FE T10

Fundamental Reasons for International Trade

• Criteria for Trade Necessity: Countries engage in international trade for several fundamental reasons:

  • Domestic Production Constraints: They cannot produce a specific product within their own borders.

  • Consumer Variety: To provide a broader selection of goods to domestic consumers.

  • Efficiency and Quality: Even if domestic production is possible, if another country specializes in that item, purchasing it may lead to higher quality and a lower price.

  • Resource Conservation: The desire to conserve limited domestic resources.

  • Comparative Advantage: Utilizing the advantages held by other nations.

• The Role of Resource Distribution:

  • The factors of production are not distributed evenly across the globe.

  • Human Capital: This is often more skilled in nations that possess higher literacy rates.

  • Physical Capital: Capital depth varies by nation, manifesting in better machinery and superior infrastructure.

  • Specialization: The unequal distribution of resources encourages nations to specialize. While some countries could potentially be self-sufficient, specialization is economically advantageous.

Core Principles of Trade Advantage

• Absolute Advantage: This is defined as "the advantage in the production of a good enjoyed by one country over another when it uses fewer resources to produce that good than the other country does."

  • Natural Endowments: Absolute advantage often results from a country’s natural resources.

  • Examples:

    • Saudi Arabia has an absolute advantage in oil.

    • Colombia has an absolute advantage in coffee.

    • Thailand has an absolute advantage in rice.

    • Canada vs. Argentina: If Canada produces $100$ pounds of beef using two ranchers, and Argentina requires three ranchers for the same output, Canada holds the absolute advantage.

• Comparative Advantage: This is defined as "the advantage in the production of a good enjoyed by one country over another when that good can be produced at lower opportunity cost in terms of other goods than it could be in the other country."

  • United States vs. China: China’s comparative advantage lies in cheap labor, allowing the production of simple consumer goods at a much lower opportunity cost. The United States’ comparative advantage lies in specialized, capital-intensive labor.

Case Study: Absolute Advantage in Malaysia and Thailand (Autarky)

• Situation Before Trade (Autarky): Both countries allocate resources between agricultural and industrial products.

  • Malaysia:

    • Agricultural Inputs: $40$ million units. Output per unit: $5$. Total: $200$ million.

    • Industrial Inputs: $20$ million units. Output per unit: $10$. Total: $200$ million.

  • Thailand:

    • Agricultural Inputs: $40$ million units. Output per unit: $15$. Total: $600$ million.

    • Industrial Inputs: $20$ million units. Output per unit: $5$. Total: $100$ million.

• Identification of Advantage:

  • Malaysia: Enjoys an absolute advantage in industrial products because it produces $10$ units per input compared to Thailand’s $5$.

  • Thailand: Enjoys an absolute advantage in agricultural products because it produces $15$ units per input compared to Malaysia’s $5$.

Case Study: Specialization and the Terms of Trade

• Specialization Strategy: Each country should specialize in the product where they enjoy an absolute advantage.

  • Malaysia specializes entirely in Industrial products.

  • Thailand specializes entirely in Agricultural products.

• Production Totals Post-Specialization:

  • Malaysia Industrial Production: $60 \text{ million inputs} \times 10 = 600 \text{ million units}$.

  • Thailand Agricultural Production: $60 \text{ million inputs} \times 15 = 900 \text{ million units}$.

• Terms of Trade (Price): The agreed price is $1$ unit of agricultural product for $1$ unit of industrial product.

• Trade Reciprocity Example:

  • Malaysia wishes to consume $200$ million units of agricultural products.

  • Malaysia imports $200$ million agricultural units from Thailand.

  • In exchange, Malaysia exports $200$ million industrial units to Thailand.

• Final Consumption Comparison:

  • Malaysia: Consumes $200$ million units of agriculture and $400$ million units of industry ($600 - 200$).

  • Thailand: Consumes $700$ million units of agriculture ($900 - 200$) and $200$ million units of industry.

  • Outcome: Both countries consume more of both products than they did in autarky, and total global production increases.

Calculating Opportunity Cost and Comparative Advantage

• Formula Logic: The opportunity cost of product A is the amount of product B given up per unit of A produced.

• Malaysia Opportunity Costs:

  • One additional unit of Agricultural products = $\frac{10}{5} = 2.00$ units of industry.

  • One additional unit of Industrial products = $\frac{5}{10} = 0.50$ units of agriculture.

• Thailand Opportunity Costs:

  • One additional unit of Agricultural products = $\frac{5}{15} = 0.33$ units of industry.

  • One additional unit of Industrial products = $\frac{15}{5} = 3.00$ units of agriculture.

