International Trade Theory and Development Strategy

Globalization: An Introduction

• Core economic meaning- the increased openness of economies to international trade, financial flows, and foreign direct investment.

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International Trade and Finance: Some Key Issues

• Many developing countries rely heavily on exports of primary products with associated risks 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

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International Trade Theory

What is international trade? – Exchange of raw materials and manufactured goods

(and services) across national borders

Classical (traditional) trade theories: – explain national economy conditions--country

advantages--that enable such exchange to happen

New trade theories: – explain links among natural country advantages,

government action, and industry characteristics that enable such exchange to happen

Classical Trade Theories

Mercantilism (pre-16th century)

– Takes an us-versus-them view of trade

– Other country’s gain is our country’s loss

Free Trade theories

– Absolute Advantage (Adam Smith, 1776)

– Comparative Advantage (David Ricardo, 1817)

– Specialization of production and free flow of goods

benefit all trading partners’ economies

Free Trade refined

– Factor-proportions (Heckscher-Ohlin, 1919)

– International product life cycle (Ray Vernon, 1966)

The New Trade Theory

As output expands with specialization, an

industry’s ability to realize economies of scale

increases and unit costs decrease

Because of scale economies, world demand

supports only a few firms in such industries (e.g.,

commercial aircraft, automobiles)

Countries that had an early entrant to such an

industry have an advantage:

– Fist-mover advantage

– Barrier to entry

New Trade Theory

Global Strategic Rivalry

– Firms gain competitive advantage trough: intellectual property, R&D, economies of scale and scope, experience

National Competitive Advantage (Porter, 1990)

Mercantilism/Neomercantilism Prevailed in 1500 - 1800

– Export more to “strangers” than we import to amass

treasure, expand kingdom

– Zero-sum vs positive-sum game view of trade

Government intervenes to achieve a surplus in

exports

– King, exporters, domestic producers: happy

– Subjects: unhappy because domestic goods stay

expensive and of limited variety

Today neo-mercantilists = protectionists: some

segments of society shielded short term

Absolute Advantage Adam Smith: The Wealth of Nations, 1776

Mercantilism weakens country in long run; enriches only a few

A country – Should specialize in production of and export

products for which it has absolute advantage; import other products

– Has absolute advantage when it is more productive than another country in producing a particular product

Comparative Advantage David Ricardo: Principles of Political

Economy, 1817

Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces

Absolute Advantage is a special case of Comparative Advantage

Heckscher (1919)-Ohlin (1933)

Differences in factor endowments not on differences in productivity determine patterns of trade

Absolute amounts of factor endowments matter

Leontief paradox: –US has relatively more abundant capital yet imports

goods more capital intensive than those it exports

– Explanation(?):

• US has special advantage on producing new products made with innovative technologies

• These may be less capital intensive till they reach mass-production state

Theory of Relative Factor Endowments (Heckscher-Ohlin)

Factor endowments vary among countries

Products differ according to the types of factors that

they need as inputs

A country has a comparative advantage in producing

products that intensively use factors of production

(resources) it has in abundance

Factors of production: labor, capital, land, human

resources, technology

International Product Life-Cycle (Vernon)

Most new products conceived / produced in the US in 20th

century

US firms kept production close to their market initially

• Aid decisions; minimize risk of new product introductions

• Demand not based on price; low product cost not an issue

Limited initial demand in other advanced countries initially

• Exports more attractive than overseas production

When demand increases in advanced countries, production

follows

With demand expansion in secondary markets

• Product becomes standardized

• production moves to low production cost areas

• Product now imported to US and to advanced countries

Classic Theory Conclusion Free Trade expands the world “pie” for goods/services

Theory Limitations:

Simple world (two countries, two products)

no transportation costs

no price differences in resources

resources immobile across countries

constant returns to scale

each country has a fixed stock of resources and no efficiency

gains in resource use from trade

full employment

New Trade Theories

Increasing returns of specialization due to economies

of scale (unit costs of production decrease)

First mover advantages (economies of scale such that

barrier to entry crated for second or third company)

Luck... first mover may be simply lucky.

Government intervention: strategic trade policy

National Competitive Advantage (Porter, 1990)

Factor endowments • land, labor, capital, workforce, infrastructure

(some factors can be created...)

Demand conditions • large, sophisticated domestic consumer base: offers an

innovation friendly environment and a testing ground

Related and supporting industries • local suppliers cluster around producers and add to

innovation

Firm strategy, structure, rivalry • competition good, national governments can create

conditions which facilitate and nurture such conditions

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?

• Is an outward-looking or an inward-looking trade policy best?

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The Importance of Exports to Different Developing Nations

• Importance of exports to developing nations

• Exports of LDCs are much less diversified than those of developed countries

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Table1: Merchandise Exports in Perspective: Selected Countries, 2005

C o p y r i g h t © 2 0 0 9 P e a r s o n A d d i s o n -W e s l e y .

