International Trade Essay: Should America utilise protectionist measures to manage the costs of international free trade?

A globalized world economy opening up markets for US exports refers to international trade which is defined as the exchange of goods and services across international boundaries. This brings about good benefits to the US economy such as higher consumption possibilities and reaping economies of scale. However, US companies and workers also face unfair foreign competition in the form of dumping and the cheap labour argument. 

Increased exports have led to the US economy gaining benefits. One such benefit is higher consumption possibilities. It allows USA to specialize and export goods in which it has a comparative advantage in and import goods in which it has a comparative disadvantage in, whereby comparative advantage refers to the situation where a country has a lower opportunity cost of producing a good as compared to another country. USA is then able to increase the overall consumption of all goods and services as compared to an autarky situation which refers to a situation of no trade but self-sufficiency instead. Hence, increased exports allow USA to enjoy higher consumption possibilities. 

Moreover, economies of scale can be reaped. With greater export demand, US firms are able to expand their capacity, enabling them to reap economies of scale which causes long run average cost to fall in the long run. As firms pass on some of these cost savings to consumers, material living standards increase as consumers get to consumer more goods at lower prices. Lower prices for domestic consumers and higher profits for domestic producers benefits the US economy.

On the other hand, American companies and workforce face unfair foreign anti-competitive practices like dumping, which refers to the situation where foreign imports are sold below cost because foreign firms are trying to drive out domestic firms to gain market power. In such situations, protectionism in the form of import tariffs is justified to be imposed in order to raise import prices so that they are more in line with prices of locally produced goods. However, lower prices could be due to lower demand or lower distribution costs, which indicates that claims of dumping are most of the time merely a disguise to elicit protection for inefficient domestic producer.

In the cheap labour argument, labour unions in developed economies such as America, commonly argue that imports from developing countries are cheap because they artificially keep costs down by exploiting their workers and hence lobby for restrictions against the imports from these developing countries. The fact that being labour abundant, developing countries have a comparative advantage in producing labour intensive goods, resulting in them having cheaper imports, is ignored. In this case, it is not justifiable for America to impose protectionism in the affected industries. 

Conversely, there are costs of increased exports and not simply just benefits. Terms of trade is defined as the ratio of export prices to import prices. With increased exports, the decrease in export prices relative to import prices would result in the revenue earned from each unit of exports to decrease, causing USA to be able to buy fewer imports than before. In addition, if USA’s inflation is lower than its trading partners, its exports become relatively cheaper than its imports especially with an increase in exports, worsening USA’s terms of trade.

Trade also brings about benefits of competition from imports which is in the case of healthy competition and not an unfair one. Competition from foreign imports forces US producers to innovate and cut costs and improve product quality. Local US consumers thus enjoy lower prices and higher product quality from both imports and domestically produced goods. Besides enabling these US companies to be more productively efficient, market power is also kept in check, reducing the extent of monopoly power in economy and ensures that domestic products which are US exports are comparable to foreign imports. Allocative efficiency is increased as well. 

Protectionism refers to the act of imposing economic policies aimed at restricting trade between countries, designed primarily to protect the domestic producers and workers from foreign competition. While imposing protection in the affected US industries might seem ideal, there are costs involved.

Firstly, USA would suffer from lower consumption possibilities. This is due to the fact that protectionism inhibits specialization according to comparative advantage. Protecting domestic firms against imports causes America to produce more of a good in which it has a comparative disadvantage in. 

[Insert diagram on impact of protectionism on consumption possibilities]

With protectionism of its domestic sector from imports, USA would produce some Good X and specialize only partially than completely in Good Y. The consumption possibilities curve thus shift down. USA then consumes at a point that is worse than the free trade outcome. Hence, protectionism limits the extent of specialization, reducing the gains from specialization and trade according to comparative advantage. 

Secondly, protectionism leads to greater allocative inefficiency as it raises the market power of US firms. They also become productively inefficient as the incentive to minimize costs is generally reduced with the monopoly profits. 

Thirdly, engaging in protectionism by America companies creates a ‘beggar thy neighbour’ effect and retaliation from trading partners. Falling import expenditure reduces the export earnings of USA’s trading partners which consequently suffer from reduced output and income, curbing the exports, output and employment of America companies. These trading partners may retaliate and impose their own import restrictions, causing USA’s exports, output and employment to suffer subsequently.

Lastly, it is politically difficult to remove protectionism once it is given. Vested interests are created and the beneficiaries, which in this case, are USA’s affected industries, would inevitably lobby against removal of protectionism. In the long run, there would be over-allocation of resources to declining sectors at the expense of expanding sectors. 

In conclusion, protectionism for the affected American industries is justifiable only in the short run to manage the cost of free trade. However, it is not justified in the long run as more consequences would have to be dealt with, suggesting that supply-side policies might be a better option in dealing with the problem instead.

JC Economics Essays (on globalisation, protectionism, international trade, and the US Economy): Economics tutor's comments - While this economics essay is generally well written, wide ranging, and covers a lot of good, solid, theoretical economic concepts and ideas, it could be further developed by use of relevant real world examples that are specific and targeted to the requirements of the question. Remember that relevant, real world, realistic, and specific examples can get students a higher grade in writing economics essays. Examiners and tutors love it when students can apply broad theories to specific contexts, with real world examples. What can you learn of the art writing from this economics paper? (Also, what can you learn about what not to write in an economics paper from this essay, in a similar vein? Think about this "counterfactual question".) How could you have tackled the question differently, or what approaches could have been taken to address this question? What other economics diagrams, concepts, or theoretical economics models could have been used, and what else could have been to develop this response further? Reflection and the reading of many different economics answers should build up a mental model which would be useful in answering economics essay questions.Thanks for reading, and cheers. Special thanks to NT for her kind and interesting contribution. 

“Protectionism is better than free trade.” Discuss the validity of this statement. [25]

Adapted from an actual H2 'A' Level Economics Examination

Introduction to Protectionism

What is protectionism? Protectionism is the government policy of imposing economic policies aimed at restricting international trade between countries, designed to protect domestic producers and workers from foreign competition brought about by trade. International trade, on the other hand, is the free and competitive exchange of goods and services across international boundaries. 

