International Economics ECO 40963

Study Questions:

1. What are the major reasons for the skepticism of many developing nations
regarding the competitive-advantage principle and free trade?

The theory of comparative advantage maintains that all nations can enjoy the benefits of
free trade if they specialize in production of those goods in which they have a
comparative advantage and exchange some of these goods for goods produced by other
nations. In addition, advanced nations claim that the existing international trading system
has provided widespread benefits and the trading interests of all the nations are best
served by pragmatic, incremental changes in the existing system and thus, to achieve
trading success, they must administer their own domestic and international economic
policies. However, on the basis of their trading experience with the advanced nations,
many developing nations have become skeptical of the distribution of trade benefits
between them and the advanced nations and these nations generally maintain that the
benefits of international trade accrue disproporationately to the advanced nations. Also,
the developing nations have argued that the protectionist trading policies of advanced
nations hinder the industrializaton of many developing nations. Among the alleged
problems plaguing the developing nations have been unstable export markets,
worsening terms of trade, and limited access to markets of industrial countries.

It has been noted that many developing nations’ exports are concentrated in only
one or a few primary products and thus unstable export markets, worsening terms of
trade, and limited access to world markets for the products can significantly reduce
export revenues and seriously disrupt domestic income and emploment level. In addition,
many developing nations feel that developed nations tend to insist that developing nations
open their markets to industrial products from the developed world, yet refuse to open
their markets to agricultural goods from the developing world. For example, United
States have used aggressive antidumping and countervailing duties to limit access to their
markets. Furthermore, the current concept of free trade supports the free movement of
products and employers, which favors the developed nations, but not the free movement
of employees (i.e., labor), which would favor the people of developing nations.

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2. Stabilizing commodity prices has been a major objective of many primary-

product nations. What are the major methods used to achieved price
stabilization?

As noted, the export prices and revenues of developing countries can be quite volatile. In
an attempt to stabilize export revenues and prices, International Commodity Agreements
(ICA) have been formed by producers and consumers of primary products about matters
such as stabilizing prices, assuring adequate supplies to consumers, and promoting the
economic development of producers. The methods used to attain these objectives are
exports controls, buffer stocks, and multilateral contracts. .

• Production and Export Controls

If an ICA accounts for a large share of total world output (or exports) of a commodity, its
members may agree on export controls to stabilize export revenues. The idea behind such
measures is to offset a decrease in the market demand for the primary commodity by
assigning cutbacks in the market supply. If successful, the rise in price due to the
curtailment in supply with the sufficient for compensate the reduction in demand, so that
total export earnings will remains at the original level.

• Buffer Stocks
Buffer stock, in which a producers’ association (of international agency) is prepared to
buy and sell a commodity in large amounts. The buffer stock consists of supplies of a
commodity financed and held by the producers’ association. The buffer stock manager
buys from the market when supplies are abundant and prices are falling below acceptable
levels, and sells from the buffer stock when supplies are tight and prices are high. A well-
run buffer stock can promote economic efficiency because primary producers can plan
investment and expansion if they know that prices will not gyrate.

• Multilateral contracts
Multilateral contracts generally stipulate a minimum price at which exporters will
purchase guaranteed quantities from the producing nations and a maximum price at

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which producing nations will sell guaranteed amounts to the exporters. Such purchases
and sales are designed to hold prices within a target range. One possible advantage of the
multilateral contract as a price- stabilization device is that, in comparison with buffer
stocks or exports controls, it results in less distortion of the market mechanism and the
allocation of resources

3. What are some examples of international commodity agreements? Why have

many of them broken down over time?

Examples of International commodity agreements are International Cocoa Organization,

International Tin Agreement, International Coffee organization, International Sugar
organization and International Wheat Agreement. These agreements are used as a price
stabilization device to stabilize export receipts, production, and prices.

However, many of them have broken down over time because production is labor-
intensive, output cutbacks are often socially unacceptable to workers. Agreeing on a
target price that reflects existing economic conditions is also troublesome. Agricultural
products often face high storage costs and are perishable. Stockpiles of commodities in
importing nation can be used to offset controls on production and export. Substitute
products exist for many commodities.

4. Why are the less developed nations concerned with commodity-price

stabilization?

