Trade Policies in

Developing
Countries
vaibhav
Introduction
There is a great diversity among the developing countries in
terms of their income per capita.

•– the key to economic development was

creation of a strong manufacturing sector.

•– The most important economic - infant

industry argument.
Trade Policies in Developing Countries

•Focus on exporting primary products

•Attempt to raise the world prices of primary
products that are exported
•Protect and encourage new industries that
produce products sold into the local market
•Encourage new industries that produce
products that are exported
Which Trade Policy for Developing Countries?
• Exports of goods and services are about 37% of GDP in
developing countries, vs. 28% for developed countries

• Developing countries are the source of about 46% of

all world exports

• About 42% of exports by developing countries go to

industrialized countries, but these are only about 38%
of industrial-country imports
Challenges Faced by Developing Countries
• Capital markets work less efficiently in many developing countries in
channeling money to the most productive uses.
• Labor markets work less efficiently in many developing countries
where the wage gap between expanding and declining sectors are
greater than in high-income countries, providing a clue that some
labor is kept from moving to its most productive use.
• Many developing countries have exports concentrated in one or a few
primary products like petroleum, coffee, cotton, gold, sugar, timber,
diamond, and bauxite/aluminum.
• Raul Prebisch and others have argued that adverse price trends for
primary products trap these developing countries into declining
incomes relative to incomes in industrialized countries.
Are the Long-Run Price Trend Against Primary Producers
Forces depressing primary product prices:
1. Engel’s law: Income elasticity of demand for food is less than 1. As global per
capita income rises, demand shifts toward luxury goods and away from
staples. If world’s supply expands at the same rate for all products, the relative
price of foods (and other primary products) are expected to fall.
2. Synthetic substitutes: The more technology advances, the more likely to
discover ways to replace minerals and other raw materials with new man-
made substitutes. Again, demand shifts away from primary products.
Forces raising the price of primary products:
1. Nature’s limits. The supply of primary products grows relatively slowly,
tending to raise primary product prices.
2. Relatively slow productivity growth in the primary sector vs. the
manufactured sector. Again, the supply of primary products tends to grow
relatively slowly.
What Is Import Substitution Industrialization (ISI)?
Import substitution industrialization (ISI) is a theory
of economics typically adhered to by developing
countries or emerging market nations that seek to
decrease their dependence on developed countries.
The approach targets the protection and incubation of
newly formed domestic industries to fully develop
sectors so that the goods produced are
competitive with imported goods. Under ISI theory, the
process makes local economies, and their nations, self-
sufficient.
Import-Substituting
• The Infant Industry Argument

• – Potential comparative advantage Protect and

Nurture

❑Example: The U.S. and Germany had high tariff rates

on manufacturing in the 19th century, while Japan had
extensive import controls until the 1970s.
Support for Import-Substituting Industrialization : Market Failure
Industrialization – Market Failure Arguments in favor of Infant
Industry Protection
• – Two market failures are identified as reasons why infant industry
protection may be a good idea:

• Imperfect capital markets justification

– financial institutions: growth of new industries will be restricted.

• • Appropriability argument
– Firms in a new industry generate social benefits for which they are not
compensated (e.g. start-up costs of adapting technology).

• Underdevelopment of other adjoining Sectors

Against - Import-Substituting Industrialization
• Industrialization Problems with the Infant Industry Argument
• 1. Timing
Example: In the 1980s South Korea became an exporter of
automobiles, whereas in the 1960s its capital and skilled labor were
still very scarce
• 2. Wrong Assumption Protecting manufacturing does no good
Example: Pakistan and India have protected their heavy
manufacturing sectors for decades and have recently begun to
develop significant exports of light manufactures like textiles.
• 3. Small Domestic Market (Demand) Inefficient Scale of production
of import competing sector.
Actual experience with ISI
• Deadweight losses from resource misallocation.

• Governments often are slow to stop protecting

local industries that remain inefficient (“do not
grow up”).

• Developing countries shifting to more outward

oriented or freer-trade policies have grown more
quickly. Examples include the Four Tigers (South
Korea, Taiwan, Singapore, Hong Kong), China, and
India
Dual Economy
• Most developing countries are characterized by economic
dualism.
• A high-wage, capital-intensive industrial sector coexists with a
low-wage traditional sector.
• Dualism is associated with trade policy for two reasons:
• Dualism is probably a sign of markets working poorly (market
failure case for deviating from free trade).
• The creation of the dual economy (an economy that is
characterized by economic dualism) has been helped by import-
substitution policies.
Problems of the Dual Economy
• The Symptoms of Dualism
• Development often proceeds unevenly and results in a
dual economy consisting of a modern sector and a
traditional sector.
• The modern sector typically differs from the traditional sector
in that it has:
• Higher value of output per worker
• Higher wages
• Lower returns to capital
• Higher capital intensity
• Persistent unemployment (especially in urban areas)
Problems of the Dual Economy

• Dual Labor Markets and Trade Policy

• The symptoms of dualism are clear signs of an economy
that is not working well, especially in its labor markets.
• Wage differentials argument
• The wage differences between manufacturing and agriculture
is a justification for encouraging manufacturing at agriculture’s
expense.
• When there is a wage differential, the manufactures wage
(WM) must be higher than the food wage (WF).
Developing countries began to reject ISI policy in the 1980s and 1990s

Nevertheless, developing countries slowly began to reject ISI

in the 1980s and 1990s after the rise of global market-driven
liberalization, a concept based on the International Monetary
Fund and the World Bank's structural adjustment programs.

ISI was gradually abandoned by most developing countries in

the 1980s and after the fall of the Soviet Union because its
initial success was ultimately unsustainable and, thereafter,
the insistence of the IMF and World Bank on their structural
adjustment programs aimed at the Global South.