Chapter 12 Factor endowment trade theory

The neoclassical model of free trade, which postulates that

12.3 The traditional theory of International Trade countries will tend to specialise in the production of the
commodities that make use of their abundant factors of
Barter transactions production (land, labour, capital, etc.)
The trading of goods directly for other goods in
economies not fully monetized  The classical comparative advantage theory of free
trade is a static model based strictly on a one-
 A transaction is an exchange of two things— variable-factor (labour cost), complete-specialisation
something is given up in return for something else approach to demonstrating the gains from trade

12.3.1 Comparative Advantage

 Hecksher-Ohlin neoclassical (or variable-proportions)
 Countries, like people, specialise in a limited range of factor endowment trade theory also enables us to
production activities because it is to their advantage describe analytically the impact of economic growth
to do so. on trade patterns and the impact of trade on the
 They specialise in activities where the gains from structure of national economies and on the
specialisation are likely to be the largest differential returns or payments to various factors of
production
Comparative advantage
Production of a commodity at a lower opportunity cost  neoclassical factor endowment model assumes away
than any of the alternative commodities that could be inherent differences in relative labour productivity by
produced. postulating that all countries have access to the same
technological possibilities for all commodities
Specialisation
Concentration of resources in the production of relatively  basis for trade arises not because of inherent
few commodities technological differences in labour productivity for
different commodities between different countries but
 Concept of relative cost and price differences is basic because countries are endowed with different factor
to the theory of international trade. supplies.

Principle of comparative advantage Factor endowment theory is based on two crucial

Asserts that a country should, and under competitive propositions
conditions will, specialise in the export of the products
that it can produce at the lowest relative cost 1. Different products require productive factors in
different relative proportions
2. Countries have different endowments of factors of
Absolute advantage production
Production of a commodity with the same amount of real
resources as another producer but at a lower absolute  The main conclusions of the neoclassical model of
unit cost. free trade are that all countries gain from trade and
world output is increased
12.3.2 Relative Factor Endowments and International
Specialisation: The Neoclassical Model Factor price equalisation
In factor endowment trade theory, the proposition that Unemployment, Resource Underutilisation, and the
because countries trade at a common international price Vent-for-Surplus Theory of International Trade
ratio, factor prices among trading partners will tend to The assumption of full employment in traditional trade
equalise models, like that of the standard perfectly competitive
equilibrium model of microeconomic theory, violates the
12.3.3 Trade Theory and Development: The Traditional reality of unemployment and underemployment in
Arguments developing nations

 Trade tends to promote greater international and Vent-for-surplus theory of international trade
domestic equality by equalising factor prices, raising The contention that opening world markets to developing
real incomes of trading countries, and making countries through international trade allows those
efficient use of each nation’s and the world’s resource countries to make better use of formerly underutilised land
endowment and labour resources so as to produce larger primary-
product outputs, the surpluses of which can be exported
12.4 The Critique of Traditional Free-Trade Theory in the
Context of Developing-Country Experience  underutilised human resources create the opportunity
to expand productive capacity and GNI at little or no
12.4.1 Fixed Resources, Full Employment, and the real cost by producing for export markets products
International Immobility of Capital and Skilled Labour that are not demanded locally

Trade and Resource Growth: North–South Models of  The opening up of the nation to foreign markets
Unequal Trade (probably as a result of colonisation) provides the
This initial assumption about the static nature of economic impetus to utilise these idle resources
international exchange—that resources are fixed, fully (mostly excess land and labour) and expand primary-
utilised, and internationally immobile with product product exportable production on the production
production functions everywhere identical —is central to frontier
the traditional theory of trade and finance.
12.4.2 Fixed, Freely Available Technology and Consumer
 Relative factor endowments and comparative costs Sovereignty
are not a given but are in a state of constant change

North–South trade models Synthetic substitutes

Trade and development theories that focus on the unequal Commodities that are artificially produced but can be
exchange between the North developed countries and the substituted for the natural commodities (e.g.,
South developing countries in an attempt to explain why manufactured rubber, cotton, wool, camphor, and
the South gains less from trade than the North pyrethrum).

