Economics Notes PDF

International trade This chapter examines trade and the circular flow of income, patterns and direction of Australia's trade and trade theories. Getty Images/Alija Imagine for a moment a world in which each country operates as a closed economy; that is, each country relies totally on its own re...

International trade This chapter examines trade and the circular flow of income, patterns and direction of Australia's trade and trade theories. Getty Images/Alija Imagine for a moment a world in which each country operates as a closed economy; that is, each country relies totally on its own resources to satisfy the wants of its citizens. There is no problem in such a world if every country has an equal allocation of resources and an equal number of citizens. But what happens when we introduce the element of inequality into our imaginary world? Assume that some countries have fewer people and more resources, and that other countries have vast supplies of some resources and no supply of others. It should be evident that, under these circumstances, if each nation continued to operate as a closed economy, living standards would differ greatly from nation to nation and opportunities for economic development would be severely curtailed. How does the real world compare with this imaginary world? We do not have to look very far to notice that we live in a world of appreciable differences. When early humans ventured beyond their immediate environment, they discovered new resources and, as civilisation spread across the Earth's surface, humans recognised the need for trade. People saw that trade provided the means by which a greater number of wants could be satisfied. We are all familiar with the practice of swapping recipes, digital files and other items among friends. This is a version of the primitive barter system, the simplest form of trade, which even today still accounts for a substantial volume of internal trade in less-developed regions of the world. Changes in the prosperity of a country's external sector can have significant effects on its domestic economy. KEY IDEA In today's global economy, international trade is a far more complex process, but the basic reason for its existence is the same. No country is so well endowed with resources that it does not have to rely on other countries for the supply of some commodities. For instance, Australia has ample supplies of coal and iron ore, while Japan does not. As a result, Japan trades with Australia to obtain these minerals for its productive processes. Australia, on the other hand, does not produce rubber, cocoa or computer chips and must rely on other nations to provide these commodities. Interdependence of this kind is a characteristic of all nations in the world today. Therefore, we can say that all contemporary nations operate as open economies. 1.1 The open economy and the external sector Circular flow of income model: a model of the economy, based on income flows from one sector of the economy to another in a circular motion, which explains levels of national income and output, and how changes in these occur Exchange rate: the value of the currency of a nation expressed in terms of the currency of another nation External (foreign) sector: that sector of the circular flow of income model that identifies economic influences external to the domestic economy Internal balance: a state of the economy in which there is full employment and acceptable levels of inflation Open economy: any nation that trades with other nations CONCEPTS One way of illustrating how our domestic economy is linked to the rest of the world is through a circular flow of income model (or 'circular flow model') incorporating the external (foreign) sector. A circular flow of income model for an open economy incorporates income flows generated by the external sector. These include leakages from the economy due to expenditure on imported commodities by residents, domestic businesses and governments. Injections into the circular flow are due to income received by residents for commodities exported to other nations. Figure 1.1 shows how the external sector fits into a typical circular flow of income model. You will recall that, if we let M stand for expenditure by residents on imports and X stand for income received by residents from exports, then the equation for total income in the economy becomes: Y = C + S + T + M or O = C + I + G + X where: Y = total income C = consumption expenditure S = savings T = taxation M = expenditure on imports O = the value of the total output of production I = investment expenditure G = government expenditure X = expenditure on exports. Equilibrium is said to be achieved in the economy when: Ip + G + X = Sp + T + M where: Ip = planned investment Sp = planned saving. From the above equation, it can be seen that it is possible to have inequality between Ip and Sp, between G and T and also between X and M, and still have overall equilibrium in the economy as long as the various inequalities compensate for one another to give overall equality. If the level of imports is greater than exports (M \> X ), then the level of economic activity (O and Y ) will contract. In Australia, there has been an increasing gap between X and M, which has contributed to an increased external debt -- investments, largely from overseas, are being used more than national savings. To narrow the difference between X and M, the circular flow of income model demonstrates that I should decrease or S increase or T increase or G decrease. In 2017 and 2018, the Australian Government delivered budget deficits (G increased more than T ) and there has been a sustained campaign to encourage an increase in national savings. International economics is an important area of economics. In studying this field we get a chance to integrate macro- and microeconomic concepts and models to create a framework within which we can apply theory to very real-world situations. Concerns such as increasing external debt, foreign ownership and international competition in industry are affected by pressures such as volatile exchange rates, decreasing commodity prices and tariffs. Economists have to make some difficult decisions to achieve their objective of external viability while maintaining internal balance, such as low levels of inflation and unemployment. Q U E S T I O N S 1 Why are import payments a leakage from the circular flow-of-information model and export income an injection into it? 2 Why is Australia described as a small, open economy? 3 How does trade assist economic growth? 1 In the past five years, has there been a consistent trend in the growth of exports and imports, or are there fluctuations? 2 Suggest reasons why the growth rates are changing. Capital: the factor of production comprising the stock of human-made resources used to create further goods and services Economic problem: the problem of deciding or choosing how to satisfy unlimited wants with limited resources Factor endowment: the supply of the factors of production (land, labour, capital and enterprise) that exists in a country Gross domestic product (GDP): the total value of final goods and services produced within an economy in a specified period of time Human capital: the knowledge, experience and skills of individuals, in which nations must invest if they are to advance Profit motive: the seeking of profit, the basic stimulus for economic activity in a free-enterprise economy Relative scarcity: limited supply of a resource Standard of living: a measure of lifestyle standards based on material and quantitative indicators, such as possessions, income, education and health standards, and housing standards Widening gap: increasing economic difference between poor nations and economically advanced nations It should now be evident that there is a similarity between the economic problem confronting an individual and the problem that faces all nations. Relative scarcity is the common element at both levels. Individuals allocate their limited income to maximise the satisfaction of unlimited wants. In the same way, nations distribute their scarce resources according to national objectives. Each nation seeks to supplement its own resources through international trade to compensate for the significant differences in factor endowment among nations of the world. 1.2.1 Unequal distribution of natural resources Nations are not endowed with the same quantity and quality of natural resources. Geographical features such as climate and topography largely determine a nation's agricultural and pastoral capabilities. For example, a country with high temperatures, low rainfall and a denuded landscape is extremely limited in its capacity to produce agricultural products and it is unlikely that such a country could support a thriving pastoral industry. Australia is fortunate in that, even though only a very small proportion of our continent is considered arable, it has been sufficient to meet most of the needs of our population The unequal distribution of mineral resources throughout the world gives rise to a vast volume of trade. Modern production processes consume enormous quantities of energy, leading to a continuous demand for minerals such as coal and oil. The oil crises in the early 1970s and in 2003--04 highlighted the extent of international economic dependence upon oil-producing nations. In one respect, these crises were a welcome development because they brought with them the realisation that oil supply is limited and that nations need to closely examine their energy requirements. In recent years, we have seen the controversial development of uranium as an alternative energy source to replace the rapidly diminishing supplies of conventional fuels. Again, the known supply of this mineral is limited to a few countries of the world. It is important to remember that a nation's supply of natural resources can change with technological development. Scientific advancement in the twentieth century has led to the inclusion of minerals such as uranium and bauxite in our endowment of natural resources. It is not unreasonable to suggest that, in years to come, much of Australia's arid land surface may become arable through the application of improved technology. 