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Posts Tagged ‘comparative advantage’

What do trade deals involve?

In the light of the Brexit vote and the government’s position that the UK will leave the single market and customs union, there has been much discussion of the need for the UK to achieve trade deals. Indeed, a UK-US trade deal was one of the key issues on Theresa May’s agenda when she met Donald Trump just a week after his inauguration.

But what forms can a trade deal take? What does achieving one entail? What are likely to be the various effects on different industries – who will be the winners and losers? And what role does comparative advantage play? The articles below examine these questions.

Given that up until Brexit, the UK already has free trade with the rest of the EU, there is a lot to lose if barriers are erected when the UK leaves. In the meantime, it is vital to start negotiating new trade deals, a process that can be extremely difficult and time-consuming.

A far as new trade arrangements with the EU are concerned, these cannot be agreed until after the UK leaves the EU, in approximately two years’ time, although the government is keen that preliminary discussions take place as soon as Article 50 is triggered, which the government plans to do by the end of March.

Articles
Trade deals are difficult to negotiate and Britain lacks the skills for the job The Conversation, Nigel Driffield (27/1/17)
Why a U.S.-U.K. Trade Deal Could be Harder than it Sounds Newsweek, Josh Lowe (26/1/17)
UK-US trade deal will have ‘very small upsides’ for Britain, says former Bank of England economist Independent, Rob Merrick (26/1/17)
Trump says he wants a U.K. trade deal. Don’t hold your breath CNN Money, Alanna Petroff (23/1/16)
Reality Check: Can there be a quick UK-USA trade deal? BBC News, Jonty Bloom (16/1/17)

Questions

  1. What elements would be included in a UK-US trade deal?
  2. Explain the gains from trade that can result from exploiting comparative advantage.
  3. Explain the statement in the article that allowing trade to be determined by comparative advantage is ‘often politically unacceptable, as governments generally look to protect jobs and tax revenues, as well as to protect activities that fund innovation’.
  4. Why is it difficult to work out in advance the likely effects on trade of a trade deal?
  5. What would be the benefits and costs to the UK of allowing all countries’ imports into the UK tariff free?
  6. What are meant by ‘trade creation’ and ‘trade diversion’? What determines the extent to which a trade deal will result in trade creation or trade diversion?
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UK trade: not all doom and gloom

The UK’s balance on trade continues to be sharply in deficit. At the same time, both manufacturing and overall production are still well below their pre-crisis levels. What is more, with a sterling exchange rate that has appreciated substantially over recent months, UK exports are at an increasing price disadvantage. The hoped-for re-balancing of the economy from debt-financed consumption to investment and exports has not occurred. Investment in the UK remains low relative to that in other major economies (see).

But other developments in the global economy are working in the UK’s favour.

Manufacturing globally is becoming more capital intensive, which reduces the comparative advantage of developing countries with low labour costs.

At the same time, the dividing line between manufacturing and services is becoming more blurred. Manufacturers in developing countries may still produce parts, such as chips or engines, but the design, marketing and sales of the products may take place in developed countries, such as the UK. Indeed, as products become more sophisticated, an increasing amount of value added may occur in developed countries.

The UK may be particularly well-placed in this regard. It can provide many high-end services in IT, business support and financial services to international manufacturers. It may have a comparative advantage in idea-intensive production.

Finally with a higher exchange rate, the UK’s terms of trade have been improving. The downside is that it makes UK exports more expensive in foreign currency terms, but it also makes commodity prices cheaper, which have already fallen in dollar terms, and also the prices of imported component parts. This helps offset the effect of the appreciation of the exchange rate on exports.

The following article by Jeremy Warner considers whether, despite its poor performance in traditional manufacturing, the UK might have hit an economic ‘sweet spot’ in its trade position.

