By Bumbu

In this post, I summarise the basic economic background surrounding international trade and how this can affect developing countries. It covers the basic economic attractions of international trade for developing countries, some sorts of government intervention in such trade and reasons for and against these[1].

The place to begin is with the important concepts of comparative advantage and the Heckscher-Ohlin model. These outline the basic reasons for free international trade and present the basic mechanism by which such trade can benefit developing countries.

We then turn to complicating features of economies which can mean that the results of international trade without government intervention are less than ideal. In particular, we consider some market failures which require corrective government intervention in the economy. These include imperfections in market conditions within an economy, apparent even when an economy is considered in isolation from others, as well as sub-optimal results which occur because of competition from foreign producers. These market failures suggest ways in which the cause of development in poor countries might be furthered by specific government interventions. These interventions may be macro-economic, involving tax and public expenditure in the domestic economy, or they may be in trade policy, involving such tools as tariffs and subsidies.

We discuss the patterns of specialisation and the distribution of gains and losses likely from trade between different sorts of economies. This suggests reasons that developing countries might want to shape the direction of their economy, again using macro-economic and trade policy.

The theory of comparative advantage

The theory holds that when two countries X and Y trade in two goods G and H, both can benefit by specialising in the good in which they have comparative advantage and then trading the goods. Country X may have an absolute advantage in both goods. That is, it may be more efficient than country Y in producing both goods. Nonetheless, country Y will have a comparative advantage at producing one of the goods. The scarce resources which are used in the production of both G and H will be more productively employed in the production of one than in the production of the other. When country X commits its scarce resources to producing good G, there is an opportunity cost of not committing them to producing H. Country Y will have a comparative advantage in producing the good whose production incurs the larger opportunity cost for country X.

To consider a simple example, begin with a situation of no trade and suppose there is a single input of production. Suppose it takes country X 10 and 15 units of input to produce a unit of G and of H respectively. Suppose it takes country Y 40 and 20 units respectively. Country X has an absolute advantage in both goods. However, consider the relative of the goods. In X, a unit of G costs 2/3 of an H (10/15). In Y, a unit of G costs 2 units of H (40/20). Even though X has lower absolute prices for both goods, than does country Y, the latter has a lower relative price of H. It thus has a comparative advantage in producing H. In this model, each country will always have a comparative advantage in one and only one of the goods except in the case where the two countries have the same relative price in a situation of no trade.

Country X has a lower absolute cost for producing both goods. Yet, if it specialises in G and imports H, the units of input freed up from abandoning production of H will produce more units of G than they produced of H. Likewise in Y. If it specialises in H and imports G, the units of input freed up from abandoning production of G will produce more units of H than they produced of G. With specialisation in one’s area of comparative advantage, the combined production by both countries of each good G and H rises when compared to the combined production of each in a situation of no specialisation. If the countries trade, as well as specialising, they can share the benefits of this greater pool of goods. 

Countries can have a comparative advantage for reasons such as differences in technology or in endowments of factors of production such as arable land.

Heckscher-Ohlin model and distribution of gains and losses from trade

Let me briefly introduce the Heckscher-Ohlin model of the gains and losses from international trade. While it is not clear that empirical evidence confirms the model, it is nonetheless useful for reasoning about trade. I will present the conclusion of the model, but will not run through the argument for these conclusions[2]. I begin by explaining the concepts of intensity and abundance.

Suppose both goods G and H use two inputs of production, K and L (capital and labour). At given prices for K and L, production of a unit of a good will likely use the inputs in a different ratio. Suppose that at any given input prices, G always uses a higher ratio of K to L than does H. This makes the production of that good K-intensive. Note that intensity is a relative concept to do with the ratio of inputs used. In this model, if G is K-intensive, this must mean that H is L-intensive. 

If country X’s endowment of inputs of production is composed of a higher ratio of K to L than country Y’s, then X is K-abundant and Y is L-abundant. Again, this is a relative concept. Country X may have a larger absolute quantity of both inputs K and L than does country Y, but, obviously, it cannot have a larger ratio of both K to L and of L to K than country Y.

