Chapter 12

International
Trade Theory
and Development
Strategy

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12.1 Economic Globalization: An
Introduction

• Globalization- many interpretations

• Core economic meaning- the increased
openness of economies to international
trade, financial flows, and foreign direct
investment
• Concerns with globalization center around
the unevenness of the process, and risks

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12.2 International Trade: Some Key
Issues
• Many developing countries rely heavily on exports of
primary products with attendant risks and uncertainty
• Many developing countries also rely heavily on imports
(typically of machinery, capital goods, intermediate
producer goods, and consumer products)
• Many developing countries have chronic deficits on current
and capital accounts which depletes their reserves, causes
currency instability, and may slow economic growth
• Recently many developing countries sought to promote
exports and accumulate large foreign exchange reserves to
cushion against crises - spurring new policy debates

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12.2 International Trade: Some Key
Issues
• Five Basic Questions about Trade and
Development
– How does international trade affect economic
growth?
– How does trade alter the distribution of
income?
– How can trade promote development?
– Can developing countries determine how much
they trade?
– Is an outward-looking or an inward-looking
trade policy best?

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12.2 International Trade: Some Key
Issues
• The Importance of Exports to Different Developing
Nations
• Importance of exports to developing nations
• Exports of developing countries are generally less
diversified than those of developed countries
• Merchandise exports as a share of GDP are often
higher for developing countries

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Table 12.1 Merchandise Exports in Perspective:
Selected Countries, 2008

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Demand Elasticities and Export Earning
Instability

• Often low price elasticity of demand for

agricultural commodities but supply shocks
• Often low price elasticity of supply for
basic commodities but demand shocks
• Result can be export earnings instability;
risks to income
• Also, low income elasticity of demand for
primary products:

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The Terms of Trade and the Prebisch-
Singer Hypothesis

• Total export earnings depend upon:

– Total volume of exports sold; and,
– Price paid for exports
• Prebisch and Singer argued commodity export prices fall
over time, so developing countries lose revenue unless
they can continually increase export volumes
• They concluded that developing countries need to avoid
dependence on primary exports
• Some evidence relative prices within manufactures are
also diverging with falling prices for low-skill products

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12.3 The Traditional Theory of
International Trade
• Comparative advantage
– specialization
• Relative factor endowments and
international specialization: the
Neoclassical model
– Ricardo and Mill (static model)
– Heckscher and Ohlin (factor endowment
theory)
• Different products require productive factors in
different ratios
• Countries have different endowments of factors of
production

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Figure 12.1 Trade with Variable Factor Proportions
and Different Factor Endowments

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Figure 12.1 Trade with Variable Factor Proportions
and Different Factor Endowments (continued)

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12.3 The Traditional Theory of
International Trade (cont’d)

• Main conclusion of the neoclassical model is that

all countries gain from trade
• World output increases with trade
• Countries will tend to specialize in products that
use their abundant resources intensively
• International wage rates and capital costs will
gradually tend toward equalization
• Returns to owners of abundant resources will rise
relatively
• Trade will stimulate economic growth

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12.3 The Traditional Theory of
International Trade (cont’d)

• Trade theory and Development: The Traditional

Arguments
– Trade stimulates economic growth
– Trade promotes international and domestic equality
– Trade promotes and rewards sectors of comparative
advantage
– International prices and costs of production determine
trading volumes
– Outward-looking international policy is superior to
isolation

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 12.4 Critique of Traditional Free-Trade Theory,
in the Context of Developing-Country
Experience
• The following assumptions of the basic
Neoclassical model have been scrutinized:
– Fixed resources, full employment, international factor
immobility
– And fixed, freely available technology and consumer sovereignty
vs product cycle, ongoing development of synthetic substitutes
for developing countries exports, and opportunities for dynamic
gains in leading sectors
– Internal factor mobility vs different types of structural rigidities;
and perfect competition vs pervasive market power
– Governmental non-interference in trade vs active trade policies
– Balanced trade and international price adjustments vs instability
– Trade gains accruing to nationals vs export enclaves with
foreign ownership; distinction between GDP and GNI becomes
important

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12.4 The Critique of Traditional Free-Trade
Theory in the Context of Developing-Country
Experience

