ECONOMICS OF LESS DEVELOPED COUNTRIESmichaelking.ie/.../uploads/2018/03/EC3040-L5-International-Trade.pdf · Theories of International Trade ... and the post-war periods, ... Understanding

EC3040b Economics of Less Developed Countries1

ECONOMICS OF LESS DEVELOPED COUNTRIES

EC3040b Spring 2018

Lecture 5

Michael King


Course Outline1. Contemporary Theories of Economic

Development 2. Policymaking: What Role for the State in

Development?3. The Role of Institutions in Development4. Aid: Does it Work? 5. Trade: Engine of Growth or Obstacle to

Development?6. Domestic and International Finance:

Opportunities and Instability7. Economic Growth and Environmental

Sustainability


ReadingsRequired1. Michael Todaro and Stephen C. Smith, Economic Development (2009) Chapter 122. Caves, Frankel and Jones, World Trade and Payments (2007) Chapter 6Supplementary 2. Frank Barry, Michael King and Alan Matthews (2009) Policy Coherence for

Development: A Scoping Report for Ireland http://www.tcd.ie/iiis/documents/discussion/pdfs/PCD_report.pdf Chapter 2 and 3

3. Hausmann, Hwang, and Rodrik, What You Export Matters. CID Working Paper No. 123, 2005 http://www.hks.harvard.edu/centers/cid/publications/faculty-working-papers/cid-working-paper-no.-123

4. Frankel and Romer, Does Trade Cause Growth? (1999) http://papers.nber.org/papers/w5476

5. Irwin and Tervio, Does trade raise income?: Evidence from the twentieth century. Journal of International Economics (2002)

6. Rodrik, Subramanian and Trebbi Institutions Rule: The Primacy of Institutions over Geography and Integration in Economic Development (2002) http://www.nber.org/papers/w9305.pdf

http://www.tcd.ie/iiis/documents/discussion/pdfs/PCD_report.pdf

http://www.hks.harvard.edu/centers/cid/publications/faculty-working-papers/cid-working-paper-no.-123

http://papers.nber.org/papers/w5476

http://www.nber.org/papers/w9305.pdf

EC3040b Economics of Less Developed Countries

Lecture Outline1. Introduction 2. Impact of Trade on Growth3. Specific Challenges Facing Developing Countries

– Prebisch-Singer Thesis4. Theories of International Trade

– Comparative Advantage– Heckscher Ohlin Model

5. Trade Strategies6. Global Trade Policy

– Trade Issues– Focus on Agriculture

4


1. Introduction: Globalisation

1. Globalization- many interpretations.2. Core economic meaning- the increased

openness of economies to international trade, financial flows, and foreign direct investment.

3. Globalisation represents benefits and opportunities as well as costs and risks to developing countries.

4. Concerns with globalization center around the unevenness of the process.


Level of Trade (% of GDP)


Stylised Facts about LDC Trade1. Majority of growth in LDC exports in manufactures, (today

over 70 per cent of their total exports up from 20 per cent since the early 1980s).

2. Exports of services by developing countries have become more important (up from 9 per cent of their exports in the 1980s to around 17 percent today).

Ø Yet while many developing countries have increased their exports dramatically in the last few decades, Africa has not.

Ø Share of world exports of African, Caribbean and Pacific (ACP) countries fell from 3.4 per cent in 1976 to 1.9 per cent in 2000 and their share in developing countries’ exports from 13.3 per cent in 1976 to 3.7 per cent in 2000.


