ECON 4321

Module 8B: International Trade and

Economic growth
Corresponding Chapter in the Book: 12
FA 2025
 INTRODUCTION
We’ll discuss the basic aspects of the theory of
economic growth
We’ll show how international trade can be used to
enhance economic growth
Developing countries have used various strategies to
enhance their economic growth
What is the role of developing country governments
and international organizations in increasing economic
growth in developing countries?

Econ 4321: International Trade 2

 THE DEVELOPING COUNTRIES
Economic development
o Economic development is defined as the goal of
attaining a standard of living roughly equivalent to
that of the average citizen in a developed country.
o Average income can be measured using per capita
GDP.
o Low GDP per capita is associated with a host of other
factors that reduce the quality of life for most of
humanity.

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 THE DEVELOPING COUNTRIES 2

The first goal of economic development is alleviating

the dire conditions billions face in developing
countries.
Problems such as malnutrition, poor housing, lack of
basic health care, lack of an infrastructure to provide
amenities like clean water, and illiteracy make it
difficult for people to improve their standard of living.
Economic development can be a complicated concept.

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THE DEVELOPING COUNTRIES 3
We assume that the various aspects of economic
development all are positively correlated with a
country’s GDP per capita.
[Link]
There are significant differences in GDP per capita across
nations.
The World Bank Group categorizes the world’s
economies into four income groups: low, lower-middle,
upper-middle, and high.
[Link]
country-classifications-by-income-level-for-2024-2025

International economics is concerned with the

relationship between international trade and economic
growth rate. Econ 4321: International Trade
5
 ECONOMIC GROWTH
Preconditions for growth
o Two important preconditions for economic growth
are property rights and the rule of law.
o For markets to work, it must be clear who owns what
o If property rights are not being properly enforced,
then far fewer transactions occur with the result of a
lower level of economic activity

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 ECONOMIC GROWTH 2
Normal economic transactions involve legally binding
contracts
If there is no effective referee to enforce business
contracts, then far fewer business contracts occur with
the result of a lower level of economic activity
In many developing countries, these conditions are not
being met
This situation is called a failed state

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 ECONOMIC GROWTH 3

Economic growth and the factors of production

o For an economy to grow, it needs resources – factors
of production.
o Since land is generally fixed, the focus will be on labor,
capital, and technology.
o A country’s labor force can increase through
population growth or immigration.
o An increase in the labor force will tend to increase the
GDP

Econ 4321: International Trade 8

 ECONOMIC GROWTH 4
Table 12.2 Economic freedom index, 2014

Highest-ranking Economic freedom Lowest-ranking Economic freedom

Countries index countries index
Hong Kong 90.1 Rep. of Congo 43.7
Singapore 89.4 Timor-Leste 43.2
Australia 82.0 Turkmenistan 42.2
Switzerland 81.6 Dem. Rep. of Congo 40.6
New Zealand 81.2 Iran 40.3
Canada 80.2 Eritrea 38.5
Chile 78.7 Venezuela 36.3
Mauritius 76.5 Zimbabwe 35.5
Ireland 76.2 Cuba 28.7
Denmark 76.1 North Korea 1.0

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 ECONOMIC GROWTH 5
Economic growth also requires an increase in the stock
of capital
Capital is the amount of money invested in business
structures and equipment
For a developing country, the stock of capital outside of
the private sector may be critically important
For capital and labor to produce the maximum output,
the economic infrastructure of the country needs to be
appropriate to the level of economic development

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 ECONOMIC GROWTH 6
In economics, technology is anything that causes
resources to be used more efficiently.
Economic growth can also be enhanced by having a
country’s level of technology increase over time.
A change in technology means that a country can
either produce more output with the same amount
of resources or alternatively produce the same level
of output with fewer resources.

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 ECONOMIC GROWTH 7
Basic growth theory
o The relationship between GDP and factors of
production is called the production function.
o The shape of the production function reflects the
phenomenon of diminishing returns.
o As the amount of a variable factor increases, the
resulting increase in output becomes smaller.
o This effect applies especially to developing countries
with low initial GDPs and increasing labor forces.

