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

Students should discuss the openness of the Singapore economy in terms of flows of goods and services, capital and labour across international borders with the use of the law of comparative advantage and the AD/AS framework in the response to the question.

The standard of living refers to the material and non-material welfare of the people. Openness to international trade in Singapore has led to an increase in the amount of goods and services available for consumption which has resulted in a rise in the material standard of living. 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.

Due to factors such as benefit of specialisation and international trade on the basis of comparative advantage, technological advancement, trade liberalisation and opening up of formerly closed economies, there has been an increase in the flows of goods and services, capital and labour across international borders. As a result, the openness of the Singapore economy has led to an increase in exports.  As Singapore has a large amount of high-skilled labour, this has occurred mainly in the form of high value-added goods in which Singapore has a comparative advantage in producing. Apart from an increase in exports, Singapore has also experienced an increase in foreign direct investments. An increase in exports and investment expenditure in Singapore has led to an increase in aggregate demand which has induced 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 has led to an increase in the amount of goods and services available for consumption which has resulted a rise in the material standard of living. An increase in national output has led to an increase in the demand for labour in the economy resulting in a fall in unemployment. As a result, the mental health of workers in the economy has improved and this is particularly true for the workers with a new found job who were jobless for a prolonged period of time. This has led to a rise in the non-material standard of living.

An increase in imports of consumer goods in Singapore has led 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.

The openness of the Singapore economy to foreign labour has led to an increase in the quantity of labour in the economy. This increase, coupled with an increase in foreign direct investments and an increase in imports of capital goods and intermediate goods has led to an increase in the production capacity. An increase in the production capacity in Singapore has led to higher economic growth and hence a more rapid rise in the 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.

Openness to international trade has caused the Singapore economy to become highly dependent on external demand. This has 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 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.

Openness to foreign labour has exerted a strain on the infrastructure of Singapore. For example, the demand for housing has risen substantially which has led to a sharp in the prices. This has caused housing to become unaffordable to some low income individuals which has lowered their material standards of living.

Openness to foreign labour has also worsened income inequity in Singapore as it has led to a large increase in the supply of low-skilled labour which has dampened the wages. Openness to international trade has also worsened income inequity in Singapore as it has led to a decrease in the demand for low-skilled labour due to its comparative disadvantage in producing low value-added goods. The wider income gap has made low income individuals worse off in relative terms which has led to a fall in their non-material standards of living, despite them being better off in absolute terms.

The increase in national output in Singapore has led to an increase in working hours and hence less leisure time resulting in a fall in the non-material standard of living.

Openness to capital flows has led to an increase in foreign direct investments in Singapore. However, foreign firms are footloose and hence if market conditions in other economies become more favourable in the future, they may pull their operations out of Singapore. For example, many foreign firms such as Hitachi, Sanyo and Seagate have relocated their manufacturing plants in Singapore to China where the cost of production is lower. If this happens, unemployment in Singapore may rise substantially.

Evaluation

The openness of the Singapore economy is likely to be beneficial to the standard of living.

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. Students should make reference to the preamble.

Point 2: Domestic firms in Singapore are small and hence foreign direct investments are important.

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

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