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International trade
- Economies of scale and International trade
The models of comparative advantage presented were base on the assumption of constant returns to scale. That is, we
assumed that if inputs to an industry were doubled, industry output would double as well. In practice many industries
are characterized by economies of scale – production is more efficient the largest scale at which it takes place. Where
there are economies of scale doubling the input to an industry will more than double the industry’s production.
Economies of scale provide an incentive to international trade - > we suppose that each country decide to produce only
the good which is able to create more quantity using the same time. But consumers in each country will still want to
consume a variety of goods. International trade makes possible for each country to produce a restricted range of goods
and to take advantage of economies of scale without sacrificing variety in consumption. Each country specialises in
producing a limited range of products which enables it to produce these goods more efficiently; these specialized
economies then trade with each other to be able to consume the full range of goods.
Economies of scale and market structure
External economies of scale occur when the cost per unit depends on the size of the industry but not necessary on the
size of any one firm (ex. The cost of each firm will fall as a result of the increased size of the industry).
Internal economies of scale occur when the cost per unit depends on the size of an individual firm but not necessarily
on that of the industry.
External and internal economies of scale have different implications for the structure of industries. An industry where
economies of scale are purely external (where there are no advantages to large firms) will typically consist of many
small firms and be perfectly competitive.
Interna economies of scale give large firms as a cost advantage over small firms and lead to an imperfectly competitive
market structure.
The theory of external economies
It is often the case that concentrating production of an industry in one or few locations reduces the industry’s cost even
if the individual firms in the industry remain small. When the economies of scale apply at the level of the industry rathe
than at the level of the individual firm, they are called external economies.
Marshall argued that there are three main reasons why a cluster of firms may be more efficient than an individual firm
in isolation:
o the ability of a cluster to support specialised suppliers
A localized industrial cluster brings together many firms that collectively provide a large enough market to support a
wide range of specialised suppliers. Key inputs are cheaper and more easily ava ilable.
o geographically concentrated industry allows labour market pooling
The cluster of firms can create a pooled market for workers with highly specialised skills. It is to the advantage of
both the producers and the workers, as the produces are less likely to suffer from labour shortages and the workers
are less likely to become unemployed.
o geographically concentrated industry helps foster knowledge spillovers
Knowledge is at least as important an input as are factor of production. This is especially true in highly innovative
industries. Companies can acquire technology through their own research and development efforts or trying to
learn from the competitors by studying their strategies and products. An import source of technical know - how is
the informal exchange of information and ideas that takes place at a personal level. And this kind of informal
diffusion of knowledge take place most effectively when an industry is concentrated in a small area, so that
employees of different companies mix socially and talk freely about technical issue.
External economies and market equilibrium
The strengths of these economies depend on the size of the industry – a bigger industry
generates stronger external economies.
Determination of output and prices?
We can assume that the larger the industry, the lower the industry’s costs. Ignoring the
international trade, the market equilibrium is when Average costs/supply curve = Demand
curve.
In the presence of external economies of scale: the largest the output, the lower the price at which the firms are willing
to sell because their average cost of production falls as industry output rises.
External economies and pattern of trade
When there are external economies of scale, international trade makes it possible to concentrate world production in a
single location, and to reduce costs by reaping the benefits of even stronger external economies. The effects of trade
are to reduce prices everywhere.
In our example of world trade in buttons, we simply assumed the Chinese industry started out wit lower productions
costs than the American industry. What might lead to such an initial advantage?
One possibility is comparative advantage – underlying differences in technology and resources. Button production is a
labour-intensive industry, which is best conducted in a country where the average manufacturing worker earns less
than a dollar an hour rather than in a country where hourly compensation is an among the highest in the world.
However, in industries characterized by external economies of scale, comparative advantage usually provides only a
partial explanation of the pattern of trade.
What does determine the pattern of specialization and trade in industries with external economies of scale?
Historical contingency: something gives a particular location an initial advantage in a particular industry, and this
advantage gets locked in by external economies of scale even after the circumstances that created the initial advantage
are no longer relevant.
Once a country has established an advantage in an industry, it may retain that advantage even if some other country
could potentially produce the goods more cheaply.
