copyright © 2010 pearson addison-wesley. all rights reserved. chapter 10 international trade and...

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 10

International Trade and Economic Growth

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.10-2

Topics to be Covered

• Economic Growth and Development

• Economic Development Strategies:– Primary Export-led Strategy– Import-substitution Strategy– Outward-looking Strategy

• Neutral Economic Growth

• Protrade vs. Antitrade Biased Growth

• Types of Technological Change

• International Flows of Labor and Capital

• Economic Analysis of Labor Migration


Economic Growth

• An economy is said to grow when its total real output or gross domestic product (GDP) rises.

• Per capita GDP is a measure of a country’s standard of living. For standard of living to rise over time, GDP must grow faster than the population.


Economic Development

• Economic Development—refers to the achievement of a quality of life for the average citizen of a country that is comparable to that enjoyed by the average citizen of a country with a modern economy, such as the U.S.

• Economic development is characterized by:– High levels of consumption– Broad-based educational achievement– Adequate housing– Access to high-quality health care, etc.

• Economic growth is essential for economic development.


• The first goal of economic development is the alleviation of the dire conditions billions face in developing countries

• Problems such as nutrition, poor housing, lack of basic health care, lack of an infrastructure to provide amenities like clean water, and illiteracy make it difficult for people to improve the standard of living

• Economic development can be a complicated concept

THE DEVELOPING COUNTRIES


• We make the assumption that the various aspects of economic development all are positively correlated with a country’s GDP per capita

• International economics is concerned with the relationship of international trade and the rate of economic growth



• GDP of Developing Countries– There are approximately 145 developing

countries in the world economy and they contain 84.3 percent of the world’s population

– In 2005, GDP per capita in the middle-income countries was $2,782 per year and for low-income countries GDP per capita is on average $602 per year

– Middle-income countries are the fastest growing economies of the three groups




Table 11.1 Distribution of World Population and Economic Output, 2005

GDP per capita

Population (millions)

% of World Population

Population Growth 1990-2000

Total GDP (millions of $)

% of World GDP

Low-Income Economies

$602 2,352 36.5% 2.1% $1,416,212 3.2%

Middle-Income Economies

$2,782 3,075 47.8% 1.3% $8,553,721 19.2%

High-Income Economies

$34,316 1,011 15.7% 0.7% $34,687,058 77.7%


• Although the standard of living in middle-income countries is low, it pales in comparison to the economic problem of the low-income countries

• GDP per capita in these countries is approximately $600 per year

• This implies a standard of living of approximately $1.60 per day.

• Some of the worst effects of poverty are the norm



• From an economic geography point of view, levels of development are not spread evenly around the world

• The high-income economies are concentrated in North America and Western Europe

• The former communist countries of Eastern Europe are middle-income countries that have a good chance of becoming high-income countries

• In the Western Hemisphere, virtually all of the countries except the U.S. and Canada are either low- or middle-income countries



• In Asia, Japan, Singapore, Australia, and New Zealand are the only high-income countries

• Nearly 2 billion people in Asia are concentrated in the low-income economies of China and India

• Africa is split between low- and middle-income economies

• The countries along the Mediterranean Basin are middle-income countries

• Most of the countries of sub-Saharan Africa, with the exception of South Africa, are in the low-income category



• Preconditions for Growth– There are two important preconditions for

economic growth, property rights and the rule of law

– For markets to work, it must be clear who owns what

– If property rights are not being properly enforced, then far fewer transactions occur with the result of a lower level of economic activity

ECONOMIC GROWTH


• Normal economic transactions involve legally binding contracts

• If there is no effective referee to enforce business contracts, then far fewer business contracts occur with the result of a lower level of economic activity

• In many developing countries these conditions are not being met

• This situation is called failed state

ECONOMIC GROWTH


• Economic Growth and the Factors of Production– In order for an economy to grow, it needs

resources – factors of production– Since land is generally fixed, the focus will be

on labor, capital, and technology– A country’s labor force can increase through

population growth or immigration– An increase in the labor force will tend to

increase the GDP

ECONOMIC GROWTH


• Economic growth also requires an increase in the stock of capital

• Capital is the amount of money invested in business structures and equipment

• For a developing country, the stock of capital outside of the private sector may be critically important

• In order for capital and labor to produce the maximum output, the economic infrastructure of the country needs to be appropriate to the level of economic development

ECONOMIC GROWTH


• In economics, technology is anything that causes resources to be used in a more efficient way

• Economic growth can also be enhanced by having a country’s level of technology increase over time

