International Trade Theory and
Development Strategy
Globalization: An Introduction
• Core economic meaning- the increased
openness of economies to international trade,
financial flows, and foreign direct investment.
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International Trade and Finance: Some
Key Issues
• Many developing countries rely heavily on exports of
primary products with associated 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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International Trade Theory
 What is international trade?
– Exchange of raw materials and manufactured goods
(and services) across national borders
 Classical (traditional) trade theories:
– explain national economy conditions--country
advantages--that enable such exchange to happen
 New trade theories:
– explain links among natural country advantages,
government action, and industry characteristics that
enable such exchange to happen
Classical Trade Theories
 Mercantilism (pre-16th century)
– Takes an us-versus-them view of trade
– Other country’s gain is our country’s loss
 Free Trade theories
– Absolute Advantage (Adam Smith, 1776)
– Comparative Advantage (David Ricardo, 1817)
– Specialization of production and free flow of goods
benefit all trading partners’ economies
 Free Trade refined
– Factor-proportions (Heckscher-Ohlin, 1919)
– International product life cycle (Ray Vernon, 1966)
The New Trade Theory
 As output expands with specialization, an
industry’s ability to realize economies of scale
increases and unit costs decrease
 Because of scale economies, world demand
supports only a few firms in such industries (e.g.,
commercial aircraft, automobiles)
 Countries that had an early entrant to such an
industry have an advantage:
– Fist-mover advantage
– Barrier to entry
New Trade Theory
Global Strategic Rivalry
– Firms gain competitive advantage trough:
intellectual property, R&D, economies of
scale and scope, experience
National Competitive Advantage
(Porter, 1990)
Mercantilism/Neomercantilism
 Prevailed in 1500 - 1800
– Export more to “strangers” than we import to amass
treasure, expand kingdom
– Zero-sum vs positive-sum game view of trade
 Government intervenes to achieve a surplus in
exports
– King, exporters, domestic producers: happy
– Subjects: unhappy because domestic goods stay
expensive and of limited variety
 Today neo-mercantilists = protectionists: some
segments of society shielded short term
Absolute Advantage
Adam Smith: The Wealth of Nations, 1776
Mercantilism weakens country in long run;
enriches only a few
A country
– Should specialize in production of and export
products for which it has absolute advantage;
import other products
– Has absolute advantage when it is more
productive than another country in producing a
particular product
Comparative Advantage
David Ricardo: Principles of Political
Economy, 1817
Country should specialize in the
production of those goods in which it is
relatively more productive... even if it has
absolute advantage in all goods it
produces
Absolute Advantage is a special case of
Comparative Advantage
Heckscher (1919)-Ohlin (1933)
Differences in factor endowments not on differences
in productivity determine patterns of trade
Absolute amounts of factor endowments matter
Leontief paradox:
– US has relatively more abundant capital yet imports
goods more capital intensive than those it exports
– Explanation(?):
• US has special advantage on producing new products
made with innovative technologies
• These may be less capital intensive till they reach massproduction state
Theory of Relative Factor Endowments
(Heckscher-Ohlin)
 Factor endowments vary among countries
 Products differ according to the types of factors that
they need as inputs
 A country has a comparative advantage in producing
products that intensively use factors of production
(resources) it has in abundance
 Factors of production: labor, capital, land, human
resources, technology
International Product Life-Cycle (Vernon)
 Most new products conceived / produced in the US in 20th
century
 US firms kept production close to their market initially
• Aid decisions; minimize risk of new product introductions
• Demand not based on price; low product cost not an issue
 Limited initial demand in other advanced countries initially
• Exports more attractive than overseas production
 When demand increases in advanced countries, production
follows
 With demand expansion in secondary markets
• Product becomes standardized
• production moves to low production cost areas
• Product now imported to US and to advanced countries
Classic Theory Conclusion
 Free Trade expands the world “pie” for goods/services
Theory Limitations:
 Simple world (two countries, two products)
 no transportation costs
 no price differences in resources
 resources immobile across countries
 constant returns to scale
 each country has a fixed stock of resources and no efficiency
gains in resource use from trade
 full employment
New Trade Theories
 Increasing returns of specialization due to economies
of scale (unit costs of production decrease)
 First mover advantages (economies of scale such that
barrier to entry crated for second or third company)
 Luck... first mover may be simply lucky.
 Government intervention: strategic trade policy
National Competitive Advantage
(Porter, 1990)
 Factor endowments
• land, labor, capital, workforce, infrastructure
(some factors can be created...)
 Demand conditions
• large, sophisticated domestic consumer base: offers an
innovation friendly environment and a testing ground
 Related and supporting industries
• local suppliers cluster around producers and add to
innovation
 Firm strategy, structure, rivalry
• competition good, national governments can create
conditions which facilitate and nurture such conditions
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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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
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Table1: Merchandise Exports in Perspective:
Selected Countries, 2005
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Demand Elasticities and Export Earning
Instability
• Low income elasticity of demand for primary
products
• Low price elasticity of demand and supply
• Export earnings instability
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The Terms of Trade and the PrebischSinger 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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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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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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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
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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
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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
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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
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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
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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)
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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
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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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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
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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
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Figure 4: Import Substitution and the Theory of
Protection
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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
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Trade Strategies for Development: Export
Promotion versus Import Substitution
• Tariff Structure and Effective Protection
– Nominal rate of protection
– Effective rate of protection
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Trade Strategies for Development: Export
Promotion versus Import Substitution
The nominal tariff rate, t, is
p  p
t
p
(13.1)
Where
p′ is the tariff-inclusive price
p is the free trade price
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Tariff Structures and Effective
Protection
The effective tariff rate, g, is
v  v
g
v
(13.2)
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
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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
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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
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Figure 5: Free-Market and Controlled Rates of
Foreign Exchange
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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
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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
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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
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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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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
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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
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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
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Figure 6: Effective Tariff Faced by Income
Groups, 1997-1998
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Case Study: Taiwan
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