UNIT 22 INTERNATIONAL TRADE

AND DEVELOPMENT
Structure
22.0

Objectives

22.1

Introduction

22.2

Trade and Development

22.3

22.4

22.5

22.2.1

Static Gains from Foreign Trade

22.2.2

Dynamic Gains from Foreign Trade

Prebisch, Singer and Myrdal Thesis

22.3.1

Objections to the Thesis

22.3.2

Causes of Deterioration in TOT

Trade strategy: Export-led Growth

22.4.1

Arguments for Inward-looking strategy

22.4.2

Arguments for Outward-looking strategy

Dual Gap Analysis

22.5.1

22.6

22.7

Balance of Payments
22.6.1

Concept and uses

22.6.2

BOP and Developing Economics

Tariffs and Effective Protection

22.7.1

22.8

22.9

Shortcomings of the Model

Effective Tariff Rate

Post-GATT International Economic Order and WTO

22.8.1

Setting up of the GATT

22.8.2

Establishment of the WTO

22.8.3

WTO and Developing countries

Globalisation and Developing countries

22.9.1

Implications of Globalisation

22.9.2

Advantages of Globalisation

22.9.3

Shortcomings of Globalisation

22.10

Let US Sum Up

22.11

Some Key Words

22.12

Some Useful Books

22.13

Answers to Check Your Progress

22.0 OBJECTIVES
After reading this unit you should be able to:

48

Illustrate the role of international trade in economic growth;

distinguish between static gains and dynamic gains from foreign trade;

explain the Prebisch-Singer-Myrdal Thesis and the underlying causes of

deterioration in long-term term-of-trade of developing countries;

discuss the merits and demerits of outward-looking and inward-looking trade

strategies;

analyse the structure of balance of payments and its significance in the process of
development;

explain the role of tariffs in international trade,

calculate the effective rate of protection,

appreciate the circumstances in which the WTO was set up and its significance
for developing economies; and

explain the implications of globalisation for developing countries.

International Trade and

Development

22.1 INTRODUCTION
Foreign trade has worked as an "engine of growth" in the past, and even in more
recent times the "outward-oriented growth strategy" adopted by the NewlyIndustrialising Economies of Asia, including South Korea, Taiwan, Singapur, and
Hong Kang, has enabled them to overcome the constraints of small resource-poor
under-developed economies. Notwithstanding a strong belief in Prebisch, Singer and
Myrdal thesis at some point of time in the history of international economic relations,
the free trade paradigm in the current WTO administered era has thrown open
innumerable opportunities for growth. Increasing spread of globalisation translated
into larger movement of goods and services across the nations. Trade is intertwined
with another element of globalisation: the spread of international production
networks. Growth of trade is firmly buttressed by international institutions of long
standing. The WTO, built on the legacy of the GATT, aims to create a commercial
environment more conducive to multilateral exchange of goods and services. Recent
years have seen substantial reductions in trade policy and other barriers inhibiting
developing country participation in world trade. Lower barriers have contributed to
a dramatic shift in the pattern of developing country trade - away from dependence
on commodity exports to much greater reliance on manufactures and services. In
addition, exports to other developing countries have become much more important.
We address all these issues in this unit.

22.2 TRADE AND DEVELOPMENT

The role of foreign trade in fostering economic development can be examined under
two headings: (i) static gains from foreign trade, and (ii) dynamic gains from foreign
trade.

22.2.1

Static Gains From Foreign Trade

The static gains from foreign trade can be briefly stated as follows.
If there is a difference between internal relative prices in autarky and those that can
be obtained internationally, then a country can improve its well-being by specialising
in and exporting the relatively less expensive domestic goods and importing goods
that are relatively more expensive.
From a development standpoint, the change in economic structure and factoral
distribution of income that is assumed to accompany this adjustment is of clear
concern. Because the economic systems of the developing countries tend to be
somewhat unresponsive to changing price incentives, at least in the short run, factors
of production may not move easily to the expanding low-cost sectors from the
contracting higher-cost sectors. In this case the adjustment process takes on the
characteristics of the "specific-factors model" and the gains from specialisation are
reduced in the short-run.
Nevertheless, even if a country's production does not change at all, there are still
gains from trade as follows:
1)

The characteristics of the import good - either in terms of quality for

consumers or productivity in the case of capital and intermediate inputs - may

49

Development Strategies

improve the economy's ability to meet consumer needs. Imports may also help
relieve short-run domestic bottleneck and permit the economy to operate closer
to its production-possibilities-frontier - that is to say, more efficiently - on a
consistent basis.
2)

The static impact of trade on the production structure of the economy that
occurs when specilaisation follows comparative advantage will result in a
relative expansion of the sector(s) using the relatively abundant factor. For
most developing countries, this results in incentives to expand labour-intensive
production instead of more capital-intensive production. This means expanding
traditional agriculture, primary goods, and labour-intensive manufactures.
International trade thus stimulates employment and puts upward pressure on
wages, as suggested in Heckscher - Ohlin explanation of the basis for trade.

