Chapter 5

International Trade and

Economic Development

1
 Globalization: An Introduction
 Globalization is one of the most frequently
used words in discussions of development,
trade, and international political economy.
 It is a process by which the economies of the
world become more integrated, leading to a
global economy and, increasingly, global
economic policymaking.

12-2
 Globalization cont…
 Globalization also refers to an emerging
“global culture,” in which people consume
similar goods and services across countries
and use a common language of business;
these changes facilitate economic integration
and are in turn further promoted by it.
 But in its core economic meaning,
globalization refers to the increased
openness of economies to international trade,
financial flows, and direct foreign investment.
12-3
 Globalization cont…
 Globalization can in many ways have a
greater impact in developing countries.
 For some people, the term globalization
suggests
 exciting business opportunities,
 efficiency gains from trade,
 more rapid growth of knowledge and
innovation, and the transfer of such
knowledge to developing countries
facilitating faster growth. 4
 Globalization cont…
 For other people, however, globalization
raises troubling concerns:
 inequalitieso may be accentuated both
across and within countries,
 environmental degradation may be
accelerated,
 the international dominance of the richest
countries may be expanded and locked in,
and
 some peoples and regions may be left
further behind. 5
 International Trade: Some Key Issues
 International trade has often played a central
role in the historical experience of the
developing world.
 In recent years, much of the attention to
trade and development issues has been
focused on understanding the spectacular
export success of East Asia. Taiwan, South
Korea, and other East Asian economies
pioneered this strategy, which has been
successfully followed by their much larger
neighbor, China. 6
International Trade: Some Key Issues
 Many developing countries
• rely heavily on exports (usually primary
products)
• rely heavily on imports (typically of
machinery, capital goods, intermediate
producer goods, and consumer products)
• suffer from chronic deficits in current and
capital accounts which depletes their
reserves, causes currency instability, and
a slowdown in economic growth. 7
 Five Basic Questions about Trade and
Development
1. How does international trade affect the rate,
structure, and character of economic
growth?
2. How does trade alter the distribution of
income and wealth within a country and
among different countries?
3. Under what conditions can trade help a
nation to achieve its development
objectives?
8
 Five Basic Questions about Trade and
Development
4. Can a developing country by its own
actions determine how much it trades or
which products and services it sells?
5. Should a developing country adopt an
outward-looking policy or an inward-looking
policy, or some combination of both?

9
 Importance of Exports to Developing Nations
 Developing countries are more dependent on

trade than developed countries are.

 While large countries are less dependent on

trade than small countries, at any given size,

developing countries tend to devote a larger
share of their output as merchandise exports
than developed countries do.
 The greater recorded share of developing-

country exports in GDP is probably due in

part to the much higher relative prices of non-
traded services in developed than in
developing countries. 10
 Importance of Exports to Developing Nations
 Nevertheless, the point remains that
developing countries are generally more
dependent on trade in international economic
relations because most trade is in
merchandise, for which price disparities are
smaller across countries.
 Moreover, the exports of developing
countries are much less diversified than
those of the developed countries.

11
 Demand Elasticities and Export Earnings
Instability
 The export performance relates to the concept
of elasticity of demand
 In the case of primary products, the income
elasticity of demand is relatively low.
 The percentage increase in quantity of primary
products demanded by importers (mostly rich
nations) will rise by less than the percentage
12
 The net result of these low income elasticity of
demand is the tendency for relative price of
primary products to decline over time.
 Since the price elasticity of demand for (and
supply of) primary commodities also tends to be
low (inelastic), any shifts in demand or supply
curves can cause large and volatile price
fluctuations.
 These two elasticity phenomena contribute to
what has come to be known as export
earnings instability, which leads to lower and
less predictable rates of economic growth.13
The Terms of Trade and the Prebisch-Singer Thesis

 Total export earnings depend on:

