Chapter 12

International
Trade Theory and
Development
Strategy

Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Globalization: An Introduction

• Globalization- many interpretations

• Core economic meaning- the increased
openness of economies to international
trade, financial flows, and foreign direct
investment.
• Concerns with globalization center around
the unevenness of the process

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-2

International Trade and
Finance: Some Key Issues
• Many developing countries rely heavily on exports of
primary products with attendant risks and uncertainty
• Many developing countries also rely heavily on imports
(typically of machinery, capital goods, intermediate
producer goods, and consumer products)
• Many developing countries suffer from chronic deficits on
current and capital accounts which depletes their reserves,
causes currency instability, and a slowdown in economic
growth

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-3

Figure 12.1 Nonfuel Primary Commodity
Prices, Nominal and Real, by Commodity
Group, 1960-2005 (2000 index = 100)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-4

Figure 12.1 Nonfuel Primary Commodity Prices,
Nominal and Real , by Commodity Group, 1960-
2005 (2000 index = 100) (continued)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-5

Five Basic Questions about
Trade and Development
• How does international trade affect economic
growth?
• How does trade alter the distribution of
income?
• How can trade promote development?
• Can LDCs determine how much they trade?
• Is an outward-looking or an inward-looking
trade policy best?
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-6
The Importance of Exports to
Different Developing Nations
• Importance of exports to developing nations
• Exports of LDCs are much less diversified
than those of developed countries

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-7

Table 12.1 Merchandise Exports in
Perspective: Selected Countries, 2005

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-8

Demand Elasticities and Export
Earning Instability

• Low income elasticity of demand for primary

products
• Low price elasticity of demand and supply
• Export earnings instability

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-9

The Terms of Trade and the
Prebisch-Singer Thesis
• Total export earnings depend on:
– Total volume of exports sold AND
– Price paid for exports
• Prebisch and Singer argue that export prices fall
over time, so LDCs lose revenue unless they can
continually increase export volumes
• Prebisch and Singer think LDCs need to avoid a
dependence on primary exports

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-10

The Traditional Theory of
International Trade
• Comparative advantage
– specialization
• Relative factor endowments and international
specialization: the Neoclassical model
– Ricardo and Mill (static model)
– Heckscher and Ohlin (factor endowment theory)
• Different products require productive factors in different ratios
• Countries have different endowments of factors of production

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-11

Figure 12.2 Trade with Variable Factor
Proportions and Different Factor
Endowments

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-12

Figure 12.2 Trade with Variable Factor
Proportions and Different Factor
Endowments (continued)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-13

The Traditional Theory of
International Trade
• Main conclusion of the neoclassical model is that
all countries gain from trade
• World output increases with trade
• Countries will tend to specialize in products that
use their abundant resources intensively
• International wage rates and capital costs will
gradually tend toward equalization
• Returns to owners of abundant resources will rise
relatively
• Trade will stimulate economic growth

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-14

The Traditional Theory of
International Trade
• Trade theory and Development: The Traditional
Arguments
– Trade stimulates economic growth
– Trade promotes international and domestic equality
– Trade promotes and rewards sectors of comparative
advantage
– International prices and costs of production determine
trading volumes
– Outward-looking international policy is superior to
isolation

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-15

The Critique of Traditional Free-Trade
Theory in the Context of Developing-
Country Experience
• The following assumptions of the
Neoclassical model must be scrutinized:
– Fixed resources, full employment, and
international factor immobility
– Fixed, freely available technology and
consumer sovereignty
– Internal factor mobility and perfect competition
– Governmental non-interference in trade

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-16

The Critique of Traditional Free-Trade
Theory in the Context of Developing-
Country Experience
– Balanced trade and international price
adjustments
– Trade gains accruing to nationals

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-17

The Critique of Traditional Free-Trade
Theory in the Context of Developing-
Country Experience
• Fixed Resources, Full Employment, and the
International Immobility of Capital and
Skilled Labor
– Challenged by North-South trade models
– Michael Porter’s Competitive Advantage theory
– Vent for Surplus theory

