintain and stimulate the competitiveness of Australian firms. This benefits Australian consumers through access to an increased range of better value goods and services. FTAs offer preferential treatment in partner countries for Australian goods, in the form of tariff elimination or reduction. For businesses already exporting goods to an FTA partner country, this increases the competitiveness of their products in those markets, especially compared to competitors from countries that do not receive preferential treatment. Lower tariffs can be a good incentive for Australian businesses to consider exporting to a new market for the first time or expanding a product range. Foreign businesses may be more interested in importing Australian products as a result of an FTA coming into force. FTAs can increase Australia’s productivity and contribute to higher GDP growth by allowing domestic businesses access to cheaper inputs, introducing new technologies, and fostering competition and innovation. (Source: DFAT) Questions 1, Define a free trade agreement. 2, How do Australian exporters gain from an FTA? 3; How do Australian consumers gain from an FTA? 4 Explain how an FTA can contribute to higher GDP growth. ISBN 978-1-875313-68-6 © Tactic Publications 2025 22 Investigating Macroeconomics Extended response 1. Australia has important economic links to the global economy. Describe the nature of these links and discuss the importance of trade to the Australian economy. (15 marks) In your response, include e — four linkages with the global economy ¢ the composition of Australia’s trade (exports and imports) e the direction of Australia’s trade ¢ the importance of trade to the Australian economy 2. (a) Explain why Australia pursues free trade agreements (FTAs). (7 marks) (b) Describe two benefits to both Australian producers and consumers of a free trade agreement. (8 marks) Past exam questions 1. An argument against free trade agreements such as the European Union is that they can a. be harder to negotiate compared with multilateral agreements. b. divert trade from a low-cost producer outside the trade agreement to a higher-cost producer within the trade agreement. increase the trade intensity of member countries. ad d. divert trade from high-cost producers within the trade agreement to lower-cost producers outside the trade agreement. 2. Which of the following statements about trade intensity is correct? a. Ahigh trade intensity ratio leads to increased dependence on foreign investment b. Australia’s trade intensity is low in comparison to China and the USA c. It measures the total value of imports and exports as a percentage of GDP d. It indicates the impact of barriers to trade on the Australian economy Multiple Choice Answers 14¢; 1£ Page 17: 1a; 2d; 3b; 4a; 5b; 6c; 7a; 8c; 9c; 10c; 11a; 12a 13b; Page 22: 1b; 2c ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 2 Free Trade and Protection 23 Free Trade and Protection - the concepts of absolute and comparative advantage, including the sources of comparative advantage * the gains from specialisation and trade using the D/S model, the PPF model and the concept of opportunity cost * types of protection, including tariffs, subsidies, quotas * arguments for protection * the impact of tariffs and subsidies using the D/S model on trade, market efficiency and the macroeconomy « the benefits of trade liberalisation ISBN 978-1-875313-68-6 © Tactic Publications 2025  24 Investigating Macroeconomics Introduction Specialisation and trade are features of all modern economies. Why? Because through specialisation and trade, countries can increase their living standards and improve the economic prosperity of their residents. Any form of trade or exchange involves gains to both buyer and seller. This is true for trade between countries as well as trade between individuals. The exchange of Specialisation and goods and services is a necessary characteristic of a specialised economy. trade result in higher living standards. But specialisation is not possible unless trade takes place. Teachers, doctors, tradesmen, miners and farmers are all specialists. The income they earn is used to purchase the goods and services they require which they do not produce themselves. People specialise in tasks to which they are best suited, that is, in which they have an advantage. Likewise, countries specialise in the production of certain goods and services to which they are best suited. Surplus production can then be exchanged or traded for other goods and services. The alternative to specialisation is self-sufficiency. This would be equivalent to people having to grow their own food, make their own clothes, build their own houses, and provide for all their own medical and other professional services. International specialisation and trade is made possible because of the uneven distribution and quality of resources between countries. Australia, for example, is well endowed with natural resources such as arable land, forests, minerals and energy supplies. Australia has become a very efficient producer of mineral resources, becoming a global leader in the export of iron ore, coal and liquefied natural gas. Japan is an example of an economy that lacks many natural resources, including mineral and energy resources, but has a relatively large skilled workforce and a highly developed industrial base. Japan has developed an expertise in producing high quality manufactured goods, such as motor vehicles and electronic equipment. Differences in the distribution of resources in terms of both quantity and quality will affect the cost of supplying goods and services. If production costs differ, then countries will benefit by specialising in the goods and services in which they are most efficient, exporting the surplus production and importing those goods and services in which they are less efficient at producing domestically. In economics, relative efficiency is measured in terms of opportunity cost, which reflects the real cost of production. For example, an accountant may be highly skilled at two tasks - auditing