CHAPTER TWO

2. THEORETICAL AND EMPIRICAL LITERATURE REVIEW,

2.1 Theoretical Literature Review

International trade is simply known as the exchange of goods and services between nations of the
world. At least two countries should be involved in the activities that are the aggregate of
activities relating to trading between merchants across borders. Traders engage in economic
activities for the purpose of the profit maximization engendered from differentials among
international economic environment of nations (Adedeji, 2006). This section highlight same
major theoretical, trade strategy, basis and gains of trade issue related with the topic of the
research and it investigates into empirical literature with an overview of the major relevant
empirical works should be examine

2.1.2 Mercantilist Trade Theory

Some of the finders are Jean Baptise Colbert and Thomas Hobbes. According to the mercantilist
trade theory the key way for a nation to become rich and powerful is to export more than it
import. That is the most key way in which a country could be prosperous was to acquire more
precious metals such as gold. The country should ensure that the volume of exports was better
than the volume of imports. Exports may be enhanced through domestic production. Controls
should exist over working hours, wage rates, and prices. The mercantilist believe that trade has to
be controlled, regulated and restricted. The control, regulation and restriction can be in the form
of increase tariffs, quotas and other commercial policies (example import licensing, embargo,
foreign exchange control, devaluation and import monopoly) that will minimize imports in order
to protect a nation’s trade position. The country can aggregate wealth from gold and silver. This
will lead to surplus exports that will add to the economic strength and riches of the country.
However, mercantilism did not favor free trade and the need for regulation to maintain order in
human affairs and economic affairs were taking for granted. In addition, the key mistake in
mercantilist thinking was the belief that trade was a zero sum activity. That is, one nation’s gain
is another nation’s loss (Ray, 2011; Akeem, 2011; Gerber, 2007).
2.1.3 Absolute Advantage Trade Theory

Absolute advantage trade theory was propounded by Adam Smith in his famous book “Wealth of
Nation” 1776. Smith advocated free trade as the best policy for nations of the world. According
to Adam Smith with free trade each nation could specialize in the production of those
commodities in which it could produce more efficiently than the other nations, and then import
those commodities in which it could produces less efficiently. That is according to the absolute
advantage trade theory, a nation should specialize in the production of export of commodities in
which it has lower cost or absolute cost advantages over others. This international specialization
of factors in production would result in increase in world output, which would be shared by
trading nations. Thus, a nation need not gain at the expense of other nations, all nations could
gain simultaneously. On the other hand, the same country should import a commodity in which it
has higher or absolute cost disadvantage granted (Ray, 2011; Kalra, 1997; Akeem, 2011)

2.1.4 Comparative Advantage Theory (Comparative Cost Principle)

The theory of comparative advantage was demonstrated by David Ricardo (1772 – 1823).
According to Ricardo a country should specialize in producing and exporting only those goods
and services which it can produce more efficiently, that is, at lower opportunity cost than other
goods and services which it should import. Comparative advantage results from different
endowments of the factors of production, that is, capital, land, labor, entrepreneurial skill, power,
resources, and technology and so on. It therefore follows that free trade is beneficial to all
countries, because each can gain if it specializes according to its comparative advantage.
Alternatively, the principle states that trade is beneficial even if a country does not have an
absolute advantage in the production of a good, but does have a cost benefit of producing the
good relative to its trading partner. This principle explains why countries specialize in producing
and exporting products based on their endowment of resources. The concept is especially
important in international trade, suggesting that countries should specialize in areas in which
they have a comparative advantage. Differently argued, in the domain of international trade, each
nation takes to the production of only those products in the manufacturer of which, she is at an
advantage in terms of skill, equipment, machinery or tradition, as compared to the other nations.
Thus, with international specialization that has become order of the day, each nation concentrates
on the making of only such products in which it has the maximum comparative advantage and
the least comparative cost (Akeem 2011; Ray, 2011).

