Economics Lecture Notes – Chapter 13

INTERNATIONAL ECONOMICS will be covered in economics tuition in the first, second, third and fourth weeks of term 3.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1          INTRODUCTION

The people in a country consume a large number of goods and services. However, no country produces all the goods and services that its people consume. Instead, countries generally produce the goods and services in which they are good at producing and import the goods and services in which they are not good at producing. In other words, countries engage in international trade. One of the major factors why international trade takes place is differences in comparative advantage. Although international trade has been occurring for thousands of years, it has increased substantially only over the last century and this has expanded the world economy substantially. This chapter provides an exposition of international economics.

2          BASIS OF SPECIALISATION AND INTERNATIONAL TRADE

2.1       The Law of Absolute Advantage (Optional but good to know)

International trade is the exchange of goods and services across international borders.

The father of modern economics, Adam Smith, was the first economist who recognised and advocated the importance and the benefit of specialisation and international trade. He put forward the law of absolute advantage in his famous book, ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, which was published in 1776.

The law of absolute advantage states that countries can gain from international trade if each specialises in producing the goods in which it has an absolute advantage. A country has an absolute advantage over other countries in producing a good when it can produce the same amount of the good with a smaller amount of resources. 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

1

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, one unit of resources can be used to produce either 2 units of good A or 4 units of good B. In country Y, one unit of resources can be used to produce either 1 unit of good A or 9 units of good B. In country X, 1/2 unit of resources is required to produce one unit of good A and 1/4 unit of resources is required to produce one unit of good B. In country Y, 1 unit of resources is required to produce one unit of good A and 1/9 unit of resources is required to produce one unit of good B. Since the amount of resources required to produce one unit of good A in country X is lower than that in country Y and the amount of resources required to produce one unit of good B in country Y is lower than that in country X, country X has an absolute advantage in producing good A and country Y has an absolute advantage in producing good B.

Suppose that country X has 400 units of resources and country Y has 200 units of resources. Further suppose that each country allocates its resources equally between the two goods.

Good A

Good B

Country X

400

800

Country Y

100

900

World

500

1700

The above table shows the amount of each good produced in each country when the resources are allocated equally between the two goods. In country X, 400 units of good A and 800 units of good B are produced. In country Y, 100 units of good A and 900 units of good B are produced. Suppose that each country completely specialises in producing the good in which it has an absolute 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 an absolute advantage. In country X, 800 units of good A are produced. In country Y, 1800 units of good B are produced. The world output of good A has increased by 300 units and the world output of good B has increased by 100 units. Suppose that country X trades 250A for 850B.

Good A

Good B

Country X

550

850

Country Y

250

950

World

800

1800

The above table shows the amount of each good available for consumption in each country after specialisation and international trade. In country X, 550 units of good A and 850 units of good B are available for consumption. In country Y, 250 units of good A and 950 units of good B are available for consumption. 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 absolute advantage.

Note:   Students are not required to explain the law of absolute advantage in the examination as it has been removed from the Singapore-Cambridge GCE ‘A’ Level Economics syllabus. Nevertheless, it is good for them to have a basic understanding of the law of absolute advantage in order to have a better understanding of the law of comparative advantage.

2.2       The Law of Comparative Advantage

In the previous section, country X has an absolute advantage in producing good A and country Y has an absolute advantage in producing good B. A natural question is, will the two countries gain from specialisation and international trade if one of them has an absolute advantage in producing both goods? This is the question that David Ricardo asked after reading ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, which was published in 1776 by Adam Smith. He answered the question in the affirmative and put forward the law of comparative advantage in his famous book, ‘On the Principles of Political Economy and Taxation’, which was published in 1817.

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, one unit of resources can be used to produce either 2 units of good A or 4 units of good B. In country Y, one unit of resources can be used to produce either 3 units of good A or 9 units of good B. Although country Y has an absolute advantage in producing both goods, each country has a comparative advantage in producing only one good. 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. Further suppose that 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. In country X, 400 units of good A and 800 units of good B are produced. In country Y, 300 units of good A and 900 units of good B are produced. 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. In country X, 800 units of good A are produced. In country Y, 1800 units of good B are produced. The world output of good A and the world output of good B have each increased by 100 units. A country will only be willing to specialise in producing a good and trade it for another good if the opportunity cost of buying the second good is less than the opportunity cost of producing it. In country X, the opportunity cost of producing 1 unit of good B is 1/2 unit of good A. Therefore, country X will only be willing to specialise in producing good A and trade it for good B if 1/2 unit of good A can be exchanged for more than 1 unit of good B (1B < 1/2A) because in this range of terms of trade, the opportunity cost of buying 1 unit of good B from country Y is less than 1/2 unit of good A. In country Y, the opportunity cost of producing 1 unit of good A is 3 units of good B. Therefore, country Y will only be willing to specialise in producing good B and trade it for good A if 3 units of good B can be exchanged for more than 1 unit of good A (1A < 3B) because in this range of terms of trade, the opportunity cost of buying 1 unit of good A from country X is less than 3 units of good B. Therefore, the range of mutually beneficial terms of trade is 2B < 1A < 3B. The actual terms of trade depend on the demand and the supply of the two goods and their elasticities of demand and supply in the two countries. 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 (350 x 2.5).

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. In country X, 450 units of good A and 875 units of good B are available for consumption. In country Y, 350 units of good A and 925 units of good B are available for consumption. 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.

Apart from tables, the benefit of specialisation and international trade on the basis of comparative advantage can also be illustrated with diagrams.

                             Country X                                                     Country Y

In the above diagrams, in the absence of specialisation and international trade on the basis of comparative advantage, the consumption possibility curve (CPC0) is the same as the production possibility curve (PPC0) in each country. In country X, 400 units of good A and 800 units of good B are available for consumption. In country Y, 300 units of good A and 900 units of good B are available for consumption. With specialisation and international trade on the basis of comparative advantage, although the production possibility curve in each country remains the same at PPC0, the consumption possibility curve shifts out from CPC0 to CPC1. In country X, 450 units of good A and 875 units of good B are available for consumption. In country Y, 350 units of good A and 925 units of good B are available for consumption. 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.

Note:   Countries do not gain equally from specialisation and international trade, unless by chance. The closer the terms of trade are to the pre-trade terms of trade in a country, the smaller will be the gain from specialisation and international trade to the country. The converse is also true. 

Students are required to be able to explain the law of comparative advantage with a numeral example in the examination. The numerical example may be illustrated with tables or diagrams.

The Principal Economics Tutor will discuss the law of comparative advantage in greater detail in the economics tuition class.

2.3       Limitations of the Law of Comparative Advantage

Trade Barriers

The law of comparative advantage assumes that there are no trade barriers. In reality, there are trade barriers. Some countries are unable to export the goods in which they have a comparative advantage in quantities that they would like due to trade barriers imposed by other countries. For example, Iran is unable to export as much oil as it would like due to economic sanctions imposed by western countries, despite its comparative advantage in producing the good. Some governments protect domestic industries by discouraging imports through the use of protectionist measures such as tariffs, import quotas and subsidies. As a result, some countries produce goods in which they have a comparative disadvantage in larger quantities than in the case without government intervention. For example, Singapore has a comparative disadvantage in producing drinkable water due to the small land area and hence limited reservoirs and water catchment areas. However, to reduce dependence on imported water, the government subsidises the production of drinking water through seawater desalination and wastewater reclamation to increase self-sufficiency in its water supply.

Product Differentiation

The law of comparative advantage assumes that there is no product differentiation. In reality, differentiated goods are produced. Furthermore, due to factors such as intra-industry specialisation, a country does not produce all types of a good. For example, Singapore’s top two exports are electronic valves and refined petroleum products. However, they are also Singapore’s top two imports. This is partly because Singapore imports and exports different types of electronic valves and refined petroleum products.

Transport Costs

The law of comparative advantage assumes that there are no transport costs. In reality, there are transport costs which may outweigh any comparative advantage or disadvantage. For example, Singapore has a comparative disadvantage in producing bricks due to the small amount of low-skilled labour. However, it produces bricks because their size and weight make them too expensive to import.

Constant Opportunity Costs of Production

The law of comparative advantage assumes that there are constant opportunity costs of production. In reality, as a country increasingly specialises in producing a good, it will experience increasing opportunity cost of producing the good. This is because resources are not equally suitable for producing different goods. As a country increasingly specialises in producing a good, it has to use resources that are less suitable for producing the good to actually produce the good. This means that increasingly more units of resources are needed to produce each additional unit of the good. Therefore, increasingly more units of other goods have to be forgone to produce each additional unit of the good resulting in an increase in the opportunity cost. This will eventually lead to the disappearance of the country’s comparative advantage in producing the good which is a reason why countries do not engage in complete specialisation in reality.

Perfect Mobility of Resources within Each Country

The law of comparative advantage assumes that there is perfect mobility of resources within each country. In reality, due to factors such as differences in skill requirements, resources are not perfectly mobile in a country.

Sources of Comparative Advantage

The law of comparative advantage does not provide an explanation for the sources of comparative advantage. The sources of comparative advantage will be explained in greater detail in Section 2.4.

Demand-side Reason for International Trade

The law of comparative advantage does not take into consideration the demand-side reason for international trade. In reality, apart from differences in supply conditions, countries also trade due to differences in demand conditions. The demand-side reason for international trade will be explained in greater detail in Section 2.5.

