International Economics

Woraphon Yamaka

Chapter 7:Trade Policies for the Developing Nations

Modified form International Economics 9th Edition byRobert J. Carbaugh

Developing nations’ trade Very dependent on the developed industrial

countries as export markets and source of imports

Exports are heavily weighted toward primary products (agricultural goods, raw materials, fuels) and labor-intensive manufactures

Share of manufactured exports is increasing, but mainly in a small number of newly industrialized nations (such as South Korea, Hong Kong)

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Developing nations and trade

Developing nations: dependence on primary products (2000)

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Developing nations and trade

Major export As % ofCountry product total exports

Nigeria Oil 96Saudi Arabia Oil 86Venezuela Oil 86Burundi Coffee 79Mauritania Iron ore 56Zambia Copper 56Ethiopia Coffee 54Chad Cotton 40

Developing nations’ concerns Question whether gains from trade with industrial

countries have been fairly distributed Face problems of unstable export markets

Concentration on one or a few primary-product exports combined with inelastic supply and demand conditions

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Developing nations and trade

Export price instability for a developing nation

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When the supply of a commodity is highly price-inelastic, decreases (or increases) in demand will generate wide variations in price. When the demand for a commodity is highly price-inelastic, (increases or decreases) in supply will generate wide variations in price as well.

Developing nations’ concerns

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Figure (a), suppose that decreasing foreign incomes cause the market demand curve for coffee to decrease to D1. With the supply of coffee being inelastic, the decrease in demand causes a substantial decline in market price, from $4.50 to $2.00 per pound. The revenues of coffee producers thus fall to $8 million. Part of this decrease represents a fall in producer profit.

Developing nations’ concernsExport price instability for a developing nation

Figure (b). Suppose that favorable growing conditions cause a rightward shift in the market supply curve of coffee to S1. The result is a substantial drop in price from $4.50 to $2 per pound, and producer revenues fall to $14 million ($2 7 million $14 million).

We see that cost and revenues can be very volatile when demand or supply conditions are inelastic.

Developing nations’ concerns Another concern is that they face worsening terms of

trade as relative value of primary products has fallen compared to manufactured goods they import( price of primary goods manufacture goods)

Face limited market access for exports because of protectionism Especially for agricultural and labor-intensive goods

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Developing nations and trade

Remedies for developing nation problems

Stabilizing commodity prices - international commodity agreements In an attempt to stabilize export prices and revenues of primary products, developing nations have attempted to form international commodity agreements (ICAs). These agreements are between leading producing and consuming nations of commodities such as coffee, rubber and cocoa about matters such as stabilizing prices, assuring adequate supplies to consumers, and promoting the economic development of producers.

1) Production and export controlsIf an ICA accounts for a large share of total world output (or exports) of a commodity, its members may agree on production and export controls to stabilize export: The countries will set the target price, if the price is expected to be low, the countries will make an agreement to reduce the production, if the price is expected to be high in the future, the countries will increase the production. (Not too swing)

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Developing nations and trade

Remedies for developing nation problems

2) Buffer stocks Another technique for limiting commodity price swings is the buffer stock, The buffer stock consists of supplies of a commodity financed and held by the producers’ association. The buffer stock manager buys from the market when supplies are abundant and prices are falling below acceptable levels, and sells from the buffer stock when supplies are tight and prices are high.

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Developing nations and trade

Buffer stocks: price ceiling and price support

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Developing nations and trade

During periods of rising in tin demand, the buffer-stock manager sells tin to prevent the price from rising above the ceiling level. However, prolonged defense of the ceiling price may result in lack of the tin stockpile, which destroy the effectiveness of this price-stabilization tool and leads to an upward revision of the ceiling price. During periods of abundant tin supplies, the manager purchases tin to prevent the price from falling below the floor level. However, prolonged defense of the price floor may exhaust the funds to purchase excess supplies of tin at the floor price and may lead to a downward revision of the floor price.

