topic 8 international trade

INTRODUCTION Do you realise that most of us are involved in international trade? For example, if you walk into a international coffee shop like The Coffee Bean & Tea Leaf, where you are able to buy Maui Blend or Tanzania Peaberry coffee, you are experiencing the effects of international trade. These days, most countries are involved in international economic activities. International trade allows us to expand our markets for both goods and services that otherwise may not have been available to us. This is the reason why you can pick between a Japanese, German or American car. As a result of international trade, the market contains greater competition, and therefore, more competitive prices, which brings cheaper products to consumers. This topic will focus on discussions about international trade.

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88 International

Trade

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Describe what international trade is and why countries trade;

2. Differentiate between absolute advantage and comparative advantage;

3. Discuss the benefits and barriers to international trade;

4. Point out the terms of trade; and

5. Propose why protection policies are needed.

TOPIC 8 INTERNATIONAL TRADE

182

WHY DO COUNTRIES TRADE?

Trade is important for a country. Without trade, a country cannot diversify its productions. Before you start reading, try to think of one important factor why trade is needed, especially international trade carried out in a country like Malaysia. A country does not only produce goods for local consumption, some of the products are exported to other countries. Those goods that cannot be produced locally are imported from other countries. This process of eexchanging goods or sale-purchase transactions for goods and services between ttwo or more countries is called iinternational trade. Basically, international economic activities refer to economic activities with other countries. Each country depends on the other to get goods and services and to carry out other economic activities such as investment and production. The advancement in computer technology and communication, and the reduction in trade restrictions make it possible to carry out international trade with ease. Generally, there are four main factors that encourage international trade between one country and another. Let us refer to Figure 8.1.

Figure 8.1: Four main factors that encourage international trade

Detailed explanation for all factors are as follows:

8.1

TOPIC 8 INTERNATIONAL TRADE 183

8.1.1 Possession of Different Production Factors

Each country has its own factors of production, different in type, quality and quantity. These differences are the main factors why countries conduct trade with one another. Different factors of production makes each country focus on different types of production. For instance, countries that have capital and high technological knowledge like Japan and United States of America, will focus on industrial products. Figure 8.2 shows the example of the automobile industry which requires high capital and technology.

Figure 8.2: Automobile industry

Source: http://www.bloomberg.com/image/irjYaws34d0U.jpg Countries that are rich with natural resources like Malaysia and China, will focus on producing main goods. For example oil, gas and so on. Because each country produces different types of goods, each country will carry out international trade to obtain goods that are not produced locally.

8.1.2 Different Climates

Difference in climate makes every country concentrate on producing different types of product. For instance, the hot and wet climate found in most of Southeast Asian countries, makes countries like Malaysia, Indonesia and Thailand focus on rubber plantation. Figure 8.3 shows an oil palm estate. Oil palm is one of the commodity crops in Malaysia.


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Figure 8.3: Oil palm is a commodity crop in tropical countries

Source: http://travel.mongabay.com/malaysia/ The cold climate in Australia and New Zealand allows both these countries to focus on the production of fruits like apples and oranges. So, different climates cause the production of different goods. The difference in agriculture produce encourages countries to trade with one another. Figure 8.4 shows grapes, which are one of the fruits planted in countries with a cold climate.

Figure 8.4: Grapes is one of the fruits produced in countries with cold climate

Source: http://tourcoverage.files.wordpress.com/2012/02/

8.1.3 Different Labour Skills

Every country has its own level of labour skills. For instance, countries like Japan, United States of America and Singapore have a skilled labour force in their industrial sector. Therefore, these countries focus on production of industrial goods. Other countries like New Zealand, Australia, China and Malaysia have a skilled labour force in the agricultural sector. The difference in labour skills causes the production of different types of goods and encourages international trade.


8.1.4 Different Consumption Patterns

Normally, different societies have different tastes, preferences and spending patterns. This situation causes the production of goods in accordance with the societys needs and preference. Therefore, each country will produce different types of goods. The different types of goods produced encourage international trade.

