specialisation versus diversification

8/2/2019 SpecialisatIon Versus Diversification

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Specialisation versus Diversification: Free trade and protectionism

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Specialisation versus Diversification:

Free trade and protectionism


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ContentsComparative Advantage ................................................................................................................. 3

Systematic Risk ............................................................................................................................... 5

Specialization versus Diversification ............................................................................................... 5

The Prisoners Dilemma and Infant Industries ............................................................................... 6

Regional Free Trade Agreements ................................................................................................... 6

Marginal Benefits of goods a and b; trade value inequalities ........................................................ 7

Market Making................................................................................................................................ 8

Free Trade and the GFC .................................................................................................................. 8

Summary ......................................................................................................................................... 9

Conclusion ..................................................................................................................................... 10

References .................................................................................................................................... 10


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(*Note: apologies for the biased selection

of cartoons.)

What is the basis for free trade? Why are

some governments (particularly the

Australian) so pro free trade? What is freetrade in theory and in practice and what

are the alternatives? Ill attempt to explain

the basics of free trade and the pro/ con

arguments below.

Briefly, free trade (as opposed to fair trade

which is very

different) is the free

exchange of goods

and services

between countries.

For free trade to

exist there must be

no government

imposed controls on

trade, be they tariffs

or import quotas.

The definition of

governmental

control can be

expanded to include

the subsidising of

domestic industries,

artificially inflating their profitability

compared to the foreign equivalent.

Fair trade, which I wont detail, is different

to free trade. Fair trade usually involves an

element of ethics in the trade process, such

as the large trading partner not taking

advantage of smaller one. Hence the

inclusion of the word fair. It could be

argued that fair trade and free trade are in

opposition as free trade is about free

market forces while fair involves ethically

directed market forces.

Comparative Advantage

Free trade does have a theoretical reason

for existence in classical economics. This is

the same justification most governments

will give for being anti-protectionist. Thisjustification is comparative advantage.

Comparative advantage assumes that

countries have an advantage in the

production of certain goods versus the

production of the

same good or

service in other

countries. This

advantage might

come about due

to presence of

natural resources,

serendipitous

development of a

high profit

industry or cheap

labour to namebut a few. Hence

an advantage to

compared to

another country.

To illustrate assume a simple two country

model; country A produces goods a and b

and country B produces goods a and b as

well.

Meshed with comparative advantage is the

concept of economies of scale. In its most

basic form economies of scale is where the

more you produce of something the

cheaper it becomes to produce. Really this

is just common sense, if you spend your

day making shoes youll get better and

quicker as you learn and improve your


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skills. Alternately if you make a pair every

now and then some time will be wasted

trying to remember what to do and where

your tools are. This form of specialisation is

the basis of mass production.

From an accounting

stand point the

production of all goods

and services require

both fixed and variable

costs. Fixed costs are

constant overheads

that must be paid

irrespective of the

amount produced,

lease payments would be an example.

Variable costs are dependent on

production.

The more you produce the more your total

variable cost rises. The sum of fixed and

variable is your cost to produce a good. As

fixed cost is a constant figure as I produce

more goods then the fixed cost will be

divided up amongst more and more items

and will reduce as a per item expenditure.

I.e. assume fixed cost is $100 and variable

cost is $10 per unit. Last week I made 10

units so cost per unit is $20 (($100/10)+$10

= $20) the following week I made 20 so my

cost per unit is $15 or (($100/20)+$10 =

$15).

The above is a very simplistic definition. As

you produce more of a good your

production should become

disproportionally cheaper up to a point.

Within reason, your per unit variable cost

will reduce as more is produced. This could

be from production efficiencies derived

from being able to specialise each step of

the production cycle.

The most relevant example of this would

be Australia. We are an exporter of

minerals because we, as a country, happento possess an

abundance of

resources.

Additionally we have

invested heavily in

the infrastructure to

process these

resources.

Free trade assumes

that goods and services can freely flow

between our two economies A and B.

Coupled with comparative advantage this

means that the country that is best at

producing a produces a and the same for

good b. In practice country A should focus

on the production of good a and country B

on good b. In theory this should mean that

the populations of both countries have

more ofa and b for less cost, time and raw

materials.