 Porter argues that “the central task facing developing Product cycle
countries is to escape from the straitjacket of factor- In international trade, the progressive replacement of
driven national advantage. . . where natural resources, more-developed countries by less-developed countries in
cheap labour, locational factors and other basic factor the production of manufactures of increasing complexity
advantages provide a fragile and often fleeting ability
to export.” 12.4.3 Internal Factor Mobility, Perfect Competition, and
Uncertainty: Increasing Returns, Imperfect Competition,
and Issues in Specialisation
 Attempts by producers to distinguish their product from
 The traditional theory of trade assumes that nations similar ones through advertising or minor design changes.
are readily able to adjust their economic structures to
the changing dictates of world prices and markets Risk
A situation in which the probabilities of the various
 The more dependent nations become on a few possible outcomes are known, but the actual outcome is
primary-product exports, the more inflexible their not known.
economic structures become, and the more vulnerable
they are to the unpredictabilities of international Uncertainty
markets A situation in which neither the actual outcome nor even
 The internal processes of adjustment and resource the precise probabilities of the various possible outcomes
reallocation that are necessary to capitalise on are known.
changing world economic conditions are much more
difficult for the less diversified developing economies  From the perspective of developing nations trying to
to realise than for their rich counterparts in the North diversify their economies and promote industrial
 By assuming either fixed or diminishing returns to exports in particular, the phenomenon of increasing
scale (fixed or increasing production costs as output returns and product differentiation (monopolistic
is expanded), the labour cost and factor endowment competition), combined with the noneconomic power
theories of trade neglect one of the most important of large multinational corporations (their political
phenomena in international economic relations. influence with many governments—see Chapter 14),
means that the first nations to industrialise (the rich
 Decreasing production costs mean simply that large nations) are often able to take advantage of these
existing firms are able to underprice smaller or new economies of scale and differentiated products to
firms and thus exert monopolistic control over world perpetuate their dominant position in world markets
markets  Second major limitation of the perfectly competitive
assumption of trade models is its exclusion of risk
Returns to scale and uncertainty in international trading arrangement
How much output expands when all inputs are
proportionately increased.

Monopolistic market control 12.4.4 The Absence of National Governments in Trading

A situation in which the output of an industry is controlled Relations
by a single producer (or seller) or by a group of producers
who make joint decisions.  Cumulative processes for inequality within nation-
states by which growth poles may expand rapidly
Oligopolistic market control while other regions stagnate can be modified by
A situation in which a small number of rival but not government through legislation, taxes, transfer
necessarily competing firms dominate an industry. payments, subsidies, social services, regional
development programmes, and so forth
Increasing returns
A disproportionate increase in output that results from a Growth poles
change in the scale of production. Regions that are more economically and socially advanced
than others around them, such as urban centres versus
Product differentiation rural areas or highway corridors in developing countries.
 Governments are often partisan players whose A situation in which the value of a country’s exports and
activist interventions in this area of industrial policy the value of its imports are equal.
are specifically designed to create a comparative
advantage where none existed before but where world 12.4.5 Balanced Trade and International Price
demand is likely to rise in the future. Adjustments

Industrial policy  Terms of trade (international commodity price ratios)

Deliberate effort by governments to guide the market by adjust to equate supply and demand for a country’s
coordinating and supporting specific industrial activities exportable and importable products so that trade is
 (guiding the market through strategic coordination of always balanced; that is, the value of exports
business investments to increase export market (quantity times price) is always equal to the value of
shares) imports.
 With balanced trade and no international capital
 When developed-nation governments pursue movements, balance-of-payments problems never
restrictive economic policies that are designed to deal arise in the pure theory of trade
with purely domestic issues such as inflation or
unemployment, these policies can have profound 12.4.6 Trade Gains Accruing to Nationals
negative effects on the economies of developing  The sixth and final major assumption of traditional
nations trade theory, that trade gains accrue to nationals in the
 Developing nations’ domestic economic policies trading countries, is more implicit than the other five
generally have little impact on the economies of rich
nations Enclave economies
Small, economically developed regions in developing
Tariff countries in which the remaining areas have experienced
A fixed-percentage tax on the value of an imported far less progress
commodity levied at the point of entry into the importing  those with substantial foreign-owned mining and
country. plantation operation

