CH 11

CHAPTER E L E V E N
11 International Economics
Tenth Edition
International Trade and Economic

Development
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
Learning Goals:
 Understand the relationship between
economic development and international trade
 Understand the relationship between the
terms of trade, export instability, and
economic development
 Compare imports substitution with export
orientation as a development strategy
 Describe the current problems facing
developing countries
Introduction
 Today most economists believe that international

trade can contribute significantly to the
development process.
 Until 1980’s, an influential minority of
economists argued that international trade
hindered development in developing nations.
 This chapter addresses these claims.
The Importance of Trade to Development
 Traditional trade theory: If each nation specializes

in their comparative advantage good, world
output increases and both nations gain.
 This suggests that developing nations should
continue to produce primary goods while
developed nations produce manufactured goods.
 Developing nations believe this pattern keeps
them from reaping dynamic benefits of industry
and maximizing their welfare in the long run.
 Developing nations view traditional trade theory

as involving adjustments to existing conditions,
while development requires changing existing
conditions.
 However, traditional trade theory can be

extended to incorporate changes in factor
supplies, technology and tastes by using
comparative statics.
 A nation’s pattern of development is not
determined once and for all, but must be
recomputed as conditions change or are expected
to change.
 As a developing nation accumulates capital and
improves technology, its comparative advantage
can shift from primary to manufactured goods.
 Beneficial Effects of Trade on Economic

Development
1. Can lead to full utilization of underemployed
resources.
2. Makes possible division of labor and
economies of scale.
3. Provides vehicle for transmission of new
ideas, new technology, new managerial and
other skills.
 Beneficial Effects of Trade on Economic

Development
4. Stimulates and facilitates the international
flow of capital from developed to developing
nations.
5. Stimulates domestic demand for new
manufactured products until efficient
domestic production becomes feasible.
6. Stimulates greater efficiency by domestic
producers to meet foreign competition.
 Endogenous Growth Theory

Lowering trade barriers will speed up the rate of
economic growth and development in the long
run by:
1. Allowing developing nations to absorb technology
developed in developed nations at faster rate
2. Increasing the benefits that flow from research and
development
3. Promoting larger economies of scale in production
 Endogenous Growth Theory

Lowering trade barriers will speed up the rate of
economic growth and development in the long
run by:
4. Reducing price distortions and leading to more
efficient use of domestic resources across sectors
5. Encouraging greater specialization and more
efficiency in production of intermediate inputs
6. Leading to more rapid introduction of new goods
and services.
The Terms of Trade and Economic
Development
 Types of Terms of Trade

 Commodity, or net barter, terms of trade (N)
 Ratio of the export price index to import price index
 Income terms of trade (I)

 Measures nation’s export-based capacity to import.
 Single factoral terms of trade (S)

 Measures amount of imports nation gets per unit of
domestic factors of production embodied in its
exports.
Development
 Types of Terms of Trade

 I and S can increase even if N does not,
increasing welfare.
 Most favorable: increases in N, I and S.
 Deterioration in all three terms of trade may
lead to immiserizing growth.
 Immiserizing growth is a theoretical
concept first proposed by Jagdish Bhagwati,
in 1958, where economic growth could
result in a country being worse off than
before the growth. If growth is heavily
export based, it might lead to a fall in the
terms of trade of the exporting country.
Development
 Commodity terms of trade in developing

nations tend to deteriorate over time because:
 Most or all productivity increases in developed
nations are passed on to workers in higher wages
and income, while increases in productivity in
developing nations are reflected in lower prices.
 Developing nations’ demand for manufactured
exports of developed nations grows faster than
developed nations’ demand for agricultural and raw
material exports of developing nations.
FIGURE 11-1. Commodity Terms of Trade and Structural Breaks,
1900-1998
Export Instability and Economic Development
 Developing world exports tend to face inelastic

international demand.
 Price fluctuations in these markets do not
significantly change the quantity sold.
 Thus price fluctuations will generate large
movements in revenues collected.
 Fluctuating environmental conditions (weather,
natural disasters, etc.) cause more and larger
supply shifts in the developing world than in the
developed world.
FIGURE 11-2 Price Instability and the Primary Exports of
Developing Nations.
 Fluctuating export prices will result in export

earnings that vary significantly from year to year.
 When export earnings rise, exporters increase
consumption, investment and bank deposits,
which multiply through the economy.
 A subsequent fall in export earnings results in a
multiple contraction of national income, savings
and investment.
 These boom-bust periods make development
planning difficult.
 Empirical Research (MacBean, 1966)