and word processing. Should she divide her Opportunity cost can time between both tasks or employ an assistant to do the word processing, even be used to measure though she is more efficient than the assistant? In this example, the accountant relative efficiency. is said to have an absolute advantage over the assistant in both auditing and word processing, but her relative advantage is in auditing. The administration assistant is not absolutely efficient in either task, but he is relatively more efficient than the accountant in word processing. Relative advantage is called ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 2 Free Trade and Protection 25 comparative advantage. The accountant is said to have an absolute advantage in both tasks, but has a comparative advantage in auditing while the assistant has a comparative advantage in word processing. In other words, the accountant would gain if she devoted all her time to her most efficient task - auditing - while employing another person to perform the other task. Jannik Sinner, from Italy, is currently the world number one tennis player. He may also excel at cooking pasta. Should Jannik divide his time between tennis and cooking? Of course not, Jannik is much better off by devoting his time to what he does relatively best - tennis - and pay someone to cook his favourite pasta. In other words Jannik’s comparative advantage is in playing tennis. At the international level, countries may also possess an absolute advantage and/or or a comparative (relative) advantage in the production of goods and services. Countries will be better off if they export goods and services in which they possess a comparative advantage and import those goods and services in which they have a comparative disadvantage. This is a key point to remember - trade is based on differences in relative cost rather than absolute cost. The concept of absolute advantage A country is said to have an absolute advantage in the production of a good or A country has an service over another country if it can produce a greater quantity of that good absolute advantage with its resources (or produce the same quantity of output with fewer resources). over another country in producing a good if it This means that a country with an absolute advantage in a good can produce can produce a greater that good at a lower absolute cost per unit. A simple model demonstrates how quantity of that good. countries can gain through based on absolute advantage. The assumptions for this model are: « the world consists of two countries - Australia and Papua New Guinea; e each country produces and consumes two goods - wheat and coffee; * resources are perfectly mobile - resources can be shifted between industries with zero displacement cost; and e transport costs are not considered. Figure 2.1 illustrates the model of absolute advantage. It shows the production possibilities for the two countries, assuming that they devote all their resources to producing either wheat or coffee. If Australia only produced wheat its total output would be 10 units. Ifit used all its resources to produce just coffee, then its output would be 5 units. Papua New Guinea with its resources can produce either 5 units of wheat or 10 units of coffee. This information is used to construct a production possibility frontier for each economy. Australia is said to have an ISBN 978-1-875313-68-6 © Tactic Publications 2025 26 Investigating Macroeconomics absolute advantage in the production of wheat, while Papua New Guinea has an absolute advantage in the production of coffee. In isolation, each country can choose to produce at any point on their production possibility curve. This will depend on the country’s preferences for the two products. Assume that Australia chooses to produce at point A, while Papua New Guinea chooses to produce at point B. Before specialisation the ‘world’ production of wheat is 8 units, while the total production of coffee is also 8 units. If both countries specialise in producing the goods in which they have an absolute advantage, then total production will increase. Australia will specialise in producing wheat and Papua New Guinea will specialise in producing coffee. The total production of both wheat and coffee will now increase to 10 units - a net increase of two units of output for each good. Figure 2.1 Absolute advantage Production possibilities Country Wheat Coffee Australia 10 olen bese tee Papua New Guinea is) or 10 Australia Papua New Guinea Before specialisation | wheat 6 2 8 ee | «(COffee 2 6 eG he ‘After specialisation | wheat | 10. 0 “AO: eee | «(coffee faeaad. 10 10 - Aftertrade | wheat | 7 3 1405 [iae| coffee (gags 7 10° al ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 2 Free Trade and Protection 27 One possible trading position is shown in the bottom table of figure 2.1. Australia may choose to keep 7 wheat and export 3 to Papua New Guinea in return for 3 units of coffee. In this case the rate of exchange would equal 1 unit of wheat to 1 unit of coffee. The rate of exchange will always lie somewhere between The rate of exchange is determined by the the opportunity cost ratios for the two goods being traded. For example, the opportunity cost ratios. opportunity cost of 1 unit of wheat in Australia is 0.5 coffee, while in Papua New Guinea, the opportunity cost of 1 wheat is 2 coffee. Australia will export wheat as long as it can get more than 0.5 units of coffee. New Guinea, on the other hand will export coffee as long at it receives more than 0.5 units of wheat. The blue dotted line represents the ‘trading’ frontier for each country based on the rate of exchange: 1 wheat = 1 coffee. After specialising and trading, each country is able to consume one more unit of both wheat and coffee. Australia If countries specialise can nowconsumeat point A*, while Papua New Guinea can consume at B*. Each and then trade, country is then able to enjoy a higher standard of living - to consume outside they can consume their production possibility frontier! What if one country had the absolute above their PPFs. advantage