12.
1 ECONOMIC GLOBALIZATION: AN INTRODUCTION
Globalization has many interpretations.
- process by which the economies of the world become more integrated, leading to a global
economy and, increasingly, global economic policymaking, for example, through international
agencies such as the World Trade Organization (WTO).
- Globalization also refers to an emerging “global culture,” in which people consume similar goods
and services across countries and use a common language of business, English; these changes
facilitate economic integration and are, in turn, further promoted by it.
Core economic meaning: the increased openness of economies to international trade, financial
flows, and foreign direct investment.
- The growing interconnection of all kinds across national governments and firms and directly
between peoples is a process that affects everyone in the world, even if so, far it still seems more
visible in the developed countries. But globalization can in many ways have a greater impact in
developing countries.
Concerns with globalization center around the unevenness of the process, and risks.
- RISKS: The potential downside of globalization is also greater for poorer countries if they
become locked into a pattern of dependence, if dualism within developing countries sharpens, or
if some of the poor are entirely bypassed by globalization.
- RISK: All countries may be affected by increased vulnerability to capital flows, as the 2008
financial crisis has seemed to confirm, but developing countries more so. All countries may
experience certain threats to their cultural identities, but developing countries the most.
- UNEVENESS: The trade rules negotiated under the auspices of the WTO are key examples of
how rules of the game are being created (rules are not balanced).
- UNEVENESS: They have greatly benefited some countries but have benefited less the poor
countries still trying to gain a foothold in growth and development through agriculture and facing
barriers put up by the very countries that are most promoting the benefits of trade openness:
Trade protectionism as practiced by developed countries tends to fall most heavily on the
poorest developing countries because developed-country protection focuses on agriculture.
Tariffs placed by developed countries on imports from developing countries—though currently
not very high by historical standards—were by 2010 still about double those placed on imports
coming from other developed countries.
- SOLUTION: International agreements are needed to level the globalization playing field for the
poor. Some of this leveling process involves international change, and some involves national
changes that can be facilitated by the international community.
12.2 INTERNATIONAL TRADE: SOME KEY ISSUES
Many developing countries rely heavily on exports of primary products with associated risks and
uncertainty
- In some of the smaller countries, a substantial percentage of the economy’s income is derived
from the overseas sale of agricultural and other primary products or commodities.
- Many other developing countries must still depend on nonmineral primary-product exports for
a relatively large fraction of their foreign-exchange earnings.
- Because the markets and prices for these exports are often unstable, primary-product EXPORT
DEPENDENCE carries with it a degree of risk and uncertainty that few nations desire. the long-
term trend for prices of primary goods is downward, as well as very volatile.
- High reliance on oil and other fuel exports has also brought with it substantial, if often hidden,
economic costs and political distortions. An outsize oil sector often acts as an enclave in the
economy, benefiting relatively few citizens, yet resulting in reduced exports from other sectors of
the economy that might do more to benefit development in the long term.
- Export dependence also extends to services, notably tourism, which is “exported” when foreign
visitors purchase domestically produced services. “Arab Spring”, such experiences also illustrate the
benefits of diversification.
Many developing countries also rely heavily on imports (typically of machinery, capital goods,
intermediate producer goods, and consumer products)
- import demands exceeded their capacity to generate sufficient revenues from the sale of exports
for much of the post–World War II period.
Many developing countries suffer from chronic deficits on current and capital accounts which depletes
their reserves, causes currency instability, and a slowdown in economic growth
- The debt burden of repaying earlier international loans and investments often becomes acute.
- A chronic excess of foreign expenditures over receipts (may be related to its vulnerability to
global economic disturbances) can significantly retard development efforts. It can also greatly
limit a low-income nation’s ability to determine and pursue its most desirable economic
strategies.
- Lessons of 2008 financial crisis
By opening their economies and societies to global trade and commerce and by looking outward to the
rest of the world, developing countries invite not only the international transfer of goods, services, and
financial resources but also the developmental or anti-developmental influences of the transfer of
production technologies; consumption patterns; institutional and organizational arrangements;
educational, health, and social systems; and the more general values, ideals, and lifestyles of the
developed nations of the world.
