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IB Diploma Economics:
International trade and economic development
With reference to specific examples, explain how the following factors are barriers to development for economically less developed countries:
With reference to specific examples, explain how long-term changes in the terms of trade is a barrier to development for economically less developed countries. HL
With reference to specific examples, evaluate each of the following as a means of achieving economic growth and economic development:
Over-specialisation in less Developed countries
How over-specialisation on a narrow range of products can be a barrier to development
Essential statement: Many less developed countries are dependent on producing primary goods and commodities which limits the number of goods they can earn export revenues from to purchase the imported goods and services it needs
Many less developed countries specialise in the production of a few primary goods and commodities. For example, in the Democratic Republic of the Congo, copper and cobalt account for over 60 per cent of export revenues. This over-specialisation means that a less developed country is badly affected when the world price of one of their main primary exports falls in price.
The country’s terms of trade will worsen if world prices drop. Thus, when world copper prices fell steadily from US$10,000 kg in 2008 to US$5,000 in 2016, the Democratic Republic of the Congo could purchase far less imports for the same volume of exports than they previously could.
Further, over time, mining and extraction industries have become far more productive. As productivity increases, supply increases and the market price decreases. Thus, many less developed countries depending on the export of primary goods and commodities have faced a long-term decline in the price of the primary goods they specialise in for export.
Developed countries have more diversified economies and produce a range of primary, manufactured goods and services for exports. The fall in export prices of a primary commodity will have relatively less of an impact on a country’s total export revenues.
The falling world prices of commodities is likely to increase poverty within less developed countries if their economies cannot be diversified to produce a wider range of goods and services.
What is dumping?
Essential statement: Increased productivity has increased the supply and decreased the prices of primary goods and commodities. Less developed countries have had to increase the output of primary goods and commodities for export to buy the same amount of imports that they could previously afford
If the output of primary goods and services is increased in less developed countries to maintain export earnings in the face of falling commodity prices, then this is likely to have negative environmental consequences. Mining and oil and gas extraction is polluting and requires the clearing of forests. Farming, fishing and logging is similarly hard on the environment. Overfishing occurs, and fish stocks become unsustainable, established forests are cleared for timber, and land is cleared to raise livestock and agriculture. Think cattle farming and soybeans on what once Brazilian rainforest was. As non-renewable resources are depleted then future generations will have less opportunities to earn income.
Economic development becomes more and more difficult with the depletion of natural resources. Less developed countries must diversify their economies to produce a wider range of goods and services. However, when production is confined to a relatively limited number of industries, investment in these industries becomes the norm and little is left over for investment in manufacturing, health and education – all things which would increase long-term economic development.
The agricultural output of less developed countries, unlike the manufactured goods and services in developed countries is largely dependent on the weather for good growing conditions. Floods, drought and disease all impact on the supply of agricultural output and therefore the revenues earned in these industries can be highly variable. This can be further compounded by the dumping of excess supply by developed countries in international markets. Less developed countries cannot compete with such anticompetitive practices.
Dumping is the export by a country or company of a product at a price that is lower in the foreign importing market than the price charged in the exporter's domestic market.
Price volatility of primary commodities
How the price volatility of primary products can be a barrier to development.
Primary goods and commodities such as copper and soybeans are undifferentiated, and because of this there is a world price that is determined by the forces of supply and demand in world markets for primary goods and commodities. This world price is faced by exporters – they are price takers – and have little to no influence on the price of the primary goods and commodities they sell in world markets.
Essential statement: The supply and demand of primary goods is often highly inelastic. A decrease in supply will cause a relatively large increase in the equilibrium price causing an improvement terms of trade of countries exporting the commodity, and a worsening of the terms of trade for country’s importing these goods.
The supply of primary goods and commodities is often highly price inelastic. For example, if the price of soybeans decreases and the price of rice increases, it can be difficult to convert farms from relatively less profitable soybeans to produce relatively more profitable rice – the resources used to produce both are not perfectly interchangeable. There is a relatively long time before significant increases in primary output can reach world markets.
Contrast this with secondary or manufactured goods, where it is easier for firms to allocate resources (e.g., labour and capital) to produce different goods in production processes in response to price changes. Output can be increased when prices increase.
The price elasticity of demand for primary goods and commodities is likely to be price inelastic because they have few if any substitutes (e.g., oil).
Taken together, the price inelastic demand and supply of primary goods and commodities, means that any changes in the world supply or demand of these products can cause tremendous changes in their short-term prices – i.e., their prices are volatile.