ABSOLUTE ADVANTAGE

In order to make it easier for you to understand the concept of absolute advantage, we will use one scenario. Assume two countries, X and Y, produce two types of products, oranges and apples. Table 8.1 shows the output quantity produced by each country using the same resource. Country X can produce 100 oranges or 10 apples using this resource. Meanwhile country Y can produce 50 oranges or 20 apples.

Table 8.1: Absolute Advantage for Country X and Y

Country Orange Apple

X 100 10

Y 50 20

8.2

ACTIVITY 8.1

Most of the labour force in Malaysia currently is from overseas such as Indonesia, Vietnam, India and Philippines. What is the effect on our local skills and expertise by these foreign workers flooding our job market?

EXERCISE 8.1

1. What do you understand from the term international trade?

2. Discuss the factors that encourage international trade.


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Table 8.1 clearly shows that country X is more efficient at producing oranges and country Y is better at producing apples. So, each country has an absolute advantage. What does it mean by absolute advantage?

This situation could be due to the possession of natural resources or high production efficiency. Country X is said to have an absolute advantage in the production of oranges and country Y has an absolute advantage in the production of apples. So, country X will specialise in producing oranges while country Y will focus on producing apples. The question now is, how much is the suitable exchange rate for these two countries to trade? Assume 30 oranges are exchanged for 10 apples. What will happen to country Y if all the resources are utilised to produce apples and exchange it with the oranges produced by country X? With this rate, country Y will get 60 oranges, which means it gets 10 fruits more than if it produced the oranges by itself. Besides that, country X also benefits from this specialisation. Through this trade, country X exchanged 60 oranges for 20 apples. Besides still having a remainder of 40 oranges, country X also received 10 more apples than if it had produced the apples by itself. Conclusively, country X received an excess of 40 oranges and 10 apples after carrying out trade with country Y. Meanwhile, country Y also got 10 oranges extra from the trade. This situation is shown in Figure 8.5.

Figure 8.5: Each country has an absolute advantage in one product

Absolute advantage is defined as a countrys ability to produce more of the product than another country can, with the same amount of resources.


This shows that both the countries benefited from the trade. There is no reason for the benefit to be equally divided. Instead, both countries got more goods after the trade. By specialising in the production of one product, and carrying out trade, both the countries obtained more goods compared with the situation if both the countries produced both the goods on their own. Assume two countries M and R produce two types of goods but the output quantity is different. Table 8.2 shows the quantity of goods that can be produced using the same specified quantity of resource.

Table 8.2: Absolute Advantage for Country M and R

Country Orange Apple

M 100 20

R 30 10 Table 8.2 shows country M can produce 100 oranges or 20 apples. Country R can produce 30 oranges or 10 apples. It is noted that country M has an absolute advantage over country R for the production of both oranges and apples. In this situation, is it necessary for the countries to specialise and trade? Assume that trade is agreed upon at the rate of 40 oranges to 10 apples. Although country R does not have absolute advantage, if it produces 10 apples, then it can exchange them for 40 oranges. The oranges it gets will definitely be more than the amount it is able to produce on its own. However, country M can afford to let go of 10 apples to produce 50 more oranges and exchange 40 oranges to get 10 apples. In this way, country M gets 10 more oranges. This situation is shown in Figure 8.6. This shows that although a country does not have absolute advantage, specialisation and trade can still be practiced and they benefit both countries.

Figure 8.6: Country M has absolute advantages in both products


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COMPARATIVE ADVANTAGE

Let us move on to comparative advantage. Firstly, let us learn its definition.

Trade is not determined by the production efficiency of certain goods but more of the opportunity cost after producing the goods compared with other countries. A country is said to have a comparative advantage in the production of certain goods if the opportunity cost is lower than in other countries. Table 8.3 shows the opportunity cost for the production of apples in the unit quantity of oranges that had to be given up.

