Module 4

International Trade and Industrialization

Strategies
The role of trade in development strategies.
- why countries trade
-who gains and loses from trade
- what the policy instruments are that can be used to promote trade
- how trade affects both efficiency in the use of resources and the distribution of
income.
- How trade instruments can be used to design industrialization strategies, each of
which has particular advantages and risks.
• A key aspect of the process of globalization has been the rapid rise in the
importance of trade in GDP.

• Globalization
• Trade Openness

• In its core economic meaning, globalisation refers to the increased

openness of economies to international trade, financial flows, and direct
foreign investment
• https://www.youtube.com/watch?v=15d818t9UZ0

• https://www.youtube.com/watch?v=wLNp3kgBuuQ&t=41s
• Trade Openness
• Economies of the world have become far more linked/integrated than in the
past; a marked effect on the developing world.
• expanded international trade in services as well as primary and manufactured goods
• portfolio investments such as international loans and purchases of stock
• direct foreign investment, especially on the part of large multinational corporations.
• Foreign aid has increased far less in real terms; dwarfed by the now much larger
flows of both private capital and remittances.
• Have developing countries been affected by these trends ?
• Examine the theories of the effects of expanded international linkages for the
prospects of development.

• Globalization
• Globalisation
• A process by which the economies of the world become more integrated,
leading to a global economy and, increasingly, global economic
policymaking—for example, through international agencies such as the World
Trade Organization (WTO) .
• The increasing integration of national economies into expanding
international markets.
• Globalisation also refers to an emerging “global culture,” in which people
consume similar goods and services across countries
• The changes facilitate economic integration and are, in turn, further promoted
by it.
• But in its core economic meaning, globalisation refers to the increased openness
of economies to international trade, financial flows, and direct foreign
investment
• The growing interconnection across national governments and firms - a
process that affects everyone in the world, more so in the developed countries.
• A key aspect of the process of globalization has been the rapid rise in the
importance of trade in GDP.
• Globalisation carries benefits and opportunities as well as costs and risks.
• True for all peoples in all countries but especially for poor families in low-income countries, for
whom the stakes are much higher.
• The potential upside is greatest for developing countries; globalisation presents new possibilities
for broad-based economic development.
• By providing many types of interactions with people in other countries, globalization can potentially
benefit developing countries directly and indirectly through cultural, social, scientific, and
technological exchanges, as well as through conventional trade and finance.
• A faster diffusion of productive ideas, such as a shorter time between innovation and adoption of new
technologies around the world, might help developing countries catch up more quickly.
• Globalization makes it possible, at least in principle, for the LDCs to more effectively absorb the
knowledge that is one of the foundations of the wealth of developed countries.
• Adam Smith wrote in 1776, “the division of labour is limited by the extent of the market.” The
larger the market that can be sold to, the greater the gains from trade & the division of labour.
Moreover, the greater is the incentive for innovation, because the potential return is much larger.
• Potential downside of globalisation is also greater for poorer countries if they
become locked into a pattern of dependence, if dualism within developing countries
sharpens, or if some of the poor are entirely bypassed by globalisation.
• The share of international investment received by the poorest countries has been on a
long-term trend of falling rather than rising.
• All countries may be affected by increased vulnerability to capital flows, as the 2008
financial crisis has seemed to confirm, but developing countries more so.
• Widespread and understandable concerns about globalisation are based on the fact that
previous great waves of globalisation, associated with the colonial period, were
extraordinarily uneven in their impact.
• For some people
• exciting business opportunities
• efficiency gains from trade
• more rapid growth of knowledge and innovation
• transfer of knowledge to developing countries, facilitating faster growth – faster ‘catch-up’
• For other people
• inequalities may be accentuated both across and within countries,
• environmental degradation may be accelerated,
• international dominance of the richest countries may be expanded and locked in,
• some peoples and regions may be left further behind.

• Nobel laureate Muhammad Yunus in 2008:

• “Global trade is like a hundred-lane highway criss-crossing the world. If it is a free-for-all
highway, with no stop lights, speed limits, size restrictions, or even lane markers, its surface
will be taken over by the giant trucks from the world’s most powerful economies.”
•
 •. Share of exports in GDP
exports have grown faster than
GDP

Trade openness
Trade openness increased from
1967 to 2013 in all regions
• Wacziarg and Welch (2008) - 141 countries over the period 1960 to 2000
• Trade openness / trade liberalization – increase (improvement) in
indicators of economic performance - physical-capital investment,
and growth in GDPpc, on average across all countries
• Trade liberalization does indeed matter for economic performance.

• Previously non-traded services have seen a recent sharp increase in trade.