Comparative advantage is often due to technological advantage. If country X is technologically advanced and country Y is not, it is likely that the former has a comparative advantage in the production of a technologically intensive good.

However, the Heckscher-Ohlin model makes a prediction about comparative advantage and the direction of trade flow even in cases where technology is assumed to be the same in the two countries in the model. The model makes the following predictions.

A country will tend to export products which are intensive in factors that are possessed by the country in abundance. So, for example, a developing country - which is labor-abundant - will tend to export products which are labour intensive. Country Y, which is L-abundant, will tend to export the labour intensive good H.

As it does so, the relative price of the abundant factor in that country will rise. To continue with our example, the developing country will see the price of labour rise relative to the price of capital - wages will rise relative to the rent. Suppose w is the factor price for L and r is the factor price for K. Country Y will see the ratio w/r rise. Real wages will rise and real rents will fall for both the labour intensive good and the capital intensive good.

Moreover, the purchasing power of owners of labour will rise and the purchasing power of owners of capital will fall. In the initial discussion of comparative advantage, international trade turned out to raise the aggregate product. With this latest prediction of the Heckscher-Ohlin model, we see reasons for thinking that the distribution of gains from international trade will be uneven. There will be some gainers and some losers from trade. According to the model, owners of labour will gain in country Y and owners of capital will lose. Its trade partner, which we might think of as a developed country, is capital abundant and tends to export the capital intensive good G. In X, owners of capital will gain and owners of labour will lose.

Finally, international trade will tend to equalise the relative prices of the two factors in the two countries. That is, the ratio w/r in country X and the ration w/r in country Y will tend to equalise.

 

The theory of comparative advantage suggests that with specialisation and international trade, aggregate global product will increase given constant amounts of factors of production and technology. For each country, there is an increase in average efficiency. Even if some industries unable to compete with imports are destroyed, the human and capital resources thus freed up can be absorbed into production in some other industry where the country has comparative advantage and where it now specialises. Since the country has comparative advantage in this latter industry, the resources have moved from low productivity protected sectors to high productivity export sectors.

Trade can potentially open up a foreign market, boosting demand for domestic products. Domestic producers can expand their production to satisfy this larger demand and even achieve economies of scale in the process. Trade liberalization can mean that imported inputs used in the production of domestically produced goods are cheaper, thus reducing domestic cost of production. Liberalization can result in greater competition from foreign firms in the domestic economy. This can lower prices and force improvements in efficiency in the local production. Liberalization can also affect the rate of economic growth by, for example, leading to greater production to meet the greater demand generated by access to foreign markets.

There are both winners and losers in this model. The model predicts that the gains from trade will outweigh the losses. Consequently, the gainers would gain from trade more than enough to compensate the losers for their loss from trade. If the losers could be adequately compensated by the gainers, then everyone would be better off as a result of trade. However, there may be many reasons why the losers from trade are not adequately compensated. Some of these reasons will be discussed in a section below on political aspects of development.

The case for government intervention: the role of history and expectations

From the above, it might seem that under free international trade between developed countries and developing ones, the wages of various factors of production will gradually converge (as per the Heckscher-Ohlin model). However, there are reasons that different economies might experience persistently different rates of investment and why similar rates of savings in two economies might lead to different rates of economic growth. Among the reasons are issues of coordination failure.

An economy may have multiple equilibriums. The market is capable of reaching each of these equilibriums and once it reaches one, it would tend to stay there, unless some force moved it away. The equilibriums may not be equally desirable from society’s point of view.

One particular instance of multiple equilibriums is one where the economy finds itself stuck in a relatively low level equilibrium because of a coordination failure. If a relevant set of agents could coordinate their actions, the economy would move to higher level equilibrium which is better for the economy and the agents concerned. However, in the normal course of things, the agents fail to coordinate and the market remains in the lower level equilibrium. This is one type of obstacle faced by developing countries wanting to develop. It also highlights the role of history a particular economy in the amount and type of investment it receives today.