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 ECONOMIC GROWTH 8
Output
(GDP)

Y4 F
Y3

Y2

Y1

L1 L2 L3 L4 Labor force (L)

Figure 12.1 Production function for a country

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 ECONOMIC GROWTH 9

Changes in the capital stock and technology

o Businesses generally use loan proceeds to invest in
structure and/or equipment.
o This increases capital stock, and the production
function shifts upwards
o Because the capital-to-labor ratio has increased, the
economy can now produce more goods and services
for any given size of the labor force

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 ECONOMIC GROWTH 10
Output F2
(GDP)

F1

Y2

Y1

L1 Labor force (L)

Figure 12.2 Shift in the production function for a country

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 ECONOMIC GROWTH 11

An improvement in technology should allow the

economy to produce more goods and services with
the same level of labor and capital.
Labor and capital can be used more efficiently.
The increase in the GDP is solely the result of
utilizing the same amount of capital and labor to
produce more goods and services.

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 INTERNATIONAL TRADE AND
ECONOMIC GROWTH
Openness and growth
o The more a country trades, the faster the economy
should be able to grow
o There is evidence of a positive correlation between
openness to trade and growth
o Openness causes an improvement in technology
o Improved technology leads to improved total factor
productivity, getting more outputs from the same
inputs.

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 INTERNATIONAL TRADE AND
ECONOMIC GROWTH 2
This is the amount of economic growth that can not be
accounted for by increases in labor or capital used.
More open economies tend to have higher growth rates
of total factor productivity.
This is a complex issue, and while the relationship
between openness to trade and growth appears to
exist, no one is sure of the size of the effect.

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 INTERNATIONAL TRADE AND
ECONOMIC GROWTH 3
Capital flows, technology transfers, and
economic growth
o Increasing the capital stock and the level of
technology in developing countries is difficult
o In developing countries, savings are low, and the
level of technology is below the world average
o FDI helps developing countries increase their capital
stock

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 INTERNATIONAL TRADE AND
ECONOMIC GROWTH 4
Transfer of technology from developed to developing
countries also increases the rate of economic growth.
But technology and knowledge are hard to measure
This limits the ability to analyze the effects of these
technology transfers accurately.
FDI flows bring in improved technology
Trade drives specialization and learning which
improves knowledge and increases total factor
productivity even without FDI

20
 ECONOMIC DEVELOPMENT
STRATEGIES

Primary products
o Natural resources or the ability to produce
agricultural products are generally referred to as
primary products.
o Exporting primary products can be quite profitable
o This can lead to increased tax revenue to enhance
economic development
o Often this is a move to a more manufacturing-based
economy

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 ECONOMIC DEVELOPMENT
STRATEGIES 2

Revenues from primary production may allow a

country to finance infrastructure development and
import capital equipment more quickly than a
country without such resources.
Primary production may be the start of a process of
producing a final good
Adding value to a primary product is an obvious first
step in economic development

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 ECONOMIC DEVELOPMENT
STRATEGIES 3

In practice, this process has been fraught with

difficulties
Higher tariffs on intermediate or finished goods may
make exporting difficult
Developed countries have done this to encourage the
processing of primary products in their countries
Countries with primary products find it more difficult
to exploit their comparative advantage

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 ECONOMIC DEVELOPMENT
STRATEGIES 4
Primary products can be a problem concerning economic
development
The prices of primary products tend to be volatile
If both the demand and supply of the product are inelastic,
then most of the changes in demand and supply are
reflected in the price
For many countries, primary products are a high percentage
of exports or GDP
The volatility of prices can cause significant changes in
terms of trade or instability for the whole economy

Econ 4321: International Trade 24

 ECONOMIC DEVELOPMENT
STRATEGIES 5
S1 S
Price

P1 F

P E

D1
D
Quantity
Figure 12.3 Equilibrium price of primary products

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 ECONOMIC DEVELOPMENT
STRATEGIES 6
Import substitution
o The purpose of an import substitution development
strategy is to increase the relative size of the
manufacturing sector.
o It can allow faster initial growth of the manufacturing
sector
o The country may conserve on supplies of foreign
exchange by importing fewer manufactured products
which may improve the trade balance
o Some of the protected industries might, in the future,
have a comparative advantage

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 ECONOMIC DEVELOPMENT
STRATEGIES 7
If the economy at an early stage of economic
development does not have a comparative advantage in
manufactured products, is there a way to increase the
size of this sector?
Governments can use domestic policies such as low
taxes on manufacturing, direct government subsidies,
or trade policy to favor the manufacturing sector.
If tariffs are sufficient to increase output, then quota
protection could be instituted instead of or along with
tariffs.

