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5. INTERNATIONAL TRADE AND ECONOMIC DEVELOPMENT:

THE TRADE POLICY DEBATE AND INDUSTRIALIZATION

5.1 International trade and Economic development

International trade (IT) refers to the cross-border movement of goods (final products or inputs)
and services. In fact international trade may maximize welfare of developing nations in the short
term. However, these nations believe that this pattern of specialization and trade leads them to a
subordinate position with developed nations and keeps them from reaping the dynamic benefits
of industries and from maximizing their welfare in the long-run. The dynamic benefits resulting
from industrial production includes a more trained labor force, more innovations, higher and
more stable prices for the nation’s exports, and higher income for citizens. Most of these
dynamic benefits accrue to developed nations, leaving developed nations poor, undeveloped and
dependent. This belief is reinforced by the observation that all developed nations are primarily
industrial while all developing nations are primarily agricultural. As a result developing nations
demand changes in the pattern of trade and reform of the present international economic system
to take in to consideration their special development needs.

Traditional trade theory can readily be extended to incorporate changes in factor supplies,
technology and tastes by the technique of comparative statics. This may indicate that a nation’s
pattern of development is not determined once and for all, but must be recomputed as underlying
conditions change or is expected to change over time. Therefore developing nations are not
necessarily or always relegated by traditional trade theory to export mostly primary commodities
and import mostly manufactured products.

5.1.1 Role of foreign trade in development

 Static gains: arise from optimum use of factor endowments/human & physical resources,
so that the national output is maximized resulting in increase in social welfare.

Assume a simple model of international trade with two countries A & B both producing wheat &
cloth. The PPC & ICs used to measure utility/welfare are shown below in figure.

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Wheat

Country A’s gain from international trade

Given the Price line (PP’), PPC (AB), Indifference Curve (IC1, IC2), and terms of trade (TT’):

 Welfare Increased as can be seen form;

 Higher Indifference curve

 Attaining the unattainable

 Export KF and Import KG

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 Numerical proof

Two countries A & B both producing wheat & cloth:

A B
Wheat 20 30
Cloth 10 45

PPC for both countries A & B,(per workers per day);

By calculating opportunity cost of producing each commodity,

A B

Opp. Cost of wheat 0.5 cloth 1.5 cloth

Opp. Cost of cloth 2 wheat 2/3 wheat

Market for Wheat:

Country A is willing to sell wheat at price > 0.5.
Country B is willing to buy wheat at price < 1.5.

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So, the price between > 0.5 & < 1.5 can work to trade with each other.
 The possible price is 1:1 (1 unit of wheat for 1 unit of cloth) and assumes that a country
A producing 20 unit of wheat want to trade 15 of them away for cloth.

Therefore, countries become better off by international trade.

 Beside the static gain from comparative advantage, by which it can contribute to the
economic development of developing nations, there are important beneficial effects that
international trade can have on economic development.
(1) When a country specializes in the production of a few goods due to international trade
and division of labor, 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 an
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.
(2) LDCs are hampered by the small size of its domestic market which fails to absorb
sufficient volume of output. 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 saving through more efficient resource

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 allocation. The existing resources are employed more productively and the resources
allocation becomes more efficient with given production functions. As a result,
unemployment and underemployment are reduced, domestic saving and investment
increases, 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.
(3) Foreign trade also helps transform the subsistence sector into the monetized sector by
providing markets for farm produce and raising the income and the standards of living of
the farmers.

5.2 Terms of trade

The total value of export earnings depends not only on the volume of these exports sold abroad
but also on the price paid for them.

 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.

The relationship or 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, where Px
and Pm represent the export and import price indexes, respectively, calculated on the same base
period. In economics, terms of trade (TOT) refer to the relationship between the price a country
pays for its imports and how much it earns from exports.

The commodity terms of trade are said to deteriorate for a country if Px/Pm falls, that is, if
export prices decline relative to import prices, even though both may rise. Many scholars have
broadly confirmed that historically, the prices of primary commodities have declined relative
to manufactured goods. The main theory for the declining commodity terms of trade is known
as the Prebisch-Singer hypothesis. It is the argument that the commodity terms of trade for
primary-product exports of developing countries tends to decline over time.

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This 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 known as import substitution.

5.3 The trade policy debate: Export promotion industrialization versus

Import substitution Industrialization

A traditional way to approach the complex issues of appropriate trade policies for development is
to set policies in the context of a broader strategy of looking outward or looking inward.