Quota  In some enclave economies in developing countries,

In international trade, a physical limitation on the quantity foreigners often pay very low rents for the rights to
of any item that can be imported into a country. use land, bring in their own foreign capital and skilled
labour, hire local unskilled workers at subsistence
Subsidy wages, and have a minimal effect on the rest of the
A payment by the government to producers or distributors economy, even though they may generatesignificant
in an industry for such purposes as preventing the decline export revenues
of that industry, expanding employment, increasing
exports, or reducing selected prices paid by consumers. “manufacturing export enclaves”
personal computer assembly, shoe and toy manufacture,
Gains from trade etc.
The increase in output and consumption resulting from
specialisation in production and free trade with other GDP
economic units, including persons, regions, or countries. is a measure of the value of output generated within
defined geographic boundaries, and gross national income
Balanced trade GNI
measures the income actually earned by nationals of that  stress the need for nations to evolve their own styles
country of development and to control their own destiny
 To the extent that the export sector, or, for that
matter, any sector of the economy, is foreign owned Import substitution
and operated, GDP will be that much higher than A deliberate effort to replace consumer imports by
GNI, and fewer of the benefits of trade will actually promoting the emergence and expansion of domestic
accrue to nationals of developing countries industries.
 A developing country’s export performance can be
deceptive unless we analyse the character and Export promotion
structure of export earnings by ascertaining who Governmental efforts to expand the volume of a country’s
owns or controls the factors of production that are exports through increasing export incentives, decreasing
rewarded as a result of export expansion disincentives, and other means in order to generate more
foreign exchange and improve the current account of its
12.4.7 Some Conclusions on Trade Theory and Economic balance of payments or achieve other objectives
Development Strategy
“strong export promotion”
Foreign-exchange earnings in which policies are explicitly geared to expansion of
The sum total of all foreign currency receipts less exports (in general, such as through a weak currency),
expenditures during a given fiscal year rather than production for the domestic market

 where opportunities for profitable exchange arise, “weak export promotion”

foreign trade can provide an important stimulus to emphasises free trade and a level playing field and is
aggregate economic growth viewed by advocates as likely to promote exports by
comparison with previous import substitution policies
12.5 Traditional Trade Strategies and Policy Mechanisms (which tend to discourage exports in relative terms)
for Development: Export Promotion Versus Import
Substitution 1. Primary outward-looking policies (encouragement of
agricultural and raw-materials exports)
Outward-looking development policies 2. Secondary outward-looking policies (promotion of
Policies that encourage exports, often through the free manufactured exports)
movement of capital, workers, enterprises, and students; a 3. Primary inward-looking policies (mainly agricultural
welcome to multinational corporations; and open self-sufficiency)
communications. 4. Secondary inward-looking policies (manufactured
 encourage not only free trade but also the free commodity self-sufficiency through import substitution)
movement of capital, workers, enterprises and
students. . . , the multinational enterprise, and an open 12.5.1 Export Promotion: Looking Outward and Seeing
system of communication Trade Barriers

 It was partly in reaction to this enclave economic

structure and partly as a consequence of the
Inward-looking development policies industrialisation bias of the 1950s and 1960s that
Policies that stress economic self-reliance on the part of most developing countries put great emphasis on the
developing countries, including domestic development of production of manufactured goods initially for the
technology, the imposition of barriers to imports, and the home market (secondary inward) and then for export
discouragement of private foreign investment. (secondary outward).
 Expanding Exports of Manufactured Goods: Benefits in
Primary-Commodity Export Expansion: Limited Theory and Barriers in Practice
Demand
Many low-income countries still rely on primary products  Multifibre Arrangement (MFA) A set of non-tariff
for a majority of their export earnings. quotas established by developed countries on imports
of cotton, wool, synthetic textiles, and clothing from
Five (5) factors working against the rapid expansion of individual developing countries
primary-product (especially agricultural) exports.
“new protectionism”
1. The income elasticities of demand for agricultural
foodstuffs and raw materials are relatively low compared
with those for fuels, certain minerals, and manufactures 12.5.2 Import Substitution: Looking Inward but Still
2. Developed-country population growth rates are now at Paying Outward
or near the replacement level, so little expansion can be
expected from this source.  import substitution entails an attempt to replace
3. The price elasticity of demand for most primary commodities that are being imported, usually
commodities is relatively low. manufactured consumer goods, with domestic sources
4. The development of synthetic substitutes of production and supply
5. The growth of agricultural protection in the developed
countries  Although initial costs of production may be higher
 When relative agricultural prices are falling, as they than former import prices, the economic rationale put
have been during most of the past five decades, such forward for the establishment of import-substituting
low elasticities mean less total revenue for exporting manufacturing operations is either that the industry
nations will eventually be able to reap the benefits of large-
scale production and lower costs (the so-called infant
International commodity agreement industry argument for tariff protection) or that the
A formal agreement by sellers of a common balance of payments will be improved as fewer
internationally traded commodity (e.g., coffee, sugar) to consumer goods are imported
coordinate supply to maintain price stability
 intended to set overall output levels, stabilise world Infant industry
prices, and assign quota shares to various producing A newly established industry, usually protected by a tariff
nations for such items as coffee, tea, copper, lead, and barrier as part of a policy of import substitution.
sugar
12.5.3 Tariffs, Infant Industries, and the Theory of
 Over-expansion of supply tends to drive down prices Protection
and curtail the growth of earnings for all countries
 Commodity agreements attempt to guarantee  Tariff protection against the imported commodity is
participating nations a relatively fixed share of world needed, so the argument goes, in order to allow the
export earnings and a more stable world price for now higher-priced domestic producers enough time to
their commodity learn the business and to achieve the economies of
scale in production and the external economies of
 Synthetic substitutes for commodities act both as a learning by doing that are necessary to lower unit
brake against higher commodity prices and as a direct costs and prices
source of competition in world export markets
 For many developing-country industries, in theory, an primarily through the use of tariffs and physical quotas,
IS strategy becomes the prerequisite for an EP we need to analyse the role and limitations of these
strategy. commercial policy instruments in developing nations

