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									International Trade and Development

The Problem of Economic Development: An Introduction


When analyzing development China and India are pockets where there has been progress… what is
striking is that the income difference per capita between states within a same country, for ex
Connecticut and Mississippi 2:1 while between rich and poor countries it is much larger… why does
such a difference exist internationally and not internally trade within countries occurs more evenly
and openly than between countries.

There are also institutional factors, greater harmony in common institutions on a national level
helps…but barriers to trade are a larger factor in this difference. The mechanisms for the elimination
of poverty inside a state do not exist between neighboring regions that is national borders are a
significant barrier to trade. This is one of the factors that explains the large discrepancies between
nations: discrimination for those without, and preferential treatment for those within the border.
What is the role of trade in the development process:

LDC (export of primary goods and labor) Advanced Countries
AC (export manufactured goods and capital and foreign aid) LDC

1776 „The Wealth of Nations‟ Adam Smith: Trade creates an opportunity for countries to grow by
creating a vent for surplus… If a society is allowed to trade internationally, puts a use for the surplus of
resources available locally. Evolution of output (production): Burma large increase in production of rice
when there were exports of rice, opening of economy, started to use land that was not being cultivated.
They were therefore able to sustain a large output of rice without decreasing other productions (Gold
Coast with cocoa). Stimulates additional work and resource effort, there is a higher output and
consumption for the economy.

    Quantity of Wine                                       Quantity of Wine



                                                                                   P*           T*

                                           Quantity of Cheese                                Quantity of Cheese

                       Home                                                     Foreign

International Trade allows Home and Foreign to consume anywhere within the red lines, which lie outside the countries‟ PPF.

Graph (autarkytrade under Ricardian model) Static gains from trade. Produce more Y (because more
expensive and therefore interesting to export) less X (relatively cheaper and interesting to import)
check the Krugman book… Uo U*
    1. gains from exchange Uo U1
    2. gains from specialization U1  U*

Diagram gives some notion of the magnitude of potential gains of change from autarky to trade, with
improved welfare. The change depends on the domestic autarky prices and international prices. The
larger the initial discrepancy, the greater the scope for gains from trade.

Another set of gains is emphasized (in reading list)… that is the dynamic gains from trade: resulting in
expansion of the production possibilities frontier, or the movement from inside the PPF onto the PPF
itself. These initial inefficiencies might be due to: lack of competition in the economy, inefficient use
of resources, monopolies (inside the PPF). - International trade results in competitive forces where the
domestic resources are used more efficiently. It also brings new products to the market, gives them
access to goods that they cannot produce themselves services or materials necessary to increase their
productivity. They can have access to more advanced technology and goods. Increase in efficiency and
generate higher output and level of income (ex fertilizer). Difference between static (admits that the
PPF stays in the same place and the gains occur along the PPF) and dynamic (shift of the actual PPF
where new levels of output are generated) gains…

Trade and contact with foreign countries also result in a learning process. Local producers learn,
information is transferred and some is very useful for these local producers. International trade can
serve as a stimulus to increase foreign direct investment, without export there is no possibility for
investment, there is no vehicle to transfer eventual profits to the foreign investor. Lively trade
relationship generating export earnings are necessary to pay back capital and financial inflow. With
these capital inflows there is a shift in the PPF, therefore that is the initial stimulus.

International trade can be very helpful to the development process. In the 18th century there is
industrialization in the north (industrial revolution) and it quickly spreads towards the south. This
process results in a shift in demand in direction of urban centres (factories) leaving the land, having
negative impacts on the production of commodities. Increased need to import raw materials that were
used in the production process, like fibres and metals and rubber, different kinds of raw materials.
Counties like Argentina and its beef exports, there was increased demand due to the industrial
revolution resulting in high levels of per capita income. DC therefore found very attractive markets in
Europe and US for their primary products, so 19th century experience is one of favourable trading
conditions from the point of view of the least developed regions of the world. There was a growing
market for their products with favourable prices and export conditions in general. Earnings were
reinvested into their own manufacturing industries, this is all seen as positive reasons for increasing
and liberalizing trade towards developing countries.

One must remark that you would expect better performance from countries that are free than the
colonies where you would have less of the benefits going to the population.

Read the Wall Street Journal Article “Aid-revamp plan spurs food fight”: Bush proposal that ¼ of the
funds of food aid should be used to buy the food in the troubled region where the food is to be locally
grown. You can provide twice as much food if you buy it locally. What are the obstacles to the
efficiency of such programs? Why is it that this process is not as efficient as one might hope?

- Protection of rents and money gained from food aid, contribution made to senators and congress to
keep them from letting these proposals through. For US food aid program multiple benefits including
those for farmers but this is of secondary importance.
If ¼ of the money was spent in Africa (effectively reducing transport costs) it would be more efficient
and development friendly; but the response to the speech was hostile.

The population in AC is willing to see their money spent for the poor, so money is allocated and then
various parasites “exclusive rights/barriers” develop resulting in profit making activities. How are these
contracts allocated? It is highly lucrative and there are a lot of barriers to entry and rules that prevent
competition, this keeps cost twice higher than it should or could be, it is clear that the administrator
has an interest in promoting efficiency (that is in distribution of aid).
Of course jobs get affected, while not as much as played out to be in the article, but politicians don‟t
care at all about this, actually the forceful opposition comes from entrepreneurs.
Normally in these restructuring experiences it is a gradual change and not a violent and sudden impact.
There is the effect of normal attrition, with very little dislocation in the labour market.
Plus aid is regulated through no-bid contracts which can cause up to 25% inflation on transport and
goods prices. In this article NGO‟s are very badly represented. But the overall issue is that of poor use
of resources to aid the poor.


II. The Role of Trade in the Development Process
Why is trade viewed as beneficial?
There is the experience of the 19th century regions of recent settlement and DC‟s that benefited from
the export of raw materials in this period.
There is a distinction to be made between landlocked countries as there is a heavy concentration of
poor and very poor countries that are landlocked. However, in the 18th and 19th century this can be
explained by the transportation costs which were significantly higher than today.

Distinction between extensive growth (no augmentation per capita) vs. intensive growth
(augmentation per capita ex: HPAEHK, Taiwan, Malaysia, and Singapore.) But in order to achieve
the latter, must have access to markets and set a focus on the export industry. Trade can be a vehicle
for increase welfare.

If trade is so good, why was there so much protest against the FTA of the Americas? Because these
agreements are biased in favor of large enterprises, strengthening the property rights of capital owners,
it is good for their profitability. There is little or no mention of the rights of workers employed.
Discussions to abolish visa‟s for businessmen and help capital move more easily though. This is clearly
in favor of the rich countries factor of production (K), like what already exists in NAFTA (ex Canada‟s
IP rights (K rental protection), this is a guarantee for investors, for the rich. With this trade agreement
US support of agricultural sector would remain in place. Conversely due to the competition policy the
partner states would have to give up public service sectors. Most are heavily subsidized- elimination of
these (no more government monopoly) moves towards a market privatization of service (this means
limitation on health and education for DC‟s). These are externalities that should be internalized
(subsidized sanitation). It is clear that there is a loss of economic sovereignty of the state, MN dictating
the rules of the game have a potentially very high cost to this system.

How can trade be harmful?
There is the example of the colonial period where robbery and expropriation were commonplace,
mostly for mining. In order for trade to be beneficial to both parties there must be some symmetry of
bargaining power. In the colonial era certain trading companies with monopolies (West Dutch Indies
Co.), trade was heavily controlled, there was not equal opportunity. The colonized were not selling at
the world prices but at the prices the colonizers dictated, they were then sold manufactured goods
emanating from the colonizing market at world prices.

Also in the Ricardian model- gains from trade for a small country when it is the large one that dictates
the terms of trade. The small one gets all the gains because it does not alter relative price in the world
market, it actually benefits from the larger country‟s economies of scale (constant cost of production).
For the small country these are the static gains from trade (a move along the PPF which in the
Ricardian model is straight).

In either case, in a trading relationship, trade is not synonym of equal benefits of both parties. Post
WWII, Singer and Prebische (Evolution of the price of imports relative to the price of exports in the
UK (1870-1938) primarily exporting manufactures and importing primary goods). The patterns of trade
of the UK was much of its trade was importing PM from DC‟s and exporting towards them
manufactured goods, study of the relative TOT of the UK (Price of imports vs. Price of exports).
Findings: Relative price of PM declined (X diminished relative to M for DC‟s) between 1870-1938 ~
decline of 10% a year of the price of PM.
Argument: if TOT go against the DC, gains from trade will tend to diminish over time. Gap between
foreign and domestic will grow as will TOT and benefits to the AC. If DC engage in trade specializing
in primary products and importing manufactures, this will deteriorate their benefits, will lose gains
from trade. The answer is diversification so as not to rely so much on primary product exports whose
prices will decline over time. Specializing in the wrong direction, like PM‟s that are subject to price
deterioration over time, this idea encourages interventionist policies. Not allowing comparative
advantage (hereafter CA) to dictate the use of a country‟s endowments and should also think of altering
production structure of the economy (decrease PM and increase manufactures).

Trade is not completely detrimental but large benefits will decline over time with specialization.
Interfering with free trade and diversifying the economy instead of simply responding to prices on the
market is a must for DC‟s.

Not sure that this page of notes comes in here… but important, about import substitution-
Arguments for import substitution: when ACs were industrializing they were not under a FT regime
but a protectionist one (with the exception of the UK). Tariffs protect local producers, all countries
protect themselves, FT is not necessarily the best thing at all times. Comparing the agricultural sector
and manufactures, higher productivity of labor and income in the latter, it is therefore more rewarding
for a society to specialize in. So if you shift labor force over time to manufactures you will achieve a
higher standard of living, agriculture is an ancient industry.

Technological progress is what improves productivity, shift resources into manufactures where the
action and growth is. The fact that a DC has a high production costs (due to inefficiencies) and lack of
experience, temporarily dooms it to primary good production, but given enough time they could
become more efficient than some of the other world producers even in manufactures. If you look at
prices and endowments of DCs, they have a clear comparative advantage in production of agriculture

and primary products (if you allow forces of CA) BUT that may not be where the true comparative
(t+1) advantage lies. The reason for this may be a lack of skilled labor, organization and set up as well as
experience, all things that can be corrected given time.
- Ex: an underlying CA in manufacturing activity, not competitive because of experience but in 5 or 10
years they will kick out previous more efficient producers. Why? Because they have a wage advantage
(L abundant). It is a question of cost/organization/development skills in L force education /suppliers

The argument against FT (reacting to world prices) is that DCs will produce primary products at first,
but one must also look into the future of markets. In the short run there is no profit but then becomes
profitable, therefore some interference in free market may be necessary. Interventionism can work if
K markets function well and there is certainty in the market (stability / legislation). Entrepreneurs in
Bangladesh will not be able to do it if they are unaided by the authorities. Why undertake training if
someone else, a competitor or the state, steals your trained workers from under your nose? To solve
this problem government should subsidize training and these activities. It is a question of externalities:
should support the first one that took the initiative. This can also be done by eliminating imperfections
in the capital market (quicker response), but interfering with trade to resolve this issue is not at all
efficient. Subsidize production yes so that that they may train more labor, but not through imposing

Import substitution turns in to an argument against FT: countries did impose restrictions on trade, it is
the most practical way to generate government revenue, it is simple to apply and enforce if not the best
way to fix things. It is true that FT would have led economy in the wrong direction. This is the basis of
import restrictions to protect the import competing manufacturing sector. Information is power the
more precise it is the easier it is to make profit for those that hold this information. Korea and Taiwan
had terrific market access in the US this stimulated certain activities (ship building industry in Korea,
conglomerates) mistakes can be dealt with but stability is indispensable in order to do so. Another
argument against specialization of primary production is that it is impoverishing, price of the latter are
highly volatile as they depend on supply and demand conditions much more than other goods. A small
change in price like: change 1% output = change 10% of price. Prices are controlled by manufacturers.
In manufactures there are a small number of firms this maintains price stability, demand keeps the
price relatively stable and workers don‟t see fluctuations reflected in their wages. DCs rely primarily on
2 or 3 primary commodities for income and export earnings, they are highly sensitive to
macroeconomic shocks. To get around that instability there must be policies that aim at stabilizing
macroeconomic environment so as to reduce the effect on income when there is a sharp fluctuation in
price. This can be done through diversification (more stable prices). Demand for manufactured goods
augments more rapidly than demand for primary goods. Income elasticity of demand on PM is lower
than on manufactures and services.

PM < Manufactures < Services
~5%   ~10-15%           ~15-20%

Scarcity generates a higher price, higher price generates substitutes. Experience of DC of 19th (regions
of recent settlement); augmentation of D for PM… Demand stimulates innovation- in this case it was
the production of synthetic materials, while in the 20th there is a different proliferation of synthetic
substitutes. It is different in the market for agricultural products, in the 19th century industrial
revolution required large imports of agricultural products into industrializing countries from DC‟s and
regions of recent settlement, while in the 2nd ½ of the 20th century there is more significant
interference through ACs agricultural subsidies J/SK/EU/US. Subsidizing which means restriction on

imports of primary products tariff escalation (duties) processed / unprocessed. All this stacks the cards
against the DCs (PM producers).


“Gains from trade” does not mean that all the actors in a relation gain equally. Arguments for
    1. Use of protectionist measures in the industrial revolution, why can‟t the DC‟s use them today.
    2. Problem of PM income elasticity, industry is competitive in production of manufactured
        products because there is a power to maintain prices at desired levels. In PM there is a large
        number of producers and perfect competition behavior (economic benefits are 0, no barriers to
        entry low initial cost), benefits the consumers rather than producers. In manufactures,
        monopolistic competition or oligopolies, producers benefit more from technological or cost
        reducing progress leads to increase in profits. Where there is greater scope for reaping benefits
        for investors, there is a greater prospect for capital accumulation, reinvestment, increased
        productivity and welfare. Therefore if a country wishes to develop it should not follow the
        dictates of CA.
    3. Myrdal‟s thesis: Simple manufacturing in DC‟s should be protected. If you have relatively
        primitive manufacturing activity in an open economy, small scale manufacturing activities can
        be negatively affected from competition (economies of scale). What we have learned is that if
        local producers are less efficient they should be driven out of business (right of consumers to
        buy from the cheapest source). From a development strategy viewpoint this is inefficient. It
        may not be a good thing to drive these producers out of business. Much of DC capital stock
        and sources of rents will become obsolete. Much of the economy skilled labor will be cast
        aside from the labor market (recycle themselves). All those rents disappear, and practically
        only rents, which provide a potential source of income which can be transformed into other
        forms of capital. Why not labor income? In a DC wages are so low people need the totality of
        these earnings in order to live. There is no excess that can be invested into capital
        accumulation; this is why small business owners must be preserved. When a corporation is on
        the brink of bankruptcy in western countries governments intervene to protect those
        companies (ex: Chrysler corp.) If it is important in AC‟s why not in DC‟s where capital is
        important and even scarcer than in ACs. It is clear that in the long term DCs have a
        comparative advantage- that is cheap and available labor when compared to ACs. Therefore it
        would be natural for labor intensive activities to take place in DC‟s. It is not done now because
        for the time being because labor is untrained and production is inefficient (ex China). Just
        because it is more costly today does not mean it will be tomorrow, the argument is therefore
        simple, protection today for prosperity tomorrow.
    4. As the prices for exports fluctuate on the world market, it may turn out that everyone ends up
        in poverty (ex coffee fluctuation). The reduction in the reliance on exports of primary
        products implies the protection of local manufacture activity. An example would be the
        emphasis on increasing subsistence agriculture (for local consumption). Importance of
        increasing productivity in this sector is that it provides a larger basket that the local
        communities consume from, if you can increase this level of consumption per head as a result
        of the efficiency of subsistence agriculture there is a floor below which consumption per
        capita will never fall through. Choice between engaging in subsistence agriculture (minimum)
        or engaging in other areas (cash crops, manufactures), but once you fix the floor you have a
        per capita consumption level basis. This will increase the reservation wage and create other
        industries where 4 dollars a day is the lowest you can pay any worker. The key to prosperity in
        DC is the existence of alternatives that provide a decent level of income for consumption. One

        needs to balance the forces of competition with the need to preserve entrepreneurial activity
        and capital. This allows for a certain degree of competition. Should there be failure, there
        should be capacity to take over failed firms. There must be some restructuring, local
        entrepreneurs selling capital stock to the efficient ones. The problem is when there is no
        restraint at all and all go bankrupt. Ex: small scale business has to sell a product at a lower
        price is unprofitable, should we close down this enterprise, no. 52‟000$ of income and 2‟000 $
        loss. If you close down that activity the macroeconomic impact is going to be larger than the
        loss saved. People will have no money to spend, the entire economy shrinks by another 50‟000
        dollars, shrinkage. It is preferable to have some protection granted, this is why bail out plans

There is a restriction on raising tariffs, not having them. This limits the countries ability to impose
them, countries agree to this in order to be able to gain on the side, that they will have restrictions
lowered to their exports. In many cases it has been voluntary but it can also be forced. Standards can be
changed by giving a subsidy as free trade may not necessarily generate an ideal situation for the DC to
prosper in.

