international trade

International Trade – Introduction & Overview

What is Trade?

Trade is the exchange of products between countries

When conditions are right, trade brings benefits to all countries involved and can be a powerful driver for sustained growth and rising living standards.

One way of expressing the gains from trade in goods and services is to distinguish between static gains from trade (i.e. improvements in allocative and productive efficiency) and dynamic gains (i.e. gains in welfare that occur over time from improved product quality, increased choice and faster innovative behaviour).

Gains from Trade – Understanding Comparative Advantage

Comparative advantage exists when a country has a ‘margin of superiority’ in the production of a good or service i.e. where the marginal cost of production is lower or has a lower opportunity cost in the production of a particular good or service.

Countries will generally specialise in and export products, which use intensively the factors inputs, which they are most abundantly endowed.

If each country specializes, then total output can be increased leading to an improvement in allocative efficiency and welfare.

Because production costs are lower, providing that a good market price can be found from international buyers, specialisation should focus on those goods and services that provide the best value

In highly developed countries, comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services.

Example of comparative advantage

Usually we take a standard two-country + two-product example to illustrate comparative advantage

  • Consider two countries producing two products – digital cameras and vacuum cleaners
  • With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below.

OUTPUT BEFORE SPECIALISATION

Digital Cameras

Vacuum Cleaners

UK

600

600

United States

2400

1000

Total

3000

1600

Working out the comparative advantage

  • To identify who should specialise in a particular product,  consider the internal opportunity costs
  • Were the UK to shift resources into supplying more vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television
  • For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners
  • If the UK chose to reallocate resources to digital cameras the opportunity cost of an extra camera is one vacuum cleaner. But for the USA the opportunity cost is only 5/12ths of a vacuum cleaner.
  • USA has comparative advantage in producing digital cameras because its opportunity cost is lowest.

Output after Specialisation

Digital Cameras

Vacuum Cleaners

UK

0 (-600)

1200 (+600)

United States

3360 (+960)

600 (-400)

Total

3000 3360

1600 1800

  • The UK specializes totally in producing vacuum cleaners – doubling its output  – now1200
  • The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners
  • As a result of specialisation output of both products has increased – a gain in economic welfare.

For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. If the two countries trade at a rate of exchange of two digital cameras for one vacuum cleaner, the post-trade position will be as follows:

  • The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
  • The USA exports 840 digital cameras and imports 420 vacuum cleaners

Post trade output / consumption

Digital Cameras

Vacuum Cleaners

UK

840

780

United States

2520

1020

Total

3360

1800

Compared with the pre-specialisation output levels, consumers now have an increased supply of both goods

Key assumptions behind trade theory

This theory of trade based on comparative advantage depends on a number of assumptions:

Occupational mobility of factors of production (land, labour, capital) -this means that switching factor resources from one industry to another involves no loss of efficiency and productivity. In reality we know that factors of production are not perfectly mobile – labour immobility for example is a root cause of structural unemployment

Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) – this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the benefits from trade are reduced. Conversely increasing returns to scale means that specialisation brings even greater increases in output.

No externalities arising from production and/or consumption – no discussion about the overall costs and benefits of specialisation and trade should ignore many of the environmental considerationsarising from increased production and trade between countries.

The standard model of trade focuses on trade between countries. In reality, most trade takes place between businesses across national boundaries – i.e. intra-industry trade. In the last twenty years we have seen huge changes in both the pattern of trade between developed and developing countries. And also the complexity of manufacturing supply chains around the world. Typically for example, a tablet computer or a smartphone will be manufactured in one or two centers but the components will have come from dozens of other countries.

Sources of Comparative Advantage

Comparative advantage is a dynamic concept meaning that it changes over time.

For a country, the following factors are important in determining the relative unit costs of production:

The quantity and quality of factors of production available for example some countries have an abundant supply of good quality farmland, oil and gas, fossil fuels. Climate and geography have key roles in creating differences in comparative advantage.

Different proportions of factors of production – some countries have abundant low-cost labour suitable for volume production of manufacturing products.

Increasing returns to scale and the division of labour – increasing returns occur when output grows more than proportionate to inputs. Rising demand in the markets where trade takes place helps to encourage specialisation, higher productivity and internal and external economies of scale. These long-run scale economies give regions and countries a significant advantage.

