Development Economics - II

RIFT VALLEY UNIVERSITY NEKEMTE CAMPUS-DEPARTMENT OF
ECONOMICS A.Y 2020/2012

CHAPTER ONE
1. POPULATION GROWTH AND ECONOMIC DEVELOPMENT
1.1. Introduction:
This chapter focuses on population growth and its overall impact on development. Being in
21st century, whether large number of population has advantage or disadvantage is still open
for argument.
The various tools measuring population growth like birth rate and death rate are used to
show the two directional relationships between the population growth and economic growth,
one being the cause and result of the other.
Development entails the improvement in people’s levels of living—their incomes, health,
education, and general well-being—and it also encompass their capabilities, self-esteem,
respect, dignity, and freedom to choose.
Finally the negative impact of population is given focus as it is a handicap for development
especially in developing countries where human development schemes are minimally present.
Basic concepts related to population growth

1) Age specific fertility rate:-the average number of children born for each specific age group
2) Total fertility rate: - is the average number of children to be born to a woman if she were to
live to the end of her child bearing years and assuming that the current age specific birth rates
remain constant throughout her child bearing years. For least developed countries it is 7 – 8
children per capita and for developed countries it is 2 or less.
3) Birth rate: -is the number of children born alive each year per 1000 people affected by
aggregate fertility rate and age distribution of the population.
 Birth rate is determined by age distribution in the short run.
 If the population is very young (reproductive age) then there will be high birth rate. This
is the case in LDCs.
 In countries with younger age population the birth rate can significantly be higher even
if total fertility rate is low.
 Total fertility rate is the only factor that determines the overall birth rate in the long run.
 Doubling time a period that a given population or other quantity takes to increase by its
present size. It is very short for LDCs compared to DCs.
4) Death rate: -is the number of deaths each year per 1000 population. It is also affected by
age distribution, it is high in developed countries and low in least developed countries; this
International Economics –II Lecture Notes –For 2nd Year Page 1

is because there is high old age in developed countries. Death rate can be very low in
younger population.
Population growth = birth rate – death rate
5) LDCs have higher population growth i.e. birth rate is greater than death rate, high
population growth leads to a younger population. This in turn leads to higher birth rate and
lower death rate this further creates “echo effect” that keeps population growth high.
6) Age distribution: - is the list of proportion of a population in different age category.
 The age distribution of least developed countries is significantly greater in < 15 age group
than that of developed countries as population pyramid speaks. This explains high children
and over all dependency ratio in LDCs.
 Dependency ratio = is the ratio of dependent group or non working age (<15+> 64) to
independent group or working age (15-64).
1.3. Trends of Population Growth and Age Structure
1.3.1. World Population Growth throughout History
According to the recent press reports the world population approaches to nine billion by
showing an increasing rate over different periods.
 When people first started to cultivate food through agriculture some 12,000 years ago, the
estimated world population was not more than 5 million.
 Two thousand years ago, world population had grown to nearly 250 million, less than one fifth of
the population of China today.
 During the period from year 1750–1950, an additional 1.7 billion people were added to the
planet’s numbers.
 But in just four decades then after (1950–1990), the earth’s human population more than doubled
again, bringing the total figure to around 5.3 billion.
 The world entered the twenty first century with over 6 billion people.
 Finally, it provides projections to 2050, when world population is expected to reach 9.2 billion.
Turning from absolute numbers to percentage growth rates, for almost the whole of human
existence on earth until approximately 300 years ago, population grew at an annual rate not
much greater than zero (0.002%, or 20 per million).
Naturally, this overall rate was not steady; there were many ups and downs as a result of
natural catastrophes and variations in growth rates among regions.
 By 1750, the population growth rate had accelerated to 0.3% per year.
 By the 1950s, the rate had again accelerated, tripling to about 1.0% per year.
 It continued to accelerate until around 1970, when it peaked at 2.35%.

 Today the world’s population growth rate remains at a historically high rate of about
1.1% per year, but the rate of increase is slowisng. However, the population growth
rate in Africa is still an extremely high 2.3% per year.
Before 1650, it took nearly 36,000 years, or about 1,400 generations, for the world population
to double. Today it would take about 58 years, or two generations, for world population to
double at current growth rates.
The reason for the sudden change in overall population trends is that for almost all of
recorded history, the rate of population change, whether up or down, had been strongly
influenced by the combined effects of famine, disease, malnutrition, plague, and war—
conditions that resulted in high and fluctuating death rates. But currently in the twentieth
century, such conditions came increasingly under technological and economic control. As a
result, human mortality (the death rate) is now lower than at any other point in human
existence because of rapid technological advances in modern medicine and the spread of
modern sanitation measures throughout the world.
In short, population growth today is primarily the result of a rapid transition from a long
historical era characterized by high birth and death rates to one in which death rates have
fallen sharply but birth rates have fallen more slowly, especially in developing countries.
1.3.2. Structure of the World’s Population
The world’s population is very unevenly distributed by geographic region, by fertility and
mortality levels, and by age structures.
Geographic Region: More than three-quarters of the world’s people live in developing
countries; less than one person in four lives in an economically developed nation.
Fertility and Mortality Trends: The rate of population increase is quantitatively measured as
the percentage yearly net relative increase (or decrease, in which case it is negative) in
population size due to natural increase and net international migration. Natural increase
simply measures the excess of births over deaths or, in more technical terms, the difference
between fertility and mortality.
Population increases in developing countries therefore depend almost entirely on the
difference between their crude birth rates (or simply birth rates) and death rates.
Rapid population growth began in Europe and other now developed countries. But in recent
decades, most population growth has been centered in the developing world.

 Compared with the developed countries, which often have birth rates near or even
below replacement (zero population growth) levels, the low-income developing
countries have very high birth rates.
From 1990 to 2008, population in the low-income countries grew at 2.2% per year, compared
to 1.3% in the middle-income countries and the high-income countries grew at 0.7% per year.
Middle-income developing countries show greater variance, with some having achieved
lower birth rates closer to those prevailing in rich countries.
 In sub-Saharan Africa, the annual birth rate is 39 per 1,000—four times the rate in
high-income countries.
 Intermediate but still relatively high birth rates are found in South Asia (24), the
Middle East and North Africa (24), and Latin America and the Caribbean (19).
 East Asia and the Pacific have a moderate birth rate of 14 per 1,000, partly the result
of birth control policies in China.
By contrast, the proportion of people over the age of 65 is much greater in the developed
nations. Both older people and children are often referred to as an economically dependent
group in the sense that they must be supported financially by the country’s working age
(usually defined as citizens between the ages of 15 and 64).
 In low-income countries, there are 66 children under 15 for each 100 working-age
while in middle-income countries, there are 41 and in high-income countries just 26.
 In contrast, low-income countries have just 6 people over 65 per 100 working-age
adults, compared with 10 in middle-income countries and 23 in high-income
countries.
 Thus the total dependency ratio is 72 per 100 in low-income countries, 51 in the
middle income countries and 49 per 100 in high income countries.
Age Structure and Dependency Burdens: Population is relatively youthful in the developing
world. Children under the age of 15 constitute more than 30% of the total population of
developing countries but just 17% for developed nations. In countries with such an age
structure, the youth dependency ratio—the proportion of youths (under age 15) to
economically active adults (ages 15 to 64)—is very high.
In general, the more rapid the population growth rate, the greater the proportion of dependent
children in the total population and the more difficult it is for people who are working to
support those who are not. This phenomenon of youth dependency also leads to an important
concept, the hidden momentum of population growth.