There are many methods of protectionism, namely, import tariffs, import quotas, subsidies, voluntary export restraints, foreign exchange restrictions, physical barriers such as making it difficult to clear unnecessary and bureaucratic custom checks and technical barriers such as differences in technical and safety standards to justify the prevention of foreign goods from being imported. Import tariffs are either levied as a fixed amount of charge per unit or levied as a fraction of the value of a unit. Thus, tariffs artificially raise import prices and reduce the quantity demanded of imports. 

What Economics diagram should be applied here? Based on the description below, what is the likely diagram here?

By examining the concept of protectionism through import tariffs, assuming that the country is a price taker as it is too small to affect world markets and prices, a small country can import as much as it wants at world price, Pw. Sw is the supply of imports and is infinitely price elastic at Pw. At Pw, domestic production is at Q1 while domestic consumption is at Q4. Thus, there is a shortage, DC, is solved by importing the goods to satisfy consumption. When there is a tariff on imports, the world supply curve shifts upwards from Sw to SW+t, with the area between Sw and SW+t being the tariff. Domestic production has now increased from Q1 to Q2 while domestic consumption has fallen from Q4 to Q3. The volume of imports has shrunk from Q1Q4 to Q2Q3. Before the tariff, consumer surplus was ACPw and producers’ surplus at ODPw.  The presence of the tariff caused the consumers’ surplus to fall from ACPw to ABPw. Therefore there is a welfare loss, a deadweight loss in area (2+4). This shows that protectionism results in a loss in welfare to society. [Tutor's Note: this is a very detailed analysis of a diagram. Always try to give analysis of diagrams that you draw in an examination.]

The Theory of Comparative Advantage

International trade operates on the basis of the theory of comparative advantage, where a country produces a good that it can produce at a lower opportunity cost compared to other countries, given its factor endowments. Here, it is assumed that the factors of production are perfectly immobile between countries and from one sector to another within countries as well as that the transportation costs of goods and services are negligible. Referring to figure 2, we use a hypothetical example between USA and Mexico’s comparative advantage. 

Figure 2 refers to two different economies, both depicting differently shaped PPCs (Production Possibilities Frontiers). How would you draw this Economics diagram?

Thus, international trade, as can be seen from the diagram, specifically by the theory of comparative advantage, enables consumers to enjoy higher consumption possibilities. 

Benefits of International Free Trade

Other benefits of international or free trade include lower prices and better product quality, greater product variety, developing countries being able to enjoy technical transfers, trade being an engine of growth for an economy and providing economic diversification. 

Firstly, countries that trade freely will enable domestic firms to face competition from foreign imports. If it is the case of intra-industry trade, it will pressure domestic firms to become more efficient and innovate new methods of production to increase efficiency, reduce cost of production and ultimately pass down the lower cost to consumers in the form of lower prices as well as better quality products from innovation in a bid to differentiate their products from rival foreign imports. If it is a case of inter-industry trade, it enables consumers to enjoy goods that the country are enable to produce due to the lack of factors of production required to produce the particular product, thus increasing product variety. For example, in Singapore, due to the tropical climate, we are not able to produce apples but owing to free trade, we are able to import apples from other temperate countries like New Zealand and USA and as a result, able to enjoy greater product variety, i.e.: enjoy a wider range of fruits, ranging from not only tropical fruits but also fruits grown in temperate climate.

Free Trade is also an engine of growth for the country. Developed and small economies like Singapore lack sufficient domestic market. Trade then exposes Singapore firms to a larger world market and enable us to fully utilise resources that are otherwise unemployed. This in turn increases output, income and employment, shifting both the AD and AS outwards. 

Limitations of International Trade

However, while free trade and specialisation may seem ideal, there are also some limitations. 

Free trade using comparative advantage may mean that in the event firms in other countries become more efficient at producing the product the first country has as a comparative advantage, the first country will become less competitive and lose its comparative advantage, which may lead to an economic crisis for the country since the country is largely dependent on the trade of this particular good. It makes the situation worse since the country is only adept at producing the particular product at a lower opportunity cost compared to other country, its initial focus on producing this good would mean that most of its workers are only trained in producing this good, leading to a case of structural unemployment when the country loses its comparative advantage. This has a somewhat similar result when the country is faced with supply problems from its sole supplier who specialise in supplying the raw materials.  This not only affect the livelihood of the people, as well as cost-push inflation due to a spike in prices of goods stemming from shortage of raw materials to manufacture the goods.  Trade restrictions due to natural disasters and war could also affect a country that depends on international trade via comparative advantage theory and thus is not independent. 

In this light, protectionism may seem like a better solution despite it causing a welfare loss as explained earlier in the tariff diagram. As countries need to protect its strategic industries and be self-sufficient to prevent the above situation from occurring and thus debilitating the country’s economic progress. Some examples are the agriculture and defence related industries. 

Furthermore, protectionism enables the country to protect domestic infant industry to better develop the economy of the country in future. New domestic industries have the potential to develop a comparative advantage in a certain product. However, due to high start up costs and a lack of economies of scale due to smaller scale of production compared to giant foreign firms, prices of the domestic goods are less price competitive compared to foreign imports. Thus, protection enables infant industries to grow and become internationally competitive in future before the protectionist measures are taken away. Nevertheless, such an argument may not be foolproof because firstly, it is difficult to identify the correct new industries which have potential to develop a comparative advantage and also politically difficult for the government to remove the protectionist measure from an infant industry which have grown up. Also, with protectionist measures, it reduces the domestic firms’ incentive to be efficient and respond to consumers demand or to reduce average costs, thus, these infant industry may never develop and build a comparative advantage in the world market because the firms are assured of being protected by the government if it does not grow.  For example, Malaysia protects its national car firm, Proton. It has been under protection from the Malaysia government and has not improved in technology unlike other Japanese car firms. 

Protection of declining industries can be another reason for protectionism as stated earlier how a country could lose its comparative advantage and be entrapped in serious structural unemployment as workers are only equipped with skills to manufacture to previous product that used to be a comparative advantage to the country. This gives time for workers to learn a new skill and find a new job in a new industry, mitigating structural unemployment. However, critics say that such protection is not perfectly viable because overtime, these declining industries are protected for too long and never change and adjust, creating a burden to the country’s economy as well as adversely affect the standard of living of the consumers as they are denied access to cheaper foreign imports. For example, Singapore used to be labour intensive but owing to the decline of the primary and manufacturing sector in Singapore, it quickly decline, go through training and move into the tertiary industry quickly without protectionist measures. 

