Free Trade Areas and ASEAN

Free Trade Areas,

Many economists from all backgrounds are great advocates of free trade. Free trade is the idea that there are no barriers to trade enforced; it aims to eliminate tariffs, quotas and all other barriers. One argument for free trade is that with constant competition in markets, countries will have to focus on what they can specialize in and what they have the greatest comparative advantage in. Equally the increased competition lowers prices, makes companies strive for efficiency more and increases general living standards. Free trade is also argued to spread the value of freedom. Milton Friedman was an advocate of free trade in his book ‘Capitalism and Freedom’ stating that all trade barriers should be removed as well as an argument in favour of a floating exchange rate.

On the other hand there are many counterarguments to free trade. One of the most significant is the idea that it could negatively affect infant industries. These are industries that have only just begun, are currently under developed and weak comparatively to international competition. If free trade existed, these industries would seldom expand and grow to, in the future, gain a comparative advantage however protectionist policies could be used to help them survive for the mean time. Comparative advantage can change over time. Also, reducing imports can help the balance of payments and tariffs can raise government revenue which can be used for national services. Another important argument is protect against dumping, this can put many farmers especially (if agricultural dumping), out of work as the prices will decrease to unacceptable levels. Lastly, to follow on with agriculture, the argument that diversifying the economy creates a stronger economy is a common one. It’s basis is that the economy will be less reliant on a single product which may be effected due to famine causing fluctuating price. These goods also have a lower income elasticity which means, with economic growth, demand changes by very small amounts.

Free trade areas such as NAFTA (North American Free Trade Area) between Canada, Mexico and US or ASEAN (Association of South East Asian Nations) are some of the biggest free trade areas in the world. ASEAN was formed on the 8^th of August 1967 by Indonesia, Malaysia, the Philippines, Singapore and Thailand. Since then, membership has expanded to include Brunei, Burma (Myanmar), Cambodia, Laos, and Vietnam. Vietnam being one of the fastest economies in the world. ASEAN covers a land area of 4.46 million km², which is 3% of the total land area of Earth, and has a population of approximately 600 million people, which is 8.8% of the world's population. Therefore the ASEAN group is a very important and strong economic group.

Recently in January 2010, China signed with ASEAN an agreement to try to limit trade barriers between these countries. This is known as the ASEAN-China Free Trade Agreement. They signed this In 2002 and after joining the free trade network China and the six of the original ASEAN members, Indonesia, Brunei, the Philippines, Malaysia, Singapore and Thailand have reduced their tariff levels at around 5% per year. As of January 1 2010, 93% of the commodities exchanged between these countries had their tariff rates reduced to zero. The newest members of ASEAN are Vietnam, Burma, Laos and Cambodia and are aiming to eliminate all of their tariffs between other ASEAN groups by 2015.

Due to the rapid expansion of Chinese -ASEAN trade, China has actually, since signing the ASEAN-China Free Trade Agreement, came out on top of the US as ASEAN’s 3^rd largest trading partner behind the EU and Japan.

The road and rail networks are limited between China and ASEAN members; exchange almost exclusively takes place by sea. The Chinese government has allocated USD 25 billion to alleviate this problem, but the construction process will take years to complete. This is a reason why the rail network is currently being built in Thailand to China. So, Free Trade appears to have great advantages and many economists advocate it and yet, we have Economic Unions like the EU and Customs Unions like MERCOSUR which all aim to have trade barriers on non member countries. So, why do you think this is? 

The Thai Baht Strengthens and the Economy’s Set to Weaken,

Walking down the street every day in central Bangkok I see numerous currency exchange rates flashed at me from large metallic boards yet something has been of striking concern rather recently. What has been catching my attention is the increasing strength of the Thai baht against major foreign currencies. Let’s look at the US dollar as an example. Currently the US dollar is worth a mere 29.8 baht which is a staggering 2.5% increase in the Thai baht’s strength (comparatively to the USD) since the beginning of this year when the exchange rate was 30.6 baht to the dollar. This is partially caused by Japan’s and the US’s recent monetary policies with objectives to weaken their currencies. The US has numerous incentives to do this.  The US's debt to China is one of many examples.  But, what does the strengthening of the Thai Baht really mean?

Well, for Thai exporters this means a lot! A stronger currency has a severely negative effect on exports. Lets look at this in a little more depth then. A Thai exporter will look to sell their product, lets say rice, for a value of 15,000 baht per ton. This exporter will ask for 15,000 baht per ton the whole year ceteris paribus (all things remaining equal, e.g no inflation). However, this 15,000 baht per year although was only 490.2 US dollars at the beginning of 2013, is now, after a mere 6 weeks into 2013, worth 503.4 US dollars. This means that fellow rice exporting countries such as India, Vietnam and Pakistan will become (comparatively to Thailand) more competitive assuming that their currencies maintain a stable (or at least a more stable) exchange rate with the US dollar. This has proved to be the case.  The Vietnamese Dong has recently had a rather stable exchange rate and the Pakistani Rupee has actually depreciated (became weaker) against the US dollar improving their competitiveness in the rice market.

