Trade Policy and the Economic Principles of Absolute & Comparative Advantage.

Hello readers, welcome back.

In my last post I described 4 key reasons or traps as to why some countries are poorer than others. I discussed many of the thoughts and ideas from leading economists such as Tim Harford and Sir Paul Collier and I hope that by reading it you now have a clearer understanding as to why such disparities exist between countries.

In today’s post, I will be looking at the idea of international trade and will consider ideas such as why we need to trade, the impacts of trade and I will explain the concept of an absolute and comparative advantage- 2 important economic concepts relating to trade. I will also keep this post short and to the point. If you have any unanswered questions or are unsure about the content discussed in this post feel free to comment below.

To start with here are a few simple reasons as to why countries want/need to trade with each other:

  • access to larger markets
  • greater variety of goods
  • increased standards of living
  • can help poorer nations escape issues such as subsistence farming
  • more competition which in turn drives lower prices
  • diplomacy
  • increased economic growth as exports can generate large revenues.

 

A few reasons as to why countries may decide not to trade with each other:

  • strategic industries
  • trade barriers
  • diplomatic issues e.g. Qatar
  • protecting workers e.g. Trump in the US
  • culturally important industries

 

There are a number of key words/economic jargon associated with trade which you may have come across in the news or whilst reading an article. I will briefly explain a few of these:

Balance of Payments- A summary of an economy’s transactions with the rest of the world in a given period of time (normally a quarter or a year).

Trade deficit- If a country imports more than it exports. Also known as the current account deficit.

Trade surplus- If a country exports more than it imports. Also known as the current account surplus.

Issues with a trade deficit:

  • Unemployment
  • Dependency & reliance on other countries

Issue with a trade surplus

  • Countries may rely on the income from exports; however this may not be guaranteed.
  • Exporting commodities such as oil-price fluctuations, which make the market very volatile and unpredictable.

 

Absolute and comparative advantage are two important concepts in international trade that largely influence how and why nations devote limited resources to the production of particular goods.

Absolute Advantage

Absolute advantage means that an economy can produce a good for lower costs than another. It means that less resources are needed to produce the same amount of goods. The idea of absolute advantage was pioneered by Adam Smith in the late 18th century as part of his division of labor doctrine. Absolute advantage doesn’t necessarily mean an economy should produce that good. This requires a country to have a comparative advantage (described below).

It is easiest to understand if we work through an example.

Let’s suppose that china can produce 30 cars and 15 planes whilst the UK can produce 24 cars and 20 planes. In this situation, China has an absolute advantage at making cars whereas the UK has one in making planes. Since each has advantages in producing certain products and services, they can both benefit from trade. If both China and the UK specialize in the products they have an absolute advantage in and buy the products they don’t have an absolute advantage in from the other entity, they will both be better off.

However lets consider a different scenario, still linked to cars and plane with China and the UK.

Suppose China can now make 30 cars and 15 planes, whereas the UK could only make 24 cars and 8 planes. This would mean that China has an absolute advantage for both. Does it still make sense for them to trade. This is where the concept of Comparative Advantage comes in.

Comparative Advantage

Whereas absolute advantage refers to the superior production capabilities of one nation versus another, comparative advantage is based on the concept of opportunity cost (the value of the next best alternative foregone). If the opportunity cost of choosing to produce a particular good is lower for one nation than for others, then that nation is said to have a comparative advantage. Even if one country has an absolute advantage in producing all goods, different countries could still have different comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading because each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative advantage drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which leads to increased productivity.

The law of comparative advantage is popularly attributed to English political economist David Ricardo and his book “Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo’s mentor James Mill originated the analysis. David Ricardo famously demonstrated how England and Portugal both benefit by specializing and trading according to their comparative advantages, Portugal with wine and England with cloth.

Now lets revisit our original example, which should hopefully make everything click. If we look at the opportunity cost in terms of producing one car and one plane, it should be easy to see why there is an incentive to trade.

