CHAPTER 16

The foreign
sector

Chapter 16 The foreign sector

ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
CHAPTER OUTLINE

LEARNING OUTCOMES
16.1 INTRODUCTION
16.2 WHY COUNTRIES TRADE
16.3 TRADE POLICY
16.4 EXCHANGE RATES
16.5 THE TERMS OF TRADE
IMPORTANT CONCEPTS

Chapter 16 The foreign sector

ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
LEARNING OUTCOMES
Once you have studied this chapter you should be able to
• explain what globalisation entails
• explain why international trade occurs
• identify various possible trade barriers
• explain how exchange rates are determined in the foreign
exchange market
• define the terms of trade and explain their significance

Chapter 16 The foreign sector

ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
16.1 Introduction LO: explain what globalisation entails

16.1 INTRODUCTION
Open economy

The extent of a country’s involvement in international trade and finance

The South African economy may be described as an open economy.

Globalisation

The process whereby the world’s economies have become increasingly

integrated.

See In the real world 16-1 Globalisation: A two-edged sword? (p. 350)
See Box 16-1 International trade and financial organisations (p. 334)
Chapter 16 The foreign sector
ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e
16.2 Why countries trade LO: explain why international trade occurs

16.2 WHY COUNTRIES TRADE

• Why do individuals trade?

• What is the basis for specialisation and exchange?

• Same applies to countries

Chapter 16 The foreign sector

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16.2 Why countries trade (cont.) LO: explain why international trade occurs

Absolute advantage
Absolute advantage

When a country, company or individual can produce a good or service at

a lower cost per unit (i.e. most efficiently) than any other entity can
produce the same good or service.

• Benefits of trade obvious

• Specialise in what you are best at

But what if an individual or country is better at everything than another

individual or country?

Chapter 16 The foreign sector

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16.2 Why countries trade (cont.) LO: explain why international trade occurs

Comparative (or relative) advantage

Comparative advantage

Two countries will benefit from trade in specific goods with one another
if the opportunity costs of production (or relative prices) differ between
the two countries.

• As long as opportunity costs (or relative prices) differ, there is always

scope for trade

• Specialise where opportunity costs are lowest

Chapter 16 The foreign sector

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16.2 Why countries trade (cont.) LO: explain why international trade occurs

Germany 2 cars OR 8 barrels of wine per day

South Africa 1 car OR 6 barrels of wine per day

• Germany has an absolute advantage in both

• South Africa has a relative advantage in wine:
Opportunity cost of of a car for 1 barrel of wine;
Lower than in Germany: of a car for 1 barrel of wine
• Germany has relative advantage in cars:
Opportunity cost of 4 barrels of wine per 1 car;
Lower than in South Africa: 6 barrels of wine per 1 car

Chapter 16 The foreign sector

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16.2 Why countries trade (cont.) LO: explain why international trade occurs

• Germany → cars
South Africa → wine
then trade at (for example) 5 barrels of wine per 1 car

• Exchange ratio must lie between the opportunity cost ratios

• If opportunity costs are similar in both countries – no benefits from

specialisation and trade

Chapter 16 The foreign sector

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16.2 Why countries trade (cont.) LO: explain why international trade occurs

Figure 16-1 Production possibilities in Germany and South Africa (p. 337)

Chapter 16 The foreign sector

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16.2 Why countries trade (cont.) LO: explain why international trade occurs

Comparative advantage in action

• Countries do not trade with each other, firms do.

Chapter 16 The foreign sector

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16.3 Trade policy LO: identify various possible trade barriers

16.3TRADE POLICY
Trade policy
Government policy that has the purpose of opening the economy to and
benefitting from international trade, while protecting domestic firms
from foreign competition and controlling the volume of imports entering
the country.