 By restricting imports, both quotas and tariffs can

 If this country were then to open its economy to improve the balance of payments.
world trade, its small size in relation to the world
market would mean that it would face a horizontal, Two (2) basic measures of protection: the nominal rate
perfectly elastic demand curve. In other words, it and the effective rate
could sell (or buy) all it wanted at a lower world
price, P2 1. Nontariff trade barrier
A barrier to free trade that takes a form other than a tariff,
 The higher the tariff, the closer to the domestic price such as quotas or (possibly arbitrary) sanitary
the sum of the world price plus the import tax will be. requirements.
 shows the extent, in percentages, to which the
12.5.4 The IS Industrialisation Strategy and Results domestic price of imported goods exceeds what their
price would be in the absence of protection
 The net effect of overvaluing exchange rates in the
context of import substitution policies is to encourage 2. Nominal rate of protection
capital-intensive production methods still further An ad valorem percentage tariff levied on imports.
(because the price of imported capital goods is
artificially lowered) and to penalise the traditional  The effective rate of protection shows the percentage
primary-product export sector by artificially raising by which the value added at a particular stage of
the price of exports in terms of foreign currencies processing in a domestic industry can exceed what it
 This overvaluation, then, causes local farmers to be would be without protection
less competitive in world markets.
Effective rate of protection
Official exchange rate The degree of protection on value added as opposed to the
Rate at which the central bank will buy and sell the final price of an imported product—usually higher than
domestic currency in terms of a foreign currency such as the nominal rate of protection.
the US dollar.
Value added
Free-market exchange rate Amount of a product’s final value that is added at each
Rate determined solely by international supply and stage of production.
demand for domestic currency expressed in terms of, say,  Effective rates of protection show the net effect on a
US dollars. firm or industry of restrictions on the imports of both
its outputs and its inputs
Overvalued exchange rate
An official exchange rate set at a level higher than its real 12.5.5 Foreign-Exchange Rates, Exchange Controls, and
or shadow value the Devaluation Decision

 Official foreign-exchange rates are not necessarily set

Tariff Structures and Effective Protection at or near the economic equilibrium price for foreign
Because import substitution programmes are based on the exchange—that is, the rate at which the domestic
protection of local industries against competing imports demand for a foreign currency such as dollars would
 just equal its supply in the absence of governmental Foreign-exchange-rate system with a highly overvalued
regulation or intervention and legally fixed rate applied to capital-and intermediate-
goods imports and a second, illegal (or freely floating) rate
In situations of excess demand, developing-country for imported consumption goods.
central banks have three basic policy options to
maintain the official rate of exchange. Devaluation
A lowering of the official exchange rate between one
1. They can attempt to accommodate the excess demand country’s currency and all other currencies.
by running down their reserves of foreign exchange
2. They can attempt to curtail the excess demand for Depreciation (of currency)
foreign exchange by pursuing commercial policies and tax The decline over time in the value or price of one currency
measures that are designed to lessen the demand for in terms of another as a result of market forces of supply
imports and demand.
3. They can regulate and intervene in the foreign-
exchange market by rationing the limited supply of
available foreign exchange to “preferred” customers  By lowering the foreign-currency price of its exports
(and thereby generating more foreign demand) while
Exchange control raising the domestic-currency price of its imports
A governmental policy designed to restrict the outflow of (and thereby lowering domestic demand), developing
domestic currency and prevent a worsened balance-of- countries that devalue their currency hope to improve
payments position by controlling the amount of foreign their trade balance vis-à-vis the rest of the world
exchange that can be obtained or held by domestic citizens
Flexible exchange rate
 Overvalued exchange rates reduce the domestic The exchange value of a national currency that is free to
currency price of imports below the level that would move up and down in response to shifts in demand and
exist in a free market for foreign exchange supply arising from international trade and finance.