Consider a developing country which is largely reliant on its primary sector. It would like to develop an export sector for manufactured goods. There is abundant labour who could be employed in manufacturing and there are entrepreneurs with sufficient resources in terms of finance and know-how to set up the industry. Nonetheless, there may be other obstacles to a move to the ‘manufacturing-export-equilibrium’ and the economy may remain at the lower level primary sector equilibrium. For, various complementary developments which make a manufacturing export sector viable may be absent. The machinery required for the manufacturing industry might require a steel industry which in turn requires iron, mining and coal industries. Yet, these latter industries may not exist, as there is insufficient demand for their products. If  the manufacturing sector existed, there would be sufficient demand for steel and thus a reason for an entrepreneur to set up a steel industry. In the absence of a manufacturing industry, there is no reason for an entrepreneur to establish a steel industry, as there is demand for the product. Similarly, if the steel industry existed, there would be sufficient demand for iron to warrant establishment of an iron industry. A similar story can be told for the coal and mining industries which create inputs for iron production. At this end, the entrepreneur who contemplates setting up a manufacturing industry sees an absence of inputs of production in the economy.

Meanwhile, at the other end, the entrepreneur sees insufficient demand for the product. The incomes and preferences of workers in the developing country may not be sufficient to generate adequate demand for the manufactured goods to warrant the initial setup costs. The entrepreneur would have to sell the products overseas. Yet, in order to do so, the economy must have adequate railways to transport the goods to a port and a shipping industry to ship the goods from the port to foreign markets. The railway and shipping industries, in turn, do not exist because there is insufficient demand for their services and insufficient inputs for their production. Demand for their shipping services would come from an export sector (like manufacturing) and demand for railways would come from industries like manufacturing or iron (to transport coal to iron producers). Inputs for railways and shipping would include steel and coal. These sorts of forward and backward linkages abound in developing economies (Hirschman 1958). The steel industry facilitates development of railway industry by increasing availability or lowering price of steel. This is a forward linkage, affecting the ease of supply of another product. The steel industry has a backward linkage to the coal industry, as expansion of the former raises demand for the latter.

Note that any one entrepreneur is unwilling to invest in establishing a mining, coal, iron, steel, manufacturing, railway of shipping industry because she is uncertain that there will be demand for her product and/or that inputs of production will be available cheaply. None of these industries is viable on its own. Yet, they are collectively viable, if only the entrepreneurs contemplating investment in each industry could coordinate and rely on the others to invest. Unless this coordination failure is resolved, the economy will remain at the lower level equilibrium.

Note this link to the section on dynamic comparative advantage. Static comparative advantage might move a country into specialising in a product given the existing low level equilibrium. Yet the country’s dynamic comparative advantage may be in some other specialisation that is not reached by the market because of coordination failure.

History plays a part in explaining why different economies might experience persistently different rates of investment and why similar rates of savings in two economies might lead to different rates of economic growth. A country with a well established industrial sector, with a variety of industries, will attract investment for establishment of new industries. The existence of complementary industries makes it profitable for entrepreneurs to invest in this economy to set up new industries. Many developed countries are like this. On the other hand, a developing country which has very little industry and, in particular, lacks various key industries, will be unattractive to investors. This is the case not only for foreign investors, but also for domestic savers. A similar rate of savings to the developed country may still yield different rates of economic growth of the two economies. Domestic savers in the developing country will be unwilling to invest in their economy for the reasons above and this will affect the rate of economic growth. Meanwhile, domestic savers in the developed country will be eager to invest in their economy because complementary industries exist and their investment is more likely to be profitable.

Remedial policies for coordination failure

In cases of coordination failure, each potential investor bases her decision on her expectation of whether other investors will invest on complementary industries in a given time period. No investor wants to be the first to make the move, because the first will face losses for at least the short run while other investors set up other industries which have linkages to the pioneering investment. The first investor’s action would have positive externalities – making it profitable for others to set up complementary industries – but brings poor returns to the investor herself (at least in the short run).