1.2.2 Unequal distribution of capital and technology The implementation of capital-intensive techniques in all types of production resulted in remarkable growth rates in productivity last century, and this growth rate is likely to continue. This, in turn, has led to greatly improved living standards in those countries where such innovation has been possible. However, the inability of many countries to accumulate capital means that these countries have been unable to develop capital-intensive forms of production. Many of the less-developed countries of the world fall into this category. Less-developed economies typically produce primary products and rely upon trade with more advanced economies to meet their needs for manufactured goods. In a sense, the capital accumulation process is self-perpetuating. Advanced economies, with established capital infrastructures, have been able both to maintain high rates of economic growth and to achieve external viability. However, the less-developed economies are continually confronted with trade deficits and have been unable to accumulate sufficient capital to establish an efficient infrastructure upon which economic growth can be based. This has led to what is often referred to as the widening gap between the gross domestic product (GDP) of advanced economies and less-developed economies of the world. FIGURE 1.2 A modern mine Shutterstock.com/Sergey Malov 1.2.3 Unequal distribution of human skills In recent decades, some economists have focused on the concept of human capital as an essential component of economic development. The term merely highlights the fact that a nation's expenditure on education and health facilities can be interpreted as investment in human capital. Generally speaking, we can say that advanced economies have populations in which the proportion of skilled labour is higher than that found in less-developed economies. Consequently, this has enabled advanced economies to diversify production and to initiate and absorb technological change. The result has been that many nations of the world rely on others for the provision of the goods and services that they do not have the skills and expertise to produce themselves. FIGURE 1.3 Advanced economies have populations with a high proportion of skilled labour, enabling them to diversify production and to initiate and absorb technological change. 1.2.4 Desire for an improved standard of living As mentioned earlier, if the Australian economy chose to operate as a closed economy, our standard of living would be severely reduced. Because endowment of natural resources, capital, technology and human skills differ from country to country, nations seek to trade with others in order to maximise their standard of living. International trade allows for a sharing of the world's resources, and enables nations to enjoy goods and services otherwise unavailable to them. 1.2.5 Profit motive In the case of free-enterprise economies, the basic stimulus for economic activity is the profit motive. In Australia, for instance, even though we frequently speak collectively of our trade with other nations, we must remember that this trade is actually undertaken by individuals and firms, or by organisations acting on behalf of individuals and firms. We have entrepreneurs who are exporters and others who are importers. All seek to maximise their profits. Although the government intervenes in the national interest, free enterprise prevails. This partly explains why we import some commodities that are already produced within our domestic economy. If entrepreneurs think that they can successfully market imported products against locally produced commodities, then they are generally free to do so. Shutterstock.com/Stas Ponomarencko Explain the similarities between the economic problem of a household and the international economic problem. 2 Identify the main motivation for international trade. 3 Explain why you think some countries are more dependent on trade than others. 4 Construct a table to show the major differences between domestic and international trade. Create an economic profile for Australia and one other country. 1 Collect statistics to describe the distribution of natural resources, human skills, standard of living, and capital and technology. 2 Collate the data into tables and graphs. 3 Present this information as an infographic to your class. At the conclusion to your presentation, make a judgement as to which country has the best factor endowment, and justify this referring to the evaluative criteria used. ECONOMICS AND ICT Capital-intensive methods of production: a production process that predominantly uses capital rather than labour Currency: the basic monetary unit of a country Economies of scale: cost efficiencies that are derived by producing a large volume of standardised products Intra-company trade: trade between affiliates of the one organisation; for example, between a home-based subsidiary and a foreign-based subsidiary of the same company Labour-intensive production: a production process that predominantly uses labour rather than capital Multinational corporation (MNC): an enterprise operating in several countries but managed from one (home) country; generally, any company or group that derives a quarter of its revenue from operations outside of its home country is considered a multinational corporation Productivity: output per unit of input per unit of time CONCEPTS Although it is possible to identify similarities between interregional and international trade, there are numerous factors that make the process of international trade much more complex. When Queensland producers wish to sell goods in New South Wales or Western Australia, they encounter fewer difficulties than if they wish to market the same goods in Japan or India. Some obvious difficulties arise because of the many differences that exist between nations. When products are traded between regions in the same country, they move within the same social and institutional system. On the other hand, when products are traded between nations, they must pass from one system into another. Nations differ in a number of ways. Different currencies A currency is the basic monetary unit that is used within a country. In most countries, only the national currency is considered to be legal tender. When a Queensland manufacturer sells goods to a New South Wales retailer, there is no issue because both parties deal in the basic Australian unit of currency: the dollar. On the other hand, when the Queensland manufacturer sells to a Japanese retailer, there are two currencies involved: Australian dollars and Japanese yen. The Japanese retailer pays for imported goods in yen and the Australian producer receives payment in dollars. For this to happen, it is necessary for the transaction to pass through the international banking system that converts the payment from one currency into another. The process is further complicated because one Australian dollar has a different purchasing power from one Japanese yen. It is, therefore, necessary to maintain rates of exchange that express the value of one currency in terms of other currencies. In recent years, the procedure for determining appropriate rates of exchange has come under a great deal of pressure because of differing inflation rates in countries around the world. Inflation results in the decline of the purchasing power of a unit of currency. Different cost structures Methods of production tend to differ greatly around the world. The labour--capital mix that producers choose to use depends very much upon the availability and relative costs of these resources within a country. In Australia, over recent decades we have witnessed a shift from labour-intensive methods of production to capital-intensive methods of production. This shift has come partly from the greater availability of capital and partly from the fact that the cost of employing labour has steadily increased. Currently, the shortage of skilled labour and the ageing of the population are other issues for Australia and its government to consider. Generally speaking, the introduction of capital-intensive methods of production increases productivity and, therefore, reduces the unit cost of goods. In countries where labour is abundant and capital is relatively scarce, production tends to be labour-intensive. Because labour productivity is low in such countries, wages are also low by our standards. It is this imbalance in wages that often leads to conflict in international trade. For instance, Australian clothing manufacturers that use labour-intensive methods of production must compete with Asian manufacturers that use similar methods, but have access to cheaper labour. This often FIGURE 1.4 Labour-intensive methods of production require a pool of