These include banking, insurance, telecommunications, retailing,
transportation, and professional services such as accounting, auditing,
and international law.
• In India, trade liberalization came rapidly in the context of the 1991
balance-of-payments crisis and imposition by the IMF of conditionalities
attached to structural adjustment loans that mandated trade liberalization
• reductions in trade protection induced higher levels of productivity in
manufacturing firms.
• Tariff reductions increased competition and caused firms to increase
their efficiency.
• Reduced import tariffs provided firms with more and cheaper access
to imported inputs. Increased competition and access to modern
inputs boosted firm-level productivity, particularly in
import-competing industries, in industries not subject to excessive
domestic regulation, and among domestic firms
• https://www.youtube.com/watch?v=5oxWxzJ_4dE
• https://www.youtube.com/watch?v=xJAdgUXQAM0
• Gains from Trade: Why Countries Trade, but not Everyone Gains
• When prices differ between countries by more than transaction costs, private traders
can profit from exporting and importing.
• More universal argument for international specialization based on aggregate
efficiency - In principle, the world as a whole could benefit if each country
specialized according to its relative efficiency
• There could be aggregate benefits to an international division of labor and
trade if this arises from real differences in efficiency.
• Practical obstacles to realizing such efficiency gains + distributing its benefits

• Examine the potential gain from trade

 •.

Measuring the efficiency and distributive effects of trade liberalization between

two countries
Apply the consumer & producer surplus to characterize the welfare gains or
losses for consumers, producers, & the nation as a whole from moving from
 •.

Both nations gain in the aggregate (Net Social Gain or surplus (NSG) > 0)
But its redistributive implications –
consumers gain at the expense of producers in the importing country (H)
Producers gain a the expense of consumers in the exporting country (R).
Hence in both countries there are aggregate efficiency gains, but also winners and losers from trading
 EFFICIENCY OF MARKETS
• Equilibrium in a market maximizes total welfare of buyers and
sellers.
• How?
• How much?

• Surplus
benefit that people receive when they buy something for less than
they would have been willing to pay;
OR
sell something for more than they would have been willing to accept.
• Willingness to pay

• Willingness to sell

• Consumer surplus

• Producer surplus
 CONSUMER SURPLUS
• Willingness to pay - the maximum price that a buyer would be
willing to pay for a good or service.
• Price < willingness to pay = Buy
• Price > willingness to pay = Not buy
• Price = willingness to pay = Indifferent

• Consumer surplus is the buyer’s willingness to pay for a good

minus the amount the buyer actually pays for it.
• Each person’s willingness to pay is a maximum. They are willing
to buy the good at any lower price.
Willingness to Pay and Demand
Schedule
Willingness to Pay and the Demand Curve
• Derive the demand schedule:

Price who buys Qd

Consumer WTP
> 100 None 0
A 100
B 80 81 – 100 A 1

C 70 71 – 80 A, B 2
D 50 51 – 70 A, B, C 3

0 – 50 A, B, C, D 4

22
 Price Who buys Qd
Willingness to pay and the demand curve >100 None 0

Price 81 - 100 A 1
71-80 A, B 2
100 A’ willingness to pay 51-70 A, B, C 3
s 0-50 A, B, C, D 4
80 B’ willingness to pay
s
70 C’s willingness to pay

50 D’ willingness to pay
s

Demand

0 1 2 3 4 Quantity
 Measuring Consumer Surplus with the Demand Curve
a) When Price = 80
(

Consumer surplus - amount a buyer is willing to pay minus the

amount the buyer actually pays
Price

The area below the

100
demand curve and A’ consumer surplus (20)

above the price s

80
measures the A’s Consumer Surplus =
70
consumer surplus in 100 – 80 = 20
a market 50

Demand
Others get no CS
because they do not
0 1 2 3 4 Quantity
buy the good at this
price
Measuring Consumer Surplus with the Demand Curve
(b) When Price = 70
A lower price makes buyers of a good better off

Price

100
A’ consumer surplus (30)
s
80
B’ consumer
70 s
surplus (10)

Tota
50 lconsumer
surplus (40)

Demand

0 1 2 3 4 Quantity
CS with Lots of Buyers & a Smooth D Curve
Price
P

At Q = 5, the marginal
buyer is willing to pay
Rs.50 for the good.
Suppose P = Rs. 30.
Then his consumer
surplus = Rs. 20.
D
Q
CS with Lots of Buyers & a Smooth D Curve

CS is the area between P

P and the D curve,
from 0 to Q.
h

Height =
Rs. 60 – 30 = Rs. 30
So,
CS = ½ x 15 x Rs. 30
= Rs. 225. D
Q
How the Price Affects Consumer Surplus

(a) Consumer Surplus at Price P

Price
A

Consumer
surplus
P1
B C

Demand

0 Q1 Quantity
How the Price Affects Consumer Surplus

(b) Consumer Surplus at Price P

Pric
e A

Initia
l
consumer
surplu
s C Consumer
P1
B surplus
to new consumers

F
P2
D E
Additional Deman
consumer
surplus to initial d
consumers
0 Q1 Q2 Quantity
• What Does Consumer Surplus Measure?

