Part Three
Problems and Policies: International and Macro
Chapter 12
International Trade Theory and Development Strategy
Key Concepts
This chapter focuses on alternative theories of international trade and trade policy in order to answer the
following questions:
How does trade affect economic growth and income distribution?
Does trade promote the achievement of development objectives?
Should less developed countries pursue outward or inward oriented trade policies, or some
combination of the two?
It is emphasized that the answers will not be the same for all countries given the great diversity that exists
among developing countries; no unique solution can be recommended as regards the role of international
trade in promoting economic development.
Section 12.1 serves as an introduction, with section 12.2 following with the central importance of
international trade in economic development is explained in detail with both theoretical arguments and
statistical evidence. The weak export performance of many developing countries is explained by low income
and price elasticities of demand for their products, and declining terms of trade (the Prebisch-Singer Thesis
described in Box 12.1).
In section 12.3, the traditional neoclassical model of international trade is reviewed, including:
Complete specialization based on the theory of comparative advantage.
The factor endowment theory that emphasizes production of those goods that intensively use a
country’s abundant factor. Graphical analysis and detailed conclusions are presented.
The traditional arguments for the impact of trade upon development are summarized.
Criticisms of traditional free trade theory are presented in section 12.4 by scrutinizing some of the
assumptions the theory makes that are typically violated in less developed countries. The text analyzes the
implications of such violations.
North-South Models of Unequal Trade: These models suggest that trade tends to reinforce the
unequal distribution of resource endowments between countries, particularly with respect to skilled and
unskilled labor. For many developing countries trade is unlikely to stimulate a shift to more
capital-intensive forms of production, and the associated benefits.
The Vent-for-Surplus theory of trade: This provides a good description of the actual experience of
many less developed countries.
The impact of the international movement of capital and skilled labor is mentioned.
The existence of monopoly and oligopoly power, product differentiation, increasing returns, and the
existence of risk and uncertainty are also discussed.
The impact of international trade is examined in terms of the effects on growth, income distribution,
poverty, and employment. To summarize, trade can be an important stimulus to rapid economic growth by
promoting greater utilization of idle human and capital resources, increasing foreign exchange earnings, and
expanding access to technological knowledge. At the same time, for a majority of developing countries,
the principal benefits of world trade have accrued disproportionately to foreign residents and wealthy
nationals (as well as to the developed countries).
Clearly, some developing countries such as Taiwan, South Korea and other Asian economies have benefited
from trade. The issue is not whether to trade but which export products to try to promote. Whether
expanding trade is economically beneficial depends on the nature of the export sector and its medium to
long term potential (for example, terms of trade), the distribution of benefits, its linkages with the rest of the
economy, and the country’s ability to respond smoothly to changing international price signals. In general
balanced success will require access to developed countries’ markets for labor-intensive manufactures,
extensive linkages between the export sector and other sectors of the economy, and the ability to influence
activities of foreign enterprises to the benefit of the local economy.
In section 12.5 two broad trade and development policy strategies are defined: outward-looking and
inward-looking development policies. Outward-looking policies encourage free trade and the free
movement of the factors of production, while inward-oriented policies encourage production for the
domestic market and restricted trade and movement of factors of production.
The major topics addressed include:
Encouraging the export of primary products.
Encouraging industrialization via the important substitution strategy.
Encouraging industrialization via the export promotion strategy.
The trade optimist/pessimist debate.
Encouraging South-South trade and economic integration.
The pros and cons of emphasizing primary product exports as a growth strategy are discussed. Five important
factors tend to work against the success of this strategy: low income and price elasticity of demand for
primary products, slow population growth in developed countries, the development of synthetic substitutes,
and agricultural protection in developed countries. Supply side factors emphasize rigidities in the
structure of production and low productivity (covered in Chapter 9).
The export of manufactured goods as a growth strategy is mentioned, particularly with respect to the
spectacular performance of the four Asian Tigers. The text cites rising protectionism by the developed
countries as a barrier against the success of this strategy. The text also points to the need for more
South-South trade.
The import substitution strategy involves identifying consumer goods with large domestic market and
simple technology to produce that are currently being imported, and replacing the imports with domestic
production. A second stage would involve expanding domestic production to more sophisticated
manufactured items, including those with linkages to the consumer goods sectors established in the first
stage. Key points mentioned include:
A built in demand for the product already exists.
The infant industry argument.
The use of tariffs and quotas.
The effective rate of protection.
The appropriate exchange rate policy.
Reasons for the failure of the strategy.
A section on foreign exchange rates reviews the concept of a foreign exchange market and discusses the
options available for maintaining an official exchange rate. Overvalued exchange rates, dual exchange
rate systems, and currency devaluation are discussed.
