Pre-class International Economics

International Economics

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Study Questions: 1. What are the major reasons for the skepticism of many developing nations regarding the competitive-advantage principle and free trade?

The theory of comparative advantage maintains that all nations can enjoy the benefits of free trade if they specialize in production of those goods in which they have a comparative advantage and exchange some of these goods for goods produced by other nations. In addition, advanced nations claim that the existing international trading system has provided widespread benefits and the trading interests of all the nations are best served by pragmatic, incremental changes in the existing system and thus, to achieve trading success, they must administer their own domestic and international economic policies. However, on the basis of their trading experience with the advanced nations, many developing nations have become skeptical of the distribution of trade benefits between them and the advanced nations and these nations generally maintain that the benefits of international trade accrue disproporationately to the advanced nations. Also, the developing nations have argued that the protectionist trading policies of advanced nations hinder the industrializaton of many developing nations. Among the alleged problems plaguing the developing nations have been unstable export markets, worsening terms of trade, and limited access to markets of industrial countries. It has been noted that many developing nations’ exports are concentrated in only one or a few primary products and thus unstable export markets, worsening terms of trade, and limited access to world markets for the products can significantly reduce export revenues and seriously disrupt domestic income and emploment level. In addition, many developing nations feel that developed nations tend to insist that developing nations open their markets to industrial products from the developed world, yet refuse to open their markets to agricultural goods from the developing world. For example, United States have used aggressive antidumping and countervailing duties to limit access to their markets. Furthermore, the current concept of free trade supports the free movement of products and employers, which favors the developed nations, but not the free movement of employees (i.e., labor), which would favor the people of developing nations. 1

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2. Stabilizing commodity prices has been a major objective of many primaryproduct nations. What are the major methods used to achieved price stabilization?

As noted, the export prices and revenues of developing countries can be quite volatile. In an attempt to stabilize export revenues and prices, International Commodity Agreements (ICA) have been formed by producers and consumers of primary products about matters such as stabilizing prices, assuring adequate supplies to consumers, and promoting the economic development of producers. The methods used to attain these objectives are exports controls, buffer stocks, and multilateral contracts. . •

Production and Export Controls

If an ICA accounts for a large share of total world output (or exports) of a commodity, its members may agree on export controls to stabilize export revenues. The idea behind such measures is to offset a decrease in the market demand for the primary commodity by assigning cutbacks in the market supply. If successful, the rise in price due to the curtailment in supply with the sufficient for compensate the reduction in demand, so that total export earnings will remains at the original level. •

Buffer Stocks

Buffer stock, in which a producers’ association (of international agency) is prepared to buy and sell a commodity in large amounts. The buffer stock consists of supplies of a commodity financed and held by the producers’ association. The buffer stock manager buys from the market when supplies are abundant and prices are falling below acceptable levels, and sells from the buffer stock when supplies are tight and prices are high. A wellrun buffer stock can promote economic efficiency because primary producers can plan investment and expansion if they know that prices will not gyrate. •

Multilateral contracts

Multilateral contracts generally stipulate a minimum price at which exporters will purchase guaranteed quantities from the producing nations and a maximum price at

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which producing nations will sell guaranteed amounts to the exporters. Such purchases and sales are designed to hold prices within a target range. One possible advantage of the multilateral contract as a price- stabilization device is that, in comparison with buffer stocks or exports controls, it results in less distortion of the market mechanism and the allocation of resources

3. What are some examples of international commodity agreements? Why have many of them broken down over time?

Examples of International commodity agreements are International Cocoa Organization, International Tin Agreement, International Coffee organization, International Sugar organization and International Wheat Agreement. These agreements are used as a price stabilization device to stabilize export receipts, production, and prices. However, many of them have broken down over time because production is laborintensive, output cutbacks are often socially unacceptable to workers. Agreeing on a target price that reflects existing economic conditions is also troublesome. Agricultural products often face high storage costs and are perishable. Stockpiles of commodities in importing nation can be used to offset controls on production and export. Substitute products exist for many commodities.