Less developed countries who are dependent on primary goods and commodities to earn export revenues, because they are less diversified in the goods they produce can suffer large losses of national income as the price of a primary good or commodity falls – e.g., copper in the Democratic Republic of the Congo. Agricultural producers supplying the domestic market can also be hard hit if, for example, there is a good harvest increasing supply and decreasing the price. The profit margins on primary goods and commodities are often very low, so low in fact, that even with a bumper harvest, the resulting decrease in price can make a whole crop unprofitable to the farmer.
What is a commodity?
However, the natural response to a farmer who is suffering from a fall in income, is to ramp up output. If the price of coffee drops and each kilogram of coffee is bringing a Rwandan coffee farmer a few dollars, then bringing more coffee to market is a way to maintain farm income. If all Rwandan coffee farmers behave in the same way, then the supply of coffee continues to increase, and the price is forced ever lower. Natural resources are exploited further, and land becomes degraded from over use making it less likely that future generations can earn an adequate income from the land.
Essential statement: As agricultural productivity increases, the world supply of agricultural commodities increases and the price falls
Inability of LDCs to access international markets
How the inability to access international markets can be a barrier to development.
Do EU Subsidies Hurt LDCs?
Long-term changes in the terms of trade for LDCs HL
Long-term changes in the terms of trade is a barrier to development for economically less developed countries.
Terms of trade (TOT) refers to the relative price of imports in terms of exports and is defined as the ratio of export prices to import prices. It can be interpreted as the amount of import goods an economy can purchase per unit of export goods.
Essential statement: A deterioration in the terms of trade can be caused either by a decrease in average export prices or an increase in average import prices
LDCs and the effect of short-term fluctuations and long-run deterioration in the terms of trade.
Many less developed countries earn proportionally more of their export revenues from primary commodities such as agricultural products, minerals and metals, and oil and gas. They earn proportionally less of their export revenues from manufactured goods.
The price of primary commodities has fallen over time.
Essential statement: The supply of primary commodities has increased at a faster rate than the increasing demand for them, causing a long-run decrease in the average export price for less developed countries and a long-run deterioration in the terms of trade
commodities: Supply and demand
The demand for primary commodities has increased. The world population has increased and developing economies such as India and China have experienced fast rates of economic growth over a relatively long period of time. All of which has contributed to the increased demand for primary commodities. The increase in demand has increased the prices for such commodities and increased the export revenues earned by countries exporting them – namely less developed countries.
However, while economic growth and population growth have increased the demand for primary goods, increases in supply have led to lower average prices for primary commodities.
The supply of primary commodities has increased. Supply-side factors have led to big increases in the supply of primary commodities; and these include:
Further, agricultural subsidies in developed countries such as the US and Europe have given producers in these countries incentives to increase supply. This results in surpluses of goods such as wheat and corn and drives their prices down.
Therefore, if less developed economies now have lower average export prices for their commodities, they will be able to purchase an increasingly less quantity of imports per unit of exports – there terms of trade continue to deteriorate.
YED and primary commodities
Income elasticity of demand and the demand for primary goods, manufactured goods, and services
Real income refers to the income of an individual or group after taking into consideration the effects of inflation on purchasing power. For example, if an individual receives a 3% salary increase over the previous year and inflation for the year is 1%, then real income increases by 1%.
In the long-run, the developed world has seen increases in real average income.
The demand for primary goods and commodities is income inelastic.
Over time, real average incomes have increased at a greater rate than the rate of increase in demand for primary goods.
The demand for secondary goods and services is income elastic.
Over time, the rate of increase in demand for secondary goods and services have increased at a greater rate than real average incomes.
Taken together, the long-term growth in real incomes has accelerated demand for secondary goods and services at a faster rate than the demand for primary goods.
Long-run increases in supply and income elasticity of demand on the terms of trade
There has been an increase in demand for primary goods and commodities as average global incomes have increased over time – prices for these commodities should have risen.
However, demand is only one half of the equation, supply being the other. The supply of primary goods and commodities has increased at a faster rate than the increase in demand (see above). Thus, over the long-run the price of primary goods and commodities has decreased.
The demand for secondary goods and services is relatively more income elastic than the demand for primary goods. Therefore, the long-run growth in real global income have increased the prices of secondary goods and services at a faster rate than that of primary goods and commodities.
As productivity increases in the manufacturing and service sectors of the world economy, the price of secondary goods and services may decrease. However, the prices of primary goods and commodities decrease at a faster rate.
Taken together, the differences in income elasticities and the conditions of supply between primary and secondary goods and services means that the prices of primary goods have fallen, and will likely continue to fall, at a faster rate than secondary goods and services.
Primary goods are produced in relatively large proportions by less developed economies and manufactured goods and services are produced in relatively large proportions by developed countries.
Developed countries tend to export proportionally more secondary goods and services and import more primary goods.