External economies potentially give a strong role to historical accident in determining who produces what and may
allow established patterns of specialization to persist even when they are in contrast with the comparative advantage.
Trade and welfare with external economies
The world is more efficient and thus richer because international trade allows nations to specialise in different
industries and gain from external economies as well as from comparative advantage.
However, sometimes it is possible that trade based on external economies may actually leave a country worse off than
it would have been in the absence of trade owing to the established advantage.
Ex. Thailand is able to produce watches at lower average cost and lower prices compared with Switzerland, but Switzerland produces the watches
for the entire world demand since it has gotten there first. The price of goods that Thailand imports would actually be lower if there were no trade,
and the country were forced to produce the good for itself.
Dynamic increasing returns
Some of the most important external economies probably arise from the accumulation of knowledge. When an individual
firm improves its products or production techniques through experience, other firms are likely to imitate the firm and
benefit from its knowledge.
! external economies arising from the accumulation of knowledge differ from the external economies consider so far, in
which industry costs depend on current output.
In this alternative situation, industry costs depend on experience, usually measured by the cumulative output of the
industry to date (fino ad oggi).
This kind of relationship is summarized by a learning curve that relates unit cost to
cumulative output. They are downward sloping because pf the effect on costs of
the experience gained trough the production. A country that has extensive
experience in an industry may have a lower unit cost than a country with little or no
experience.
When costs fall with cumulative production over time rather than with current rate
of production this is referred to as a case of dynamic increasing returns.
Interregional trade and economic geography
External economies are even more decisive in shaping the pattern of interregional trade – trade that takes place
between regions within countries.
Factors of production such as labour and capital play less decisive role in interregional trade than in inte rnational trade
for the simple reason that such factors are highly mobile within countries, while resources play a secondary role.
National welfare arguments against free trade
Most tariffs, import quotas, and other trade policy measures are undertaken primarily to protect the income of
particular interest groups. Although economists frequently argue that deviations from free trade reduce national
welfare, there are some theoretical grounds for believing that activist trade policies can sometimes increase the welfare
of the nation as a whole.
The terms of trade argument for a tariff
One argument for deviating from free trade comes directly out of cost-benefit analysis:
For a large country that is able to affect the prices of foreign exporters, a tariff lowers the price of imports and generates
a terms of trade benefit (the tariff distorts production and consumption incentives). It is possible, however, that in some
cases the terms of trade benefits of a tariff outweigh its costs, so there is a terms of trade argument for a tariff.
For a sufficiently small tariff, the terms of trade benefits must outweigh
the costs.
However, at small tariff rates, a large country’s welfare is higher than
with free trade. As the tariff rate is increased, the costs eventually begin
to grow more rapidly than the benefits and the curve relating national
welfare to the tariff rate turns down. A tariff rate that completely
prohibits trade (tp in Figure 10-2) leaves the country worse off than with
free trade; further increases in the tariff rate beyond tp have no effect,
so the curve flattens out. At point 1 on the curve in Figure 10-2,
corresponding to the tariff rate to, national welfare is maximized. The
tariff rate to that maximizes national welfare is the optimum tariff. The optimum tariff rate is always positive but less
than the prohibitive rate (tp) that would eliminate all imports.
What policy for export sectors?
Since an export subsidy worsens the terms of trade, and therefore unambiguously reduces national welfare, the optimal
policy in export sectors must be a negative subsidy, that is, a tax on exports that raises the price of exports to
foreigners. Like the optimum tariff, the optimum export tax is always positive but less than the prohibitive tax that
would eliminate exports completely.
➔ The terms of trade argument against free trade has some important limitations.
Most small countries have very little ability to affect the world prices of either their imports or their exports, and the
terms of trade argument is of little practical importance to them. For big countries like the United States, the problem is
that the terms of trade argument amounts to an argument for using national monopoly power to extract gains at other
countries’ expense. The United States could surely do this to some extent, but such a predatory policy would probably
bring retaliation from other large countries. A cycle of retaliatory trade moves would, in turn, undermine the attempts
at international trade policy coordination.
The terms of trade argument against free trade, then, is intellectually impeccable but of doubtful usefulness. In practice,
it is more often emphasized by economists as a theoretical proposition than actually used by governments as a
justification for trade policy.
