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2.6.2 Trade Did you know 10 multinational corporations control nearly everything you buy? Can you name them? AQA 2.6 T HE INTERNATIONAL ECONOMY 2.6.2 W HAT YOU NEED TO KNOW The model of comparative advantage A simple numerical example to illustrate the principle of comparative advantage and the associated benefits of trade The distinction between comparative and absolute advantage The model shows that specialisation and trade can increase total output Other economic benefits of trade, such as the ability to exploit economies of scale and increased competition The costs of international trade The reasons for changes in the pattern of trade between the UK and the rest of the world The nature of protectionist policies, such as: tariffs, quotas and export subsidies How to illustrate the effects of imposing a tariff on imports The causes and consequences of countries adopting protectionist policies The main features of a customs union The main characteristics of the Single European Market (SEM) The consequences for the UK of its membership of the European Union (EU) The arguments for and against the UK’s membership of the EU The role of the World Trade Organisation (WTO) A BSOLUTE A DVANTAGE Absolute advantage is a situation where a country can produce a good or service using fewer resources than that of another country. In other words, it can produce more of that good or service more cheaply. This is best illustrated with an example: Imagine two countries who only produce two goods – cars and bicycles Assume they split their resources equally between cars and bicycles Cars Bicycles Country A 6,000 3,600 Country B 5,000 1,000 TOTAL OUTPUT 11,000 4,600 Country A has an absolute advantage in the production of both cars and bicycles C OMPARATIVE A DVANTAGE Economist David Ricardo noted however that it was possible for a country not to have an absolute advantage in the production of a good, but through specialisation could gain from international trade if they had a lower opportunity cost Comparative advantage is therefore where a country can produce a good at a lower opportunity cost than that of another Using the previous example, we can calculate the opportunity cost of each country’s production in terms of cars and bicycles Cars Bicycles Opportunity Cost Country A 6,000 3,600 1 car = 0.6 bicycles 1 bicycle = 1.7 cars Country B 5,000 1,000 1 car = 0.2 bicycles 1 bicycle = 5 cars TOTAL OUTPUT 11,000 4,600 Even though Country A is better at producing both goods, it is 1.2 times better than Country B at producing cars, but 3.6 times better at producing bicycles Or put another way, if Country A wants to produce 1 extra bicycle, it must forego 1.7 cars, whereas Country B would need to forego 5 cars for the same decision C OMPARATIVE A DVANTAGE So, Country A has a comparative advantage in the production of bicycles and Country B has a comparative advantage in the production of cars. Therefore, it makes sense for Country A to specialise in the production of bicycles, whilst Country B specialises in the production of cars Lets assume that due to its low production of bicycles, Country B decides to put all its resources into cars. However, Country A decides to mainly specialise in bicycles, but still maintain 25% of its total production capacity in cars. So it halves car production and puts this into the production of bicycles. Cars Bicycles *Calculation Country A 3,000 5,400* 3,600 + (3,000 x 0.6) Country B 10,000* 0 5,000 + (1,000 x 5) TOTAL OUTPUT 13,000 5,400 As a consequence, total output of cars has increased from 11,000 to 13,000 and the output of bicycles has increased from 4,600 to 5,400, which demonstrates an improvement in economic welfare for all Thus, we can see that whilst Country B has the ability to produce bicycles, it makes little sense in doing so because the opportunity cost in terms of cars is so high, therefore Country B should import bicycles from Country A using profits generated from its sale of cars to Country A B ENEFITS OF TRADE Increased overall global output As a result of comparative advantage Greater competition How important is trading to the UK car market and the UK economy? Trade opens international borders, promoting a greater degree of competition Employment opportunities Export industries create employment through the expansion of aggregate demand Encouragement of specialisation, leading to greater efficiency If a country is to trade effectively it needs to specialise in order to compete, which drives down costs and unit prices Improved quality of goods and services Via increased competition and dynamic efficiency, the overall quality of goods and services can be enhanced H OW IMPORTANT IS TRADE TO THE UK? C OSTS OF TRADE Over-specialisation If a country aims to engage in trade, it will need to specialise, however if world demand falls, this can give an economy significant problems Structural unemployment Over-specialisation may create structural unemployment, which may be magnified in particular regions in the UK Infant industries Some