EC336 Economic Development in a Global Perspective

EC336Economic Development in a Global Perspective Abhishek chakravarty 2012-13 Lecture 3

Lecture Outline In this lecture we will discuss theories of international trade, and analyse whether the theoretical arguments are consistent with developing country experience. The bulk of the material is from Todaro and Smith, chapter 12.

Developing Countries and Trade Developing countries are typically more dependent on trade than developed countries: Exports Data in 2008

Developing Countries and Trade Primary products tend to be the major export commodities for several developing countries. This places these countries at a disadvantage in the international market, as primary products have characteristics that make them much less profitable exports than manufactures. The income elasticity of demand for primary products is low. The percentage increase in quantity demanded of agricultural products and raw materials by rich importing nations will rise by less than the percent increase in their national income. Estimates show a 1% increase in developed country incomes only increases imports of foodstuffs by 0.6%, but raises imports of manufactures by 1.9%.

Developing Countries and Trade Primary products also have very low price elasticity of demand, so any shift in the supply or demand curves of these products leads to very large price fluctuations. Low income and price elasticity of demand for primary products together create export earnings instability for countries relying on primary product exports, which has been linked to low and unpredictable rates of income growth. Prebisch-Singer Hypothesis: Terms of trade (Px/Pm) for primary products have declined due to low income and price elasticities of demand, and will continue to do so, resulting in a transfer of income from poor to rich countries.

Developing Countries and Trade Hence many developing countries have tried for decades to diversify their exports towards manufactures. Dramatic shifts in this direction have been made by the East Asian tigers, China, and other countries we saw in the table. However the price of manufactures exported by developing countries has also declined by about 3.5% per year over the 1980s, and the terms of trade have tilted in favour of manufactures exported by developed nations in the 1990s. There is therefore a growing role for the export of commercial services from developing countries, which have indeed increased dramatically in the last two decades.

Neoclassical Theories of Trade The most basic neoclassical model of international trade is Ricardo’s theory of comparative advantage, which states that countries should specialise in the production of goods in which they have a relative cost advantage. To illustrate the concept, assume there are two countries England and Portugal producing two goods, cloth and wine. England can produce either 400 units of cloth or 100 units of wine with full employment of resources. Portugal can produce 800 units of cloth or 400 units of wine with the same resources.

Neoclassical Theories of Trade Portugal therefore has an absolute advantage in the cost of production of both goods. However there can still be gains from trade due to differing opportunity costs of production with each country. If England wishes to produce 1 extra unit of wine, the opportunity cost is 4 units of cloth. For Portugal, the opportunity cost of producing 1 extra unit of wine is only 2 units of cloth. Therefore Portugal has a comparative advantage in the production of wine. Similarly, the opportunity cost of 1 extra unit of cloth for England is ¼ units of wine. For Portugal the opportunity cost of 1 extra unit of cloth is ½ units of wine, which is twice as much. So England has a comparative advantage in cloth production.

Neoclassical Theories of Trade Suppose before trade, both countries divide their resources equally in the production of both goods and consume what is produced: Now suppose Portugal shifts resources away from cloth to wine, and England from wine to cloth:

Neoclassical Theories of Trade If both countries agree to trade 3 units of cloth for 1 unit of wine, they can consume more of both goods than without trade: The model rests on assumptions of no transportation costs, constant returns to scale in production, and perfect mobility of factors of production between goods. This model illustrates the gains from international trade, and formed the initial basis for arguments in favour of trade liberalisation without government intervention.

Neoclassical Theories of Trade Ricardo’s model was developed further into the Hecksher-Ohlin factor endowments trade model to account for differences in stocks of labour and capital across countries. The factor endowments model assumes that each country has access to the same production technology for all goods, unlike the comparative advantage story which relies on differing productivity levels for the same levels of resources. The gains from trade in the Hecksher-Ohlin theory arise from differing factor prices due to different stocks of labour and capital across countries. E.g. Labour will be cheap in labour-abundant economies.

Neoclassical Theories of Trade • Different factor prices lead to cost and price advantages in production of labour-intensive goods for labour-abundant countries and capital-intensive goods for capital-abundant countries. • Trade then allows nations to benefit from specialisation in the production of commodities for which it has abundant resources, and exporting them in exchange for commodities which it cannot produce as cost-effectively due to factor shortages. • Hence the two baseline assumptions for the model to yield gains from trade are: • Different goods require productive factors in different proportions. • Countries have different endowments of factors of production.

