Preview

1. Preview • Trade policy in developing countries: Infant Industry Argument and Import-Substituting Industrialization • Results of Favoring Manufacturing: Problems of Import-Substituting Industrialization • Trade liberalization Since 1985 • Trade and Growth: Takeoff in Asia

2. Preview • Controversies in Trade • Technology and Externalities • The “Brander-Spencer anlysis” • Globalization and Low-wage Labor • Globalization and the Environment

3. The Infant Industry Argument From World War II until 1970s: Many developing countries attempted to accelerate their development by limiting imports of manufactured goods (“import-substitution policy”). • Goal: To foster a manufacturing sector serving the domestic market.

4. The Infant Industry Argument (cont.) The most important theoretical economic argument for import-substitution is infant industry argument: Developing countries have a potential comparative advantage in manufacturing, BUT new manufacturing industries in developing countries cannot initially compete with well established manufacturing in developed countries  Government should temporarily support new industries (using tariffs or import quotas) until they have grown strong enough to meet international competition

5. The Infant Industry Argument (cont.) Historical evidence that some of the world’s largest market economies began their industrialization behind trade barriers: • United States had high tariff rates on manufacturing in the 19th century; • Japan had extensive import control until the 1970 The infant industry argument seems highly plausible, and in fact it has been persuasive to many governments, but economists have pointed out many pitfalls in the argument, suggesting that it must be used cautiously…

6. The Infant Industry Argument (cont.) Problems with the Infant Industry Argument: • It’s not a good idea to try to move today into the industries that will have a comparative advantage in the future. For example in the 1980s, South Korea became an exporter of automobiles: it would probably not have been a good idea for South Korea to have tried to develop its auto industry in the 1960s, when capital and skilled labor were still very scarce.

7. The Infant Industry Argument (cont.) 2. Protecting manufacturing does no good unless the protection itself helps make industry competitive. For example Pakistan and India have protected their manufacturing sectors for decades and have recently begun to develop significant exports of manufactured goods. BUT they export light manufactures like textile, not the heavy manufactures they protected  They would have developed their manufactured exports even if they would have not protected manufacturing (“pseudoinfant industry”)

8. The Infant Industry Argument (cont.) If an industry is supposed to be able to earn enough returns to be worth developing…why don’t private investors develop the industry without government help? Example: the U.S. biotechnology industry attracted hundreds of million of dollars of capital years before it made a single commercial sale

9. The Infant Industry Argument (cont.) Market Failure Justification for Infant Industry Protection: the fact that it is costly and time consuming to build up an industry is not a good argument for government intervention, unless there is some domestic market failure that prevent private markets from developing the industry as rapidly as they should.

10. The Infant Industry Argument (cont.) Two markets failures why infant industry argument may be a good idea: 1. Imperfect capital markets. If a developing country does not have a set of financial institutions (such as efficient stock markets and banks) that would allow savings from traditional sectors (such as agriculture) to be used to finance investment in new sectors (such as manufacturing) then low initial profits would be an obstacle to investment, even if the long term returns on the investment would be high. First best policy: to create a better capital market Second best policy: protection of new industries to earn current profits

11. The Infant Industry Argument (cont.) 2. Appropriability argument. Firms in a new industry (not any industry!) generate social benefits for which they are not compensated. Pioneering firms may, in addition to producing physical output, create intangible benefits (such as knowledge or new markets) in which they are unable to establish property rights. First best policy: to compensate firms for their intangible contributions Second best policy: encourage entry into a new industry by using trade policy

12. The Infant Industry Argument (cont.) Problems with the Infant Industry Argument: • In practice it is very difficult to evaluate which industry really warrant special treatment. • There are risks that a policy intended to promote development will end up being captured by special interests. • There are many stories of infant industries that have never grown up and remain dependent on protection