The domestic market failure argument against free trade
Many economists have made a case against free trade based on the argument that these concepts, consumer and
producer surplus in particular, do not properly measure costs and benefits.
Why might producer surplus not properly measure the benefits of producing a good?
a) The possibility that the labour used in a sector would otherwise be unemployed or underemployed,
b) The existence of defects in the capital or labour markets that prevent resources from being transferred as
rapidly as they should be to sectors with high returns,
c) The possibility of technological spillovers (ricadute tecnologiche) from industries that are new or particularly
innovative.
These can all be classified under the general heading of domestic market failures → some market in the country
is not doing its job right—the labor market is not clearing, the capital market is not allocating resources
efficiently, and so on.
Figure 10- 3 illustrates the domestic market failure argument against free
trade. Figure a shows the conventional cost-benefit analysis of a tariff for a
small country (which rules out terms of trade effects).
Figure b shows the marginal benefit from production that is not taken
account of by the producer surplus measure.
The figure shows the effects of a tariff that raises the domestic price from
PW to PW + t. Production rises from S1 to S2, with a resulting production
distortion indicated by the area labelled a. Consumption falls from D1 to
D2, with a resulting consumption distortion indicated by the area b.
If we considered only consumer and producer surplus, we would find that
the costs of the tariff exceed its benefits. Figureb shows, however, that this
calculation overlooks an additional benefit that may make the tariff
preferable to free trade. The increase in production gives a social benefit
that may be measured by the area under the marginal social benefit curve
from S1 to S2, indicated by c. In fact we can show that if the tariff is small enough, the area c must always exceed the
area a + b and that there is some welfare-maximizing tariff that gives a level of social welfare higher than that of free
trade.
The domestic market failure argument against free trade is a particular case of a more general concept known in
economics as the theory of the second best - > This theory states that a hands-off policy (politica del non intervento) is
desirable in any one market only if all other markets are working properly. If they are not, a government intervention
that appears to distort incentives in one market may actually increase welfare by offsetting (compensando) the
consequences of market failures elsewhere.
When economists apply the theory of the second best to trade policy, they argue that imperfections in the internal
functioning of an economy may justify interfering in its external economic relations.
Defense for free trade
There are two lines of defense for free trade: The first argues that domestic market failures should be corrected by
domestic policies aimed directly at the problems’ sources ; the second argues that economists cannot diagnose market
failure well enough to prescribe policy.
Domestic market failures need domestic policy change - > It is always preferable to deal with market failures as directly
as possible because indirect policy responses lead to unintended distortions of incentives elsewhere in the economy.
Trade policies justified by domestic market failure are always “second-best” rather than “first-best” policies.
Any proposed trade policy should always be compared with a purely domestic policy aimed at correcting the same
problem. If the domestic policy appears too costly or has undesirable side effects, the trade policy is almost surely even
less desirable—even though the costs are less apparent.
Most deviations from free trade are adopted not because their benefits exceed their costs but because the public fails
to understand their true costs.
The second defense of free trade is that because market failures are typically hard to identify precisely, it is difficult to
be sure what the appropriate policy response should be.
Income distribution and trade policy
When looking at the actual politics of trade policy, however, it becomes necessary to deal with the reality that there is
no such thing as national welfare; there are only the desires of individuals, which get more or less imperfectly reflected
in the objectives of government.
How do the preferences of individuals get added up to produce the trade policy we actually see?
There is no single, generally accepted answer, but there has been a growing body of economic analysis that explores
models in which governments are assumed to be trying to maximize political success rather than an abstract measure of
national welfare.
Electoral competition
Political scientists have long used a simple model of competition among political parties to show how the preferences of
voters might be reflected in actual policies.
Suppose two competing parties are willing to promise whatever will enable each to win the next election, and suppose
policy can be described along a single dimension, say, the level of the tariff rate. And finally, suppose voters differ in the
policies they prefer.
a result, the apparel industry is one in which low-wage nations have a strong comparative advantage and high-wage
countries have a strong comparative disadvantage. It is also traditionally a well-organized sector in advanced countries.
