FACULTY OF ECONOMICS, UNIVERSITY OF PORTO 1EC305: INTERNATIONAL TRADE

Chapter 2 - International trade theory 2.3. Growth and trade

Sources of long-run economic growth

Increases in countries endowments of production factors (e.g., physical capital, labor, and land); Improvements in production technologies (and other intangible influences on resource productivity).

Trade and Growth

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Economic growth is shown graphically as an outward shift of the countrys production possibility frontier (PPF). Since growth affects both production and consumption, then it also affects international trade.

Balanced (neutral) growth

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A proportionate increase in all resources and consumption so that trade also expands proportionately to the growth of the economy

PPF shifts out proportionately so that its relative shape is the same.

After growth, the economy continues to produce and consume the two goods in the same ratios as before growth (Figure A).
Pugel, 2012, p.123

Biased growth
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Biased growth arises:

when the countrys endowments of different factors grow at different rates or when the improvements in production technologies are larger in one of the industries than in the other.

Two types of biased growth:

Anti-trade biased growth Pro-trade biased growth

Anti-trade Biased Growth

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When growth occurs as a result of an increase in the resource used intensively in the production of import goods

the output of import goods will rise relative to the output of export goods, and the international trade of this country will fall (Figure B).

Pugel, 2012, p.123

Pro-trade Biased Growth

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When growth occurs as a result of an increase in the resource used intensively in the production of export goods

the output of export goods will rise relative to the output of the import goods, and international trade will expand by more than the rate of growth (Figure C).

Pugel, 2012, p.123

Growth in only one factor: the Rybczinski theorem

In a two-good world, and assuming that product prices are constant, growth in the countrys endowment of only one factor of production leads:
To

an increase in the output of the good that uses the growing factor intensively; To a decrease in the output of the other good.

Growth in only one factor: the Rybczinski theorem

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QY 2 Q 2Y shape= PX / PY

Exemple: Increase in capital endowment (Y relatively intensive in capital).

shape = PX / PY Q 1Y 1

PPF 1 PPF 2 Q
2X Q 1X

QX

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Changes in the countrys willingness to trade

As production and consumption change with growth, a countrys willingness to engage in international trade can change (increase or decrease)
This

occurs even if the relative price between two products stays constant

We can examine changes in the countrys willingness to trade in the three cases of figures A, B and C.

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Effects on the countrys terms of trade

If the country is small, its trade has no impact on the international price ratio (the countrys terms of trade)

Figures A, B and C represent the full analysis of growth by the small country

In each of the cases the country gains in the sense that it reaches a higher community indifference curve.

If the country is large enough for its trade to have an impact on the international equilibrium:

changes in the countrys willingness to trade can alter the countrys terms of trade, affecting the extent to which the country benefits from its growth.

Economic Growth and Terms of Trade for a Large Country

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If growth reduces the countrys willingness to trade at any given price (Anti-trade biased growth)

The reduction in the countrys demand for imports reduces the relative price of the import good improvement in the countrys terms of trade (shown in a flatter price line in the Figure).

Pugel, 2012, p.129

Economic Growth and Terms of Trade for a Large Country

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In this case, country gets two benefits from growth:

The

production benefits from growth as PPF shifts

out; The benefit from improved terms of trade as it receives a better price for its exports relative to the price that it has to pay for its imports.
The

improvement in the terms of trade allows the country to reach the higher level of well-being associated with the community indifference curve through C6.

Economic Growth and Terms of Trade for a Large Country

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If growth increases the countrys willingness to trade at any given price (Pro-trade biased growth)

The increase in the countrys demand for imports increases the relative price of the import good deterioration in the countrys terms of trade. The production benefits from growth as PPF shifts out; The country is hurt by the subsequent decline in the terms of trade as it receives a lower price for its exports relative to the price that it has to pay for its imports.

In this case, the overall effect on the countrys well being is not clear:

If the terms of trade do not decline too much the country gains overall from the growth; If the terms of trade decline substantially the countrys well-being could fall immiserizing growth (Bhagwati, 1958).

Immiserizing Growth
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Immiserizing Growth: growth that results in a reduction of the countrys welfare level.

By expanding its ability to produce wheat (the export good), the large country increases its supply of exports, driving down the relative price of wheat in world markets (increasing the relative price that it must pay for its imports).
Pugel, 2012, p.130

The decline in the countrys terms of trade is so bad that it outweighs the benefits of the extra ability to produce.

Is Immiserizing Growth Common?

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No, because three conditions must hold:

The countrys growth must be strongly biased toward expanding the countrys supply of exports, and the expand in exports supply must be large enough to cause a noticeable deterioration in its terms of trade. The foreign demand for the countrys exports must be price inelastic, so that an expansion in the countrys export supply leads to a large drop in the international price of the export product (terms of trade will deteriorate substantially). Before growth, the country must be heavily dependent on trade, so that a substantial declining in its terms of trade will lead to a reduction in national welfare great enough to offset the gains from being able to produce more.