One way to deal with this is government action. The state can be the first actor, willing to bear some losses for the sake of the positive externalities. The state seeks out the key sectors  - call them leading sectors - whose development would spur the development of complementary sectors through forward and backward linkages. Backward linkages usually have direct consequences by raising demand for inputs. Forward linkages generally have more diffuse effects. They increase supply of something which is an input in many things, so that investment in any one of them rather than in others is not assured. Moreover, the input will be only one input among others for the other product and if prices of other inputs stay the same, the effect of lower price of one input may be small. Sectors which have been thought to be leading sectors in this sense include heavy industry, exports, tourism, transportation and agriculture.

If the government invests in a leading sector, preferably a very low profitability sector (in which private entrepreneurs would therefore be unlikely to invest), they can change the expectation of entrepreneurs. Without government action, each entrepreneur expected that no private investor would make the first move (as this would not be profitable in the short run for any investor). Accordingly, no entrepreneur was prepared to make a move in the future. With government action, entrepreneurs expect that, in the future, there will be some complementary industry necessary for the profitability of their own enterprise and so, will be willing to undertake the investment.

Capital markets

Opponents of government action grant that the government action could resolve the coordination failure, but argue that it is not the only - nor the best - way to do this. The problem is that the first mover would face losses in the near future. However, it may well be profitable in the longer run as complementary industries set up to take advantage of the linkages created by the first mover. Accordingly, first movers should be able to borrow against their longer-run expected profitability to tide them through their short run losses.

In many developing countries, credit markets may be poor and so first movers may be unable to find a willing lender. This is indeed a market failure and could justify remedial government intervention. However, many would argue that the appropriate role of the government would be to fix the credit market and not to set up the leading sector as a public enterprise. This is in keeping with the rule of thumb that it is best to deal with a market failure as directly as possible, as less direct policy tends to lead to unintended distortions of incentives elsewhere in the economy (Krugman and Obstfeld 2003: 227).

This does not seem to be the end of the matter, however. Research in the implications of asymmetric information suggests that in many cases it may be best to see capital market imperfections as inherent and not simply something that governments can fix (see Stiglitz and Weiss 1981). Banks would have to be willing to lend to a firm that sells below cost in the hope that it will eventually increase productivity enough to become a viable competitor. This would be highly risky for a bank, which is at an information disadvantage in judging the credibility of the firm’s pronouncements about its own future profitability despite current losses. This situation of asymmetric information is an inherent feature of the operation of economies. Once we take seriously the intractability of these capital market imperfections – rather than supposing them to be easily remedied by government intervention – government protection may be optimal(Stiglitz and Charlton 2005: 32).

The case for protectionism

Increasing returns to scale

Expansion in the scale of production often reduces the average unit cost of a product. These lead to increasing returns to scale. To realise gains from increasing returns there must be a sufficiently large market for the product. If the market is small, a profitable product may never make it onto the market. It may be that if increasing returns to scale are not realised, then the cost (and thus price) of the product will remain too high for potential consumers.

 For instance, there may be a close substitute which is of inferior quality but which has complete market share. Given the market share, its producer can realise increasing returns to scale and thus sell the product at a relatively low price. The innovative producer of a substitute which is of higher quality may be unable to break into the market because potential consumers will not immediately shift from the inferior to the superior product. Consumers need time to find out about a product, to build trust in it from seeing others buy it, to be convinced out of brand loyalty or habit or to wait for the inferior product to wear out before they buy a new one. In the short run, the superior product will have only a very small market share and the inferior product will retain its dominant position. This means the superior product sees insufficient demand to warrant increased scale of production. Accordingly, it does not experience increased returns to scale and cannot reduce its price to come close to the cheaper inferior product. This higher price further disadvantages the superior product.