Trade was severely restricted in the interwar period, the level of protection was increased leaving the
DC in the cold. It was a case were recent episodes of severe restrictions on trade, DCs wanted to
become independent of ACs by not relying on PM exports towards these „unreliable relationship‟
trading partners.

Kravis reading: study on the regions of recent settlement (PM exports towards EU during industrial
revolution). He explains that the experience should not be attributed to the sole access to foreign
markets. Trade is not the sole engine of growth but its handmaiden. We would observe rapid growth of
exports to the rest of the world (if trade was the explanation to growth) pulls rest of economy to higher
growth path, higher in rate of growth with output lagging behind the higher rate of growth of exports.
In fact for US ratio Exports/GDP ~ 6-7 % did not grow relative to the rest of the economy. Exports are
a constant not an engine. Agricultural exports to Europe were the main export of US:
1800 – 69%
1899 – 33%
Investment of foreigners into the economy- expect foreigner capitalists to make investment must have
higher rent returns. Sector that attracted most foreign capita was the railroads, revenues in 1870 show
that only 5% is accounted for by carrying merchandize for exports.
Time path growth of output following higher exports (not the other way around). Therefore if trade
did not serve as an engine of growth, must have been other factors.
          - empty lands
          - migration
There are also institutions which are conducive to capital accumulation (small businesses and
entrepreneurial qualities). Trade works depending on the conditions prevailing in the market.

A commodity produced in an enclave produces no stimulus for growth in exports. Ex: the mining
industry in Africa, mining and engineering and entrepreneur from abroad. No dissemination or very
little for the economy to benefit from. How much learning takes place, the formation of skill and
augmentation of productivity of labor is a proven factor. Sets stage for other expansion industries.
Augmentation in general or managerial skills gives rise to an increase in exports. Other important
factors for growth are:
Where do the revenues go?
          - local factor earners

        - foreign factor owners
How is that income spent?
        - local produce
        - imports (negative)
The distribution of income is important in generating growth, how much is saved? The more is saved
the more can be spent in the future with local capital formation.
When there is local instability money is placed outside of the country due to regime uncertainty.


Export stimulus resulting externalities can have a long term positive effect on the economy, other
sectors have to be suppliers to the export sector for such linkages to exist and for a positive transfer to
occur (spillovers and learning processes technology transfers…) How is the export income distributed
(unequal distribution = social instability = high risk assessment); spent (local or imports); saved or
invested? The elite tends to consume luxury goods from abroad, more inclined to invest abroad in safe
financial instruments.

The question of the capacity of the economy to benefit from the export stimulus sound
infrastructure that will facilitate both trade and production; functioning capital market (entrepreneurs
can obtain K and invest it if there is scarcity of mobile K, but if there is not capacity to invest in the
type of business that would benefit from these new opportunities); IP laws and protection. Some DC‟s
have this in place, large benefits and good distribution of revenues within the economy (HPAE) and
vice versa.

Other branch of literature: empirical examination of export growth performance and growth of
economy  tricky because exports are a part of output of the economy, so expect a positive correlation
between these two aspects (increase in exports would mean increase in output, change will be
positively correlated). If you imagine and economy 10% of countries output, if this remains the same
1:1, so how do you measure this?

Michaely GNP (GDP+ any income earned by local residents abroad – earnings of foreigners in local
economy) tends not to change very much in AC‟s: if high rate of ^(X/GNP) will have high rate of
^(GNP) (positive correlation) The relationship is only valid for counties that have an industrial base
(^X - ^GNP) ≈ ^GNP
He also looked at the correlation between the proportion of X to GNP and the growth of GNP that is to
say, instead of looking at the percentage of exports relative to GNP as above. Turns out there is no
positive correlation, countries that are big exporters that expand GNP, it is the expansion of (^X-
^GNP). Countries have different propensities to X or M, small country very high X/GNP will not
necessarily have a higher (^X-^GNP) ≈ ^GNP a larger state will rely much less on exports will have a
small ratio, the more diversified will be its product mix.
Balassa also looks at a cross country analysis of DC‟s … what is the impact if country‟s export growth
accelerates. 1% increase in growth of X ≈ 1/25 of GNP- there is a positive influence or relationship that
is detected in the data of DC‟s when these are related.

None of these analyses proves that some policies will result in a stronger growth performance because
we are not sure of what factors are responsible for the growth. Internal factors and externalities that
may influence growth are many and complex (political and economic factors).

III: An Introduction to Theories of Economic Development

- Post WWII- decolonization it was believed that colonial rule had a lot to do with underdevelopment
and once that obstacle was removed all would be fine…  There was a lot of hope that progress would
be very rapid in the DCs.
- There was a big shift of thinking after the great depression with Keynesianism and the role of
government (50‟s and 60‟s) increased its role in case of underemployed resources (K or L); must create a
demand, supply will follow (demand side policies).
- Vicious cycle hypothesis (Big Push theory), in a DC with a small industrial base entrepreneurs will
lack incentive to undertake large investment projects (take advantage of economies of scale) that result
in large output flows, if there is no corresponding demand to absorb this output, therefore their
evaluation for the prospects of an eventual project were negative. Would need a large n° of these
projects to be undertaken at the same time so that there would be diversified supply, demand would
take care of itself. Ex: Shoe factory and Increasing Returns to Scale- a lot of shoes and employment, but
who will buy the shoes? However, in the event that all these industries developed simultaneously,
enough generation of wealth from workers getting an income, this would create the required demand.
There are demand externalities: expansion of one industry creates demand for other industries
(demand spillovers). There is no taking into account of positive externalities of creating the particular
industry; there is no compensation for being the first one –appropriability- (Krugman). The answer to
this problem would be a big push effort by the government that would coordinate investment on a
large scale in order to industrialize- provide the infrastructure necessary.

-Export pessimism: there is also the presumption that the DC product cannot be profitably sold abroad
(also Krugman). What state is the market in? Is it a multiple equilibrium situation- low productivity
state    vs.    industrialized     state     (IRS,   labor    employed      and     capital   buildup).
Hirschman argues about unbalanced growth. Subsidizing investment to the key activities that will
create incentive for the investors, give a big shock and have the private sector follow, reliance on
market forces and signal, private initiatives… For that you need functioning capital markets.

- Singer and Prebische view trade as a danger to the development process as the gains from trade
diminish over time, they seem to imply that DC‟s would actually be hurt during the trading process.
Myrdal will give possible negative effects of trade. As these rents are flowing, you can look for
opportunities to invest. Anything that cuts this off is seen badly (like running small businesses into the
ground by freeing up trade). In DC if you do not have the rents the opportunities will go to the
foreigners. Capital owners going out of business and concerns about unemployment (associated with
import competition in AC‟s) much more worrying in the DC‟s. In a DC‟s there is much less scope for
putting unemployed workers into productive use, if a sector goes bankrupt you cannot do anything
about it. This is something that is specific to DC‟s. He also sees development as being dualistic. You
have stimulus coming though trade (like exports) there will be centers of attraction, when that activity
starts to grow has negative implications for other parts of the economy. Migration of productive factors
in the direction of these centers of activities, this means high urban unemployment.
Development does not take place evenly; there are certain areas that are growing and others that
stagnate. This will attract productive factors from other regions of the economy or continent, and will
leave these other regions without sufficient factors (as L and K and E move towards these centers
draining the other areas). This is a concern because it leaves the periphery in a worse position than
they were before the stimulus (most productive mobile factors will leave). This means uneven
development (Hirschman).


IV. Trade Policy and Economic Development

- Import-substitution
        - Imposition of QRs
        - Use of tariffs (specific or ad valorem)
                 o Increase productivity of local manufacturing activity by imposing QRs
                 o Show tariff and quota graphs
                           specific tariff
                           ad valorem
                           auction of quota (exactly the same as a tariff…) This is called a tariff
                              equivalent to a quota The two policies are identical in terms of their
                              impact on welfare and the economy.
                                   However, there is a problem of exclusive importer or
                                       corruption… there is no redistribution of the revenue collected
                                       in this situation
                                   First come first serve
                 o Restrictions = higher profits that can then re-channeled into capacity formation.
                 o How much do producers benefit from this situation? To get an additional unit
                      produced, you must have a higher price, this also corresponds to the cost of
                      production. The supply curve represents the cost of producing another unit in the
                      economy. Demand curve tells us how much consumers are willing to pay for
                      goods and services.
                           Look at the Krugman (ch. 8) for these economic theories

                                                            Consumer loss is equal to the blue area
                                                            between the PT and PW lines (deadweight
                                                            losses- 2 triangles)

                                                            Producer gain is represented by the yellow
                                                            and blue striated area (between PT, PW
                PW                                          and S curves)
                                                            Government revenue is the area in red. In
                                                            the event of a quota there would be no
                                                            government revenue (unless auctioned).

        -   What are the consequences on the restrictions on trade?
                  o Consumers surplus
                  o Producers surplus                Krugman again
                  o Economy as a whole
                            Show the deadweight losses and such
        -   Generate positive externalities. These benefits have to go beyond the deadweight losses …
            little triangles

           -   Small DC‟s – What you pay for a commodity does not depend on your size but on market
                   o The capacity of a country to influence import price:
                              Has to do with size
                              Also exerts influence on price even if small
                                       Cannot influence it if the market is competitive.
                              If not perfectly competitive then restricting imports will oblige foreign
                                 exporters to reduce the prices.
                              There are certain costs to switching from one to another.
                              This exercise looks at countries
                                       Markets segmented
                                       Different pricing policies
                                              o Relationship between capacity of market to pay and
                                                   price charged by suppliers. Depends on ability of people
                                                   to pay for the product.
                              The poorer the country (lower per/capita) the lower the price charged in
                                 the market
           -   Even small DC on products that are imported by a large manufacturer (logo brand name)
               there is market power attached to that, DC‟s can get a lower price by putting a restriction
               on trade. The manufacturer will absorb some of that increase in the price. It can therefore
               force P* to diminish….  There is a TOT improvement
           -   Deadweight loss:
                   o May be impact on price charged by foreign producers/supplier… improvement in
                        TOT (small country cannot affect TOT in a competitive environment only);
                   o Stimulate production of manufactured goods, benefits of this have to be compared
                        with the deadweight loss triangles.
           -    Export taxes and subsidies (export subsidy graphs)
                   o What if I am subsidizing exports, how does that affect welfare?
                              What is going to happen if P* for exports like wigs (Taiwan early stages
                                 very labor intensive)  What is it going to do to the domestic price…
                                 how is the price affected by subsidizing exports of wigs to the US
                                       P* + S is what the producers will get if they export wigs;
                                          therefore the domestic price goes up.
                                       Is there a deadweight loss- yes, difference between producer
                                          surplus + loss of consumer surplus+ loss of government
                   o Prof starts to laugh about old American women and wigs exported from
                        Taiwan… hmmmm  The policy causes output to expand but at the same time
                        generates a deadweight loss.
                   o If there are no Taiwanese consumers of wigs there is no consumption loss… if it
                        is only made for foreign market
                   o The flatter the supply curve, the greater the impact of output on any given
                        subsidy and the relatively lower would be the deadweight loss in relation to the
                        amount of output generated by this subsidy measure. (Very similar to import tax,
                        difference is how the producer is going to approach market policies)
                   o Add TOT effect to deadweight loss of the two triangles.


- QRs and/or tariffs, combinations of protectionist instruments, plus subsidizing exports while
restricting imports and/or other exports. Production is being subsidized; firm gets a payment per unit of
- Analysis of a export (production) subsidy (graph) from a general equilibrium p o v. Aims at
expanding production of import competing good with a production subsidy instead of restricting
imports. Total compensation for producers per unit of output is P*+T (S) this costs the government
money. Consumers are actually unaffected they continue to consume Po, in contrast to tariff,
deadweight loss is the G cost, and therefore there is a smaller welfare loss. Tariff is blunter, there is the
same benefit for the producers, but it damages the consumers, takes away their surplus more than is
gained by the G through the protection. Export subsidies also raise the price for consumers. So it is
clear that direct subsidies to producers are more efficient from a welfare aspect.

Qualitative analysis of the protection:

- To what degree is the policy biased Bias index (Kruger text)
B= (QM domestic price of importables / PM* world price of importables) / (QXdomestic price of
exportables/PX*foreign price of exportables)  nature of the trade regime and the intensity of that
trade regime can be measured by this index.

- What is the degree of effective protection- not every industry will be affected in the same manner by
the activist trade policies; ex: motorcycle producer, relying on imports of engines from abroad
(intermediate good) to produce import competing domestic motorcycles- where they have a cost
disadvantage so they cannot compete on the world market- assume that a TJ 100% (tariff on final good)
is put on imported motorcycles to facilitate this activity. That means that there should be duty free
import of those parts that could not be produced locally (engine import duty free) T I 0% is the tariff on
the intermediate good. TJ 100% means that PJ = 1000$  QJ = 2000$ (price of imported motorcycle);
engine 500$ QIJ = 0.5 (value of parts in total value of good), now getting 1500$ as value added in
assembling activity from 500 to 1000$  effective rate of protection is 200%. TJ - aIJ TI /1- aIJ –
depends on nominal rate of tariffs on imports of final goods and on the imports of intermediate goods,
usually lower that for final goods. The degree to which intermediate goods a IJ make up for the rate of
protection. It is the effective rate of protection that reflects the increase of productivity.

- Import substitution period (late 50s and 60s) Brazil effective rate of protection 1958 average 150%;
17% -502 % and 1960 60% - 687% of effective protection. The higher value of the imported
intermediate goods used in local production the higher the effective tariff rates. 1967 Chile 175% was
the highest nominal rate of protection form -23% (processing importing manufactured goods or
subsidized exportables, have to pay higher rates) to 1140% TI > TJ if you get negatives. Some industries
are getting enormous rates of protection and other very little, this is not always planned.

Consequences of import substitution:
- economy produces more import competing goods, less stimulus to the export sector (shift due to
prices- like Indonesia between -19% 5400%). Relationship with value added at distorted prices and
value added in FT. There is therefore the manufacturing import competing sector to be stimulated, K
being invested in these activities, exports grow very slowly and actually shrink over time.

- Change in structure of BOP- becomes heavily dependent on intermediate goods as well as other
goods necessary to production activities. An example is the Latin American balance of payments in the

70‟s, 90% of imports are raw materials and intermediate goods. Therefore BOP becomes rigid- less
flexibility in adjusting to disturbances, this is a disadvantage of relatively more rigid trade accounts…

- When a country heavily dependent on M raw materials and intermediate goods, any fluctuation in
prices (reduced or heightened) or any efforts to economize on M results in a reduction of final goods
they are used to produce. In order to generate adjustment in the trade balance (oil price shock or other
disturbance, like paying interest on foreign loans) to provide or generate trade surplus is a lot more
difficult to do when it is more rigid… Because when you reduce M, consequences will be immediate
(BOP threatened). At the same time it is also difficult to expand exports as it has been discouraged
(shrunk and uncompetitive), entrepreneurs that had a choice between foreign and domestic production
will have switched to the latter because it was more lucrative.

