How can free trade lead to an increase in economic welfare?
Countries trade with each other so that their inhabitants can enjoy a higher standard of living. Very few (if any) countries attempt to supply all their own economic needs. Factor endowments, climate, skills and knowledge vary greatly from one country to another. Thus, complete economic self-sufficiency at an acceptable standard of living is impossible, or at least very difficult, for a number of reasons:
- Size of Population: Small population limits opportunities for large-scale production. For a “small” country to take advantage of significant economies of scale it must be able to export its goods so as to gain access to larger markets and import other goods which it would be uneconomic to produce domestically.
- Nature of soil and climate: Some countries have unsuitable soil and climate to produce certain goods so these goods must be imported.
- Resources: Some countries have limited supplies of mineral and energy resources and so have to import large amounts of oil, coal, steel, etc.
- Skills and Technology and Capital: Some countries lack the necessary human, technological and capital resources to produce certain goods, thus either these resources or the final goods themselves must be imported.
The rationale for free trade follows from the reasons outlined above. The main reasons being:
- Efficiency is encouraged: Trade intensifies competition which puts pressure on firms to be more efficient.
- Economies of scale/size: Industries where significant economies of scale apply might not be feasible if production had to be confined to the level of demand within national frontiers. This is especially true of small economies such as Rwanda’s where those wishing to expand often have to look to export markets.
- Exports earn foreign currency: Which helps countries pay for their import bills for essential commodities like oil and raw materials. It is important that export revenues should, as far as possible, pay for imports since any Balance of Payments (BoP) current account deficit not met by capital inflows must be financed by running down foreign exchange or by foreign borrowing – neither of which courses of action is desirable over the long term.
- Exports are an injection into the economy: Greater exports means greater production and therefore increased employment potential. By causing a magnified increase in national income (via the multiplier) increased exports also boost economic growth.
- A healthy export trade creates confidence and encourages investment: The opening up of export markets gives businessmen and investors’ confidence to expand their activities/increase investment since they are no longer confined to the home market.
Furthermore, in times of national economic recession, economic recovery may depend on the expansion of exports.
- Imports are often essential to industrial and commercial life: Raw material and energy imports which are incorporated into finished products boost the economy, since without these essential imports production of some goods could not take place. Moreover, while imports are detrimental to domestic employment in so far as they complete with home produced goods, they also create employment by supplying essential raw materials and in the import/ export, distribution, transport, sales and retail sectors.
- Consumption possibilities are increased: Trade extends the consumption possibilities of a country beyond its own production frontier.
(viii)The Law and comparative advantage/costs: Perhaps, the main justification for free trade is this law which states: a country should concentrate on production of those goods in which it is relatively more efficient and obtain its other requirements by trading. A country has a comparative advantage in production of a given commodity if the opportunity cost, i.e. the amount of the other good which must be sacrificed to produce one unit of the good in question, of the good is lower in that country. Thus, it will be mutually beneficial for countries to trade so long as there is some difference in their relative efficiencies in the production of the commodities.
The Law of Comparative Advantages in More Detail.
Each country has a different factor endowment and different skills, knowledge and experience. Thus, the cost of producing goods – in terms of resources used (i.e. opportunity cost) – will vary from one country to another. Free trade increases economic welfare by enabling countries to take advantage of international specialisation to their mutual benefit. For Example:
|Production of Wheat per man (units)
|Production of Cloth per man (units)
|Cost of one unit of Wheat (in units of cloth)
|Cost of one unit of Cloth
(in units of Wheat)
This schedule indicates that a person in the UK can produce 10 units of wheat or 2 units of cloth. The opportunity cost of wheat (i.e. its cost in terms of amount of cloth foregone) is 1/5 in the UK and 8/15 in the USA.
It is clear that the USA has an absolute advantage in both goods, i.e. it can produce goods more efficiently (i.e. at lower opportunity cost) than the UK. But even in this situation, both countries can gain if each country specialises in the product in which they have a comparative or relative advantage.
The USA has a comparative advantage in the production of cloth since if it produces 1 unit of cloth it forgoes the possibility of producing 15/8 (17/8) units of wheat whereas the UK to produce 1 unit of cloth would have to forgo 5 units of wheat, (i.e. the USA has a smaller opportunity cost for cloth).
The UK has a comparative advantage in the production of wheat, since it produces 1 unit of wheat it forgoes 1/5 of a unit of cloth while the USA to produce 1 unit of wheat would have to sacrifice 8/15 of a unit of cloth.
(8/15 > 1/5 therefore opportunity cost of wheat is smaller in UK).