2.4       Sources of Comparative Advantage

Differences in Factor Endowments

Factor endowments vary among countries. For example, Argentina has much fertile land, Saudi Arabia has large crude oil reserves and China has a large amount of low-skilled labour. As goods differ in terms of the resources that are required to produce them, a country has a comparative advantage in producing a good that intensively requires resources it has in abundance. For example, Argentina has a comparative advantage in growing wheat because of its abundance of fertile land, Saudi Arabia has a comparative advantage in producing oil because of its abundance of crude oil reserves and China has a comparative advantage in producing textile because of its abundance of low-skilled labour.

Economies of Scale

Recall that economies of scale refer to the decrease in average cost when the scale of production expands. A country may have a comparative advantage in producing a good through large-scale production. This occurs in industries where production is subject to substantial economies of scale such as the steel industry and the cement industry.

Note:   Comparative advantage may not remain static. Instead, it may change over time and this is commonly known as dynamic comparative advantage. An example is Singapore which has acquired its comparative advantage in producing high value-added goods over time.

2.5       Demand-side Reason for International Trade

The law of comparative advantage provides the supply-side reason for international trade. However, in addition to differences in supply conditions, international trade takes place due to differences in demand conditions.

Suppose that Singapore and Japan have identical production possibility curve and hence identical supply curve for fish which means that neither country has a comparative advantage over the other in producing fish. If the demand for fish is higher in Singapore than in Japan, the price of fish in Singapore will be higher than that in Japan. In this case, Singapore will import fish from Japan. Conversely, if the demand for fish is higher in Japan than in Singapore, the price of fish in Japan will be higher than that in Singapore. In this case, Japan will import fish from Singapore. In these cases, international trade will take place due to differences in demand conditions.

The world price of fish is determined by the world demand and the world supply. If the demand for fish is higher in Singapore than in Japan, the price in Singapore will be higher than that in Japan. In this case, the world price of fish will be below the price in Singapore and above the price in Japan.

In the above diagram, the world price of fish (PW) which is determined by the world demand and the world supply, is below the price in Singapore (PS) and higher than the price in Japan (PJ). At PW, the shortage of fish in Singapore (QD – QS) is equal to the surplus in Japan (QS – QD), which means that the world demand is equal to the world supply. Therefore, Singapore will import fish from Japan.

2.6       Advantages and Disadvantages of International trade

Advantages of International trade

Greater Amount of Goods and Services Available for Consumption

Due to differences in comparative advantage among countries, international trade increases the amount of goods and services available for consumption in a country. Refer to Section 2.2 for the explanation. An increase in the amount of goods and services available for consumption in a country will lead to a rise in the material standard of living.

Greater Variety of Goods and Services Available for Consumption

Due to factors such as specialisation and lack of resources, certain goods and services are not produced in a country. Therefore, international trade increases the variety of goods and services available for consumption in a country. An increase in the variety of goods and services available for consumption in a country will lead to a rise in the material standard of living.

Lower Prices of Goods and Services

Due to comparative disadvantage, some goods and services can only be produced in a country at high costs resulting in high prices. Therefore, international trade allows consumers in a country to import the goods and services at lower prices from other countries. As international trade exposes firms to greater competition, it will induce them to reduce prices in order to increase competitiveness by increasing labour productivity and decreasing productive inefficiency to lower the cost of production. International trade increases the demand for the goods produced by some firms which will enable them to increase their scales of production to increase output. When this happens, they may reap more economies of scale which will lead to a fall in their costs of production resulting in lower prices. International trade allows firms to import cheaper intermediate goods which will lead to a fall in their costs of production resulting in a fall in prices.

Engine of Growth

Through an increase in exports, international trade increases aggregate demand in some economies. This is particularly true in small economies with low domestic demand and developing economies where households have low purchasing power. When aggregate demand increases, national output will rise. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Technological Transfers

International trade allows some countries to import better production technologies from other countries. This is particularly true in developing economies where the production technologies are less advanced. When this happens, the production capacity in the economy will increase. Furthermore, with better production technologies, labour productivity in the economy will rise which will lead to a fall in the cost of production in the economy. An increase in the production capacity and a fall the cost of production in the economy will lead to an increase in aggregate supply resulting in an increase in national output. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment. Assuming aggregate demand is rising which is the normal state of the economy, an increase in aggregate supply will also lead to a smaller rise in the general price level.

Disadvantages of International trade

Over-dependence on Other Economies

International trade may cause an economy to become susceptible to a recession in other economies. International trade may cause an economy to become over-dependent on exports. If this happens, a recession in other economies which will lead to a decrease in exports in the economy is likely to lead to a large decrease in aggregate demand. When this happens, national income will fall substantially which will lead to a sharp rise in unemployment. For example, as international trade had increased the exports of Singapore substantially, the 2008-2009 Global Financial Crisis caused by the Subprime Mortgage Crisis in the United States led to a fall in exports in Singapore resulting in a large decrease in aggregate demand and hence national income. Similarly, international trade may cause an economy to become susceptible to high inflation in other economies. International trade may cause an economy to become over-dependent on imports. If this happens, high inflation in other economies will lead to a substantial rise in the prices of imports in the economy. When this happens, imported inflation is likely to rise sharply. For example, as international trade had increased the imports of Singapore substantially, the high inflation in other economies in 2008 due to the oil price shock was a major factor which caused inflation in Singapore to soar to 6.6 per cent which was a level not seen since 1981. International trade may also cause a country to become over-dependent on imports of vital goods such as food, water and armaments. This is undesirable as it may put the country at great risk in the event that international trade is disrupted which may happen in times of war.

Demise of Infant Industries

International trade may prevent infant industries from growing. Infant industries are small and hence have a cost disadvantage over their mature foreign competitors which are bigger. Therefore, in the face of international trade, infant industries may not be able to grow. If this happens, the number of goods of comparative advantage and hence the range of goods produced in the economy will decrease in the long run. When this happens, the rate of economic growth will fall and the volatility of economic growth will rise.

Rise in Structural Unemployment

International trade may lead to a rise in structural unemployment. The production of low value-added goods such as disk drives requires low-skilled labour. An economy may have a comparative disadvantage in producing low value-added goods due to a small amount of low-skilled labour. Therefore, international trade may lead to a more rapid decline in the low value-added industries. If this happens, more low-skilled workers will not have enough time to undergo education and training in order to acquire new skills and knowledge which will lead to a rise in structural unemployment.

Dumping

International trade may subject a country to dumping. Dumping occurs when imports are sold at prices below their marginal costs. This is often done with the help of foreign government subsidies. A country which engages in international trade may be subject to dumping. If dumping occurs, although consumers will benefit from lower prices in the short run, domestic firms may be driven out of the market in the long run which will lead to job losses resulting in a rise in unemployment. Furthermore, in the event that foreign firms monopolise the domestic market, they are likely to raise prices to increase profits and this may cause consumers to suffer from high prices.

Worsening Income Inequity

International trade may worsen income inequity. For example, the production of high value-added goods such as pharmaceuticals requires high-skilled labour. Developed economies have a comparative advantage in producing high value-added goods due to the large amount of high-skilled labour. Therefore, international trade will lead to an expansion of the high value-added industries which will increase the demand for high-skilled workers resulting in a rise in the wages. However, developed economies have a comparative disadvantage in producing low value-added goods due to the small amount of low-skilled labour. Therefore, international trade will lead to a contraction of the low value-added industries which will decrease the demand for low-skilled workers resulting in a fall in the wages. A rise in the wages of high-skilled workers and a fall in the wages of low-skilled workers due to international trade will cause income inequity to worsen.

Note:   The Principal Economics Tutor will discuss the advantages and disadvantages of international trade in greater detail in the economics tuition class.

2.7       Pattern of Trade between Singapore and the Rest of the World

The pattern of trade between Singapore and the rest of the world refers to the types of goods that Singapore imports and exports. It is determined by three factors: supply factors, demand factors and government policies.

Singapore’s Exports and Imports are affected by Supply Factors

The production of high value-added goods such as pharmaceuticals requires high-skilled labour and the production of low value-added goods such as disk drives requires low-skilled labour. Singapore had a comparative advantage in producing low value-added goods due to the large amount of low-skilled labour and hence it exported mainly low-value-added goods which included semiconductors and disk drives, and to a lesser extent, television sets, radios, clothing and plastics. However, over the last few decades, the skills and knowledge of labour in Singapore have increased substantially due to factors such as the great emphasis on education and training. Therefore, it now has a comparative advantage in producing high value-added goods due to the large amount of high-skilled labour and hence it exports mainly high value-added goods which include high-end electronics such as electronic valves, and high-end chemicals such as refined petroleum products, and to a lesser extent, engineering products such as civil engineering equipment parts and pharmaceuticals. In addition to high value-added goods, Singapore exports high value-added services such as financial services, education and healthcare. Although it continues to export low value-added goods such as semiconductors and disk drives, the share of these goods in total exports has decreased. Singapore virtually does not have factor endowments and hence has a comparative disadvantage in extracting natural resources such as crude petroleum. Furthermore, it has limited fertile land and hence has a comparative disadvantage in agriculture. Therefore, Singapore imports crude petroleum and agricultural products. Due to the small amount of low-skilled labour, Singapore also has a comparative disadvantage in producing low value-added goods such as textile and furniture which results in the import of these goods.