- Waste of resources: if you restrict on luxury goods, you create more distortions in the form of
incentives in the local economy to produce them even though it is not efficient. You create trade
diversion in your own market.

- Typically efforts to improve trade account have been much more difficult, so more restrictions on
trades or subsidies to exports, all these new measures that were induced in a crisis atmosphere created
huge uncertainty in these countries (bombarded with different and haphazard measures), there is no
certainty. There is a natural tendency for entrepreneurs to try and influence what kinds of policies will
be put in place through lobbying and bribing (rent seeking activities). These incentives are reduced
when the official does not have the leeway to give in, but in an unstable environment, changes in
policies that are the product of lobbying are easily justified. Then the whole system gets shaken up and
highly inefficient. Policy measures are implemented to please lobbyists and not on the basis of national
interest, trade balance rigidity also contributes to this vicious cycle.

- The effort to generate high levels of productivity by restricting foreign competition, or the restriction
of domestic competition India – rationing of allocation proportional to their capacity. Very little
incentive to expand your market as you cannot produce any additional units (cannot adequately
respond to demand), don‟t compete on prices or quality, no incentives all around. Cannot sell more
units anyway, there is no possibility of expansion, very negative impact on production and kills the
efficiency that would result from a competitive environment.

- Although domestic competition is healthy, foreign competition can be detrimental in some cases as it
drives everybody out of business it especially in a country trying to strengthen or develop an industrial
base. Competition is a very healthy process as it identifies inefficient producers, those that are better
take the market share and are able to charge better prices. Either have to improve efficiency (due to
quality and pricing pressures) because of lower prices from competitors and loss of clients, if their costs
do not respond they will suffer a loss of competition. This is a very clear signal that they are not doing
everything right, must fundamentally revise their mode of operation OR sell their enterprise to
another producer that is more efficient (gives rise to EOS), higher rate of return. Involves K changing
hands from inefficient to efficient producers who can eventually become competitive on an
international level. It is not the same thing as opening up to a foreign competition that will squash all
local competition that is simply not given enough growing space.

How do you manage to get out of this vicious cycle?

- Special exchange or interest rates to importers of intermediate K that are producing import
competing goods. Very different from production subsidies as they target the purchase of K, if you have

a special price for machinery, or a special interest rate, these are subsidies targeted to K accumulation
(not paying per unit of output). The subsidy to buy machinery is different in that production requires
the use of a number of different inputs (K, L, various services) if you subsidize only one, you do not get
this effect, you get a distorted technology of production being employed. Cost structure will result in a
certain ideal of K and L to produce, but if I pay you 50 % of any machine that you purchase, then price
of L 1$ and price of machine 5$ rather than 10$  relatively cheaper than L (overly K intensive
technology that will be used). Not appropriate for the conditions that are prevailing in that economy,
results in inefficiency.

- The problem of lobbying, an amount of precious resource (entrepreneurs that should be focusing on
management and reducing costs, increased efficiency) they should not be trying to influence politics.
They are wasting their time.

- Also, if there is a high degree of taxation of imports on final goods; try to evade tariffs by smuggling
goods. This results in higher transport costs and also a loss of resources. The additional resources used
to evade tariffs, waste of police resources that are being used to monitor the activities of smugglers.
None of this would be necessary if there is FT.


- Import substitution gives rise to conglomerates- problem is that the markets for their products are
very small, but thanks to the protection they have had high rates of return that were reinvested into
similarly protected products. This is a problem because the scale of production in each of the products
is relatively low and therefore there is no hope of competing on the world market (limited capacity to
take advantage of economies of scale). Quickly reach saturation and expand into other industries
without ever reaching efficiency. A lot of spreading, and very little specialization or focus in an
industry with a possibility of being more efficient, like late 1970‟s and early 80‟s in Latin America.

- The worse consequences of these policies was therefore: loss of efficiency due to lack of competition,
unproductive profit seeking activities, small size of market, relatively unstable environment through
rapid change in policies and rigidity of BOP and subsequent crisis due to rigidity.

Costs of export substitution:

- higher prices for exportable commodities, heavy burden for consumers… losses of efficiency… in
Latin American economic strategies involved simple import substitution with relatively
technologically primitive methods.

- When machines become obsolete in the ACs they are sold on the world market to DCs, if you are
trying to develop an industry with high L intensity and low K this is a good plan. After some time L
becomes more capable of taking on more complex tasks with more advanced consumer durables but
also machinery.

- When analyzing export promotion or export substitution then secondary export substitution, one
should not neglect the political conditions… possibility of exporting to very lucrative markets like the
US with a great deal of cooperation in the economic sphere. Subsidization, consultation, counseling,
advice on what types of activities these countries can compete in.

- Implications of directly unproductive activities: a tariff also leads to smuggling (compared with FT
environment). Imposition of a tariff reduces welfare so tariff evasion (or smuggling) will improve it.
Graph in a general equilibrium with tariff inclusive domestic price ratio… Income consumption line
graph (indifference curves) with budget constraints point of tangency between the latter and IC that
determines the optimal consumption point for the consumer giving welfare maximization. What the
professor has desperately and tediously tried to explain to us is the impact of a tariff on income levels
and welfare.  in the end there is a steeper budget constraint, its slope is identical to the slope of the
price line of the tariff inclusive domestic price ratio.

- Tariff revenue is redistributed in the form of a lump sum transfer (receive a transfer just by being a
citizen of this country): how does the government decide to distribute this transfer. In economic
theory consumers decide what to do with revenue… spending on X and Y in the manner that they
choose according to income consumption line. So if you take the tariff revenue and give it back to the
consumers, able to exchange a bundle with the world economy (parallel to world price line),
consumers can go back and buy more, the government does not absorb anything. Consumer ends up
paying effectively just 5$ and able to consume as much imports as if the tariff was not in place, that
means that the impact of the tariff on the income of the consumer is zilch.

V. Directly Unproductive Profit Seeking Activities

Assumptions for smuggling analysis (there is a graph here…):
- smuggling with melted ice- a fraction of the goods being transported will melt away due to transport
costs (does not involve any physical use of resources but just evaporation). If transport was absorbing L
and K the PPF curve would have to shift inwards, so lets keep it simple. If the tariff is 100% with cost
of transport only (25%) ¼ when smuggling then those engaging in this activity are gaining. That means
that 75% arrive but that is still cheaper than to buy official imports. Consumers in a domestic economy
face a price that is 1.33* that of world price instead of 2* and higher than under FT, consumer will
choose cheapest. Smuggling or rent seeking activity that exists due to the implementation of a tariff are
common, however, the more authorities tighten down the less efficient that activity becomes. There is
a reduction of welfare (C* Ct) and reduction in level of utility of bringing in other commodities into
the domestic market. The point of getting into this discussion is to illustrate that for any given trade
regime the cost of this smuggling depends on type of goods, vigilance of the authorities; these will
determine degree to which transport costs increase and also the degree to which smuggling replaces
the imported goods (can be between 5 and 10%). This is an additional cost to protection.

- Illustrates that protection is a costly instrument that must be used carefully. There is also quite a bit
of literature on what kinds of methods are used by smugglers, (Pitt in readings) where the capacity of
smugglers to evade customs officials depends on the volume of official trade that they use to mask the
unofficial trade that takes place (relationship to customs officials). What is interesting is the
relationship between domestic price of M or X and the world price of an M or X good. Suppose that by
importing you have the capacity to under invoice (pay lower effective tariff rates) your imports, the
consequence being not domestic price in competitive environment but a lower price, because will not
be Pt as the importers will not be paying 100%. This is something that a smuggler could not pull off,
the system is corrupt in that sense that the above is possible. Domestic price of export good subject to
tax tends to be higher that the world price – the export tax. Why? Because when official get the chance
to send more units, this means less tax per unit. Kruger focuses on rent seeking activity or the amount

of waste associated with licensing schemes and bureaucratic involvements of the government, will
deter foreign and domestic investors because there is a lack of stability.
Trade liberalization
5 authors to read and know for the exam: Myrdall, Nerkse, Kravis, Rosenstein Rodin?, Hirschman-
Exam on material until the end of January…

VI. The Problems of Trade Liberalization in Developing Countries

Trade liberalization became very fashionable in the late 70‟s and early 80‟s benefits for DCs of doing so.
Why was there this wave of recommendations, it was the international debt crisis (1973 oil price shock
huge shift of income from petroleum consuming nations to petroleum producing nations). Gulf states
split revenue between depositing funds into banks in EU countries and US and keeping it at home, but
there was a huge pile up. Barriers to spending money even if you have it (Nigeria and cement tankers).
There were very large deposits made into the financial institutions but there was recession in ACs
while savings went up tremendously in DCs without a way to invest them. So what the banks did is
they sent agents around DCs to find borrowers so countries in Latin America and Asia (countries that
have been a long time out of financial system back in the 1930‟s great depression had declared
moratoria on interest payments) which had not been paying interest on the their pre great depression
debts. In the 1960‟s these L American countries finally decided to talk to the creditors (who got
peanuts back) because of that experience they were not looking at LatAm. Started settling their debts
in the 60‟s and then you have oil shock and banks flooded with liquidities, then LatAm became a great
candidate for borrowing. Massive lending and little scrutiny in relation to the projects that they were
going to be used in… as far as businesses are concerned LatAm and Asia also found it interesting.

- This went on throughout the 1970‟s (1979 chairman takes over federal bank of US) although
expansive monetary policy, the federal reserve engaged in massive monetary expansion leading to
inflationary pressures, in 1979 wanted to bring it under control increase in interest rate in dollar
denominated assets. DCs who had borrowed on floating rate basis (adjusted regularly) went from 3 or 4
% interest rate to 15 to over 20% ones…Plus if you are a DC you have to pay risk premium. Many DCs
were in a pickle. At the same time the tight monetary policy resulted in the collapse of commodity
markets, DCs depend a lot on prices (1982 was a recession) so diminishing returns. Result was that
countries could not pay anymore, Mexico, Brazil, Argentina, Chile… situation where the commercial
banks made all these massive loans and DCs were saying that they could not pay interest on these loans
because if interest cannot come when it is due then the loan has to be declared as non performing,
which you have to write off (bankruptcy- banks have to adjust books). There were some loans
outstanding that did not have interest payments coming in, this is where US treasury and IMF come in
providing funds to be used to pay interests on their loans. DCs accepted this kind of relationship
because their assets would be seized. Whole idea of trade liberalization is based on this pressure on DCs
to use their L and K to produce goods and services to produce dollars to be able to pay their debts. This
is important to understand the change in prescription in regards to DC and their development
switching from import substitution to export oriented policies.

- How to keep the international banking system solid and how to get DCs to pay interest on these
loans. By organizing banks to have a larger spread between the borrowing and the lending rates,
because of uncertainty, but it is also because the FED advised this as a means to strengthen the banking
system. Much of these policies were not designed as a way to benefit DCs but to enable them to
transfer larger amounts of their income to ACs so the debt commitment could be honored. However,
these commitments are actually a result of the excessively high interest rates that were charged by ACs
to the DCs... it‟s a bit sick actually.

„The case for trade liberalization in DCs‟, so what are the gains? (very little and very much a PR
exercise to win over the governments and populations)

1. Access without barriers to intermediate goods and inputs so will be able to produce more efficiently,
makes sense but in the context- import substitution there was an emphasis on the concept that inputs
could come in with relatively low cost to encourage final good production . There were restrictions and
rationing on inputs but that was due to the scarcity of foreign exchange (India) but the access was more
liberal anyway compared to inputs on final goods.
2. Take advantage of Economies of Scale, small market vs. access to a large market, but this also has
flaws. It involves dismantling of trade barriers in other countries not your country, that the ACs reduce
their trade barriers on L intensive manufactured goods.
3. Reagan and Thatcher phase it was more fashionable to take a critical stance against government
intervention in the economy the less the better, therefore less intervention in the area of trade the
4. Schumpeter- found that something drastic had to happen to move the economy of the world from a
path of slow growth to a path of high growth… historically, he argues for a big shift or discontinuity.
The introduction of a new good for example (for ex: steam engine), telecommunications that give
drastic changes in productivity. Also new markets that open up, this also gives a tremendous impetus to
growth. A new input of raw materials and natural resources (colony), carrying out or new organization
of an industry (Ford) this has revolutionized the production of manufactured goods. So where does
liberalization fit into this theory?

Rapid trade liberalization consequences: squashing import competing sectors which drives down the
price of L (w) and rentals on other kinds of inputs that go into production and causes them to shift into
other sectors that are more profitable after the elimination of protection, so some go into exports. But
in DCs if there is elimination of barriers without creation of other productive sectors, this results in
declining factor rewards, unemployment, stagnation (especially in non traded goods and services),
expenditure decline (lower demand and lower revenues) and no stimulus to profitability elsewhere in
the economy other than lower factor prices (the only advantages that creates export possibilities). If
you look at the evolution of GDP sometimes 5 to 10% decline for the DCs, called the lost decade where
they lost out and struggled back to the pre-opening levels. It‟s not necessarily the move away from
import substitution that is evil but it is the rapidity with which they were forced to do it (lack of
privileged access, discrimination). The phasing out of this policy would have to be gradual for it to be
effective letting opportunities develop in export markets. The argument against rapid adjustment is
that it was too abrupt resulting in too much dislocation because of the sudden decrease in productivity.


Permanence and credibility of liberalization policy, the public must believe that it is permanent. If
they do not, there is an immediate rush effect on consumer behavior. Pressures in the financial markets
due to household consumption expanding at the expense of savings, increasing pressure on interest
rates so entrepreneurs do not make investments. Export sector does not expand, credibility goes down,
pressure both from the import competing sector and political circles.

Definition of durables: any consumer good which lasts more than a year („clothing is typically defined
as a non durable‟)

Without credibility trade liberalization is not successful, it destabilizes the macro economy without
brining about the beneficial effects expected. In the case of Argentina, quantitative restrictions were
removed and then reinstated to benefit from a temporary stimulus to exports. Liberalizing through
foreign exchange auctions then revoking this method effectively hurts the export sector. Government
set exchange rates are typically over evaluated, bad for exporters. Reversals are frequent, and for this
reason agent are very skeptical about government commitment and therefore policy changes end up
not being effective in stimulating agents and shifting resources away from import competing to export

The reasons why trade liberalization may lack credibility (Rodrick):

- Government is following inconsistent policies or those that should be implemented along with
liberalization of trade but are not implemented. For DCs an important source of revenue are tariff
revenues or quota auctions, liberalization of trade has resulted in sharp reduction of these revenues
giving rise to fiscal problems. At the same time governments are under pressure to service foreign debts
and provide basic services to the population. Another example of inconsistency is that DCs often have
fixed currency, to provide a certain degree of macroeconomic stability. Trade liberalization calls for a
devaluation of currency, exportables are still fetching the same price on the world market. There needs
to be a stimulus to the export sector, a very effective way is through currency devaluation, the
government enables the exporters to get more for their money… Receiving more local currency for
your exports is quite the initiative as a lot of the expenditure of exporters are paid in local currency but
they are being paid in foreign currency. ½ of the currency devaluation should be equal to ½ the
magnitude of the tariffs. Relationship between devaluation that accompanies liberalization and the
bulk of domestic debt and foreign creditors is denominated in foreign currency. The interest payments
on the debt are also significant in regard to the total budget of the government. When there is
devaluation, the weight of the debt becomes much more important.

- Also the issue of dynamic inconsistency of policies, this problem arises when the government
promises to pay things like export subsidies and goes back on it‟s word once the agent has implemented
the policies that the government wants. This raises the question of whether agents can trust the
government, the answer is often no, in ACs governments have more advanced resources to meet their
commitment. In advanced countries the system depends very much on the credibility of the
government, not paying or other losses of credibility would be devastating, value their credibility

- Unclear motives of the government, they have been pressured by IOs and have not done the
liberalization policies well in parallel. Since they have been issued under pressure, as soon as the
pressure lifts, so will the policies.