• A change in technology means that a country can either produce more output with the same amount of resources or alternatively produce the same level of output with fewer resources

ECONOMIC GROWTH


• Basic Growth Theory– The relationship between GDP and factors of

production is called the production function– The shape of the production function reflects the

phenomenon of diminishing returns– As the amount of a variable factor increases, the

resulting increase in output becomes smaller– This effect is especially applicable in developing

countries with low initial GDPs and increasing labor forces

ECONOMIC GROWTH


ECONOMIC GROWTH

Figure 11.1 Production Function for a Country

Real GDP (Y)

Y4

Y3

Y2

Y1

L1 L2 L3 L4 Labor Force (L)

F


• Changes in the Capital Stock and Technology– Businesses generally use loan proceeds to

invest in structure and/or equipment– This increases capital stock and the

production function shifts upwards– Because the capital-to-labor ration has

increased, the economy can now produce more goods and services for any given size labor force

ECONOMIC GROWTH


ECONOMIC GROWTH

Figure 11.2 Shift in the Production Function for a Country

Real GDP (Y)

Y2

Y1

L1 Labor Force (L)

F1

F2


• An improvement in technology should allow the economy to produce more goods and services with the same level of labor and capital

• Labor and capital can be used more efficiently

• The increase in the GDP is solely as the result of being able to utilize the same amount of capital and labor to produce more goods and services

ECONOMIC GROWTH


Trade and Growth

• Economic growth is shown graphically as an outward shift of the country’s production possibility frontier (PPF).

• Since growth affects both production and consumption, then it also affects international trade.


• Openness and growth– The more a country trades, the faster the

economy should be able to grow– There is evidence of a positive correlation

between openness to trade and growth– Openness causes an improvement in

technology– Improved technology leads to improved total

factor productivity, getting more outputs from the same inputs

INTERNATIONAL TRADE AND ECONOMIC GROWTH


Table 11.2 Economic Freedom Index, 2007

Highest-Ranking Countries

Economic Freedom Index

Lowest-Ranking Countries

Economic Freedom Index

Hong Kong 89.29 Guinea-Bissau 45.71

Singapore 85.65 Angola 43.47

Australia 82.69 Iran 43.33

U.S. 81.98 Rep. of Congo 43.00

New Zealand 81.59 Turkmenistan 42.54

U.K. 81.55 Burma 40.14

Ireland 81.31 Zimbabwe 35.81

Luxembourg 79.31 Libya 34.48

Switzerland 79.05 Cuba 29.68

Canada 78.72 North Korea 3.000


More open economies tend to have higher rates of growth of total factor productivity

• This is a complex issue and while the relationship between openness to trade and growth appears to exist, no one is sure of the size of the effect



• Capital Flows, Technology Transfers, and Economic Growth– Increasing the capital stock and the level of

technology in developing countries is difficult– In developing countries, the savings are low

and the level of technology is below the world average

– FDI helps developing countries increase their capital stock



• Transfer of technology from developed to developing countries also increases the rate of economic growth

• But technology and knowledge are hard to measure

• Thus limits the ability to accurate analyze the effects of these technology transfers

• FDI flows bring in improved technology• Trade drives specialization and learning which

improves knowledge which increases total factor productivity even without FDI




5-28

The Effects of Economic Growth (cont.)

• Growth is usually biased: it occurs in one sector more than others, causing relative supply to change.– Rapid growth has occurred in U.S. computer

industries but relatively little growth has occurred in U.S. textile industries.

– According to the Ricardian model, technological progress in one sector causes biased growth.

– According to the Heckscher-Ohlin model, an increase in one factor of production (ex., an increase in the labor force, arable land, or the capital stock) causes biased growth.



5-29

Fig. 5-6: Biased Growth



5-30

The Effects of Economic Growth (cont.)

• Biased growth and the resulting change in relative supply causes a change in the terms of trade.

– Biased growth in the cloth industry (in either the domestic or foreign country) will lower the price of cloth relative to the price of food and lower the terms of trade for cloth exporters.

– Biased growth in the food industry (in either the domestic or foreign country) will raise the price of cloth relative to the price of food and raise the terms of trade for cloth exporters.

– Suppose that the domestic country exports cloth and imports food.