• Fixed Resources, Full Employment, and the

International Immobility of Capital and Skilled Labor
– Challenged by North-South trade models
• Porter’s “Competitive Advantage” theory:
– Traditional trade theory applies only to basic factors
(unskilled labor, physical resources)
– But creation of advanced factors (knowledge resources,
specialized infrastructure) is the first priority
– Central task to “escape from the straightjacket of factor-
driven national advantage”

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12.4 The Critique of Traditional Free-Trade
Theory in the Context of Developing-Country
Experience

• Alternative Theories
• Vent for Surplus theory

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Figure 12.2 The Vent-for-Surplus Theory of
Trade

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12.4 The Critique of Traditional Free-Trade
Theory in the Context of Developing-Country
Experience (cont’d)

• Fixed, Freely Available Technology and

Consumer Sovereignty
– Challenged by the Product Cycle theory
– Development of synthetic substitutes for
developing country exports

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12.4 The Critique of Traditional Free-Trade
Theory in the Context of Developing-Country
Experience (cont’d)

• International Factor Mobility, Perfect Competition,

and Uncertainty: Increasing Returns, Imperfect
Competition, and Issues in Specialization
– Structural realities in developing countries
– Increasing returns and exercise of monopolistic control
over world markets
– Risk and uncertainty inherent in international trading
arrangements

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12.4 The Critique of Traditional Free-Trade
Theory in the Context of Developing-Country
Experience (cont’d)

• The Absence of National Governments in

Trading Relations
– Definite role for State
– Industrial policy is crafted by governments
– Commercial policies instruments (tariffs,
quotas) are state constructs
– International policies can result in uneven
distribution of gains from trade

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12.4 The Critique of Traditional Free-Trade
Theory in the Context of Developing-Country
Experience (cont’d)

• Balanced Trade and International Price

Adjustments
– Unrealistic (example: impact of oil price hikes
of the 1970s)

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12.4 The Critique of Traditional Free-Trade
Theory in the Context of Developing-Country
Experience (cont’d)

• Trade gains accruing to nationals

– Enclave economies are promoted by trade
– Difference between GDP and GNI becomes
important

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12.4 The Critique of Traditional Free-Trade
Theory in the Context of Developing-Country
Experience (cont’d)

• Some Conclusions on Trade Theory and

Economic Development Strategy
– Trade can lead to rapid economic growth under
some circumstances
– Trade seems to reinforce existing income
inequalities
– Trade can benefit developing countries if they
can extract trade concessions from developed
countries
– Developing countries generally must trade
– Regional cooperation may help developing
countries
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Concepts for Review

• Absolute advantage • Comparative advantage

• Autarky • Current account
• Balanced trade • Customs Union
• Barter transactions • Depreciation
• Capital account • Devaluation
• Commodity terms of trade • Dual exchange rate
• Common Market • Economic Integration
• Economic Unions

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Concepts for Review (cont’d)

• Effective Rate of Protection • Factor price equalization

• Enclave economies • Flexible exchange rate
• Exchange Control • Foreign-exchange earnings
• Export dependence • Free market exchange rate
• Export earnings instability • Free trade
• Factor endowment trade • Free trade area
theory

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Concepts for Review (cont’d)

• Gains from trade • Increasing returns

• General Agreement on • Industrialization Strategy
Tariffs and Trade (GATT Approach
Globalization • Industrial policy
• Globalization • Infant industry
• Growth poles • International commodity
• Import substitution agreements
• Income elasticity of • Inward-looking
demand development policies

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Concepts for Review (cont’d)

• Managed float • Official exchange rate

• Monopolistic market control • Oligopolistic market control
• Multifiber Arrangement • Outward-looking
(MFA) development policies
• New protectionism • Overvalued exchange rate
• Nominal rate of protection • Parallel exchange rate
• Nontariff trade barriers • Prebisch-Singer thesis
• North-South trade models

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Concepts for Review (cont’d)

• Price elasticity of demand • Returns to scale

• Primary products • Risk
• Product Cycle • Specialization
• Product differentiation • Subsidy
• Quotas • Synthetic substitutes
• Regional trading bloc • Tariffs
• Rent • Trade creation
• Trade deficits

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Concepts for Review (cont’d)

• Trade diversion • Vent-for-surplus theory of

• Trade liberalization international trade
• Trade optimists • Wage-price spiral
• Trade pessimists • World Trade Organization
• Uncertainty (WTO)
• Undervalued exchange rate
• Uruguay Round
• Value added

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