Relationship between free trade economic growth

relationship between free trade economic growth

and investment policy can achieve that. Free trade is a source of economic growth .. production links between the EU and China mean that in over Countries that are open to international trade tend to grow faster, innovate, through trade and global value chains helps drive economic growth and . that free trade is protected and helps support business opportunities. University of the Free State. Abstract. The relationship between trade and economic growth has continued to dominate the debate in trade and development.

It could be argued perhaps that the above example is not really valid because, when a specialization of production is adopted which initially favors labor-intensive, low labor productivity goods, it would be more difficult or even impossible to achieve high levels of productivity in the future, when the unoccupied labor force is used up. However, there are no cogent reasons why this pattern of specialization would lead to a permanent fall in labor productivity or its rate of growth.

In fact, it can be argued that the opposite is more likely to happen. Indeed, the pattern of specialization favoring labor-intensive commodities brings forth higher levels of productive employment and of consumption during the first stages of the process. Some of this increased consumption may be directed to higher spending on education. As a consequence, it would be easier in the future and not more difficult to adopt modern technologies with high labor productivity, or produce goods which are highly capital-intensive and with high labor productivity.

Finally, a third criticism of the principle of comparative advantage sustains that a specialization in labor-intensive goods could have a negative effect on technological progress.

Benefits of free trade

In general terms, this is another criticism that does not seem to have many points in its favor. It has already been shown that an initial specialization in labor-intensive goods generates higher productive employment and can lead to higher spending on education. Both factors directly stimulate technological progress. Either way, the issues raised by the different possible paces of technological progress are important, and it is the case that setting up the production of some particular commodities may indeed further technological progress Nelson and Winter, ; Dosi, Pavitt and Soette, Without these technology generating industries, the process of technological development can be held back or, alternatively, a country may run the risk of losing the basis for autonomous technological development.

Frequently, the technology generating industries have a long maturing process. It is precisely for this reason that it is necessary to start them in the relatively early stages of industrialization.

Clearly, this last element does not retract from the benefits which can be obtained by using the principle of comparative advantage. However, it does demand certain flexibility in order to avoid becoming a rigid and unworkable rule. That is to say, a developing economy should use its comparative advantage to best advantage. As well as this, it should develop a few 7 industries which will be in a position to generate technological progress, from the start of the industrialization process, and which will have a spread effect on the training of a wider group of industries and workers, even if these industries are capital-intensive.

The well-known conclusion of the model is that countries will export commodities that are intensive in their abundant resources, and import commodities intensive in scarce resources.

An additional conclusion, which is rarely spelled out as clearly as required, is that productive resources will be fully utilized. It is recognized that, when an economy dismantles barriers to trade, obstacles may appear that cause some resources to get idle, but sooner rather than later, these obstacles will be overcome and those resources will then be productively absorbed. We shall first review some empirical research on the results achieved about this theory, separating out the two different hypotheses involved.

Since no evidence exists about resource utilization, we shall consider a different but closely related question, namely, whether or not economic growth is enhanced thanks to trade liberalization.

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The results have been rather inconclusive Helpman, To the best of our knowledge, there is hardly any evidence for this. Our own investigation, however, gives a negative answer for Mexico.

But the results of one single case study cannot, of course, be the basis for a general conclusion on this issue. We shall now review results pertaining to the effect of trade liberalization on gdp growth. For example, Greenaway et al. They used different indicators of liberalization and included, besides a trade opening indicator, initial gdp, initial schooling, the investment ratio, population growth, and terms of trade changes, which were all found to be influential in determining cross country patterns of growth.

They found that the liberalization effect is initially neutral or negativeand then positive, tracing out a J curve. They thus concluded, "liberalization may impact favorably in growth of real gdp per capita. However, the effect would appear to be lagged and relatively modest" p. The Greenaway et al.

relationship between free trade economic growth

Yanikkaya carried out a study for 80 countries over the period, and examined econometrically the relationship between several measures of trade restrictions, along with the commonly used average tariff rates. He found that trade restrictions had a positive and statistically significant effect on economic growth, essentially driven by developing countries. We refer finally to the results of studies specifically devoted to Latin American economies. In this respect, Lora and Barrera carried out an econometric study for 19 countries for the period.

With the rate of growth of output as dependent variable, and a trade reform index devised by Lora10 as well as the inflation tax, volatility of inflation and the degree of scholarship of the work force as control variables, they concluded that the trade reform had a positive effect on the average rate of growth, either directly or indirectly, through its impact on investment or on labor productivity.

However, their inference cannot be taken as conclusive, since their study did not control for other factors that may have an effect on economic growth. In fact, using also the Lora trade reform index, but with a much wider set of control variables and exploring alternative specifications, Escaith and Morley carried out econometric research for 17 Latin American countries for the period to assess the effects of reforms on growth.

Comparative advantage, economic growth and free trade

With regard to trade, they concluded, "trade liberalization and opening to imports tend to negatively affect the rate of growth, controlling for other factors.