International negotiations and trade policy
Our discussion of the politics of trade policy has not been very encouraging. We have argued that it is difficult to devise
trade policies that raise national welfare, and that trade policy is often dominated by interest group politics.
Yet, in fact, from the mid-1930s until about 1980, the United States and other advanced countries gradually removed
tariffs and some other barriers to trade, and by so doing aided a rapid increase in international integration. Mos t
economists believe, especially in the case of the United States, that this progressive trade liberalization was highly
beneficial. Given what we have said about the politics of trade policy, however, how was this removal of tariffs
politically possible? The great liberalization of trade was achieved through international negotiation_._ That is,
governments agreed to engage in mutual tariff reduction. These agreements linked reduced protection for each
country’s import-competing industries to reduced protection by other countries against that country’s export industries.
The advantages of negotiation
- a mutual agreement helps mobilize support for freer trade.
- negotiated agreements on trade can help governments avoid getting caught in destructive trade wars –
international negotiation helps to avoid trade war.
Even though each government acting individually would be better off with protection, they would both be better off
if both chose free trade.
Each government will be better off if it limits its own freedom of action, provided the other country limits its freedom of
action as well. A treaty can make everyone better off.
International Trade Agreements: A Brief History
Internationally coordinated tariff reduction as a trade policy dates back to the 1930s.
Multilateral negotiations began soon after the end of World War II. Originally, diplomats from the victorious Allies
imagined such negotiations would take place under the auspices of a proposed body called the International Trade
Organization, paralleling the International Monetary Fund and the World Bank. In 1947, unwilling to wait until the ITO
was in place, a group of 23 countries began trade negotiations under a provisional set of rules that became known as
the General Agreement on Tariffs and Trade , or GATT (the ITO was never established because it ran into severe political
opposition, especially in the United States).
Officially, the GATT was an agreement, not an organization—the countries participating in the agreement were officially
designated as “contracting parties,” not members. In practice, the GATT did maintain a permanent “secretariat” in
Geneva, which everyone referred to as “the GATT.” In 1995, the World Trade Organization , or WTO, was established,
finally creating the formal organization envisaged 50 years earlier (However, the GATT rules remain in force).
One way to think about the GATT-WTO approach to trade is to use a mechanical analogy: It’s like a device designed to
push a heavy object, the world economy, gradually up a slope—the path to free trade.
The principal ratchet in the system is the process of binding. When a tariff rate is “bound,” the country imposing the
tariff agrees not to raise the rate in the future.
In addition to binding tariffs, the GATT-WTO system generally tries to prevent non-tariff interventions in trade. Export
subsidies are not allowed, with one big exception: Back at the GATT’s inception, the United States insisted on a loophole
(scappatoia) for agricultural exports, which has since been exploited on a large scale by the European Union.
New import quotas are generally forbidden except as temporary measures to deal with “market disruption,” mean
surges of imports that threaten to put a domestic sector suddenly out of business.
The lever used to make forward progress is the process known as a trade round, in which a large group of countries get
together to negotiate a set of tariff reductions and other measures to liberalize trade. Eight trade rounds have been
completed since 1947, the last of which—the Uruguay Round, completed in 1994— established the WTO.
The first five trade rounds under the GATT took the form of “parallel” bilateral negotiations, where each country
negotiates pairwise with a number of countries at once. The ability to make more extensive deals, together with the
worldwide economic recovery from the war, helped to permit substantial tariff reductions (+Tokyo round and Kennedy
round).
The Uruguay round
The eighth round of global trade negotiations carried out under the GATT began in 1986, with a meeting in Uruguay
(hence the name Uruguay Round).
- The Uruguay Round cut tariff rates around the world.
- More important than this overall tariff reduction were the moves to liberalize trade in two important sectors:
agriculture and clothing.
- A final important trade action under the Uruguay Round was a new set of rules concerning government
procurement, purchases made not by private firms or consumers but by government agencies. Such procurement
has long provided protected markets for many kinds of goods and the set new rules should open up a wide range of
government contracts for imported products.
Administrative Reforms: From the GATT to the WTO
Much of the publicity that surrounded the Uruguay Round, and much of the controversy swirling around the world
trading system since then, has focused on the round’s creation of a new institution, the World Trade Organization.
In 1995, this organization replaced that had administered the GATT.
