ECS3702 International Trade PDF

ECS3702 - INTERNATIONAL TRADE 1 INTRODUCTION 4.5.4 Empirical Relevance. 1.1 Introduction 4.6 Empirical Tests of the Heckscher-Ohlin Model. 1.2 The globalization of the w...

ECS3702 - INTERNATIONAL TRADE 1 INTRODUCTION 4.5.4 Empirical Relevance. 1.1 Introduction 4.6 Empirical Tests of the Heckscher-Ohlin Model. 1.2 The globalization of the world economy 4.6.1 The Leontief Paradox. 1.3 International trade and the nation’s standard of living 4.6.2 Explanations of the Leontief paradox and Other Empirical Tests of the 1.4 South Africa in world trade H-O Model 1.5 International economic theories and policies 4.6.3 Factor Intensity Reversal 1.6 Current international economic problems and challenges 4.7 Criticisms of the factor proportions theory 4.8 Alternative theories of trade 2 WHY NATIONS TRADE: THE CLASSICAL THEORY 4.8.1 International Trade and Economies of scale 2.1 Introduction 4.8.2 International Trade and Imperfect Competition 2.2 Mercantilists’ views on trade 4.8.3 Trade based on dynamic technological differences 2.3 Classical theorists 4.8.31 The Technological Gap Model 2.3.1 Trade based on absolute advantage (Adam Smith) 4.8.3.2 The Product Cycle Model 2.3.2 Illustration of Absolute Advantage. 2.3.3 Ricardian theory of comparative advantage (David Ricardo) 5 TARIFF AND NONTARIFF BARRIERS TO TRADE 2.3.4 Equal advantage. 5.1 Introduction 2.4 Gains from Trade 5.2 Tariffs 2.5 Comparative advantage and opportunity costs. 5.2.1 Specific and ad valorem tariffs 2.5.1 Comparative Advantage and the Labour Theory of Value 5.2.2 Partial Equilibrium Analysis of a Tariff. 2.5.2 The Opportunity Cost Theory. 5.3 The Optimum Tariff 2.5.3 The Production Possibility Frontier under Constant Costs 5.4 The rate of Effective Protection 2.5.4 Opportunity Costs and Relative Commodity Prices 5.5 Nontariff barriers to trade 2.6 The basis for and the gains from trade under constant costs. 5.5.1 Import quotas 2.6.1 An illustration of the Gains from Trade. 5.5.2 Other Nontariff Barriers 2.7 Empirical tests of the Ricardian model. 5.6 Arguments for protection. 2.8 Criticisms of the classical theory 6 TRADE LIBERALISATION AND ECONOMIC INTEGRATION 3 THE STANDARD THEORY OF INTERNATIONAL TRADE 6.1 International and regional approaches to free trade 3.1 Introduction 6.2 The international approach and the WTO 3.2 The production frontier with increasing costs 6.3 The regional approach 3.3 Community indifference curves 3.4 Equilibrium in isolation 7 DIRECT FOREIGN INVESTMENT AND MULTI-NATIONAL CORPORATIONS 3.5 The basis for and the gains from trade with increasing costs 7.1 Mobility of the factors of production 3.5.1 Illustrations of the basis for and the gains from trade with increasing 7.2 Motives for international capital flows costs 7.3 Welfare effects of international capital flows 3.5.2 The gains from exchange and from specialization 7.3.1 Effects on the Investing and host countries 7.3.2 Other Effects on the Investing and host countries 4 THE BASIS OF TRADE: THE FACTOR PROPORTIONS THEORY 7.4 Multinational corporations 4.1 Introduction 7.4.1 Reasons for the existence of Multinational Corporations 4.2 Assumptions of the theory 7.4.2 Problems created by Multinational Corporations in the Home and 4.2.1 Basic assumptions host Countries. 4.2.2 Meaning of the assumptions 4.3 Factor intensity, factor abundance, and the shape of the production frontier 4.3.1 Concept of factor intensity. 4.3.2 Concept of Factor Abundance. 4.3.3 Factor Abundance and the Production Frontier 4.4 Factor endowments and the factor proportions theory 4.4.1 The Heckscher-Ohlin Theorem 4.4.2 Illustration of the Heckscher-Ohlin Theory. 4.5 Factor - price equalization and income distribution. 4.5.1 The Factor price Equalisation Theorem. 4.5.2 Effect of trade on the Distribution of Income: The Stolper-Samuelson Theorem. 4.5.3 The Specific-Factors Model. H.Crassas – 2015 – ECS3702 - International Trade Page 1 ECS3702 - INTERNATIONAL TRADE STUDY UNIT 1 – INTRODUCTION 1.1 INTRODUCTION International economics concerns the exchange of goods, services, factors of production and capital across national boundaries. We focuses on the flows of goods, services, labour and direct foreign investment between countries. The module in international finance examines the exchange of financial assets and liabilities and the monetary aspects of international economics. In both international and domestic trade, voluntary exchanges of goods and services increase the economic welfare of the parties concerned, whether they be individuals, companies or countries. The fundamental proposition of all trade is that voluntary trade is mutually beneficial. There are a number of important differences between domestic and international trade. Goods in different sovereign countries are priced in different national currencies. Thus the exchange of goods and services between countries also requires the exchange of different national currencies. Governments can impose a wide range of commercial policies on imports and exports of goods and services which are absent from domestic trade. 