See In the real world 16-2 Liberalising

international trade through regional
integration (p. 352)

Chapter 16 The foreign sector

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16.3 Trade policy (cont.) LO: identify various possible trade barriers

Import tariffs
• Protective tariffs
o To protect domestic firms against import competition
• Revenue tariffs
o To raise government revenue

Two categories:
• Specific tariffs (fixed)
• Ad valorem tariffs (percentage)

Chapter 16 The foreign sector

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16.3 Trade policy (cont.) LO: identify various possible trade barriers

Other measures
• Import quotas
• Subsidies
• Other non-tariff barriers
• Exchange controls
• Exchange rate policy

Chapter 16 The foreign sector

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16.3 Trade policy (cont.) LO: identify various possible trade barriers

Arguments for the use of trade barriers

• The balance of payments
• Dumping
• Export subsidies
• Infant industries
• Employment
• Government revenue
• National security

Arguments against trade barriers

• Retaliation by trade partners
• Welfare cost to society
• Inefficiency

Chapter 16 The foreign sector

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 LO: explain how exchange rates are determined in the
16.4 Exchange rates
foreign exchange market

16.4EXCHANGE RATES
nge rate
Price of a currency in terms of another currency

See Box 16-2 Direct

and indirect quotation
of exchange rates
(p. 342)

Chapter 16 The foreign sector

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 LO: explain how exchange rates are determined in the
16.4 Exchange rates (cont.)
foreign exchange market

The foreign exchange market

Foreign exchange market

The international market in which one currency can be exchanged for

other currencies.
• Foreign exchange market (forex market)
– demand for a currency
– supply of a currency
– equilibrium exchange rate

• Appreciation and depreciation

NB: Always check which currency is being analysed – important because

exchange rate always involves two currencies

Chapter 16 The foreign sector

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 LO: explain how exchange rates are determined in the
16.4 Exchange rates (cont.)
foreign exchange market

Figure 16-2 The foreign exchange market (p. 343)

Chapter 16 The foreign sector

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 LO: explain how exchange rates are determined in the
16.4 Exchange rates (cont.)
foreign exchange market

• The demand for dollars

See Box 16-3 The speculative nature of the foreign exchange market (p. 347)

• The supply of dollars

• The equilibrium exchange rate

Chapter 16 The foreign sector

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 LO: explain how exchange rates are determined in the
16.4 Exchange rates (cont.)
foreign exchange market

Changes in supply and demand: currency

depreciation and appreciation
Figure 16-3 A
decrease in the
supply of dollars (p.
345)

Chapter 16 The foreign sector

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 LO: explain how exchange rates are determined in the
16.4 Exchange rates (cont.)
foreign exchange market

Table 16-1 Changes in supply and demand of dollars: a summary (p. 345)

Chapter 16 The foreign sector

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 LO: explain how exchange rates are determined in the
16.4 Exchange rates (cont.)
foreign exchange market

Table 16-2 Impact of changes in rand/dollar exchange rate for South Africa (p. 345)

Chapter 16 The foreign sector

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 LO: explain how exchange rates are determined in the
16.4 Exchange rates (cont.)
foreign exchange market

Intervention in the foreign

exchange market

Figure 16-4 Managed floating

(p. 346)

Chapter 16 The foreign sector

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 LO: explain how exchange rates are determined in the
16.4 Exchange rates (cont.)
foreign exchange market

Exchange rate policy

Exchange rate policy

The manner in which a country manages its currency in respect to

foreign currencies and the foreign exchange market. The exchange rate
policy is managed by the central bank.

With a floating currency, there are basically only three policy

options:
• Do nothing
• Intervene in the foreign exchange market
• Use interest rates to influence

Chapter 16 The foreign sector

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 LO: define the terms of trade and explain their
16.5 The terms of trade
significance

16.5THE TERMS OF TRADE

Terms of
trade
The ratio between export prices (expressed as an index) and import
prices (also expressed as an index); the rate at which a country can trade
domestically produced goods for imported goods.

Chapter 16 The foreign sector

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IMPORTANT CONCEPTS

• Open economy • Direct quotation

• Globalisation • Indirect quotation
• Absolute advantage • Appreciation
• Comparative (or relative) • Depreciation
advantage • Foreign exchange market
• Equal advantage • Floating exchange rates
• Trade policy • Speculation
• Import tariffs • Managed floating
• Import quotas • Exchange rate policy
• Exchange rate • Terms of trade

Chapter 16 The foreign sector

ECONOMICS FOR SOUTH AFRICAN STUDENTS 6e