- Anticipated political cost of liberalization, it is the cost associated with the pressures coming from
those standing to lose from liberalizations, entrepreneurs in the import competing industry, they are
concerned about loss of profitability. There could be workers protesting and social unrest as
liberalization policy redistributes income from those employed in the income competing sector to
those in exports. Entrepreneurs, have accumulated wealth, they are very influential and diversified
(production, banking, media)… In the case of Latin America –Chile- that large enterprises would have
their own banks and used them as financial mechanisms. Over time a larger and larger volume of assets
held by the banks were loans to enterprises that owned the banks and operated in the import
competing sector were not able to pay their loans to the bank so that the crisis in import competing
become a financial crisis as well.

What measures could be employed by the authorities to improve credibility?
(1) Making commitments to IOs that these policies are permanent, that would tie the government‟s
hands, enhancing credibility
(2) Could similarly tie its hands on domestic policies; maintain a balanced budget, no legal budget.
(3) Measures that focus on trade liberalization that would result in slow reduction of government

Falvey and Kim article „Timing and sequencing issues in Trade Liberalization‟

In the case of the financial sector in DCs, financial system that is heavily controlled by the
government, capital controls, banks have to purchase a certain amount of government debt; those who
have most attractive investment opportunities are those that are ready to pay the highest interest rates.
If you are going to succeed with any kind of reform need credit allocated efficiently. Another issue
concerns the liberalization of the capital account. The balance of payments is the sum of all
transactions between nationals and foreigners in the market for goods, goes into the trade account (M
and X of goods). There is also trade in services, and services can be of different kinds, buying insurance
or financial services abroad or paying interest on loans or dividends to a foreign entity. When you take
the trade in goods and service accounts you get the sum of the current account of the balance of
payments. If you decide to buy treasury bonds, you are importing a foreign security, this is considered
to be a capital outflow. Capital account transactions are different from the trade account, when all is
added up you get the balance of payments. Now we want to focus on liberalization of capital accounts
(not just imports of goods and services but also trade in assets continues to be highly restricted).

Why is capital account liberalization important? Liberalization of trade allows reallocation of resources
which typically requires an increase in investment in the export sector and one very important source
of finance for the export sector, is from abroad. You therefore need some degree of openness in the
capital markets. On the other hand you do not want financial institutions borrowing from abroad to
lend to consumers domestically for the purchasing of consumer durables, when there is not credibility
in liberalization. Access to finance is something that can take away from the credibility of the
liberalization. It is something that facilitates larger purchases, contributes to a larger ballooning of the
trade deficit, and makes for successful trade liberalization less likely.

Economists have been careful to distinguish financing investment from financing of consumption. So
liberalization of the capital account should facilitate borrowing for the purpose of investment but not
the imports of inventories on the part of businesses and consumer durables . A more conservative
approach to liberalization of the capital account (lifting restrictions on international asset movements
between DC and the rest of the world) would be only after successful trade liberalization has taken
place. There are capital imports and capital exports, restriction in DCs are primarily on the latter, what
foreign enterprises can purchase in DCs, some sectors are not open, or up to 49% of shares… another
restriction is on capital imports, residents in the DC taking funds outside, that has been highly
restricted as they try to avoid capital flight. The cases where it would not be beneficial are those where
you have lack of credibility and you open the capital account, facilitating imports of capital and that
tends to work against the policies. If you have not liberalized trade, should never try to open capital
account first. It gives incentives to producers which do not correspond to already distorted incentives
(prices). Relatively high price of importable, if you allow for lending and borrowing to take place (FDI)
they will be tempted to invest in the import competing sector and produce import competing goods,
they are producing them at the margin so the Marginal Cost of Production is equal to the domestic
price. That is, at the margin twice as high as the world price of these goods, but as the DC has the

possibility to buy it on the world market and at the world price, it is wasting resources. More will be
domestically produced and less will be imported, there is therefore a waste of resources, which is
augmented with capital inflow when there is a tariff on imports.

Speed of liberalization of the trade account, two possibilities:
Cold turkey liberalization (abruptly and completely at once): generates a great deal of sudden pressure
to adjust, losses in rents on the part of production factors employed in import competing sector (cold
turkey), the price of the commodity of production has just dropped very suddenly due to the sudden
elimination of tariff barriers. The advantage of doing things suddenly is that you get the benefit of
removing restriction quickly, and it is also easier to get the public to accept a sudden and total
liberalization of trade from a political perspective in an atmosphere of crisis than it is to implement a
gradual system. In the 1980‟s debt crisis, under pressure to liberalize, unique opportunity for the
government to sell reforms to the public rather than a policy that is going to be dragged on over years
and to continually convince them. The advocates of cold turkey approach pointed this out even though
the adjustment costs of such measures tend to be higher than those in gradual change.
Liberalizing it gradually (10 or 15 years - over an extended period of time): very different in terms of
implementation, Prof is for a more gradual approach. The problem with cold turkey is that in the
import competing sector factors of production become unproductive, capital and labor and entire
industry… this leads to certain externalities which should be avoided that related to the sharp drop of
expenditures and income. A more appealing adjustment mechanism would apply gradual pressures to
contract, for increased profitability. The decline should be allowed to take a number of years so that
there can be a gradual movement, smaller drop in incomes, expenditure and enhance macro economic
stability and therefore the entire economy is negatively affected by that.


VII. Capital Flows and Debt Problems of Developing Countries

The Debt Crisis: enormous interest burden, very significant amount compared to their trade volumes.
The problem when they had to service the payments. Intervention of international organizations,
providing financing that would assure that the interest payments would arrive to the commercial banks
in time. Governments were trying to maintain the solvency of their own financial system. Talk about
trade liberalization, of current and capital accounts, this was all part of this restructuring. Governments
in DC were asked to liquidate some financial assets, so that the proceeds to pay interest on government
debts. It was a difficult period, they were no longer receiving credits. After credit was no longer
available, but had to pay back, this was a very abrupt reversal of capital flows. With the capital inflows
drying up, resulted in sever drop in investment, expenditure and economic activity. Stagnation,
referred to as the lost decade, took 10-15 years to get over the hump. For creditors, this was not very
conducive for repayment, various proposals to lighten the burden, so that growth can resume and the
capacity for these countries to pay debts and interest on the loans would increase (Brady, Canon, Sachs

- Interest converted to principle when it is due (10-15, 18% interest); it was impossible for these
countries; one solution was capitalizing some of the interest payments, pay only 5% and the other 7%
would be capitalized. Debt could them be purchased on secondary markets, and then use these
secondary instruments to make investments in a DC. There is a market for debt which commercial
banks are able to trade in the market with other holders or investors. If a country has a low capacity to

pay interest on a debt, interest sold (ex: Bolivia 1980‟s the market price was very low in relation to the
face value, it was so low that Bolivia managed to secretly buy back most of its own debt at 11 cents to
the dollar, paying only 11% of its debt). Traded on secondary at a discount, solution is to lend money
from official sources to buy back their debt, or have an international facility that would purchase these
debts and then deal with the countries to reschedule the payments in a way that is consistent with
their economic prospects and their capacity to pay over time (Canon plan?).

- When a country is heavily indebted and can‟t service its debt capital flight problem, local residents,
prefer to take their funds out of the country, government is already desperate, investors are in a very
precarious position (purchasing bonds, depositing) they fear that there will be a reneging on the
commitment. Individuals, firms, residents, foreigners have a strong incentive to take their money
outside of the economy. If it is in foreign currency, take it out secretly, or send it legally. This
amounted to 50 to 60% of the debt.

- Shortage of investment, low expenditure, prospect of high taxation, numerous ways in which asset
holders perceive high risks. Move money outside of the country until confidence is destroyed. So to
deal with that confidence, must make larger export earning, bring about privatization, make
everything more manageable, putting pressure on governments to eliminate certain social programs
that are expensive. Give investors the ability to exchange these debts for cash so that private firms can
pay their taxes with these debts. If you allow enterprises to use debt instruments to pay future taxes,
then holders can sell these instruments to enterprises in DC and the latter can The future tax is
therefore lost to the government who simply gets a certificate then use them to pay their taxes..

- These schemes have been debated throughout the 90‟s, difficult period, but a number of countries
managed to show progress relatively quickly and were able to resume a pattern of growth in the 90‟s.
So a decline of their debts in relationship to GDP, increases the country‟s credit worthiness. Foreign
banks come back in and give loans again. So this whole problem of debts from the 1970‟s was much less
debated, in the case of African economies the debts are not owned to private banks. It was mainly
governments of the advanced countries, and over the past few years some progress has been made in
eliminating those debts.

- Now we have a new generation of crisis that have to do with the liberalization of the capital account,
allowing for greater mobility of capital over boarders. Unlike the crisis in the 1980‟s the similarity in
the case of the 1980‟s has to do with the common nature of the external shock, low interest rate and
easily available credit; then higher interest rates, collapse of commodity prices under the Reagan

- Exhibit of relatively large current account (importing too much relative to your exports) you are
therefore accumulating debts ratio of current > GDP… even if you have a balanced current account, if
your rate of interest exceeds your rate of growth you are financing your imports with a growing debt.
Your economy must grow at least equal to the rate of interest. Countries that are importing in excess,
debts are growing significantly, what investors do is extrapolate these kinds of patterns into the future
and concerned about where this debt to GDP is headed (risk of servicing problems). Large deficit in
current account means relative growth of debt to GDP and country is likely be in some big issues. If it
is a transitory situation, large project for example, investors will not be concerned as opposed to when
deficit reflects excessive consumption relative to investment. More hesitant to purchase debts in those
countries or investing or making loans to private enterprises in the country, inflows of capital start to
dry up, there is tendency for interest rates charged by those foreign creditors that still do lend, to get
increasingly higher. So drawing down of reserves at the central bank, to keep a fixed exchange rate,

observers monitor these reserves, pressures start to develop in FE market. What it usually turns into is
that before reserves of CB is fully depleted, devalues by 20 or 30% depending on depth, new exchange
rate regime and many consequences.

- Another characteristic is a large fiscal deficit- imbalance between government revenues from
collecting taxes and its expenditures on services. Dependant very heavily on borrowing, from creditors
or on local market, sometimes banks are obliged to purchase government bonds, this is a way to make
income. There is also a situation of open markets and banks find it appropriate for their portfolio to
purchase. But as deficit persists, less and less likely for them to pay back fully, and the more likely it is
going to resort to inflationary policies and reduce the burden of its debts. If you have a budget deficit
that is causing debt of government to grow over time, you have increasing vulnerability to heightened
taxation or other forms of taxation of assets of individuals, and this kind of fear typically results in
situations that bring about crisis. Growing fears leads either go to safer asset or capital flight, draining
the reserves of the CB and pushing them to devaluate. Either persistent large current accounts of the
government, made the economy vulnerable to the crisis, makes the economy more fragile and prone to
a crisis.

- Debts structure in DCs (private firms, banking institutions, government) tend to be short term rather
than long term, in foreign currency rather than domestic currency, in the form of debt rather than
equity (ownership in assets, part ownership in a productive enterprise …). How these deficits being
financed (structure of financing and what kind of financial structure results in a deficit)

- Short term rather than long term debts: borrow for 30 year period, you have plenty of time to do
many things, to restructure the economy, to spend the money you borrowed on productive assets, to be
in a position to pay off the dept. You are free to lock in those assets in productive investment that
would yield high rate of return. Alternatively, if you are borrowing on a 3 month basis, each time you
have to pay back and borrow again. Need to re convince the lender each time, constantly demonstrate
the capacity to repay. And if for some reason have a difficulty in repaying any of these loans when they
come due (changed conditions in world market, international financial market conditions have
changed, not you but more lucrative offers elsewhere), if you cannot renew, potentially have a crisis
situation, may don‟t have the money that may be tied up in an investment project. Need to get a new
loan to pay the old loan (treasury bills or bonds), 95% of treasury bills given by US is to roll over from
one debt to another. This puts the borrower in a difficult situation. Have to convince investor to come
back with cash to finance the repayment of the outstanding maturing debts. Because environment in
DC changes much more quickly over time, much more specialized than AC, more vulnerable to price
shocks and changes in market conditions. Affects enthusiasm of investors, can change very quickly. So
the country is in a more vulnerable position, country is unable to get the amount of loans it needs to be
able to pay. In reality: countries that have a stable macro-economy (surplus or balance) are likely to be
able to convince creditors to lend over long period of time. The greater the confidence of the investor
in the long term balance… the more likely it is that the economy whether commercial banks, private
companies or governments will be about to borrow long term.

- Foreign rather than domestic currency: when more fragile, greater prospect of currency devaluation
will influence the attitude of investors who will demand that this devaluation prospect… if you are
risk neutral, how much more will you demand from the government to ensure for the devaluation. On
local currency denominated loans rather than foreign currency denominated loans. So perceptions of a
devaluation being in the cards increases the costs of borrowing in local currency… borrow in dollars
get a lower interest rate, hope that with various connections, will be able to get dollars and hedge your

exposure. In any case this tendency for loans in domestic currency to have higher interest rates, the
foreign ones to be cheaper. Shift from one to the other, which also increases vulnerability.

- Debt rather than equity: 2 ways of financing CA deficit. FDI, buying assets in the economy and this
being used to pay for exports, gives foreigners ownership rights; another way is by borrowing is debt
finance rather than equity (borrowing from foreigners)… sharing the profits is a lot less risky from the
point of view of the economy, being indebted makes the economy vulnerable, those you owe the
money to… the foreign owner is sharing the risk with the local owner. With a loan they can still
demand payment.


Perception of agents (asset holders): about the long term credit worthiness of a country that is, the
capacity of country to stabilize ratio of debt to GDP. Transitory (attractive investment opportunities-
ambitious projects, purchase of imports and large borrowing) budget deficits of the government, if they
are perceived this way or rather permanent or out of control, changes everything. If the resources are
being used efficiently generate income and improve capacity to pay off its debts… but if deficit is
made by consumption rather than investment deficits. These are the issues that the investors are going
to be looking at. What is the investiture being given to?

Poor banking regulations is another problem, not mature financial systems, being reformed, developed.
Regulation that governs behavior of the banking system, restrictions on who they can lend to, degree
of risk they can bear, loan portfolios, what kind of loans are proper, what is the composition or type of
loan. Loans in real estate (as economy grows) price rise, earn profit, attractive area for commercial
banks. Often there is a financial crisis, and real estate prices crash, and the percentage of the loan
portfolio that is going to the real estate sector and uncontrolled (too large), making these banks more
vulnerable. Foreign banks that lend and see negative impacts, stop lending, so there is a situation with
lack of liquidity from other sources. And these cause individuals to come withdraw their liquidities
because there is lack of trust. Poor banking regulations that do not provide a framework were banks do
not over expand themselves and take their portfolio into risky areas.

At a corporate level, firms depend more on debt rather than equity for the purpose of financing. If you
are an enterprise and need money:
1) Sell shares on an organized market or to individual investors that want to share ownership
2) Borrow from a commercial bank locally or abroad (if large enough investment)
In DCs there is a rather high ratio of equity to debt. Regulation is not as investor friendly as ACs, there
is more scope for owners for the enterprise which may deprive other shareholders of enjoying their full
benefits as share holders. This is particularly a problem of crony capitalism- elite that controls
enterprises have a relatively free hand in dealing with the assets of these corporations, this makes
outsiders (investors) apprehensive about participating in these enterprises by buying shares [Indonesia-
Suharto dynasty]. Preference would be more transparent agreements like loan contracts which
stipulate the exact amount of returns for investment (unless bankruptcy). This is why the balance sheet
of enterprises in DCs characterized on debt to loan ratio than ACs.

Poor regulations affecting banking system, private firms, weak enforcement mechanisms result in
possibility of having extensive lending taking place by banks in types of portfolios and loans (not
diversified enough) which make the banks vulnerable to a shock. When a particular sector is in a
price decline and the bank has extensive exposure to that sector, there is mechanism that requires the

financial institutions to liquidate assets in that market rather than acquire more in order to diminish
risk. Tend to be vulnerable to serious valuation changes that put them at the mercy of insolvency crisis
(since Asian Crisis 1997 this has been improved upon).