Investment in research & development which can drive innovation and invention

Fluctuations in the exchange rate, which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers.

Import controls such as tariffs, export subsidies and quotas – these can be used to create an artificial comparative advantage for a country’s domestic producers.

The non-price competitiveness of producers – covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support. Many countries are now building comparative advantage in high-knowledge industries and specializing in specific knowledge sectors – an example here is the division of knowledge in the medical industry, some countries specialize in heart surgery, others in pharmaceuticals.

Institutions – these are important for comparative advantage and important for growth too. Banking systems are needed to provide capital for investment and export credits, legal systems help to enforce contracts, political institutions and the stability of democracy is a key factor behind decisions about where international capital flows.

Comparative advantage is often a self-reinforcing process.

  • Entrepreneurs in a country develop a new comparative advantage in a product either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets
  • Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on
  • The expansion of an industry leads to external economies of scale.

Wider Benefits of International Trade

Many countries have seen a growing share of their GDP directly linked to overseas trade, our chart below tracks data for India, one of the fast-growing BRIC nations. India joined the WTO in 1991.

Prior to joining the WTO, Indian trade as a share of GDP was low by global standards at just 15%. That figure has doubled in the last twenty years

Some of the broader gains from trade are:

Welfare gains: Supporters of trade believe that trade is a ‘positive-sum game’ – all counties engaged in open trade and exchange stand to gain

Economies of scale – trade and increased market size allows firms to exploit scale economies leading to lower average costs of production that might be passed onto consumers

Competition / market contestability – trade promotes increased competition particularly for domestic monopolies that would otherwise face little competition. Trade is a spur for higher productivity – a stimulus to higher business efficiency across many industries.

Dynamic efficiency gains from innovation – trade enhances choice and stimulates product and process innovations bringing better products for consumers and enhances the standard of living

Access to new technology and inflows of new knowledge: trade, like investment, is a mechanism by which countries can have access to new technologies. Trade is a stimulus to the exchange of ideas and inflow of human capital. Openness to trade allows imports of capital equipment at lower prices.

Rising living standards and a reduction in poverty – a growing body of evidence shows that countries that are more open to trade grow faster over the long run and have higher per capita income than those that remain closed. Growth through trade directly benefits the world’s poor although free trade is not necessarily equitable

The UNDP believe that greater openness in trade can be a major factor behind reducing extreme poverty. For example in the case of Cambodia, access to markets is estimated to have contributed to a decrease in extreme poverty from 35% in 2002 to 25.8% in 2010.

DO FREE TRADE AGREEMENTS MATTER? EVALUATING THE IMPACT OF FTAs ON SINGAPORE’S DOMESTIC EXPORTS OF GOODS

Singapore is a small, open economy, highly dependent on external demand. In 2010, external demand accounted for nearly three-quarter of Singapore’s total demand. Singapore’s dependence on trade means that trade barriers erected by other countries result in significant welfare losses for Singapore.
Click here for the full article.
Trade Stats

Trade Statistics Booklet (Singapore’s Pattern of Trade)

This annual booklet provides an overview of Singapore’s trade and overseas investments for the past year. The trade statistics are in both real & nominal terms for Merchandise Trade, Services and Direct Investment Abroad. View the latest booklet.

International Agreements

In addition to Singapore’s strong internal infrastructure and pro-trade policies, its international network of agreements further enhances its attractiveness for investment holding, making Singapore the logical choice for trade and investment. Click here.

Protectionism – Import Controls

Often times there are trade disputes between countries perhaps because one or more parties believes that trade is being conducted unfairly, on an uneven playing field, or because they believe that there is an economic or strategic justification for some form of import control.

Protectionism represents any attempt to impose restrictions on trade in goods and services. The aim is to cushion domestic businesses and industries from overseas competition.