Table 8.3: Comparative Advantage for Apples

Country Opportunity Cost of 1 Apple

M 5 oranges (100/20)

R 3 oranges (30/10) Based on Table 8.3, we can see that country M is forced to give up five oranges to produce one apple. Whereas, country R had to give up three oranges to produce one apple. This difference allows for specialisation and trade is carried out between the two countries. Relatively, country R is more efficient in producing apples. Although it does not have an absolute advantage, country R has a comparative advantage in producing apples. Table 8.4 shows opportunity cost in the production of oranges in the quantity of apples that had to be given up. Since country R has a comparative advantage in producing apples, country M will have a comparative advantage in producing oranges. Table 8.4 shows that the opportunity cost for country M to produce oranges is 1/5 apples. Whereas, it is 1/3 apples for country R. Because 1/5 is smaller than 1/3, country M has to sacrifice a little apple to produce oranges compared with country R. Relatively, country M is more efficient in the production of oranges.

Table 8.4: Comparative Advantage for Oranges

Country Opportunity Cost of 1 Orange

M 1/5 Apples (20/100)

R 1/3 oranges (10/30)

Comparative advantage refers to a countrys ability to produce a product with lower relative cost compared with other countries.

8.3


As a conclusion, comparative advantage is an iimportant condition for specialisation and trade, not absolute advantage. What is important is which country can afford to produce a product with rrelative efficiency and not which country can produce a cheaper product. Whether trade or not, depends on the oopportunity cost and not the quantity of resources utilised in the production. A country will specialise in the production of goods for which it has a llower opportunity cost compared with other countries.

BENEFITS OF INTERNATIONAL TRADE

Almost all the countries worldwide carry out international trade. This is because international trade benefits those countries involved. The benefits derived from international trade are stated in Figure 8.7.

8.4

EXERCISE 8.2

1. Provide the definitions of absolute advantage and comparative advantage.

2. What is the difference between the concepts of absolute advantage

and comparative advantage?

ACTIVITY 8.2

International trade has existed in Malaysia since the Malacca Malay Sultanate era. Try to think what could have been the benefits gained from international trade at that time and try to compare them with the benefits of international trade at this present time.


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Figure 8.7: Four benefits of international trade

Now let us look at Table 8.5 for a detailed explanation of all these benefits.

Table 8.5: The Benefits of International Trade

The Benefits of International Trade Description

Acquire Goods that Cannot be Produced Locally

People in every country need a variety of goods. However, every country is unable to produce all the goods wanted and needed. Therefore, trade between countries is carried out to acquire goods that cannot be produced locally.

For instance, Malaysia specialises in the production of oil palm and rubber to be exported to other countries. In return, Malaysia obtains goods that cannot be produced in this country such as aeroplanes, apples and oranges.

Widen the Market for Local Products

A countrys production can be marketed widely through international trade. Goods that are locally made can be exported to other countries. A higher production quantity will help to efficiently utilise factors of production.

This will reduce the cost of production and the price. It will increase the living conditions of the people.

Increase Efficiency in Usage of Production Factors

International trade encourages specialisation. Specialisation means each country specialises in producing a particular product which it can do efficiently. This will ensure efficiency in usage of production factors.

Acquire Modern Technology

International trade allows modern technology to be imported from developed countries to developing countries. Modern technology will enable developing countries to increase their production capabilities. International trade also allows developing countries to enjoy the usage of high technology products like computers, digital cameras and such.


INTERNATIONAL TRADE BARRIERS

International trade is often related to loss of jobs for local people. For instance, if free enterprise is allowed for the automotive industry, then the Proton factory may have to be shut down due to its inability to compete with foreign automotive companies. This will directly cause many of our local workers to lose their jobs and eventually the unemployment rate will rise. In order to overcome this problem, the government will have to intervene by imposing a free trade barrier. There are two types of trade barriers; ttariff which can be divided into three types and nnon-tariff barriers such as quotas, subsidy, voluntary export restraint (VER), foreign currency control and other restrictions to control international trade.

8.5.1 Tariffs

Do you know what tariff means?

Tariff can be divided into three types, namely ad-valorem tariff, sspecific tariff and compound tariff. Let us refer to Table 8.6 to identify the differences in these tariffs.

Tariff is a tax on foreign goods upon importation.

8.5

ACTIVITY 8.3

There are also other benefits from international trade. Try to list down other benefits and discuss your list with your classmates.

