Assessment Details Format: Case studyLength/Duration: 2000 wordsTask Description: Please download the instruction sheet under "Supporting Resources" belowGoal: Case Study Report (based on Modules 1- 4

Module 1

Introduction to global economy

The main driver of the increased pace of globalization, which has resulted in increased trade, and the flow of capital and labour across international boundaries, is the improvement in technology. Technological advancements have reduced the cost of communication and transportation, making it easier for countries to trade with each other. Additionally, a peaceful international environment has greatly aided countries in depending on each other. As a result of increased trade and cross-border investment, many countries have experienced improvements in their standard of living.

Globalisation has indeed led to increased flow of labour and capital across international boundaries. Capital tends to move from locations where the rate of return is lower to where the rate of return is higher. Workers also tend to move from one country to another due to differences in standard of living and better educational opportunities for their children. However, labour mobility is relatively more restricted compared to capital mobility. Despite the increase in the standard of living across the globe due to rapid globalisation, many developing countries still face deep poverty, while Europe and the US economies are grappling with slow growth and high unemployment.

Although there has been a significant decrease in tariffs worldwide, achieving a worldwide free trade agreement is not easy, and hence regional trading blocks are gaining popularity. Examples of regional economic integration include ASEAN, NAFTA, and the EU.

The increased interdependence among countries due to international trade has led to a greater need for international cooperation and institutions to manage trade-related disputes and issues. The World Trade Organization (WTO) plays an important role in setting and enforcing global trade rules and resolving trade disputes among its member countries. The International Monetary Fund (IMF) provides financial assistance to member countries facing balance of payments difficulties and works to promote international monetary cooperation and exchange rate stability. These institutions help to promote a more stable and predictable international economic environment, which can benefit all countries involved in international trade.

Module 2

Why countries trade with each other ??

This module explains why some countries try to restrict imports and discusses the sources of absolute and comparative advantage. Under mercantilism, trade was viewed as a zero-sum game, where all countries could not gain from trade. A strong government was needed to restrict imports. Adam Smith, using the concept of absolute advantage, showed that trade based on absolute advantage can potentially benefit all countries, and no government involvement is required. Absolute advantage is based on the productivity of workers.

Adam Smith showed that mutually beneficial trade is possible only when a country has absolute advantage in the production of at least one product. However, some developing countries do not have an absolute advantage in the production of any commodity. David Ricardo showed that even if a country does not have an absolute advantage in the production of any commodity, mutually beneficial trade is possible, but it must be based on comparative advantage. Comparative advantage can be determined by looking at the opportunity cost of production. Trade based on comparative advantage can potentially benefit all countries.

Both Adam Smith and Ricardo explicitly assumed that everything was produced by labour. The comparative advantage-based theory of trade was further refined by others by using the concept of the production possibility frontier (PPF). The PPF is a graphical tool that allows the use of all types of resources (such as capital, labour, and land) in the production of every commodity. Using the PPF, where several inputs can be used in the production process, the comparative advantage of a country can be easily determined, and trade based on comparative advantage can benefit all countries. The benefits are maximized when countries specialize based on their comparative advantage. However, in this module, straight-line PPFs are used, which means that opportunity cost is fixed. However, real life is often characterized by increasing opportunity cost. Can trade benefit all countries if production involves increasing opportunity cost?

Module 3

This module focuses on relatively more recent trade theories. Except for mercantilism, all trade theories show that free trade can potentially benefit all countries (i.e., free trade is a positive sum game). Ricardo’s theory of comparative advantage and its predecessor Adman Smith’s theory of absolute advantage are based on the assumption differences in technologies across countries. In other words, if technologies were identical then one country would not have comparative advantage over another country. In this section, standard trade theory is discussed where production is subject to increasing opportunity cost. Using the concepts of production possibilities frontier (PPF) and community indifference curves (society wants to reach the highest possible curve as it represents a heights standard of living), it is sown that international trade based on comparative allows a country to consume beyond its production capacity (i.e., along a higher community indifference curve well above its PPF). Trade creates jobs in export-oriented sectors, but job Heckscher-Ohlin (H-O) theory starts by assuming that technologies are identical. H-O theory shows that comparative advantage arises due to differences in endowments of primary factors of production (capital and labour are 2 important primary factors of production). H-O theory shows that a country will export that commodity, which issues its abundant factor intensively. This means that the US, which is capital abundant, will export capital intensive (and import labour intensive) products. Factor price equalisation (FPE) theorem shows that if trade takes place based on H-O theory then prices of primary factors of production will be equalised across countries, even if the primary factors of production were internationally immobile. In real life, FPE does not hold because not all products are internationally traded. Stolper-Samuelson theorem shows that (if trade takes place based on H-O theory) and price of a commodity increases then the reward (i.e., the price) for the factor that is used intensively in its production increases relative to the other factor. This means that in a country like the US, the distribution of income will move in favour of capital owners and the working class will be relatively worse- off. Early empirical evaluation (by Leontief) of H-O theory using the US data showed that the US imports were capital intensive, which is known as Leontief paradox. This unexpected result can be attributed to, among other things, the definition of labour and capital used (where all type of labour, skilled and unskilled, were treated equally) and the fact that all assumptions of H-O theory do not hold in real life.

losses occur in import competing industries. The overall effect of free trade is positive. In the presence of increasing opportunity cost, complete specialisation is not an option.

Presence of economies of scale in some industries can also lead to comparative advantage. Intra-industry trade involves trade in varieties of a product (e.g., cars, mobile phones, wine, beer etc.). Intra-industry trade takes place among countries that have a similar standard of living. Such trade is beneficial because it allows consumption of new varieties that may in fact be more expensive than domestic varieties (so lower price is not the motivation for imports). Product life cycle theory is based on the premise that comparative advantage is not fixed. Advanced products are produced in high-income developed countries. At the beginning of the first stage of the life of the product (i.e., the new product stage), the product is meant for domestic consumption and may be exported towards the end of this stage. In the second stage (i.e., matured product stage), the product is exported and towards the end may even be imported. In the third stage (i.e., standardised product stage), the technology to produce the product is well known and hence it is produced at a location where cost of production is lower. In other words, in the last stage, the product is imported. Some companies like (Boeing and Airbus) gained comparative advantage because of government support in early stages. However, the success of the strategic trade policy cannot be guaranteed.

Module 4

Trade Restrictions :

Tariff (which is tax on imports) is the most popular method of restricting imports. Free trade increases total surplus (consumer plus producer surplus, which is a measure of the welfare of the economy). Introduction of a tariff by a small country has no effect on international market price but a tariff introduced by a large country decreases the international market price. When a small country imposes a tariff, the welfare of the economy decreases.

When a large country imposes a tariff then the welfare of the economy can increase because the decrease in consumer surplus is smaller and only a small part of the tariff revenue collected by the government is extracted from consumer surplus. Tariff leads to inefficiency in both large and small countries. The inefficiency arises from increased inefficient domestic production and some consumers are forced to switch to other products (forced substitution). Due to the threat of retaliation, a large country will not try to improve its welfare by imposing a tariff. A tariff of intermediate goods does not provide positive effective protection.