2.1.5 Heckscher – Ohlin Trade Theory (factor endowment theory).

This is an explanation of trade patterns, offered by the Swedish economist Bertil Heckscher and
subsequently developed by his pupil, Eli Ohlin, that contend that international trade is based on
differences in comparative costs and attempts to explain the factors that make for differences in
comparative costs. Different goods require different factor proportions, and different countries
have different relative factor endowments; countries will tend to have comparative advantages in
producing the goods that use their abundant factors more intensively; for this reason each
country will end up exporting its abundant factor goods in exchange for imported goods that use
its scarce factors more intensively. That is, the model takes up the case of two trading countries
with different endowment facilities. A nation that has a factor available in plenty would have it at
a lower cost as well. The other country likewise would have relatively cheaper, the other factor
that it has in abundance. The model works on the presumption of two goods and two factors.
Such a proposition is known as factor – abundance hypothesis. Thus, according to the theory, a
nation should produce and export a product for which the large amount of the relative abundance
resources is used. Such countries should import the commodity in which a great deal of its
relative scarce and expensive factors is used (Shim et al. 1995; Kalra, 1997; Akkem, 2011; Ray,
2011). The Heckscher-Ohlin model and Ricardian trade theory both predict that trade promotes
the specialization of a country so that it can realize trading gains (Oster Feld, 2007).
From the above discussions, it could be seen that trade is an engine of economic growth. This is
because; (1) there is efficient allocation of resources; (2) it encourages investment; (3) it leads to
division of labor and specialization; (4) it increases resource productivity; (5) total world output
of commodities seems to increase (6) increase in the world output will increase the variety of
goods available to consumers; (7) there is an increase in competition which bring prices down;
(8) there is technological transfer; (9) there is also job creation; (10) generation of income and
relaxation of foreign exchange restraints; (11) maintains balance of payment position and
promotes world peace. However, sometimes foreign trade may come with some challenges like
language barriers and currency differentials (Akeem, 2011; Nnadozie, 2003).
.
2.2 The Basis and Gains of Trade
Almost all economies engage in the international trade since international trade is essentially a
mechanism, which links the countries of the world through commodities, service flows and
factor movements (mannur, 1996). Trade is exchange of goods and services, out which gains
from trade come in the form of economic utilities satisfaction to customers. International trade is
concerned with the business transaction that takes place between citizens of different nations
with consideration of commercial diplomacy. That emanate from such transactions nations trade
with each other for fundamentally the same reasons that individuals or regions engage in
exchange of goods and services to obtain the benefits of specialization.

Countries differ interims of natural resource endowments, climate conditions, mineral resources
and mines labour and capital resources, technological capitalises, enterprinals and managerial
skills and a whole host of other variables with determine the capabilities of countries to produce
gods and services in the most efficient manner i.e. at possible lowest cost of production. Thus,
since nations like individuals, are not equal suited to produce all goods, either because they are
different endowed or for other reasons, all would benefit if each specialized in what it could do
best and obtained its other needs thorough exchange.

One of the immediate causes of international trade is the existence of the differences in the
process of goods and services between countries. But price are reflection placation of the cost of
production, production cost in turn cost intranet reflection of wages paid to labour, the cost of
capital, the valve of land the cost of rate material. And, especially the degree of affiance of
productive process. The cost of production are comprise all these elements although any one
element may be powerful enough to be the determining factors in particular international cost –
price relationship the factors of production are not the only influences on cost and prices. The
efficiency with which they a rued i.e. productivity is also of importance.

The classical and neoclassical economists attached so much importance to international trade in a
country development that thus regarded it as an engine of growth. The benefits from trade are
specialize in the production of a few goods due to international trade and division of labour, it
exports those commodities which it produces cheaper in exchange for what others can produce of
at a lower cost. It gains from trade and the increases in national income which in turn, raises the
level of output and the growth rate of economy. Thus, the higher the level of output through
trade tends to break the vicious circle of productivity and promotes economic development (Ml
Jhinqan P. 274).

Arise in export leads to an increase in national output. This an example of what Rostov calls” A
leading sector’ in a full employment economy. A favourable change in demand abroad or an
innovation reducing cost at home, may expand exports, improve the term of trade on large the
gains from trade. This will increase and in turn leads to still higher incomes through higher
savings; more trade means more growth.

