OCR Economics A-level Macroeconomics Topic 4: The Global Context 4.5 Trade policies and negotiations Notes
Different methods of protectionism Protectionism is the act of guarding a country s industries from foreign competition. It can take the form of tariffs, quotas, regulation or embargoes. o Tariffs Tariffs are taxes on imports to a country. It could lead to retaliation, so exports might decrease. The impact of tariffs is that the quantity demanded of domestic goods increases, whilst the quantity demanded of imports decreases. The tariff diagram illustrates the effects of imposing a tariff. The original quantity of imports is Q2 Q1, and the new quantity of imports is Q4 Q3. The purple shaded rectangle shows the revenue the government gains from imposing the tariff. This could help finance government expenditure. The two blue triangles show the area of deadweight loss of welfare, as a result of the tariff. o Quotas
A quota limits the quantity of a foreign produced good that is sold on the domestic market. It sets a physical limit on a specific good imported in a set amount of time. It leads to a rise in the price of the good for domestic consumers, so they become worse off. o Export subsidies This is a form of government intervention to encourage goods to be exported rather than sold on the domestic market. The government might use direct payments, tax relief, or provide cheap access to credit. o Embargoes This is the complete ban on trade with a particular country. It is usually politically motivated. o Excessive administrative burdens ( red tape ) Excessive administration increases the cost of trading, and hence discourages imports. It makes it difficult to trade with countries imposing red tape, and is particularly harmful for developing countries which are unable to access these markets. It is harder to notice this type of protectionism, which is why it is favoured among some countries. The costs and benefits of protectionism Benefits of protectionism If a country employed several protectionist measures, then a trade deficit would reduce. This is because they will be importing less due to tariffs and quotas on imports. Infant industries might need protecting. These are industries which are relatively new and receive support. Protectionism is usually short term until the industry develops, at which point the industry can trade freely. Protectionism could be used to correct market failure. It can deal with demerit goods and protect society from them.
Governments might employ protectionist measures to improve the current account deficit. Governments might want to protect domestic jobs. Costs of protectionism Protectionism could distort the market and lead to a loss of allocative efficiency. It prevents industries from competing in a competitive market and there is a loss of consumer welfare. Consumers face higher prices and less variety. By not competing in a competitive market, firms have little or no incentive to lower their costs of production. It imposes an extra cost on exporters, which could lower output and damage the economy. Tariffs are regressive and are most damaging to those on low and fixed incomes. There is a risk of retaliation from other countries, so countries might become hostile. Protectionism could lead to government failure. The case for and against free trade Free trade is the act of trading between nations without protectionist barriers, such as tariffs, quotas or regulations. Free trade provides the following benefits: Countries can exploit their comparative advantage, which leads to a higher output using fewer resources and increases world GDP. This improves living standards. Free trade increases economic efficiency by establishing a competitive market. This lowers the cost of production and increases output. By freely trading goods, there is trade creation because there are fewer barriers. This means there is more consumption and large increases in economic welfare. More exports could lead to higher rates of economic growth. Specialising means countries can exploit economies of scale, which will lower their average costs.
The following costs could be considered: Free trade has resulted in some job losses, since countries with lower labour costs have entered the market. Free trade might have contributed to some environmental damage. This is especially from the increase in manufacturing. International competitiveness Measures of international competitiveness International competitiveness is the ability of a nation to compete successfully overseas and sustain improvements in real output and living standards. Countries can compete with price and non-price competitiveness. For example, the quality of goods and services and the rate of innovation can change how competitive a country is. Relative unit labour costs The unit labour cost is how much labour costs per unit of output. Generally, the cheaper the relative unit labour costs, the more competitive the country in manufacturing. For example, countries such as China, India and Bangladesh have lower labour costs than countries such as the UK and US, which means that a lot of production requiring manufacturing, such as textiles, clothes and technology, has moved abroad. However, higher prices could compete if a niche market is targeted or by using product differentiation. Quality is also important: German cars are famous for their quality, so consumers might be willing to pay more for them. The more productive a country becomes, the lower its unit labour costs. This makes the country more internationally competitive. Relative export prices This is the ratio of one country s export prices relative to another country, and it is expressed as an index. The lower the relative export price, the more competitive the country.