  • Tariffs – A tariff is a tax that raises the price of imported products and causes a contraction in domestic demand and an expansion in domestic supply. The net effect is that the volume of imports is reduced and the government received some tax revenue from the tariff.
  • Quotas – quantitative limits on the level of imports allowed.
  • Voluntary Export Restraint Arrangements – where two countries make an agreement to limit the volume of their exports to one another over an agreed period of time.
  • Embargoes – a total ban on imported goods.
  • Intellectual property laws (patents and copyrights).
  • Preferential state procurement policies – where a government favour local/domestic producers when finalizing contracts for state spending e.g. infrastructure projects
  • Export subsidies – a payment to encourage domestic production by lowering their costs. Soft loans can be used to fund the ‘dumping’ of products in overseas markets. Well known subsidies include Common Agricultural Policy in the EU, or cotton subsidies for US farmers.
  • Domestic subsidies – government financial help for domestic businesses facing financial problems e.g. subsidies for car manufacturers or loss-making airlines
  • Import licensing – governments grants importers the license to import goods.
  • Exchange controls – limiting the foreign exchange that can move between countries.
  • Financial protectionism – for example when a national government instructs its banks to give priority when making loans to domestic businesses.
  • Murky or hidden protectionism – e.g. state measures that indirectly discriminate against foreign workers, investors and traders. A government subsidy that is paid only when consumers buy locally produced goods and services would count as an example.

Quotas, embargoes, export subsidies and exchange controls are examples of non-tariff barriers

Tariffs

China joined the WTO in 1991 and since then average import tariffs have been falling on a consistent basis. Our analysis diagram below shows the standard effects of an import tariff on an imported product. The world price before the tariff is Pw and at this price, domestic demand is Qd and domestic supply is Qs.

Because of the tariff, the import price rises to Pw + T. This causes a contraction in demand to Qd2 and an expansion of supply to Qs2. The result is that the volume of imports falls to quantity M. Tariffs have welfare consequences, one of which is that the welfare of consumers who must now purchase the imported product at a higher price has fallen – there is a deadweight loss of consumer surplus. The effects of a tariff on quantities depend on the price elasticity of demand and price elasticity of supply of domestic businesses that have been given a cushion of increased competitiveness by the tariff.

The Economic and Social Case for Protectionism

  • Infant industry argumentCertain industries possess a possible comparative advantage but have not yet exploited economies of scale . Short-term protection allows the ‘infant industry’ to develop its comparative advantage at which point the protection could be relaxed, leaving the industry to trade freely on the international market.
  • Externalities and market failure: Protectionism can also be used to internalize the social costs of de-merit goods. 
  • Protection of jobs and improvement in the balance of payments
  • Protection of strategic industries: The government may also wish to protect employment in strategic industries, although value judgments are involved in determining what constitutes a strategic sector.
  • Anti-dumping dutiesDumping is a type of predatory pricing behaviour and a form of price discrimination. Goods are dumped when they are sold for export at less than their normal value. The normal value is usually defined as the price for the like goods in the exporter’s home market. Recent examples of disputes about alleged dumping have included
    • India complaining about the dumping of bus and truck tires from China and Thailand
    • The EU imposing an anti-dumping tariff on Norwegian farmed salmon in response to complaints from farmers in Scotland and Ireland
    • EU shoemakers alleging that Chinese and Vietnamese shoe manufacturers have illegally dumped leather, sports and safety shoes in the EU market
    • In 2009 EU imposed temporary “anti-dumping” taxes on Chinese wire, candles, iron and steel pipes, and aluminum foil from Armenia, Brazil and China.

In the short term, consumers benefit from the low prices of the foreign goods, but in the longer-term, persistent undercutting of domestic prices will force the domestic industry out of business and allow the foreign firm to establish itself as a monopoly.  Once this is achieved the foreign owned monopoly is free to increase its prices and exploit the consumer.  Therefore protection, via tariffs on ‘dumped’ goods can be justified to prevent the long-term exploitation of the consumer.

The World Trade Organisation allows a government to act against dumping where there is genuine‘material’ injury to the competing domestic industry. In order to do that the government has to be able to show that dumping is taking place, calculate the extent of dumping (how much lower the export price is compared to the exporter’s home market price), and show that the dumping is causing injury. Usually an ‘anti-dumping action’ means charging extra import duty on the particular product from the particular exporting country in order to bring its price closer to the “normal value”. Tariffs are not a major source of tax revenue for the Government that imposes them. In the UK for example, tariffs are estimated to be worth only £2 billion to the Treasury, equivalent to only around 0.5% of the total tax take. Developing countries tend to be more reliant on tariffs for revenue.