cheap labour, as in this clothing factory. Shutterstock.com/humphery results in Australian companies moving their production offshore, as in the case of Bonds Clothing and Billabong. Banks, communication companies and some other businesses have moved their telephone call centres offshore for the same reason. A further factor that contributes to differing cost structures is the size of the domestic market. Domestic markets in Australia are relatively small and local producers are often unable to attain the economies of scale that are available to their foreign competitors. The disadvantage faced by our local producers is obvious. A prime example of an industry that suffered this market disadvantage is the Australian motor vehicle manufacturing industry. This industry was often criticised for the inefficiency resulting from its fragmentation. Our vehicle assembly plants were tiny compared with those that existed in Japan, the USA and countries such as South Africa and South Korea, and it was argued that there were too many producers for the size of the domestic market. The result was that Australian consumers had to pay a relatively high price for all motor vehicles, whether they were imported or locally produced. The main reasons for this were the inability of domestic firms to benefit from economies of scale, and the high level of tariffs on imported vehicles. In 2017, the last of the manufacturing plants in Australia was closed and Australia now has no motor vehicle manufacturing at all. Transport cost is another factor that leads to differing cost structures between nations. It arises from -- and varies according to -- the distances over which goods must be carried, either to be processed or marketed. Australia suffers in this regard because of its vast land mass and relative isolation from major world markets. Australia's productive activities are scattered over an area that is approximately 25 times the size of Great Britain and almost as large as the USA, excluding Alaska. The distance to major Asian seaports and to the US west coast is about 12 000 kilometres, and the major European markets lie more than 17 000 kilometres from Australia. The result is clear: Australian exports and imports incur higher costs than they would if foreign markets were closer. Social differences International trade frequently encounters barriers such as different languages, customs, habits and tastes, which create difficulties that are not normally encountered within a nation. Religion has often been cited by economists as a social factor that can have significant repercussions in terms of the economic development of some countries. For instance, the prevalence of Hinduism as a religion in India and parts of South-east Asia has a widespread effect upon the customs and habits of its followers. It denies Australia what might otherwise be a substantial market for beef. The Hindu faith promotes vegetarianism and 'ahimsa' -- respect for life. The cow is venerated and protected by devotees of Hinduism. Technical differences A constant source of frustration for exporters has been the variety of technical specifications that exists from country to country. Typical examples are the different voltage systems for electrical appliances, and the left-hand- and right-hand-drive specifications for motor vehicles. A producer wishing to penetrate a foreign market may have to alter production processes if the requirements of the potential market differ from those in the established domestic market. Such alterations usually lead to higher production costs. If there are higher risks associated with the potential market, foreign producers may decide that penetration is uneconomical. Such markets are, therefore, often left to domestic producers. Different national policies Decisions made by governments as well as by individual enterprises have a major influence on the pattern of world trade. KEY IDEA Even though international trade theory (see Section 1.6) clearly demonstrates the many advantages to be gained from free trade between nations, the real world is far removed from the theoretical world described in economists' models. International cooperation may be desirable, but the prime function of democratic governments is to put the welfare of their own citizens first. In a sense, all governments are profit-maximisers in a competitive market place, attempting to secure an advantage over their competitors. For this reason, governments continually interfere with the process of international trade, altering their policies to accommodate changing conditions in their domestic economies. For instance, Australia in recent years has been actively pursuing free trade arrangements with various nations, while Japan and the European Union are still in favour of protecting their domestic industries, particularly agriculture, from international competition. The problems of impoverished countries are often accentuated by social structures that lead to an inequitable distribution of national income. It is not uncommon to find in these countries that a significant proportion of national income accrues to a minority ruling class that determines national policies. Consequently, household disposable incomes are often far lower than is suggested by per capita figures. This means that, even though there are many countries with populations exceeding Australia's, their consumer markets may be smaller than ours. Multinational corporations It is estimated that multinational corporations now produce more than 25 per cent of the world's GDP. The ten largest multinationals each have an annual output that exceeds the individual GDP of 120 nations in the world. These kinds of figures indicate the enormous influence that multinationals have on international trade. Indeed, if one considers the multinational companies as separate economies, the top 100 economies in the world contain 69 multinational corporations and 31 countries. Intra-company trade is a common feature of multinationals. Subsidiary companies of one corporation scattered throughout the world will often trade with each other, shutting out competitors and distorting the market. Transfer pricing is the practice of setting artificially high prices when one subsidiary company buys from another subsidiary company, thereby reducing apparent profits and avoiding taxation -- shifting profits from high-taxing countries such as Australia and paying taxes in the lowest-taxing jurisdictions. Multinational corporations tend to be highly mobile and show no hesitation in shifting their productive activities from nation to nation. A phenomenon of recent years has been the movement of multinationals into China as the Chinese Government has sought to attract foreign capital, technology and expertise. In some cases, corporations have moved their operations from Taiwan to China to take advantage of cheaper labour costs. Consider the implications for the economy that suddenly loses the production previously generated by a multinational corporation. identify conditions in Australia that may create difficulties for overseas trading firms. 2 Identify at least five multinational companies that operate in Australia. List some of their products. 3 How might an Australian multinational company operating in China be of benefit to China? You are a junior trade official and have been given the task of investigating and reporting on the ease with which Australian companies might be able to enter trading agreements with countries in the African or Latin American regions. 1 Choose one country in one of the above regions. 2 Investigate conditions that Australian firms may experience when trading in the chosen country. Follow the link to Austrade and use the information available on this website as the basis for your inquiry. 3 Design a web page that could be used by firms interested in seeking trade opportunities in your chosen country. 4 Include a list of other websites that could be used for further information. Austrade ECONOMICS AND ICT 1.3 Advantages and disadvantages of international trade Many people suspect that international trade operates as a zero-sum game; that is, they think of it like a game of football -- a competition with rules that has one winner and one loser. Specifically, people sometimes believe that if our trading partners are gaining as a result of international trade, Australia must be losing. In this view, exported goods represent a gain for the economy and imported goods represent a loss for the economy. This idea is nothing new; it dominated economic and political thought from the sixteenth to the eighteenth centuries. Known then as 'mercantilism', it led to government policies that encouraged exports and discouraged imports. Adam Smith's writing in The Wealth of Nations \(1776) showed that the zero-sum game myth was not valid. 1.3.1 The costs and benefits of trade In spite of people's apprehensions about trade, both imports and exports are at an all-time high in Australia (see Figure 1.5). For trade to occur it must make both nations better off. This is a positive-sum game, not a zero-sum game, because both sides gain. Q U E S T I O N S 1 Identify conditions in Australia that may create difficulties for overseas trading firms. 2 Identify at least five multinational companies that operate in Australia. List some of their products. 3 How might an Australian multinational company operating in China be of benefit to China? You are a junior trade official and have been given the task of investigating and reporting on the ease with which Australian companies might be able to enter trading agreements with countries in the African or Latin American regions. 