To design the most beneficial strategy: Individual nations must appraise their present and prospective
situations in the world community realistically in the light of their specific development objectives.
Five Basic Questions about Trade and Development
Focus on traditional and more contemporary theories of international trade in the context of five basic
themes or questions of particular importance to developing nations.
1. How does international trade affect economic growth?
- This is the traditional “trade as an engine of growth” controversy, set in terms of
contemporary development aspirations.
2. How does trade alter the distribution of income?
- Is trade a force for international and domestic equality or inequality? In other words, how
are the gains and losses distributed, and who benefits?
3. How can trade promote development?
- Under what conditions can trade help a nation to achieve its development objectives?
4. Can LDCs determine how much they trade?
- how much it trades or which products and services it sells?
5. What is the best trade policy? Outward-looking or an inward-looking?
- outward-looking policy (freer trade, expanded flows of capital and human resources,
etc.)
- inward-looking (protectionism in the interest of self-reliance)
IMPORTANCE OF EXPORTS TO DEVELOPING NATIONS
Exports of LDCs are less diversified than those of developed countries.
- Manufactured exports themselves are highly diverse in the extent of their skill and technology
content.
- many developing countries are also dependent on one or a few commodity exports. In addition to
losing the benefits of maintaining a competitive manufacturing sector, this carries substantial
risks of facing falling relative prices in the long run and highly unstable prices in the short run.
Developing countries are generally more dependent on trade than developed countries are.
- much higher relative prices of nontraded services in developed than in developing countries.
- most trade is in merchandise, for which price disparities are smaller across countries
Among developing countries, small countries are more dependent on foreign trade than most relatively
large developing countries.
- This is reflected in the case of traditionally export-oriented Japan, whose merchandise exports
amounted to roughly 13% of GDP in 2012. In contrast, many developing countries with similar
sized populations export a much higher share of output, including Nigeria, Bangladesh, Russia,
Mexico, Philippines, and Vietnam, and have a merchandise export share that is substantially
higher than that of Japan.
Demand Elasticities and Export Earnings Instability
Low-income elasticity of demand for primary products
- The percentage increase in quantity of primary agricultural products and most raw materials
demanded by importers (mostly rich nations) will rise by less than the percentage increase in their
gross national incomes (GNIs)
- Consequently, when incomes rise in rich countries, their demand for food, food products, and raw
materials from the developing nations goes up relatively slowly, whereas demand for
manufactures goes up relatively rapidly. The net result of these low-income elasticities of demand
is the tendency for the relative price of primary products to decline over time.
Low price elasticity of demand and supply
- any shifts in demand or supply curves can cause large and volatile price fluctuations
Export earnings instability
- Wide fluctuations in developing country earnings on commodity exports resulting from low price
and income elasticities of demand leading to erratic movements in export prices (lower and less
predictable rates of economic growth).
The Terms of Trade and the Prebisch-Singer Hypothesis
Total export earnings depend on:
1. Total volume of exports sold
2. Price paid for exports
Prebisch and Singer argue that export prices fall over time, so LDCs lose revenue unless they can
continually increase export volumes
Prebisch and Singer think LDCs need to avoid a dependence on primary exports
12.3 THE TRADITIONAL TRADE THEORY
COMPARATIVE ADVANTAGE MODEL
- Production of a commodity at a lower opportunity cost than any of the alternative commodities
that could be produced.
Diverse preferences and needs, as well as varied physical and financial endowments, make trade
economically profitable.
- People usually find it profitable to trade the things they possess in large quantities relative to their
tastes or needs in return for things they want more urgently. Because it is virtually impossible for
individuals or families to provide themselves with all the consumption requirements of even the
simplest life, they usually find it profitable to engage in the activities for which they are best
suited or have a comparative advantage in terms of their natural abilities or resource
endowments. They can then exchange any surplus of these home-produced commodities for
products that others may be relatively more suited to produce.
Countries specialize in products in which they have a comparative advantage in terms of their natural
abilities.
- Countries, like people, specialize in a limited range of production activities because it is to their
advantage to do so. They specialize in activities where the gains from specialization are likely to
be the largest.