Other reasons for protectionism includes protection from unfair foreign competition and raising employment in domestic firms and improving trade position of the country. 

Evaluation/ Conclusion

In conclusion, although both protectionism and free trade and specialisation has both its pros and cons, free trade is ultimately better because protectionism only serves as a temporary measure to problems caused by free trade , with many arguments for protectionism debatable in the long run. Welfare losses stemming from protectionism are also borne by consumers as consumers would have benefited from increased trade and suffer from retaliation if protectionist measures were imposed. Instead, countries should take a pro-trade stance and use macroeconomic policies like supply-side policies, improving education and retraining, better infrastructure to develop infant industries and strategic industries as well as ensure smooth transition out from structural labour rigidity from declining sectors.     

JC ECONOMICS ESSAYS: Economics tutor's comments: A more direct approach to this economics question on protectionsim would be to directly tackle the statement: first, in what cases would protectionism be better than free trade? Then, second, write the anti-thesis: how is free trade better? Finally, conclude with an evaluative statement with a justification for the viewpoint. However, this economics essay does a more exploratory and discussion-based kind of approach, which makes for an interesting reading, but may not be the most time effective or efficient strategy in an Economics examination. How would you rearrange these economics content and materials to make the essay address the question more directly, clearly, and efficiently? As a quick reminder, also remember to draw relevant economics diagrams and also to think of how you could make the essay better. What can you learn from the strengths of this economics paper, in a similar vein? Do think through the essay as you read and reflect on it. Thanks for reading and cheers!

Hints and Approaches to H1 and H2 A Level Economics Essay Questions for Practice

H1 and H2 A Level Economics Essay Questions for Practice (Hints and Approaches)

Essay Questions: Quick Recap and Introduction

These are the promised Economics hints (covering Economics concepts, definitions, ideas, arguments, and logical approaches) for the Economics essay questions for practice posted in my earlier post. 

(Do please see the bottom of this page for the relevant links if you want to refer to that post.)

Suggested Economics Tutor's Hints

Q: "Protectionism is better than free trade.” Discuss. [15]

HINT: Define protectionism, and international trade. List and explain various methods of protectionism (tariffs, quotas, subsidies). Talk about gains from trade, and maybe terms of trade. Thesis argument: protectionism is better than free trade. Why? Think about the infant industry argument and other arguments you could use. Anti-thesis argument: on the other hand, free trade is beneficial. Why? Define comparative advantage, opportunity cost. Show the diagram for the small country case, demonstrating deadweight loss from tariffs. You may discuss quotas too. Discuss other reasons why trade is beneficial. Be sure to give examples from Singapore/China/USA/UK. Conclude with a justified argument – which is better, why, or are both equally important?  

Q: Explain how imperfect information can lead to market failure, using examples from Singapore. [10]

HINT: Define market failure, and imperfect information. Define merit and demerit goods also. Explain how this leads to market failure – overconsumption (in what case?) and underconsumption (in what case?). Draw and explain diagrams. Use examples from Singapore, such as healthcare (Medisave, Medishield), etc. You may bring in other areas if you wish. List other forms of market failures. Other forms of market failures are important too, such as externalities. How would you conclude?  

Q: Explain comparative advantage and why international trade is beneficial for countries. [10]

HINT: Define comparative advantage and international trade. Talk about gains from trade, and terms of trade. Free trade is beneficial. Why? Demonstrate that countries can consume outside their PPC (on the PPC is for the autarky case) when their consumption possibilities increase (the trade case has CPC); draw diagrams. Explain the diagrams. Can also show the diagram for the small country case, demonstrating deadweight loss from tariffs; argue that protectionism is bad. Define and explain protectionism briefly. Discuss other reasons why trade is beneficial. Be sure to give examples from Singapore or China/USA/UK. 

Q: Explain the likely demand and supply factors affecting the oil (petroleum) market. [10]

HINT: Define demand and supply; talk about market prices and equilibrium output and how these are determined. Factors affecting the demand for oil are: derived demand (define), substitutes and complements (define), population changes, expectations, and rising incomes. Which of these is most likely? Factors affecting the supply of oil are: cost of production, expectations on the part of producers, number of firms, and government policies on the part of OPEC producers.  Which of these is most likely? Draw the demand and supply diagram with simultaneous shifts, explain it, and conclude your essay.

Q: Explain the difference between public goods and merit goods, using examples from the United Kingdom. [10]

HINT: Define public goods and merit goods. Define market failure, and say that these are instances of market failure. Why? Public goods are non rival and non excludable – leading to P = MC = 0 and also to the free rider problem, respectively. Give UK examples. Merit goods are goods that have positive externalities or due to imperfect information are underconsumed. Give UK examples (see next question for further hints). What is the difference, based on the explanations that you have written? Which is the most important difference?

Q: Explain using economic theory why in the United Kingdom, entry to national museums and art galleries is free and tickets to the opera are subsidised. [10]

HINT: Define public good and merit goods, and define market failure. The central problem here is underconsumption. National museums and art galleries can be considered quasi-public goods or merit goods. Why (for each of the possibilities), justification? Opera can be considered a merit good. Why, justification? Talk about imperfect information and positive externalities. Talk about a paternalistic state; talk about government intervention. Conclude.

Q: Discuss how the Singapore government deals with negative externalities in Singapore. [10]

HINT: Define market failure, externalities in general, and talk about negative externalities in particular. Focus on car congestion, cigarette smoking for this paper to make it easier. Draw the negative externality diagram and explain why it is a problem. What should the government do? Either impose taxes or quotas. Define those, explain, show. For congestion in particular, talk about ERP and COE. Conclude with the limitations of government policies.

Q: Explain how fiscal policy in the USA can be used to increase the circular flow of income in the USA. [10]

HINT: Define fiscal policy, and circular flow. Draw the circular flow diagram. Explain it. When G is increased, what happens to the circular flow? When corporate taxes are lowered, what happens to I, and in turn what happens to circular flow?  I, G, X are injections, and S, T, M are withdrawals. Talk about net injections and net withdrawals, but focus on injections. Give examples from the USA. (You may also in the course of the essay, define and discuss GDP, national income, standard of living.)