Neoclassical Theories of Trade The factor endowment trade model can be illustrated in the two-country, two-good case: Imagine a labour-abundant less developed country (LDC) with production possibility frontier PP between labour-intensive agricultural goods and capital-intensive manufacturing goods. Before trade: consuming at A on the production possibility frontier. After trade: Manufacturing goods are available more cheaply in return for agricultural goods from capital intensive developed country. So LDC can export BD of agricultural good in return for DC of manufactures, consume outside PP, and be better off. C P A Less Developed Country domestic price ratio (Pa/Pm)L Manufacturing D B International price ratio (Pia/Pim) 0 P Agriculture

Neoclassical Theories of Trade And the developed country case: The capital-abundant developed country has production possibility frontier P’P’ between labour-intensive agricultural goods and capital-intensive manufacturing goods. Before trade: consuming at A’ on the production possibility frontier. After trade: Agricultural goods are available more cheaply in return for manufacturing goods from labour intensive LDC. So the developed country can export B’D’ of manufactures in return for D’C’ of agricultural goods, consume outside P’P’, and be better off. P’ Developed Country domestic price ratio (Pa/Pm)D B’ C’ Manufacturing D’ A’ International price ratio (Pia/Pim) 0 Agriculture P’

Neoclassical Theories of Trade The factor endowments trade model makes several other important predictions besides just demonstrating gains from trade. 1. Rising opportunity costs in production prevents specialisation in production. This is unlike in the comparative advantage case where factors of production are perfectly mobile between commodities in production. 2. Given identical production technologies across countries, equalising domestic price ratios to international price ratios with increased trade will lead to factor price equalisation across trading countries. E.g. Wages will rise in the LDC due to more intensive use of labour after trade, and the price of capital will decline due to reduced production of manufactures.

Neoclassical Theories of Trade 3. Within countries, the economic return to owners of abundant resources will rise relative to those to owners of the scarce factor due to more intensive use of the former. For LDCs this implies a higher share of national income going to labour and more equality in income distributions. 4. Trade allows countries to move beyond their production possibility frontier in terms of amounts of goods consumed and capital goods available to purchase. Hence trade promotes economic growth in LDCs by giving them access to cheaper imported machinery and equipment for increased production. For all of the above theoretical benefits from trade to be realised, unfettered trade based on free markets without government intervention is argued to be necessary by proponents of free trade.

Critique of Trade Theory: LDC Experience • To see why neoclassical trade theory does not fit well with the real world experience of developing countries, we need to analyse the main assumptions the theory is based on: • 1. All productive resources are fixed in quantity and quality across nations, and are fully employed. • 2. The technology of production is fixed, or similar freely available globally, and the spread of technology benefits all. Consumer tastes are also fixed independent of the influence of producers. • 3. Within countries, factors of production can be transferred from one productive activity to another without a high cost, and perfect competition prevails in the economy with no risks or uncertainties. • 4. The national government plays no role in international economic relations. Trade is carried out between several anonymous producers and consumers, and prices are set by the forces of supply and demand. • 5. Trade is balanced for each country at any time, and countries can adjust to changes in international prices with minimum dislocation. • 6. The gains from trade that accrue to any country benefit the nationals of that country.

Critique of Trade Theory: LDC Experience We can examine each assumption in the context of the position of LDCs in the international economic system: 1. Fixed resources, Full employment, and immobile factors of production Obviously in reality the world economy experiences rapid change, and factors of production are not fixed in quantity or quality. Also factors often do not determine international specialisation in production as theory suggests; rather international forces directly affect specialisation in production and factor use. E.g. LDCs can find themselves locked into a low-growth situation because they specialised initially in labour-intensive primary products, and therefore did not benefit from increased domestic capital, technical skills, and entrepreneurship ability which comes from producing capital or technology-intensive goods.

