In the Washington Consensus trade liberalization is considered as an important policy to spur economic growth. Looking at different trade theories this recommendation is reasonable. However some economists argue that trade liberalization is not necessarily good for growth. They point to shortcomings of the underlying theories or to empirical studies that could not find these beneficial effects.
Therefore this paper will try to answer the question “Is trade liberalization good for economic performance?”. Mostly, economic performance is equalized with economic growth or output. The author is aware of the fact that an increase in GDP is not the only way economic performance could be measured, but due to the limited space the paper will solely focus on this measure, while other things such as sustainability or equality will be neglected. To answer the question the paper will first outline some of the well-known trade theories to give the reader an impression of how free trade could benefit economic performance. Thereafter, exemplarily it will be shown that dropping some of the underlying assumptions can change the predictions entirely. Also with some showcase examples it will be illustrated what happens if one looks at the long term development. Lastly, the paper will look at available empirical research, summarize the results and draw a short conclusion.
1. Introduction
In the Washington Consensus trade liberalization is considered as an important policy to spur economic growth.[1] Looking at different trade theories this recommendation is reasonable. However some economists argue that trade liberalization is not necessarily good for growth. They point to shortcomings of the underlying theories[2] or to empirical studies that could not find these beneficial effects.[3]
Therefore this paper will try to answer the question “Is trade liberalization good for economic performance?”. Mostly, economic performance is equalized with economic growth or output. The author is aware of the fact that an increase in GDP is not the only way economic performance could be measured, but due to the limited space the paper will solely focus on this measure, while other things such as sustainability or equality will be neglected. To answer the question the paper will first outline some of the well-known trade theories to give the reader an impression of how free trade could benefit economic performance. Thereafter, exemplarily it will be shown that dropping some of the underlying assumptions can change the predictions entirely. Also with some showcase examples it will be illustrated what happens if one looks at the long term development. Lastly, the paper will look at available empirical research, summarize the results and draw a short conclusion.
2. Is trade liberalization good for economic performance?
One of the first cases for trade liberalization was made by Adam Smith based upon absolute advantages. His argument was further developed by Ricardo, who stated the law of comparative advantage and showed that even if a country is in an inferior position in the production of all goods it can still participate and gain from trade. Here the disadvantaged nation should specialize in the production of the commodity where its absolute disadvantage is smaller. The other nation should specialize in the commodity where its absolute advantage is biggest. Therefore, again due to the fact that the countries allocate their resources to their most efficient (or least inefficient) sectors the overall output increases and due to trade they can both consume more.[4] The theory was restated later, showing the same result but using opportunity costs, instead of relative costs in terms of labor.[5] While those theories emphasize the differences in technology as cause of trade between countries the Heckscher-Ohlin-Samuelson model emphasizes differences in factor endowments to make their case for free trade. Additionally they show that factor prices will equalize under a free flow of products.[6] However, in all these theoretical models trade and the gains from trade liberalization are explained due to the differences between countries. A more recent attempt to show benefits from trade between similar countries are economies of scale. Here an industry faces a production function where output grows proportionally stronger than input. Again, if one assumes a two countries example, it is reasonable that each country focuses on the production of one good and maximizes the effects of economies of scale and imports the respective other good.[7] In these theoretical explanations, although output is increased, there is no general improvement in the growth rate. It is merely a one time level effect, due to improved efficiency, but not a change in the slope of the growth path.[8] However, if trade liberalization leads to this higher output, as predicted, and has no other detrimental effects it can be seen as good for economic performance and the question could be answered with yes.
Unfortunately, as Robinson puts it, because of the construction and the very strong assumptions underlying these theories some of the problems occurring with the move to free trade are ruled out by definition.[9] Therefore, in the following the paper will show some examples how dropping only few assumptions can counter those predicted output increases. Further, it will be shown how liberalization of trade can affect the growth prospects in the long run.
As an example, underlying the models there is the assumption that labor and capital are both mobile across the different sectors of production. So if a country decides to adapt free trade a reshuffling of resources and prices will occur. Some less efficient industries will have to close down. Luckily, the resources employed in those industries can find employment in the expanding sector where a country has its comparative advantage. Here lays a major shortcoming of the theory, since the capital used in the production of one good is probably not useful for the production of another good. Therefore, the effectively used capital stock will decrease when a country liberalizes its trade. The same argument can be made for workers. During his work a worker acquires firm and sector specific human capital. Even if the worker is able to find employment in another sector immediately, those skills will be worth less.[10] Further, when there is a transition period where workers are not employed, general human capital will be lost, even if they just shift from a less productive to a more productive company in the same sector.[11] Although trade liberalization leads to more efficient allocation of resources, the occurring reshuffling process might lead to a loss of the parts of the production stock, which partly or entirely outweigh the positive effects.
[...]
[1] Cf. Rodrik, D. (2003), p. 10
[2] Cf. Robinson, J. (1973), p. 14
[3] Cf. Ackah, C., Morrissey, O. (2007), p. 1
[4] Cf. Salvatore, D. (2005), pp. 32 - 36
[5] Cf. Salvatore, D. (2005), p. 39
[6] Cf. Krugman, P. (1987), p. 132
[7] Cf. Salvatore, D. (2005), p. 91
[8] Cf. Lucas, R. (1988), p. 12
[9] Cf. Robinson, J. (1973), p. 15
[10] Cf. Hudson, M. (2007), pp. 104ff
[11] Cf. Pavoni, N. (2008), p.1
- Quote paper
- Daniel Detzer (Author), 2010, Is trade liberalization good for economic performance?, Munich, GRIN Verlag, https://www.grin.com/document/153651
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