NATIONAL AND INTERNATIONAL

ECONOMY

SPECIALISATION AND TRADE

 Why does Malaysia have to TRADE with the rest of the world?
 Why do developed countries trade with ‘third world countries’?

- Don’t have natural resources

- Small country and cannot manufacture (‘mass produce’) on a big scale so not ‘efficient’
enough
- Don’t have skilled workers
- Specialise producing products ‘good’ at making
- So consumers have more choice at cheaper prices
- Some countries achieve lower costs of production
- SPECIALISATION  efficient resource use  increased production  increased employment
 improved standard of living

COMPARATIVE ADVANTAGE

- One country produces a product at a relatively lower cost (‘opportunity cost’)

 The product you are going to produce goes on the ‘Bottom’ of the ‘formulae’

 The country with the lowest ‘opportunity cost’ for that product should specialise in producing it

ASSUMPTIONS OF THE LAW OF COMPARATIVE ADVANTAGE

Why do you think the ‘law of comparative advantage’ is too simple and therefore is not such a good
way of explaining why trade is ‘good’?

- constant return to scale (constant levels of efficiency)

- no trade barriers
- no transportation cost 2.
- perfect factor mobility
- no negative ‘side-effects’ (environment)

TERMS OF TRADE

- differences in ‘opportunity cost’ enable trade to take place because both countries are able to
consume beyond their ‘Production Possibility Frontiers’ (PPF)
- the TOT is an index number which is an average if export and import prices

INDEX OF TOT = Index of Export Prices

Index of Import Prices

RESTICTIONS ON FREE TRADE (PROTECTIONISM)

ADVANTAGES AND DISADVANTAGES OF ‘FREE TRADE’

ADVANTAGES

- Higher living standards

- We can get things we don’t have (choice) at lower prices
- Some countries have lower cost of labour in developing world (workers)  export most
production to world because it is efficient (economies of scale)
- Increased employment opportunities if SPECIALISATION (doing one thing really well)

DISADVANTAGES

- Domestic industries ‘uncompetitive’ producers go bankrupt  unemployment

- Global companies to dominant
- Developing countries small local producers cannot develop and grow (‘infant industry
argument’)
- Economic ‘problems’ become global

INTERDEPENDENT - All the countries in the world depending on each other for trade

THE EFFECT OF ‘PROTECTIONIST’ POLICIES

TARIFFS 3.

Tax on imports  increased costs for importers  increased prices  increased competitiveness
for domestic production

QUOTAS
Physical limit on quantity or value of imports

SUBSIDIES TO DOMESTIC PRODUCERS

Government grant  lower costs of production  increased supply

NON-TARIFF BARRIERS

- Health and safety regulations

- Environmental regulations
- Bureaucracy (time to ‘fill in forms’)
- Exchange rate manipulation

IMPACT OF PROTECTIONISM

- Higher consumer prices

- Less competition for domestic producers
- Less import tax revenue
- Reduced specialisation  less output  less AD  less income  falling standard of living

TRADING BLOCKS AND THE WORLD TRADE

ORGANISATION

TRADING BLOCK – A group of countries in a geographic region who reduce ‘trade barriers’
between member nations whilst imposing restrictions on none-members.
FREE TRADE AREAS – removal of trade barriers
CUSTOMES UNIONS – common ‘external tariffs’ (tax on non-member countries imports
COMMON MARKETS – free movement of ‘factors of production’
MONETARY UNIONS – same currency (Euro)

4.
COSTS AND BENEFITS

COSTS
Trade Diversion: away from low cost producers in non-member countries
Distortion of Comparative Advantage: reduces specialisation
Transition Costs (minor point): change price lists
Governments lose ability to make own economic policy decisions

BENEFITS
Trade Creation: between members
Increased Investment: sell goods freely within ‘trading block’
Increased Economic Power: unified force
Elimination of Transaction Costs: cost of changing currencies
Price Transparency: compare prices easily
Elimination of Currency Fluctuations: encourages increased investment

WORLD TRADE ORGANISATION

Promote free trade and settle disputes

Conflicts with ‘trade block’ agendas

GLOBALISATION

GLOBALISATION
Increased economic integration between countries.
Increased over last 50 years
Trade increased as proportion of global GDP
Resulted in increased Foreign Direct Investment (FDI)
Increased capital flows between countries
Movement of people

