In this video we’ll examine free trade, its advantages and disadvantages. Additionally,
we’ll look at the relationship between investment and economic growth and take it a bit further
with a discussion on multinational corporations and foreign direct investment.
Generally, international trade focuses on the movement of goods and services around
the world. In this video, we’re going to focus on free trade and consider its advantages
and disadvantages.
Free trade occurs when goods and services can be bought and sold between countries or
sub-national regions without tariffs, quotas or other restrictions being applied. Essentially,
there are no restrictions on the sale and purchase of goods and services between countries.
Benefits of free trade are numerous for both the exporting country and the importing trade
partners. For the importing country, they have access to an increased number of goods
and services, thus increasing consumer choice.
Second, competition from abroad pushes domestic firms to increase their efficiency as business
competition intensifies.
Third, countries have an incentive to focus on producing products for which they have
a competitive advantage and develop these industries.
Finally, rising exports can be a significant driver of economic growth. As a country specializes,
their goods and services become more desirable abroad and the increased demand for their
exports will boost local industry, create jobs, raise incomes and lead to economic growth.
However, the story of free trade would be incomplete without considering some of its
costs. For domestic firms that struggle to compete against foreign competition, the loss
of business can result in job losses and perhaps lead some firms to shut down.
Increased production, particularly in manufacturing, can lead to higher amounts of pollution when
producing for larger market distribution.
The gains of free trade are likely to benefit high income earners and the wealthy more so
than those with lower incomes and of less wealth.
Finally, an infant industry, or an industry that is just starting, may be crushed before
it has a chance to develop. This is usually given as a case for protectionism.
We now need to discuss investment, which focuses on business spending and how it ultimately
leads to economic growth.
If you pay close attention to the circular flow, you’ll see that there is a close relationship
between savings and investment. The market for loanable funds, or money that can be borrowed,
consists of firms borrowing on the demand side and savers on the supply side. For economies
with a strong banking system, they can match the deposits of savers with the borrowing
needs of firms. Here we see the equilibrium real interest rate at R* and quantity of Q*.
In countries where banking systems are not as well developed or as well trusted, the
disconnect can inhibit investment and limit growth potential.
An economy can increase savings by increasing income and also by improving the quality of
banking institutions.
If savings increases in an economy, it will increase the supply of loanable funds and
cause the supply curve for loanable funds to shift to the right. This results in a lower
real interest rate and thus a higher quantity of loanable funds demanded. Remember - at
cheaper borrowing rates, firms are more likely to borrow and this increase in savings should
lead to just that.
This is a summary of the Harrod Domar model which examines the relationship between increased
savings and economic growth. When savings increases, this should spur on increased investment
which should increase the capital stock. When the quantity of the capital stock of an economy
increases, they possess more capital with which to produce so are capable of producing
more goods and services than before. This results in economic growth. Rising economic
growth leads to higher incomes which then leads to higher savings again and the cycle
repeats.
This is one of the key reasons why there is a focus for many economies to strengthen their
banking system.
Now let’s look at the role of multinational corporations.
An multinational corporation (MNC) is an enterprise producing goods or delivering services in
more than one country.
An MNC usually has its management headquarters in one country, considered the home country,
while also operating in other countries, the host countries.*
Common examples of MNCs are shown here, with McDonalds, BMW and Apple. McDonald’s and
Apple are American companies that operate around the world and BMW is a German company
that also has operations abroad.
There are many advantages to countries that host MNCs.
Let’s use BMW’s operations abroad to help explain some of these.
If BMW sets up a factory in a new country, it will create jobs for the local economy.
If many companies across various sectors are doing this, it will lead to economic growth.
With that will come rising incomes for the workers as well as the local businesses that
serve these companies. The multiplier effect will increase the effect of that growth.
The rise of MNCs in a country will attract investment domestically and abroad, which
should spur further increases in the capital stock. As companies bring their expertise
from abroad, it is likely that domestic human capital will improve as they learn new processes,
technologies and methods of production.
Additionally, overseas competition in product markets should lead to greater choice for
consumers.
Expanding overseas also has benefits for the MNC itself. Global expansion allows access
to markets that were difficult to serve before. With global sales and production, MNCs can
benefit more from economies of scale.
They can choose to operate in countries that have less regulated corporate environments
and save on compliance costs. The MNCs may also be attracted into countries by a country’s
government itself, by offering the MNC tax relief or subsidies to setup production there.
The discussion would be incomplete without considering the disadvantages of MNCs as well.
The lax regulatory environments mean that MNCs can locate in countries where they are
free to pollute more, or even potentially exploit the local labour force. Beyond this,
if the MNCs profits are not reinvested locally and sent back to their home country – the
benefits to the host country may be limited significantly.
The competitive pressure of some MNCs may be too much for domestic firms and that may
cause some firms to face a decline in sales or shut down entirely.
As the MNC rises in influence, they may be able to exert pressure on the government to
take measures in favor of the MNC. These decisions may prioritize the MNC over the needs of the
population.
Next, let’s look at foreign direct investment, or FDI.
Foreign direct investment (FDI) is the category of international investment that reflects
the objective of a resident entity in one economy to obtain a lasting interest in an
enterprise resident in another economy.
Alternatively, one could say that FDI occurs when a firm in one country purchases an interest
in a company in another country.
Let’s look at the benefits of FDI to the host country.
Inflows of money can boost domestic production and lead to job creation. With increased production
and more people working, this will lead to economic growth as more is being produced.
Firms are likely to introduce technology and capital to the recipient country and share
industry expertise. This will help improve the quality of capital and also the skills
of the working population. Some countries require forced technology transfer in exchange
for access to their market.
The skills improvement should generate productivity gains and have further benefits for the economy.
By now you should have a better understanding of free trade, investment and its relationship
with growth, multinational corporations and FDI.
If you have any questions, leave them below and let’s try and answer them together.
That’s us done for now and I will see you in the next one!