1 Choose one country in one of the above regions. 2 Investigate conditions that Australian firms may experience when trading in the chosen country. Follow the link to Austrade and use the information available on this website as the basis for your inquiry. 3 Design a web page that could be used by firms interested in seeking trade opportunities in your chosen country. 4 Include a list of other websites that could be used for further information. Austrade ECONOMICS AND ICT The winners With international trade, the winners include consumers (buyers) and domestic companies that export goods (sellers). First, let's consider the benefits to buyers. Consumers see the benefits of trade in terms of variety and price. International trade results in consumers having access to a wider variety of goods and services. Think about some of the imported goods and brands that you buy on a regular basis. If imports were not available, you would have a more limited range of goods and services to purchase. Sometimes, the price of the imported good is less than that of the Australian-produced good, thus saving consumers money. This occurs because producers in foreign companies can produce goods -- including motor vehicles, textiles and clothing -- at a lower cost than Australian producers. These lower costs often result in lower prices, which benefit consumers by increasing their purchasing power. The competition provided by imported goods and services provides incentives for Australian producers to improve the quality of their goods and the efficiency of their production methods while keeping prices low. Domestic sellers also benefit from trade. Domestic companies that export have a market that is far larger than the domestic market, and producing for a larger market allows them --5 0 5 10 15 20 25 1959 1966 1973 1980 1987 1994 2001 2008 2015 Per cent of GDP Exports Imports Trade balance FIGURE 1.5 Australian exports, imports and trade balance as a proportion of GDP Source: Australian Bureau of Statistics (ABS), Australian national accounts, cat. no. 5206.0, ABS, Canberra, March 2016. (CC BY 2.5 AU) (https://creativecommons.org/licenses/by/2.5/au/) 1 Using the Internet, locate the most recent graph or statistics showing Australian exports, imports and trade balance. Use these figures to analyse the most recent trends for the Australian economy. 2 Use the statistics you have located to explain the following statement from Adam Smith in The Wealth of Nations: 'If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it off them with some part of the produce of our own industry.' the opportunity to grow and produce on a larger scale. These economies of scale permit such companies to benefit from efficiencies and produce goods at a lower average cost. The lower production costs help the companies be more competitive, and can result in lower prices for consumers. Benefits of trade extend beyond the immediate buyers and sellers. International trade can result in economic growth and an improved standard of living. Trade gives countries access to physical capital (technology, tools and equipment) that is not produced domestically. This physical capital often results in increased productivity, which drives economic growth and an improved standard of living. Access to global markets increases export opportunities for developing nations. Examples include China, which has become a manufacturing powerhouse, and India, which is a leader in exporting services. Both countries have experienced development and growth that would not have happened without access to global markets. Many economists believe that countries can escape poverty through increased trade. Recent research suggests the income gap between rich and poor countries could be reduced by 50 per cent if trade barriers were removed. The losers Some third parties are worse off because of international trade. The most obvious third-party losers are companies selling products that cannot compete in a global market. An example is the Australian motor vehicle manufacturing industry, which was forced to shut down because imported motor vehicles were more competitive. When businesses shut down, workers lose their jobs. This is painful for workers, who must then be retrained and learn new job skills to find new employment. Net benefits of trade Economists argue that international trade has net benefits for a nation; in other words, the benefits outweigh the costs. This does not always seem obvious to many people because the costs are often more visible than the benefits; for example, it is relatively easy to identify businesses or industries that have shut down because of trade. Similarly, it is not difficult to identify people who have lost jobs in affected industries. It is more difficult, however, for consumers to identify how much cheaper their food, clothing, electrical goods and cars are because of international trade. The lower prices paid by consumers and businesses mean they have more money to spend on other items. As a result, there are businesses that have experienced more growth as a result of that spending, and this would not have happened without international trade. Q U E S T I O N S 1 Explain the objectives of trade under mercantilism. 2 Define what is meant by a 'zero-sum game'. 3 Explain who gains from international trade and give an additional example of each 'winner'. 4 Identify the 'losers' from international trade and give an example of each. 5 Explain why many economists consider that international trade is of net benefit to a nation 1.4 Why international trade is important to Australia International trade is important to Australia for many reasons. Without international trade, Australia's economic growth would be much slower, and hence our living standards would be much lower. KEY IDEA External stability: the situation in which there are no unwanted movements of foreign reserves in the balance of payments CONCEPTS Trade fluctuations can cause instability in the Australian economy. Fluctuations in demand for Australia's primary exports -- such as beef, wool, coal, iron ore and other minerals -- have repercussions within our economy. Producers need to expand or decrease production to match world demand for their product, and while coal and other minerals can be stockpiled, it is difficult to stockpile many agricultural products. Without the demand for our primary products internationally, domestic production would fall, and living standards would decline. The fluctuations in price for these goods can also have an impact on the Australian economy and affect the demand for products. Australian governments earn royalties from the sale of our minerals. An increase in world prices and demand for such a product increases the amount of money governments (both state and federal) receive, while a decline in price or demand results in a decline in revenue for governments. As the value of exports as a percentage of GDP is high for Australia by world standards, any change in world demand and prices will affect the domestic economy. In addition, Australia's level of imports is high by world standards, also affecting the domestic economy and government economic policy. International trade has been the catalyst for the high level of foreign investment in Australian enterprises. While the merit of such investment can be debated, foreign investment in Australian enterprises has meant a higher economic growth rate than would otherwise have been the case. The increasing interdependence of the world's economies means trade is very important to individual countries. International tourism, the increasing numbers of overseas students studying in Australia, the growing importance of multinational corporations, economic integration, world conflicts, and world economic conditions (such as the Global Financial Crisis in 2008) all mean that Australia is more susceptible than ever to the impact of changes to world trade and world economic events. Australia is particularly interested in a stable world monetary system, because if liquidity does not expand as trade expands, then the industrialised countries will curtail demand for industrialised goods and this means curtailing imports of raw materials. There are many other reasons why trade is vital to Australia. For example, employment is generated by increased trade. Further, as Australia is not self-sufficient, it is necessary to rely on other countries for imports to provide goods that we are not able to produce domestically. Our standard of living is affected by world trade. 1.4 Why international trade is important to Australia International trade is important to Australia for many reasons. Without international trade, Australia's economic growth would be much slower, and hence our living standards would be much lower. KEY IDEA External stability: the situation in which there are no unwanted movements of foreign reserves in the balance of payments CONCEPTS Australia's external stability is vital to our continued wealth. External stability is the situation in which there are no unwanted movements of foreign reserves. This is indicated by the balance of payments (see Chapter 4), which summarises a nation's dealings with the rest of the world over a period of time, usually a year. It records all the payments made to other nations, as well as all the payments received from other nations over the year. Major payments and receipts recorded in the current account include exports and imports of merchandise, services and income from foreign investments. If Australia is paying out more foreign currency for these current account items than it receives from other nations, the balance on current account is in deficit. If receipts exceed payments, the current account is in surplus. The inflows and outflows of foreign currency that represent foreign investment, foreign loans and adjustments of reserve currency holdings are major items of the capital financial account. 