Another source of vulnerability to shocks and speculatory attacks and crises are political shocks. When
there are elections, this can mean significant changes in economic policies. In ACs this does not mean
significant changes so that there is a very minor impact on prices once results are announced. When
change in government in DC because of greater kinds of divergences in political systems (less mature,
greater fluctuations in income, greater degree inequality in population) creates greater changes on
economic policy orientation, elections result in period of uncertainty, and after another period if there
is doubt on the rhetoric. First capital flight before the election, send assets abroad (convert local
currency) foreign investors reduce portfolios (stocks or bonds denominated in local currency sold) and
do not renew loans that they have given locally.

DCs are also vulnerable to prices depending on an external shock, shocks to the TOT (key commodity,
imported ex: petroleum) paying for fuel, expansion of current account deficit leading to worries about
countries debt accumulation is sustainable or not. Once these doubts come into the market, people get
concerned, investors pull out. Particularly those that are very poor, rely very heavily on just 1-3
commodities for their exports (ex: Ethiopia and coffee) if the prices change there will be a huge impact.

Changes in the rate of interest in the world market (debt crisis of the 80‟s and the US efforts to reduce
inflation). In the absence of such an increase of the rates of interest they would not have the
difficulties they experienced until today.

The problem of contagion: DCs are linked to their neighbors, other DCs that have similar trading
patterns, and when one has a financial crisis and is forced to undertake drastic economic policy
changes, others are affects (Argentina devaluation in Peso, effect on other economies; becomes more
interesting source of food exports rather than Uruguay and Brazil, shift). These shifts in demand
patterns result in deterioration of current account for other economies, making them vulnerable to
similar types of crisis. Depends how they fare, convince creditors, weather declining currencies of
neighbors, have to be strong in a number of other categories in order to not be contaminated. On the
trade (trade account) side this is an important factor (devaluation in one country deterioration of
current account dependent on foreign loans to plug this deficit)… how to maintain a fixed exchange
rate in this environment.

Another contagion mechanism is through the financial markets. Investors don‟t fully investigate the
conditions prevailing in the economy where they are making loans. It is very difficult to know what
condition the economy is in, especially when the authorities are concealing data and level of economic
difficulty it is undergoing. They also have big investors (large commercial banks) and they have their
informers, privileged access to information, don‟t invest unless you are sure of what you are doing.
Well connected with government officials of DCs (former officials as well) and of their own country
that keep them informed of risks. Most of the smaller investors and financial institutions, that don‟t
have the exposure that exceeds hundreds of millions of dollars, not the same information, rather more
„trigger happy‟. Will liquidate assets of other neighboring countries as well, people sell assets and ask
questions later, every second counts. There is a tendency for uniformed investors to liquidate assets in
other states because they are right next door. Observers in the market don‟t know who is selling, is it
people that know what they are doing? Or is it the uninformed? This is how you get movements that
are not based on fundamental conditions presiding in a country but fear. In a world were information

is imperfect agents often act in a way that do not reflect reality but to protect themselves instead of
waiting. This leads to contagion.

If these people who don‟t know are selling these assets and driving them to a level much lower than
reality, why don‟t the smart ones buy low and wait? Because it leads a country to not have access to
borrowing and credit becoming much more expensive. Payments interrupted and liquidities scarce,
enterprises are not getting paid by customers and cannot buy inputs. This leads to real disturbances for
countries that would otherwise not be subjected to speculative attacks or foreign investors not willing
to lend…

Government budget deficit that makes the country more vulnerable, how long can the country
maintain a fixed exchange rate:
1) Reserves available
2) Magnitude of the deficit
Replaced what professor explained to us in class with:

Explanation from Wyplosz (20.4): First generation theory sees crises as the outcome of a conflict
between policies and a fixed exchange rate regime. With perfect capital mobility, monetary policy
must be fully dedicated to the fixed exchange rate if that is the chosen regime. If governments don‟t
recognize this point they may let the domestic supply of money grow too fast, perhaps because this
looks like an easy way to finance a budget deficit interest rates decline and capital flows out.




       M= R+D





The CB follows a policy of continuous expansion of the domestic component D of the money supply M. To keep the exchange
rate constant it must intervene on the foreign exchange market and keep the money supply constant in face of a constant
demand. Foreign exchange reserves R steadily decline, towards ultimate exhaustion. The attack occurs at point B, when reserves
are just sufficient to absorb the sales of domestic money ΔM = BC induced by the expectation that after the crisis, the exchange
rate will float and depreciate continuously, raising the domestic interest rate and reduce money demand by ΔM.

This graph shows what happens over time. The asset side of the monetary base (M) is the sum of the
CB‟s foreign exchange reserves (R) and domestic credit (D). The CB intervenes on an open market to
increase the amount of domestic credit that it offers to commercial banks: this is the upward sloping

trajectory of D. The derived demand for the monetary base is driven by the public‟s preference, LM
M=R+D =L (i)
We ignore the evolution of output and assume that price level is constant. Nominal interest rate is
driven by the interest parity condition, which sets the domestic interest rate equal to the foreign rate,
after adding to the latter the capital gain to be had from holding foreign currency over the period:
A long as the markets believe that the fixed exchange rate will be upheld, if only for another day, the
expected change in the exchange rate (ΔS/S) is nil, and the domestic interest rate i is equal to the
foreign exchange rate i*. This implies that the demand for money stays constant. But how can the
money supply stay constant when the monetary authority is increasing domestic credit at the same
time? The answer is seen in the graph: to keep the money supply M equal to the constant money
demand L(i), the CB has to sell its reserves R at the same time as it expands domestic credit D. This is
tracked in the graph as the path of R over time. For a while foreign exchange reserves can be run down
gradually. Yet there is a natural lower bound to this process: either the reserves will be exhausted, or
foreign CBs will turn off the flow of lent reserves. It is crucial to realize that if R reaches zero, the fixed
exchange rate system must be abandoned. At this point at the very latest, the CB is forced to abandon
its peg for lack of ammunition. A naïve extrapolation of this rend would point to point A as the „day of
reckoning.‟ After that day one might reason, inflation will rise, as will nominal interest rates (if prices
are flexible) and the exchange will plummet as will the demand for money, as investors stamped out
the door…

This reasoning is flawed! Market traders will not wait idly by until exchange rate collapses but attempt
to anticipate this event, which in the end might lead to very large speculative profits. They understand
that once the fixed exchange rate regime is abandoned – a certainty given the CBs known
determination to let D expand- the exchange rate will be floating, and depreciating, so ΔS will be
negative. In this case, interest rate i must increase (i=i*-ΔS/S). If the interest rate increases, the demand
for money will fall, and M=R+D =L (i) tells us by how much, say ΔM. 2 This reduction occurs as agents
simply sell their own money for foreign currency. Who buys the domestic currency? The CB, to honor
its standing commitment to defend the parity under attack. In the end, the fall in money demand ΔM
must be matched by a fall in foreign exchange reserves ΔR.

But when? Buy foreign exchange too late, and the exchange rate has already depreciated. Buy foreign
exchange too early, and miss out on the higher interest rates at home which will obtain as the money
supply drops appreciably. Point B represents the one point in time when reserves reach the level ΔM,
the correctly anticipated decline in the money supply post-attack. This is the last moment when
everyone will be able to swap domestic currency for foreign money at the still fixed exchange rate. The
crisis takes the form of a sudden sale of domestic money- a speculative attack- which provokes a
dramatic fall in central bank reserves from point B to point C, where reserves have been exhausted.
When R=0, the parity must be abandoned, thereafter by M=D, will continue to grow while the
exchange rate, now floating, continues to depreciate.

Two aspects are striking:

  For simplicity, we treat money and monetary base as the same, or equivalently, look at the derived demand for the monetary base
    ΔM =L (i*)- L(i*-ΔS/S)

     1) The exchange rate regime was doomed long before the crisis, its day of reckoning only delayed
        by the existence of a large enough stock of foreign exchange rate reserves. The attack merely
        determines the timing of the collapse.
     2) No one is surprised. Everyone saw it coming and was just waiting for the right time to act. The
        crisis was fully anticipated.

Second Generation Crises: While first generation crises are the outcome of policies that are
incompatible with a fixed exchange rate regime, second generation crises are self fulfilling.

                            M                                                                    M



             a) Self-Fulfilling crisis                                                      b) No Crisis

The CB has a policy fully compatible with the maintenance of a fixed exchange rate: domestic credit is kept constant. If a crisis
suddenly occurs, it can behave roughly in two ways. In Panel (a), the market believes the CB will attempt to offset losses of
reserves in foreign exchange markets interventions to keep the money supply, and the interest rate unchanged. The attack and
its consequences vindicate the markets‟ view that the CB will cave in to pressure. In Pannel (b) instead, the market believes that
the CB is much less likely to increase domestic credit, so the money supply falls by the full amount of foreign exchange market
interventions. The interest rate increase, which attracts capital from abroad and replenishes the stock of reserves. The CB proves
it mettle, reserves are not exhausted, and the crisis does not occur. The aftermath for the real economy may however, be quite

If exogenous loss of confidence occurs, domestic money is sold and the CB is forced to spend its foreign
exchange reserves to uphold the exchange rate peg (in graphs we assume that this exhausts remainder
of R). If market participants anticipate the central bank to maintain the money supply at its previous
level by creating sufficient domestic credit, then the crisis will be vindicated ex post (a). M remains
constant, but the CB has lost its reserves and is unable to maintain a fixed exchange rate. But if the CB
does not increase domestic credit, the M contracts y the full amount of the attack (b). In this case the
interest rate increases sharply, which makes domestic assets attractive to international investors and
reserves are quickly replenished (attack fails). Summarizing if the market expects the CB not to give in
to an attack by relaxing monetary conditions, it will expect the interest rate to rise after the attack. 3 If
on the other hand the market correctly anticipates the CB will not let interest rate rise (not attract
enough capital inflow), it is considered to be self fulfilling: that is it occurs because it is expected to

  This is especially true when one considers that many ‘one way speculators’ often operate with near zero capital: the speculator
borrows domestic money at the domestic rate and purchases foreign exchange at the rate believed to be overvalued, and then invests it
at the foreign interest rate. When the attack comes, the debt is paid off using part of the capital gain, Nothing scares such a speculator
more than a sudden rise in domestic interest rates, since that means painfully higher refinancing cost and often financial ruin.

succeed, even though pre-attack monetary policy was fully compatible with the fixed exchange rate
regime. The weakness does not lie in the observed policies but in the expected CB reaction. So why
would it do so?
    1) high interest rates represent contractionary monetary policy rising unemployment
    2) high interest rates may create financial difficulties for short term borrowers, and may lead to
        default  can hurt the banking system
    3) high interest rates may also affect the finances of highly indebted governments

Review session

Lobbying, smuggling activity from a tariff.
Cost for society depends on the enforcement, the greater the repression, the greater resource waste, no
new output is being created. Trying to evade authorities: goods smuggled to avoid tax can take up 5-
15% of national income. Simplest model : transport costs „melting iceberg‟ cost of transport is the
disappearance of a fraction of the value of good (goods disappear).
Can also result of improvement of welfare, low cost to smugglers and no or very low enforcement.
Tariff restrictions  smuggling brings the economy closer to FT, if costs of smuggling are relatively
small, will improve welfare.

We looked at where the economy is at the same level of welfare with a tariff and no smuggling and
tariff with smuggling. People will always choose the cheapest source of supply, be it official or
unofficial ones. PsCs if the cost of smuggling was lower, would have a flatter price line, tangency of
IC would be higher. In this diagram (Cs utility) implied that consumption of importable good (Ps) is
satisfied by the smugglers, all imports are being smuggled in this diagram.

Other model: Pitt (Indonesia) relationship between official importers and officials. This generates
possibilities for importer to import more than they are declaring (corruption), leading to less than full
enforcement. There is a certain fraction of official imports that is being smuggled, so official importers
(in competition with each other) all have the incentive to offer these imported commodities at a price
that is lower than P*+T. Observation that domestic price of imported taxable merchandise is lower
than (beyond Pitt don‟t have to read).

When supply curve is flatter, deadweight loss of export subsidy is lower.

Semester II: International Trade and Development

Continuation of : VII- Capital Flows and Debt problems of the DCs
Role of the IMF and other financial institutions

    1) Liquidity problem: assets exist but in the wrong form, they cannot be converted into liquidity
       quickly when needed. This could mean the structure of a balance sheet of commercial banking
       system is unable to meet creditor demands for withdrawal, or the inability of the government
       to uphold the fixed exchange rate… If the central bank is illiquid, or unable to provide foreign
       exchange demands but still has enough capacity to meet withdrawals thought the exchange
       rate window.

           If the crisis proves to be of this sort, the international community (organizations) should
           provide liquidity, as this problem is „easily‟ solved and can be effectively dealt with through

    2) Solvency problem: country as a whole can have sever budgetary problems, a shortage of
       income relative to expenditure, in these cases the IMF has to be more careful. There needs to
       be intervention, but not without a program to redress problems of solvency and restore
       balance and growth to the economy. It is a much more delicate issue.

What are the advantages and disadvantages of providing funding to a crisis and thereby altering the
incentive structure of both the debtor and the creditor.

    1) Advantage: facilitates the return to normal financial conditions through an outside injection,
       therefore debtors can pay creditors. This can be helpful in minimizing the costs or disruption
       associated with the given crisis.

    2) Disadvantage: reduces the hardship faced by both creditors and debtors, gives rise to the so
       called „Moral Hazard Problem.‟ The budget deficit of debtor countries, balance sheets,
       imbalances are not managed as would be the case in the absence of a financial institution,
       there can therefore be a greater degree of neglect. Lenders are less careful about loans because
       of the „safety net‟ mechanism, and the risk if lending to debtor is reduced. Therefore it can
       induce greater volume of lending, pushes down rates of interest so heightens both the rate of
       indebtedness and the propensity for other crisis‟s.

This is why it is so important to evaluate the appropriate degree of intervention, to avoid the above

VIII: Trade Policy and Unemployment in Developing Countries

In spite of rapid industrialization many people are unemployment or underemployed in DCs today, a
serious and hard to tackle problem. This means that although a lot of people find work, they do not
work full time and spend a lot of their time being idle (sometime 40-50% of the Labor force).

Arthur Lewis: One of his worries was trying to figure out how to get people to move from agriculture
to manufacturing, that is to enable the latter sector to find labor in countries were 80 or 90% of the
population is spread out over land. How to achieve industrialization? You have to incite the population
to move from rural  to urban sectors. Lewis‟s argument was to pay a 50% premium in manufactures
in order to encourage the shift. He was far from foreseeing that the real problem was not in getting
people to shift from agriculture to manufactures but exactly the opposite.

Post WWII saw an effort in DCs to increase productivity in manufactures and therefore a raise in
wages of that sector in relation to that in agriculture. This also means setting export restrictions on
agriculture (taxes/bans) in order to have cheaper food in the economy (less wages necessary to workers
in manufacturing) to lower cost of living (ex: Argentina and beef). This fuels industrialization, but also
puts a downwards pressure on agricultural wages and therefore income through these price-ceiling

Why would individuals want to shift from rural to urban? For the income, but also for the
infrastructure, entertainment, education, health, water, electricity is better in urban centers. Cities are
more interesting to live in, concentration of activities means that there is a greater amount of agents so
lower transaction costs for buyer and seller. City life is therefore more attractive than living in the
country side.

Harris Todaro Model: If wages were perfectly flexible equal wages would be paid in industry and
agriculture and there would be no unemployment. For a variety of reasons however workers in the
urban formal sector are paid higher than equilibrium wages. At the same time, in the rural sector and
the informal urban sector wages rise and fall according to supply and demand. Here LM workers find
employment in good jobs in the cities, LA remain behind in the countryside working at a lower wage
of wA. Those who migrated from the countryside to the city find themselves employed in the urban
informal sector. As a result, many people end up in relatively unproductive dead-end service sector
jobs in the cities. Urban overcrowding due to high rates of migration from rural areas to cities and high
informal sector employment is a fact of life in many low and middle income countries. The main point
of Harris-Todaro is that if the expected urban wage ...
     • equals rural income there is no incentive to migrate.
     • is greater than rural income there is a great incentive to move from country to city
     • were less than rural incomes there would be an incentive to move in the other direction.
         (South Korea in recent years)
One failing of the Harris-Todaro model assumes migrants are risk-neutral.