Outward-looking development policies: “encourage not only free trade but also the free
movement of capital, workers, enterprises and students, and an open system of communications.”

Inward-looking development policies: encourage indigenous “learning by doing” in

manufacturing and the development of technologies appropriate to a country’s resource
endowments.

A debate regarding these two philosophical approaches has been carried on in the development
literature since the 1950s.

 The debate pits (oppose) 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 desire of developing nations to industrialize is natural in view of the fact that all developed
nations are industrial while all developing nations primarily agrarian.

Having decided to industrialize, developing nations had to choose between import substitution
and export- oriented industrialization. Both policies have advantages and disadvantages.

Industrialization through import substitution: is a way of promoting domestic

industrialization, particularly in consumer goods through import restriction, so that domestic
market is preserved for domestic products, which can thus takeover markets already established
in the country.

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  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)—all behind the protection of high
tariffs and quotas on these imports.

IS policies are largely based on the belief that economic growth can be accelerated by actively
directing economic activity away from traditional agriculture and resource-based sectors of the
economy towards manufacturing.
 For example, if a fertilizer import occurs, import substitution entitles for establishment of
a domestic fertilizer industry to produce substitutes for fertilizer imports.

The main advantages of this policy are the following:

 The market for industrial products already exists, as evidenced by imports of the
commodity, so that risks are reduced in setting up an industry to replace imports.
 It is easier for developing nations to protect their domestic market against foreign
competition than to force developed nations to lower trade barriers against their
manufactured exports.
 Foreign firms are induced to establish tariff factories to overcome the tariff wall of
developing nations.

 In the extreme, import-substitution policies could lead to complete self-sufficiency.

Against those advantages, there are the following disadvantages.

 Domestic industries grow accustomed to protection from foreign completion and have no
incentive to become more efficient

 Import substitution leads to inefficient industries because the smallness of the domestic
market, which does not allow to take advantage of economies of scale.

 After the simpler manufactured imports are replaced by domestic production, import
substitution becomes more difficult and costly as more capital incentive and
technologically advanced imports have to be replaced by domestic production.

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Export promotion : is the governmental efforts to expand the volume of a country’s exports
through increasing export incentives, and other means to generate more foreign exchange and
improve the current account of its balance of payments or achieve other objectives.

It is used by many countries and regions to promote the goods and services from their companies
abroad. This is good for the trade balance and for the overall economy. The historical evidence
of such export-oriented economies are: South Korea, Taiwan, Singapore, Hong Kong, China,
and others in Asia.

Export promotion can also have incentive programs designed to draw more companies into
exporting.
Governments do this by providing assistance in:
 the marketing and product identification and development,
 by arranging payment guaranty schemes,
 pre-shipment and post-shipment financing,
 Trade visits, training, trade fairs, and foreign representation.

The main advantages of export promotion are the following:

 It overcomes the smallness of domestic market and allows a developing nation to take
advantage of economies of scale. This is particularly important for many developing
nations that are very poor and small.
 Production of manufactured goods for export requires and stimulates efficiency
throughout the economy. This is especially important when the output of an industry is
used as an input by another industry in the economy.
 The expansion of manufactured exports is not limited ( as in the case of import
substitution) by the growth of the domestic market.

The two serious disadvantages of export promotion as a policy are:

 It may be very difficult for developing nation to set up exporting industries because of the
competition from the more established and efficient industries in developed nations.

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  Developed nations often provide a high level of protection for their simple labor-
intensive commodities in which developing nations already have or can soon acquire a
comparative advantage.

5.4 Balance of Payments and Macroeconomic Stabilization

Balance of payments: is a systematic and summary record of a country’s economic and financial
transactions with the rest of the world over a period of time. .

Balance of payment of a country is one of the important indicators for International trade, which
significantly affect the economic policies.

 Each receipt of currency from residents of the rest of the world is recorded as a credit
item (a plus in the accounts) while each payment to residents of the rest of the world is
recorded as a debit item (a minus in the accounts).

Balance of Trade and Balance of Payments

The Balance of Trade: takes into account only the transactions arising out of the exports and
imports of the visible terms, it does not consider the exchange of invisible terms such as the
services rendered by shipping, insurance and banking, payment of interest and dividend,
expenditure by tourists, etc.

The balance of payments takes into account the exchange of both the visible and invisible terms.
Hence, the balance of payments presents a better picture of a country’s economic and financial
transactions with the rest of the world than the balance of trade.

