International Trade Theory and Development Strategy Chapter 12 International Trade Theory and Development Strategy

Globalization Over the past several decades, the economies of the world have become increasingly linked: International Trade Portfolio Investments Direct Foreign Investment These linkages have had a marked effect on the developing world. Trade between developing countries Investments from the developed countries How developing countries have been affected by these trends?

International Trade and Finance: Some Key Issues Many developing countries rely heavily on exports of primary products. Markets for these exports are often unstable, therefore, primary-product export dependence carries with it a lot of risk and uncertainty. Many developing countries also rely heavily on imports (typically of machinery, capital goods, intermediate producer goods, and consumer products). Many developing countries suffer from chronic deficits on current and capital accounts which depletes their reserves, causes currency instability, and a slowdown in economic growth.

Balance of Payments = Current Account + Capital Account. Classical international trade theory: some key issues. Balance of Payments = Current Account + Capital Account. Current Account: net flow of goods and services. Export receipts minus import payments for transfer of goods and services. Capital Account: net flow of capital. Net foreign lending and investment minus repayment of principal and interest on outstanding foreign loans.

Figure 12.1: Nonfuel primary commodity prices, nominal and real, by commodity group (1960-2005) (2000 index = 100)

Figure 12.1: Nonfuel primary commodity prices, nominal and real, by commodity group (1960-2005) (2000 index = 100)

Five basic questions about trade and development How does international trade affect economic growth? How does trade alter the distribution of income? How can trade promote development? Can LDCs determine how much they trade? What is the best trade policy? Outward-looking or an inward-looking?

Importance of exports to developing nations Exports of LDCs are less diversified than those of developed countries. Developing countries are generally more dependent on trade than developed countries are. Among developing countries, small countries are more dependent on foreign trade than most relatively large developing countries.

Table 12.1- Merchandise exports in perspective: selected countries (2005)

Demand elasticities and export earnings instability. Low income elasticity of demand for primary products. A 1% increase in MDC’s income leads to an increase of imports by less than 1% Low price elasticity of demand for primary commodities A 1% decrease in prices leads to an increase of imports by less than 1% Together, the two elasticity phenomena contribute to the Export Earnings Instability.

The terms of trade and the Prebisch- Singer thesis. Total export earnings depend on: Total volume of exports sold. Price paid for exports. Prebisch and Singer argue that (commodities) export prices fall over time, so LDCs lose revenue unless they can continually increase export volumes. Prebisch and Singer think LDCs need to avoid a dependence on primary exports.

Traditional Theory of International Trade Comparative advantage model. Factor endowments model.

Traditional Theory of International Trade Comparative Advantage Model: Diverse preferences and needs, as well as varied physical and financial endowments, make trade economically profitable. Countries specialize in products in which they have a comparative advantage in terms of their natural abilities.

Traditional Theory of International Trade Comparative Advantage Model: Manufactured commodities are relatively cheaper to produce in country A. Agricultural products can be produced at a lower relative cost in country B. Country A produces manufactures (i.e. cameras, automobiles, etc.) more cheaply than B and exchange these products for B’s agricultural produce (i.e. fruits, vegetables, etc.). Principle of Comparative Advantage: countries should completely specialize in the export of commodities that they can produce at lowest relative cost.

Factor Endowments Model: Traditional Theory of International Trade Factor Endowments Model: Modification of the comparative advantage model to account for differences in factors supplies (i.e. land , labor, capital) between countries Trade arises from: Technological differences (i.e. different labor productivity levels)

Two assumptions in Factor Endowments Model: Traditional Theory of International Trade Two assumptions in Factor Endowments Model: Different products require productive factors in different relative proportions. Agricultural goods are more labor intensive than manufactured goods (i.e. growing tea requires more labor per unit capital than building a TV set) and vice versa. Countries have different endowments of factors of production Some countries are capital abundant (i.e. U.S., France, Italy, etc.) while others are labor abundant (i.e. India, Colombia, Egypt, etc.)