– total volume of exports sold and
– price paid for exports
 If export prices decline, a greater volume of
exports will have to be sold merely to keep
total earnings constant.
 Similarly, on the import side, the total foreign
exchange expended depends on both the
quantity and the price of imports. 14
 If the price of a country’s exports is falling
relative to the prices of the products it imports,
it will have to sell that much more of its export
product to secure the same level of imported
goods that it purchased in previous years.
 The name for the ratio between the price of a
typical unit of exports and the price of a typical
unit of imports is called the commodity terms
of trade, and it is expressed as Px/Pm.
 The main theory for the declining commodity
terms of trade is known as the Prebisch-Singer
hypothesis.
15
 It states that there was and would continue to
be a secular (long-term) decline in the terms of
trade of primary- commodity exporters due to
a combination of low income and price
elasticities of demand.
 This known as import substitution. decline
would result in an ongoing transfer of income
from poor to rich countries that could be
combated only by efforts to protect domestic
manufacturing industries through a process
that has come to be

16
The Traditional Theory of International
Trade

 Barter transaction: is an exchange of two

things- something is given up in return for
something else.
 The barter transaction is the basic component
of human activity throughout the world.
17
 The principle of comparative advantage
 Because it is impossible for individuals or
families to provide themselves with all the
consumption requirements, they usually
find it profitable to engage in the activities
for which they are best suited or have a
comparative advantage in terms of their
natural resource endowments.
 They can then exchange any surplus of
these home-produced commodities for
products that others may be relatively more
suited to produce. 18
 Specialization based on comparative
advantage arises, therefore, to some extent in
even the most primitive of subsistence
economies.
 Countries specialize in activities where the
gains from specialization is likely to be the
largest.
 The concept of relative cost and price
differences is basic to the theory of international
trade.
19
 The principle of comparative advantage,
asserts that a country will specialize in the
exports of the products that it can produce at
the lowest relative cost.

 Even if a country has absolute advantage in

the cost of both commodities, it can still benefit
from trade because of the differences in
comparative advantage that give rise to
beneficial trade.
20
 Relative factor endowments and international
specialization: the Neoclassical model
 The classical comparative advantage theory
of free trade is a static model based on a one-
variable-factor (labor cost) and complete-
specialization approach to demonstrate the
gains from trade.
 This theory primarily associated with David
Ricardo and John Stuart Mill, was modified
in the 20th century, by Eli Hecksher and Berti
Ohlin to take into account differences in factor
supplies (mainly land, labor, and capital) on
international specialization. 21
 The Hecksher-Ohlin neoclassical factor
endowment trade theory also enables us to
describe the impact of economic growth on
trade patterns and the impact of trade on the
structure of national economies and on the
differential returns or payments to various
factors of production.
22
 The basis of trade arises because countries are
endowed with different factor supplies.
 Countries with cheap labor will have a relative cost and price
advantage over countries with relatively expensive labor in
commodities that make intensive use of labor.

23
 The countries with cheap labor should focus on

the production of labor-intensive products and

export the surplus in return for imports of

capital-intensive goods.

24
 Countries who well endowed with capital will
have a relative cost and price advantage in the
production of manufactured goods.
 These countries can benefit from
specialization in and export of capital-
intensive manufactures in return for imports
of labor-intensive products from labor-
abundant countries. 25
 Main conclusions of the neoclassical model of
free trade
 All countries gain from trade and world output is
increased.
 Due to increasing opportunity costs associated
with resource shifting among commodities with
different factor intensities of production,
complete specialization will not occur as in the
classical comparative-advantage model.
 Countries will tend to specialize in products that
use their abundant resources intensively.
 They will compensate for their scarce resources
by importing products that use these scarce
resources most intensively.
 But rising domestic costs and prices in excess
of world prices will prevent complete 26
specialization from occurring.
 Main conclusions of the neoclassical model of
free trade
 Given identical technologies of production

throughout the world, the equalization of

domestic product price ratios with the
international free-trade price ratio will tend to
equalize factor prices across trading
countries. It makes the important prediction that
international real wage rates and capital costs
will gradually tend toward equalization.

