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Personal, Social and Humanities Education Section
Curriculum Development Institute
Education Bureau 2015
Background
This resources pack is published to support the learning and teaching of Topic J in the
Economics Curriculum. The relevant contents and concepts in Topic J, including the principle
of comparative advantage, trade barriers, balance of payment account and exchange rate,
etc., are briefly explained in this resources pack. Authentic data are also used to help students
to understand the Hong Kong’s comparative advantage, trade pattern and the importance of
trade to Hong Kong, etc. Other than the contents mentioned above, this resources pack also
provides supplementary information of the updates in concepts, definitions and compilation
methods of relevant contents by the Census and Statistics Department in 2012.
It is our honour to have Dr. Kwong Che-leung, Charles to develop this resource pack for the
Education Bureau. He is very familiar with the Senior Secondary Economics Curriculum and
experienced in developing relevant teaching materials.
This resources pack was uploaded to the website of the Education Bureau (http://www.edb.
gov.hk) for teachers’ reference. If you have any comments and suggestions on this pack,
please send them to:
Chief Curriculum Development Officer
(Personal, Social and Humanities Education)
Curriculum Development Institute
Education Bureau
13/F., Wu Chung House
213 Queen’s Road East
Wanchai, Hong Kong
Fax: 2573 5299
E-mail: [email protected]
International Trade and Finance
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Topic J International Trade and Finance
Contents
Background .................................................................................................... 1
Content
Learning Outcomes .......................................................................................... 4
1. Introduction.................................................................................................. 5
2. Why do countries trade: Absolute Advantage, Comparative Advantage
and Gains from Trade.................................................................................. 5
2.1 Absolute Advantage, Comparative Advantage and Specialization ....... 5
2.2 Terms of Trade and Gains from Trade .................................................. 8
3. Pattern of Trade in Hong Kong................................................................. 10
4. Importance of Trade to Hong Kong Economy........................................ 14
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5. Trade Barriers............................................................................................ 15
5.1 Types of Trade Barriers........................................................................ 15
5.2 Effects of Tariff and Quota on Price and Output for
a Small Open Economy........................................................................ 16
5.3 Trade Barrier Faced by Hong Kong...................................................... 22
5.4 Hong Kong’s Attempt to Overcome Trade Barriers............................... 22
6. Brief Introduction to the Balance of Payment Account.......................... 23
7. Exchange Rate............................................................................................ 26
7.1 Meaning of Exchange Rate ................................................................. 26
7.2 Effect of a Change in the Exchange Rate on Import Price
and Export Price .................................................................................. 26
7.3 Linked Exchange Rate in Hong Kong: A Brief Introduction ................. 28
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Topic J International Trade and Finance
Topic J
International Trade and Finance
Learning Outcomes
After completing this topic, you should be able to:
Explain the concepts of absolute advantage, comparative advantage and the gains from
trade.
Illustrate the principle of comparative advantage by examining the trade pattern of Hong
Kong.
Discuss the importance of trade to Hong Kong economy.
Explain the effects of trade barriers on price and output for a small open economy.
Discuss how Hong Kong attempts to overcome trade barriers.
Explain briefly the main components of the balance of payments account.
Define the meaning of exchange rate and how exchange rate affects import and export
prices.
Outline the main features of the linked exchange rate system in Hong Kong.
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1Introduction
The volume of global trade has been increasing for the past decades. The average annual
growth of global trade reaches about 6% during the period of 1990-2008. Though a negative
growth rate of 12%, mainly caused by the adverse effect of 2008 global financial crisis, was
recorded in 2009, global trade demonstrated a strong rebound of 13.9% in 2010. A positive
growth of 5% is maintained in 2011.1
In this unit, it seeks to explain why countries trade by using the concept of absolute and
comparative advantage. It will then examine the pattern and importance of trade to the
Hong Kong economy and discuss the trade barriers facing Hong Kong. After that, the
main components of balance of payments account will be introduced briefly. It will then be
followed by the discussion of exchange rate and how it affects the prices of imports and
exports. Before ending the unit, the main features of the linked exchange rate will be briefly
discussed.
2
Why do countries trade: Absolute Advantage,
Comparative Advantage and Gains from Trade
2.1 Absolute Advantage, Comparative Advantage and Specialization
Nations, like individuals, are not equally good at producing all kinds of goods because
countries are endowed with different natural resources and equipped with different production
skills and technology. It is not difficult to deduce that a country can specialize in what it could
do best and obtain its other needs through exchange. By doing so, all countries participating
in trade will benefit. If trade does not benefit the participating countries, they will not engage
in trade. In this section, we will use the concepts of absolute and comparative advantage to
illustrate how countries gain from trade.
Data from World Trade Organization (http://www.wto.org/english/news_e/pres12_e/pr658_e.htm#appendixchart2 accessed on 17 July 2012)
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Topic J International Trade and Finance
A country is said to have an absolute advantage over another in the production of
good X if it can use the same amount of resources to produce more X than the other country.
A country is said to have a comparative advantage over another in the production of good
X if it can produce one unit of X at a lower opportunity cost (i.e. the highest-valued good(s)
forgone). We can illustrate these concepts by using a simple two-country model.
Suppose there are two countries: Country A and B. Each country has 10 units of
resources. Their output per unit of resources are as follows:
Table 1 Production Conditions: Amount of Output Produced by One Unit of Resources
比較優勢
Country
Output per unit of resource
A
60 units of wheat
or 20 units of textiles
or
B
20 units of wheat
or 10 units of textiles
or
Table 1 shows that Country A has the absolute advantage in producing wheat and textile
as it can produce more of both goods in Country A than it does in Country B with the same
amount of resource. Or we can say that with one unit of resources, Country A can produce
more wheat or textiles than Country B does. Common sense may suggest that Country A
is more efficient in the production of both products and it can produce both products for
consumption. Country A needs not open up for trade as exchange with Country B will not
bring it additional benefits. However, we do observe mutually beneficial trade takes place
among countries though some countries, such as the US, have absolute advantages over
other countries, such as India, in producing most of the products.