The Hidden Momentum of Population Growth
The most important consequence of echo effect is that population growth has an enormous
inertia which is called population inertia Imagine that a country has had high population
growth rate implementing a policy to bring down total fertility rate. Even if the policy where
to be successful the population size would over shoot the desired limit before it comes down
to an acceptable level. The reason is simply high population in the past leads to younger age
distribution. A relatively large fraction of the population continues to be at the age where they
are just to marry and have families. Therefore, even total fertility rate were reduced
substantially, the higher number of young people would lead to a large number of births.
The two basic reasons for this are:
i. High birth rate cannot be altered over a single night
ii. The age structure of LDCs
In the case of population growth, this momentum can persist for decades after birth rates
drop. There are two basic reasons for this. First, high birth rates cannot be altered
substantially overnight. The social, economic, and institutional forces that have influenced
fertility rates over the course of centuries do not simply evaporate at the urging of national
leaders. Consequently, even if developing countries assign top priority to the limitation of
population growth, it will still take many years to lower national fertility to desired levels.
The second and less obvious reason for the hidden momentum of population growth relates to
the age structure of many developing countries’ populations. There is a great difference
between age structures in less developed and more developed countries.
From the Ethiopia demographics data, young people greatly outnumber their parents. When
their generation reaches adulthood, the number of potential parents will inevitably be much
larger than at present.
The Demographic Transition

Demographic transition is the process by which fertility rates eventually decline to
replacement levels. The demographic transition has three stage and all contemporary
developed nations have more or less passed through the same three stages of modern
population history.
Stage I: High Fertility and Mortality: Before their economic modernization, developed
countries for centuries had stable or very slow-growing populations as a result of a
combination of high birth rates and almost equally high death rates.

Stage II: Declining Mortality
Stage II began when modernization, associated with better public health methods, healthier
diets, higher incomes, and other improvements, led to a marked reduction in mortality that
gradually raised life expectancy from under 40 years to over 60 years. However, the decline
in death rates was not immediately accompanied by a decline in fertility. As a result, the
growing divergence between high birth rates and falling death rates led to sharp increases in
population growth compared to past centuries. Stage 2 thus marks the beginning of the
demographic transition (the transition from stable or slow-growing populations first to
rapidly increasing numbers and then to declining rates).
Stage III: Declining Fertility
Finally, stage 3 was entered when the forces and influences of modernization and
development caused the beginning of a decline in fertility; eventually, falling birth rates
converged with lower death rates, leaving little or no population growth. Figure 1.3 depicts
the three historical stages of the demographic transition in Western Europe.
Figure 1.4 shows the population histories of contemporary developing countries, which
contrast with those of Western Europe and fall into two patterns.
Birth rates in many developing countries today are considerably higher than they were in
preindustrial Western Europe. This is because women tend to marry at an earlier age. As a
result, there are both more families for a given population size and more years in which to
have children.
In the 1950s and 1960s, stage 2 of the demographic transition occurred throughout most of
the developing world. The application of highly effective imported modern medical and
public health technologies caused death rates in developing countries to fall much more
rapidly than in nineteenth-century Europe. Given their historically high birth rates (over 40
per 1,000 in many countries), this has meant that stage 2 of the demographic transition has
been characterized by population growth rates well in excess of 2.0% per annum in most
developing countries.

Figure1.4. the Demographic Transition in Western Europe
Source: Todaro 11th edition (Figure 6.5 pp. 279) Development Economics
With regard to stage 3, we can distinguish between two broad classes of developing
countries. In case A in Figure 6.6, modern methods of death control combined with rapid and
widely distributed rises in levels of living have resulted in death rates falling as low as 10 per
1,000 and birth rates also falling rapidly, to levels between 12 and 25 per 1,000. These
countries, including Taiwan, South Korea, Costa Rica, China, Cuba, Chile, and Sri Lanka,
have thus entered stage 3 of their demographic transition and have experienced rapidly falling
rates of overall population growth.
But, some developing countries fall into case B of Figure 1.4. After an initial period of rapid
decline, death rates have failed to drop further, largely because of the persistence of
widespread absolute poverty and low levels of living and more recently because of the AIDS
epidemic. Moreover, the continuance of still quite high birth rates as a result of these low
levels of living causes overall population growth rates to remain relatively high. These
countries, including many of those in sub-Saharan Africa and the Middle East, are still in
stage 2 of their demographic transition. Though fertility is declining, it remains very high in
these parts of the world.

Figure 1.5.The Demographic Transition in Developing Countries
Source: Todaro 11th edition (Figure 6.6 pp. 280) Development Economics
The important question, therefore, is this: When and under what conditions are developing
nations likely to experience falling birth rates and a slower expansion of population? To
answer this question, we need to ask a prior one. What are the principal determinants or
causes of high fertility rates in developing countries, and can these determinants of the
“demand” for children be influenced by government policy? To try to answer this critical
question, we turn to a very old and famous classical macroeconomic and demographic model,
the Malthusian “population trap,” and a contemporary and highly influential neoclassical
microeconomic model, the household theory of fertility.
 Effects of children
Cost of children takes two forms:
1. Direct cost: - cost of food, clothing, schooling, health cost and cost of looking after.
2. Indirect cost: - these are the opportunity cost of a child that is measured by the
amount of income forgone in the process of bringing the child .i.e. the time spent at
home with a child, if that was spent on income earning activities. Opportunity cost of
a child is roughly proportional to the ongoing wage rate multiplied by the number of
Hours spent in parenting the child.
In a society where the opportunity cost is low, fertility rate tends to be high. Gender
bias has an effect on fertility rate. Because the wage rate for females is very low,

female works at home in which its opportunity cost is perceived to be extremely low.
Unemployment also decreases opportunity cost of children.
 Income improvement and fertility
 When non–wage income increases, fertility rate increases. Assuming that
children are normal goods.
 When wage income increases, budget line tilts upward and this reduces
fertility rate.
 The effect of Gender bias
 Female are looking after children. Now, suppose wage income of male increases.
Then, this will have similar effect to non – wage income. This increases fertility
rate.
 If the wage income of female increases, it reduces fertility rate.
 But if there is no gender bias, increasing the wage rate for male & female – will
have similar effects.
2.2. From population Growth to Economic Development
In general population growth can have positive or negative effect on economic development.
A large population means loss per capita resource. But more population means more
productive resource. The net effect must depend on the relative weights of these two
contrasting effects
Some Negative effects
A. The Malthusian view
According to Malthus, when wage rises above subsistence, they are eaten away by the higher
population. I.e. when income increases; people marry earlier & have more children which
depress the wage to its biological minimum. Increasing population at geometric rate on a
fixed amount of land (supplies & food) which increase at arithmetic rate will lead to
diminishing marginal contribution to food production. Then in the long run keeps the PCI of
a nation to some stagnant subsistence level
Criticisms: 1) Human being does not always react to economic progress by having more
children, and recent experience suggests that the opportunity cost of children increases as the
economy develops.
2) Economic progress shifts families from extended to nuclear families.
3) Malthus ignores the impact of technological progress in reducing the effect of diminishing
return to population growth.

4) Population is endogenous & is a decreasing function of PCI, But Malthus said and
increasing function
B. Population, Poverty & inequality
High rate of population growth exacerbate poverty problem. It also worsens income
inequality. This is based on the assumption that population growth is higher among the poor
than among the rich.
 One evidence show that the poor might need to have larger number of children for old age
security.
 Poor are also more risk averse than the rich. This means that the poor has higher fertility rate
 When we come to cost of bringing children, some argue high fertility rate others low.
 In poor society female has higher participation in labor work. The opportunity cost of children
must be higher among the poor.
The rich usually invest more on children than the poor. The cost of children is high for the
rich than the poor. Richer families have lower fertility rate.
C. Negative impact of population on environment
Population growth brings environmental degradation. Most of infrastructures, common
property resource, fisheries etc, are under priced or given freely. Population growth increase
the pressure on their natural resources
Positive aspects of population growth
Population growth can have a tie effect on technical progress. The positive effects taken two forms:
o Population growth may spare technical progress out of the pressure created by high
population density. This is the demand driven view explored by Boserup (1981)
o Population growth creates a larger pool of potential innovators and therefore, a
larger stock of ideas & innovation that can be put to economic user. This is the
supply driven view taken from Simon (1977)
A larger population is a diverse population. The larger the population, the larger would be the
number of people with useful ideas so that the higher the rate of technical changes. But there
should be enough education.
Human Capital: Education and Health in Economic development
 Human Capital: Productive investments embodied in human beings including skills,
abilities, ideas, health and locations often resulting from expenditures on educations,
on the job training programmers and medical cares.
 The two human capital issues; education and health are closely related to each other’s
because health is a pre requisite for increasing productivity and successful education

