ECON1086: Business in a Globalised Economy
Week 2 Tutorial Solution
The jury is still out on whether the CPTPP benefits everyone.
How do economists generally compare levels of economic development between two countries?
Economic development: an improvement of the living standards and quality of life in a country.
Economic growth: an increase in the size of a country’s economy which is typically measured by gross domestic product (GDP), total production of goods and services in the economy.
Economic development is a broader concept than economic growth. Because economy growth is a key driver for living standards improvements, economists usually use GDP per capita (e.g., all expressed in the same currency) to compare levels of economic development across countries. To account for the overall price difference across countries, economists use purchasing power parity (PPP) adjusted GDP per capita.
Is this a good measure of economic development? Why or why not? Discuss
“GDP is a measure of economic activity; Using GDP as a measure for Economic Development is in fact marked by confusion between economic activity and social welfare or well-being” (OECD yearbook 2014). So, there are varied arguments for GDP as a measure of Economic Development.
Arguments supporting as “A good measure”:
The growth rate of real GDP is often used as an indicator of the general health of the economy. In broad terms, an increase in real GDP is interpreted as a sign that the economy is doing well (International Monetary Fund). The real rate Many aspects of living standards and quality of life do increase with the GDP per capita.
With no GDP growth in a country, it seems impossible to deliver an improvement in living standards that spans literacy, life expectancy, schooling years, health care et al.
Arguments supporting as “Not a good measure”
It does not tell us how evenly the incomes are distributed across subgroups. For example, a country can experience a huge increase in GDP per capita over time, but also high inequality, meaning a small group of people benefit from the living standards improvement more than the rest.
It does not account for leisure time. For example, people in country A are richer than those in country B, simply because they work much longer hours each year. thus, to fix this, we might use GDP per capita per working hour.
It does not capture the black markets which are common in some less developed countries.
It only includes market activities and does not include household activities such as children care at home, housework at home. You can image that developing countries’ GDP per capita is thus underestimated.
It does not account for environment costs. For example, town A is much richer than town B, because town A has many metal factories that yield a large GDP, at the cost of environment pollutions.
Some increase in per capita GDP does not necessarily make people better off. E.g., replacement of infrastructure after a disaster which boosts the GDP growth.
It does not account for non-material wellbeing or happiness. For example, Bhutan has much lower GDP per capita than many other countries, but people there have much higher happiness.
How do economists generally compare globalisation (openness) between two countries and why?
Trade/GDP = (Imports + exports) / GDP
We will need to divide the total trade values by the GDP to produce a meaningful comparison across countries.
Consider two countries A and B. A’s economy is $100 and B’s is $500. Trade (X+M) from both countries is $50. While trade is the same, A is more open to trade than B because trade as a share of GDP (or taking into account the size of the economy) is bigger. So, a small country can have a very high openness, despite that its absolute trade value is small due to its small size of economy.
Use this website to show openness in a few countries –
http://wits.worldbank.org/visualization/openness-to-trade-dashboard.html.
Do you observe a pattern between openness and GDP per capita?
There exists a positive relationship between openness and GDP per capita. This holds from two dimensions:
1) over time, given a country (you can pick one from the map, say Vietnam), an increase in openness is associated with an increase in GDP per capita;
2) across countries, the scatter plot also suggests a positive relationship between openness and GDP per capita, despite being weak.
Explain openness in words à how would you explain this to someone in year 11 of high school? [Practice explaining things intuitively, you’ll need this at work]
Hint: Trade Openness is measured by the ratio/percentage of country’s total trade (import and export) and GDP. Use above example to explain (Question 3 response) more clearly.
Run a quick overview of consumer and producer surplus.
Please revisit the tutorial solution of week 1 in this regard
Using a demand and supply diagram explain the welfare implications of a deal that lowers the price of imports.
See the figure above. If we further reduce tariffs so that the import prices go down, then the green line (Pw+tariff) will be pushed down further towards the red line (Pw). It can be seen that:
the imports increase
govt revenues go down
CS increases
PS decreases
deadweight loss decreases (the area A+B will become smaller)
interpretation of the above in the context of US importing sugar from Brazil: with the lower import prices of sugar caused by lower tariffs
US consumers want to buy more sugar, while the US sugar firms (or import competing firms) are willing to supply less. Thus, US relies more on imports, and need to import more sugar from Brazil.