Trade Optimists and Trade Pessimists

• Trade pessimist arguments– Limited growth of world demand for primary exports– Secular deterioration in terms of trade – Rise of developed world protectionism

• Trade optimist arguments– Trade Liberalization promotes competition and

efficiency– Generates pressure for product improvement– Accelerates overall growth– Generates needed foreign exchange


Optimism: Blair Commission on Africa

• Blair Commission on Africa noted that, if sub-Saharan Africa could manage to increase its share of world exports by just 1%, it would generate over US$70 billion (3 times greater than current level of aid)


2. Impact of Trade on Growth

• Frankel and Romer (1999) examine the correlation between trade and income using a countries’ geographic characteristics. – Results provide evidence of a quantitatively large and

robust relationship running from trade to income.• Irwin and Tervio (2000) use Frankel and

Romer’s geographic attributes (distance from potential trading partners) to identify the effects of trade on income. – Using data from the pre-World War I, the interwar,

and the post-war periods, they confirm the hypothesis that countries that trade more as a proportion of their GDP have higher incomes.


Impact of Trade on Growth

• Rodrik, Subramanian and Trebbi (2002) estimate the respective contributions of institutions, geography, and trade in determining income levels around the world.– The results indicate that the quality of institutions

“trumps” everything else.– Once institutions are controlled for, trade is almost

always insignificant, and often enters the income equation with the “wrong” (i.e., negative) sign, although trade too has a positive effect on institutional quality.


Impact of Trade on Growth

• Success of East Asia is suggestive of the importance of trade.

• Simple data analyses for all low income countries is suggestive of a relationship between exports and GDP growth.

• Evidence to suggest that the higher productivity export baskets (measured by EXPY) are a strong and robust predictor of subsequent economic growth.


Low Income Countries: GDP Growth and Merchandise Trade

-2

-1

0

1

2

3

4

5

6

7

8

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Year

% G

DP

Gro

wth

Rat

e

0

10

20

30

40

50

60

70

80

Mer

chan

dis

e T

rad

e %

of

GD

P

LIC GDP Growth

LIC Merch Trade


Productivity Level of Exports v’s Subsequent Economic Growth

Source: Hausmann, Hwang and Rodrik (2005)


3. Challenges facing LDCs

• Many developing countries1. Rely heavily on exports of primary products with

attendant risks, long term price declines and low income elasticity of demand.

2. Rely heavily on imports (for many countries import demand exceed capacity to generate funds from exports).


Importance of Exports to Developing Countries

• Merchandise (primary goods and manufactures) exports greater share of GDP in developing countries.

• Smaller countries tend to export more.• Services are less important in developing

countries and are less amenable to cross border trade.


Merchandise Exports in Perspective, 2005


Demand Elasticities and Export Earning Instability

• Low income elasticity of demand for primary products:– 0.6 for foodstuffs.– 0.5 for agricultural raw

materials such as rubber and vegetable oils.

– In contrast 1.9 for manufactured goods.

• Results in a decline in the relative price of primary products.

• Low price elasticity of demand and supply leads to export earnings instability.

Inelastic Supply causing large price fluctuations


Nonfuel Primary Commodity Prices, Nominal and Real, by Commodity Group, 1960-2005

(2000 index = 100)


Nonfuel Primary Commodity Prices, Nominal and Real, by Commodity Group,

1960-2005 (2000 index = 100)


Prebisch-Singer Thesis• Total export earnings depend on:

– Total volume of exports sold and– Price paid for exports

• Commodity Terms of Trade: Relative prices of exports to imports indices.

• Real primary product prices have declined by an average annual rate of 0.6% per year.

• Prebisch and Singer argue that export prices fall over time, so LDCs lose revenue unless they can continually increase export volumes.

• Prebisch and Singer: LDCs need to avoid a dependence on primary exports.


4. Theories of Trade: Comparative Advantage

• Comparative advantage: ability to produce a particular good/service at a lower opportunity cost. – Not the same as absolute advantage: ability

to produce a particular good at a lower absolute cost.

• Comparative advantage leads to specialization.


• Absolute Advantage

• Comparative Advantage

Note: Marked in green is the commodity that each country will produce23

Malaysia UgandaDVD Players per hour 6 1T-shirts per hour 4 2

Malaysia UgandaDVD Players per hour 6 1T-shirts per hour 4 2


Law of Comparative Advantage

• LCA: Even if one nation has an absolute disadvantage with respect to other nation in production of both commodities, there is still a basis for mutually beneficial trade.