- Why should costs differ from country to country? The answer is to be found in international
differences in the structure of costs and prices. Some things (manufactured goods) are relatively
cheaper to produce in Germany and can profitably be exported to other countries like Kenya;
other things (agricultural goods) can be produced in Kenya at a lower relative cost and are
therefore imported into Germany in exchange for its manufactures.
EXAMPLE:
Manufactured commodities are relatively cheaper to produce in country A. Agricultural products
can be produced at a lower relative cost in country B.
Country A produces manufactures (i.e. cameras, automobiles, etc.) more cheaply than B and
exchange these products for B’s agricultural produce (i.e. fruits, vegetables, etc.).
- Because the commodity cost differences between countries are greater for the manufactured
goods than for agricultural products, it will be to Germany’s advantage to specialize in the
production of manufactured goods and exchange them for Kenya’s agricultural produce.
Principle of Comparative Advantage: countries should completely specialize in the export of
commodities that they can produce at lowest relative cost.
- So even though Germany may have an absolute advantage in the cost of both commodities, its
comparative cost advantage lies in manufactured goods. Conversely, Kenya may be at an absolute
disadvantage vis-à-vis Germany in both manufacturing and agriculture. It is this phenomenon of
differences in comparative advantage that gives rise to beneficial trade even among the most
unequal trading partners.
FACTOR ENDOWMENT MODEL
- primarily associated with David Ricardo and John Stuart Mill, was modified and refined in the
twentieth century by two Swedish economists, Eli Hecksher and Bertil Ohlin,
- The neoclassical model of free trade, which postulates that countries will tend to specialize in the
production of the commodities that make use of their abundant factors of production (land, labor,
capital, etc.).
Modification of the comparative advantage model to account for differences in factor supplies (i.e. land,
labor, capital) between countries
- enables us to describe analytically the impact of economic growth on trade patterns and the
impact of trade on the structure of national economies and on the differential returns or payments
to various factors of production.
Trade arises from: Technological differences (i.e. different labor productivity levels)
- CLASSIC LABOR COST MODEL: trade arises because of fixed but differing labor
productivities for different commodities in different countries.
- FEM: assumes away inherent differences in relative labor productivity by postulating that all
countries have access to the same technological possibilities for all commodities
- If domestic factor prices were the same, all countries would use identical methods of production
and would therefore have the same relative domestic product price ratios and factor
productivities.
- Countries with cheap labor will have a relative cost and price advantage over countries with
relatively expensive labor in commodities that make intensive use of labor
TWO ASSUMPTIONS IN FEM:
1. Different products require productive factors in different relative proportions.
o Agricultural goods are more labor intensive than manufactured goods (i.e. growing tea
requires more labor per unit capital than building a TV set) and vice versa.
o certain products will always be relatively more capital-intensive while others will be
relatively more labor-intensive.
2. Countries have different endowments of factors of production
o Some countries are capital abundant (i.e. U.S., France, Italy, etc.) while others are labor
abundant (i.e. India, Colombia, Egypt, etc.)
Capital abundant countries incompletely specialize in the production of capital-intensive commodities
(i.e. electronic equipment, aircrafts, computers).
Labor abundant countries incompletely specialize in labor intensive commodities (i.e. food, raw
materials, minerals).
- encouraged developing countries to focus on their labor- and land-intensive primary-product
exports
- by trading these primary commodities for the manufactured goods that developed countries were
theoretically best suited to produce, developing nations could realize the enormous potential
benefits to be had from free trade with the richer nations of the world.
FIGURE 12.
- Nations are assumed to be operating initially at some point on their concave (or increasing
opportunity cost) production possibility frontier, determined by domestic demand conditions.
- Figure 12.1 portrays the theoretical benefits of free trade with Less Developed World’s domestic
(no-trade) production possibility frontier shown in Figure 12.1a and Rest of World’s frontier in
Figure 12.1b.
- Note that with a closed economy, both countries will be producing both commodities. However,
Less Developed World, being poorer, will produce a greater proportion of food products in its
(smaller) total output.
- It will therefore reallocate resources away from its costly capital-intensive manufacturing sector
and specialize more in labor-intensive agricultural production.