Less developed countries tend to export proportionally more primary goods and import more secondary goods and services.
Over time, there has been an increasing quantity of imports that can be purchased by developed economies from less developed economies, for a given quantity of the exports they produce. Developed countries have generally experienced an improvement in their terms of trade.
Conversely, in the long-run there has been decreases in the quantity of imports that can be purchased by less developed economies from developed economies, for a given quantity of the exports they produce. Less developed countries have generally experienced a deterioration in their terms of trade.
What are the terms of trade?
Effect on the current account
Price elasticity of demand for exports and imports and the current account of less developed countries
Primary goods and commodities are price inelastic. The percentage change in quantity demanded for a primary export or import will be less than the percentage change in its price. The long-term decrease in the price of primary goods has caused a relatively small change in the quantities demanded.
Less developed countries produce proportionally more primary goods and commodities. They earn proportionally more of their export revenues from the sale of primary products in markets abroad.
Export revenues are equal to the average price of the exported goods multiplied by the quantity sold. As the price of exported primary goods has decreased relatively more over time than the increase in quantity sold, export revenues flowing to less developed countries has fallen.
Many less developed countries produce relatively few secondary goods such as the capital goods that are needed in production processes (e.g., tractors for farming, and mining equipment to extract metals). Capital goods have price inelastic demand. Also, as less developed economies strive to diversify their economies towards the production of secondary goods and services, capital goods need to be imported. To build operational factories, machinery, equipment and information technology systems need to be imported. Less developed countries have increased their imports of expensive capital equipment, and this has increased the demand for these price-inelastic goods and accelerated their increase in price.
Taken together, falls in export revenues and increases in import expenditure, less developed countries have generally experienced a deterioration in the balance of their current accounts.
Consequences of worsening TOT
Consequences for LDCs of deteriorating terms of trade
The developing countries have suffered a worsening of their terms of trade over a long period of time. At the heart of this situation is their over dependence on primary commodities. Exports of primary commodities tend to be income inelastic, so that, as world incomes grow, there is a less than proportionate increase in demand for primary commodities. This contrasts with the demand for manufactures and services which tend to be highly income elastic – as world incomes increase, there is a more than proportionate increase in the demand for the latter. Thus, there has been a constant upward demand pressure on the export prices of the rich countries and a constant downward pressure on the export prices of the primary goods of the developing countries.
The situation is no better on the supply side. The manufactured goods of the developed countries are largely produced by large multinational corporations who exert a great deal of monopoly power in their markets and can fix price and output in their favour. In contrast to this, the supply of primary commodities is likely to fluctuate considerably due to factors, such as the weather, that are outside the control of producers. The price of coffee, for example, tumbled due to Vietnam entering the market as a major producer, causing over-supply.
As a result, the prices that the developing countries obtain for their exports of primary commodities have risen less rapidly than the prices that they have had to pay for their imports of manufactured goods.
This puts them in the situation of 'getting nowhere fast' – they must export ever greater quantities of primary commodities to be able to import a given amount of manufactured goods.
Michael Marley, the former President of Jamaica, described the situation of the developing countries as being akin to a person "trying to walk up the down escalator". He illustrated his point using the example of the deteriorating terms of trade for Jamaica in relation to sugar and tractors. In 1965, it took 21 tons of Jamaican sugar to buy one Ford tractor. By 1979, the equivalent tractor cost 58 tons of sugar. This deteriorating trend has continued since 1979 for the developing countries and therefore has impacted adversely on their incomes, living standards and efforts to develop. The long run decline in the terms of trade of developing countries is a crucial barrier to their development (this links to the section 'Barriers to economic growth and / or development').
Moreover, the short-term volatility of commodity prices, largely due to supply side changes associated with the weather, droughts, floods etc, mean that significant changes can occur on the current accounts of the developing countries. All this makes the formulation of development plans extremely difficult, as the uncertainties governments face make it hard to make accurate predictions about the future.
IMPACT on LDCs
Impact of decline in terms of trade on a developing economy
A decline in the terms of trade means the price of exports falls relative to imports. Imports become more expensive.
Typically, a country will have lower living standards and less ability to import.
Suppose a developing country exports coffee beans and imports manufactured goods.
Impact of decline in terms of trade on a developing economy
Suppose a developing country exports coffee beans and imports manufactured goods:
Many developing countries concentrate on producing primary products, but there is likely to be a fall in the terms of trade when you concentrate on primary products. This is because:
Terms of trade and commodities
The cotton wars
Student question: Explain why US taxpayers are paying Brazilian cotton growers nearly $150 million a year.