13. Import Substituting Industrialization (cont.) Import-substituting industrialization: In most developing countries the basic strategy for industrialization has been to encourage domestic industry by limiting imports of manufactured goods (through tariffs and quotas) BUT: Why not to encourage both import-substitution and exports? By protecting import-substituting industry, countries draw resources away from actual or potential export sectors.  A country’s choice to seek to substitute for imports is also a choice to discourage export growth

14. Import Substituting Industrialization (cont.) Why have countries preferred to choose import-substitution rather than export growth? Answer: A mixture of economics and politics. • Until the 1970s many developing countries were skeptical about the possibility of exporting manufactured goods • Import-substitution directly benefited powerful, established interest groups, while export promotion had no natural constituency

15. Import Substituting Industrialization (cont.) • The 1950s and 1960s saw the high tide of import-substituting industrialization. • In the larger developing countries, domestic products almost completely replaced imported consumer goods (with the notable exception of sophisticated manufactured goods such as computers and precision machine tools). • The most extreme example was India: in the early 1970s, India’s imports of products other than oil were only about 3 percent of GDP

16. Import Substituting Industrialization (cont.) Did import-substituting work as a strategy to encourage growth of manufacturing? Answer: Yes! (examples: Latin America and India) BUT the goal was economic development… Did import-substituting industrialization promote economic development? Answer: Economists have serious doubts. Many economists approved import substituting measures in the 1950s and early 1960s. Since 1960s this strategy has come under increasingly harsh criticism. Much of the focus of economic analysts and of policy makers has shifted from trying to encourage import-substitution to trying to correct the damage done by bad import-substitution policies.

17. Problems of Import-Substituting Industrialization Import-substituting industrialization began to lose favor when it became clear that countries using this strategy were not catching up with advanced economies, even if they developed a domestic manufacturing industry. Example: India was poorer relative to the U.S. in 1980 than it had been in 1950, the first year after it had achieved independence. Why didn’t import-substituting industrialization work the way it was supposed to?

18. Problems of Import-Substituting Industrialization (cont.) Infant industry argument is not as universally valid as many people had assumed. A period of protection will not create a competitive manufacturing sector if there are fundamental reasons why a country lacks a comparative advantage in manufacturing. Poor countries have problems of social organization and lack: • skilled labor; • entrepreneurs; • managerial competence.

19. Problems of Import-Substituting Industrialization (cont.) These problems cannot be solved by trade policy! An import quota can allow an inefficient manufacturing sector to survive, but it cannot directly make that sector more efficient. The infant industry argument is that, given the temporary shelter of tariffs or quotas, the manufacturing industries of developing countries will learn to be efficient. In practice this is not usually true…

20. Problems of Import-Substituting Industrialization (cont.) What are the costs of import-substituting industrialization? • Distorted incentives. The high rates of effective protection allowed industries to exist even when their cost of production was three or four times the price of the imports they replaced.

21. Problems of Import-Substituting Industrialization (cont.) 2) Promote production at an inefficiently small scale. The domestic markets are only a small fraction of the size of that of the US. or the E.U.  often, the whole domestic market is not large enough to allow an efficient-scale production facility. 3) Opponents of import-substituting industrialization also argue that it has aggravated income inequality and unemployment

22. Problems of Import-Substituting Industrialization (cont.) By the late 1980s the critique of import-substituting industrialization had been widely accepted, not only by economists but also by international organizations like the World Bank, and even by policy makers in the developing countries themselves. Statistical evidence suggests that developing countries that followed relatively free trade policies had, on average, grown more rapidly than those that followed protectionist policies  Shift in actual policies, as many developing countries removed import quotas and lowered tariff rates.

23. Trade Liberalization Since 1985 The shift of developing countries toward free trade is the big trade policy story of the past two and a half decades.

24. Trade Liberalization Since 1985 What effects did these policies have? • A dramatic increase in the volume of trade. The share of trade in GDP has tripled over the period 1970-2008, with most of the growth happening after 1985.

25. Trade Liberalization Since 1985 2) A change in the nature of trade. Before the change in trade policy, developing countries mainly exported agricultural and mining products. After 1980 the share of manufactured goods in developing country exports surged, dominating the exports of the biggest developing countries.