If free trade does not exist then countries

will be producing goods and services that

they do not have a comparative advantage

in. Thus total production will be less than

efficient. People will have less of a and b

than they could have.

Protectionism is the artificial protecting of

a domestic industry from foreign

competing industries importing into your

country. It can be direct or indirect

subsidies, quotas, tariff imposition etc.

Basically it is some action by the

government to give local producers an

advantage over foreign, usually at some

cost to local taxpayers. This is an important


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point, protectionism does impose a direct

cost for the consumer. A tariff barrier, for

example, means the cost of the import will

directly go up by some percentage. Other

methods are a little more subtle but will

result in a financial imposition upon the

taxpayer. This cost is usually very easy to

calculate and is often used as a reason for

not engaging in protectionist policies.

Free trade has numerous costs which are

hard to place a dollar figure against. These

costs revolve around social engineering

and the nature of risk. Ill detail some of

the commonly recognised and other less

common but still significant risks below.

Systematic Risk

The free trade world system could be

categorised as a network of

interdependent nodes, all reliant upon

each other. Each node in this network

performs a specialised function which the

network as a whole depends on to

continue operating.

A basic rule of thumb is that the bigger a

system is the greater the risk of the system

crashing. Imagine a supply chain to

produce a widget. If the raw materials for

the widget are manufactured next door

your risk is less than if those materials

were manufactured in another country.

The risk is greater because you have to

contend with sovereign risk of two

countries, not one and travel (and

incumbent risks) is also much greater. That

is the network is only as strong as its

weakest link.

Specialization versus Diversification

Systematic risk falls under the broader

debate concerning specialization and

diversification. Superannuation funds

diversify to minimise risk. Diversification

comes at the cost of not being able to take

full advantage of the big growth

investments. Conversely if all your

investments back one company then youllbe wiped out should it fail.

Harking back to the previous network

argument, if one specialised portion of the

network fails the whole system fails.

Specialisation creates efficiency but it also

promotes weakness and a lack of flexibility.

The situation globally is one of increased

specialisation.

Looking again at the example of Australia

and this time with our major trading

partner of China illustrates this point. The

majority of Australias manufactured goods

are produced in China. Australias

weakness in local manufacturing makes us

dependent on China for the majority of our

manufactured products, in turn we are

susceptible to risks from China. It is not

inconceivable that China will experiencesome form of political turmoil similar to

that of the recent North African civil unrest

in the near future. Should that happen

what will happen in Australia?

For a further example look at Europe in the

later half of 2011. The intermingling of the

economies results in all of Europe being at


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risk from the financial problems of Greece,

Spain and Italy.

The Prisoners Dilemma and the

Infant Industries Argument

The prisoners dilemma is an aspect of

game theory describing how individuals

have an incentive to cheat despite there

being valid reasons not to. This incentive

revolves around the prisoners perception

of risk.

The theory is illustrated by a scenario

where the police hold two prisoners in

custody suspected of a crime. The

prisoners are separated and despite the

absence of evidence to convict both are

offered a deal to inform on the other. Both

prisoners understand the police have

insufficient evidence to convict

nevertheless they have an incentive to

inform on the other BEFORE they are

informed on by their accomplice.

There are parallels to this situation and a

countries tariff relationship with its trading

partners. To illustrate, free trade provides

financial benefits to both participants (a &

b) however country A has a political

incentive to place tariffs on imports from B

to give an advantage to their home grown

industries. Of course once one country has

started imposing trade barriers the other

country should follow suit to balance out

the discrepancy in advantage. What thisshows is that a free trade situation is

fundamentally unstable.

This particular argument meshes very well

with the Infant industry argument against

free trade. An infant industry is one that is

starting out and by definition it will not

have acquired the economies of scale of

the overseas equivalent. Following the

logic of free trade, because this industry is

not as efficient as the overseas alternative

then it should not be pursued. This

argument does not consider that while the

new industry might be relatively inefficient

at inception it can become more efficient

and may develop economies of scale that

exceed the foreign competitors. That is

comparative advantages can change over

time.