3)

Since most of the developing countries are far removed from full employment
situation, another potential gain from foreign trade has been elaborated by Hla
Myint. Myint suggests that unemployment represents a potential production
supply that exceeds domestic demand in the developing country. In this
instance, foreign trade can provide a 'vent for surplus', that is, a large market
that will permit the country to increase its output and employment
(conceptually, to move from well inside its production-possibilities-frontier to
a point near or perhaps on the PPF). Myint argues that vent for surplus is a
more convincing explanation of why countries start to trade, while comparative
advantage helps us to understand the types of commodities countries ultimately
trade. From a development standpoint, the gains in income, employment, and
needed import goods can influence the development process in a positive
manner.

However, these gains from trade are limited by a number of factors; among these the
more important are as follows:
One, given the economic characteristics of many primary goods and labour-intensive
manufactures, many observers question the desirability of a relative growth in the
production of traditional goods, particularly if this growth is at the expense of
modern manufacturing. Because of the lower income, low price elasticities of
demand for these products and the instability in supply of agricultural and primary
production, greater specialisation in these goods can result in a greater instability of
income, even in the static sense.
Two, to the extent that the developing country is a large country in terms of export
goods, supply may well lead to undesired terms-of-trade effects that will
significantly reduce the expected static gains from trade and lead to a distribution of
the gains from trade that favours the more developed trading partner.
Three, expanding production of basic labour-intensive products and relying on the
industrialised countries for manufactures and capital goods not only can lead to a
critical economic dependency but also inextricably links the economic health of the
developing country to that of the industrialised country.
Four, to the extent that developing countries are characterised by high rates of
unemployment, the impact of increased demand for labour on the wage level is often
limited.

50

To sum up, the static gains from trade for a developing economy originate from the
traditional gains from exchange and specialisation as well as, perhaps from a vent for
surplus. However, because of the inflexibilities in the traditional economies and the
nature of the traditional labour-intensive exports, the relative static gains from trade
may be less than those for the more flexible industrial economy and also may be
reduced by the undesirable effects of increased economic instability and terms-oftrade behaviour.

22.2.2

Dynamic Gains from Foreign Trade

International Trade and

Development

The biggest potential impact of trade on development rests with dynamic effects.
Dynamic effects may be both positive and negative.
A)

B)

Dynamic Positive Effects: The principal positive effects may be stated as

follows:
i)

The expansion of output brought about by access to the larger

international markets permits the developing countries to take advantage
of economies of scale that would not be possible with the limited
domestic market. Thus, industries that are not internationally
competitive in an isolated market may well be competitive by way of
international trade through expansion of market.

ii)

Since comparative advantages change over time and with economic

development, international trade can foster the development of infant
industries into internationally competitive ones by providing the market
size and exposure to products and processes that would not happen in its
absence. This of course is one of the reasons cited for using trade policy
instruments to restrict imports or promote exports, although these are
problems with using the policies in practice.

iii)

Other dynamic influences of trade on economic development arise from

the increased investment resulting from changes in the economic
environment, the increased dissemination of technology into the
developing country, exposure to new and different products, and changes
in institutions that accompany the increased exposure to different
countries, cultures and products.

Dynamic Negative Effects: As conditions in the developing countries differ

so dramatically from the theoretical models, the static application or
comparative advantage may not be very helpful in providing guidelines for
trade and specialisation in a dynamic developing economy setting. It is
important to examine briefly several of the more important disadvantages of
unrestricted trade for the developing country, particularly since these concerns
can have important implications for trade policy.
i)

The possible negative effects of trade on development arise from factors

that are ignored when focussing on static comparative advantage to
delineate factors and importsFor example, market imperfections in
developing countries generally result in private costs and benefits being
different from social costs and benefits. Relying on private (market)
prices in this environment can lead to a pattern of trade that is not
consistent with either relative social costs or long-term development
goals of the country.

ii)

In a broader dynamic context, it must also be recognised that since the

production linkages vary between different commodities or sectors, the
overall effect of exports on growth and is likely to vary fromcommodity
to commodity. Some commodities thus act like "growth poles" for the
entire economy while others such as primary production have little effect
outside their own sector.

iii)

A further complication arises from the variation in the returns to scale

characteristic among commodities. Thus, a country might not appear to
have a relative cost advantage in a particular product at the level of
production needed to fill the home market, but there might well be a
comparative advantage in that product at a higher level of production. In

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Development Strategies

a similar fashion, a product that appears to have a current cost advantage

but is characterised by decreasing returns to scale may find its export
possibilities very limited.
iv)

From an internal perspective, the domestic supply and demand

conditions that underlie both current and future comparative advantage
have been and will continue to be influenced both by the imperfect
nature of the markets and by government policy.

v)

The operation of markets and the characteristics of traded goods often

differ between the developing countries and the industrialized countries.
Many argue that these differences result in the greater share of trade
related benefits going to the industrialised countries and may even
contribute to the furthering of underdevelopment in the developing
economies.

To sum up, while empirical analysis often supports the idea of a positive connection
between the expansion of international trade and growth in income, a certain
ambiguity remains. The manner and the degree to which trade influences growth and
development is complex and often country-specific. The nature of the effect appears
to vary with the degree of development, the nature of the economic system, and
world market. World business cycles in particular seem to play an important role.
While empirical analysis has not as yet provided a conclusive answer to the links
between trade and growth, some of the recent models of growth through endogenous
technological change that incorporate various effects of international trade might
prove more successful.