Import substitution and export promotion
Most economists and policymakers view LDCs as consisting of large “traditional” and “modern” sectors. Hence development has come to be seen as a process of contracting the traditional sector and its growth-retarding institutions in favour of a growing modern industrial sector.
Less developed countries (LDCs) have adopted two alternative strategies for achieving industrialisation – an inward-looking strategy and an outward-looking strategy. These two strategies are 'import substitution' and 'export promotion'.
South Korean industrialisation
Import substitution. An inward-looking strategy is an attempt to withdraw, at least in the short run, from full participation in the world economy. This strategy emphasises import substitution, i.e., the production of goods at home that would otherwise be imported.
This can economise on scarce foreign exchange and ultimately generate new manufactured exports without difficulties associated with the exports of primary products if economies of scale are important in import substituting industries and if the infant industry argument applies. The strategy uses tariffs, import-quotas and subsidies to promote and protect import-substitute industries.
Export promotion. In contrast, an outward-looking strategy emphasises participation in international trade by encouraging the allocation of resources in export-oriented industries without price distortions. It does not use policy measures to shift production arbitrarily between serving the home market and foreign markets.
In other words, it is an application of production according to comparative advantage; the current expression is that, the LDCs should ‘get prices right’. This strategy focuses on export-promotion, whereby policy measure such as export subsidies, encouragement of skill formation in the labour force and the use of more advanced technology, and tax concessions generate more exports, particularly labour intensive manufactured exports in accordance with the principle of comparative advantage.
Now these two strategies may be compared and evaluated:
Import subsitution strategy
Import Substitution Strategy:
For various reasons, many LDCs have ignored primary-exports-led growth strategies in favour of import substitution (IS) development strategies. These policies seek to promote rapid industrialisation and, therefore, development by erecting high barriers to foreign goods in order to encourage domestic production. A package of policies, called import substitution (IS), consists of a broad range of control, restriction and prohibitions such as import quotas and high tariffs on imports.
The trade restrictions are intended to “protect” domestic industries so that they can gain comparative advantage and substitute domestic goods for formerly imported goods. IS policies are largely based on the belief that economic growth can be accelerated by actively directing economic activity away from traditional agriculture and resource-based sectors of the economy towards manufacturing.
The broad range of tariffs, quotas and outright prohibitions on imports that are part of IS policies are clearly not a form of infant industry protection. The infant-industry argument states that sectors and industries that can reasonably be expected to gain comparative advantage, after some learning period, should be protected.
But the broad protection under IS policies usually protect all industries indiscriminately, whether they generate technological externalities or have any chance of achieving competitive efficiency.
IS policies were advocated due to a very sharp decline in the prices of commodities and raw materials exported by many LDCs. It can be convincingly argued that low-income elasticity of demand for primary products implied that, in the long run, the terms of trade of primary product exporters would deteriorate.
In short, the IS approach to development applies the strategic argument for protection to one or more targeted industries in the LDCs. That is, the government determines those sectors best suited for local industrialisation, erects barriers to trade on the products produced in these sectors in order to encourage local investment and then lowers the barriers over time as the industrialisation process gains momentum.
If the government has targeted the correct sectors, the industries will continue to thrive even as protection comes down. In practice, however, the trade barriers are rarely removed. In the end, countries that follow IS strategies tend to be characterised by high barriers to trade that grow over time.
Development through Import Substitution Versus Exports:
During the 1950s, 1960s and 1970s, most developing nations made a deliberate attempt to industrialise rather than continuing to specialise in the production of primary commodities (food, raw materials, and minerals) for export as prescribed by the traditional trade theory.
Having decided to industrialise, the developing nations had to choose between industrialisation through import substitution and export-oriented industrialisation. Both policies have advantages and disadvantages.
An import substitution industrialisation (ISI) strategy has three main advantages:
Import substitution in Russia
Against these advantages are the following disadvantages:
In the post-Second World War (1939-45) period, many LDCs, after achieving independence, tried to reduce their reliance on imports, focused on IS policies, and a few, like Brazil, had a short period of success following that strategy. But, by and large, the countries following these strategies stagnated or grew very slowly.
Protectionist barriers were erected mainly to help support domestic industries but also to help some firms which enjoy high profits by being insulated from outside competition. In some cases, the inefficiencies were so great that the value of the imported inputs was higher than the volume of output at international prices.
Protection had been granted at times by using the infant-industry argument — the argument that new industries had to be protected until they could establish themselves properly to meet the competition. But in many of the developing countries, the infants never seemed to grow up—protection became permanent.
The idea behind IS policies was that, developing economies would grow faster if they forced their economies to expand their industrial sectors and that faster growth was well worth the short- run cost of lost international trade. But import substitution policies are now seen as having failed to bring rapid economic growth to developing countries.