1.5 Australia's trade Exports: goods that Australia sells to foreign nations Imports: goods that enter Australia from overseas CONCEPTS This section is concerned with the composition and direction of Australia's imports and exports. Imports are goods that enter Australia from overseas, while exports are goods that Australia sells to foreign nations. 1.5.1 Commodities traded Imports Australia's imports reflect the structural composition of the Australian economy, and are shown in Figure 1.6. FIGURE 1.6 Major Australian merchandise imports, 2016 (A\$m) Source: DFAT 2017 Passenger motor vehicles 21 403 Refined petroleum 14 289 Telecommunications equipment and parts 11 970 Crude petroleum 7 953 Medicaments 7 617 Australia is reliant on overseas sources for many of the manufactured items that we use in our day-to-day living, as shown in Figure 1.7; consumption goods and services and intermediate goods make up the bulk of Australia's imports. Intermediate goods -- also known as producer goods or semi-finished products -- are goods (such as partly finished goods) used as inputs in the production of other goods. Exports Australia has 'ridden on the sheep's back' for much of its history since European settlement. This phrase was commonly used to describe Australia's reliance on wool, which was for so long our major export. As Figure 1.8 shows, this is no longer the case. FIGURE 1.7 Australia's import volumes Sources: ABS and Reserve Bank of Australia, 2001--2018. All rights reserved. 2 4 8 16 32 \$b 2 4 8 16 32 \$b 2001 2009 2017 2001 2009 2017 Quarterly, 2014--15 prices, log scale Consumption Services Intermediate Captial IGURE 1.8 Major Australian merchandise exports, 2016 (A\$m) Iron ore and concentrates 53 703 Coal 42 326 Gold 18 857 Natural gas 17 911 Beef 7 401 Source: DFAT 2017 Figure 1.8 shows that Australia's main exports come from the resources sector, which outstrips the rural, services and manufacturing sectors combined, as shown in Figure 1.9. In 2016, exports totalled A\$259 065 million while imports totalled A\$266 905 million, resulting in a merchandise trade deficit of A\$7840 million. Australia is reliant on overseas sources for many of the manufactured items that we use in our day-to-day living, as shown in Figure 1.7; consumption goods and services and intermediate goods make up the bulk of Australia's imports. Intermediate goods -- also known as producer goods or semi-finished products -- are goods (such as partly finished goods) used as inputs in the production of other goods. Exports Australia has 'ridden on the sheep's back' for much of its history since European settlement. This phrase was commonly used to describe Australia's reliance on wool, which was for so long our major export. As Figure 1.8 shows, this is no longer the case. FIGURE 1.7 Australia's import volumes Sources: ABS and Reserve Bank of Australia, 2001--2018. All rights reserved. 2 4 8 16 32 \$b 2 4 8 16 32 \$b 2001 2009 2017 2001 2009 2017 Quarterly, 2014--15 prices, log scale Consumption Services Intermediate Captial 1.5.2 Direction of Australia's trade For much of Australia's history, its main trading partner was Great Britain. In more recent times, however, Australia's trade has had an increasingly Asian focus, starting with Japan, and more recently with China, India and other Asian nations. Imports Three Asian nations were in the top five of Australia's import sources in 2016. These were China, Japan and Thailand, which together accounted for 35.2 per cent of our imports. The USA and Germany rounded out the top five. This reflects the growing importance of our trade with Asia, and Australia's greater participation in the Asian economy and regional trading blocs such as Asia-Pacific Economic Cooperation (APEC) and the Association of Southeast Asian Nations (ASEAN). FIGURE 1.10 Australia's main merchandise import sources, 2016 China 22.3% USA 11.2% Japan 7.4% Thailand 5.9% Germany 5.1% Source: DFAT FIGURE 1.9 Australia's export volumes Use Internet sources to find the most recent statistics showing the value of imports, exports and trade deficit for Australia. The Department of Foreign Affairs and Trade, the Australian Bureau of Statistics, and the Reserve Bank of Australia Chart Pack would be suitable sites for finding this information. Department of Foreign Affairs and Trade Australian Bureau of Statistics Reserve Bank of Australia Exports Given that our exports are primarily from the resources sector, it would come as no surprise that Australia exports primarily to nations that manufacture elaborately transformed manufactured goods. Four Asian nations are among the top five, these being China, Japan, Republic of Korea (South Korea) and India, with the USA being the other top five destination for our exports. This is shown in Figure 1.11. FIGURE 1.11 Australia's main merchandise export destinations, 2016 China 31.6% Japan 14.0% Republic of Korea 7.0% USA 4.8% India 4.3% Source: DFAT Use the Internet to find the two most recent years for trade statistics. 1 Analyse these statistics and the changes from one year to the next, and show these changes as percentages. 2 Show these changes for type of exports and imports, and also for import and export destinations. ECONOMICS IN ACTION 1.5.3 Implications of changes in trade The trend to see Asia as our most important market for exports and source of imports has several implications for Australia: 1 Australia must continue to pursue membership of ASEAN, and maintain membership of APEC and the Trans-Pacific Partnership trade agreement. In addition, we need to make and continue free trade agreements with individual countries in Asia, as we have already done with China, Japan, Thailand, Singapore and many other countries. 2 The improvement in living standards in Asian nations gives Australia the opportunity to broaden its export base to include areas such as tourism and education. For example, there are increasing numbers of people from China visiting Australia as a result of the rise in income of the Chinese people. In addition, there are many Chinese students (in both secondary schools and universities) enrolling in Australian educational institutions. 3 Increasing our markets for exports, and increasing the competition from imports for domestic producers, mean that Australia is increasingly subject to fluctuations in world economic conditions. 4 Australia has an opportunity to increase export markets and thus economic growth, and domestic consumers are given better opportunities to buy goods on the Australian market. It is in Australia's interests to prioritise improving relationships with its Asian neighbours, with a focus on expanding access to their markets. 5 Australia's industry is under greater pressure to maintain and improve efficiency to increase market share. Therefore, increasing productivity in Australian industries is a major objective of current economic policy. 1.6 Trade theories 1.6.1 The principle of absolute advantage Absolute advantage: the ability of a nation to produce commodities more efficiently than another nation Domestic consumption: goods and services consumed in the country where they are produced Specialisation: the specific use of resources in narrowly defined economic activities CONCEPTS The principle of absolute advantage argues that it is to the mutual benefit of all if trade takes place after each nation has devoted its resources to those productive processes in which it has an absolute advantage. KEY IDEA Adam Smith's theory of absolute advantage (The Wealth of Nations, 1776) states that a nation is said to have an absolute advantage in the production of a commodity when it is able to produce that commodity more efficiently than another nation. The principle of absolute advantage can be illustrated by a simple model in which we make certain assumptions. There are only two countries, Australia and Zigland (an imaginary country). Each country has an equal quantity of resources, but not of the same quality. Each country attempts to produce and consume only two commodities: wool and television sets. The resources of each country are perfectly mobile; that is, they can be moved from one industry to the other at no cost. If trade takes place, there are no transfer costs. Figure 1.12 illustrates the production-possibilities curves for the two countries in our model. The production-possibilities curve is simply the line that connects all the alternative maximum-output combinations that each country can produce with its stock of land, labour, capital and enterprise. Each country can choose only one output combination at any one time. If Australia devotes all its resources to the production of wool, it is capable of producing 10 million bales yearly, but is unable to produce any television sets. However, if Australia devotes all its resources to the production of television sets, it is capable of producing 6 million sets yearly, but is unable to produce any wool. Suppose that Australia settles for the output combination