BA 187 – International Trade

1. BA 187 – International Trade Krugman & Obstfeld, Chapter 10 Trade Policy & Developing Countries

2. An Overview of Developing Countries

3. Lesser Developed Countries (LDC’s) • LDC’s are not a homogeneous group • Fourth World vs. Third World Countries • Fourth World countries are LDC’s whose living standards are very low (sub-Saharan, Nepal, India) • Second World vs. First World Countries • Second World countries are previously non-market economies of central and Eastern Europe which exhibit characteristics of LDC’s. • Low Income - Per capita Incomes < $725 • Lower-Middle Income - $726 <Per capita Incomes > $2,900 • Upper-Middle Income - $ 2901 < Per capita Incomes < $8,955 • High Income - Per capita Incomes > $8,955

4. Characteristics of LDC’s vs Others Source: World Bank, World Development Report 1996.

5. Trade and LDC’s vs Others Source: World Bank, World Development Report 1996.

6. Trade & Development

7. Static vs. Dynamic Effects of Trade • Static Effects of Trade on Development • Developed in Standard Trade Model. • Mutual Gains by specializing in goods with comparative advantage. • For LDC’s this should expand sectors that are labor-intensive. • Primary effect to reduce unemployment, not raise real wage. • Trade acts as “vent for surplus” labor. • Possible problems • Greater instability in income if inelastic demand, undesirable terms of trade effects from export expansion. • Dynamic Effects of Trade on Development • Infant industry argument if economies of scale & cost advantage. • Free trade has positive antitrust effects, increased investment, dissemination of technology, & builds market institutions. • Assumes export sector is linked to rest of economy. If not, economy may develop export “growth poles” that do not spillover.

8. Problems in Trade and Development LDC Export Instability

9. Export Instability • Export Instability: • Export earnings of LDC’s fluctuate more than export earnings of Developed Countries. • Problem given high degree of openness of LDC’s, so export variability leads to GNP variability which is undesirable. • Causes of Export Instability: • All reasons associated with fact that LDC exports more heavily concentrated in primary products than manufactures. • Agriculture products have inelastic supply, fluctuations in demand lead to large swings in export prices and revenues. • Primary products are necessities or inputs with inelastic demand, supply changes lead to large swings in export prices and revenues. • LDC export bundle has high degree of commodity concentration. Lack of export diversity exposes LDC income to industry variations.

10. 1. Inelastic Supply & Fluctuations in Demand 2. Inelastic Demand & Fluctuations in Supply Price Price S S1 S2 D2 D D1 Quantity Quantity Causes of Export Instability

11. Policies to Stabilize Export Earnings • Several policies have been tried by LDC’s to stabilize their export earnings. None has been very successful. International Commodity Agreements (ICA’s) • International Buffer Stock Agreements: • If world price falls below set floor, international agency enters market and buys good until floor attained. • If world price rises above set ceiling price, agency sells good. • International Export Quota Agreements: • Producer Cartel chooses target sale price, forecasts demand, sets quantity produced to achieve target price. Prod’n quotas adjusted if demand fluctuates to keep target price. • Compensatory Financing: • If export earnings fall below some forecast level, international agency (IMF) extends short-term loan, repaid later

12. Problems with ICA’s in Practice • LDC’s have been enthusiastic users of ICA’s. Problems with ICA’s in practice fall into two categories. • Are effective ICA’s possible? • Crucial for buffer stocks are levels of ceiling & floor prices . • If this price range does not include LR free-market equilibrium world price then agreement will not be sustainable. • Crucial for export quotas are ability to forecast demand and for agreement to control all exporters of the good. • Are ICA’s desirable? • ICA’s may reduce export earnings and welfare of producing countries. • Crucial whether price changes due to variations in supply or demand. • If price changes from demand shifts then ICA’s can hurt nation. • If price changes from supply shifts then ICA’s can help nation.

13. Problems in Trade and Development LR Decline in LDC Terms of Trade

14. LR Decline in LDC Terms of Trade • Alleged there is persistent tendency for LDC’s terms of trade (TOT) to fall over time. • Prebisch-Singer hypothesis from statistical studies in 1950’s. • Inferences invalid due to measurement error in terms of trade (exports f.o.b./imports c.i.f.) and quality changes in manufactures. • Recent evidence mixed, more primary product price declines. • Reasons for Alleged LR Decline in LDC TOT • Differing income elasticities of demand for primary versus manufactured products. • Unequal market power in product and factor markets, particularly oligopoly pricing in manufactures. • Technical change has reduced demand growth for primary products. • Multi-national corporations (MNC’s) worsen through transfer pricing when LDC’s have restrictions on repatriating profits.

15. Policies to Stop LDC’s Declining TOT • Export Diversification • LDC’s should diversify into manufactured exports to reduce volatility of export earnings based only on primary products. Difficult to do. • Export Cartels • Use monopoly power to increase export price of commodity. • Requires no substitutes for good & no exporters cheat on cartel price. • Also Need Demand inelastic, both in SR and LR. • Import and Export Restrictions • Generally require country to be “large” for significant effect on TOT. • Economic Integration Projects • LDC’s may form free-trade areas or common markets among selves or with both LDC’s and Developed Countries.. • Increase trade between, develop unified presence in world markets, facilitate transfer of technology and capital.

16. Inward vs. Outward Looking Strategies • Appropriate trade strategy for an LDC? • Inward-Looking Strategy • Emphasizes import-substitution, attempts to withdraw from trade. • May work if economies of scale in import substitutes or infant industry argument for potential exports. • Outward-Looking Strategy • Emphasizes increase international trade from comparative advantage. • Focus is on efficient allocation of factors in prod’n. • May also involve export-promotion policies. • Empirical Results • Economic performance of outward-oriented economies braodly superior to that of inward-oriented economies in terms of avg. growth in real GDP, per capita GDP, income dist’n but not inflation.

17. Problems in Trade and Development Economic Dualism

18. Economic Dualism • Dual Economy • Developing economy that is divided into two sectors with significantly different levels of development. • Generally think of a modern (high wage, high value output per worker, capital-intensive) vs. a traditional sector. • Reasons for Dualism • Markets within the economy are working poorly, particularly factor markets. Wage differentials argument combined with high urban unemployment. • Import-substitution trade policies can aggravate dualism. Capital-intensity of import-substituting industries lead to wage differential. • Export-promoting trade policies can cause dualism if export sector disconnected from rest of domestic economy (growth pole).