The economies that abandoned import substitution earliest – such as Korea, and Taiwan – became the most rapidly growing, and now nearly developed, economies. Those that held on to import-substitution policies the longest, such as economies in Africa and South Asia, have been the slowest growing economies of the world.
A common characteristic of industries in IS economies was that, they often failed to adopt new technologies even when they were available. This was due to an inherent contradiction in IS policies. Import-substitution policies are intended to promote the establishment of industries with higher rates of technology growth by offering protection as an incentive, but that very same protection reduces the competition which serves as an incentive for firms to innovate, invest and apply new technologies. Under protection, there is an incentive for an initial innovation, but once a new industry is established in the protected environment, there is little need to engage in creative destruction.
Slow Technological Progress under IS Policies:
The proximate reason for the failure of import-substitution policies is the gradual slowdown of technological progress. The likely cause of this slowdown can be found in the Schumpeterian model of endogenous technological progress.
For the process of creative destruction to work, there must be destruction as well as creation. If an initial creation is not followed by a second creation, which implies the destruction of the first creation’s advantage, then economic growth stops.
In India, Pakistan and many African countries, government planners and anti-market bureaucrats encouraged or even mandated collusion among protected industries. Thus, the initial closing of the market to foreign imports provided a onetime spurt of innovation as new firms were established to take advantage of the profit offered by the protected market.
But then the lack of foreign competition made further innovation less interesting and obstruction of others more lucrative. Hence, eventually, the rate of technological innovation slowed, and so did economic growth.
Seen in this light, import substitution is at best a temporary measure for increasing economic growth. But if there are only short-run gains in growth and those gains come at the cost of short-run static losses from protection, the attractiveness of import substitution is greatly diminished. Recall that import substitution proponents claimed that IS policies would lead to higher long-run growth. The widespread abandonment of import-substitution policies in recent decades should, therefore, not be surprising.
Export promotion strategy
Outward-Looking Development Policies:
As opposed to import substitution (IS) policies, some LDCs have adopted outward-looking development strategies. These policies involve government targeting of sectors in which the country has potential comparative advantage. Thus, if a country is well endowed with low-skilled labour, the government would encourage the development of labour-intensive industries in the hope of promoting exports of these products.
This type of strategy includes government policies such as keeping relatively open markets so that, internal prices reflect world prices, maintaining an undervalued exchange rate so that export prices remain competitive in world markets, and imposing only minimum government interference on factor markets so that wages and rent reflect true scarcity. In addition, successful exporters often enjoy external benefits in the form of special preference for the use of port facilities, communication networks, and lower loan and tax rates.
A trade-cum-growth strategy focusing on exports is called export-led growth. Under this strategy, firms get the encouragement to export in a variety of ways, such as being given increased access to credit often at a subsidised rate.
On the other hand, there are two serious disadvantages of export-led growth strategy:
Only a few countries have followed outward-oriented development strategies for extensive period of time, but those that have done so have been very successful. They include Japan in its post-World War II reconstruction and the newly industrialised countries (NICs) of Asia— Hong Kong, South Korea, Singapore, and Taiwan. In part, because of their success and because of high economic cost of import-substitution policies, many other countries have recently begun to adopt more outward-oriented policies.
Export promotion and import substitution: An OVERALL EVALUATION
An Overall Assessment:
Does the choice of which trade strategy to employ make a difference in the performance of the developing country economy? The World Bank’s World Development Report (1987) examined the experience for 41 LDCs in an attempt to answer this question. It classified countries according to four categories of trade strategy.
A country was classified as a strongly outward oriented economy (SO) if it had few trade controls and if its currency was neither overvalued nor undervalued relative to other currencies and thus did not discriminate between exports and production for the home market in incentives provided.
A country was classified as a moderately outward oriented economy (MO) if the incentives biased production slightly towards serving the home market rather than exports, effective rates of protection were relatively low, and the exchange rate was only slightly biased against exports (i.e., home currency slightly overvalued).
A moderately inward oriented economy (MI) clearly favours production for the home market rather than for export through relatively high protection because of import controls and exports are definitely discouraged by the exchange rate.
Finally, a strong-inward-oriented economy (MO) if the incentives biased production slightly toward serving the home market rather than exports, effective rates of protection were relatively low, and the exchange rate was only slightly biased against exports (i.e., home currency slightly overvalued).
A moderately inward oriented economy (MI) clearly favours production for the home market rather than for export through relatively high protection because of import controls and exports and definitely discouraged by the exchange rate. Finally, a strong-inward-oriented economy (SI) exhibits comprehensive incentives towards import substitution and away from exports through more severe measures than in MI.