JC Economics Essays - Economics Tutor's Comments: These are some suggested hints (possible approaches, possible ideas/ concepts/ logic/ economics materials) to the Economics essay questions posted earlier (with a few general instructions, ideas, and pointers/tips for students). Do remember to think through them, and see if there are other Economics ideas, concepts, and approaches that you could use in addition to those provided by Economics tutors. 

For the earlier post on JC Economics Essays' questions for practice: H1 and H2 A Level Economics Essay Questions for Practice. 

For ease of reference, here is my List of Economics Exam Questions for Practice. Note that these questions are practical, heuristic, and training questions that test fundamental Economics understanding and fundamental, basic application. Some students have kindly, and rightly, pointed out that these questions in the "List" are for training purposes, and not all are reflective of the rigour of A levels or introductory undergraduate Economics - true!  

Explain the concept of comparative advantage and, using relevant examples from the USA, explain the likely factors that determine the comparative advantage of the United States. (15 marks)

Introduction - International Trade

This Economics essay is about international trade, and discusses the likely factors that determine the comparative advantage in trade for the USA. 

Comparative Advantage

What is "comparative advantage"? Comparative advantage is the idea that a country should trade in a good in which it has the lowest opportunity costs in producing that good. Even if a country has absolute advantage in the production of all goods than another country, the idea of comparative advantage is that the opportunity costs matter and that hence both countries can still trade, and gain from trade.

Generally, trade models built upon the theory of comparative advantage have the following assumptions: Perfect mobility of the FOP (factors of production), which means that resources used in one industry can be substituted for another perfectly; constant returns to scale, which means that doubling the inputs in each country leads to a doubling of total output; there are no externalities arising from production and/or consumption (and by extension there are no other associated market failures); and transportation and other transaction costs are negligible.

Factors Affecting Comparative Advantage

What determines comparative advantage, and in this particular context the comparative advantage of the USA?

Dynamic Concept - Dynamic Comparative Advantage

First, it should be noted that comparative advantage is a dynamic concept, which means that it can and does change over time. Some companies enjoy a comparative advantage in a product they have produced for several years, only to find that eventually they face increasing competition as rival producers from other countries enter the market. For instance, Ford used to be able to sell their cars competitively overseas, but with the rise of Korean cars and Japanese cars - predominantly Japanese cars - now, many people worldwide perceive Japanese and Korean cars as good as, if not better, than American cars.

Factors of Production - Quality and Quantity

Also, the quantity and quality of the factors of production available would definitely affect the comparative advantage of the USA (in particular, the natural resources that a country possesses, the size and efficiency of the available labour force, the productivity of the existing stock of capital inputs, and the skill and organisational talent of its entrepreneurs and risk-taking businessmen). Focusing narrowly instead on labour and capital, to focus this Economics paper, any economy can improve the quality of its labour force and increase the stock of capital available to therefore expand the productive potential in industries in which it has a comparative advantage. In the case of the USA, this means that the US government can focus on improving the productivity of its labour force and raising employment, as well as focusing on their current capital-intensive approach to production.

Industrial Policy and R&D?

In Singapore, in contradistinction to the USA, there has been industrial policy that aims to direct comparative advantage, since after all comparative advantage is indeed a dynamic concept. Investment in research and development can lead to dominance in certain industries, and industrial policy helps to keep this keen and targeted (R&D is very important in industries where patents give some firms significant market advantage, and hence market dominance). In the case of the USA, military firms (once termed the military-industrial complex) can be seen as an area in which R&D served to keep the comparative advantage of the USA in military weaponry and high technological areas.

Yet Other Factors - Inflation, Protectionism, and Non-price Competitiveness

There are also other factors affecting the comparative advantage of countries, which may be important or relevant in the case of the USA. These other factors are inflation rates, protectionist measures, and nonprice competitiveness of producers in terms of product design and other such preference-related measures.

First, long-term rates of inflation compared to other countries would worsen competitiveness and hence cause a decline in the comparative advantage of that particular good. This would affect all producers not just the USA per se.

Secondly, in terms of protectionism, import controls such as tariffs and quotas can be used to create an artificial comparative advantage for domestic producers. In the case of the USA, protectionist measures are sometimes used (as Ha Joon Chang once mockingly said, this was akin to "kicking away the ladder").

Lastly, the nonprice competitiveness of producers, such as the product design, reliability, and the quality of after-sales support also affects comparative advantage. In this area, the USA has a lot of fans and some of its products are quite popular worldwide, for instance the infamous or for that matter famous iPhone and other Apple products.

JC Economics Essays: Economics Tutor's comments - This Economics essay on international trade in the context of the USA is short, sharp, and to the point - and it does make an attempt at addressing the requirements of the Economics question. There are many good elements in this writing and analysis that are worthy of learning and study. However, the usual tutor's questions are: how can this paper be made better? For instance, think about the conclusion - this Economics paper does not have a conclusion that brings in the relevant real world context of the USA. How would you craft an evaluative, nuanced, and clear conclusion for this Economics paper? Also, what other economic ideas or real-world arguments can you think of? Finally, think about the alternative approaches and methods in which you could approach this Economics question. Think through the process of writing, especially for examinations, tests, and term projects. Thanks for reading and cheers!

Discuss whether the undervalued yuan (RMB) is the only cause of China’s rising inflation and trade surplus with the US. [25] (Rephrased Economics Question)

In recent years, it has been argued that the undervalued renminbi (RMB / yuan) is the major cause of China’s burgeoning inflation and massive trade surplus vis-à-vis developed countries, especially the USA. From 2007-21012, economists worldwide argued that China should revalue the yuan.

Discuss whether “the undervalued yuan” is the only cause of China’s rising inflation and huge trade surplus with the USA. [25]

Introduction

China has often been accused by the West of using her fixed exchange rate to maintain an “undervalued yuan”, meaning that her currency (yuan, renminbi, RMB) is cheaper than it otherwise should be in a floating exchange rate, relative to other currencies. 

This Economics paper argues that having an undervalued currency encourages demand for Chinese exports, which could arguably lead to demand-pull inflation, whilst concomitantly causing imported inflation for China, as its imports from its trading partners are relatively more expensive. Hence, it can be strongly argued that China’s inflationary woes indeed stem in part from an undervalued yuan, and, to a large extent, the high demand for low-priced Chinese exports is responsible for China’s huge trade surplus.