Article
Unbalanced but lucky, Britain hits an economic sweet spot The Telegraph, Jeremy Warner (8/9/15)

Data
UK Trade (Excel file) ONS (9/9/15)
(See, for example, Worksheet 1. You can search for longer series using Google advanced search, putting www.ons.gov.uk in the ‘site or domaine’ box and searching for a particular series, using the series identifier found at the top of each column in the Excel file, such as BOKI for balance on trade in goods.)
Exchange rate data Bank of England Statistical Interactive Database

Questions

  1. Explain the difference between the balance on trade, the balance on trade in goods and the balance of payments on current account.
  2. Why has the UK not experienced a re-balancing of the economy as hope for by the Chancellor of the Exchequer, amongst others?
  3. What is meant by the ‘terms of trade’?
  4. What would cause an ‘improvement’ in the terms of trade?
  5. Are the UK’s terms of trade likely to move in the UK’s favour in the coming months? Explain.
  6. What current factors are mitigating against a recovery of UK manufacturing exports?
  7. Is de-industrialisation necessarily a ‘bad thing’?
  8. Does the development of new capital-intensive technologies in manufacturing mean that the UK could become a net exporter of manufactures? Explain why or why not.
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Free trade from Cairo to Cape Town

A deal has just been signed between 26 African nations to form a new free trade area, the Tripartite Free Trade Area (TFTA). The countries have a population of 625 million (56% of Africa’s total) and a GDP of $1.6 trillion (63% of Africa’s total). The deal effectively combines three existing free trade areas: the Common Market for Eastern and Southern Africa, the Southern African Development Community and the East African Community.

Although the deal has been signed by the nations’ leaders, it still needs parliamentary approval from each of the countries. It is hoped that this will be achieved by 2017. If it is, it will mark a major step forward in encouraging intra-African trade.

The deal will involve the removal of trade barriers on most goods and lead to a reduction in overall tariffs by more than 50%. The expectation of the leaders is that this will generate $1 trillion worth of economic activity across the 26 countries through a process of trade creation, investment, increased competition and the encouragement of infrastructure development. But given the current poor state of infrastructure and the lack of manufacturing capacity in many of the countries, the agreement will also encourage co-operation to promote co-ordinated industrial and infrastructure development.

Up to now, the development of intra-African trade has been relatively slow because of poor road and rail networks and a high average protection rate – 8.7% on exports to other African countries compared with 2.5% on exports to non-African countries. As a result, intra-African trade currently accounts for just 12% of total African trade. It is hoped that the development of TFTA will result in this rising to over 30%.

Much of the gains will come from economies of scale. As Kenyan academic Calestous Juma says:

“By having larger markets, it signals the possibility of being able to manufacture products at a scale that is cost-effective. For example, where you need large-scale investments like $200m to create a pharmaceutical factory, you couldn’t do that if you were only selling the products in one country.”

The question is whether the agreement signed on the 10 June will lead to the member countries fully taking advantage of the opportunities for trade creation. Agreeing on a deal is one thing; having genuinely free trade and investing in infrastructure and new efficient industries is another.

Videos and audio
African leaders ink trade deal Deutsche Welle (11/6/15)
African leaders sign pact to create ‘Cape to Cairo’ free trade bloc euronews (10/6/15)
Africa Free Trade Analysis BBC Africa, Calestous Juma (9/6/15)

Articles
African Leaders To Sign Free Trade Agreement To Create Common Market International Business Times, Aditya Tejas (10.6.15)
EAC, COMESA and SADC Blocs Ink ‘Historic’ Trade Deal allAfrica, James Karuhanga (11/6/15)
Tripartite Free Trade Area an Opportunity Not a Threat allAfrica, Sindiso Ngwenya (9/6/15)
Africa a step closer to free trade area Business Report (South Africa), Rob Davies (11/6/15)
The Cape to Cairo trade ‘super bloc’ is here; 15 surprising – and shocking – facts on trade within Africa Mail & Guardian (Kenya), Christine Mungai (8/6/15)
The tripartite free trade area agreement in Africa is bound to disappoint Quartz Africa, Hilary Matfess (10/6/15)
Africa creates TFTA – Cape to Cairo free-trade zone BBC News Africa (10/6/15)
Will the Cape to Cairo free-trade zone work? BBC News Africa, Lerato Mbele (10/6/15)
African free trade still some way off BBC News, Matthew Davies (10/6/15)
Zambia not to benefit from Africa’s TFTA Medafrica, Geraldine Boechat (10/6/15)