22.3 PREBISCH, SINGER AND MYRDAL THESIS

Prebisch-Singer-Mydral Thesis states that the terms of trade of the developing
countries have declined over a long period of time, much to their disadvantage. The
thesis is so named after the names of the three economists who popularized it, viz.,
Raul Prebisch, Hans W.Singer and Gunnar Myrdal.
The problem of long-run deterioration in the terms of trade refers to the fact that,
over the span of several decades or so, there has been a persistent tendency for the
commodity terms of trade (price of exports/price of imports) to fall for developing
countries. If the world is viewed as consisting of two groups of countries - the
developing countries (DCs) and the industrialized countries (ICs) - then the
implication is that the commodity terms of trade have been improving for ICs, since
exports from DCs(ICs) are imports into ICs(DCs). In other words, the international
economy is transferring real income from DCs to ICs.
The thesis emerged in response to statistical studies showing that, particularly for
Great Britain, the TOT had risen dramatically in the 50-to-100-year period ending
with World War II. The inference was made that since the IC's TOT had improved,
the DC's TOT must have deteriorated.

22.3.1 Objections to the Thesis

A number of economists pointed out that such an inference was invalid for the
following reasons:
i)

52

One reason concerns the way international trade are recorded. Exports are
usually recorded f.o.b.(free on board) which means that insurance and
transportation costs are not included; however, imports are usually recorded
c.i.f.(inclusive of cost, insurance and freight). Hence Pexports/Pimports for the ICs
could have been rising because as has been the case over the long run,
transport costs had been falling. Thus, the use of the reciprocal of the IC's

TOT as an indication of the DC's TOT is invalid, since the recording procedure
could be consistent with improving TOT for both DCs and ICs due to the
decline in transportation costs.
ii)

International Trade and

Development

Another reason for objection to long-run studies of TOT behaviour concerns

quality changes in products. It is very difficult to incorporate quality changes
into price indexes, and a rise in price for a product may not indicate a true
price increase if the quality of the product purchased has also improved.
Quality improvement have been greater in manufactured goods than in primary
products in the long-run. Thus, since the share of primary products in DCs
exports is larger than in DCs imports, even if Pexports/Pimports is falling for the
DCs this may not be a true 'deterioration' in TOT. While the DCs may be
paying relatively more for their imports, they may also be receiving relatively
better products.

Despite these objections, there is considerable concern over the trend of TOT for
DCs.

22.3.2

Causes of Deterioration in TOT

Several reasons have been offered for the long-run TOT decline of DCs.
1) Differing elasticities of demand for primary products and manufactured
goods
Empirical evidence indicates that the income elasticity of demand is higher for
manufactured products them for primary products. Consequently as DCs and ICs
both grow, they devote a larger percentage of their incomes to the purchase of
manufactured goods and smaller percentage on primary products. Since many DCs
are net exporter of primary products and net importer of manufacturers, the prices of
their imports will rise more rapidly than the prices of their exports, other things being
equal.
2) Unequal market power in product and factor markets in ICs and DCs
The general point is that primary products are sold in competitive world markets,
while manufactured goods are often sold in an oligopolistic market setting where
prices can be higher than would be the case with perfect competition. In addition,
labour markets in ICs may contain imperfectly competitive elements if labour unions
are strong and thus wages are relatively high, while labour in the primary-product
sector in DCs is not organized and cannot exert upward pressure on wages and
prices. The result is that prices of primary products do not have the upward pressures
put upon them that prices of manufactured goods do; therefore, the TOT of the DCs
suffer. There may also be an asymmetry in price behaviour; primary-product prices
may be slow to rise in the upswing of business cycles but fall in downswings, while
manufactured goods prices rise in upswings and are slow to fall in downswings.
Over the long run, DCs TOT decline.
3)

Technical change

The nature of technical change has worked to reduce the growth rate of demand for
primary products. Those reduction in the growth of demand has therefore, other
things being equal, resulted in less upward pressure on primary-product prices.
4)

Multinational Corporations and Transfer Pricing

The behaviour of MNCs through the mechanism of transfer pricing can worsen the
DCs TOT. Suppose that a MNC operates a subsidiary in a DC that is sending inputs
to another subsidiary in an IC and at the same time the subsidiary in the IC sending
inputs to DC subsidiary. Since both subsidiaries are part of the same enterprise, such
trade is called intra-firm trade. In intra-firm trade, prices are largely arbitrary because

53

Development Strategies

the goods do not pass through organized markets, and the recorded prices are merely
bookkeeping entries for the firm.
Check Your Progress 1
1)

Examine the nature of static gains from foreign trade.

..
..
..
..
..
..
..

2)

Examine the nature of dynamic gains from foreign trade.

..
..
..
..
..
..
..

3)

What do you mean by terms of trade? Account for the long-term deterioration
of terms of trade for developing countries.
..
..
..
..
..
..
..

22.4

54

TRADE STRATEGY : EXPORT-LED

GROWTH

What is the appropriate trade strategy for DCs. Economists and policy-makers have
debated two competing strategies regarding the trade sector: (i) inward-looking
strategy, and (ii) outward looking strategy.