Singapore’s Exports and Imports are affected by Demand Factors

Suppose that Singapore and Japan have identical production possibility curve and hence identical supply curve for fish which means that neither country has a comparative advantage over the other in producing fish. If the demand for fish is higher in Singapore than in Japan, the price of fish in Singapore will be higher than that in Japan. In this case, Singapore will import fish from Japan. Conversely, if the demand for fish is higher in Japan than in Singapore, the price of fish in Japan will be higher than that in Singapore. In this case, Japan will import fish from Singapore. In these cases, international trade will take place due to differences in demand conditions.

Singapore’s Exports and Imports are affected by Government Policies

The Singapore government has provided infrastructures such as Jurong Island for high-end chemical manufacturing and Biopolis for pharmaceutical manufacturing. It has also given incentives such as grants and tax concessions to attract foreign high-end chemical firms and pharmaceutical firms to invest in Singapore. As a result, Singapore has developed a comparative advantage in producing high-end chemicals and pharmaceuticals resulting in an increase in exports of these goods. Singapore has signed 20 free trade agreements and this has also led to an increase in foreign direct investments. As a large number of these investments were made by multinational corporations with high-end production technologies, this has helped Singapore develop a comparative advantage in several high value-added industries resulting in an increase in exports of goods produced in these industries. To reduce dependence on imported water, the Singapore government subsidises the production of drinking water through seawater desalination and wastewater reclamation to increase self-sufficiency in its water supply. This has led to a decrease in the import of water.

Note:   The Principal Economics Tutor will discuss the pattern of trade between Singapore and the rest of the world in greater detail in the economics tuition class.

3          PROTECTIONISM

Although international trade is beneficial, free trade may be undesirable which gives rise to the arguments for protectionism. Protectionism is the use of measures by the government to protect domestic industries from foreign competition.

3.1       Protectionist Measures

Tariffs

Tariffs are taxes imposed on imports. The government can protect domestic industries by increasing tariffs to increase the prices of imports. When this happens, households and firms will switch from imports to domestic goods.

In the above diagram, the domestic demand and the domestic supply are DD and SD respectively. The world supply is SW and hence the world price is PW. Domestic firms charge a price of P0 to match the world price of PW. At P0, the quantity demanded (QD0) is greater than the quantity supplied (QS0) and the import is (QD0 – QS0). If the government imposes a tariff (t), firms will increase the price from P0 to P1 where P1 is P0 + t. When the price rises from P0 to P1, the quantity demanded will fall from QD0 to QD1 and the quantity supplied will rise from QS0 to QS1 and hence the import will decrease from (QD0 – QS0) to (QD1 – QS1). However, a tariff will lead to a fall in the consumer surplus from the sum of area 1, area 2, area 3, area 4 area 5 and area 6, to the sum of area 1 and area 2. Although area 3 will be captured by firms in the form of producer surplus and area 5 will be captured by the government in the form of tax revenue, area 4 and area 6 are not captured by any party is hence the deadweight loss.

Import Quotas

An import quota is a limit imposed on the quantity of a good that can be imported into a country. The government can protect domestic industries by imposing import quotas which will decrease the quantity of imports. When this happens, domestic residents will buy more domestic goods.

Subsidies

The government can protect domestic industries by giving them subsidies to decrease their costs of production and hence prices. When this happens, households and firms will switch from imports to domestic goods.

Procurement Policies

The government can protect domestic firms by adopting a policy of buying domestic goods and services to decrease the quantity of imports even if domestic goods and services are more expensive or of lower quality than imports.

Voluntary Export Restraints

Voluntary export restraints are agreements between two economies where the government of the exporting economy agrees to limit the quantities of certain goods exported to the importing economy. They are usually signed in the face of threatened actions by the government of the importing economy. The government can protect domestic firms by signing voluntary export restraints with exporting economies to decrease the quantity of imports. When this happens, domestic residents will buy more domestic goods.

Exchange Controls

Exchange controls are limits imposed on foreign currency made available to domestic residents. The government can protect domestic firms by imposing exchange controls to decrease the quantity of imports. When this happens, domestic residents will buy more domestic goods.

Health and Safety Regulations

The government can protect domestic firms by setting restrictive health and safety standards of imports to decrease the quantity. When this happens, domestic residents will buy more domestic goods.

Embargoes

An embargo is a ban imposed on the export or the import of a good. The government can protect domestic firms by imposing embargoes to decrease the quantity of imports. When this happens, domestic residents will buy more domestic goods.

Note:   Students are not required to draw the tariff diagram in the examination as it is not in the Singapore-Cambridge GCE ‘A’ Level Economics syllabus. However, they are required to be able to explain how tariffs will lead to a rise in the prices of imports, a fall in the quantity of imports and deadweight loss.

3.2       Arguments For and Against Protectionism

Infant Industry Argument (Sunrise Industry Argument)

Protectionism may allow infant industries to grow. Infant industries are small and hence have a cost disadvantage over their mature foreign competitors which are bigger. Therefore, in the face of international trade, infant industries may not be able to grow. If this happens, the number of goods of comparative advantage and hence the range of goods produced in the economy will decrease in the long run. When this happens, the rate of economic growth will fall and the volatility of economic growth will rise. By providing protection to infant industries, the government can help firms in the industries expand their scales of production. When firms in infant industries expand their scales of production, they will reap more economies of scale. A fall in average cost will allow them to lower their prices which may enable them to compete with their mature foreign competitors, at which point protection can be removed. If this happens, the number of goods of comparative advantage and hence the range of goods produced in the economy will increase in the long run. When this happens, the rate of economic growth will rise and the volatility of economic growth will fall. However, this argument is not without its counter-arguments. First, protectionism will reduce competition which may foster inefficiency and this may lead to the outcome that the protected industries never become competitive. Second, protection is hard to remove once it is given due to resistance from vested interests and this will put a strain on the government budget which may compel the government to decrease expenditure on other important areas such as education and infrastructure to avoid a budget deficit and this may result in adverse consequences for the economy in the long run.

Declining Industry Argument (Sunset Industry Argument)

Protectionism allows declining industries to decline at a slower rate. Recall that the structure of the economy changes when some industries expand and some industries contract and this may be due to technological advancements, changes in comparative advantage or changes in the pattern of demand. When this happens, the expanding industries create jobs and the contracting industries lose jobs. However, as workers who lose their jobs in the contracting industries possess low skills, they do not have the relevant skills and knowledge to find jobs in the expanding industries which require high skills and this leads to structural unemployment. By providing protection to declining industries, the government can help them phase out at a slower rate. If this happens, low-skilled workers who are employed in the industries will have more time to undergo education and training in order to acquire the relevant skills and knowledge to find jobs in the expanding industries. When this happens, structural unemployment will be lower. However, providing protection to declining industries may reduce the incentive for low-skilled workers who are employed in the industries to acquire the relevant skills and knowledge to find jobs in the expanding industries. This will prolong the inefficient use of resources in the economy which will prevent the economy from more fully reaping the benefit of specialisation and international trade on the basis of comparative advantage.

Job Protection Argument

Protectionism may reduce job losses in an economy in a recession. Job losses occur in a recession due to a fall in the demand for labour in the economy caused by a decrease in production. By making imports more expensive or domestic goods cheaper, the government can induce households and firms to switch from imports to domestic goods. When this happens, the demand for domestic goods and services will rise which will lead to an increase in the demand for labour in the economy and this will reduce job losses. However, this argument is not without its counter-arguments. First, if the trading partners retaliate, the reduction in job losses in the protected industries may be offset by an increase in job losses in other industries. Second, job losses in other industries may also increase in the absence of retaliation if protectionism leads to a fall in the national incomes and hence the imports of the trading partners.

Balance of Payments Argument

Protectionism may correct a persistent balance of payments deficit. A persistent balance of payments deficit is undesirable for the economy as it may lead to high imported inflation, lower national income, higher unemployment and rising public debt. By making imports more expensive or domestic goods cheaper, the government can induce households and firms to switch from imports to domestic goods. When this happens, the current account and hence the balance of payments will improve. If the economy has a persistent balance of payments deficit, the improvement may correct the deficit. However, this argument is not without its counter-arguments. First, if the trading partners retaliate, export revenue will fall which will worsen the current account and hence the balance of payments. Second, export revenue may also fall in the absence of retaliation if protectionism leads to a fall in the national incomes and hence the imports of the trading partners. Third, if the persistent balance of payments deficit is due to a high cost of production or low product quality in the economy, protectionism will not solve the root cause of the problem.

Anti-dumping Argument

Protectionism is a countervailing measure against dumping. Recall that dumping occurs when imports are sold at prices below their marginal costs which is often done with the help of foreign government subsidies. A country which engages in international trade may be subject to dumping. If dumping occurs, although consumers will benefit from lower prices in the short run, domestic firms may be driven out of the market in the long run which will lead to job losses resulting in a rise in unemployment. Furthermore, in the event that foreign firms monopolise the domestic market, they are likely to raise prices to increase profits and this may cause consumers to suffer from high prices. By providing protection to industries which are subject to dumping, the government can help them compete fairly with their foreign competitors. However, this argument is not without its counter-arguments. First, dumping is difficult to prove as it is difficult to measure marginal cost in reality. For firms that engage in mass production on assembly line, marginal cost is virtually impossible to measure. Second, if lower prices of imports are due to greater efficiency of foreign firms rather than dumping with the help of foreign government subsidies, protectionism may invite retaliation which will lead to a fall in exports resulting in a deterioration in the balance of payments and a fall in economic growth.