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The clue to the seemingly paradox depicted above lies in the concept of comparative
advantage. We have two ways to understand the concept.
First, a vertical comparison of the figures in Table 1 shows that the degree of Country
A’s advantage over Country B in wheat is 3 to 1 (i.e. 60/20) while the advantage in textile is
only 2 to 1 (20/10). Comparatively, Country A has a greater advantage in producing wheat
and a lesser advantage in producing textile. Viewing the same situation from Country B’s
angle, Country B has absolute disadvantage in producing both goods, but the extent of
disadvantage is greater in wheat and lesser in textile. Therefore, as we are merely comparing
the comparative advantage, not absolute advantage, in producing the two goods, we can
observe that Country A has comparative advantage in the production of wheat and Country
B has comparative advantage in the production of textile.
Second, we can illustrate the same concept by looking at the opportunity costs of
producing wheat and textile in Country A and B. From Table 1, we can calculate that Country
A must give up 3 units of wheat in order to obtain 1 unit of textile. Then the opportunity
cost (sometimes called the “resource cost”) of producing 1 unit of textile is equal to 3 units
of wheat foregone. By the same reasoning, Country A must give up 1/3 unit of textile to
produce 1 unit of wheat. Then the opportunity cost of producing 1 unit of wheat is 1/3 unit
of textile foregone. The same analysis can be applied to Country B. The opportunity cost of
producing wheat and textile in Country A and B is shown in table 2.
Table 2 Opportunity Cost of Producing Wheat and Textile
Country
Opportunity Cost of Producing
1 unit of wheat
1 unit of textile
A
1/3 unit of textile
3 units of wheat
B
1/2 unit of textile
2 units of wheat
Table 2 shows that Country A incurs lower opportunity cost in producing wheat while
Country B incur lower opportunity cost in producing textile. We say that Country A is
comparatively more efficient (or has comparative advantage) in the production of wheat
while Country B is comparatively more efficient (or has comparative advantage) in the
production of textile.
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Topic J International Trade and Finance
2.2 Terms of Trade and Gains from Trade
Up to here, an important question is left unanswered: how can we infer that a country
specializing in the production with comparative advantage and trading with others will gain
from trade? To answer this question, we can introduce the concept of terms of trade, which
are determined by the ratio of a country’s export price to its import price. That means it
indicates how many units of import can be exchanged for one unit of export.
Suppose both Country A and Country B agree the terms of trade of 2.5 units of wheat for
1 unit of textile. Will both countries gain from trade? Absolutely yes! To see why, without
trade, Country A must give up 3 units of wheat to obtain 1 unit of textile. But now if Country
A imports 1 unit of textile from Country B, it gives up only 2.5 units of wheat. Country A gains
0.5 units of wheat for each unit of textile purchased abroad.
Then, how about Country B? Country B is also willing to accept the exchange under the
existing terms of trade. Country B’s opportunity cost of producing 1 unit of textile is 2 units of
wheat foregone. But now if Country B exports 1 unit of textile to Country A, it gets 2.5 units
of wheat. Country B gains 0.5 units of wheat for each unit of textile sold abroad.
The above example illustrates how both countries can gain from specialization and
trade. However, to realise the gains from trade, one general rule must be followed: For both
trade partners to gain from trade, the terms of trade must lie between the opportunity
costs of the two countries. In our example, Country A is not willing to buy textile from
Country B if the terms of trade is 3.5 units of wheat for 1 unit of textile since Country A would
rather produce it at home at lower resource cost. Put it concretely, Country A is willing to
purchase 1 unit of textile for anything less than 3 unit of wheat while Country B is willing to
sell 1 unit of textile for anything more than 2 units of wheat. Mutually beneficial trade can
take place anywhere between these limits, when transaction cost is zero.
The terms of trade can be 2.5 units of wheat for 1 unit of textile
2.5 units of wheat= 1unit of textile
For both trade partners to gain from trade, the terms of trade
must lie between the opportunity costs of the two countries.
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We have noticed how Country A gains from purchasing 1 unit of textile from Country
B and how Country B gains from selling 1 unit of textile to Country A. Then, how about the
total gains from trade under the prevailing terms of trade that is 2.5 units of wheat for 1 unit
of textile? Let’s see how to calculate the total gain from trade.
Country A has comparative advantage in the production of wheat and therefore, it specialises
in producing wheat. Suppose it spent all its 10 units of resources to produce wheat. It can
produce a maximum of 600 units (60 x 10) of wheat. Similarly, Country B has comparative
advantage in the production of textile and therefore, it specializes in producing textile.
Suppose it spends all its 10 units of resources to produce textiles. It can produce a maximum
of 100 units (10 x 10) of textiles.
With trade, Suppose Country A retains 400 units of wheat for its own consumption
and exports 200 units of wheat to Country B in exchange for 80 units of textiles (200/2.5).
Likewise, Country B retains 20 units of textiles for consumption and exports 80 units of
textiles in exchange for 200 units of wheat (80 x 2.5). Without trade, Country A can convert
the 200 units of wheat into 662/3 units of textiles (200/3). The total output available for
consumption for Country A will be 400 units of wheat and 662/3 units of textiles. Similarly,
Country B can convert 80 units of textiles into 160 units of wheat (80 x 2). Country B will
then have a total consumption of 20 units of textiles and 160 units of wheat, when there is no
trade. The outcomes with and without trade are summarised in Table 3. It demonstrates that
both Country A and B gains from trade if they specialise in the production with comparative
advantage and exchange the outputs with other country.
Table 3 Gains from Trade
Country A
Country B
Production after specialisation
600 units of wheat
100 units of textiles
Consumption with trade
400 units of wheat
80 units of textiles
200 units of wheat
20 units of textiles
Consumption without trade
400 units of wheat
662/3 units of textiles
160 units of wheat
20 units of textiles
Total gains from trade
131/3units of textiles
40 units of wheat
2.3 Some Remarks
Trade takes place on the basis of comparative advantage, not absolute advantage.
