Department of Economics Queen s University ECON 239: Development Economics Assignment # 3 Due Date: Wednesday, November 26, :30 am (in class)

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1 Department of Economics Queen s University ECON 239: Development Economics Assignment # 3 Due Date: Wednesday, November 26, :30 am (in class) Section A (50 percent): Discuss the validity of the following statements. In your answer define or explain as precisely as possible any terms or concepts which are underlined, with particular reference to the context in which they are being used. The text for each answer should be as concise as possible, but you should include diagrams or examples where appropriate. All questions have equal value. UNSUPPORTED ANSWERS WILL RECEIVE NO MARKS. A1. While import substitution policies may create welfare reducing distortions to trade in the short term, they are justified because they generate growth in the long term. The idea behind IS policies (at least in principle) is to impose tariffs (or other trade barriers) on foreign imports to allow domestic producers to expand their production. Assuming a small open economy and competitive markets, in the short term the overall impact of such a policy is illustrated in Figure 1. The tariff raises the domestic price from P to P t causing domestic supply to rise and domestic demand to fall, so that imports are squeezed out. Overall welfare is reduced because the resulting increase in domestic prices lower consumer surplus by an amount represented by the area P t DBP, which exceeds the combined gain in producer surplus, P t CAP and tariff revenue CDEF. However, in the long term it is possible that there are dynamic gains from expanding domestic production (due to economies of scale or learning by doing effects), which more that offset these short term losses. If firms make the investments necessary to achieve these gains and become competitive with foreign producers, then eventually the tariff barrier can be lifted. One problem with this argument is that once the tariffs are in place it becomes very costly (economically and politically) to remove them if producers efficiency does not improve. Knowing this, firms may have little incentives to make the necessary improvements. Thus, the potential gains depend very much on the credibility of the government s plans to eventually remove the tariff barrier. Another problem with the IS strategy, if it is applied on a broad scale, is that it can lead to an overvalued domestic currency by reducing the demand for foreign imports, the supply of domestic currency on world currency markets is reduced, thereby increasing its price. This can have negative affects on the country s exporting industries because now these goods 1

2 Price Domestic Supply P t C D P* A B Domestic Demand Imports Quantity Figure Figure 1: Static 3: Welfare welfare impact Impact of aoftariff a Tariff more that offset these short term losses. If firms make the investments necessary to achieve these gains and become competitive with foreign producers, then eventually the tariff barrier can be lifted. One problem with this argument is that once the tariffs are in place it becomes very costly (economically and politically) to remove them if producers efficiency does not improve. Knowing this, firms may have little incentives to make the necessary improvements. Thus, the potential gains depend very much on the credibility of the government s plans to eventually remove the tariff barrier. Another problem with the IS strategy, if it is applied on a broad scale, is that it can lead to an overvalued domestic currency by reducing the demand for foreign imports, the supply of domestic currency on world currency markets is reduced, thereby increasing its price. This can have negative affects on the country s exporting indstries because now these goods become more expensive from the perspective of foreign consumers and the demand for them will tend to decline. become more expensive from the perspective of foreign consumers and the demand for them will tend to decline. A2. Learning by doing effects should influence how developing countries conduct trade policy. Despite the benefits that free trade brings in theory to all countries, several countries intervene in their foreign trade and guide it in directions that are more beneficial to those countries in the long run. This translates into trade policy through means such as import substitution or export promotion. Learning by doing (LBD) provides one justification for conduct of trade policy. Section B (60 percent): Answer the following Long Questions. LBD refers to the learning and assimilation of new technologies during the process of production B1. Consider the following simple rural labour market which lasts for two periods. Suppose workers have a reservation wage of $10, but that the minimum wage needed to maintain their nutritional status is $14. In period 1, the value to employers of their work effort is $20. However, if the are paid less than $14 then their nutritional status will deteriorate, and in period 2 their productivity will fall to $14. Suppose there are two employers in the labour market (A and B) and that there is random matching of workers with employers. This means that in period 2 they will hire one of the workers that they hire in period 1 with probability 1/2. In period 1, the employers choose whether to pay the low wage of $10 (which is just enough to hire the worker), or the high wage of $14 which will maintain their nutritional status. Assume that in period 2, both employers pay $10. 4 on a big scale. This can happen through employees learning in the use of the new technologies and methods used in the specific production process, or through a general improvement in learning and innovations producing efficiencies in production. See pages of Ray s textbook and the figure on page 670 which demonstrates how when LBD result in cost improvements (downward shifting in supply curve) over the long run that may justify a policy of import substitution. Thus even though such a policy may be inefficient in the short run, it may turn the industry internationally competitive through LBD effects. A3. South Korea s export driven growth during the postwar period is an excellent example of the benefits of opening an economy s borders to unfettered global market forces. FALSE Although South Korea did open up to international trade, its exporters did not face unfettered global market forces. In fact, South Korea s industrial and export policy involved 2

