International Trade

Benefits of trade

International trade: exchange of goods and services across international boundaries. Countries trade with each other because they obtain some benefits. These are:

• Specialization: the production by a country of a range of goods and services it can produce at a low cost. If you are efficient in producing something, you will be able to produce more of it. If you can produce certain goods and services only at a high cost, then you will be wasting resources. Therefore, if a country specializes→ total output ↑ and consumption ↑

Differences in factor endowments make specialization possible

• Economies of scale involve the ability of a firm to ↓ average costs by increasing its size and Q produced.

If a country trades its potential market becomes larger and so the possibility of achieving economies of scale.

• Increases the variety and quality of g&s available to consumers.

• Allows countries to buy needed resources.

• ↑Competition → ↑Efficiency• Knowledge flow• Makes countries interdependent, decreasing

possibility of wars.• All these advantages imply ↑ domestic output

and therefore greater economic growth.

Arguments for Protectionism

1. Qualified arguments: can be justified under particular conditions. They are valid on the expectation that long term benefits of protectionism are greater than short-term costs.

2. Questionable arguments have limited validity. Might offer short-term solutions to problems.

3. Incorrect arguments. Based on incorrect economic reasoning.

Qualified arguments

1. Infant industry argument. An infant industry is a new domestic industry that has not had the time to become efficient and may therefore be unable to compete with more mature foreign firms. In order to be able to grow in size and achieve economies of scale (lower production costs) a new firm may need protection from imports until it has grown in size. Mainly used by LDCs.

It is one of the strongest arguments and is consistent with the theory of comparative advantage. However, protection should be eliminated once the industry is mature enough.

Problems: 1. Identify the industries; 2. Protected industres may lose the incentive to become more efficient; 3. Governments may continue to protect an industry longer than needed.

2. Strategic trade policy. Industries considered to be important to the future growth of an economy should receive protection until they achieve the necessary economies of scale. Ex: computers, telecommunications, semiconductors. This argument appeared in the 1980s and is very similar to the previous one, with some differences:

1. It also applies to MDCs.

2. It involves other protection measures such as subsidies, tax advantages, low interest loans and gov financing of R&D.

Used by US and EU to justify protection of high-tech industries. Source of disagreements under the WTO.

Problems: 1. Identification of the industries; 2. Selection of appropriate protectionist policies; 3. It is likely that all or most DCs will use protection for the same industries at the same time, wich contradicts the idea of creating comparative advantage; 4. Gov might continue to protect these industries longer than needed.

3. Efforts of a LDC to diversify. Diversification means to increase the variety of goods and services produced. It can be thought as the opposite of specialization (basis of comparative advantage). Some countries might be better off diversifying their production and exports, as in the case of LDCs that are highly specialized in the production and export of one or few commodities.

Arguments against excessive specialization:– Fluctuations in global D or S → fluctuations in prices

of primary goods → unstable export revenues.– ↓export or export prices → ↓export rev and ↓incomes

Arguments in favour of diversification:– When LDCs move away from production of primary

products and into manufactured products the benefits are: increased employment, increased use of more advanced technologies and greater use of more highly skilled labour. All these favour growth and development.

To be able to diversify, countries may have to use protectionist policies in order to keep out imports of goods that they would like to produce themselves. The expectation is that the long term benefits of diversification will be greater that the short term costs (inefficiencies) of protection.

Problem: selection of industries appropriate for protection.

4. National defence. Certain industries that are essential for national defence (aircraft, weapons, chemicals, certain minerals) should be protected so that a country can produce them itself.

Problem: it can be used by industries that have an indirect use in defence, such as steel, to try to acquire protection against foreign competition. Also, it is difficult to determine what is essential for national defence. In the US, goods such as candles, gloves and umbrellas receive protection on this argument.

Questionable arguments

1. Tariffs as a source of government revenue. More common in LDCs: ease with which imports can be taxed. In contrast, income taxes are more difficult to levy and collect in LDCs for three reasons: a. Large shares of the population live on very low

incomes

b. Large proportion of people self-employed and working in the informal sector

c. Poor enforcement of tax collection and high tax evasion rates.