27
Main conclusions of the neoclassical model of
free trade

28
 Main conclusions of the neoclassical model of
free trade
 By enabling countries to move outside their

production possibility frontiers and secure

capital as well as consumption goods from
other parts of the world, trade is assumed to
stimulate economic growth.
 If developed countries have the comparative

advantage in producing higher-skill capital

goods, trade would lower the price of
equipment and machinery and stimulate
investment and growth for developing
29
countries.
 Trade theory and development: the traditional
arguments
 We are now in a position to summarize the

theoretical answers to our five basic questions

about trade and development derived from the
neoclassical free trade model.
1. Trade is an important stimulus of economic
growth. It enlarges a country’s consumption
capacities, increases world output, and
provides access to scarce resources and
worldwide markets for products without which
poor countries would be unable to grow.
30
 Trade theory and development: the traditional
arguments
2. Trade tends to promote greater international
and domestic equality by equalizing factor
prices, raising real incomes of trading countries,
and making efficient use of each nation’s and
the world’s resource endowments (e.g., raising
relative wages in labor-abundant countries and
lowering them in labor-scarce countries).
3. Trade helps countries achieve development by
promoting and rewarding the sectors or the
economy that possess a comparative
advantage, whether in terms of labor efficiency 31
or factor endowments.
 Trade theory and development: the traditional
arguments
4. In a world of free trade, international prices and
costs of production determine how much a
country should trade in order to maximize its
national welfare.
5. To promote growth and development, an
outward-looking international policy is required.
In all cases, self-reliance based on partial or
complete isolation is asserted to be
economically inferior to participation in a world
of unlimited free trade. 32
Some Criticisms of Traditional Free-Trade Theory in the
Context of Third World Experience
 Six assumptions of the Neoclassical model
must be scrutinized:
1. All productive resources are fixed in quantity
and constant in quality across nations and are
fully employed.
2. The technology of production is fixed(classical
model) or similar and freely available to all
nations (factor endowment model). The spread
of such technology works to the benefit of all.
Consumer tastes are also fixed and
independent of the influence of producers 33
3. Within nations, factors of production are
perfectly mobile between different production
activities, and the economy as a whole is
characterized by the existence of perfect
competition. There are no risks or uncertainties
4. The national government plays no role in
international economic relations; trade is
carried out among many atomistic and
anonymous producers seeking to minimize
costs and maximize profits. International prices
are therefore set by the forces of supply and
demand. 34
5. Trade is balanced for each country at any
point in time, and all economies are readily
able to adjust to changes in the international
prices with a minimum of dislocation.

6. The gains from trade that accrue to any

country benefit the nationals of that country.

35
 Let us take a critical look at each of these
assumptions in the context of the
contemporary position of developing
countries in the international economic
system.
 Some of these criticisms form the rationale
for other, non-neoclassical theories of trade
and development, including vent-for-surplus,
structuralist, and North-South models.

36
 1. Fixed Resources, Full employment, and the
International Immobility of productive factors
 In reality, factors of production are not fixed in
quantity or in quality.
 The relative factor endowments and
comparative costs are not given but are in a
state of change.
 The factor endowments and comparative costs
are often determined by the nature and of
international specialization.
37
 If rich nations (the North) are well endowed with
capital, entrepreneurial ability, and skilled labor, their
continued specialization in producing manufactured
goods and use these resources intensively will create
the necessary conditions and economic incentives for
their further growth.
 By contrast, developing world countries (the South),
endowed with abundant supplies of unskilled labor, by
specializing in products that intensively use unskilled
labor and for which world demand and terms of trade
are very unfavorable, will find themselves locked into a
comparative advantage in unskilled, unproductive
activities. This will in turn inhibit /hinder the domestic
growth of needed capital, entrepreneurship, and
technical skills. 38
 Some economists have challenged the static
neoclassical model through the so-called
North-South trade models that focus on
trade relations between rich and poor
countries, whereas the traditional model was
assumed to apply to all nations.