Factors influencing international competiveness Ability to attract FDI from MNCs If a country can attract more FDI, it increases their productive capacity. This can help produce long term growth and raise living standards. Ability to produce or attract entrepreneurs Entrepreneurs help develop new ideas and stimulate innovation. This keeps a country ahead with technology and gives them an edge in the market, which makes them more competitive. Ability to attract (skilled) labour from abroad This might fill a skills gap in, for example, IT or biotechnology, and improves the quality of the labour force. If there is a skills gaps, firms face higher costs. The UK s ability to attract FDI depends on: - The skills and flexibility of the labour force, which could lower unit labour costs. - The UK acts as a gateway to Europe, especially with the free trade within the EU. The EU forms 16.5% of world trade and is the world s largest trading bloc. - The relatively low tax rate. - Stability in the economy and financial system. Unit labour costs Unit labour costs rise when wages increase at a faster rate than productivity. China s large population means wages are generally low, but the rise of the middle class and consumer spending is pushing wages up. Exchange rate A depreciation in the real exchange rate makes exports relatively cheaper, so the country becomes more internationally competitive. If the price of imports increases as a result of a devaluation, then the cost of raw materials would increase, which would be particularly damaging to small firms. It is important to remember that devaluating the currency is not a policy relevant for countries with floating exchange rates, such as the UK. Quantity and quality of skills possessed by a nation s workers
This refers to the skills of human capital. If there are limited skills, the economy cannot expand its productive potential. The more skilled the workforce, the more productive it is. It also means goods and services are of a better quality, which improves international competitiveness. Flexibility of labour Part time and temporary contracts help limit a firm s costs, which lowers unit labour costs. Additionally, if the labour market is flexible and geographically or occupationally mobile, it can better respond to economic shocks and changes in demand or supply, which can help improve competitiveness. Economic stability If inflation is low and stables, firms are more able to plan their investment and spending, because they know what future prices will be. Deflation or high and uncontrollable inflation makes it hard to plan for the future. For example, the UK government could try and reform the banking sector so it is more resilient to shocks. Tax policies e.g. low income tax A lower tax rate provides an incentive to earn more, since consumers and firms know they will keep more of their income. A low income tax might attract more skilled labour, too. The UK government has tried to increase competitiveness by lowering the corporation tax rate from 21% to 20% in 2015. This is the joint lowest in the G20 and should help increase inward investment. Regulation Excessive regulation (red tape) can make it hard for firms to invest, and it could raise their average costs of production. The UK government has established the Red Tape Challenge, which aims to simplify regulation for businesses, so it is cheaper and easier to meet environmental targets and create new jobs. It should help to encourage investment and innovation, so domestic firms can become more internationally competitive. In France, there are excessive employment laws that make it hard for small enterprises to compete. Rate of innovation This is calculated by the proportion of GDP invested in new capital. If a country innovates more, they are likely to develop new, more advanced technology that can
help them become more competitive. It could increase the quality of the goods and services produced. It could be argued that non-price factors such as availability, reliability, quality, design and innovation are more important than price factors. Interest rates It can be considered whether the UK s low interest rates have helped the international competitiveness of the UK. It has encouraged spending, which increased AD and growth. However, it can be seen as a deterrent for foreign investors, since they get a low return on investment. The increase in AD might cause demand-pull inflation, which could make UK goods more expensive than elsewhere. This might increase imports, if they are cheaper than domestic goods, which could worsen the current account deficit. However, this means the UK has a capital account surplus. A depreciation of the pound would result in a lower return on investment for investors, which might reduce demand. The UK gets a lot of investment in the London property market. A lack of investment would result in a lack of research and development. Competitiveness is limited by exchange rates in other countries. However, it should be considered whether strengthening the domestic economy or becoming more internationally competitive is more important. Significance of international competitiveness Benefits of being internationally competitive Being internationally competitive is vital in the light of the global economy. The UK s vision is quite short-termist and profit driven, whilst Germany has a lot of small and medium-sized enterprises (SMEs), many of which are family run. SMEs tend to focus on supply-side policies for long run growth, rather than MNCs which are profit driven. This is especially the case in machinery, auto parts and electrical equipment. As of 2015, the UK is the 9 th most competitive country in the world. Switzerland is the most competitive, whilst Germany is 5 th. Despite being a small country, Switzerland is the most competitive since it is a tax haven, which encourages a lot of inward financial flows. If a country becomes more competitive, such as Germany, they can gain a reputation for their exports, which might make them more price inelastic. As a result, they might be able to demand higher prices for their goods and services.
By operating in a competitive market, firms can reach out to more consumers. For example, only 32% of McDonald s sales are generated in America, whilst 40% were from Europe and 23% from Asia, Africa and the Middle East. This can also help firms gain economies of scale, which can help lower its average costs of production. Problems of being internationally competitive The economic importance of education and health spending could be considered. It could help improve the skills and productivity of human capital which can make the country more internationally competitive, but the effectiveness of the spending is questionable. Is the investment better spent elsewhere? Being innovative is not always successful, and it could lead to funds being wasted. A lower tax rate might mean the government receives fewer tax receipts, which could limit public spending. It depends on how important public services are to each country, however. If firms are operating in a competitive environment, infant industries might find it hard to compete, so they are forced out of the market. Also, the supernormal profits of large firms might be eroded away, which could limit the amount of investment in R&D. If jobs are offshored, the domestic country might face job losses and structural unemployment. However, it could benefit the recipient country. The stages of economic integration o Free trade areas This is where countries agree to trade goods with other members without protectionist barriers. For example, the North American Free Trade Agreement (NAFTA) is a free trade area, as is the European Free Trade Association (EFTA). They allow members to exploit their comparative advantages, which increases efficiency. o Customs union Countries in a customs union have established a common trade policy with the rest of the world. For example, they might use a common external tariff. They also have free trade between members. The European Union is an example of a Customs Union.
