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Global EconomicsEco 6367

Dr. Vera Adamchik

Trade Policies

For the

Developing

Nations

Chapter 7

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How do we define a developing nation?

The term developing countries refers to countries with low to moderate levels of income per capita (i.e., GDP per capita adjusted for purchasing power parity).

The attention to developing countries is not surprising, given that over 2 (or 5, according to some estimates) billion people live in these countries.

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Trade is important for developing countries:

• Exports of goods and services on average are about 44% of GDP in developing countries, while for developed countries exports are about 21% of GDP on average.

• Developing countries are the source of about 40% of all world exports.

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• In spite of the importance of trade to developing countries, the size of the economies and their trade flows creates the impression that these economies are becoming insignificant (or marginalized) in global trade.

• Over half of exports by developing countries go to industrialized countries, but these are only a little over 1/3 of industrial-country imports. More than a half of world trade is between industrialized countries.

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Questions to address in Chapter 7:

• What role can trade and trade policy play in development?

• How can trade and trade policy be used to boost incomes and economic growth in poor countries?

• In choosing a trade policy, should a developing country just follow the trade-policy guidelines laid out in Chapters 2-6? Or are developing countries so different that they need a separate trade policy analysis?

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Developing-Nation Trade Characteristics:

• exports tend to focus on primary products (such as agriculture, forestry, minerals, raw materials, and fuels) and these are often called traditional exports;

• many developing countries have exports concentrated in one or a few products like petroleum, coffee, cotton, gold, sugar, timber, diamonds, and bauxite/aluminum.

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Trade Problems of the Developing Nations

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Trade Problems of the Developing Nations:

1. Unstable export markets;

2. Worsening terms of trade;

3. Limited market access;

4. Agricultural export subsidies of advanced countries.

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1. Unstable export markets

• Economists maintain that a key factor underlying the instability of primary-product prices and producer revenues is the low price elasticity of the demand and supply schedules.

• As a result, a shift in either demand or supply could cause large decrease in prices and revenues.

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• The first explanation for price instability in developing-country exports focuses on an inelastic supply curve of exports [the situation is illustrated in Figure 7.1a on p. 232 in the textbook]. The supply curve tends toward vertical, reflecting the supply inelasticity characterizing primary products. For example, at the end of the harvesting period, a farmer has little choice but to sell most of the crop on the market, regardless of price. A shift of the export demand curve, in conjunction with a given inelastic supply curve, yields a relatively large price change.

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• A second explanation for price instability focuses on inelastic demand for the export good [the situation is illustrated in Figure 7.1b on p. 232 in the textbook]. This is usually the case for primary products because either the demand is a derived demand for use in a final good or the product is a food product that characteristically faces low price elasticities. Shifts in the supply curve because of factors such as variable weather conditions (e.g., droughts, flooding, hurricanes, etc.) in the producing countries can then cause substantial price instability.

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• A third explanation offered for instability is the high degree of commodity concentration in the export bundle, although this explanation is debated in the literature. In some developing countries, one or two goods constitute a majority of the total export earnings. This lack of diversification implies that dramatic price rises (or declines) in the one or two goods will cause total export earnings to rise (or fall) dramatically. If the bundle of goods were more diversified or less concentrated, then a price increase in some goods could be offset by price declines in other goods, making for greater stability in the total value of the export bundle.

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2. Worsening terms of trade

• Developing nations complain that their commodity terms of trade has deteriorated in the past century or so, suggesting that the prices of their exports relative to their imports have fallen.

• Does the fear of falling prices sound reasonable? Empirical analyses are inconclusive…

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• There are at least two major forces depressing, and at least two forces raising, the trend in the prices of primaries relative to manufactures:

• Engel’s law (low income elasticities of demand for primary products);

• Synthetic substitutes, recycling, conservation;

• Nature’s limits;• Relatively slow productivity growth in the

primary sector.

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3. Limited market access

• Tariffs imposed by the industrial countries on imports from developing countries tend to be higher than those they levy on other industrial countries (EU, NAFTA) [Chapter 8].

• Developing countries are also plagued by tariff escalation [Chapter 4].

• Antidumping and countervailing duties have become popular substitutes for traditional trade barriers.

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• Tariff rates on agricultural products are generally much higher than tariff rates on manufactured products or service. For example, in the 2000s, the average tariff rates on non-agricultural products were 4.2% for Canada, 3.8% for the EU, 3.9% for Japan, and 4.4% for the US. On agricultural products, however, the average tariff rates were 21.2% for Canada, 15.9% for the EU, 18.6% for Japan, and 10.3% for the US.

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4. Agricultural export subsidies of advanced countries

• In addition to high tariffs, agricultural producers also benefit from substantial subsidies. According to estimates from the OECD, government subsidies on average account for some 17% of the cost of agricultural production in Canada, 21% in the US, 35% in the EU, and 59% in Japan. In total, OECD countries spend more than $300 billion a year in subsidies to agricultural producers.

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• Developing nations have been pushing hard for reforms that would allow their producers greater access to the protected markets of the developed nations. Estimates suggest that removing all subsidies on agricultural production alone in OECD countries could return to the developing nations of the world three times more than all the foreign aid they currently receive from the OECD nations (WTO, Annual Report 2002, Geneva: WTO, 2002). In other words, free trade in agriculture could help to jump-start economic growth among the world’s poorer nations and alleviate global poverty.

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In-class exercise 1

You are an adviser to the government of a country whose exports are mainly a few primary products and whose imports are mainly manufactured products. You are asked to prepare a short report on the policies that can stabilize export prices or earnings. What will the main points of your report be?

