ByDr. Kumarasinghe P J

Many LDCs rely heavily on exports (some of them on primary products)

Many LDCs also rely heavily on imports (typically of machinery, capital goods, intermediate producer goods, and consumer products)

How does international trade affect economic growth?

How does trade alter the distribution of income?

How can trade promote development? Can LDCs determine how much they trade? Is an outward-looking or an inward-looking

trade policy best?

Of course, it is hard to generalize here because developing countries differ greatly in terms of resources that they have, their preferences, technologies and so on

For some countries, trade is more important

Generally speaking, developing countries are more dependent on export than the developed countries

Small countries tend to depend more on trade than large countries

Income elasticity of demand =(percentage change in

demand)/(percentage change in income) For primary products, the income

elasticity of import demand tends to be low

percentage change in demand of imports of primary products divided by the percentage change in income of importing (mostly developed) countries

What if this elasticity is less than one? Most developing countries tend to export

more to developed countries So, the estimate of elasticity in the

developed countries matters Typically, the income elasticity of

demand for imported food in the developed countries is estimated to be less than 1

For industrial products and petroleum products, it is much higher than 1

The low income elasticity of demand means that relatively speaking, prices of primary products in the world market do not rise as fast as the prices of industrial products

Price elasticity of demand =(percentage change in quantity

demanded)/(percentage change in price) Price elasticity of supply =(percentage change in quantity

supplied)/(percentage change in price)

These are also low for primary products These low elasticities mean that shifts in

supply or demand lead to wild fluctuations in the prices

These lead to instability in export earnings and to lower economic growth

Value of exports depends upon the volume of exports and price of exports

If export prices fall, to maintain the same export earnings, more needs to be exported

Total import bill depends upon the import prices and the volumes

If import prices go up, more needs to be spent on imports to maintain the same volume of imports

Or the volume of imports has to fall if the import bill needs to remain the same

Terms of trade Price of exports (Px) divided by the price

of imports (Pm) Because there are many items of exports

and imports, indexes of export and import prices are used

Also called commodity terms of trade

The terms of trade of the non-oil producing developing countries have deteriorated

Prebisch-Singer hypothesis or thesis: There has been a long term decline in the

terms of trade for countries exporting primary goods because of low price and income elasticities

In that sense, the result has been a transfer of income from the poor to rich countries

Many developing countries have increased their export of manufacturing goods

However, studies have shown that real prices of manufacturing goods exported by developing countries have fallen

Export price of textile goods is a good example

Traditional theory of international trade One basis for trade among individuals or

regions or nations has been comparative advantage

For example, Oita prefecture may have a comparative advantage in citrus fruits

A country is said to have a comparative advantage in a good if the opportunity cost of producing that good is lower in that country than in some other country

Opportunity cost is the loss of the other goods that could have been produced with the resources that are used to produce the good in question

If a country can produce only rice and computers, the opportunity cost of a computer is the loss of rice that could not be produced because the resources were used to produce the computer

Absolute advantage: Consider only one input: labor

If an hour of labor in country A can produce more of a good than an hour of labor in country B, country A has an absolute advantage in the production of the good

Absolute advantage: If one hour of labor can produce one computer in country A but in country B it takes two hours of labor to produce the same, then which country has an absolute advantage in computers?

Here, we are not looking at the opportunity costs

Absolute advantage is not the basis for trade

If country A has an absolute advantage over country B in the production of both goods, it may still be advantageous to trade

Ricardian (or classical) theory of trade Ricardo considered only one input: labor

An exampleNumber of hours of labor needed to

produce one unit of a productCountry Computers RiceJapan 2 6Indonesia 4 8

Which country has an absolute advantage in the production of computers? Of rice?

Which country has a comparative advantage in the production of computers? Of rice?

Factor endowments and trade (the neoclassical theory)

Heckscher-Ohlin theory: two inputs (capital and labor), two countries, two goods, perfect competition

Assumption: Technology is the same in both countries

The basis for trade is the differences in resources that the two countries have

Labor will be relatively cheaper in the labor abundant country

Capital will be relatively cheaper in the capital abundant country

Assumption: agriculture needs more labor relative to capital in both countries

Similarly, manufacturing needs more capital relative to labor

The country with relatively abundant capital will specialize in the production of that good which intensively uses capital and export that good

The country with the relatively more abundant labor will specialize in the production of that good which intensively uses labor and export that good

This theory served as one of the bases for developing countries specializing in primary products

Figure 12.1 Trade with Variable Factor

Proportions and Different

Factor Endowments

Without trade, the “Developing World” is producing and consuming at point A

With trade, it gets a better terms of trade than the domestic rate (international price ratio)

With trade, it produces at B and consumes at C

Export? Import?