39
 It focus on the unequal exchange between the
North developed countries and the South
developing countries in an attempt to explain
why the South gains less from trade than the
North.
 The North-South models argue, for example,
that initial higher endowments of capital in the
industrialized North generate external
economies in manufacturing output and higher
profit rates.

40
 The assumption of full employment in traditional
trade models violates the reality of
unemployment and underemployment in
developing nations.
 Underutilized labor create the opportunity to

expand productive capacity and GNP at little or

no real cost by producing for export markets
products that are not demanded locally. This is
known as the vent-for-surplus theory of
international trade.

41
 According to the vent-for-surplus theory, the
opening of world markets to the LDCs, creates
opportunities to make use of formerly
underemployed land and labor resources to
produce greater output for exports to foreign
markets.
 In terms of the production possibility analysis,
the vent-for-surplus argument can be
represented by a shift in production from point
V to point B in Figure 5.1.

42
 In Figure 5.1, before trade, the resources of the
closed developing world economy were
underutilized. Production was occurring at point
V, with OX primary products and OY
manufactures were being produced and
consumed.
 With trade will utilize the idle resources and
expand primary products exportable production
from OX to OX’ at point B. given the
international price ratio Pa/Pm, the amount of
VB primary products can be exported in
exchange for the amount VC manufactures.
43
Figure 5.1 The Vent-for-Surplus
Theory of Trade in LDCs

44
 The result that the final consumption point, C, is
attained with the same primary products (X)
being consumed as before but with Y’ – Y more
imported manufactures now available.

45
 2. Internal Factor Mobility and Perfect
Competition
 The traditional theory of trade assumes that
nations are readily able to adjust their economic
structures to the changing dictates of world
prices and markets.
 Movements along production possibility
frontiers involving the reallocation of resources
from one industry to another are extremely
difficult to achieve in practice. This is especially
true in developing nations, where production
structures are often rigid and factor movements
46
are largely restricted.
 The assumption of perfect competition is also
not realistic due to factors like:
» monopolistic and oligopolistic market control along
with widespread product differentiation, intra-
industry trade, and external economies of
production
– risk and uncertainty in international trading
arrangements.

47
 3. Fixed, Freely Available Technology and
Consumer Sovereignty

 Technological changes are rapidly growing

and being dispersed to maximize the returns
of their owners throughout the world.
 Consumer preferences and tastes are also
created and reinforced by the advertising
campaigns that dominate local markets.

48
 4. The Absence of National Governments in
Trading Relations

 Traditional trade theories neglect the crucial

role that national governments can and do
play in the international economic arena:
– Growth poles

– Industrial policy

– Tariffs, import quotas, and export subsidies

49
 5. Balanced Trade and International Price
Adjustments
 The theory of international trade is not only a
full-employment model but also one in which
flexible domestic and international product and
resource prices always adjust instantaneously
to conditions of supply and demand.
 The terms of trade adjust to equate supply and
demand for a country’s exportable and
importable products imports so that trade is
always balanced; that is, the value of exports
is always equal to the value of imports. 50
 With balanced trade and no international
capital movements, balance of payments
problems never arise in the pure theory of
trade.
 However, in some periods, as seen following
the rapid increase in international oil prices in
the 1970s, balance of payments deficits
become the major concern of all nations.

51
 6. Trade Gains Accruing to Nationals
 If developing countries benefit from trade, it is
the people of these countries who reap the
benefits.
 However, with the proliferation of multinational
corporations and increasing foreign ownership
of companies in a wide range of countries,
country’s own citizens, especially those in
lower income brackets, may not benefit from
exports earnings.
52
 Trade Strategies for Development: Export
Promotion versus Import Substitution
 A traditional way to approach the complex
issues of appropriate trade policies for
development is to set these specific policies in
the context of a broader strategy of looking
outward or looking inward.