Increasing returns to scale in an industry might mean that an infant industry in a developing country cannot compete against import from established foreign producers. Government protection from such imports can allow the infant industry to become more competitive.

Learning by doing

Sometimes assimilation of new techniques of production is possible only through ongoing production at a sufficiently large scale. There may also be increased productivity merely from increased labor skills arising from accumulated experience rather than from any change in technology (sometimes referred to as the Horndal effect). The learning process may also involve innovation which improves the quality of a product or the efficiency of its production. For instance, a type of circuitry may have been designed in foreign conditions where heat and humidity are not a big problem. Use of the circuitry may be sub-optimal in the greater heat and humidity of the domestic environment. Domestic producers can innovate and modify the product to cope with the different conditions (Ray 1998: 669).

Learning by doing may not be possible for an industry if it must face import competition which already has the benefits of having learnt from experience. A government may want a domestic industry to achieve the benefits of learning by doing and thus become more competitive. It may protect the industry from imports in order to give it time to learn.

Dynamic comparative advantage

The existence of increasing returns to scale and learning by doing can mean that an industry is unable to compete against imports from established foreign producers. However, the theory of comparative advantage suggests that there will always be some industry in which the country would have comparative advantage and thus where it could competitively produce.

Why, then would a country want to develop an industry which is outside its area of comparative advantage rather than letting free trade guide the country to its area of comparative advantage? To answer this, it is useful to distinguish static and dynamic comparative advantage. There may be industries in which a country does not currently have comparative advantage, but in which it could have comparative advantage in the future. In such cases, free trade is likely to lead the country towards a specialisation which may be worthwhile in the short run, but which may be best in the long run.

One reasons attaches to the existence of positive externalities of the operation of specific industries which do not attach to the operation of other industries. Positive externalities are a sort of market failure in which the market equilibrium produces less of a good than is socially optimal. In our case, the market may fail to promote an industry even though, from a social optimum point of view, it is highly desirable. From this latter point of view, the particular industry may be judged to generate more advantages in the long run than the area of (static) comparative advantage would generate.

Here are some examples of such positive externalities. The growth of some industries prompts other developments in the country. For instance, it might spur a local industry for intermediate inputs, as we saw in the case of coordination failure. It might yield knowledge and technical expertise which can spill over into other industries within the country as employees eventually leave one industry for another. It might lead the government to improve key infrastructure necessary for the industry to prosper (such as, roads or electrification) or institutions (such as, intellectual property law or bankruptcy law) to assist the industry if it is sufficiently important to the economy. Depending on the level and type of inputs and technology involved in the industry this public expenditure can promote various sorts of specialised technical education or improve telecommunications infrastructure and so on. In these ways, the industry in which a country specialises can affect the development of the country not merely in increasing its income through the income directly generated through exports, but also through flow-on effects or positive externalities which pave the way for other industries to establish themselves. While the area of (static) comparative advantage would maximise export receipts in the short run, some other industry may turn out to be preferable in the long run.

Another reason relates to the fact that, for many developing countries, the area of comparative advantage lies in primary sector areas such as agriculture and mining. Primary products are generally those obtained directly by transforming natural resources. Agriculture, fishing and mining are examples of primary sectors of economies. This contrasts with the secondary sector of economies which involves processes such as manufacturing and construction where primary products serve as inputs.

It is an established empirical observation that as consumer budgets grow, consumers spend a decreasing proportion of their budget on primary products such as foods[3]. A greater proportion is spent on luxuries rather than necessities and many sorts of primary products fall under the latter classification rather than the former. A greater proportion is also spent on processed goods. As income grows, the demand for primary products is likely to grow, but will do so at a decreasing rate.

There is a tendency for developing countries that export mostly primary products and import the bulk of their manufactured goods, to see their terms of trade (the price of a country’s exports divided by the price of its imports) decline. Other contentions in the literature include the claim that primary product prices tend to fluctuate widely. If this is the case, it may contribute to economic instability of countries which rely on the primary sector.