Other Arguments

There are several other arguments for protectionism which include the strategic industry argument and the diversification argument. Some industries produce vital goods such as food, water and armaments, where over-dependence on imports may put the country at great risk in the event that international trade is disrupted which may happen in times of war. Protectionism helps a country maintain a certain degree of self-sufficiency in these areas. A highly specialised economy, such as Cuba with sugar, is very susceptible to world market fluctuations which may lead to economic instability. Protectionism helps an economy achieve greater diversification which reduces these risks.

In addition to the counter-arguments of the arguments discussed above, protectionism is criticised on other grounds. First, protectionism through some measures such as increasing tariffs will lead to higher prices for consumers. Furthermore, it will lead to deadweight loss as the fall in the consumer surplus is not fully captured by firms in the form of producer surplus and captured by the government in the form of tax revenue. Second, protectionism precludes the realisation of the benefit of complete specialisation and international trade.

Note:   Although there are several arguments for protectionism, some arguments are stronger than others. For example, the strategic industry argument is stronger than the job protection argument. In fact, protectionism was one of the major factors that led to the massive job losses in the Great Depression of the 1930s. Therefore, in times of recession, governments should refrain from protectionism.

The Principal Economics Tutor will discuss the arguments for and against protectionism in greater detail in the economics tuition class.

4          THE TERMS OF TRADE

The terms of trade refer to the number of units of imports that can be obtained with one unit of exports. It is expressed as the ratio of the price of exports to the price of imports.

                               Price of exports
Terms of trade = ————————-
Price of imports

The terms of trade can be expressed as an index.

                                 Price index of exports
Terms-of-trade index = ——————————— × 100
Price index of imports

If the terms of trade rise which means that the price of exports rises relative to the price of imports, they are said to have improved or moved in a favourable direction. If the terms of trade fall which means that the price of exports falls relative to the price of imports, they are said to have deteriorated or moved in an unfavourable direction.

4.1       Factors Affecting the Terms of Trade

Changes in the terms of trade may be due to three factors: demand factors, supply factors and the exchange rate factor.

Demand Factors

When the demand for exports rises, the price will rise which will lead to a rise in the terms of trade. Conversely, a decrease in the demand for exports will lead to a fall in the price resulting in a fall in the terms of trade. When the demand for imports falls, the price will fall which will lead to a rise in the terms of trade. Conversely, an increase in the demand for imports will lead to a rise in the price resulting in a fall in the terms of trade.

Supply Factors

When the supply of exports falls, the price will rise which will lead to a rise in the terms of trade. Conversely, an increase in the supply of exports will lead to a fall in the price resulting in a fall in the terms of trade. When the supply of imports rises, the price will fall which will lead to a rise in the terms of trade. Conversely, a decrease in the supply of imports will lead to a rise in the price resulting in a fall in the terms of trade.

Exchange Rate Factor

When the exchange rate rises, the price of imports in domestic currency will fall which will lead to a rise in the terms of trade. Conversely, a fall in the exchange rate will lead to a rise in the price of imports in domestic currency resulting in a fall in the terms of trade.

4.2       Effect of a Change in the Terms of Trade on the Balance of Trade

The effect of a change in the terms of trade on the balance of trade depends on the cause of the change.

Demand Factors

When the demand for exports rises, the price will rise which will lead to a rise in the terms of trade. An increase in the demand for exports will also lead to an increase in the quantity. When the price and the quantity of exports rise, export revenue will increase which will lead to an improvement in the balance of trade. Conversely, when the demand for exports falls, the price will fall which will lead to a fall in the terms of trade. A decrease in the demand for exports will also lead to a decrease in the quantity. When the price and the quantity of exports fall, export revenue will decrease which will lead to a deterioration in the balance of trade.

When the demand for imports falls, the price will fall which will lead to a rise in the terms of trade. A decrease in the demand for imports will also lead to a decrease in the quantity. When the price and the quantity of imports fall, import expenditure will decrease which will lead to an improvement in the balance of trade. Conversely, when the demand for imports rises, the price will rise which will lead to a fall in the terms of trade. An increase in the demand for imports will also lead to an increase in the quantity. When the price and the quantity of imports rise, import expenditure will increase which will lead to a deterioration in the balance of trade.

Therefore, when the demand for exports or imports changes, the terms of trade and the balance of trade will change in the same direction.

Supply Factors

When the supply of exports rises, the price will fall which will lead to a fall in the terms of trade. An increase in the supply of exports will also lead to an increase in the quantity. When the price of exports falls and the quantity rises, if the demand is price inelastic, which means that the decrease in the price will lead to a smaller proportionate increase in the quantity demanded, export revenue will decrease which will lead to a deterioration in the balance of trade. However, if the demand for exports is price elastic, which means that the decrease in the price will lead to a larger proportionate increase in the quantity demanded, export revenue will increase and hence the balance of trade will improve. Conversely, when the supply of exports falls, the price will rise which will lead to a rise in the terms of trade. A decrease in the supply of exports will also lead to a decrease in the quantity. When the price of exports rises and the quantity falls, if the demand is price inelastic, export revenue will increase which will lead to an improvement in the balance of trade. However, if the demand for exports is price elastic, export revenue will decrease and hence the balance of trade will worsen.

When the supply of imports falls, the price will rise which will lead to a fall in the terms of trade. A decrease in the supply of imports will also lead to a decrease in the quantity. When the price of imports rises and the quantity falls, if the demand is price inelastic, import expenditure will increase which will lead to a deterioration in the balance of trade. However, if the demand for imports is price elastic, import expenditure will decrease and hence the balance of trade will improve. Conversely, when the supply of imports rises, the price will fall which will lead to a rise in the terms of trade. An increase in the supply of imports will also lead to an increase in the quantity. When the price of imports falls and the quantity rises, if the demand is price inelastic, import expenditure will decrease which will lead to an improvement in the balance of trade. However, if the demand for imports is price elastic, import expenditure will increase and hence the balance of trade will worsen.

Therefore, when the supply of exports (imports) changes, the terms of trade and the balance of trade will change in the same direction if the demand for exports (imports) is price inelastic. However, if the demand for exports (imports) is price elastic, the terms of trade and the balance of trade will change in opposite directions.

Exchange Rate Factor

When the exchange rate rises, the price of imports in domestic currency will fall which will lead to a rise in the terms of trade. When the price of imports falls, the quantity demanded will rise. If the demand for imports is price elastic, which means that the decrease in the price will lead to a larger proportionate increase in the quantity demanded, import expenditure will increase which will lead to a deterioration in the balance of trade. Furthermore, a rise in the exchange rate will increase the price of exports in foreign currency which will lead to a decrease in the quantity demanded. Since the price of exports in domestic currency will not be affected by a rise in the exchange rate, a decrease in the quantity demanded will lead to a decrease in export revenue. Therefore, even if the demand for imports is price inelastic, which means that import expenditure will fall, if the sum of the price elasticities of demand for exports and imports is greater than one, the decrease in export revenue will be greater than the decrease in import expenditure which will lead to a deterioration in the balance of trade, assuming export revenue is equal to import expenditure initially. This will be explained in greater detail in Section 4.3.

When the exchange rate falls, the price of imports in domestic currency will rise which will lead to a fall in the terms of trade. When the price of imports rises, the quantity demanded will fall. If the demand for imports is price elastic, which means that the increase in the price will lead to a larger proportionate decrease in the quantity demanded, import expenditure will decrease which will lead to an improvement in the balance of trade. Furthermore, a fall in the exchange rate will decrease the price of exports in foreign currency which will lead to an increase in the quantity demanded. Since the price of exports in domestic currency will not be affected by a fall in the exchange rate, an increase in the quantity demanded will lead to an increase in export revenue. Therefore, even if the demand for imports is price inelastic, which means that import expenditure will rise, if the sum of the price elasticities of demand for exports and imports is greater than one, the increase in export revenue will be greater than the increase in import expenditure which will lead to an improvement in the balance of trade, assuming export revenue is equal to import expenditure initially. This will be explained in greater detail in Section 4.3.

Therefore, when the exchange rate changes, the terms of trade and the balance of trade will change in the same direction if the sum of the price elasticities of demand for exports and imports is less than one. However, if the sum of the price elasticities of demand for exports and imports is greater than one, the terms of trade and the balance of trade will change in opposite directions.

Note:   Although the terms of trade are affected by changes in the prices of exports and imports, the balance of trade is affected by changes in the prices and the quantities of exports and imports.

4.3       The Marshall-Lerner Condition

The Marshall-Lerner condition states that for a devaluation of domestic currency to improve the balance of payments, the sum of the price elasticities of demand for exports and imports must be greater than one.

A fall in the exchange rate will lead to a rise in the price of imports in domestic currency. When the price of imports rises, the quantity demanded will fall. If the demand for imports is price elastic, which means that the increase in the price will lead to a larger proportionate decrease in the quantity demanded, import expenditure will decrease which will lead to an improvement in the balance of trade. If the demand for imports is price inelastic, import expenditure will rise. However, the balance of trade may not deteriorate. A fall in the exchange rate will decrease the price of exports in foreign currency which will lead to an increase in the quantity demanded. Since the price of exports in domestic currency will not be affected by a fall in the exchange rate, an increase in the quantity demanded will lead to an increase in export revenue. Therefore, if the sum of the price elasticities of demand for exports and imports is greater than one, which means that the Marshall-Lerner condition holds, the increase in export revenue will be greater than the increase in import expenditure which will lead to an improvement in the balance of trade, assuming export revenue is equal to import expenditure initially. However, if the sum of the price elasticities of demand for exports and imports is less than one, which means that the Marshall-Lerner condition does not hold, the increase in export revenue will be less than the increase in import expenditure which will lead to a deterioration in the balance of trade, assuming export revenue is equal to import expenditure initially.

