Chapter 17
International
Trade
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International Trade
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Does Trade Cause Growth?
Arguments for Trade: Comparative
Advantage.
Arguments for Tariffs.
Path Dependence of Comparative
Advantage.
Arguments about Income Distribution,
Child Labor, & the Environment.
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International Trade (Cont)
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Terms of Trade.
Import Substitution & Export Expansion
in Industry.
Global Production Sharing & Borderless
Economies.
DC Import Policies.
Expanding Primary Export Earnings.
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International Trade (Cont)
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Agriculture Protection.
Trade in Services.
The Mankiw Debate.
Intellectual Property Rights.
Foreign Exchange Rates.
Domestic Currency Overvaluation.
Domestic Currency Devaluation.
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International Trade (Cont)
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The Real Exchange Rate (RER).
Dual Exchange Rates.
The Impossible Trinity: Exchange Rate
Stability, Free Capital Movement, &
Monetary Autonomy.
Currency Crises.
Managed Float Plus.
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International Trade (concluded)
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Regional Integration.
The Euro & U.S. Dollar as Reserve
Currencies.
Promotion & Protection of Infant
Entrepreneurship.
Black Market & Illegal Transactions.
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Does Trade Cause Growth?
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Is the high correlation between trade &
GDP per capita a result of income causing
trade?
Frankel & Romer (1999) find that trade
causes growth.
Winters (2004): productivity growth
attributed to increased import
competition, technological improvements
embodied in imports, export expansion,
and learning through trade.
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Caveats
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In short run, LDCs’ trade liberalization in 1980s
& 1990s associated with reduced growth.
Uncertain whether poorest in LDCs benefit
from trade.
Lundberg & Squire (1999) find openness
negatively correlated with income growth
among poorest 40% of LDCs’ population, but
positively correlated with growth among
higher-income groups.
Dollar & Kraay (2004) say poor grow as much
as others.
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Caveats
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Trade liberalization increases resource
allocation efficiency but hurts trade
balance (Parikh) & can perpetuate budget
crisis (Mosley et al.).
Conclusion: liberal trade is beneficial in
long run if not undertaken abruptly but
sequenced as part of comprehensive
program of economic reform.
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Arguments for Trade:
Comparative Advantage
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Welfare is greatest when each country
exports products whose comparative
costs are lower at home than abroad
(steel in Japan and textiles in Pakistan)
and imports goods whose comparative
costs are lower abroad than at home
(textiles in Japan and steel in Pakistan)
(Table 17-1).
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Arguments for Trade:
Comparative Advantage
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Elaborations of
comparative advantage
Factor proportions theory: HeckscherOhlin – nation gains from trade by
exporting the good whose production
requires the intensive use of the country’s
relatively abundant (& cheap) factor of
production & importing the good whose
production requires the intensive use of
the relatively scarce factor.
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Elaborations of
comparative advantage
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Multinational corporations (MNCs) invest
in LDCs to take advantage of cheap labor
or natural resources.
Technological advantage: comparative
advantage based on technological
advantage – new product or production
process that gives country (such as US or
Japan) temporary monopoly in world
market until other countries can imitate.
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Product cycle model (Vernon)
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DCs have comparative advantage in
nonstandardized goods, while LDCs (with
abundant unskilled labor) have comparative
advantage in standardized goods.
Illustration: cotton textiles shift from England
(mid-18th to mid-19 centuries) to Japan (late
19th to early 20th centuries) to South Korea,
Taiwan, China, Hong Kong, Singapore (1960s)
& subsequently joined by Thailand (1980s) &
eventually displaced by other competitors.
Automobiles & call center outsourcing may
follow same pattern.
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Other costs of trade barriers
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Romer: trade barriers thwart new
goods & productive activities from
abroad.
Winters: trade restrictions & price
distortions reward rent seeking,
corruption, & predatory behavior;
undermine greater competition.
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Benefits of free trade
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More efficient resource allocation
(comparative advantage).
Introduces new goods & productive
activities.
Widens markets.
Improves division of labor.
Utilizes surplus productive capacity.
Stimulates greater managerial effort.
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Arguments for tariffs
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Increasing returns to scale.
External economies.
Technological borrowing.