- for every unit of agriculture that Less Developed World exports to Rest of World, it can import 2
units of manufactured goods.
- CONCLUSION: All countries gain from trade and world output is increased.
CAM FEM
CAM claims complete specialization: FEM claims incomplete specialization:
- produce only the comparative advantage good. - capital abundant country will produce labor
intensive products too, but it will spend more of
its endowment base on capital intensive
commodities.
CAM makes no such claim. FEM claims factor price equalization between
trading nations.
- increased labor demand in LDCs pushes w/r up
- up increased capital demand in MDCs pushes
w/r down.
Trade Theory and Development: The Traditional Arguments
1. Trade is an important stimulator of economic growth
a. enlarges consumption, increase world output, provides access to scarce resources
2. Trade tends to promote greater international and domestic equality
a. by equalizing factor prices, raise real incomes of trading countries, make efficient use of
each nation’s resource endowments (e.g., raising relative wages in labor-abundant
countries and lowering them in labor-scarce countries).
3. Trade help countries achieve development by promoting and rewarding sectors of the economy
where individual countries possess a comparative advantage (economies of scale)
4. International prices and costs of production determine how much a country should trade in
order to maximize its national welfare
a. Countries should follow the principle of comparative advantage and not try to interfere
with the free workings of the market through government policies that either promote
exports or restrict imports.
5. To promote growth and development, an outward-looking international policy is required
a. self-reliance based on partial or complete isolation is asserted to be economically inferior
to participation in a world of unlimited free trade.
12.4 THE CRITIQUE OF TRADITIONAL FREE-TRADE THEORY IN THE CONTEXT OF
DEVELOPING-COUNTRY EXPERIENCE
- to recognize that the real world is beset by national protectionism, international noncompetitive pricing
policies, and other market failures.
Basic assumptions of the traditional neoclassical trade model:
1. All productive resources are fixed in quantity and constant in quality across nations and fully
employed
2. Technology of production is fixed and freely available to all nations
3. Factors of production are perfectly mobile between different production activities within nations
4. National government plays no role in international economic relations
5. Trade is balanced for each country at any point of time
6. Gain from trade that accrue to any country benefit the nationals of the country
Fixed Resources, Full Employment, and the International Immobility of Capital and Skilled Labor.
Factor endowments and comparative costs are not given but are in a state of constant change
- In reality, the world economy is characterized by rapid change, and factors of production are
fixed neither in quantity nor in quality.
- LDCs: locked into a stagnant situation that perpetuates their comparative advantage in unskilled,
unproductive activities. Static efficiency can become dynamic inefficiency.
1. North-South trade models – Trade and development theories that focus on the unequal
exchange between the North developed countries and the South developing countries in an
attempt to explain why the South gains less from trade than the North.
2. Michael Porter’s Competitive Advantage Theory - He argues that standard trade theory applies
only to basic factors like undeveloped physical resources and unskilled labor
3. Vent for Surplus theory - The contention that opening world markets to developing countries
through international trade allows those countries to make better use of formerly underutilized
land and labor resources so as to produce larger primary-product outputs, the surpluses of which
can be exported.
Fixed, Freely Available Technology and Consumer Sovereignty.
Consumer sovereignty – consumers hold the power to influence production decisions, based on what
goods and services they purchase. It is thought that consumer preference will influence what firms decide
to produce.
Technological change impacts developing-countries’ export earnings.
- Development of synthetic substitutes for developing country exports.
- Product Cycle theory
Internal Factor Mobility, Perfect Competition, and Uncertainty: increasing returns, imperfect
competition, and issues in specialization.
The assumption that nations are readily able to adjust their economic structure to fit the international
market is not realistic
- Reallocations of resources are extremely difficult to achieve in practice
- Structural realities in developing countries
- Increasing returns and hence decreasing costs of production
- Exercise of monopolistic control over world markets
- Risk and uncertainty inherent in international trading arrangements.
The Absence of National Governments in Trading Relations:
There is no “international government” to act in case of the generation of growth poles.
Highly uneven gains from trade can easily become self-sustaining
- 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.
World Trade Organization
Balanced Trade and International Price Adjustments.