To realise the gains from trade, a country should specialize in the production with
comparative advantage and exchange the output with others
To make trade mutually beneficial, the terms of trade must lies between the opportunity
costs of the two countries.
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Topic J International Trade and Finance
3
Pattern of Trade in Hong Kong
Hong Kong has always been an export-oriented economy. Hong Kong’s trade pattern
reflects its comparative advantage. Before China’s open door policy, Hong Kong’s main
domestic exports include clothing, textiles, plastics and electronics, which shared about 60%70% of Hong Kong’s total domestic exports during the period of 1959-1980. It is revealed
that all major export sectors are light industries producing consumer goods (Table 4). The
production of these goods are labour-intensive. It indicates Hong Kong had comparative
advantage in the production of labour-intensive goods over its major trade partners such as
the US and the UK in the 1960s and 1970s. The comparative advantage in labour-intensive
production was mainly due to the abundant supply of semi-skilled labour during that period
of time. Since Hong Kong has always been in lack of arable land and natural resources, it
explains why Hong Kong did not specialise in the production of capital-intensive products in
the past and the present.
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Table 4 Percentage Share of Major Products in Domestic Exports 1959-1980 (selected
years)
Year
Clothing
Textiles
Plastics
Electronics
1959
34.8
18.1
7.0
--
1964
36.6
16.0
11.0
2.4
1973
38.3
12.1
10.6
12.4
1977
39.7
7.6
9.2
12.7
1980
34.1
6.7
7.9
13.9
Source: Chen (1990: 26)
Table 5 shows the major imports during the 1960s to 1970s. Foodstuff, consumer goods
and raw materials occupied about 80%-90% of Hong Kong’s imports. This import pattern
reflects the point made earlier that Hong Kong is not endowed with ample supply of arable
land and natural resources. It has a comparative disadvantage in producing foodstuff, raw
materials and capital goods and thus these items are imported from foreign countries.
However, it is of interest to note two salient facts. First, the proportion of foodstuff import
had been decreased continuously. This trend is attributable to the low income elasticity
of foodstuff. When household income rises, the demand for foodstuff increases less than
proportionately. Second, though Hong Kong has comparative advantage in producing
consumer goods, it continues to import an increasing amount of consumer goods. Related
to the previous point, the rise in household income has caused the consumers to demand
for more high-end and sophisticated consumer goods such as electrical appliance, which
have high income elasticity.
Table 5 Percentage Share of Major Products in Imports 1964-1980 (selected years)
Year
Foodstuff
Consumer
Goods
Raw Materials
Capital Goods
1964
24.7
19.7
44.3
8.5
1968
20.7
23.9
43.8
8.6
1972
17.5
25.8
41.0
12.8
1976
16.0
21.4
44.1
12.6
1980
10.8
26.4
41.6
14.4
Source: Chen (1990: 30)
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Topic J International Trade and Finance
The above discussion sketches Hong Kong’s trade pattern before late 1970s. Hong
Kong’s trade pattern has been change dramatically by China’s open door policy adopted
in the early 1980s. China’s opening up has attracted substantial foreign direct investment
(FDI) flowing from Hong Kong to the mainland. China is endowed with a huge pool of labour
and abundant supply of land. To capture the cost advantage, the Hong Kong businessmen
have moved their production base to the mainland since the early 1980s. Since then, Hong
Kong firms concentrate on product design, development and marketing while the mainland
becomes the production base for Hong Kong firms. After the processing in the mainland,
the products will be exported to Hong Kong and then re-export to overseas markets. Some
may expect that as China will have more and more direct trade with other countries/region,
including Taiwan, Hong Kong’s role as a re-export centre will diminish. However, recent
statistics show that Hong Kong remains a robust growth in re-exports (Table 6) which indicates
that Hong Kong possess the comparative advantage in providing re-export services over
other trading ports.
Table 6 Growth Rate in Re-exports trade 2000-2010 (selected years)
Year
Growth rate of re-exports
2000
18.1
2005
11.7
2008
6.0
2010
22.8
Source: Census and Statistics Department (2011), Hong Kong Annual Digest of Statistics 2011, p. 62.
Since the mainland has served as Hong Kong’s production base, goods domestically
produced in Hong Kong and exported to overseas market (i.e. domestic exports) has
diminished continuously from HK$180,967 million in 2000 to HK$69,512 million in 2010. On
the contrary, as mentioned above, re-exports surged from HK$1,391,722 million in 2000 to
HK$2,961,507 million in 2010. Table 7 clearly demonstrates that the proportion of domestic
exports in total exports has dropped while the proportion of re-export has occupied a major
share in total exports.
Table 7 Percentage Share of Exports and Re-exports in Total Exports 2000-2010
(selected years)
Year
Share of domestic
exports
Share of domestic reexports
2000
2005
2010
11.5
6.0
2.3
88.5
94.0
97.7
Source: Figures are calculated based on the data from Census and Statistics Department (2011), Hong Kong Annual
Digest of Statistics, p. 62.
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While the mainland specialises in the production of labour-intensive product, Hong
Kong has been investing heavily in hardware and software infrastructure to upgrade its
transportation network, telecommunication system, financial system, and human resources,
through which develops its comparative advantage in providing various services. The export
value of services rose from HK$315,012 million in 2000 to HK$826,856 million in 2010. The
value of export of services was about 12 times of that of domestic exports of commodities in
2010, which reflects that Hong Kong has transformed from a manufacturing centre of light
industrial products into a service exporting hub since China’s opening up in the early 1980s.
The main exports of services include transportation services, travel services, financial
services and merchanting (business) and other trade-related services. Their proportions in
total exports of services in 2010 are depicted in Figure 8.
Figure 8 Percentage Share of Major Service Exports in Total Service Exports 2010
Transportation services
28.4%
Travel services
20.8%
30.0%
Financial services
Merchanting and other
trade-related services
11.8%
Source: Census and Statistics Department (2011), Hong Kong Annual Digest of Statistics, p. 78.
