SRJC H2 ECONS 9757 Q6 MS

Q6. Many people feel that free trade is unfair. Some blame it for the loss of jobs; others for worsening balance of payments deficit. Source: adapted from World Economic Forum. (a) Explain how free trade helps to alleviate the problem of scarcity. [10] (b) Assess the relevance of protectionism in view of the statement above. [15] SUGGESTED ANSWERS TO PART A Introduction Clarify key terms: Scarcity arises because there are limited economic resources but unlimited human wants. Thus, resources are scarce or insufficient to satisfy all wants. Without free trade, each country would have to be self-sufficient and can only consume what it can produce with its given resources. Direction: Free trade is needed to extend a nation’s consumption possibility frontier beyond its production possibility frontier i.e. it enables the people in the country to consume more goods and services than what the country could produce on its own. Hence, the Theory of Comparative Advantage can be used to explain how free trade alleviate the problem of scarcity. Body P1: Countries should specialize and trade goods which they have comparative advantage in arising from differences in factor endowments as they can benefit in terms of efficiency in resource allocation.  A country is said to have comparative advantage in the production of a good if it can produce that good at a lower opportunity cost than another country.  The opportunity cost of producing Good X is the amount of the other good which has to be sacrificed in order to produce an additional unit of Good X.  The assumptions are there are two countries in the world, USA and China, producing two goods, cloth and wheat. Both countries have the same amount of resources which are fully employed and equally divided between the productions of both good s before specialisation. There are constant returns to scale and perfect mobility of factors of production within the country. Transport cost is negligible and there is free trade between the two countries. Table 1 below shows the possible output before specialization. Country/Goods Cloth (metre) Wheat (kg) USA 500 500 China 400 100 World 900 600 From Table 1, we can see that by dividing their resources equally in the production of wheat and cloth, USA can produce 500m of cloth and 500kg of wheat. To produce 1 more unit of cloth, the resources for wheat production has to be channelled to produce more cloth. As a result, the output of wheat falls by 1kg. So the opportunity cost of producing 1 m of cloth in USA is 1 kg of wheat. China can produce 400m of cloth and 100kg of wheat. By the same reasoning, China’s opportunity cost of producing 1 m of cloth is 0.25 kg of wheat. Since China incurs a lower opportunity cost of produ cing cloth, China is said to have a comparative advantage in the production of cloth. Hence, China will specialise in cloth production. According to the Theory of Comparative Advantage, both countries will gain if each specialises in the production of the good in which she has the comparative advantage. Hence, USA, which has the comparative advantage in wheat will specialise in the production of wheat and China will specialise in the production of cloth. In this way, both countries are being cost-efficient as they are producing efficiently in terms of what they give up least in  they are being both productively efficient and resources are also allocated in the most efficient manner. P2: To benefit from free trade based on comparat ive advantage, mutually beneficial terms of trade have to be established between the two countries. Table 2 below shows the output after specialisation. Country/Goods Cloth (metre) Wheat (kg) USA 0 1000

China 800 0 World 800 1000 Assuming constant returns to scale , the output of wheat in the USA will double after specialisation. Initially, only half of its resources are allocat ed to wheat production and the total output is 500kg.However, after specialisation, all its resour ces in cloth production are transferred to wheat production. In other words, the total amount of resources allocated to wheat production has now increased by 100%. This results in the same % incr ease in total output, assuming constant returns to scale. This means that total out put of wheat increases to 1000kg wh ich is twice that of the amount before specialisation. To show how both countries can gain from trade, mutually beneficial terms of trade must be determined. In a two-country, two-commodity model, the terms of trade must lie within the opportunity cost ratios of the two countries for trade to be mutually beneficial. From Table 1, we observed that the opportunity cost of producing 1 kg of wheat in USA is 1 m of cloth and the opportunity cost of producing 1 kg of wheat in China is 4 m of cloth. For the USA to produce 1 m of cloth, she forgoes 1 kg of wheat. Thus, she is willing to trade only if she can get more than 1 m of cloth for every kg of wheat she exports to China. Similarly for China to produce 1 kg of wheat, she forgoes 4 m of cloth. Thus she is not willing to pay more than 4 m of cloth for every kg of wheat imported from USA. Thus, for trade to be mutually beneficial, the terms of trade must lie between the opportunity cost ratios of producing the goods in the two countries i.e. 1 metre of cloth < 1 kg of wheat < 4 metre of cloth. P3: When countries exchange goods based on their comparative advantage with mutually beneficial terms of trade, their consumer welfare will increase. Assuming the rate of exchange or terms of trade is 1 kg of wheat 2 m of cloth, which lies within the domestic opportunity cost of production of the 2 countries and USA exports 250 kg of wheat in exchange for 500 m of cloth from China. Table 3 shows the consumption possibilities when trade takes place. Country/Goods Cloth (metre) Wheat (kg) USA 500 750 China 300 250 World 800 1000 Comparing the situation before (Table 1) and after trade (Table 3), it can be seen that the USA is now able to consume 250 kg more wheat without a fall in cloth consumption. Thus, she gains 250 kg of wheat by trading with China. China also gains from trade with the USA. Her consum ption of cloth falls by 100m while that of wheat increases by 150 kg. Certainly this is better than bef ore trade. This is because before trade, if China reduces her cloth production and consumption by 100m, she is able to produce only 25 kg of wheat. With trade, she can buy 150 kg of wheat from the USA by giving up or selling the same amount of cloth (i.e. 100m of cloth). Thus, her net gain is 125 kg of wheat. After specialisation and trade, both the USA and China are able to consume more goods and services to satisfy their wants. They will be consuming bey ond their PPCs (a point which is desirable yet unattainable before trade), hence alleviating scarcity. P4: There are dynamic gains from trade in the form of innovation, technological advances and productivity improvements over time, leading to a rise in productive capacity. By increasing competition, trade promotes research and development and helps to drive technological innovations, resulting in improvements in producti vity and product quality over time. As countries specialise, they gain experience in the production of the goods and are able to improve their efficiency in producing it. As a result, the country will have an increase in the quality of resources. That will means that the PPC can actually shift outwards to encompass more points outside the original PPC.

This means that people can now access the point in ABCD and thus the problem of scarcity has been alleviated. Conclusion In summary, free trade allows consumption to take place beyond PPC, hence alleviating the problem of scarcity. The extent of the point beyond PPC will depend on the difference in the opportunity cost incurred an