1.2 THE GLOBALIZATION OF THE WORLD ECONOMY Globalization in 1870-1914 resulted from the Industrial Revolution in Europe and the opening up of new, resource-rich, but sparsely populated lands in North America (the United States and Canada), South America (Argentina. Chile, and Uruguay), Australia and New Zealand, and South Africa. These lands received millions of immigrants and vast amounts of foreign investments, principally from England, to open up new lands to food and raw material production. This period of modern globalization came to an end with the breakout of World War 1 in 1914. The second period of rapid globalization started with the end of World War II in 1945 and extended to about 1980. It was characterized by the rapid increase of international trade as a result of the dismantling of the heavy trade protection that had been put in place during the Great Depression that started in the United States in 1929 and during World War II. As all revolutions, however, today's globalization brings many benefits and advantages but also has some disadvantages; Although labor migration generally leads to the more efficient utilization of labor, it also leads to job losses and lower wages for less-skilled labor in advanced nations and harms ("brain drain") the nations of emigration. Financial globalization and unrestricted capital flows lead to the more efficient use of capital throughout the world, as well as provide opportunities for higher returns and risk diversification for individuals and corporations. But they also seem to lead to periodic international financial crises. Finally, are we running out of resources such as petroleum, other minerals, water? Is the world headed for a climate disaster? Globalization is being blamed for world poverty and child labor in poor countries, job losses and lower wages in rich countries, as well as environmental pollution and climate change throughout the world. Globalization has many social, political, legal, and ethical aspects, and so economists need to work closely with other social and physical scientists, as well as with the entire civil society, to give globalization a more human face. Globalization is important because it increases efficiency in the production of material things; it is inevitable because we cannot hide or run away from it. 1.3 INTERNATIONAL TRADE AND THE NATION’S STANDARD OF LIVING A rough measure of the economic relationship among nations, or their interdependence, is given by the ratio of their imports and exports of goods and services to their gross domestic product (GDP). The GDP refers to the total value of all goods and services produced in the nation in a year. The United States relies to a relatively small extent on international trade. First of all, there are many commodities—coffee, bananas, cocoa, tea, scotch, cognac—that the country does not produce at all and it has no deposits of such minerals as tin, tungsten, and chromium, which are important to certain industrial processes, and it has only dwindling reserves of petroleum, copper, and many other minerals. H.Crassas – 2015 – ECS3702 - International Trade Page 2 Much more important quantitatively for the nation's standard of living are the many products that are produced domestically but at a higher cost than abroad. We will see later that these account for most of the benefits or gains from trade. In general, the economic interdependence among nations has been increasing over the years, as measured by the more rapid growth of world trade than world production but there are many other crucial ways in which nations are interdependent, so that economic events and policies in one nation significantly affect other nations (and vice versa). For example, if the United States stimulates its economy, increasing demand for goods and services, which stimulate the economies of other nations that export those commodities. Finally, trade negotiations that reduce trade barriers across nations may lead to an increase in the exports of high-technology goods and thus to an increase in employment and wages in those industries in the United States, but also to an increase in imports of shoes and textiles, thereby reducing employment and wages in those sectors. 1.4 SOUTH AFRICA IN WORLD TRADE South Africa, with an index of openness exceeding 20 percent, is a relatively open economy. However, the index declined between 1985 and 1994. The index measures exports as a percentage of GDP. During the 1980s, South Africa suffered severe international sanctions. Trade sanctions did not, however, affect the volume of exports significantly as South Africa remained the most important and reliable supplier of precious and base metals and minerals. Of far greater concern were financial sanctions. South Africa experienced large-scale capital flight and relatively low economic growth over this period. To finance the outflow of capital, the country was compelled to reduce imports by imposing restrictive monetary and fiscal policies, which led to slow growth. Exports in 1985 were thus high relative to GDP, which was reflected in a high index of openness. By 1994, while exports continued to grow, the economy grew even more rapidly as financial sanctions were removed and foreign capital flowed into the country. Above-average growth in South African exports coupled with sluggish GDP growth pushed the index significantly higher, to about 27 percent in 2001. The gravity model postulates that the bilateral trade between two countries is proportional, or positively related, to the product of the two countries’ GDPs and to be smaller the greater the distance between the two countries. That is, the larger and the closer the two countries are, the larger the volume of