relies on adequate health. At the same time education plays a key role in increasing
ability of people to absorb modern technology and to develop the capacity for self
sustaining growth and development.
Linkages between Health and Education as joint investments in Economic development
 Health and education are investments made on the same individuals
 Greater health capital may raise the return on investments in education for several
years because of several reasons.
 Health is an important factor in school attendance
 Healthier children are more successful in school and learn more efficiently
 Deaths of school-age children also increase the cost of education per worker
 Longer life spans raise the return to investments in education
 Healthier individuals are more able to productively use education at any point in life.
Health and Economic Development
Health and economic development show a two-way relationship. Development generally
improves the health system where as better health increases productivity, social cohesion and
economic welfare.
Health: – Health status of a household can be taken as an indicator of wellbeing. In addition
to struggling on improving their per capita income, many people in developing countries fight
a constant battle against malnutrition, disease and ill health. The health status of individuals
can be assessed by infant mortality rate and under 5 mortality rate (both measured out of
1000 live births), and life expectancy.
Major indicators for health (poor/better)
1. Nutrition:
According to M.P.Todaro, a minimum caloric requirement per adult is necessary to maintain
adequate health. For a basic need it would be around 2200k cal / day/ adult
2. Anthropometry Measures: Anthropometry can be used to asses’ nutritional status at
individual and population level. A decline in an individual’s anthropometric index from one point in
time to another could indicate illness and /or nutritional deficiency. At population level, similarly it
indicates the prevalence of diseases and malnutrition. To construct anthropometric indices we need
weight, height and age of individuals.
There are three measures.
1) Stunting
2) Wasting Children <5
3) Body mass Index

A. Stunting: is measured by dividing the height of the child by its age. Low height to
age ratio is an indication of stunting (shortness). It is associated with poor overall economic
condition and repeated exposure to adverse condition.
B. Wasting: - is measured by dividing the weight of the child by its height. Low weight
(kg) to height (meter) is an indication of thinness. It is a short run measure of mal
nutrition.
C. Body Mass Index (BMI): This is a measure of adult malnutrition. This measure is
obtained by dividing the weight (kg) of an individual by the square of his/her height
(meter). This measure does not hold for pregnant and individuals with some health
problems.
- If BMI > 18.4, the individual is normal.
- If 17 < BMI < 18.4, the individual is in Grade -I chronic energy deficient.
- If 16 < BMI < 17, the individual is in Grade -II chronic energy deficient.
- If BMI<16, the individual is in Grade- III chronic energy deficient.
Education and Economic Development
Education helps individuals fulfill and apply their abilities and talents. It increases
productivity, improves health and nutrition, and reduces family size. Schooling presents
specific knowledge, develops general reasoning skills, causes values to change, increases
receptivity to new ideas, and changes attitudes toward work and society.
Education is an input in to the material wellbeing of a society. It helps people to earn more
income. Education is not an input only but by itself it is an achievement because it allows
individual to participate in decisions that determines the wellbeing of his society and himself.
Hence literacy and enrolment rate are taken as indicator of wellbeing. Literacy is measured
above 15 years (a person who could read and write is literate).
The principal institutional mechanism for developing human skills and knowledge is the
formal educational system. The more people are educated the more rapid the development.
Therefore all countries have committed themselves to the goal of universal education in the
shortest possible time.
Literacy
Literacy, the ability to read, write, and comprehend information, is obviously a fundamental
component of human resource development. The percentage of LDC adults who are illiterate
has fallen from 60% in 1960 to 31 % in 1995. However, as a result of rapid population
growth, the actual number of adult illiterates has risen over the same period by nearly 150

million.
Education and Economic Growth
Without such manpower, which, it was assumed, could be created only through the formal
educational system, development leadership in both the public and private sectors would be
woefully lacking.
The expansion of educational opportunities at all levels has contributed to aggregate
economic growth by:
(1) Creating a more productive labor force and endowing it with increased knowledge and skills;
(2) Providing widespread employment and income-earning opportunities
(3) Creating a class of educated leaders to fill vacancies left by departing expatriates or otherwise
vacant positions
(4) Providing the kind of training and education that would promote literacy and basic skills while
encouraging "modern" attitudes on the part of diverse segments of the population.
Education, Internal Migration, and the Brain Drain
Education seems to be an important factor influencing rural-urban migration. Numerous studies of
migration in diverse countries have documented the positive relationship between the educational
attainment of an individual and his or her propensity to migrate from rural to urban areas. Basically,
individuals with higher levels of education face wider urban-rural real-income differentials and
higher probabilities of obtaining modern-sector jobs than those with lower levels of education
Education also plays a powerful role in the growing problem of the international migration of high-
level educated workers-the so-called brain drain from poor to rich countries. This is particularly true
in the case of scientists, engineers, academics, and physicians, many thousands of whom have been
trained in home country institutions at considerable social cost only to reap the benefits from and
contribute to the further economic growth of the already affluent nations.
The international brain drain deserves mention not only because of its effects on the rate and
structure of LDC economic growth but also because of its impact on the style and approach of Third
World educational systems. The brain drain, broadly construed, has not merely reduced the supply of
vital professional people available within developing countries; perhaps even more serious, it has
diverted the attention of the scientists, physicians, architects, engineers, and academics that remain
from important local problems and goals. These include the development of appropriate technology;
the promotion of low-cost preventive health care; the construction of low-cost housing, hospitals,
schools, other service facilities; the design and building of functional yet inexpensive labor intensive
roads, bridges, and machinery; the development of relevant university teaching materials; and the
promotion of problem-oriented research on vital domestic development issues.

CHAPTER TWO
HUMAN CAPITAL: Education and Health in Economic Development
Introduction
 Health and education are important objectives of development
 Health and education are also important components of growth and development
Human capital means the ability of a worker to supply productive labor to an employer (wage
employment) or herself (self-employment).
Health and education are two obvious potential determinants of labor quality,
Human Capital to Schultz was the acquisition “of all useful skills and knowledge
Education and health are basic objectives of development; they are important ends in
themselves. Health is central to well-being, and education is essential for a satisfying and
rewarding life; both are fundamental to the broader notion of expanded human capabilities
that lie at the heart of the meaning of development.
. Health and Education in developing countries

Health:
 Healthy people can work harder and think more clearly than unwell workers.
 Healthy workers are therefore relatively more productive. It is therefore appropriate to
say that health is part of an individual’s human capital.
 Over the last century, the average level of health has improved in the world, for
several reasons.
1) Advances in medicine.
2) Better nutrition.
These developments have led to higher growth and economic development.
The distribution of health and education within countries is as important as income
distribution.
Investing in Education and Health: The Human Capital Approach
The analysis of investments in health and education is unified in the human capital approach.
Human capital is the term economists often use for education, health, and other human
capacities that can raise productivity when increased.
Of course, health and education also contribute directly to well-being. For example,
education increases empowerment and self-sufficiency in major matters in life.

The impact of human capital investments in developing countries can be quite substantial.
Education costs include any direct tuition or other expenditures specifically related to
education, such as books and required school uniforms, and indirect costs, primarily income
forgone because the student could not work while in school.
For an individual in a developing country deciding whether to go on from primary to
secondary education, four years of income are forgone. This is the indirect cost.
There is also a direct cost, such as fees, school uniforms, books, and other expenditures.
Improving Health and Education: Why Increasing Income Is Not

Sufficient?
Health and education levels are much higher in high-income countries. The main Reasons
are:
 With higher income, people and governments can afford to spend more on education
and health, and with greater health and education, higher productivity and incomes are
possible.
Because of these relationships, development policy needs to focus on income, health, and
education simultaneously to address the problems of absolute poverty.
People will spend more on human capital when income is higher.
The evidence shows that the better the education of the mother, the better the health of her
children. “Mother’s health knowledge alone appears to be the crucial skill for raising child
health. Health status, also affects school performance in developing countries. Better health
and nutrition leads to:
 earlier and longer school enrollment,
 better school attendance, and
 More effective learning.
To improve the effectiveness of schooling, we must improve the health of children in
developing countries. Indeed, the links from health to educational attainment in developing
countries must increase stronger.
Finally, there are other important benefits to investment in one’s health or education. An
educated person provides benefits to people around him or her, such as reading for them or
coming up with innovations that benefit the community.