Comparison of the Two Strategies:
Employment Generation and Income Distribution:
In general, countries adopting outward-looking strategy have done better than those which adopted inward-looking strategy. Moreover, empirical evidence suggests that outward orientation rather than inward orientation may lead to more equal income distribution.
The main reason for this is that, the expansion of labour-intensive exports generates employment opportunities, while import-substitution policies often result in capital-intensive production processes that displace labour.
Foreign Exchange Reserve:
Another benefit of outward-looking strategy is that foreign exchange reserve is earned permanently. On the other hand, under inward-looking strategy foreign exchange is lost temporarily because the replacement of imports of final goods by domestic production requires imports of raw materials, capital equipment, and components. The end result may be increased rather than decreased dependence on imports.
Theory and Evidence:
The World Bank’s finding and advocates of the doctrine of comparative advantage led to the recommendation of the LDCs which adopt more outward-looking policies. Indeed, the world economy in the late 1980s and the 1990s saw a strong emergence of support for the market.
During the 1980s and the 1990s emphasis focused on the importance of outward-looking economic policies to foster growth and development in the developing countries. Formal statistical analysis has consistently shown that there is a close link between sustained economic growth and development and the ability to export successfully in the world economy.
For example, it has been found that, in the 1970s and 1980s, developing countries’ with open economies grew at 4.5% per year in contrast with an annual growth rate of 0.7% in closed economies. The growth rates of open industrialised economies were also found to be larger than those of their closed counterparts.
In recent years, no country with an inward-focused policy has proved successful in attaining or sustaining a high internal growth rate of GDP. As an example, during the past two decades (1990-2008) Sub-Saharan Africa has lagged behind other developing countries in growth in both exports and income.
By relying on traditional exports with low income elasticities instead of moving into exports with greater growth potential, African countries have sacrificed many of the potential gains that could have been had from fast proliferating globalisation.
In contrast, GDP grew by 7.6% in six of the major East Asian countries and 3.0% in Latin America as exports expanded at 15.7% and 9.6%, respectively, in the two areas. Consequently, Africa’s share of world trade has fallen from 4% in 1980 to less than 2% today.
The critical factor here is that, successful outward-looking policies have generally proved ineffective in attracting investment necessary to stimulate growth and development in developing countries as a group. It is more than pure investment, however, as the foreign component of this investment traditionally brings with it not only scarce capital but also a transfer of technology, management skills, organisational skills, and entry into highly competitive international markets.
In sum, the evidence is convincing that freer trade does impact positively on growth.
Flaws of Outward-Looking Policies:
Despite the seeming advantage of outward-looking policies, some economists and policymakers are reluctant to support the policy fully because of:
Protectionist Barriers: The expansion of manufactured exports, such as that attained by Hong Kong, South Korea, Singapore and Taiwan (the “four Asian Tigers”) can run into protectionist barriers in the industrialised countries. Since the labour-intensive manufactured exports pose a threat to well-established industries in industrialised countries (e.g., textiles-and shoes), restrictions such as the Multi-Fiber Arrangement (MFA) in textiles and apparel may stifle this route to development for many LDCs.
Shortage of Skilled Manpower:
In addition, the export path may require skilled labour, which is in short supply in LDCs. A huge amount of resources has to be devoted for necessary skill formation and knowledge acquisition. (No doubt import substitution also runs into the same problem).
Fallacy of Composition:
There is a ‘fallacy of composition’ in the outward-looking strategy. It is because while any one country may face high price elasticities of demand in exports of manufactured goods, the demand facing all LDCs is less elastic than that facing any one country. Sharp fall in prices may occur if all LDCs follow the same pattern.
Lack of Association between Export Growth and Industrialisation:
In addition, some empirical studies fail to find any positive relationship between exports and industrialisation. Some studies suggest that the positive link occurs only above some threshold income level.
Wanted: A Combination Strategy:
In the ultimate analysis, it seems that the two trade strategies—import substitution and export promotion—are not mutually exclusive. They may go hand in hand and may reinforce each other. So, what is called for is a strategy which seeks to combine the virtues of the two strategies.
In fact, some mix or sequence of the two strategies may be appropriate in some cases. For example, South Korea engaged in IS before embarking on its export-led growth path. In cases of infant industries this may be a good strategy.
In addition, it has been suggested that economic integration among LDCs may offer benefits because it is a combination of an outward-looking strategy (through freer trade with other LDC partners) and an inward-looking strategy in which the customs union as a whole is turning away from the rest of the world economy.
In any event, the precise extent to which a country should turn outward or inward depends on its own external and internal characteristics. The policies to be recommended can be decided on a case-by-case basis.