The trade pattern portrayed above illustrates that Hong Kong specialised in production
with comparative advantage. However, one point is worth noting. Comparative advantage
is not static, merely based on factor endowment. Comparative advantage is dynamic and
determined by political, economic and policy factors. It is best illustrated by the political
changes in the mainland in the late 1970s, which inaugurated the open door policy. The
policy change allows Hong Kong to move its production base to the mainland. With Hong
Kong’s substantial investment in hardware and software infrastructure, Hong Kong acquires
competitive edge (acquired comparative advantage) in providing services to the overseas
market.
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Topic J International Trade and Finance
4
Importance of Trade to Hong Kong Economy
Trade participation is the degree of ‘openness’ of a country in terms of trade. One of
the common measure is the trade/output ratio which is defined as (X + M) / GDP where X,
M and GDP denotes the value of exports, the value of imports and gross domestic product
respectively. The ratio is to measure the degree of openness of an economy. A higher
ratio represents a higher degree of openness and vice versa. The ratio also indicates
the importance and reliance of trade to a region/country. Countries with a high ratio
(such as Hong Kong) are more economically sensitive and substantially affected by
external factors such as the level of global trade and the economic growth of the
trading partners. Hong Kong’s trade/output ratio has demonstrated a rising trend in the
past decades. The ratio recorded in 2005 was 385% while the figure reached to 439.8%
in 2010.2 Hong Kong’s high trade/output ratio indicates that the performance in the trade
sector has significant impacts on Hong Kong economy. The importance can be summarized
as follows:
Contribution to GDP: As discussed in Topic F, net exports NX (exports minus imports)
is one of the components contributing to the GDP of a country. Other things being
constant, higher NX leads to higher GDP and vice versa. In 2011, NX contributed about
9.8% to Hong Kong’s GDP.3
Employment creation: Trade not only contributes directly to GDP, but also stimulates
labour demand for various economic sectors such, banking, finance, logistics, wholesale
and retail.
Financing imports: Hong Kong is in lack of natural resources and our food and raw
materials rely very much on imports. In addition, production base of Hong Kong had
moved to the mainland since the 1980s, most of Hong Kong’s manufacturing products
we consume daily are also imports. To finance the huge amount of imports, we need to
maintain a sizable growth in exports Therefore, both imports and exports are vital to the
operation of our economy and daily life.
Foreign currency: As mentioned in the previous point, exports are needed to finance
imports. Further, the retained foreign currency earned from exports is important to
maintain Hong Kong’s linked exchange rate system since our currency issuance is fully
backed by the US dollars. The foreign exchange earned from the external sector is
crucial to maintain the operation of the linked exchange rate system. This issue will be
further explored in Section 7.3.
2
Figures are calculated based on the data from Information Service Department, Hong Kong 2010, p. 451.
3
Figures from Census and Statistics Department (http://www.censtatd.gov.hk/hkstat/sub/so50.jsp accessed on 23 July
2012)
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Import quota
Voluntary export
restraints (VERs)
Administrative
barriers
rier
Tariff bar
5
Non-tar
barriersiff
Trade Barriers
5.1 Types of Trade Barriers
In light of the gains from trade discussed in Section 2, one may incline to think that
free trade has been prevailing in the global economy. However, protectionist practices are
common in reality. Countries create trade barriers to protect their domestic industries, more
specifically their domestic producers and workers, from foreign competition. Trade barriers
include two main categories: tariff barrier and non-tariff barriers.
Tariff barrier refers to a tax imposed on imported goods at the point of entry into the importing
country. Traditionally, the main objective of imposing tariff is to raise government revenue.
However, tariffs are now used generally to protect domestic industries and employment. A
tariff increases the prices of imported goods in domestic market. It makes foreign goods
less competitive and domestic goods become more attractive. It therefore protects domestic
production and in turn stimulates employment.
Non-tariff barriers (NTBs) are trade restrictions other than tariffs to protect domestic
industries and employment. Some of the major NTBs are briefly discussed below:
Import quota: An import quota refers to a direct restriction on trade, which is a
physical restriction on the quantity of goods that may be imported and it generally
limits imports to a level below that which would occur under free-trade conditions.
Voluntary export restraints (VERs): VERs refer to a situation where an importing
country “induces” (more accurately, “force”) a foreign country to reduce its export
of a commodity “voluntarily”. If the exporting country does not accept the VER, the
importing country may threaten it with more restrictive NTBs.
Administrative barriers: It refers to the technical, administrative, and other
regulations imposed on imports. Some common examples of this category include
safety regulations for automobile and electrical equipment, health regulations for
the hygienic production and packaging of imported food products, and labelling
requirements showing origin and contents. All these increase the production costs of
the exporting countries.
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Topic J International Trade and Finance
5.2 Effects of Tariff and Quota on Price and Output for a Small Open
Economy
Note: Starting from S4 in 2013/14, i.e.2016 HKDSE Examination,
students are NOT expected to analyse the effects of tariff and quota for
a small open economy on consumer surplus, producer surplus, total social
surplus and deadweight loss.
5.2.1 Gainers and Losers under Free Trade
To better understand the impacts of tariff and quota on an economy, we will first examine
how the importing country gains from trade, and who are the winners and losers in importing
country under free trade. Referring to Figure 1 below:
Figure 1 How Free Trade Affects Welfare in an Importing Country
Price of Apple
Domestic Supply
A
Price
before Trade
B
Price
after Trade
D
World Price
C
Imports
Domestic Demand
0
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Quantity of Apple
Suppose Country A produces apple and the output is supplied for domestic consumption
before any trade takes place. If the world price is lower than the domestic price (i.e. price
before trade), the country has an incentive to import apple as they can enjoy the same good
at a lower price. Once free trade begins, the domestic price will fall to the world price. If the
importing country is a small open economy, Country A is only one of many apple producers
in the world; it has to follow the world price to remain competitive.
