International Trade and Economic Growth Chapter 10 International Trade and Economic Growth

Topics to be Covered Trade and Development Trade and Growth Trade and Growth: Some Additional Comments International Flows of Factors

Economic Growth An economy is said to grow when its total real output or gross domestic product (GDP) rises. Per capita GDP is a measure of a country’s standard of living. For standard of living to rise over time, GDP must grow faster than the population.

Economic Development Economic Development—refers to the achievement of a quality of life for the average citizen of a country that is comparable to that enjoyed by the average citizen of a country with a modern economy, such as the U.S. Economic development is characterized by: High levels of consumption Broad-based educational achievement Adequate housing Access to high-quality health care, etc. Economic growth is essential for economic development.

Strategies for Economic Development Primary Export-led Development Strategy Import-Substitution Development Strategy Outward-looking Development Strategy

Primary Export-Led Development Strategy This strategy involves policies designed to exploit natural comparative advantage by increasing production of a few export goods most closely related to the country’s resource base. Country examples include Columbia (coffee), Mexico and Nigeria (petroleum), and Malaysia (rubber).

Advantages of Primary Export-led Development Strategy This strategy would encourage more intensive use of existing or abundant resources. It could help attract foreign investment. It may provide linkage effects or benefits to other industries as a result of one industry expanding.

Arguments Against Primary Export-led Strategy The world markets for primary products do not grow fast enough to support this type of development. The prices of primary products relative to the prices of manufactured goods will tend to fall over time due to sluggish demand or oversupply.

Terms of Trade of Developing Countries Refer to Figure 10.1 Terms of trade of oil exporting countries have experienced sharp increases; non-oil exporters have more stable, albeit declining, terms of trade. A group of countries with market power can improve its terms of trade by restricting supply. The declining terms of trade of non-oil exporters is more likely due to policies of other developing countries (i.e., OPEC) than to market conditions in developed countries.

FIGURE 10.1 Terms of Trade of Developing Countries

Import-Substitution Development Strategy These policies are designed to promote rapid industrialization and development by erecting high barriers to foreign goods to encourage local production.

Arguments Against Import-substitution Strategy The high barriers to trade rarely come down. This strategy limits the development of raw materials producing industries that supply inputs to the protected industries (usually producing consumer goods). Since imported capital goods with low tariffs are used extensively in local production, employment does not grow fast in the newly industrializing sector. The strategy encourages citizens to spend scarce resources to lobby or bribe government officials to protect their industries.

Outward-Looking Development Strategy Governments identify and support the target manufacturing sectors in which the country has potential comparative advantage. Policy tools: control the factor markets, undervalued exchange rate and additional benefits for successful exporters Successful country examples include Japan, South Korea, Singapore, Taiwan and China since the mid-1980s.

Trade and Growth Economic growth is shown graphically as an outward shift of the country’s production possibility frontier (PPF). Since growth affects both production and consumption, then it also affects international trade.

Graphical Analysis: An Economy Before Growth Occurs Refer to Figure 10.2 Given PPF and terms of trade line, show: Equilibrium production point Equilibrium consumption point PR line with slope indicating the initial ratio of production of the two goods CR line with slope indicating the ratio in which the two goods are consumed

FIGURE 10.2 Patterns of Production and Consumption with Neutral Growth

Neutral Economic Growth A proportionate increase in all resources and consumption so that trade also expands proportionately to the growth of the economy. After growth, the economy continues to produce and consume the two goods in the same ratios as before growth (refer to Figure 10.2).

Conditions Necessary for Neutral Growth Graphically, the new production possibility frontier (PPF) must be a proportionate expansion of the old PPF. Consumption of both goods must increase by the same proportion as income increases. In other words, the income elasticity of demand for both goods must be equal. See Table 10.1 for example.

TABLE 10.1 Example of Neutral Economic Growth

Other Types of Growth Pro-trade Biased Growth Anti-trade Biased Growth

Pro-trade Biased Growth When growth occurs as a result of an increase in the resource used intensively in the production of export goods, then the output of export goods will rise relative to import production, and international trade will expand by more than the rate of growth of GDP. This is called pro-trade biased growth (refer to Figure 10.3 and Table 10.2). Graphically, the PR line rotates away from the CR line.

FIGURE 10.3 Location of Production Following Pro-trade Biased Growth

TABLE 10.2 Example of Pro-trade Biased Growth

Anti-trade Biased Growth When growth occurs as a result of an increase in the resource used intensively in the production of import goods, then the output of import goods will rise relative to the output of export goods, and the international trade of this country will fall. This is anti-trade biased growth (refer to Table 10.3). Graphically, the PR line rotates toward the CR line indicating a tendency toward autarky.

TABLE 10.3 Example of Anti-trade Biased Growth

Technological Change Technological (technical) change— occurs when the same amount of output can be produced with fewer factor inputs, or when the same amount of inputs can produce greater amounts of output.

