Trade Policy The need for trade policy 1
• Advantages of free trade: expands the PPF of each participating
country transforming some commodities, exports, into quantities
of other commodities, imports.
• Implication: the more trade there is, the larger the number of
production possibilities, and everyone is better off.
• However, the world is riddled with barriers to trade.
• Why do countries try to guide the direction of trade? (focus on
policies pursued by individual countries: unilateral policy)
Outline:
1. The need for trade policy
2. Import substitution
3. Export promotion
4. Some facts on trade policy
1 • N ↑ capital and labour demand
The need for trade policy 2
• But shrinking textile sector releases a higher proportion of L to K than
required in the car industry. Labour becomes less scarce.
• This imbalance can absorbed if productions become more labour-
intensive
• It happens only if producers face the incentive to become more
labour-intensive
• This requires that the wage rate on labour must fall, while the rental
rate on K must rise
• Owners of L are hurt by opening N to trade, owners of K gain
• Trade can increase income inequality
Case (b): skewed income distribution affects the composition of imports
• Rich demand imported luxury goods
• This drives up the price of foreign exchange
• Hence, it may become difficult to acquire imported inputs necessary
for the development process
3 4
• To understand why trade policies arise, we have to look at the actual
gains from trade:
– (1) How are gains distributed?
– (2) What happens to trade gains in the long-run?
(1)Trade policy as a consequence of inappropriate distribution
Case (a): trade does not imply and generalised increase in welfare
Any production factor that is intensively used in a commodity in the
absence of trade is likely to be hurt when opening to trade results in
increased imports of that commodity.
Causal mechanism:
• Suppose N produces cars and textiles, and cars are more capital-
intensive than textiles
• N opens to trade with S, and imports textiles
• N ↑ car production, N ↓ textiles
2
The need for trade policy 3
(2) Long-run aspects of trade gains
• If LDCs have relative abundance in labour, should they always
produce primary goods?
• Terms of trade of primary goods exporters tend to deteriorate:
the demand growth for those commodities decreases because
of the reduction in the budget share as income grows
• So what seems to be the optimal specialisation today, it could
deliver decreasing income growth in the long run (so failing to
catch up with DCs) and balance-of-payments difficulties
• Country’s government might want to alter its comparative
advantage through policies aimed at K accumulation
1
 The need for trade policy 4 The need for trade policy 5
(3) Market failures
80

60
• Even if agents want to switch to manufactured goods
Percentage Change in the Terms of Trade, 1980--93

40 production, they are faced with major problems: capital

20
markets imperfections, complementary factors (e.g.
infrastructures, human capital) are not present because of
0
0 5000 10000 15000 20000 25000
coordination failures (many individuals should act together to
-20 generate the right conditions)
-40

• Market failures generate need for government intervention

-60

-80

P e r-ca pita in co m e
5 6

Import substitution 1 Import substitution 2

• Import Substitution (IS) Strategy: government erects barriers to
importation of foreign goods, these goods will be substituted by
producing them domestically.
Price

– To-be-developed sectors receive high protection.

• Instruments: tariffs and quotas

Tariff is a % that is applied to the value of an imported item, with the p*(1+[t/100])
resulting sum of money going to the government. Tariffs make the price
of imports higher, allowing domestic manufacturers to enter the p*

business.

Quota is the stipulation of a maximum quantity on a particular good, above

O A C D B Quantity
which no more of that good can be imported.
7 How a tariff works 8

2
 Import substitution 3 Import substitution 4
• Tariffs and quotas are equivalent, except for distributional
effects (tariffs generate a revenue for government)
Price

• However, we observe both under Import Substitution policy.

Why?
Note: CD = EB

Price After
Quota
• Reason 1: political power of business groups that pocket the
p*
revenue in the case of quotas

• Reason 2: government lacks of complete information on the

domestic supply curve
O A C E D B Quantity

How quota works 9 10

Import substitution 6 Import substitution 7

Price

Price

Note: CD = C'D' = EB
Possible Price
p*(1+[t/100]) After Quota

M
M p*
p*

O A C C' D B Quantity O A C C' E D D' B Quantity

11 Quota under incomplete information 12

Tariff under incomplete information

3
Import substitution: welfare effects 1 Import substitution: welfare effects 2
Price

Price
Imports
Exist

R S
Q
Imports Cease

P W V U T
p*(1+[t/100])

p*
Internationally
Competitive

O A C D B Quantity

O A B Quantity

Static welfare effects of a tariff 13 Dynamic welfare effects: learning by doing 14

Import substitution: welfare effects 2 Import substitution: welfare effects 4

• Dynamic welfare effects (Learning by Doing, Spillovers, Increasing
Returns) support the case for import substitution
Average Cost, Price