Proof

Let PX be the price of exports in foreign currency,
PM be the price of imports in domestic currency,
PXDC be the price of exports in domestic currency,
│PEDM│ be the price elasticity of demand for imports,
│PEDX│ be the price elasticity of demand for exports,
BOT be the balance of trade and E be the exchange rate.

Assume that │PEDM│ = 0.6,
BOT = PXDCQX – PMQM = 0 (i.e. PXDCQX = PMQM) and
E↓ = 10%.

E↓(10%) → PM­↑(10%) → QM↓(6%) → PMQM­↑(4%)(approximately)

Since PMQM increases by 4%, the BOT will improve only if PXDCQX increases by more than 4%.

E↓(10%) → PX↓ (10%) → QX­↑

Since a fall in E will not affect PXDC, PXDCQX will increase by more than 4% only if QX increases by more than 4%, which means that │PEDX│ > 0.4. Therefore, a devaluation of domestic currency will improve the BOT only if │PEDX + PEDM│ > 1 (i.e. the Marshall-Lerner condition holds), assuming export revenue is equal to import expenditure initially.

The demand for imports is likely to be price inelastic in Singapore as domestic goods are not a close substitute for imports due to the limited overlap. However, the demand for exports is likely to be price elastic in Singapore as there exist many substitutes. Singapore exports mainly high value-added goods which include high-end electronics such as electronic valves, and high-end chemicals such as refined petroleum products, and these goods are also produced in many other developed economies such as the United States. Therefore, the Marshall-Lerner condition is likely to hold in Singapore.

The Marshall-Lerner condition is more likely to hold in the long run than in the short run. This is because exports and imports are generally subject to contractual agreements and hence are unlikely to respond significantly to a change in the prices in the short run. Furthermore, imports are unlikely to respond significantly to a change in the prices in the short run as time is required for consumers to change their consumption patterns and for firms to develop domestic substitutes.

Apart from the fact that the Marshall-Lerner condition may not hold, there are also other reasons why a devaluation of domestic currency may not improve the balance of payments. First, if there is no or little excess production capacity in the economy, firms will need to increase production capacity to be able to increase output for export. However, as it takes time to increase production capacity, a devaluation of domestic currency may not lead to a significant increase in export revenue in the short run. Second, a fall in the exchange rate will lead to a rise in the prices of imported intermediate goods in domestic currency which will increase the cost of production of exports, and this is particularly true if the exports have high import content such as the case in Singapore. As an increase in the cost of production of exports will lead to a rise in the prices, other things being equal, a devaluation of domestic currency may not lead to a significant increase in export revenue.

Note:   Although the Marshall-Lerner condition holds when the sum of the price elasticities of demand for exports and imports is greater than one, the price elasticities of demand for exports and imports need not be greater than one individually. In other words, it is not necessary for the demand for exports and the demand for imports to be price elastic for the Marshall-Lerner condition to hold. 

Although the Marshall-Lerner condition is a requirement for a devaluation of domestic currency to improve the balance of payments, it is not a requirement for a devaluation of domestic currency to increase aggregate demand. This is because unlike net exports in the balance of payments which are measured at current prices, net exports in aggregate demand are measured at base-year prices. In other words, although net exports in the balance of payments are measured in nominal terms, net exports in aggregate demand are measured in real terms.

The Principal Economics Tutor will discuss the Marshall-Lerner condition in greater detail in the economics tuition class.

5          FREE TRADE AGREEMENT

A free trade agreement (FTA) is an agreement between two or more economies to remove or reduce barriers to trade with the objective of increasing the cross-border movement of goods and services between the economies. Singapore has signed over 20 FTAs which is the highest number in the world. Signing more FTAs will bring about both benefits and costs in Singapore.

Beneficial Effects: Improvement in the Balance of Payments

If Singapore signs more FTAs, the balance of payments may improve. When tariffs on Singapore’s goods are removed or reduced in the FTA member countries, firms that import and sell Singapore’s goods in the FTA member countries will decrease prices to maintain competitiveness. Therefore, signing FTAs in Singapore will make Singapore’s goods cheaper in the FTA member countries. When this happens, exports in Singapore to the FTA member countries will increase which will lead to an improvement in the current account and hence the balance of payments of Singapore. For example, the USSFTA which came into effect in 2004 led to an increase in Singapore’s exports to the United States. Furthermore, firms in non-member countries that export goods to the FTA member countries and want to circumvent the tariffs will invest in Singapore. By setting up production facilities in Singapore, the goods that they produce in Singapore and export to the FTA member countries, which will be subject to lower or no tariffs, will be cheaper than those that they produce in non-member countries and export to the FTA member countries, other things being equal. This will lead to an increase in their sales and hence profits. When this happens, the increase in foreign direct investments in Singapore will lead to an improvement in the capital and financial account and hence the balance of payments. For example, apart from an increase in exports, the USSFTA also led to an increase in foreign direct investments in Singapore.

Beneficial Effects: Increase in Aggregate Demand

Signing more FTAs in Singapore may lead to an increase in aggregate demand resulting in an increase in national output and hence national income. The increase in exports and investment expenditure in Singapore will lead to 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. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Beneficial Effects: Increase in Aggregate Supply

If Singapore signs more FTAs, aggregate supply will rise. When tariffs on imported intermediate goods from the FTA member countries are removed or reduced in Singapore, firms that import these goods will decrease prices to maintain competitiveness. Therefore, signing more FTAs in Singapore will lead to a fall in the prices of imported intermediate goods. For example, Singapore has signed over 20 FTAs and this has led to a fall in the prices of imported intermediate goods. When this happens, the cost of production in the economy will fall which will lead to an increase in aggregate supply. An increase in aggregate supply will lead to an increase in national output and hence national income resulting in a fall in unemployment. Assuming aggregate demand is rising which is the normal state of the economy, an increase in aggregate supply will also lead to a smaller rise in the general price level resulting in lower inflation and if this makes Singapore’s goods and services relatively cheaper than foreign goods and services, net exports will rise which will lead to an improvement in the current account and hence the balance of payments.

Beneficial Effects: More Rapid Increase in Aggregate Supply in the Long Run

Signing more FTAs in Singapore will lead to a more rapid increase in aggregate supply in the long run. The increase in investment expenditure in Singapore will lead to a more rapid increase in the production capacity in the economy in the long run, assuming net investment is initially positive. Therefore, aggregate supply will rise at a faster rate in the long run. When this happens, assuming aggregate demand is rising which is the normal state of the economy, national output and hence national income will rise at a faster rate which may decrease unemployment, and the general price level will rise at a slower rate resulting in lower inflation which may improve the balance of payments.

Detrimental Effects

Although signing more FTAs in Singapore will bring about beneficial effects to the economy, it will also bring about detrimental effects. Signing FTAs in Singapore will make goods from the FTA member countries cheaper in Singapore due to the removal or reduction in tariffs on the goods. Therefore, if Singapore signs more FTAs, imports from the FTA member countries will increase. Imports will also rise due to the increase in national income. Furthermore, the rise in the general price level due to the increase in aggregate demand may make Singapore’s goods and services relatively more expensive than foreign goods and services which will lead to a decrease in net exports. The increase in foreign direct investments will lead to a larger increase in outward income remittances in the long run. For example, the increasing number of foreign firms in Singapore has led to rising outward income remittances. If these happen, the current account and hence the balance of payments will deteriorate, assuming the demand for exports is price elastic. Cheaper imports from the FTA member countries in Singapore will induce households and firms to switch from domestic goods to imports resulting in a decrease in the demand for domestic goods. When this happens, aggregate demand will fall which will lead to a decrease in national output and hence national income resulting in a rise in unemployment. Furthermore, 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. The production of low value-added goods such as disk drives requires low-skilled labour. Signing more FTAs in Singapore will lead to a more rapid decline in the low value-added industries if the FTA partners are developing economies which have a comparative advantage over Singapore in producing low value-added goods due to their larger amounts of low-skilled labour. If this happens, the rate at which low-skilled workers in Singapore are laid off will increase which will lead to a rise in structural unemployment. Since signing more FTAs in Singapore will increase exports and imports, the economy will become more susceptible to adverse economic conditions in other economies, such as recession and high inflation. As the exports and imports of Singapore are already very high, this may cause the economy to become unstable. Furthermore, if Singapore signs more FTAs, some infant industries that produce high value-added goods such as photonics and nanotechnology may not be able to survive if the FTA partners are developed economies where many high value-added goods are produced in mature industries. If this happens, the number of goods of comparative advantage and hence the range of goods produced in Singapore will decrease in the long run which will decrease the rate and increase the volatility of economic growth. If Singapore signs more FTAs, the more rapid expansion of the export industries that produce high value-added goods will lead to a more rapid increase in the demand for high-skilled workers and the more rapid decline in the low value-added industries will lead to a more rapid decrease in the demand for low-skilled workers. This will result in a more rapid increase in the wages of high-skilled workers and depress the wages of low-skilled workers which will cause income inequity to worsen.