 While export instability is greater for developing
nations, the degree of instability is not very large
in an absolute sense.
 Great fluctuation in export earnings of developing
nations did not lead to significant fluctuations in
their national income, savings and investments,
and did not interfere with development efforts.
 MacBean concluded costly commodity agreements
demanded by developing nations are not
warranted.
 Commodity Agreements
 Buffer Stocks involve the purchase of the
commodity when the commodity price falls
below an agreed minimum price, and the sale
of the commodity out of the stock when the
commodity price rises above the maximum
price.
 Example: International Tin Agreement, 1956
 Export controls regulate the quantity of a
commodity exported by each nation in order
to stabilize commodity prices.
 Example: International Sugar Agreement, 1954
 Purchase contracts are long-term multilateral
agreements that stipulate a minimum price at
which importing nations agree to purchase a
specified quantity of the commodity and a
maximum price at which exporting nations
agree to sell specified amounts of the
commodity.
 Example: International Wheat Agreement, 1949
Import Substitution versus Export Orientation
 During the 1950s, 1960s, and 1970s developing

nations made deliberate efforts to move
production away from primary goods towards
more industrialized production.
 Potential gains
 Faster technological progress and growth
 Creation of higher paying jobs
 Higher multipliers and accelerators through
greater linkages in production process
 Improved terms of trade, price stability
 Relief from balance of payments difficulties
 Strategies for industrialization

 Import substitution industrialization (ISI)
 Replace imports of industrial goods with
domestic production by reducing import access

to the domestic economy.
 Export oriented industrialization
 Expand industrialization through efforts to
expand domestic exports of industrialized

products.
 Proven to be more effective than import
substitution.

Advantages:
 The market for the product already exists
 It is easier to close the domestic market to
imports than to establish new industries in the
face of foreign competition.
 Foreign firms will be encouraged to invest
domestically to avoid the barriers to trade.

Disadvantages:
 Protected industries have reduced incentives
to improve and become competitive.
 The domestic economy may be too small to
exploit available economies of scale.
 Import substitution is difficult for more
complex products.
 Trade Liberalization and Growth in

Developing Countries
 Many countries that had earlier followed
import substitution strategies began to
liberalize, starting in the 1980s.
 Facilitated by the World Bank.
 Improvements in productivity and growth.
 Export-oriented Industrialization
Advantages:
 Allows for the exploitation of available
economies of scale
 International competition spurs greater
domestic efficiency
 Industrial expansion is not limited by the scale
of the domestic economy.
 Export-oriented Industrialization
Disadvantages:
 May be difficult to set up export industries
due to competition from more established
industries
 Developed nations often provide high level of
effective protection for industries producing
simple labor-intensive commodities in which
developing nation may have comparative
advantage.
Current Problems Facing Developing
Countries
Case Study 11-1 The East Asian Miracle of
Growth and Trade
Case Study 11-2 Change in Commodity Prices
over Time
Case Study 11-3 The Growth of GDP of Rich
Countries, Globalizers, and Nonglobalizers
Case Study 11-4 Manufactures in Total
Exports of Selected Developing Countries
Case Study 11-5 The Foreign Debt Burden of
Developing Countries
Appendix to Chapter 11
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CHAPTER E L E V E N

International Trade and Economic

 Today most economists believe that international

 Traditional trade theory: If each nation specializes

 Developing nations view traditional trade theory

 However, traditional trade theory can be

 Beneficial Effects of Trade on Economic

 Beneficial Effects of Trade on Economic

 Endogenous Growth Theory

 Endogenous Growth Theory

 Types of Terms of Trade

 Income terms of trade (I)

 Single factoral terms of trade (S)

 Types of Terms of Trade

 Commodity terms of trade in developing

 Developing world exports tend to face inelastic

 Fluctuating export prices will result in export

 Empirical Research (MacBean, 1966)

 During the 1950s, 1960s, and 1970s developing

 Strategies for industrialization

domestic production by reducing import access

expand domestic exports of industrialized

 Import substitution industrialization (ISI)

 Import substitution industrialization (ISI)

 Trade Liberalization and Growth in

 All rights reserved. Reproduction or translation of this work beyond

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