To produce one car, China would have to forego 1/2 a plane whereas the UK would only have to forego 1/3 plane. Since the opportunity cost is lower for the UK, it makes sense for the UK to focus on producing planes. To produce one plane, China would have to forego 2 cars whereas the UK wold have to forego 3 cars, thus it makes sense for China to focus and specialise on producing cars.

Therefore we can say that although absolute advantage is important, comparative advantage is what determines what a country will specialize in.

Sources Used:

http://www.investopedia.com/terms/a/absoluteadvantage.asp

http://www.investopedia.com/ask/answers/033115/what-difference-between-comparative-advantage-and-absolute-advantage.asp

https://www.boundless.com/economics/textbooks/boundless-economics-textbook/international-trade-31/introduction-to-international-trade-124/absolute-advantage-versus-comparative-advantage-493-12589/

http://www.economicshelp.org/blog/glossary/absolute-advantage/

Why are some countries poorer than others?

Hello readers, welcome back to my blog. I was recently at an economics summer school at the debate chamber and one of the things that we discussed was the issue of poverty.  In this post I thought I would share with you some of these ideas, as well as some of the aspects regarding poverty that I leant from Collier’s book, “The Bottom Billion”. In reality there are hundreds of reasons as to why a country may be poor and the exact reasons may vary from country to country. For example North Korea is poverty stricken primarily because it is led by a morally corrupt bankrupt communist monarchy and it has total state control which results in fear and resentment, with little money being invested in public services. On the other hand countries such as the Democratic Republic of Congo (DRC) is ravaged by internal conflict, and has a weak divided

Screen Shot 2017-08-30 at 18.49.27state. In this post I will be going through 4 of the key factors that can lead to countries being poorer than others. These 4 factors are the same 4 ‘traps’ that Collier describes in his book:

Poor Governance, Conflict, Natural Resources and Landlocked Countries. I will consider each of these individually.

 

 

  1. Poor Governance & Corruption

Three quarters of the bottom billion live in countries that are either failing, or recently were failed states – countries such as Somalia, Haiti, Sudan, Zimbabwe. While governments do not function, or exist only to benefit themselves, development is ultimately impossible. It’s difficult to price these things, but Paul Collier estimates that each failed state costs the global economy $100 billion.

Corruption is a disease which must be cured or at least attempted to be treated since it is fundamentally causing poverty by diverting government funds away from the public and into individual offshore bank accounts. Corruption is frustrating for countries as they are left behind others and is also dis-heartening and dis-empowering.

While the most obvious perpetrators are crooked policemen or customs officials, which everyone knows about, they are the tip of the iceberg. Red tape is where real endemic corruption happens – a slowing and over-complicating of simple processes, from starting businesses, buying or selling property, to the law courts, all require ridiculous amounts of paperwork, interviews, visits to ministry offices. In the Cameroon courts in 2001, when it was rated the world’s fifth most corrupt country, chasing an unpaid invoice took 58 separate procedures.

‘Every procedure is an opportunity to extract a bribe’ says Tim Harford in the “Undercover Economist”. The slower the standard processes, the greater the temptation to pay ‘speed money’.’ Imagine having to bribe your telephone company and all your utility companies, paying an aside for your driver’s license and to pass your exams. Imagine having to bribe the post office every time you bought something by mail order, bribing the bank clerk to let you take money out of your own account, paying your doctor to give you a prescription, and then the chemist to give it to you. That’s the reality of endemic corruption, the abuse of power at every level. For more information on corruption check out my post on Corruption and if you have time to spare, give my EPQ a read which is based on the issue of corruption in Kenya.

2. Conflict

73% of those in the poorest billion of the world’s population are either involved in or recovering from civil war. In the fight against poverty, civil war creates a vicious circle – war causes poverty, and low income contributes to tension. Low growth means high unemployment and thus plenty of angry young men ready to fight. Conflict then destroys infrastructure and scares away investors, leaving even fewer opportunities. In order to tackle this issue, establishing treaties, trust and peace has to be the major goal to reduce conflict.