On the whole, the present review leads to the conclusion that the main propositions of the Heckscher-Ohlin model may or may not be complied with in reality, and that the latter is a more likely scenario for developing economies.

We will argue below that this is probably because many of the theory's assumptions are generally invalid, particularly in developing countries. To argue our hypothesis, we will consider the reasoning behind the Heckscher-Ohlin model.

Our aim is to show that, when some of its underlying assumptions are subject to small changes, the conclusion that a Pareto optimum will be attained, and more specifically the assumption that resources will be fully utilized, are no longer valid. Furthermore, countries will not necessarily trade according to their comparative advantage.

It may be worth pointing out that neoclassical authors have recognized that the conclusion of the model is not immune to changes in the assumptions, so much so that a very interesting analytical apparatus was developed under the concept of domestic distortions, where the consequences of removing some assumptions are studied.

The following observations, therefore, are not so much meant to criticize the internal coherence of the neoclassical theory of international trade, as to discuss the consequences of removing some assumptions that are seldom given the importance they deserve.

This neglect is particularly important in cases where policy proposals to open up an economy are put forward. To start with, we assume the existence of an economy that was previously closed, and which is opened up to imports, thanks to the complete elimination of tariffs and other trade barriers.

In this situation, the price of commodities in the domestic market will be the same as in international markets. The opening up of the economy will have generally provoked the lowering of the ruling price for each and every commodity, since domestically produced commodities have to compete with imports. However, thanks to the opening up, the price and private profitability for each and every commodity will become the same as their social price and profitability.

Moreover, in branches with comparative advantage, prices will fall less than costs, which results in an increase in profitability. The reverse goes for commodities where the country does not enjoy comparative advantage. If resources were mobile, domestic production in branches where price and profitability had fallen would shrink. This would result in the release of production factors.

The latter, however, would be readily demanded in production branches with comparative advantage, where prices that lie even slightly below international prices serve to ensure plentiful demand. Accordingly, imports would drop and additional exports would be generated. The economy would move along its production possibility frontier, no resources would be left idle, and there would be benefits in terms of greater efficiency of the economy.

As can be seen, the equalization of private and social prices and profitability is fundamental in the neoclassical theory of international trade and in neoclassical economic theory in general. But this is a very general statement, and it seems useful to discuss in more detail what this would exactly amount to. In order to gain insight into the necessary conditions, we will concentrate on only two of them, namely, high elasticity of demand, and high elasticity of supply.

In fact, the theory of economic equilibrium usually does not take into account, or alternatively, takes for granted, certain elements of both demand and supply. We are going to present two examples that show that this approach may give rise to misleading conclusions. Suppose first that the economy's opening up to imports brings about a reduction in the price of some commodities, which results in a reduction in output.

In order to achieve a certain degree of realism, we will further suppose that production factors are immobile, but that their income is flexible downwards. Apparently, for the conclusion of the theory, this would not pose a major problem. Indeed, it may so occur that the fall in factor incomes that follows the fall in production as induced by the opening up to imports brings about a fall in domestic demand.

Unless external demand increases sufficiently enough to compensate for that fall, the decline in domestic demand will be accompanied by a reduction of total demand. On the other hand, assume that demand is infinitely price elastic, but that supply is not very elastic.

The latter could be the consequence of many factors, for instance, rigidities, asymmetric information, etc. For example, assume that the potential improvement in competitiveness and profits of some industries as brought about by trade liberalization is known to the producers, but not to the banks.

In that case, firms in sectors with comparative advantage will not be able to obtain the necessary finance, and production cannot increase Stiglitz and Weiss, Accordingly, resources will be released in branches without comparative advantage, but will not be demanded in branches with potential comparative advantage; some resources will remain unused, and the potential comparative advantage will not materialize, since supply will be unable to respond to the potential increase in profits.

The two previously considered situations lead to the conclusion that price elasticity of both supply and demand must be very high to guarantee that trade liberalization preserves a full utilization of resources. When these conditions are absent, an economy that opens up to foreign trade will face obstacles to move along its production possibility frontier.

It may be the case that production falls below the production possibility frontier, that resources will not be fully utilized, and that the Pareto optimum will not be attained. In particular, suppose that elasticity of demand is high, so that total demand expands due to liberalization, but elasticity of supply is low. Then liberalization will bring about a mismatch between supply and demand, and a trade deficit will appear.

If the latter is persistent, this would require, or even force, sooner rather than later, a contraction of domestic demand and output. Now, this possibility, which cannot be excluded a priori, is hidden from view in the neoclassical story because of its underlying assumptions.

Supporters of trade liberalization sometimes accept that it may bring about a decline in output, due to some less efficient domestic firms being unable to withstand foreign competition, or due to low short-run elasticity of foreign demand, but they apparently believe that the fall will be short-lived.

