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International Trade

Introduction - Definitions Trade refers to the exchange of goods and services between countries. Pattern of trade refers to the composition, volume and direction of trade in a country. Pattern of trade is based on the theory of comparative advantage (CA). Based on theory of CA, countries should specialise in production of goods they have CA in and export it for goods it does not have CA in producing. A country is said to have CA over another country if it incur lower opportunity cost in performing an activity. Free Trade agreement refers to binding agreement between two or more countries to reduce or remove trade barriers and to facilitate cross border movement of goods and services between territories of the parties. The agreement typically involves reducing import tariffs and relaxing restriction in capital flow. Globalisation refers to the increasing integration of global economies resulting in greater interdependence. It may be defined as an expansion in the volume and variety of cross-border transactions in goods and services and in international capital flow. Protectionism refers to any actions that the government may take to influence market forces to provide an advantage to domestic industries over foreign producers through imposition of trade barriers on foreign goods and services.

International Trade

Basis of Trade (supply side reasons) There are differences in factor endowments in different countries which give rise to differences in factor costs of production and hence different opportunity costs when producing the goods (for instance developing countries such as India have abundant natural resources and cheap labour and in developed countries like Singapore have more capital and highly skilled labour). Countries should specialise in the production of goods they have lower opportunity cost and trade on the basis of the theory on comparative advantage (CA) Some countries will face a lower opportunity cost in the production of certain goods and services relative to other countries. Based on theory of CA, countries should specialise in production of goods they have CA (Developing country producing resource intensive good such as agriculture and developed country producing high value-added good like pharmaceutical products) because it lowers unit cost of production. Countries should import goods they do not have CA in as opportunity cost of production within country is higher. As a result of specialisation, there would be more efficient allocation of resources and a resultant increase in world output for the same amount of resources. The country (for instance Singapore) has a small domestic market. Hence domestic demand is too small for efficient production and therefore firms in the county are unable to enjoy significant Economies of scale (EOS) (which refers to the lowering of average cost of production due to increase in scale of

production). Trading allows the country to produce for a larger market. As a result of the production for exports due to trade, it increases the scale of production and this enable firms in small domestic market to reap EOS. There will be a larger volume of goods for domestic and foreign consumption. Basis of Trade (Demand side reasons) There are needs for product differentiation due to differences in consumers taste and preferences. Product differentiation in the form of perceived differences in quality of goods among different countries may prompt the exchange of goods among countries. Trade would increase level of product differentiation as it gives consumers access to greater volume and variety of goods hence enjoy a higher material standard of living There are differences in consumption pattern in different countries. Price of same good may differ between countries. Price will be lower in country with lower demand for good and it will be in the interest for country with higher demand for good to trade so as to obtain goods at lower price.

International Trade

Why Singapore sign FTAs with countries (China for eg.)? Singapore sign FTAs with diverse countries due to gains of trade arising with theory of comparative advantage (CA). There are differences in factor endowments in different countries which give rise to differences in factor costs of production. China, endowed with low cost labour, have CA in the production of labour intensive good while Singapore, endowed with highly skilled labour and more capital, has CA in production of capital intensive goods like microchips and pharmaceutical products. Both countries should specialise in the production of goods they have comparative advantage in as it lowers unit cost of production and import goods they do not have CA in as opportunity cost of production within country is higher. As a result of specialisation and trade, there would be more efficient allocation of resources and consumers in both countries will be able to enjoy larger volume of goods and enjoy higher material standard of living. FTA which minimise barriers to trade help facilitate the enjoyment even greater volume of goods and services by Singapore. Singapore sign FTA with regional and distant economies to diversify economic reliance on any one particular region. Being a trade-driven economy, Singapore is highly susceptible to external shocks from her trading partners. For example, if US experience an economic downturn, demand for Singapore export will be reduced. This will reduces Singapore net export and aggregate demand (AD) will shift to the left. GDP growth in Singapore will be affected. Having closer economic integration with more distant economies

will reduces Singapores economic reliance on country such as US. In the face of economic downturn, Singapores export demand may still be supported by market like China when our major trading partner faces recession. This helps cushion Singapores economic fluctuation. Singapore sign FTAs with regional and diverse economies to attract greater inflow of foreign direct investment (FDIs). When FTAs are signed with economies with diverse factor endowments, Singapore will be importing intermediate goods at lower prices. Cost of production in Singapore will be lower, improving her international competitiveness. Therefore, multinational companies (MNCs) are more willing to locate their production in Singapore as it could improve their products price competitiveness. This will increase AD and results in actual economic growth and higher employment level. Greater inflow of FDIs brings in more capital equipment helps improve Singapores capital account and increase LRAS contributing to potential growth. This helps Singapore achieve sustained economic growth in the short run and long run.