53
 Outward-looking development policies
– policies that encourage exports, often
through the free movement of capital,
workers, enterprises, and students; a
welcome to multinational corporations; and
open communications.
 Inward-looking development policies
– policies that stress economic self-reliance on
the part of developing countries including
domestic development of technology, the
imposition of barriers to imports, and the
discouragement of private foreign investment.
54
 A lively debate regarding these two
philosophical approaches has been carried on
in the development literature since the 1950s.
 The debate pits the free traders, who advocate
outward-looking export promotion strategies of
industrialization, against the protectionists, who
are proponents of inward looking import
substitution strategies.
 The latter predominated into the 1970s; the
former gained the upper hand in the late 1970s
and especially among Western and World Bank
economists in the 1980s and early 1990s. 55
 Advocates of import substitution (IS) believe that a
developing economy should initially substitute
domestic production of previously imported simple
consumer goods (first-stage IS) and then substitute
through domestic production for a wider range of more
sophisticated manufactured items (second-stage IS).
 Advocates of export promotion (EP) of both primary
and manufactured goods cite the efficiency and
growth benefits of free trade and competition, the
importance of substituting large world markets for
narrow domestic markets, the distorting price and cost
effects of protection, and the tremendous successes
of such export-oriented economies as South Korea,
Taiwan, Singapore, Hong Kong, and China. 56
 Export Promotion: Looking Outward and
Seeing Trade Barriers
a) Primary-Commodity Export Expansion
 Many low-income countries still rely on primary
products for a majority of their export earnings.
 With the notable exception of petroleum
exports and a few needed minerals, primary-
product exports have grown more slowly than
total world trade.
 There are different factors working against the
rapid expansion of primary-product and
especially agricultural exports. 57
On the demand side
 Low income elasticities of demand for

agricultural foodstuffs and raw materials

 Developed-country population growth rates

are now at or near the replacement level, so

little expansion can be expected from this
source.
 Relatively low price elasticity of demand for

most primary commodities

 Development of synthetic substitutes

 Growth of agricultural 12-58 protection in the

On the supply side
 Structural rigidity of many rural production

systems in developing countries.

 Developed-country trade and foreign-aid
policies that depress agricultural prices
in the least developed countries and
discourage production.

59
b) Expanding Exports of Manufactured Goods
 The expansion of manufactured exports has
been encouraged by the spectacular export
performances of countries like South Korea,
Singapore, Hong Kong,Taiwan, and China.
 However, the major problem has been the

widespread protection in developed nations

against the manufactured exports of
developing countries.

60
Import Substitution: Looking Inward but Still Paying
Outward
 It is an attempt to replace commodities that are being

imported with domestic sources of production and

supply.
 A principal mechanism of the import substitution

strategy is the erection of protective tariffs or quotas.

 The basic economic rationale for such protection is

the infant-industry argument. Tariff protection is

needed to allow the now higher-priced domestic
producers enough time to learn the business and to
achieve the economies of scale in production and the
external economies of learning by doing that are
necessary to lower unit costs and prices.
12-61
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
62
 Tariff Structure and Effective Protection
 Import substitution programs are based on the
protection of local industries against competing
imports primarily through the use of tariffs and
physical quotas.
 Whatever the means used to restrict imports, such
restriction always protects domestic firms from
competition with producers from other countries.
 To measure the degree of protection, we need to ask
by how much these restrictions cause the domestic
prices of imports to exceed what their prices would
be if there were no protection. There are two basic
measures of protection: the nominal rate and the
effective rate. 12-63
 Nominal rate of protection
It shows the extent, in percentages, to which
the domestic price of imported goods
exceeds what their price would be in the
absence of protection.
p  p
t
p
Where
p′ is the tariff-inclusive price
p is the free trade price
64
 Effective rate of protection
It shows the percentage by which the value
added at a particular stage of processing in a
domestic industry can exceed what it would
be without protection.
v  v
g
v
where
v′ is the value added per unit of output,
inclusive of the tariff

v is the value added per unit of output

65
under free trade