To illustrate the gains to be made from trade consider the following:
If the USA and the UK follow the law of comparative advantage and the USA specialises in cloth while the UK specialises in wheat then the total gain in production will be:
|USA’s Output UK’s Output
[ USA specialises in cloth]
|USA’s Output UK’s Output
[ UK specialises in Wheat]
By reallocating resources the total output has increased by 31/8 units of wheat and 1/3 unit of cloth.
Naturally, the reallocation that would take place in reality would be much greater than one unit and hence the gains would be very significant.
Note: the principle of Comparative Advantage can be extended from the above 2 commodity-2 country example to apply to the real world where many countries trade in numerous commodities.
However, there are a number of problems (i.e. buts) to the practical application of the law. These are:
- Whether trade will be beneficial will depend on the terms of trade – i.e. the rate at which products exchange on world markets as well as on the opportunity costs ratio. From the example given above for specialisation and trade to be advantageous to both countries the terms of trade must lie between:
15/8 and 5 (units of wheat) for cloth, and 1/5 and 8/15 (units of cloth) for wheat
Why? Well, to explain the cloth terms of trade – it costs the UK 5 units of wheat to produce 1 unit of cloth so if the UK can get a unit of cloth for any figure less than 5 units of wheat it will be better off. Likewise, it costs the USA 15/8 units of wheat to produce 1 unit of cloth so if the USA can get more than 15/8 units of wheat for a unit of cloth it’s better off.
The precise rate at which the exchange takes place will depend on the relative bargaining strengths of both sides.
- If transport costs are very high they will greatly reduce and may even eliminate the gains from specialisation and trade.
- The benefits of trade may not be evenly distributed.
- There may not be perfect factor mobility – workers laid off in the industry which is comparatively disadvantaged may not be able to take up employment in the industry that’s expanding.
- There may not be constant returns to scale – i.e. 2 men need not necessarily produce twice as much as one man (though that is what is assumed in the example given above). In fact diminishing returns may set in when output exceeds a certain level.
- It may be very difficult to discover where the advantages lie (i.e. with which countries). Relative costs are very hard to work out and much trade is carried out simply to obtain more variety, maybe actually against the strict theory of comparative advantage. Protectionism
Despite the advantages of free trade, protectionism – i.e. restriction or prevention of imports – occurs to some extent in some countries.
It may take one or a combination of the following forms:
- Quotas – restriction on the amount of particular products which can be imported.
Advantages: the size of the quota is flexible and can quickly be changed ( or ); government and domestic firms know the maximum level of imports in advance and can take decisions accordingly; can be of use in restricting imports in the face of BoP current account deficit.
Disadvantages: Yields no revenue to the government; tends to establish monopolies of larger importers and reduce competition thereby increasing prices and maybe reducing quality; they tend to require frequent changes which cause uncertainty; with many different distribution channels it’s difficult to establish when the last unit of the quota has been imported.
- Tariffs – taxes on imports, usually calculated as a percentage of the price of the good at time of importation.
Advantages: raises revenue for the government; discourage imports (by raising the price of foreign products) and therefore is of help in times of BoP current account deficit.
Disadvantages: hinders the trading process by adding to the administrative burden; by raising the price of imports it may cause/exacerbate inflation and eventually increase export prices; the effectiveness of tariffs depends on the elasticity of demand for imports – if inelastic, dearer imports merely raise the total import bill (because quantity will not fall much.)
- Embargos – total loan on the importation of a commodity. Generally used only in extreme circumstances e.g. UK embargo on importation of Irish Cattle due to outbreak of Foot and Mouth in Ireland.
Why restrict free trade if it is beneficial?
- The infant industry argument – an industry may need some protection against “mature” competitors in the early stages of its development. However, it is frequently the case that infant industries protected in this manner never develop to optimal efficiency and so cannot survive when protection is withdrawn.
- To maintain domestic employment during a recession – if there is low domestic demand, a country may introduce import restrictions so as to reserve the domestic market for domestic producers and thus protect national employment.
- To allow non-viable industries to decline gradually – in this way the economic and social costs will be reduced.
- To prevent “Dumping” – e. the sale of goods on the domestic market at prices lower than the costs of production in their origin, i.e. to protect domestic producers against unfair competition.
- Strategic reasons –g. protection of agriculture, since a country without its own food supplies would be very vulnerable in times of war or economic recession.
- BoP deficit – if imports constantly exceed exports there is a great temptation to introduce protective measures (but this does not solve the underlying problems).
- Protection against low wage economies – since they have a big cost advantage.
