CHAPTER 5: TOPHAT

Absolute Advantage

Absolute advantage is an economic concept that is used to refer to a country's superior production capability. Specifically, it refers to the ability to produce a certain good or service at lower cost (i.e., more efficiently) than another country. Absolute advantage as an economic theory was established by Adam Smith in the late 1700's. He proposed that countries should trade with each other when they had an absolute advantage over the other at producing a certain good or commodity. So for example if Country A was the world's leading producer of pizza and Country B was the world's leading producer of beer, then Country A would trade pizza to Country B for beer. This theory proved that both countries benefitted through trade because they were able to specialize on producing what they were best at. Mathematically both countries would reduce their total effort and overall production would increase as compared to each country producing both items on their own. The limitation of this theory is that it limits a country's production only to what it can reasonably attain an absolute advantage in. Globally only a handful of countries can have an absolute advantage in producing any one good or commodity (in theory actually only one country can mathematically have an absolute advantage). It is also very possible for some countries to have no absolute advantage at all in anything. And yet there is still advantage for those countries to trade ... even the most disadvantaged nations trade for the exports of more advantaged nations, and both sides benefit because their needs are met and overall global trade increases. Absolute advantage does have some applicability though in that modern nations tend to specialize in things that they are good at producing. They just don't limit themselves to only the things they have absolute advantage in.

Key Post World War II International Institutions

Another post WWII outcome was the formation of a number of international institutions which helped further the goal of ensuring a lasting peace and prosperity. The following were all formed between 1944 and 1949: The IMF (International Monetary Fund) - to stabilize the international financial system and provide support for countries facing balance of payment and debt crises. The United Nations - to prevent security crises and to support humanitarian causes. The World Bank - initially to provide financial support for the reconstruction of Europe after the war, it now focuses on developing nations. Nato (North Atlantic Treaty Organization) - the Western post war security alliance between 29 member states.

Comparative Advantage Principle

Comparative Advantage - a country should specialize in producing and exporting only those goods and services which it can produce more efficiently (at lower opportunity cost) than other goods and services (which it should import). Comparative advantage results from different endowments of the factors of production (capital, land, labor) entrepreneurial skill, power resources, technology, etc. It therefore follows that free trade is beneficial to all countries, because each can gain if it specializes according to its comparative advantage. The comparative advantage theory came from David Ricardo in the early 1800's and surpassed earlier theories at explaining international trade. It proved that if countries specialized in the things that they were relatively good at producing, and traded with other countries for things they were less efficient at producing, then mathematically both countries would benefit. These benefits increased as more and more countries were involved in trade, and as they each specialized further.

Comparative Advantages in Modern International Business

Comparative Advantages are the unique strengths that a country possesses in global competition that can either be naturally endowed or can be achieved through focused investment and government policies.

Factor Proportions Theory

Factor Proportions Theory says that nations focus on producing things for which they have the most abundant and cost effective resources (or factors of production), and trade for the things where they have the scarcest or most expensive resources. This theory goes beyond absolute advantage in explaining the benefits of countries focusing on their relative strengths which is still very relevant in today's world. While a country may not have an absolute advantage, it still makes sense for it to specialize in producing certain goods and trading for others. In Factor Proportions Theory countries focus on producing goods where they have the most abundant factors of production (resources, capital, skilled labour, etc.).

Common Tariff Measures

Import Duty - when a country imposes a tax on imported goods from another country. Anti-dumping Duty (AD) - occurs when a foreign manufacturer sell goods in the United States at less than fair value, causing injury to the U.S. industry. AD cases are company specific; the duty is calculated to bridge the gap back to a fair market value. An example of this is the anti-dumping duties imposed by the US government on Bombardier aircraft. Countervailing duties (CVD) - established when a foreign government provides assistance and subsidies, such as tax breaks to manufacturers that export goods to the U.S., enabling the manufacturers to sale the goods cheaper than domestic manufacturers. CVD cases are country specific, and the duties are calculated to duplicate the value of the subsidy. One example of this is the US countervailing duties imposed on the Canadian Softwood lumber industry.

Common Non Tariff Measures

Import Quotas - when a country restricts the import quantity of a product or category of product. This is often implemented as a prohibitively high import duty on quantities that exceed the import quota. An example of this is the Canadian Dairy industry which has strict import quotas for dairy products. Subsidies - when a country provides financial support to companies in a domestic industry with the goal of making it more competitive. In the above examples the US government has accused the Canadian government of unfairly subsidizing both Bombardier as a company (through bailouts and financial support) and the softwood lumber industry (through industry incentives). Local Content Requirements - when a country imposes percentages of local content required to meet low tariff or duty free tariff rates, and imposes a higher tariff if the local content requirement is not met. This is a key requirement under NAFTA (now USMCA) and has been a long standing requirement for the North American automotive industry. Technical Standards - the defined standards required by a government for products in a particular industry can create a barrier to imported products. For example the US EPA has strict requirements on automobile emissions that must be met by foreign companies. Bureaucratic Procedures - a final non-tariff measure is the establishment of highly bureaucratic procedures to be followed in order to grant approval to import products. China as an example has a fairly high level of bureaucratic processes which could be viewed as a non-tariff trade barrier.

