Chapter 11:

Trade Policy in Developing Countries

Industrialization through import substitution

From World War II to the 1970s, most countries tried to limit the import of
manufactured goods to accelerate development and foster an industrial sector that would supply
the domestic market.

The infant industry argument

Developing countries have a potential comparative advantage in manufacturing over

new manufacturing industries, which cannot compete. Given this, the government should
support new industries until they reach a sufficient size to face international competition,
through tariffs or import quotas as temporary measures.

Problems of the infant industry argument

Trying to move towards industries that will have comparative advantages in the future is
not always a good idea. A country that is accumulating capital, when it accumulates enough,
will present a comparative advantage over other capital-intensive industries. Likewise, it is
important that the protection of manufactures makes the industry competitive. So, the
development of industries raises questions because it generates a net cost for the economy. In
addition, if there is evidence of success in the nascent industries, private investors would focus
on helping to develop it, however, they prefer the current benefits and forget about the behavior
of the market in the future.

Market failures as justification for infant industry protection

Two market failures have been identified as reasons for protecting an infant industry:
capital market imperfections and the appropriability problem.

The justification for imperfections in the capital market: If a developing country

does not have a set of financial institutions that allow savings in traditional sectors, which is
used to finance new sectors. Then, the ability of these companies to finance investment in new
sectors will be restricted. The optimal policy is to create a capital market with protection of new
industries that increase profits to ensure rapid growth.

The appropriability argument: Firms in a new industry generate social benefits that
are not compensated. In some cases, the entry of a new industry exceeds the costs, due to the
appropriability problem, for which an optimal response is to compensate the companies for their
intangible contributions. But when this is not possible, a second best can be chosen through
tariffs or other trade policies.
So there are various cases where industries fail to grow or depend on protection.

Promotion of the industry through protection

In many developing countries, the basic strategy for industrialization has been to
develop industries oriented towards the domestic market, using trade restrictions such as tariffs
and quotas to encourage the substitution of imported manufactures for domestic products. So,
the strategy of fostering domestic industry by limiting imports of manufactured goods is known
as import substitution industrialization.

First, it was believed that industrialization was necessarily based on a substitution of

imports by national industry, rather than on the growth of exports of manufactured products.
Second, most of the policies of industrialization through import substitution fit in with the
existing policies.

So, as a strategy to encourage the growth of manufacturing production, import

substitution industrialization has worked remarkably well, and this is evident in developing
countries. Also, the focus of many of the approaches of economic analysts and economic policy
has shifted from trying to promote import substitution to trying to correct the damage caused by
inadequate import substitution policies.

The results of the policy to support manufacturing production: The problems of

industrialization through import substitution

This strategy began to lose support when the countries that applied this policy did not
catch up with the advanced countries. One argument could be that poor countries lack skilled
labor, entrepreneurs, competent executives, and have social organization problems that make it
difficult to maintain a reliable supply of all goods, so an import quota may allow survival. to an
inefficient manufacturing sector, but it does not directly make that sector a more efficient
industry.

The competition for these benefits usually causes several companies to enter a market
where there is not even enough space for one, and production is carried out on a very inefficient
scale. Furthermore, import substitution industrialization eliminates this option since it focuses
production on the domestic market.

Trade liberalization since 1985

 As a result of the questions with industrialization, a series of developing countries
decided to promote lower tariffs and eliminated quotas on imports and other restrictions on
trade.

Chart 1: Trend in average tariff rates for all developing countries

Cited by: International Economy

The graph shows the reduction in tariff rates in developing countries from more than
30% since the 1980s to almost 10% today.

Trade liberalization in developing countries has caused an increase in the volume of

trade and the proportion of trade in GDP has tripled, and a higher percentage of growth was
obtained. Another effect was a change in the products exported from trade, which from 1980
where a higher proportion of manufactured goods in the exports of developing countries
skyrocketed. So, with respect to liberalization there is a great dispute since in some countries
like India where there has been an accelerated growth while in Brazil it was less.
Chapter 12:

Controversies in Trade Policy

Sophisticated arguments for activist trade policy

Technology and externalities

If a company is producing knowledge that other companies can also use without paying,
that industry is producing additional production that is not evidenced by company incentives.
However, in advanced countries there are important high-tech industries where generating
knowledge is essential in the company. So, governments should promote those industries that
have technological externalities.

The reasons for public sector support for high-tech industries

Although high-tech industries produce social benefits due to knowledge, it is not always
related to the generation of knowledge. Likewise, the spillover effect of innovation and
technological externalities also occur in industries that are not high-tech at all. So, the policy
must try to subsidize the generation of knowledge that is not appropriated by the company.

Imperfect Competition and Trade Policy

In some industries, few companies compete, but the existence of small numbers of
companies does not usually apply to the assumptions of perfect competition. Then, the
companies will obtain benefits above what the investments of the same risk can obtain in any
part of the economy, this is known as excess return. Which will produce an international
competition to appropriate these benefits.

The Brander-Spencer analysis

For example: There are two companies competing (Max and Pro) and each country is
different, so if both produce, they will make losses. But if Max produces before Pro, Pro will
make a profit and Pro will have no incentive to enter.

Globalization and low wage work

The increase in exports from developing countries has generated a movement against
globalization. These denounced the low wages and working conditions in the factories of the
third world where it was manufactured for Western markets. However, despite this movement,
economists mention that due to trade they can buy more technology and goods and are
employed. So, they can earn low wages, but they earn more than they could if globalization
didn't exist.
  Trade agreements should include clauses aimed at improving wages and working
conditions in poor countries.
 Consumers will feel better if they buy products made by workers who have received a
decent wage.
 The inclusion of labor standards in trade agreements would favor the proportion of
adequate wages for workers.