Factor Endowments Model: Traditional Theory of International Trade Factor Endowments Model: Capital abundant countries incompletely specialize in the production of capital intensive commodities (i.e. electronic equipment, aircrafts, computers). Labor abundant countries incompletely specialize in labor intensive commodities (i.e. food, raw materials, minerals).

Trade with variable factor proportions and different factor endowments

Trade with variable factor proportions and different factor endowments

The Traditional Theory of International Trade Non-similar Conclusions: CAM claims complete specialization: produce only the comparative advantage good. FEM claims incomplete specialization: capital abundant country will produce labor intensive products too, but it will spend more of its endowment base on capital intensive commodities.

The Traditional Theory of International Trade Non-similar Conclusions: FEM claims factor price equalization between trading nations. increased labor demand in LDCs pushes w/r up up increased capital demand in MDCs pushes w/r down. CAM makes no such claim. Remark: w/r = wage/rental ratio

The Traditional Theory of International Trade Shared Conclusion: all countries gain from trade Trade stimulates economic growth, enlarges a country’s production and consumption capacity, thus increases world output. Trade promotes international and domestic equality through equalization of factor prices. Trade help countries achieve faster development by promoting / rewarding sectors of comparative advantage.

The Critique of Traditional Theory 1. All productive resources are fixed in quantity and constant in quality across nations, and are fully employed. - Factors of production essential to growth (e.g. physical capital, skilled labor, ability to carry out technological research, etc.) are NOT fixed either in quantity or in quality. - Rich nations (North) are well endowed with these vital resources and specialize in highly profitable production processes (i.e. manufactures). - Poor nations (South) with large supplies of unskilled labor specialize in less profitable activities (i.e. agriculture, textile).

The critique of traditional theory in the context of LDC experience. 2. Technology of production is fixed (in CAM) or freely available to all nations (in FEM). - Technological improvement led to massive productivity growth. - Those economies with improved technology are primary beneficiaries of productivity growth.

The critique of traditional theory in the context of LDC experience. 3. Resources are perfectly mobile within national boundaries - Reallocation of resources among industries is difficult to achieve (very costly), especially in developing economies, due to: Rigid economic and social infrastructures (i.e. roads, railways, power locations, credit and marketing arrangements, etc.). Largely restricted factor movements (i.e. cumulative capital investment sunk in existing infrastructure over time).

The critique of traditional theory in the context of LDC experience. 4. National governments play no role in international economic relations. International prices determined by demand and supply. - Activist government intervention via industrial policy to create a comparative advantage where the world demand is likely to rise in the future (i.e. Japan in 50s and 60s). - Governments use tools of commercial policy (i.e. tariffs, quotas, subsidies) to influence commodity prices.

The Critique of traditional free-trade theory in the context of developing-country experience Fixed Resources, Full Employment, and the International Immobility of Capital and Skilled Labor. Factor endowments and comparative costs are not given but are in a state of constant change North-South trade models. Michael Porter’s Competitive Advantage Theory. Vent for Surplus theory.

The Critique of traditional free-trade theory in the context of developing-country experience Fixed, Freely Available Technology and Consumer Sovereignty. Technological change impacts developing-countries’ export earnings. Development of synthetic substitutes for developing country exports. Product Cycle theory

The Critique of traditional free-trade theory in the context of developing-country experience Internal Factor Mobility, Perfect Competition, and Uncertainty: increasing returns, imperfect competition, and issues in specialization. The assumption that nations are readily able to adjust their economic structure to fit the international market is not realistic Reallocations of resources are extremely difficult to achieve in practice Structural realities in developing countries Increasing returns and hence decreasing costs of production Exercise of monopolistic control over world markets Risk and uncertainty inherent in international trading arrangements.