3 substantial protectionism, ranging from erecting tariff barriers to protect its infant industries in the early 1960s, to significant subsidization (directly or indirectly) of its exporters. As we have seen, these policies are likely to have negative welfare affects in the short run (especially since South Korea was not a large economy). However, these policies acted to protect domestic firms from lower cost foreign competitors, allowing them to take advantage of learning by doing possibilities and overcome capital market imperfections. Moreover, foreign direct investment was limited. Unlike many other developing countries, many of South Korea s industries did eventually become more competitive than their counterparts in Europe and North America, so that the government has been able to scale back these protectionist policies more recently. A4. Take the car textiles example studied in class and Ray Chapter 16. Recall that each of these goods is produced by capital and labour, but cars use capital more intensively. Now an increase in the relative price of cars will cause more resources to go into car production. Show that this flow of resources will cause the ratio of capital to wage income to rise. As more resources go into car production the more capital intensive industry and out of textiles, the demand for capital must rise relative to the demand for labour. Consequently, the price of capital, r will tend to rise, while the price of labour, w, will tend to fall. This adjustment is illustrated by the movement from A to B in the Edgeworth box in Figure 2. The slope of the isoquants at the point where they are tangent becomes shallower in going from A to B, so that the equilibrium relative factor prices w r decreases. In other words, the rate of r to w rises. Note that as the relative price of capital income rises, both industries will optimally become less capital intensive. The offsets the fact that resources have flowed into the relatively more capital intensive industry. Section B (50 percent): Answer the following Long Questions. B1. (25 percent) Freedonia is a hypothetical LDC that produces two goods rubber and microchips using two factors of production land and labour. Rubber production uses land relatively more intensively, so that microchip production uses labour relatively more intensively. Freedonia is a small open economy that trades freely in international markets, and faces world prices for rubber given by P R and for microchips given by P M. 3

4 O T B Capital A O C Labour Figure 2: Figure Car 3: textiles B2(a) example Because the car industry is more capital intensive than textiles, it will experience a bigger increase in its average costs of production as the relative cost of capital rise. Thus, it will be more adversely affected by the change in part (a). (c) Now combine the observations in parts (a) and (b) to show that textile production will still be proþtable, though the total production of textiles will decline. Supplement your understanding by drawing production possibility frontiers, relative price lines, and the corresponding production points. The rise in relative costs that occurs as resources shift from textiles to cars will eventually offset the increase in the relative price of cars. In a competitive equilibrium both industries make zero proþts, the rise in the relative average cost continues until it exactly offsets the price advantage of the car industry. This is why complete specialization does not take place and explains the bowed out shape of the production possibilities frontier: as the relative price of cars increases and resources ßow into the car industry, the relative unit cost of cars rises. Figure 3: Freedonia before the Price Change (a) For simplicity, suppose that a good is fully imported, so that there are no domestic (a) On ab3. diagram (20 percent) showing Here isthe economy s large countryproduction argument forpossibilities an optimal tariff. frontier and indifference curves, illustrate a situation where the world relative prices of rubber and producers of it. On a diagram, draw the domestic demand curve and the foreign microchips are such that Freedonia exports rubber and imports microchips. supply curve of the good to this country and show the free trade equilibrium. Mark See Figure 3. 6 (b) Suppose that, for some reason, the demand for rubber in the world economy declines relative to microchips, so that P R /P M declines. Illustrate on a diagram like the one in part (a) how this is likely to affect the consumption and production of the two goods in Freedonia, and hence the exports/imports of each. See Figure 4. 4