- Political Purposes –g. anti-apartheid sanctions against South Africa.
- To raise revenue for the government – through tariffs.
If a country imposes restrictions on its imports in order to protect certain of its industries then it will lose some of the advantages of international specialisation and its real income per head will fall. It can be assumed that the industries which the restriction are designed to protect are industries in which the country no longer has a comparative advantage and waste will occur in continuing to use resources in these industries instead of transferring them to areas where the country has a comparative advantage.
Import restrictions will mean higher prices and a reduction in variety of product for everybody but some groups will benefit in other ways. Firms in protected industries will now remain in business and make increased profits. Employment in these industries will be maintained and perhaps increased as production is increased to fill the gap left by import restriction. Similarly industries which supply the protected industries will benefit if the object of the restrictions is to favour an “infant industry” or to diversify the economy, and these objectives are achieved, then benefit will accrue to the country as a whole and to the particular groups concerned.
The benefits gained above will be far outweighed by the costs imposed on the rest of the country by way of less output at a higher cost. Higher prices in the protected industries will mean a reduction in the demand for the products of other industries. Export demand will fall as foreign countries suffer a fall in income due to the reduction in their exports to the country imposing the restrictions. Foreign countries will suffer losses in the same way as the country imposing the restrictions and may, themselves, retaliate in a similar way making the losses even more severe.
It has so far been assumed that the country’s objective in imposing restrictions was the maximisation of economic welfare but the country may have other objectives in mind. These might include a desire for self-sufficiency in some products for strategic or defence reasons, or the wish to preserve some particular, maybe traditional, way of life. To the extent that import restrictions achieve these objectives they will presumably benefit all, but the economic costs will be as indicated as above.
BALANCE OF PAYMENTS
The balance of payments accounts represent a record of all transactions between residents and firms located in one country and the rest of the world. Depending on the nature of the transaction, the details will be recorded in either of two accounts: the current account or the capital account.
The Current Account
The current account records current income from and current payments to the rest of the world. The transactions concerned may be related to visible trade; invisible trade; profit, interest and dividend flow; or international transfers. Transactions leading to income received by the host country are entered with a plus sign whereas transactions requiring payments abroad are entered with a minus sign.
Visible trade – or merchandise trade – is concerned with trade in tangible items such as food, manufactures, etc. Exports are entered with a plus sign while imports are entered with a minus sign. Invisible trade relates to trade in services such as transport, financial and other services and also includes income and expenditure relating to tourism. Profit, interest and dividend flows result from the foreign ownership of assets. Domestic owners of foreign assets receive property income from abroad whereas foreign owners of domestic assets receive property income from the host country. International transfers relate to transactions such as foreign aid; private transfers such as remittances from emigrant workers, etc. It is not uncommon for all items, other than visible trade, to be collectively referred to as invisibles.
The Current account balance (% of GDP) in Rwanda was last reported at -7.49 in 2010, according to a World Bank report released in 2011. The Current account balance (% of GDP) in Rwanda was -7.28 in 2009, according to a World Bank report, published in 2010. The Current account balance (% of GDP) in Rwanda was reported at -5.35 in 2008, according to the World Bank.
The sum of current incomes and payments, both visible and invisible, gives the current account balance. A surplus on current account, representing an excess of foreign earnings over foreign expenses, suggests that a country is ‘paying its way in the world’. A deficit would indicate that the country concerned was either incurring net foreign liabilities or using up foreign assets to finance the deficit.
The Capital Account
The capital account records changes in overseas assets and liabilities. When a foreign multinational invests in the domestic economy, the multinational acquires an asset. However, the economy acquires a liability in the sense that there will be a subsequent outflow of repatriated profits to provide a return on this inward investment. The reason why the inward investment is desirable, of course, is the fact that typically the investment will generate enough earnings not only to finance repatriated profits, but also to provide incomes for domestic employees. When a multinational invests in a foreign country, foreign assets are being acquired which should lead to an inflow of property income on the current account at a later date.
Net capital account (BoP; US dollar) in Rwanda
The Net capital account (BoP; US dollar) in Rwanda was last reported at 285,635,385 in 2010, according to a World Bank report released in 2011. The Net capital account (BoP; US dollar) in Rwanda was 200,000,000 in 2009, according to a World Bank report, published in 2010. The Net capital account (BoP; US dollar) in Rwanda was reported at 210,060,000 in 2008, according to the World Bank. Net capital account includes government debt forgiveness, investment grants in cash or in kind by a government entity, and taxes on capital transfers. Also included are migrants’ capital transfers and debt forgiveness and investment grants by nongovernmental entities. Data are in current U.S. dollars.