The composition of less developed nations’ exports emphasis on primary products and
these nations concentrated in only one or a few primary products. Thus, a poor harvest or
a decrease in market demand for that product can significantly reduce export revenues
and seriously disrupt domestic income and employment levels. In addition, export prices
and receipts can be very volatile when supply and demand conditions are price-inelastic.
Therefore, it is vital important for them to enact commodity price stabilization policies to
increase their level of income and standard of living.

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5. The average person probably never heard of the Organization of Petroleum

Exporting Countries until 1973 or 1974, when oil prices skyrocketed. In fact,
OPEC was founded in 1960. Why is it that OPEC did not achieve worldwide
prominence until the 1980s? What factors contributed to OPEC’s problems in
the 1980s?

The Organization of Petroleum Exporting Countries (OPEC) is a group of nations that

sells petroleum on the world market. The OPEC nations attempt to support prices higher
than would exist under more competitive conditions to maximize member-profits. OPEC
was operating obscurely in 1960s due to OPEC members behaved like individual
competitive sellers and each nation itself was so unimportant relative to the overall
market that changes in its export levels did not significantly affect international prices
over a sustained period of time. By agreeing to restrict competition among themselves via
production quotas, however, OPEC was able to capture control of petroleum pricing in
1973 and 1974, when the price of oil rose from approximately $3 to $12 per barrel.

During the1970s, OPEC was successful in increasing the revenues of its

members. One reason is that the long-run price elasticity of oil supply in non-OPEC
nations is inelastic. Estimates in the 1970s put the non-OPEC supply elasticity between
0.33 and 0.67, suggesting that a 1% increase in the OPEC price will induce only a 0.5 %
increase in non-OPEC output. In addition, the demand for gasoline in the United States
was also estimated to be inelastic, having a long-run price elasticity coefficient of 0.8.
Moreover, OPEC was able to dominate the world oil market, accounting to more than 2/5
of world production, 2/3 of world reserves, and more than 4/5 of world exports.

By the 1980s, however, OPEC increasingly faced the pressure that often leads to
the demise of cartels. The OPEC price hikes had induced non-OPEC nations to develop
new production techniques and initiate new discoveries. The result was a fall in the
OPEC share of the world market from 56 % in 1973 to 33 % in 1986. The OPEC price
hikes also led to decrease oil demand owing to increased usage of smaller autos and
insulation and the switch to substitute energy sources, including coal and nuclear power.
Furthermore, the recession of 1981—1983 led to weakening demand and oil prices

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tumbling to less than $11 per barrel by 1986. Despite the market difficulties, OPEC was
resilient and continues to operate as a cartel at the millennium.

6. Why is cheating a typical problem for cartels?

A cartel is a group of firms formally agreeing to control the price and the output of a
product. The goal of a cartel is to reap monopoly profits by replacing competition with
cooperation. However, if a cartel is holding up prices by restricting output, there is a big
incentive for member to cheat by increasing output, even a little bit. Breaking ranks can
mean very large profits. Using the following exhibit, we can demonstrate how a cartel
works and why a cartel member has an incentive to cheat.

55 MC
Price per LRAC
barrel
(Dollars)
45 MR2
40

30 MR1
20

10

0 2 4 6 8 10 12 14

Quantity of oil
(Millions of barrels per day)

From the exhibit above, assume that a representative oil producers operating in a
perfectly competitive industry would be in long run equilibrium at a price of $30 per
barrel, producing 6 million barrels per day and making zero economic profit. A cartel can
agree to raise the price of oil from $30 to $45 per barrel by restricting the firms to 4
million barrels per day. As a result of this quota, the cartel price is above $35 on the
LRAC curve, and the firm earns a daily profit of $40 million. However, if the firm cheats

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on the cartel agreement, it will set the cartel price equal to the MC curve and earn a total
profit of $ 80 million by adding an additional $40 million. If all firms cheated, the
original long-run equilibrium would be re-established.

7. The generalized system of preferences is intended to help developing

nations gain access to world markets. Explain.