An inward-looking strategy is an attempt to withdraw, at least in the short-run,

from full participation in the world economy. This strategy emphasise import
substitution, that is, the production of goods at home that would otherwise be
imported. This can economise on scarce foreign exchange and ultimately generate
new manufactured exports if economies of scale are important in the importsubstitution industries and if the infant industry argument applies. The strategy uses
tariffs, import quotas, subsidies to import-substitute industries, and other measures of
this type.

International Trade and

Development

An outward-looking strategy emphasizes participation in international trade by

encouraging the allocation of resources without price distortions. It does not use
policy measures to shift production arbitrarily between serving the home market and
foreign markets. In other words, it is an application of production according to
comparative advantage.
Some analysts go further and focus particularly on export promotion, whereby policy
steps such as export subsidies, encouragement of skill accumulation in the labour
force and the use of more advanced technology, and tax breaks are used to generate
more exports, particularly labour-intensive manufactured exports in accordance with
the Heckscher-Ohlin Theorem.

22.4.1

Arguments for Inward-looking Strategy

The advocates of inward-looking strategy plead that inward-looking policies

encourage indigenous talent, learning to do things by oneself, domestic technological
development and suitable range of products, avoiding the ill-effects of demonstration
from the outside world. Given gaps of development between the developing and the
developed countries, inward-looking strategy is advocated as an inevitable one.

22.4.2

Arguments for Outward-looking Strategy

The advocates of outward-looking strategy argue that openness is useful to bring

about good educational effects, new ideas and new techniques, growth of new forms
of organization, etc. They believe that free trading encourages learning by trade and
implies achievements of dynamic transformation of the economy into higher
standards of living. Free trade is a win-win situation, all the trading partners stand to
gain through productivity improvements, notwithstanding diversities in their
domestic institutions and policies.
Quotas and other quantitative restrictions, on the other hand, interfere with price
mechanism, involve allocative and X-inefficiencies, create distortions and impede
the progress of competitive and industries.
Effects of these two types of strategies on growth of output, employment, income
generation and income inequalities could also be of diverse nature, and no general
inference can be drawn in this context.

22.5 DUAL-GAP ANALYSIS

A two-gap analysis of capital requirements for economic growth has been put forth
by Hollis Chenery and Michael Bruno. This two-gap approach to economic
development argues that saving gap and foreign exchange gap are two separate
and independent constraints on the achievement of a target rate of growth in DCs.
According to this analysis, foreign capital fills both the gaps and helps to attain the
target rate of growth.
The size of gaps can be calculated by assuming a target growth rate and a given
capital-output ratio. To illustrate, if the target growth rate is 8 per cent per annum,
and the capital-output ratio is 4:1, then the country must save 32 per cent of its
national income to attain the growth target. But if the domestic rate of saving is 28

55

Development Strategies

per cent, the saving gap is 4 per cent of national income. This gap can be filled by
foreign capital. Similarly, a fixed relationship is envisaged between targeted foreign
exchange requirements and net export earnings to find out the foreign exchange gap
which can be covered by foreign capital inflow.
The two gaps can be explained in terms of the national income accounting identities
as follows:
EYIS=MX=F
where
E is national expenditure
Y is national income
S is saving
M is imports
X is exports
F is net capital inflow
(I S) represents the domestic saving gap and (M X) is the foreign exchange gap.
It may be mentioned here that the two gaps are always equal in the ex-post sense in
any given accounting period but they may differ ex-ante like the basic national
income identities. The reason in this case being that in the long run those who make
decisions about savings, investment, exports and imports are different people.
The dual-gap analysis is based on the following assumptions:

Savings and foreign exchange cannot be substituted for each other.

The potentional savings of a country cannot be transformed into exports.

Export promotion and import substitution policies are ruled out.

There are certain structural rigidities and non-substitutability between different

types of goods.

On the basis of these assumptions, the ex-ante gaps with different growth rates of
income can be explained with the help of Fig. 22.1.

Ex - ante Gaps

IS
MS

C
B

R1

Target Growth Rate

Fig 22.1: Dual Gap Analysis

In Fig. 22.1, target growth rates are measured on the x-axis; y-axis measures ex-ante
gaps. (I S) curve shows the saving gap and (M X) curve represents the foreign
exchange gap.
At point C, both the gaps are equal and the target growth rate achieved is OR with
OC inflow of foreign capital.

56

In case the targeted growth rate is OR1, the foreign exchange gap is larger than the
savings gap by AB. As a result, this growth rate will not be achieved as the inflow of
foreign capital is not adequate to fill the larger foreign exchange gap OG1.