Note:   The benefits of signing more FTAs to Singapore are likely to outweigh the costs. Due to limited overlap between imports and domestic goods in Singapore, the increase in imports is unlikely to have a large effect on the demand for domestic goods and hence is unlikely to lead to a large decrease in aggregate demand. In contrast, as Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, the increase in exports and investment expenditure is likely to lead to a substantial increase in aggregate demand. Therefore, signing more FTAs in Singapore is likely to lead to an increase in aggregate demand which will lead to an increase in national output and hence national income resulting in a fall in unemployment. Indeed, aggregate demand in Singapore has been rising which can partly be attributed to the signing of over 20 free trade agreements, which is the highest number in the world. Furthermore, domestic firms in Singapore are small and hence have limited financial resources for investment and research and development and this constrains the growth of the production capacity in the economy and hence economic growth. Therefore, the increase in foreign direct investments which will lead to a more rapid increase in the production capacity in the economy and hence higher economic growth is likely to be very beneficial to the economy. This is particularly true in view of the fact that foreign direct investments are generally made by multinational corporations which typically have high-end production technologies, apart from their substantial financial resources.

The Principal Economics Tutor will discuss free trade agreement in greater detail in the economics tuition class.

6          GROWTH OF CHINA

China is one of the fastest growing economies in the world and is currently the second largest behind the United States. Its rapid economic growth over the last few decades has propelled it to become one of the world’s manufacturing powerhouses. The growth of China will bring about both costs and benefits in Singapore.

Detrimental Effects: Deterioration in the Balance of Payments

The growth of the Chinese economy may lead to a deterioration in the balance of payments of Singapore. The production of low value-added goods such as disk drives requires low-skilled labour. Due to its larger amount of low-skilled labour, China has a comparative advantage over Singapore in producing low value-added goods. When the Chinese economy grows, the supply of the low value-added goods produced in China will increase which will lead to a fall in the prices. When this happens, the demand for the low value-added goods produced in Singapore will fall as people switch to the low value-added goods produced in China. Therefore, the growth of the Chinese economy will lead to a fall in Singapore’s exports of low value-added goods. For example, Singapore’s exports of hard disks have decreased partly due to the growth of the Chinese economy. Furthermore, due to the same reason, Singapore’s imports of low value-added goods from China will increase. When these happen, the current account and hence the balance of payments of Singapore will deteriorate. When the Chinese economy grows, households will become more affluent which will lead to a larger consumer market. Therefore, the growth of the Chinese economy will attract foreign direct investments away from Singapore. For example, the growth of foreign direct investment in Singapore has generally decreased over the last two decades partly due to the growth of the Chinese economy. Furthermore, due to the same reason, firms in Singapore will increase investments in China. When these happen, the capital and financial account and hence the balance of payments of Singapore will deteriorate.

Detrimental Effects: Decrease in Aggregate Demand

When the Chinese economy grows, aggregate demand in Singapore may fall which may lead to a decrease in national output and hence national income. The decrease in net exports and investment expenditure in Singapore will lead to a decrease in aggregate demand which will induce firms to decrease production resulting in a decrease in national output. When firms decrease production, they will employ less factor inputs from households and hence will pay them less factor income which will lead to a decrease in national income. A decrease in national output will lead to a fall in the demand for labour in the economy resulting in a rise in unemployment. A decrease in aggregate demand in Singapore will lead to a fall in the general price level resulting in deflation. A decrease in aggregate demand in Singapore will lead to a surplus of goods and services resulting in a fall in the general price level. Furthermore, when aggregate demand in Singapore falls which will induce firms to decrease production, the decrease in the demand for factor inputs in the economy will lead to a fall in the prices. When this happens, the cost of production in the economy will fall which will induce firms to decrease prices to maintain competitiveness resulting in a fall in the general price level. When the general price level falls, households may expect it to fall further. If this happens, consumption expenditure will fall which will lead to a further decrease in aggregate demand.

Detrimental Effects: Decrease in Aggregate Supply

The growth of the Chinese economy may lead to a decrease in aggregate supply in Singapore. When the Chinese economy grows, the world demand for resources such as oil will increase which will lead to a rise in the prices. For example, the rapid growth of the Chinese economy before the 2008-2009 Global Financial Crisis was a major factor which led to the rapid rise in oil prices. When this happens, the cost of production in Singapore will rise which will lead to a decrease in aggregate supply. A decrease in aggregate supply will lead to a decrease in national output and hence national income resulting in a rise in unemployment. A decrease in aggregate supply will also lead to a shortage of goods and services resulting in a rise in the general price level and hence higher inflation, and if this makes Singapore’s goods and services relatively more expensive than foreign goods and services, net exports will fall which will lead to a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic.

Detrimental Effects: Higher Structural Unemployment and Worsening Income Inequity

When the Chinese economy grows, structural unemployment in Singapore will rise and income inequity will worsen. As China has a comparative advantage over Singapore in producing low value-added goods, the growth of the Chinese economy will lead to a more rapid decline in the low value-added industries in Singapore. When this happens, the rate at which low-skilled workers in Singapore are laid off will increase which will lead to a rise in structural unemployment. Furthermore, a more rapid decline in the low value-added industries will lead to a more rapid decrease in the demand for low-skilled workers. This will depress the wages which will cause income inequity to worsen.

Detrimental Effects: Less Rapid Increase in Aggregate Supply in the Long Run

When the Chinese economy grows, aggregate supply in Singapore may rise at a slower rate in the long run. The decrease in investment expenditure in Singapore will lead to a less rapid increase in the production capacity in the economy in the long run, assuming net investment remains positive. Therefore, aggregate supply will rise at a slower rate in the long run. When this happens, assuming aggregate demand is rising which is the normal state of the economy, national output and hence national income will rise at a slower rate which may increase unemployment, and the general price level will rise at a faster rate resulting in higher inflation which may worsen the balance of payments.

Beneficial Effects

Although the growth of the Chinese economy will bring about detrimental effects to the Singapore economy, it will also bring about beneficial effects. When the Chinese economy grows, households will become more affluent and hence their demand for high value-added consumer goods such as pharmaceuticals will rise. Furthermore, when firms in China increase output, they will need more high-value-added capital goods and intermediate goods. The production of high value-added goods requires high-skilled labour. Due to its larger amount of high-skilled labour, Singapore has a comparative advantage over China in producing high value-added goods. Therefore, the growth of the Chinese economy will lead to a rise in Singapore’s exports of high value-added goods. For example, Singapore’s exports of pharmaceuticals have increased partly due to the growth of the Chinese economy. The increase in outward foreign direct investments in Singapore will lead to a larger increase in inward income remittances in the long run. For example, the increasing number of Singapore firms in China has led to rising inward income remittances in Singapore. When these happen, the current account and hence the balance of payments will improve. When the Chinese economy grows, some firms will become larger. When this happens, some of them will expand overseas to Singapore due to several reasons such as the high availability of high-skilled labour which is essential for moving up the value-added chain and this will lead to an improvement in the capital and financial account and hence the balance of payments. For example, Singapore has attracted thousands of Chinese firms to invest in the economy partly due to its high availability of high-skilled labour. Due to the increase in exports and investment expenditure in Singapore, aggregate demand will rise which will lead to an increase in national output and hence national income resulting in a fall in unemployment. When the Chinese economy grows, it will produce more of the intermediate goods that Singapore needs. Given that China is a low-cost producer, Singapore will switch the import of these goods from high-cost producers to China. When this happens, the prices of imported intermediate goods in Singapore will fall which will lead to a fall in the cost of production in the economy resulting in an increase in aggregate supply. When aggregate supply rises, national output and hence national income will rise which will lead to a fall in unemployment. The increase in investment expenditure will lead to a more rapid increase in the production capacity in the economy and hence aggregate supply in the long run, assuming net investment is initially positive. When this happens, assuming aggregate demand is rising which is the normal state of the economy, national output and hence national income will rise at a faster rate which may decrease unemployment, and the general price level will rise at a slower rate resulting in lower inflation which may improve the balance of payments.

Note:  The benefits of the growth of the Chinese economy to the Singapore economy are likely to outweigh the costs. Due to the large amount of high-skilled labour and hence comparative advantage in producing high value-added goods in Singapore, Singapore’s exports consist of mainly high value-added goods with low value-added goods accounting for a smaller proportion of total exports. Therefore, economic growth in China is likely to lead to a larger increase in exports of high value-added goods than the decrease in exports of low value-added goods in Singapore which will lead to an increase in aggregate demand resulting in an increase in national output and hence national income. This is particularly true in view of the fact that Singapore is continually moving up the value-added chain. Indeed, the exports of Singapore have been increasing over the last few decades when China has been experiencing rapid economic growth. Furthermore, Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand. Therefore, the increase in exports is likely to lead to a substantial increase in aggregate demand resulting in a substantial increase in national output and hence national income. In addition, as Singapore imports a large amount of intermediate goods due to lack of factor endowments, the increase in imports of cheaper intermediate goods from China is also likely to be very beneficial to the Singapore economy as the cost of production in the economy is likely to fall substantially.

The Principal Economics Tutor will discuss the growth of China in greater detail in the economics tuition class.

7          GLOBALISATION

Globalisation refers to the increased integration of economies through an increase in flows of goods and services, capital and labour across international borders.

7.1       Trend Towards Globalisation

The first episode of globalisation began around the mid-19th century and ended with the outbreak of the First World War in 1914. The second episode of globalisation began when the Second World War ended in 1945 and continues today. There are several factors which lead to globalisation and they include 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.