trade between them is expected to be. The United Kingdom, Japan, the United States and Germany have been South Africa's main trading partners for some time, although not always in that order. More recently, South Africa has increased its imports from China. South Africa got more than 40 percent of its imports from these five countries and sent more than 40 percent of its exports to them. As regards trading blocs, South Africa sent more than 34 percent of its exports to the European Union. Since the mid-1980s, the US has diminished while the EU has increased in importance as regards trade with South Africa. Another important trend that has emerged recently is that South Africa is increasingly becoming the port of entry into Africa, with significant amounts of imports being re-exported to other parts of Africa. South Africa remains partly dependent on primary sector commodities for its exports, but the contribution by manufactured and semi-processed goods has grown significantly. Unlike many developing countries which depend on the exports of a few primary products, South Africa can be classed as a semi-industrialised country and the contribution of the industrial sector to exports is increasing steadily, motor vehicle exports contributed about 5 percent to South Africa's exports in 2006. Machinery and equipment are, as is to be expected for a developing economy, the most important of South Africa's imports. South Africa also imports the bulk of its oil needs, despite having a significant oil from coal capability in Sasol. South African imports and exports as percentages of GDP for the period 1960 to 2007 show no significant trend for both exports and imports over the entire period. In the post 1994 period, however, an upward trend in both variables is evident. Generally, the share of exports and imports in GDP has averaged 25 percent over the period. H.Crassas – 2015 – ECS3702 - International Trade Page 3 1.5 INTERNATIONAL ECONOMIC THEORIES AND POLICIES The purpose of economic theory in general is to predict and explain. That is. economic theory abstracts from the details surrounding an economic event in order to isolate the few variables and relationships deemed most important in predicting and explaining the event. Along these lines, international economic theory usually assumes A two-nation, two-commodity, and two-factor world. No trade restrictions to begin with Perfect mobility of factors within the nations but no international mobility Perfect competition in all commodity and factor markets No transportation costs. Starting with the simplifying assumptions, international economic theory examines the Basis for and the gains from trade The reasons for and the effects of trade restrictions Policies directed at regulating the flows of international payments and receipts The effects of these policies on a nation's welfare and on the welfare of other nations The effectiveness of macroeconomic policies under different types of international monetary systems. The Subject Matter of International Economics This economic and financial interdependence of nations is affected by, and in turn influences, the political, social, cultural, and military relations among nations. Specifically, international economics deals with international trade theory, international trade policy, the balance of payments and foreign exchange markets, and open-economy macroeconomics. International trade theory analyzes the basis and the gains from trade. International trade policy examines the reasons for and the effects of trade restrictions. The balance of payments measures a nation's total receipts from and the total payments to the rest of the world, Foreign exchange markets are the institutional framework for the exchange of one national currency for others. Open-economy macroeconomics deals with the mechanisms of adjustment in balance-of-payments disequilibria (deficits and surpluses). It analyzes the relationship between the internal and the external sectors and how they are interrelated or interdependent with the rest of the world economy under different international monetary systems. International trade theory and policies are the microeconomic aspects of international economics because they deal with individual nations treated as single units and with the (relative) price of individual commodities. On the other hand, since the balance of payments deals with total receipts and payments, as well as with adjustment and other economic policies that affect the level of national income and the general price level of the nation, these are often referred to as open-economy macroeconomics or international finance. 