ICE – Trade – 2nd May 2014.
The Economic Environment of Business – Lecture 4
–Trade
Why do we trade?
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Why trade?
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Different factor endowments - some economies are rich in natural resources while others have relatively
little. Trade enables economies to specialise in the export of some resources and earn revenue to pay for imports
of other goods.
Increased welfare - specialisation (where countries have a comparative advantage - see the next section for
more detail on this) and trade allow countries to gain a higher level of consumption than they would do
domestically and this leads to increased welfare and higher living standards.
To gain economies of scale - with specialisation and production on a larger scale than may be possible
domestically, a country may be able to gain more economies of scale. This will lead to lower average costs and
benefit consumers through lower prices.
Diversity of choice - trade enables us to access goods and services that we may not be able to produce
ourselves. What would be an example in your country of goods that you can only get through trade?
Political / historical reasons - some trade takes place for political and other reasons relating to history and
tradition, though this is generally diminishing in importance.
Increased competition - increased global competition may help to spur domestic productivity improvements
and give domestic firms a better incentive to innovate and improve their products. This will benefit consumers.
Trade may be an 'engine for growth' - increased trade may help to spur greater domestic economic growth and
drive further improvements in living standards.
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Absolute and Comparative Advantage
 Absolute and comparative advantage
 Absolute advantage exists when one country is able to
produce a good more cheaply in absolute terms than another
country.
 Comparative advantage exists when one country is able to
produce a good more cheaply, in comparison to other goods
produced domestically, than another country.
 Comparative advantage is a principle of economics which
states that trade between TWO countries will be
MUTUALLY beneficial as long as their domestic
opportunity costs of production differ.
Limitations of Comparative Advantage
 Limitations of comparative advantage theory
 We need to be careful as comparative advantage theory does not explain all changes in
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trade patterns. It is an important explanation, but you also need to take into account
that:
Transport costs and tariffs will change the relative prices of goods and may therefore
'blur' the impact of comparative advantage.
Exchange rates do not always relate exactly to what comparative advantage theory
suggests as they have many other determinants - this may also negate the theory.
Imperfect competition may lead to prices being different to opportunity cost ratios.
Imperfect competition may also lead to the exploitation of economies of scale which may
adjust to what comparative advantage theory suggests should happen.
Comparative advantage theory is a static theory and does not take account of some of the
more dynamic elements determining world trade. In particular, the factor of
production capital is not a natural resource, and so may come outside the scope of the
theory.
Free Trade and Protectionism
 Free trade may be beneficial, but governments will often be under
intense pressure to protect against overseas imports to prevent the
loss of domestic jobs and they see protection against imports as an
answer to this - at least in the short-term. Protection therefore
offers a short term solution, but may leave a longer term problem
for the next government to sort out.
 Free trade is trade that occurs between countries without any
barriers or hindrances. This means that firms are able to sell
directly into a country as easily as the firms within that country
are able to trade. The firm exporting into the country should not
face any additional barriers, taxes, regulations or any other
obstacles that prevent them selling their goods/services
Why protect?
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Costs of trade
However, completely free trade may have a number of costs for some economies. These may
include:
Adjustment costs - changes in comparative advantage may require adjustments in the structure of
industry and these may take some time. While they are taking place there may be employment costs
from the changeover.
Environmental costs - free trade may lead to firms relocating to where environmental and other
regulations are most lax. This could cause long-term environmental problems.
Arguments in favour of protectionism
So, why do some governments still protect trade? The main reasons include:
To safeguard domestic employment - as protectionist polices reduce import penetration. In
terms of the identity AD = C + I + G + (X-M), the lower is M, the greater will be aggregate
demand and thus the higher the level of domestic output and employment.
To correct balance of payments disequilibrium - as demand for imports is dampened and
exports promoted. This makes the domestic output appear to be competitive as the most common
policy used is a deliberate depreciation of the domestic currency.
Why protect?
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To prevent labour exploitation in developing economies - this is really a moral argument as it
rests on making imports more accurately reflect their true cost of production. However, it might also
reduce imports from some of the poorest economies in the world.
To prevent dumping - which is where economies sell goods in overseas markets at a price below the
cost of production. Domestic consumers pay more than those buying overseas. Such low prices are part of
a policy to destroy rivals in exports markets.
To safeguard infant industries - as shifts in comparative advantages arise so some countries become
able to enter new markets. Their fledgling industry needs some protection from the power of already
established competitors.
To enable a developing country to diversify - this is similar to the infant industries argument. Many
developing countries are heavily dependent exports of primary commodities. This can leave them very
exposed to changes in international commodity prices. If they want to diversify and develop new export
revenue streams, they may need to protect these new industries from full exposure to international
competition for a while.
Source of government revenue - where protectionism takes the form of a tariff, apart from reducing
demand for imports via the impact of a higher price, this will also raise revenue for the government, like
any other tax. The revenue raising function will be most successful where the demand for imports is price
inelastic.