As comparative advantages do change over

time skills and industries that are at a

disadvantage today may well prove to be

at an advantage tomorrow.

To remain viable an industry group must

maintain a certain critical mass. If an

industry shrinks too much then the loss of

skills might be too much to be overcome.

That industry might then be lost to that

particular economy. The only way to

resurrect it might be to rebuild from

scratch which would require enormous

quantities of both resources and time.

Regional Free Trade Agreements

FTAs are agreements between two or more

countries. FTAs cover much more than

trade flows, they can also detail foreign

investment practices, IP and a host of

activities which fall under the heading of

trade. The best known example would be

the NAFTA (North American Free TradeAgreement) between the USA, Canada and

Mexico.

Non-signatories to the agreement will

usually be penalised by tariffs or some

protection mechanism. The NAFTA

regulations allow countries to be sued by

corporations for obstruction to the free


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trade process. This type of agreement is

dependent in their being equalities in the

power and influence of member countries.

In practice, power equality is not the case.

Marginal Benefits of goods a and b;

trade value inequalities

Marginal benefit is an economists term to

express the additional satisfaction that a

consumer will derive from the

consumption of an additional unit of some

good or service. This concept is linked tothe concept of supply and demand

equilibrium and is an attempt to

mathematize psychological responses for

the convenience of economists.

The relationship between price, quantity,

supply and demand is usually graphed as

per the image below.

As price increases suppliers of a good or

service are eager to supply more. But as

the price increases for the same good

consumers will buy less. This concept ties

in with our own common sense and has

been well demonstrated time and again.

Thats why retailers have sales.

What will happen is that price and supply

will oscillate around an equilibrium point

due to the dynamic affect of a shifting

price on suppliers and consumers. It is very

unlikely that a stable price will be reached

though day to day fluctuations should start

to minimise. Of course that is dependent

upon a situation of perfect information

where suppliers and consumers possess

sufficient information to make decisions.

Why do consumers buy less and less of an

item as the price increases? This is what

the theory of marginal benefit attempts to

explain. Marginal benefit is the additional,

subjective benefit a consumer derives fromthe consumption of one extra unit of good

or service (UGS).

As more and more is consumed this

marginal benefit will tend to decline at

some rate. To illustrate, the second can of

Coke will not satisfy thirst to the same

degree as the first can. The third can even


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less so and so on. For a consumer to carry

on purchasing the UGS price must fall so

that satisfaction can be maintained.

This concept is illustrated by the first

packet of chips being much better than thethird! A consumer will carry on purchasing

up to the point where the marginal benefit

of the UGS is equal to the marginal benefit

of the dollar value of the product in cash.

By the way money has a marginal benefit

too.

Why is this important? Most UGS will have

differing marginal benefits. Free trade will

only work when there is equal trade

between countries. That is marginal benefit

of good a equals the marginal benefit of

good b. If this is not the case then there is

net shift of value from one country to

another.

This is because good a has a higher

marginal benefit then good b. Higher

marginal benefit means people will buy

more ofa than b. More a bought will result

in a trade imbalance, the country desiring a

must borrow or potentially sell off capital

to raise funds to buy the additional UGS

required. They cannot just sell more ofb as

due to its lesser marginal benefit they must

disproportionately cut bs price to increase

quantity sold.

This graph illustrates the point. The area

within the dotted lines represents the

value of trade, simply calculated by

multiplying Price by Quantity. In this

example UGS b earns less than UGS a.

Selling more will flood the market and

given the slope of the demand curve force

price down and probably reduce the area

of the revenue box. This situation becomes

extreme when one country is significantly

larger than the other.

Country a makes furnishings and timber

products, country b produces lumber from

tree felling. Another way of stating thecomparative marginal benefit example

from previous would be of the concept of

value addition; finished goods have more

value added to them than the raw

materials they are comprised of.

Manufacturing, machining, moulding, etc

adds value far in excess of the raw

materials (lumber) injected into a product.

That is a finished good will cost

disproportionately more than the raw

materials it is comprised of. So country a

will generate more revenue than country b.

This is called a trade imbalance and means

a net influx of wealth into country a, in

part, at the expense of country b.

