Chapter 10

Trade Policy in Developing Countries

Prepared by Iordanis Petsas

To Accompany
International Economics: Theory and Policy, Sixth Edition
by Paul R. Krugman and Maurice Obstfeld
 Chapter Organization
Introduction
Import-Substituting Industrialization
Problems of the Dual Economy
Export-Oriented Industrialization: The East Asian
Miracle
Summary

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 Introduction
There is a great diversity among the developing
countries in terms of their income per capita.
Why are some countries so much poorer than others?
For about 30 years after World War II trade policies in
many developing countries were strongly influenced
by the belief that the key to economic development
was creation of a strong manufacturing sector.
The best way to create a strong manufacturing sector
was by protecting domestic manufacturers from
international competition.

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 Introduction
Table 10-1: Gross Domestic Product Per Capita, 1999 (dollars)

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Import-Substituting Industrialization
From World War II until the 1970s many developing
countries attempted to accelerate their development
by limiting imports of manufactured goods to foster a
manufacturing sector serving the domestic market.
The most important economic argument for
protecting manufacturing industries is the infant
industry argument.

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Import-Substituting Industrialization
The Infant Industry Argument
It states that developing countries have a potential
comparative advantage in manufacturing and they can
realize that potential through an initial period of
protection.
It implies that it is a good idea to use tariffs or import
quotas as temporary measures to get industrialization
started.
Example: The U.S. and Germany had high tariff rates on
manufacturing in the 19th century, while Japan had
extensive import controls until the 1970s.
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Import-Substituting Industrialization
Problems with the Infant Industry Argument
It is not always good to try to move today into the
industries that will have a comparative advantage in
the future.
Example: In the 1980s South Korea became an exporter
of automobiles, whereas in the 1960s its capital and
skilled labor were still very scarce.
Protecting manufacturing does no good unless the
protection itself helps make industry competitive.
Example: Pakistan and India have protected their heavy
manufacturing sectors for decades and have recently
begun to develop significant exports of light
manufactures like textiles.
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Import-Substituting Industrialization
Market Failure Justifications for Infant Industry
Protection
Two market failures are identified as reasons why
infant industry protection may be a good idea:
Imperfect capital markets justification
If a developing country does not have a set of financial
institutions that would allow savings from traditional sectors
(such as agriculture) to be used to finance investment in new
sectors (such as manufacturing), then growth of new industries
will be restricted.
Appropriability argument
Firms in a new industry generate social benefits for which they
are not compensated (e.g. start-up costs of adapting
technology).
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Import-Substituting Industrialization
Promoting Manufacturing Through Protection
Import-substituting industrialization
The strategy of encouraging domestic industry by
limiting imports of manufactured goods
Many less-developed countries have pursued this strategy.
Has import-substituting industrialization promoted
economic development?
Many economists are now harshly critical of the results
of import substitution, arguing that it has fostered high-
cost, inefficient production.

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Import-Substituting Industrialization
Why not encourage both import substitution and
exports?
A tariff that reduces imports also necessarily reduces
exports.
Until the 1970s many developing countries were
skeptical about the possibility of exporting
manufactured goods.
In many cases, import-substituting industrialization
policies dovetailed naturally with existing political
biases.

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Import-Substituting Industrialization
Table 10-2: Exports as a Percentage of National Income, 1999

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Import-Substituting Industrialization
Results of Favoring Manufacturing: Problems of
Import-Substituting Industrialization
Many countries that have pursued import substitution
have not shown any signs of catching up with the
advanced countries.
Example: In India, after 20 years of economic plans
between the early 1950s and the early 1970s, its per
capita income was only a few percent higher than
before.

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Import-Substituting Industrialization
Why didnt import-substituting industrialization work
the way it was supposed to?
The infant industry argument was not as universally
valid as many people assumed.
Import-substituting industrialization generated:
High rates of effective protection
Inefficient scale of production
Higher income inequality and unemployment

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 Import-Substituting Industrialization
Table 10-3: Effective Protection of Manufacturing in Some Developing
Countries (percent)

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 Problems of the Dual Economy
Most developing countries are characterized by
economic dualism.
A high-wage, capital-intensive industrial sector
coexists with a low-wage traditional sector.
Dualism is associated with trade policy for two
reasons:
Dualism is probably a sign of markets working poorly
(market failure case for deviating from free trade).
The creation of the dual economy (an economy that is
characterized by economic dualism) has been helped
by import-substitution policies.
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 Problems of the Dual Economy
The Symptoms of Dualism
Development often proceeds unevenly and results in a
dual economy consisting of a modern sector and a
traditional sector.
The modern sector typically differs from the traditional
sector in that it has:
Higher value of output per worker
Higher wages
Lower returns to capital
Higher capital intensity
Persistent unemployment (especially in urban areas)

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 Problems of the Dual Economy
Dual Labor Markets and Trade Policy
The symptoms of dualism are clear signs of an
economy that is not working well, especially in its
labor markets.
Wage differentials argument
The wage differences between manufacturing and
agriculture is a justification for encouraging
manufacturing at agricultures expense.
When there is a wage differential, the manufactures
wage (WM) must be higher than the food wage (WF).