shown by point A in Figure 1.12(a). This means that the Australian economy produces 5 million bales of wool and 3 million television sets. At this stage, no trade takes place between the two nations in our model. Each nation operates as a closed economy and all production is for domestic consumption. In the same way, we can analyse Zigland's production-possibilities curve in Figure 1.12(b). We can see that Zigland's maximum output limit is either 5 million bales of wool or 10 million television sets yearly. Let us imagine that Zigland settles on the output combination shown by point B; that is, 3 million bales of wool and 4 million television sets. By comparing Australia's production-possibilities curve with that of Zigland, we can see that Zigland has an absolute advantage over Australia in the production of television sets, because it is able to produce more sets while using the same quantity of resources. On the other hand, Australia has an absolute advantage over Zigland in the production of wool; that is, Australia can produce more wool than Zigland, using the same quantity of resources. It follows that, if each country chooses to specialise in the production of the commodity for which it has an absolute advantage and decides to trade its surplus with the other, there are considerable advantages to be gained by all. As Figure 1.13 shows, specialisation by each nation leads to a significant increase in the overall output of the two-nation economy in our model. Prior to specialisation, when each nation was operating as a closed economy and was attempting to meet its own domestic requirements in both commodities, the total output of wool was 8 million bales and the total output of television sets was 7 million (Figure 1.13(a)). With the introduction of specialisation and a mutual agreement to trade with each other, total output of both commodities is increased to 10 million units per annum (Figure 1.13(b)). It is evident that the opportunity cost of each nation operating as a closed economy is equivalent to 2 million bales of wool and 3 million television sets. The terms under which trade will take place between the two nations in our model will depend upon negotiations. Australia might agree to trade provided that at least 3 million television sets are received in exchange for its surplus wool (this is the volume of consumption of television sets in Australia before specialisation). Zigland might agree to trade provided that at least 3 million bales of wool are received in exchange for its surplus television sets. A minimum rate of exchange between the two nations would be one bale of wool for one television set. A possible trade outcome that both countries might agree to is shown in Figure 1.13(c). If we compare the distribution of commodities in (c) with the distribution in (a), it is evident that specialisation and trade have increased consumer welfare in both countries through the greater availability of both commodities. FIGURE 1.12 The principle of absolute advantage 10 9 8 7 6 5 4 3 2 1 0 10987654321 11 Bales of wool (million) Television sets (million) Year's output New production- possibilities curve 11 A Australia's production possibilities: year's output a b 10 9 8 7 6 5 4 3 2 1 0 10987654321 11 Bales of wool (million) Television sets (million) Year's output New production- possibilities curve 11 B Zigland's production possibilities: year's output s a result of a more efficient use of resources, the overall output of our two-nation economy has increased. This is the essence of all international trade theory. When economists argue for a reduction in protection levels and for more specialisation, they are advocating a more efficient use of the world's resources to increase output levels in the world economy. Q U E S T I O N S 1 What are the advantages of specialisation in world trade? 2 Restate the theory of absolute advantage in your own words. 3 Do you think that the theory of absolute advantage still applies in today's world? Give reasons for your answer. How does the principle of absolute advantage apply in cases where one nation's capacity exceeds another's in the production of all commodities? Under these conditions, it may appear that the more efficient nation has no benefit to gain from trade. Economists have shown that this may not be true if the principle of comparative advantage can be applied. Theories of trade are based on a number of propositions that are useful in explaining how trade should occur, the gains that accrue and the fact that trade is a dynamic concept. KEY IDEA FIGURE 1.13 The principle of absolute advantage Bales of wool (millions) Television sets (millions) a Production and consumption without trade Australia 5 3 Zigland 3 4 Total production 8 7 b Production with specialisation Australia 10 0 Zigland 0 10 Total production 10 10 c Possible consumption Australia 6 4 Zigland 4 6 Total consumption 10 10 CONCEPTS David Ricardo's theory of comparative advantage (1817) argues that nations may benefit from specialisation and trade even in cases where one nation has an absolute advantage over another nation in the production of all commodities. Once again, to illustrate this principle, we use the simple two-nation, two-commodity model. The assumptions are the same as those used to develop the principle of absolute advantage. There are only two countries, Australia and Zagland (an imaginary country). Each country has an equal quantity of resources, but not of the same quality. Each country attempts to produce and consume only two commodities: wheat and motor vehicles. The resources of each country are perfectly mobile; that is, they can be moved from one industry to the other at no cost. If trade takes place, there are no transfer costs. Figure 1.14 shows the production-possibilities curves for the production of wheat and motor vehicles in Australia and Zagland. Comparing the two curves, we see that Australia has an absolute advantage over Zagland in the production of both commodities. If Australia devotes all of its resources to the production of wheat, it can produce more than Zagland, and if Australia devotes all of its resources to the production of motor vehicles, it can again produce more than Zagland. It may appear that Australia has nothing to gain FIGURE 1.14 The principle of comparative advantage 10 9 8 7 6 5 4 3 2 1 0 10987654321 11 Wheat (million tonnes) Motor vehicles (hundred thousands) Year's output New production- possibilities curve 11 A Australia's production possibilities: year's output 10 9 8 7 6 5 4 3 2 1 0 10987654321 11 Wheat (million tonnes) Motor vehicles (hundred tho from trade with Zagland. However, Figure 1.15 shows this to be incorrect. Let us assume that, before specialisation and trade, Australia produces an output combination as indicated by point A on its production-possibilities curve; that is, 6 million tonnes of wheat and 200 000 motor vehicles yearly. At the same time, Zagland produces the output combination indicated by point B on its production-possibilities curve; that is, 2 million tonnes of wheat and 200 000 motor vehicles yearly. At this stage, both countries operate closed economies in which all production is entirely for satisfying domestic consumption. Total annual production in the two-nation model stands at 8 million tonnes of wheat and 400 000 motor vehicles. Figure 1.15 shows that Australia has the greatest absolute advantage in the production of wheat and that Zagland has the least disadvantage in the production of motor vehicles. If the principle of comparative advantage is applied so that Australia concentrates on wheat production and Zagland on motor vehicle production, total annual output in the two-nation model will rise to 10 million tonnes of wheat and 400 000 motor vehicles. In this case, the gain from specialisation is in wheat production. Once again, the terms of trade between the two nations will depend upon negotiations. Australia will trade its surplus wheat provided that at least 200 000 motor vehicles are received in return (the level of Australia's motor vehicle output prior to specialisation). By the same token, Zagland will trade its surplus motor vehicles provided that 2 million tonnes of wheat are received in return (the level of Zagland's wheat output prior to specialisation). Figure 1.15 shows a possible outcome from specialisation and trade, where both Australians and Zaglanders benefit from greater consumption of wheat without reducing their consumption of motor vehicles. FIGURE 1.15 The principle of comparative advantage Wheat (million tonnes) Motor vehicles (100 000 units) a Production and consumption without trade Australia 6 2 Zagland 2 2 Total production 8 4 b Production with specialisation Australia 10 0 Zagland 0 4 Total production 10 4 c Possible consumption after trade Australia 7 2 Zagland 3 2 Total production 10 4 Under what circumstances can there be mutual benefits from trade when one of the countries has an absolute advantage in all types of production? 2 How can trade between two nations be mutually beneficial? 3 a What are the basic assumptions made in the theory of comparative advantage? b When each of these basic assumptions is removed, does the theory of comparative advantage still work? Explain your answer. 4 Explain the principle of comparative advantage. 5 What is the difference between the principle of absolute advantage and the principle of comparative advantage? What criticisms might be levelled at the theory of comparative advantage? ECONOMICS CHALLENGE Figure 1.16 shows two countries and their production without trade. Use this information to answer the following questions. 