A step towards freer trade

The Doha Round of the World Trade Organization (WTO) has been making little progress as many countries fail to agree to trade policy reform. Rather than wait for a general agreement the WTO agreed to implement a partial agreement known as the The Trade Facilitation Agreement (TFA).

The TFA essentially makes customs procedures easier, saving time and other costs. It is estimated that this will raise trade by $1trillion a year and be as effective as cutting all tariffs.

The benefits of free trade are well known. There is greater specilization and trade, resources are allocated more efficiently and consumer surplus will rise. Of course there will be losers, as resources are reallocated and some structural unemployment is caused. The key is to look at this as long-term gain at the price of some shorter term pain in a few sectors.

Note how long this agreement has taken however. At least fifteen years in the making, including three years to get countries to ratify the agreement. A big plus is that Developing countries will probably be winners from this agreement. Critics of the WTO have often suggested that they favour the developed countries, but this seems to make life easier to access the markets of the richer countries.

The BBC covers the story here

This story is most directly useful to IB students as it deals with global trade agreements and the WTO. However VCE students need to understand the benefits of trade and Australia is a party to all WTO agreements, so is also an example of Australian trade policy.

Free trade is the way to prosperity - but now it is under threat.

Donald Trump's election will provide a great many challenges, including a threat to the environment. The greatest threat will, however, be to free trade and so the prosperity and wellbeing of the whole world.

That might sound a bit dramatic, and I am trying not to be political here. The fact is that specialization and trade are the basis of all the gains we have made in the standard of living and anything that restrict that makes us worse off. This is a lesson known for many years and most persuasively put by Smith and Ricardo and refined by J.S. Mill and all economists working in the field since.

There are costs of free trade. The one that is presently causing people like Donald Trump to get elected is that some industries decline due to trade. For one place to specialize in a good or service others cannot. This means some people lose their jobs in industries which are uncompetitive. People so affected tend to be pretty unhappy about it.

Economists point out that while some industries decline, others grow and so resources in a country transfer from one industry to another. The result is improved efficiency in the allocation of resources and a higher standard of living for everyone. The costs of adjustment are temporary.

It's a difficult sell, but until now we have relied on the education, good sense and long term vision of those in government to do no more than slow transition and cushion the blow for those affected. Now we have people being elected who are happy to pander to those who shout loudly, but don't have the necessary perspective. Make no mistake if the free trade arrangements we have worked so hard to build over more than one hundred years are unwound we will all suffer.

There are many articles out there on this issue right now. Below is the Guardian's.

The Guardian article is here

International Trade benefits the world, but not everybody in the world

Adam Smith and David Ricardo gave economics the theory of International Trade by 1817 (Smith 1776) and what they said remains the basis of the reason economists favour free trade over protection.

The theory says that countries should specialise according to their comparative advantage and as a result overall production will rise and these gains in output will be redistributed through trade (i.e. swapping of goods and services).

To achieve specialisation a country must grow some industries while others shrink (those in which other countries specialise). The result will be more jobs in some industries and less in others.

The loss of jobs is regrettable and is referred to as an 'adjustment cost.' Economists are fully aware of this cost and could explain to those who are now unemployed the overall benefit of the process. It will not be a popular message with the unemployed.

The World Bank is reported to have written a report confirming Smith and Ricardo's conclusions. The growth of free trade (Globalization) has led to overall more jobs, but some have lost out. They estimate 20% of job losses in some areas, like the USA, are due to free trade.

The problem is that there is no guarantee that a country will gain as many jobs through their specialization as they lose. Portugal is a good example. They have lost many jobs to lower cost manufacturing nations (such as Eastern Europe and China), but don't have the comparative advantage in high tech and knowledge based industries they need to replace those jobs.

So the World Bank report is basically saying Smith and Ricardo were right.

The BBC covers the story here

Steel tariffs may hurt more than just the steel industry

The world is presently seeing a bout of 'economic nationalism' over steel. The US and China are just two countries who are raising tariffs on steel but this will have wide ranging implications for many.