4. Why are the less developed nations concerned with commodity-price stabilization?

The composition of less developed nations’ exports emphasis on primary products and these nations concentrated in only one or a few primary products. Thus, a poor harvest or a decrease in market demand for that product can significantly reduce export revenues and seriously disrupt domestic income and employment levels. In addition, export prices and receipts can be very volatile when supply and demand conditions are price-inelastic. Therefore, it is vital important for them to enact commodity price stabilization policies to increase their level of income and standard of living. 3

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5. The average person probably never heard of the Organization of Petroleum Exporting Countries until 1973 or 1974, when oil prices skyrocketed. In fact, OPEC was founded in 1960. Why is it that OPEC did not achieve worldwide prominence until the 1980s? What factors contributed to OPEC’s problems in the 1980s?

The Organization of Petroleum Exporting Countries (OPEC) is a group of nations that sells petroleum on the world market. The OPEC nations attempt to support prices higher than would exist under more competitive conditions to maximize member-profits. OPEC was operating obscurely in 1960s due to OPEC members behaved like individual competitive sellers and each nation itself was so unimportant relative to the overall market that changes in its export levels did not significantly affect international prices over a sustained period of time. By agreeing to restrict competition among themselves via production quotas, however, OPEC was able to capture control of petroleum pricing in 1973 and 1974, when the price of oil rose from approximately $3 to $12 per barrel. During the1970s, OPEC was successful in increasing the revenues of its members. One reason is that the long-run price elasticity of oil supply in non-OPEC nations is inelastic. Estimates in the 1970s put the non-OPEC supply elasticity between 0.33 and 0.67, suggesting that a 1% increase in the OPEC price will induce only a 0.5 % increase in non-OPEC output. In addition, the demand for gasoline in the United States was also estimated to be inelastic, having a long-run price elasticity coefficient of 0.8. Moreover, OPEC was able to dominate the world oil market, accounting to more than 2/5 of world production, 2/3 of world reserves, and more than 4/5 of world exports. By the 1980s, however, OPEC increasingly faced the pressure that often leads to the demise of cartels. The OPEC price hikes had induced non-OPEC nations to develop new production techniques and initiate new discoveries. The result was a fall in the OPEC share of the world market from 56 % in 1973 to 33 % in 1986. The OPEC price hikes also led to decrease oil demand owing to increased usage of smaller autos and insulation and the switch to substitute energy sources, including coal and nuclear power. Furthermore, the recession of 1981—1983 led to weakening demand and oil prices 4

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tumbling to less than $11 per barrel by 1986. Despite the market difficulties, OPEC was resilient and continues to operate as a cartel at the millennium.

6. Why is cheating a typical problem for cartels?

A cartel is a group of firms formally agreeing to control the price and the output of a product. The goal of a cartel is to reap monopoly profits by replacing competition with cooperation. However, if a cartel is holding up prices by restricting output, there is a big incentive for member to cheat by increasing output, even a little bit. Breaking ranks can mean very large profits. Using the following exhibit, we can demonstrate how a cartel works and why a cartel member has an incentive to cheat.

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MC

Price per

LRAC

barrel (Dollars) 45

MR2

40 30

MR1

20 10

0

2

4

6

8

10

12

14

Quantity of oil (Millions of barrels per day)

From the exhibit above, assume that a representative oil producers operating in a perfectly competitive industry would be in long run equilibrium at a price of $30 per barrel, producing 6 million barrels per day and making zero economic profit. A cartel can agree to raise the price of oil from $30 to $45 per barrel by restricting the firms to 4 million barrels per day. As a result of this quota, the cartel price is above $35 on the LRAC curve, and the firm earns a daily profit of $40 million. However, if the firm cheats

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on the cartel agreement, it will set the cartel price equal to the MC curve and earn a total profit of $ 80 million by adding an additional $40 million. If all firms cheated, the original long-run equilibrium would be re-established.

