Trade Policy in Developing Countries "Economically, what is the - - PowerPoint PPT Presentation

Trade Policy in Developing Countries

"Economically, what is the di¤erence between restricting imports of iron to bene…t iron producers and restricting sanitary improvements to bene…t undertakers?" Henry George (1886) Fall 2009

Huw Lloyd-Ellis () Econ239 Fall 2009 1 / 25

Import Substitution

Basic idea , ! erect barriers to foreign imports , ! satisfy demand with domestic (less e¢ciently–produced) substitutes , ! allow domestic producers to become more e¢cient , ! eventually remove the trade barriers Main policy tools: , ! Tari¤s , ! Quotas (often combined with tari¤ beyond quota) , ! Non–tari¤ barriers

Huw Lloyd-Ellis () Econ239 Fall 2009 2 / 25

The Impact of Import Barriers (Small Open Economy)

Implicit assumptions: , ! competitive markets , ! all the parties get equal weight in the welfare analysis , ! world price, P, is independent of domestic policy Static Welfare Consequences , ! Domestic consumers’ loss = PBDPt , ! Domestic producers’ loss = PACPt , ! Government revenue gain = CDEF , ! Net deadweight loss = ACE + BDF

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Domestic Supply Domestic Demand Price P Quantity Consumer Surplus Producer Surplus Figure: Measuring Economic Welfare

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Domestic Supply Domestic Demand Price P* Autarky Price A B Imports Quantity Figure: Import Sector with no Policy Intervention

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Domestic Supply Domestic Demand Price P* A B Imports Quantity Pt C D Figure: Impact of Tari¤

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Domestic Supply Domestic Demand Price P* A B Imports Quantity Pt C D Figure: Loss in Consumer Surplus

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Domestic Supply Domestic Demand Price P* A B Imports Quantity Pt C D Figure: Gain in Producer Surplus

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Domestic Supply Domestic Demand Price P* A B Imports Quantity Pt C D Figure: Deadweight Loss due to Tari¤

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Potential Dynamic Bene…ts From protecting domestic “infant” industry “Learning–by–doing” e¤ects , ! cost reductions that can only be achieved through on–going production Spillovers to other industries , ! e.g. through e¤ects on public education system Increasing returns to scale , ! DC producers often have a …rst–mover advantage , ! LDC producers must achieve an e¢cient scale to compete

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p* pt Price Quantity A B Domestic Demand Domestic Supply Figure: Short Term Increase in Domestic Production due to Tari¤

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p* pt Price Quantity Domestic Demand

Internationally Competitiv e

Figure: Long Term – after cost reductions due to learning

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Av erage Cost, Price Quantity

p* Average Cost Curve Qf Qd a b Figure: Increasing Returns and Protection

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Problems with the Import Substitution Strategy

Protection may induce continued ine¢ciency , ! becoming competitive requires costly e¤ort and investment , ! incentives to incur costs depend on ultimate removal of trade barriers , ! BUT once protected, removal of barriers becomes di¢cult — why ? , ! domestic producers may have little incentive to invest ) ultimately depends on credibility of the government’s strategy

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Detrimental impact on primary exports due to exchange rate distortions , ! widespread IS reduces demand for foreign currency , ! domestic currency becomes overvalued , ! foreign prices of domestic exports rise and demand for them contracts , ! tends to hurt primary goods producing sectors (e.g. agriculture),

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Example: Import Substitution in Brazil

Brazil has a large internal market 1949–1964: IS responsible for 25% of growth in demand for domestic manufacturing , ! imports fell from 14% to 6% of total supply 1965–74: shift towards export promotion , ! rapid export growth 1975–1982: return to IS, but for capital goods , ! created powerful domestic groups with vested interests in continuation of inward–looking policies

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The Move away from Import Substitution

Many LDCs ran into severe debt crises in the 1980s crises were not caused by IS policies, but it made it di¢cult to react , ! overvalued currencies — di¢cult to obtain foreign currency via exports , ! mis–allocation of resources due to distorted internal prices Strongly in‡uenced structural adjustment programs imposed by creditors (e.g. IMF) , ! required the removal of trade barriers as a condition for new lending.

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Export Promotion

Basic idea , ! provide preferential treatment to exporters of manufactured goods , ! once they are established, remove this aid Main policy tools used in export promotion are: , ! export subsidies , ! reduced import duties on material inputs , ! preferential credit access and terms of that credit.

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The Impact of Export Subsidies

E¤ective world price for producers increased to Ps = (1 + s)P Static Welfare Consequences , ! Domestic producers’ gain = PBDPs. , ! Domestic consumers’ loss = PACPs , ! Cost of government subsidy = CDFE , ! Net deadweight loss = ACE + BDF.

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Domestic Supply Domestic Demand Price P* Autarky Price A B Exports Quantity Figure: Export Sector with no Policy Intervention

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Domestic Supply Domestic Demand Price P* A B Exports Quantity Ps C D E F Figure: Impact of Export Subsidy

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Domestic Supply Domestic Demand Price P* A B Exports Quantity Ps C D E F Figure: Loss in Consumer Surplus

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Domestic Supply Domestic Demand Price P* A B Exports Quantity Ps C D E F Figure: Gain in Producer Surplus

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Domestic Supply Domestic Demand Price P* A B Quantity Ps C D E F Figure: Deadweight Loss due to Subsidy

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Dynamic Bene…ts , ! Allows producers to overcome credit market failures , ! Learning–by–doing / positive externalities , ! Allows producers to overcome …rst mover advantage Exchange Rate E¤ects , ! increase in demand for domestic currency (from foreign consumers) , ! domestic currency becomes overvalued , ! real export prices rise , ! hurts other exporters (primary and manufacturing)

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