There is clear evidence that those LDCs which have increased exports of manufacturers have succeeded in increasing export earnings. There is also ample evidence that producers in these respond favourably to economic incentives.
The East Asian countries have demonstrated clearly the viability of trade policies in promoting industrialisation through reliance on foreign markets (as opposed to domestic markets) and were based on dynamic comparative advantage that went beyond reliance on primary commodities.
The East Asian experience clearly demonstrated that the earlier export pessimism that underlay the ideas of IS was perhaps more an indicator of inward-oriented trade and payment regimes than an outward focus based on a dynamic comparative advantage. The East Asian experience suggests that LDCs with an outward focus would not lock themselves permanently into a pattern of primary product specialisation.
So the conclusion is that a clear understanding of comparative advantage and the importance of fostering the presence of correct relative prices of products and factors is central to harnessing the potential role of international trade in promoting the development of newly industrialising countries.
The export trap
Trade liberalisation is the removal or reduction of restrictions or barriers on the free exchange of goods between nations. This includes the removal or reduction of tariff obstacles, such as duties and surcharges, and nontariff obstacles, such as licensing rules, quotas and other requirements
Advantages of Trade Liberalisation:
Comparative advantage. Trade liberalisation allows countries to specialise in producing the goods and services where they have a comparative advantage (produce at lowest opportunity cost). This enables a net gain in economic welfare. Trade liberalisation leads to removal of tariff barriers and the market price will fall from P1 to P2. This leads to significant increase in consumer surplus of areas 1+2+3+4.
Lower prices. The removal of tariff barriers can lead to lower prices for consumers. E.g. removing food tariffs in West would help reduce the global price of agricultural commodities. This would be particularly a benefit for countries who are importers of food.
Increased competition. Trade liberalisation means firms will face greater competition from abroad. This should act as a spur to increase efficiency and cut costs, or it may act as an incentive for an economy to shift resources into new industries where they can maintain a competitive advantage. For example, trade liberalisation has been a factor in encouraging the UK to concentrate less on manufacturing and more on the service sector.
Economies of scale. Trade liberalisation enables greater specialisation. Economies concentrate on producing particular goods. This can enable big efficiency savings from economies of scale.
Inward investment. If a country liberalises its trade, it will make the country more attractive for inward investment. For example, former Soviet countries who liberalise trade will attract foreign multinationals who can produce and sell closer to these new emerging markets. Inward investment leads to capital inflows but also helps the economy through diffusion of more technology, management techniques and knowledge.
Problems of Trade Liberalisation:
Structural unemployment. Trade liberalisation often leads to a shift in the balance of an economy. Some industries grow, some decline. Therefore, there may often be structural unemployment from certain industries closing. Trade liberalisation can often be painful in the short run, as some industries and some workers suffer from the decline in uncompetitive firms. Though net economic welfare improves, it can be difficult to compensate those workers who lose out to international competition.
Environmental costs. Trade liberalisation could lead to greater exploitation of the environment, e.g. greater production of raw materials, trading toxic waste to countries with lower environmental laws.
Infant-industry argument. Trade liberalisation may be damaging for developing economies who cannot compete against free trade. The infant industry argument suggests that trade protection is justified to help developing economies diversify and develop new industries. Most economies had a period of trade protectionism. It is unfair to insist that developing economies cannot use some tariff protectionism. Because of this argument, some argue that trade liberalisation often benefits developed countries more than developing countries.
Trade liberalisation explained
The problem with the trade liberalisation and comparative advantage argument is that for many less developed countries their comparative advantage lies in the production of primary goods and commodities. The production of agricultural products tends to be relatively labour intensive in less developed countries, and because labour is cheap primary production in these countries can be competitive with more capital-intensive agriculture in developed countries. Fewer environmental regulations and/or less effective enforcement of such regulations can be another source of comparative advantage in the production of primary goods and commodities in less developed countries. For example, a beef farmer in Costa Rica may be able to clear rainforest, dam water supplies for irrigation and dump stock effluent in ways that a New Zealand beef farmer could not.
However, as we have seen in this section, the prices of primary goods and services have been trending down over the long-term as well as being volatile in the short-term. Incomes in less developed countries have been falling as a result.
In developing countries, the source of comparative advantage in manufactured goods may arise from them having a surplus of low-skilled labour that maintains downward pressure on wage rates. Labour costs are low in developing countries, and manufacturing industries can be labour intensive and competitive with the developed world. However, to maintain this comparative advantage wages need to be kept low and this leads to lower standards of living and rising rates of poverty.
Further, multinational companies that operate in developing countries benefit from low labour costs and any increase in wage rates will lead to a loss of profitability. If wage rates rise at a General Motors car assembly plant in Indonesia then, all things being equal, that car plant will be less profitable.
