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Trade Policy in Developing Economies

Posted by mjmedlock on June 28, 2011 in international economics |

There are some common themes in trade policy in developing economies

  • Favoring manufacturing
  • Attempts to use trade to cure uneven development (the dual economy)
  • Trade policy is often seen as a cure for the unfair international economic system

Why manufacturing?

 

  • Prestige: manufacturing is visible evidence of progress i.e. factories are sexy!
  • Manufacturing jobs almost always pay higher wages than agricultural jobs

Infant industry argument

The fact that, historically several large important economies have developed behind trade barriers that protected domestic manufacturing (E.g. USA, Germany & Japan) is often on used to justify tariffs, subsidies and other barriers. The argument is that developing countries need to protect their infant industries until they are able to compete with industries in developed economies. This seems like a plausible argument; however there are problems with the infant industry argument.

  • It is not necessarily a good idea to divert resources from present day industries which do have a comparative advantage into industries that are assumed to have comparative advantage in the future.
  • An industry must have the capacity to be competitive and there is no guarantee that protecting an industry will make it competitive. In fact, sheltering firms from the need to innovate and be efficient, protection might even have a negative effect on the competitiveness of industry. This is a situation witnessed by India many and South American economies.
  • There is an argument that investors are short sighted and therefore need the promise of government protection in order to persuade them to invest. However, this belief is not borne out by the evidence.
  • As with all calls for government to protect or nurture particular industries the major question to ask is which industry to favor? We have stated previously some reasons why manufacturing industry is favored, but what criteria should be used to evaluate the particular manufacturing industries? If there is no clear rationale for choosing an industry, then industries and firms will be chosen based on the biases of those in power and the ability of people within that industry to influence the government decision makers.
  • It is important to note that some industries have developed successfully in some countries that have had an infant industry protection regime. However, would these industries have been successful anyway? (We cannot honestly say yes or no) Perhaps more importantly we should look at the cases where infant industry programs have been unsuccessful. These cases far outweigh the number of successful cases. Again, industries in Latin America and the Indian subcontinent serve as a very good example of the dangers involved in infant industry policies.
  • Finally, nothing is free. To give someone special treatment means to deny someone else resources. These may be consumers, taxpayers, education or other industries.

Market failure

An argument for subsidizing certain industries is that firms in developing countries need help because there is market failure in many developing nations. This means that firms are not able to get access to the capital they need for investment, or if they can get capital then the capital is prohibitively expensive. While this situation does exist is developing economies, most economists agree that the best way to deal with poorly functioning capital markets Is not through subsidies, but through measures to improve the way markets work. In other words, better legislation and oversight.

A final argument for governments to support infant industries is that industry pioneers often create for society and the firms that follow some benefits.  The argument goes like this: if pioneers won’t be able to enjoy all the benefits they create then they will be put off starting firms. Again, although this sounds like a reasonable and logical argument, there is little if any evidence to show this is true.

Dual economy

 

A feature of many developing economies is the dual economy. This is the existence of a small relatively much better paid class of employees in an economy where most people are poor. The argument goes that by creating better paid manufacturing jobs a country will lift people out of poverty. Therefore, developing countries need policies that encourage manufacturing. The best way to do this is through a trade policy that protects domestic industry.

It is true that in developing economies manufacturing jobs do pay significantly higher wages that agricultural jobs. However, the very existence of a dual economy begs the question: Why does this country have a dual economy in the first place? The answers are usually one or a mixture of the following.

  • Poorly functions markets. Fix this problem and people will get easier access to capital at a price that makes it attractive for them to invest in profitable business ideas.
  • Lack of government investment in infrastructure, especially education. Is it an accident that Japan, China and the Asian Tiger economies have a long record of investment in educating their people and have seen strong and consistent economic growth?
  • Trade policies themselves have a role in creating dual economies as the policy of favoring manufacturing over agriculture means that there is often too little investment in developing a country’s agricultural potential.

Exploitation: righting the wrongs of an unfair international economic system

 

There cannot any disagreement that developing countries have been heavily exploited in the past. Nor can we say that exploitation has entirely finished.

The key argument of modern exploitation is based on the fact that people in less developed economies earn less money for the same work as workers in developed economies. But there are two things wrong with this argument. Firstly, having cheaper labor can be an advantage, not a disadvantage: After all this is why China is developing quickly in many manufacturing industries. Secondly, the better wages of advanced economy workers tends to be the result of investments in education and training. Again evidence shows us that the more a country invests in education and training the more productive workers become. This leads to workers getting higher wages.

Further reading on trade policy

Industrial policy in advanced economies part 1

Industrial policy in advanced economies part 2

 

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