Educational Supply and Demand

The amount of schooling received by an individual can be determined by many non market
factors, demand and supply, like any other commodity or service.
However, since most education is publicly provided in less developed countries, the
determinants of the amount demanded turn out to be much more important than the
determinants of supply.
On the demand side, the two principal influences on the amount of schooling desired are:
(1) a more educated student's prospects (prediction) of earning considerably more income
through future modern-sector employment (the family's private benefits of education) and
(2) the educational costs, both direct and indirect, that a student or family must bear.
The amount of education demanded is thus in reality a derived demand for high-wage
employment opportunities in the modern sector.
On the supply side, the quantity of school places at the primary, secondary, and university
levels is determined largely by political processes, often unrelated to economic criteria. Given
mounting political pressure, public supply of these places is fixed by the level of government
educational expenditures.
The amount of schooling demanded sufficient to qualify an individual for modern sector jobs
appears to be determined by the combined influence of the following four variables:
1. The wage or income differential. This is the wage differential between jobs in the
modern sector and those outside it (family farming, rural and urban self employment,
etc.), which for simplicity we can call the traditional sector. The greater the income
differential between the modern and traditional sectors, the greater the quantity of
education demanded.
2. The probability of success in finding modern-sector employment. An individual who
successfully completes the necessary schooling for entry into the modern-sector labor
market has a higher probability of getting that well paid urban job than someone who
does not.
3. The direct private costs of education. These expenses include school fees, books,
clothing, and related costs.
4. The indirect or opportunity costs of education. At this point, for each year the child
continues his education, he in effect foregoes the money income he could expect to earn
or the output he could produce for the family farm. This opportunity cost of education
must also be included as a variable affecting its demand.

Under the conditions where the modern-traditional or urban-rural wage gap is high,
employers choose candidates with high educational level.
As job opportunities for the uneducated diminish, individuals must safeguard their position
by acquiring a complete primary education.
Supply and amount demanded are equated not by a price-adjusting market mechanism but
rather institutionally, largely by the state. The social benefits of education for all levels of
schooling fall far short of the private benefits. At first, it is primarily the uneducated who are
found among the ranks of the unemployed.
Social versus Private Benefits and Costs

Typically in developing countries, the social costs of education (the opportunity cost to
society as a whole) increase rapidly as students climb the educational ladder.
The private costs of education (those borne by students themselves) increase more slowly or
may even decline.
To a large degree, the problem of divergent social versus private benefits and costs has been
artificially created by inappropriate public and private policies with regard to wage
differentials, educational selectivity, and the pricing of educational services.
Today, private calculations of the value of education exceed its social value, which must take
account of unemployment.
Moreover, despite the substantial distortions just reviewed, it seems clear that the expansion
of educational opportunities has contributed to aggregate economic growth by
 creating a more productive labor force and endowing it with increased knowledge and
skills;
 providing widespread employment and income-earning opportunities for teachers,
school and construction workers, textbook and paper printers, school uniform
manufacturers, and related workers;
 creating a class of educated leaders to fill vacancies
 Providing the kind of training and education that would promote literacy and basic
skills
Education, Inequality, and Poverty

Studies have also confirmed that contrary to what might have been assumed, the educational
systems of many developing nations act to increase income inequalities.

In other hand, if for financial or other reasons the poor are effectively denied access to
secondary and higher educational opportunities, the educational system can actually
perpetuate and even increase inequality within generations in developing countries.
The private costs of primary education (especially in view of the opportunity cost of a child’s
labor to poor families) are higher for poor students than for more affluent students, and the
expected benefits of primary education are lower for poor students. The poor are therefore
more likely to drop out during the early years of schooling.
As a result school attendance, and school performance, tend to be much lower for children of
poor families than for those from higher-income backgrounds. This is greatly compounded by
the lower quality of schools attended by the poor, plagued by poor teaching and teacher
truancy and inadequate facilities.
Thus in spite of the (often very recent) existence of free and universal primary education in
many developing countries, children of the poor, especially in rural areas, are often unable to
proceed beyond the first few years of schooling.
.The Gender Gap: Women and Education

Young females receive considerably less education than young males in almost every
developing country. In 66 out of 108 countries, women's enrollment in primary and
secondary education is lower than that of men by at least 10 percentage points.
This educational gender gap is the greatest in the poorest countries and regionally in the
Middle East and North Africa. The educational gender gap is especially great in the least
developed countries in Africa, in countries such as Niger, Mali, Guinea, and Benin.
Why is female education important? The answer is that educational discrimination against
women hinders economic development and reinforces social inequality.
Closing the educational gender gap by expanding educational opportunities for women is
economically desirable for four reasons:
1. The rate of return on women's education is higher than that on men's in most
developing countries.
2. Increasing women's education not only increases their productivity on the farm and in
the factory but also results in greater labor force participation, later marriage, lower
fertility, and greatly improved child health and nutrition.
3. Have an important impact on breaking the vicious cycle of poverty and inadequate
schooling.

.Consequences of Gender Bias in Health and Education
Education of girls has also been shown to be one of the most cost-effective means of
improving local health standards. Studies by the United Nations, the World Bank, and other
agencies have concluded that the social benefits of increased education of girls are more than
sufficient to cover its costs.
Inferior education and health care access for girls shows the interlinked nature of economic
incentives and the cultural setting. In many parts of Asia, a boy provides future economic
benefits, such as support of parents in their old age and possible receipt of a dowry upon
marriage, and often continues to work on the farm into adulthood. A girl, in contrast, marry
often at a young age, and will then move to the village of her husband’s family, becoming
responsible for the welfare of her husband’s parents rather than her own.
A girl from a poor rural family in South Asia will in many cases perceive no suitable
alternatives in life than serving a husband and his family; indeed, a more educated girl may
be considered “less marriageable.”
The evidence on gender bias in Africa is mixed, with some studies finding a small pro-female
bias and others a small and possibly rising pro-male bias.
Studies show that mothers’ education plays a decisive role in raising nutritional levels in rural
areas. The level of child stunting, a valid indicator of child under-nutrition, is much lower
with higher education attainment of the mother at every income level.
Coupled with the result that in many countries, mothers’ education tends to make a
disproportionately larger health difference toward daughters than sons, as Duncan Thomas
has reported, we can expect major benefits for girls.
Much depends on the context, on whether gains from income growth and also the benefits of
public investments in health and education and other infrastructure are shared equitably.
In general, two basic reasons why better nutrition raises economic growth:
 . Increased quantity of labour supply (more people can enter the labour force)
 . Improved quality of labour supply (people can work harder, or think more clearly)
and
 Schooling may raise income because education makes people more productive and
efficient
 Income may raise schooling because richer countries can afford to spend more on
education.

Internal Migration, and the Brain Drain

Education seems to be an important factor influencing rural-urban migration. Numerous
studies of migration in diverse countries have documented the positive relationship between
the educational attainment of an individual and his or her propensity to migrate from rural to
urban areas.
Education also plays a powerful role in the growing problem of the international migration of
high-level educated workers-the so-called brain drain from poor to rich countries. This is
particularly true in the case of scientists, engineers, academics, and physicians, many
thousands of whom have been trained in home country institutions.
The brain drain, in developing countries has diverted the attention of the scientists,
physicians, architects, engineers, and academics who remain from important local problems
and goals.
Education and Rural Development

If national development is to become a reality in Third World nations, there must be a better
balance between rural and urban development. Although agricultural development represents
the main component of any successful rural development program simply because 60% of
LDC rural populations are engaged directly or indirectly in agricultural activities, rural
development must nevertheless be viewed in a broader perspective.
The goals of rural development cannot simply be restricted to agricultural and economic
growth. Rather, they must be viewed in terms of a balanced economic and social
development with emphasis on:
 The equitable distribution of the benefits of higher levels of living.

 the creation of more productive employment opportunities both on and off the farm;
 more equitable access to arable land;
 more equitable distribution of rural income;
 more widely distributed improvements in health and nutrition; and
 Broadened access to both formal (in-school) and non formal (out-of-school)
education, for adults as well as children.
END OF CHAPTER 2