Free International Market (market always in equilibrium)
Demand is equal to the supply (no balanced of payments problems)
- Unrealistic (oil price hikes of the 70s).
Trade gains accruing to nationals:
If developing countries benefit from trade, it is the people of these countries who reap the benefits
However, enclave economies are promoted by trade e.g.
- foreigners often pay very low rents for the right of using the land
- bring their own foreign capital
- bring their own foreign skill labor
- hire local (cheap) unskilled labor
- Therefore, minimum effect on the rest of the economy
Difference between GDP and GNI becomes important
SOME CONCLUSIONS ON TRADE THEORY & ECONOMIC DEVELOPMENT STRATEGY
Trade can lead to rapid economic growth under some circumstances
Trade seems to reinforce existing income inequalities
Trade can benefit LDCs if they can extract trade concessions from developed countries
LDCs generally must trade
Regional cooperation may help LDCs
Introduction to Trade Theory
What It’s For
The first purpose of trade theory is to explain observed trade. That is, we would like to be able to start
with information about the characteristics of trading countries, and from those characteristics deduce what
they actually trade, and be right. That’s why we have a variety of models that postulate different kinds of
characteristics as the reasons for trade.
Secondly, it would be nice to know about the effects of trade on the domestic economy.
A third purpose is to evaluate different kinds of policy. Here it is good to remember that most trade
theory is based on neoclassical microeconomics, which assumes a world of atomistic individual
consumers and firms. The consumers pursue happiness (“maximizing utility”) and the firms maximize
profits, with the usual assumptions of perfect information, perfect competition, and so on. In this world
choice is good, and restrictions on the choices of consumers or firms always reduce their abilities to
optimize. This is essentially why this theory tends to favor freer trade.
Varieties of Theory
Neoclassical theory has been successful because it is simple (though it may not always look simple when
you’re learning it). For example most neoclassical trade theories assume that the world only has two
countries (which means that country A’s exports must be country B’s imports). They also usually assume
only two commodities in international trade. If you try to “generalize” by adding more countries or
commodities, the math breaks down and you don’t get clear results.
One of the most important, and limiting, assumptions in neoclassical trade theory is that firms produce
under conditions of perfect competition. Any industry that is controlled by a small number of firms is not
perfectly competitive. There is a whole area of economics, initially developed by Joan Robinson in the
1920's, that explores what happens under imperfect competition. We won’t get into it in this course, but
if there are significant “economies of scale” (which means that per-unit costs are smaller for bigger
firms), then you can get very different policy recommendations out of your model.
Does this mean that the simple neoclassical models are useless? No. Their most important use is as a
way to help you think through a set of issues. Neoclassical theory is especially good at pointing out the
links between different markets. But you should be suspicious if you hear anyone saying that a theory
“shows” that one policy or another is the right one in the real world.
The most famous neoclassical model is also the simplest — the model developed by the English political
economist David Ricardo in the early 1800s. It’s simple because Ricardo assumes that there is only one
“factor of production” (i.e. type of input) — labor. This model makes the point that trade should, in
principle, benefit both parties even if one is more efficient. More sophisticated models were developed in
the current century as economists learned more math. The best-known is the Heckscher-Ohlin model,
named after a couple of Swedish economists, which is often called Heckscher-Ohlin-Samuelson (HOS)
because of the important contributions made by the U.S. economist Paul Samuelson. HOS includes two
factors of production (e.g. labor and land), and it shows that particular factors of production may be hurt
by trade, though it still agrees with Ricardo that there are overall gains from trade.
There are many other varieties of trade theory, making different assumptions and getting different results.
One kind that has gotten a lot of attention in recent years assumes increasing returns to scale, which
means that large producers are more efficient than smaller producers. Ricardo, as noted above, assumed
constant scale returns. Neoclassical theories like HOS assume decreasing returns and get generally
similar results. If you allow increasing returns then bigger is better, and one nation may end up
dominating an industry, but it's hard to say which nation will do so. In this case, the ability to intimidate
and bluff may be important. So increasing returns undermines the ability of theory to explain or predict
observed trade. Perhaps more seriously, scale economies may stack the deck against late-developers.