The Critique of traditional free-trade theory in the context of developing-country experience The Absence of National Governments in Trading Relations: There is no “international government” to act in case of the generation of growth poles. Highly uneven gains from trade can easily become self-sustaining Industrial policy is crafted by governments. Commercial policies instruments (tariffs, quotas) are state constructs. International policies can result in uneven distribution of gains from trade. World Trade Organization

The Critique of traditional free-trade theory in the context of developing-country experience Balanced Trade and International Price Adjustments. Free International Market (market always in equilibrium) Demand is equal to the supply (no balanced of payments problems) Unrealistic (oil price hikes of the 70s).

The Critique of traditional free-trade theory in the context of developing-country experience Trade gains accruing to nationals: If developing countries benefit from trade, it is the people of these countries who reap the benefits However, enclave economies are promoted by trade e.g. foreigners often pay very low rents for the right of using the land bring their own foreign capital bring their own foreign skill labor hire local (cheap) unskilled labor Therefore, minimum effect on the rest of the economy Difference between GDP and GNI becomes important

Some conclusions on trade theory and economic development strategy. Trade can lead to rapid economic growth under some circumstances. Trade can reinforce existing income inequalities. LDCs generally must trade. Regional cooperation may help LDCs.

Trade Strategies for Development: Export Promotion versus Import Substitution Export promotion (outward-looking trade policies) by free traders: Encourage not only free trade but also free movement of capital, workers, firms, ideas, technology, etc. Import substitution (inward-looking trade strategies) by protectionists. Stress the need for LDCs to evolve own style of development via restrictions on movements of goods, services, capital, people, etc.

Trade Strategies for Development: Export Promotion versus Import Substitution Export promotion strategy: -Efficiency and growth benefits of free trade and competition. -Benefits of substituting large world markets for narrow domestic markets. -Recent successes of export oriented economies of South Korea, Taiwan, Singapore, China, etc. -Distorting (theoretical) price and welfare effects of protection

Implementing import substitution strategy: Trade Strategies for Development: Export Promotion versus Import Substitution Implementing import substitution strategy: -Substitute domestic production for previously imported simple consumer goods in the first stage of IS process (i.e. hand radios) * -Substitute for a wider range of more sophisticated manufacture items in the second stage (i.e. HD TVs) * * behind protection -In the long run, obtain benefits of greater domestic industrial diversification and start exporting some previously imported manufacture items.

Figure 12.4: Import substitution and the theory of protection.

The industrialization strategy approach to export policy Focus on government interventions to encourage exports (industrial policy). Without proper attention to incentives, industrial policies may be counterproductive WTO rules and industrial policies. Governments can… Assist an emerging industry as long as it does not give domestics firm a significant advantage over foreign Competence and political authority of governments. International agencies should help governments vs governments lack the needed skills and they may be better off using less interventionist strategies

Reconciling the arguments: the data and consensus. Neither the trade optimists nor the trade pessimists are always right. There are many factors that determine whether trade is good or bad for a country. Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

South-South trade and economic integration: looking outward and inward. Economic Integration: Theory and Practice. The growth of trade among developing countries. Benefits? Integration encourages rational division of labor among a group of countries and increases market size. Provides opportunities for a coordinated industrial strategy to exploit economies of scale. Trade creation. Trade diversion.

South-South trade and economic integration: looking outward and inward. Regional trading blocs (economic unions) and the globalization of trade. NAFTA. MERCOSUR. SADC. ASEAN. Local conditions matter. Do blocs promote growth or retard the progress of globalization.

Trade policies of developed countries: the need for reform. The major obstacle to LDC export expansion has been the various trade barriers erected by developed nations against the principal commodities exports of developing countries. Rich-nation economic and commercial policies matter for LDCs. Tariff and non-tariff barriers to LDC exports. Overall effect of developed-country tariffs, quotas, and other barriers has been to lower the effective price received by LDCs for their exports. International dispute 1995 Uruguay Round 2001 Doha Round

Figure 12.6: Effective tariff faced by income groups (1997-1998)