Similarly, the “Developed World” gets a better terms of trade with trade

Its production and consumption point before trade is A´

With trade? Production? Consumption? Export? Import?

Compare the Developing World’s consumption before trade (point A) and after trade (point C)

Note that point C involves more of both goods

Compare the Developed World’s point of consumption before trade (A´) and after trade (C´)

Thus, both gain from trade

Implications of the Heckscher-Ohlin theory:

(1) PPF being concave, there is increasing opportunity cost of producing more of a good

Thus, as the Developing World produces more of agricultural goods, the opportunity cost of doing so increases

Thus, there is no complete specialization as is possible in the case of the Ricardian theory

(2) Prices of resources in the two countries tend to equalize with trade

In the Developing World, the wage rate will have to rise as the demand for labor goes up

Price of capital will fall In the Developed World, the opposite will

happen

(3) The theory predicts that the returns to labor will increase in the developing countries making income more equal

This is because the number of workers far exceeds the owners of capital

(4) Trade will promote growth If developed countries have a

comparative advantage in producing sophisticated machines, developing countries can get them at a lower price with trade

This will help growth Six assumptions of the neoclassical trade

model have to be scrutinized (1) Fixed resources, full employment, and

international factor immobility (2) Fixed, freely available technology and

consumer sovereignty (3) Internal factor (input) mobility and

perfect competition

(4) Governmental non-interference in trade

(5) Balanced trade and international price adjustments

(6) Trade gains accruing to nationals Let us look at these assumptions: (1) If developed countries are endowed

initially with more capital and skilled labor, trade will make them grow faster

Developing countries with relatively more unskilled workers will lose out as the commodity terms of trade worsens for them

Factor endowments and comparative costs keep changing as a result of trade

North-South Models of Unequal Trade These models suggest that trade tends to

reinforce the unequal resource endowments between countries, particularly with respect to skilled and unskilled labor

Similarly, there is neither perfect competition nor full employment in the developing countries

According to economist Lha Myint, the unemployed and underemployed land and labor in the developing countries can be used to produce goods not in demand in the local markets

This is the vent-for-surplus theory of international trade

Figure 12.2 The Vent-for-Surplus Theory of Trade in LDCs

Before trade, the production and consumption is at point V

Because of unemployment, the country is inside the PPF

Often colonization of a developing country opened up the international market

Production of exportable? Importable? The point of production after trade is B The point of consumption after trade is C

This model may fit the reality in the developing countries in the past in a better way

However, the beneficiaries of such trade were often the colonizers

Also, one implication is that the developing countries can be stuck with specialization in primary products

As a result, they may be unable to diversify

Historically, migration of skilled and (in some cases) unskilled labor has been a fact of life

Similarly, capital flight is a fact of life. The domination of multinationals have

made mobility of capital and labor easier (2) Technology has also not been fixed

Synthetic substitutes of natural products like jute fiber, cotton, rubber etc have been developed and many developing countries have lost their shares of the market as a result

Similarly, multinationals with big advertising budgets can change tastes and preferences of people in developing countries

Think about coca-cola versus the production of indigenous cola

(3) Internal mobility of inputs may not be easy in developing countries

Given that the infrastructure is geared towards accommodating current production in developing countries, changing the structure of production according to price signals in the international market is certainly not costless

In fact, developed countries often block imports of goods such as textile products from developing countries on the ground that it creates unemployment in the developed countries

Such trade restrictions cost about 2% of GNP of the developing countries according to the United Nations

The classical and neoclassical theories assume either constant or decreasing returns to scale

Constant returns to scale: if you double inputs, output is doubled

Decreasing returns to scale, if you double inputs, output is less than doubled

Increasing returns to scale? This is quite common and can lead to

oligopoly (a few producers) (4) National governments do play a large

role in trade relations Ministry of International Trade and

Industry (MITI) (now METI: Ministry of Economy, Trade and Industry) helped create comparative advantage in Japan

South Korea and Taiwan later followed the lead of Japan

Tariffs (taxes on imports), quotas and export subsidies are often used by developed countries to keep out exports from developing countries