1 Identify: a which country has the absolute advantage b which country has the comparative advantage c which country is at a comparative disadvantage, and in which product does it have the least comparative disadvantage? 2 Demonstrate how the countries would benefit from specialising and trading. FIGURE 1.16 Motor vehicles Television sets Pacifica 250 100 Europa 160 80 Harvard economist Michael Porter introduced his theory of competitive advantage in 1990, in which he argues that a nation's prosperity relies on the ability of its industry to be innovative and to adopt technology. 1.6.3 The principle of competitive advantage Competitive advantage (of a nation): trade advantage obtained through the capacity of a nation's industries to innovate and upgrade Self-sufficiency: the ability of a nation to produce sufficient products to meet its own needs from domestic sources CONCEPTS Porter developed four broad criteria for a nation to achieve competitive advantage of its industries. These are illustrated in Porter's Diamond of National Advantage, shown in Figure 1.17. Factor conditions: the nation must have an advantage in factors of production; for example, skilled labour or infrastructure. Porter argues that nations need not be well endowed with the factors; they can be created through investment for infrastructure and highly specialised training of the workforce. Demand conditions: the nation can benefit from having a clear view of consumer demand by first developing a domestic market to help anticipate international market needs. Related and supporting industries: a nation can gain an advantage by having efficient and internationally competitive supplier industries. Firm strategy, structure and rivalry: conditions governing company creation, organisation and management, and domestic rivalry need to be disciplined, flexible and supportive of innovation. FIGURE 1.17 Porter's Diamond -- determinants of national competitive advantage Circumstances in one country may be different from, yet just as effective as, those of another country seeking competitive advantage, as long as the four conditions in the diamond complement each other. Trade offers nations the opportunity to share the world's resources and provides access to resources that might otherwise not be available. International trade theory is concerned not only with the efficient use of resources within nations, but also with efficient resource allocation in the world as a whole. If nations try to be completely self-sufficient, the potential gains from production are not maximised. There are always opportunity costs associated with attempts to maintain self-sufficiency. If all nations in the world were to specialise, overall global output would increase as a result of a more efficient use of resources. In the real world, nations tend, for varying reasons, to cling to self-sufficiency. Specialisation requires that nations become dependent upon each other for the provision of essential goods and services. It is this fear of dependence that often generates criticism of international trade theory. Firm strategy, structure and rivalry Related and supporting industries Demand conditions Factor Conditions 1.6.4 Intra-industry and intra-company trade Intra-industr y trade: trade that occurs when a nation imports and exports the same good simultaneously Transfer price: the price charged for goods by one subsidiary of a multinational corporation to another subsidiary of the same company in another country CONCEPTS Other economists have suggested that the theories already described do not allow for intra- industry and intra-company trade. Intra-industry trade occurs when a nation imports and exports the same good simultaneously. This may be explained by such factors as seasonal variations in climate ( for example, Australia imports strawberries from New Zealand during the Australian summer) and differentiated products ( for example, Australia imports wine from France and Germany, while exporting wine to New Zealand at the same time). While intra-industry trade allows consumers to have a wider choice of products available, it results in the loss of economies of scale associated with specialisation. Nearly all intra-industry trade occurs between economically advanced countries, which are able to afford the additional costs associated with variety of product. Some 35 per cent of world trade in manufacturing is carried out within companies. Intra- company trade occurs between the affiliates of the one organisation; for example, between a home-based subsidiary and a foreign-based subsidiary of the same company. In this situation, the importer and the exporter are essentially the same company. This often happens when there is vertical integration within the company. For example, a company may mine coal in one country and use it in steel mills in another country, or manufacture sports shoes in one country and retail them in another. The difficulty with this is the use of transfer pricing. The transfer price is the price charged by one subsidiary of a multinational corporation on the sales to another subsidiary of the same company in another country. Such prices are often calculated to reduce company tax, by making paper profits as high as possible in countries with low taxation, and small profits in countries with higher taxation. When this happens, a country loses taxation revenue, shareholders (if any) lose profits in that country, and terms of trade and balance of payments are affected. Q U E S T I O N S 1 How would the principle of competitive advantage apply to Australia? 2 Why does most intra-industry trade occur between nations that are economically advanced? 3 How does intra-company trade interfere with other theories of trade? 1.7 Challenges in trade Australia faces some challenges and issues in its international trade policies. These include: 1 International competitiveness: this measures a country's ability to compete in international markets for goods and services. Australia's record here is poor and we need to improve our competitiveness. This is a major challenge for Australia. 2 Trade liberalisation: this is a policy designed to promote free trade and reduce protection levels between nations. Our free trade agreements and membership of regional trading blocs need to be enhanced and further developed. 3 Brexit: the withdrawal of Great Britain from the European Union is an opportunity for Australia to once again view Britain as a major trading partner. The potential to increase trade with Britain is now here, providing governments and the private sector with new opportunities to explore areas of comparative advantage and mutual benefits on which trade agreements could be based. 4 Exchange rate: you will consider the exchange rate for Australia in Chapter 3. The rate of exchange for the Australian dollar with other currencies is important. When the exchange rate is high, exports are less competitively priced and decrease. When the currency depreciates, the price of imports will increase, impacting on domestic consumers. 5 Maintaining our balance of payments position: this is yet another issue and will be dealt with in full in Chapter 4. 'Balance of payments' refers to Australia's international financial position. Australia is usually in deficit on the current account, which looks at our trading position. ECONOMICS CHALLENGE Devise a trade and industry strategy for Australia, applying your understanding of the theories of trade. 1 Identify an industry in which Australia may have an absolute advantage, or one upon which you consider it desirable for Australia to focus. (This will require some research.) 2 How might the government support the industry to maintain and develop its competitive advantage and so promote international trade? 3 Prepare a one-page summary accompanied by a supporting infographic (include specific facts and figures). 1.1 True/False For each statement, indicate whether you consider it to be True (T ) or False (F). 1 The concept of 'opportunity cost' highlights the benefits that can be gained from world trade. 2 To enjoy the benefits of specialisation, countries need to trade. 3 Exports are a leakage from the circular flow of income model because goods are sent overseas. 4 A country that has an absolute advantage in the production of all goods cannot gain from specialisation and trade. 5 Different countries have a comparative advantage because opportunity costs differ. 6 Consumers gain when a business exports a good to overseas nations. 7 An open economy is one that trades freely with the rest of the world. 8 Revenue from exports is considered to be a leakage from the circular flow. 9 Multinational corporations produce more than 25 per cent of global production. 10 Technical differences are not a problem in international trade. 