                                                                     WM : /w


                      M                          MPLA

                 OA          LA                          LM        OM


There is a fixed amount of land, so the more workers there are, the lower the MPL. So how do
landlords determine the number of workers? There is an incentive the hire until the MPL of the last
worker employed = wage. In manufactures there is also a fixed amount of capital (what land is to
agriculture). We assume that wages in manufactures are fixed ( through unions, government
intervention) above market clearing level, a lot of L markets in DCs are characterised by this. So how
are jobs allocated (/w = fixed wage) if the wage makes it that a lot more people compete for few jobs
available (LM).

The simplest way is to assume that jobs are distributed randomly, say 50 jobs for 100 workers who
therefore have a 50-50 chance of getting a job on any given day. This is called „random job allocation

Probability =    # workers in city (LU) / # of jobs manufactures (LM)
                 LU + LM = total # of workers in manufacturing sector
                 LA = total # of workers in agricultural sector
                 /L= total L force in entire economy
                 /L= LA + LM + LU  relate these variables to trade policy measures

- Workers don‟t care about the location (city / country) but about income.
                 WA = expected income in agriculture
                 WM * probability of having a manufacturing job
- Workers are risk neutral, they only care about average income
        City π /W = WA (worker is indifferent, there is no location preference)

                                                                        WM : /w


                                       WA           MPLA

                 OA           LA             LU            LM         OM


How do we determine the # of workers that stay in the countryside?
WA = π /W = (LM / LM + LU) /W
(LM + LU)WA = LM /W  (no sacrifice, location indifferent)

Use hyperbola to determine the WA  blue dotted rectangle should have the same surface area as blue
rectangle equilibrium wage agricultural when you have LU  LM that are willing to risk joblessness
some days in the hopes of a higher wage.


Haris Todaro Model Again…


IX: Terms of Trade of Developing Countries

You will be rich if you are producing a commodity or service and these are expensive relative to the
commodities you buy for consumption vice versa poor. Your income depends on relative prices. We
will try to explain why these relative prices are working so well for rich countries and are so much in
disfavor of the poor people in DC‟s. Prices are the key variables.

Coffee production: very hard, got to get rid of weeds growing around the coffee, very labor intensive.
Harvesting, coffee beans ripen individually, so have to pick them individually. Very time consuming.
Getting 80 cents for a kilo, 2 dollars a day when it is favorable period. 60-70 cents a kilo, cost more to
pick than what he is making. Lack of food, running water and electricity. Why is it that someone that
works so hard all day earns so little? It has to do with TOT. IF M de la Rosa was getting 35 dollars a
pound, he would be doing much better. We could pay that, so why don‟t we? What makes up the

You don‟t observe variations in prices on the market, but you do where it is traded. At the
supermarket, prices go up when world coffee prices are rising, but are not going down when the world
coffee prices are falling. Puzzle, why he is getting so little, why such a difference between what it costs
and what we pay for it. ½ the people in Guatemala live on less than 2 dollars a day (worse than M de la

Why are they being paid so much less that what it is being sold at the supermarket:
There are very few large enterprises that dominate the coffee market, the amount of profit depends on
profit margin which is agreed on between the distributor and the MN that is producing the good. For
the retailers, limited amount of space, they have a choice between selling a top brand coffee (1 $ retail
value added) or another cheaper brand where the distributor mark up will be lower. This is one of the
market mechanisms through which the relatively prestigious brands (lots of R&D) inducing the
consumer to pay a very high price because of the real or imaginative unique characteristics of these
products. The consumer is paying for this. Branded products, they are the ones that generate for the
retailers a higher value for sale. Most of the retailers will not have a complete range of coffee products,
the smaller the shop the more they will go towards the higher priced products (great deal of value

Therefore if I wanted to import coffee from Guatemala – administrative obstacles and market
obstacles- would be very difficult and next to impossible. There is a difficulty for entering the market
as a retailer, as an intermediary buying the coffee from the producers in Guatemala and selling to MN,
they will not deal with me. What is interesting is that you don‟t really have profits for these various
stages of marking up the price 35 cents 8 $ Starbucks… you don‟t have very much pure profits in any
of those areas. The bulk of this gap between price received by producer and price paid by consumer is
accounted for by various types of designing, marketing and promoting activities. Before large profits,
MN wanted to keep competitors out, spend money to differentiate their product, to make it more
appealing to the consumer, more convenient, designing the product itself they have been able to make
it so difficult for new entrants to come into the business and sell the product directly to consumers that
they effectively control the market. Plus there is a mechanism of very high fixed costs, would have to
spend hundreds of millions of dollars. Encounter severe competition (fair and unfair) from competitors.

The important point, which takes decades to develop, of structuring this market for coffee, results in a
situation you are buying mostly services of people in the advanced countries (accountants, designers,
lawyers…). We manipulate what they produce to create value and obstacles to competition. And we
end up driving the price of this product 20-30 times higher that it was at purchase. This is income
stream to factors of production in the advanced countries, only 5 % or so end up in the income stream
in DC‟s.

[Fair Trade: another product differentiation gimmick, very little impact in DC‟s. Fundamentally doesn‟t
change anything. Organizations that buy the coffee at a higher price, or provide things the
communities need; its giving them a little more income in relation to poverty level, it is not the kind of
improvement that is necessary in the market. A lot of companies use this as a commercial, commands
consumer interest.]

Vietnamese entry into the coffee market had an impact, supply is an important factor. On the demand
side, the way the market is structured, less product differentiation, higher demand. Because of this
tendency for the retail price to be totally divorced from production price, very little prospect for
demand growth. 1970‟s the UNCTAD conference and efforts to stabilize TOT and enhance them in the

DC‟s, through a more equitable distribution of world income. AC initially pretended like they were
interested in this (Cold War camps) and there was an effort to be sympathetic in the west towards
some of these problems in DC‟s, did cooperate in these discussions. In the case of coffee not inclined to
create an agreement that would fix a band and then use international funds to purchase coffee when
the price was low and sell coffee stocks when the price was high. The coffee producing nations don‟t
cooperate significantly enough to keep prices stable; entry of Vietnam into the market has made things
move faster. In contrast with OPEC, greater interest and resources, plus it has technological factors
that limit a lot of the OPEC members to increase production, automatic limit of supply. This is not the
case with coffee. The nature of coffee, elasticity of its supply, financial situation in which the coffee
producers are, makes it inconceivable for a cartel to emerge on the coffee side to bring up the price. Oil
can be exported only through terminals, control of supply can be rigorously put into place, measure
how much is being taken out and survey exports. With coffee you cannot do that, you cannot regulate
its exports, can be taken over the border in sacs, cannot be controlled.

Cocoa: again most of the chocolate that we observe has very high value added, and those activities
absorb most of the cost of production. If there was a more competitive chocolate industry, would have
lower prices. Also very harsh living conditions for workers, producers don‟t get very good treatment
from these buyers. Other problem is the extensive use of child labor in cocoa plantation 224‟000 child
laborers in Africa. The ILO in Geneva, trying to persuade farmers to put younger children in school
while the older children are doing the hazardous work (handing of pesticide and machinery to clear
underbrush). Very similar to coffee industry, alarming and important to be aware of it, ILO efforts are
not really going to change the lives of these people in a significant manner.

What is the problem here? As with coffee emphasis is set on the fact that the problem is not excessive
profits of handlers but that when these do exist, result in responses that created costs of production in
particular advertising, marketing distribution costs, to absorb these huge gaps between production and
retail cost. These feed the income streams of advanced countries and creating effective barriers to

General issue of TOT from the point of view of DC‟s... Why are these prices so low, why are they
getting so little? Not just because it is so abundant. If in producing countries like Guatemala, they had
an alternative job that would offer them 200 $ a day instead of 2 $ a day and this was also the case in
other coffee producing countries. The answer is creating other opportunities for the people in DC‟s
(more lucrative) so that they would not be willing to pick it unless the price is higher like 35$ a pound.
As long as people are willing to work for 2$ a day, you will have these low prices. Range of
opportunities determines how much they are getting.

Why don‟t they have many opportunities? The key to understanding the unfavorable TOT experienced
by DCs is to understand that they have very few alternatives in terms of using their productive
resources and this forces them to engage in production of commodities which have very low prices/low
income. Reasons: lack of physical and human capital which is only accumulated if you have a high
enough income to set aside and accumulate. In DCs experience scarcity of capital and they don‟t have
an income that is high enough to be able to save and accumulate, this makes the range of activities they
can productively engage in small. Africa or IMF list - highly indebted 37 of them rely on Primary
commodities for ½ of their revenues ; for 15 of them 90% of export earnings with export of
commodities, focus on small number (3 or less) of commodities. Ethiopia and Burundi 60 and 80% of
export earnings from coffee exports. There is also scarcity of fertile soil, problems with growing any
kind of crops, no capital and no land (small rainfall and fertility). Also, DCs being poor in capital and
therefore focusing on primary product production, the development of synthetic substitutes is

something that has served to impose a ceiling on prices of certain commodities. As commodities
become expensive technologies that replace natural commodities emerge and substitution takes place
and serves to limit the scope for growth in prices due to scarcity. Lack of political power in
international arena prevents them from using an imitation of what their original product was or is, so
substitutes can be easily introduced without paying compensation of the original. This is a long run
phenomena that deteriorates DC TOT.

Also the problem of AC restrictions of imports of agricultural products of DC‟s. There are WTO
negotiations going on for this, there has not been much done in this respect. They maintaining these
markets for their own producers, access is granted in exceptional cases and there are various forms in
which it is granted, but it is often tied to political objectives. In the case of US, restrictions on imports
of agricultural products do allow for privileged access (LDCs and some DCs) and these quotas are
allocated to those that provide political and military support to the administration. Sugar quota which
is highly restrictive giving cash because you allow head of state to buy sugar locally at low prices and
sell in the restricted US market at a higher price. Although some restrictions have been addressed in
the EU such as banana trade (US Ecuadorian bananas to have greater access in 1999), and EU was
forced to allow them to enter their market with less restrictions.

Even access to advanced country markets from DC is access for MN operating in these countries and it
is not the type that would improve the TOT and living conditions for those producing primary
products in DCs. By not giving access to producers in DCs the policy narrows the range of activities
that DCs can engage in. You cannot produce tobacco, sugar, bananas in a lucrative market, you do
coffee, cocoa.

Another issue is the subsidization of agriculture in AC offered to local producers (1 billion a day). Very
lucrative, deprives those in DCs of having a market. Most of the farmers in AC should be doing other
things, it does not pay to do so. Because of billion dollars a day subsidies it is lucrative and they are
keen on fighting for this right.

Export subsidies: for agricultural products from the advanced countries to the DC‟s, subsidizing exports
of cotton or rice from ACs in direct competition with the producers in DCs. Not only do they deprive
them through local subsidies but they distort the world market. There used to be a dairy industry in
Jamaica and rice in Ghana. So how is this bad?
         1) It further narrows the range of activities that the people in DC‟s can engage in, they are
         facing severe competition from actors in the ACs who are getting subsidized this is not letting
         the market work!!!! This is depravation of producers opportunities in DCs. What is wrong with
         distributing rice at half price in Ghana? In ACs when we talk about competition „disruption‟
         government that is resourceful, capacity to deal with those that are adversely affected,
         subsidize retraining and help affect firms,
         2) Don‟t have the capital markets that allow entrepreneurs to borrow the funds, the capacity
         to use these resources; they do not have anything else to do, well maybe cocoa… So in Ghana
         what you had was rice distributed at lower prices, local rice production was negatively
         affected by that, those that were released by rice sector did not find other activities, this can
         easily be negative. Lets say it generated 40 million dollars, if we are bringing in 30 million
         dollars of imported rice, consumers will be happy about that, for a while. If the 40 initial
         million disappear, lack of capital and they cannot transition into other activities, the national
         income drops by those 40 million. Improves by 10 million for the cheaper rice… net loss of
         income flow of 30 million dollars… That means that people in Ghana have less money to
         spend on all other goods produced in Ghana. Contraction of everything.


Options available to DC which suffer from scarcity of capital, and some also in terms of the soil at their
disposal. Abundant soil and capacity to participate in the global economy… but even so, the
phenomenon of Tariff escalation… Refining of raw materials is discouraged in DCs. This creates an
environment where a small number of activities can be undertaken in DCs. If you channel everything
into production of a small number of products, you will have a very large amount of this. The key to
understanding the lower prices, is to understand the low number of activities practiced.

Rents: for an economy to be able to set aside savings and transform them into physical capital or
human capital it is essential that there is capacity for society to save and to invest that into capital
accumulation. We are able to provide the next generation with capital to guarantee them with a high
standard of living. Most of us in the ACs have this capacity, there is a lot of redistribution. These kinds
of transfers of savings from one group to another group, in DCs which are unable to save because
incomes are so low and most of the earnings are necessary to subside, unable to accumulate capital...

Also, the population does not directly benefit from resources, Canada vs. Nigeria. There is no sharing of
oil rents. In other DCs that are rich in mineral resources, it is where the elite shares the rents with
foreign companies/government officials instead of distributing the rents to the population. When you
see poverty in Ghana, most of the land is given to mining companies as exploitation of resources.
Shared between MN their government (which then protect their interests) and some narrow elite.
The masses typically do not share in those rents. When a government is elected and wants to rediscuss
the rents, these governments are immediately labeled as radical and nationalist and therefore
unreliable as trading partners. But unless these rents are shared, there will be very little capital
accumulation and income flow that is enjoyed by AC to get these economies moving on a path of
growth. As long as the income goes to foreign entities and local elite that spend abroad, you will not
have development and renewed opportunities.

Problems are profound and to be addressed in an effective manner one would have to rethink the
system of North South economic relations. There are signs of conditions changing to some extent,
especially in the market for natural resources (growth of India and China). That kind of price
movement has resulted in greater awareness of DCs of the value that is at stake and therefore a greater
degree of contest for these resources. China is extremely interested in obtaining control of these
resources through peaceful market mechanism. It is willing to pay top dollar for access to oil and gas
fields as well as mines, which they require in order to feed their tremendous manufacturing sector.
They are going around offering deals, this creates an alternative for DC which does not really exist in a
monolithic western economy. Having new players on the scene interested in these things and offering
cash and not necessarily being involved in a cooperative relationship when it comes to western powers.
Gives a possibility.

Rent: is something that you enjoy without having to earn it. You do not have to perform a service or
produce something. It is like if you own a patent or land. They are streams of income that you do not
have to do anything to get it. Rents are very important as they are what allows an economy to save and
accumulate assets. Wages in DCs are what is needed to reproduce the labor, it is not possible to set
them aside. To be able to set aside income you need rents. How much of oil rents does Nigeria get and
how much does Norway get (80%) which it distributes in public services and guarantees a very high
standard of living. Until we get that mechanism in place in DCs we will not have a situation where the

rents can be converted into physical and human capital stimulating the economy. It is a very profound
problem and we cannot achieve it by buying fair trade produced products.

Look into the whole Charles Taylor thing (Prof says that his prosecution has a lot to do with
challenging multinationals…) Chavez thing also. „Rogue states?‟

We need to look at things more objectively. Where does the WTO fit in all this it‟s the members that
have to do something about the evolution of the world trading system. What about the rise of China
and India; rise as an indication that something might change. Have an eye on changing the system,
Trojan horse? The choice for China was not one of either participating or not in the trading system…
easy choice „the only thing worse than joining the WTO is not joining the WTO…‟ This can facilitate
their growth (higher than other economies) alters it in a very significant way. In near future,
significant change in the system as different countries will have the economic power and capacity to
purchase resources, to offer competing contracts. ((Chinese involvement in South America))…

The reason we are earning high real wages is because DCs are earning low real wages.

Factor ownership and the nature of the system does not change when you change these policies. There
are benefits but they are much more in favor of the advanced countries than for the DCs. There is
redistribution of income that takes place whenever you have changes in prices. Property rights over
these natural resources, if you have a system whereby incomes in DCs rise because of a more open
trading system creating demand for labor in DCs, you may increase it to the point of enabling these
workers to accumulate savings and educate changes. They will start to question the property rights
scenario. Also talking about IP, to copy, to produce through imitation, these issues may also be raised.
All those things can be affected by changes of prices.