ACTIVITY 8.4

International trade barriers are efforts made by a country to restrict or reduce the total imported goods from other countries. Other countries that wish to carry out trade with Malaysia for example, will have to go through the international trade barriers implemented by the government of Malaysia. Try to think of the effects on local production if Malaysia does not implement any trade barrier on foreign countries.


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Table 8.6: Types of Tariffs

Types of Tariff Explanation Example

Ad-Valorem Tariff Import tax that is calculated based on the percentage of the value of the imported goods.

If the import tax for a car is 50%, then the tax that is imposed on a RM20,000 imported car is RM10,000.

Specific Tariff

Fixed tax figure that does not depend on the value of the imported goods. Although the value of goods keep changing, the total tax imposed is fixed.

One tonne of teak wood was imposed an import tax of RM200. It does not matter whether the price of the teak wood increases or decreases, the tax imposed is the same at the rate of RM200 per tonne.

Compound Tariff A combination of specific and ad valorem tariffs often applied to manufactured products embodying raw materials that are subject to tariffs.

A country needs to pay a specific tax of $50 plus 5% of the product value that it imported.

Tariff will cause the cost of imported goods to go up and this means the price of the goods will increase as well. Indirectly, it reduces the local consumers intention to purchase the imported goods.

8.5.2 Non-tariffs

Non-tariff barrier can be divided into five categories. Let us learn more on these five categories. (a) QQuotas How do we define quotas?

Implementation of quotas will not influence government revenue. In fact,

quotas provide protection for local firms. There is no more competition from foreign firms once the quota is fulfilled.

Quota is the maximum limit set on the quantity of a good that can be imported into a country in a given period of time.


The main effect of quota is that it increases the price of the imported goods. But because of the limited quantity of goods, consumers are willing to spend a lot of money to get these products.

(b) Subsidy How about subsidy? What can you say about it?

Government grants subsidies to the producers to improve their market

position. With subsidy, producers can market their products at prices that are lower than their actual cost. Subsidies can be in various forms such as outright cash disbursements, tax concessions, loans at below market interest rates, and so on. Two types of subsidies that are usually used are domestic production subsidy which is granted to producers of import-competing goods; and eexport subsidy which is granted to producers of goods that are exported to foreign countries.

(c) Voluntary Export Restraint (VER) With VER, governments are able to moderate the intensity of international

competition by allowing the less efficient domestic producers to participate in markets that would otherwise concurred by foreign producers that can sell product at a lower price.

(d) FForeign Currency Control Besides tariffs and quotas, governments can also control the foreign

currency used for import. Government can impose various forms of controls to influence international trade activities such as import. Among the methods used to control the quantity of goods imported is by controlling the total foreign currency that is usually used to import the goods. Another alternative is by selling the foreign currency at a higher rate compared with the market rate.

(e) OOther Restrictions Besides these, the government can also use other methods to reduce usage

of imported goods. For example, the government can direct all its departments to use only locally made products such as using the national car Proton.

Government can also direct financial institutions such as banks to reduce the giving of loans to support purchase of imported goods.

Subsidy is payments made by the government to domestic producers to improve their trade competitiveness.


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TERMS OF TRADE

Trade will only take place if it benefits both countries that carry out trading. The exchange rate agreed upon by both countries are called tterms of trade. Now, what does it mean by terms of trade?

There are two methods of measuring terms of trade for a country:

(a) Price; and

(b) Goods. Let us look at these two methods further.

8.6.1 Price

Firstly, let us learn the definition of price terms of trade.

The terms of trade can be measured using this formula:

Px = Export price Pm = Import price

Price terms of trade means the ratio of price of export commodity to price of import commodity in a country.

8.6

Price terms of trade = Px / Pm

Terms of trade can be defined as the ratio of price or quantity of export commodity to price or quantity of import commodity.

EXERCISE 8.3

1. Discuss FOUR benefits of international trade.

2. What are the methods undertaken to restrict free trade between countries?


When export price drops and import price goes up or does not change, the price terms of trade for that country will deteriorate. Instead, when export price increases or does not change and import price reduces, the price terms of trade will increase.

