ECO 224

LECTURE 5: INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT

INTRODUCTION

The role of foreign trade in economic development is considerable. The classical and neo-
classical economists attached so much importance to international trade in a counry’s
development that they regarded it as an engine of growth. The opposite view holds that
historically foreign trade has led to international inequality whereby the rich countries have
become richer at the expense of the poor countries. It is, therefore, contended that even if LDCs
are required to sacrifice the gains from international specialisation, they can attain a higher rate
of development by following the policies of import substitution. We shall first discuss how
international trade helps economic development and then the opposite view as to how far it has
inhibited the development of LDCs.

IMPORTANCE OF INTERNATIONAL TRADE

Foreign trade possesses great importance for LDCs. It provides the urge to develop the
knowledge and experience that make development possible, and the means to accomplish it.
Haberler opines, “My overall conclusion is that international trade has made a tremendous
contribution to the development of less-developed countries in the 19th and 20th centuries and
can be expected to make an equally big contribution in the future . . . and that substantial free
trade with marginal, insubstantial corrections and deviations, is the best policy from the point of
view of economic development.”

DIRECT BENEFITS
When a country specialises in the production of a few goods due to international trade and
division of labour, it exports those commodities which it produces cheaper in exchange for what
others can produce at a lower cost. It gains from trade and there is increase in national income
which, in turn, raises the level of output and the growth rate of economy. Thus, the higher level
of output through trade tends to break the vicious circle of poverty and promotes economic
development.
An LDC is hampered by the small size of its domestic market which fails to absorb sufficient
volume of output. This leads to low inducement to investment. The size of the market is also
small because of low per capita income and of purchasing power. International trade widens the
market and increases the inducement to invest income and savings through more efficient
resource allocations.
The introduction of foreign trade opens the possibility of a “vent for suplus” (orpotential surplus)
in the primary producing LDCs. Since land and labour are underutilised in the traditional
subsistence sector in such a country, its opening up to foreign trade provides larger opportunities
to produce more primary products for export. It can produce a surplus of primary products in
exchange for import of manufactured products which it cannot itself produce. Thus, it benefits
from international trade. The vent for surplus theory, as applied to an LDC, is explained in Fig.
1. Before trade with under-utilised resources, the country is producing and consuming OX1 of
primary products and X1E of manufactured products at point E inside the production possibility
curve AB. With the opening up of foreign trade, the production point shifts from E to D on the
production possibility curve AB. Now the utilisation of formerly underutilised land and labour
enables the country to increase its production of primary exportables from OX1 to OX2 without
any sacrifice in the production of other goods and services. Given the international terms of trade
line PP1, the country exchanges ED (= X1X2) more of primary exportables against EC larger
manufactured importables. Moreover, many under-developed countries specialise in the
production of one or two staple commodities. If efforts are made to export them, they tend to
widen the market. The existing resources are employed more productively and the resources
allocation becomes more efficient with given production functions.

As a result, unemployment and under-employment are reduced; domestic savings and investment
increase; there is a larger inflow of factor inputs into the expanding export sector; and greater
backward and forward linkages with other sectors of the economy. This is known as the “staple
theory of economic growth”, associated with Watkins Foreign trade also helps to transform the
subsistence sector into the monetized sector by providing markets for farm produce and raises
the income and the standards of living of the peasantry. The expansion of the market leads to a
number of internal and external economies, and hence to reduction in cost of production. These
are the direct or static gains from international trade.

INDIRECT BENEFITS
Besides, there are indirect dynamic benefits of a high order from foreign trade, as pointed out by
Mill. By enlarging the size of the market and the scope of specialisation, international trade
makes a greater use of machinery, encourages inventions and innovations, raises labour
productivity, lowers costs and leads to economic development. Moreover, foreign trade acquaints
people with new products, tempts and goads them to work harder to save and accumulate capital
for the satisfaction of their new wants. It also leads to the importation of foreign capital and
instills new ideas, technical know-how, skills, managerial talents and entrepreneurship. Lastly, it
fosters healthy competition and checks inefficient monopolies. Let us study these indirect
benefits of foreign trade to under-developed countries in detail.