So in a simplified manner you can see the problem with the appreciating Thai Baht for Thai exporters, their prices are becoming less competitive because of the strengthening (appreciation) of the Thai baht. Luckily (for Thailand) Vietnam is predicted to suffer from a drought problem causing a scarcity of supply (smaller quantity of rice produced), this therefore reduces the international supply of rice shifting the demand for Thai exporters in the rice industry to the right (an increase) as importers (purchases) of Vietnamese rice now look for other exporters to satisfy their demand.

Unfortunately, for Thailand, competition is hardly scarce either so although the drought issues and other limiting factors to the supply of rice in other countries will still occur, Thailand is unlikely to absorb a much larger proportion of demand. In fact, in relation to the strengthening currency, Thailand’s rice exports are far more likely to shrink than remain stable because the currency’s strength will have a far greater effect. Although other political schemes of a price guarantee method have significantly affected the Thai rice exports, the example stands for all products.

Private industries now look to the government to lower interest rates, reducing the amount of capital inflows. This reduces the demand for the currency as less people are converting their money  into Thai Baht in order to save their money in high interest earning accounts. The lower interest rates discourages foreigners from saving in Thailand and encourages money to be driven out of Thailand’s capital account and injected into other countries with higher interest rates. You’d want to get the highest rate of interest possible wouldn't you? Well on a more macro scale, this explains the outflows of the capital account which flow into other economies (other countries with higher interest rates). As shown on the graph the reduction in demand for the Thai currency and the increase in supply (as less money is being saved by domestic savers, so more is on the market) will lead to the depreciation of the Thai baht. It’s important to note that this is the THB to USD exchange rate, this means it’s the market for Thai Baht or rather, how much the Thai Baht is worth in USD. The graph represents the value of Thai Baht in US dollars, while before I have been talking about it the other way around, the value of the US dollar in Thai Baht. I have been mentioning USD to THB exchange rates because these are much more commonly used and known about however when focusing on only the effects on the value of the THB then we should always use the THB to USD exchange rate. That is, the market for the Thai Baht rather than that for the US dollar. The depreciation of the THB, as mentioned before, will make Thai exports more competitive again as 1USD will be worth more baht than it was before. In other terms, the cost of 15,000 baht for foreign importers of rice will be far less in their currency than before. So, appreciation is a serious problem that the Thai economy currently faces, what should they do?

It should be noted that the depreciation of the Thai Baht should, theoretically speaking, lead to an increase in inflation caused by the increased demand for exports. The increased demand for exports will increase aggregate demand for the economy as whole, this will cause demand pull inflation where the increased demand in relation to fixed long run aggregate supply will increase the price level. This is shown by the graph to the right as price rises from P1 to P2 due to a shift of demand for AD1 to AD2. To a smaller extent, the increase in import prices for Thailand will cause cost push inflation. This is when the cost of imports, which may be raw materials used for manufacturing for example, rise in price. This increase in costs for producers (who use these raw materials) results in a shift in supply to the left (a smaller amount of supply) as there is less incentive for suppliers to keep on producing their products due to greater costs in manufacturing and thus, lower profits.  

In the long term , when the price elasticity of demand is more elastic (that is, when price changes, demand changes by a greater percentage), then the depreciation of the Thai Baht will lead to an increase in total revenue (due to a greater demand) and benefit the Thai economy greatly. Appreciation having the opposite effect which is what’s happening right now. Because exports contribute to around 2/3^rds of the Thai economy, this is a serious economic and political issue that will test the face of Thai political leadership. 

The Prisoner’s Dilemma,

Game theory tries to offer a mechanism to solve problems of strategic interaction. This is when your benefit depends not only on your own choices but equally on those of others around you. Strategic interaction is fundamental to economics, whether one firm decides to compete or cooperate with another in a market place is just one of many examples. Such an example on a macro scale could be for the product of oil. OPEC (one of the most famous swing producers) shows us that cooperation in a market place can be incredibly successful however, of course, we know that competition can be very important for a market economy. It is competition that keeps industries efficient, trying to cut down costs and striving for a more competitive production line. It was the large amounts of competition and laissez faire (do nothing) governmental approach in the industrial revolution that led to numerous important technological inventions. This competitiveness can reduce the risk of inflation, reduce the significance of a social hierarchy and improve the standard of living for the majority. These two choices, to compete or cooperate in an economy are very important.

When two companies or a group of companies supplying the same product have informally agreed to set a minimum price for the market place there poses a great dilemma. This situation can be expressed by the graph on the right hand side. The market price, or what the price should be, is at 'P' on the graph however the informally agreed price is at 'Pm'. If we look from a single company’s prospective we see two options, cooperation or competition. Cooperation being to agree to the informal price and keep to the informal agreement while the latter, to compete is to go against the terms previously agreed and lower your prices below 'Pm'. This will suddenly increase your demand in the very short term as your prices will be lower than your competitors and therefore all of those interested in buying the product each of you both supply, will choose to buy from the company that lowered their prices instead.