Intraindustry trade.
Changes in factor endowment.
Revenue.
Improved employment & balance of
payments.
Other arguments.
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Path dependence
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Historically remote events influence
subsequent specialization.
QWERTYUIOP: to reduce jamming from
typing & provide salespersons easy access
to typewriter’s brand name.
QWERTYUIOP dominates computer
keyboards.
Other examples of path dependence: Silicon
Valley & Bangalore, India.
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Special arguments for
interfering with free trade
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Income distribution: does skill-biased
technological progress or trade hurt
unskilled labor in DCs?
Debate on what causes increased skill
premium.
Most economists attribute increased skill
premium to skill-biased technical progress.
Moreover, free trade increases national
income which can be used to redistribute
income. But will the state redistribute?
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Child labor
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100 million children: 10% of world’s
children are working full time.
1 of 5 of primary aged children not
enrolled in school.
Child labor, however, largely reflects
poverty of the children’s households.
Countries more open to trade have lower
incidence of child labor (Neumayer & de
Soysa).
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Child labor
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More child labor when poor credit
markets & transitory income shocks.
In Mexico, subsidized mothers of
children benefited more from grants than
children working. Increased school
attendance.
Chaudhuri (2003): sanctions against
child-labor countries produce perverse
effects.
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Trade & environment
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LDC pollution havens do not distort
comparative advantage.
In fact, free trade is generally good for
the environment.
Trade openness raises world incomes
which reduce pollution concentrations
(Antweiler, Copeland, & Taylor 2001).
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Shifts in terms of trade
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High export primary commodity
concentration ratios among some
primary product producers of Africa &
Central America.
Greater volatility in export prices &
earnings.
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Commodity terms of trade (CTT)
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Price index of exports/price index of imports.
Example: if export prices increase 10% &
import prices 21%, CTT drops 9%.
1.10/1.21=0.91.
Prebisch & Singer argue that CTT in primary
product exports (LDCs) decline in long run.
Inferred from inverse of rising terms of trade,
1876-80 to 1938 of Britain, a manufactures
exporter & primary product importer.
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Why did Prebisch & Singer think
LDC terms of trade fell?
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Engel’s Law: as income increases,
proportion spent on manufactured goods
rises & proportion spent on primary
products falls, resulting in excess supply
of primary products & excess demand for
manufactured goods, contributing to
increasing relative prices in manufactured
goods.
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Empirical data
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Figure 17-1 shows declining trend
for price of nonoil commodities
relative to exports of manufactures,
1948 to 2001.
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Other terms of trade measures
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Spraos: if extend Britain’s primary prices
between 1939 & 1973, questionable whether
Prebisch-Singer is correct.
Export purchasing power (CTT X quantity
index of exports) may have increased when
CTT fell.
Single factoral terms of trade = CTT X
output per combined factor inputs in export
production.
Relevant is change in terms of trade
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LDCs’ terms of trade
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Kindleberger (1956) argues that LDCs,
not primary product producers, are
vulnerable to declining terms of trade
because they cannot easily shift
resources in accord with shifting
patterns of comparative advantage
(Table 17-2).
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Import substitution &
export expansion in industry
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NBER (1978, 1981): export promotion
generally more effective than highly
protected import substitution in
expanding output & employment.
Substituting domestic output for imports
emphasizes good more likely to use much
more capital per unit of labor, less
efficient.
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Export promotion preferable
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Export promotion includes advantages:
(1) international competition, encouraging quality
control, new products & techniques, & good
management;
(2) cost economies from increased market size;
(3) information provided by DC users improves
quality;
(4) cost to society more visible than protection; &
(5) efficient firms not limited by domestic demand
growth.
Export promotion relies on pricing incentives,
such as market exchange rates.
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Mexico v. South Korea (1980s)
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Mexico provided incentives for import
substitutes & discouraged export
development.
South Korea virtually no incentives for
import substitution while heavily
encouraging exports through capital
subsidies, depreciation allowances, &
import duty exemptions.
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Mexico v. Korea (1980-1992)
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Mexico’s real annual growth: 1.6% in
industry & -0.2% overall.
Korea’s real annual growth: 11.6% in
industry & 8.5% overall.