Strategic arguments - a particular product or industry might be of strategic importance to a country
e.g. agriculture or coal, and protectionism may be justified on the grounds that it is keeping alive an
industry which plays a vital part in the economy perhaps because of social, political or military reasons.
Arguments against protectionism
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Arguments against protectionism
Though protection is often seen as a convenient political solution for countries (and has been extensively used even in recent years),
it does also have a number of problems. This means that it is not always the best solution for a country. These problems include:
Downward multiplier effects - if a country successfully protects against imports, this will reduce the level of imports. However,
one country's imports are another country's exports and this reduction in exports will lead to a multiplied effect. This may even
reduce demand for exports from the country that raised the protectionist measures in the first place, but will certainly reduce world
output.
Retaliation - any protectionist measure tends to be instantly met with some form of retaliation. This will tend to mean that any
success in protecting against imports leads to a fall in exports when the retaliation starts to bite.
Costs - tariffs (and other protectionist measures) tend to lead to a cost on society. If we look at the tariff diagram in figure 1 below
we can see that the tariff leads to a reduction in imports. Some of the benefits from the reduced imports are passed to domestic firms
in the form of higher prices and the government in the form of revenue, but the triangles either side of the blue shaded area
represent a welfare cost to society. Consumers will be paying higher prices for many of the goods and services they consume.
Inefficiency of resource allocation - the imposition of tariffs or other protection may not be the best solution. Firms may be
able to shelter behind the tariff wall and remain inefficient. They may not have an incentive to reduce costs and become fully globally
competitive if they believe that the tariffs will continue. This will be true also where infant industries are protected. If the tariffs
remain in the long-term, the infant industry may never 'grow-up'. Firms operating with higher costs may be unable to achieve export
competitiveness. In short, resources will not be allocated to their most efficient uses.
Bureaucracy - many protectionist measures are very bureaucratic to enforce. This is likely to reduce choice for domestic
consumers and perhaps lead to possible corruption and other administrative costs. These will not be beneficial for the economy.
Economic Integration
 The world is becoming smaller - perhaps not literally, but
certainly in terms of international trade. Improved
productivity, technological development (e.g. ecommerce) and better transport infrastructures are all
contributing to globalisation. This increased
interdependency makes trade issues and trade performance
even more important. The traditional scenario of national firms
producing a significant proportion of domestic output is no longer
true. 'Off shoring‘/outsourcing means that many national
services are run from other countries where the cost base is lower
and footloose production means that goods can be produced
anywhere and transported to their markets worldwide. This
enables companies to reduce costs and gain from significant
economies of scale.
Globalisation
 Reduced costs - firms will move to different countries to
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minimise their production costs
Led to sourcing of suppliers and services worldwide
Improved quality - quality has risen as firms are able to
source their supplies from the best location
Global web - firms (particularly multinationals) are able to
build a global network of supply chains
Transport and communications
Trade liberalisation
Yes to globalisation
 For
 Capital flows will be determined by comparative advantage of nations
 There will be a wide distribution of technology and 'technology' and
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'skills' transfer
Wider choice for consumers
Dismantling of any trade barriers
An increase in the level of world trade
Increased access to economies of scale making products cheaper and
more efficient to produce
Trade determined fully by comparative advantage
Increased worldwide economic growth
More efficient global markets
No to globalisation
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Investment flows will often ignore the less developed countries (LDC's)
Labour costs are driven down and living standards may also be driven down
Increased monopoly power for multinational corporations
Increased urbanisation in many countries
International capital is mobile, but labour is not
Conditions of employment deteriorate and governments put under pressure by
multinational corporations
Less democratic control of economic forces as power moves to multinational
corporations
Financial instability
Unsustainable development around the world
Growth of consumerism which may not be appropriate to every country
Balance of Payments
 The balance of payments accounts measure the international trade
performance of an economy and show how well they are managing
to match imports and exports of goods and services and the flows
of investment in and out of the country. The accounts are usually
split into two parts - the current account and the capital account.
The current account shows trade in goods and services while the
capital account shows flows of investment into and out of the
country.
 Overall the balance of payments accounts will always balance
(hence the name), though there may be deficits or surpluses on the
various sections within the overall accounts. They must balance as
any flows of foreign exchange into and out of the country must
ultimately match. If there is a deficit in trade on goods and
services, then this must be compensated by an inflow of
investment funds
Current Account
 The current account records imports and exports of goods
(sometimes known as the 'balance of trade' or 'visible trade') and
imports and exports of services (sometimes known as 'invisible
trade'). It often also records income flows (flows of interest,
profits and dividends that may have arisen from investment flows)
and transfers of money. Details of the exact components of the
current account will differ from country to country, but it
essentially shows the trade in goods and services.
 The balance of trade in goods is often known simply as the
'balance of trade' and this represents visible exports minus visible
imports. The current account balance is the net balance of all of
these items - the net balance of trade in goods and the net balance
of trade in services and net income flows
Capital Account
 The capital account of the balance of payments records the flows of money into and out
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of a country for investment and other purposes. There will be inflows of money (credits)
and outflows of money from a country (debits).