As the price of apple falls, the domestic quantity of apple demanded will rise and
the domestic quantity of apple supplied will fall. Thus, with trade, the domestic quantity
demanded will not be equal to the domestic quantity supplied. The importing country will
import the amount equals to the difference between the domestic quantity demanded and
the domestic quantity supplied.
When a country imports a good, domestic consumers are better off as they can now
enjoy the good at a lower price. The domestic producers are worse off as they have to sell
their output at a lower price, which is caused by foreign competition.
We can have a closer look at the gains and losses from trade by using the concepts of
consumer surplus, producer surplus, and total surplus that we learned in Topic E.
Knowledge Recap
Recap
Knowledge
Consumer surplus: Consumer surplus is equal to a buyer’s willingness to pay
minus the amount the buyer actually pays. It measures the welfare of a consumer.
Higher consumer surplus indicates higher consumer welfare and vice versa.
Producer surplus: Producer surplus is equal to the amount consumer paid for a
good minus the seller’s cost. It measures the welfare of a producer. Higher producer
surplus indicates higher producer welfare and vice versa.
Total surplus: Total surplus is equal to the amount of consumer surplus plus
producer surplus. If we sum up the consumer surplus and producer surplus of all
consumers and producers, it measures the welfare of the whole society. Higher
total surplus indicates higher economic well-being in the society and vice versa.
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Topic J International Trade and Finance
Figure 1 shows that before trade, consumer surplus equals area A and producer surplus
equals area B+C. Total surplus is equal to area A+B+C. After trade, consumer surplus
becomes area A+B+D as the consumers now pay lower price and consume higher output.
Producer surplus is area C as area B now becomes consumer surplus after trade. The
total surplus after trade is area A+B+C+D. The society gains an additional area of D, which
represents the increase in total surplus and gains from trade. The changes in consumer
surplus, producer surplus and total surplus are summarized in Table 1.
Table 1 Change in Consumer Surplus, Producer Surplus and Total Surplus after Trade
Consumer Surplus
Producer Surplus
Total Surplus
Before Trade
A
B+C
A+B+C
After Trade
A+B+D
C
A+B+C+D
Change
+ (B + D)
-B
+D
The Area D shows the increase in total surplus
and represents the gains from trade.
Here, we have two important remarks to make:
When a country imports a good, domestic consumers are better off and domestic
producers are worse off.
When a country imports a good, total surplus is increased and the economic well-being
of the country rises.
5.2.2 Tariff
International trade often creates winners and losers. The losers may insert political
pressure on the government to impose trade restrictions such as tariffs and quotas. This
section examines how tariff affects the price, output, and economic well-being of the society.
Suppose now Country A imposes a tariff which raises the local price above the world
price. Thus, the domestic price of apple will rise to the world price plus the tariff. As the
domestic price rises, the domestic quantity of apple demanded will fall and the domestic
quantity of apple supplied will rise. The quantity of imports will fall and the market will move
closer to the domestic market equilibrium that occurred before trade.
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Figure 2 The Effects of a Tariff
Price of Apple
Domestic Supply
A
Deadweight Loss
B
Price with
Tariff
Price without
Tariff
C
E
D
Tariff
F
World Price
G
Import
with Tariff
0
Q
S
1
Q
S
2
Domestic Demand
Q
D
2
Q
D
1
Quantity of Apple
Imports without Tariff
How does the tariff affect the economic well-being of Country A? Before the tariff,
consumer surplus is equal to area A+B+C+D+E+F. Producer surplus is area G. Total surplus
is then equal to area A+B+C+D+E+F+G. Government earns no revenue.
After the levy of a tariff, consumer surplus becomes area A+B because domestic price
goes up and quantity demanded drops. Producer surplus increases from area G to area
C+G as the domestic price goes up. Government derives a tariff revenue (area E), which is
equal to the amount of imports times the size of the tariff (for each unit of apple imported).
We notice that the total surplus after the tariff is equal to A+B+C+E+G. Compared with the
total surplus before the tariff, that is area A+B+C+D+E+F+G, the total surplus after the tariff
drops by the area D+F, which is the deadweight loss caused by the tariff.
The deadweight loss exists because the tariff has changed the incentive of the domestic
and foreign producers and distorted the optimum resources allocation (i.e. maximum of total
surplus). From an intuitive perspective, we notice that consumers are worse off because they
have to pay a higher price and consume a lower quantity of output, which is represented
by the decrease in consumer surplus (area C+D+E+F), where there is a gain in producer
surplus by the area C and government revenue by the area E. Thus, there is a fall in social
surplus /deadweight loss (area D+F).
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Topic J International Trade and Finance
The changes in consumer surplus, producer surplus and total surplus after tariff are
summarized in Table 2.
Table 2 Changes in Consumer Surplus, Producer Surplus and Total Surplus after
Tariff
Before Tariff
After Tariff
Change
Consumer Surplus
A+B+C+D+E+F
A+B
﹣(C+D+E+F)
Producer Surplus
G
C+G
+C
Government Revenue
None
E
+E
Total Surplus
A+B+C+D+E+F+G
A+B+C+E+G
﹣(D+F)
The Area D + F shows the fall in total surplus and
represents the deadweight loss of the tariff.
Here, we have two important remarks to make:
A tariff reduces the quantity of imports and moves the domestic market closer to its
equilibrium without trade.
With a tariff, total surplus in the market decreases by an amount of area D+F which is
the deadweight loss to the society.
5.2.3 Import Quota
As mentioned in Section 5.1, an import quota refers to a direct restriction on trade,
which is a physical restriction on the quantity of goods that may be imported and it generally
limits imports to a level below that which would occur under free-trade conditions.
Then who have the right to import? In general, the government will issue import licences
to some designated importing firms which become the licence holders. The licence holders
have the incentive to import as much as they are permitted, provided that the domestic price
is higher than the world price.
In our case, an import quota alters the supply of apple available in Country A. Below
the world price, only domestic producers will supply the output. If the domestic price is
above the world price, licence holders will have the incentive to import. The total supply
is equal to the domestic supply plus the quota amount at each price level. Therefore, the
supply curve, above the world price, shifts to the right by the amount of the quota.