in both goods, that is, one country could produce both commodities more efficiently? Would it still be possible for both countries to gain in terms of higher consumption? To answer this question and show that it is possible for countries to gain even though they do not have an absolute advantage we need to look at the concept of comparative advantage. The concept of comparative advantage When a country has an absolute advantage in the production of both goods, its comparative advantage lies where its absolute advantage is greatest. The country that has no absolute advantage has a comparative advantage in the good where A country has a its absolute disadvantage is smallest. A country is said to have a comparative comparative advantage advantage in producing a good or service if it can produce that good or service in producing a good if it can produce that good at at a lower opportunity cost than another country. To illustrate the principle a lower opportunity cost of comparative advantage for a country we will employ the same assumptions we used for the model of absolute advantage, except the two countries will be Australia and Japan, and the two commodities will be computers and wool suits. Figure 2.2 illustrates the production possibilities frontiers for both Japan and Australia. Japan has an absolute advantage in the production of both computers and wool suits. It can produce a greater output of both goods from a given quantity of resources than can Australia. Japan’s greatest absolute advantage, however, is in computers, while Australia’s least disadvantage is in wool suits. In other words, Japan has a comparative advantage in computers and Australia has a comparative advantage in wool suits. Comparative advantage is measured in terms of opportunity cost. For Australia, the opportunity cost of producing eight computers is the sixteen wool suits that cannot be produced. ISBN 978-1-875313-68-6 © Tactic Publications 2025 28 Investigating Macroeconomics Figure 2.2 Comparative advantage rod Possibilitie: portunity Co 20 1 wool suit 1 computer Australia Japan Before specialisation After specialisation After trade The opportunity cost of one computer therefore, is two wool suits. In Japan, the opportunity cost of one computer is only one wool suit. The opportunity cost of producing computers is lower in Japan than in Australia. Conversely, the opportunity cost of producing 16 wool suits in Australia is the 8 computers foregone. The opportunity cost of one wool suit in Australia, therefore is 0.5 of a computer. In Japan, the opportunity cost of one wool suit is one computer. Wool suits is thus relatively cheaper to produce in Australia than in Japan. In our example, Australia has a lower opportunity cost in producing wool suits while Japan has a lower opportunity cost in producing computers. Australia should therefore specialise in producing wool suits while Japan should devote its resources to producing computers. ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 2 Free Trade and Protection 29 Both countries will gain if they specialise on the basis of comparative advantage and then trade their surplus production. The results are summarised in figure 2.2, given that Australia chooses to produce and consume initially at point C on its production possibility curve, while Japan chooses point D on its production frontier. After specialisation, total production of both computers and wool suits has increased by two units. Australia will export wool suits to Japan and import computers. The rate of exchange between computers and wool suits will again lie between the opportunity cost ratios. Australia will want to receive more than 0.5 computer for each wool suit it sells to Japan, while Japan will want to receive more than 1 wool suit for each computer it exports to Australia. In figure 2.2, one possible rate of exchange is shown - 1 computer for 1.4 wool suits or 1 wool suit for 0.71 computer. The blue dotted lines represent the ‘trading’ frontiers for each country based on the rate of exchange: 1 computer for 1.4 wool suits (or 1 wool suit for 0.71 computer). Australia keeps 9 wool suits and exports 7 to Japan. Japan keeps 15 computers and exports 5. After specialising and trading, each country is able to consume one more unit of each good. Australia can now consume at point C*, while Japan can consume at D*. Each country is then able to enjoy a higher standard of living - to consume outside their production possibility frontier! The theory of comparative advantage has demonstrated that countries gain by Comparative advantage specialising in the production of goods in which they have an opportunity cost is the basis for advantage. That is, in goods which they are relatively more cost efficient. In international trade - not fact, it is comparative advantage and not absolute advantage that is the basis absolute advantage. for international trade. It is the difference in relative and not absolute costs that is important. Figure 2.3 provides a summary of the theory of international specialisation. In Case 1, Australia has an absolute advantage in wheat and Papua New Guinea has an absolute advantage in coffee. But the reason why both countries are able to gain as a result of specialisation and trade is because their opportunity costs differ. Australia has a lower opportunity cost in producing wheat (0.5 coffee) compared with Papua New Guinea (2 coffee), while the opportunity cost of producing coffee is lower in New Guinea (0.5 wheat) compared with Australia (2 wheat). This means that Australia actually has a comparative advantage in wheat and Papua New Guinea has a comparative advantage in coffee. This is why specialisation results in an increase in production. In Case 2, Japan has an absolute advantage in the production of both goods but is relatively more efficient in computers while Australia is relatively more efficient in wool suits. Again there is a difference in opportunity costs, that is, there is a difference in comparative costs. When both countries specialise based on comparative advantage they