The WTO has become the organization that opponents of globalization love to hate; it has been accused by both the left
and the right of acting as a sort of world government, undermining national sovereignty.
How different is the WTO from the GATT?
o From a legal point of view, the GATT was a provisional agreement, whereas the WTO is a full-fledged international
organization; however, the actual bureaucracy remains small (a staff of 500).
o The GATT applied only to trade in goods; world trade in services—that is, intangible things like insurance,
consulting, and banking—was not subject to any agreed-upon set of rules. So the WTO agreement includes rules
on trade in services because modern economies have increasingly focused on the production of services rather
than physical goods. In practice, these rules have not yet had much impact on trade in services; their main
purpose is to serve as the basis for negotiating future trade rounds. Moreover, advanced countries have
experienced a shift from depending on physical capital to depending on “intellectual property,” which is
protected by patents and copyrights. So, defining the international application of international property rights has
also become a major preoccupation. The WTO tries to take on this issue.
o The most important new aspect of the WTO, however, is generally acknowledged to be its “dispute settlement”
procedure. A basic problem arises when one country accuses another of violating the rules of the trading system.
A dispute can arise when one country adopts a trade policy or violates the WTO agreements. Under GATT rules
there were international tribunals that would take several years to issue a ruling; and even when it did, it was
easier to block.
Benefit and costs
The progress on agriculture hurt the small but influential populations of farmers in Europe, Japan, and other countries
where agricultural prices are far above world levels. These losses were much more than offset by gains to consumers
and taxpayers in those countries. Similarly, the liberalization of trade in textiles and clothing produced some
concentrated pain for workers and companies in those industries, offset by considerably larger but far less visible
consumer gains.
Given these strong distributional impacts of the Uruguay Round, it is actually remarkable that an agreement was
reached at all (only thanks to a set of political calculations).
Many developing countries supported the round because of the new opportunities it would offer to their own textile
and clothing exports. Also, some of the “concessions” negotiated under the agreement were an excuse to make policy
changes that would eventually have happened anyway.
An important factor in the final success of the round, however, was fear of what would happen if it failed. By 1993,
protectionist currents were evidently running strong in the United States and elsewhere.
The End of Trade Agreements?
The ninth major round of world trade negotiations began in 2001 with a ceremony in the Persian Gulf city of Doha. But
as we’ve already noted, no agreement was ever reached. It’s important to realize that the failure of the Doha Round
does not undo the progress achieved in previous trade negotiations. Remember that the world trading system is a
combination of “levers”—international trade negotiations that push trade liberalization forward—and “ratchets,”
mainly the practice of binding tariffs, which prevent backsliding. The levers seem to have failed in the latest trade round,
but the ratchets are still in place: The reductions in tariff rates that took place in the previous eight rounds remain in
effect. As a result, world trade remains much freer than at any previous point in modern history.
In fact, Doha’s failure owes a lot to the success of previous trade negotiations. Because previous negotiations had been
so successful at reducing trade barriers, the remaining barriers to trade are fairly low, so that the potential gains from
further trade liberalization are modest. Most of the potential gains from a move to freer trade would come from
(such as manufacturing), then growth of new industries will be restricted by the ability of firms in these industries to
earn current profits. Low initial profits will be an obstacle to investment even if the long-term returns on the
investment will be high. The first-best policy is to create a better capital market, but protection of new industries,
which would raise profits and allow more rapid growth, can be justified as a second-best policy option.
➔ Firms in a new industry generate social benefits for which they are not compensated.
Both the imperfect capital markets argument and the appropriability case for infant industry protection are clearly
special cases of the market failure justification for interfering with free trade. The difference is that in this case, the
arguments apply specifically to new industries rather than to any industry.
Promoting Manufacturing through Protection
Although there are doubts about the infant industry argument, many developing countries have seen this argument as a
compelling reason to provide special support for the development of manufacturing industries. In principle, such
support could be provided in a variety of ways. For example, countries could provide subsidies to manufacturing
production in general, or they could focus their efforts on subsidies for the export of some manufactured goods in
which they believe they can develop a comparative advantage.