Components of Balance of Payments

Balance of payments is generally grouped under the following heads:

A) Current account: : visible and invisible accounts. The visible subaccount records the
values of imported and exported goods, where as the invisible sub-account records values
of imported and exported services; interests, profits and dividends received; interests,
profits and dividends paid; unilateral receipts and payments.

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The balance on the visible accounts of the current account is termed as the trade balance
whereas the sum of the visible trade balance and the invisible balance is termed as the current
account balance.

Trade Balance = Receipts for exported goods – Payments on imported goods

 Current Account Balance = Trade balance + Invisible Balance

B) Capital account: The capital Account consists of short-terms and long-term capital
transactions. A capital outflow represents a debit and a capital inflow represents a credit.

For instance, if an American firm invests 100 million birr in Ethiopia, this transaction will be
represented as a debit in the US balance of payments and a credit in the balance of payments of
Ethiopia.

Capital Account Balance = Capital Inflows – Capital Out flows

Unilateral Transfers Account

Unilateral transfers is another terms for gifts. These unilateral transfers include private
remittance, government grants, disaster relief etc. Unilateral payments received from abroad are
credits and those made abroad are debits.

Official Settlements Accounts: represent the holdings by the government or official agencies of
the means of payment that are generally accepted for the settlement of international claims.

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Balance of payments items

Credits Debits .

Current Account Current Account

1. Merchandise Exports 1. Merchandise Imports

(Sale of Goods) (Purchase of Goods)

2. Invisible Exports 2. Invisible Imports

(Sale of Services) (Purchase of Services)

(a) Transport service (a) Transport Service sold purchased from abroad

(b) Insurance services (b) Insurance Service sold purchased from abroad

(c) Foreign tourist (c) Tourist Expenditure abroad

Expenditure in country (d) other services purchased

(d) Other services sold

Abroad from abroad

(e) Income received on loan and (e) Income paid on loans and investment

Investments abroad in home country

Capital Account Capital Account

3. Foreign long-term 3. Long-term investments abroad

Investments in the home

(a) Direct investments in the home (a) direct investment abroad

(b) Foreign investments (b) investments in foreign securities

in domestic Securities
(c) Other investments (c) other investments abroad

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 of foreigners

(d) Foreign Government’s (d) Government loan to foreign country

Loan to the home country

4. Foreign short-term investment 4. Short-term investments abroad.

in home country.

Unilateral Transfers Account Unilateral Transfers Account

5. Private remittances 5. Private remittance abroad
Received from abroad

6. Pension payment 6. Pension payments abroad

Received from abroad

7. Government grants 7. Government grants abroad

Received from abroad

Official Settlements Account Official Settlements Account

8. Official sales of foreign currencies 8. Official purchase of foreign currencies or

or other reserve assets abroad other reserve assets from abroad

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Disequilibrium in Balance of payments

 The balance of payments is in disequilibrium when there is either a surplus (excess of

revenues over expenditure) or a deficit (excess of expenditures over revenues) in the
balance of payments. When there is a deficit in the balance of payments, the demand for
foreign exchange exceeds the supply of it.

 A number of factors may cause disequilibrium in the balance of payments:

 Large-scale development expenditures usually increase the purchasing power, aggregate

demand and prices, resulting in substantially large imports.

 Cyclical fluctuations in general business activity (depression always bring shrinkage in

world trade).

 In a developed country, the disposable income is generally very high and, therefore, the
aggregate demand, too, is very high. At the same time, production costs are very high
because of the higher wages. This naturally results in higher prices. These two factors-
high aggregate demand and higher domestic price may result in the imports being much
higher than the exports.

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Stabilization policies

A coordinated set of mostly restrictive fiscal and monetary policies aimed at reducing inflation,
cutting budget deficits, and improving the balance of payments.

There are four basic components to stabilization program:

1. Abolition or liberalization of foreign-exchange and import controls

2. Devaluation of the official exchange rate

3. A stringent (accurate) domestic anti-inflation program consisting of:

(a) Control of bank credit to raise interest rates and reserve requirements;

(b) Control of the government deficit through curbs on spending, including in the areas of
social services for the poor and staple food subsidies, along with increases in taxes and in
public-enterprise prices;

(c) Control of wage increases, in particular abolishing wage indexing; and

(d) Dismantling of various forms of price controls and promoting freer markets.

4. Greater hospitality to foreign investment and a general opening up of the economy to

international commerce.

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