Inflation

First and foremost, it has to be argued that China’s inflationary woes stem partly from the undervalued RMB. With a relatively undervalued RMB, Chinese goods appear cheaper relative to other countries’ goods, and this causes an increase in the demand for Chinese exports, in contradistinction to other countries’ domestically produced goods or even goods from other exporting countries. This is because with increased demand for Chinese exports, (X-M) increases, and since AD = C + I + G + (X-M), there arises demand-pull inflation. Inflation is defined as a persistent and sustained increase in the general price level, and demand-pull inflation is caused by rapid and persistent increases in AD.

On the cost-push side, the undervalued yuan may have made imported inflation a real possibility and thus may have pushed up the AS curve. This is because if China imports inputs or factors of production, especially and furthermore so if those natural resources are then used as inputs to produce exports, then this might cause inflation in China if these inputs rise in price. Given that the cheaper yuan makes other countries’ currencies look more expensive, this is a real possibility.

Inflation in China, on the other hand, is also caused by the rapid growth they experienced in recent times. There has been rising domestic consumption due to the rapidly expanding middle classes in China, and that would have raised C. At the same time, rising optimism about business prospects have led firms to undertake investments, thus raising I as well. Since AD = C + I + G + (X-M), it is clear that these increase AD. Hence, AD also shifts to the right, thus causing demand-pull inflation due to rapid domestic Chinese economic growth, which is not solely related to growth in exports.

Trade Surpluses

Secondly, the “undervalued yuan” can be blamed for the mounting trade surplus China has with its trading partners, predominantly America, since American consumers’ high demand for cheap Chinese goods caused the Chinese to sell massive amounts of goods to Americans. As China uses a fixed exchange rate regime, this balance of trade disequilibrium is not automatically corrected, unlike under a freely floating exchange rate regime. Concomitantly, prices of imports remain relatively high, from the Chinese perspective, since the yuan was kept low. This leads in theory to import expenditure being low, whilst export expenditure is high. Hence, the low value of the Chinese yuan will continue to encourage other countries to import cheap Chinese goods, and thus incur a growing trade deficit; on the other hand, China will, theoretically, continue to accumulate surpluses given the low value of the yuan. Hence, it seems that the criticisms of the undervalued yuan seem justified here.

Other Countries’ Declining Comparative Advantage

Nonetheless, the “undervalued yuan” cannot be the only cause of this huge trade surplus; America’s slowly declining comparative advantage, where comparative advantage refers to the relatively lower opportunity cost of a country in producing a good relative to other trading countries, in manufacturing has led to weakening US exports, whilst, on the other hand, it might be possible to argue that China has developed a new, dynamic comparative advantage in manufacturing, especially cheap and lower-end products. For instance, the American steel industry has been too reliant on protectionism for many years, and this has contributed to her mounting trade deficit, because it has become less export competitive, while the Chinese improved consistently over recent years. Hence, perhaps the trade surpluses are due to American weaknesses and Chinese strengths.

Conclusion

Thus, while it can be strongly argued that the “undervalued yuan” does indeed have a part to play in China’s rising inflation and huge trade surpluses, it cannot be considered the only cause of these problems, and China’s increasing prosperity, especially for the middle classes, her rising economic growth, and the falling productivity and comparative advantage of the developed nations who are her trade partners are realistic and relevant alternative explanations for the same phenomena. 

JC Economics Essays: Tutor's Comments - This Economics essay was actually written under examination conditions by a Chinese student. First, it has to be praised: the English is very well written and fluent, and the student has clearly got a very good understanding of the Chinese economy and a good knowledge of international economic events. Secondly, it has to be said that the quantity and quality of this Economics essay far exceed what I would have expected as an Economics tutor, because this was written under examination conditions and by someone whose native language is not English. This just goes to show that if one puts one heart into doing something, and tries one's best - one can achieve many great things in life. As an Economics tutor, seeing such work and effort in my students' Economics essays is one of the joys of teaching. If you were to write this essay, how would you approach it? Would the approach be similar or different? Thanks for reading and cheers. 

(b) "Fiscal policy works best to achieve price stability in a small and open economy like Singapore." To what extent do you agree with this assertion? [17]

(b) "Fiscal policy works best to achieve price stability in a small and open economy like Singapore." To what extent do you agree with this assertion?

Inflation brings about some adverse effects to the economy and hence it is important for governments to implement policies to curb inflation. The policies used would differ according to the type of inflation as well as the nature of the economy. This paper discusses if fiscal policy works best to achieve price stability in a small and open economy, and uses Singapore as a case study in particular. First, it should be noted that Singapore is a small and open economy with no natural resources, relying heavily on trade, international capital flows, and foreign direct investments to drive growth. This paper argues that fiscal policy can be used, but its impacts are massively limited given Singapore’s context.

What is fiscal policy?

Fiscal policy refers to the manipulation of government expenditure and taxation to achieve macroeconomic goals. A contractionary fiscal policy could be used to curb inflation. Government expenditure could be reduced or taxation could be increased. With a lower government expenditure, this would translate to a lower aggregate demand (AD) which consists of AD = Consumption + Government expenditure + Investment + Net Exports, or AD = C + I + G + (X-M).

Through the multiplier process, a fall in G would lead to a multiple fall in AD. With a fall in AD, firms would accumulate inventories and this would be a signal to reduce production and output. Firms will reduce their number of workers hence resulting in a fall in output and a rise in unemployment and a fall in national income. With a fall in household incomes, there is a fall in spending and hence through the multiplier process, this would result in a contractionary effect on the economy. Hence, AD would shift to the left as shown, resulting in a fall in the general price level.

With higher taxes such as income taxes, this would reduce the disposable incomes of consumers and hence this would also reduce consumption expenditure, shifting the AD curve to the left, and, hence, also resulting in a fall in the general price level.

Limitations of Fiscal Policy in Singapore’s Context

However, the effectiveness of fiscal policy would depend on the size of the multiplier. In the case of Singapore, the size of the multiplier is small due to the high marginal propensities to save and import. This is firstly due to compulsory savings such as the Central Provident Fund (CPF), and, secondly, a high marginal propensity to import, among other factors. Because Singapore is a small and open economy that relies heavily on foreign trade, there would be high leakages from the economy. Also, it would also be difficult to reduce government expenditure for long-term, major projects. Increasing personal income tax could also result in a disincentive to work and a higher corporate tax could drive businesses away from Singapore.