• Comparative Advantage Conclusion:

  • Thailand has the comparative advantage in Agricultural products (0.33 < 2.00).

  • Malaysia has the comparative advantage in Industrial products (0.50 < 3.00).

Restrictions to Free Trade

• Tariff Barriers: A tariff is a tax imposed on exported or imported goods. Reasons for imposition include:

  • Reducing consumption of products with negative externalities.

  • Generating government revenue (significant for smaller countries).

  • Reducing imports to fix a trade balance deficit.

• Categories of Tariffs:

  • Specific Tariff: A fixed monetary charge imposed on each unit of an imported product.

  • Ad-Valorem Tariff: A tax calculated as a percentage of the total value of the imported products.

• Non-Tariff Barriers:

  • Import Quota: Government-imposed limits on the quantity of a specific good that can be imported.

  • Quota Rent: Unlike tariffs, quotas do not automatically generate government revenue. However, the government may charge fees (rent) to companies for the right to import.

  • Export Quota / VER: Voluntary Export Restraints are negotiated limits on exports agreed upon by both the exporting and importing nations to stabilize markets.

  • Subsidies:

    • Export Subsidy: Financial aid that allows exporters to sell at lower prices. This is often viewed as "dumping" by importing nations.

    • Import Subsidy: Given for essential products that are not produced sufficiently within the domestic market.

Balance of Payments (BOP)

• Definition: The Balance of Payments is a record of a country’s transactions in goods, services, and assets with the rest of the world. It tracks sources (supply) and uses (demand) of foreign exchange.

  • Credits: Funds entering the country.

  • Deductions: Funds leaving the country.

• The Three Components of BOP:

  1. Current Account: The sum of net exports ($X - M$), net income from investments abroad, and net transfer payments.

     • Trade Deficit: Imports > Exports.

     • Trade Surplus: Exports > Imports.

  2. Financial Account: Records monetary movements including direct investment, portfolio investment, and financial derivatives.

  3. Capital Account: Usually the smallest component. Records intangible goods (trademarks, copyrights), debt forgiveness, and assets taken by migrants.

• Economic Implications of BOP Status:

  • BOP Deficit: Must borrow from other countries. Fuels short-term growth but leads to long-term debt to pay for consumption.

  • BOP Surplus: Provides enough capital for domestic production. Boosts short-term growth but risks dependency on export-driven demand in the long run.

Analysis of Malaysia’s Balance of Payments (2005–2013)

• Current Account: Malaysia maintained a Current Account surplus throughout the period 2005–2013.

• Financial Account: Typically exhibits a reverse trend to the current account to support it. It was in deficit for the entire period except for $2011$.

• Deficit Drivers: The primary factor contributing to the financial account deficit was direct investment in assets.

• Overall Balance: Registered a positive value in most years, excluding $2008$ and $2010$, resulting in a strengthened reserve position for the nation.

Exchange Rates and Systems

• Definition: The price of one country's currency in terms of another. It represents the ratio at which two currencies are traded.

  • Example: If the rate is $RM3$ per US$1, a laptop costing US$1,500 requires a Malaysian to exchange $RM4,500$.

• Exchange Rate Systems:

  1. Fixed Exchange Rate: Governments set a specific rate. Pegging one currency to another is a primary example.

  2. Managed Floating: The currency floats within a pre-determined range. The government intervenes (buying/selling domestic/foreign currency) if the rate moves outside the boundaries.

  3. Floating Exchange Rate: Determined solely by market forces of supply and demand without government intervention. Equilibrium occurs where quantity demanded equals quantity supplied.

• Market Mechanics:

  • If the supply of a currency (e.g., British Pound) increases and demand decreases, the equilibrium exchange rate falls.

  • This causes the pound to depreciate and the other currency (e.g., US Dollar) to appreciate.

Factors Influencing Currency Demand and Supply

• Demand for Pounds (Supply of Dollars):

  • Entities importing British goods into the US.

  • US citizens traveling in Great Britain.

  • Investors wanting to buy British stocks, bonds, or financial instruments.

  • US companies planning to invest in Great Britain.

  • Speculators anticipating a decline in the Dollar’s value.

• Supply of Pounds (Demand for Dollars):

  • Entities importing US goods into Great Britain.

  • British citizens traveling in the US.

  • Investors wanting to buy US financial instruments.

  • British companies planning to invest in the US.

  • Speculators anticipating a rise in the Dollar’s value.

Appreciation vs. Depreciation

• Currency Appreciation (Strengthening):

  • An increase in the value of one currency relative to another in a floating system.

  • Factors: Government policy, higher interest rates, trade surpluses, and business cycles.

• Currency Depreciation (Weakening):

  • A fall in the value of a currency in a floating system.

