International Economics I

(Econ 2081)

Chapter Four

Trade, Growth and Development

1
Can foreign trade has a propulsive role in the
development of a country?
◦ Classical and neo classical economists argue that
foreign trade can be a propelling force in
development.
◦ “…………By means of it (foreign trade), the
narrowness of the home market does not hinder the
division of labor in any particular branch of art or
manufacture from being carried to the highest
perfection. By opening a more extensive market for
whatever part of the produce of their labor may
exceed the home consumption, it encourages them
to improve its production powers, and to augment
its annual produce to utmost, and thereby to
increase the real revenue and wealth of the society.”
2
A most important indirect dynamic benefit,
according to John Stuart Mill is
◦ “The tendency of every extension of the market to
improve the process of production. A country which
produces for a larger market than its own, can
introduce a more extended division of labor, can
make greater use of machinery, and is likely to
make inventions and improvements in the process
of production.”
In sum, the indirect benefits of trade on
development are:
◦ induce innovations, and increase productivity;
◦ increase saving and capital accumulation
◦ educative effect
3
The traditional arguments in favor of
international trade, vis-à-vis their
implication on development
◦ Trade is an engine of growth
◦ Trade tends to promote greater international and
domestic equality.
◦ promote and reward the sectors of the economy
where individual countries poses a comparative
advantage
◦ maximize national welfare
◦ To promote growth and development, an
outward-looking international policy is
required.
4
Some critics argue that differences in
economic structure among countries, bias
the gains from trade in favor of the
technologically advanced and industrialized
countries and against the poor countries.
Promote the production of primary products
in poor countries:
◦ inelastic demands in the export market,
◦ demand trend is not rising very rapidly,
◦ excessive price fluctuations and
◦ trade bans.

5
Within poor nations, disproportionately to
foreign residents and wealthy nationals.
Besides, when developed nation
governments pursue restrictive economic
policies designed to deal with purely
domestic issues like inflation or
unemployment, these policies can have
profound negative effects on the economies
of poor nations.
However, Third World governments’
economic policies generally have little
impact on the economies of rich nations and
hence the reverse is not true. 6
4.2. Criticisms of Traditional International Trade
Theories
Explicit and implicit assumptions are often
contrary to the reality.
◦ All productive resources are fixed in quantity and
quality - fully employed and no international
mobility
◦ The technology of production and consumers’
tastes are fixed
◦ Factors of production are perfectly mobile within
perfect competition.
◦ Government plays no role
◦ Trade is balanced
◦ Gains from trade
7
4.3. The Terms of Trade and the Prebisch-
Singer Hypothesis
The total value of export and import
depends on quantity and price
The real or social opportunity costs of a
unit of imports will rise when export
prices decline relative to import
Commodity terms of trade (TOT)  ratio
between the price of a typical unit of
exports to the price of a typical unit of
imports
8
The prices of primary commodities have
declined relative to manufactured goods.
◦ TOT worsen over time for the nonoil-
exporting developing countries
The main theory for the declining
commodity TOT is known as the
Prebisch-Singer hypothesis
◦ Secular decline in the terms of trade of
primary- commodity exporters due to
 low income and price elasticities of demand.
◦ Led to
 import substitution
 diversify into manufactures exports
9
Thisstructural change has not brought
many benefits
◦ Relative prices within manufactures have also
diverged

10
4.4. Other Characteristics of Developing
Countries Trade
A. Importance of Exports
 Export is important to the economic
well-being of developing countries
 Developing countries are typically more
dependent on trade

11
Table 6.1 Merchandise Exports in Perspective: Selected
Countries, 2008

12
B. Demand Elasticities and Export
Earnings Instability
Low income elasticity of demand for
primary products
Low price elasticity of demand and
supply for agricultural commodities.
◦ any shifts in demand or supply curves can
cause large and volatile price fluctuations
Result can be export earnings instability;
risks to income

13
4.5. Trade Strategies for Development
Outward looking policies might include:
Abolition of tariffs and other forms of
protectionism.
Elimination of subsidies to domestic producers
Encouraging flows of international capital and
the activities of MNCs
Permitting labour mobility between countries
Maintaining open contact with the rest of the
world
Other export promotion policies. e.g.
advertising, trade fairs etc. 14
Rationales for outward-looking policies
The welfare gains from tariff reduction
Efficiency when exposed to international
competition.
Benefiting from the growth of other
countries
Economies of scale from the size of world
markets.
As part of ‘structural adjustment’ to qualify
for World Bank aid.

15
Inward looking policies might include:
High levels of protectionism e.g. tariffs,
quotas
Subsidies of domestic producers
Other import substitution policies
Encouraging the development of locally
acquired skills, e.g. learning by doing.
Prohibition on the activities of
multinational companies.

16
Rationales for inward-looking policies
Self-reliance
To maintain own pace of development and
encourage economic growth only in such a
way as to preserve its own cultural context.
With protection indigenous industries can
achieve the necessary economies of scale
and technological sophistication to compete
in world markets.
As a means of preserving traditional forms
of life.
17
Evaluation
Inward-looking theorists suggest that a
country is doomed to providing low-
growth primary products for developed
countries if it remains fully open to trade.
Outward-looking theorists claim that an
inward-looking country will stagnate and
lose the dynamic benefits of trade.
It is possible for a developing country to
mix policies.

18
-----End of Chapter Four-----

19