International Trade

Impact of globalisation to Singapore Globalisation helps increase consumer welfare as consumer can obtain lower priced good because Singapores trading partners are able to produce them more efficiently due to their comparative advantages. Globalisation enables consumers in Singapore to have access to goods Singapore does not produce and thus enjoys greater variety and choices of goods and services. Furthermore, access to larger market allows domestic firms to reap internal EOS due to increase in scale of production. This translates to lower priced goods for consumers. Therefore it will improve material standard of living of Singapore consumers. Globalisation can help Singapore improve balance of payment position and achieve sustained economic growth. Globalisation lead to greater inflow of foreign direct investment (FDIs) which brings in long term capital inflows which improves the capital account. Access to larger market allows Singapore to sell more export. Assuming imports remain unchanged, it will improve Singapores current account. Hence, it will improve Singapores balance of payment position. As net exports increases due to access to larger market, aggregate demand will increase and it leads to a multiple increase in national income, resulting in actual economic growth and higher employment level. Technological transfer from FDIs as well as increase in capital accumulation helps increase productive capacity of Singapore. It increases LRAS contributing to potential growth which helps Singapore achieve sustained economic growth. Globalisation opens Singapore up to many alternative suppliers for its imports and

allows for price stability. Globalisation brings about increase competition among countries and this reduces price of imported goods due to greater level of competition from alternative supplier. This lowers general price level in the economy, lowering imported inflation.

Globalisation can also lead to higher level of structural unemployment in the labour intensive industries in Singapore. This is because Singapore is exposed to greater level of competition from lower cost foreign producer like China and India with abundance of low cost workers. Hence Singapore does not have CA in the labour intensive industries. Workers retrenched in these industries are unable to gain employment in sunrise industries such as knowledge-based industry as they do not have the necessary skills.

Globalisation can also cause Singapore to suffer from greater vulnerability of demand and supply shocks in the world market. As Singapore increasingly specialise in its CA such as pharmaceutical production, it will need to depend on foreign imports to produce their goods and to provide for necessities. Hence if price of imports like oil and food increase, Singapore will suffer from imported inflation. In addition, Singapores reliance on export demand results in increased vulnerability to demand shocks such as 2008 financial recession in USA which dramatically decrease demand for Singapores export and cause a recession in Singapore

International Trade

Globalisation can worsen balance of payment position in Singapore. With increased mobility of short term capital like hot money brought about by advancement in technology can lead to outflow of hot money to countries with better investment prospects and this will worsen the capital account. With increased level of trade, consumer gain access to greater variety of imported goods and services. This may increase import expenditure and if import expenditure increase more quickly than export revenue, this will worsen current account. Globalisation can widen income disparity in Singapore. With increased human capital mobility, firms can source for labour all around the world. There is increase demand for skilled workers and fall in demand for lower skilled workers. This results in an increase in wages or those with relevant skills while the lower skilled workers will have low income. This contributes to widening income gap.

International Trade

Assumption of free trade Constant opportunity cost when a country specialise Faces increasing opportunity cost when producing more quantity of the good as resources use to produce is less suited to production of specialise goods Negates the CA they have Assume immobility of factors of production between countries. Theory of CA is based on these immobile factors of production between countries. This results differences in factor endowments in different countries which give rise to differences in factor costs of production and hence different opportunity costs when producing the goods (for instance developing countries such as India have abundant natural resources and cheap labour and in developed countries like Singapore have more capital and highly skilled labour). Countries should specialise in the production of goods they have lower opportunity cost and trade on the basis of the theory on comparative advantage (CA).