3. Natural Resources

Another poverty trap is natural resources. It sounds a little paradoxical to suggest that natural resource wealth is a factor in poverty, but you only have to consider that Sudan, Angola, and Zimbabwe all have oil to see how this plays out. It’s rare for natural resource wealth to come back to the people. Sometimes this is simply because the revenues end up in the foreign bank accounts of the elite, or the profits go to large TNC’s who operate in many different countries. A major problem related to this is resource dependency. When oil is discovered for example, the demand for infrastructure and business development in that area will immediately outweigh any other concerns. As the oil is pumped, other sectors of the economy contract, and thus when oil runs out these sectors are left far behind the rest. In Angola, the oil has been labelled a curse since the government and the elite take all the proceeds, meaning they have little incentive to invest in the country.

4. Landlocked Countries 

38% of the bottom billion live in landlocked countries,  and these pose a real challenge to development. Being landlocked doesn’t have to be a disaster, as long as your neighbours have decent infrastructure and allow you to use their ports. Collier gives the example of Switzerland, who can trade through Italy or Germany. If your neighbours don’t like you, or if they are “basket-case countries”, there is no way you can export. Compare Switzerland with Uganda, which shares borders with Kenya, Sudan, Somalia, Rwanda, The Congo, and Tanzania. Without dependable ways to export, landlocked countries such as Uganda or Rwanda are unable to participate in the global economy. Despite this these countries have made efforts to trade and have invested in air-freighted produce.

Collier suggests that the British empire and colonialism could be held responsible to some extent as he says: “A reasonable case can be made that these places should never have become countries”. “However: the deed is done. These countries exist and they will continue to do so.” The best we can do is make sure that landlocked countries are prioritised in aid. That being said in Moyo’s book ‘Dead Aid’, she argues that aid is often proposed as a solution to poverty, yet sometimes a country can actually experience a fall in GDP per capita during a sustained period of aid and that perhaps we should develop other strategies and aim towards an aid-free world.

Here are a few other factors which haven’t been discussed, that can lead to a country being poor:

Natural Disasters, Lack of property rights, foreign exploitation, lack to technological development, literacy, social unrest, lack of productivity, lack of infrastructure, religion & culture, diplomatic relations, sanctions, quality of land, ‘Brain Drain’, poor healthcare, subsistence farming, terrorism & conflict.

 

Sources Used:

https://makewealthhistory.org

https://www.forbes.com/sites/johngoodman/2015/05/21/why-are-some-countries-rich-and-others-poor/#76fd442d3e6e

https://www.weforum.org/agenda/2014/08/countries-development-inequality/

http://evonomics.com/why-are-some-countries-poor-and-others-rich/

The Bottom Billion – Paul Collier – A Summary

https://davidmays.org/BN/ColBott.html

CPI-H the new measure of inflation.

Hello readers, welcome back to my blog. Last time I shared with you my EPQ into the effects of corruption in Kenya. If you didn’t get a chance to read it, I hope you leaned some valuable points from the summary and now understand why corruption is so damaging in developing countries. In today’s post I thought I would discuss the idea of inflation and the new measure, CPI-H that has recently been introduced. Understanding inflation is important in economics as it determines how expensive things are, influences interest rates and can affect savings.

 

Inflation is the sustained increase in the general price level and is officially measured through CPI in the UK. CPI stands for consumer price index and is essentially a virtual shopping basket of over 700 goods and services, which are weighted according to relative importance. These goods and services such as transportation, food and medical care, are chosen by using the ONS Family expenditure survey and 150 different regions across the country are considered.

The value is calculated by taking price changes over time for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living. The CPI statistics cover professionals, self-employed, poor, unemployed and retired people in the country and thus can be unrepresentative of certain groups of people as an average figure is produced. The most recent figure for inflation in the UK was 1% in September 2016.