Resources may be unemployed or under employed If export is the modern efficient sector it
leads to expanding more resources to be drawn from under employed and low productivity sector
to occupations where they are more productive. This is another gain from trade.

Moreover, many under developed country have specialized in the production of one or two stable
commodities. If efforts are mode to export them, they tend to widen the market. The existing
resources are employed more productively and the resources allocation becomes more efficient
with given production function. As a result unemployment and under employment are reduce;
domestic saving and investment increases: there is large inflow of factor inputs in to the
expanding export sector and greaser back ward and forward linkages with other sector of the
economy.

2.2.1 Trade Strategies and Development: import Substitution vs. Export

promotion
In a broader sense the trade policies that have been undertaken by developing countries for the
past four decades can be categorized as outward looking and in ward looking development
policies. Proponents of the view that trade brings development encourage outward looking
development policy to straighten(1973),quoted in Todaro (1994), the outward looking
development policy “encouraged not only free trade but also free movement of capital, workers,
enterprises , students and open system of communications”(p.484).In contrast opponents of
traditional view advocate an inward looking development policy. This policy stresses the need
for LDCs to implement their own styles of development to their resource endowments.

I. Import Substitution Trade Strategy

According to Salvatore (1990), three advantage of the IS strategy can be cited:
 1) The market for industrial product already exists, as evidenced by import of the
commodity, so that risk are reduced in setting up an industry to replace imports

2) It is easier for developing nations to protect their domestic market against foreign
computation then to force the developed nation to lower trade barriers against their
manufactured exports.

3) Foreign firms are induced to establish the so called “Tariffs factories “to over comes the
tariff well of developing nations”(p.327)

One of the principal argument for the policy of import substitution is that it avoids the
uncertainties and risk involving in finding markets for import substitution in industries because
when the import are shut off an already established market is secured for the new industries.

Another argument is based on contention that the demand of developing countries for industrial
import increases much more rapidly than the foreign demand for its export. Such countries
export primary products which have a sluggish foreign demand and are therefore unable to
import industrial products sufficiently in exchange for exports. Thus, the need arises for
producing industrial goods at home to meet the domestic demand (I bid 1990).

The employment argument in support of industrialization by import substitution contented that

import substitution is necessary to provide gainful employment to the existing unemployment to
absorb surplus man power arising from increase in agricultural tariffs productivity through the
use of modern labour saving techniques and to engage the growing labour force of population
increases.

The ultimate aim of industrialization via import substitution is to achieve self-sufficiency in the
production of finished consumer goods, intermediate goods and machinery; and to export them
to developing and developed countries. That it was believed that industrialization would be
facilitated through a protectionist regime.

“.. Import substitution is generally necessary for outward growth to succeed. Most important;
the success of import substitution is linked to the development of productivity in the
agricultural sector. If the latter falls to grow rapidly, import substitution will fail and
successful export based growth will not occur” (p.536).
II. Export Promotion Strategy
Export promotion strategy is purposeful government effort to expand the volume of a country’s
export through export incentives and other means in order to generate more foreign exchange
and improve the current account of its balance of payment. (Todaro P. 68).

By mid 1960s many developing counties abandoned the import substitution industrialization
strategy as the strategy could not provide what had been thought it would. The consensus was
that the import substitution industrialization strategy encouraged rent seeking and inefficient use
of recourses that left the protected industry totally unfit for the perceived completion at a later
stage. Since the mid-1960s.Therefore the export promotion stratagem has become the favoured
strategy. Countries one after the other adopted this export promotion strategy especially
following the impressive growth performance of East Asian countries that had used export
promotion strategy dominantly. (Getinet A 1999).

The arguments in favour of the export promotion strategy are numerous and include the
following the first is the dual gap argument is which the strategy would make possible the avi
liability of critical imported inputs that would boost domestic capacity utilization and hence total
factor productivity. The other arguments is that export promotion strategy leads to increasing
market size of developing country and render all the benefits that are associated with large scale
operation i.e. economics of scale related arguments (I bid 1999).