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-18

Figure 12.3 The Vent-for-Surplus
Theory of Trade in LDCs

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-19

The Critique of Traditional Free-Trade
Theory in the Context of Developing-
Country Experience
• Fixed, Freely Available Technology and
Consumer Sovereignty
– Challenged by the Product Cycle theory
– Development of synthetic substitutes for
developing country exports

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-20

The Critique of Traditional Free-Trade
Theory in the Context of Developing-
Country Experience
• International Factor Mobility, Perfect Competition,
and Uncertainty: Increasing Returns, Imperfect
Competition, and Issues in Specialization
– Structural realities in developing countries
– Increasing returns and exercise of monopolistic control
over world markets
– Risk and uncertainty inherent in international trading
arrangements

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-21

The Critique of Traditional Free-Trade
Theory in the Context of Developing-
Country Experience
• The Absence of National Governments in
Trading Relations
– Definite role for State
– Industrial policy is crafted by governments
– Commercial policies instruments (tariffs, quotas)
are state constructs
– International policies can result in uneven
distribution of gains from trade

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-22

The Critique of Traditional Free-Trade
Theory in the Context of Developing-
Country Experience
• Balanced Trade and International Price
Adjustments
– Unrealistic (oil price hikes of the 70s)

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-23

The Critique of Traditional Free-Trade
Theory in the Context of Developing-
Country Experience
• Trade gains accruing to nationals
– Enclave economies are promoted by trade
– Difference between GDP and GNI becomes
important

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-24

Some Conclusions on Trade Theory
and Economic Development Strategy

• Trade can lead to rapid economic growth under

some circumstances
• Trade seems to reinforce existing income
inequalities
• Trade can benefit LDCs if they can extract trade
concessions from developed countries
• LDCs generally must trade
• Regional cooperation may help LDCs

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-25

Trade Strategies for Development:
Export Promotion versus Import
Substitution
• Export promotion: looking outward and seeing trade
barriers
– Primary-commodity export expansion, limited demand
• Low income elasticities
• Low population growth rates in developing economies
• Decline in prices implies low revenue
• Lack of success with international commodity agreements
• Development of synthetic substitutes
• Agricultural subsidies
– Primary-commodity export expansion, supply rigidities
• Expanding Exports of manufactured goods: Some
successes

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-26

Trade Strategies for Development:
Export Promotion versus Import
Substitution
• Import substitution: looking inward but still
paying outward
– Tariffs, infant industries, and the theory of
protection

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-27

Figure 12.4 Import Substitution
and the Theory of Protection

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-28

Trade Strategies for Development:
Export Promotion versus Import
Substitution
• 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

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-29

Trade Strategies for Development:
Export Promotion versus Import
Substitution
• Tariff Structure and Effective Protection
– Nominal rate of protection
– Effective rate of protection

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-30

Trade Strategies for Development:
Export Promotion versus Import
Substitution
The nominal tariff rate, t, is

p  p
t (13.1)
p
Where
p′ is the tariff-inclusive price
p is the free trade price

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-31

Tariff Structures and Effective
Protection

The effective tariff rate, g, is

v  v
g (13.2)
v
Where
v′ is the value added per unit of output,
inclusive of the tariff
v is the value added per unit of output
under free trade
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-32
Trade Strategies for Development:
Export Promotion versus Import
Substitution
• Standard argument for tariff protection
– Sources of revenue
– Response to chronic BOP problems
– Help foster industrial self-reliance
– Greater control over economic destinies
• Must be applied selectively and wisely

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-33

Trade Strategies for Development:
Export Promotion versus Import
Substitution
• Foreign-exchange rates, exchange controls,
and the devaluation decision
– Currencies of developing countries are
overvalued (excess of local demand over
available exchange)
• Can run down reserves
• Can curtail excess demand through taxes, tariffs,
dual exchange rates
• Can use exchange controls

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-34

Figure 12.5 Free-Market and
Controlled Rates of Foreign Exchange

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-35

Trade Strategies for Development:
Export Promotion versus Import
Substitution
• Chronic payments deficits can be
ameliorated by a currency devaluation
– Difference between depreciation and
devaluation
– Higher import prices result in an inflationary
wage-price spiral
– Distributional effects