Econ 4321: International Trade 27

 ECONOMIC DEVELOPMENT
STRATEGIES 8
Import substitution has created a number of problems
for the countries that pursue it.
The infant manufacturing sector is not internationally
competitive and is producing substitutes for imports
that cost more and may be of lower quality.
This reduces the welfare of consumers and/or their
ability to produce other goods and services at
competitive prices.
Protected industries are larger than they should be in a
free market.

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 ECONOMIC DEVELOPMENT
STRATEGIES 9

Since the economy is not using its resources efficiently,

it is not growing as fast as it could
Slow economic growth may mean slow growth in
employment
With a growing labor force, this is a problem
An import substitution policy tends to make the
domestic industry more capital-intensive than would
otherwise be the case, further reducing job creation.

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 ECONOMIC DEVELOPMENT
STRATEGIES 10
Another problem relates to public choice.
In an economy with much protectionism, there is a lot
of rent-seeking activity.
It will be challenging to withdraw protectionism as
firms and workers in the protected industry will lobby
to keep the current level of protection from being
removed.
The industries never adjust fully to world competition
and, over time, become relatively more inefficient.

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 ECONOMIC DEVELOPMENT
STRATEGIES 11

Beginning in the 1970s and continuing into the 21st

century, most countries pursuing the import-
substitution development policy are in the process of
abandoning it.
Countries are willing to go through this process due to
the widespread realization that an inefficient
manufacturing sector does not enhance overall
economic growth.

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 ECONOMIC DEVELOPMENT
STRATEGIES 12

Export promotion
o A development strategy based on developing
industries in line with the country’s comparative
advantage
o More effective than import substitution
o Export promotion implies an increase in the relative
size of the manufacturing sector.
o For manufacturing to thrive, there is an active role for
the government.

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 ECONOMIC DEVELOPMENT
STRATEGIES 13
The preconditions for growth are important
Manufacturing usually is more infrastructure intensive
than agriculture
The development of a sufficient infrastructure will involve
the participation of the government
Services must be internationally competitive in both price
and quality
Development of the manufacturing sector requires
increases in the amount of human capital

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 ECONOMIC DEVELOPMENT
STRATEGIES 14

Taxation of industries must be competitive about

competitive countries
The government needs to have reasonable polices
concerning FDI
The government needs to avoid protectionism to the
greatest extent possible
Exchange rates need to be determined by market forces

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 ECONOMIC DEVELOPMENT
STRATEGIES 15
If executed properly, the export promotion has a
number of advantages
More resources flow into the comparative advantage
sectors and away from the comparative disadvantage
Faster economic growth increases the rate of job
creation
May improve the country’s chance of creating a more
favorable balance between exports and imports
It works better than import substitution

Econ 4321: International Trade 35

 OFFICIAL DEVELOPMENT
ASSISTANCE
Developed countries can assist developing countries
through what is popularly known as “foreign aid.”
The correct term for this transfer of resources from
developed countries to developing countries to assist in
the process of economic development is official
development assistance (ODA)
Accomplished through the actions of properly
functioning governments
Is a small part of economic development

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 OFFICIAL DEVELOPMENT
ASSISTANCE 2
The role of official development assistance
o Structural change is frequently accompanied by an
increasing degree of urbanization.
o Basic infrastructure becomes more critical to
accommodate a rising percentage of the population
living in urban areas.
o Infrastructure investment is not cheap, and
governments of poor countries may be hard-pressed
to afford these investments.

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 OFFICIAL DEVELOPMENT
ASSISTANCE 3
Many of these investments require a substantial amount
of foreign exchange, and it may be challenging to obtain
the needed amount.
This is where ODA can play a valuable role in the
process of economic development.
Developing countries typically have small or weak
capital markets making long-term financing
problematic.
The required sums are not as formidable to a
developing country.

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 OFFICIAL DEVELOPMENT
ASSISTANCE 4
Flows of official development assistance
o ODA is not a major factor in economic development
o The total is less than 1% of the collective GDPs of
developing countries.
o The total amount of ODA is not large relative to the
size of the developing countries.
o For developed countries, these flows are tiny.