Inward capital flows – i.e. those generating liabilities for the home economy – are entered with a plus sign whereas outward flows – i.e. those generating overseas assets – are entered with a minus sign. These capital flows are referred to as foreign direct investments (FDI) if they finance the acquisition of real assets (such as factories) or as portfolio investments if they finance the purchase of financial assets (such as government bonds, bank deposits, etc). Also included is foreign borrowing (+ sign) or lending (- sign) by domestic private sector financial institutions. Official capital flows refer to government borrowing (+ sign) or lending (- sign) and to changes in official reserves at the Central Bank (increases with a – sign, reductions with a + sign).
All capital inflows are recorded with a plus sign whereas capital outflows are recorded with a minus sign. However, it is the minus entries that represent an increase in the economy’s overseas assets or a reduction in overseas liabilities.
It is important to note that the Balance of Payments, taken in total, must exactly balance. All transactions should lead to a double-entry of equivalent values but with opposite signs. For example, if a Rwandan exporter of merchandise to Kenya invoices in RWF to the value of RWF10m, then the Kenyan importer must spend the Kenyan Shillings (KES) equivalent to purchase RWF10m to settle the account. That means somebody else must be selling RWF10m to buy KES. The exporter’s transaction leads to a + RWF10m entry on the current account whereas the seller of the RWF10m is causing an entry of –RWF10m on either the current or capital account (depending on why KES are being purchased). Therefore the surplus on the current account should be exactly matched by a deficit on capital account of an equal amount. As the figures are never 100% accurate a balancing item is typically required to balance the accounts.
The balance of payments, taken overall, must balance. However, subsections of the accounts may not be in balance. For example, a deficit on current account typically represents an excess of current expenditures over current earnings. This deficit must be financed somehow, and the financing of it will be reflected in a surplus on the capital account. This in turn means an increase in foreign liabilities or a decline in foreign assets. The excess is being financed whether by using up official foreign reserves or foreign borrowing or some other capital inflow.
A balance of payments deficit is generally interpreted to mean a reduction in the official reserves held at the Central Bank. This reduction may be caused by a current account deficit which is not being financed by private sector capital inflows, or alternatively despite a surplus on current account a larger outflow of private sector capital is occurring. A balance of payments surplus is indicated by an increase in official reserves.
THE TERMS OF TRADE
The terms of trade are concerned with the rate at which one country’s goods exchange for those of other countries. Changes in the terms of trade indicate whether a country must export more or less in order to purchase a given volume of imports. A terms of trade index (TOT) can be calculated as:
TOT = weighted average of export prices x 100
weighted average of import prices
The index is a trade-weighted one, i.e. the various prices are weighted according to the relative importance of that product regarding the total value of imports or exports. The prices are dominated in a single currency and the index is typically set equal to 100 in a base year (the year in which the weightings are established).
An improvement in the terms of trade is indicated by an increase in the index, an adverse change by a reduction. An ‘improvement’ means that less needs to be exported to purchase a given volume of imports (or more imports for a given volume of exports). An improvement can result from:
- An increase in export prices;
- A reduction in import prices;
- An increase in the nominal exchange rate (Section 14A).
An improvement in the terms of trade does not necessarily benefit the balance of payments or employment. For example, an increase in domestic prices means fewer goods need be exported to purchase a given volume of imports. However, it may now be more difficult to sell these goods with the result that the value of exports may fall. A fall in the price of an important import (such as oil) typically represents an unambiguous improvement in the terms of trade.
INTER-INDUSTRY AND INTRA-INDUSTRY TRADE
What is the source of comparative advantage? Why do countries differ in their abilities to produce goods and services? David Ricardo (1722 – 1823), who first formulated the theory of comparative advantage, suggested that differences in labour productivity between countries were the reason for differences in relative costs between countries. Access to different levels of technology could explain differences in labour productivity.
Two Swedish economists (Heckscher and Ohlin) developed this analysis further and argued that even countries with access to similar technologies could have different relative costs due to differences in their overall endowment of factors of production. Countries would tend to specialise in producing those products requiring the factors in which they were favourably endowed. For example, countries with a relative abundance of labour would tend to specialise in labour intensive products whereas countries with a relative abundance of capital would tend to specialise in capital intensive products. Differences in natural resources would also play their part in determining relative costs between countries.
The important point about the above analysis is the focus on the differences between countries. Given the differences in factor endowments different countries would tend to specialise in different products. This type of specialisation is the basis for inter-industry trade. This is where countries export different products from the ones they import. For example, the Rwandan economy exports tea and coffee and cassiterite and iron ore, all raw materials but imports manufactured goods.