Other Possible Solutions

On the other hand, the Singapore government can also use contractionary monetary policies (in Singapore’s case, an exchange rate policy), or supply-side policies instead to tackle inflation, rather than just fiscal policy.

Monetary Policy, in Singapore’s Context

Monetary policy refers to the use of interest rates to achieve macroeconomic objectives. In Singapore’s case, her monetary policy is tied to exchange rates, and Singapore uses a form of exchange rate policy because Singapore is dependent on external demand. Therefore, it is more effective to control exports and imports in Singapore’s context. Hence, the exchange rate is used as a tool of monetary policy in Singapore instead.

In Singapore, a managed float system is adopted where the Singapore dollar is allowed to fluctuate within a band against a basket of currencies of her trade partners. The central bank will then intervene in the foreign exchange market to move the exchange rate to a desired level by buying up or selling the Singapore dollar using her foreign reserves, when the currency level approaches the bands. For instance, to curb inflation, the Singapore central bank (the MAS) could buy up the Singapore dollar, resulting in an appreciation of the Singapore dollar. This appreciation of the Singapore dollar would lead to a fall in the price of imports in terms of Singapore dollars. This would lead to a lower cost of living as the price of imported products would be lower. With a lack of natural resources, Singapore depends heavily on imports as inputs to manufacture our exports. Therefore, the fall in the price of imports would lead to a fall in the cost of production.

The lower price of imports would also mean that consumers switch away from local goods and purchase more imports instead, assuming they are substitutes. With an appreciation of the Singapore dollar, this would mean that Singapore’s exports are more expensive in foreign currency terms and hence less price-competitive. Assuming demand for exports to be price-elastic, this would lead to a more than proportionate fall in quantity demanded of exports from Singapore. If the Marshall-Lerner condition holds, this would lead to a fall in net exports and hence a fall in AD. The AD curve would shift to the left, resulting in a fall in the general price level, ceteris paribus.

Limitations of Singapore’s Exchange Rate Policy

However, there are limitations to the effectiveness of Singapore’s exchange rate policy. Intervention in the foreign exchange market to generate an appreciation of the currency would require Singapore to maintain significant reserves. A fall in export earnings through an appreciation of the dollar would also lead to a worsening of the current account.

On the other hand, besides fiscal and monetary policies, the Singapore government could also use supply-side policies to tackle both demand-pull and cost-push inflation. With supply-side policies, the aggregate supply (AS) could be increased through labour retraining and education. By increasing the productivity of workers, in the long run, the cost of production would fall, resulting in a rightward shift of the LRAS curve, leading to a fall in the general price level, ceteris paribus. Cost-push inflation can also be curbed using wage and income policies. For instance, a flexible wage structure would enable wages to be adjusted downwards. In Singapore, the National Wages Council (NWC) recommends the level of wage increases. This could control labour costs and ensure that wage increases do not outstrip productivity increases.

However, supply-side policies would not work effectively if AD continues to increase. Therefore, there is a need to use both contractionary fiscal or monetary policy to reduce AD to reduce the upward pressure on prices. In the long run, supply-side policies are important to curb inflation.

Conclusions

In concluding, it should be mentioned there could also be considerable time lags involved in the implementation of policies. It takes time for policymakers to gather data. There could also be implementation lags due to the time taken to implement suitable policies. Once policies are implemented, there could also be impact lags as it takes time for policies to take effect. Also, due to the characteristics of the Singapore economy, it is arguably better to adopt contractionary monetary policy using exchange rates to curb inflation, as Singapore’s monetary policy is in the form of exchange rate policy. This poses a tricky problem, in that, with a small multiplier in Singapore’s context, the effectiveness of fiscal policy is limited, yet the benefits of supply-side policies might only be reaped in the long run. However, it should also be noted that curbing inflation could lead to a trade-off with another macroeconomic objective of unemployment. By curbing inflation, a fall in national output will occur and that might lead to an increase in unemployment. In the final analysis, fiscal policy is only one of many solutions and its impact is massively limited in Singapore, and as such as plethora of policies should be used instead of one single policy.

JC Economics Essays: Tutor's Comments - This paper was written by an Economics tutor friend of mine, who was my former classmate at the NIE (National Institute of Education), doing PGDE (Postgraduate Diploma in Education, JC, Economics specialisation). For part (a) of this question, see the suggested "model" Economics answer why low inflation is an important macroeconomic aim of the Singapore government.  My usual tutor's comments and questions apply here to this essay: what do you like about this paper, and what have you learnt here? Also, what have you studied that is different or similar to what is written in this Economics paper? Using your knowledge of macroeconomics, what diagram must you use here to explain the words? Remember, although this was written under simulated examination conditions by an Economics tutor, you can always think of other ways to improve it, refine it, and make it better suit the context. Also remember that you should know how and when to apply your Economics concepts and theories, rather than just merely memorising and regurgitating. Be sure to think hard, clearly, and properly when writing your Economics essays, especially during examination conditions. Thanks for reading, and cheers!

Analyse the impact of FTAs on the Singapore economy and assess the extent to which the impact of FTAs has been positive. [25m]

Free Trade Agreements (FTAs) are highways that connect Singapore to major economies and markets. With FTAs, Singapore-based exporters stand to enjoy many benefits like tariff concessions, preferential access to certain sectors, and faster entry into markets.

Analyse the impact of FTAs on the Singapore economy and assess the extent to which the impact of FTAs has been positive. [25m]

Note: The original essay was edited two-fold - first, to fit into this JC Economics Essay blog post; second, to remove diagrams/graphics. Hence it is entirely in verbal (English) form. 

A Free Trade Agreement (FTA) is a legally-binding agreement to liberalise trade and bring about closer economic integration between member countries. FTAs aim to remove barriers to trade and investment and create a free flow of goods, services, investment, and people. Under a FTA, member countries provide each other with favourable treatment for goods, services, and investment. Such favourable treatments include reduced tariffs, easier access to markets, and opening up of various sectors for investment opportunities. Thus, FTAs help to foster and facilitate the flow of trade and investment between Singapore and its trading partners with the aim of achieving economic growth and development. FTAs bring about both positive and negative impacts on the Singapore economy. However, the government has implemented policies to mitigate these negative impacts and the overall impact of FTAs on the Singapore economy is largely positive.