5.
CAUSES

Reduced transportation costs (‘containerisation’)

Reduced cost of communication
Reduction in trade barriers
Opening up of China/collapse of communism
Growth of ‘trading blocks’
Increased importance of ‘transnational companies’ (TNCs)  moving manufacturing to ‘low
cost’ countries
Technology Transfer

EFFECTS

INDIVIDUAL COUNTRIES
Specialisation  improved living standards
Increased inequality
Risks of ‘contagion’ (problems spread)

GOVERNMENTS
Increased tax revenues
TNCs avoid tax

PRODUCERS
Benefit from ‘economies of scale’
‘Technology Transfer’ – invest in developing countries, modern management techniques =
increased productivity

CONSUMERS
Increased ‘consumer surplus’ and choice
WORKERS

Employment opportunities BUT developing countries workers exploited 6.

‘external costs’ (negative externalities)

BALANCE OF PAYMENTS

THE CURRENT ACCOUNT

TRADE IN GOODS BALANCE: exports – imports in goods

TRADE IN SERVICES BALANCE: export – imports in goods

INVESTMENT INCOME (Now ‘SECONDARY BALANCE’): Earned from assets owned overseas

CURRENT TRANSFERS: Money received from foreign institutions ‘minus’ paid to

CURENT BALANCE: sum of the above = ‘current account deficit/surplus’

CAPITAL AND FINANCIAL ACCOUNTS

- These change with changes of ownership

DIRECT FOREIGN INVESTMENT

- Investment into a country by foreign firms

PORTFOLIO

- Shares and bonds

SHORT-TERM CAPITAL

- ‘hot money’

FOREIGN CURRENCY RESERVES

- Foreign currency denominations for trade purposes

CAUSES OF DEFICITS ON CURRENT ACCOUNT 7.

NB ‘surpluses’ caused by opposite of point below

- Low productivity
- Relocation of manufacturing to ‘low labour cost’ countries
- Appreciation of exchange rate
- Economic growth  more imports

HOW TO REDUCE CURRENT ACCOUNT DEFICITS

- Expenditure Reducing Policies: ‘deflationary’ Monetary and Fiscal Policies  reduced imports
- Expenditure Switching Policies: tariffs, quotas, export subsidies
- Devaluation/Depreciation
- Supply-side Policies:
Training and education  productivity
Reduce corporation tax
Improved infrastructure

SIGNIFICANCE OF GLOBAL TRADE IMBALANCES

- USA and UK ‘persistent’ (always) have current account deficits

- China and ‘oil exporters’ persistent surpluses

PROBLEMS WITH DEFICITS

- Indicates goods and services ‘uncompetitive’  rising unemployment

- Forced to borrow overseas to ‘finance deficit’
- Depreciation of currency under ‘floating exchange rate’

PROBLEMS WITH SURPLUSES

- Increased AD  inflation
- Living standards lower than ‘could be’
- Appreciation in currency
- Other countries impose trade restrictions
EXCHANGE RATES 8.

- Rate which one currency exchanges for another

TRADE-WEIGHTED INDEX – weighted against ‘basket’ of other currencies

EXCHANGE RATE SYSTEMS

FIXED – seldom used e.g. China

FLOATING – ‘market forces’
MANAGED – central bank ‘intervention’
REVALUATION – increase ER under ‘fixed’ ER system
DEVALUATION – decrease ER under fixed ER system
APPRECIATION – increase under ‘floating’
DEPRECIATION – decrease under ‘floating’

FACTORS INFLUENCING FLOATING EXCHANGE RATE

- Relative Interest Rate - (‘hot money’ flows)

- Inflation Rate (cost push) relative to other countries = ‘competitiveness’
- Current Account Balance – supply > demand  depreciation
- Foreign Direct Investment – inward investment  demand for domestic currency
- Speculation – state of economy, future prospects

GOVERNMENT INTERVENTION

- Foreign Currency Transactions: central bank sell  depreciation

- Interest Rates: lower ‘base rate’ (IR’s)  less rate of return on cash balance (‘hot money’) 
selling  depreciation

COMPETITIVE DEVALUATION – to improve economic growth (by increasing ‘international ‘price

competitiveness’), ‘engineer’ a depreciation  improved trade balance. Start ‘currency war’.
 9.
IMPACT OF CHANGES IN EXCHANGE RATE