5 Figure 4: Freedonia after the Price Change The production point shifts from P 1 to P 2, so that Freedonia produces less rubber and more microchips than before. The consumption point shifts from C 1 to C 2 so that, as drawn, Freedonia consumes less of both goods. Clearly, society is worse off as a result of the price change because Freedonia is a net exporter of Rubber. As drawn, both rubber exports and microchips imports have decreased. However, in general the impact on imports and exports is ambiguous and depends on society s preferences. In particular, the price changes have both income and substitution effects. (c) Explain the distributional consequences of the deterioration in the terms of trade described in (b) for landowners and workers. A rubber production contracts, land and labour becomes available for use in microchip production. However, if the relative prices of land and labour remained unchanged, the ratio of this land to labour would be higher than is optimal for microchip production (since microchips production is more labour intensive than rubber production). As a result, an expansion of microchip production would leave some land unused. This excess supply of land causes the price of land to fall relative to labour, which induces both sectors to become more land intensive. This process continues until a new efficient production point is achieved. In the process, land is made worse off and labour is made better off. (d) Given your answers to (b) and (c), and assuming the government of Freedonia is only concerned with static welfare effects, how would you expect its trade policy to be influenced by political power of (1) landlords and (2) labour unions? 5

6 If landlords have significant political influence, they might be able to get the government to protect the rubber industry in the face of the fall in rubber prices. For example, the government could follow an export promotion policy by subsidizing exports of rubber so as to make rubber production more profitable again. If labour unions have more political power, they might be able to get the government to follow an import substitution policy which protects the microchip sector and raise wages even further. (e) Suppose instead the government recognizes that the terms of trade deterioration is likely to continue in the future and is concerned with dynamic welfare effects. How would you expect this perspective to influence its trade policy? If the relative price of rubber is anticipated to decline in the long term, it makes sense for the country to move away from exporting rubber and towards exporting microchips. If credit markets are imperfect and the are significant externalities involved, it is likely that the private sector won t achieve this switch on its own. Such concerns might motivate a trade policy which favours microchip production over rubber production. If Freedonia has a large internal market (like Brazil), it may make sense for its to follow and import substitution policy, which protects its microchip industry, allowing it to achieve full economies of scale, and learn by doing. If instead, the internal market is small (like South Korea), a policy of subsidizing exports of microchips and thereby switching the country s trade flows may be relatively more efficient. B2. (25 percent) (a) Since institutions in the developed world have clearly delivered in producing high growth, should developing countries simply model their institutions after those of the developed countries? See class notes and readings on Second-best institutions, especially Rodrik s paper. Argue why first-best institutions may not deliver in the developing countries. (b) Despite the existence of democracy in many developing countries, why does political corruption occur there? See class notes and readings on political corruption, especially the relevant parts of Keefer and Khemani s paper, and Pande s paper on political corruption in low-income countries. The reasons were also discussed in detail in class. (c) Reforms in the education sector demand innovative approaches that need to be evaluated carefully. Comment in the light of the readings for the last two lectures. See readings from the last two lectures - the ones on why randomized experiments produce a clean evaluation, and the last lecture on innovative experiments in education sector and the 6

7 implications of these. Rather than focusing on the specifics of the experiments themselves, show what lessons are indicated by economic theory, the experience of past interventions like Progressa, and the recent evidence from randomized experiments. 7