• This nation should specialize in the production and export of the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage in greater (this is the commodity of its comparative disadvantage).

24


Heckscher-Ohlin (Neo-classical model)

• Ricardo and Mill– Trade arises out of differing labour productivities.

• Heckscher and Ohlin (factor endowment theory)– Same labour productivities for a particular product as

same technology, irrespective of country (proportion used will depend on relative prices).

– Different products require productive factors in different ratios.

– Countries have different endowments of factors of production (land, labour, capital) and relative factor prices will differ.


Heckscher-Ohlin

• Countries endowed with capital will have a relative cost and price advantage in the production of manufactured goods and vice versa.

• Trade is an opportunity to capitalise on abundant resources.

• Theory encourages developing countries to focus on labour and land intensive primary exports.


Understanding the H-O Graphs1. PP is the local production frontier. In the absence of trade, country

produces and consumes on the PP, say point A.2. Relative prices between the two goods at point A is simply the slope of

the tangent to the PP curve. The slope measures how much of one good you have to give up to obtain one unit of the other good.

3. The relative price ratios are different in the developing and developed countries reflecting the level of abundance of each factor of production.

4. When free trade is introduced, the prices equalise.5. The developing country will reallocate resources away from its costly

capital intensive manufacturing sector and will specialise in more labour intensive agricultural production as can get more manufactured goods for one unit of agricultural goods

6. Production takes place where the new free trade price line meets the PP curve.

7. Consumption can take place along the new price line, leading to exports and imports.


Trade with Variable Factor Proportions and Different Factor Endowments


Trade with Variable Factor Proportions and Different Factor Endowments


Heckscher-Ohlin• 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 as consumption

can move beyond the production possibilities frontier.


Heckscher-Ohlin1. Trade stimulates economic growth.2. Trade promotes international and domestic

equality.3. Trade promotes and rewards sectors of

comparative advantage.4. International prices and costs of production

determine trading volumes.5. Outward-looking international policy is

superior to isolation.


Empirical evidence for Heckscher-Ohlin

• Wages have not equalised with LDCs.• Weak empirical evidence supporting theory.• But is all labour comparable?• Same industries use different technologies.• Many more advanced models have been

proposed and tested empirically.


Critique of Heckscher-Ohlin • The following assumptions of the Neoclassical

model must be scrutinized:

1. Fixed resources and full employment (and

International factor immobility).

2. Fixed, freely available technology (and consumer

sovereignty).

3. Internal factor mobility and perfect competition.

4. Governmental non-interference in trade.

5. Trade gains accruing to nationals.


Critique of Assumption 1 • Fixed Resources, Full Employment (and International

Factor Immobility)– Factors of production are not fixed in quantity or quality (in

particular for capital, education, scientific capabilities).– Endogeneity: Some high skill endowments can be determined by

trade rather than the other way around.

– Assumption of full employment violates the reality in developing countries.

– Un- and under-employment means a developing country can expand production at little or no cost.

– North-South trade models points to the opposite result due to • External economies in manufacturing output• Rise in monopoly power• Differential income elasticities of demand

• Capital mobility


Critique of Assumption 2• Fixed, Freely Available Technology and

Consumer Sovereignty– Synthetic substitutes have replaced developing

country exports in many commodities such as rubber, wool, cotton, jute etc.

• 1950-1980 the share of natural rubber in total rubber consumption fell from 62% to 28%.

– The power of multinationals (and their marketing budgets) undermines the assumption of fixed and independent consumer tastes.


Critique of Assumption 3

• Internal Factor Mobility, Perfect Competition, and Uncertainty: – Assumes that developing countries can adjust their

economic structures easily – difficult in practice.– Increasing returns and exercise of monopolistic

control over world markets – countries to industrialise first are able to take advantage.