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-36

Trade Optimists and Trade Pessimists:
Summarizing the Traditional Debate

• Trade pessimist arguments

– Limited growth of world demand for primary exports
– Secular deterioration in terms of trade
– Rise of “new protectionism”
• Trade optimist arguments
– Trade Liberalization promotes competition and
efficiency
– Generates pressure for product improvement
– Accelerates overall growth

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-37

Trade Optimists and Trade Pessimists:
Summarizing the Traditional Debate

• The industrialization strategy approach to export

policy
– Focus on government interventions to encourage
exports (industrial policy)
– Without proper attention to incentives, industrial policies
may be counterproductive too (South Korean case)
– WTO rules and industrial policies
– Competence and political authority of governments

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-38

Reconciling the Arguments:
The Data and Consensus
• Neither the trade optimists nor the trade
pessimists are always right
• There are many factors that determine
whether trade is good or bad for a country

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-39

South-South Trade and Economic
Integration: Looking Outward and
Inward
• Economic Integration: Theory and Practice
– The growth of trade among developing countries.
– Integration encourages rational division of labor among
a group of countries and increases market size
– Provides opportunities for a coordinated industrial
strategy to exploit economies of scale
– Trade creation
– Trade diversion

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-40

South-South Trade and Economic
Integration: Looking Outward and
Inward
• Regional trading blocs (economic unions) and the
globalization of trade
– NAFTA
– MERCOSUR
– SADC
– ASEAN
– Local conditions matter
– Do blocs promote growth or retard the progress of
globalization

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-41

Trade Policies of Developed
Countries: the Need for Reform
• Rich-nation economic and commercial policies
matter for LDCs
– Tariff and non-tariff barriers to LDC exports
– Adjustment assistance for displaced workers
– General impact of economic policy
• 1995 Uruguay Round and WTO
• Despite 8 liberalization rounds over 50 years trade
barriers remain in place in agriculture and textiles
• Doha Development Round 2001 has tilted the
focus on the needs of the developing world

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-42

Figure 12.6 Effective Tariff Faced
by Income Groups, 1997-1998

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-43

Case Study: Taiwan

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-44

Concepts for Review

• Absolute advantage • Comparative

• Autarky advantage
• Balanced trade • Current account
• Barter transactions • Customs Union
• Capital account • Depreciation
• Collective self-reliance
• Devaluation
• Commodity terms of trade
• Dual exchange rate
• Common Market
• Economic Unions

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-45

Concepts for Review

• Effective Rate of
Protection • Flexible exchange rate
• Enclave economies
• Exchange Control
• Export dependence
• Export earnings
instability
• Factor endowment
trade theory
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-46
Concepts for Review (cont’d)

• Factor mobility • Growth poles

• Factor-price equalization • Import substitution
• Foreign-exchange • Income elasticity of
demand
earnings
• Income terms of trade
• Free trade
• Increasing returns
• Gains from trade
• Industrial policy
• General Agreement on
• Industrialization Strategy
Tariffs and Trade (GATT Approach
Globalization

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-47

Concepts for Review (cont’d)

• Infant industry • Multi-Fiber Arrangement

• International commodity (MFA)
agreements • New protectionism
• Inward-looking • Nominal rate of protection
development policies • Nontariff trade barriers
• Managed float • North-south trade models
• Monopolistic market • Official exchange rate
control
• Oligopolistic market control

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-48

Concepts for Review (cont’d)

• Outward-looking • Rent
development policies
• Returns to scale
• Overvalued exchange rate
• Risk
• Parallel exchange rate
• Prebisch-Singer thesis • Specialization
• Price elasticity of demand • Subsidies
• Primary products • Synthetic substitutes
• Product Cycle • Tariffs
• Quotas • Trade creation
• Regional trading bloc • Trade deficits

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-49

Concepts for Review (cont’d)

• Trade diversion • Vent-for-surplus theory of

• Trade liberalization international trade
• Trade optimists • Wage-price spiral
• Trade pessimists • World Trade Organization
(WTO)
• Uncertainty
• Undervalued exchange
rate
• Uruguay Round
• Value added

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12-50