5-31

Fig. 5-7a: Growth and Relative Supply



5-32

Fig. 5-7b: Growth and Relative Supply



5-33

Pro-trade Biased Growth

When growth occurs as a result of an increase in the resource used intensively in the production of export goods, then the output of export goods will rise relative to import production, and international trade will expand by more than the rate of growth of GDP. This is called pro-trade biased growth

Export-biased growth reduces a country’s terms of trade, generally reducing its welfare and increasing the welfare of foreign countries.


anti-trade biased growth

• When growth occurs as a result of an increase in the resource used intensively in the production of import goods, then the output of import goods will rise relative to the output of export goods, and the international trade of this country will fall. This is anti-trade biased growth

Import-biased growth increases a country’s terms of trade, generally increasing its welfare and decreasing the welfare of foreign countries.


Strategies for Economic Development

• Primary Export-led Development Strategy

• Import-Substitution Development Strategy

• Outward-looking Development Strategy


Primary Export-Led Development Strategy

• This strategy involves policies designed to exploit natural comparative advantage by increasing production of a few export goods most closely related to the country’s resource base.

• Country examples include Columbia (coffee), Mexico and Nigeria (petroleum), and Malaysia (rubber).


• Revenues from primary production may allow a country to finance infrastructure development and the importing of capital equipment more easily than a country without such resources

• Primary production may be the start of a process of producing a final good

• Adding value to a primary product is an obvious first step in economic development

ECONOMIC DEVELOPMENT STRATEGIES


Advantages of Primary Export-led Development Strategy

• This strategy would encourage more intensive use of existing or abundant resources.

• It could help attract foreign investment.

• It may provide linkage effects or benefits to other industries as a result of one industry expanding.


Arguments Against Primary Export-led Strategy

• The world markets for primary products do not grow fast enough to support this type of development.

• The prices of primary products relative to the prices of manufactured goods will tend to fall over time due to sluggish demand or oversupply.


• Primary products can be a problem with respect to economic development

• The prices of primary products tend to be volatile/fluctuate

• If both the demand and supply of the product are inelastic, then most of the changes in demand and supply are reflected in the price

• For many countries, primary products are a high percentage of exports or GDP

• The volatility of prices can cause major changes in terms of trade or instability for the whole economy




Table 11.4 World Primary Commodity Prices, 2000-2005 (Percentage change over previous year)

Commodity Group 2000 2001 2002 2003 2004 2005

All Commodities 1.7 –3.6 0.8 8.1 19.4 12.1

Food & Tropical Beverages –0.1 0.4 0.4 2.3 13.2 8.8

Vegetable Oilseeds & Oils –20.3 –6.4 24.9 17.4 13.2 –9.5

Agricultural Raw Materials 3.1 –3.9 –2.4 19.8 9.9 7.1

Minerals, Ores, & Metals 12.4 –10.8 –2.7 12.4 40.7 26.2

Crude Petroleum 56.6 –13.3 2.0 15.8 30.7 41.3


Terms of Trade of Developing Countries

• Refer to Figure 10.1

• Terms of trade of oil exporting countries have experienced sharp increases; non-oil exporters have more stable, terms of trade.

• A group of countries with market power can improve its terms of trade by restricting supply.

• The declining terms of trade of non-oil exporters is more likely due to policies of other developing countries (i.e., OPEC) than to market conditions in developed countries.


FIGURE 10.1 Terms of Trade of Developing Countries


• Import Substitution– The purpose of an import substitution

development strategy is to increase the relative size of the manufacturing sector

– It can allow faster initial growth of the manufacturing sector

– The country may conserve /organize on supplies of foreign exchange by importing fewer manufactured products which may improve the trade balance

– Some of the protected industries might in the future have a comparative advantage



• If the economy at an early stage of economic development does not have a comparative advantage in manufactured products, is there a way to increase the size of this sector?

• Yes, Governments can use domestic policies such as low taxes on manufacturing, direct government subsidies, or trade policy to favor the manufacturing sector

• If tariffs are not sufficient to increase output, then quota protection could be instituted instead of or along with tariffs



• Import substitution has created a number of problems for the countries that pursue it

• Infant manufacturing sector is not internationally competitive and is producing substitutes for imports that cost more and may be of lower quality

• This reduces the welfare of consumers and/or their ability to produce other goods and services at competitive prices

• Protected industries are larger than they should be in a free market



• Since the economy is not using its resources efficiently, it is not growing as fast as it could

• Slow economic growth may mean slow growth in employment

• With a growing labor force this is a problem• An import substitution policy tends to make

the domestic industry more capital intensive than would otherwise be the case further reducing job creation



• It will be difficult to withdraw protectionism as firms and workers in the protected industry will lobby to keep the current level of protection from being removed

• The industries never adjust fully to world competition and over time become relatively more inefficient