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 Problems of the Dual Economy
Figure 10-1: The Effect of a Wage Differential
Value of marginal
products, wages
B
WM
A

C WF

PF x MPLF PM x MPLM

OM L1 L2 OF
Labor employed Labor employed
in manufactures in food

Total labor supply

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 Problems of the Dual Economy
The Harris-Todaro model
It links rural-urban migration and unemployment that
undermines the case for favoring manufacturing
employment, even though manufacturing does offer
higher wages.
Countries with highly dualistic economies also seem to
have a great deal of urban unemployment.
An increase in the number of manufacturing jobs will
lead to a rural-urban migration so large that urban
unemployment actually rises.
It helps the wage differentials argument to be in
disfavor with economists.
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 Problems of the Dual Economy
Trade Policy as a Cause of Economic Dualism
Trade policy has been accused both of:
Widening the wage differential between manufacturing
and agriculture
Fostering excessive capital intensity
Wage differentials are viewed as:
A natural market response
The monopoly power of unions whose industries are
sheltered by import quotas from foreign competition

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 Export-Oriented Industrialization:
the East Asian Miracle
From the mid-1960s onward, exports of
manufactured goods, primarily to advanced nations,
was another possible path to industrialization for the
developing countries.
High performance Asian economies (HPAEs)
A group of countries that achieved spectacular
economic growth.
In some cases, they achieved economic growth of more
than 10% per year.

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 Export-Oriented Industrialization:
the East Asian Miracle
The Facts of Asian Growth
The World Banks definition of HPAEs contains three
groups of countries, whose miracle began at different
times :
Japan (after World War II)
The four tigers: Hong Kong, Taiwan, South Korea, and
Singapore (in the 1960s)
Malaysia, Thailand, Indonesia, and China (in the late 1970s
and the 1980s)
The HPAEs are very open to international trade
Example: In 1999, exports as a share of gross domestic
product in the case of both Hong Kong and Singapore
exceeded 100% of GDP (132 and 202 respectively).
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 Export-Oriented Industrialization:
the East Asian Miracle
Trade Policy in the HPAEs
Some economists argue that the East Asian miracle
is the payoff to the relatively open trade regime.
The data in Table 10-4 suggests that the HPAEs have
been less protectionist than other, less developing
countries, but they have by no means followed a policy
of complete free trade.
Low rates of protection in the HPAEs helped them to
grow, but they are only a partial explanation of the
miracle.

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 Export-Oriented Industrialization:
the East Asian Miracle
Table 10-4: Average Rates of Protection, 1985 (percent)

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 Export-Oriented Industrialization:
the East Asian Miracle
Industrial Policy in the HPAEs
Several of the highly successful economies have pursued
industrial policies (from tariffs to government support
for research and development) that favor particular
industries over others.
Most economists have been skeptical about the
importance of such policies because:
HPAEs have followed a wide variety of policies, but
achieved similarly high growth rates.
The actual impact on industrial structure may not have
been large.
There have been some notable failures of industrial
policy.
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 Export-Oriented Industrialization:
the East Asian Miracle
Other Factors in Growth
Two factors can explain the rapid growth in East Asia:
High saving rates
Rapid improvement in public education
The East Asian experience refutes that:
Industrialization and development must be based on an
inward-looking strategy of import substitution.
The world market is rigged against new entrants,
preventing poor countries from becoming rich.

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 Summary
Trade policy in less-developed countries is concerned
with two objectives: promoting industrialization and
coping with the uneven development of the domestic
economy.
Government policy to promote industrialization has
often been justified by the infant industry argument.
Many less-developed countries have pursued policies
of import-substituting industrialization.
These policies have fostered high-cost, inefficient
production.
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 Summary
Most developing countries are characterized by
economic dualism.
Dual economies have a serious problem of urban
unemployment.
The difference in wages between the modern and
traditional sectors have sometimes been used as a
case for tariff protection of the industrial sector.
The HPAEs have industrialized not via import
substitution but via exports of manufactured goods.

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