Fair trade issue: suppose  you have two activities, for producing baskets 2 $ a day and 2$ a day for
coffee; and then you get   2.50$ a day from Max Havelaar … picking coffee gets more attractive than
basket weaving … result    is that price of coffee goes down (producers shifted from basket weaving to
growing coffee). So that   even with the premium, they still get 2$ a day. The only way to get the
income up is to raise the income in every other activity . This is why fair trade is not a fundamental
solution to the problem, it is a much deeper one and involves a large number of issues.

What about micro-credit? Works and is helpful. It is a very significant way of overcoming
imperfections in capital markets in DCs. This gives people with initiatives the means to their ends.


We are going to assume that there are two large countries trading with each other. If we look at the
policies regarding taxation for fuel, very similar across EU, while the Canada and US are different.
Countries that are major producers tend to tax fuel less. Differences in taxation policies. Primary
products that are supplied inelastically are heavily taxed, in that sense the AC are acting relatively in
unison in such markets.

Fuel: relatively inelastic resource… graph 1….




Major users of fuel are industrial firms, it will take an enormous investment to revamp factories in
order to make them more fuel efficient. There are a lot of barriers to these economies in making
changes in order to be more efficient. This is an ideal market for authorities to tax because taxation
results in a relatively small welfare loss in relation to the amount of tax revenue collected. Deadweight
loss is relatively smaller. What happens when we impose a tax?



          Tax/unit                           FT (p* ; q*)



Pc price consumer pays
Pp price received by producer

Small distortion, triangle represents deadweight loss. In the fuel market this diagram is an accurate
representation of what we had up until the last few years until the attack on Iraq. Consumers were
paying about 5 times more than the price of the world market. Now things have changed, tax still at
one franc but consumer is paying 60 or 70 centimes for the gas. We consider these taxes to be

burdensome, unhappy about paying so much for fuel. In EU we have more economical vehicles and
our lifestyles are different it is actually to our benefit. We are experiencing a loss of consumer
surplus, but part of it goes back to the consumers through government redistribution of revenue. There
is also another part that comes out of the pockets of the producing nations. Taxes are an instrument
that shift rents.

All these things affect market prices, any kind of impediment to trade or any instrument that goes
against free trade, creates an excess supply and drive prices down affecting the TOT. Policies that
affect the market for primary products are policies that affect the TOT.

Free market: graph 3



          Tax/unit                            FT (p* ; q*)



Red triangle is the deadweight loss
Blue rectangle is what they gain by the rise in price

Assumption that there are two regions that trade with each other and 2 different products… Most of
what is produced in the south is produced for exports only. The other country consumes imported
primary products but does not produce these products. Assume perfect competition. Price is the
intersect of supply and demand schedule…

Now change the rules of the game, instead of individual producers coming to the market and North
buying. Producers organize themselves and sell the products as one. To eliminate competition, that is
for the sale for the same of this product monopoly/cartel. They push the price up as high as they can.
How do they figure this out? Cost can be derived from the supply curve (how much is sold for how
much price). They will look at demand curve and they will figure out what the marginal revenue is for
the sale of an additional unit produced. As you increase sales by one unit how much extra revenue do
you get. Marginal revenue is downward sloping. What is the total revenue?

Chart 1

          Units                         Demand                      TR                  MR
1                                 100                       100                100
2                                 99                        198                98
3                                 98                        197                96
4                                 97                        196                94

The more I want to sell the lower I have to bring the price down. MR is always less than the price
except for the first unit. Where the marginal revenue intersects with the supply curve is the ideal.
They will then sell price P1 gain to the south of monopolizing sales of its primary product, it is the
difference between the loss of producer surplus associated with the decline in the sales from q* to q1.
Lose profits equal to the black triangle, but they gain a transfer of income of the black rectangle
through driving up the price… it is larger so they win and that‟s why they do it.

What are some alternative arrangement that can emerge from the market? A trading company that
buys from competitive producers in DCs and sells to competitive producers in the ACs. There is
nobody else that the producers can sell their coffee* to, they are the only intermediary so that the
producers don‟t have much of a choice who they sell their coffee to. That intermediary has
monopsomy power can give the price it wants. … acts as the monopoly vis-à-vis the consumer market.

Graph 4



                  Tax/unit                       FT (p* ; q*)



Will construct a D schedule and the associated MR curve, guide to the intermediary to maximize
profits…also will need to ask what the extra cost is of buying the extra unit from the producers. The
more units the higher the price, the more I drive up the price of what I want to acquire. The MC of
buying an extra unit is something that goes up relative to the supply curve. See image 2. MC moves up
faster than the AC (MC) per unit. What price will the producers receive and what will the consumer
pay and what price will be set on the market and how is this different from the cartel?

The intermediary will take where the MC = MR... Producers will get P2; P* is what they would have
gotten in a free market; P1 if there is a cartel. Powerful intermediaries and MN will do anything to
organize the market to benefit their country. P3 is what is charged to the consumers.

        Units                     Supply                    TC                          MC
1                         10                        10                         10
2                         11                        22                         12
3                         12                        36                         14
4                         13                        52                         16
5                         14                        70                         18

When we were talking about coffee and cocoa… initially there was this sort of relationship (colonial
period and the West Indies Trading co) once greater competition was introduced, these profits started
to attract competitors. If there is legal and financial capacity, there will be pressure of existing
intermediary. Then the MN creates barriers to entry, through various kinds of methods getting space
on the shelf, packaging, advertising, technological improvements, to essentially make it unprofitable
for anyone to try to compete. Therefore they no longer end up pocketing that rectangle, but they
spend it all on marketing, which means that you pay very high prices at the consumption point. Net
result is that the producers get similarly low prices and consumers similarly high prices as if someone
had a monopoly. That wedge is maintained but it no longer represents profit but expenses on various
services that the intermediaries have to perform in order to keep competition low.

[Resistence to GMO‟s has a lot to do with the enormous amounts of rents that are at stake.
International agreements allow the developers to get the rents, duplication of these seeds are against
the law. Even if you have your crops pollinated by GMO pollen, Monsanto will take you to court even
if it wasn‟t your choice (was seen in Canada). There are enormous rents at stake and the EU does not
want to pay these rents. José Bovet is an eminence grise, this is all orchestrated by the authorities.
Government is protecting the firms and then manipulates the consumers.]

Price depends also on government policies, taxes, subsidies and the way the market is structured, All
this influences the prices that the producers receive and the consumers pay. There were times where
primary products where controlled by the producers (colonies). Rubber in Indonesia, Anglo-Dutch
monopoly Henry Ford and rubber growth in Brazil making more competition. Market arrangements
and institutions are very important.

Empirical evidence considering the evolutionary TOT in DCs. TOT have been shown to decline for the
producers of primary products over the last couple of centuries. For anything that goes back further
than 1800‟s there are not so good statistics, after there are the GB stats. From the middle of 19 th to
present day there has been an erosion of primary products relative to the manufactured goods. Price of
primary products relative to manufactures (Singer-Prebische) show a 1% annual decline; 0.5 % (non
fuel) 0.6% decline… ?

The theoretical predictions of classical economists were exactly opposite to that, they believed that
they should rise. Thing that is scarce is land; while L and K would be accumulated and more and more
manufactures were produced bringing down the price of these. Therefore there was no limit in
production of manufactured goods while primary product production limit is fixed. That didn‟t turn
out to be the case, which has a lot to do with the technological progress making synthetics. This makes
them less useful than what might be admitted in the past. Replacing natural fibers for example. As for

the behavior of prices (Yang) evolution of these prices for the 20th century, disaggregate products into
categories foods from non food agricultural products, metals, also food and fibers… food strictly
defined and tropical beverages… Behavior varies according to the products. The greater decline is not
uniform for all the categories but differs substantially.

Price indication:
1900-1986:        metal prices have been declining at the rate of 0.82% a year on average (not uniform
                  over 20th century, 1900-1941 decline 1.7%; 1942-1986 increase 0.5 %--> very sensitive
                  to industrial activity/growth trying to return to gold standard, great depression
                  negative for macroeconomic growth now with Chinese growth, flying high…)
                 non-food agricultural products decreased 0.84% /year
                 agricultural food prices decreased 0.36%/year
                 tropical beverages (tea, coffee, cocoa) increased 0.63%/year
                 cereals declined 0.86% a year

What are the implications of these diverse price movements different DCs are impacted differently
by these price movements. Rapid decline in the price of cereals, is an improvement in the TOT for any
country that imports cereals. And the increase in tropical beverages is an improvement in TOT for
those countries that are exporting these products. Always differentiate between these countries. There
is no iron law. In fact a country like India has been an important exporter of manufactured goods,
changing in the prices in primary products have not affected India‟s TOT, decline of price of products
they export was offset by those that they import that also declined. What are they importing what are
they exporting?

Effectively influencing the price for a group of primary product producing countries, OPEC has the
power to influence the price of petroleum (coffee would be impossible). What are the ingredients for a
cartel to function: financial resources, need for a dominant producer, the latter is important for
organization of production cartel so that he can threaten any other producer with punishment if an
agreement is violated as to control free rider problem. Suppose you have a producer organization that is
designed to create scarcity and price control, there is an agreement of what each country can produce.
How to punish violators, dominant producer with excess capacity can flood the market in such a way
that the pain for the violator will force them to comply. Curtail the supply from Q* to Q1. Once the
price is driven up the individuals would have the incentive to sell a little more at a high price. This is
curtailed by the dominant producer. This is something that exists in the oil market (Saudi Arabia was
dominant producer). Also limitation capacity forced the other producers to comply as they were simply
not capable of producing more.


Level of prices in primary commodities depend on the income with products who‟s prices fluctuate a
lot. When the prices are high you can pay off the loans you took when the prices were low. There is
also a possibility to get insurance. For large producers these mechanisms exist (trade in commodities in
futures markets) dealing with fluctuations is possible. Large agricultural producers are able to transact
in forwards markets, these are highly developed and they are organized. Concentrated in North
America and the whole world trade through these markets… These kinds of developments can be
neutralized if producers have the possibility of selling their output for future delivery today. Fix the
price today for delivery tomorrow. Some of these markets have very long horizons. Small producers do
not have access to these markets. Large producers have large collateral in their account to protect from

fluctuation, providing a guarantee to the brokerage firms. The producers in DCs that do not have this
kind of collateral cannot deal with these issues and therefore do not participate in forward markets.

This difference in the capacity of individual producers is based exclusively on their differences in
wealth. Big producers can hedge and participate in these markets while the latter cannot. Therefore
they are also more likely to disappear from the markets. Ex: reports of grippe aviaire. Consumption has
been reduced by a lot, governments of ACs are going to provide support to their poultry producers.
This kind of insurance scheme is something that is not available in DC as the richer the society the
larger the producers the greater the survival capacity. Asymmetries.

Take advantage of market mechanism to protect themselves from uncertainties and stable price. DC
governments have not done very much and it is very difficult to be helpful to their producers given the
international arena. There have been some efforts at stabilizing prices or increasing them for their
    1) The organization of a „Marketing Board‟ sets a price and purchases from individual producers
         and buys that particular amount. Producers therefore know that they will get their product for
         a certain price which reduces some of the uncertainties. These are not efficient as they are a
         carryover from the colonial period, when there was a single buyer and single price. This was a
         mechanism used to preserve monopsomy or single buyer position (taxation mechanism). This
         also implies that there is a ban on exports as one has to sell all the crop to the marketing board.
         Typically the military (relatively large stock of vehicles) end up smuggling the crops to
         neighboring countries and keeping the benefit. It has turned out to be more of a taxation
         mechanism. It does provide stability of price without it being attractive.
    2) Also various international commodity agreements in a number of commodities in order to
         stabilize prices were proposed. A fund would be established that would be used to purchase
         the commodity in question should the price fall below a certain minimum level. It was to
         maintain fluctuation within a given range so the price would never go above or below (sell
         when high; buy when low). Buffer stocks agreements. Such an agreement is costly as it implies
         that you have storage facilities and you need financial resources to buy the stock. Financial
         resources means cooperation from consuming nations, but the scheme itself is not really
         compatible with these countries. Because the more they offer to finance acquisition of buffer
         stocks, the larger the average buffer stock and the higher is the average… the more you have
         to absorb from the market and the higher is the average price in the short run. If you have less
         resources the price will tend to be on the average lower. Why does more resources (financing
         to the program) imply a higher price and less a lower price? These markets are open to any
         buyer and seller. It is enough for the speculators to know that there will be greater potential
         purchases because the buffer stock program is being funded more generously it will result on a
         higher price for the given commodity. The more anticipated purchases the higher the price, all
         you need is for the market to know that there is a high demand. So for the advanced countries
         it is not in their interest to support large financing. Their objective was to act as if they were
         cooperating with DCs but not to really do anything at all. In other cases the arrangements
         collapsed as the prices set were actually too low (such as tin). These attempts could be
         interesting if both producing and consuming nations were interested in these sorts of schemes.
         But this is not the case.
    3) Cartel is another arrangement such as OPEC. This is one of the cartels that has been relatively
         successful in regulating supply and influencing the price. Due to the peculiar nature of the
         petroleum product;
               a. role of dominant supplier (Saudi Arabia)

            b.  capacity constraints are very tight on most of the producers (assigns a quota that is at
                the level of the capacity) there is little scope for cheating,
            c. inelasticity of this capacity/supply and of the demand (hard to expand even in long
       This all means that changes in the policy of the cartel can have an effect on the market price
       without permanently destroying the cartel itself. In the case of an elastic demand, consumers
       respond to the higher price and start to consume something else. All these conditions are key
       to permit the cartel the manipulate the price, this is not the case in most commodity markets
       (coffee vs. petroleum-the former is more difficult to monitor).
    4) Import substitution policies and export promotion, these are policies that countries have
       pursued, even subconsciously in order to get away from the dependency on primary

X: International Factor Movements and Technology Transfer

International trade in factor services suppose that the productivity of a worker in the AC of a certain
skill is 100 $/a day in DC 2$/day… what if we take them and put them in an AC. This is a potential
gain from trade of 98$/day. Heavy equipment 500$/day in AC while in a DC where there is a scarcity
of K 1000$/day. So by transferring from AC to DC we can gain from services of both K or L. Factor
services have been readily traded for most of the history of mankind. International lending and
borrowing was highly mobile and labor mobility, there was no prevention of working in another
country. There was just an infectious disease issue. People didn‟t have passports there were no boarder
patrols, if you want to work in another country it was your business. Openness to labor and capital

Things started to get rough in the 20th century, CW and turmoil in 3rd world, created a situation of
instability in respect to property rights of foreign enterprises (expropriation, nationalization,
confiscation). Many of the MN were hesitant in making investments or exporting their capital to DCs.
The conditions under which this capital can operate, restrictive in terms of ownership, controls on
repatriation transactions... Made it unattractive to invest abroad, the AC and some DC, but not in most
of them... In the 1960‟s and 70‟s rapid growth of EU economies with scarcity of labor as the EU MN
were investing in EU. This resulted in large inflows of foreign workers. So the limitations on capital
mobility due to the relatively insecure property rights foreign firms could not expect to be protected
and resulted in reliance of imports of labor into those countries where these firms did operate.
International debt crisis of the 80‟s another revolution. ACs began to dictate the terms of which their
capital was being used in the DC, the others had no choice. Owed too much money to the ACs and
therefore there was considerable pressure during this period of the DCs and a larger scope for MN
ex. big push for privatization…

Within the WTO there have been efforts to strengthen the property rights of MN that make
investments in DCs. BTA between the US and other economies also call for much stronger protection
of property rights of K owners from abroad. This makes them more interesting for production such as
outsourcing, or other activities that are L intensive. There are many other considerations. We now see
extensive unemployment in western European economies with the MNs that are investing in countries
that are relatively cheap (delocalization).