• Beginning in the 1970s and continuing into the 21st century, most countries pursuing the import-substitution development policy are in the process of abandoning it

• Countries are willing to go through this process now due to the widespread realization that an inefficient manufacturing sector does not enhance overall economic growth




Table 11.5 GDP Growth in Developing Countries in Latin America and Asia, 1990-2000 (Percentage Change)

Region/Country Percent Change in GDP 1990-2000 Region/Country Percent Change in GDP 1990-2000

Developing Countries 4.8

Latin America 3.3 Asia 6.0

Argentina 4.3 China 10.3

Brazil 2.9 Hong Kong 4.0

Chile 6.7 India 5.9

Columbia 3.0 Indonesia 4.2

Ecuador 1.8 Iran 3.6

Mexico 3.1 Israel 5.1

Peru 4.7 Malaysia 7.0

Uruguay 3.4 Pakistan 3.7

Venezuela 1.6 Philippines 3.3

Korea 5.8

Saudi Arabia 1.5

Singapore 7.9

Taiwan 6.4

Thailand 4.2

Turkey 3.8


• Export Promotion– A development strategy based on developing

industries in line with the country’s comparative advantage

– More effective than import substitution– Export promotion implies an increase in the

relative size of the manufacturing sector– For manufacturing to thrive/grow , there is an

active role for government



• The preconditions for growth are extremely important

• Manufacturing usually is more infrastructure intensive than agriculture

• The development of a sufficient infrastructure will involve the participation of the government

• Services must be internationally competitive in both price and quality

• Development of the manufacturing sector requires increases in the amount of human capital



• Taxation of industries must be competitive in relation to competitive countries

• The government needs to have reasonable polices with respect to FDI

• The government needs to avoid protectionism to the greatest extent possible

• Exchange rates need to be determined by market forces



• If executed properly, export promotion has a number of advantages

• More resources flow into the comparative advantage sectors and away from comparative disadvantage

• Faster economic increase the rate of job creation

• May improve the country’s chance of creating a more favorable balance between exports and imports

• It works better than import substitution!



• Developed countries can assist developing countries though what is popularly known as “foreign aid”

• The correct term for this transfer of resources from developed countries to developing countries to assist in the process of economic development is official development assistance (ODA)

• Accomplished through the actions of properly functioning governments

• Is a small part of economic development

OFFICIAL DEVELOPMENT ASSISTANCE


• The Role of Official Development Assistance– Structural change is frequently accompanied

by an increasing degree of urbanization– To accommodate a rising percentage of the

population living in urban areas, basic infrastructure becomes more critical

– Infrastructure investment is not cheap and governments of poor countries may be hard pressed to afford these investments



• Many of these investments require a substantial amount of foreign exchange and it may be difficult to obtain the needed amount

• This is where ODA can play a valuable role in the process of economic development

• Developing countries typically have small or weak capital markets making long term financing problematic

• The required sums are not as formidable/huge to a developing country




Table 11.6(a) Net Official Development Assistance to Developing Countries in 2005

Donor Country

Official Development Assistance ($ Millions) % of GDP

Australia $1,449 0.20%

Austria $1,260 0.41%

Belgium $1,360 0.37%

Canada $2,816 0.25%

Denmark $1,739 0.67%

Finland $693 0.36%

France $8,862 0.42%

Germany $9,236 0.33%

Greece $207 0.09%

Ireland $482 0.24%

Italy $2,686 0.15%

Japan $17,265 0.38%



Table 11.6(b) Net Official Development Assistance to Developing Countries in 2005

Donor Country

Official Development Assistance ($ Millions) % of GDP

Luxembourg $187 0.51%

Netherlands $3,529 0.57%

New Zealand $224 0.20%

Norway $2,033 0.69%

Portugal $224 0.12%

Spain $2,362 0.21%

Sweden $2,256 0.63%

Switzerland $1,407 0.38%

United Kingdom $8,509 0.39%

United States $25,836 0.21%

Total Assistance $94,622 0.29%


Technological Change

• Technological (technical) change—occurs when the same amount of output can be produced with fewer factor inputs, or when the same amount of inputs can produce greater amounts of output.


Types of Technological Change

• Neutral technological change—an innovation that reduces by an equi-proportionate amount the quantity of factors required to produce a given level of output.

• Labor-saving (capital-saving) technological change—an innovation that leads to a reduction in the use of labor (capital) relative to other factors in the production of a given level of output.


Industry Effects of Technical Change

• If neutral technical progress occurs in one industry, the output of that industry will increase at the expense of the other.