CHAPTER THREE
Rural-Urban Interaction, Migration, and Unemployment
Introduction
Not surprisingly agriculture often accounts for a large share of national output in LDCs. As
economic development proceeds, individuals move from rural to urban areas.
Internal migration was thought to be a natural process in which surplus labor was gradually
withdrawn from the rural sector to provide needed manpower for urban industrial growth.
In contrast to this viewpoint, it is now abundantly clear from recent LDC experience that
rates of rural-Urban migration continue to exceed rates of urban job creation and to surpass
greatly the absorption capacity of both industry and urban social services. Migration today, at
the largest LDC cities, is the major factor contributing to the urban surplus labor.
The Migration and Urbanization Dilemma

By 2050, world population could reach 9.2 billion people, and nowhere will population
growth be more dramatic than in the major cities of the developing world.
According to U.N. estimates, the world's urban population had reached 2.6 billion by 1995,
with 66% (1.7 billion) living in urban areas of developing countries. The United Nations
projects that in 2025, over 4.1 billion, or 80%, of the urban dwellers of the world will reside
in less developed regions.
It is true that cities offer the cost reducing advantages of agglomeration economies and
economies of scale and proximity as well as numerous economic and social externalities
(e.g., skilled workers, cheap transport, social and cultural amenities), the social costs of a
progressive overloading of housing and social services increased crime, pollution, and
congestion.
A long with the rapid spread of urbanization are the growth of huge slums and shantytowns.
Today slum settlements represent over one-third of the urban population in all developing
countries. Most of settlements are without clean water, sewage systems, or electricity. For
example, metropolitan Cairo is attempting to cope with a population of 10 million people
with a water and sanitation system built to serve 2 million.
Their misguided policies regarding urban planning and outmoded building codes often mean
that 80% to 90% of new urban housing is illegal.
Given the widespread dissatisfaction with rapid urban growth in developing countries, the
critical issue that needs to be addressed is the extent to which national governments can

formulate development policies that can have a definite impact on trends in urban growth.
With birthrates beginning to decline in many LDCs the serious and worsening problem of
rapid urban growth and accelerated rural-urban migration will undoubtedly be one of the
most important development and demographic issues of the early twenty-first century. And
within urban areas, the growth and development of the informal sector as well as its role and
limitations for labor absorption and economic progress will assume increasing importance.
The Urban Informal Sector

The existence of an unorganized, unregulated, and mostly legal but unregistered informal
sector was-recognized in the early 1970s in LDCs.
The bulk of urban informal sectors include:
 hawking,
 street vending,
 Letter writing, and junk collecting,
 prostitution, drug peddling, and snake charming.
 Mechanics and carpenters,
 small artisans,
 barbers, and personal servants.
Studies reveal that the share of the urban labor force engaged in informal-sector activities
is growing and now ranges from 30% to 70%, the average being around 50%.
The informal sector is characterized by:

 a large number of small-scale production and service activities that are
individually or family owned and uses labor intensive and simple technology.
 self-employed workers have little formal education, generally unskilled, and lack
access to financial capital.
 worker productivity and income tend to be lower in the informal sector than in the
formal sector.
 workers in the informal sector do not enjoy the measures of protection afforded
by the formal modern sector in terms of job security, decent working conditions,
and old-age pensions.
 Most workers entering this sector are recent migrants from rural areas unable to
find employment in the formal sector.

 Their motivation is usually to obtain sufficient income for survival, relying on
their own indigenous resources to create work.
In terms of its relationship with other sectors, the informal sector is linked with the rural
sector in that it allows excess labor to escape from rural poverty and underemployment.
The formal sector depends on the informal sector for cheap inputs and wage goods for its
workers, and the informal sector in turn depends on the growth of the formal sector for a
good portion of its income and clientele.
The formal sector in developing countries has a small base in terms of output and
employment. However, some studies have shown the informal sector generating almost one-
third of urban income.
As a result of its low capital intensity, only a fraction of the capital needed in the formal
sector is required to employ a worker in the informal sector, offering considerable savings to
developing countries so often plagued with capital shortages. By providing access to training
and apprenticeships at substantially lower costs the informal sector can play an important role
in the formation of human capital and more likely to adopt appropriate technologies and
make use of local resources, allowing for a more efficient allocation of resources.
Promotion of the informal sector is not, however, without its disadvantages.
 the informal sector lies in the strong relationship between rural-urban migration.
 The informal sector could aggravate the urban unemployment problem by attracting
more labor than the formal sector could absorb.
 Furthermore, there is concern over the environmental consequences of a highly
concentrated informal sector in the urban areas.
 Many informal-sector activities cause pollution and congestion and inconvenience to
pedestrians. Moreover, increased densities in slums and low income neighborhoods,
coupled with poor urban services, could cause enormous problems for urban areas.
Economic theory of Rural – Urban Migration

The Lewis Model: Two Fundamental Resource
Flows
The most important of many rural – Urban interactions is the synergetic role that agriculture
plays in the development of the non-agricultural sector. Agriculture sector provides the
supply of labor to industry and the surplus of food that allows a non-agricultural labor force

to survive. These are the two fundamental resource flows from agriculture, and they lay at the
heart of the structural transformation that occurs in most developing counters.
Industry supplies input to agriculture; tractors, pump sets chemicals of various kinds and so
on. With a large population in the rural sector agriculture is often a major source of demand
for the products of industry.
Lewis out lined a view of development based on the fundamental resource flows. This
approach views economic development as the progressive transformation of a “Traditional”
sector in to “Modern” sector goes, beyond the narrower picture of agriculture –to- industry
transformation. The starting point of the Lewis model is the idea of a dual economy.
Dualism is the co-existence of “traditional” and “modern”. The traditional sector is often
equated to the agriculture sector which after all produces the traditional output of all
societies. In contrast, the modern sector is the industrial sector which produces manufactured
commodities.
At the same time “traditional” can mean the use of older techniques of production that are
labor intensive and employ simple instruments. In contrast “Modern” might refer to the use
of new technology which is intensive in the use of capital finally. Furthermore, “traditional”
refers to traditional forms of economic organization and “modern” describes production
organization on capitalist principles which is carried out for economic profits.
The traditional sector in this model is viewed as a supplier of labor where as the role of
modern sector is to soak up this supply. Why isn’t all the supply immediately absorbed? The
answer is that the scale of the modern sector is limited by the supply of capital. Thus capital
accumulation in the modern sector becomes the engine of development.
The fundamental assumption is that labor is virtually unlimited in supply being drawn from a
vast traditional sector where as the rate of savings and investment limits the pace of
development.
The main idea of Lewis model is that there is a large surplus of labor in the traditional sector
of the economy that can be removed at little or no potential cost.
Sir W. Arthur Lewis Urban industrialists increase their labor supply by attracting workers
from agriculture who migrate to urban areas when wages there exceed rural agricultural
wages. Lewis, writing in 1954, is concerned about possible labor shortages in the expanding
industrial sector.
Lewis believes in zero (or negligible) marginal productivity of labor in subsistence
agriculture, a sector virtually without capital and technological progress.

In the Lewis model, capital is created by using surplus labor (with little social cost). Capital
goods are created without giving up the production of consumer goods. However, to finance
surplus labor, additional credit may sometimes be needed.
The significance of Lewis’s model is that growth takes place as a result of structural change.
An economy consisting primarily of a subsistence agricultural sector (which does not save) is
transformed into one predominantly in the modern capitalist sector (which does save).
Critics of the Lewis Model
Critics question the assumption of an unlimited labor supply. They believe the capitalist wage
rate may rise before all surplus rural labor is absorbed.
Industrial wages, then, must increase to motivate rural workers to migrate. Lewis’s critics
argue that the larger industrial labor force contributes to greater food demand, but the
capacity to produce food is unchanged. Thus, food prices rise. Accordingly, the industrial
sector must increase wages to pay for the increased price of food. Lewis overestimates the
extent that the availability of cheap rural migrant labor can stimulate industrial growth.
The Harris – Todaro Model

The Todaro model postulates that migration proceeds in response to urban-rural differences
in expected income rather than actual earnings. The fundamental premise is that migrants
consider the various labor market opportunities available to them in the rural and urban
sectors and choose the one that maximizes their expected gains from migration.
Expected gains are measured by the difference in real incomes between rural and urban
work and the probability of a new migrant's obtaining an urban job.
The worker should seek the higher-paying urban job.
Simple economic theory would then indicate that such migration should lead to a reduction in
wage differentials through the interaction of the forces of supply and demand, in areas of both
emigration and immigration.
Unfortunately, such an analysis is not realistic in the context of the institutional and economic
framework of most developing nations.
 First, these countries are beset by a chronic unemployment problem that a typical
migrant cannot expect to secure a high - paying urban job immediately. In fact, it is
much more likely that on entering the urban labor market, many uneducated, unskilled
migrants will either become totally unemployed or will seek casual and part-time
employment.
 No permanent income calculation.