The trade optimist and trade pessimist arguments are listed. This is a good summary of the major issues
relating to inward versus outward oriented trade strategies. Trade pessimists focus on the limited growth
of world demand for primary exports, the deterioration in the terms of trade for many developing
countries specializing in the production of primary products for export, and the rise of protectionism
within the developed countries. The trade optimists focus on economic efficiency: the promotion of
competition, getting prices right, improving resource allocation, and achieving economies of scale.
Section 12.6 on “The Industrialization Strategy Approach to Export Policy,” argues that, during the last two
decades, several countries have pursued a strategy that emphasizes following an industrialization path
through expanding presence in global markets. This strategy is broadly sympathetic to the arguments of trade
optimists but also places heavy emphasis on government efforts to promote industrial export growth rather
than leaving industrialization entirely to the market mechanism. This section discusses the experience of
several countries, especially the South East Asian economies, with this strategy.
Section 12.7, on South-South trade outlines arguments why developing countries should move in the
direction of economic integration. Economic integration among developing countries at relatively equal
stages of development with similar market sizes and an interest in coordinating their efforts stand to gain
the most. Mercosur, the Andean Bloc, and the Southern African Development Community are mentioned.
The final section of the chapter, 12.8, discusses how developed countries can reform their trade policies to
promote the expansion of world trade by lowering tariff barriers, lowering export subsidies such as those
used by Japan, expanding domestic adjustment assistance, and considering macroeconomic policies in the
context of the developed as well as the developing world’s needs.
A chapter concludes with a case study on Taiwan.
Lecture Suggestions
It is essential to develop the assumptions and conclusions of neoclassical trade theory, as well as the
nature of the criticisms offered in the text, in some detail. It is useful to emphasize that this is one of the
most controversial issues in development economics. A distinction between the logic of the arguments
and their empirical relevance should be made. This may take several lectures, depending on the
background of the students.
A first lecture should include a statistical overview of trade patterns and experiences, followed by a
discussion of the theory of comparative advantage. You might discuss:
the classic comparative advantage model
the case of specialized factors of production and increasing opportunity costs of production
the budget line and gains from trade
the fact that small countries may gain more from trade.
You will need to make a decision of how much time you wish to devote to the Neoclassical model. As the
authors note the factor endowment approach is analogous to the classical labor cost approach. The
advantage of the former is that it is much more easier to explain. A discussion of the labor cost approach
coupled with a very general discussion of what the factor endowment approach implies (that capital rich
economies should trade their capital-intensive products for labor and land-intensive products of
economies where capital is relatively scarce) should suffice and allows you to cover section 12.4’s
critique of free-trade theory and section 12.2’s discussion of the Prebisch-Singer hypothesis. If your class
has many students majoring or minoring in economics there is a good chance that they will be familiar
with neoclassical trade theory and an equally high chance that they have seen little in the way of critiques.
A discussion of how comparative advantage changes over time can be interesting in terms of the shift
from labor to capital-intensive production. This is a good introduction to the North-South model. Many
students may have seen this type of theory in a political science class. A role for government can be
introduced here in terms of encouraging saving and investment, promoting stability, providing appropriate
education, providing infrastructure, and encouraging research and development.
A simple illustration of declining net barter terms of trade may be helpful for some students, especially
non-majors (for example, an increasing tonnage of copper exports required per car imported). It is
worthwhile to explain that quality changes must be taken into account to arrive at a balanced assessment.
Note also that the terms of trade effect can be expected to vary across countries and commodities. Some
studies suggest that there has not been a decline in the terms of trade, though there have been great
fluctuations. See for example:
Davis Sapsford and VN Balasubramanyam. “The Long-run Behavior of the Relative Price of Primary
Commodities: Statistical Evidence and Policy Implications.” World Development 22(11):1737–45
November 1994.
However, note that the 2010 paper by Harvey et al -cited in Box 12.1 (page 612)- argues strongly that
there has been a significant long-term decline on the commodity terms of trade. Regardless of whether or
not the commodity terms of trade are declining the impact of sharply different income elasticities of
demand for the labor and land-intensive exports of peripheral economies versus those for the
capital-intensive exports of economies in the center the impact on peripheral economies’ balance of
payments can be enough to limit their growth.
One way to summarize and develop the chapter in class is to provide a number of arguments, first for
liberalization and then for international trade industrial policies. Liberalization arguments include
(1) increased technical efficiency (returns to scale); (2) economic or allocative efficiency; (3) accelerated
technical progress (due to increased contacts with the world market, subcontracts that provide technical
training, etc.); (4) decreased shortages of foreign exchange and restricted commodities; (5) decreased
losses from rent-seeking activities; and (6) increased investment due to cheaper capital goods. Arguments
against liberalization include: (1) adjustment and dislocation, (2) dynamic comparative advantage including
infant industries, (3) declining terms of trade, (4) fluctuating export earnings with dependence on exports
of a handful of primary exports (due to weather uncertainties on the supply side and developed country
business cycles on the demand side), (5) strategic trade policy arguments, (6) product discrimination,
(7) growing protectionism, and (8) unequal bargaining power.
