Development Economics

Prof. Vasant SukhatmeVisiting Professor

University of TampaSpring semester 2012Apr 10 -12 - 17, 2012

Economic globalization

• Core economic meaning of globalization: more trade between countries; greater capital flows; foreign direct investments flowing unimpeded; greater economic integration

• Concern about globalization comes from the unevenness of the process and the consequences for segments of the population

• Also cultural concerns re homogenization

Some key issues in trade

• Many developing countries rely on exports of primary products – agricultural and mineral

• Considerable price uncertainty of these products which creates uncertainty re export earnings

• Developing countries have poor manufacturing base and hence must rely on developed countries for imports of machinery and intermediate products; again vulnerable

Key issues -- 2

• Many developing countries run BOP deficits, leading to loss of international reserves that they hold for international transactions

• Two main approaches to this: export promotion strategy or import substitution strategy; considerable debate in development circles on this matter

Basic questions

• How does international trade affect economic growth?

• How does trade alter income distribution?• How can trade promote development?• Which strategy works best: outward-looking

or inward-oriented?• Can developing countries determine how

much they trade?

Key issues - 3

• For many developing countries, exports as a fraction of GDP is large (Malaysia 90%; Indonesia 27%; Mexico 27%; Kenya 16%; Jamaica 16%; India 15%; Brazil 13%)

• Exports generally not diversified – one or only a few products loom large in exports

• Not true for larger developing countries such as China, Brazil, India, etc

Demand and supply elasticities and earnings instability

• Demand curves for primary products are generally quite price inelastic

• So are supply curves• This makes export earnings prone to

fluctuations when there is either a supply side shock or a demand side shock

• These fluctuations create uncertainty for long-term planning purposes

Terms of trade

• T-o-t defined as the ratio of export price index to import price index

• Statistical evidence exists that t-o-t is exhibiting a long term declining trend even though there have been episodes of rising or flat t-o-t, at least for some countries

• The decline in t-o-t implies a transfer of income from developing countries to the developed

Comparative advantage

• Countries trade with each other because it is profitable to do so; different people have different tastes or preferences; they have different abilities; people may have different endowments

• Hence, comparative advantage – countries will tend to specialize in those products in which they have a relative cost advantage and then trade with others

Ricardian model

• Simple assumptions – 2 countries; 2 factors of production, L and K; 2 products, X and Y; full employment of both factors; technology the same in both countries and is not changing in either country

• Different products require inputs in different relative proportions ---X more labor intensive and Y more capital intensive

Ricardo - continued

• Country with relatively more L will have a cost advantage in production of the good that requires relatively more labor and hence will export that good (X)

Diagrams of Ricardian model

• Draw production possibility frontiers for countries A and B; A has relatively more L; country B has relatively more K. A ends up exporting good X; B exports good Y.

• Autarky relative price ratios are different from each other in countries A and B; the price ratios tend to converge after trade opens up between the two countries

Ricardian conclusions

• After trade opens up, country A is able to consume at a point that lies outside its PPF; those are the gains from trade

• After trade opens up, the sum total of goods X and Y produced by the 2 countries is higher than what is was before trade started

• Both countries gain from trade• Converging product price ratios lead to

convergence of factor prices

Critique of Ricardian model

• In the “real” world, factors of production are not fully employed

• Technology is not the same in both countries• Factors are not perfectly mobile between

sectors that produce the 2 goods• Not all citizens gain – some are harmed and

income distribution also changes• Static efficiency can lead to dynamic inefficiency

Further critiques

• Product markets are not necessarily competitive; they may be monopolistic or monopsonistic

• Firms then manage to charge higher than competitive prices and consumers lose from such behavior

• Some product prices are frequently highly unstable, esp prices of primary products

Conclusions on trade theory and development

• Trade can be a strong stimulus to growth (witness the successes in Chile, Malaysia, Taiwan, Singapore, Hong Kong, Thailand, Brazil, and China, among others)

• However, export-oriented growth may well result in change in economic structure of a country so that benefits go to a small few and vast numbers are impoverished.

Additional conclusions

• There is no viable alternative to trade – the international economic system is really the only realistic way to obtain scarce capital and technology from HICs

• Most overall benefits come from as-free-as-possible trade; hence move to an open orientation.

Trade strategies for development

• Export promotion – followed by many countries, incl South Korea, Malaysia, Thailand, Chile, etc

• Governments of above have championed export promotion strategies by giving various export incentives to generate export earnings and foreign exchange

• Governments have had to be selective in terms of what exports to promote

Trade strategies -- 2

• Early success of Japan shortly after WWII when the government encouraged steel exports, ship-building exports, and then later electronics led to other countries following the same strategy

• But not all industries chosen have succeeded and hence this kind of strategy has not always worked

Trade strategies - 3

• Import substitution strategy – impose high import tariffs on manufactured and industrial products in an effort to encourage growth of those sectors at home (infant industry argument)

• Strategy has not worked well in any country since domestic firms in those sectors have no incentive to improve their cost structures.

Trade strategies - 4

• Protected behind high tariff walls, domestic industrial products production remains high cost. To the extent these kinds of products are used in producing export products, the IS strategy handicaps growth of the country’s exports.

• Consequently, an IS strategy leads to low export growth as well as low import growth. Increasing isolation from the outside world.

Trade strategies - 5

• How to measure tariff protection? Two measures: Nominal rate of protection and Effective rate of protection.

• Nominal rate of protection = (P’ – P)/P, where P is the price of the industry’s product in the absence of any import tariff and P’ is the price of the product when an import tariff is in place. Example on next slide.

Nominal protection

• Suppose the landed price in Tampa of an automobile imported from Sweden is $40,000; the import tariff rate is 25%; then the price that a customer will pay to drive off with the car is 40,000+25% of 40,000 = $50,000. Nominal rate of protection = (50,000 – 40,000)/40,000 = 25%.

Effective rate of protection

• ERP = (V’ – V)/V where V is the value added without any import duties and V’ is value added with the import duty. ERP is the difference between value added (percent of output) in domestic prices and value added in world prices, expressed as a percentage of V.

ERP - 2

• ERP can be either positive or negative, depending on whether V<V’; for developing countries ERP is generally highly positive.

• ERP is a more useful concept compared to nominal rates of protection because it takes into account the protection granted to the final product and also to inputs.

Trade pessimism

• This is the sense that developing countries have poor export prospects because the products they export are not experiencing rapid demand growth (products being primary agricultural products and minerals) and because their overall prices are trending downward (terms-of-trade falling).

• Further, developed countries are producing substitutes for these export products.

Trade optimists

• The optimists argue that trade liberalization has large positive effects on economic growth and export performance.

• Liberalization promotes competition, leads to improvements in product quality, attracts foreign capital and expertise, and removes distortions that interfere with optimal allocation of capital.

Optimists -- 2

• The experiences of China, Malaysia, Chile bear out these optimists’ arguments.

• To provide greater impetus for trade liberalization, numerous regional trading arrangements or blocs have come into existence – NAFTA; ASEAN; MERCOSUR; etc.

• WTO Uruguay Round of 1995 was successfully completed.