To help developing nations gain access to world market, many industrial nations offer
assistance known as a Generalized System of Preferences (GSP). Under this generalized
system of preferences, major industrial nations temporarily reduce tariffs on designed
manufactured imports from developing nation below the levels applied to imports from
other industrial nations. The GSP is not a uniform system, however, because it consists of
many individual schemes that differ in the types of products covered and extend of tariff
reduction. For example, since its origin in 1976, the U.S. GSP program has extended
duty-free treatment to about 3000 items. Beneficiaries of the US program include some
150 developing nations and their dependent territories. Like the GSP program of other
industrial nations, the US program excludes certain import-sensitive products from
preferential tariff treatment. These products include electronic items, glass, certain steel
and iron product, watches, and some types of footwear. Limits also exist on the amount
of a particular product reach beneficiary can export to the United States.

Although the GSP program provides preferential access to industrial countries’

market, several factors erode its effectiveness in reducing trade barriers faced by
developing nations. First, preferences mainly apply to products that already relatively low
tariff. Second, tariff preference can be eroded by non-tariff measures, such as
antidumping duties and safeguards. Thus, developing nations have been frustrated about
limited access to the markets of industrial countries.
8. How are imported-substitution and exported promotion policies use to aid in
the industrialization of developing nations?

During 1950s and 1960s, many developing nations used import substitution to promote
their internal industrialization. Import Substitution involves extensive use of trade
barriers to protect domestic industries from import competition. The strategy is inward-

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oriented in that trade and industrial incentives favor production for the domestic market
over the export market. Encouraging economic development via import substitution has
several advantages: -
• The risks of establishing a home industry to replace imports are low because the
home market for the manufactured goods already exists.
• It is easier for a developing nation to protect its manufacturers against foreign
competitors than to force industrial nations to reduce their trade restrictions on
products exported by developing nations.
• To avoid the import tariff walls of the developing country, foreigners have an
incentive to locate manufacturing plants in the country, thus providing jobs for local
workers.

By the 1970s, however, many developing nations were abandoning their import
substitution strategies and shifting emphasis to export-led growth. Exported promotion
policy is outward oriented because it links the domestic economy. Instead pf pursuing
growth through the protection of domestic industries suffering comparative disadvantage,
the strategy involves promoting growth through the export to manufactured goods. Trade
controls are either nonexistent or very low; in the sense that any disincentives to export
resulting from import barriers are counterbalanced by export subsidies. Industrialization
is viewed as a natural outcome of development instead of being an objective pursued at
the expense of the economy’s efficiency. Export promotion policies have several
advantages: -
• They encourage industries in which developing countries are likely to have a
comparative advantage, such as labor-intensive manufactured goods.
• By providing a larger market in which to sell, they allow domestic manufacturers
greater scope for exploiting economies of scale.
• By maintaining low restrictions on imported goods, they impose a competitive
discipline on domestic firms that force them to increase efficiency.

In conclusion, Export-led growth policies introduce international competition to

domestic markets, which encourage efficient firms and discourage inefficient ones. By

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creating a more competitive environment, they also promote higher productivity and
hence faster economic growth. Conversely, import substitution policies relying on trade
protection switch demand to products produced domestically. Exporting is then
discouraged by both the increased cost of imported inputs and the increased cost of
domestic inputs relative to the price received by exporters. Therefore, countries
emphasizing export promotion have tended to realize higher rate of economic growth
than countries emphasizing import substitution policies.

9. Describe the strategy that East Asia used from the 1970s to the 1990s to
achieve high rates of economic growth. Can the Asian miracle continue into
the new millennium?

The East Asian economies have realized remarkable economic growth. The foundation of
such growth has included high rates of investment, the increasing endowments of an
educated workforce, and the use of export-promotion policies.

The East Asian tigers are highly diverse in natural resources, populations,
cultures, and economic policies. However, they have in common several characteristics
underlying their economies success, i.e. high rate of investment, and high and
increasing endowments of human capital due to universal primary and secondary
education.

To foster competitiveness, East Asian government have invested in their people

and provided a favorable competitive climate for private enterprise. They have also kept
their economies open to international trade. The East Asian economies have actively
sought foreign technology, such as licenses, capital-good imports, and foreign training.
It is widely recognized that East Asian economies have followed a flying-geese
pattern of economic growth in which countries gradually move up in technological
development by following in the pattern of countries ahead of them in the development
process. For example, Taiwan and Malaysia take over leadership in apparel and textiles
from Japan as Japan moves into the higher-technology sectors of automotive, electronic

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and other capital goods. A decade of so later, Taiwan and Malaysia are able to upgrade to
automotive and electronics products, while the apparel and textile industries move to
Thailand, Vietnam and Indonesia.