Korea spurred by scale economies,
international competition, price
flexibility, & no agricultural & foreign
exchange shortages.
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India v. East Asia
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India: import substitution
industrialization limited: “narrow
domestic market, high costs &
technological backwardness.”
East Asia: exports facilitated learning
through economies of scale &
increasing returns, while foreign
markets source for knowledge
acquisition (D’Costa 200).
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Global Production Networks (GPNs)
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View of economists that LDCs exports primary
goods & importer manufactures outdated in last 2
decades (except for Africa & Central America).
Low-income countries’ (LICs’) manufacturing
exports as percentage of total exports rose from
about 20% in 1981 to almost 80% in 2001 &
middle-income countries’ (MICs’) from 24% in
1981 to almost 70% in 2001.
Even without India & China, rise in
manufactures substantial
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Major explanations for LICs’ &
MICs’ transformation
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Reduced protection, especially in
industries a part of global production
networks (GPNs) (Table 17-3).
Many LDCs moved up value-added
ladder.
LICs (low-income countries) expand
exports of low technology exports.
MICs (middle-income countries)
exports’ level of technology increased.
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East & Southeast Asia, India (after
1991)
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Rapid growth in international trade &
FDI result of expanding GPNs.
Much from international trade & foreign
investment shifting from production &
exchange of final consumer goods to
production & exchange of parts &
components, making it difficult to
identify nationality of many products.
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Manufacturing value-added in large
number of countries, including LDCs
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Figure 17-4 indicates proportion of countries’
value-added in producing a US automobile.
Compare to Henry Ford’s Model T in 1921; or
1950 – all US autos produced within the
country.
In 1998, US comprises only 37% of auto’s
value-added.
Fig. 17-5 shows how cross-border networks
capture increasing share of production & trade.
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GPNs enable production to be
broken into discrete stages
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LDCs undertake activities requiring low skilled labor,
low tech component of high-tech goods.
China & India have expanded range of products
exported.
US comparative advantage in producing & exporting
high-value added portion of production (innovative
software, fully assembled product).
US companies reduce cost of information &
communications technology (ICT) equipment by 10-30%
by making equipment in factories around the world,
increasing US growth by 0.3 percentage points yearly,
1995-2002.
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Increased division of labor in GPNs
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Japan sought export platforms abroad,
sometimes not even majority ownership.
Malaysia & Thailand – advantage in labor
intensive goods.
GPN participation is contributing to
independent technological innovation in
Asian LDCs, such as China, India,
Malaysia, & Thailand.
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DC import policies
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World Trade Organization/General
Agreements on Tariffs and Trade
(WTO/GATT) administers rules of
conduct in international trade.
WTO applies only to economies where
market prices are the rule.
China joined in 2001.
As of 2005, Russia was not a member.
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DC import tariffs
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DC manufacturing tariffs discourage the
processing of natural-resource-based
goods, especially hurting Africa.
The Uruguay Round (1986-94) tariff cuts
reduced DC tariffs to an average of 5-6%
of value, ranging from 15% in agriculture
and 11% in textiles and clothing to 4% in
industrial products.
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Misleading rates: more protective
than rates suggest
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Tariff rates are higher on laborintensive goods, in which LDCs have
comparative advantage.
Effective rate of tariff usually higher
than nominal rate for manufactured &
processed goods.
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Misleading rates
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Tokyo Round (1974-79) protection on LDC
goods according to processing state was:
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3% on stage 1 (raw material, e.g., raw
cotton)
23% stage 2 (low-level processing, as
cotton yarn)
20% stage 3 (high-level processing, as
cotton fabrics)
15% stage 4 (finished product, e.g.,
clothing)
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Misleading rates
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54% of DC imports from LDCs are
at stage 1; 29% at stage 2; 9% at
stage 3; & 8% at stage 4.
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Example
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Assume DC has no tariff on raw cotton imports
but a 5% tariff on cotton yarn imports.
Assume raw cotton sells for $600 per ton and
cotton yarn for $700 a ton, with $100 value
added by the cotton yarn industry.
5% nominal cotton yarn tariff ($35) is small
fraction of total sales value but 35% effective
tariff rate on $100 value added.