Benefit of Specialisation and International Trade on the Basis of Comparative Advantage

The benefit of specialisation and international trade on the basis of comparative advantage is a factor which leads to globalisation. 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. For example, if country X has to forgo 2 units of good B to produce 1 unit of good A and country Y has to forgo 3 units of good B to produce 1 unit of good A, country X is said to have a comparative advantage over country Y in the production of good A. Assuming there are only two countries that can produce only two goods, if country X specialises in producing good A and country Y specialises in producing good B, the amount of each good in each country available for consumption will increase. Therefore, countries can gain from specialisation and international trade on the basis of comparative advantage. The benefit of specialisation and international trade on the basis of comparative advantage has been a main driver of globalisation since the first episode of globalisation which began around the mid-19th century.

Technological Advancement

Technological advancement is a factor which leads to globalisation. Information and communications technology has improved dramatically over the last two decades, most notably the invention of the internet. The internet has increased the ease of access and the availability of product information which has increased international trade. Furthermore, it has reduced the coordination costs of multinational corporations that have production facilities in more than one country which has led to an increase in foreign direct investment. In the past, transport costs were high. Therefore, many foreign goods were more expensive than domestic goods even though substantial differences in comparative advantage existed among countries which limited international trade. With the invention of faster, larger and more fuel-efficient planes and ships, transport costs have fallen substantially which has removed a major barrier to international trade resulting in an increase in international trade. In addition to an increase in international trade and foreign direct investment, improvement in information and communications technology and transportation has led to an increase in flows of labour across international borders.

Trade Liberalisation

Trade liberalisation is a factor which leads to globalisation. Trade liberalisation refers to the removal or reduction in barriers to trade between economies. The World Trade Organisation (WTO) which was established in 1995, and its predecessor organisation the General Agreement on Tariffs and Trade (GATT) which was established in 1948, provide a forum for negotiating agreements aimed at reducing barriers to international trade. They have conducted eight rounds of negotiations from the Geneva Round to the Uruguay Round resulting in many trade agreements involving the 161 WTO members. In addition, individual economies have reduced barriers to trade by signing free trade agreements with other economies on a bilateral as well as multilateral basis. For example, Singapore has signed over 20 free trade agreements which have reduced barriers to trade. These trade agreements have reduced barriers to international trade which have led to an increase in international trade.

Opening Up of Formerly Closed Economies

The opening up of formerly closed economies is a factor which leads to globalisation. For example, since the Chinese economy opened up in 1978, it has been importing and exporting increasingly more goods and services. China is now the largest exporter in the world and a major importer from many countries. Furthermore, it has become both a major destination and source of foreign direct investment due to several factors such as its low cost of production, fast-expanding consumer market and fast-growing firms. The opening up of formerly closed economies such as China has led to an increase in international trade and foreign direct investment.

7.2       Costs and Benefits of Globalisation to Developing Economies and Developed Economies

Globalisation will bring about both costs and benefits to developing economies (LDEs) and developed economies (DEs).

Beneficial Effects to LDEs: Improvement in the Balance of Payments

Globalisation may lead to an improvement in the balance of payments of LDEs. The production of low value-added goods such as disk drives requires low-skilled labour. Due to their larger amounts of low-skilled labour, LDEs such as China have a comparative advantage over DEs such as the United States in producing low value-added goods. Therefore, globalisation will lead to an increase in exports of low value-added goods in LDEs. For example, China’s exports of televisions and disk drives have increased through globalisation. When this happens, the current account and hence the balance of payments will improve. Furthermore, globalisation will lead to a flow of foreign direct investments from DEs to LDEs due to the lower costs of production in LDEs. When this happens, the capital and financial account of LDEs will improve. For example, China’s share of foreign direct investment in Asia has generally increased through globalisation.

Beneficial Effects to LDEs: Increase in Aggregate Demand

Aggregate demand in LDEs may rise due to globalisation which may lead to an increase in national output and hence national income. The increase in exports and investment expenditure in LDEs will lead to 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. An increase in national output will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Beneficial Effects to LDEs: Increase in Aggregate Supply

Aggregate supply in LDEs may rise due to globalisation. The import of better production technologies from DEs in LDEs will lead to a rise in labour productivity in LDEs resulting in a fall in the cost of production in the economy and hence an increase in aggregate supply. For example, China imports many advanced production technologies from the United States. An increase in aggregate supply will lead to an increase in national output and hence national income resulting in a fall in unemployment. Assuming aggregate demand is rising which is the normal state of the economy, an increase in aggregate supply will also lead to a smaller rise in the general price level resulting in lower inflation, and if this makes their goods and services relatively cheaper than those in DEs, their net exports will rise which will lead to an improvement in the current account and hence the balance of payments.

Beneficial Effects to LDEs: More Rapid Increase in Aggregate Supply in the Long Run

Globalisation may lead to a more rapid increase in aggregate supply in LDEs in the long run. The import of better production technologies from DEs and the increase in investment expenditure in LDEs will lead to a more rapid increase in the production capacity in the economy in the long run, assuming net investment is initially positive. Therefore, aggregate supply will rise at a faster rate in the long run. When this happens, assuming aggregate demand is rising, national output and hence national income will rise at a faster rate which may decrease unemployment, and the general price level will rise at a slower rate resulting in lower inflation which may improve the balance of payments.

Detrimental Effects to DEs

Globalisation may bring about detrimental effects to DEs. Due to the same reasons that may lead to an improvement in the balance of payments of LDEs, an increase in aggregate demand and a more rapid increase in aggregate supply in the long run, the balance of payments of DEs may worsen, aggregate demand may fall and aggregate supply may rise at a slower rate in the long run. Due to LDEs’ comparative advantage over DEs in producing low value-added goods, among other factors, globalisation will lead to a more rapid decline in the low value-added industries in DEs. When this happens, the rate at which low-skilled workers in DEs are laid off will increase which will lead to a rise in structural unemployment. Furthermore, a more rapid decline in the low value-added industries will lead to a more rapid decrease in the demand for low-skilled workers. This will depress the wages which will cause income inequity to worsen.

Beneficial Effects to DEs: Improvement in the Balance of Payments

Globalisation may lead to an improvement in the balance of payments of DEs. The production of high value-added goods such as pharmaceuticals requires high-skilled labour. Due to their larger amounts of high-skilled labour, DEs have a comparative advantage over LDEs in producing high value-added goods. Therefore, globalisation will lead to an increase in exports of high value-added goods in DEs. For example, Singapore’s exports of pharmaceuticals have increased through globalisation. The flow of foreign direct investments from DEs to LDEs will lead to a larger increase in inward income remittances in DEs in the long run. For example, the increasing number of Singapore firms in China has led to rising inward income remittances in Singapore. When these happen, the current account and hence the balance of payments will improve. When LDEs grow, some firms will become larger. When this happens, some of them will expand overseas to DEs due to several reasons such as the high availability of high-skilled labour which is essential for moving up the value-added chain and this will lead to an improvement in the capital and financial account and hence the balance of payments. For example, Singapore has attracted thousands of Chinese firms to invest in the economy partly due to its high availability of high-skilled labour.

Beneficial Effects to DEs: Increase in Aggregate Demand

The increase in exports and investment expenditure in DEs will lead to an increase in aggregate demand which will lead to an increase in national output and hence national income resulting in a fall in unemployment.

Beneficial Effects to DEs: Increase in Aggregate Supply

Aggregate supply in DEs may rise due to globalisation. The import of cheaper intermediate goods from LDEs in DEs will lead to a fall in the cost of production in the economy and hence an increase in aggregate supply in DEs. For example, Singapore imports many cheaper intermediate goods from China. The cost of production in DEs will also fall due to an inflow of cheaper labour from LDEs, both high-skilled and low-skilled, as wages in DEs are higher than those in LDEs. For example, Singapore attracts many cheaper workers from China to work in the economy.

Beneficial Effects to DEs: More Rapid Increase in Aggregate Supply in the Long Run

Globalisation may lead to a more rapid increase in aggregate supply in DEs in the long run. The inflow of foreign labour and the increase in investment expenditure in DEs will lead to a more rapid increase in the production capacity in the economy in the long run, assuming net investment is initially positive. Therefore, aggregate supply will rise at a faster rate in the long run.

Detrimental Effects to LDEs

Globalisation may bring about detrimental effects to LDEs. Due to the same reasons that may lead to an improvement in the balance of payments of DEs, the balance of payments of LDEs may worsen. The outflow of labour in LDEs may lead to a decrease in the supply of labour resulting in a decrease in aggregate supply. The problem of brain drain may make it difficult for them to move up the value-added chain which may lead to lower economic growth in the long run. The flow of foreign direct investments made by multinational corporations into LDEs may lead to the closure of smaller domestic firms that reap less economies of scale, and if this causes the economies to become over-dependent on these corporations that are footloose, unemployment may rise substantially if they pull their operations out of the economies in the future due to more favourable market conditions in other economies. 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. Due to the lax labour law and low environmental standards, the entry of multinational corporations into an economy may lead to labour exploitation and environmental degradation which may lower the standard of living.

Note:   LDEs are likely to benefit more from globalisation than DEs due to several reasons. Households in LDEs are poorer and hence have less purchasing power than those in DEs and this constrains the growth of consumption expenditure in LDEs. Therefore, LDEs are more dependent on external demand than DEs and hence LDEs are likely to benefit more from an increase in exports than DEs. For example, China is more dependent on external demand than the United States and the high export growth and hence high economic growth in China over the last few decades has propelled it to the second position of the world ranking of GDP, behind the United States. However, small DEs, due to their small domestic demand, may be more dependent on external demand than large LDEs and hence small DEs may benefit more from an increase in exports than large LDEs.  Furthermore, domestic firms in LDEs are smaller and hence have less financial resources for investment and research and development than those in DEs and this constrains the growth of the production capacity and hence economic growth in LDEs. This problem in LDEs is exacerbated by the low savings due to the low incomes which lead to a low supply of loanable funds resulting in high interest rates and hence high costs of borrowing. Therefore, an increase in foreign direct investments which will lead to a more rapid increase in the production capacity in the economy is likely to be more beneficial to LDEs than to DEs. This is particularly true in view of the fact that foreign direct investments are generally made by multinational corporations which typically have high-end production technologies, apart from their substantial financial resources.

