International Trade and Economic Growth 1

International Trade and Economic Growth 1

Chapter Outline

I.Introduction

II.The Developing Countries

A.Economic Development

B.GDP of Developing Countries — Table 10.1

III.Economic Growth

A.Preconditions for Growth

property rights

rule of law

PASSPORT: Economic Freedom Indexes — Table 10.2

B.Economic Growth and the Factors of Production

C.Basic Growth Theory — Figure 10.1

D.Changes in the Capital Stock and Technology – Figure 10.2

IV.International Trade and Economic Growth

A.Openness and Growth

PASSPORT: Openness and Growth— Table 10.3

B.Capital Flows, Technology Transfers, and Economic Growth

V.Economic Development Strategies

A.Primary Products

Figure 10.3

Table 10.4

PASSPORT: OPEC — Figure 10.4

B.Import Substitution

C.Export Promotion

PASSPORT: Economic Development in East Asia versus Latin America — Table 10.5

VI.Official Development Assistance

A.The Role of Official Development Assistance

B.Flows of Official Development Assistance — Table 10.6

1. Multilateral Development Organizations

D.The World Bank and Regional Development Banks

E.The United Nations Agencies

Teaching Notes and Tips

I.Introduction

Notes

Over the first nine chapters, some of the economic problems of the developing countries were mentioned. The purpose of this chapter is to more carefully explore the relationship between international trade and economic development.

Teaching Tip

Of necessity, this chapter is only half a loaf. Many of the issues facing developing countries in the world economy are linked to the material covered in the second half of the book. As mentioned in Chapter 1, international economics can be roughly divided into two parts. As a result, the coverage of international economics and the developing countries must be covered in two chapters.

II.The Developing Countries

Notes

In Chapter 1, we covered the place of the developing countries in the world economy in terms of output, trade, population, and economic growth. This section starts by introducing the area of economic development. The second part of the section is a review of some of the data contained in Chapter 1 (Table 10.1).

Teaching Tip

Economic development is a separate area in economics that touches on almost every other area in economics. This makes economic development both fascinating and hard to study at the same time. However, many of the problems associated with developing countries are highly correlated with GDP per capita. Using GDP per capita as a proxy for many problems is both highly convenient but also quite realistic. For example, GDP per capita is much higher in Mexico than it is in Nicaragua. As a result, it would be difficult to find an area where economic conditions in Nicaragua are better than they are in Mexico.

III.Economic Growth

Notes

The section starts with the idea that unless certain conditions are met it is hard for any economy to grow. However, once these preconditions are met it is fairly easy to capture the concept of economic growth as a function of labor, capital, and technology in a simple graph. Subject to diminishing returns, increases in the labor force increase real GDP. Increases in the capital stock and technology cause upward shifts in the production function.

Teaching Tip

Explain that many of the very poorest countries of the world are in this condition because the government is unable to perform the most basic functions of protecting property and enforcing the law. In high-income countries, we simply take this for granted. Tragically, many of the world's poorest people cannot.

IV.International Trade and Economic Growth

Notes

In Chapter 2, we introduced the concept of the dynamic gains from trade. One of these gains is faster economic growth. At this point, we can define that gain a bit more precisely. International trade tends to increase total factor productivity in an economy. This increase will shift the production function upward. There is now sufficient empirical evidence on this point to make us confident in saying that the more an economy trades with the rest of the world, the faster it will grow. In a similar vein, the production function will shift upward as a country attracts FDI and the higher level of technology associated with it.

Teaching Tip

The empirical research on international trade and economic growth is a perfect example of economics in action. Economists start with a proposition that something logically should be true. The next step is rather simple empirical tests that mature into more sophisticated tests. If everything works, the end of this process is something that can be taught to undergraduate students as being "true."

V.Economic Development Strategies

Notes

There are three common economic development strategies that have been employed in developing countries: primary products, import substitution, and export promotion. The possession of primary products may allow a country to grow faster if the earnings from the production and export of these products are efficiently invested for economic development. Import substitution involves implicit or explicit subsidies to manufacturing that replaces imports. This strategy is being abandoned by most countries that have tried it because it tends to place resources in what may be comparative disadvantage industries. Export promotion seems to work better because it encourages the development of manufacturing industries based on the country's comparative advantage.

Teaching Tip

The decline in the use of import substitution as a development strategy mirrors the increase in the use of the term "structural adjustment." Some countries in Latin America have ended up with problems similar to former communist countries such as Hungary or Poland.