Types of Technological Change Neutral technological change—an innovation that reduces by an equi-proportionate amount the quantity of factors required to produce a given level of output. Labor-saving (capital-saving) technological change—an innovation that leads to a reduction in the use of labor (capital) relative to other factors in the production of a given level of output.

Industry Effects of Technological Change If neutral technical progress occurs in one industry, the output of that industry will increase at the expense of the other. If technical progress allows an industry to save on the use of the factor it uses less intensively, then the output of that industry could rise or fall.

Economic Growth and Terms of Trade for a Large Country With neutral economic growth, the terms of trade of the large country will tend to fall as the country grows. Pro-trade biased growth will cause the terms of trade to deteriorate more than under neutral growth. Anti-trade biased growth will lead to an improvement in the terms of trade.

Immizerizing Growth Immizerizing Growth—growth that results in a reduction of the country’s welfare level. Refer to Figure 10.4. Is immizerizing growth common? ⇒No, because: Precise conditions on both the nature of growth and world demand must hold. Government policy (e.g., tariffs) can be used to counteract the negative effects of growth.

FIGURE 10.4 Immizerizing Growth

International Flows of Factors Labor and migration Capital and multinational corporations

Labor Flows The U.S., Canada, Australia, and other countries have experienced large inflows of migrants (see Table 10.4). Migration has resulted from government policies such as: Guest worker program (Europe) in which foreign workers are invited to temporarily relocate and work in a host country

TABLE 10.4 U.S. Immigration, 1820–2005a

TABLE 10.4 U.S. Immigration, 1820–2005a (cont.)

TABLE 10.4 U.S. Immigration, 1820–2005a (cont.)

Reasons for Migrating Better economic circumstances in another country. Refuge from political tyranny or devastation. Reunion with other family members.

Brain Drain vs. Brawn Drain Brain Drain—process whereby skilled workers leave their homeland and relocate abroad. Brawn Drain—the outflow of unskilled workers to other countries.

U.S. Capital Flows In the 19th century, the U.S. was a capital-importing country. For much of the 20th century, the U.S. was a capital exporter. Since 1985, the U.S. has moved from being the world’s largest net creditor to being the world’s largest net borrower.

Direct Foreign Investment and MNC’s Direct Foreign Investment—happens when a domestic firm acquires ownership or control of the operations of a foreign firm. Multinational Corporations (MNCs)— firms that own and operate capital in one or more foreign countries.

Features of U.S. MNCs Manufacturing accounts for the largest share of U.S. MNC employment Refer to Table 10.5.

TABLE 10.5 Employment of Nonbank U.S. MNCs in 2009

U.S. MNCs (cont.) Almost 60% of U.S. MNC employment is in developed countries, primarily in Western Europe Refer to Table 10.6.

TABLE 10.6 Employment of U.S. MNC Foreign Affiliates, by Area, 2009

TABLE 10.6 Employment of U.S. MNC Foreign Affiliates, by Area, 2009 (cont.)

What Special Advantages do MNCs Have? MNCs may have access to special technology. There may be increasing returns to scale that accrue to a firm operating plants in many locations. Marketing seeking and Export platform FDI

Economic Analysis of Factor Movements The case of labor migration Definition of terms: Marginal Product of Labor (MPL) Diminishing Returns to Labor Value of Marginal Product of Labor (VMPL) Profit-maximizing Rule Effects of immigration of foreign workers

Marginal Product of Labor (MPL) and Diminishing Returns MPL—the additional amount of output that can be produced with the addition of one more worker to the production process. Diminishing returns to labor—the fact that as more and more workers are added to the production process, holding all other factors constant, the marginal product of labor will eventually decline.

Value of Marginal Product of Labor (VMPL) VMPL—the monetary value of the marginal product of labor or, alternatively, the marginal revenue to producers from hiring the last worker. In equation form: where P is product price.

VMPL Curve and Equilibrium Refer to Figure 10.5 VMPL curve is downward-sloping due to diminishing returns and also represents the demand-for-labor curve. Given a fixed supply of workers, the interaction of the demand and supply in the labor market determines the wage rate. The area under the VMPL curve represents labor income and income paid to capital owners.

FIGURE 10.5 Distribution of Income Between Labor and Capital

Effects of Foreign Labor Migration Consider Figure 10.6. Wages are driven downward. Increase in labor force results in more output produced. There is an income redistribution effect: domestic labor loses income while capital owners benefit because the increased production leads to more intensive use of capital and to a rise in its rental prices.

FIGURE 10.6 The Economic Effects of Labor Immigration

Conclusions International factor flows tend to lower the incomes of those factors in the host country that directly substitute for this factor and tend to raise the incomes of other factors. Given the income redistribution effects, countries will impose policies to limit international trade flows.