In Figure 3, it is shown that after the quota, the domestic price will rise. The domestic
quantity of apple demanded will fall and the domestic quantity of apple supplied will rise.
The quantity of imports will fall and the market will move closer to the domestic market
equilibrium that occurred before trade.
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Figure 3 The Effects of an Import Quota
Price of Apple
Domestic Supply
A
Domestic Supply
+
Import Supply
Quota
B
Price with
Quota
Price without
Quota
C
E’
D
Equilibrium
with Quota
F
E’’
World Price
G
Import
with Quota
0
Q
S
1
Q
S
2
Domestic Demand
Q
D
2
Q
D
Quantity of Apple
1
Imports without Quota
How does the import quota affect the economic well-being of Country A? Before the
quota, consumer surplus is equal to area A+B+C+D+E’+E”+F. Producer surplus is area G.
Total surplus is then equal to area A+B+C+D+E’+E”+F+G.
After the levy of a quota, consumer surplus becomes area A+B because domestic price
goes up and quantity demanded drops. Producer surplus increases from area G to area C+G
as the domestic price goes up. Licence holders derives a profit (area E’+E’’), which is equal
to the amount of imports times the difference between the domestic price and world price.
We notice that the total surplus after the quota is equal to A+B+C+E’+E”+G. Compared with
the total surplus before the quota, that is area A+B+C+D+E’+E”+F+G, the total surplus after
the quota drops by the area D+F, which is the deadweight loss caused by the quota.
The changes in consumer surplus, producer surplus and total surplus after quota are
summarized in Table 3.
Table 3 Changes in Consumer Surplus, Producer Surplus and Total Surplus after
Quota
Consumer Surplus
Producer Surplus
License-Holder Surplus
Total Surplus
Before Quota
A+B+C+D+E’+E”+F
G
None
A+B+C+D+E’+E”+F+G
After Quota
A+B
C+G
E
A+B+C+E’+E”+G
Change
﹣(C+D+E’+E”+F)
+C
E’+E”
﹣(D+F)
The Area D + F shows the fall in total surplus and represents the deadweight loss of the quota.
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Topic J International Trade and Finance
Here, we have three important remarks to make:
Because the quota raises the domestic price above the world price, domestic buyers of
the good are worse off, and domestic sellers of the good are better off.
Licence holders are better off because they make a profit from buying apple at the lower
world price and selling it at the higher domestic price.
Both tariff and quota raises domestic price, reduces welfare of consumer, increase
welfare of domestic producers, and creates deadweight loss. However, they have one
major difference: government gets revenue from levying a tariff but have no revenue by
imposing a quota. The licence holders earn a profit if the government imposes a quota.
5.3 Trade Barrier Faced by Hong Kong
After years of global trade liberalization promoted by General Agreement on Tariffs and
Trade (GATT), the predecessor of World Trade Organization (WTO), trade barriers, such as
tariff and quota, facing Hong Kong have diminished. However, since Hong Kong’s exporting
firms have their production base in the mainland. Trade barriers facing China will adversely
affect the trade performance in Hong Kong. The European Union (EU) and the US are the
two major exporting markets for China. In recent years, the EU and US have from time to
time accused China of infringing intellectual property rights and dumping. Dumping refers to
the practice of selling a product in the overseas market at a price lower than the production
costs. The main objective of dumping is to use low price to drive away local producers and
the exporting country can monopolise the local market. If these accusations are found to be
valid, a punitive tariff will be imposed on imports from China. Punitive tariff is an extra tariff
charged on imports. This is introduced because a country has done business in an illegal or
unfair way.
Another common trade barrier includes imposing of environmental and safety standards
for imports by the EU and US. As a developing country, China is relatively weak in maintaining
a high level of environmental and safety standards. To fulfil the requirements, China will
incur higher production costs which reduce the competitiveness of the Chinese products.
The brief discussion illustrates the fact that Hong Kong does not face many trade
barriers directly, but encounters them indirectly, arising from the ones facing China.
5.4 Hong Kong’s Attempt to Overcome Trade Barriers
To overcome the trade barriers, both the business sector and the Hong Kong SAR
Government have put ongoing efforts to promote trade.
Trade promotion: In 2006, there were 77 international trade fairs in Hong Kong, those held
by the Hong Kong Trade Development Council were more than 30, attracting about 460,000
buyers. In 1966, the Hong Kong Trade Development Council was established to act as the
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international marketing and promotion arm for Hong Kong-based traders, manufacturers
and service providers.
The role of the government: To sustain the growth of trade, the government must provide
adequate hardware and software infrastructure. The hardware infrastructure includes
convention and exhibition facilities for the trade fairs and promotion, transportation and
telecommunication network. The software infrastructure includes the maintenance of an
effective and impartial legal system as well as upgrading human resources. On top of that,
the government has made effort to draw closer economic links with trade partners by signing
trade agreements. Examples include Mainland and Hong Kong Closer Economic Partnership
Arrangement (CEPA) and Hong Kong had signed a Free Trade Agreement with the Member
States of the European Free Trade Associations (EFTA).
The role of international economic institution: Hong Kong is a member of major
international economic and trade organization such as WTO, Asia-Pacific Economic
Cooperation (APEC) and the Pacific Economic Cooperation Council (PECC). The main
objective of joining these organizations is to engage Hong Kong to be active players in
these organizations to promote trade and cooperation. No less important than that, in case
Hong Kong comes into trade conflict with other countries, the dispute can be settled and
adjudicated through the tribunal system in the international organization (e.g WTO dispute
settlement system).
6
Brief Introduction to the Balance of Payment
Account
All open economies have numerous transactions of goods, services and assets with
the rest of the world every day. A review of the balance of payment (BOP) account is a
good way to understand these transactions. The BOP account is a record of the economic
transactions of a country’s trade with other countries (typically a year or a quarter).