• Consumer Surplus - measures the benefit that buyers

receive from a good as the buyers themselves perceive
it - preferences of buyers.
 Producer Surplus
Cost and Willingness to Sell

• Willingness to sell: produce and sell the good/service only

if the price > cost

• Price > Cost = Sell

• Price < Cost = Not Sell
• Price = Cost = Indifferent

• Producer surplus is the amount a seller is paid minus the

cost of production (OR, seller’s cost).
• Willingness to sell / Cost of sellers
Price and number of sellers Price Who buys Qs
Derive the supply schedule from the cost data < 500 None 0
500 - 599 D 1
600- 799 C, D 2
800 - 899 B, C, D 3
>= 900 A, B, C, D 4
Measuring Producer Surplus with the Supply Curve
(a) Price = 600 (slightly less than 600)

Price

Supply

The area below

900
the price and
800
above the supply
curve measures
600 the producer
500 surplus in a
D’s producer
market
surplus (100)

0 1 2 3 4
Quantity
 Measuring Producer Surplus with the Supply Curve
(b) Price = 800 (slightly less than 800)

Price

Suppl
Tota y
lproducer
900 surplus (500)

800

600 C’s producer

500 surplus (200)

D’ producer
s
surplus (300)

0 1 2 3 4
Quantity
PS with Lots of Sellers & a Smooth S Curve
P
PS is the area between
P and the S curve, from
0 to Q. S
The height of this
triangle is
Rs. 40 – 15 = Rs. 25. h
So,
PS = ½ x b x h
= ½ x 25 x Rs. 25
= Rs. 312.50 Q
How a Lower Price Reduces PS
P 1. Fall in PS
due to sellers
leaving market
If P falls to $30, S
PS = ½ x 15 x Rs. 15
= Rs.112.50
Two reasons for the fall
in
2. Fall in PS due to
PS.
remaining sellers
getting lower P
Q
 How the Price Affects Producer Surplus
(a) Producer Surplus at Price P1

Price
Supply

PS = ½ x b x h

B
P1
C
Producer
surplus

0 Q1 Quantity
Copyright©2003 Southwestern/Thomson Learning
 How the Price Affects Producer Surplus
(b) Producer Surplus at Price P2

Price
Additional producer Supply
surplus to initial
producers

D E
P2 F

B
P1
Initial C
Producer surplus
producer to new producers
surplus

0 Q1 Q2 Quantity
• Efficiency - If an allocation of resources maximizes total surplus

• Inefficient Allocation – some of the potential gains from trade

among buyers and sellers are not being realized.
Efficiency and Distributive effects of trade liberalization

•.
 •.

Both nations gain in the aggregate -Net Social Gain (NSG) > 0
But its redistributive implications –
consumers gain at the expense of producers in the importing country (H)
Producers gain a the expense of consumers in the exporting country (R).
Hence in both countries there are aggregate efficiency gains, but also winners and losers from trading
Because trade liberalization creates positive NSG with winners and losers, taxes and transfers can be used to
compensate the losers and achieve Pareto optimality after compensation.
Pareto optimality means that there will be no losers from the reform after compensation has been paid.
Consumers can be taxed of (a) in Home to compensate producers for their losses, and producers can be taxed of (a
+ b) in Rest of World to compensate consumers for their losses. In both cases, gainers still gain after tax because
NSG > 0. In principle, a Pareto-optimum reform should be politically feasible.
• While both countries gain from trade, these gains can be unequal
• b+c in the importing country H need not always be equal to (c + d) in the
exporting country R
• Particularly true when the trade agreement is between an
industrialized and a developing country
• in part due to the unequal capacity of the countries to adjust their
production patterns to the new terms of trade and specialize to maximize
gains. Trade has thus been denounced as resulting in “unequal exchange.”
• Complement trade agreements with “behind the border” assistance
for developing countries to help them adapt their production
structures to their comparative advantages in trade; “Fair Trade for
All”
• Differential skills components of the goods traded
• Developed country
• If low skilled goods are exported by developing countries, trade will induce a
decline in low-skill wages in the industrialized country relative to high-skill wages,
and an increase in low-skill wages in the developing country relative to high-skill
wages.
• Low-skill workers in the industrialized country who anticipate this relative decline
in purchasing power may strongly resist trade agreements
• Inequality
• Developing country
• Poverty reduction - income gains for low-skill workers
• Reduction in inequality - decline in income disparity between high- and low-skill
workers
 Using Trade Policy for Development: Tariffs and Subsidies
•Trade provides important opportunities for growth,
technology transfers, and public revenues.
•Govt authority over national borders - exert significant
direct influence on trade; and can also exert pervasive
influence on trade incentives and trade-related
behavior though other policies.
 Using Trade Policy for Development: Tariffs and Subsidies
• Import tariffs: protecting sectors
• Import protection: One of the most common trade policies where
governments take measures to limit foreign competition in domestic
markets.
• Import restriction - by many kinds of administrative measures such as
• safety standards (e.g. sanitary and phytosanitary standards for food imports),
• trade preferences that admit goods from some countries but not from others,
• quantity restrictions, and, the most common method,
• tariffs, also called ad valorem import taxes.
• Restrict market opportunities in order to serve some national policy
agenda, including consumer safety, protection of domestic firms
and/or jobs, food security, and geopolitical goals.
• Tariffs may also be introduced in response to lobbying, from
employers or workers who want to restrict competition from foreign
firms to protect profits or jobs.
 Using Trade Policy for Development: Tariffs and Subsidies
• Efficiency and redistributive effects of an import tariff
• Assumptions:
• Imports are perfect substitutes for the domestic good
• Importing country is small, so changes in imports do not affect the world
price (p$)