7. The generalized system of preferences is intended to help developing nations gain access to world markets. Explain. To help developing nations gain access to world market, many industrial nations offer assistance known as a Generalized System of Preferences (GSP). Under this generalized system of preferences, major industrial nations temporarily reduce tariffs on designed manufactured imports from developing nation below the levels applied to imports from other industrial nations. The GSP is not a uniform system, however, because it consists of many individual schemes that differ in the types of products covered and extend of tariff reduction. For example, since its origin in 1976, the U.S. GSP program has extended duty-free treatment to about 3000 items. Beneficiaries of the US program include some 150 developing nations and their dependent territories. Like the GSP program of other industrial nations, the US program excludes certain import-sensitive products from preferential tariff treatment. These products include electronic items, glass, certain steel and iron product, watches, and some types of footwear. Limits also exist on the amount of a particular product reach beneficiary can export to the United States. Although the GSP program provides preferential access to industrial countries’ market, several factors erode its effectiveness in reducing trade barriers faced by developing nations. First, preferences mainly apply to products that already relatively low tariff. Second, tariff preference can be eroded by non-tariff measures, such as antidumping duties and safeguards. Thus, developing nations have been frustrated about limited access to the markets of industrial countries. 8. How are imported-substitution and exported promotion policies use to aid in the industrialization of developing nations?

During 1950s and 1960s, many developing nations used import substitution to promote their internal industrialization. Import Substitution involves extensive use of trade barriers to protect domestic industries from import competition. The strategy is inward-

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oriented in that trade and industrial incentives favor production for the domestic market over the export market. Encouraging economic development via import substitution has several advantages: •

The risks of establishing a home industry to replace imports are low because the home market for the manufactured goods already exists.

•

It is easier for a developing nation to protect its manufacturers against foreign competitors than to force industrial nations to reduce their trade restrictions on products exported by developing nations.

•

To avoid the import tariff walls of the developing country, foreigners have an incentive to locate manufacturing plants in the country, thus providing jobs for local workers. By the 1970s, however, many developing nations were abandoning their import

substitution strategies and shifting emphasis to export-led growth. Exported promotion policy is outward oriented because it links the domestic economy. Instead pf pursuing growth through the protection of domestic industries suffering comparative disadvantage, the strategy involves promoting growth through the export to manufactured goods. Trade controls are either nonexistent or very low; in the sense that any disincentives to export resulting from import barriers are counterbalanced by export subsidies. Industrialization is viewed as a natural outcome of development instead of being an objective pursued at the expense of the economy’s efficiency. Export promotion policies have several advantages: •

They encourage industries in which developing countries are likely to have a comparative advantage, such as labor-intensive manufactured goods.

•

By providing a larger market in which to sell, they allow domestic manufacturers greater scope for exploiting economies of scale.

•

By maintaining low restrictions on imported goods, they impose a competitive discipline on domestic firms that force them to increase efficiency. In conclusion, Export-led growth policies introduce international competition to

domestic markets, which encourage efficient firms and discourage inefficient ones. By

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creating a more competitive environment, they also promote higher productivity and hence faster economic growth. Conversely, import substitution policies relying on trade protection switch demand to products produced domestically. Exporting is then discouraged by both the increased cost of imported inputs and the increased cost of domestic inputs relative to the price received by exporters. Therefore, countries emphasizing export promotion have tended to realize higher rate of economic growth than countries emphasizing import substitution policies.

9. Describe the strategy that East Asia used from the 1970s to the 1990s to achieve high rates of economic growth. Can the Asian miracle continue into the new millennium?

The East Asian economies have realized remarkable economic growth. The foundation of such growth has included high rates of investment, the increasing endowments of an educated workforce, and the use of export-promotion policies. The East Asian tigers are highly diverse in natural resources, populations, cultures, and economic policies. However, they have in common several characteristics underlying their economies success, i.e. high rate of investment, and high and increasing endowments of human capital due to universal primary and secondary education. To foster competitiveness, East Asian government have invested in their people and provided a favorable competitive climate for private enterprise. They have also kept their economies open to international trade. The East Asian economies have actively sought foreign technology, such as licenses, capital-good imports, and foreign training. It is widely recognized that East Asian economies have followed a flying-geese pattern of economic growth in which countries gradually move up in technological development by following in the pattern of countries ahead of them in the development process. For example, Taiwan and Malaysia take over leadership in apparel and textiles from Japan as Japan moves into the higher-technology sectors of automotive, electronic