VI.Official Development Assistance

Notes

Over the last 50 years, the governments of the developed countries have attempted to assist the developing countries through ODA. Theoretically, ODA should allow the developing countries to develop infrastructure at a faster rate than would have been possible without it. However, this process has not worked as well as envisioned for several reasons. First, the amount of money being disbursed has been small relative to the needs of the developing countries. Second, much of the money has passed from government to government in the form of "tied" aid. This has left the multilateral institutions such as the World Bank with an astonishingly small amount of money to disburse relative to the needs of the developing countries. Likewise the UN agencies are attempting to provide technical assistance on trade, industrialization, and environmental issues with very little personnel or money.

Teaching Tip

Despite some issues over efficient management and environmental concerns, the World Bank has been a very successful institution. The IBRD borrows money in a free market, loans it to developing countries, and easily has maintained its credit rating in the world capital market.

Brief Answers to Problems and Questions for Review

1.Economic development is defined as a goal each country attempts to achieve. The goal of economic development is the attainment of a standard of living roughly equivalent to that of the average citizen in a developed country. In most of the world's countries, low GDP per capita is associated with a host of other factors that reduce the quality of life for most of humanity. In the poorest countries, there is pervasive malnutrition and chronically poor housing. Past basic food and housing, the lack of access to basic health care is also a threat to the lives of billions of people. The goal of economic development is the alleviation of these dire conditions for billions of people.

2.The two preconditions for economic growth are property rights and the rule of law. In order for a market economy to work properly, it is necessary for market participants to know who owns what. Without this knowledge, it is difficult for the usual buying and selling that characterizes economic activity to flourish. Second, markets cannot function properly without the rule of law. Economic activity is something like a game with rules. Unless the government is there to enforce the rules, market participants will be reluctant to play the game. As a result, it is necessary for the government to be able to enforce the rules and arbitrate the disputes that are a part of economic activity.

3.In the figure below, the size of the labor force is shown on the horizontal axis and real GDP is shown on the vertical axis. The positive relationship indicates that as the labor force increases, real GDP will increase. However, along any given production function the capital stock has been held constant. If the capital stock increases, then the entire production function would shift upwards from F to F'.

4.A typical production function is shown below with the labor force on the horizontal axis and real GDP on the vertical axis. This relationship indicates that real GDP would change if the size of the labor force changed. However, any given production function assumes that the capital stock and the level of technology is constant. Another way of expressing technology is total factor productivity. This refers to an economy's ability to mix capital and labor more efficiently to produce a higher level of output with the same inputs. If total factor productivity increases, then the entire production function would shift upward as shown. International trade tends to increase total factor productivity. Trade tends to move resources from comparative disadvantage industries to comparative advantage industries. This movement makes the resources that have been moved more productive and increases the economy's output for any given level of labor and capital.

5.In the context of economic development, FDI is the process of moving capital from the capital-abundant developed countries to the capital-scarce developed countries. However, more than just the capital is being moved. Usually, it would be true that the level of technology in the developed countries is higher than it is in the developing countries. The result is that FDI moves not only capital but involves a transfer of technology. This is beneficial to the developing countries as it allows them access to higher levels of technology. In terms of economic growth, the production function for the developing country would shift upward not just because of an increase in the capital stock but also as a result of an improvement in the level of technology.

6.International trade in goods and services can lead to technology transfers. An example of this is learning by doing. International trade usually involves countries becoming more specialized in the production of certain products. Because of specialization, countries become better at producing certain goods or services. This sort of specialization causes an improvement in knowledge that increases total factor productivity. The process of exporting intensifies the learning by forcing firms to compete with other specialized firms in the world economy. The same types of effects occur when domestic firms are forced to compete with more efficient foreign firms. The result is that international trade leads to an increasing accumulation of knowledge that can increase total factor productivity.

7.First, the production and export of primary products may be quite profitable. This can be a source of tax revenues for the government that can be used for economic development. Exporting primary products may be a major source of foreign exchange that can be used to purchase imported capital equipment necessary to enhance economic development. Finally, primary products may be used as inputs into the production of higher value added products. This can make it easier for a developing country to industrialize relative to other countries that do not have primary commodities. However, this type of industrialization may be difficult if developed countries have a tariff structure where the effective rate of protection escalates with the degree of processing. Also, the prices of primary products can be quite volatile. At a minimum, this may lead to instability in the exchange rate and make the economy more unstable. If the product is a large percentage of GDP, then large changes in the price of the product may tend to make the whole economy unstable. The bottom line is that in an economy where primary products are important, it may be more difficult to keep the economy on a stable growth path.