Application of a tariff t yields a domestic price pd

= ep$ (1 + t ),
The import tariff benefits producers, hurts
consumers, benefits government through tariff
revenues, and creates a net social loss relative
to free trade.
The inefficiency cost is measured by areas (b +
d ).
The redistributive gains to the benefit of
producers and government have a sharp cost
both for consumers and for society at large.
 Using Trade Policy for Development: Tariffs and Subsidies
•.

.
• Production subsidies: “picking winners”
• A common trade policy to promote the competitiveness of firms with export
potential involves subsidizing potential “winners”.
• These subsidies typically come in the form of state-subsidized credit, financial
guarantees, technological assistance acquired from abroad, subsidies to R&D,
and trade fairs to promote the firms on the international market.
• The subsidies improve the competitiveness of the selected firms and help
them gain scale to become competitive without subsidy.
• Production subsidies to potential winners have been extensively used in the
export-oriented industrialization (EOI) strategy.
• While potentially beneficial in the long term, the short-term effect of an export
subsidy is to create a gain for the subsidized firms at a cost to government.

• PLI
• https://www.youtube.com/watch?v=nOy2YpYLR68
 Module 5
Economic Growth and Human
Capital
• GDPpc growth
• cornerstone of development.
• Yet, one of the most difficult economic outcomes to explain and predict
• many competing theories, also many different potentially effective strategies
to accelerate growth.

• Harrod–Domar model identifies the rate of saving and the choice of

technique (the incremental capital-output ratio, or ICOR) as the two
determinants of a country’s growth rate.
Capital Accumulation for Growth: Harrod
Domar Model
• The Harrod–Domar model - developed in the 1930s and 1940s
following the Great Depression
• Used extensively in the 1950s, when the main objective of
development was to accelerate GDP growth
• To show: How capital accumulation sustains growth; and
• How savings and technology determine capital accumulation
• Assumptions of the Model
• 1. The economy is closed to trade and foreign direct investment. Hence all
investment has to come from domestic savings.
• 2. Capital and labour are used in fixed proportions in production. Hence there are
no substitution possibilities among inputs.
• 3. Capital is the limiting factor to output growth, not labour. Labour is in unlimited
supply. Hence population growth and labour availability are not issues.
• 4. There are constant returns to scale for each factor. Hence the return to capital
at the margin is always the same, whatever the level of the stock of capital.
• 5. Technology (the production function) is such that a fixed quantity of additional
capital (ΔK ) gives us a fixed proportional increase in output (ΔY)
• where the proportionality factor is k = ΔK/ΔY = ICOR, or the incremental capital output ratio
• The higher the ICOR, the less productive the technology is, i.e. we will need more additional
capital per unit of increment of output (ΔY = 1). Hence the ICOR is the inverse of the
marginal productivity of capital.
•ΔK/ΔY = ICOR
•The structural form of the model consists in three
equations:
•1. An aggregate production function: ΔY = (1/k)ΔK,
obtained from the definition of the ICOR.
•2. A savings function: S = sY, where S is aggregate
savings and s is the rate of savings out of national
income Y.
•3. An investment function, where the demand for
investment (I ) is equal to available savings (S ): I ≡ ΔK
= S. Investment (I) increases the stock of capital
•
•
• Policy implications for accelerating growth:
• raise the rate of saving (i.e. promote savings through stronger financial
institutions)
• lower the ICOR (i.e. increase the marginal productivity of capital through
better technology).
• Domestic saving can also be complemented by foreign aid transfers,
provided they are used for investment.
• With growth driven by capital accumulation, savings (domestic and foreign)
and technology are the answers to growth.
• Even with international capital movements and foreign direct investment,
the model remains relevant because domestic savings are indeed the main
source of investment.