A l l r i g h t s r e s e r v e d . 1 2 - 1 9

Demand Elasticities and Export Earning Instability

• Low income elasticity of demand for primary products

• Low price elasticity of demand and supply

• Export earnings instability

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The Terms of Trade and the Prebisch-Singer Thesis

• Total export earnings depend on:

– Total volume of exports sold AND

– Price paid for exports

• Prebisch and Singer argue that 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

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The Traditional Theory of International Trade

• Main conclusion of the neoclassical model is that all countries gain from trade

• World output increases with trade • Countries will tend to specialize in products that use

their abundant resources intensively • International wage rates and capital costs will

gradually tend toward equalization • Returns to owners of abundant resources will rise

relatively • Trade will stimulate economic growth

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The Traditional Theory of International Trade

• Trade theory and Development: The Traditional Arguments – Trade stimulates economic growth

– Trade promotes international and domestic equality

– Trade promotes and rewards sectors of comparative advantage

– International prices and costs of production determine trading volumes

– Outward-looking international policy is superior to isolation

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The Critique of Traditional Free-Trade Theory in the Context of Developing-Country Experience

• The following assumptions of the Neoclassical model must be scrutinized:

– Fixed resources, full employment, and international factor immobility

– Fixed, freely available technology and consumer sovereignty

– Internal factor mobility and perfect competition

– Governmental non-interference in trade

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– Balanced trade and international price adjustments

– Trade gains accruing to nationals

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• Fixed Resources, Full Employment, and the International Immobility of Capital and Skilled Labor

– Challenged by North-South trade models

– Michael Porter’s Competitive Advantage theory

– Vent for Surplus theory

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• Fixed, Freely Available Technology and Consumer Sovereignty

– Challenged by the Product Cycle theory

– Development of synthetic substitutes for developing country exports

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• International Factor Mobility, Perfect Competition, and Uncertainty: Increasing Returns, Imperfect Competition, and Issues in Specialization

– Structural realities in developing countries

– Increasing returns and exercise of monopolistic control over world markets

– Risk and uncertainty inherent in international trading arrangements

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• The Absence of National Governments in Trading Relations – Definite role for State

– 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

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• Balanced Trade and International Price Adjustments

– Unrealistic (oil price hikes of the 70s)

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• Trade gains accruing to nationals

– Enclave economies are promoted by trade

– Difference between GDP and GNI becomes important

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Some Conclusions on Trade Theory and Economic Development Strategy

• Trade can lead to rapid economic growth under some circumstances

• Trade seems to reinforce existing income inequalities

• Trade can benefit LDCs if they can extract trade concessions from developed countries

• LDCs generally must trade

• Regional cooperation may help LDCs

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Trade Strategies for Development: Export Promotion versus Import Substitution

• Export promotion: looking outward and seeing trade barriers – Primary-commodity export expansion, limited demand

• Low income elasticities • Low population growth rates in developing economies • Decline in prices implies low revenue • Lack of success with international commodity agreements • Development of synthetic substitutes • Agricultural subsidies

– Primary-commodity export expansion, supply rigidities

• Expanding Exports of manufactured goods: Some successes

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• Import substitution: looking inward but still paying outward

– Tariffs, infant industries, and the theory of protection

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Figure 4: Import Substitution and the Theory of Protection




• The IS industrialization strategy and results

– Protected industries get inefficient and costly

– Foreign firms benefit more

– Subsidization of imports of capital goods tilts pattern of industrialization and contributes to BOP problems

– Overvalued exchange rates hurt exports

– Does not stimulate self-reliant integrated industrialization

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• Tariff Structure and Effective Protection

– Nominal rate of protection

– Effective rate of protection

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p

ppt

The nominal tariff rate, t, is

Where

p′ is the tariff-inclusive price

p is the free trade price

(13.1)

Tariff Structures and Effective Protection

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v

vvg

The effective tariff rate, g, is

Where

v′ is the value added per unit of output,

inclusive of the tariff

v is the value added per unit of output

under free trade

(13.2)


• Standard argument for tariff protection

– Sources of revenue

– Response to chronic BOP problems

– Help foster industrial self-reliance

– Greater control over economic destinies

• Must be applied selectively and wisely

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• Foreign-exchange rates, exchange controls, and the devaluation decision – Currencies of developing countries are overvalued

(excess of local demand over available exchange) • Can run down reserves

• Can curtail excess demand through taxes, tariffs, dual exchange rates

• Can use exchange controls

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Figure 5: Free-Market and Controlled Rates of Foreign Exchange

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• Chronic payments deficits can be ameliorated by a currency devaluation

– Difference between depreciation and devaluation

– Higher import prices result in an inflationary wage-price spiral

– Distributional effects

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Trade Optimists and Trade Pessimists: Summarizing the Traditional Debate

• Trade pessimist arguments – Limited growth of world demand for primary exports

– Secular deterioration in terms of trade

– Rise of “new protectionism”

• Trade optimist arguments – Trade Liberalization promotes competition and efficiency

– Generates pressure for product improvement

– Accelerates overall growth

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Trade Optimists and Trade Pessimists: Summarizing the Traditional Debate

• 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 too (South Korean case)

– WTO rules and industrial policies

– Competence and political authority of governments

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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

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South-South Trade and Economic Integration: Looking Outward and Inward

• Economic Integration: Theory and Practice

– The growth of trade among developing countries.

– 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

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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

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Trade Policies of Developed Countries: the Need for Reform

• Rich-nation economic and commercial policies matter for LDCs – Tariff and non-tariff barriers to LDC exports – Adjustment assistance for displaced workers – General impact of economic policy

• 1995 Uruguay Round and WTO • Despite 8 liberalization rounds over 50 years trade

barriers remain in place in agriculture and textiles • Doha Development Round 2001 has tilted the focus

on the needs of the developing world

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Figure 6: Effective Tariff Faced by Income Groups, 1997-1998

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Case Study: Taiwan



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