1. Economics Chapter 8 International trade

2. Trade: Exchange of goods and services International trade: Exchange of goods and services between countries or regions. Example 1. USA and China USA sells computer to China China sells garment to USA 2. HK and other regions exports electronics goods Imports rice and cars

3. International trade

6. Mutual benefits Why trading? Mutual benefits Free trade benefits both buyers and sellers. Exporting country will gain from P x > Production cost, P X > P L Importing country will gain from P M < Production cost, P M < P L HKUSATrade? If exports / imports Loss  Gain  Loss  Gain 

7. Absolute advantage Definition Adam Smith If a country can produce more Good X than other countries by using the same amount of resources, then this country has an absolute advantage in producing Good X. Given the same input of resources:  China has an absolute advantage in producing Good X Conversely, USA has an absolute disadvantage. ChinaUSA Production of Good X 1,000 units300 units

8. Absolute advantage Comparison of same goods among countries. Determined by productivity. Technologically advanced  higher productivity in all good  absolute advantage Conversely, low level technology  low productivity  absolute disadvantage

9. Absolute advantage Each unit of resources can produce: Good X (units)Good Y (units) Country A85or25 Country B120or40 YesNo a. Country B must have more resources.  b. Country B is more technologically advanced.  c. Country B must have a higher total output than Country A.  d. Country B has an absolute advantage in the production of both goods.  e. Country B has an absolute advantage in producing Good X since each unit of resources can produce more X than Y.  ∵ Compare the same goods among countries

10. Case study: Absolute advantage Suppose Japan and USA both have 2,000 units of resources. They use half of their resource (1,000 units) to produce food and clothes on their own. Total resources (units) Total production of food (units) Total production of clothes (units) USA2,0005,000and6,000 Japan2,0004,000and8,000 Total output-9,000and14,000

11. Case study: Absolute advantage Each unit of resources can produce: For each unit of resources USA produce more food than Japan  USA has absolute advantage on food  Japan has absolute disadvantage on food Japan produce more clothes than USA  Japan has absolute advantage on clothes  USA has absolute disadvantage on clothes Food (units)Clothes (units) USA5or6 Japan4or8

12. Case study: Absolute advantage Suppose Japan and USA specialize on producing goods with absolute advantages, i.e. USA uses all the resources to produce food. Japan uses all the resources to produce clothes. Total output of food and clothes  Total resources (units) Total production of food (units) Total production of clothes (units) USA2,00010,000and0 Japan2,0000and16,000 Total output-10,000and16,000

13. Case study: Absolute advantage Suppose USA exchanges 4,500 units of food for 7,000 units of clothes with Japan. After international trade: Compare with the output before trade: Total resources (units) Total production of food (units) Total production of clothes (units) USA2,0005,500and7,000 Japan2,0004,500and9,000 Total output-10,000and16,000 Total resources (units) Total production of food (units) Total production of clothes (units) USA2,0005,000and6,000 Japan2,0004,000and8,000 Total output-9,000and14,000

14. Case study: Absolute advantage Assume that Free trade No transaction cost Through international trade USA gainsJapan gains 500 units of food  500 units of food 1,000 units of clothes  1,000 units of clothes Total output  1,000 units of food  2,000 units of clothes Conclusion Specialize in production of goods with absolute advantage Through international trade Mutual benefits

15. Comparative advantage Definition David Ricardo A country can produce Good X at a lower opportunity cost than other countries. Limitation of the principle of absolute advantage A technologically advanced country  Absolute advantage in all goods  Why import??? E.g. Japan has high level of technology Absolute advantage in all goods, but still imports from other countries

16. Comparative advantage Each unit of resources can produce: Country A has absolute advantage in both Good X and Y. Good X (units)Good Y (units) Country A50or25 Country B10or2

17. Comparative advantage

18. Convert the table to show the opportunity cost: Good XGood Y Country Aor Country Bor Table 8.2: Unit costs of producing Good X and Y in Country A and B. Good X (units)Good Y (units) Country A50or25 Country B10or2

19. Comparative advantage Country A has a lower opportunity cost in producing Good Y.  Country A has comparative advantage in Good Y. Country B has lower opportunity cost in producing Good X.  Country B has comparative advantage in Good X. No country can have a comparative advantage in all goods. Low opportunity cost in Good X  High opportunity cost in Good Y Good XGood Y Country A0.5Yor2X Country B0.2Yor5X Table 8.2: Unit costs of producing Good X and Y in Country A and B.