1.6 CURRENT INTERNATIONAL ECONOMIC PROBLEMS AND CHALLENGES Economic problems and challenges being faced by the world economy. These include: 1. The deep financial and economic crisis 2. Trade protectionism in advanced countries 3. Excessive fluctuations and misalignment in exchange rates and financial crises 4. Structural imbalances in the USA, slow growth in Europe and Japan, and insufficient restructuring in transition economies 5. Deep poverty in many developing countries 6. Resource scarcity, environmental degradation, climate change, and unsustainable development. H.Crassas – 2015 – ECS3702 - International Trade Page 4 These are the problems that the study of international economic theories and policies can help us understand and evaluate suggestions for their resolution. The most serious economic problem in the world today is the slow growth and high unemployment facing the United States and most other advanced countries. On the trade side, the most serious problem is rising protectionism in advanced countries in the context of a rapidly globalizing world. On the monetary side are the excessive volatility of exchange rates and their large and persistent misalignments. A brief description of these problems and challenges follows: 1. Slow Growth and High Unemployment in Advanced Economies after "the Great Recession " In 2010 and 2011, advanced economies experienced slow growth and high unemployment as they came out the great recession. The 2008-2009 crisis started in the U.S. subprime (high-risk) housing mortgage market in August 2007 and then spread from there to the rest of the world. Nations responded by rescuing financial institutions, slashing interest rates and introducing economic stimulus packages. Even though the recession was officially over in 2010, slow growth and high unemployment remain the most serious economic problems facing most advanced nations. 2. Trade Protectionism in Advanced Countries in a Rapidly Globalizing World With free trade, each nation will specialize in the production of the commodities that it can produce most efficiently and, by exporting some of them, obtain more of other commodities than it could produce at home. In the real world, however, most nations impose some restrictions on the free flow of trade. Although invariably justified on national welfare grounds, trade restrictions are usually advocated by and greatly benefit a small minority of producers in the nation at the expense of the mostly silent majority of consumers. 3. Excessive Fluctuations and Misalignment in Exchange Rates and Financial Crises Periodic financial crises have also led to financial and economic instability and dampened growth in advanced and emerging markets such as the financial crisis in Southeast Asia in 1997 and in the United States in 2007. These can disrupt the pattern of international trade and specialization and can lead to unstable international financial conditions throughout the world. 4. Structural Imbalances in Advanced Economies and Insufficient Restructuring in Transition Economies National and regional challenges quickly become global economic problems in our interdependent world. The United States faces deep structural imbalances in that the United States is simply living beyond its means by borrowing excessively abroad. The result is huge capital inflows, an overvalued dollar, huge and unsustainable trade deficits, and unstable financial conditions. Transition economies (communist countries) require additional economic restructuring in order to establish full-fledged market economies and achieve more rapid growth. Inadequate growth in these areas dampens the growth of the entire world economy and leads to calls for protectionism. 5. Deep Poverty in Many Developing Countries Even though many developing countries, especially China and India, have been growing very rapidly, some of the poorest developing nations, particularly those of sub-Saharan Africa, face deep poverty, unmanageable international debts, economic stagnation, and widening international inequalities in living standards. 6. Resource Scarcity, Environmental Degradation, Climate Change, and Unsustainable Development Growth in rich countries and development in poor countries are now threatened by resource scarcity, environmental degradation, and climate change. The price of petroleum, food and other raw materials has risen sharply during the past few years. Environmental pollution is dramatic in some parts of China and the Amazon forest is rapidly being destroyed. And we are witnessing very dangerous climate changes that may have increasingly dramatic effects on life. H.Crassas – 2015 – ECS3702 - International Trade Page 5 STUDY UNIT 2 – WHY NATIONS TRADE: THE CLASSICAL THEORY 2.1 INTRODUCTION We at the historical development of trade theory from the seventeenth century through the first part of the twentieth century. We seeks to provide answers to the following questions: 1. What is the basis for trade? 2. What are the gains from trade? 3. What is the pattern of trade? We first summarize the historical development of trade theory and then by discussing the theoretical principles used to explain the effects of international trade. 2.2 Mercantilists’ Views On Trade Mercantilists were a group of writers in Europe during the period 1500 to 1800, they were merchants, bankers, government officials and philosophers. International trade can be viewed as either a zero sum game or as a positive sum game. Their motivation for trade was self-interest and the gains of winners are offset by the losses of the losers, hence the expression "zero sum game". According to the mercantilists, the economic welfare of a country depends on a strong foreign trade surplus and would contribute to greater spending and to an increase in domestic output, employment and prosperity. Mercantilists argued that to achieve these objectives, governments should encourage exports and restrict imports by imposing tariffs, quotas and other commercial policies. Self-interest was therefore the driving force behind trade. In this respect, the mercantilists were no different from the classical theorists. However, mercantilism fails to