The ability of the theory of comparative advantage to explain the pattern of international trade has been diminished by the growth of intra-industry trade. This is where countries import and export similar products. For example, many economies both import and export motorcars; Ireland imports and exports whiskey, etc. By emphasising the differences between countries the theory of comparative advantage fails to explain intra-industry trade which has much to do with similarities between countries.
Intra-industry trade is based on product differentiation. Countries will import and export variations, usually branded versions, of a basic product. Thus Germany exports BMWs while importing Citroens, etc. The growth of intra-industry trade is linked to an increasing demand for greater consumer choice and the existence of economies of scale in production. With rising prosperity in a country, consumers tend to want greater choice regarding the goods they purchase. If this greater choice was to be catered for exclusively by home producers, there would be a tendency for a larger number of relatively small producers to emerge. However, where there is relatively free international trade, producers can cater for similar market segments in different countries and exploit any economies of scale that might exist. We would therefore expect intra-industry trade to be more important, the more integrated economies are and the more similar they are in terms of living standards. Not surprisingly, intra-industry trade is the dominant feature of the growing trade in consumer goods between the member-states of the EU.
FREE TRADE AND PROTECTION
There are gains from international specialisation and trade. International specialisation can be expected to result in a more efficient use of global resources. This in turn implies improved living standards for consumers in the countries concerned. However, it is commonplace for governments to have commercial policies which include a range of barriers to free international trade. For example:
- Tariffs – a tax on imports having the effect of raising the price of the imports on the domestic market.
- Quotas – an upper limit on the quantity of a product that it is permissible to import.
- Non-tariff barriers –
- Export subsidies – enables exporters to sell in foreign markets at prices that do not reflect the true relative cost.
Trade barriers are designed primarily to protect domestic producers from foreign competition. A range of arguments has been put forward in support of protectionist measures:
- Unemployment – there can be major adjustment costs if domestic industries are forced to adjust to foreign competition. This can be particularly so when there is a significant shift in comparative advantage from one country or region to another. For example,
- the growing competitiveness of China and many SE Asian economies in manufactured goods poses major problems for European economies.
- Infant industries – some industries may require protection from superior foreign competitors if they are to develop and prosper. Particularly where efficiency is based on economies of scale, protectionist measures may enable an industry to develop on the home market and become internationally competitive in the longer term.
- Strategic industries – the government, for political reasons, may consider it undesirable to be over-dependent on foreign suppliers of certain products such as food or armaments.
- To improve the balance of payments.
Free international trade can result in gainers and losers and therefore have important implications for the distribution of income in society. Despite long-term benefits there may be significant short-term costs. Governments must decide, usually under pressure from local interests, where the balance of advantage lies. However, there is no economic case for the permanent protection of inefficient domestic industries. Inefficiencies in one sector inevitably translate into higher costs in other sectors either by way of higher input prices or less demand or both. The result is living standards lower than they might otherwise be.
IMPACT OF A TARIFF
The effect of the imposition of a tariff can be illustrated as in Figure 13.3.
 Whiskey in Ireland and USA and Whisky in Scotland and Canada
The S and D curves represent domestic supply and demand conditions. If we assume that the country can import as much as it wishes at the prevailing world price (known as the ‘small country assumption’), this can be illustrated with a perfectly elastic supply curve (Sw) drawn at the world price (pw). If the country’s commercial policy is to keep out imports completely, the domestic price will be po with domestic production at qo. If the country adopts a policy of free trade, the domestic price will fall to the world price pw, domestic production falls to q1, consumption expands to q2, with q2 – q1 being imported.
Assume, starting from a position of free trade, the country imposes a per unit tariff (t) on imports. This can be illustrated by an upward shift of the world supply curve by an amount equal to the tariff (Sw → Stw). The effect of the tariff is to benefit domestic producers at the expense of domestic consumers and foreign producers. The domestic price rises to p1, which is the world price plus the tariff (pw + t). Domestic production expands from q1 to q3, but domestic consumption falls from q2 to q4. Imports, which were q2 – q1, fall to q4 – q3. The government’s tariff revenue from these imports is q4 – q3 times t (indicated by the shaded area abcd).
Consumers’ surplus has fallen by pwp1cf as a result of the tariff. This has been converted into increased profits for domestic producers (pwp1be), tariff revenue for the government (abcd) and payment for the higher costs of domestic producers (eba). The triangle dcf represents a deadweight loss (i.e. a loss with no corresponding gain).