Market Making

This is a situation where one country is so

much larger than its trading partner that isable to dominate the market. If country A

is significantly larger than country B then A

can exert influence over the domestic

industries of B. This situation is edging into

the fair trade arena and may not be a free

trade related issue.

Free Trade and the GFC

An interesting point that is often

overlooked is that free trade andglobalisation are strongly linked.

Globalisation, again in theory, is a good

thing. This is because globalisation and the

reduction in regulation in financial markets

means that finance can now easily cross

borders. So a country can now more easily

attract foreign investment to start up local

industries and create jobs. Reduced


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regulations means money can go where its

needed and everyone wins.

Great in theory. The reduction in financial

regulation from globalisation was also a

direct cause of the Global Financial Crisis.Reduced regulatory controls resulted in a

swathe of banks and investment houses

investing heavily in a sector they knew

nothing about. Risk was high but the rate

of return was enormous.

Inadequate regulatory controls allowed

these companies to gamble with peoples

savings and mortgages. The damage

caused by financial globalisation will be felt

for years to come and has had a direct and

dire impact on many peoples lives.

Summary

Free trade is the flow of goods andservices between countries

unimpeded by non-trade related

costs like tariffs, quotas etc.

Fair trade is the ethical trade ofgoods and services, where one

partner does not take advantage of

the others relative weakness. See

Fair Trade Coffee as an example.

The principle theoretical andpractical advantage of free trade is

comparative advantage. This

results in efficiencies of production

being

achieved fromspecialisation

and mass

production.

That is; more

for everyone

using less

resources.

Free trade has considerable risksthough. Such as:-

1. Systematic risks from specialisationmaking one country vulnerable to

political fluctuations in another.

2. The incentive to cheat. Free tradecreates a financial incentive for

one country to impose protection

before the other to try and derive a

short term political and/or

economic benefit. Free trade is

inherently unstable.

3. Infant industries would find it nearimpossible to commence

operations due to the advantagesof established industries.

Comparative advantages can

change over time.

4. Specialisation can lead to a loss ofskills. If there is sufficient loss of

skills then that industry might not

be recoverable.

5. Trade value inequalities. Value ofamight be less than b. Ultimately

this will lead to a net shift in

wealth from the producers of a to

the producers of b. Value addition

to a < value addition to b means

trade imbalance.

6. Market making. One country is somuch larger than the others that

they distort trade in their favour

due to their sheer

size.

Globalisation is a good thing

in theory. The

practice of

globalisation is

not quite so rosy.

See GFC.


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Conclusion

Free trade is a good thing. It results in

people having more for less. However to

look at the direct cost benefits free trade

as being the only decider on an optimaltrade policy overlooks the many significant

social benefits that protectionism

possesses (or costs that free trade has). It

is hard to put a dollar value on these

benefits, suffice it to say they are, for the

reasons cited, worth having.

Diversification versus specialisation is one

facet of the protectionism discussion that

is often overlooked. As an investor youwould not put all your money in one

company. Why then as a country would

you rely upon one industry? The real

question becomes what is the appropriate

level of protection that will permit a

country to possess the social benefits of

protection whilst still enjoying the

economic benefits of free trade?

I believe that free trade is so popular apolicy because it is so easy to put a price on

the cost of protection. As an economic

rationalist argument free trade is very hard

to beat.

The costs of free trade are far more subtle

and do not have as direct or immediate an

impact as those of protection. Instead the

cost of free trade will take time to make

itself felt in the gradual whittling away ofdomestic industry. Again the economic

rationalist approach would be to consider

that to be a reallocation of resources to

more efficient sectors of the economy from

the less efficient.

I would argue that a strong manufacturing

base is an essential element of any

developed economy. Unfortunately I am

not able to definitively say what

percentage of an economy should be

devoted to manufacturing.

For Australia, much is made of the fact thatthe numbers employed in manufacturing

have not fallen from 10 years ago.

Australias population has grown over that

time which means manufacturing has

fallen as a percentage of total

employment.

If this trend is not reversed or stopped

Australia will be known for only two things;

a tourist destination and a bunch of holes

in the ground. The writing is on the wall.

References

Many, many references. But mainly

Wikipedia.

specialisation versus diversification

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