Critique of Trade Theory: LDC Experience Also factors of production are seldom fully employed in production, especially in LDCs. The reality is there usually widespread unemployment or unemployment of productive resources, specifically labour. New trade theories called “North-South” trade models focus on trading relations between rich and poor countries. A typical such model argues that a capital-abundant industrialised “North” country experiences external economies in manufacturing and higher profit rates. This combined with monopoly power generates higher Northern growth rates through greater capital accumulation. Further adding higher income-elasticity of demand for manufactured goods creates a competitive advantage for the North over the poorer, slower growing South that is less industrialised. Porter’s Competitive Advantage of Nations theory: There are big differences in quality of factors of production between rich and poor countries. Standard trade models assume basic, identical factors like undeveloped physical resources and unskilled labour as factors of production across countries. However these theories do not apply when one considers advanced factors like labour with specialised skills, knowledge resources like government institutes and research universities etc. New trade theories also focus on how LDCs can exploit underutilised factors of production to benefit from trade. An example is the vent-for-surplus theory of international trade, which shows how LDCs can move from producing inside the production possibility frontier to the frontier itself, and then consume outside the frontier to benefit from trade.

Critique of Trade Theory: LDC Experience Vent-for-surplus theory of trade

Critique of Trade Theory: LDC Experience 2. Fixed and Available Technology and Consumer Sovereignty Technological change is taking place rapidly and directly affecting international trading relationships. E.g. The development of synthetic rubber, wool, and cotton substitutes since World War II has led to declining LDC market shares in these products. However the availability of new technologies has also benefited many developing countries by allowing them to follow the product cycle of developed countries in production and fill in the manufacturing gaps left by the latter. Consumer tastes are also deeply affected by advertising campaigns initiated by MNCs, and therefore not fixed and immovable as theory suggests.

Critique of Trade Theory: LDC Experience 3. Internal Factor Mobility, Perfect Competition, and Uncertainty: In economies that have become gradually dependent on a few primary commodities for export, production structures will be largely oriented towards these goods and very difficult to change in response to changes in international markets. It is likely that transport and communication networks, power locations, credit arrangements etc. will all be geared towards certain sectors in LDCs, and will therefore involve very high costs of dislocation. There are additional problems, as developed countries often use tariffs to block low-cost manufacturing goods produced in LDCS that do re-orient their economies. The argument is usually that domestic industry and employment needs to be protected, but then LDCS do not receive the gains from trade described by the theory.

Critique of Trade Theory: LDC Experience Constant or Decreasing Returns to Scale in production are also not realistic assumptions. Large existing firms are often able to dominate and control industries by producing in bulk at very low cost due to Increasing Returns to Scale, and therefore also dominate international markets. This may prevent LDC entry into these markets as producers. Perfect competition assumes perfect information about goods and prices with no risk or uncertainty. This is also not the case for LDCs, as primary products have historically been subject to very volatile export prices in relation to manufactures making foreign exchange earnings from year to year unpredictable. 4. No Government Involvement in Trade Relations Governments actively attempt to prevent increasing inequality within their countries using legislation, tax and subsidy policy, and welfare programmes. However there is no international equivalent to prevent inequality between countries, and so unequal gains from trade can easily become self sustaining.

Critique of Trade Theory: LDC Experience In fact the most spectacular successes among developing countries in the international market are successful because of government intervention, rather than the lack of it. South Korea actively supported its export industries, and Japan set up an entire ministry to promote its exports. The WTO was instituted in 1995 to attempt to create equal trading relations across countries, but developed countries often exert a strong influence within it to protect their own industries using tariffs at the expense of LDCs. (We will see more on the WTO in the next lecture.) 5. Balanced Trade and International Price Adjustments In the theory, terms of trade always adjust so that countries break even in international markets and there are no debts or balance of payments crises. Clearly this is not the case in reality, often due to unexpected price shocks that governments are not prepared for such as the oil price shock in the 1970s.

Critique of Trade Theory: LDC Experience 6. Trade Gains accruing to Nationals There are often enclave economies within LDCS, where foreign firms with high bargaining power can pay very low rents and set up production with their own capital and skilled labour, and hire only unskilled local labour at low wages. In such cases, locals benefit very little when these firms export to foreign markets. The proliferation of MNCs with globalisation is important in this context as the beneficiaries from trade in LDCS can often be nationals from the developed world that manage the MNC rather than the local populace. Summary Trade can definitely increase economic growth rates through higher foreign exchange earnings and access to capital goods produced internationally. However the conditions under which LDCs can benefit from trade depend largely on developed countries. Often particular protectionist policies are necessary for LDCs to achieve some level of development before entering international markets.

EC336 Economic Development in a Global Perspective