The BOP account consists of two accounts: (i) current account, and (ii) capital and financial
account. Current account includes the following components:
Balance of trade in goods (value of exports of good – value of imports of goods)4
Balance of trade in services (value of exports of services – value of imports of services)
The sum of the balance on goods and the balance on services is equal to net exports.
If net exports are positive, the country has trade surplus. If net exports are negative, it
has trade deficit.
The goods account covers principally exports and imports as shown in merchandise trade statistics, but adjusted for
coverage and valuation. For example, one major adjustment for coverage is the adoption of the change of ownership
principle in the BoP statistical system. Following this principle, goods sent abroad for processing without a change of
ownership are not covered in the goods account. On the other hand, for goods sold under merchanting, although the goods
involved have never been entered into the economy where the owner resides in, they are recorded in the goods account of
the owner’s economy given that there has been a change of ownership of the goods.
4
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Topic J International Trade and Finance
Net external factor income flow5 (external factor income inflow – external factor income
outflow) (income received for providing use of labour, financial resources or natural
resources to non-resident – income payments on obtaining use of labour, financial
resources or natural resources from non-resident)
If a Hong Kong resident buys a US bond and receives interest from the US, it is recorded
as income received on investment. It is a positive number in the current account. If a
US resident buys a Hong Kong bond and Hong Kong pays interest to the US resident,
it is recorded as income payment on investment. It is a negative number in the current
account.
Net flow in current transfer: Current transfers are transactions in which real or financial
resources that are likely to be consumed immediately or shortly are provided without
the receipt of equivalent economic values in return. It equals to the difference between
transfers received by local citizens and transfers made to overseas residents. When
a Hong Kong resident receives donation from an overseas charity organization, it is
transfers received by local citizen. It is a positive number in the current account. When
a Hong Kong resident donates money to an overseas organization, it is transfers made
to overseas residents. It is a negative number in the current account.
The sum of net exports, net external factor income flow and net flow in current transfer
is equal to the current account balance.
Note: Trade balance refers to visible trade balance in the curriculum and assessment, though the Census
and Statistics Department has ceased to publish visible trade balance statistics. It has started to publish
trade and services balance statistics since September 2012.
Following the recommendation in the Sixth Edition of the Balance of Payments and International Investment Position
Manual released by the International Monetary Fund, the term “primary income” and “secondary income” have been
adopted to replace the former terms “factor income” and “current transfers” respectively since September 2012.
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Capital and financial account records external transactions in capital transfers, and
the acquisition and disposal of non-produced, non-financial assets (such as trademarks and
brand names). The account includes the following components:
Capital and financial inflow: For example, there is a capital inflow into Hong Kong if
an US resident buys a bond issued by a Hong Kong firm. It is a positive number in the
capital and financial account.
Capital and financial outflow: For example, there is a capital outflow from Hong Kong
if a Hong Kong resident buys a bond issued by a US firm. It is a negative number in the
capital and financial account.
Reserve assets
The sum of capital and financial inflow and capital and financial outflow is the balance
on capital and financial account.
The sum of current account balance and balance on capital and financial account
is equal to the balance of payments.
There is one important feature of the BOP account. For individual accounts, it can be
positive or negative. For example, we can have a positive current account balance and a
negative balance on capital and financial account. However, the balance of payments
account must always be zero. Why?
To illustrate, in 2009, US’s current account balance is -US$706 billion and capital and
financial account is US$506 billion. The BOP account is -US$200 billion. It indicates that
foreign countries, such as China and Japan, are holding US$200 billion. These countries
have three options to use the US dollars:
Spend the money to buy US goods and services (but we know that the foreign countries
do not choose this option. Otherwise, it should have already been shown in the current
account.)
Invest in US assets.
Do not spend the US$ and hold it.
Either investing in US assets or increasing holding of US$ (reserve assets) are shown
as positive entries in US capital and financial account. Therefore, a current account
deficit must be balanced by a capital and financial account surplus. The overall BOP
account must be zero. If the current account deficit is not exactly balanced by the capital
and financial account surplus, there must be some transactions unrecorded. Then, the
statistical discrepancy, “net errors and omissions”, will be included to balance the BOP.
Though the terms used in the Hong Kong case maybe different from what we discussed
above, the overall concepts are the same.
Note: Sub-classification of the Capital and financial account is NOT required in the curriculum and assessment.
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Topic J International Trade and Finance
7
Exchange Rate
7.1 Meaning of Exchange Rate
The exchange rate is the amount of domestic currency needed to buy one unit of
foreign currency. To illustrate, the exchange rate of HK$:US$ is 7.77, which means that we
need to use HK$7.77 to buy US$1. The exchange rate of HK$:€ is 9.44 means that we need
to use HK$9.44 to buy one euro. A rise in exchange rate, for example HK$9.6:€1, means
that we need more domestic currency to buy one euro, which indicates a depreciation
of domestic currency. It follows that a fall in exchange rate indicates an appreciation of
domestic currency.
7.2 Effect of a Change in the Exchange Rate on Import Price and Export
Price
A small open economy faces prices of internationally traded goods and services in fixed
price denominated in foreign currency. For example, a supermarket in Hong Kong would like
to import a bar of chocolate from Belgium and the international price is €1 per bar. Suppose
the exchange rate HK$:€ is 9.44. Then, we can convert the world price into domestic price
(i.e. price denominated in domestic currency) by using the following equation:
Pd = ePf
…… (1)
where Pd is domestic price, e is exchange rate and Pf is international (world) price.
Substituting the exchange rate and the international price into the above equation, we have
Pd = (9.44 x 1)
Pd = $9.44
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International Trade and Finance
The above result shows that we need to pay HK$9.44 (ignoring transportation costs) to
import one chocolate bar from Belgium. What will happen if HK$:€ exchange rate rises to
9.6? Straightforwardly, the domestic price will rise to HK$9.6 due to the depreciation of HK$.
The Belgium chocolate becomes more expensive (and less competitive) in the Hong Kong
market. Hong Kong will buy less chocolate from Belgium and at the same time, Belgium’s
volume of exports to Hong Kong will decrease.