Economic Arguments against Protectionism

  • Market distortion: Protection can be an ineffective and costly means of sustaining jobs.
    1. Higher prices for consumers: Tariffs push up the prices faced by consumers and insulate inefficient sectors from competition.  They penalize foreign producers and encourage the inefficient allocation of resources both domestically and globally.
    2. Reduction in market access for producers: Export subsidies depress world prices and damage output, profits, investment and jobs in many developing countries that rely on exporting primary and manufactured goods for their growth.
  • Loss of economic welfare: Tariffs create a deadweight loss of consumer and producer surplus. Welfare is reduced through higher prices and restricted consumer choice.
  • Regressive effect on the distribution of income: Higher prices that result from tariffs hit those on lower incomes hardest, because the tariffs (e.g. on foodstuffs, tobacco, and clothing) fall on those products that lower income families spend a higher share of their income.
  • Production inefficiencies: Firms that are protected from competition have little incentive to reduce production costs. This can lead to X-inefficiency and higher average costs.
  • Trade wars: There is the danger that one country imposing import controls will lead to “retaliatory action” by another leading to a decrease in the volume of world trade. Retaliatory actions increase the costs of importing new technologies affecting LRAS.
  • Negative multiplier effects: If one country imposes trade restrictions on another, the resultant decrease in trade will have a negative multiplier effect affecting many more countries because exports are an injection of demand into the global circular flow of income.
  • Second best approach: Protectionism is a ‘second best’ approach to correcting for a country’s balance of payments problem or the fear of structural unemployment. Import controls go against the principles of free trade. In this sense, import controls can be seen as examples of government failure arising from intervention in markets.

The Importance of Imports

A simplistic view of trade is that exports are good and imports are bad. But that assumption quickly crumbles when you look more closely. We could consume all the goods and services leaving Britain as exports. We are, in effect, exporting our standard of living. So why do we do it? To paraphrase one Nobel Prize winning economist, “What a country really gains from trade is the ability to pay for the imports that it wants.”

Yet in the public imagination, more imports sounds like a bad idea. The tough global economic environment makes calls for protectionism grow louder. Yet such steps would not be recommended by some economists who analyzed what happened to India when it slashed tariffs in 1991, under pressure from the IMF. As part of those reforms, India reduced duties on imports from an average of 90% in 1991 to 30% in 1997. Not surprisingly, imports doubled in value over this period. But this didn’t cause manufacturing to collapse. In fact, output grew by over 50%. By looking at what was imported and what it was used to make, the researchers found that cheaper and more accessible imports gave a big boost to India’s industrial growth.

Tariff cuts didn’t just mean that Indian consumers could import more consumer goods (though they did). It gave Indian manufacturers access to a variety of intermediate and capital goods, which had earlier been too expensive. The rise in imports of intermediate goods was much higher, at 227%, than the 90% growth in consumer-goods imports.

Theory suggests several ways in which greater access to imports can improve domestic manufacturing. First, cheaper imports may allow firms to produce existing goods using the same inputs as before, but at a lower cost. They could also open up new ways of producing existing goods, and even allow entirely new products to be made. All this seemed to hold in India. Lower import tariffs lead to an expansion in product variety through access to new inputs. About 66% of the growth in India’s imports of intermediate goods after liberalization came from goods the country had simply not bought before the tariff cuts.

Source: EconoMax, June/July 2009, author Tom White

Economic nationalism

Economic nationalism is a term used to describe policies which are guided by the idea of protecting a country’s home economy, i.e. protecting domestic consumption, jobs and investment, even if this requires the imposition of tariffs and other restrictions on the movement of labour, goods and capital.

Examples of economic nationalism include China’s controlled exchange of the Yuan, and the United States’ use of tariffs to protect domestic steel production.

The term gained a more specific meaning in 2005 and 2006 after several European Union governments intervened to prevent takeovers of domestic firms by foreign companies. In some cases, the national governments also endorsed counter-bids from compatriot companies to create ‘national champions’. Such cases included the proposed takeover of Arcelor (Luxembourg) by Mittal Steel (India). And the French government listing of the food and drinks business Danone (France) as a ‘strategic industry’ to block potential takeover bid by PepsiCo (USA).