For East Asian economies, strong export platform has underlain their flying-geese
pattern of development. East Asian governments have utilized several versions of an
export platform, such as bonded warehouses, free-trade zones, joint ventures, and
strategic alliances with multinational enterprises. Governments supported these
mechanisms with economic policies that aided the incentives for labor-intensive exports.

By the late1990s, East Asia’s economies showed signs of fatigue, however, we

believe that the past growth of East Asian was underlaid by the wise policies of the
governments and the profit-seeking behaviors of the people and the slowdown of the late
1990s was as cyclical that the cycle would turn. Moreover, China’s accession into the
WTO in the late 1990s envelops it in a web of global trading rules—everything from
lower tariffs to antidumping regulations to wholesale removal of rules destructing
distribution and retailing, and stiff penalties for intellectual property piracy. Thus, the
Asian miracle would resume and will continue into the new millennium

10. How has China achieved the status of a high-performing Asian economy? Why
has China’s normal-trade-relation status been a source of controversy in the
United States? What are the likely effects of China’s entry into the WTO?

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In the early 1970s, the value of China’s exports and imports was less than $ 15 billion,
however, at the millennium, its exports and imports exceed $200 billion, and it was the
world’s 10th largest exporters, lagging behind only the major industrial countries. An
important goal of China’s economic reforms in the late 1970s was to open the economy
to international trade and investment flows. Also, China opened its economy to foreign
investment and joint ventures. Being heavily endowed with labor, China specializes in
labor-intensive manufacturing.

At the millennium, China had made all of the easy economic adjustments in its
transition toward capitalism: letting farmers sell their own produce and opening its doors
to foreign investors and salespeople. Also, China has dismantled much of its centrally
planned economy and permitted free enterprise to replace it. For example, a massive
restructuring of state-owned industries, which were losing money; a cleanup of bankrupt
state banks, and establishment of a monetary system with a central bank free of
Communist Party or government control.

To further the policy of opening, the Chinese government applied to become a

member of the World Trade Organization to enable China to gain full nondiscriminatory
treatment in its trade relations with WTO members, especially the United States as well
as providing China access to the WTO’s multilateral trade dispute resolution process.

For many U.S. firms, China has been a difficult market to enterprise, due largely
to Chinese government policies, with attempt to protect and promote domestic industries.
Chinese trade policies generally attempt to encourage import of products that are deemed
beneficial to China’s economic development and growth, such as high technology and
machinery and raw material used in the manufacture of products for export. For those
goods and services that are not considered to be high priority, or which compete directly
with domestic Chinese firms, often face extensive array of trade barriers, such as high
tariffs, non-tariff barriers, trading and distribution right, and investment restriction.
Moreover, enforcement of laws to protect intellectual property rights of foreigners has

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been another problem in China. Among the largest and most obvious offenders in China
have been factories producing CDs, audiocassettes, videos, and video games.

China’s accession into the WTO envelops it in a web of global trading rules—
everything from lower tariffs to antidumping regulations to wholesale removal of rules
destructing distribution and retailing, and stiff penalties for intellectual property piracy.
Besides affecting its domestic economy, China’s accession to the WTO will affect trade
everywhere, as seen in the following table:

North America North America farmers will get a new market for millions of tons
of gain. Computer, telecom-gear, semiconductor producers will
get tariff-free access to China
Mexico Shoe and garment manufactures will be handicapped as quotas
restricting Chinese exports to the United states are lifted
European Union Imports of Chinese dishes, shoes, and kitchen utensils will
increase as Europe eliminates quotas
Japan Imports of various consumer goods will increase as more
Japanese manufactures shift production to China-based suppliers.
Electronics, vehicle, and equipment exports will increase.
Southern Asia Malaysia, Indonesia, Thailand, and the Philippines will lose
foreign investment to China. Pressure will increase to upgrade
industries and workforces.
Taiwan Its trade surplus with China will decline. More production will
shift to China, enhancing competitiveness of Taiwanese tech
companies.
South Korea Exports of fabrics to China’s expanding apparel industry could
decrease, as could outflow of steel and industrial gear.

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