International Trade and

Development

If the target growth rate is OR2, the saving gap is larger than the foreign exchange
gap by ED. This growth rate cannot be achieved because the inflow of foreign capital
is insufficient to inflow of foreign capital to meet the larger saving gap OF2. It is not
possible to curtail imports due to The nature and limited flexibility of the productive
system and of the composition of consumer demand. Chenery, however, suggests
changes in the exchange rate and restrictions of the pattern of consumption and
distribution of income to remove these structural rigidities. Such measures may
succeed in bringing about adjustments in the two-gaps without foreign capital but
they will hinder growth.
The foreign capital needed to fill the gap is determined by the dominant gap at a
given point in time.
1) If the saving gap is larger than the foreign exchange gap, the country is said to be
in a savings constraint. In this case, over the long run the amount of foreign
capital required will equal the gap between the increase in investment and the
increase in savings generated by rising income. When the savings gap ceases to
exist, the target growth rate will be ensured.
2) If the foreign exchange gap is larger than the savings gap, the country is said to
be in a foreign exchange constraint. The inflow of capital can help overcome the
foreign exchange gap and over the long period the required foreign capital will
equal the difference between the increase in imports and exports and the target
growth rate of economy will be ensured.
3) The model postulates stable values of the parameters for the future. This is
unrealistic as the marginal savings rate and capital-output ratio change over time.
4) The model treats all types of capital investments as homogeneous. This is
unrealistic because the capital requirements of developing countries pertain to
different sectors, projects and industries.
5) Apart from the saving gap and foreign exchange gap, the developing countries
also suffer from other equally important gaps in technology and infrastructure.
To sum up, dual-gap analysis may have some limited utility in the calculation of
short-run capital requirements but over the longer run it is not of much use.

22.6 BALANCE OF PAYMENTS

The principal tool for the analysis of the monetary aspects of international trade is
the balance of payments settlement.

22.6.1 Concept and Uses

Balance of payments (BOP), is a systematic record of all international economic
transactions, visible and invisible, of a country during a given period usually a year.
In other words, the statement is a device for recording all the economic transactions
within a given period between the residents of a country and the residents of other
countries. The BOP of a country, technically speaking, always balances. Such
equality in the debit and credit sides of the BOP, known as equilibrium, has no
economic significance. It simply results from the double entry book-keeping
procedure which is used to record the transactions.

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Development Strategies

The analysis of the BOP can be done in terms of its two major sub-divisions, vij,(A)
viz., i) Current account, and (ii) Capital account.
A)

Current Account: The current account can be broken in to two parts, viz.
one, balance of trade, and two, balance of invisibles.
The balance of trade (BOT) deals only with exports and imports of
merchandise (or visible items).
The balance of invisibles (BOI) shows the net receipts on account of
invisibles. These include the remittances, net service payments, etc.
It is not necessary that BOT should always balance; more often than not it will
show either a surplus or a deficit. Similarly, the BOI will always show either a
surplus or a deficit. A surplus on BOT may be matched with a surplus or
deficit on BOI. If the surplus on BOI equals the deficit on BOT, the current
account will show a net balance. But then there is no reason why these two
balances should always be equal, again, always in opposite directions. As a
matter of fact, the balance on current account can always show a deficit or a
surplus. A surplus on current account leads to an acquisition of assets or
repayment of debts previously contracted, and a deficit involves withdrawal of
previously accumulated assets or is met by borrowings.

B)

Capital Account: The capital account presents transfers of money and other
capital items and changes in countrys foreign assets and liabilities resulting
from the transactions recorded in the current account. The deficit on the
current account and on account of capital transactions can be financed by
external assistance (loans and grants), borrowings from the International
Monetary Fund and allocation of the Special Drawing Rights.

Uses: The BOP account provide a link between the increase in gross external debt
and the portfolio and spending decisions of the economy.
Thus, increase in gross external debt

+
+

Current account deficit

direct and long-term portfolio capital
changes
increases in official reserve
other private capital outflows

The above equation shows that an increase in external debt can have three broad
sources: i) current account deficits not financed by long-term capital inflows,
ii) borrowing to finance a reserve build-up, and iii) private outflows of capital.

22.6.2

BOP and Developing Economies

It is well-known in development economics that developing economies invariably

start as debtor economies. In the process of development itself these economies have
to import a great deal of capital goods, consumer goods, food and raw materials, and
spares and components. They also have to import some new technologies and hence,
the total exchange outgo cannot be matched by export earnings. But it is expected
that soon, as the new capital goods and technologies begin to become effective and
their products are directed towards exports, export goods and services become
competitive in cost and quality. In that case, the volume of exports expands and, in
due course, begins to overtake exports. A developing economy then moves on from
being a debtor country to a balanced one in terms of BOP and, finally, becomes a
creditor country exporting more than it imports and giving credit to buyers. Thus,
from being a net debtor in the beginning, it becomes a net creditor in the end and, in
fact, begins to invest abroad rather than have others bending to and investing in it.

58

22.7 TARRIFS AND EFFECTIVE PROTECTION

International Trade and

Development

More generally, governments do not adhere to free trade despite the strong case for
the efficiency and welfare gains from trade that has been clearly established and
accepted. Policymakers have proven very resourceful in generating different devices
for restricting the free flow of goods and services. Among these, the most important
are import tariffs.
Tariffs, generally speaking, are of two types: (i) specific tariff, and (ii) ad valorem
tariff
A specific tariff is an import duty that assigns a fixed monetary (rupees) tax per
physical unit of the good imported. Thus, a specific duty might be Rs.25 per ton
imported or Rs.2 per kg. The total import tax bill is levied in accordance with the
number of units coming into the importing country and not according to the price or
value of the impoprts. Tax authorities can collect specific tariffs with ease because
they need to know only the physical quantity of imports coming into the country, not
their monetary value. However, specific tariff has a fundamental disadvantage as an
instrument of protection for domestic producers because its protective value varies
inversely with the price of the import.
The ad valorem tariff is levied as a constant percentage of the monetary value of 1
unit of the imported good. Thus, if the ad valorem tariff is 10 per cent, an imported
good with a world price of Rs.100 will have Rs.10 tax added as the import duty. If
the price rises to Rs.200 because of inflation, the import levy rises to Rs.20.
Although the ad valorem tariff preserves the protective value of the trade interference
for home producers as prices increase, there are difficulties with this tariff instrument
because customs inspectors need to make a judgment on the monetary value of the
imported good. Knowing this fact, the seller of the good is tempted to under-value
the goods price on invoices in order to reduce the tax burden. On the other hand,
customs officials may deliberately overvalue a good to counteract undervaluation or
to increase the level of protection and tariff revenue. Nevertheless, ad valorem
tariffs have come into widespread use.