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 OFFICIAL DEVELOPMENT
ASSISTANCE 5
ODA flows from developed to developing countries take
on two general forms
The money can move directly from government to
government
This transfer can be a grant, or it can be a loan
The transfers are often “tied” to the donor country
The donor may specify the money to be used for a
particular project

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 OFFICIAL DEVELOPMENT
ASSISTANCE 6
The money may have to be spent on goods and/or
services produced in the donor country.
The developing country may have to purchase goods
and/or services that are not completely appropriate.
The money can move from the developed countries to
various multilateral development organizations, who
then transfer the money or provide services to the
developing countries.

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 OFFICIAL DEVELOPMENT
ASSISTANCE 7
Multilateral development organizations
o The World Bank and regional development banks
o The World Bank is headquartered in Washington, DC,
and is a collection of five closely associated
institutions.
o The heart of the institution is the International Bank
for Reconstruction and Development (IBRD)
o The original purpose of the IBRD was to provide
reconstruction loans after the Second World War.

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 OFFICIAL DEVELOPMENT
ASSISTANCE 8
Loans are still made for reconstruction from natural
disasters
The focus today is on loans to middle-income countries
for specific infrastructure projects
The World Bank finances the activities at favorable
interest rates
There are four other institutions in the World Bank
Group

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 OFFICIAL DEVELOPMENT
ASSISTANCE 9
The International Development Association (IDA)
provides no-interest loans to low-income countries for
infrastructure.
The International Finance Corporation (IFC) invests in
business opportunities in developing countries that
may be underserved without IFC participation.
The Multilateral Investment Guarantee Agency (MIGA)
promotes FDI by providing guarantees to foreign
investors.

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 OFFICIAL DEVELOPMENT
ASSISTANCE 10
The International Centre for Settlement of Investment
Disputes encourages FDI by providing a facility for the
conciliation and arbitration of investment disputes
between companies and host countries.
While generally successful, the World Bank Group has
experienced some problems.
In the 1980s, there were problems with rescheduling
loan repayments from heavily indebted countries.

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 OFFICIAL DEVELOPMENT
ASSISTANCE 11
On occasion, the bank was found to be in violation of its
own lending policies
This led to reforms of its internal operations
The most common criticism of its lending policies was
that it did not consider the environmental impacts of
the projects it was funding.
Today environmental considerations are seriously
considered.

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 OFFICIAL DEVELOPMENT
ASSISTANCE 12
The most recent initiatives concerned funding
projects for governments of developing
countries to reduce corruption
Less well-known are three regional banks
o The Asian Development Bank
o The African Development Bank
o The Interamerica Development Bank
They supplement the World Bank and function
much like the IBRD.

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 OFFICIAL DEVELOPMENT
ASSISTANCE 13
The United Nations Agencies
o United Nations Conference on Trade and Development
(UNCTAD)
o United Nations Industrial Development Organization
(UNIDO)
o United Nations Development Program (UNDP)
For the most part, these UN agencies do not
provide ODA in the form of money, they provide
technical assistance in many areas of economic
development.
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 OFFICIAL DEVELOPMENT
ASSISTANCE 14
UNCTAD assists developing countries in the process of
integrating into the world economy
It is the focal point for issues on international trade and
economic development.
UNIDO assists nations in developing a manufacturing
sector
UNDP is not primarily concerned with economic issues
It is concerned with the effect of economic growth on
the noneconomic aspects of economic development

49
Econ 4321: International Trade
 SUMMARY
1. The economic development of a country can be defined
as an increase in a country’s standard of living as
measured by a country’s GDP per capita.
2. There are approximately 145 developing countries in
the world economy, containing 85% of the world’s
population.
3. Economic development has many characteristics, most
of which are positively correlated with GDP per capita.

Econ 4321: International Trade 50

 SUMMARY 2
4. Two critical preconditions for economic growth are
property rights and the rule of law.
5. The economic growth of a country can be enhanced by
increasing its labor force, increasing its stock of capital, or
increasing its level of technology.
6. The theory of economic growth indicates that as the size of
the labor force increases, the amount of real GDP an
economy can produce increases at a decreasing rate –
diminishing returns.

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 SUMMARY 3

7. Empirical studies indicate that the more open an

economy, the faster it grows.
8. There are three development strategies used by
developing countries concerning international trade:
primary products, import substitution, and export
promotion.
9. Developed countries assist developing countries in
their economic development through official
development assistance.

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 SUMMARY 4

10. The World Bank Group and the regional development

banks provide loans to low- and middle-income
countries for specific projects.
11. The United Nations has several organizations that deal
with various economic and noneconomic aspects of
economic development.

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