26. Trade Liberalization Since 1985 (cont.) Has open trade delivered better results that import-substituting in terms of economic development? Answer: the picture is mixed. Brazil and other Latin America countries: growth rates have been slower since the trade liberalization of the late 1980s than they were during import-substituting industrialization. Increase in inequality. India: experienced an impressive acceleration of growth, but…how much of this acceleration can be attributed to free trade? BUT one thing is clear: the old view that import-substitution is the only path to development has been proved wrong. A number of developing countries have achieved extraordinary growth while becoming MORE, not less, OPEN TO TRADE!

27. Trade and growth: takeoff in Asia By the 1970s there was a widespread disillusionment with import-substituting industrialization as a development strategy. BUT what could take its place? A possible answer began to emerge as economists and policy makers took note of some surprising success stories in the developing world. Some economies experienced a dramatic acceleration in their growth and began to converge on the incomes of advanced economies.

28. Trade and growth: takeoff in Asia (cont.) At first a group of relatively small economies (the so called “Asian tigers”): • South Korea (started its economic growth in the 1960s) • Taiwan • Hong Kong • Singapore Then these successes began to spread and the list now include the world’s two most populated nations: • China (started its economic growth at the end of the 1970s) • India (started its economic growth in 1990)

29. Trade and growth: takeoff in Asia (cont.)

30. Trade and growth: takeoff in Asia (cont.) What caused these economic takeoffs? Each of the countries we mentioned experienced a major change in its economic policy: reduced government regulation in a variety of areas, including a move toward free trade. The most spectacular change was in China, where Deng Xiaoping, who had taken power in 1978, converted a centrally planned economy into a market economy.

31. Trade and growth: takeoff in Asia (cont.) All the policy reforms were followed by a large increase in the economy’s openness (as measured by the share of exports in GDP). • Asian success stories demonstrated that the proponents of import-substituting industrialization were wrong: It is possible to achieve development through export-oriented growth!

32. Trade and growth: takeoff in Asia (cont.)

33. Trade and growth: takeoff in Asia (cont.) BUT it is unclear at which extent trade liberalization explain these success stories. Trade liberalization were only part of the economic reforms these nations undertook, which makes it difficult to assess the importance of trade liberalization per se. AND Latin America countries which liberalize trade and shifted towards exports did not see comparable economic takeoffs other factors played a crucial role in the Asian miracle!

34. Trade and growth: takeoff in Asia (cont.) Although the implications of Asia’s economic takeoff remain somewhat controversial, one thing is clear: It is not true that the world economy is rigged against new entrants and that poor countries cannot become rich. Never before in human history have so many people experienced such a rapid rise in their living standards…

35. Controversies in Trade Policies Three main controversies over international trade have risen over the last three decades: • in the 1980s: Sophisticated arguments for government intervention in trade in advanced countries to protect “high-technology” industries; • in the 1990s: Dispute over the effects of growing international trade on workers in developing countries; • more recently: Concern about the intersection between environmental issues and trade policy.

36. Technology and externalities The argument: If firms in an industry generate knowledge that other firms can use without paying for it, the industry is producing some extra output. Where such externalities (=cost or benefit which affects a party who did not choose to incur that cost or benefit) can be shown to be important, there is a good case for subsidizing the industry. Note that it is the same argument for the infant industries of developing countries.

37. Technology and externalities (cont.) In high technology industries, firms devote a great deal of their resources to improve technology by: • spending on Research & Development or • be willing to take initial losses on new product and processes to gain experience. Firms can appropriate some, but not all, of the benefits of their own investment in knowledge (otherwise they would not investing!). Some of the benefits go to other firms that can imitate the ideas and techniques of the leaders (example: “reverse engineering” in electronics)

38. Technology and externalities (cont.) Patents law provide only weak protection for innovators • Under free trade high technology firms do not receive as strong an incentive to innovate as they should. Should the U.S. government subsidize high technology industries? We need to exercise some caution: • Can the government target the right industries or activities? • How important, quantitatively, would the gains be from such targeting?