22.7.1 Effective Tariff Rate

An issue relating to trariffs concerns the choice of the appropriate tariff rate when
evaluating the impact of tariffs. The issue involves the distinction between the
nominal tariff rate on a good and the effective tariff rate, more commonly known as
the effective rate of protection (ERP).
The nominal rate is simply the rate listing in a countrys tariff schedule, whether it is
an ad valorem tariff or a specific tariff that can be converted to an ad valorem
equivalent by dividing the specific tariff amount per unit by the price of the good.
The ERP is defined as the percentage change in the value added in an industry
because of the imposition of a tariff structure by the country rather than the existence
of free trade. When using the ERP we are concerned about the extent to which
value added in the domestic import-competing industry is altered by the existence
of the whole tariff structure.
The ERP can be illustrated with a numerical example.

Consider a situation in which good F is the final good and goods A and B are
intermediate inputs used in making F. Assume that A and B are the only
intermediate inputs and that 1 unit each of A and B is used in producing 1 unit
of the final good F. Intermediate goods A and B can be either imported or
produced in their country but compete with imports and thus have their prices

59

Development Strategies

influenced by the tariffs on the competing imports. Suppose that, under free trade,
the price of the final good (PF) is Rs.1,000 and the prices of the inputs are PA =
Rs.500 and PB = Rs.200. In this free trade situation, the value added is Rs.1,000
(Rs.500 + Rs.200) = Rs.1000 Rs.700 = Rs.300.
B

Now consider a situation where protective tariffs exist: a prime mark next to a price
(P) indicates a tariff-protected price. Suppose that the tariff rate (tF) on the final
good is 10 per cent and that the tariff on input A (tA) is 5 per cent and on input B (tB)
it is 8 per cent. If we assume that the country is a small country then the domestic
prices of the goods with the tariffs in place are
B

PF = Rs.1000 + 0.10 (Rs.1000) = Rs.1000 + Rs.100 = Rs.1100

PA = Rs.500 + 0.05 (Rs.500) = Rs.500 + Rs.25 = Rs.525
PB = Rs.200 + 0.08(Rs.200) = Rs.200 + Rs.16 = Rs.216
B

The value added in industry F under protection is Rs.1,100 (Rs.525 + Rs.216) =

Rs.1,100 Rs.741 = Rs.359. The industry has experienced an increase in its value
added because of the tariffs, and therefore the factors of production working in
industry F are able to receive higher returns than under free trade. There is thus an
economic incentive for factors of production in other industries to move into industry
F. Since the effective rate of protection is the percent change in the value added
when moving from free trade to protection, the ERP in this example is

Value added under protection Value added with free trade

Value added with free trade
=
=

VA' VA Rs.359 Rs.300

=
VA
Rs.300
0.197, or 19.7%

Thus, the factors of production in industry F have benefited from the tariffs, although
consumers have lost. A more common formula for calculating the ERP for any
industry j utilizing inputs designated as i is

ERPJ =

t j i aij t j
1 i aij

Where aij represents the free-trade value of input i as a percentage of the free-trade
value of the final good j, tj and ti represent the tariff rates on the final good and on
any input i, respectively, and i means that we are summing over all the inputs. In
the example, the aij for input A is Rs.500/Rs.1000 or 0.50, and the value of the aij for
input B is Rs.200/Rs.1000 or 0.20.
This method of calculating the ERP has the advantage of illustrating three general
rules about the relationship between nominal rates and effective rates of protection.
These rules are as follows:
1) If the nominal tariff rate on the final good is higher than the weighted-average
nominal tariff rate on the inputs, then the ERP will be higher than the nominal
rate on the final good.
2) If the nominal tariff rate on the final good is lower than the weighted-average
nominal tariff rate on the inputs, then the ERP will be lower than the nominal
rate on the final good.

60

3) If the nominal tariff rate on the final good is equal to the weighted average
nominal tariff rate on the inputs, then the ERP will be equal to the nominal rate
on the final good.

International Trade and

Development

Overall, the nominal tariff rate is useful for assessing the price impact of tariffs on
consumers. For producers, however, the effective note is more useful because factors
tend to flow toward industries with relatively higher ERPs. In the assessment of
development prospects and economic planning in the developing countries, a strong
case can be made for ERPs as analytical tools, even more so than nominal rates of
protection.
Check Your Progress 2
1)

State in brief Prebisch-Singer Thesis. Also account for long-term deterioration

in terms of the trade.
.
.
.
.
.

