International Trade

Sex aside, trade is probably the oldest form of human interaction. Evidence of trade between groups, both near and distant, goes back to prehistoric times. Specialisation and exchange are fundamental to our everyday lives. ‘You catch the fish and I’ll milk the cows’ type contracts are trade bargains we all continuously make. As nations we also trade at a great rate, and since the end of World War II international trade has grown dramatically. In Australia, for example, our imports and exports have risen from about 15 to 20 per cent of GDP since the 1980s.

For all its antiquity and contemporary rates of growth, international trade is controversial and much public policy debate is about barriers which are or might be raised against it. The fact that it is controversial raises two questions. First, what is about it that explains its long life and its contemporary popularity? Second, if it is as good as all that, why do some groups oppose it so vehemently? Why, for example, in 1997 did we – as a nation – decide to maintain trade barriers against cars and textiles, footwear and clothing?

The gains from trade

Economists explaining the gains from trade typically draw on two concepts – absolute and comparative advantage.

Absolute advantage

The essence of absolute advantage is simple enough. Adam Smith wrote about the gains to be had from specialising. It takes no great leap of understanding to appreciate that if Sri Lanka is good at growing tea and Australia is good at growing wool, it would make sense for Sri Lanka to specialise in tea and Australia in wool. The gains to be had from specialisation and trade are both important and obvious.

Comparative advantage

Comparative advantage is another notion. The insight that trade can be mutually beneficial between two parties even if one party is hopeless at everything is one of the few propositions in economics that can be demonstrated to be true and is nontrivial.

A country has comparative advantage in the
production of a particular product if it can produce it relatively more cheaply (in terms of sacrificing production of another good) than another country. Consider two countries – Orchardovia and Bananaland – each producing two goods – apples and oranges – with 100 workers. In Orchardovia it takes one worker one year to produce a tonne of apples and one year for a worker to produce a tonne of oranges. In Bananaland, it requires two workers to produce a tonne of apples in a year and four workers to produce a tonne of oranges. Suppose with no trade, 25 tonnes of apples and 75 tonnes of oranges are produced in Orchardovia and 20 tonnes of apples and 15 tonnes of oranges in Bananaland.

Now consider the opportunity cost of oranges (what has to be sacrificed in order to produce an orange) in each country. In Orchardovia the opportunity cost of producing a tonne of oranges is one tonne of apples. In Bananaland an extra tonne of oranges costs two tonnes of apples. Therefore the opportunity cost of oranges is less in Orchardovia, which means that it can produce oranges relatively more cheaply (in terms of apples) than Bananaland. Orchardovia has a comparative advantage in the production of oranges. Similarly, Bananaland has a comparative advantage in the production of apples.

‘So what?’ you may ask. The key insight is that even though Bananaland is not as good as Orchardovia at producing anything (in this two-good world), trade between the countries will still be mutually beneficial.

To see this, let Orchardovia concentrate all its resources in orange production and let Bananaland devote all of its resources to apple production. Orchardovia now produces 100 tonnes of oranges and Bananaland produces 50 tonnes of apples. If Orchardovia exports 20 tonnes of oranges and in return receives 30 tonnes of apples, then it will have 30 tonnes of apples and 80 tonnes of oranges to consume. It is better off than before trade. On the other hand, Bananaland now has 20 tonnes of apples and 20 tonnes of oranges to consume. It is also better off (see table 1). The fact that both countries are left better off is a result of each country specialising where it has comparative advantage. By co-operating in this way consumption possibilities are expanded beyond the production possibilities of individual countries.
 

Thus the gains from trade have a logical underpinning and do not rest in some flimsy preference for flash foreign brands. Yet, as noted, most public discussions are not about this wonderful way of converting oranges into apples, or wool into tea, or beef into potatoes, etc. Rather they are about persuading governments to inhibit these conversions and to call this inhibiting activity protection.

Protection – how and why

Why on earth would governments come under pressure to inhibit trade? Why call it protection? And how do they do it? Taking the last question first, there is a large number of trade inhibiting policies. A few of them are listed in table 2. The traditional one is a tariff. Consider the tariff Australia applies to motor vehicle imports. In 1998 this tariff is 20 per cent. This means that when you import your Mazda for, say, $15 000, you must pay $3000 import duty through the Customs Department. Your Mazda costs you $18 000. And Australian car manufacturers in Australia could charge $3000 more for their local versions of a Mazda. It is as simple as that. Protection or – as it might equally be called – taxation of imported goods, always involves some device that raises the price of goods.

Why call such a device ‘protection’? One answer to that is that the people who benefit from taxation of imports – the people who produce goods which have their prices bid up at home – are indeed protected from imports. But the rest of us are clearly taxed. Why don’t we call trade inhibiting measures taxation? It would seem that the people who are being taxed have not put together as good a public relations program as the people who are being protected.
 