Overall post-Tokyo Round effective protection
was 2% for raw materials, & 15-20% for
processed & manufactured products.
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Other trade restrictions
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MFA (Multifiber Arrangement),
“voluntary” export restraints, mostly by
China beyond the 2005 phase out.
Other nontariff barriers (NTBs): trigger
price arrangements, antidumping duties,
industrial subsidies, and so forth.
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Generalized system of tariff
preferences (GSP)
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DCs grant of duty- & quota-free access to
eligible products.
US provides more liberal preferences for
Caribbean Trade Preference for 24 countries;
Andean Trade Preference for Bolivia, Colombia,
Ecuador, & Peru to reduce drug production &
trafficking; & African Growth & Opportunity
Act – duty-free access for virtually all products,
including apparel made in Africa from U.S. yarn
& fabrics (World Bank).
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Generalized system of tariff
preferences (GSP)
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European Union GSP available to all LDCs,
including China in certain categories of goods.
Preferences for LDCs have not been reliable,
frequently have been removed, and have
diverted exports from LDCs denied access.
LLDC (least-developed countries’) preferences
mean that developing countries with ¾ of
world’s $1/day poor do not benefit.
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Generalized system of tariff
preferences (GSP)
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Top 9 beneficiaries of U.S. preferences
are Thailand, Indonesia, India,
Philippines, Venezuela, South Africa,
Russia, Turkey, & Chile, mostly middleincome countries.
Cline (2004) calls for DCs to provide
“immediate free entry for imports from
‘high risk’ low-income countries,” the
best way to reduce LDC poverty.
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Expanding primary export earnings
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Staple theory of growth:
Canada’s expansion of wheat
production spurred growth in the
19th-century.
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Expanding primary export earnings
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Reduced agriculture protection: Burfisher
et al. (2003) indicate that eliminating
global agriculture policy distortions
(tariffs & subsidies) would mean annual
world static welfare gain of 0.2% of global
GDP.
1999-2001: protection by U.S. 29.6%, EU
56.0%, & 152.9% for Japan.
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Effect of OECD subsidies
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Increasing OECD support to sugar resulted in
world price below production costs of some of
the most efficient LDC sugar subsidies (Figure
17-8a).
Small (2004): full liberalization would increase
GDP per capita in seven West African cotton
dependent countries by 14%.
However, African-Caribbean-Pacific low-income
economies receiving EU preference would be
hurt at expense of other LDCs (sugar & cotton).
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Trade in services
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U.S. comparative advantage in services
& financial assets.
During Uruguay (1986-94) & Doha
(2002-) Rounds, U.S. led in efforts to
liberalize trade among services.
Trade in services is 25% ($1.2 trillion) of
1999 total world trade.
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Trade in services
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By 2015, $6 trillion additional income in
LDCs from liberalization in services.
Management consulting, legal,
accounting, engineering, advertising,
insurance, health, educational, transport,
trade, tourism services, & software.
Many LDCs fear dismantling of public
services, although WTO members can
determine which activities are open to
foreign providers.
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Trade in services
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China, India, & the Philippines would
benefit from increased trade.
As communication costs fall, U.S. &
other DCs are increasingly outsourcing
skilled services.
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The Mankiw debate
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In the 2004 Economic Report of the President,
the Council of Economic Advisors, whose
chair was Gregory Mankiw, wrote:
“One facet of increased services trade is the
increased use of offshore outsourcing in which
a company relocates labor-intensive service
industry functions to another country . . . When
a good or service is produced more cheaply
abroad, it makes more sense to import it than
to provide domestically.”
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The controversy
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This is an application of the theory of
comparative advantage.
However, amid the 2004 election, with
Democratic challengers focused on job
insecurity and inadequate health insurance,
this comment immediately sparked a
public debate.
Politicians of both parties condemned
Mankiw’s statement while most prominent
economists supported Mankiw.
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Intellectual property rights (IPR)
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The U.S., as leader in patents, trademarks, &
copyrights, forms of IPR, is vulnerable to losses
from unprotected rights & piracy.
WTO provides 10-20 years of protection to many
forms of IPR.
Bhagwati (2002) is critical of lengthy patent
protection, blaming pharmeceutical companies &
U.S. government for pressure on WTO & LDCs.
