Chapter 11
Trade Policy in Developing Countries
■ Chapter Organization
Import-Substituting Industrialization.
The Infant Industry Argument.
Promoting Manufacturing Through Protectionism.
Case Study: Mexico Abandons Import-Substituting Industrialization.
Results of Favoring Manufacturing: Problems of Import-Substituting Industrialization.
Trade Liberalization since 1985.
Trade and Growth: Takeoff in Asia.
Box: India’s Boom.
Summary
■ Chapter Overview
The final two chapters on international trade, Chapters 11 and 12, discuss trade policy considerations in
the context of specific issues. Chapter 11 focuses on the use of trade policy in developing countries and
Chapter 12 focuses on new controversies in trade policy.
Although there is great diversity among developing countries, they share some common policy concerns.
These include the development of domestic manufacturing industries, the uneven degree of development
within the country, and the desire to foster economic growth and improve living standards. This chapter
discusses both the successful and unsuccessful trade policy strategies that have been applied by developing
70 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
Many developing countries pose the creation of a significant manufacturing sector as a key goal of
economic development. One commonly voiced argument for protecting manufacturing industries is the
infant industry argument, which states that developing countries have a potential comparative advantage in
manufacturing and can realize that potential through an initial period of protection. This argument assumes
market failure in the form of imperfect capital markets or the existence of externalities in production. Such
a market failure makes the social return to production higher than the private return. Without some
government support, the argument goes, the amount of investment that will occur in this industry will be
less than socially optimal levels. Government support can theoretically raise investment up to the socially
optimal level. Given these arguments, many nations have attempted import-substituting industrialization,
where government support is focused on those industries that compete directly with imports. In the 1950s
and 1960s, the strategy was quite popular and did lead to a dramatic reduction in imports in some
countries. The overall result, though, was not a success. The infant industry argument did not always hold,
as protection could let young industries survive but could not make them efficient. The methods used to
protect industries were often complex and overlapped across industries, in some cases leading to
exorbitantly high rates of protection. Furthermore, protection often led to an inefficiently small scale of
production within countries by creating competition over monopoly profits that would not have existed
without protection. By the late 1980s, most countries had shifted away from the strategy, and the chapter
includes a case study of Mexico’s change from import substitution to a more open strategy.
Since 1985, many developing countries have abandoned import substitution and pursued (sometimes
aggressively) trade liberalization. The chapter notes two sides of the experience. On the one hand, trade
has gone up considerably and changed in character. Developing countries export far more of their GDP
than prior to liberalization, and more of it is in manufacturing as opposed to primary commodities. On the
other hand, the growth experience of these countries has not been universally good, and it is difficult to tell
if the success stories are due to trade or due to reforms that came at the same time as liberalization. While
countries such as the “Asian Tigers,” China and India, have experienced spectacular rates of growth
following trade liberalization, only part of this growth can be attributed to trade reform. Furthermore,
countries such as Brazil and Mexico that have also moved toward freer trade have not experienced the
same rates of economic growth.
■ Answers to Textbook Problems
1. The countries that seem to benefit most from international trade include many of the countries of the
Pacific Rim: South Korea, Taiwan, Singapore, Hong Kong, Malaysia, Indonesia, and others. Though
Chapter 11 Trade Policy in Developing Countries 71
© 2018 Pearson Education, Inc.
the experience of each country is somewhat different, most of these countries employed some kind of
infant industry protection during the beginning phases of their development but then withdrew
protection relatively quickly after industries became competitive on world markets. Concerning
whether their experiences lend support to the infant industry argument or argue against it is still a
matter of controversy. However, it appears that it would have been difficult for these countries to
engage in export-led growth without some kind of initial government intervention. Similarly, both
China and India have experienced rapid economic growth following economic liberalization and
increased openness. Although part of their growth may be attributed to a reduction in trade barriers,
other factors certainly played a role. This disparity is underscored by the fact that nations such as
Mexico and Brazil also liberalized trade but have yet to see comparable rates of economic growth.
2. The historical trade policy of the United States in terms of tariff rates is fairly similar to that of
developing countries in the 20th century. Tariff rates in the United States averaged around 40% until
3. a. The initial high costs of production would justify infant industry protection if the costs to the
b. An individual firm does not have an incentive to bear development costs itself for an entire
industry when these benefits will accrue to other firms. The first firm will not factor in how its
4. One explanation for this divergence is the 1994 North American Free Trade Agreement (NAFTA).
Mexico’s proximity to a major market (the United States) magnified the apparent benefits of free
trade. Joining NAFTA required Mexico to liberalize trade much more than Brazil. While Brazil is a
72 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
© 2018 Pearson Education, Inc.
member of Mercosur (along with Argentina, Bolivia, and Paraguay), this agreement does
considerably less to liberalize trade than NAFTA and the participants represent less lucrative export
markets than NAFTA. Thus, the perceived benefits of trade liberalization for Brazil may have been
smaller.
In addition, the promised benefits of trade liberalizations have not necessarily manifested in Brazil,
with the country experiencing slower economic growth since trade liberalizations in the 1980s.
Furthermore, there is a perception that freer trade has magnified income inequality in Brazil. This
point of view may have reduced the public’s appetite for free trade in Brazil. Interestingly, free trade
has not necessarily translated into stronger growth in Mexico either, though most economists blame
sluggish growth more on poor education than on trade liberalizations.
5. In some countries, the infant industry argument simply did not appear to work well. Such protection
will not create a competitive manufacturing sector if there are basic reasons why a country does not
have a competitive advantage in a particular area. This was particularly the case in manufacturing