In most developing countries, however, the basic strategy for industrialization has been to develop industries oriented
toward the domestic market by using trade restrictions such as tariffs and quotas to encourage the replacement of
imported manufactures by domestic products - the strategy of import-substituting industrialization.
Why not encourage both import substitution and exports? A tariff that reduces imports also necessarily reduces exports.
By protecting import-substituting industries, countries draw resources away from actual or potential export sectors. So
a country’s choice to seek to substitute for imports is also a choice to discourage export growth.
The reasons why import substitution rather than export growth has usually been chosen a s an industrialization strategy
are a mixture of economics and politics.
- Until the 1970s many developing countries were sceptical about the possibility of exporting manufactured goods.
They believed that industrialization was necessarily based on a substitution of domestic industry for imports rather
than on a growth of manufactured exports.
- In many cases, import-substituting industrialization policies are in conform with existing political biases.
The 1950s and 1960s saw the high tide of import-substituting industrialization. Developing countries typically began by
protecting final stages of industry , such as food processing and automobile assembly. In the larger developing countries,
domestic products almost completely replaced imported consumer goods (although the manufacturing was often carried
out by foreign multinational firms). Once the possibilities for replacing consumer goods imports had been exhausted,
these countries turned to protection of intermediate goods , such as automobile bodies, steel and petrochemicals.
Problems of Import-Substituting Industrialization
Import-substituting industrialization began to lose favour when it became clear that countries pursuing import
substitution were not catching up with advanced countries. In fact, some developing countries lagged further behind
advanced countries even as they developed a domestic manufacturing base. India was poorer relative to the United
States in 1980 than it had been in 1950, the first year after it achieved independence.
Why didn’t import-substituting industrialization work the way it was supposed to? The most important reason seems to
be that the 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. Experience has shown that the reasons for failure to develop often run deeper than a
simple lack of experience with manufacturing. Poor countries lack skilled labor, entrepreneurs, and managerial
competence and have problems of social organization that make it difficult for these countries to maintain reliable
supplies of everything from spare parts to electricity. These problems may not be beyond the reach of economic policy,
but they 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
less-developed nations will learn to be efficient. In practice, this is not always, or even usually, true.
- Cost of policies used to promote industry
Many countries used excessively complex methods to promote their infant industries. That is, they used elaborate and
often overlapping import quotas, exchange controls, and domestic content rules instead of simple tariffs.
- Tendency of import restrictions to promote production at an inefficiently small scale
The domestic markets of even the largest developing countries are only a small fraction of the size of that of the United
States or the European Union. Often, the whole domestic market is not large enough to allow an efficient-scale
production facility.
- When this small market is protected, say, by an import quota, if only a single firm were to enter the market, it could
earn monopoly profits.
The answer to the problem of scale for small countries is to specialize in the production and export of a limited range
of products and to import other goods. Import-substituting industrialization eliminates this option by focusing
industrial production on the domestic market.
Trade Liberalization since 1985
Beginning in the mid- 19 80s, a number of developing countries moved to lower tariff rates and removed import quotas
and other restrictions on trade. The shift of developing countries toward freer trade is the big trade policy story of the
past two and a half decades. After 1985, many developing countries reduced tariffs, removed import quotas, and in
general opened their economies to import competition.
Trade liberalization in developing countries had two clear effects. One was a dramatic increase in the volume of trade.
The other effect was a change in the nature of trade. Before the change in trade policy, developing countries mainly
exported agricultural and mining products. But then the share of manufactured goods in developing-country exports
surged, coming to dominate the exports of the biggest developing economies.
Has the switch to more open trade delivered better results? The answer is that the picture is mixed.
Growth rates in Brazil and other Latin American countries have actually been slower since the trade liberalization of the
late 1980s than they were during import-substituting industrialization.
India, on the other hand, has experienced an impressive acceleration of growth—but there is intense dispute about how
much of that acceleration can be attributed to trade liberalization.
➔ The old view that import substitution is the only path to development has been proved wrong, as a number of
developing countries have achieved extraordinary growth while becoming more, not less, open to trade.
Trade and Growth: Takeoff in Asia
As we have seen, by the 1970s there was 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— cases of economies that experienced a
dramatic acceleration in their growth and began to converge on the incomes of advanced nations.
