2011 Essay Question 6

Question

‘The Singapore economy is open to the world, in trade and investment. This is both a matter of policy and necessity because of our size and limited resources. In 2008, our trade to GDP ratio was 360%, the highest in the world.’

(Ministry of Trade and Industry, Singapore, 2009)

Discuss whether the openness of the economy is beneficial or harmful to the standard of living in Singapore. [25]

Answer

Note: Students should discuss the openness of the Singapore economy to international trade, foreign direct investment and labour flows. As this question is asking about the effect of the openness of the economy on the standard of living, students need to explain the theory of comparative advantage.

The standard of living refers to the material and non-material welfare of the people. The openness of the Singapore economy to international trade will lead to an increase in the amount of goods and services available for consumption which will result in a rise in the material standard of living and this can explained with the law of comparative advantage.

The law of comparative advantage states that countries can gain from international trade if each specialises in producing the goods in which it has a comparative advantage. A country has a comparative advantage over other countries in producing a good when it can produce the same amount of the good at a lower opportunity cost. In other words, it can produce the same amount of the good by forgoing a smaller amount of other goods. Suppose that there are two countries, country X and country Y, producing two goods, good A and good B. Further suppose that there are perfect mobility of resources within each country, constant opportunity costs of production, no economies of scale, no transport costs, no trade barriers and no product differentiation.

Good A Good B
Country X 2 4
Country Y 3 9

The above table shows the amount of each good that can be produced in each country with one unit of resources. In country X, if one unit of resources is used to produce 2 units of good A, the same unit of resources cannot be used to produce 4 units of good B. Therefore, the opportunity cost of producing 1 unit of good A in country X is 2 units of good B. By the same token, the opportunity cost of producing 1 unit of good B in country X is 1/2 unit of good A. In country Y, if one unit of resources is used to produce 3 units of good A, the same unit of resources cannot be used to produce 9 units of good B. Therefore, the opportunity cost of producing 1 unit of good A in country Y is 3 units of good B. By the same token, the opportunity cost of producing 1 unit of good B in country Y is 1/3 unit of good A. Since the opportunity cost of producing good A in country X is lower than that in country Y and the opportunity cost of producing good B in country Y is lower than that in country X, country X has a comparative advantage in producing good A and country Y has a comparative advantage in producing good B. Suppose that country X has 400 units of resources and country Y has 200 units of resources and each country allocates its resources equally between the two goods.

Good A Good B
Country X 400 800
Country Y 300 900
World 700 1700

The above table shows the amount of each good produced in each country when the resources are allocated equally between the two goods. Suppose that each country completely specialises in producing the good in which it has a comparative advantage.

Good A Good B
Country X 800 0
Country Y 0 1800
World 800 1800

The above table shows the amount of each good produced in each country when each country completely specialises in producing the good in which it has a comparative advantage. Suppose that given the demand and supply of the two goods and their elasticities of demand and supply in the two countries, the terms of trade are 1A : 2.5B. Further suppose that country X trades 350A for 875B.

Good A Good B
Country X 450 875
Country Y 350 925
World 800 1800

The above table shows the amount of each good available for consumption in each country after specialisation and international trade. Since the amount of each good in each country available for consumption has increased, we can conclude that countries can gain from specialisation and international trade on the basis of comparative advantage. As the amount of each good in each country available for consumption has increased, the standard if living has risen, other things being equal.

The production of high value-added goods requires high-skilled labour. As Singapore has a large amount of high-skilled labour, it has a comparative advantage in producing high value-added goods. Therefore, the openness of the Singapore economy to international trade, coupled with the trend towards globalization due to factors such as the benefit of specialisation and international trade on the basis of comparative advantage, technological advancement, trade liberalisation and the opening up of formerly closed economies, will lead to an increase in exports of high value-added goods. The Singapore government has been improving the country’s infrastructure, increasing the quality of labour in the economy and cutting corporate income tax. Therefore, the openness of the Singapore economy to foreign direct investment, coupled with the trend towards globalization, will lead to an increase in foreign direct investment. An increase in exports and investment expenditure in Singapore will lead an increase in aggregate demand which will induce firms to increase production resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. Students should explain the multiplier effect. An increase in national output in Singapore may lead to an increase in the amount of goods and services available for consumption which will lead to a rise in the material standard of living. An increase in national output will lead to an increase in the demand for labour in the economy resulting in a fall in unemployment. When this happens, the morale and self-confidence of the workers who were previously unemployed but have found a job may rise which may improve their mental health and this may lead to a rise in their non-material standards of living. In addition, the mental health of the workers who were previously employed and have remained employed may improve as they may experience a higher sense of job security and this may lead to a rise in their non-material standards of living.