8.6.2 Goods

How about terms of trade for goods.

Goods terms of trade can be measured with the following formula:

Qx = Export quantity Qm = Import quantity

When the same export quantity can obtain a lesser import quantity, the goods terms of trade will increase.

Instead, when the same export quantity can obtain more import quantity or lower export quantity can obtain the same import quantity, then the goods terms of trade will drop.

WHY PROTECTION POLICIES ARE NEEDED

Although it is agreed that international trade can increase the welfare of the trading countries, there are some countries still implementing protectionism economic policy of restraining free trade between nations. Let us refer to Figure 8.8 to identify reasons why protection policies are needed.

Goods terms of trade measures the ratio of quantity of export commodity to quantity of import commodity in a country.

Goods terms of trade = Qx / Qm

8.7


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Figure 8.8: Reasons why protection policies are needed

The explanation for all the reasons are given as follows:

8.7.1 Protect New Industries

Each country has a new industry to promote. New industries are not ready to compete with foreign firms and need government assistance and support to continue their operations. Without the governments help, they could face strong competition and may even have to be shut down if they fail to survive the competition. For instance, in the mid 1980s, the automobile industry in Malaysia was still new and needed government assistance. This industry was in its infancy stage and was not ready to compete with foreign giant firms such as Ford Company and Honda Company. In the beginning, the industry was not competitive in many aspects such as price, cost of production and product quality.

8.7.2 National Security

Certain goods used by citizens have to be produced by the individual countries themselves. These countries cannot depend on other countries to produce such goods. This could be for security reasons. For instance, if Malaysia depends on Thailand fully to get its supply of rice, and if war takes place between Malaysia and Thailand, then this could affect our national security as Thailand can restrict the supply of rice to Malaysia.


8.7.3 Diversify Local Economic Activities

It is necessary to diversify a countrys economic activities, which will contribute towards national income through foreign exchange. If a country depends a lot on specific export industry, it can cause a decrease in national income if the industry deteriorates. For example, Malaysia exports palm oil overseas. If the price of palm oil in the international market drops suddenly and Malaysia does not have another source of income, then Malaysia will have no choice but to only depend on the export of oil palm. Therefore, protection is required for other industries to diversify the countrys economic activities.

8.7.4 Protect Resources

Protectionism can also be used to protect local industries and its resources. When consumers start depending on imported goods, it will not encourage domestic economic activities. This will affect the demand for local sources of production including labour. This will cause the unemployment rate to go up. Other related social problems such as robberies, thefts and political instability will emerge.

8.7.5 Anti-dumping

What does anti-dumping refer to?

This situation will encourage imports. If this continues, it will seriously affect the local industry. Therefore, protection policies are needed to look after the welfare of the local industries because they contribute towards a countrys economy.

Anti-dumping refers to the activities of foreign firms that have excess production and sells this to other countries for a much cheaper price compared with the price sold in its own country.


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International trade is a process of exchanging goods or sale-purchase transactions for goods and services between two or more countries.

Factors that encourage countries to trade with one another are possession of different production factors, climate, labour skills and different consumption pattern.

Absolute advantage is a countrys ability to produce more of the product than another country can, with the same amount of resources.

Comparative advantage refers to a countrys ability to produce a product with lower relative cost compared with other countries.

Among the benefits of international trade are to acquire modern technology and widen the markets for local products.

There are a few barriers that are commonly used in international trade such as tariffs and non-tariffs such as quotas, subsidy, voluntary export restraint, foreign currency control and other restrictions for various reasons. The reason are to protect new industries, national security, diversify a countrys economic activities and avoid dumping.

Terms of trade can be measured either in price or goods.

ACTIVITY 8.4

Try to list other reasons why protectionism and trade restrictions are needed. Discuss your answers with your classmates.

EXERCISE 8.4

1. What is the meaning of terms of trade?

2. Why is a protection policy needed?


Absolute advantage

Anti-dumping

Barriers

Comparative advantage

Good term of trade

Price term of trade

Protection policies

Quota

Subsidy

Tariff

Term of trade