  • Factors: Economic fundamentals, interest rate differentials, political instability, and investor risk aversion.

Impacts of Exchange Rate Movements

• On Exports: If the Ringgit Malaysia (RM) depreciates, Malaysian goods become cheaper for foreigners, likely increasing exports.

• On Imports: If the RM depreciates, imported goods become more expensive, leading domestic buyers to substitute them with local goods.

• Macroeconomic Effect: When exports increase and imports decrease, aggregate expenditure rises, leading to an increase in GDP.

• Beneficiaries: The export sector and businesses that earn revenue in foreign currency but have costs in domestic currency.

• Losers: The import sector.

Questions & Discussion

• Scenario 1: If the exchange rate in terms of US dollars per unit of euros increases, which currency weakened?

  • Response: US dollars.

• Scenario 2: If the Australian dollar weakens against the Canadian dollar, did the exchange rate increase or decrease in terms of Australian dollars per unit of Canadian dollars?

  • Response: Increase.

• Scenario 3: If the exchange rate in terms of yen per unit of the Mexican pesos decreases, which currency weakened?

  • Response: Mexican pesos.

• Scenario 4: If the British pound (£) appreciates against the US dollar, did the exchange rate increase or decrease in terms of pounds per unit of US dollars?

  • Response: Decrease.

Exercise: Production Output Analysis

• Data Table:

  • Country A: Wheat = $30$ units, Corn = $15$ units.

  • Country B: Wheat = $5$ units, Corn = $10$ units.

• Absolute Advantage Analysis:

  • Country A has the absolute advantage in Wheat (30 > 5).

  • Country A has the absolute advantage in Corn (15 > 10).

• Opportunity Cost and Comparative Advantage Analysis:

  • For Country A, the opportunity cost of $1$ unit of corn is $2$ units of wheat ($\frac{30}{15}$).

  • For Country B, the opportunity cost of $1$ unit of corn is $0.5$ units of wheat ($\frac{5}{10}$).

  • Country B has the comparative advantage in producing corn.

  • For Country A, the opportunity cost of $1$ unit of wheat is $0.5$ units of corn ($\frac{15}{30}$).

  • For Country B, the opportunity cost of $1$ unit of wheat is $2$ units of corn ($\frac{10}{5}$).

  • Country A has the comparative advantage in producing wheat.

Reasons for Trade:

Countries trade for several basic reasons:

• Limited Production: They can't make everything at home.

• Consumer Choice: To offer more options to buyers.

• Efficiency & Quality: Buying from a country that makes something better and cheaper.

• Resource Saving: To save their own limited resources.

• Comparative Advantage: To benefit from what others do best.

Resource Distribution:

Resources are not equally spread worldwide:

• Human Capital: Skills vary; more skilled workers in countries with higher literacy.

• Physical Capital: Infrastructure and machinery are better in some nations.

• Specialization: Countries focus on what they do best, even if they could be self-sufficient.

Trade Advantages:

• Absolute Advantage: A country can produce something using fewer resources.      Formula: None needed, based on resource comparison.      Example: Saudi Arabia with oil; Canada with beef.

• Comparative Advantage: A country can produce a good at a lower opportunity cost.
  Formula: Opportunity Cost = What is given up / What is gained.      Example: China with cheap labor for basic goods; the U.S. for specialized items.

Case Study:

• Malaysia & Thailand: Specialization helps each country produce more than without trade.

• Production After Specialization: Malaysia focuses on Industry; Thailand on Agriculture.

• Exchange Benefits: Both countries gain more products post-trade than in isolation.

Opportunity Cost Calculation:

• Malaysia's Cost:

  • 1 unit of Agriculture = 2 units of Industry lost.

  • 1 unit of Industry = 0.5 units of Agriculture lost.

• Thailand's Cost:

  • 1 unit of Agriculture = 0.33 units of Industry lost.

  • 1 unit of Industry = 3 units of Agriculture lost.

Conclusion: Thailand has a comparative advantage in Agriculture, Malaysia in Industry.

Trade Restrictions:

• Tariffs: Taxes on imports/exports to manage trade.

• Non-Tariff Barriers: Quotas, subsidies, and export limits to control trade volume.

Balance of Payments (BOP):

• Records all economic transactions between countries.

Exchange Rates:

• How much one currency is worth in terms of another.

• Formula: Exchange Rate = Value of Currency A / Value of Currency B.

• Can be fixed or floating based on market forces.

• Influences imports/exports directly.

Currency Value Changes:

• Appreciation: Currency gains value.

• Depreciation: Currency loses value.

Impact on Economy:

• Stronger currency may reduce exports; weaker values boost exports.