International Economics Tenth Edition CHAPTER E L E V E N 11 International Economics Tenth Edition International Trade and Economic Development Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Learning Goals: Understand the relationship between economic development and international trade Understand the relationship between the terms of trade, export instability, and economic development Compare imports substitution with export orientation as a development strategy Describe the current problems facing developing countries Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Introduction Today most economists believe that international trade can contribute significantly to the development process. Until 1980’s, an influential minority of economists argued that international trade hindered development in developing nations. This chapter addresses these claims. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Importance of Trade to Development Traditional trade theory: If each nation specializes in their comparative advantage good, world output increases and both nations gain. This suggests that developing nations should continue to produce primary goods while developed nations produce manufactured goods. Developing nations believe this pattern keeps them from reaping dynamic benefits of industry and maximizing their welfare in the long run. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Importance of Trade to Development Developing nations view traditional trade theory as involving adjustments to existing conditions, while development requires changing existing conditions. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Importance of Trade to Development However, traditional trade theory can be extended to incorporate changes in factor supplies, technology and tastes by using comparative statics. A nation’s pattern of development is not determined once and for all, but must be recomputed as conditions change or are expected to change. As a developing nation accumulates capital and improves technology, its comparative advantage can shift from primary to manufactured goods. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Importance of Trade to Development Beneficial Effects of Trade on Economic Development Can lead to full utilization of underemployed resources. Makes possible division of labor and economies of scale. Provides vehicle for transmission of new ideas, new technology, new managerial and other skills. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Importance of Trade to Development Beneficial Effects of Trade on Economic Development Stimulates and facilitates the international flow of capital from developed to developing nations. Stimulates domestic demand for new manufactured products until efficient domestic production becomes feasible. Stimulates greater efficiency by domestic producers to meet foreign competition. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Importance of Trade to Development Endogenous Growth Theory Lowering trade barriers will speed up the rate of economic growth and development in the long run by: Allowing developing nations to absorb technology developed in developed nations at faster rate Increasing the benefits that flow from research and development Promoting larger economies of scale in production Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Importance of Trade to Development Endogenous Growth Theory Lowering trade barriers will speed up the rate of economic growth and development in the long run by: Reducing price distortions and leading to more efficient use of domestic resources across sectors Encouraging greater specialization and more efficiency in production of intermediate inputs Leading to more rapid introduction of new goods and services. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Terms of Trade and Economic Development Types of Terms of Trade Commodity, or net barter, terms of trade (N) Ratio of the export price index to import price index Income terms of trade (I) Measures nation’s export-based capacity to import. Single factoral terms of trade (S) Measures amount of imports nation gets per unit of domestic factors of production embodied in its exports. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Terms of Trade and Economic Development Types of Terms of Trade I and S can increase even if N does not, increasing welfare. Most favorable: increases in N, I and S. Deterioration in all three terms of trade may lead to immiserizing growth. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Terms of Trade and Economic Development Commodity terms of trade in developing nations tend to deteriorate over time because: Most or all productivity increases in developed nations are passed on to workers in higher wages and income, while increases in productivity in developing nations are reflected in lower prices. Developing nations’ demand for manufactured exports of developed nations grows faster than developed nations’ demand for agricultural and raw material exports of developing nations. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 11-1. Commodity Terms of Trade and Structural Breaks, 1900-1998 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Export Instability and Economic Development Developing world exports tend to face inelastic international demand. Price fluctuations in these markets do not significantly change the quantity sold. Thus price fluctuations will generate large movements in revenues collected. Fluctuating environmental conditions (weather, natural disasters, etc.) cause more and larger supply shifts in the developing world than in the developed world. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 11-2 Price Instability and the Primary Exports of Developing Nations. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Export Instability and Economic Development Fluctuating export prices will result in export earnings that vary significantly from year to year. When export earnings rise, exporters increase consumption, investment and bank deposits, which multiply through the economy. A subsequent fall in export earnings results in a multiple contraction of national income, savings and investment. These boom-bust periods make development planning difficult. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Export Instability and Economic Development Empirical Research (MacBean, 1966) While export instability is greater for developing nations, the degree of instability is not very large in an absolute sense. Great fluctuation in export earnings of developing nations did not lead to significant fluctuations in their national income, savings and investments, and did not interfere with development efforts. MacBean concluded costly commodity agreements demanded by developing nations are not warranted. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Export Instability and Economic Development Commodity Agreements Buffer Stocks involve the purchase of the commodity when the commodity price falls below an agreed minimum price, and the sale of the commodity out of the stock when the commodity price rises above the maximum price. Example: International Tin Agreement, 1956 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Export Instability and Economic Development Commodity Agreements Export controls regulate the quantity of a commodity exported by each nation in order to stabilize commodity prices. Example: International Sugar Agreement, 1954 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Export Instability and Economic Development Commodity Agreements Purchase contracts are long-term multilateral agreements that stipulate a minimum price at which importing nations agree to purchase a specified quantity of the commodity and a maximum price at which exporting nations agree to sell specified amounts of the commodity. Example: International Wheat Agreement, 1949 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Import Substitution versus Export Orientation During the 1950s, 1960s, and 1970s developing nations made deliberate efforts to move production away from primary goods towards more industrialized production. Potential gains Faster technological progress and growth Creation of higher paying jobs Higher multipliers and accelerators through greater linkages in production process Improved terms of trade, price stability Relief from balance of payments difficulties Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Import Substitution versus Export Orientation Strategies for industrialization Import substitution industrialization (ISI) Replace imports of industrial goods with domestic production by reducing import access to the domestic economy. Export oriented industrialization Expand industrialization through efforts to expand domestic exports of industrialized products. Proven to be more effective than import substitution. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Import Substitution versus Export Orientation Import substitution industrialization (ISI) Advantages: The market for the product already exists It is easier to close the domestic market to imports than to establish new industries in the face of foreign competition. Foreign firms will be encouraged to invest domestically to avoid the barriers to trade. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Import Substitution versus Export Orientation Import substitution industrialization (ISI) Disadvantages: Protected industries have reduced incentives to improve and become competitive. The domestic economy may be too small to exploit available economies of scale. Import substitution is difficult for more complex products. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Import Substitution versus Export Orientation Trade Liberalization and Growth in Developing Countries Many countries that had earlier followed import substitution strategies began to liberalize, starting in the 1980s. Facilitated by the World Bank. Improvements in productivity and growth. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Import Substitution versus Export Orientation Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Import Substitution versus Export Orientation Export-oriented Industrialization Advantages: Allows for the exploitation of available economies of scale International competition spurs greater domestic efficiency Industrial expansion is not limited by the scale of the domestic economy. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Import Substitution versus Export Orientation Export-oriented Industrialization Disadvantages: May be difficult to set up export industries due to competition from more established industries Developed nations often provide high level of effective protection for industries producing simple labor-intensive commodities in which developing nation may have comparative advantage. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Import Substitution versus Export Orientation Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Current Problems Facing Developing Countries Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 11-1 The East Asian Miracle of Growth and Trade Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 11-2 Change in Commodity Prices over Time Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 11-3 The Growth of GDP of Rich Countries, Globalizers, and Nonglobalizers Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 11-4 Manufactures in Total Exports of Selected Developing Countries Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 11-5 The Foreign Debt Burden of Developing Countries Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Appendix to Chapter 11 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

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