Bhagwati: WTO should concentrate on trade
liberalization & not collecting royalties.
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Intellectual property rights (IPR)
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LDCs’ royalty, licensing, and
administrative costs have increased.
Ghosh (1993) complains that LDCs
need to increase their payments of
patents for life-saving drugs.
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Foreign exchange rates
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The present system is a managed
floating exchange rate system.
Hybrid of single floats of major
currencies, independent float, pegged
currencies, & crawling peg.
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Domestic currency overvaluation
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Figure 7-9 shows Nigerian naira (N) price of
foreign (U.S. $) exchange, for example
N150=$1.
In a free market, this exchange rate is
determined by the intersection of demand &
supply curves.
If the Central Bank of Nigeria uses exchange
controls to limit its citizens’ purchase of U.S.
dollars for equipment, materials, consumer
goods, and travel, demand is repressed from D1
to D2, changing foreign exchange rate from
N150=$1 to N75=$1.
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Overvaluing N (naira) or
other local currencies
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Discourages import substitutes (making
imports cheap) and exports (making exports
less lucrative).
Most LDCs’ prices of foreign exchange are
lower than market rates (N75=$1 is lower than
N150=$1), meaning that they are biased
against exports, a mistake that Meiji Japan
(1868-1912) and South Korea (last half of 20th
century) did not make.
Both countries had rapid growth during these
periods.
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Domestic currency devaluation
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Usually preferable to surcharges,
compensating duties, exchange controls,
licenses, or quotas.
Devaluation rations imports through the
market, encourages import substitution, &
promotes exports.
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The Impossible Trinity
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Attaining goals of exchange rate stability,
free capital movement, & monetary
autonomy is impossible, according to
Reisen (1991).
12 European Union members had to
sacrifice monetary autonomy for a
common currency (euro) and free capital
movement.
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Eurozone & CFA poor record
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In 2005, European Central Bank VicePresident Papademost expressed concern
about macroeconomic underperformance
of eurozone members relative to noneuro OECD members.
Francophone West African countries
(CFA) forewent growth by maintaining
fixed currencies from 1948 to 1994 (UN
1994).
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Currency crises
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Before Asian 1997-98, Russia’s 1998,
Mexican 1994, & Argentine 2001-02
crises, the countries had overvalued
currencies.
Argentina’s currency board was too rigid
to increase its competitiveness in the late
1990s, 2001-03.
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Stiglitz (2002) faults the U.S. & IMF
for the Argentine crisis
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
In the early 1990s, the IMF gave
Argentina an “A” grade when it balanced
the budget & kept inflation under
control, despite high unemployment.
U.S. failed to provide trade credits to
Argentina as it did to Mexico in 1995, or
as Japan did to East Asian LDCs during
their crises.
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Regional Integration
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Some LDC leaders, reacting to DC
protectionism, few scale economies, &
declining terms of trade, have advocated
economic integration.
Economic integration: a grouping of nations
that reduces or abolishes barriers to trade &
resource movements among member
countries.
Integration ranges along a continuum from its
loosest form (preferential trade arrangement)
to the most advanced integration (complete
economic & monetary union, such as the
United States in 1789).
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Regional economic continuum
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Preferential trade arrangement: lower
tariff & other trade barriers among
member countries than nonmembers.
[1982-95: Preferential Trade Area for
Eastern & Southern Africa States
(PTA)].
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Regional economic continuum
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Free trade area (FTA): North American
Free Trade Agreement (U.S., Mexico, &
Canada, signed 1993).
Free trade of goods & most services &
free capital movement in most sectors
but not free labor migration.
FTAs need rules of origin to ensure that
a majority of the value-added originates
in member countries.
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Customs union
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Goes beyond free trade area to retain
common trade barriers against the rest of
the world.
Mercosur (Brazil, Uruguay, Argentina,
& Paraguay) provides for progressive
tariff reduction & free movement of
people.
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Common market
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Goes beyond customs union to
allowing free labor & capital
movement among member states.
Despite the name, European Union
has only attained this.
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Economic union
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Unifies members’ monetary & fiscal
policies (EU has not achieved this
yet).
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Complete economic &
monetary union
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13 states of United States in
1789.