Common markets establish free trade in goods and services, a common external tariff and allow free movement of capital and labour across borders. When the EU was established, it was a Common Market. EU citizens can work in any country in the EU. Other features of a customs union include: - Safety measures for imported goods, such as for food, are common across all members. - There are common customs rules and procedures. - There is a structure for the combined administration of the nations within the Customs Union. - There is a common trade policy. This helps to create and guide trading relationships with countries and blocs outside the Customs Union. o Monetary union This is sometimes called a currency union. Members of a monetary union share the same currency. This is more economically integrated than a customs union and free trade area. The Eurozone is an example of this. A common central monetary policy is established when a monetary union is formed. The single European currency, the Euro, was implemented in 1999 to form the Eurozone. Monetary unions use the same interest rate. The Euro, for example, floats against the US Dollar and the Pound Sterling. Member nations are required to control their government finances, so budget deficits cannot exceed 3% of GDP. This is one of the four convergence criteria countries have to meet in order to join the Euro. The other three are: - Gross National Debt has to be below 6% of GDP - Inflation has to be below 1.5% of the three lowest inflation countries - The average government bond yield has to be below 2% of the yield of the countries with the lowest interest rates. This ensures there can be exchange rate stability. The optimal currency zone is created when countries achieve real convergence. Member countries have to respond similarly to external shocks or policy changes. There has to be flexibility in product markets and labour markets to deal with shocks. This could be through the geographical and occupational mobility of labour, and wage and price flexibility in labour markets. Fiscal transfers could be used to even out some regional economic imbalances. o Economic union
This is made up of a common market with a customs union. The members have common freedom of movement of goods, services, capital and labour, as well as a common external trade policy. The EU is an economic union. Economic unions with common currencies are called economic and monetary unions. The internal and external consequences of economic integration Trade creation and trade diversion With more trading blocs, trade has been created between members, but diverted from elsewhere. Trade creation occurs when a country consumes more imports from a low cost producer, and fewer from a high cost producer. Trade diversion occurs when trade shifts to a less efficient producer. Usually, a country might stop importing from a cheaper producer outside a trading bloc to a more expensive one inside the trading bloc. Moreover, protectionist barriers are often imposed on countries who are not members, so trade is diverted from producers outside the bloc to producers within the trading bloc. The UK trades mainly with the EU, at the expense of former trade links in the Commonwealth. Reduced transaction costs Since there are no barriers to trade or no border controls, it is cheaper and simpler to trade. Economies of scale Firms can take advantage of a larger potential market in which to trade. For example, the EU has 500 million people to sell to. By specialising, firms and countries can exploit their comparative advantages, and the gains of efficiency and advanced technology can be reaped. Enhanced competition Since firms operate in a more competitive market, they become more efficient and there is a better allocation of resources. There could be the long run benefits of dynamic efficiency too, although these benefits are not always spread evenly across each member. Migration By being a member of a Customs Union, the supply of labour is increased, which could help fill labour shortages. However, this might mean some countries lose their best workers.
This summary by the BBC summarises the main costs and benefits of EU membership for the UK: http://www.bbc.co.uk/news/uk-politics-20448450 The role of the WTO in promoting free trade The WTO promotes world trade through reducing trade barriers and policing existing agreements. It also settles trade disputes, by acting as the judge, and organises trade negotiations. Every member of the WTO must follow the rules. Those who break the rules face trade sanctions. In addition to trade in goods, the WTO covers the trade in services and intellectual property rights. As of 2015, there are 161 member states in the WTO. The progress made and difficulties faced by the WTO, such as agricultural disputes and trade agreements Trading blocs might distort world trade or adversely affect those who do not belong to them. There could be an inefficient allocation of resources as a result of policies such as the EU CAP. Conflicts between blocs could lead to a rise in protectionism. A common external tariff contradicts the WTO s principles, since although there is free trade between members, protectionist barriers are imposed on those who are not members. Some countries might argue that the WTO is too powerful, or that it ignores the problems of developing countries. This could be since developed countries do not trade completely freely with developing countries, which limits their ability to grow. Setting up a customs union or a free trade area could be seen to violate the WTO s principle of having all trading partners treated equally. This is especially if a common external tariff is applied. However, they can complement the trading system and the WTO strives to ensure that non-members can trade freely and easily with the members of a trade bloc.