20. Comparative advantage Textbook p.36 Each unit of resources can produce: Good X (units)Good Y (units) Country A6,000or7,200 Country B4,000or6,000 Good XGood Y Country Aor Country Bor Table 8.2: Unit costs of producing Good X and Y in Country A and B.

21. Comparative advantage Each unit of resources can produce: Good X (units)Good Y (units) Country A6,000or7,200 Country B4,000or6,000 YesNo a. Country A has more resources.  b. Country A has an absolute advantage in producing Good X.  c. Country A has a comparative advantage in producing Good X.  d. Country A has a comparative disadvantage in producing Good X.  e. Country A has a comparative advantage in producing Good X since the opportunity cost of producing Good X is lower than that of Good Y.  ∵ Compare the same goods among countries

22. Absolute advantage & Comparative advantage Absolute advantage: A country with high productivity (usu.  technology) Can be all types of goods Comparative advantage A country with lower costs in producing a certain kind of goods Comparatively a certain kinds of goods only

23. Principle of comparative advantage If a country 1. specializes in and exports goods in which it has a comparative advantage, and 2. imports goods in which it has comparative disadvantage, the world’s total output will increase and both countries will benefit.

24. Principle of comparative advantage Assumptions Only 2 countries, Country A and Country B Only 2 types of goods, Goods X and Goods Y Amount of goods produced by each unit of resources is fixed Barter system (exchange of goods) No transaction cost

25. Comparative advantage Good XGood Y Country A0.5Yor2X Country B0.2Yor5X Table 8.2: Unit costs of producing Good X and Y in Country A and B. Country A vs. Country B Produce 1X0.5Y0.2Y Produce 1Y2X5X Table 8.3: Unit costs of Country A and B. Lower cost B should produce Good X Lower cost A should produce Good Y

26. Principle of comparative advantage Therefore, after specialization: Country ACountry B Specialize production in Good Y Good X Exports Good Y Good X Imports Good X Good Y

27. Comparative advantage After specialization (Good X) Effect on Good XEffect on Good Y Country A produces 1 less unit of X - 1X+0.5Y Country B produces 1 more unit of X +1X-0.2Y Total outputUnchanged+0.3Y Country A vs. Country B Produce 1X0.5Y0.2Y Produce 1Y2X5X Table 8.3: Unit costs of Country A and B.

28. Comparative advantage After specialization (Good Y) Country A vs. Country B Produce 1X0.5Y0.2Y Produce 1Y2X5X Table 8.3: Unit costs of Country A and B. Effect on Good XEffect on Good Y Country A produces 1 more unit of Y - 2X+1Y Country B produces 1 less unit of Y +5X-1Y Total output+3XUnchanged

29. Potential gain from trade Potential gain (highest possible gain) Gain before deducting the cost (transaction cost) of trade, such as transportation costs If transaction cost is involved, Actual gain < Potential gain

30. After specialization (Good X) Cost saved by Country A = 0.5Y Cost paid by Country B = 0.2Y World Total cost saving = 0.3Y Total increase in output = World total cost saving = 0.3Y Effect on Good XEffect on Good Y Country A produces 1 less unit of X - 1X+0.5Y Country B produces 1 more unit of X +1X-0.2Y Total outputUnchanged+0.3Y Potential gain from trade

31. From the example: Countries specialize in producing goods with lower opportunity cost International trade is mutually beneficial to 2 countries Potential gain form trade = Cost difference between 2 countries = 0.3Y Next questions: Which country gains more? Is the gain evenly distributed among 2 countries?