Cultural and environmental issues

The advance of globalization is causing damage to the environment, since it has been shown
that environmental standards in developing countries are lower than those in advanced
countries. So, questions are generated based on trade agreements where environmental
standards should be included.

 The progress of international trade harms the environment, factories pollute the air,
dump waste into rivers, farmers use fertilizers that cause water pollution, among others.
 Countries that are richer generate more environmental pollution.
 The Kuznets environmental curve refers to the inverted U relationship between per
capita income and environmental damage.
 Then, the increase in per capita income of a country due to economic growth causes
greater environmental damage.
 There is growing concern about the possibility that globalization allows highly polluting
industry to move to pollution havens, where in some countries there are strong
environmental controls and in others, less restriction is generated.
 Carbon tariffs consist of charging importers of goods from countries without policies
against climate change an amount proportional to the amount of carbon dioxide emitted
by these goods. This will be an incentive to limit the emission of carbon dioxide and for
countries with lax measures, improve their policies and generate actions against climate
change.
Chapter 13:

National Income Accounting and the Balance of Payments

Macroeconomics allows the efficient use of scarce resources, as well as the factors that
cause unemployment and the measures to avoid it.

 Its main objective is to ensure full employment in countries open to international trade.
 The world saving rate allows to determine the speed with which the world stock of
productive capital can grow.
 If spending is equal to income, then the value of a country's imports and exports are
equal.
 To study international macroeconomics, two essential tools must be used. The
accounting of national income that records all the expenses that contribute to the
product of a country and the formation of income. Then there is the accounting of the
balance of payments, which allows to observe the variations of the level of external
indebtedness of a country, as well as the evolution of the imports and exports of the
competitive industrial sectors.
 The gross national product (GNP) of a country is the value of all final goods and
services produced by its factors of production and is obtained by adding the total
expenditure on final products.
 National accounting with respect to national income breaks down the GNP into four
uses such as: investment, public spending, consumption, and the current account
balance.
 In each period, the GNP obtained from a country must be equal to its national income,
likewise, only final goods and services are counted.
 Countries can save by exporting more than they import or reduce their wealth, but in a
closed economy, national savings and investment do not coincide.
 In a closed economy, all goods or services that are not purchased must be used by
companies to build new factories, manufacture goods, among others.

This leads to defining a fundamental identity of closed economies as follows:

Y =C + I +G
 However, when foreign trade occurs, products can be purchased by external agents, and
national spending on the acquisition of goods from abroad. Then, the exports and
imports represented by X and M respectively are presented. Imports from abroad are
part of the suppliers' GNP and are not considered in the national GNP. Likewise,
exports add to the national income of the national economy.
In an open economy, national income is given by the sum of spending by residents and non-
residents on goods and services produced by domestic factors of production.

Y =C + I +G+ X− M

The current account balance and foreign debt

 The difference between exports and imports is called current account balance or current
account:

CC =X−M

 Measures the magnitude and direction of external indebtedness.

 Current account deficit: This occurs when a country's imports are greater than its
exports, that is, the number of purchases from abroad is greater than its sales.
 Current account surplus: This occurs when a country's exports are greater than
imports.
 The foreign wealth of a country with a surplus increase because non-residents pay for
imports not covered by their exports through international loans, which are then
amortized.
Savings and current account
 In a closed economy, national saving is equal to investment, so wealth can increase
through capital accumulation.
So, it looks like this:
S=Y −C−G
We can also write the GNP identity of a closed economy
Y =C + I +G as I =Y −C−G
S=I
So national saving is equal to investment in a closed economy.
S=I +CC
 Acquiring foreign wealth or saving capital can be done in an open economy, while in a
closed economy it is saved through capital accumulation.
 Private saving is the saving of disposable income instead of being consumed, and this
is the national income. But when subtracting the net taxes obtained from individuals
and companies, the formula for private savings is:
P
S =Y −T −C
 Public savings, government income is given through net taxes, T, and the purchases
made are consumption, G.
 G
S =T −G
Both form national saving, formulated as follows:
p g
S=Y −C−G= (Y −T −C )+ ( T−G )=S + S
 Balance of payments accounting
 The balance of payments is a detailed record of the composition of the current account
balance and the different transactions that are financed.
 An income from abroad is placed as a credit and a (+) sign.
 The current account records the transactions of exports and imports of goods and
services.
 The purchase or sale of financial assets, an asset being a means to acquire wealth such
as shares, money, public debt, among others. Likewise, all international purchases or
sales of financial assets are recorded in the financial account of the balance of
payments. This account is the difference between foreign sales and purchases of goods
and services. It also measures the difference between the accumulation of liabilities and
the acquisition of assets by foreigners.
 And in the capital accounts transfers of wealth between countries, international
movements of assets, activities that are not carried out in the market, non-financial,
among others, are recorded.
Cuenta corriente+Cuenta financiera+Cuenta Capital=0
 Exports and imports are divided into three categories: goods (export and import of
merchandise), services (payments for legal assistance, tourist expenses), income
(interest and dividends paid between countries and profit) to be recorded in the balance
of payments.
 The money supply is managed by the Central Bank, which is the responsible
institution. Foreign assets held by central banks are official international reserves and
are used to combat domestic economic crises.
 The balance of operations or balance of payments is the level of net financial flows
of the central bank. Then the sum of the current account balance and the capital account
minus the part of the financial account is through this balance.
References:
Krugman, P., Obstfeld, M. & Melitz, M. (2012). International Economics Theory &
Policy (9th ed.) Pearson.