8.An import substitution development strategy is an attempt to increase the size of the manufacturing sector by replacing imports. This is accomplished with some combination of high tariffs, quotas, or other forms of explicit or implicit subsidies. An export promotion strategy is an attempt to increase the size of the manufacturing sector by relying on the maximum growth of industries that rely on the country's comparative advantage. In the long run, export promotion strategies seem to work better. Import substitution may involve the transfer of resources into industries for which that country does not have a comparative advantage. This lowers the total output of the economy. An export promotion strategy has a better chance of increasing economic growth as resources are encouraged to flow into industries for which that the country has a comparative advantage.

9.Official development assistance (ODA) describes the transfer of resources from developed to developing countries to assist in the process of economic development. ODA is a relatively unimportant factor in economic development because it is so small. In 2002, the total global flow of ODA was less than $65 billion. This amount represents less than one percent of the collective GDPs of the developing countries. While ODA may be important for selected countries at particular points in time, it does not have a substantial effect on overall economic growth in the developing countries.

10.The name World Bank is really a term used to describe the operations of five different parts of the institution. The International Bank for Reconstruction and Development (IBRD) borrows money in the international capital markets and loans it to middle-income countries for specific economic development projects. The International Development Association (IDA) gathers money donated by the developed countries and makes concessionary loans to low-income countries. The International Finance Corporation (IFC) makes loans to private-sector firms in developing countries. The Multilateral Investment Guaranty Agency (MIGA) and the International Centre for Settlement of Investment Disputes encourage FDI in developing countries by providing insurance on these investments and providing a mechanism for the settlement of disputes, respectively.

11.The UN provides assistance to economic development primarily in the form of technical assistance. UNCTAD provides technical assistance to developing countries in the process of integrating into the global economy and for trade negotiations. UNIDO provides technical assistance for countries in the process of increasing the industrial sector of the economy. A large number of other UN agencies have at least a tangential role in the process of economic development. The activities of these agencies with respect to economic development are coordinated by the UN Development Program (UNDP).

Multiple-Choice Questions

1.The goal of economic development is for the _____ countries to achieve a standard of living roughly equivalent to that of _____ countries.

a.developed, developing

*b.developing, developed

c.middle-income, low income

1. high-income, middle income

2.In the low- and middle income countries _____ and _____ of the population respectively are illiterate.

a.5%, 10%

b.7%, 14%

c.16%, 20%

*d.17%, 38%

3.GDP per capita in the high-income countries is approximately:

a.$451.

b.$2,000.

c.$15,000.

*d.$26,964.

4.GDP per capita in low-income countries is less than _____ per year.

*a.$500

b.$2,000

c.$5,000

d.$7,500

5.Which of the following is a precondition for economic growth?

a.A high level of technology

b.A high K/L ratio

*c.The rule of law

d.Free trade

6.The rule of law is important to economic growth as it is necessary for the enforcement of _____ .

a.free trade

b.emigration

*c.contracts

d.industrial policy

7.Which of the following is not one of the factors of production?

a.Land

b.Labor

c.Capital

*d.Property rights

8.Which of the following countries has a large amount of economic freedom?

*a.Hong Kong

b.Libya

c.Zimbabwe

d.Laos

9.In order for GDP per capita to grow, it is necessary for _____ growth to be in excess of _____ growth.

a.population, GDP

b.labor, capital

*c.GDP, population

d.land, capital

10.The graphical relationship between real GDP and the size of the labor force is known as:

a.the Kuznets curve.

*b.the production function.

c.the technology curve.

d.the demand curve.

11.The production function:

a.is linear.

b.is undefined for low-income countries.

c.slopes downward and to the right.

*d.slopes upward to the right.

12.In the figure above, an increase in the labor force:

*a.increases real GDP.

b.decreases real GDP.

c.shifts the production function upward.

d.shifts the production function downward.

13.In the figure above, which of the following would cause an upward shift in the production function?

a.An increase in the labor force.

b.A decrease in the labor force.

*c.An increase in the capital stock.

d.A decrease in the capital stock.

14.In the figure above, which of the following would cause an increase in real GDP?

a.A decline in the labor force

*b.An improvement in technology

c.A decrease in the capital stock

d.A decline in technology

15.In the figure above, an increase in real GDP with an unchanged labor force could happen as a result of:

a.a smaller capital stock.

*b.a higher level of technology.

c.a lower level of technology.

d.higher oil prices.

16.An improvement in technology would tend to:

a.cause a movement to the right along an existing production function.

b.cause a movement to the left along an existing production function.

*c.cause an upward shift in the production function.

d.have no effect on the production function.

17.The theory of comparative advantage indicates that international trade should increase the output of the economy by moving resources from _____ to _____ industries.