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135
CHAPTER OUTLINE
I. Nearly all developing countries try to accelerate the pace and in uence the
pattern of industrialization. Two main trade strategies have been pursued
for this purpose: inward- looking import substitution and export- led,
outward- looking industrialization. The core premise of import substitution
is that infant industries need protection to survive, while the premise of
outward- looking industrialization is that domestic producers must become
internationally competitive.
II. Import substitution was nearly universal in the 1960s and remained wide-
spread until quite recently. This strategy entails identifying large domestic
markets served by imports, assessing the technical feasibility of domestic
production, and then erecting protective barriers to shield ostensible infant
industries from import competition. After an initial burst of growth, import
substitution generally bogs down because domestic markets are limited in
size and infant industries remain too uncompetitive to penetrate export
markets. In contrast, the export- led strategy of East Asia’s “tigers” has
been outstandingly successful. These countries have been interventionist
and protectionist to varying degrees, but they shared four key characteris-
tics: a disciplined focus on policies to promote rapid economic develop-
ment, prudent management of macroeconomic policy and exchange- rate
policy, exible factor markets, and insulation of exports from domestic
price distortions.
III. Governments have four basic policy instruments at their disposal to in u-
ence the industrialization pro cess: tariffs on imports, quantitative restric-
tions on trade, various forms of subsidy, and exchange- rate policy.
Protective tariffs involve signi cant ef ciency losses, particularly when
Trade Policy
CHAPTER 19
136 | Chapter 19
effective rates of protection are quite high. Import quotas have similar
effects, with the added disadvantage of bestowing monopoly power and
scarcity rents on favored rms. Subsidies and other market preferences can
achieve similar ends, with less of a deadweight loss to the economy. These
instruments can be applied to very speci c products or rms. Exchange-
rate policy, however, affects all producers of tradables in a more even-
handed fashion. An overvalued real exchange rate renders exports less
pro table and imports less expensive, while an undervalued real exchange
rate has the opposite effects. Ironically, efforts to shield domestic produc-
ers from import competition discriminate, through exchange- rate effects,
against exports as well as against imports.
IV. Where these instruments have been geared to protect import- substitution
industries, they typically impose heavy costs on consumers, discourage
exports (limiting import capacity), induce excessively capital- intensive
investments, discourage backward linkages, promote po liti cal rent- seeking
activity in lieu of competitive market adjustments, and ultimately lead to
arrested growth. Where the instruments have been used to encourage
outward- looking industrialization, the result generally has been rapid
growth in income and productivity, although the direction of cause- and-
effect remains uncertain.
V. To induce domestic entrepreneurs to commit capital to new industries,
there may well be a need for some form of protection, but it should be used
selectively to support infant industries that show clear promise of growing
up and becoming competitive. Not all developing countries, of course,
have the capacity to intervene so judiciously. In any case, once competitive
production is within reach, no further protection is justi ed.
VI. The spread of outward- looking trade strategies, together with multilateral
agreements to reduce barriers to international trade, has sparked rapid
growth of manufactured exports from developing countries after 1965.
This trend bene ts all trading countries. Yet, within each country, trade
creates losers as well as gainers. Since the bene ts of trade tend to be
spread widely, while the costs are borne narrowly by par tic u lar sectors,
shifts in comparative advantage have bred po liti cal pressures in many
industrial economies to impose new nontariff barriers to trade. Such reac-
tions are quite costly to the developed country itself, but even more so for
developing countries that lose access to large export markets.
VII. More sophisticated recent research indicates that open economies per-
form better than closed ones. Still, some notable skeptics remain. In gen-
eral, trade helps poverty reduction as well. Even though some suggest that
outward orientation creates more sweatshops, evidence does not corrobo-
rate this suggestion.
Trade Policy | 137
Boxed Examples
Box 19–1: Effective Rates of Protection
Box 19–2: The Two- Country Model with a Tariff
Box 19–3: Is China’s Exchange- Rate Policy Unfair?
Box 19–4: Labor Activists and Labor Outcomes in Indonesia
There are four boxed examples in Chapter 19. The rst is an in- depth explanation
of effective rates of protection (ERP). The second example illustrates the effects
of tariffs using the two- country model. The third case study gives details on
China’s manipulation of exchange rates and the advantages and disadvantages for
this action. The nal box example highlights the movement and progress toward
fair labor in Indonesia.
In the New Edition
This chapter distinguishes itself from the sixth edition as a free- standing chapter
devoted to trade policy. The narrative builds on the broad discussion of trade and
development in the previous chapter. It reviews import substitution as a trade strat-
egy and the consequences of trade protection. This is followed by discussion of
export orientation, including experience with export pro cessing zones. Evidence is
presented on trade, growth, and poverty alleviation. The chapter concludes with
an examination of key issues on the global trade agenda, including the impact of
China and India on global trade competition, sweatshops and labor standards, the
Doha Round of trade negotiations, and temporary labor migration as a strategy to
alleviate world poverty.
Class Notes
Chapter 19 focuses on the impact of world development on jobs and living stan-
dards in the United States and other industrialized countries. In addition, many of
today’s pressing policy concerns in the developing countries, such as neglected
agricultural development, low capital productivity, serious balance- of- payments
constraints, and low rates of job creation, are at least in part a legacy of inef cient
trade policies. This story needs telling. Since most students start out with a ten-
dency to accept the argument for heavy protectionism, they can gain a great deal
of insight from seeing a detailed analysis of the costs of trade interventions and the
relative ef cacy of tariffs, quotas, and subsidies.