1.2 Terminology Select the correct term from the list below that describes each statement. A Comparative advantage F Specialisation B Absolute advantage G Intra-company trade C Competitive advantage (of a nation) H Open economy D Imports I Factor endowment E External stability J Human capital 1 Trade between affiliates of the one organisation; for example, between a home-based subsidiary and a foreign-based subsidiary of the same company 2 The ability of a nation to produce commodities more efficiently than another nation 3 The knowledge, experience and skills of individuals, in which nations must invest if they are to advance 4 Goods that enter Australia from overseas 5 The supply of the factors of production (land, labour, capital and enterprise) that exists in a country 6 The specific use of resources in narrowly defined economic activities 7 The ability of a nation to produce a product at a lower opportunity cost of production than another nation 8 The situation in which there are no unwanted movements of foreign reserves in the balance of payments 9 Trade advantage obtained through the capacity of a nation's industries to innovate and upgrade 10 Any nation that trades with other nations.3 Multiple-choice questions Select the correct response to each of the following: 1 The principle of comparative advantage shows: A that nations can benefit from specialisation and trade even if they do not have an absolute advantage. B that nations ought to operate as closed economies. C that nations ought to concentrate on the production of only one commodity that will give a surplus that can be traded. D that nations can only benefit from multilateral trade. 2 A country (A) has an absolute advantage over another country (B) in the production of coal if: A A's total output of coal is greater than B's. B A can produce more coal over a year. C there is more demand for coal in A. D A can produce coal at lower resource cost per unit than B. 3 The principle of comparative advantage shows that the benefits of trade rely on: A resource costs. B opportunity cost. C marginal costs. D transport costs. 4 Australia's main trading partners are: A Russia and China. B New Zealand and the USA. C China and Japan. D China and the USA. 5 International trade increases the standard of living of a country because it: A increases the range of goods and services available. B enables the government to increase its revenue through the collection of tariffs. C creates employment in import-competing industries. D overcomes high transportation costs. 6 The principle of comparative advantage is based on: A the concept of opportunity cost. B the money cost of producing a good. C increasing opportunity costs. D constant opportunity costs. Countries will gain by concentrating on a limited range of goods because: A producers discover new and more efficient techniques. B their scale of operation will warrant mass production methods and the increased use of capital. C they are more likely to improve the product itself as a result of improved skill and research. D all of the above. 8 Australian exports are comprised mainly of: A manufactured products. B farming machinery and plant. C clothing and textiles. D agricultural and mining products. 9 A nation will gain if: A exports increase and imports decrease. B exports decrease and imports increase. C both exports and imports increase. D both exports and imports decrease. 10 When a country exports: A domestic producers gain and domestic consumers gain. B domestic producers lose and domestic consumers gain. C domestic producers gain and domestic consumers lose. D domestic producers lose and domestic consumers lose. 11 Australian exports are classified into four sectors. The ranking of these export sectors, from largest to smallest is: A services, manufacturing, mining, agriculture. B mining, services, manufacturing, agriculture. C manufacturing, mining, services, agriculture. D mining, manufacturing, services, agriculture. 12 Which of the following does not explain the change in direction of Australia's pattern of trade in recent years? A The Asia-Pacific region has achieved higher rates of economic growth than Europe and the USA. B The discovery and development of major natural gas reserves in Australia is expanding. C Lower transport costs have given Australia an advantage when exporting to the Asia-Pacific region compared with Europe. D China has become a more significant participant in world trade. 13 The fundamental economic advantage of free world trade is: A the easing of political tensions between nations. B all nations will develop similar industries. C all nations will share equally in the world's wealth. D a more efficient allocation of resources. 4 International trade is said to be due to differences in countries' comparative costs, which refers to: A the relative efficiency of production of goods in different countries. B prices of exported goods compared to the price of imported goods. C the average cost of making different goods in one country. D the relative amounts of immobile resources used in different countries in the manufacture of export goods. 15 International trade takes place because of: A inequalities in factor endowments between nations. B governments' desires to protect their industries. C differences in price levels in various countries. D inequalities in the terms of trade. 1.4 Short response questions 1 Describe three ways in which international trade differs from domestic trade. 2 Briefly identify three reasons why the overseas sector is so important to the domestic economy. 3 How can trade between two nations be mutually beneficial? 4 Explain how events in an overseas economy can affect Australia's trade. 5 Do you agree that Asian nations will become more important as Australia's trading partners? Why or why not? 6 Which nations have decreased in importance as Australia's trading partners? Why? 7 Describe how the composition of trade has changed over the past 20 years. 8 Explain how increased tourism from overseas benefits Australia. 9 Identify three reasons why China has become Australia's main trading partner. 10 Distinguish between absolute and comparative advantage. 1.5 Activities 1 Imagine that you own a secluded tropical island. Climatic conditions on your island indicate that it is suited to the production of either pineapples or bananas. Preliminary studies indicate that your resources are capable of the annual output combinations set out in Figure 1.18. GURE 1.18 Bananas (cartons) Pineapples (cartons) 9000 0 8000 500 6000 1400 4000 2200 2000 3100 1000 3600 0 4000 a Plot a production-possibilities curve based on the output combinations. b Assuming that current prices for cartons of bananas and pineapples at the nearest mainland market are \$8 and \$16 respectively, which output combination would you choose? Why? 2 Figure 1.19 shows the production patterns of two countries with equal quantities of resources, which they divide evenly between consumer goods and capital goods production. Each country is at present producing all its own consumer and capital goods. FIGURE 1.19 Country Consumer goods Capital goods Riverland 1800 900 Bushland 2100 700 Total production 3900 1600 a Which of the following statements are true? i Riverland has an absolute advantage in the production of consumer goods. ii Riverland has an absolute advantage in the production of capital goods. iii Riverland has an absolute advantage in the production of neither type of good. iv Bushland has an absolute advantage in the production of consumer goods. v Bushland has an absolute advantage in the production of capital goods. vi Bushland has an absolute advantage in the production of neither type of good. b Answer the following questions in relation to opportunity cost. i For Riverland, what is the opportunity cost of producing 1 unit of consumer goods? ii For Bushland, what is the opportunity cost of producing 1 unit of consumer goods? iii Which country has a comparative advantage in the production of consumer goods? iv For Riverland, what is the opportunity cost of producing 1 unit of capital goods? v For Bushland, what is the opportunity cost of producing 1 unit of capital goods? vi Which country has a comparative advantage in the production of capital goods? If both countries decide to specialise and trade in the goods in which they have a comparative advantage, each can produce twice the amount of goods in which it specialises. Compile a table showing their production after they specialise. ii Assuming each country wishes to consume at least the same amount of goods before specialisation, work out a possible consumption pattern after specialisation and trade. 3 An economics teacher asked a group of economics students to outline the main advantage to be gained from increasing Australia's exports. The teacher received five answers: a 'Exports provide jobs for our workforce.' b 'Exports help us to obtain cheaper unit costs.' c 'Exports give us a surplus of money from overseas.' d 'Exports help to spread the market risk.' e 'Exports utilise excess capacity.' Comment on the economic reasoning supporting each response. 1.6 Inquiries Select one inquiry topic from the list below (or create your own) and, following a selected inquiry model such as the economic model for problem solving, conduct an inquiry that can be presented to your class. 1 Investigate the composition of Australia's exports and imports, and changes that have occurred in the past 20 years. What problems are associated with such composition, and what further changes could be beneficial for the Australian economy? 2 Investigate the changing nature of the composition and direction of Australia's trade. Is this due to changes in the domestic economy rather than world events? 3 Given that international trade is much more complicated than interregional trade, do you agree that Australia should promote the development of import replacement industries? Is this policy consistent with the principles upon which international trade is theoretically based? You can find answers to selected review questions within this chapter on NelsonNet. Review of Chapter 1 answers