2.3 Empirical Literature

Empirically, there appears to be good evidence that international trade affects economic growth
positively by facilitating capital accumulation, industrial structure upgrading, technological
progress and institutional advancement. Specifically, increased imports of capital and
intermediate products, which are not available in the domestic market, may result in the rise in
productivity of manufacturing (Lee, 1995). More active participation in the international market
by promoting exports leads to more intense competition and improvement in terms of
productivity
Ezike et al. (2012) studied on the topic ‘Macroeconomic impact of trade on Nigerian growth: An
empirical evaluation’. They found out that exports and foreign direct investment inflows were
positive and are significant determinants of economic growth in Nigeria
 Atoyebi et al. (2012) empirically examined the impact of international trade on economic
growth in Nigeria from 1970 – 2010. Their empirical investigations revealed that three of the
variables were statistically significant at 5% and those variables were export, foreign direct
investment and exchange rate. They were positively related to real GDP while the other variables
such as import, inflation rate and openness had a negative impact on real GDP.

Lin and Li (2002) examined the contribution of foreign trade to China’s economic growth and
found that the previous reviews on foreign trade underestimated the contribution of exports to
GDP growth by overlooking the indirect impacts of exports on domestic consumption,
Investment, government expenditures and imports. They proposed a new estimation method And
found that a 10% increase in exports resulted in a 1% increase in GDP in the 1990 China In his
study on the impact of exports on economic growth for Eastern and Southern Africa Countries,

Other country specific studies were also conducted to test the export-growth relationship. Begum
and Shams Uddin (2000) have tested the relationship for Bangladesh for 1961-92.They
employed the “Feder type” production function in their analysis. Their main finding was that the
sum of the productivity differential and externality effects of the export sector is positive
implying that reallocation of resources from the non-export to export sector will enhance the
productive capacity of the economy. Therefore through this effect export growth can induce
output growth.
Kediri (1998) estimated two models (conventional and "Feder type") of the export growth
relationship for Ethiopia. His result confirmed a positive and significant impact of Exports on
economic growth in both models. Furthermore, he runs the Granger non-causality Test to see the
direction of causality and found out that the positive association runs from Exports to economic
growth.
According to Faye Ensermu (2001) the rate of growth of real export has a positive effect on the
rate of economic growth in the context of the Ethiopian economy. In other words, it has tested
the validity of the hypothesis which is consistent with Ethiopia’s objective. In the long run, it
even contributed greater than the real investment to gross domestic product (I/Y). Thus, export
has a role to play by real investment to gross domestic product (I/Y) in explaining economic
growth. He claims this is true, since the occurrence of unit root and the presence of co-
integrating relationships support the use of error correction models, making it possible to
distinguish between the short run and long run effects of export on economic growth.
The study conducted by Gemechu,(2002) support the contribution of real exports to economic
growth in the context of Ethiopian economy in the short run whereas, Chemeda (2001) says the
contribution of real exports to economic growth in the context of Ethiopian economy is greater in
the long run than in the short run.

In sum, most empirical studies support the positive contribution of trade on economic growth.
From the comprehensive literature, both static and dynamic gains from trade could be found. The
static gains from international trade refer to the improvement in output or social welfare with
fixed amount of input or resource supply. They are mainly the results from the increase in
foreign reserves and national welfare. Firstly, opening up to the global market offers an
opportunity to trade at international prices rather than domestic prices. This opportunity provides
a gain from exchange, as domestic consumers can buy cheaper imported goods and producers
can export goods at higher foreign prices. Furthermore, there is a gain from specialization. The
new prices established in free trade encourage industries to reallocate production from goods that
the closed economy was producing at a relatively high cost (comparative disadvantage) to goods
that it was producing at a relatively low cost (comparative advantage). By utilizing its
comparative advantage in international trade, a country could increase the total output and social
welfare.
In Ethiopia the number of studies conducted so far on contribution of foreign trade on economic
growth of Ethiopia which is not enough which need further study is required. Therefore this
study was help in filling knowledge gap in such area and despite all these strong theoretical
foundations, there is still not much convincing empirical evidence on the impact of trade on
economic growth in Ethiopia, hence, the need for this study.