Suppose the export sector of a developing country is heavily dependent on primary products. One way for the country to increase its national income is to simply try and sell more of the primary products. However, there is a limit to how far it can grow its share of the market in these products.

Another way for it to increase its income is to move into a further step in the production chain which transforms primary product into final product. Suppose country A exports raw wool (a primary product) to country B which processes and dyes it and makes woollen clothing from it. Consider this clothing as the final product, a product which is not used as input in any further production process. If country A begins to process its raw wool rather than exporting it, it can enter a new market – that for processed wool or for dyed wool or woollen garments. Country A can increase its income in this way for the following reason. Consider the value of the final product, the woollen garment, to be an amount Z. Amount Z can be analysed into component amounts of value added at the various steps in the chain of its production. The raw wool has a value of V, the processing and dyeing of the raw wool adds a value W, making the processed wool into wool cloth adds a value X and making this cloth into clothing adds a value of Y, where V+W+X+Y=Z. If country A exports the raw wool, its income is V. If it exports at a later stage in the chain of production, its income is the increased amount V+W+… This strategy for greater economic growth and development is known as moving up the value-added chain towards higher value added production.

If a country expects that in the long run a specialisation in, say, manufacturing is more lucrative or stable than a specialisation in a primary sector, it might promote more capital- and technology-intensive industries in which the country does not currently have a comparative advantage but in which it could become competitive.

Types of activist trade policy: Import substitution and export promotion

We have seen some reasons that governments might want to actively promote particular industries through policy. Import substitution and export promotion are two sorts of policies countries can follow to promote industries. Both ways distort market outcomes and both involve significant government intervention.

Import substitution involves barriers to imports and perhaps government support for the import competing sectors. The aim is to let the import competing firms become established and become competitive. They can become more competitive by, say, acquiring organisational experience, increasing returns to scale, building relationships with suppliers of inputs in order to get these at a low cost, perhaps developing new technology or techniques particularly adapted to the domestic market and so on.

Suppose a local substitute for a currently imported product is just as good or better (more suited to local conditions). Suppose also that the product type has increasing returns to scale, such that it is difficult for the fledgling domestic import competing producer to sell at sufficiently low prices to compete with the imports. Import protection can be used to reduce the share of imports in the relevant market and thus leave more of the market for the domestic producer. This can allow the latter to increase its scale of production and also gain other advantages such as experience and may help it become more competitive. The hope is that the producer will eventually become competitive enough to survive without protection.

Export promotion involves government promotion of exports. Means of doing this include subsidies for inputs and for production, cheap access to imported inputs (perhaps through import quotas reserved for selected exporters) and preferential credit at below market rates to facilitate borrowing for investment.

Developed country consumers, generally would prefer developing countries to adopt export promotion than import substitution, as the developed country consumers would thus have access to cheap imports from these countries. Moreover, export promoting countries tend to have fewer import barriers than import substituting countries. This is attractive to developed country exporters who may want to access the markets of certain large developing countries.

For the developing countries themselves, import substitution can lead to entrenched business interests in the import competing sector who take for granted the government protection from cheaper imports. They may not believe that this period of support by the government is limited. Accordingly, they might see no reason to take advantage of the period of shelter from competition to become more competitive. They may never become sufficiently competitive as to be able to survive without government protection. Then the business interest acts simply as a drain on government money and domestic consumers face higher prices with no compensating benefit.

Note that for a protected industry to become competitive, it may need access to a large market. The industry cannot reach a sufficient scale of production to benefit from increasing returns and falling average cost of production if there is not sufficient demand for its product. For many developing countries, the domestic market may not be large enough, meaning that the industry needs to access export markets to become more competitive. This leads in the direction of export promotion policies. Some of the government protection for the fledgling domestic industry might continue, but one sort of support – namely import barriers to stop foreign competition is no longer on the cards. Exporting to a foreign market involves competing against foreign producers. Export promotion is thus preferable to import substitution for many developing countries, as it allows access to larger markets.

