International Economics I

(Econ 2081)

Chapter Four

Trade, Growth and Development

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 Can foreign trade has a propulsive role in the
development of a country?
◦ Classical and neo classical economists argue that
foreign trade can be a propelling force in
development.
◦ “…………By means of it (foreign trade), the
narrowness of the home market does not hinder
the division of labor in any particular branch of
art or manufacture from being carried to the
highest perfection. By opening a more extensive
market for whatever part of the produce of their
labor may exceed the home consumption, it
encourages them to improve its production
powers, and to augment its annual produce to
utmost, and thereby to increase the real revenue
and wealth of the society.” 2
A most important indirect dynamic benefit,
according to John Stuart Mill is:
◦ “The tendency of every extension of the market
to improve the process of production. A country
which produces for a larger market than its
own, can introduce a more extended division of
labor, can make greater use of machinery, and is
likely to make inventions and improvements in
the process of production.”
In sum, the indirect benefits of trade on
development are:
◦ induce innovations, and increase productivity;
◦ increase saving and capital accumulation;
◦ Its educative effect. 3
The traditional arguments in favor of
international trade, vis-à-vis their
implication on development
◦ Trade is an engine of growth
◦ Trade tends to promote greater international
and domestic equality.
◦ promote and reward the sectors of the economy
where individual countries poses a comparative
advantage.
◦ maximize national welfare.
◦ To promote growth and development, an
outward-looking international policy is
required.
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Some critics argue that differences in
economic structure among countries, bias
the gains from trade in favor of the
technologically advanced and industrialized
countries and against the poor countries.
Promote the production of primary
products in poor countries:
◦ inelastic demands in the export market,
◦ demand trend is not rising very rapidly,
◦ excessive price fluctuations and
◦ trade bans.

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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.
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Within poor nations, disproportionately to
foreign residents and wealthy nationals.
Besides, when developed nation
governments pursue restrictive economic
policies designed to deal with purely
domestic issues like inflation or
unemployment, these policies can have
profound negative effects on the economies
of poor nations.
However, Third World governments’
economic policies generally have little
impact on the economies of rich nations
and hence the reverse is not true. 7
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?
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4.2. Criticisms of Traditional International Trade
Theories
Explicit and implicit assumptions are often
contrary to the reality.
◦ All productive resources are fixed in quantity and
quality - fully employed and no international
mobility.
◦ The technology of production and consumers’
tastes are fixed.
◦ Factors of production are perfectly mobile within
the nation. The economy as a whole is
characterized by perfect competition.
◦ Government plays no role.
◦ Trade is balanced.
◦ There is gains from trade. 9
4.3. The Terms of Trade and the Prebisch-
Singer Hypothesis
 The total value of export and import depends on
quantity and price
 The real or social opportunity costs of a unit of
imports will rise when export prices decline relative
to import
 Commodity terms of trade (TOT)  ratio between
the price of a typical unit of exports to the price of a
typical unit of imports declining over time.
 They argued that there was and would continue to
be a secular (long-term) decline in the terms of trade
of primary- commodity exporters due to a
combination of low income and price elasticities of
demand. 10
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, considered later in
this chapter.

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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.
The prices of primary commodities have
declined relative to manufactured goods.
◦ TOT worsen over time for the nonoil-
exporting developing countries.
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The main theory for the declining commodity
TOT is known as the Prebisch-Singer
hypothesis
◦ Secular decline in the terms of trade of
primary- commodity exporters due to
 low income and price elasticities of
demand.
◦ Led to
 import substitution
 diversify into manufactures exports
This structural change has not brought many
benefits
◦ Relative prices within manufactures have also
diverged. 13
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.

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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
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4.4. Other Characteristics of Developing
Countries Trade
A. Importance of Exports
 Export is important to the economic
well-being of developing countries
 Developing countries are typically more
dependent on trade.

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Table 6.1 Merchandise Exports in Perspective: Selected
Countries, 2008

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B. Demand Elasticities and Export
Earnings Instability
Low income elasticity of demand for
primary products
Low price elasticity of demand and
supply for agricultural commodities.
◦ any shifts in demand or supply curves can
cause large and volatile price fluctuations
Result can be export earnings instability;
risks to income.

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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.

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4.5. Trade Strategies for Development
Outward looking policies might include:
Abolition of tariffs and other forms of
protectionism.
Elimination of subsidies to domestic producers.
Encouraging flows of international capital and
the activities of MNCs.
Permitting labour mobility between countries.
Maintaining open contact with the rest of the
world.
Other export promotion policies. e.g.
advertising, trade fairs etc.
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Rationales for outward-looking policies
The welfare gains from tariff reduction
Efficiency when exposed to international
competition.
Benefiting from the growth of other
countries
Economies of scale from the size of world
markets.
As part of ‘structural adjustment’ to
qualify for World Bank aid.

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Inward looking policies might include:
High levels of protectionism e.g. tariffs,
quotas
Subsidies of domestic producers
Other import substitution policies
Encouraging the development of locally
acquired skills, e.g. learning by doing.
Prohibition on the activities of
multinational companies.

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Rationales for inward-looking policies
Self-reliance
To maintain own pace of development and
encourage economic growth only in such a
way as to preserve its own cultural context.
With protection indigenous industries can
achieve the necessary economies of scale
and technological sophistication to
compete in world markets.
As a means of preserving traditional forms
of life.
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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

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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

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 Evaluation
Inward-looking theorists suggest that a
country is doomed to providing low-
growth primary products for developed
countries if it remains fully open to
trade.
Outward-looking theorists claim that an
inward-looking country will stagnate and
lose the dynamic benefits of trade.
It is possible for a developing country to
mix policies.
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 Trade Optimists and Trade
Pessimists:
Summarizing the Traditional Debate
Trade pessimist arguments:
◦ Secular deterioration in terms of trade.
◦ Specializing in comparative advantage
inhibits industrialization, skills
accumulation, and entrepreneurship.
◦ Limited growth of world demand for
primary exports.

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Trade optimist arguments - trade
liberalization
◦ Promotes competition and efficiency.
◦ Generates pressure for product
improvement.
◦ Accelerates overall growth.
◦ Attracts foreign capital and expertise,
which are in scarce supply in most
developing countries.

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◦ Generates foreign exchange to use for
food imports if agricultural sector lags
behind or suffers natural catastrophes.
◦ Eliminates distortions caused by
government interventions including
corruption and rent-seeking activities.
◦ Promotes equal access to scarce
resources.

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Some cite countries such as South Korea
as examples of the success of outward-
looking policies, others mention
countries like Chile (or, earlier, Japan) as
beneficiaries of initially inward-looking
policies. Others argue that these
countries in fact pursued mixtures of
policies targeted at specific industries.

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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.

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-----End of Chapter Four-----

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