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and other capital goods. A decade of so later, Taiwan and Malaysia are able to upgrade to automotive and electronics products, while the apparel and textile industries move to Thailand, Vietnam and Indonesia. For East Asian economies, strong export platform has underlain their flying-geese pattern of development. East Asian governments have utilized several versions of an export platform, such as bonded warehouses, free-trade zones, joint ventures, and strategic alliances with multinational enterprises. Governments supported these mechanisms with economic policies that aided the incentives for labor-intensive exports. By the late1990s, East Asia’s economies showed signs of fatigue, however, we believe that the past growth of East Asian was underlaid by the wise policies of the governments and the profit-seeking behaviors of the people and the slowdown of the late 1990s was as cyclical that the cycle would turn. Moreover, China’s accession into the WTO in the late 1990s envelops it in a web of global trading rules—everything from lower tariffs to antidumping regulations to wholesale removal of rules destructing distribution and retailing, and stiff penalties for intellectual property piracy. Thus, the Asian miracle would resume and will continue into the new millennium

10. How has China achieved the status of a high-performing Asian economy? Why has China’s normal-trade-relation status been a source of controversy in the United States? What are the likely effects of China’s entry into the WTO?

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In the early 1970s, the value of China’s exports and imports was less than $ 15 billion, however, at the millennium, its exports and imports exceed $200 billion, and it was the world’s 10th largest exporters, lagging behind only the major industrial countries. An important goal of China’s economic reforms in the late 1970s was to open the economy to international trade and investment flows. Also, China opened its economy to foreign investment and joint ventures. Being heavily endowed with labor, China specializes in labor-intensive manufacturing. At the millennium, China had made all of the easy economic adjustments in its transition toward capitalism: letting farmers sell their own produce and opening its doors to foreign investors and salespeople. Also, China has dismantled much of its centrally planned economy and permitted free enterprise to replace it. For example, a massive restructuring of state-owned industries, which were losing money; a cleanup of bankrupt state banks, and establishment of a monetary system with a central bank free of Communist Party or government control. To further the policy of opening, the Chinese government applied to become a member of the World Trade Organization to enable China to gain full nondiscriminatory treatment in its trade relations with WTO members, especially the United States as well as providing China access to the WTO’s multilateral trade dispute resolution process. For many U.S. firms, China has been a difficult market to enterprise, due largely to Chinese government policies, with attempt to protect and promote domestic industries. Chinese trade policies generally attempt to encourage import of products that are deemed beneficial to China’s economic development and growth, such as high technology and machinery and raw material used in the manufacture of products for export. For those goods and services that are not considered to be high priority, or which compete directly with domestic Chinese firms, often face extensive array of trade barriers, such as high tariffs, non-tariff barriers, trading and distribution right, and investment restriction. Moreover, enforcement of laws to protect intellectual property rights of foreigners has

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been another problem in China. Among the largest and most obvious offenders in China have been factories producing CDs, audiocassettes, videos, and video games. China’s accession into the WTO envelops it in a web of global trading rules— everything from lower tariffs to antidumping regulations to wholesale removal of rules destructing distribution and retailing, and stiff penalties for intellectual property piracy. Besides affecting its domestic economy, China’s accession to the WTO will affect trade everywhere, as seen in the following table: North America

North America farmers will get a new market for millions of tons of gain. Computer, telecom-gear, semiconductor producers will

Mexico

get tariff-free access to China Shoe and garment manufactures will be handicapped as quotas

European Union

restricting Chinese exports to the United states are lifted Imports of Chinese dishes, shoes, and kitchen utensils will

Japan

increase as Europe eliminates quotas Imports of various consumer goods will increase as more Japanese manufactures shift production to China-based suppliers.

Southern Asia

Electronics, vehicle, and equipment exports will increase. Malaysia, Indonesia, Thailand, and the Philippines will lose foreign investment to China. Pressure will increase to upgrade

Taiwan

industries and workforces. Its trade surplus with China will decline. More production will shift to China, enhancing competitiveness of Taiwanese tech

South Korea

companies. Exports of fabrics to China’s expanding apparel industry could decrease, as could outflow of steel and industrial gear.

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