Unintended Consequences of Protectionism

Increased Consumer Prices - when import tariffs are imposed to protect domestic producers the result is ultimately higher prices for consumers. This is true in Canada where we pay some of the highest prices in the world for dairy, which is a highly protected industry. Collateral Damage to Other Industries - this happened in the early 2000's when then President Bush imposed import tariffs on the US steel industry. The tariffs ranged fro 8%to 30% and were well intentioned, with the goal of protecting the 187,000 American steel industry workers from cheaper imported foreign steel. The actual result was that higher steel prices caused the loss of an estimated 200,000 jobs in industries that used steel as a key input. Reduced competitiveness - domestic industries that are protected for a long time by high import tariffs can become uncompetitive. A great example is the North American textile industry. It used to be highly protected by import tariffs, and then the WTO ruled that those tariffs needed to be phased out over a 15 year period. Despite 15 years of advanced notice that the tariffs were being phased out the industry was unable to adapt and was decimated in traditional strongholds like Montreal and New York.

Mercantilism

Mercantilism is an economic theory that holds there is a fixed amount of wealth in the world and that a nation's prosperity depends on its success in accumulating wealth by exporting more than it imports, thereby earning profits from its exports. Mercantilism was prevalent during the European colonization of the new world between 1600 and 1800. The idea behind the theory was that nations were primarily motivated by maximizing their sovereign wealth. In this era Kings and Queens sent out their explorers and forces to colonize the new world and bring back wealth in the form of valuable goods such as spices, gold and silver. Wealth creation was heavily based on exploiting these weaker nations through colonization. Trade with other sovereign nations in Europe had the goal of increasing the further accumulation of wealth by maintaining a positive balance of trade. Mercantilism was the prevalent driver of trade strategy during Friedman's "Globalization 1.0 - the era of Countries Globalizing". Mercantilism became an outdated concept as the colonies began to gain their own independence. It was also quite limited as a trade theory because in principle, it means that trade only happens if it benefits the trading nation and results in a positive balance of trade by maximizing exports over imports. This is of course mathematically impossible since total exports and total imports must equal each other on a global basis ... so if everyone was adhering to the principle of mercantilism there would be no trade. It does provide some useful background though in that nations still strive for a positive trade balance where possible. This explains some of the recent shift in global trade towards more nationalist views such as "America First", Brexit, and the current US / China trade discussions.

Protectionism

Protectionism is the action of a government to help its country's trade or industry by taxing goods bought from other countries.

GATT and the WTO

The other key institution that was formed initially in 1948 was the General Agreement on Tariffs and Trade (GATT) which transitioned to become the World Trade Organization (WTO) in 1995. The WTO oversees global trade, sets rules and "referees" disputes between member countries. Member countries generally agree to abide by the WTO's rules and then form additional free trade agreements outside of the WTO that layer overtop. It is important to understand that they don't have a legally binding role, but that most member countries (of which there are now 164) will abide by WTO rulings. As discussed in Chapters 1 and 2, GATT and the WTO played key roles as a driver of modern globalization by setting the tone for a slow and steady global movement towards freer and freer trade over most of the last 70 years. During this time tariffs steadily declined, as can be seen in the following chart showing US tariff rates over time. Tariff rates in the US have declined steadily from an average of 33% just prior to GATT to roughly 5% today. Global tariff rates have declined during this same period by similar proportions.

Intended Consequences of Protectionism - When governments impose tariffs they usually do so for well intended reasons.

These may include: providing protection to an industry during its early / formative years protecting domestic industries from powerful and lower priced global competitors generating government tax revenue protecting strategic industries, particularly around national defense

Other Forms of Government Intervention

Trade sanctions - when a country imposes restrictions on doing business with another country, usually for geo-political reasons. Examples include the current US sanctions on Iran or North Korea, or the EU's sanctions on Russia following the annexation of Crimea in the Ukraine in 2014. Boycotts or Embargoes - a more extreme form of sanction where all economic activity with a country is suspended. An example of this would be the US relations with Cuba since the Cuban missile crisis of the early 1960's. Insurrection and War - in extreme cases when military action takes place this obviously has the impact of severely limiting trade for the duration of the military activity.

Ted Talk "When Ideas Have Sex"

which talks about the evolution of ideas as combinations of ideas that have come before them, and the role that trade has played in the global exchange of ideas. There is a segment of the video which talks about comparative advantage, but the video is also great at setting the stage for the importance of trade in human development and innovation. In the video, the speaker illustrates comparative advantage with the example of Adam and Oz ... Adam makes axes and Oz makes spears. In the example Adam is better than Oz at making both spears and axes, but it is still advantageous for both of them to specialize on what they are relatively best at and trade with each other for the rest. Specializing on what you are relatively good at creates additional productivity increases of its own, and that productivity only increases over time the more you focus. The second point made about trade in the video is that it has been key historically to innovation, as the exchange of ideas between cultures occurred over time through trade. In today's world this is still true, and the pace of innovation and exchange of ideas has increased exponentially due to technology and the internet.