There are other reasons why export promotion is desirable. A developing country may need income  for, say, servicing international debt. Greater export earnings are a way to do this.

Expected distributions of gains and losses in various types of international trade

Tariff barriers and export promotion

Suppose a developing country imposes a tariff on an import. This will raise the price at home. This hurts domestic consumers and benefits domestic import-competing producers. The government also receives a tariff revenue, boosting its ability to spend. There is an efficiency loss as domestic producers produce more than they would and domestic consumers consume less than they would under an efficient market equilibrium.

Assessing the overall wisdom of the tariff depends on distributional features and on the social importance placed on a dollar of cost or benefit accruing to different groups. For instance, it matters whether the producer gain accrues mostly to wealthy owners of resources or to low wage workers. It matters whether the consumer loss is borne mostly by poorer than average people or by the affluent. It also matters whether the government puts its tariff revenue to good use. These are effects in the short run. There may be other relevant effects in the longer run. We have come across these effects in previous chapters. The import competing industry may be an infant industry which needs only temporary protection and which may promise future benefits which outweigh the costs of the protection. These benefits may be in the form of externalities for the rest of the economy or in the form of a surer and more stable source of export revenue in the future.

Consider an export subsidy. The exporting country experiences a rise in price. Its producers gain, its consumers lose and the government also loses as it must foot the bill of the subsidy. There is an efficiency loss as domestic producers produce more than they would and domestic consumers consume less than they would under an efficient market equilibrium.

Again, the wisdom of the subsidy depends on things like distributional effects, externalities and potential long run effects. As we have seen in previous chapters, a well thought out export subsidy can allow an infant industry to establish itself and to become a competitive export earner in the long run. There may also be positive externalities such as rectifying coordination failures and moving to a better market equilibrium if multiple equilibriums are on offer. Moreover, if the consumers who lose at home are affluent and the producers are mostly low skill workers, then these results become more acceptable. 

Let us note the effects of these measures for trade partners. The producer in the trade partner country X, facing an import barrier, experiences a fall in demand as the tariff raises prices for consumers in the importing country Y. Depending on the size of Y’s market for the relevant good relative to the size of world market, country X will also undergo a change in price of the good. If Y has a small market, then the tariff makes very little difference to price in X. If Y has a large market relative to world market, then the price in X will fall by some amount smaller than the size of the tariff. So, producers in X face a fall in revenue as demand for the product falls. Consumers in X will benefit from a fall in price if Y is a sufficiently large market, but will face no effects otherwise.

In the long term, if the import competing producer in Y ceases to be an infant industry and grows up to become competitive, then the producer in X will face grater competition in the world market and may even see its market share shrink.

In the case of an export subsidy by country Y, the importing country X undergoes a fall in price. Consumers in X benefit and the import competing producer in X finds it harder to compete and, if the subsidy is substantial enough, could be driven out of business.

 

Trade between a developed country and a developing one

Recall that the Heckscher-Ohlin model predicts that the relative prices of factors of production will tend to equalise across trading partners. If a developed country trades with a developing one, we expect the former country to export a capital intensive product and the latter to export a labor intensive product. The model leads us to expect that owners of capital will become wealthier in the developed country and less wealthy in the developing country. Similarly, we expect that the owners of labour will become wealthier in the developing country and less wealthy in the developed country. Conditions of production are so different in the two countries, that there should be plenty of gains. Labour in the developing country can expect a rise in wages and consumers in the developed country can expect much cheaper goods. 

Yet, the large differences in conditions of production also mean that distributional effects of free trade between such countries are likely to be large. Gains to consumers from much cheaper imported products are expected to outweigh the losses to specific small groups. However, those who stand to lose, in a developed country often organise themselves to oppose free trade with a developing country. Fear of a fall in real income or of losing jobs have led to US protection of particular sectors such as the auto industry, agriculture and textiles. (Krugman and Obstfeld 2003: 228-32).