1. Import of Capital Goods Against Export of Staple Commodities. Foreign trade helps to
exchange domestic goods having low growth potential for foreign goods with high growth
potential. The staple commodities of under-developed countries are exchanged for machinery,
capital goods, raw materials, and semi-finished products required for economic development.
Being deficient in capital goods and materials, they are able to quicken the pace of development
by importing them from developed countries, and establishing social and economic overheads
and directly productive activities. Thus, larger exports enlarge the volume of imports of
equipment that can be financed without endangering the balance of payments and the greater
degree of freedom makes it easier to plan domestic investment for development.

2. Important Educative Effects. Foreign trade possesses an “educative effect”. Under-

developed countries lack in critical skills, which are a greater hindrance to development that is
the scarcity of capital goods. Foreign trade tends to overcome this weakness. For, it is, in the
words of Haberler, “the means and vehicle for the dissemination of technical knowledge, the
transmission of ideas, for the importation of know-how skills, managerial talents and
entrepreneurship.” The importation of ideas, skills and know-how is a great stimulus to
technological progress in under-developed countries. It provides them with an opportunity to
learn from the successes and failures of the advanced countries.
Foreign trade helps in accelerating the development of poor countries by facilitating the selective
borrowing of ideas, skills and know-how from the developed countries and adopting them in
accordance with their factor endowments. Even the rapid development of the USA, Japan and
Soviet Russia has been the result of the educative effect of foreign trade.

3. Basis for Importation of Foreign Capital. Foreign trade provides the basis for the
importation of foreign capital in LDCs. If there were no foreign trade, foreign capital would not
flow from the rich to the poor countries. The volume of foreign capital depends, among other
factors, on the volume of trade. The larger the volume of trade, the greater will be the ease with
which a country can pay back interest and principal. It is, however, much easier to get foreign
capital for export-increasing industries than for import substitution and public utility industries.
But from the point of view of the importing country, the use of foreign capital for import
substitution, public utilities and manufacturing industries is more beneficial for accelerating
development than merely for export promotion. Foreign capital not only helps in increasing
employment, output and income but also smoothens the balance of payments and inflationary
pressures. Further, it provides machines, equipments, know-how, skills, ideas, and trains native
labour.

4. Checking of Inefficient Monopolies. Foreign trade benefits an LDC indirectly by fostering

healthy competition and checking inefficient monopolies. Healthy competition is essential for the
development of the export sector of such economies and for checking inefficient exploitative
monopolies that are usually established on the grounds of infant industry protection.
ITS CRITICISMS
The foregoing analysis, based as it is on the comparative cost doctrine, has been criticised by
economists like Prebisch, Singer and Myrdal. They opine that historically international trade has
retarded the development of LDCs. Three arguments are usually advanced in support of this
view that international trade has impeded development.

1. Strong Backwash Effects. International trade has strong backwash effects on the LDCs,
according to Myrdal. He writes, “Trade operates (as a rule) with a fundamental bias in favour of
the richer and progressive regions (and continues) and in disfavour of the less developed
countries.” Unhampered trade between two countries of which one is industrial and the other
underdeveloped, strengthens the former and impoverishes the latter. The rich countries have a
large base of manufacturing industries with strong spread effects. By exporting their industrial
products at cheap rates to LDCs, they have priced out the small-scale industry and handicrafts of
the latter. This has tended to convert the backward countries into the producers of primary
products for exports. The demand for primary products being inelastic in the export market, they
suffer from excessive price fluctuations. As a result, they are unable to take advantage
of either a fall or a rise in the world prices of their exports. The importing countries take
advantage of the cheapening of their products because of the inelastic market for their exports.
Similar advantages follow when there is any technology improvement in their export production.
When the world prices of their products rise, they are again unable to benefit from it. Increased
export earnings lead to inflationary pressures, malallocation of investment expenditure and
balance of payments difficulties when they are wasted in speculation, conspicuous consumption,
real estate, foreign exchange holdings, etc.

2. Adverse Effect of International Demonstration Effect. It has been contended that the
operation of the international demonstration effect through foreign trade has adversely affected
capital formation in LDCs.

3. Secular Deterioration in Terms of Trade. In the opinion of Prebisch there has been a secular
deterioration in the terms of trade of the LDCs. It implies that there has been an international
transfer of income from the poor to the rich countries and that the gains from international trade
have gone more to developed countries at the expense of the former, thereby, reducing their level
of real income and hence capacity for development.