A tax on imported goods and services

A restriction on the amount of a good that can be imported (either in quantity or value terms)

A licence restricting who can import

A payment made by the government to assist businesses in production

The reasons why they haven’t are simple enough. The people who stand to benefit from a particular piece of protection are typically clustered in some way and pretty much aware of the benefits of the protection, and for them the benefits are significant. Whereas the people paying the tax are typically widely dispersed, and for each of them the cost of the protection is quite small – even if in aggregate the costs are large. And even where people are aware of the costs there is a tendency to overrate the benefits.

Whatever the reason, it is certainly a very effective public relations program to be able to describe as protection a situation which boils down to Australians in protected industries saying to Australian consumers, ‘give me some of your money so that I can keep doing what I am doing.’

Protection (taxation) and jobs

Protection is said to increase jobs in import competing industries. This is because those industries will be larger, due to the more favorable conditions that they experience. But an industry developed behind a wall of protection tends to become inefficient. While competition at home might be hot, real efficiency tests require international competition. The main pain from sustaining inefficient industries happens through reduced incomes. But it is not as if those reduced incomes enable employment to be maintained. Take, for example, Australia’s two most heavily protected industries, the textiles, clothing and footwear (TCF) and passenger motor vehicles (PMV) industries. Chart 1 shows that employment has been steadily falling in these industries over the past thirty years. This is despite large fluctuations in the level of protection. There is no link between protection and jobs, with the high levels of protection in the early mid-1980s seemingly unable to halt the flow of jobs out of these industries.

Chart 1a: Does protection affect employment?
Clothing and footwear

Chart 1b: Does protection affect employment?
Motor vehicles

The perception that protectionism saves jobs is further weakened when we look at the effect of protection on employment in the whole economy. Protection (taxation) means those inputs for production that are (or could be) imported will be more expensive. For example, a farmer will have to pay more for machinery, as will a manufacturer who uses computers. With increased costs will come a scaling down of production, and therefore job losses. This is most evident in export industries, where demand is very sensitive to price. Therefore it is naïve to just focus on the import competing industries when looking at the employment effects of protection (taxation). Protection should not be looked at in terms of protecting jobs in import competing industries, but rather transferring resources – including labour – from efficient, non-protected industries, to inefficient protected ones.

Paul Krugman in a 1993 article provides an illustration of the confusion between protection (taxation) and jobs:

An entrepreneur starts a new business that uses a secret technology to convert US wheat, lumber and so on into cheap high quality consumer goods. The entrepreneur is hailed as an industrial hero – although some of his domestic competitors are hurt, everyone accepts that occasional dislocations are the price of free market economy. But then an investigative report discovers that what he is really doing is shipping the wheat and lumber to Asia and using the proceeds to buy manufactured goods – whereupon he is denounced as a fraud who is destroying American jobs.

Protection pushes import prices up, which means that consumers cannot afford as many goods and services. Tariffs cost the average Australian family $1000 per year. If tariffs were cut then they would be able to purchase an extra $1000 of goods and services. This would not only benefit the consumer, but would also benefit producers, as demand would increase. The flow on from this would be increased production and employment.

To summarise, tariffs and other protective devices place a hidden burden on consumers and producers in non-protected industries. The aim of this hidden premium is to keep jobs in Australia; however, it seems to have little effect on the industries that it is supposed to assist. To everyone else in the economy this premium is a cost that limits consumption and production.

Sometimes proponents of protection (that is, protection for them, taxation for you) will say ‘some industries must be able to compete, but what about a bit of protection to help them get started.’ This is the so-called infant industry argument. But experience shows it is very difficult to pick industries to protect (and to know which ones you are taxing), and even harder to withdraw support once given to them.

Protection levels have been falling in Australia. For example, the effective rate of assistance (to be thought of as the cost advantage that domestic producers gain as a result of protection) in manufacturing (the main beneficiary of protection in Australia) fell from 15 per cent in 1989-90 to 6 per cent in 1996-97 and is expected to fall to 5 per cent in 2000-01. This is largely due to tariff cuts in the TCF and PMV industries. This downward trend has been in place for quite some time, as can be seen in chart 2. What can also be seen in this chart is that despite the tariff cuts in the PMV and TCF industries, protection in these industries is still quite high, with an effective rate of assistance in 1996-97 of 28 per cent in the PMV industry and 25 per cent in TCF.

Chart 2: Average effective rates of assistance to manufacturing, textiles, clothing and footwear and passenger motor vehicles.