While specialisation according to comparative advantage can increases the aggregate income of both countries, the pattern of specialisation may nonetheless be problematic. This is for reasons familiar from our discussion of dynamic comparative advantage and of complementary industries. The developing country may experience an expansion of low-skilled labour-intensive industries as competing industries in the developed trade partner shut down and relocate, but at the same time the developing country experiences a flight of some technically intensive industry to the developed country. This may be because the latter country may have better infrastructure and easier access to high-technology inputs and other complementary industries than does the developing country. The developing country may be unhappy with this division of specialisation.

It is important to differentiate between developing countries at varying stages of development and with varying degrees of wealth as the divide between the Least Developed Countries (LDC) and the middle income developing countries can be substantial. Some developing countries will have better infrastructure than others. Suppose trade between developed and developing includes not just two countries, but three -  a developed country, a middle income developing country and an LDC. The existence of better infrastructure and complementary industry in the middle income than in the LDC may mean that investors relocate some low skill labour intensive industry to the former rather than the latter. This may be despite the latter country having lower wages, as wages are only one component of cost of production.

 

Trade between two developed countries

We can expect that developed countries have depth of product variety and that any differences in proportions of various factors of production will be relatively small. For these reasons, distributional effects will be small and we can expect fewer impediments to trade between such countries. Indeed, the EU is an example of such trade.

Much of their trade might be in similar, but differentiated, products or in goods that do not use substantially different proportions of factors of production. Similar products can be differentiated in terms of features like branding. The main effect for such trade may be a bigger market without a drastic change in factor prices. Here trade is more likely to bring actual Pareto improvements.

Suppose one developed country produces only white wine and another produces only red. Suppose consumers in both countries want to try both kinds of wine. Free trade allows each country to keep half its domestic wine and export the other half. Consumers have more variety and producers do not have to downsize in either country. It seems that no one stands to lose from trade in this case. The only opposition might be if there is monopolistic or oligopolistic production in autarky. The monopolist will want to resist free trade as this will eat their super profits.

Trade between two developing countries

The optimistic result for free trade in the previous case required two factors: (i) similar per capita income (so that products demanded are similar and thus unlikely to vary much in terms of factor composition) and also (ii) a certain depth of consumption or input variety. Developing countries can satisfy the first criterion, but they fail the second.

Such trade can serve the need to exploit markets on a larger scale than that permitted by import substituting industrialization. Suppose two developing countries open free trade between themselves. They were import substituting before and are now jointly import substituting, This allows them a bigger market. If the industries simply located in one country each, cutting out duplications and thus reaping returns to scale from the larger market, they could be more successful.

However, there is no reason to expect such harmony where each major industry picks one country, so that each country has one major industry. If one of the countries is larger or has better infrastructure or better access to skilled workers, it would end up with both industries and the other would be left with none. The more similar the countries, the more likely that the location choices of industry will be evenly distributed. However, increasing returns mean that even a small advantage can magnify over time, through a process termed agglomeration. The process involves a chain of activities in which each additional link heightens the prospects of a fresh link to be forged.

Locational choices are like this. Recall the earlier discussion of complementary industries with regard to the problem of coordination failure. The absence or presence of complementary industries can influence an entrepreneur’s decision to invest in a region. A slightly better climate for industry can prompt the location there of one industry. This makes it more likely that fresh industries will locate there and so on (Ray 1998: 740-2).

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References

Hirschman, A. O.; 1958; The Strategy of Economic Development; Yale University Press; New Haven

Krugman, Paul and Maurice Obstfeld; 2006; International economics : theory and policy (7^th ed); Addison-Wesley; Boston MA

Ray, Debraj; 1998; Development Economics; Princeton University Press; Princeton

Stiglitz, Joseph and Andrew Charlton; 2005; Fair Trade for all; Oxford University Press; New York

Stiglitz, Joseph and Andrew Weiss; 1981;” Credit rationing in markets with imperfect information”; American Economic Review; vol 71 issue 3