US government’s tax tariffs are less.
US consumer surplus increases because consumers can buy sugar at much cheaper prices.
US producer surplus decreases because sugar firms cannot complete with Brazil’s sugar firms for that low price, and some of them will be out of the business.
Deadweight loss is less because now we have the efficiency gain (resources allocated to where it has highest payoffs) from reducing tariffs.
Using a demand and supply diagram explain the welfare implications of a deal that raises the price of exports.
See the diagram below, in this case, the price with free trade line will be further pushed up. Thus, domestic CS will further decrease, and PS will further increase. But the gain of PS will be more than the loss of CS, thus net positive gains from the trade will be even larger (that is, the blue area will be larger, when the price with free trade line moves upwards).
Interpretation of the above in the context of Brazil exports sugar to the US:
With a higher export price, the domestic sugar firms in Brazil will expand their production hence more supply of sugar. Producer surplus increases. The consumers in Brazil now pays higher prices, thus decrease their demand, and the consumer surplus decreases. However, the net gains (blue area) is shown to be positive and getting big if we further push up the price with free trade.
Imagine that you work for a major Australian confectionary company that specialises in fruit-based candies. You hear that Australia is looking to sign a Free Trade Agreement with a major banana exporter. Discuss the implications of this agreement for your company. In particular, what should you do now if you expect that the agreement will come to force in 3 months?
The major banana exporter in the international market is assumed/expected to have comparative advantage and lower opportunity cost
Free Trade Agreement maintain the lower prices (no addition of tariff) and the benefit passes on to the Australian consumer as well as the Australian producers using bananas as an intermediate input.
Given three months to the agreement to come to force, the company may take the step to expand the production.
Find a suitable company from this exporter/exporting country.
What are FTAs, and who benefits from them?
A free trade agreement (FTA) is an international treaty between two or more economies that reduces or eliminates certain barriers to trade in goods and services, as well as investment.
Benefits:
With an FTA, the barriers to trade are usually reduced or eliminated. Thus, the imported goods are more affordable (cheaper) for consumers.
Not only the final consumption goods are cheaper, the prices of many intermediate goods are also cheaper with FTAs, thus firms importing these intermediate goods as their production inputs will also benefit. This is particularly important for firms in developing countries who reply on importing some intermediate inputs from developed countries because their domestic technology does not enable them to produce the intermediate inputs domestically.
Lower tariffs mean that exporters can enter international markets more easily. They tend to expand its production and international market (recall that the export prices will go up due to a larger market induced by FTAs.)
FTAs not only reduces tariffs of goods and services, but they also make the investment in foreign countries less challenging, because FTAs members agreed to have more transparent, predictable business environment which are vital for business. For example, we often see more foreign investment within FTAs. As a multinational firm in the US, I might find attractive to set up a factory or even buy a factory in a developing country and ask this factory to produce and export some simple intermediate goods back to US where my key and final production occurs. Having a factory in a developing country is much cheaper than buying intermediate goods domestically due to the high wages in the US. At the same time, developing countries within FTAs often benefit from foreign investment, and opportunities to learn from firms of developed countries, because they can either import important intermediate inputs from developed countries more easily, or they have access to advanced technology via investment cooperation.
Potential costs:
Some Import competing firms might not be able to compete with firms from another country, thus they are forced to be out of business.
Governments will have less tax revenues, but in the long run, if FTAs promote higher volumes of trade and investment, and increase employment, enhance consumers real purchasing power, and stimulate economic growth. These gains are likely to outweigh the tax revenue loss.
There are some risks or concerns of more FDI from the country A (e.g. Australia) to country B (Vietnam) within a FTA.
First, people might be afraid that the production activities originally in Australia now are reallocated to the Vietnam, thus loss of employment for Australia.
Second, the intellectual property (e.g., patents, trademarks et al.) enforcement are less strong in developing countries, thus there is a risk with intellectual property protection for Australian firms.
Third, the labour standards in developing countries are also not up to that in the developed countries. Some multinational firms might over exploit the low wages by offering very poor working conditions.
