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BA 187 – International Trade. Krugman & Obstfeld, Chapter 10 Trade Policy & Developing Countries. An Overview of Developing Countries . Lesser Developed Countries (LDC’s). LDC’s are not a homogeneous group Fourth World vs. Third World Countries

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BA 187 – International Trade

Krugman & Obstfeld, Chapter 10

Trade Policy & Developing Countries

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Lesser Developed Countries (LDC’s)

  • LDC’s are not a homogeneous group

  • Fourth World vs. Third World Countries

    • Fourth World countries are LDC’s whose living standards are very low (sub-Saharan, Nepal, India)

  • Second World vs. First World Countries

    • Second World countries are previously non-market economies of central and Eastern Europe which exhibit characteristics of LDC’s.

  • Low Income - Per capita Incomes < $725

  • Lower-Middle Income - $726 <Per capita Incomes > $2,900

  • Upper-Middle Income - $ 2901 < Per capita Incomes < $8,955

  • High Income - Per capita Incomes > $8,955

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Characteristics of LDC’s vs Others

Source: World Bank, World Development Report 1996.

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Trade and LDC’s vs Others

Source: World Bank, World Development Report 1996.

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Static vs. Dynamic Effects of Trade

  • Static Effects of Trade on Development

    • Developed in Standard Trade Model.

    • Mutual Gains by specializing in goods with comparative advantage.

    • For LDC’s this should expand sectors that are labor-intensive.

      • Primary effect to reduce unemployment, not raise real wage.

      • Trade acts as “vent for surplus” labor.

    • Possible problems

      • Greater instability in income if inelastic demand, undesirable terms of trade effects from export expansion.

  • Dynamic Effects of Trade on Development

    • Infant industry argument if economies of scale & cost advantage.

    • Free trade has positive antitrust effects, increased investment, dissemination of technology, & builds market institutions.

    • Assumes export sector is linked to rest of economy. If not, economy may develop export “growth poles” that do not spillover.

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Problems in Trade and Development

LDC Export Instability

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Export Instability

  • Export Instability:

    • Export earnings of LDC’s fluctuate more than export earnings of Developed Countries.

    • Problem given high degree of openness of LDC’s, so export variability leads to GNP variability which is undesirable.

  • Causes of Export Instability:

    • All reasons associated with fact that LDC exports more heavily concentrated in primary products than manufactures.

    • Agriculture products have inelastic supply, fluctuations in demand lead to large swings in export prices and revenues.

    • Primary products are necessities or inputs with inelastic demand, supply changes lead to large swings in export prices and revenues.

    • LDC export bundle has high degree of commodity concentration. Lack of export diversity exposes LDC income to industry variations.

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1. Inelastic Supply &

Fluctuations in Demand

2. Inelastic Demand &

Fluctuations in Supply











Causes of Export Instability

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Policies to Stabilize Export Earnings

  • Several policies have been tried by LDC’s to stabilize their export earnings. None has been very successful.

    International Commodity Agreements (ICA’s)

  • International Buffer Stock Agreements:

    • If world price falls below set floor, international agency enters market and buys good until floor attained.

    • If world price rises above set ceiling price, agency sells good.

  • International Export Quota Agreements:

    • Producer Cartel chooses target sale price, forecasts demand, sets quantity produced to achieve target price. Prod’n quotas adjusted if demand fluctuates to keep target price.

  • Compensatory Financing:

    • If export earnings fall below some forecast level, international agency (IMF) extends short-term loan, repaid later

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Problems with ICA’s in Practice

  • LDC’s have been enthusiastic users of ICA’s. Problems with ICA’s in practice fall into two categories.

  • Are effective ICA’s possible?

    • Crucial for buffer stocks are levels of ceiling & floor prices .

      • If this price range does not include LR free-market equilibrium world price then agreement will not be sustainable.

    • Crucial for export quotas are ability to forecast demand and for agreement to control all exporters of the good.

  • Are ICA’s desirable?

    • ICA’s may reduce export earnings and welfare of producing countries.

    • Crucial whether price changes due to variations in supply or demand.

    • If price changes from demand shifts then ICA’s can hurt nation.

    • If price changes from supply shifts then ICA’s can help nation.

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Problems in Trade and Development

LR Decline in LDC Terms of Trade

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LR Decline in LDC Terms of Trade

  • Alleged there is persistent tendency for LDC’s terms of trade (TOT) to fall over time.

    • Prebisch-Singer hypothesis from statistical studies in 1950’s.

    • Inferences invalid due to measurement error in terms of trade (exports f.o.b./imports c.i.f.) and quality changes in manufactures.

    • Recent evidence mixed, more primary product price declines.

  • Reasons for Alleged LR Decline in LDC TOT

    • Differing income elasticities of demand for primary versus manufactured products.

    • Unequal market power in product and factor markets, particularly oligopoly pricing in manufactures.

    • Technical change has reduced demand growth for primary products.

    • Multi-national corporations (MNC’s) worsen through transfer pricing when LDC’s have restrictions on repatriating profits.

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Policies to Stop LDC’s Declining TOT

  • Export Diversification

    • LDC’s should diversify into manufactured exports to reduce volatility of export earnings based only on primary products. Difficult to do.

  • Export Cartels

    • Use monopoly power to increase export price of commodity.

    • Requires no substitutes for good & no exporters cheat on cartel price.

    • Also Need Demand inelastic, both in SR and LR.

  • Import and Export Restrictions

    • Generally require country to be “large” for significant effect on TOT.

  • Economic Integration Projects

    • LDC’s may form free-trade areas or common markets among selves or with both LDC’s and Developed Countries..

    • Increase trade between, develop unified presence in world markets, facilitate transfer of technology and capital.

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Inward vs. Outward Looking Strategies

  • Appropriate trade strategy for an LDC?

  • Inward-Looking Strategy

    • Emphasizes import-substitution, attempts to withdraw from trade.

    • May work if economies of scale in import substitutes or infant industry argument for potential exports.

  • Outward-Looking Strategy

    • Emphasizes increase international trade from comparative advantage.

    • Focus is on efficient allocation of factors in prod’n.

    • May also involve export-promotion policies.

  • Empirical Results

    • Economic performance of outward-oriented economies braodly superior to that of inward-oriented economies in terms of avg. growth in real GDP, per capita GDP, income dist’n but not inflation.

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Economic Dualism

  • Dual Economy

    • Developing economy that is divided into two sectors with significantly different levels of development.

    • Generally think of a modern (high wage, high value output per worker, capital-intensive) vs. a traditional sector.

  • Reasons for Dualism

    • Markets within the economy are working poorly, particularly factor markets. Wage differentials argument combined with high urban unemployment.

    • Import-substitution trade policies can aggravate dualism. Capital-intensity of import-substituting industries lead to wage differential.

    • Export-promoting trade policies can cause dualism if export sector disconnected from rest of domestic economy (growth pole).