Chapter 14
Trade Policies for Developing Countries
Overview
This chapter examines trade issues affecting developing countries. It begins by noting differences
between high-income developed or industrialized countries and low- and medium-income
developing countries, as well as differences among the developing countries. Some developing
countries are growing quickly, while others are stagnating or declining.
The comparative advantages of developing countries (relative to industrialized countries) derive
from abundance of unskilled labor and, for many, abundance of natural resources, as well as a
tropical climate for agriculture. Furthermore, financial capital markets and labor markets are less
efficient in developing countries. Given these differences, a developing country must decide
what trade policy (and other government policies) to adopt. (1) It can focus on exporting primary
products based on the country’s comparative advantage in natural resources and its tropical
climate. (2) It can adopt a policy that tries to raise world prices for its export of primary products
by joining international cartels or taxing its exports. (3) It can tax and restrict imports of
manufactured goods to develop new domestic industries through import substitution. (4) It can
promote and subsidize new export products, especially manufactured goods. Given the less
efficient capital and labor markets, there may be a role for an active government trade policy.The
box “Special Challenges of Transition” discusses the roles of trade and trade policy in the efforts
by the developing countries of Central and Southeastern Europe and the former Soviet Unionto
shift from communist central planning to more market-oriented economies.
Some developing countries rely on primary products for most of their exports. Evidence
indicates that these countries appear to have experienced a slow deterioration in their terms of
trade over time. It appears that the adverse effects of Engel’s Law and the development of
synthetic substitutes have been more important than the limits of natural scarcity and slow
growth of productivity in primary-goods production. The conclusions are tentative, because there
are biases in the data—declining transport costs and faster unmeasured quality improvements for
manufactured goods (including new manufactured products).
One possible approach to the problem of declining primary product prices is to form
international cartels to raise their prices. OPEC did this for oil in the 1970s. The analysis of a
cartel as a group that has monopoly power because it controls a large part of the world’s
production indicates the limits to this power and why cartels usually erode over time. Demand
becomes more elastic over time, new competing supplies from outside the cartel enter the
market, increasing the noncartel supply elasticity and decreasing the cartel’s market share, and
cheating by cartel members often increases over time. The oil price increase from 2004 to 2008
indicates that OPEC still has some power, but other factors also seem to be important in this
price rise. Outside of oil, the prospects for even temporary success of primary product cartels
seem poor, and there are currently no effective cartels.
Import-substituting industrialization (ISI) was the dominant policy in the 1950s and 1960s, and it
is still important today. At its best, it is an application of the infant-industry argument, guided by
the existence of a market for the goods produced by the new domestic producers, with tariff
revenues that may be justified by the developing-government argument, and it can also improve
the country’s terms of trade by reducing demand for imports. However, because the terms of
trade effects are usually small, it imposes substantial economic costs through deadweight losses
—it often results in domestic industries that have high costs, domestic monopoly power, and
low-quality products. Countries like Taiwan and South Korea that have shifted from a policy of
ISI to a more outward-oriented policy that encourages development through exporting usually
grow faster with the outward-oriented policy, and comparison of countries that had
outward-oriented policies with those that practiced ISI shows that the former grew more quickly
on average.
Developing countries have turned increasingly toward emphasizing new exports of manufactured
goods to industrialized countries as their trade policy to promote development. The success of
this policy can be limited by protectionism in the industrialized countries, but reasonable success
is still possible.
Tips
The chapter is designed so that the instructor can emphasize some policy issues more than others,
if this is desired. The introduction and first section provide the setting. Most courses probably
will include the theory and practice of ISI, and comparisons with outward-oriented policies. This
is a topic on which much evidence has been gathered since the 1970s, with a relatively clear
consensus against the earlier hopes for the ISI strategy. Most courses also probably will want to
cover the section on “Exports of Manufactures to Industrial Countries,” because this follows
from the discussion of outward-oriented policies. By contrast, the sections on primary products
and cartels may be omitted if it is necessary to conserve time for other topics.
The second section of Appendix D has a technical treatment of optimal export taxes and the
optimal markup for an international cartel.