Some argue, that trade liberalisation benefits consumers in the developed world and multinational corporations operating in the developing world at the expense of increasing levels of relative poverty, low wages, poor working conditions and increases in income inequality in developing countries.
If developing countries removed their barriers to trade, then the price of imported goods would decrease, and the purchasing power of consumers would increase. However, domestic firms in developing economies would not necessarily be able to compete with an influx of less expensive imported goods. Demand for domestic goods would decline as the demand for cheaper imported substitutes increased – demand deficient unemployment would increase, and average household incomes would fall. Poverty could be exacerbated.
Also, the theory of comparative advantage rests on the assumption that resources will be allocated to their best (most efficient) use. However, this is not easily done as factors of production are often not perfectly mobile and interchangeable between industries.
There must always be doubt in the minds of entrepreneurs and governments in developing countries about expensive restructuring of firms and industries to allocate resources most efficiently. There is no guarantee that trade barriers will not be raised again by developed countries in response to more efficient competition from developing countries.
The World Trade organisation (WTO)
The World Trade Organization encourages all countries to agree to the removal of barriers to trade whilst at the same time asking the developed world to consider the needs of developing countries. It encourages developed countries to remove agricultural subsidies and to stop dumping, and to allow imports of manufactured goods from less developed countries free of tariffs and quotas to encourage industrialisation and economic growth in less developed countries.
Essential statement: The long-term aim of the WTO is to encourage developed nations to implement trade agreements that consider the circumstances of developing countries so that LDCs can decrease their dependence on primary exports and increase the size of their manufacturing sectors
The WTO encourages economic integration through regional free trade agreements that allow developing countries to gain from liberalised trade (e.g., economies of scale) with other countries that have a similar level of economic development. In this way, the benefits of free trade can be gained without the large disadvantages that come with economic integration with developed countries.
The role of the WTO
The purpose of the WTO is to ensure that global trade commences smoothly, freely and predictably. The WTO creates and embodies the legal ground rules for global trade among member nations and thus offers a system for international commerce. The WTO aims to create economic peace and stability in the world through a multilateral system based on consenting member states (currently there are slightly more than 140 members) that have ratified the rules of the WTO in their individual countries as well. This means that WTO rules become a part of a country's domestic legal system. The rules, therefore, apply to local companies and nationals in the conduct of business in the international arena. If a company decides to invest in a foreign country, by, for example, setting up an office in that country, the rules of the WTO (and hence, a country's local laws) will govern how that can be done. Theoretically, if a country is a member to the WTO, its local laws cannot contradict WTO rules and regulations, which currently govern approximately 97% of all world trade.
Trade liberalisation is the primary objective of the WTO. The WTO works to help trading countries and regional trading blocks to reduce and eventually remove such barriers to trade as quotas and tariffs on those goods and services which are imported. It also works to remove the subsidies given to domestic industries by their governments which are unfair to international producers, and to export subsidies which are unfair to local firms having to compete with subsidised imported goods and services. The WTO proposes, monitors and governs disputes over anti-dumping legislation. Dumping, in international trade, is the export by a country or company of a product at a price that is lower in the foreign market than the price charged in the domestic market. As dumping usually involves substantial export volumes of the product, it often has the effect of endangering the financial viability of manufacturers or producers of the product in the importing nation.
What is the WTO?
There are four main roles of the WTO:
The WTO failing poor countries?
Diversification and economic growth and development.
Diversification and economic growth and development
Diversification involves a reallocation of resources into new activities that broaden the range of goods or services produced. Earlier we saw that a major disadvantage of over-specialisation involves losing the benefits of diversification. We learned that diversification by adding value to locally produced goods provides the benefits of more varied production, increased employment, establishing more firms, and using higher skill and technology levels.
It is hardly possible to overemphasise the importance of diversification as a strategy for growth and development. It permits countries to achieve the following important objectives:
Diversification means that a country becomes less dependent on the sale of its primary goods for its income. Over time, through industrialisation, GDP rises allowing more income to be saved. Increases in investment in human and physical capital lead to increases in productivity and national output. Government gains more tax revenue and can target spending on improving educational attainment and health services thereby increasing economic development and the country’s HDI. In this way a country can break the cycle of poverty.
For some countries, particularly African landlocked countries such as Chad, Mali, and Niger, the prospects for diversification and economic development are not good. Many countries do not have the legal infrastructure or good governance necessary for economic development. Many politicians are only interested in gaining and holding onto power to make themselves and their friends and families rich. Many do not have to be re-elected and even when there are elections the outcome is fixed. Focus must be on responsible governance, creating the legal and financial infrastructure necessary for long-run economic growth and development.
Diversification in Botswana
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