comprehend the further effect of a trade surplus. For example: Hume showed that a favourable trade balance tends to lead to higher domestic inflation and reduced competitiveness and thus to greater imports in the long run. Smith attacked the mercantilists' view that the size of the world's economic pie is constant and that a nation's gain from trade is at the expense of its trading partners. According to Smith, world output is not a fixed quantity. Trade between countries allows them to take advantage of specialisation and the division of labour to improve their productivity and thereby increase world output. Mercantilits views are important for two reasons; 1. The ideas of Adam Smith, David Ricardo, and other classical economists can best be understood if they are regarded as reactions to the mercantilists' views on trade and on the role of the government. 2. Today there seems to be a resurgence of neo-mercantilism, as nations plagued by high levels of unemployment seek to restrict imports in an effort to stimulate domestic production and employment. 2.3 CLASSICAL THEORISTS The most prominent classical theorists are David Hume (1711 - 1776), Adam Smith (1723 - 1790), David Ricardo (1772 - 1823), Robert Torrens (1780 - 1864) and John Stuart Mill (1806 - 1873). The classical theory of trade involves to explain international trade between countries through the principles of Absolute advantage advanced by Smith Comparative advantage advanced by David Ricardo. H.Crassas – 2015 – ECS3702 - International Trade Page 6 2.3.1 Trade Based On Absolute Advantage (Adam Smith) Unlike the mercantilists, Adam Smith believed that all nations would gain from free trade and advocated a policy of laissez- faire. Free trade, with each nation specialising in that commodity in which it has absolute advantage would lead to an efficient allocation of world resources and would maximize world welfare. Adam Smith started by stating the fact that for two nations to trade with each other voluntarily, both nations must gain, this meant: Factories could specialise in specific tasks resulting in a considerable increase in output and thus in trade. Resources are utilized in the most efficient way and the output of commodities will rise. Nations could also be expected to concentrate on producing goods they make most cheaply. He believed that productivity of labour was the main determinant of production costs. He therefore approached the determination of absolute advantage and trade from the supply side only and ignored the effects of changes in demand. Laissez-faire - an economic system in which transactions between private parties are free from government interference such as regulations, privileges, tariffs, and subsidies. The principle of absolute advantage explains both the pattern of trade and the gains from trade. However, the classical theory is based on a number of simplifying assumptions, these are: 1. Producers and consumers display rational behaviour. 2. There are only two countries and two commodities. Each good has identical characteristics and some of each good is consumed in both countries. 3. There is full employment. 4. Labour is the only factor of production. 5. Each country has a fixed endowment of resources, and all units of each particular resource are identical. 6. Perfect competition exists. 7. Factors of production are mobile between the two commodities and within the country, but not between countries. 8. There are no barriers to trade. 9. Production shows constant returns to scale, i.e. hours of labour per unit of production of a good do not change. 10. No transport costs. 11. The level of technology is fixed for both countries, although the technology may differ. 2.3.2 Illustration Of Absolute Advantage Country X Country Y Good A (units/hour) 24 42 The following table shows the output per day of two countries on the Good B (units/hour) 12 7 basis of the above assumptions. Remember, in this model, each country Autarky prices 2A:1B 6A:1B produces either one or the other product. Autarky prices - (domestic terms of trade) refer to the rate at Country X is the more efficient producer of good B (12>7) which a unit of one good exchanges for the other good in Country 2 is the more efficient producer of good A (42>24) each country in the absence of trade between the two Thus, countries. Country 2 has an absolute advantage in the production of good A. Country X has an absolute advantage in the production of good B. Such specialisation does not imply that the two countries will begin to trade, trade will depend on the terms of trade. Country X, using all its resources, can produce either 24 units of good A or 12 units of good B. Country X, which has an absolute advantage in good B, can produce 2A if it gives up the production of 1B. The autarky prices of Country X are 2A:1B. Country X will not participate in trade if it cannot get at least 2A for 1B. Country Y, by using all its resources, can produce 42A or 7B. Country Y, which has an absolute advantage in good A, can produce 6A if it gives up the production of 1B. Its domestic terms of trade are 6A:1B. Country X will not participate in trade if it cannot get at least 6A for 1B from Country I. It will be even better off if it can trade fewer than 6A for 1B. For trade to take place between the two countries, the international terms of trade must fall between the two countries’ domestic terms of trade, (2A