The Singapore economy is open to the world, in trade and investment. This openness to trade is a necessity because of its small size and lack of natural resources.

Figure 1 illustrates the effect of a tariff on imports. The original import expenditure for country A is shown by area Oaeq0, the price of imports is Oa and the quantity of imports is Oq0. For a country with price-elastic demand for imports, when the tariff is imposed, the price of imports rises to Ob and the quantity of imports fall to Oq1. Import expenditure is represented by area Obfq1. There is a reduction in import expenditure as the fall in quantity demanded of imports is greater than the rise in price of imports. For a country with price-inelastic demand for imports, when the tariff is imposed, the price of imports rises to Oc and the quantity of imports fall to Oq2. Import expenditure is represented by area Ocdq2. There is an increase in import expenditure as the fall in quantity demanded of imports is less than the increase in price of imports.

This illustrates the positive impact of free trade on the Singapore economy and is one of the key reasons why Singapore campaigns actively for the removal of tariffs and the setting up of FTAs. It has a relatively price-inelastic demand for imports since it has no natural resources and has to import both food as well as inputs for production. Imposing tariffs on such goods will have more adverse effects for its economy than gains.

On the export side, domestic producers in Singapore gain from an enlarged export market. Thus, they are able to reap internal economies of scale and earn greater export revenue. In addition, the reduction, or removal, of tariffs results in cheaper exports, which will lead to an increase in export demand and revenue. The increase in net exports increases aggregate demand and in turn increases national income, employment, and short-run growth if the economy is operating below full employment. On the other hand, if the economy is near or at full employment, the boost of net exports might lead to demand-pull inflation.

The other benefit that FTAs bring to the Singapore economy is that it allows countries to specialise in producing goods in which they have a comparative advantage in to a greater extent. Comparative advantage is the idea that relative opportunity costs of production must be taken into account when trading between countries. Consumers benefit from lower-priced goods, as Singapore’s trading partners are able to produce these goods more efficiently due to their comparative advantage. Also, there is both a greater variety of goods available and better quality of products. The removal of tariffs means that domestic producers face greater competition from foreign producers, which will boost the efficiency of domestic production and the quality of products.

Lastly, Singapore benefits from greater foreign direct investment. Foreign Direct Investment (FDI) refers to long-term capital inflows, which typically takes the form of a Multinational Corporation (MNC) investing in an enterprise that is outside the economy of the MNC. The greater inflow of capital will have a positive impact on the Balance of Payment (BOP), creating a surplus in the BOP. Foreign direct investment will also result in an increase in capital accumulation, which increases the productive capacity of the economy and short-run economic growth. In addition, the diffusion of technology from the MNCs to domestic producers will increase the level of productivity and lead to long-run economic growth.

On the other hand, FTAs bring about negative impacts on the Singapore economy. First, structural unemployment arises in industries that are in direct competition with other lower-cost trading partners due to a loss of comparative advantage.  There will be a decline in production levels and employment in some of Singapore’s sectors such as manufacturing. This results in structural unemployment, as these workers are not equipped with the skills required to work in the newly-created sectors. In addition, new technology increases the importance on skills and substitutes for relatively low-skill inputs. Technology replaces low-skilled jobs, exacerbating the problem of unemployment.

Second, FTAs cause member countries to become more vulnerable to external events. FTAs foster closer trade links among member countries, and as a result increases the interdependence of their economies. This means that a recession in one country may quickly spread to other countries, which are its trading partners, an effect known as the “contagion effect”. In the case of Singapore, higher reliance on imports makes the economy more vulnerable to the threat of imported inflation, while reliance on exports to drive economic growth may make Singapore more vulnerable to external shocks. There is also the possibility of an increase in long-term capital outflow due to greater opportunities in member countries.

The above illustrate that FTAs have both positive and negative impacts on the Singapore economy. The government has put in place measures to mitigate the negative impacts and has been largely successful in reducing the problems of demand-pull inflation, structural unemployment and vulnerability to external shocks.

To tackle the threat of demand-pull inflation due to the growth in exports and investment, as well as the threat of imported inflation, the Singapore government has put in place an exchange rate policy of gradually appreciating the Singapore Dollar. A gradual appreciation of the Singapore Dollar keeps the price of imports relatively low, reducing the possibility of imported inflation. A gradual appreciation of the Singapore Dollar also prevents excessive increases in export demand and hence aggregate demand, reducing demand-pull inflation.

To tackle structural unemployment, Singapore has adopted manpower policies to equip workers with the skills required to work in the newly created industries, for instance biotechnology. The government also spearheads Research & Development (R&D) projects to develop new areas of growth and new dynamic comparative advantage, such as the biomedical sector, in the face of the erosion of Singapore’s comparative advantage in an attempt to search for new markets.

The government uses supply side policies to deal with the third problem of vulnerability to external shocks. Singapore’s economic strategy is outward-oriented. Small and Medium Enterprises (SMEs) are encouraged to venture overseas to reduce the dependence of our current account on exports and hence, the Balance of Trade (BOT). With SMEs investing abroad, this will lead to an inflow in the current account in the long run. This helps to reduce the vulnerability of Singapore’s economy to changing global conditions.

There is evidence that the above policies have been successful. The exchange rate policy has been effective in keeping inflation at a consistently low and stable level. The government also managed to develop new high-value added industries such as biomedical and life sciences to replace jobs in the lower-skilled manufacturing sector, in which Singapore is rapidly losing its comparative advantage. The outward orientation policy has also proven to be effective in helping Singapore cope with changes in global conditions. However, it takes time for supply side policies to work. Thus, in the short run the drawbacks of FTAs appear to be large, but in the long run, the positive impact of FTAs outweighs the negative impact when the policies take effect.

In conclusion, the signing of FTAs brings about benefits and detriments. Nevertheless, the long-run benefits tend to outweigh the short-run drawbacks and the Singapore’s government policies to mitigate the negative effects of FTAs have been relatively successful. Singapore is a small economy with a lack of natural resources. It benefits from the removal of tariffs, as its demand for imports is inelastic. Domestic producers benefit from entry into the markets of its trading partners and consumer welfare increases as consumers are able to obtain lower cost goods produced by Singapore’s trading partners.  FTAs also encourage foreign direct investment and technology transfer from MNCs, which contribute towards economic development and growth of Singapore. The main negative impacts of FTAs are demand-pull inflation, structural unemployment and vulnerability to external shocks. These impacts have been mitigated by the exchange rate policy, supply side policy and outward orientation measures put in place by the Singapore government. The Singapore government continues to campaign for the setting up of FTAs as they seek new opportunities in emerging markets such as China, India, Russia, and Latin America.