The capital account breaks down into a number of sub-sections:
(i) Direct and portfolio investment - direct investment is productive investment. In
other words it is investment in plant, equipment, machinery or factories - investment
that will help with the process of wealth creation. Portfolio investment on the other hand
is investment in paper assets like shares. There may be both inflows and outflows of
portfolio investment.
(ii) Other financial flows - this heading can cover a range of short-term monetary
flows like bank deposits from overseas residents, loans into a country from abroad and so
on. These short-term flows often arise to take advantage of changes in interest rates
between countries and are sometimes called 'hot-money flows'. These flows are often of
a purely speculative nature.
(iii) Flows to and from reserves - all countries hold reserves of foreign currency and
this section measures any changes in these reserves. If the government were trying to
influence the exchange rate e.g. trying to create an appreciation in the rate, then they
may sell some of their foreign currency reserves and buy their own currency instead.
Balance of Payments – 1 - influences
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Domestic economic growth will lead to a higher level of imports. The rate of growth of imports
will depend on the income elasticity of demand for imports. An income elastic demand for imports
will mean that imports grow faster than GDP. This will tend to lead to a balance of payments
deficit.
Economic growth in the rest of the world will lead to a higher level of exports. The rate of growth
of exports will depend on the income elasticity of demand for exports. An income elastic demand
for exports will mean that exports grow faster than GDP. This will help to prevent a balance of
payments deficit.
Changes in demand for exports and imports in response to price changes will depend upon the
price elasticities of demand. The more price elastic is demand, the greater will be the
responsiveness to any price change.
The change in the balance of payments will therefore depend on:
The difference between the price elasticity of demand for exports and the price elasticity of
demand for imports, and the rate of economic growth in the UK and the rest of the world.
The price competitiveness of UK exports - this will be determined by UK productivity, the rate of
inflation in the UK compared to the rest of the world and the exchange rate.
The non-price competitiveness of UK exports - this is dependent on factors like quality, reliability,
after-sales service and so on.
Problems
 A current account deficit is generally thought to be
undesirable (particularly in the long term) even if it is funded
by a surplus on the capital account. In a sense it is
advantageous as the deficit means that the country is enjoying
a higher standard of living in the short-term. This is thanks to
the higher level of consumption through imports. However,
the deficit is being funded by inflows of investment and this
will mean interest and dividend payments flowing out of the
country in the future. This inward investment also leaves the
country more exposed to the whims of external investors.
The greater the deficit and the longer it lasts, the more of an
issue this will be.
Problems - 2
 A current account surplus is less of an issue than a deficit, but
it does mean that the country may not be enjoying as high a
standard of living as it could be. It would be possible for the
economy to boost demand and economic growth without
running into a balance of payments deficit. So a current
account surplus could be seen as an indication of underperformance.
 A current account surplus, under a floating exchange rate
system, is likely to exert upward pressure on the exchange
rate, with all the problems which that may cause.
Correcting a balance of payments
 Policies to correct a balance of payments deficit
 There are two principal types of policy to correct a balance of payments deficit. They
are:
 Expenditure-switching policies - these are policies that are aimed at encouraging
people to switch their spending from imported goods to domestic goods. These policies
might include tariffs and protectionism in general, manipulation of exchange rates to
change the relative prices of imports and supply-side policies aimed at improving the
competitiveness of national firms. If these policies are successful spending will switch
from imports to domestic spending and the current account will improve.
 Expenditure-reducing policies - these are policies that aim to reduce domestic
expenditure and therefore reduce the level of imports. The main expenditure-reducing
policies are deflationary monetary and fiscal policies. These may include increasing tax,
cutting government expenditure or increasing interest rates. The impact of these policies
would be to reduce the level of aggregate demand and therefore the demand for imports.
Lower income levels mean lower spending on imports and a consequent improvement in
the current account. The extent of this improvement will depend on the income
elasticity of demand for imports. The higher the income elasticity, the greater the
improvement there will be in the current account.
Consequences of a balance of
payments problem
 A surplus on the capital account means that there are more investment funds flowing
into the country than out. This may be to fund a deficit on the current account of the
balance of payments. This inward investment may be helpful to the economy and help
create jobs and boost growth, but anyone investing in an economy expects a return. This
means that a surplus on the capital account will lead to outflows of interest and
dividends in the future.
 The inflow of funds may exert an upward pressure on the exchange rate as the demand
for the domestic currency will increase. This might adversely affect the current account if
the increase in export prices makes exports less competitive.
 A capital account deficit on the other hand will mean a net outflow of investment funds.
This means the country is building up a portfolio of overseas investments, which will
lead to future returns of interest, profit and dividends. This may be beneficial in the
medium-term. However, short term speculative outflows of funds may have disastrous
effects on an economy in terms of the depreciation of the exchange rate, loss of
confidence, impact on investment, output and jobs. Several countries in recent years e.g.
Thailand, Indonesia, Russia and Brazil have been badly affected by these speculative
outflows of funds.