From March 2017 however, the ONS will be changing the official of measure of inflation in the UK to CPI-H, which will add accommodation and the costs of owning a house to the consumer basket. In the most recent data, the shift would have raised the inflation measure from 1 per cent in September under the CPI measure to 1.2 per cent, calculated using CPIH. It is thought that this change is to better reflect everyday price changes, which will include the cost of owning a home. The change is likely to show inflation is higher than currently indicated. Although CPI already includes the cost of renting and running a home, it leaves out special costs faced by property owners. CPIH will include what are called the “costs of housing services associated with owning, maintaining and living in one’s own home”.

It is important to note that statisticians estimate what it would cost homeowners to rent the property they live in, rather than tracking the cost of a mortgage.

One potential implication of changing this is that the Bank of England’s Monetary Policy Committee sets its base interest rate with reference to a 2% CPI target and an asymmetric target of +/- 1%, therefore a different inflation measure which was consistently higher could lead to interest rates being kept higher as well.

Below is a recent article published a few days ago, which discusses the concept in more detail, if you are interested:

http://www.independent.co.uk/news/business/analysis-and-features/cpih-inflation-measure-level-what-is-it-why-care-uk-statistics-authority-economy-currency-a7869171.html

Corruption is hampering development and economic prosperity.

Hello readers, welcome back to rsira-economics.com. In this post I thought I would share with you my extended project qualification which is based on the issue of corruption in a developing country. I chose to use Kenya to analyse the effects of corruption as, not only is Kenya a country ravaged by corruption, but because my parents were born in Kenya and I still have active connections and roots there. I have also made frequent visits to Kenya, thus allowing me to use my economic knowledge to explain in a more rigorous and objective manner my observations during these visits.

Within my report I have evaluated the extent of corruption, examined how there are both micro and macro effects and have tried to show show what the economy may have looked like, had it been subject to minimal corruption. The research piece is in excess of 5000 words, so if you don’t fancy sifting through it, I suggest you take a look at some of my other posts instead if you haven’t already read them, or stay tuned and wait for my new posts that will be coming soon. In particular, I will be revisiting Brexit, taking a look at Tesla and Amazon as well as looking at economic principals such as the idea of comparative advantage and trade policy. I will also be examining the roles of key economic institutions such as the IMF and the World Bank, as well as evaluating and reviewing some economics books that I have recently read. I will however give a brief summary of my key findings so that if you aren’t able to read the full report you can still get a flavour as to what the situation is in Kenya and understand some of the main economic implications of corruption. Although if you are really interested in the issue of corruption and would like to examine all my findings as well as see how I presented my research, feel free to give it a read and post any comments/criticisms/ideas below.

Extended Project Qualification

 

Corruption in Kenya in a nutshell:

In terms of my findings, I divided my report into a number of subheadings and presented the information under these.

Overview of corruption in Kenya:

Over the last 20 years, corruption has become ubiquitous in Kenya and it is clear that the issue is not just limited to a few ‘rogue officials at the top’. An anti-corruption commission has been at work in Kenya since 1997, although to date, Kenya is still classified as one of the most corrupt states in the world, with the 2016 Transparency International (TI) report ranking it at 145 out of 173.

Causes of corruption:

Corruption in Kenya has failed to be eradicated, let alone improve, primarily due to poor governance and extreme poverty. There are also people in power who benefit from it, and the existing governance institutions lack both the will and capacity to stop them from doing so. So widespread is the problem in Kenya it is difficult to know how to change the status quo. Does one start with the ‘street-level traffic policeman’, ‘the bureaucratic middle’ or at the ‘very top’? , It is estimated that fraud and corruption costs Kenya 1 billion US dollars a year, although the exact figures are not available. From my research I discovered that there is potential for Kenya from its young population and its well-established export economy; however this is juxtaposed with the reality of widespread corruption and deprivation, hence making the challenge seem impossible.