– Risk and uncertainty inherent in international trading arrangements make specialisation a risk when poor.


Critique of Assumption 4• 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.– Despite the WTO, there is no international

organisation to protect the interests of weaker countries.


Critique of Assumption 5

• Trade gains accruing to nationals– Enclave economies are promoted by trade.– Difference between GDP and GNI becomes

important.


4. A Closer Look at Trade Strategies for Development

1. Export Promotion Policies (Outward looking)• Efficiency and growth benefits of free trade,

competition, large world markets.2. Import Substitution Policies (Inward looking)

• Greater domestic industrial diversification, opportunity to develop higher value added internationally competitive industries.

3. Industrialisation Strategy Approach• Optimistic about export led growth but envisions an

active role for government in influencing the type and sequencing of exports.


Export Promotion: Primary Products

• Primary-commodity exports have grown more slowly that total exports. Reasons include: – Low income elasticities (<1).– Low population growth rates in developed economies– Decline in prices implies low revenue.– Lack of success with international commodity agreements

to set output levels, stabilise prices and assign quota shares (success for OPEC with oil but not for tin, sugar or coffee agreements).

– Development of synthetic substitutes.– Agricultural subsidies in developed countries (e.g. CAP).– Supply rigidities reduce scope for export expansion.


Export Promotion: Manufactured Goods

• By developing manufacturing export industries countries in East Asia grew exports by over 20% per year.

• Manufactured goods made up over 80% of export earnings.

• During 1980’s 20 of 24 industrialised countries increased protection against LDC manufactured goods.

• WTO has removed many formal barriers but implicit barriers remain (rules of origin and technical requirements).


Import Substitution

• Typical strategy– Erect tariff barriers or quotas on certain imported

commodities.– Set up local industry to produce these goods (often as

joint ventures with MNCs).• The objective

– Eventually reap the benefits of large scale production and lower costs from learning by doing.

– Improve BofP in the process by reducing expensive imports.

• IS could be seen as a prerequisite for EP


Import Substitution & Theory of Protection• P1 and Q1 is the domestic

equilibrium under autarky.• Under free trade, LDC face

perfectly elastic demand curve. Can buy or sell at P2, domestic consumers gain but producers lose out, Q2 to Q3 is imported.

• Tariff is imposed raising price to Pt, domestic demand reduces from Q3 to Q5, domestic production is increased from Q2to Q4. If Pt is above P1 then imports are prevented.

• cdfe = revenue generated.• Short run: Consumers subsidise

producers Long run: Industries can be developed.


Import Substitution: Results

• Largely unsuccessful– Protected industries become inefficient and costly.– Foreign firms can benefit more.– Government subsidization of imports of capital goods

can tilt pattern of industrialization and contribute to BOP problems.

– Overvalued exchange rates designed to reduce the cost of intermediate goods can hurt primary exports.

• As a result does not stimulate self-reliant integrated industrialisation.


Trade Protection

• 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


Industrialisation Strategy Approach• Optimistic about export led growth but envisions active role for

government.– Focus on government interventions addressing market failures to

encourage exports (industrial policy).

• Without proper attention to incentives, industrial policies may be counterproductive.

• Mainstream view is to avoid picking winners.• WTO rules on industrial policies

– Allowed to build industry specific infrastructure.– Can assist an emerging industry as long as it does not discriminate

between domestic and foreign firms.– Can promote foreign investment, specialised human capital formation

and innovation strategies.

• Competence of governments crucial.


Economic Integration

• The growth of trade among developing countries.

• Integration encourages rational division of labor among a group of countries and increases market size.– A Free Trade Area = Free internal trade– Customs Union = Common external tariff and free

internal trade– Common Market = Customs Union plus free

movement of capital and labour


South-South Trade and Economic Integration

• Regional trading blocs (economic unions) and the globalization of trade.– NAFTA

– MERCOSUR

– SADC

– ASEAN

• Risks that the more industrialised countries will benefit most.