Let us consider the case of exports from Hong Kong. Suppose Hong Kong exports
a watch to Belgium and the domestic price is HK$944. To export the watch, we need to
convert the domestic price into world price using equation (1). Suppose the original HK$:€
exchange rate is 9.44. Rearranging the terms of (1), we have:
Pd / e = Pf
€(944/9.44) = Pf
€100 = Pf
When the HK$:€ exchange rate depreciates to 9.6, the world price becomes:
€(944/ 9.6) = Pf
€98.3 = Pf
The export price of the Hong Kong watch decreases from €100 to €98.3 due to a rise
in HK$:€ exchange rate (i.e. depreciation of HK$). The Hong Kong watch becomes less
expensive (and more competitive) in the Belgium market. Hong Kong will export more
watches to Belgium and at the same time, Belgium’s volume of imports from Hong Kong will
increase.
In a word, a rise in exchange rate (i.e. depreciation of domestic currency) increases
import price and decreases export price. Volume of imports will fall and volume of exports
will rise.
On the contrary, a fall in exchange rate (i.e. appreciation of domestic currency)
decreases import price and increases export price. Volume of Imports will rise and volume
of exports will fall.
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Topic J International Trade and Finance
7.3 Linked Exchange Rate in Hong Kong: A Brief Introduction
In the summer of 1982, it was announced that China would recover its sovereignty over
Hong Kong and China and Britain would formally negotiate the details of the handover. The
annunciations shook people’s confidence about Hong Kong’s future, which caused selling
of Hong Kong dollar. In 1983, the panic selling of Hong Kong dollars drove the US$:HK$
exchange rate to historic low of US$1:HK$9.6 on 24 September 1983. The government
acted swiftly to regain the confidence of the citizens and investors by establishing the linked
exchange rate system in October 1983.
Hong Kong is one of the few countries/regions in the world where currency (except
10-dollar note and coins) are issued by private commercial banks. The primary objective
of the linked exchange rate system is to maintain exchange rate stability. Under the linked
exchange rate system, the note-issuing banks are required to submit US dollars (at HK$7.80
= US$1) to the Hong Kong Monetary Authority (HKMA) for the account of the Exchange Fund
(EF) in return for Certificates of Indebtedness (CIs). The note-issuing banks are allowed to
return the banknotes to the EF to get back US dollars. This requirement ensures that all the
banknotes issued are fully backed up by foreign reserves. The requirement also applies to
the case of government-issued notes and coins. Transactions between the HKMA and the
agent bank responsible for storing and distributing the coins to the public are settled against
US dollars at the rate of HK$7.80 to one US dollar. In a nutshell, all Hong Kong dollars are
therefore fully backed by US dollars held by the Exchange Fund.
The linked rate of HK$7.80 = US$1 is a guarantee convertible rate between EF and the
note-issuing banks. However, the HK$:US$ exchange in the market (i.e. the transactions
between the public and all licensed banks) is subject to free floating. The exchange rate in
market fluctuates in accordance to the flow of fund into and out of the Hong Kong dollar. To
maintain exchange rate stability, the HKMA will buy and sell US dollars in the open market.
Specifically, according to the rules of Convertibility Undertaking, HKMA will buy US dollars
from licenced banks at HK$7.75 to one US dollar (strong-side Convertibility Undertaking)
and sell US dollars at HK$7.85 to one US dollar (weak-side Convertibility Undertaking).6 The
Convertibility Undertaking is to ensure exchange rate not much deviating from the peg rate.
For details, see the information from the Hong Kong Monetary Authority (http://www.hkma.gov.hk/eng/key-functions/
monetary-stability/linked-exchange-rate-system.shtml accessed on 27 July 2012)
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The primary advantage of the linked exchange rate system is to bring exchange rate
stability. However, it comes with a cost. Since Hong Kong dollars are pegged with US dollars,
Hong Kong’s interest rates cannot deviate very much from those of the US. Otherwise, it
will bring about unwanted capital inflows and outflows, which causes fluctuations to the
exchange rate in the market. To illustrate, in the early 1990s, Federal Reserve in the US
lowered interest rate to boom the slow recovery of the US economy. However, Hong Kong
economy in the early 1990s had already entered a rising phase. Interest rates in Hong Kong
were increased to curb the rising inflation, but the rise in interest rate lasted for just one month
as the interest rate differential between the US and Hong Kong brought massive inflow of
capital to Hong Kong. To maintain exchange rate stability, interest rate had to be lowered
again. Therefore, under the linked exchange rate system, Hong Kong lacks a completely
independent monetary policy. That said, all exchange rate systems have its costs and
benefits. A system should be maintained provided that its benefits exceed its costs.
References:
Census and Statistics Department (2011), Hong Kong Annual Digest of Statistics 2011.
Chai, J. C. C. and Kwong, C. C. L. (1996), ‘Trade and Investment Relations with China,’ in Ho, H. C. Y. and L. C. Chau
(eds) The Hong Kong Economy in Transition, Hong Kong: Asian Research Services, pp. 109-118.
Chen, E. K. Y. (1990), ‘The Economic Setting,’ in Lethbridge, D. (ed) The Business Environment in Hong Kong, Hong
Kong: Oxford University Press, pp. 1-51.
Information Service Department, Hong Kong 2010
Jao, Y. C. (1996) ‘Recent Development in Money and Banking,’ in Ho, H. C. Y. and L. C. Chau (eds) The Hong Kong
Economy in Transition, Hong Kong: Asian Research Services, pp. 39-54.
Kreinin, M. E. (1991), International Economics: A Policy Approach, Harcourt Brace Jovanovich, pp. 244-248.
Lipsey, R.G., Courant, P. N. and Purvis, D. D. (1994), Economics, 8th Canadian edition, Harper Collins, pp. 835-838.
Mankiw, N G (2004), Principles of Economics, 3rd edition, Thomson, South-Western, pp. 175-199.
Hubbard, R. G. and O’Brien, A. P. (2007), Economics, 3rd edition, Pearson, pp. 978-984.
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