A tariff is a tax on imports. The aim of raising the price of imports on the domestic market is to reduce demand for them. It is hoped that this will lead to import substitution, domestic consumers switch to domestically produced products. This will raise domestic output and employment and might reduce a current account deficit.

The diagram below shows the effects of the imposition of a tariff on steel by the Chinese on British made steel. (This is referred to in the BBC article linked below.)

Rather than analyse this standard graph today I want to look at the wider implications of the imposition of tariffs. Space will mean much of this article just suggests further investigation.


There are both gains and losses from using tariffs. When evaluating the imposition of a tariff we might look at the long-run and short-run implications, the effect on stakeholders, such as consumers, firms and governments and the advantages and disadvantages of the tariff.

There are no long-run justifications for putting a tariff on trade because it prevents specalization and the exploitation of comparative advantage. We know from economic theory that in the long- run everyone gains from trade. However in the short-run this might not be true. 

The article describes how China may be 'dumping' steel on the world market - that is selling steel below the cost of production. If this is the case then this is unfair and other countries steel industries will contract and jobs are lost. Even if the Chinese are not dumping (because they are able to produce steel more cheaply) another country might not want to see the sudden contraction of its steel industry with the resultant structural unemployment. Therefore in the short-run they protect their industry and manage its decline due to the loss of comparative advantage,

The stakeholders in the protected industry are often consumers. They lose out due to the imposition of tariffs because they pay higher prices and so lose consumer surplus. Another stakeholder is the government on the importing country. They gain tariff revenue and avoid paying greater unemployment benefits, both of which affect the government budget deficit. Notice here that the consumers who pay higher steel prices (by paying more for the goods made with steel) might be saved from higher taxes needed to pay unemployment benefits!

The static gains and loses represented by the diagram miss the dynamic gains and losses that can occur. The most obvious loss is that a trade war can result from placing tariffs on goods. This is evidenced in the article where one country imposing tariffs causes others to retaliate. The net effect is less overseas trade and slower economic growth worldwide. 

There are always more questions to ask in economics and students should look to find the right questions to ask to reach a valid judgement on the effects of any policy measure.

The BBC article is here 

This article is especially relevant to IB students who will find the tariff diagram is virtually always drawn at some point on Paper 2. However VCE and IB students need to practice evaluation - making a judgement based on economic theory and for that they need to ask wider questions about who is affected and how.

Will tax deal end transfer pricing?

Today many firms are multinationals and operate around the world. This has brought many benefits and the effect of globalization on living standards has been considerable.  (This is actually the continuation of specialisation and trade you learn about in the first weeks of any economics course).

One of the drawbacks of this globalisation has been that multinationals have developed ways to pay their tax in countries where the profit taxes (corporate taxes) are lowest. This is, of course, rational behaviour for after-tax profit maximizing firms.

Transfer pricing works like this. Say you are a publisher and sell a really excellent economics textbook in the UK. The profit tax in the UK is 30%. Schools in Malaysia want to buy the book. Rather than sell them the book from the UK at £33 the publisher sells the books to their subsidiary in Singapore for £6, just over the cost of production. The subsidiary then sells the books to the Malaysian schools making all the profit in Singapore where the profit tax rate is just 10%.

I'm not bitter, but that's what Simon and Schuster did with my textbook, paying royalties only on the £6 earned in the UK.

This is perfectly legal. Firms such as Starbucks have bought their coffee from their Swiss subsidiary for the whole of Europe at high prices so the profit is declared in low tax Switzerland. Google have paid just £130m tax in ten years in the UK.

Now the OECD (The Organization for Economic Cooperation and Development - the 'rich countries club') have signed a deal to make multinational firms pay tax where they really earn it. This means they should pay profit tax on all the operations in the country where their activities take place.

It will be difficult to police, and only 31 countries have signed. This means firms might just start declaring their profits in a country which has not signed. However the system they hope to implement should allow countries to demand tax on the amount of tax the firm would have made if declared correctly.

The BBC covers the story here

This issue has direct relevance to IB Paper 2 and for taxation policy. For VCE this is a topic that is relevant to trade and budgetary policy.