Expansion of efficient industries and of foreign demand, so the argument goes, will sooner rather than later drag with it domestic and aggregate demand, and employ the resources released from less efficient firms, even as it lifts the external constraint. However, this needs not be the case. In fact, if output declines, in the short-run, profits will also be reduced, and the degree of utilization of the productive capacity will fall off.

Thus firms will not be stimulated to enlarge their productive capacity with new investments, and no recovery, least of all a strong one, will necessarily take place. Insufficient price elasticity of demand and supply may also contribute to an understanding of the reason why countries that drastically reduce tariffs and eliminate nontariff restrictions to trade do not necessarily specialize according to comparative advantage.

It may be so that demand and supply elasticity are higher for capital-intensive than labor-intensive commodities. But this last problem, namely, that resources are not used in their most efficient way is, at least from the present writer's perspective, of rather secondary importance when compared to the cost and waste entailed when resources are left idle.

Of course this should be done in a flexible and not a rigid way, taking into account the technological spread effects of different industries. Specialization according to comparative advantage would allow a country to reduce its average capital-output ratio, which will open up the possibility of a higher rate of growth of output for any given rate of investment.

Alternatively, specialization in labor-intensive commodities will require a smaller share of investment, and will result in a higher rate of growth of consumption for a given rate of growth of output. In both cases, increased employment and consumption in the short term are favored, without medium and long term employment and consumption being jeopardized. It is true that, in order to achieve these favorable effects, employment growth would have to be higher.

But this is not an important cost for a developing economy having a large surplus of unemployed labor. It should be noted that the countries which have grown faster during the postwar period have specialized in accord with their comparative advantage.

This is particularly the case of Southeast Asian countries and Japan. This strategy is well reflected in the structure of their foreign trade. To quote one among many studies available, Fujii and Levy conclude the following about the experience of Korea: The evolution of the export structure of Korean manufactured goods shows that On the other hand, we have seen that the policy proposal to drastically liberalize trade goes further than the theory of comparative advantage, as it implicitly assumes that, in a freely competitive economy unfettered by government interference, market signals and forces will, on the one hand, ensure full utilization of resources, and on the other, direct production and investment in accordance with its comparative advantage.

However, empirical studies on developing economies do not appear to support this conclusion. Our own review of the logic of the Heckscher-Ohlin model suggests that, in an economy ruled by free competition and without governmental interference, market signals and forces are not by themselves sufficient to provide the necessary incentives to producers so that they fully use the available resources, and produce and trade according to comparative advantage.

Developing countries cannot rely exclusively on market forces, and a change in the pattern of specialization to accelerate demand for labor, thus absorbing unemployment, requires State intervention.

Paradoxically, this last statement is much less heterodox than it appears at first sight. Indeed, the analysis of the so-called "internal distortions" drew exactly this conclusion a long time ago, adding that government intervention, through taxes and subsidies, should happen precisely at the point where internal distortions present themselves the neoclassical theory of "optimum intervention".

relationship between free trade economic growth

It is indeed a pity that this very interesting branch of the neoclassical theory of international trade seems to have been forgotten today. Note, however, that an economy may free from barriers its international trade, and still be characterized by strong State intervention. For an interesting historical illustration on this issue, see especially Senghaas In 4Ki and Yi represent the value of capital goods and the value of the product, respectively.

We are simplifying the analysis because, as already stated, average labor productivity is a weighted average, where the weights are the shares from each "generation" in relation to total labor.

relationship between free trade economic growth

Some of these criticisms can be found in Rosand in Prasch Spending on education is considered in national accounting as consumption spending. We do the same here. The capacity to establish technologically advanced industries in developing economies is limited because of the relative scarcity of professional and technically skilled labor Westphal, and It can be safely assumed that growth will not be enhanced unless resources are more fully utilized.

A part of the research has been theoretical, devoted to widen and refine the model, mostly by extending the number of factors and type of goods considered. Lower tariffs on UK exports will enable a higher quantity of exports boosting UK jobs and economic growth.

Economies of scale If countries can specialise in certain goods they can benefit from economies of scale and lower average costs; this is especially true in industries with high fixed costs or that require high levels of investment. The benefits of economies of scale will ultimately lead to lower prices for consumers and greater efficiency for exporting firms.

relationship between free trade economic growth

Increased competition With more trade, domestic firms will face more competition from abroad. Therefore, there will be more incentives to cut costs and increase efficiency.

It may prevent domestic monopolies from charging too high prices.

Benefits of free trade | Economics Help

Trade is an engine of growth. Make use of surplus raw materials Middle Eastern countries such as Qatar are very rich in reserves of oil, but without trade, there would be not much benefit in having so much oil. Japan, on the other hand, has very few raw materials; without trade, it would have low GDP. Tariffs may encourage inefficiency If an economy protects its domestic industry by increasing tariffs industries may not have any incentives to cut costs.

He made the argument there is no point in protecting the Scottish wine industry if it would cost 30 times the price of importing wine from warmer countries. Smith also argued that if our competitors become better off, they will be able to buy more of our exports.