The tables at the end of the World Development Report are good sources of current statistics to update
textbook material on which countries are experiencing a rapid expansion of exports and which stagnant or
negative growth. The WDR tables include statistics on the nature of exports. For example, the importance
of high tech exports (as percent of a country’s manufactured exports) is a good indication of how
countries exploit world markets to diversity away from primary products.
The discussion of three trade strategies (primary product exports, import substitution, and export promotion
for manufactured goods) and the discussion of South-South trade possibilities provide a good introduction
of alternative trade policies. For each of the models, it is useful to discuss the pros and cons. The North-South
model of unequal trade illustrates the dangers of specializing in the production of primary products for
export. If you do not want to spend much time on this topic, then shorten the technical discussion, including
the graphs, and present a general description of each strategy. Comment on how well each strategy has
worked for select countries. Introduce primary product exports as an engine of growth after the theoretical
material in the beginning of this chapter has been covered. The following points can be included in class
discussion.
Developing countries may tend to have a comparative advantage in primary products because of their
stage of development.
Arguments in favor of this strategy include the ability to earn foreign exchange to finance growth,
primary exports can help growth (referring to the experience of the now developed countries), and
how exporting primary products can be a key part of an overall growth strategy.
Arguments against include the North-South model, demand factors, terms of trade effects, and
ineffective linkage effects.
Introduce linkage effects: forward, backward, consumption, and fiscal. Positive linkages create value
added in the economy and contribute to positive changes in job, spending, and income.
Summary: the need to diversify across products and sectors, the need to increase demand at a low
income level, the need to create advanced factors and/or the role government can play in this area,
the possibilities for South-South trade as an answer to developed country protection.
The following points can be elaborated on with respect to import substitution:
A market for the good already exists, the country thinks it can gain comparative advantage in production
of that good, industrial growth is key to development, and a current account deficit can be reduced.
The infant industry argument.
Three policies: tariffs, quotas, and an overvalued exchange rate. Spend time on the mechanics of each, and
how they all fit together. Use supply and demand graphs, talk about monopoly power resulting from the
use of a quota, and talk about differentiated goods resulting in a need for a quota on top of a tariff.
Discuss the supply and demand for foreign exchange and the exchange rate as the “price” of the foreign
currency. Make sure students understand that the aim of an overvalued exchange rate is to reduce the cost
of imported intermediate and capital goods for IS industries. Also emphasize that overvalued exchange
rates reduce the competitiveness of goods in the export market. Stress that some developing countries
have fixed exchange rate systems. Exchange rate policy can hurt export industries, help finance a
payments deficit, encourage capital intensive production, and reduce backward linkages.
Conclusions: limited domestic market, scale economies may result in monopoly power, infants never
grow up (and maybe cannot because of a lack of complementary factors such as skilled labor,
inadequate input supplies, and poor infrastructure), the tendency for temporary tariffs to become
permanent, input industries receive less protection, choice of technology and employment creation,
migration and neglect of the rural sector, and a failure to improve productivity.
Export promotion (EP) of manufactured goods is in part a response to the failure of import substitution.
Export promotion involves targeting sectors with a (potential) comparative advantage in world trade to
realize economies of scale and productivity growth. Trade liberalization is often considered as EP policy
because it reduces incentives to produce for home over foreign markets. Some successful countries such
as South Korea have effectively combined IS and EP strategies across time and industries, as detailed in
the new case study at the end of this chapter.
EP is more market based, in that countries are forced to compete on the world market. Pro trade
arguments apply here. Policies include government subsidies for export, removing factor price distortions,
and other specific policies used by South Korea or Taiwan. Discuss its success in absorbing the growth of
the labor force and the general advantages of increasing exports in terms of earning foreign exchange,
attracting foreign investment, and preventing bottlenecks related to the agricultural sector.
It is helpful to offer a simple numerical example of the divergence between nominal and effective rates of
protection: Suppose a country has an economy-wide tariff of 10%. It decides to protect stereos, raising its
tariff rate—but no other rates—to 40%. It uses 50 cents of material inputs per dollar of output. What is the
nominal rate of protection (before and after)? What is the effective rate of protection (before and after)?
Most students know about the success of Taiwan’s export oriented growth strategy. This case study looks
at the various factors that have led to Taiwan’s success including initial import substitution policies.