countries are concerned that infant and new industries struggle to compete with MNCs, thus creating local problems and limited employment opportunities as firms struggle to establish themselves Dumping Countries that enjoy significant absolute advantages in the production of certain goods, often agricultural, may sell their surpluses at very low prices, and drive local producers out of the market Environmental concerns The process of transporting large quantities of goods around the world is costly and uses up significant quantities of scarce resources PATTERNS Trading blocs in numbers. OF T RADE Whilst international trade has in general terms increased, around 730% over the last 30 years, the pattern of trade has altered significantly. The most significant changes have been: The growth of trading blocs The formation and growth of trading blocs such as the EU and NAFTA which encourage greater free trade amongst members, whilst discouraging trade outside the bloc, has led to significant trade creation across the globe The majority of leading economic nations operate within a trading bloc and have several agreements with other nations Emergence of Middle Income Countries (MIC’s) Countries such as India and China have become significant global players in terms of all aspects of trade The collapse of communism in Russia and other Eastern bloc states has opened up global markets significantly PATTERNS OF T RADE Deindustrialisation The future of UK exports. Traditional western nations, including the UK, have seen a period of deindustrialisation occur as comparative advantage in the production of many goods has shifted to China, India and the Far East However, this has been replaced with growth in the provision of financial services and other tertiary markets The UK now experiences a deficit on the balance of payments current account in terms of goods, but a surplus in terms of services Strictly Come Dancing's format has been sold to 43 countries but what does Britain’s biggest cultural export tell the world? P ROTECTIONIST P OLICIES Policies designed to protect domestic industries. India faces criticism for blocking global trade deal, but is it justified? Tariffs Taxes placed on imported goods that are not applied to domestic goods Quotas A physical limit on the volume of imports entering a country For example, Thailand has imposed a quota of 54,440 tonnes of corn on China Embargoes A total ban on imported products For example, the USA has had an embargo on products from Cuba since 1959 The UK has imposed embargos on Syrian oil exports as a political measure Subsidies Government payments to domestic firms to help reduce production costs and improve competitiveness Administrative barriers Countries might employ measures such as complex legal forms, health and safety inspections and specific product specifications to discourage imports by raising costs P ROTECTIONIST P OLICIES : TARIFFS Price Domestic Supply Problems of Tariffs: Consumers face a higher price of P1 and consumer surplus falls by A+B+C+D indicating a fall in overall welfare. P1 A B C World Price + Tariff D P World Price Q1 Q2 Q3 Q4 Quantity Before the tariff is imposed domestic supply is Q1 and domestic demand Q4, but after the tariff, domestic supply extends to Q2, whilst demand contracts to Q3, so imports have been reduced from Q1-Q4 to Q2-Q3. Area C is the revenue gained from the tariff, which may invite retaliation from other countries. Areas B and D represent a net loss to society, as they are not collected by any economic agent in the process. C AUSES AND C ONSEQUENCES OF P ROTECTIONIST P OLICIES We have seen that through comparative advantage and empirical data, there are strong economic reasons for international trade to occur. However, developed and developing nations may benefit in different ways, or not at all. As a result, there are a number of arguments that might justify the implementation of protectionist measures. These include: Infant industries Young industries are unlikely to be able to compete against established MNCs in developed countries, thus require protection, at least in the short term To prevent ‘dumping’ Over-production in developed countries may be released into markets of developing nations, which undercuts domestic prices and domestic producers may be forced to leave the market Domestic employment Protectionist measures might help to protect domestic jobs if infant industries are allowed to grow or local firms aren’t undercut by MNCs from developed countries C AUSES AND C ONSEQUENCES OF P ROTECTIONIST P OLICIES Externalities Some goods, such as illegal drugs and weapons may be considered to have significant harmful effects on society, and should be blocked from domestic markets Balance of Payments Placing restrictions on imports may help to reduce a balance of payments deficit on current account D ISCUSSION /D EBATE What are the necessary conditions for free trade? Is protectionism ever justified? Support your answer with the articles below and your own research into current political opinion. Margaret Thatcher’s view of