5. Global Trade Policy: Context• The creation of the World Trade Organisation

(WTO) at the conclusion of the Uruguay Round in 1995 was an important watershed for the international trade regime.

• In addition there has been an unprecedented recent increase in the number of preferential regional trade agreements (RTAs). – More of them have a North-South membership.– Often include provisions which go well beyond the

lowering of trade barriers.


Tariff Rates

• Common external tariff (CET) - most visible element of EU trade policy

• In general, the EU tariff on manufactured goods is low; excluding petroleum, the average non-agricultural Most Favoured Nation (MFN) tariff is 4.0 per cent (WTO, 2007).

• However, tariffs on products of particular interest to developing countries, such as textiles, clothing and footwear, can be double this level.


EU Preferences for Developing Countries

• EU’s trade policy towards developing countries originally took the form of autonomous non-reciprocal preferential arrangements. – E.g. Generalised System of Preferences (GSP) available to all

developing countries.

• A GSP Plus extends duty-free access for most sensitive products:– If countries can show that they comply with a range of conditions

on human and labour rights, environmental protection, the fight against drugs and good governance.

– Limited to lower-income economies, land-locked countries, small island nations and those countries which can demonstrate that their economies are poorly-diversified.


EU Preferences for Developing Countries

• In 2001, EU decided to admit all products from countries on the UN list of LDCs duty- and quota-free as part of ‘Everything but Arms’ (EBA) scheme.

• Further multilateral trade liberalisation holds risks for LDCs (i.e. Preference Erosion).


Tariff Rates in Agriculture

53

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

LDCs LAC Asia LDCs LAC Asia LDCs LAC Asia LDCs LAC Asia LDCs LAC Asia

AUS CHE EU USA Japan

Total ad valorem equivalent Applied Tariff in Agriculture (estimated) Source: www.macmap.org

Source: King and Matthews (2011) PCD Indicators for Ireland - forthcoming


Tariff Rates in Manufacturing

54

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

LDCs LAC Asia LDCs LAC Asia LDCs LAC Asia LDCs LAC Asia LDCs LAC Asia

CHE AUS EU Japan USA

Total ad valorem equivalent Applied Tariff in Manufacturing (estimated) Source: www.macmap.org

Source: King and Matthews (2011) PCD Indicators for Ireland - forthcoming


EU Regional Trade Agreements

• Trade relations with ACP countries now based on reciprocal free trade agreements which will take the form of Economic Partnership Agreements (EPAs). – Cover trade in goods, services and agricultural

products.– Addresses non-tariff and technical barriers to trade.– Provisions on competition policy, protection of

intellectual property rights and public procurement.


Criticisms of EPAs• Many NGOs are critical of what they see as

undue pressure on LDC to join EPAs.– Making weak economies open their markets for both

goods and services to EU imports.– Agreeing to rules on investment (previously rejected

in the ongoing Doha Round of multilateral trade negotiations).

– Concerned at the the loss of tariff revenue asymmetrical bargaining power between the two parties.

– Significant commitment to provide funding to help ACP countries to meet the challenges of preparing for free trade with the EU.


Technical Barriers to Trade• Products imported into the EU must also comply

with relevant regulations, where they exist, to meet health, safety and environmental objectives.

• WTOs Agreement on Technical Barriers to Trade requires members to avoid discrimination against imported products and to avoid creating unnecessary obstacles to international trade.

• Work by the World Bank on the impact of TBTs in Africa has shown that many indigenous small and medium sized companies face considerable barriers exporting because of TBTs.


Rules of Origin• Rules of origin (ROO) exist within all preferential

trading agreements (PTAs) to prevent third countries taking advantage of PTA concessions.

• To be granted preferential status, goods must be wholly obtained (e.g. grown, mined) in the beneficiary country or, where this is not the case, have undergone sufficient processing there.