Hypothetically speaking, let’s assume this group of companies only contains two companies and that these two companies have arranged the minimum pricing agreement before, and in full knowledge of, a nearby long term oil contract with the US. The oil contract being for an up and coming war, which due to scarce resources and sudden great demand puts them in a weak bargaining position (making them vulnerable to lose their consumer surplus).

Now, with this information, the dilemma really starts to be of great importance. You and ‘company 2’ have agreed to share the contract profit received equally (with each of you equally contributing to the oil supply as well). The options and payoffs from this contact of one company, your company are as follows:

(assuming that the contact is predicted to have a £25 mil profit margin when demanded by you and company 2 with the agreed minimum price. Also you and company 2 being the two only oil suppliers in the market).

Company 2:       Your Decisions:	Cooperate	Compete
Cooperate	(£12.5mil), (£12.5mil)	(£0), (£20mil)
Compete	(£20mil), (£0)	(£5mil),(£5mil)

The top row represents your decisions which correlates to the 2^nd payoff in brackets. Company 2’s payoffs are listed first and are represented by the far left column.

Lets look at the options, option one, choosing to cooperate has 2 possibilities. Firstly both of you follow this same line of logic and both cooperate. This allows the greatest total profit to be obtained and shared equally. The second outcome is that your opponent competes without your knowledge, they then lower their profit margins to let’s say £20mil making themselves more competitive and secure the contract. You therefore get nothing. When you choose to compete, the same option applies to you when your opponent chooses to cooperate, blindly ignorant of your deceitful ways.  Lastly there is the option that both of you compete, each trying to gain the advantage, then the price is determined by how low each of you compete with each other to secure the contract. As you both are competing against each other after agreeing £12.5mil profit margin each, cooperating again is very unlikely so the likely price is to be less than £12.5mil, let’s say £10mil profit for the overall contract. Due to ease of modelling, let’s say that the US agrees a £5mil contract with both you and the other company securing the same quantity of oil supplied. With these possible outcomes comes the basis of prisoner’s dilemma and its application in economics.

Now, imagine you are considering company two’s decisions. If they cooperate then you can obtain £12.5mil by equally cooperating or £20mil by competing. So you compete, it’s only logical! You gain £7.5mil greater profit. So now imagine that company two decides to compete, if you cooperate you get nothing but company 2 gets everything. If you compete too you at least get £5mil, so you compete again. Competing is a dominant strategy for you and as company 2 is in the same situation it is only logical that they will conclude the same thing. Just ask what would the other player do, and what is the best response to this. But wait, competing is the best strategy? 

Let’s have a look at this:

Company 2:       Your Decisions:	Cooperate	Compete
Cooperate	(£12.5mil), (£12.5mil)	(£0), (£20mil)
Compete	(£20mil), (£0)	(£5mil),(£5mil)

The cells/ areas with a blue border represent Company 2’s dominant strategy (to compete). The green filled cells/ areas represent your dominant strategy (again to compete). Therefore the bottom right side cell is the logical outcome, neither you nor company two can change your/their choice and set to gain an advantage (assuming that the other stays with the original choice to compete). There is no unilateral incentive for either of you to change from the original strategy. This is what is known as a Nash equilibrium. So, Nash’s equilibrium tells us that the ideal solution, or rather rational solution is for both of you to compete and gain £5mil each but wait, is this really the case? If both cooperate you both gain £7.5mil greater than if you both compete, so is this the rational solution at all? This is a major flaw in Nash’s equilibrium and is an argument against game theory. Other arguments include that people aren't rational (emphasized in the Flood-Dresher experiment). On moves 83 through to 98 both player cooperated in the Flood Dresher experiment which was a simple game to demonstrate the prisoner’s dilemma. Both players therefore reaped the greatest benefits however this took at total of 82 turns before they began to sustainably cooperate. In our situation we have only one turn and a contract of this significance is unlikely to come along anytime soon, so we can’t learn our ‘opponent’s’, ‘company 2’s’ strategy. The late 1950’s Ohio state studies at Ohio State University which followed a similar game to demonstrate the prisoner’s dilemma showed that most participants chose to ‘compete’ or ‘defect’ most of the time, following the dominant strategy and yet if they cooperated a greater benefit could be achieved between them. The sum of cooperation pay outs is greater than the sum of any other scenario in the table however it seems fundamentally human nature to defect in aspiration of obtaining a greater amount of wealth than your opponent. Perhaps its evolutionary or instinctive to compete rather than cooperate, it’s human nature, or perhaps there is another explanation.

As one of the great unsolved dilemmas of game theory, the prisoner’s dilemma still poses a great flaw in it's very fundamental fabric of application and equally creates great questions about the very nature of human beings and whether we are truly rational creatures. So, ask yourself, what would you do?