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Several kinds of policies that conceptually can stabilize prices or export earnings have been used at various times. Several of such policies are listed below, but none of them has been judged very successful in practice.

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(1) An international buffer stock agreement. In this agreement, producing nations set up an international agency endowed with funds and a quantity of the commodity. If the world price of the good falls below the floor, the agency will buy it to bring the price up to the floor. On the other hand, if the world price rises above the ceiling, the agency will sell the good to bring the price down to the ceiling.

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(2) An international export quota agreement. In this agreement, producing countries choose a target price for the good and make a forecast of world demand for the coming year. Then they determine the quantity of supply that will, conjunction with estimated world demand, yield the target price. If the forecast of demand is correct and supplying countries adhere to their quotas, then the price in the coming year will be at the target level.

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(3) Multilateral contracts generally stipulate a minimum price at which importers will purchase guaranteed quantities from the producing nations and a maximum price at which producing nations will sell guaranteed amounts to the importers (that is, a target range for prices).

As compared to (1) and (2), multilateral contracts result in less distortions of the market mechanism since they do not involve output restraints or setting target prices.

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(4) Compensatory financing when an international agency provides a short-term loan to a developing country if its export earnings fall below the forecast level. When the developing country’s export earnings rise above the trend, the loan can be repaid. Advocates of this approach emphasize that it is superior to international commodity agreements because compensatory financing does not interfere with the market price setting mechanism.

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In-class exercise 2

• You are an adviser to the government of a country whose exports are mainly a few primary products and whose imports are mainly manufactured products. You are asked to prepare a short report on the policies that can combat a long-run deterioration of the terms of trade (TOT). What will the main points of your report be?

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Several general policy measures have been suggested for alleviating the alleged secular deterioration of the TOT of developing countries:

1. the formation of an export cartel by developing countries;

2. increased export diversification into manufactured goods;

3. the use of developing-country import or export restrictions to improve the TOT;

4. the formation of economic integration projects (such as free-trade areas or common markets) among the developing countries themselves.

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1. Formation of an export cartel

o If individual suppliers compete with each other prices will fall to relatively low levels.

oOPEC or any cartel colludes to reduce output levels which increase price and profits for individual firms.

oProfits are maximized where MC=MR.

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Obstacles to collusion:

1) number of sellers: greater number of sellers makes collusion more difficult

2) cost and demand differences: make it difficult to agree on price

3) potential competition: possibility of new firms entering market would cause agreement to break apart

4) economic downturn: falling profits make firms more likely to reduce prices

5) substitute goods: if consumers have alternatives available, higher cartel prices may cause consumers to shift purchases

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2. Export diversification

• The manufactured goods would presumably be labor-intensive goods in accordance with abundant labor supplies and the H-O theorem.

• Such a strategy is easier to recommend than to implement, and long-term measures such as increased education may be necessary.

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3. Import and export restrictions

• Economists are generally skeptical of the value to any particular developing country of adopting such trade restrictions. To influence the TOT, a country must be large in the economic sense in one or more of its export commodities, and this may not be the case for many developing countries.

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4. Economic integration projects

• These projects may be, for example, free- trade area or common markets [Chapter 8]. However, such unions run into difficulties regarding the sacrifice of national sovereignty and the distribution of benefits among the partner countries.

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Aiding the Developing Countries

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• World Bank (http://www.worldbank.org )

• International Monetary Fund (http://www.img.org)

• Generalized System of Preferences (GSP), a system where a large number of industrialized nations permit reduced duties or duty-free entry for a selected list of products if those products are imported from particular developing countries)

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Economic Growth Strategies

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The developing countries face a basic choice of the extent to which they wish to become active participants in the world economy through outward-looking policies or to turn inward through import-substitution policies.

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• An inward-looking strategy is an attempt to withdraw, at least in the short run, from full participation in the world economy.

• The strategy emphasizes import substituting industrialization (ISI), that is, the production of goods at home that would otherwise be imported.

• The strategy uses tariffs, import quotas, subsidies to import-substitute industries, and other measures of this type.

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• ISI could raise national skill levels, bring terms-of-trade gains, and allow planners to economize on market information (since they can just take industrial imports themselves as a measure of demand that could be captured with the help of protection).

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• Studies of ISI and related policies, however, show that income growth is negatively correlated with antitrade policies like ISI, and positively correlated with outward-oriented policies that are closer to free trade. The available evidence supports the fears about ISI raised by the analysis in Chapters 4-5.

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• In contrast, an outward-looking strategy emphasizes participation in international trade. It does not use policy measures to shift production arbitrary between serving the home market and foreign markets.

• Some analysts go further and focus particularly on export promotion, whereby policy steps such as export subsidies, encouragement of skill accumulation in the labor force and the use of more advanced technology, and tax breaks are used to generate more exports.

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• Countries concentrate on developing exports of manufactured goods, especially those that are intensive in less-skilled labor.

• This has been a slowly prevailing trend since the 1960s, though ISI also remains practiced in developing countries.

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• Relying on exports of manufactures has its risks, however. Developing nations have rightly complained about import barriers against their new manufactures erected by the industrialized countries. Such barriers have indeed been higher than the barriers on manufactures traded between industrialized countries.

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• Still, evidence shows that an outward-oriented trade policy encouraging exports of manufactures is part of the most promising strategy for most developing countries.

• Countries emphasizing export promotion have tended to realize higher rates of economic growth than countries emphasizing import-substitution policies.