To sum up, the Todaro migration model has four basic characteristics:
1. Migration is stimulated primarily by rational economic considerations of relative
benefits and costs, mostly financial but also psychological.
2. The decision to migrate depends on expected rather than actual urban-rural real wage
differentials
3. The probability of obtaining an urban job is directly related to the urban employment
rate and thus inversely related to the urban unemployment rate.
4. Migration rates in excess of urban job opportunity growth rates are not only possible
but also rational and even likely in the face of wide urban-rural expected income
differentials. High rates of urban unemployment are therefore inevitable outcomes of
the serious imbalance of economic opportunities between urban and rural areas in
most underdeveloped countries.
.Comprehensive Strategies for Employment and Migration

The main comprehensive migration and employment strategies in developing countries are
the following.
1. Creating an appropriate rural-urban economic balance.
2. Expansion of small-scale, labor-intensive industries. Expansion of these mostly small-
scale and labor-intensive industries in both urban and rural areas is very important.
3. Elimination of factor-price distortions. make better use of scarce capital resources.
4. Choosing appropriate labor-intensive technologies of production. the development of
small-scale, labor-intensive rural and urban enterprises; and to the development of low-
cost, labor-intensive methods of meeting rural infrastructure needs, including roads,
irrigation and drainage systems, and essential health and educational services.
5. Modifying the direct linkage between education and employment. Moreover, the
creation of attractive economic opportunities in rural areas would make it easier to
redirect educational systems toward the needs of rural development.
6. Reducing population growth through reductions in absolute poverty and inequality,
particularly for women, along with the expanded provision of family planning and
rural health services. Clearly, any long-run solution to LDC employment and
urbanization problems must involve a lowering of current high rates of population

growth.
CHAPTER 4
AGRICULTURE & ECONOMIC DEVELOPMENT
4.1. Introduction
Today, most development economists share the consensus that far from playing a passive,
supporting role in the process of economic development, the agricultural sector in particular
and the rural economy in general must play an indispensable part in any overall strategy of
economic progress, especially for the low-income developing countries.However; even if the
contribution of agricultural sector in developing countries to the total GDP is high, its
productivity found to be unsatisfactory.
4.2. Trends of Agricultural Growth: Past progress and current challenges
According to World Bank estimates, the developing world experienced faster growth in the
value of agricultural output (2.6% per year) than the developed world (0.9%per year) over the
period 1980 to 2004. Correspondingly, developing countries’ share of global agricultural
GDP rose from 56% to 65% in this period, far higher than their 21% share of world
nonagricultural GDP.
In marked contrast to the historical experience of advanced countries’ agricultural output in
their early stages of growth, which always contributed at least as much to total output as the
share of the labor force engaged in these activities, the fact that contemporary agricultural
employment in developing countries is much higher than agricultural output reflects the
relatively low levels of labor productivity compared with those in manufacturing and
commerce.This implies as the role of agriculture in specific countries reveals a great deal of
variation. A recent news posted by the United Nations Food and Agriculture Organization
(FAO)identifies as agricultural production continues to rise around the world, broadly
keepingpace with the rising population. But progress has been very uneven.
4.2.1. Agriculture and Rural Development
Rural development is not the same as agricultural development. The agrarian community
requires a full range of services such as schools, shops, banks, machinery dealers, and so on.
Rapid changes in agricultural markets lead to complete reassessments of the role of
agriculture.
In the perspective of rural development, agriculture has a lead role to play in the economic
welfare of a region due to its impact on different sectors: economic (income), social

(employment, quality of life, health) and environmental (landscape, biodiversity, preservation
of natural resources, and carbon sequestration), in addition to its importance as a provider of
primary raw materials for the food and other industries (foodstuffs, fibres, bio-fuels, and
timber). Rural and agricultural development and equitable distribution of the benefits of
economic growth are crucial for the global reduction of poverty and hunger.
The rural economy plays an important role with regard to employment, since the economic
growth in urban centres is too slow to generate sufficient employment to absorb the migrated
labour force, particularly in transition countries. The contribution of agriculture is obvious in
rural areas where it is one of the major economic activities, although small semi-urban
centres play a major role in the economic growth of rural areas.
4.3. The Structure of Agrarian systems in the Developing World
The evolution of agricultural production commonly occurs in three stages: (1) peasant
farming,; (2) mixed farming; and (3) commercial farming.The traditional peasant farm where
the major concern is survival visualize the subsistence agriculture thatis the livelihood of
most farmers in LDCs.
Agriculture accounts for the significant portion of production in developing countries in
provision of output and by labor force absorption. For example, the average proportion of
outputs from agriculture is close to 30% in low income countries, 20% in middle income
countries, and 1-7% in developed countries. Substantial amount of the labor force is living in
rural areas in developing countries (around 72%, In Ethiopia 83%). In middle income
countries it is 60% and in developed countries it is 20%.
There is a downward trend in the share of labor force in agriculture as the economy grows.
Agriculture has lower productivity compared to other sectors. Some of the reasons for this
are:
- Capital intensity is very low (lack of mechanization).
- There is intense pressure on land.
-poor land management, etc
A major reason for the relatively poor performance of agriculture in lowincome regions has
been the neglect of this sector in the development priorities of their governments, which the
initiatives just described are intended to overcome.
Moreover, if agriculture is not protected by irrigation, readily available pesticides and
fertilizer, it is very risky. It could be a price risk or output risk. Most farmers in LDCs are
poor and risk averse. Thus they cannot adapt new technology easily. They will choose

activities that are less risky and also low return instead of choosing activities with high risky
and high return. As a result agriculture productivity is very low in LDCs.
4.3.1. Characteristics of Agriculture sector:
 There are millions of people involving in decision making where as they are few in
other sectors
 Seasonality & geographical dispersion of agriculture production creates a need to
have an extensive system of storage & transportation system.
 Weather adds extra elements of uncertainty to agriculture production and volatility of
prices. Due to output & price risk, stabilization of income is difficult.
All the above special characteristics of agriculture complicate the task of policy makers. It is
also difficult for the government to design agricultural strategy.
Reasons for government intervention in the agricultural sector
1. Incomplete market in insurance & credit market: i.e. credit & insurance market are
incomplete (or totally missing) in agricultural sector.
2. Public good & increasing return to scale. Government would intervene to provide
public goods. Eg providing water dam. Once the dam is constructed, there is no cost
by adding more farmers for use.
* Government’s provision prevents monopoly power
3. Imperfect information: Government supply of information can be thought of as a
type of public good. However dissemination of information is costly, but the benefit is
to those who receive it
e.g. -Price information
-New technology
-Quality products
4. Externality (positive externality) successful adoption of a new technology by one
farmer conveys valuable information to his neighbors & hence gives them a
significant externality. The existence of this externality has been used to justify the
necessity of subsidizing farmers to adopt a new technology.
5. Income distribution:-the distribution of income generated by a free market is one of
the reasons for government intervention.
Markets in Agriculture
Markets in agriculture are highly imperfect & sometimes missing. In the context of missing
markets; information incentives& the existence of limits to contractual enforcement are very