Questions

  1. Distinguish between a free trade area, a customs union and a common market.
  2. What does the law of comparative advantage imply about the gains from forming a free trade area?
  3. Distinguish between trade creation and trade diversion.
  4. Why is it likely that there will be considerable trade creation from TFTA? Would there be any trade diversion?
  5. Why are small countries with a relatively low level of economic development likely to experience more trade creation than larger, richer ones?
  6. What barriers might remain in trade between the TFTA countries?
  7. Why might smaller, less developed members of TFTA be worried about the removal of trade barriers?
  8. Why might concentrating on developing local capacity, rather than just lowering tariffs, be a more effective way of developing intra-African trade
  9. What ‘informal’ barriers to trade exist in many African countries?
  10. Why is it that ‘Ordinary Africans are most probably not holding their breath’ about the gains from TFTA?
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The UK and the single market

A key debate for some months has been the UK’s membership of the European Union. The debate has centred around the desire to return some powers back to the UK, but this has extended into the possibility of a referendum on our membership of the preferential trading area. So, let’s take a step back and consider why any country would want to be a member of a preferential trading area.

Preferential trading areas can be as basic as a free trading area or as advanced as a currency, or even political union. The eurozone is clearly a currency union, but the European Union, of which the UK is a member, is a common market. A common market has no tariffs and quotas between the members, but in addition there are common external tariffs and quotas. The European union also includes the free movement of labour, capital and goods and services. Membership of a preferential trading area therefore creates benefits for the member countries. One such benefit is that of trade creation. Members are able to trade under favourable terms with other members, which yields significant benefits. Countries can specialise in the production of goods/services in which they have a comparative advantage and this enables greater quantities of output to be produced and then traded.

Other benefits include the greater competition created. By engaging in trade, companies are no longer competing just with domestic firms, but with foreign firms as well. This helps to improve efficiency, cut costs and thus lower prices benefiting consumers. However, from a firm’s point of view there are also benefits: they have access to a much wider market in which they can sell their goods without facing tariffs. This creates the potential for economies of scale to be achieved. Were the UK to completely exit the EU, this could be a significant loss for domestic firms and for consumers, who would no longer see the benefits of no tariffs on imported goods. Membership of a preferential trading area also creates benefits in terms of potential technology spillovers and is likely to have a key effect on a country’s bargaining power with the rest of the world. As is a similar argument to membership of a trade union, there is power in numbers.

There are costs of membership of a preferential trading area, but they are typically outweighed by the benefits. However, estimates suggest that the cost of EU regulation is the equivalent of 10% of UK GDP. Furthermore, while the UK certainly does trade with Europe, data suggests that only 13% of our GDP is dependent on such exports. The future is uncertain for the European Union and Britain’s membership. There are numerous options available besides simply leaving this preferential trading area, but they typically have one thing in common. They will create uncertainty and this is something that markets and investors don’t like. Vince Cable warned of this, saying:

There are large numbers of potential investors in the UK, who would bring employment here, who have been warned off because of the uncertainty this is creating.

The impact of the UK’s decision will be significant and not just for those living and working in the economy. The world is no interdependent that when countries exist (or typically enter) a preferential trading area the wider economic effects are significant. While any change in the UK’s relationship with the EU will take many months and years to occur and then further time to have an effect, the uncertainty created by the suggestion of a change in the relationship has already sent waves across the world. The following articles consider the wider single market and the current debate on UK membership.