CURRENT ACCOUNT

- Devaluation/Depreciation  falling price exports/increasing price imports  increased

competiveness  improved BOP’s
- MARSHALL-LERNER CONDITION (‘J-CURVE EFFECT’) Short run, demand and supply of
exports and imports inelastic (takes consumers and producers time to adjust)  deterioration
in trade balance. Long run = improvement

ECONOMIC GROWTH AND EMPLOYMENT

- Devaluation/depreciation  increased AD  increased real output  falling unemployment

INFLATION

- Increased price of imported commodities, capital goods, semi-finished goods  increased

costs of production  cost-push inflation
EMERGING AND DEVELOPING
ECONOMIES

THE HUMAN DEVELOPMENT INDEX (HDI)

Made up of three (3) measures:

‘GDP per head’ - measured at purchasing power parity
‘Health’ – life expectancy
‘Education’ – number of years at school

LIMITATIONS OF HDI: only concerned with long-term development outcomes, doesn’t

recognise levels of inequality

ADVANTAGES OF HDI: broader measure than GDP per capita, the ‘three measures’ are all
significant factors that contribute to a ‘decent standard of living’

OTHER INDICATORS
- Clean water
- male population employed in agriculture
- energy consumption
- internet access
- mobile phone
- civil rights
- democracy
- inequality

FACTORS INFLUENCING GROWTH AND

DEVELOPMENT

PRIMARY PRODUCT DEPENDENCY AND VOLATILITY OF COMMODITY

PRICES

HARD COMMODITIES – mined or extracted

 SOFT COMMODITIES – agricultural

Depending on ‘primary commodities’ is an issue because:

- supply and demand inelastic in short-run

- fluctuations in producers revenues = hard to plan output and invest
- exchange rate fluctuations  uncertain revenues and difficult for governments to plan
economic development
- cash crops are exported = little for domestic consumption
- protectionism
- finite ‘hard commodity’ supplies
- appreciation of currency if commodity in high demand
- falling ‘terms of trade’ (TOT)

THE PREBISCH-SINGER HYPOTHESIS

 primary products income inelastic, manufactured income elastic, therefore rising real incomes 
manufactured product demand increases at a greater rate  prices rise more quickly  TOT
deteriorate for developing countries

 HOWEVER …
- developing countries have a comparative advantage in primary products
- FDI (foreign investment) into developing countries increased in recent years

SAVINGS GAP: THE HARROD-DOMAR MODEL

Countries with low GDP per capita cannot save  difficult to finance investment  limited ‘capital
accumulation’ THEREFORE the ‘savings gap’ must be filled my FDI

FOREIGN CURRENCY GAP

Shortages of foreign currencies caused by:

- Dependency on primary products

- Dependency on imported oil and manufactured goods
- Interest payments on debt
- ‘Capital Flight’ – transferring cash to foreign banks

DEMOGRAPHIC FACTORS
- Populations increase at geometric rate, food production arithmetic
- Countries with population growth > GDP = falling GDP per capita
- Aging population  smaller working population  support elderly (high ‘dependency ratios’)
DEBT
Caused by”

- Falling terms of trade

- Developing countries borrowing at low IR’s but cannot make interest payments when IR’s rise
- Borrowing to pay for higher oil prices
- Loans for investment projects
- Depreciation of currency
- Loans to finance military spending

ACCESS TO CREDIT AND BANKING - Entrepreneurs need to be able to borrow

INFRASTRUCTURE – physical and organisational structures and facilities required for

efficient operation

EDUCATION/SKILLS – school enrolment ratio  literacy/numeracy  productivity

ABSENCE OF PROPERTY RIGHTS – no assets  banks won’t loan

THE IMPACT OF NON-ECONOMIC FACTORS IN DIFFERENT COUTRIES

- Week/inefficient government  resources not allocated efficiently
- Civil wars
- Corruption  inefficient allocation of resources, increased business costs, less FDI