Impacts on a Microeconomic level (for those who don’t know this considers the behaviour of individuals and firms in making decisions):

One example of corruption on a micro economic level which most Kenyans are familiar with is corruption in the Kenyan Police Force.

Kenyan police officers refer to corruption not as stealing but as eating According to a survey by Transparency international, in 2011, 90% of respondents perceived the Kenyan police to be corrupt or extremely corrupt and there is a 60% probability of being asked for a bribe when interacting with police forces. In 2001 a Transparency International (TI) survey showed that the average urbanite Kenyan paid 16 bribes a month mostly to the police or public works, to secure services they should have received for free.

The obvious solution would be to pay police officers a higher salary, as this would reduce the need for officers to resort to seeking bribes and would therefore reduce the incentive for this form of corruption. The problem is however the Kenyan economy cannot afford to pay more for its public services, suggesting that it is poverty that causes corruption.

There appears to be little incentive for Kenyan officials in power to take steps to reduce corruption. As an example from 2003 to 2006, the then president Kibaki’s cabinet spent 14 million dollars on new Mercedes cars for themselves and in late 2008, several members of Kibaki’s parliament were found to have taken large “allowances”, which were not legally part of their official compensation. The legal system is also impacted upon by corruption and in Kenya the general consensus is that you are guilty until proven rich.

Corruption also poses a security issue as it leads to violent protests and for that reasons Kenya is termed as one of the most dangerous countries in the world.

 

Impacts on a Macroeconomic Level (this looks at the whole economy in terms of employment, growth and inflation etc.)

Kenya’s growth suffered a low 5.6% in 2014 when it could easily be around 7-8%, whilst creating jobs along the way. This was because corruption was capping the extent to which the economy could grow and diverting money away from public services.

Corruption also impacts the economy from decreased tax revenues, as corrupt officials, individuals or firms evade taxes/fines in return for bribes, which instead of contributing to the government’s public purse, fuels the hidden economy.

In terms of education there was a major corruption scandal in the education system in Kenya where 4.2 billion shillings ($46 million) went missing from the Ministry of Education. The UK which contributed about $77 million to Kenya’s free primary education program, demanded a refund of its money and the British High Commissioner to Kenya at the time, stated significant reforms would be needed before the UK would consider contributing to such funds.

Poor schooling has resulted from this lack of investment meaning many of those leaving school are not equipped with sufficient skills exacerbating unemployment.

At a macro level it is clear that corruption is clearly causing poverty since money is being diverted from Kenya and its people.

Foreign Aid

On the face of it, it may seem that foreign aid is the best way to reduce poverty in Kenya and eliminate corruption; however, it can actually exacerbate the problem at hand. In the past fifty years, over $1 trillion in development related aid has been transferred from rich countries to Africa and this has had little effect. Economists like Dambisa Moyo argue for an aid free world although in reality this would be unfeasible and what’s actually needed is more efficient aid.

Solutions

Economically corruption is known as a ‘wicked’ problem. That is, it is so complex that it can only ever be partly solved/controlled it can never be completely eradicated.

Barack Obama said on his visit to Kenya, discussed earlier. There is a need for “visible prosecutions” to show citizens action was being taken. For example Botswana, the least corrupt country in Africa has a prosecution rate well above the international average for corruption related offences.

Social media has also been used effectively as an anticorruption tool. It was actually first introduced in Russia and now Facebook has a ‘Name and shame your corrupt politicians’ facility.

My Conclusion

Major goals for Kenya in the future include addressing the challenges of poverty, inequality, poor governance, low investment and low firm productivity to achieve rapid, sustained growth rates that can transform the lives of ordinary citizens. Kenya’s vision 2030 is one such programme that has been designed with this in mind and has set a realistic aim of 2030 to achieve this. Kenya vision 2030 is an achievable aspiration provided the scourge of corruption in Kenya can be tackled.