Assume no transport cost Transport cost not taken to consideration when considering free trade. If transport cost is high, it may not be necessarily cheaper to import good it do not have base on theory of CA

Assume no trade restriction like protectionism which reduces benefit of free trade Consumers cannot enjoy the cost saving from reaping EOS due to trade tariffs

Assumes mobility of factors of production within country Immobility of factors of production implies gains from trade are significantly diminished. CA the country has may be displaced by the costs the immobility of factor of production creates (for eg. Bad transport network in China may results high transport cost. Intermediates goods use to produce specialised good within country may incur high cost to country negate CA.

International Trade

Protectionism Protectionism may be justified to protect infant industry. The country may have potential comparative advantage in an infant industry. However, it cannot compete with established foreign industries due to lack of EOS that its rival enjoy. At initial stage of operation, infant industry faces high initial cost of production, unless output is expanded sufficiently to reap EOS and to establish global market share. Therefore, it is necessary to protect infant industry until it can produce as cheaply as foreign rivals until without protection. Automobile industry in Japan and electronics in Taiwan are examples where protection of infant industries was successful. The increase in net export from these industry increase AD, which results in a multiple increase in national income, generating jobs for the countries.

leading to a fall in purchasing power of our trading partners, resulting in fall in demands for domestic exports produced by home country. This fall in demand will lead to firms employing less factors of production. As labour is a derived demand, it will lead to massive unemployment. Protectionism may be implemented by the government to encourage consumption of domestic goods and this helps cushion the fall in demand for domestic exports and help to prevent massive unemployment. Protectionism may be justified to correct persistent balance of payment deficit if the deficit is due to an increasing trade deficit. Persistent balance of payment deficit might result in an increasing foreign debt. If country lacks foreign reserve, it will not be able to manage its economy using exchange rates and be more susceptible to external shock. Furthermore country may have to borrow from International Monetary of Fund to finance its foreign debt which may cause it to lose autonomy in policy making. Persistent balance of payment deficit might also result in the weakening of currency. A fall in the value of the currency is undesirable as it will reduce the countrys ability to import capital goods hindering potential growth. For example, in USA, large amount of tariffs is levied on Chinas goods to reduce the large trade deficit of USA.

Protectionism may be justified to prevent dumping. Dumping is the practice where exports are sold at price below marginal cost of production. If this practice is allowed, cheaper imports will outsell domestic goods and decrease demand for domestic goods. This will cause domestic firm to close down. For example, during economic downturn in India, if China were to adopt the practice of dumping, it will aggravate unemployment problems in India. Protectionism in the form of import tariffs may be imposed to prevent the practice of dumping.

Protectionism may be justified to maintain domestic employment in times of worldwide recession. Worldwide recession means a fall in global income

International Trade

Protectionism may not be justified as it leads to loss of consumer surplus. Protectionism results in higher prices levied on consumers leading to loss of consumer welfare.

Protectionism may breed over-reliance in the industry. Industries that are protected by the government may be reliant on the funds given by the government. As a result they may not be willing to engage in research and development in product and process innovation. This may result in low quality, high prices and limited variety of goods, resulting in wastage of resources.

Domestic demand and domestic supply are represented by D and S. We assume country is too small to affect world price and is a price taker. World Price is at P, Q1 is demanded, Q0 is supplied by domestic producer and thus QoQ1 is imported. If government impose tariffs of PP1, Price of commodity by domestic market is increased to P1. Total consumption decrease to Q3 and Q2Q3 is imported. Imposition of tariffs imposes cost to society. Consumers have to pay higher price and consumer surplus fall from DCP to DCP1. Some part of loss of consumer surplus (PP1AC) is transferred to producer surplus (PP1EG), government tax revenue (EABF). The area EFG and ABC represent welfare loss to society.

Protectionism is not justified as it will lead to loss of gains from specialisation and free trade. Free trade allows country to specialise in what it has comparative advantage in and results in more efficient allocation of resources. Free trade also allows EOS to be exploited, leading to greater cost savings. Protectionism lowers efficiency as country produce goods it do not have comparative advantage in and may not operate on a scale that fully exploit EOS. Therefore, consumers in this society face higher prices and limited variety of goods and services.

Protectionism is not justified as it can lead to trade war among countries, with each of them cutting back on imports. As exporting countries will experience fall in income and employment, their purchasing power declines and their ability to import will diminish. This would mean a fall in export revenue for country imposing tariffs. It denies countries of the benefits of free trade.