39. Technology and externalities (cont.) A general principle is that trade and industrial policy should be targeted specifically on the activity in which the market failure occurs • Policy should seek to subsidize the generation of knowledge that firms cannot appropriate. BUT it is quite difficult to identify and measure that knowledge generation.

40. The “Brander-Spencer analysis”: Imperfect competition and Strategic Trade Policy Argument: Market failure due to the lack of perfect competition justifies government intervention (Brander-Spencer analysis). In some industries there are only a few firms in effective competition  the assumptions of perfect competition does not apply. There will be excess returns: firms will make profits above what equally risky investments elsewhere in the economy can earn  International competition over who gets these profits

41. The “Brander-Spencer analysis”: Imperfect competition and Strategic Trade Policy (cont.) In this case it is possible, in principle, for a government, to alter the rules of the game to shift these excess returns from foreign to domestic firms. A subsidy to domestic firms, by deterring investment and production by foreign competitors, can rise the profits of domestic firms by more than the amount of the subsidy. If there are no effects on domestic consumers (for example the firms are selling only in foreign markets) this capture of profits from foreign competitors would mean the subsidy raises national income at other countries’ expense.

42. The “Brander-Spencer analysis”: An example Suppose that • two firms competing,each from a different country: Boeing (United States) and Airbus (European Union). They are both aircraft manufacturers • there is a new product, a superjumbo aircraft, that both firms are capable of making; • each firm can make only a yes/no decision: either to produce superjumbo aircraft or not.

43. The “Brander-Spencer analysis”: An example (cont.)

44. The “Brander-Spencer analysis”: An example The table reflects the following assumption: either firm alone could earn profits making superjumbo aircraft, but if both firms try to produce them, both will incur losses. Which firm will actually get the profits? This depends on who gets there first. Suppose Boeing is able to get a small head start and commits itself to produce superjumbo aircraft before Airbus can get going. Airbus will find that it has no incentive to enter. The outcome will be in the upper right part of the table, with Boeing earning profits.

45. The “Brander-Spencer analysis”: An example (cont). Now comes the Brander-Spencer point: The European government can reverse this situation. How? Suppose the European government commits itself to pay its firm a subsidy of 25 if it enters. What is the result? The table of payoff is now different

46. The “Brander-Spencer analysis”: An example (cont).

47. The “Brander-Spencer analysis”: An example (cont). In this case it will be profitable for Airbus to produce superjumbo aircraft whatever Boeing does. Boeing now knows that whatever it does, it will have to compete with Airbus and will therefore lose money if it chooses to produce  Now it is Boeing that will be deterred from entering The government subsidy has removed the advantage of a head start that we assumed was Boeing’s and has conferred it on Airbus instead

48. Problems with the “Brander-Spencer analysis This strategic trade policy argument might seem to provide a compelling case for government activism. BUT What are the pitfalls of this argument? • Insufficient information. It may be very difficult to fill in the entries in the table of payoffs. If the government gets it wrong, a subsidy may turn out to be a costly misjudgment.

49. Problems with the “Brander-Spencer analysis (Cont.) Suppose that Boeing has some underlying advantage (e.i. a better technology) so that even if Airbus enters, Boeing will still find it profitable to produce. Airbus, however, cannot produce profitably if Boeing enters. Suppose that the EU government provides a subsidy to induce Airbus to produce. In this case the subsidy won’t act as a deterrent to Boeing, and the profits of Airbus will fall short of the subsidy’s value. • The policy will turn out to have been a costly mistake! The desirability of strategic trade policies depends on the exact reading of the situation…

50. Problems with the “Brander-Spencer analysis (Cont.) • Industries are not isolated. If one industry is subsidized, it will draw resources from other industries and lead to increases in their costs.  Even if the government has a precise understanding of one industry, this is not enough, because it also needs an equally precise understanding of those industries with which that industry compete for resources.