At first, these success stories involved a group of relatively small East Asian economies: South Korea, Taiwan, Hong
Kong, and Singapore. Over time, however, these successes began to spread; today, the list of countries that have
experienced startling economic takeoffs includes the world’s two most populous nations, China and India.
What caused these economic takeoffs?
Each of the countries experienced a major change in its economic policy around the time of its takeoff. This new policy
involved reduced government regulation in a variety of areas, including a move toward freer trade.
In each case, these policy reforms were followed by a large increase in the economy’s openness, as measured by the
share of exports in GDP.
So it seems fair to say that these Asian success stories demonstrated that the proponents of import-substituting
industrialization were wrong: It is possible to achieve development through export-oriented growth.
- Controversies in Trade Policy
Sophisticated Argument for Activist Trade Policy
Nothing excludes the desirability of government intervention in trade. Activist government policy needs a specific kind
of justification; it must neutralize some preexisting domestic market failure.
The difficulty with market failure arguments for intervention is being able to recognize a market failure when you see
one. Economists studying industrial countries have identified two kinds of market failure that seem to be present and
relevant to the trade policies of advanced countries:
(1) the inability of firms in high-technology industries to capture the benefits of that part of their contribution to
knowledge that spills over (si riversa) to other firms and
(2) the presence of monopoly profits in highly concentrated oligopolistic industries.
Technology and Externalities
The discussion of the infant industry noted that there is a potential market failure arising from difficulties of
appropriating knowledge. If firms in an industry generate knowledge that other firms can use without paying for it, the
industry is in effect producing some extra output—the marginal social benefit of the knowledge—that is not reflected in
In the 1990s, a growing anti-globalization movement—originally started in 1968 in Europe, alleged harm international
trade was doing to workers in the developing countries by producing equality in working conditions and wages, by using
the benefits that poorer counties could offer for Western markets. The anti-globalization group targets such
organizations and groups as the World Bank, the Organization for Economic Cooperation and Development (OECD), the
World Trade Organization (WTO), International Monetary Fund (IMF) and free trade agreements as General Agreement
on Trade in Services (GATS), the North American Free Agreement (NAFTA) and such.
Trade and Wages Revisited
Activists pointed to the very low wages earned by many workers in developing-country export industries. These critics
argued that the low wages (and the associated poor working conditions) showed that, contrary to the claims of free
trade advocates, globalization was not helping workers in developing countries.
The case for believing that trade is beneficial to workers in the low-wage country actually becomes stronger: Standard
economic analysis says that while workers in a capital-abundant nation like the Japan might be hurt by trade with a
labour-abundant country like Vietnam, the workers in the labour-abundant country should benefit from a shift in the
distribution of income in their favour.
In our given case, economists argue that while wages in Vietnam are very low compared with wages in Japan, that
situation is inevitable because of the lack of other opportunities in Vietnam, which has far lower overall productivity.
And it follows that while wages and working conditions in the Vietnam may appear terrible, they represent an
improvement over the alternatives available in the country. Indeed, the rapid rise of employment in foreign factories
indicated that workers preferred the jobs they could find there to the alternatives.
The standard economist’s argument, in other words, is that despite the low wages earned by workers in developing
countries, those workers are better off than they would have been if globalization had not taken place.
Labour Standards and Trade Negotiations
Whether and to what extent international trade agreements should also contain provisions aimed at improving wages
and working conditions in poor countries.
The most modest proposals have come from economists who argue for a system that monitors wages and working
conditions and makes the results of this monitoring available to consumers.
Suppose that consumers in advanced countries feel better about buying manufactured goods that they know were
produced by decently paid workers. Then a system that allows these consumers to know, without expending large
efforts on information gathering, whether the workers were indeed decently paid offers an opportunity for mutual gain.
Because consumers can choose to buy only “certified” goods, they are better off because they feel better about their
purchases. Meanwhile, workers in the certified factories gain a better standard of living than they otherwise would have
had.
Proponents of such a system admit that it would not have a large impact on the standard of living in developing
countries, mainly because it would affect only the wages of workers in export factories, who are a small minority of the
work force even in highly export-oriented economies. But they argue that it would do some good and little harm.