The wages in Singapore are high compared to the wages in many other economies and the government has been cutting personal income tax. Therefore, the openness of the Singapore economy to labour flows, coupled with the trend towards globalization, will lead to an increase in the supply of labour. When this happens, wages will fall which will lead to a fall in the cost of production. In addition, the quantity of labour in the economy will rise which will lead to an increase in the production capacity in the economy. The openness of the Singapore economy to international trade, coupled with the trend towards globalization, will lead to an increase in imports of capital goods. This, coupled with an increase in foreign direct investment will lead to an increase in the quantity of capital in the economy. A fall in the cost of production and an increase in the production capacity in Singapore will lead to an increase in aggregate supply and hence an increase in national output and a fall in unemployment resulting in a rise in both the material and non-material standards of living.

The openness of the Singapore economy to international trade, coupled with the trend towards globalization, will lead to an increase in imports of consumer goods which will lead to an increase in the quantity and the variety of goods and services available for consumption resulting in a rise in the material standard of living.

Although the openness of the Singapore economy is beneficial to the standard of living in some ways, it is harmful to the standard of living in other ways.

The production of low value-added goods requires low-skilled labour. As Singapore has a small amount of low-skilled labour, it has a comparative disadvantage in producing low value-added goods. Therefore, the openness of the Singapore economy to international trade, coupled with the trend towards globalization, will induce households and firms in Singapore to switch from domestic low value-added goods to imported of low value-added goods resulting in a fall in the demand for domestic goods and services and hence aggregate demand. Other things being equal, this will lead to a fall in national output. A decrease in national output in Singapore may lead to a decrease in the amount of goods and services available for consumption. If this happens, the material standard of living will fall. Furthermore, when national output falls, the demand for labour in the economy will fall which will lead to a rise in unemployment. When this happens, the morale and self-confidence of the workers who have lost their jobs may fall which may worsen their mental health and this may lead to a fall in their non-material standards of living. In addition, the mental health of the workers who have not lost their jobs may worsen as they may experience a lower sense of job security and this may lead to a fall in their non-material standards of living.

As Singapore has a comparative disadvantage in producing low value-added goods, the openness of the Singapore economy to international trade, coupled with the trend towards globalization, will lead to a decline in the low value-added industries which will cause the low-skilled workers who are employed in the industries to lose their jobs resulting in a rise in structural unemployment and hence a fall in the non-material standard of living. This is particularly true in view of the fact that workers who are structurally unemployed tend to be unemployed for a relatively long period of time.

The wages in Singapore are high compared to the wages in many other economies. Therefore, the openness of the Singapore economy to labour flows, coupled with the trend towards globalization, will lead to a large increase in the supply of low-skilled labour. This will decrease the wages which will worsen income inequity . Furthermore, as Singapore has a comparative advantage in producing high value-added goods and comparative disadvantage in producing low value-added goods, the openness of the Singapore economy to international trade, coupled with the trend towards globalization, will increase the demand for high-skilled labour and decrease the demand for low-skilled labour which will increase the wages of high-skilled workers and decrease the wages of low-skilled workers resulting in an increase in income inequity. Assume that as a result of this, the wages of low-skilled workers rise less than proportionate than the wages of high-skilled, low income individuals will be worse off in relative terms which will lead to a fall in their non-material standards of living, despite them being better off in absolute terms.

Singapore has a small domestic demand due to the small population and the high savings rate. Therefore, the openness of the Singapore economy to international trade, coupled with the trend towards globalization, will lead to a disproportionately high level of exports. This will led to high volatility of economic growth and hence wide fluctuations in the standard of living in Singapore. For example, the 2008-2009 Global Financial Crisis caused by the Subprime Mortgage Crisis in the United States led to a fall in exports in Singapore. As the domestic exports accounted for a large proportion of the national output in Singapore due to the openness to international trade, aggregate demand fell substantially. This led to a large decrease in national output resulting in a sharp fall in the standard of living. In the global economic recovery in 2010, exports rose in Singapore which led to a substantial increase in aggregate demand resulting in a large increase in national output and hence the standard of living.

Evaluation

The benefits of the openness of the Singapore economy is likely to outweigh the costs.

Point 1: Singapore has a small domestic demand and hence is highly dependent on exports and Singapore virtually does not have factor endowments and hence is highly dependent on imports. Singapore is also highly dependent on foreign direct investment due to the small size of its domestic firms. Students should elaborate on the points and make reference to the preamble.

Point 2: Although the benefits are likely to outweigh the costs,, the government should not neglect the costs. For example, the government should reduce income inequity with measures such as education and training. Students should elaborate on this point with reference to the concept of inclusive economic growth.

A more elaborate answer to 2011 Essay Question 6 will be provided in the economics tuition class.

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