The Principal Economics Tutor will discuss the costs and benefits of globalisation to developing economies and developed economies in greater detail in the economics tuition class.

7.3       Costs and Benefits of Globalisation to Singapore

Globalisation has brought about both costs and benefits to Singapore.

Beneficial Effects to Singapore: Improvement in the Balance of Payments

Globalisation has led to an improvement in the balance of payments of Singapore. Globalisation has increased the imports of Singapore substantially over the last few decades and this is largely due to lack of factor endowments and the embracement of free trade. Singapore’s imports are now close to 200 per cent of its national income. The production of low value-added goods such as disk drives requires low-skilled labour. Singapore has a comparative disadvantage in producing low value-added goods due to the small amount of low-skilled labour. Therefore, Singapore imports mainly low value-added goods. However, globalisation has increased the exports of Singapore by a larger amount in the same period and this is largely due to the signing of many free trade agreements and control over the exchange rate. Singapore’s exports are now over 200 per cent of its national income. The production of high value-added goods such as pharmaceuticals requires high-skilled labour. Singapore has a comparative advantage in producing high value-added goods due to the large amount of high-skilled labour. Therefore, Singapore exports mainly high value-added goods. The larger increase in exports than imports in Singapore has led to an improvement in the current account and hence the balance of payments. Globalisation has led to a substantial increase in outward foreign direct investments in Singapore and this is largely due to the increase in investment opportunities in emerging economies such as China and the efforts of the Singapore government to increase outward foreign direct investments in order to increase inward income remittances. However, globalisation has led to a larger increase in inward foreign direct investments in Singapore and this is largely due to the high quality of labour, the low corporate income tax and the good infrastructure. The larger increase in inward foreign direct investments than outward foreign direct investments in Singapore has led to an improvement in the capital and financial account and hence the balance of payments.

Beneficial Effects to Singapore: Increase in Aggregate Demand

Aggregate demand in Singapore has risen due to globalisation which has led to an increase in national output and hence national income. Due to limited overlap between imports and domestic goods in Singapore, the increase in imports has not led to a large decrease in the demand for domestic goods and hence has not led to a large decrease in aggregate demand. In contrast, as Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, the increase in exports and investment expenditure has led to a substantial increase in aggregate demand. Therefore, globalisation has led to an increase in aggregate demand in Singapore 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. The increase in national output has created many jobs for the expanding labour force which has led to lower unemployment.

Beneficial Effects to Singapore compared with those to Other Economies: Increase in Aggregate Demand

The demand-side benefits of globalisation are greater in Singapore than in many other economies. As Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, the increase in exports due to globalisation has led to a substantial increase in aggregate demand. Furthermore, domestic firms in Singapore are small and hence lack the financial resources to make large investments. Therefore, the increase in foreign direct investments made by multinational corporations due to globalisation has also increased aggregate demand quite substantially. Large economies like the United States, by contrast, are more dependent on domestic demand and have large firms with the financial resources to make large investments and hence have benefited from the increase in exports and foreign direct investments due to globalisation to a smaller extent.

Beneficial Effects to Singapore: Increase in Aggregate Supply

Globalisation has led to an increase in aggregate supply in Singapore. Globalisation has led to an increase in the amount of imported capital goods and intermediate goods and a rise in the number of foreign workers and immigrants in Singapore which have resulted in a more rapid increase in the production capacity in the economy and hence aggregate supply. Furthermore, the increase in foreign direct investments has also led to a more rapid increase in the production capacity in the economy and hence aggregate supply. Due to the larger increase in aggregate supply, national output and hence national income has risen by a larger extent which has led to lower unemployment. Furthermore, the general price level has risen by a smaller extent resulting in lower inflation.

Beneficial Effects to Singapore compared with those to Other Economies: Increase in Aggregate Supply

The supply-side benefits of globalisation are greater in Singapore than in many other economies. Singapore virtually does not have factor endowments. Therefore, the increase in the amount of imported intermediate goods due to globalisation has increased aggregate supply substantially. Furthermore, Singapore has a small labour force due to the small population. Therefore, the rise in the number of foreign workers due to globalisation has also increased aggregate supply substantially. Large economies like Japan, by contrast, have more factor endowments and a larger labour force and hence have benefited from the increase in the amount of imported intermediate goods and the rise in the number of foreign workers due to globalisation to a smaller extent.

Detrimental Effects to Singapore: Greater Susceptibility to a Recession in Other Economies

Globalisation has increased the susceptibility of the Singapore economy to a recession in other economies. A recession in other economies will lead to a decrease in the external demand for Singapore’s goods and services. When this happens, as globalisation has led to high dependence of the Singapore economy on external demand with the domestic exports accounting for a large proportion of the aggregate demand, aggregate demand in Singapore is likely to fall substantially which is likely to lead to a large decrease in national output and hence national income resulting in a substantial rise in unemployment. 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 resulting in a large decrease in aggregate demand which led to a large decrease in national output and hence national income. In contrast, globalisation has increased the susceptibility of large economies such as the United States to a recession in other economies to a lesser extent.

Detrimental Effects to Singapore: Greater Susceptibility to High Inflation in Other Economies

Globalisation has increased the susceptibility of the Singapore economy to high inflation in other economies. High inflation in other economies will lead to a substantial rise in the prices of imports in Singapore. When this happens, as globalisation has led to high imports in Singapore, Singapore will experience high imported inflation. For example, the high inflation in other economies in 2008 due to the oil price shock was a major factor which caused inflation in Singapore to soar to 6.6 per cent which was a level not seen since 1981. In contrast, globalisation has increased the susceptibility of large economies such as Japan to high inflation in other economies to a lesser extent.

Detrimental Effects to Singapore: Higher Structural Unemployment

Globalisation has increased structural unemployment in Singapore. The production of low value-added goods such as disk drives requires low-skilled labour. Singapore has a comparative disadvantage in producing low value-added goods due to the small amount of low-skilled labour. Due to this reason, among other factors, globalisation has led to a more rapid decline in the low value-added industries. For example, the relocation of manufacturing plants by firms that produced low value-added goods in Singapore, such as Hitachi, Sanyo and Seagate, to China where the cost of production was lower caused the low value-added industries in Singapore to decline at a faster rate. As a result, the rate at which low-skilled workers are laid off has increased which has led to a rise in structural unemployment. In contrast, globalisation has led to a more rapid decline in the low value-added industries in many other economies to a lesser extent.

Detrimental Effects to Singapore: Worsening Income Inequity

Globalisation has worsened income inequity in Singapore. The production of high value-added goods such as pharmaceuticals requires high-skilled labour. Singapore has a comparative advantage in producing high value-added goods due to the large amount of high-skilled labour. Therefore, globalisation which has increased the export market has led to an expansion of the high value-added industries and this has increased the demand for high-skilled workers resulting in a rise in the wages. However, as Singapore has a comparative disadvantage in producing low value-added goods, globalisation has led to a contraction of the low value-added industries and this has decreased the demand for low-skilled workers resulting in a fall in the wages. The rise in the wages of high-skilled workers and the fall in the wages of low-skilled workers due to globalisation have caused income inequity to worsen. The Gini coefficient in Singapore, which is a measure of inequality of income distribution, is above the internationally recognised alarming level of 0.4 and is one of the highest among developed countries. Even after taking into consideration taxes and transfer payments, the Gini coefficient in Singapore still remains above 0.4 while those of other developed countries all fall below 0.35. In contrast, globalisation has worsened income inequity in many other economies to a lesser extent.

Note:   Singapore is likely to have benefited more from globalisation than other economies. Although globalisation has caused some problems in Singapore, with the use of exchange rate policy, and to a lesser extent, expansionary fiscal policy and short-term supply-side policies, the government has managed the problems well. Furthermore, measures to reduce income inequity, such as transfer payments, progressive taxes, education and training, tightening restrictions on low-skilled foreign workers, have been put in place by the government. In addition, with education and training, structural unemployment will fall in the long run. When this happens, resources will be channelled from less productive uses where the economy has a comparative disadvantage to more productive uses where the economy has a comparative advantage. Due to the small domestic demand of the Singapore economy, the small size of domestic firms, lack of factor endowments and the small labour force, globalisation has benefited Singapore substantially. Coupled with an export-driven economic growth strategy, a loose foreign worker policy and FDI-friendly policies, globalisation has helped Singapore achieve a high rate of economic growth over the last few decades, propelling it to near the top of the world ranking of GDP per capita. According to the International Monetary Fund, Singapore now has the third highest GDP per capita in the world, behind Qatar and Luxembourg. Furthermore, in the absence of globalisation, economic growth in Singapore would have been substantially lower as consumption expenditure had not increased substantially due to the culture of thrift, the compulsory savings scheme and the absence of a generous welfare system.

The Principal Economics Tutor will discuss the costs and benefits of globalisation to Singapore in greater detail in the economics tuition class.

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