important (the concepts demand & Supply are not enough). An essential property of
imperfect markets is that they are contagious: A market failure in some sectors can lead to
problems in the other sector. Land & labour are important assets in the economy. Land
endowment distribution is more unequal than the distribution of labour endowment. This
creates a difference in land – labour ratio.
If there is no input market, then the operational distribution of land / labour ratio is also
different. But if there is an input market, the operational distribution of land – labour ratio
would be more or less equal.
Sources of and need for credit demand: Rural market context
Who provides rural credit? First, there are the formal or institutional lenders: government
banks, commercial banks, credit bureaus and so on. The main problem with formal lender is
that they often do not have personal knowledge regarding the characteristics and activities of
their clientele.
Generally there are two types of lenders in rural areas.
A. Institutional lenders
Formal lenders these include government banks, commercial banks & credit Bureaus , etc
.the main problems in institutional lenders is that they do not have personal knowledge
regarding the characteristics & activities of their clients.
B. Informal lenders: Informal lenders are willing to accept properties as collateral which the
formal one does not accept e.g.
Why credit is needed?
1. Capital is required to start up a new business or expand scale of an existing business (to
buy a fixed capital investment)
2. Credit is also required to finance ongoing business because the outlay & income do not
occur at the same time (cash for working capital).
3. The need for consumption. Demanded by poor individuals due to harvest failure, illness, etc
CHAPTER FIVE
THE TRADE POLICY DEBATE AND INDUSTRIALIZATION
5.1. Introduction
In this chapter we move to trade policy issues by examining a wide range of LDC
commercial policies. These include import tariffs, physical quotas, and export promotion
versus import substitution, exchange-rate adjustments, international commodity agreements,
and economic integration.

“It is ironic that while national (LDC) markets are opening, global markets remain
restricted. Where can developing nations sell their products unless global markets are also
freed of protectionist restraints?”
William H. Draper III, UNDP Administrator, 1992
International trade has often played a crucial role in the historical development of the third
world. Unlike the few oil – producing states and a few newly industrializing countries like
south Korea, Taiwan and Singapore, most developing countries must depend on non mineral
primary – product exports for the majority of their foreign exchange earnings. Because the
market and prices for these exports are often unstable, primary product export dependence
carries with it a degree of risk and un\certainty that few nation desire.
Besides many developing countries rely on the importation of capital goods to fuel their
industrial expansion and satisfy the rising consumption in aspirations of their people. For
most developing nations, import demands have increasingly exceeded their capacity to
generate sufficient revenues from the sale of exports. This has led to deficit on the current
account ( an excess of import payments over export receipts for goods and services) were
often compensated by a surplus on the capital account of their balance of payment in excess
of repayment of principal and interest on former loans and investments). But debt burden has
become increasingly acute. This is related to LDCs vulnerability to global economic
disturbances and significantly retards development efforts.
Countries by opening their economies and societies to global trade and commerce and by
looking outward to the rest of the world, developing countries can get the international
transfer of goods, services and finical resource.
Hence, the question in this chapter is what sort of trade policy developing countries should
follow that contributes significantly to the process of economic development. Generally
speaking it is important to see the broader categories of trade namely the out ward looking
and inward looking with in which we can have many different aspects of trade policy for each
commodity. Finally, we will spend some time in the analysis of the welfare effect of tariff.
Learning Objectives
After studying this chapter, you will be able to
 Know traditional theories of mercantilists and different classical theories
International trade
 Discuss the arguments for and against export promotion vis-à-vis import substitution
trade strategies of development.

 Explain the impacts of trade policies such as tariffs, foreign exchange rates, foreign
exchange controls, and the devaluation.
 explain why developing countries need to have South-South Trade and Economic
Integration
 explain why regional trade organizations are demanded in today's globalization of the
world
5.2. The Traditional Theory of International Trade
The phenomenon of transactions and exchange is a basic component of human activity
throughout the world. Even in the most remote villages of Africa, people regularly meet in
the marketplace to exchange goods, either for money or for other goods through simple barter
transactions. A transaction is an exchange of two things—something is given up in return for
something else.
Why do people in different regions make trade?
‘Give what you have to get what you want’
People trade basically because it is profitable to do so. Different people possess different
abilities and resources and may want to consume goods in different proportions. There is
different resource endowment and preferences. Hence, no country is totally self – sufficient
in terms of goods and services. This necessitates specialization. Countries specialize in
activities where the gains from specialization are likely to be the largest.
5.2.1. Mercantilists
Mercantilists were probably the first group of persons who discussed the importance of
foreign trade for a nation’s economic prosperity. During the late 17th century and in the
earlier decades of 18th century the trade policies of the most European countries reflected the
impact of mercantilists that maximization of exports to other countries and a simultaneous
policy of restricting the imports was essential for a nation’s economic prosperity. For
mercantilists trade is a win – lose game i.e. one country can be benefited only at the expense
of the other nations (trade was a zero sum game). Hence countries should encourage exports
and restrict imports to increase their accumulation of Gold. In any event mercantilists
advocated strict government control of all economic activity and preached economic
nationalism.
At a more sophisticated level of analysis there were more rational reasons for the
mercantilists’ desire of the accumulation of precious metals. This is because the accumulated
precious metals could strengthen the power of rulers, generate more money (i.e. more gold

coins) in circulation and greater business activity. Further, by encouraging exports and
restrict imports the government would stimulate national output and employment
5.3. The classical theory of international trade
5.3.1. Adam Smith’s Theory of Absolute Advantage
Adam smith led an eloquent and vigorous attack up on mercantilist theories of international
trade in his book wealth of Nations in 1776. Smith argued that it was absurd to a
manufacture a commodity in a country at a great expense if a similar commodity could be
supplied by a foreign country at a lower cost. He said,
“ … It is foolish to grow grapes in hot houses in Scotland when better and cheaper (grapes)
can be got from Portugal or France.”
He, thus, opposed the imposition of tariffs on the goods imported from other countries. And
recommended that trade among different countries should be free and based on absolute cost
advantage.
According to Adam smith trade between countries is profitable and it can be a win – win
game based on absolute advantage. If country A can produce more of a commodity with the
same amount of real resources than country B (i.e. at a lower absolute unit cost) then country
A is said to have absolute advantage over country B. So countries can specialize in the
production of a commodity in which they have the absolute advantage.
To make the idea of Adam smith clear let us observe the following illustration. Suppose there
are two countries; Ethiopia and America. For simplicity sake we shall measure all costs in
terms of labor. Then if in Ethiopia one unit of labor per day can produce 10 number of cars
or 20 quintal of maize, in America then the same amount of labor can produce 20 number of
car or 15 quintal of maize. The position is as follows
Country Commodity A – Car Commodity B – maize
USA 20 15
Ethiopia 10 20
Table 5.1: Absolute advantage Theory of Adam Smith
Evidently USA has an absolute cost advantage over Ethiopia in the production of car(as 20 is
greater than 15) while Ethiopia has an absolute cost advantage over USA in the production of
maize as 20 is greater than 10) .As we can see from Table 1 above USA and Ethiopia have
absolute cost advantage in the production of commodity A(car) and commodity B(maize),
respectively
5.3.2. David Ricardo’s Doctrine of Comparative Advantage

David Ricardo in his principles of political economy (1817) furnished a more precise
formulation of the theory of international trade. David Ricardo did not object smiths absolute
advantage; he just converted to the idea of international trade to the celebrated principle of
comparative advantage of “doctrine of comparative costs” by raising Ricardo’s question
which says:
What if country is more productive than another country in all lines of production? Does it
still trade benefits both countries?
According to David Ricardo, there is a room for trade even when one country has absolute
advantage over the production of both commodities. A country has comparative advantage
over another if in producing a commodity it can do so at a relatively lower opportunity cost in
terms of the forgone alternative commodities that could be produced. Taking two countries,
A and B, each producing two commodities X and Y, country A is also said to have
comparative advantage in the production X if its absolute advantage margin is greater or if
its absolute disadvantage is less in X than in Y.
Assumptions
 Labor is the only factor of production
 Labor is immobile between countries.
 All labor is of the same quality and characteristics
 There is perfect competition in the labor market.
Arithmetical example:
Suppose in Portugal a unit of wine costs 80 hours and a unit meter of cloth costs 90 hours of
labor; in England a unit of wine costs 120 hours and a unit meter of cloth costs 100 hours of
labor. The comparative cost position will be shown as follows
Countries Per unit labor cost of production
Wine Cloth
Portugal 80 90
120 100
England
Cost Ratio in terms of 80/120=0.67 90/100=0.9
Portugal ( Terms of Trade)
Table 5. 2. Comparative Advantage Theory of David Ricardo