European Union: if the ‘outs’ get their way, we’ll end up like Ukraine Guardian, Vince Cable (16/5/13)
Conservative MP James Wharton champions bill to guarantee EU referendum Independent, Andrew Grice (16/5/13)
Nick Clegg shifts ground over EU referendum The Guardian, Patrick Wintour (15/5/13)
Cameron tells EU rebels to back referendum law Reuters, Peter Griffiths (16/5/13)
The EU and the UK – the single market BBC Democracy (4/3/13)
Single market dilemmas on Europe BBC News, Stephanie Flanders (14/5/13)
Lord Wolfson: I back the single market – but not at any cost The Telegraph, Lord Wolfson (19/1/13)
EU focuses on returning single market to health Financial Times, James Fontanella-Khan (8/5/13)

Questions

  1. What other examples of preferential trading areas are there? How close are they to the arrangement of the European Union?
  2. In each of the above examples, explain the type of preferential trading area that it is.
  3. What are the benefits and costs of being a member of a preferential trading area such as the EU? How do these differ to being a member of a) a free trade area and (b) a customs union?
  4. What options are open to the UK in terms of re-negotiating its relationship with the EU? In each case, explain how the benefits and costs identified in question 3 would change.
  5. Why is the UK’s decision so important for the global economy? Would it be in the interests of other economies? Explain your answer.
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Banana War Ends

Trade is generally argued to be good for economic growth, as it allows countries to specialise in those goods in which they have a comparative advantage and thus produce and consume more of all goods in total. However, trade inevitably leads to winners and losers, especially as countries impose tariffs on imports in order to protect domestic industries. This has been the case in the banana industry.

Banana growers in the former European colonies have long been protected by EU tariffs, helping to prevent competition from their Latin American banana growers. But, now things could be about to change. In December 2009, most of the nations concerned reached an agreement in Geneva for tariffs imposed by the EU to be gradually reduced.

The European Union had imposed no duty on bananas from their former colonies, but had imposed tariffs on banana imports from other countries. This meant that those countries now benefiting from zero import duty could sell their bananas for a much lower price, therefore restricting the other nations (who did have to pay an import duty) from competing effectively.

With the World Trade Organisation in attendance, an agreement was signed that puts an end to this trade dispute dating back over 2 decades. The Director General of the WTO, Pascal Lamy said:

‘This is a truly historic moment … After so many twists and turns, these complicated and politically contentious disputes can finally be put to bed. It has taken so long that quite a few people who worked on the cases, both in the Secretariat and in member governments have retired long ago.’

This trade war has been ongoing for many years and this agreement represents a big step in the right direction. With a fairer playing field in this banana market, countries in Latin America will now be much more able to compete with other nations. As economists argue that trade is good, a reduction in protectionist measures should be seen as a good thing and will benefit the countries concerned. The following articles consider this trade resolution.

Banana war ends after 20 years BBC News (8/11/12)
WTO: Historic signing ends 20 years of EU-Latin American banana disputes 4-Traders, WTO (8/11/12)
EU, Latin America nations mark end of ‘banana war’ Fox News (8/11/12)
Banana war ends after 20 years The Telegraph (9/11/12)
Infamous banana dispute ends Sky News (9/11/12)

Questions

  1. What is comparative advantage and how does it lead to gains from trade?
  2. How does a tariff help protect a country’s domestic industry?
  3. Using a diagram, illustrate the effect of a tariff being imposed on banana imports from Latin America. Is there a cost to society of such a policy?
  4. Now, show what happens when this tariff is removed by the EU. Who benefits and who loses?
  5. What is the role of the World Trade Organisation?
  6. How does a tariff affect a country’s ability to compete with other nations?
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Talk is cheap

The article linked to below is an extract (printed in the Guardian) from a new book by Dan Atkinson and Larry Elliott (economics editor for the Guardian). The introduction to the article summarises its theme quite effectively:
“We don’t manufacture anything any more. Most of the world won’t buy our records or watch our films. Only our gift of the gab is keeping Britain’s economy ticking over. But how long can the hot air last, ask Larry Elliott and Dan Atkinson “

Talk is cheap Guardian (18/5/07)


Questions
1. Explain the underlying trade performance of the UK in recent years for (a) trade in goods and (b) trade in services.
2. “Labour believes Britain is at the cutting edge of the knowledge economy and that Britain’s well-educated (sic), highly skilled (sic) and entrepreneurial (sic) workers are ready to kick German, American, Japanese and Chinese butt all round the global village.” Discuss the extent to which this is true.
3. Assess the extent to which the theory of comparative advantage can help explain the differences in trade performance outlined in the article.
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