International Trade and Economic Growth

 Summary and Review of Basic Concepts

International trade can affect the level of economic growth of an economy. If the economy has been experiencing unemployment, then growth can come about with the reemployment of factors of production. If factors are fully employed, then economic growth requires new factors of production, or equivalently, technological innovation that allows existing factors to produce more output.

One strategy for economic development is to encourage production and export of primary products such as agricultural products and natural resources. By expanding the size of the market through international trade, a country may be able to utilize its resources more fully (vent for surplus argument). The development of an export sector may also expedite the process of building infrastructure (linkages).

Some opponents of primary export-led growth argue that prices of primary products have been falling relative to prices of manufactured goods. Countries emphasizing primary products in their export program then may receive a declining share of the gains from trade. The statistical evidence on this issue is inconclusive.

An alternative plan for economic development emphasizes import substitution. In this approach, a government erects high import barriers to encourage local production in selected industries. The rationale for the strategy is similar to the infant industry argument for protection.

Drawbacks to import substitution are that the import barriers often remain well beyond the period that was originally intended and inhibit the growth of (linked) industries that supply inputs to the protected industry. The system also encourages citizens to expend resources to convince officials that their businesses are worthy of special protection.

Countries adopting an outward looking growth strategy look to integrate their economies with the rest of the world. Policies include keeping domestic markets open to foreign firms; promoting efficient resource allocation by decontrolling wages and rents; and providing indirect subsidies to successful exporters. Examples of countries that have had success with outward oriented growth policies include Japan, Hong Kong, Korea, Singapore, and Taiwan.

In economies with fully employed factors, growth can only result from factor growth and technical innovation. Variations in factor growth and technical innovation affect the manner in which a country grows, and will in turn, carry implications for the country's pattern of trade over time.

Neutral economic growth occurs when the economy continues to produce and consume the goods in the same ratios as it did before growth. (Figure 10.2) Graphically, this requires:

the new PPF must simply be a proportionate expansion of the old PPF

consumption of all goods must increase equiproportionately as income increases

When growth results from an increase in the factor used intensively in export goods, then export production will tend to rise relative to the production of import competing goods, and by a greater percentage than the growth in GDP. This is called pro-trade biased growth.

(Figure 10. 3)

When growth results from an increase in the factor used intensively in the import good, then the output of the importables will rise relative to export production, and by a greater percentage than the growth in GDP. This is anti-trade biased growth. In some cases, growth could actually lead to a switch in trade patterns.

Technical change occurs when the same amount of output can be produced by fewer factor inputs, or when the same amount of inputs can produce greater amounts of output. Change can be described as neutral technical change, labor-saving technical change or capital-saving technical change.

When a large country grows, increased output of the exportable or increased demand for the importable good could result in welfare-decreasing price changes. The country's terms of trade could change for neutral as well as biased economic growth. Pro-trade biased growth could worsen the terms-of-trade impact, while anti-trade biased growth could improve it (in the large country case).

In an extreme case, biased growth could actually make a country worse off. If pro-trade biased growth of an exportable with inelastic demand is combined with a strong terms-of-trade effect, the magnitude of the deterioration in the country's terms of trade can lower overall welfare below the pre-trade level, resulting in immizerizing growth. However, the conditions required for this are so extreme that it is more of a theoretical curiosity than a real threat.

A boom in a commodity can have surprising effects on an economy that is abundant in this resource, a phenomenon known as the "Dutch Disease." A substantial price rise in a commodity will draw resources from the rest of the economy into the expanding commodity sector. Other sectors may actually contract. When large deposits of natural gas were discovered in the Netherlands (in the 1960s), energy-intensive production expanded, as predicted by the Rybczynski Theorem. In the 1970s, crude oil price quadrupled, increasing the demand for natural gas because it is a substitute for oil in many industrial applications (e.g., generation of electricity). The higher relative price of energy caused greater specialization in the production of energy. Deindustrialization also occurred and unemployment rose (due to labor-market inflexibility). Some view the overall effects as a case where growth reduced welfare.