2) Argue for and against inward-looking trade strategy.

.
.
.
.
.
3) Distinguish between balance of trade and balance of payments. Also distinguish
between current account and capital account of balance of payments.
.
.
.
.
.
4) What do you mean by effective rate of protection? How is it calculated?
.
.
.
.

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Development Strategies

22.8 POST-GATT INTERNATIONAL ECONOMIC

ORDER AND WTO
As has often been pointed out, the one issue on which economists are in almost
unanimous agreement is the social gains to be made by specializing and trading on
the basis of comparative advantage and, correspondingly, opposition to protection.
In spite of this view, the world continues to experience continual pressures to restrict
the movement of goods, services, and factors between countries. Indeed, countries
seem to continue to find new and novel ways to restrict these activities. Efforts
nevertheless have been made to bring nations together and reach multi-lateral
agreements that have a bearing on the movement of goods, services and factors.

22.8.1 Setting up of the GATT

Originally, as a part of the multi-lateral initiatives, the International Trade
Organisation was proposed to be set up along with the World Bank and the IMF on
the recommendations of the Bretton Woods Conference, 1944. But as the ITO could
not be set up, the US, UK and a few other countries set up in1947 an interim
organization about trade named GATT (General Agreement on Tariffs and Trade)
The GATT was biased in favour of developed countries and was called informally as
the rich nations club. The developing countries insisted on setting up of the ITO;
the move came to be opposed by the USA. To solve the issue the UN appointed a
committee in 1963; the committee recommended as a possible alternative a via
media, UNCTAD (United Nations Conference on Trade and Development). The
UNCTAD was set up in 1964. The UNCTAD could manage to get some concession
for the developing countries, more important among which was the GSTP (General
Scheme for Trade Preferences). The GATT was also made progressively more
liberal.

22.8.2 Establishment of the WTO

The Uruguay Round of the GATT sought to expand the scope of the organization by
including services, investment and intellectual property rights. The Uruguay Round
proposals were accepted by all the members of the GATT.
The Uruguay Round agreement provided for the setting up of the WTO. The WTO
started functioning from January 1, 1995.
Objectives: The agreement reiterates the following objectives of GATT:

Raising standards of living and incomes, ensuring full employment, expanding

production and trade, and optimal use of worlds resources, at the same time
extending the objectives to services and making them more precise.

Introduces the idea of sustainable development in relation to the optimal use of

worlds resources, and the need to protect and preserve the environment in a
manner consistent with the various levels of national economic development.

Recognises the need for positive efforts designed to ensure that developing
countries, especially the least developed ones, secure a better share of growth in
international trade.

The WTO is a forum where countries continuously negotiate the exchange of trade
concessions to trade restrictions all over the world. The WTO already has a
substantial agenda for further negotiations in many areas, notably certain services
sector.

62

22.8.3 WTO and Developing Countries

International Trade and

Development

An effective WTO can serve the interests of developing countries in many ways:
1) It facilitates trade reforms.
2) It provides a mechanism for setting disputes.
3) It strengthens the credibility of trade reforms.
4) It promotes transparent trade regimes that lower tranctions costs.
WTO is likely to generate global income gains up to $200 billion a year, with
somewhere between a third and a half of the gains going to developing countries,
particularly to the ones that have reduced their own protection and locked in the
benefits of earlier reforms.
However, there are critics too. Many believe WTO will bring in destruction of
biodiversity and peoples livelihoods by encouraging over-exploitation of natural
resources, creating pollution through increasing transportation, habitat loss by
infrastructure development, and so on. This it will do by forcing countries to:

relax export rules that to date prohibit or restrict the exploitation of forests,
fisheries and minerals,

encourage export policies that spread monoculture,

relax import rules that control the un-hindered dumping of all kinds of products,
including polluting and hazardous wastes,

accept intellectual property regimes,

accept with few conditionalities, investment in several sectors by foreign firms

and industrialists, with little regard for its ecological and social impacts.

22.9 GLOBALISATION AND DEVELOPING

COUNTRIES
Globalisation, according to the Chambers 20th Century Dictionary, means to make
global, that is worldwide, or effecting or taking into consideration the whole world or
all people. It has become a buzzword not only for India but across the world.

22.9.1 Implications of Globalisation

Globalisation in its totality implies the following:
1) There is a spread of international trade.
2) People migrate from one country or region to another, temporarily or
permanently.
3) Money or means of payment are exchanged on an increasing scale between
countries or regions.
4) Capital flows from one country to another to help produce goods and services.
5) Finance-not necessarily linked to the production of goods and services flows
between different countries.
6) Traditional corporations arise which increasingly engage in the activities listed
so far.
7) Technology is traded as between different countries. Increasingly, with the
spread of the patent regimes governed by the WTO, frontier technologies take an
increasingly proprietary form.
8) Spread of print and electronic media.

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Development Strategies

9) Growth in trade and production of services of all kinds shipping, insurance,

banking, health care and, of course, finance.
In brief, globalization implies: being able to manufacture in the most cost-effective
way possible anywhere in the world; being able to procure raw materials and
drawing management resources from the cheapest source anywhere in the world;
having the entire world as a single market.