32. Terms of trade determine the distribution of gains Before trade: Suppose the terms of trade: 1X = 0.4Y Trade. Total gain is shared by Country A (0.1Y) & B (0.2Y) Country A vs. Country B Produce 1X0.5Y0.2Y Produce 1Y2X5X Table 8.3: Unit costs of Country A and B. Country A’s gain from importing 1X Domestic cost of 1X 0.5Y Import price 0.4Y Cost saved 0.1Y Country B’s gain from exporting 1X Domestic cost of 1X 0.2Y Export price 0.4Y Gain 0.2Y

33. Terms of trade determine the distribution of gains Before trade: Suppose the terms of trade: 1X = 0.3Y Trade. Total gain is shared by Country A (0.2Y) & B (0.1Y) Country A vs. Country B Produce 1X0.5Y0.2Y Produce 1Y2X5X Table 8.3: Unit costs of Country A and B. Country A’s gain from importing 1X Domestic cost of 1X 0.5Y Import price 0.3Y Cost saved 0.2Y Country B’s gain from exporting 1X Domestic cost of 1X 0.2Y Export price 0.3Y Gain 0.1Y

34. Terms of trade determine the distribution of gains Before trade: Suppose the terms of trade: 1X = 0.1Y No trade. Country B will lose if trading. Country A vs. Country B Produce 1X0.5Y0.2Y Produce 1Y2X5X Table 8.3: Unit costs of Country A and B. Country A’s gain from importing 1X Domestic cost of 1X 0.5Y Import price 0.1Y Cost saved 0.4Y Country B’s gain from exporting 1X Domestic cost of 1X 0.2Y Export price 0.1Y Loss 0.1Y

35. Case study (textbook p.39) Given the domestic costs: Country A: 1Y = 2X and Country B: 1Y = 5X Country A exports Good Y, because opportunity cost is lower. Conversely, Country B exports Good X. Opportunity costCountry ACountry B Produce 1X0.5Y0.2Y Produce 1Y2X5X Term of tradeExports YA’s gainB’gain 1Y = 1XNo trade-- 1Y = 2XCountry A03X 1Y = 3XCountry A1X2X 1Y = 4XCountry A2X1X 1Y = 5XCountry A3X0 1Y = 6XNo trade-- Mutual benefits

36. Case study (textbook p.39) Conclusion Mutual benefits Cost of importers > Terms of trade > Cost of exporters If term of trade = Cost of importer Importer’s gain = 0 Exporter’s gain = max. (i.e. potential gain) If term of trade = Cost of exporter Importer’s gain = max. (i.e. potential gain) Exporter’s gain = 0 If term of trade > cost of importer or term of trade < cost of exporter No trade Determination of term of trade Depends on the bargaining power of the countries E.g. Bilateral trade negotiations bet. USA and China

37. Conditions for mutually beneficial trade Each party has a comparative advantage Different opportunity costs in producing different goods Mutual beneficial terms of trade Terms of trade lies between domestic costs of both parties Cost of importer > Terms of trade > Cost of exporter Reasonable cost of trade Low transaction cost Transportation Negotiation Trade protection policies

38. Advantages of international trade Social development Exchange of products Native products E.g. teapots, art-crafts Cultural interflow Cultural exchange during communication and negotiation E.g. Western businessmen learn Chinese culture

39. Advantages of international trade Economical aspect Comparative advantage Lower cost Specialization More experience and knowledge Better use of technology Economies of scales Specialization allows increasing scale of production Thus, lower average cost Technological interflow Trade enhance technological interflow Higher productivity Enhancement of competition Higher quality of domestic products Lower cost to produce domestic products with advanced technology

40. The effects of exchange rate on international trade Think about this: A Japanese car costs ¥1,500,000 Assume the exchange rate is HKD1 = JPY10 How much should a HK citizen pay for this car in terms of HKD? HK$ 1 can be converted into JP¥ 10  The car costs HK$1,500,000 / 10 = HK$150,000 If HKD depreciates against JPY, what do you think about the price of the car in terms of HKD? If the exchange rate is now HKD1=JPY9, The car costs HK$1,500,000 / 9 = HK$166,666.67 The same car, but the price . HK people suffer.

41. The effects of exchange rate on international trade Think about this: Assume you have no special preference towards rice from different countries. If HKD depreciates against AUD, and HKD appreciates against THB (Thai Baht). Which one will you choose? Why?