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African Economic Community (AEC)
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AEC (in operation since 1991) seeks to create
African Common Market (ACM) in six stages,
using the nine existing regional trade organizations
(RTOs) as building blocs.
Daniel Bach, ed., Regionalisation in Africa (1999):
African RTOs (including ACM) exist only on
paper.
Borders not costly impediments to movements of
goods & resources in Africa, as there is a large
volume of unrecorded trade, including drugs &
mineral smuggling, even in failed states.
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Many LDC attempts at economic
integration not successful
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East African Cooperation (EAC) broke up
in 1996, as Uganda & Tanzania accused
Nairobi & other cities in Kenya as
receiving overwhelming amount of new
industrial investment.
Market size of many unions is too small to
attract industries that require substantial
internal economies of scale.
Still we can expect increasing efforts at
South-South integration & trade.
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LDC efforts at regional economic
integration with DCs
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All 15 EU members before 2004 plus Slovenia
were high income countries.
Poland, Czech Republic, Hungary, Slovakia,
Estonia, Latvia, Lithuania, Malta, & Cyprus
(EU’s 10 acceding countries) are middle-income
countries.
10 acceding countries benefit from continuing
structural reforms, specialization & scale
economies from integration into world’s largest
market (455 million in 2004), free movement of
labor after 2011, & attraction of capital flows
because of lower labor & other input costs.
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WTO/GATT allows RTOs
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Regional trade organizations (RTOs)
can remove barriers among members
(in no more than 10 years after
formation) if they don’t raise trade
barriers against nonmembers.
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RTOs’ trade diversion & creation
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Trade diversion – reduces world welfare: a
member country displaces imports from a
lowest-cost third country (NAFTA diverts U.S.
sourcing from lower-cost Korea, Taiwan, & Asia
to Mexico).
Trade creation – increases world welfare:
beneficiary country’s firms displace inefficient
domestic producers in a member country
(NAFTA increases Mexico’s exports of
electronic products & ladies’ dresses to the
U.S.).
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RTOs & world welfare
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Grossman & Helpman (1994) argue that political
pressure to form RTOs are greater when members’
firms gain more from trade diversion than they lose
from trade creation, thus reducing world welfare.
Frankel (1997): RTOs more likely to spur net trade
creations when number of RTOs in world is low;
transport costs between world regions are high;
transport costs within RTO are low; preference for
RTO goods is low; & asymmetries among member
states (in GDP & number of member nations) are
low; & elasticity of substitution between domestic
& foreign goods is high.
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Economists’ opposition to FTAA
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Free Trade Area of the Americas (FTAA)
opposed.
Not so much because of net trade
diversion.
Hufbauer & Schott (1994) oppose the
United States negotiating NAFTA’s
expansion country by country.
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Economists’ opposition to FTAA
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Movement of resources back & forth in
FTAA as RTOs continually change
composition of their membership.
When the U.S. & other countries pursue a
“blight” of bilateral & multilateral
agreements, the trading system resembles
a “spaghetti bowl” (Bhagwati 2002)
(Figure 17-11).
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Euro & U.S. Dollar as LDC
Reserve Currencies
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Dollar-dominated world monetary system
replaced by 2 ½ - polar system: dollar,
euro, & yen.
By 2010: euro reserves are expected to be
one-half of what dollar reserves are
(Polack 1998).
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Promotion & protection of
infant entrepreneurship
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Dynamic gains from learning management &
technology by doing (from being open to
international trade) are substantial.
Technological borrowing can proceed from
imported product to a copy, with slow
improvement, to finer grades & specialties.
Experience, improved endowment of human &
physical capital, & shift in comparative advantage
can promote infant entrepreneurship.
Meiji Japan; post-1970 Asian Tigers; &
contemporary Chile.
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Black markets & illegal transactions
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Black markets for foreign exchange form in
response to restrictions on trade & controls on
currency transactions (Figure 17-9 above).
Mid-1983: black market premium 30% in
Nigeria, 27% in Pakistan, 26% in Mexico.
Illegal & black-market transactions important
components of international trade in 1990:
186% of legal export earnings in Columbia,
184% in Bolivia, 121% in Mexico, & 39% in
Pakistan.
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