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 = P � BDP t , ! Domestic producers’ loss = P � ACP t , , ! Government revenue gain = CDEF , ! Net deadweight loss = ACE + BDF Huw Lloyd-Ellis () Econ239 Fall 2009 3 / 25

Price Domestic Consumer Supply Surplus P Producer Domestic Surplus Demand Quantity Figure: Measuring Economic Welfare Huw Lloyd-Ellis () Econ239 Fall 2009 4 / 25

Price Domestic Supply Autarky Price P* B A Domestic Demand Quantity Imports Figure: Import Sector with no Policy Intervention Huw Lloyd-Ellis () Econ239 Fall 2009 5 / 25

Price Domestic Supply C D P t P* B A Domestic Demand Quantity Imports Figure: Impact of Tari¤ Huw Lloyd-Ellis () Econ239 Fall 2009 6 / 25

Price Domestic Supply C D P t P* B A Domestic Demand Quantity Imports Figure: Loss in Consumer Surplus Huw Lloyd-Ellis () Econ239 Fall 2009 7 / 25

Price Domestic Supply C D P t P* B A Domestic Demand Quantity Imports Figure: Gain in Producer Surplus Huw Lloyd-Ellis () Econ239 Fall 2009 8 / 25

Price Domestic Supply C D P t P* B A Domestic Demand Quantity Imports Figure: Deadweight Loss due to Tari¤ Huw Lloyd-Ellis () Econ239 Fall 2009 9 / 25

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 Huw Lloyd-Ellis () Econ239 Fall 2009 10 / 25

Price Domestic Supply p t p* Domestic Demand B A Quantity Figure: Short Term Increase in Domestic Production due to Tari¤ Huw Lloyd-Ellis () Econ239 Fall 2009 11 / 25

Price Internationally Competitiv e p t p* Domestic Demand Quantity Figure: Long Term – after cost reductions due to learning Huw Lloyd-Ellis () Econ239 Fall 2009 12 / 25

Av erage Cost, Price b p* Average Cost a Curve Quantity Q d Q f Figure: Increasing Returns and Protection Huw Lloyd-Ellis () Econ239 Fall 2009 13 / 25

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 Huw Lloyd-Ellis () Econ239 Fall 2009 14 / 25

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), Huw Lloyd-Ellis () Econ239 Fall 2009 15 / 25

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 Huw Lloyd-Ellis () Econ239 Fall 2009 16 / 25

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. Huw Lloyd-Ellis () Econ239 Fall 2009 17 / 25

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. Huw Lloyd-Ellis () Econ239 Fall 2009 18 / 25

The Impact of Export Subsidies E¤ective world price for producers increased to P s = ( 1 + s ) P � Static Welfare Consequences ! Domestic producers’ gain = P � BDP s . , ! Domestic consumers’ loss = P � ACP s , , ! Cost of government subsidy = CDFE , ! Net deadweight loss = ACE + BDF . Huw Lloyd-Ellis () Econ239 Fall 2009 19 / 25

Price Domestic Supply P* A B Autarky Price Domestic Demand Quantity Exports Figure: Export Sector with no Policy Intervention Huw Lloyd-Ellis () Econ239 Fall 2009 20 / 25

Domestic Price Supply C D P s P* B F E A Domestic Demand Quantity Exports Figure: Impact of Export Subsidy Huw Lloyd-Ellis () Econ239 Fall 2009 21 / 25

Domestic Price Supply C D P s P* B F E A Domestic Demand Quantity Exports Figure: Loss in Consumer Surplus Huw Lloyd-Ellis () Econ239 Fall 2009 22 / 25

Domestic Price Supply C D P s P* B F E A Domestic Demand Quantity Exports Figure: Gain in Producer Surplus Huw Lloyd-Ellis () Econ239 Fall 2009 23 / 25

Domestic Price Supply C D P s P* B E F A Domestic Demand Quantity Figure: Deadweight Loss due to Subsidy Huw Lloyd-Ellis () Econ239 Fall 2009 24 / 25

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