42. Depreciation and exports Suppose garments are exported to Europe. Price of garment made in HK = HK$100 Exchange rate: HK$100 = €11 Export price = €11 HKD depreciation: Exchange rate: HK$100 = €10 Local price = HK$100 Export price = €10 Price   Qd  (Law of demand) That is, quantity demanded of HK garment export increases. P (€) Export volume HK garments 11 10 Q1Q1 Q2Q2 0

43. Appreciation and exports Suppose garments are exported to Europe. Price of garment made in HK = HK$100 Exchange rate: HK$100 = €11 Export price = €11 HKD appreciation: Exchange rate: HK$100 = €12 Local price = HK$100 Export price = $100 = €12 Price   Qd  (Law of demand) That is, quantity demanded of HK garment export decreases. P (€) Export volume HK garments 12 11 Q2Q2 Q1Q1 0

44. Depreciation and imports Suppose watches are imported from Europe. Price of European watch = €110 Exchange rate: HK$100 = €11 Import price = HK$1000 HKD depreciation: Exchange rate: HK$100 = €10 Import price = $110 x (100/10) = HK$1100 Price   Qd  (Law of demand) That is, quantity demanded of European watches import decreases. P ($) Import volume European watches 1100 1000 Q2Q2 Q1Q1 0

45. Appreciation and imports Suppose watches are imported from Europe. Price of European watch = €110 Exchange rate: HK$100 = €11 Import price = HK$1000 HKD appreciation: Exchange rate: HK$100 = €12 Import price = $110 x (100/12) = HK$916.7 Price   Qd  (Law of demand) That is, quantity demanded of European watches import increases. P ($) Import volume European watches 1000 916.7 Q1Q1 Q2Q2 0

46. The effects of exchange rate on international trade Summary Case study in textbook p.46: Change in revenue which is brought be depreciation or appreciation depends on the price elasticity of demand. Try yourself!!! ExportsImports PriceQdPriceQd Depreciation  Appreciation 

47. Trade in Hong Kong Merchandise trade (Goods) Exports Garments Electronic products Toys Jewellery (accounted for more than 60% of total domestic exports in 2008)

48. Trade in Hong Kong Merchandise trade (Goods) Retained imports Raw materials (e.g. gold, silver) Semi-finished goods (e.g. LCD display, plastic button) Capital goods (e.g. truck, machine) Consumption goods (e.g. clothes, TV) Fuel Food (accounted for more than 99% of total retained imports in 2008)

49. Trade in Hong Kong Trade in services Exports of services (Exports have higher value than imports) Financial consultation Commerce Accounting Transportation Entertainment Imports of services (Imports have higher value than exports) Tourism Insurance

50. Trade in Hong Kong Major trading partners Total trade volume Import suppliers Export markets Re-exports SourcesDestinations The Mainland USAThe Mainland USAJapanThe MainlandJapanUSA JapanTaiwanNetherlandsTaiwanJapan TaiwanKoreaUKKoreaGermany High Low Value of goods

51. Trade in Hong Kong Trade based on comparative advantage Low opportunity cost: Exports Goods (e.g. garments, electronic products) Services Low opportunity cost: Re-exports High opportunity cost: Imports Goods (e.g. capital goods) Services

52. Importance of trade to Hong Kong’s economy Acquiring consumption goods and raw materials HK is lack of resources Rely on imports Hugh demand of daily necessities (e.g. food) and raw materials (e.g. coal) Favourable to the development of high value- added industries HK has comparative advantage in specializing in value-added industries E.g. finance and commercial industrials

53. Importance of trade to Hong Kong’s economy Trade generates huge income In 2010, GDP = $1,748.1billion International trade is very important to HK economy Imports Value of imports of goods = $3,395.1 billion (194.2% of GDP) Value of imports of services = $396.6 billion (22.7% of GDP) Exports Value of exports of goods = $3,061.3 billion (175.1% of GDP) Value of exports of services = $835.0 billion (47.8% of GDP)

54. Pros and Cons of free trade Pros Consumers More choices Cheaper and higher quality imported goods Workers Products can be sold worldwide  More job opportunity More profits  Higher wages Businessmen Open new markets  More profits Owners of Trading firm More business for the company Service providers (e.g. banks, transportation firms) More business  More income

55. Pros and Cons of free trade Cons Workers Keen international competition  Close down of factories  unemployment or  less profits  Lower wages Local famers Large quantity imported farm products  Less sales  Poor livelihood Local consumers High quality products are for exports  Buy only low quality products locally