Not only is Australia reducing protection, but many other countries around the world are as well. What are the implications of this for Australia? Well, the news is generally good. Our exporters will not have to overcome the barriers that they once did. This will increase demand for our exports, meaning more production and jobs for us and increasing our standard of living.

The domestic economy in a world context

Chart 3 sets out some recent trends in Australian trade patterns. Merchandise trade with Association of South-East Asian Nations (ASEAN), which includes Thailand, Brunei, Indonesia, Malaysia, Singapore, Philippines and Vietnam, has grown in importance, from 8·8 per cent of total trade in 1988-89 to 15·5 per cent in 1996-97. This is an enormous increase. Trade with China and South Korea has also seen similar booms. On the other hand trade with the United States has fallen from 10·2 per cent of total trade to just 7·0 per cent over the same period. Perhaps surprisingly, our trade with Japan is not experiencing the same increase that has occurred in our trade with other Asian nations. In fact the share of Japan’s trade has fallen, from 27·2 per cent to 19·5 per cent. This is not to say that Japan is no longer important to Australia, (it still remains our largest trading partner), just less so than it used to be. Another area where our trade has fallen is in Europe, but this fall is not quite as dramatic.

Figures for investment show trends that follow the ones for trade. In 1990-91, investment in Australia by Asia Pacific Economic Cooperation (APEC) countries, excluding Japan, was under 29 per cent. By 1994-95 this share had risen to about 31·5 per cent. While not as sharp as the increase in trade, it is still an indication that our international trade relationship with Asia is becoming stronger, especially with South-East Asia. This is at the expense of our more traditional trading partners such as Europe, the United States and Japan.

Chart 3: Australia's exports by country of destination

Multilateral trade agreements

Obviously Australia is not alone in benefiting from a reduction in another country’s protection barriers: every country benefits. It is for this reason that governments have been keen to reach agreements where the parties concerned reduce protective barriers to other signatories of the deal. The most obvious example of this is the General Agreement on Tariffs and Trade (GATT). The GATT is a multilateral (involves many parties) agreement between most countries in the world, specifying limits on tariffs and regulations on other protection barriers. The most recent round of the GATT was in Uruguay in 1993. Some of the major agreements reached were:

•  a reduction of tariffs, opening up agriculture and textiles;
•  the creation of new rules freeing up the trade of services; and
•  the creation of the World Trade Organization.

There are also many other major trade agreements in force, one of which is the North American Free Trade Agreement (NAFTA). NAFTA includes Canada, the United States and Mexico in a free trade zone. The most relevant trade agreements to Australia are APEC and CERTA. Closer Economic Relations Trade Agreement (CERTA) is a bilateral (involves only two parties) agreement between Australia and New Zealand where, among other things, tariffs between the two countries are eliminated.

Asia-Pacific Economic Cooperation (APEC) is a similar agreement whereby member countries have committed to reduced trade barriers. There are 18 member countries in APEC that include Australia, Japan, the United States, and many of the developing Asian economies. These member countries account for about 55 per cent of world GDP. At present each industrialised country has agreed to achieve free and open trade with the region by 2010, and each developing country has agreed to do this by 2020.

While agreements between countries might be a useful way of encouraging trade policy reform, reducing protection would be beneficial for an individual country regardless of the actions of other governments. The argument that Australia should not reduce trade barriers further until our trading partners reduce theirs is misguided. Over the past 15 years or so many countries have substantially reduced their trade barriers on a completely unilateral basis – that is, without regard to the actions of other countries. These countries, which include New Zealand, the Philippines, Singapore, Sri Lanka and Vietnam for example, have performed well as have a number of countries in Latin America and Eastern Europe. Indeed, the lesson from these experiences is not just how mistaken it is to wait for others but rather how important it is to go first.

References

ABS (Australian Bureau of Statistics) 1997, Australia Economic Indicators December 1997, AGPS, Canberra.

Brown, N. and J. Wiblin 1997, Trade Liberalisation: Opportunities for Australia, AGPS, Canberra.

Department of Foreign Affairs and Trade 1996, The APEC Region: Trade and Investment, November, AGPS, Canberra.

Industry Commission 1997, Trade and Assistance Review 1996-97, AGPS, Canberra.

Krugman, P. 1993, ‘What do undergraduates need to know about trade,’ American Economic Review, Vol. 83(2).

Pearce, D. and S. Cuthbertson 1993, Let’s Talk Tariffs, Centre for International Economics, Canberra.

Pearce, D and A.Stoeckel 1996, One Shoe Per Person, Centre for International Economics, Canberra.

Sandy Cuthbertson and Leon Berkelmans are Managing Director and Research Assistant respectively at the Centre for International Economics, Canberra and Sydney.

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