JC Economics Essays - Tutor's Commentary:  Once again, note that the original was edited two-fold - first, to fit into this JC Economics Essay blogpost; second, to remove diagrams. It is well written and crafted, and was done professionally. Given that this essay was written professionally and not under examination conditions, if an Economics student could write about half the standard of this paper, he would get more than a decent grade. Having said that, the usual questions apply: how can I write an essay better? How can I improve on this paper? 

"Singapore is among economies worldwide that have the most to gain from globalisation." Discuss. [25]

"Singapore is among economies worldwide that have the most to gain from globalisation." Discuss. [25]

Economics Tutor's Note: This Economics A level examination question has been modified; it was attempted in 2009 by one of my MJC students. 

Globalisation refers to the rising volume of economic activities taking place across countries worldwide, which includes the exchange of goods and services through trade, capital through capital flows, labour as well as technology. These impacts are most often than not far reaching which means that the spatial extent to which these exchange occur is fairly wide and dense. This paper discusses whether Singapore is among the countries worldwide that have the most to gain from globalisation. 

Looking at Singapore’s economy, its nature is small and open – Singapore’s resources are scarce, therefore she depends heavily upon the trade of goods and services, and the international flow of labour and capital. Since the 1980s, Singapore has been faced with strong economic growth, low unemployment with some structural unemployment and generally low inflation rates accompanied by a healthy balance of payment surpluses. Such attributes allow Singapore to gain from globalization.

Firstly, Singapore gains from globalization due to its increase in the market reach as market size increases. With an increase in market size, exports will also increase as more goods are traded to more countries, leading to an increase in the net exports. Using the AD-AS analysis, with an increase in the net exports, the AD will increase because AD = C + I + G + (X-M). This will lead to actual growth, as AD shifts to the right.

Insert the AD-AS diagram. Think: how would it look like, and what lines, labels, and other details would you need to draw this? 

Therefore, as such, the increase in the AD from AD1 to AD2 results in economic growth through actual growth and also resulting in a decrease in unemployment rates. In addition, balance of payments improves, assuming that the Marshall-Lerner condition holds. However, due to Singapore’s small multiplier, because of her high savings rate due to the compulsory savings scheme leading to a high MPS (Central Provident Fund) and because of her lack of natural resources resulting in a high MPM, the increase in economic growth or national income may not be that significant and thus its gains are arguably small.

Via globalization, Singapore also gains as firms here can now find cheaper factors of production overseas, for example, China is set upon as a good premise for investments as it has comparative advantage in land, which is abundant and labour, which are cheap. This will therefore reduce the cost of production resulting in the savings achieved by the producers to pass on the savings to the consumers. In addition, firms can also import cheap foreign labour as well as import foreign machinery to boost the levels of factors of production in Singapore. The improvement in the quality and the quantity of factors of production allow the inflation to be kept at a low level as cost push inflation is prevented.

Cheaper production costs which results in cheaper domestic products improves Singapore’s export competitiveness and therefore encourages economic growth. Also the balance of payment position may also improve from globalization due to increased investments, which would likely boost the capital account. With foreign investment overseas, this could improve Singapore's current account. Furthermore, with globalization, investment levels in export-oriented industries could increase, attributed to an increase in the inflow of foreign direct investment. As such, both the quality and quantity of exports is affected. Quality is improved due to more advanced technology, which increases the quality of capital together with more capable human resources which improves the quality of labour. This will increase Singapore's long run productive capacity, resulting in possible potential growth. This is especially important seeing that FDI has been the main engine of long run potential economic growth in Singapore.

However, while Singapore gains from globalization, it also experience some losses or costs. Firstly, Singapore can potentially face demand-pull inflation because of an increase in export numbers, heavily accentuated with over increase in investment and consumption levels. This leads to an increase in the levels of aggregate demand and demand pull inflation could occur shortly after. This will lead to detrimental effects in Singapore, for example, the housing prices could soar. With increases in capital inflows, there could be possible asset bubbles from loose monetary policies in other countries. Hence, inflation could be a possible issue. 

Besides demand pull inflation, Singapore might experience a loss in comparative advantage. Comparative advantage is when a country produces and trades a good which it produces at a lower opportunity cost than another country. This might be seen in the sunset industries where there is low value added-ness, and low skilled and low waged jobs. The closing down of these industries, together with labour immobility, causes structural unemployment, leading to income inequity.

Lastly, Singapore may also face volatile external shocks. If our main trading partners experiences recession, Singapore’s macroeconomic goals may be affected, particularly economic growth, employment and balance of payment as trade may decrease and result in decreased exports. Also, the imposing of protectionism and establishment of barriers of trade due to political turmoil may also result in the aforementioned effects. Hence, it can be seen that Singapore may be made more vulnerable to external events.  

Therefore, while Singapore gains from international trade and global factor mobility in the long run, there may be limitations. This highlights the need for policies to be established, such as Singapore's focus on the managed exchange rate and supply side policies in general, to come up with strategies so that Singapore can gain most from globalization while reducing losses. Singapore's use of exchange-rate focused monetary policy ameliorates inflation because of its gradual appreciation, whilst Singapore's supply side policies effectively address retraining and skills-upgrading to target structural unemployment and maintaining flexibility in the face of a volatile external environment. 

JC ECONOMICS ESSAYS - Economics Tutor's Comments: There are many aspects of this economics essay that can be improved on, but overall this is a very well written economics paper, interesting and well-thought out; overall, this is a really good effort in Economics! NOTE: This economics question is an amended version of the H2 A level Economics paper. This economics response written by my student was recently edited for flow and made more relevant to the 2014, 2015 context, as it was written in 2009. Grammatical and spelling errors were also changed, from the original submission. Most importantly, the initial original conclusion has been made and modified into the evaluative conclusion required for the highest evaluation grade in the current 2014 economics A level essay paper section. Thanks for reading and cheers.