A stronger step would be to include formal labour standards—that is, conditions that export industries are supposed to
meet—as part of trade agreements.
While economic theory suggests that the minimum wage reduces the number of low-skill jobs available, reasonable
economists argue that such effects are small and are outweighed by the effect of the minimum wage in raising the
income of the workers who remain employed.
Labour standards in trade, however, are strongly opposed by most developing countries, which believe that the
standards would inevitably be used as a protectionist tool: Politicians in advanced countries would set standards at
levels that developing countries could not meet, in effect pricing their goods out of world markets.
Environmental and Cultural Issues
Many critics argue that globalization is bad for the environment. It is true that environmental standards in developing-
country export industries are much lower than in advanced-country industries. It is also true that in a number of cases,
substantial environmental damage has been and is being done in order to provide goods to advanced-country markets.
On the other hand, there are at least as many cases of environmental damage that has occurred in the name of
“inward-looking” policies of countries reluctant to integrate with the global economy.
As in the case of labour standards, there is debate over whether trade agreements should include environmental
standards. On one side, proponents argue that such agreements can lead to at least modest improvements in the
environment , benefiting all concerned. On the other side, opponents insist that attaching environmental standards to
trade agreements will in effect shut down potential export industries in poor countries, which cannot afford to maintain
anything like Western standards.
An even critical issue involves the effect of globalization on local and national cultures. It is unmistakably true that the
growing integration of markets has led to a homogenization of cultures around the world. Much but not all of this
homogenization is also Americanization.
One can therefore make a market failure argument on behalf of policies that attempt to preserve national cultural
differences. But it becomes clear that another principle is involved: the right of individuals in free societies to entertain
themselves as they like.
The WTO and National Independence
One recurrent theme in the anti-globalization movement is that the drive for free trade and free flow of capital has
undermined national sovereignty. In the extreme versions of this complaint, the World Trade Organization is
characterized as a supranational power able to prevent national governments from pursuing policies in their own
interests. How much substance is there to this charge? The short answer is that the WTO does not look anything like a
world government; its authority is basically limited to that of requiring countries to live up to their international trade
agreements. However, the small grain of truth in the view of the WTO as a supranational authority is that its mandate
allows it to monitor not only the traditional instruments of trade policy —tariffs, export subsidies, and quantitative
restrictions— but also domestic policies that are de facto trade policies ( there have been cases in which the WTO has
seemed to some observers to be interfering in domestic policy).
Globalization and the Environment
Concerns about human impacts on the environment are growing in much of the world. In turn, these concerns are
playing a growing role in domestic politics.
Globalization, Growth, and Pollution
Both production and consumption often lead, as a by-product, to environmental damage. Factories emit pollution into
the air and sometimes dump effluent into rivers; farmers use fertilizer and pesticides that end up in water; consumers
drive pollutionemitting cars. As a result economic growth, which increases both production and consumption, leads to
greater environmental damage.
However, other things are not equal. For one thing, countries change the mix of their production and consumption as
they grow richer, to some extent in ways that tend to reduce the environmental impact. In addition, growing wealth
tends to lead to growing political demands for environmental quality. As a result, rich countries generally impose stricter
regulations to ensure clean air and water than poorer countries.
In the early 1990s, Princeton economists Gene Grossman and Alan Krueger, studying the relationship between
national income levels and pollutants such as sulfur dioxide, found that these offsetting effects of economic growth lead
to a distinctive “inverted U” relationship between per-capita income and environmental damage known as the
environmental Kuznets curve.
The idea is that as a country’s income per capita rises due
to economic growth, the initial effect is growing damage to
the environment. Thus, China, whose economy has surged
in recent decades, is in effect moving from point A to point
B.
But when a country gets sufficiently rich, it can afford to
take action to protect the environment.
What does this have to do with international trade? Trade liberalization is often advocated on the grounds that it will
promote economic growth. To the extent that it succeeds in accomplishing this end, it will raise per-capita income. Will
this improve or worsen environmental quality? It depends which side of the environmental Kuznets curve an economy is
on.
However, the environmental Kuznets curve does not, by any means, necessarily imply that globalization is good for the
environment. In fact, at a world level, globalization has indeed harmed the environment—at least so far.
