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A Case for Trade Liberalization in Developing Countries

Essay by review  •  December 23, 2010  •  Research Paper  •  3,893 Words (16 Pages)  •  2,798 Views

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Introduction

"Economies that sign free trade agreements tend to see an increase in their overall growth rates of about 0.6 percent annually during the first five years after implementation - gross domestic product is about 3 percent higher at the end of five years as a result of an agreement" (DR-CAFTA).

Trade liberalization is becoming more prevalent around the globe. Many argue its shortcomings and benefits for all parties involved, but none can argue the theoretical and empirical evidence arguing for free trade between specializing nations. Although no model perfectly represents what truly happens in the real world, it can begin to show the direction in which a nation needs to follow to benefit from free trade. Developed countries are practically guaranteed to benefit from free trade, but it is also true the developing countries benefit. With financial help in the form of investment and the formation of regulations and policies, developing countries can benefit just as much from trade as already developed countries.

Economic Models for Trade:

Ricardian Model

To fully understand free trade, it is important to understand the modern economic models that attempt to explain it and show its significance. The most basic model for trade is the Ricardian Model, developed by David Ricardo. By using the idea of comparative advantage, the Ricardian model begins to shape the theory that trade between nations is in fact desirable. This model starts with a straight line representing the production possibilities for two goods within a nation. The straight line covers the assumptions that consumers have no preference between imported and domestic goods, and that there is perfect competition between these two countries and each country has a fixed amount of resources to work with (Yarbrough 28).

Within these assumptions, including the assumption that technology remains constant between the two countries, the model demonstrates that each country would benefit from trade. The country that uses comparatively less labor and capital to produce a good than the second country would export that good to the second country. By freeing up the labor and capital within the second country from importing the good, it can now all be used to produce more of the second good to export to the first country (see Figure 1). This creates specialization, and a surplus of capital and labor that can now be used for economic growth. Since each country now has two options of getting the goods they need, which are producing domestically or trading internationally, they will choose the option that is most beneficial to them according to the opportunity cost. Both countries will gain from trading (Yarbrough 38-41).

Figure 1

Neoclassical Model

Over time, nations have learned to specialize in what they are best at producing, whether it is a labor intensive or capital intensive good or service. This model is a good starting point in understanding the importance and efficiency of trade between nations, but it is a simplified model that takes many assumptions along with it. One problem stems from the fact that nations in reality do not specialize entirely in the one good that is most efficient for them to produce. The Neoclassical, or increasing-cost, model accounts for this by comparing relative prices instead of just a unit of opportunity cost, like the Ricardian Model (Yarbrough 76). This causes the production possibilities frontier to be curved instead of just a straight line. In creating the curved line, as the country moves along the frontier, they are giving up more and more of one good to produce the second good, and eventually it is not worth the loss of so many of one good to gain another unit of the first good. Therefore, they do not produce all of one good, but it still proves beneficial to specialize in that one good (Yarbrough 76).

Heckscher-Ohlin Theorem

Going a step further, the Heckscher-Ohlin Theorem states that a production possibilities frontier must also demonstrate a "production bias" for that particular nation. Countries that are capital abundant are better suited to produce capital intensive goods such as the automobile industry, and also countries that are labor abundant are better suited to produce labor intensive goods such as textiles.

By trading with one another, there will then be less demand for the relatively scarce resource in the country. If the country is labor abundant, they have comparatively less capital. So before trade the owners of capital make a significantly higher profit due to demand of capital, but when the markets open prices of capital intensive goods suddenly go down because the other country is capital abundant and is able to charge less for the same good (Yarbrough 81). Even though they are not literally transferring the capital to the capital scarce country, they are inadvertently doing so because they are selling the capital intensive goods in that country at much lower prices. The owners of capital in the first country now lose profit and according to the model, eventually incomes within the country will converge.

In this more realistic view of trade, there appear to be "winners" and "losers" within the economy due to the income convergence. The key is that the country as a whole is benefiting, which is better for everyone. Also, prices have to be lower for the capital intensive goods within the country, so even though the capital owners within the country are theoretically making less profit, they are saving money on the goods that are now being imported. The country can also put regulations and policies in place which can make up for some of the loss.

Leontif Paradox

Upon further investigation of the Heckscher-Ohlin Model, Leontif discovered through research that it did not accurately represent the trends occurring in the real world. This research is known as the Leontif Paradox. In his study during the 1940's he found that the United States, even though they are comparatively capital abundant, had exports that were 30% more labor intensive than the import substitutes (Yarbrough 144). This could possibly be explained by the taste bias, where different countries have different demands for products, or it could possibly be explained by the home bias, where countries are prone to buying domestic products as opposed to imported products (Yarbrough 145). While these may provide some insight as to the difference in real life and theory, a more likely difference stems from the difference in

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