22.9.2 Advantage of Globalisation

Supporters of globalisation argue along the following lines.
One, globalisation helps remove X-inefficiency. In the absence of globalization,
prolonged protection of domestic industry has serious distortionary effects on cost
structures. Exposure to competition acts as bracing cold shower.
Two, globalisation helps improve the allocative efficiency of resources, reduce the
capital output ratio and increase the labour productivity, help to develop the export
spheres and the export culture, increase the inflow of capital and updated technology
into the country, increase the degree of competition in the domestic economy, reduce
the relative prices of industrial and manufactured goods, improve the terms of trade
in agriculture and, in general, give a boost to the average growth rate of the economy
in the years to come.
Three, globalisation helps to restructure the production and trade pattern in a capitalscarce labour abundant economy in favour of labour-intensive goods and labourintensive techniques.
Four, with the entry of foreign competition and the removal of import tariff barriers,
domestic industry will be subject to price-reducing and quality-improving effects in
the domestic economy.
Five, with the entry of foreign capital, the aggregrate gross and net investment
proportions to GDP will go up, and with a reduced capital output ratio the growth
rate will go up.
Six, efficiency of banking and financial sectors will increase with the opening up of
these areas to foreign capital and foreign banks.

22.9.3 Disadvantages of Globalisation

On the flip side, globalisation has its fit-falls also.
One, the speed at which capital moves across boarders, the rapid evolution of
management and marketing requirements, increase the pressure for structural and
conceptual restructuring to a breaking point. This is multiplying the human and
social costs of the globalisation process to a level that tests the social fabric of the
democracies in an unprecedented way.
Two, globalisation process is in essence a tremendous redistribution of economic
power at the world level which will increasingly translate into a redistribution of
political power.
Three, in the globalisation economies of the world are ironically moving away from
one another more than coming together. This change is bound to have a profound
destabilising effect.
Four, globalisation process challenges some familiar assumptions. Until now, for
instance, it was conventional wisdom that technological change and increases in

64

productivity would translate into higher wages. But in the last few year,
technological changes have eliminated more firms than they have created.

International Trade and

Development

In short, globalisation is not a free lunch. A developing economy will have to

prepare itself for globalisation; for this well-coordinated initiatives need be taken in
the different sectors of the economy.
In the rapidly globalising world, international trade, based on comparative
advantages among nations, is set to emerge as the most critical determinant of
economic development. A whole set of multilateral negotiations have been set up in
motion; these aim to provide a perfectly free trade environment so that goods,
services and capital may move across the globe without any restrictions and
constrains. The World Trade Organisation has emerged as the standard-bearer.
Check Your Progress 3
1) Why did the WTO came to be established? What are its objectives?
.
.
.
.
.
.
2) What do you mean by globalisation? What are its implications?
.
.
.
.
.
.
3) State the advantages and shortcoming of globalisation?
.
.
.
.
.
.
.

65

Development Strategies

22.10 LET US SUM UP

This unit discussed the implications for, and the effects of, the international economy
on the developing nations. The role of international trade in economic growth was
explained. The unit then went on to discuss the gains from trade, including static
gains and dynamic gains from foreign trade. The unit then explained the PrebischSinger-Myrdal Thesis and the underlying causes of deterioration in long-term-oftrade of developing countries. The merits and demerits outward-looking and inwardlooking trade strategies were discussed. The unit then analysed the structure of
balance of payments and its significance in the process of development. The role of
tariffs in international trade was discussed, and how the effective rate of protection is
calculated was explained. The circumstances in which the WTO was set up were
described and its significance for developing economies was discussed. Finally he
implications of globalisation for developing countries were discussed.

22.11 KEY WORDS

:

It occurs when a nation can produce a commodity at a

lower cost than the other nation.

Capital Intensive Goods :

The proportion of capital is higher than the other

factors of production in the production of these goods.

Factor Endowment

It refers to the units of labour required to produce one

unit of output.

Labour Coefficient

It refers to the units of labour required to produce one

unit of output.

Labour-Intensive Goods :

The proportion of labour is higher than the other

factors of production in the production and these.

World Terms of Trade :

These terms refer to the exchange ration in the world

economy when there is free trade.

Absolute advantage

22.12

SOME USEFUL BOOKS

Kenner, Peter B. (1994) The International Economy (3rd edn.) Cambridge University
Press: Cambridge
Krugunan, Paul and Maurice Obstfeld (2003) International Economics: Theory and
Policy (6th edn.), Pearson Education, Singapore
Meier, Gerald M. and James E. Rauch (2000), Leading Issues in Economic
Development, (7th edn.) Oxford University Press: New York and London
Ray, Debraj (1998) Development Economics, Oxford University Press: New Delhi

22.13 ANSWERS/HINTS TO CHECK YOUR

PROGRESS
1) Check Your Progress 1
1) See Sub-section 22.2.1
2) See Sub-section 22.2.2
3) See Sub-section 22.2.3

66

2) Check Your Progress 2

International Trade and

Development

1) See Section 22.3

2) See Sub-section 22.4.1
3) See Section 22.6
4) See Sub-section 22.7.1
3) Check Your Progress 3
1) See Sub-section 22.8.1
2) See Sub-section 22.9.1
3) See Sub-sections 22.9.2 and 22.9.3

67