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SSC351 Study Guide

Nations are increasingly joined together by an unceasing flow of goods and services.  Malaysia is no exception.  We ship enormous volumes of goods such as electronic chips, electrical appliances, palm oil, and cars to other countries; and in return we get hundreds of millions of dollars worth of flour, airplanes, and construction machinery from other countries. 
What are the economic forces that lie behind the surge in international trade?  Simply put, trade promotes specialization, and specialization increases productivity.  Over the long run, increased trade and higher productivity raise living standards for everyone.  Gradually, countries have realized that international trade is one of the surest roads to economic prosperity. Still, trade is not a blessing at all time to everyone.  With growing trade, imports displace domestic production and employees lose their jobs.
International vs. Domestic Trade
How does the analysis of international trade differ from that for domestic markets?  Here are three differences:
  1. Expanded Trading Opportunities.  The major advantage of international trade is that trading horizons are expanded.  If people were forced to consume only what they produced at home, the world would be poorer on both the material and spiritual planes.  Malaysians could consume no American wheat, Americans could consume no Malaysian palm oil, and most of the world would be without Kentucky Fried Chicken (a US product) or Proton Wajas (a Malaysian product) or Manchester United (a UK product).
  2. Sovereign NationsTrading across frontiers involves people and firms living in different nations.  Each nation is a sovereign entity that regulates the flow of people, goods, and assets crossing its borders.  This contrasts with domestic trade, where there is a single currency, trade and money flow freely within the borders, and workers can more easily to follow jobs.  Sometimes, political barriers to trade are erected when affected groups object to foreign trade and nations impose tariffs or quotas.  This practice, called protectionism, is analyzed later.
  3. Exchange RateMost nations have their own currencies.  I want to pay for a Japanese car in Ringgits, while Toyota wants to be paid in Japanese yen.  The international financial system must ensure a smooth flow of ringgits, yet, and other currencies -- or else risk a breakdown in trade.

An economy that engages in a significant amount of international trade is called an open economy.  A useful measure of openness is the ratio of the country's exports or imports to its GDP.  Many nations, particularly in Western Europe and East Asia (including Malaysia), are highly open economies and export and import more than 50% of their GDPs.

Nations find it beneficial to participate in international trade for several reasons:  because of diversity in the conditions of production, because of decreasing costs of production, and because of differences in tastes among nations.

Diversity in Conditions of Production.  Trade may take place because of the diversity in productive possibilities among countries.  In part, these differences reflect endowments of natural resources.  One country may be blessed with a supply of petroleum, while another may have a large amount of fertile land.  Or a mountainous country may generate large amounts of hydroelectric power that it sells to its negihbours, while a country with deep-water habours may become a shipping center.

Decreasing Costs.  A second reason for trade arises because many manufacturing processes enjoy economies of scale; that is, they tend to have lower average costs of production as the volume of out expands.  So when a particular country gets a head start in a particular product, it can become the high-volume, low-cost producer.  The economies of scale give it a significant cost and technological advantage over other countries, which find it cheaper to buy form the leading producer than to make the product themselves.

Differences in Tastes.  Yet, a third cause of trade lies in preferences.  Even if the conditions of production were identical in all regions, countries might engage in trade if their tastes for goods were different.  For example, suppose that Thailand and Malaysia produce fish from the sea and meat from the land in about the same amounts, but the Thais have a great fondness for meat while the Malays are partial to fish.  A mutually beneficial export of meat from Malaysia and fish from Thailand would take place.  Both countries would gain from this trade; the sum of human happiness in increased.

PROTECTIONISM is any policy adopted by a country to protect domestic industries against competition from imports.  To protect local industries, countries impose trade barriers in the form of:

  1. Tariff is a tax levied on imports.  Let's assume that Malaysia imposes a tariff of 10% on imported cars.  If a Toyota costs RM100,000, then the domestic price including the tariff would be RM110,000.  .  Prohibitive tariff is imposing a very high tax as to completely discourage any imports.  Imagine what would happen if Malaysia imposes a 100% tariff on imported cars.  The Toyota in the above example will carry a price tag of RM200,000!  Prohibitive tariff thus kill off all trade.  Non-prohibitive tariff is more moderate that might discourage the imports of foreign goods, but not entirely.  It is useful to remember that a tariff tend to raise price, lower the amounts consumed and imported, and raise domestic production.
  2. A Quota is a limit on the quantity of imports. Malaysia has quotas on many products including rice and computers.  Quotas have the same qualitative effect as tariffs.  A prohibitive quota (one that prevents all imports) would achieve the same result as a prohibitive tariff.  A less stringent quota might limit imports to, say 200 foreign cars or 1,000 units of Nokia telephones.  Although there is no essential difference between tariffs and quotas, some subtle differences do exist.  A tariff gives revenue to the government, perhaps allowing other taxes to be reduced and thereby off-setting some of the harm done to consumers in the importing country.  A quota, on the other hand, puts the profit from the resulting price difference into the pocket of the importers lucky enough to get a permit or license to import.
  3. Transportation Cost is the cost of moving goods and has the same effect as tariffs, reducing the extent of beneficial regional specialization.  For example, if the cost to transport palm oil from Malaysia to France is too high, it will make the price of palm oil in Paris very expensive.  But there is one difference between protection and transportation costs:  transport costs are imposed by nature -- by distance, mountains, and rivers -- whereas restrictive tariffs are squarely the responsibility of nations.
  4. Export Subsidies and grants.
  5. Embargo.
  6. Exchange control.
  7. Import licenses.

Notes on items 4, 5, 6, and 7 above will be published later.