To put the discussion of protectionist policies in some historical perspective you should consult:
1. Ha Joon Chang. Kicking Away the Ladder, Anthem Press, 2003
2. Ha Joon Chang. Bad Samaritans, Bloomsbury Press, 2008.
nDiscussion Topics
Discussion topics may be of more interest after the next chapter is covered.
Does trade reinforce existing inequalities? This fits in nicely with the North-South model. Discuss
supply and demand basics and vicious circles.
Creating a demand for wage goods, and increasing value-added are two important goals for growth.
How does trade impact either of these goals?
Can all countries pursue export led growth and be successful? What are the limitations if any?
Can import substitution and export promotion of manufactured goods be pursued at the same time?
What are the difficulties in terms of selecting appropriate policies?
Compare and contrast a successful strategy of import substitution (Korea, Taiwan) with a disastrous
one (e.g. Argentina).
Sample Questions
Short Answer
1. What are the terms of trade? What factors lead them to change over time?
Answer: The ratio of the price of a country’s exports to that of its imports both in index form.
Changes in the pattern of relative demand as income or tastes change in various parts of
2. Briefly explain the major argument of the factor endowment trade theory.
Answer: Countries will tend to specialize in the production of commodities making intensive use
3. You are a lobbyist hired by a less developed country to try to prevent a developed country from
increasing trade barriers against labor-intensive manufactured imports such as textiles. Make your
case, arguing from both developed and developing country perspectives, in terms of who gains and
who loses.
Answer: Requires synthesis of the neoclassical theory of international trade as applied to developed
countries and benefits of outward looking trade policies from the developing country point
4. Explain why a country’s gains from trade may not accrue to nationals. Indicate the differential
effects on GNP and GDP.
Answer: Discussed in the chapter; students should note that some of the value of output is repatriated
5. Provide a concise statement about the relationship between a developing country’s emphasis on the
export of traditional commodities and: (a) export earnings stability; (b) comparative advantage;
(c) terms of trade.
Answer: (a) Traditional commodities may tend to experience greater price fluctuations; (b) less
developed countries tend to have a comparative advantage in traditional commodities;
6. Evaluate critically the following statement: In light of the experience of the last two decades, free
trade is the best trade policy for most developing countries.
Answer: Discussed at length in the chapter.
7. When and under what circumstances is intervention in international trade justified on market correction
grounds? What preconditions would have to be met from the government side for there to be a reasonable
likelihood of success?
Answer: This will depend on what you cover in lecture.
8. In the North-South model, how are “basic factors” distinguished from “advanced factors,” and what
are the implications for growth and development possibilities?
Answer: Basic factors include relatively unskilled labor, physical resources, location, and general
infrastructure. Advanced factors include education and firm specific human capital,
9. Briefly, what are the major causes of export earnings instability for developing countries?
Answer: Low price and income elasticities of demand leading to erratic movements in export
prices.
10. What are the key ingredients of Taiwan’s successful entry into world markets? What lessons can
other developing countries draw from Taiwan’s experience with global markets?
Answer: The new case study discusses some of the key factors of Taiwan’s success in global markets.
The case study focuses mostly on economic variables but social variables (such as the work
11.Explain briefly the vent-for-surplus theory of international trade. What is the relevance of this theory
to the current development experience of low-income economies?
Answer: Discussed in the text.
12. A country simultaneously raises tariffs on manufactured goods and overvalues the exchange rate.
Why might these seemingly contradictory policies be pursued together?
Answer: Students should show they understand why a general import substitution strategy could
13. What are the drawbacks of overvaluing the exchange rate as an import substitution policy?
Answer: Discourages exports and leads to trade deficit or to use of exchange controls.
14. After a policy of import substitution has begun, a developing country finds that employment has not
risen significantly and that urban unemployment seems to be rising. Explain how these
developments might be connected.
Answer: Modern sector enrichment with wage increases/migration/capital intensive industries.
15. Many developing countries have a static comparative advantage in the production of one or two
primary products. In what ways might specialization in these products contribute to growth and
development? In what ways might this fail to contribute?
Answer: Calls for a discussion of short and long run effects as in the text.
16. Taiwan and Jamaica are both islands that have pursued export-oriented development strategies, but
Jamaica has experienced increases in unemployment and poverty, while Taiwan has experienced
decreases. How might you explain this?
Answer: The type of exports, commodity or manufactured, may matter. You may wish to use other
17. Discuss some of the factors that lead infant manufactured goods industries to become more efficient
over time, and some of the factors that might lead them to fail to do so.
Answer: Industries with significant learning by doing; firms threatened by a specific deadline for
tariff reductions.
18. (a) Under what circumstances is the effective rate of protection of a tariff greater than the nominal
rate? (b) Why is this a concern for developing countries?
Answer: (a) When tariffs on final goods exceed those on intermediate and capital good inputs.