Practise comparative advantage, PPC diagrams and free-trade calculations in IB Economics HL questions covering specialization, imports, exports and trade effects.
Study the following extract and answer the questions that follow.
Free Trade Agreement between the European Union and Indonesia
(1) The European Union (EU) and Indonesia are currently negotiating a free trade agreement (FTA). The agreement will aim to increase trade, avoid trade protection and expand foreign direct investment (FDI). Indonesia has the largest economy and population in Southeast Asia. The EU is Indonesia's third-largest trading partner.
(2) The FTA could see the clothing and footwear industry in Indonesia increase by over 10 %. However, the labour-intensive manufacturing industry has historically been known for poor working conditions and low wages. On the other hand, increased output could decrease the high unemployment in Indonesia (currently at 12 % ). The EU expects its car industry to benefit from the FTA. The agreement would encourage the EU to specialize in cars, and Indonesia to specialize in clothing, therefore both countries could benefit from comparative advantage.
(3) Since Indonesia's main competitors already have trade agreements with the EU, establishing an FTA is a priority for the Indonesian government. The EU has a potential market of 510 million consumers, and may offer areas for growth during a time of lower global trade and uncertainty due to the trade war between the United States and China.
(4) However, recent trade issues between the EU and Indonesia have slowed down negotiations. The EU announced that palm oil biodiesel is unsustainable and will phase these fuels out by 2030. Experts say that palm oil causes excessive deforestation and contributes to climate change. Indonesia is the world's largest exporter of palm oil.
(5) The EU has imposed tariffs on biodiesel exports from Indonesia, which may result in Indonesia losing a market worth over US$450 million. Palm oil represents 12% of Indonesia's total exports, contributes approximately 2.6 % to gross domestic product (GDP), and the industry employs more than 15 million people. The EU is Indonesia's largest palm oil customer. Additionally, some EU manufacturing businesses are unhappy with the tariffs as they rely on palm oil to produce their products, such as processed foods.
(6) In response, Indonesia filed a lawsuit with the World Trade Organization (WTO), stating that the EU's policy on biodiesel is unfair and is damaging the international image of palm oil. Indonesia claims it is committed to sustainable production practices and to protecting its forests.
(7) To make up for losing the EU's market, Indonesia is actively exploring other markets to boost its exports of palm oil. Other countries like China, India and Russia have a more relaxed policy on palm oil and have growing demand for it. Indonesia has also retaliated to the tariff through an investigation into whether EU dairy products exported to Indonesia benefited from subsidies, and has recommended a 20 %-25 % tariff on EU dairy products.
(8) However, the EU has tried to lower tensions by offering a US$17 million grant to improve trade conditions and capacity in preparation for the FTA. Experts have said that the FTA could support the development of legal and sustainable palm oil production through supporting good governance and capacity building. Indonesia has stated it would welcome help to decrease any market failure caused by palm oil.
Using a production possibilities curve (PPC) diagram to illustrate comparative advantage, explain why the EU would export cars to Indonesia and Indonesia would export clothing to the EU (paragraph 2).
Using information from the text/data and your knowledge of economics, discuss the economic effects on Indonesia of establishing a free trade agreement with the EU.
Text A - Overview of Vietnam
(1) Economic reforms in Vietnam during the past 30 years have led to rapid economic growth, which has transformed a poor nation into a lower middle-income economy. The percentage of the population with an income of less than US$1.90 a day declined from 38% in 2002 to below 2 % in 2018.
(2) Vietnam used to be a food-insecure nation, in which many people sometimes lacked access to affordable food, but it is now a leading exporter of basic food commodities. It also aims to become an exporter of high quality and processed food products. However, agricultural production only accounts for 18 % of gross domestic product (GDP), although it uses 40 % of the land and employs 43 % of the labour force. Due to the growing rural population, land is often divided up between a greater number of farmers, causing some farms to become smaller. These farms have fewer opportunities to benefit from economies of scale and lower average costs of production.
(3) Vietnam's rapid growth and industrialization, focused on export-oriented manufacturing, have had a harmful impact on the environment. Electricity consumption has tripled since 2010, growing faster than GDP. Electricity generation, which mainly uses fossil fuels, accounts for approximately 60 % of Vietnam's carbon emissions. Demand for water continues to increase. Unsustainable exploitation of natural resources, such as land, fisheries, and timber, could negatively affect prospects for long-term growth. In addition, Vietnam's primary sector is highly vulnerable to the climate and is therefore subject to supply shocks.
(4) Vietnam has signed several free trade agreements (FTAs). Its first FTA was a partnership with Japan in 2008. Both Vietnam and Japan are members of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which took effect at the beginning of 2019. These FTAs also promote inward foreign direct investment (FDI). In addition, Vietnam has introduced policies to attract foreign investment, such as tax incentives and spending on infrastructure.
(5) Japan is the biggest provider of foreign aid to Vietnam and the largest source of FDI. Japanese firms and aid agencies are jointly financing large-scale projects, including port infrastructure and a high-speed railway, which will reduce the Hanoi to Ho Chi Minh journey time from about 35 hours to under six hours. Other Japanese-funded aid projects are in the areas of health care, education, and the environment.
Text B - Trade and investment flows between Vietnam and Japan
(1) Japan imports seafood and consumer products such as textiles, leather shoes and processed foods from Vietnam, because Vietnam has a comparative advantage in such items. Conversely, Vietnam imports machinery, technology, and raw materials for production from Japan. Gradually barriers to trade are being removed. In 2020, Vietnam began exporting lychees (a luxury fruit) to Japan after five years of negotiations on quality standards. The improved access to the Japanese market has increased the number of consumers and the revenue earned by Vietnamese lychee farmers.
(2) Japanese firms invest in Vietnam, particularly in urban areas, because wages are low and they can export from Vietnam to other CPTPP members and to China and Indonesia. Panasonic, a Japanese multinational company (MNC), relocated a major factory, which manufactures refrigerators and washing machines, from Thailand to Vietnam in 2020. The construction of a coal-fired power plant is mainly funded by Japanese firms. The Japanese government is promoting further investment by subsidizing over 30 firms that are relocating from China to Vietnam. Most of these firms are food processors or producers of manufactured goods (for example, medical equipment).
Text C - Roles of the central bank in Vietnam
(1) The central bank in Vietnam has been lowering interest rates since mid-2019. However, it has kept the minimum reserve requirement at 3 % of commercial bank deposits, despite suggestions that this requirement could be lowered.
(2) The central bank also regulates the exchange rate of the dong (Vietnam's currency). It actively intervenes in the foreign exchange market to stabilize the rate when necessary. In April 2020, there was downward pressure on the dong due to the lower interest rates and fewer foreign tourists. However, the central bank has a large amount of reserve assets, which were used to prevent the dong from depreciating.
Table 1: Economic data for Vietnam
* 2018 figure
Table 2: Development data for Vietnam
* 2018 figure
Using a production possibilities curve (PPC) diagram to show comparative advantage, explain why Vietnam would export seafood to Japan while Japan would export machinery to Vietnam (Text B, paragraph 1).
Countries often specialize and trade according to the theory of comparative advantage. Explain the limitations of this approach.