will increase their consumption. In Case 3, country A has an absolute advantage in the production of both goods but has no comparative ISBN 978-1-875313-68-6 © Tactic Publications 2025 30 Investigating Macroeconomics Figure 2.3 The gains from specialisation Case 1 Wheat Coffee Comment Australia 10 or 5 Australia has an absolute (and comparative) advantage in wheat, Papua New Guinea has an absolute (and comparative) Papua N.G 5 or 10 advantage in coffee. Case 2 Computers Wool Suits Japan has an absolute advantage in both Australia 8 or 16 goods. Australia has a comparative advantage in wool suits, and Japan has a comparative advantage in computers. Japan 20 or 20 n absolute ad advantage since the opportunity costs are the same in both countries. In other words absolute advantage on its own is not sufficient to explain international specialisation. International trade hinges on differences in opportunity costs - comparative advantage. Comparative advantage using inputs Is it possible to determine comparative advantage when comparing the quantity of inputs to produce a good rather than comparing total production? For example the following table shows the number of labour hours it takes to produce one bicycle and one computer in two different countries. s | Computers | 30 hrs 20 hrs 40 hrs 50 Ars Who has the absolute advantage? The answer is that Country X has an absolute advantage in both products since it takes less hours to produce both bicycles and computers compared to Country Y. But which country has the comparative advantage? Clearly we can see from the table that Country X’s biggest advantage is in producing computers while country Y’s least disadvantage is in producing bicycles. This means that Country X has a comparative advantage in computer production while Country Y has a ISBN 978-1-875313-68-6 © Tactic Publications 2025 Chapter 2 Free Trade and Protection comparative advantage in bicycle production. Can we still use opportunity cost ratios? The answer is yes, but it is calculated differently. The formula to use to calculate the opportunity cost of bicycles compared to computers when using inputs is: the number of hours to produce a bicycle divided by the number of hours to produce a computer. So in Country X the opportunity cost of 1 bicycle = 30 hrs/20 hrs = 1.5 While the opportunity cost of 1 computer = 20hrs/30hrs = 0.67 In Country Y, the opportunity cost of 1 bicycle = 40 hrs/50 hrs = 0.8 While the opportunity cost of lcomputer = 50hrs/40hrs = 1.25 Comparative advantage is still identified by who has the lowest opportunity cost. This means that Country X has a comparative advantage in producing computers while Country Y has a comparative advantage in producing bicycles. The sources of comparative advantage What determines a country’s comparative advantage? What are the sources of comparative advantage? Comparative advantage is determined by the quantity and quality of the nation’s labour or human resources, natural and capital resources, and by technological progress. The sidebar shows some well-known areas of specialisation for several countries. Comparative advantage can be based on differences in climate and endowment of natural resources. Australia has traditionally had a comparative advantage in many primary industries such as agriculture and mining: wheat, wool, beef, iron ore, coal and natural gas. The Middle East Country Specialisation is endowed with vast oil supplies, Canada has [Ajstalia.| ron ore, coal, education extensive ld’s forests and Brazil produces most of the coff Brazil coffee, sugar world’s coffee. Nr (naearer ake Canada __|wheat, timber Comparative advantage is not just limited to China clothing, consumer goods endowments of natural resources. It is also ‘France | aircraft, wine iS determined by the quantity and quality of a Germany WeieRGGhIIGS country’s labour and capital resources. For example, ‘Korea___| ships, chemicals Switzerland is renowned for its watch making : : iG : : SAAS: oil industry and the provision of banking services. DT eae, (ext F a Ee The United States has developed a comparative __| watches, banking services _ advantage in the television and film industry as well | Ynited States | arms & ammunition as computer software. Comparative advantage can and does change over time with improvements in technology and productivity. Japan became a major manufacturing nation post World War II. Over time Japan developed a comparative advantage in many industries, including motor vehicles and electronics. Australia has now developed a comparative advantage in education services and in medical research. Not all countries take advantage of the theory of comparative advantage. Countries may choose to support and protect industries that are not ISBN 978-1-875313-68-6 © Tactic Publications 2025  Investigating Macroeconomics economically efficient for cultural or political reasons - the tradeoff is a lower level of national income and a lower standard of living. The theory of comparative advantage is the theory of free trade. It is one of the most important principle of economics. Specialisation and trade has enabled the spectacular increase in global living standards witnessed over the past century. Many people attempt to criticise the theory of comparative advantage by arguing that it is based on simple assumptions such as zero transport costs. But transport costs can easily be incorporated in the model without affecting the validity of the theory. The model also assumes that the resources in the trading nations are relatively mobile. This means that resources such as labour and capital equipment could be transferred from one industry to another at a constant cost (straight line PPFs). Again this is just a convenient simplification and has no relevance to the model’s conclusions. The theory of comparative advantage does actually help to explain global trade patterns. Countries will in the long run achieve a higher standard of living if they pursue policies that promote free trade. Review The production possibilities for two countries Apland and Orland are shown below.