STRATEGIES INFLUENCING GROWTH AND

DEVELOPMENT

MARKET ORIENTATED STRATEGIES

TRADE LBERALISATION – removal of trade barriers  lower prices (increased consumer

surplus)  improved standard of living
PROMOTION OF FOREIGN DIRECT INVESTMENT – trade liberalisation, deregulation of capital
markets, make easier for multi-nationals to build factories, tax incentives
REMOVAL OF GOVERNMENT SUBSIDIES – inefficient allocation of resources because of
reduced competition  less incentive to minimise costs
FLOATING EXCHANGE RATE SYSTEMS – more internationally ‘price competitive’
MICRO-FINANCE SCHEMES – small business loans to poor people (97% woman)
PRIVATISATION – greater efficiency

INTERVENTIONIST STRATEGIES

DEVELOPMENT OF HUMAN CAPITAL – The skills, knowledge and talents of the workforce.
Improved through

PROTECTIONISM – education and training  increased productivity, tariffs, quotas etc.

MANAGED EXCHANGE RATES – ‘engineered’ depreciation  competitiveness
INFRASTRUCTURE DEVELOPMENT – expensive but vital to development
PROMOTING JOINT VENTURES – Between foreign investors and local business partner.
Advantages are: reduced costs and risks, less vulnerability to political instability … HOWEVER …
loss of control to local partner (technology), different strategic interests

BUFFER STOCK SCHEMES – Ceiling Price/Floor Price  storage or release of stocks to

reduce price fluctuations. HOWEVER … floor to high  surpluses/too low  insufficient stocks,
costs of storage, cheating (‘black market’)

OTHER STRATEGIES

INDUSTRIALISATION: THE LEWIS MODEL

Key features

- Surplus labour to high productivity industrial sector

- Marginal productivity of agricultural workers close to zero (‘law of diminishing returns’)
- Opportunity cost of transfer is close to zero
- Increased productivity/profitability  increased wages  attracts more workers
- Savings are zero therefore requiring FDI
HOWEVER … Trans-national Companies profits are ‘repatriated’ (go back overseas), there is
an assumption of surplus labour in agricultural sector

THE DEVELOPMENT OF TOURISM

- Source of foreign exchange
- Investment by global companies  multiplier effects
- Improved infrastructure (roads)
- Employment
- Increased tax revenues  reduction absolute poverty
- Demand for tourism is income elastic
- Preservation of national heritage

HOWEVER ….

- Adverse effect current account (imported food for tourists, profits ‘repatriated’)
- Fluctuations in demand due to trade cycle
- External Costs – waste, pollution, water shortages for locals
- Terrorism threat
- Employment only low skilled

DEVELOPMENT OF PRIMARY INDUSTRIES

Works if:

- Demand is income elastic

- Country has a comparative advantage)

FAIR-TRADE SCHEMES (guaranteed ‘fair price’)

Advantages – higher price, increased revenues  extra money for health and education,
protection from fluctuating price  plan/invest with confidence
Criticisms – extra money very small, geographically isolated farmers cannot join scheme, distortion
of ‘market prices’  encourages overproduction, no incentive to improve quality, and some of the
extra profits only end up in the hands of retailers

AID
- ‘voluntary transfer’ of resources and/or loans from one country to another
- Reduces ‘absolute poverty’
- Provides short-term emergency relief

TYPES OF AID

- TIED AID – conditions attached

- BILATERAL AID – directly from one country
- MULTILATERAL AID – to individual countries channelled through an organisation (World
Bank)

AID ….
- Reduces absolute poverty
- Fills ‘savings gap’
- Funds for investment
- Improves ‘human capital’
- Increases incomes

BUT ….

- Reinforces developed countries dominance

- Dependency
- Corruption
- Distort market forces
- Donor countries can exert political in influence
- Interest on loans must be paid

DEBT RELEIF

- IMF, World Bank, Governments, Banks owed money

HEAVILY INDEBTED POOR COUNTRIES INITIATIVE

POSITIVE: increased business confidence  investment, environmental gains (conditions
attached to cancellation of debt)
HOWEVER … corruption, shareholders/stakeholders in banks ‘forgiving’ debt are adversely
affected

INTERNATIONAL INSTITUTIUIONS – ‘THE WORLD BANK’ (International Bank

for Reconstruction and Development)

- Original idea was to supply long-term loans

- 1970’s focus on agricultural reforms by giving loans and expertise (advice/technical help)
- Today, the World Bank imposes ‘conditions’ (STRUCTURAL ADJUSTMENT PROGRAMS)
with loans. The focus now is reducing poverty, education, healthcare