• Developing countries have claimed that the rules of origin applied by the EU are too strict and should be relaxed to stimulate industrial growth and encourage exports.


Rationale for Aid for Trade

• Developing countries do not seem able to take advantage of the market access opportunities which are open to them.

• Turning opportunities into additional trade flows requires additional support.


Improvements in EU Trade Policy

• EU committed to ensuring a development-friendly and sustainable outcome of the Doha Development Agenda.

• EU strategy:– Shows awareness that trade liberalisation can have

negative consequences for poor people.– Calls for support for poverty impact analysis of trade

policies and reform.– Calls for measures to mitigate the negative impacts of

trade reform on the poor. – Recognises the importance of trade capacity building

in the least developed countries.


Agriculture: Importance for Developing Countries

• Agricultural sector: driving force behind economic development in most LCDs.

• Recent decline in the $1-a-day poverty rate in developing countries— from 28 per cent in 1993 to 22 per cent in 2002—has been mainly the result of falling rural poverty.

• Developed countries have protected high-cost domestic production by a variety of measures including tariffs and producer and export subsidies.

• Developing countries have often discriminated against their agricultural sectors through heavy taxation and the adoption of import-substituting industrialisation strategies.


Agriculture: Importance for Developing Countries

• The extent of both types of interventions has been slowly declining over time, as a result of the Uruguay Round of WTO negotiations and internal reforms in developed countries.

• Higher food prices: majority of the world’s poor are net food consumers rather than net food producers. – Proportion of smallholder farmers with net food

surpluses among the rural poor is actually quite small in most countries.


The EU�s Common Agricultural Policy

• During the past 15 years, the EU’s Common Agricultural Policy (CAP) has undergone significant reform.

• A large share of support to farmers, which was previously paid by consumers through high institutional prices, now paid by taxpayers as direct payments to farmers with no direct link with the quantities they produce.

• In addition, the EU has granted preferential access to agri-food exports from many low income and least developed countries under a variety of preferential schemes.


Effects of EU Cap Reform

• Traditional image of a "fortress Europe" that is

closed to developing countries’ exports, while

the EU dumps considerable quantities of surplus

agricultural products on these countries, to the

detriment of local producers, no longer fully

corresponds to the new CAP arrangements.

• Nonetheless, it remains the case that EU

farmers are still heavily supported, even if this

support is provided in less market-distorting

ways than in the past.


Agricultural Policy Issues• Market Access: EU tariffs for the key Irish agricultural

products of beef and dairy products are very high ( risk

of preference erosion).

• Export Subsidies: Negative consequences for

developing countries are not uniform. Although local

producers are always damaged, developing countries

which are net importers of food benefit from more

favourable terms of trade when the EU taxpayer

subsidises their imports.

• Domestic Supports: The key distinction in the WTO

disciplines on domestic support payments to farmers is

between those payments deemed to distort trade and

those payments which do not.


Food Standards, Animal Health and Traceability Rules

• European food safety legislation has been drastically overhauled and updated since mid-1990s.

• One concern is that higher standards may make it more difficult for developing country exporters to access the EU market, despite reductions in formal tariffs.

• This may not be because the food exported by developing countries is less safe, but because these countries may lack the testing and standards infrastructure to certify that their food exports meet EU standards.


EU Doha Offer

• EU offered to accept – Very significant disciplines on CAP support, – Moving towards elimination of export

subsidies– Significant reductions in tariff protection


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.


The Data and Consensus• Neither the trade optimists nor the trade

pessimists are always right– When world economy is expanding more

open countries perform better and vice versa. – Effective and highly interactive relationships

between the public and private sectors are crucial.

Documents

ECONOMICS OF LESS DEVELOPED COUNTRIESmichaelking.ie/.../uploads/2018/03/EC3040-L5-International-Trade.pdf · Theories of International Trade ... and the post-war periods, ... Understanding