protectionism. Is this still a valid political argument today? What are Donald Trump’s views? Does it depend on the economic climate? C USTOMS U NIONS What’s the difference between a single market and a free trade agreement? A customs union has the following core features: 1. A common set of import duty rates applied on goods from third countries i.e. a Common External Tariff (CET) 2. Duty-free and quota-free movement of tradable goods among members 3. Common safety measures for regulating the importation of goods from third parties e.g. food standards 4. A common trade policy that guides the trading relationships with third countries/trading blocs outside the Customs Union The EU is the biggest customs union in the world Each member of the customs union cannot pursue their own international trade policy. Instead, trade negotiations are conducted on behalf of all member states, unlike a free trade area where each member is allowed to set their own tariffs against non-members T HE S INGLE E UROPEAN M ARKET (SEM) It is important to differentiate a customs union from the Single European Market (SEM) In addition to having no internal trade barriers and a common external tariff, the SEM also involves the free movement of goods, services, capital and labour which promotes deeper economic integration and market liberalisation SEM Fact 1: The SEM has a 23% share of global GDP SEM Fact 2: It is estimated that the SEM has boosted GDP by around 2-3% for its members SEM Fact 3: Around 3% of the EU labour force work in a different member state SEM Fact 4: In 2015, exports to the SEM accounted for 44% of all trade T HE U K AND THE E UROPEA N U NION (EU ) The Single market has 28 member states and is a major world trading power. As an economic force, it is larger than the USA. The UK voted to leave in 2016. Advantages Disadvantages Trade creation Trade is encouraged within member states because there are no barriers, so additional trade is created within the bloc. Trade diversion The existence of the common external tariff, diverts trade away from the EU. Goods within the SEM may be more expensive, and this could damage consumer welfare. Competition Stronger competitive forces within the SEM can drive productive and dynamic efficiency, which will benefit consumers. Monopolies In some markets e.g. gas and electricity, tariffs have seen significant merger activity and the creation of large monopolies seeking to exploit the available economies of scale. Access to markets The SEM creates a market of 28 countries and a population of over 500m, offering significant scope for businesses to expand. Unemployment In some countries, workers may lose their jobs as production is transferred to member states with lower labour costs. Freedom of movement There is the right to live and work anywhere within the SEM without restriction which boosts labour mobility. Cost Membership of the SEM costs the UK around £15b per year. B REXIT The specification requires you to be able to analyse the consequences for the UK of its membership of the EU, so by definition, you should also consider the consequences of Brexit. A referendum was held on Thursday 23 June 2016, to decide whether the UK should leave or remain in the European Union Leave won by 52% to 48% The referendum turnout was 71.8%, with more than 30 million people voting However, the UK will remain a member of the EU until Article 50 of the Lisbon Treaty is invoked, which gives the UK and the EU two years to agree the terms of the split There remains a great deal of uncertainty as to how the full process will work because the decision by a member country to leave the EU is unprecedented In the interim however, any EU law still stands in the UK and the UK will continue to abide by all previously established treaties and agreements, but it will not take part in any current decision making T HE W ORLD T RADE O RGANISATION (WTO) The WTO’s mission statement: “The WTO is the international organisation whose primary purpose is to open trade for the benefit of all.” WTO’s $1trn deal in 2013. Progress towards complete trade liberalisation has increased in recent years. One of the main organisations involved in this has been the World Trade Organisation. Established in 1995, its purpose is to promote free trade by persuading countries to abolish import tariffs and other barriers The WTO is the only international agency overseeing the rules of international trade It polices free trade agreements and settles trade disputes between governments and organises trade negotiations WTO decisions are absolute and every member must abide by its rulings There are currently 160 members Most Favoured Nation (MFN) status is required for all members providing trade advantages such as reduced tariffs R ESEARCH TASK Whilst the WTO has made progress towards complete free trade, it has been criticised for favouring western developed nations. Find out some examples of current trading disputes between nations and what role the WTO is currently playing. Do you think the WTO is successful in meeting the aims of its mission statement?