What are the gains from trade in factor services. Exports of K from ACs to DCs and what does that
imply in terms of welfare? How are these benefits divided between countries? Welfare implications?
What are the restrictions on these flows and what is at stake in the world today when it comes to

international factor movements? Try to understand the attitudes of the ACs in regards to these factor
flows. Again, the system is designed in such a way as to benefit the most powerful actors.

Bhagwati reading. K intensive country (US) and L intensive country (Mex). There is a certain amount
of capital stock available in US and marginal productivity of L in US is a function of the number of
workers employed to work on that capital. There is a diminishing marginal productivity of labor.




                             L0          L1

Area of Wo  Lo (total employment in US) is the total amount of output in US economy before
migration. When you allow migration, there is increase from Lo to L1. There is a net gain for the US
which is the triangle above W1 and under MPLA. Everything that lies above the W1 line is what K
owners get after migration. Before migration capital owners are getting ABC; after they are getting
If you turn this around and do the Mexican side you see that Mexican output diminishes. The migrant
workers were getting L1DLo. This of course assumes that there is no unemployment in either
economy. In reality it all depends on how you explain the unemployment.


Graphs distributed by Prof …
Labor mobility: controls, such as quotas or guest worker programs were there is scarcity. This is a
situation where there is a possibility for employers to discriminate against illegal aliens, they have less
rights. Even though there are legal rights that are the same for the illegal aliens and the citizens, they
will not complain as they are afraid that they will lose their status. Many of these occupations in
Europe and the US there is this wedge because the workers don‟t have the same rights. Such as not
being able to get the same wage as the native workers. If you allow them to have legal status but ban
illegal immigration, their wages will shoot up. Anytime there is a discrepancy between MPLs, keeping
restriction on migration keeps efficiency gains away. Every worker that you let in increases the total
welfare of the world economy. Redistribution on a massive scale, affecting social cohesion and other
things, it is politically unacceptable. Where are you going to accommodate all the immigrants,
congestion problem, severe decline in income of native workers, this is not an attractive kind of
development for the majority of the Swiss population. Other countries have more space for immigrant
population. There is a significant amount of land that is used inefficiently and where there is necessity

of L in order to exploit these sectors. It seems to be more effective to tolerate inflow of foreign labor in
order to raise the value of these areas rather than unrestricted migration. Threat to cultural hegemony,
political and social equilibrium, infrastructure problems… One policy does not fit all. There are
similarities across countries and that is tolerating migration where the factors of domestic assets would
not attain their full value in the absence of having access to foreign labor. Demography argument, that
is the requirement of replacement of an aging population. Proportion of population that is active in the
population that is diminishing, this means that you have to have a larger tax rate being paid by the
active members than the inactive members of the population. If you allow immigrants to come in and
become part of this active population it sets back the date of when pension problems will become
acute. The calculations are that you need inflows in the teens of percentage of labor force to make the
active part of the population continually stable. This is not a solution, as they are way too demanding.
Solutions are likely to be of lowering the benefits of those who retire, encouraging individuals to find
other programs, extending the working age and finding other sources to contribute to pension
programs, encourage women to have more children and become members of the labor force.

1973 and exporting capital: end of massive migration to European countries. From the point of view of
enterprises exporting capital is much more interesting as long as the property rights of capital owners
are well developed. This is something that has increased in the 80‟s and 90‟s. The focus in the case of
the US and Mexico is NAFTA, didn‟t work very well.

Graph n°2. If you start from a situation where you have unrestricted migration (GE) and then you set a
quota, kick people out and get only (GE‟) the wage rises. If you impose this restriction on migration,
there will be welfare consequences for the two countries.


                                                  D                       R*


                   MPKM                               MPKA

                                     E        G                      OM


Free and unrestricted factor of production movements between Mexico and the USA.
ABGE: increase in GDP for Mexico
ACGE:: decrease in GDP for America
ADGE: Earnings of American capital in Mexico
ABD: increase in GNP of Mexico

ABC: increase in GNP of America

No matter what factor is allowed to move there will be the same increases in output. If you have the
same technology and you achieve a level of MPK which is identical in the two countries there will be
no difference in MPL… if there is a difference its that there is not the same technology. If it is the same
there will be equalization of both MPK and MPL (which is not allowed to move in this case).
Equilibrium will be reached if either K or L are allowed to move freely. In the real world this does not
Is there a possibility to get more benefits from exporting factor services than triangle ADC. It can if it
is, as in this model, the only exporter, it can behave as a monopolist. How can it do this? It would look
at the demand of K in Mexico (BA) if you are a monopolist and you are confronted with this demand
you will look at the Marginal revenue schedule (originate at B and be steeper- slope twice as large as
the demand schedule) and will compare it to the cost of exporting another output. How much is
forgone by exporting? CG….

                                            H                            RM
                                                    I                    RM’
                                      A    A
                                           K        D                    R*       T
                                                    J                    RA’
                                            L                            RA

                 OA                       E F                         OM


Intersection between MR schedule and MPKA schedule (GF), this is where the monopolist is going to
price himself. If you want to achieve GF which is the optimal quantity of capital exports, how do you
identify those that have the right to operate in Mexico. To have exactly GF units of capital exported
there are two ways, one is to impose a tax (T) on any earnings that American capital owners in Mexico.
They will have the interest to export while their earning are more than T, what they could earn in the
US. How does this tax affect the GDP of America in contrast to unrestricted capital mobility (ADC)
AKL is loss in potential gains from trade in K services due to a restriction on K exports associated with
the tax rate.

HIDK-AKL is the increase in GNP of America by imposing a tax at the rate T on exports of capital, it is
over and above what would be enjoyed under unrestricted capital mobility. RA goes down and Rm
(what you receive per exported units of capital) goes up… The rental on capital in Mexico goes up, we
get more per unit therefore you get better TOT (price of rental on capital in Mexico relative to the
price of the commodity which is going to US for payment). MPK in US is going to be lower than in the
case of unrestricted K mobility. There is a misallocation of capital in the world economy.

From a Mexican objective? What if Mexico is the party that decides the rules of the game and not the
US. Would it pay for Mexico to restrict trade in capital services. Suppose it could impose a tax on the
income of American exporters, would it pay and what would be its ideal?


                                           A       B                     RM’
                                     K     N       L                     R*       Ø
                                           D       C                     RA’


                 OA                      E F                           OM


The Marginal cost of acquiring an extra unit of K from America. The ideal is where MPK for Mexico
and the MC of acquiring an extra unit intersect. Mexico then puts in a tax Ø…
ABCD: taxes on K imports collected by Mexico
NLCD-KAN: is increase in GNP of Mexico as result of imposing a tax Ø on imports of K from US
KLCD: decline in GNP of America as a result of America having imposed a tax Ø on imports of K from
((DCP<KLE loss for US is area KLCD))
KAFE (decline in GDP of Mexico as a result of Ø) represents a relatively smaller change in output of
Mexico if you have a restriction on imports. What is more important is the GNP of Mexico (what
comes back to the country). But even though this declines there is a NLCD-KAN (due to lower volume
of trade). Most of KAFE that is lost, not produced to loss of trade, this would have gone to American
capital owners (only KAN would have gone to Mexico). There is an overall improvement in TOT.

The big point the Prof wants to make is that it matters who has the capacity in the world economy to
set the rules on trade in factor services as they influence the TOT of the countries that engage in factor
services trade. This leaves the other party with a small gain. In the case where Mexico dictates the rules
(green) it gains more than the US… in the case of US it is in purple (HILC) change graph!!! Who sets
the rules, how why and who does it advantage and disadvantage. Trade whether it is in goods or in
factor services has a potential for both parties to gain, relatively equally in free trade. When there is an
asymmetry, there are regulations and strict rules (standards and factor movements), this has
consequences. These are illustrated in the above graphs. In the real world it is what keeps some
countries rich and others poor.

If you are a very powerful country can you do any better than this (purple) trapezoid, without
violating international law (case which we shall examine later)… What if you go for the whole triangle
ABC; you would have to engage in a „buy out‟ of Mexican capital to American capital owners at the
Mexican market price and then allow for the American K owners to bring additional capital into

Mexico to the point where the MPK is equalized across countries… without paying a higher wage to
the Mexican workers more than what is was paid before. Discrepancies between MPK, permits for a
higher gain, but make sure that the foreign factor owners are getting exactly the same income they
were getting before the buy out… reorganization of world economy to get higher efficiency and
organization Globalization. MPK in Mexico is very high, the price you have to pay is high, several
times earnings. Once you buy this, whatever it is worth (GOM), with its high rate of return you pay a
lot, then you send more (GE) American K into the economy, this also results in equalization of MPL
(working with the same K per head) across the countries… That is why in order to get all the gains,
you have to continue paying the Mexicans what they were receiving before the buyout, Mexican
incomes will not be affected by this policy, GNP of Mexico will remain unchanged. There is an
allocation that is perfectly efficient, there will be more output ABC, and all will go to America. Enables
the active country to get everything. There have been pressures throughout the 1980‟s to do this.
Massive privatization programs under pressure from the IMF and the WB… also financial pressure 80‟s
and 90‟s and on the former planned economies. In most cases it is foreign MNs and corrupt officials.
There has been a large transfer of ownership from local hands to foreigner.


The case of natural resource exploitation is different from a buyout… there is a third factor involved
which is the material in the ground (L and K being the others). What is currently being debated in the
DCs is how to best redistribute rents from exploitation that the MN provides to the country providing
the natural resources. The tendency is increasingly towards treating MN as service providers and not as
part owners. Remembers that in the case of a buy out resources are not in play, it is simply K...

The next point is: What would happen if the stock of K shrank in the DC meaning that MPL would
shift down (less K for L to work with)… This would increase the scope for gains from trade in factor
services as the countries differ more… Basic rule is that the more divergence there is between
countries before they start to trade the greater the gains from trade.

The importance of understanding this is because this increases the triangle even more after the buyout
has taken place.

                   MPLM                             MPLA

                                     E     G                        OM

The more different we are the more scope there is for benefiting from trade. North gets the additional
output, the K owners in M get the same income as before. Instead of owning capital they own other
financial instruments which render equivalent gains. The workers will have an unchanged situation as
well if their wages remain the same. (ex) K owners and workers will remain unchanged, the ownership

is what changes, and all the benefits accrue to the advanced country (the whole triangle). The further
gains from trade of reshuffling the capital stock when the differences are so large (graph above) are

Foreign Direct Investment

UNCTAD 2001 Global stocks of FDI
    60 thousand MN
    820 thousand affiliates
    6 trillion $ of foreign K owned by firms of ACs
    4 trillion located in other ACs and 2 trillion in the DC
          o 1.1 trillion East and South East Asia
          o 675 billion Latin America
          o 95 billion Africa (0.5% of the total)

Flows are the increases in these stocks. These have increasingly been directed to LDC, recent flows are
much more directed towards DCs than they used to be (rise of China and India)?

1986-1993- 41% of total direct investment reaching DC
1997- …- 1/3 of total flow of FDI (less because of the Asian financial crisis cooled it down)

Relatively few DCs receive the bulk of the FDI from the ACs
     top 10 DCs get 70% of the total
     poorest 49 DCs get 0.3% of the total

Electronics, petrochemicals, chemicals, petroleum  97% of investment in DCs is done from internal
sources, only 3% on the average is foreign. This can also vary in the case of certain economies such as
Singapore 20% or HK 10% where it is much more important.
As a whole FDI accounts for % of new capital formation:
     8.5% Asia
     7.5% Africa
     14.1% Latin America

Very often FDI represents acquisition and change of ownership, not increased (new) K formation.
Acquisitions can even and are often financed by resorting to local capital markets, borrowing in local
financial markets in order to make purchases. It does not imply that new fresh foreign capital is
flowing in. It could involve an inflow of funds but acquisition of existing capital in the local market or
you may have a situation where the MN from abroad purchases local capital by borrowing in the local
market, you therefore get nothing. There are 3 scenarios that lead to very different outcomes for the
local economy:
     fresh money and fresh factories,
     fresh/borrowed money and/or new/acquired local factories (K)
     borrowed money and acquired local factories (K)

What are the benefits of FDI for DCs the above +…
    building/acquiring and revamping
    creating activities, raising the level of welfare
    often brings new technologies and production processes, can have a spread effect

        bring in managerial ability, training labor, organizational innovations…

FDI does not play a key role in most of DCs but it is concentrated in certain sectors

1977-78 (28 industries)- motor vehicles, electrical machinery, metal products, plastics, pharmaceuticals
chemicals foreign ownership share up to 20% of these industries and foreign owned enterprises
accounted for 30% of the production in these industries. This is in spite of the fact the FDI plays a very
minor role in Indian economy, 0.1% of gross domestic investment of that period in the late 1970‟s. But
it really depends on the industries.

Different forms of FDI:
     Green field investments, new factories being build by foreign companies (start from scratch)
        here the foreign MN may want to expand its production by creating another facility, or a
        center for R&D or it may want to take advantage of low cost L in order to produce a particular
        input in which it is intensive, or avoid high trade cost by creating an intermediary location
     Another is Mergers and Acquisition, acquire some capital and then add more to modernize.
        This gives a relatively smoother access to the market if you can already acquire an existing
        producer or product, you acquire networks, consumer loyalty, then you modify the product a
        little bit, modernize production or product and it is a lot easier to do. Also to take existing
        producers out of the market, you eliminate a competitor. One of the key elements in mergers
        and acquisition. Merger between two competitors will reduce the competition in a market, the
        benefitors of this are the firms that are third parties in the market. Benefit from the market
        being tightened up without the additional costs of restructuring (Compaq and HP merged;
        Dell price went up)

How does FDI differ from portfolio investments? When you have the former you are taking over
management of the enterprise, the latter you become an owner which you may some have influence
over, but you don‟t have the same kind of involvement in the management as in the FDI. In some
countries when you have portfolio investment of over 10% you are considered in the FDI because
there is a higher level of control.

What kinds of FDI do we have?
    Horizontal: when a firm sets up production facilities in different country, in the same kind of
        activities as the firm engages in at home (produce cars in US, produce cars in China).
    Vertical: customers or suppliers of the firm, backward FDI where you acquire an input
        provider (VW acquires a firm that produces tires) and forward FDI if you are buying a user
        (VW buys car dealership).
    Conglomerates: involved in many different activities around the globe

What type of FDI will take place depends on industry. If there are a lot of barriers to trade... horizontal
FDI if you are a auto producer in Japan and you find there are barriers to trade (VERs or taxes) you
may find it in your interest to develop production facilities in those markets that have less barriers.
When you have different costs differences across countries there will be a tendency for vertical FDI to
take place high L costs in Germany it is more interesting to have pieces produced in another country,
different locations for production according to cost.

Readings: Brecher-Diaz; Brecher-Choudhri

From Brecher-Choudhri:

2 commodities, one exported and one imported + foreign K, how does this affect the wellbeing of a DC.
PPF inside is before foreign K, outer PPF with the aid of foreign K…

How does foreign capital inflow affect the receiving countries‟ welfare?
Note: It only has a positive effect on welfare if the K inflow (PPF) improves the TOT of the receiving
economy. In any case, what is crucial is analyzing what happens to the TOT.



There is an uneven expansion of the PPF because the FDI goes more to the primary product production
rather than to manufactures. The consequence of this expansion is a fall in the price of the good (lower
price line), therefore an effective reduction in TOT. This country is a major producer of a good, so it
could regulate out put in order to keep the price constant, but let us assume that it does not exercise
this right (restrict production). If the price were to remain constant it would produce at C where the
price is the same as at point A. But the price does not remain constant and therefore it goes to position

The effect on welfare will be determined by how much needs to be paid in rents on the FDI to the
investing parties. Must pay the market rental of MPK… Take a new price ratio A‟‟ and draw a tangent
to the „old‟ PPF to get point A°. A° shows how much of the economy‟s output is being produced by
domestically owned productive factors, it is what they earn.

F-G: share of output give to foreign K owners (H-?)
F-H is the price line corresponding to the new lower price
Once you subtract what you have to pay foreign K owners, there is a smaller capital bundle.
Therefore, foreign K inflow does not do anything in this model which assumes full employment; what
it earns in excess from the FDI inflow will be lost through the depressing price.

Real World: Unemployed resources exist and there are some positive spillover effects which should not
be neglected.


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