Much of the analytical insight can be conveyed with nothing more dif cult
than supply- and- demand graphs. Of the technical topics, you will enjoy teaching
the effective rate of protection. This is a powerful tool for showing the extent of the
inef ciencies that can be bred by modest- looking tariffs. For some of the more con-
troversial topics, it is important to delineate the differences between the stances
of the developed countries and less- developed countries. Students should be able
to develop informed opinions on these core differences in the trade talks. It would
138 | Chapter 19
also be a good time to review the basic differences between custom unions and
free- trade areas and their implications for developing countries. In anticipating
this possibility, the questions on regionalism from the previous Question Bank
have been retained.
QUESTION BANK
Concept Map
Trade Policy
Import Quotas
Effective Rates of Protection
The Two- Country Model with a Tariff
Production Subsidies
Exchange- Rate Management
Export Orientation
Favoring Exports
Multiple- Choice Questions
1. What was GATT?
a. an international or ga ni za tion that oversaw multilateral trade negotiations
and tariff policies
b. a voluntary export- restriction agreement governing international trade in
textiles
c. a free- trade area in southeast Asia
d. an Eastern Eu ro pe an trading bloc that disbanded in the early 1990s
2. The essence of outward- looking development is that it:
a. relies on primary exports until domestic industry is ef cient enough to
compete in export markets.
b. gets prices right and lets the free market dictate the development of man-
ufactured exports.
c. establishes an incentive system that induces rms to seek export markets.
d. subsidizes export- oriented manufacturing rms.
3. When the government auctions import licenses, it captures the quota rent. Who
gets the quota rent when the government administratively allocates import
licenses?
a. the foreign producer of the imported product
b. the importers
c. the domestic consumer
d. the domestic producers of the import substitutes
4. The effective rate of protection mea sures how much:
a. investment will be drawn into the protected industry.
b. pro t can be earned by producing the protected product.
c. the margin of price over input cost for domestic producers can exceed the
margin at world market prices.
d. the price of the product increases due to the tariff.
5. Effective rates of protection in developing countries typically:
a. are very high for manufactured consumer goods.
b. differ widely from industry to industry.
c. discriminate against the agricultural sector.
d. all of the above.
6. Other things being equal, the effective rate of protection for domestic pro-
ducers of steel nails will be higher:
a. when the tariff on imported nails is low.
b. when the tariff on imported steel is low.
c. when the value added in converting steel to nails is high.
d. all of the above.
7. Zawana faces world prices for nished radios and radio components, which
are 100 shillings and 95 shillings, respectively. There is a 30 percent tariff on
imported radios and no tariff on imported components. The effective rate of
protection for the radio assembly industry in Zawana is:
a. 30 percent.
b. 60 percent.
c. 600 percent.
d. 5 percent.
8. Suppose Kenya imports lm at a border price of $5 per roll. If there are 70
Kenyan shillings to the dollar and Kenya imposes a 50 percent tariff on
imported lm, then the domestic price of the imported lm per roll is:
a. 350 shillings.
b. 105 shillings.
c. 525 shillings.
d. 400 shillings.
9. To minimize losses to consumer surplus, protection for infant industries should
be provided through:
a. subsidies.
b. quotas.
c. tariffs.
d. an overvalued exchange rate.
10. Economists generally prefer the use of subsidies instead of protective tariffs
because:
a. subsidies create smaller deadweight losses.
b. subsidies can be targeted more carefully.
c. the visible cost of subsidies creates an automatic incentive to phase out
protection.
d. all of the above.
11. What effect do high import tariffs have on a country’s export industries?
a. Tariffs reduce the demand for foreign exchange, so the home currency
appreciates; this hurts exports.
b. Tariffs reduce the demand for foreign exchange, so the home currency
depreciates; this boosts exports.
c. Tariffs reduce the demand for foreign exchange, so the home currency
appreciates; this boosts exports.
d. Tariffs do not affect exports, just imports.
12. Malawi’s currency, the kwacha, is overvalued when the kwacha price of
foreign exchange rate is:
a. too high compared to the equilibrium free- trade exchange rate.
b. too low compared to the equilibrium free- trade exchange rate.
c. rising.
d. falling.
13. Which of the following is NOT an argument in favor of export- oriented
development over import substitution?
a. International competition compels domestic producers to become more
ef cient.
b. Exposure to world markets enhances opportunities to learn new
technologies.
c. Producing for export permits greater specialization.
d. Outward- looking development favors rms that are better at rent seeking.
14. What credit- market policy did the Korean government use to promote
exports in its transition toward a rapidly industrializing nation?
a. The government liberalized nancial markets and let market forces
allocate credit.
b. The government set high interest rates on loans to exporters to screen out
low- productivity investments.
c. The government cut off credit to exporters to make them compete for
loans overseas.
d. The government used low- interest- rate loans as a form of indirect subsidy
to exporters.
142 | Chapter 19
IDs and Paired- Concept Questions
These terms can be used individually as short- answer identi cation questions, or
they can be used in pairs. In the latter case, ask students to explain (1) the meaning
and signi cance of each of the two terms and (2) the relationship between them.
2. Tariff revenue, quota rent
4. Overvalued exchange rate, import- GDP ratio
6. Outward- looking strategy, global market
8. GATT, most- favored- nation principle
10. Effective rate of protection, value added