Disadvantages of tariffs: regressive tax (negative impacts on income distribution) and negative effects on allocative efficiency.

LDCs should make efforts to reform their tax systems, improve tax collection systems and gradually phase out reliance on tariffs as a source of government revenue.

2. Means to overcome balance of payments deficit. A balance of payments deficit occurs when the outflow of money from a country is greater than the inflow. It usually happens when imports are greater than exports. Imposing barriers to the entry of imports limits the need to make payments abroad.

However: ↓imports→ ↓exports in the exporting countries. There is a risk that these countries may retaliate by imposing protectionist measures of their own. In this case all countries would be worse off: ↓ in international trade and worsening balance of payments problems (↓imports + ↓exports).

3. Anti-dumping. Dumping is the practice of selling a good in international markets at a price below the cost of production (usually by providing export subsidies). It is considered to be an unfair practice and is illegal according to int’al agreements.

According to this argument, if a country suspects that a trading partner is practising dumping, it should have the right to impose tariffs or quotas in order to limit imports of the dumped good.

Main problem: it is difficult to prove that dumping is being practised, so it is often used by many governments as an excuse to protect their domestic producers when this is not necessary or justified.

4. Protection of domestic employment. Import restrictions cause consumers to shift consumption away from imports and towards domestic produced goods. As domestic production increases, unemployment falls.

Problem: if UE in the domestic country falls, this means that UE has increased in those countries that now export less. These may retaliate by imposing import restrictions, with the result that all countries will be worse off.

Incorrect arguments

• Wage protection argument. Some foreign countries can produce at lower costs because of low wages, so that imports from those countries will sell at lower prices and domestic firms will not be able to compete.

Although very popular, this argument is based on incorrect economic reasoning as lower wages ≠ lower production costs.

Economic Integration

• Achieved by an agreement to reduce or eliminate trade barriers between countries. In this way countries become economically interdependent.

• A trading bloc is a group of countries that have agreed to reduce trade and other barriers in order to encourage free or freer trade and cooperation between them.

• There are different degrees of integration. Starting from the lowest:

• Free trade area. A group of countries that agree to gradually eliminate trade barriers between themselves. Each country keeps the right to apply protectionist policies when trading with non-member countries. The trade of some products mught still be protected.

Example: NAFTA=CA, MX, US• Customs union. Same conditions as free trade

area plus adoption of common policy towards non-member countries. Also, in negotiations with other countries the member countries act as a group.

• Example: CEFTA (Central European Free Trade Agreement).

• In a common market, countries that have formed a customs union decide to– eliminate remaining tariffs in trade and– eliminate all restrictions on movements of factors of

production (labour and capital) within them...

(and continuing to have a common external policy).

Example: European Economic Community, precursor of the EU.

• Economic and monetary union. Economic union involves the unification of the monetary and fiscal systems of the members, with a unified system of economic policy making. Countries maintain political identity.

• Monetary union is achieved by adopting a common currency. Ex: eurozone countries.

• Eurozone countries still have separate fiscal systems and only a partially unified policy-making system.

Pros and cons of trading blocs

Benefits:

1. Increased competition.

2. Economies of scale.

3. Use of new technologies (as a consequence of 1).

4. Lower prices for consumers.

5. Increased investment: internal by firms from a member country or external by outsider firms, which escape the tariff imposed by the trading bloc on imports from outside.

6. Better use of factors of production.

7. Improved production efficiency, allocative efficiency and greater economic growth (already mentioned).

8. Political advantages: Reduced likelihood of hostilities between countries becoming increasingly interdependent and political cooperation resulting from economic integration.

Disadvantages:

1. Trading blocs are a ‘second best’ solution, being inferior to a complete elimination of trade barriers (=first best).

2. May create obstacles for global free trade. Some economists believe that conflicts between trading blocs might arise, difficulting the process of global integration.

3. Unequal distribution of gains from trading blocs, as not all members obtain the same benefit.

4. Gains may be limited if major trade links are with outside countries. For instance, LDCs have strong trade links with DCs and more limited trade with each other. What would be the gains of a trading bloc between LDCs???