 Overvalued currencies reduce the return to local Managed float

exporters and to import-competing industries that are A fluctuating exchange rate that allows central bank
not protected by heavy tariffs or physical quotas. intervention to reduce erratic currency fluctuations
Exporters receive less domestic currency for their
products than would be forthcoming if the free- Wage–price spiral
market exchange rate prevailed. A vicious cycle in which higher consumer prices (e.g., as a
 In the absence of export subsidies to reduce the result of devaluation) cause workers to demand higher
foreign-currency price of exports, exporters, mostly wages, which in turn cause producers to raise prices and
farmers, become less competitive in world markets worsen inflationary forces.
because the price of their produce has been artificially
elevated by the overvalued exchange rate Undervalued exchange rate
 Chronic payments deficits resulting primarily from An official exchange rate set at a level lower than its real
current account transactions (exports and imports) or shadow value
can possibly be ameliorated by a currency
devaluation  By altering the domestic price and returns of
“tradable” goods (exports and imports) and creating
Dual exchange rate (parallel exchange rate) incentives for the production of exports as opposed to
 domestic goods, devaluation will benefit certain  New protectionism The erection of various non-tariff
groups at the expense of others trade barriers by developed countries against the
manufactured exports of developing nation
 Note that while a neutral exchange rate favours
producing for neither the export market nor the Trade liberalisation
domestic market, and free-market economists tend to Removal of obstacles to free trade, such as quotas,
favour it because of its “level playing field” in that nominal and effective rates of protection, and exchange
respect, in contrast, an undervalued exchange rate is controls
strongly export promoting
 This is because it raises the local prices that firms 12.6 The Industrialisation Strategy Approach to Export
receive for goods that can be exported relative to Policy
prices of non tradable goods that are sold only to
domestic buyers, thus motivating a reorientation of 12.6.1 Export-Oriented Industrialisation Strategy
firms toward the export market.
Industrialisation strategy approach
A school of thought in trade and development that
12.5.6 Trade Optimists and Trade Pessimists: emphasises the importance of overcoming market failures
Summarising the Traditional Debate through government policy to encourage technology
transfer and exports of progressively more advanced
Trade optimists products
Theorists who believe in the benefits of free trade, open
economies, and outward-looking development policies. 12.7 South–South Trade and Economic Integration

Trade pessimists 12.7.1 Economic Integration and Development Strategy

Theorists who argue that without tariff protection or
quantitative restrictions on trade, developing countries Economic integration
gain little or nothing from an export-oriented, open- The merging to various degrees of the economies and
economy posture economic policies of two or more countries in a region.

Trade pessimists tend to focus on four (4) basic Economic union

themes: The full integration of two or more economies into a
single economic entity.
(1) the limited growth of world demand for primary
exports; Regional trading bloc
(2) the secular deterioration in the terms of trade for An economic coalition among countries within a
primary producing nations; geographic region, usually characterised by liberalised
(3) the rise of “new protectionism” against manufactured internal trade and uniform restrictions on external trade,
and processed agricultural goods from developing designed to promote regional economic integration and
countries; and growth.
(4) the presence of market failures that reduce the ability
of developing countries to move up to export higher-value Customs union
products A form of economic integration in which two or more
nations agree to free all internal trade while levying a
common external tariff on all nonmember countries.
Free-trade area
A form of economic integration in which free trade exists
among member countries, but members are free to levy
tariffs on nonmember countries.

Common market
A form of economic integration in which there is free
internal trade, a common tariff, and the free movement of
labour and capital among partner states.

Autarky
A closed economy that attempts to be completely self-
reliant.

Trade creation
Shift, upon formation of a customs union, in the location
of production from higher-cost to lower-cost member
states.

Trade diversion
Shift, upon formation of a customs union, of the location
of production of formerly imported goods from a lower-
cost nonmember state to a higher-cost member nation