Remedies for developing nation problems

3) Multilateral contractsThis is another method of stabilizing commodity prices. Such contracts generally stipulate a minimum price at which importers will purchase guaranteed quantities from the producing nations and a maximum price at which producing nations will sell guaranteed amounts to the importers. Such purchases and sales are designed to hold prices within a target range. Trading under a multilateral contract has often occurred among several exporting and importing nations

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Developing nations and trade

Generalized system of preferences (GSP)But experience with commodity agreements has been mixed, at best, and application of the GSP is spotty

Cartels (Trade agreement) Attempt to restrict competition among producers and

support higher prices for their product to maximize profit of nations such as OPEC

Face obstacles:

Incentive to cheat (one may cheat)

Number of sellers (The larger the number of sellers, the more difficult it is to form a cartel)

Cost and demand differences (Such differences result in a different profit-maximizing price for each member, so there is no single price that can be agreed upon by all members)

Potential competition (Attracting many new competitions, thus a successful cartel thus depends on its ability to block the market)

Economic downturns

Substitute goods (buyers can substitute other goods)

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Developing nations and trade

Cartels (OPEC agreement)13

Developing nations and trade

As a cartel, OPEC can increase the price of oil from $20 to $30 per barrel by assigning production quotas to its members. The quotas decrease output from 1,500 to 1,000 barrels per day and permit producers that were pricing oil at average cost to realize a profit. Each producer has the incentive to increase output beyond its assigned quota, to the point at which the OPEC price equals marginal cost. But if all producers increase output in this manner, there will be a surplus of oil at the cartel price, forcing the price of oil back to $20 per barrel.

Growth strategies

Import substitution Trade barriers protect emerging domestic industries

Popular in 1950s and 1960s

Involves extensive use of trade barriers to protect domestic industries from import competition. The strategy is inward oriented in that trade and industrial incentives favor production for the domestic market over the export market

Export-led growth Focus on export of manufactures as engine of growth

Became more common starting in 1970s

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Developing nations and trade

Besides seeking economic assistance from advanced nations, developing nations have pursued two competing strategies for industrialization: an inward-looking strategy (import substitution) in which industries are established largely to supply the domestic market, and foreign trade is assigned negligible importance; and an outward looking strategy (export-led growth) of encouraging the development of industries in which the nation enjoys comparative advantage, with heavy reliance on foreign nations as purchasers of the increased production of exportable goods.

Import substitution: Advantage The risks of establishing a home industry to replace

imports are low because the home market for the manufactured good already exists.

It is easier for a developing nation to protect its manufacturers against foreign competitors than to force advanced nations to reduce their trade restrictions on products exported by developing nations.

To avoid the import tariff walls of the developing nation, foreigners have an incentive to locate manufacturing plants in the nation, thus providing jobs for local workers.

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Growth strategies

Import substitution: Disadvantage Because trade restrictions shelter domestic industries from

international competition, they have no incentive to increase their efficiency.

Given the small size of the domestic market in many developing nations, manufacturers cannot take advantage of economies of scale and thus have high unit costs.

Because the resources employed in the protected industry would otherwise have been employed elsewhere, protection of import-competing producers automatically discriminates against all other producers, including potential exporting ones. (Inefficient production)

Once investment is sunk in activities that were profitable only because of tariffs and quotas, any attempt to remove those restrictions is generally strongly resisted.

Import substitution also breeds corruption. The more protected the economy, the greater the gains to be had from illicit activity such as smuggling.

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Growth strategies

Export-led growth: Advantage Encourages industries in which developing countries

are likely to have a comparative advantage - such as labor-intensive manufactures

Export markets allow domestic producers to utilize economies of scale

Low level of trade restrictions forces domestic firms to remain competitive

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Growth strategies

Export-led growth: Disadvantage Main disadvantage to export-led growth is that it

depends on the ability and willingness of (advanced) industrial nations to absorb large quantities of manufactures from developing countries

In other words, it is sensitive to economic cycles and protectionist pressures in the export markets

It depends on the market, not us

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Growth strategies

Growth strategies: case studies Brazil - import substitution in computers East Asian newly industrialized countries - export-led growth

Generally very successful, until 1997 crisis

High rates of investment and building human capital Problems overlooked: pollution, income distribution

Vulnerable (weaken) to protectionist reactions elsewhere

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Growth strategies

Growth strategies: case studies China - transformation from extreme import-

substitution to focus on exports

Dramatic change in China’s role in the world economy has accompanied rapid growth in its domestic economy

Heavy state role in economy (legacy of central planning) raises issues of fairness

Political issues, lack of enforcement of some agreements (intellectual property) complicate economic relations (One of US-CHN trade war reason)

Accession to the WTO will mean adherence to global trade rules

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Growth strategies