• If technical progress allows an industry to save on the use of the factor it uses less intensively, then the output of that industry could rise or fall.


Economic Growth and Terms of Trade for a Large Country

• With neutral economic growth, the terms of trade of the large country will tend to fall as the country grows.

• Pro-trade biased growth will cause the terms of trade to deteriorate more than under neutral growth.

• Anti-trade biased growth will lead to an improvement in the terms of trade.


Immizerising Growth

• Immizerising Growth—growth that results in a reduction of the country’s welfare level.

• Refer to Figure 10.4 (next slide).


FIGURE 10.4 Immizerizing Growth


Is Immizerising Growth Common?

• No, because:– Precise conditions on both the nature of growth

and world demand must hold.– Government policy (e.g., tariffs) can be used to

counteract the negative effects of growth.


Dutch Disease

• The phenomenon of a boom or good fortunes for one part of a country’s economy eventually leading to very bad times for the economy as a whole is known as the Dutch disease.

• Refer to Global Insights 10.1 The Dutch Disease


International Flows of Factors

• Labor and migration• Capital and multinational corporations


Labor Flows

• The U.S., Canada, Australia, and other countries have experienced large inflows of migrants (see Table 10.5).

• Migration has resulted from government policies such as:– Guest worker program (Europe) in which foreign

workers are invited to temporarily relocate and work in a host country


TABLE 10.5 U.S. Immigration, 1820–20051


Reasons for Migrating

• Better economic circumstances in another country.

• Refuge from political tyranny or devastation.

• Reunion with other family members.


Brain Drain vs. Brawn Drain

• Brain Drain—process whereby skilled workers leave their homeland and relocate abroad.

• Brawn Drain—the outflow of unskilled workers to other countries.


U.S. Capital Flows

• In the 19th century, the U.S. was a capital-importing country.

• For much of the 20th century, the U.S. was a capital exporter.

• Since 1985, the U.S. has moved from being the world’s largest net creditor to being the world’s largest net borrower.


Direct Foreign Investment and MNC’s

• Direct Foreign Investment—happens when a domestic firm acquires ownership or control of the operations of a foreign firm.

• Multinational Corporations (MNCs)—firms that own and operate capital in one or more foreign countries.


Features of U.S. MNCs

• Manufacturing accounts for the largest share of U.S. MNC employment (refer to Table 10.6 Employment of Nonbank U.S. MNCs).

• Almost 70% of U.S. MNC employment is in developed countries, primarily in Western Europe (refer to Table 10.7).


TABLE 10.6 Employment of Nonbank U.S. MNCs in 2006 (worldwide, parent, and affiliate)


TABLE 10.7 Employment of U.S. MNC Foreign Affiliates, by Area, 2006


What Special Advantages do MNCs Have?

• MNCs may have access to special technology.

• There may be increasing returns to scale that accrue to a firm operating plants in many locations.


Outsourcing

• Outsourcing—the movement or shifting of production by a firm to a foreign location.

• See Global Insights 10.2 for more details.


Economic Analysis of Factor Movements

• The case of labor migration

• Definition of terms:– Marginal Product of Labor (MPL)

– Diminishing Returns to Labor

– Value of Marginal Product of Labor (VMPL)

• Profit-maximizing Rule

• Effects of immigration of foreign workers


Marginal Product of Labor (MPL)

• MPL—the additional amount of output that can be produced with the addition of one more worker to the production process.


Diminishing Returns

• Diminishing returns to labor—the fact that as more and more workers are added to the production process, holding all other factors constant, the marginal product of labor will eventually decline.


Value of Marginal Product of Labor (VMPL)

• VMPL—the monetary value of the marginal product of labor or, alternatively, the marginal revenue to producers from hiring the last worker. In equation form:

where P is product price.


VMPL Curve and Equilibrium

• Refer to Figure 10.5

• VMPL curve is downward-sloping due to diminishing returns and also represents the demand-for-labor curve.

• Given a fixed supply of workers, the interaction of the demand and supply in the labor market determines the wage rate.

• The area under the VMPL curve represents labor income and income paid to capital owners.


FIGURE 10.5 Distribution of Income Between Labor and Capital


Effects of Foreign Labor Migration

• Consider Figure 10.6 (next slide).

• Wages are driven downward.

• Increase in labor force results in more output produced.

• There is an income redistribution effect: domestic labor loses income while capital owners benefit because the increased production leads to more intensive use of capital and to a rise in its rental prices.


FIGURE 10.6 The Economic Effects of Labor Immigration

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