– Protection to develop domestic industries

• Problem: infant industries do not grow spontaneously, active effort and

investments from the industrialists side is required. To create incentives
b for restructuring of organisations and cost reductions, protection must
be limited and expire at some point, whether or not the infant industry
Average Cost Curve has grown
p
Foreign Profits • This bears a key role for the State: making credible the threat that
a
protection is temporary. It will be removed, even if competitiveness has
not been achieved, and despite the loss of political support from the
industrialists.
Qd Qf Computers

Dynamic welfare effects: increasing returns 15 16

4
 Export promotion 1 Export promotion 2
• Cogent reasons for IS disappear in countries with • Introduce a subsidy: s% of export price for every unit exported
small internal markets • Effect 1: The effective international price is now p*(1+s/100),
production moves up the S curve and domestic demand reduces; the
gap between the two is the larger level of exports
• Not having enough economic space to develop
domestic industry, the obvious choice to trade • Effect 2: increased exports let the international price fall as supply is
greater; price (at the same time) falls to p** before it reaches the new
patterns is outward orientation: promoting equilibrium p**(1+s/100)
(nonprimary) exports • Note: the effectiveness of EP depends on how elastic is the demand for
the export good under scrutiny. If its price elasticity is high, the price
will not fall much below p*, as the outside world absorbs the greater
• EP instruments: export subsides (also reduced import quantity of exports. If demand is rigid, EP could even be completely
ineffectual.
duties, and preferential credit)
17 18

Export promotion 3 Export promotion 4

Price

• Welfare effects of EP
Exports, New
• Domestic consumers pay a higher price, so they
p**(1+[s/100])
M N
Q
Exports, Old R
loose M+N consumer surplus
p*
p**
S T U
• Producers gain: M+N+Q
• Government pays a subsidy = N+Q+R+S+T+U
• Suppose we weigh the actors equally, we are left
with an overall welfare loss = N+R+S+T+U
• If the good is a luxury one, EP can be a way to
redistribute income by taxing the rich (just like in
O C A B D Quantity the IS case)
Effects of an export subsidy 19 20

5
 Some facts on trade policy Summary
• Import substitution and the infant industry argument What have we learned?
were applied in the 1960s and 1970s - Policy of unrestricted trade (neoclassical view) does not mean
• From the 1980s on, Latin America, Turkey, Philippines improvements for all groups
and other LDCs moved away from IS policies, to a - Distributional effects: trade affects the prices inputs which are
package of stabilisation and structural adjustment generally owned in different proportions by different social groups.
policies instigated by the IMF and the World Bank Inputs that are intensively used in the production of the imported
commodity must lose value, whereas inputs that are intensively
• How did we come to that? employed in the production of exportables must gain
• Firstly, IS failures have to do with arising of entrenched - Gains from trade may not accrue because of market imperfections
domestic interests that use protection as monopolistic or exports of primary commodities may experience a long-run fall
right rather than a temporary measure to develop in prices (Prebisch-Singer hypothesis)
domestic industries - Import substitution: it could create entrenched domestic groups with
• Secondly, the debt crisis following the 1973-74 oil vested interests in protection
shocks - Export promotion: export subsidies and their welfare effects
- Facts on Trade policy: a shift from IS to EP
21 22

References
Core readings:
*** Ray D., (1998), Development Economics, Princeton University Press, Chapter: 17
** Thirlwall A.P., (2006), Growth & Development, eighth ed., Palgrave
** Perkins D.H., Radelet S. and Lindauer D.L., (2006), Economics of Development, 6th edition, Chapter 19
** Chang, Ha-Joon and Ilene Grabel (2004) Reclaiming Development: an alternative economic policy manual
London: Zed Books, chapter 7
Recommended readings:
** Meier G.M. and Rauch J.E., (2005), Leading Issues in Economic Development, 8th edition. Chapter IIIA is
devoted to trade; the book reports excerpts from two articles by Rodrik (pp.163-169 and pp.560-572) on
state capacity to build effective intervention and the effectiveness of export promotion: there are insightful
discussions on South Korea, Taiwan, Brazil, Bolivia, Kenya, Turkey and India.
* Todaro M.P. and Smith S.C., (2006), Economic Development, Addison-Wesley, chapter 13; it contains a fairly
non-technical exposition of import substitution and export promotion, covering the main points; good case
study in appendix: South Korea
* Rodriguez, F. and Rodrik, D., (2000), “Trade policy and economic growth: a sceptics guide to cross-national
evidence”, in B. Bernanke and K. Rogoff eds, NBER Macroeconomics Annual 2000. This is an
comprehensive, critical survey of the literature on the effects of trade openness on economic growth.
** Rodrik D., (1998), “Globalisation, social conflict and economic growth”, The World Economy, vol.21, pp.143-
58. It is the Raul Prebisch lecture delivered at UNCTAD in 1997, and is useful to understand the
relationships behind the abandonment of the import substitution strategy.
** Lall S., (1994), ‘The East Asian Miracle: Does the Bell toll for Industrial Strategy?’, World Development, 22, 4
** Pack H., (2000), ‘Industrial Policy: Growth elixir or Poison?, World Bank Research Observer, 151, 1
23