From the above table we observe that costs of producing both commodities are lower in
Portugal. In this case Portugal has absolute advantage over both commodities. However
Portugal has comparative advantage over England in the production of wine relatively to
cloth because Portugal labor cost involved in producing 1 unit of wine is only 67 percent of

England’s labor cost involved in production of 1 unit of wine while she has to involve 90
percent of England’s labor cost to produce one meter of cloth. Hence, Portugal can trade by
specializing in the production of wine.
5.4. Trade Strategies for Development: Export Promotion versus Import
Substitution
A convenient and instructive way to approach the complex issues of appropriate trade
policies for development is to set these specific policies in the context of a broader LDC
strategy of looking outward or looking inward. In the words of Paul P. Streeten, outward-
looking development policies "encourage not only free trade but also the free movement of
capital, workers, enterprises and students. . . , the multinational enterprise, and an open
system of communications.
By contrast, inward-looking development policies stress the need for LDCs to evolve their
own styles of development and to control their own destiny. This means policies to encourage
indigenous "learning by doing" in manufacturing and the development of indigenous
technologies appropriate to a country's resource endowments. According to proponents of
inward-looking trade policies, greater self-reliance can be accomplished only if you restrict
trade, the movement of people and communications, and if you keep out the multinational
enterprise, with its wrong products and wrong want -stimulation and hence its wrong
technology.
Within these two broad philosophical approaches to development, a lively debate has been
carried on in the development literature since the early 1950s. This is the debate between the
free traders, who advocate outward-looking export promotion strategies of industrialization,
and the protectionists, who are proponents of inward-looking import substitution strategies.
The balance of the debate has swung back and forth, with the import substitutors
predominating in the 1950s and 1960s and the export promoters gaining the upper hand in
the late 1970s and, especially among western and World Bank economists, in the 1980s and
1990s. Among many Third World economists and certain developed-country advocates of
the "new" or "strategic" trade theories, however, the philosophical foundations of import
substitution and collective self-reliance remained almost as strong in the 1990s as they were
in prior decades.
Basically, the distinction between these two trade-related development strategies is that
advocates of import substitution (IS) believe that LDCs should initially substitute domestic
production of previously imported simple consumer goods (first -stage IS) and then

substitute through domestic production for a wider range of more sophisticated
manufactured items (second - stage IS)-all behind the protection of high tariffs and quotas
on these imports. In the long run, IS advocates cite the benefits of greater domestic
industrial diversification ("balanced growth") and the ultimate ability to export previously
protected manufactured goods as economies of scale, low labor costs, and the positive
externalities of learning by doing cause domestic prices to become more competitive with
world prices.
By contrast, advocates of export promotion (EP) of both primary and manufactured goods
cite the efficiency and growth benefits of free trade and competition, the importance of
substituting large world markets for narrow domestic markets, the distorting price and cost
effects of protection, and the tremendous successes of the East Asian export-oriented
economies of South Korea, Taiwan, Singapore, and Hong Kong.
In practice, the distinction between IS and EP strategies is much less pronounced than many
advocates would imply. Most LDCs have employed both strategies with different degrees of
emphasis at one time or another. For example, in the 1950s and 1960s, the inward-looking
industrialization strategies of the larger Latin American and Asian countries such as Chile,
Peru, Argentina, India, Pakistan, the Philippines, and Bangladesh were heavily IS-oriented.
By the end of the 1960s, some of the key sub-Saharan African countries like Nigeria,
Ethiopia, Ghana, and Zambia began to pursue IS strategies, and some smaller Latin
American and Asian countries also joined in.
However, since the mid-1970s, the EP strategy has been increasingly adopted by a growing
number of countries. The early EP adherents-South Korea, Taiwan, Singapore, and Hong
Kong-were thus joined by the likes of Brazil, Chile, Thailand, and Turkey, which switched
from an earlier IS strategy. It must be stressed, however, that even the four most successful
East Asian export promoters have pursued protectionist IS strategies sequentially and
simultaneously in certain industries. So it is inaccurate to call them free traders, although
they are definitely outward-oriented. Against this background, we can now examine the issue
of outward-looking export promotion versus inward-looking import substitution in more
detail by applying the following fourfold categorization:
1. Primary outward-looking policies (encouragement of agricultural and raw material
exports)
2. Secondary outward-looking policies (promotion of manufactured exports)
3. Primary inward-looking policies (mainly agricultural self-sufficiency)

4. Secondary inward-looking policies (manufactured commodity self sufficiency through
import substitution)
5.4.1. Export Promotion: Looking Outward and Seeing Trade
Barriers
The promotion of LDC primary or secondary exports has long been considered a major
ingredient in any viable long-run development strategy. The colonial territories of Africa and
Asia, with their foreign-owned mines and plantations, were classic examples of primary
outward-looking regions. It was partly in reaction to this enclave economic structure and
partly as a consequence of the industrialization bias of the 1950s and 1960s that newly
independent states, as well as older LDCs, put great emphasis on the production of
manufactured goods initially for the home market (secondary inward) and then for export
(secondary outward). Let us therefore look briefly at the scope and limitations of LDC export
expansion, first with respect to primary products and then with respect to manufactured
exports.
Primary-Commodity Export Expansion: Limited Demand, Shrinking Markets
Many low-income LDCs still rely on primary products for most of their export earnings.
Nevertheless, with the notable exception of petroleum exports and a few needed minerals,
primary-product exports have grown more slowly than total world trade. Moreover, the LDC
share of these exports has been falling over the past few decades. Because food, nonfood
agricultural products, and raw materials make up almost 40% of all LDC exports and for
many Poor countries constitute their principal source of foreign-exchange earnings, we need
to examine the factors affecting the demand for and supply of primary-product exports.
Demand Side
On the demand side, there appear to be at least five factors working against the rapid
expansion of Third World primary-product and especially agricultural exports to the
developed nations (their major markets). First, the income elasticity of demand for
agricultural foodstuffs and raw materials are relatively low compared with those for fuels,
certain minerals, and manufactures. For example, the income elasticity of demand for sugar,
cacao, tea, coffee, and bananas have all been estimated at less than one, with most in the
range of 0.30-0.56. This not only contributes to problems of export earnings instability but
also means that only a sustained high rate of per capita income growth in the developed
countries can lead to even modest export expansion of these particular commodities from the
LDCs. Such high growth rates prevailed in the 1960s but have not been matched since.

Second, developed-country population growth rates are now at or near the replacement level.
So, little expansion can be expected from this source. Third, the price elasticity of demand for
most primary commodities is relatively low. When relative agricultural prices are falling, as
they have been during most of the past three decades, such low elasticities mean less total
revenue for exporting nations. For example, between June 1980 and June 1982, the price of
sugar fell by 78%, rubber by 37%, and copper by 35%. Between 1989 and 1991, commodity
prices fell by about 20%. Tin prices were so low that melting was no longer profitable. And
the real prices of coffee and tea were lower than at any time since 1950. With the exception
of the mid -1970s, non-oil real commodity prices fell by almost 40% between 1957 and 1998.
Such a decline, especially in the 1980s and 1990s when prices fell by over 35% has hurt the
least developed countries the most. They reached a l3-year low in 1999.
A device that is widely used to attempt to modify the tendency for primary product prices to
decline relative to other traded goods is that of establishing International Commodity
Agreements. Such agreements are intended to set overall output levels, to stabilize world
prices, and to assign quota shares to various producing nations for such items as coffee, tea,
copper, lead, and sugar. To work effectively, they require cooperation and compromise
among participants. Commodity agreements can also provide greater protection to individual
exporting nations against excessive competition and the overexpansion of world production.
Such over-expansion of supply tends to drive down prices and curtail the growth of earnings
for all countries.
In short, commodity agreements attempt to guarantee participating nations a relatively fixed
share of world export earnings and a more stable world price for their commodity. It is for
this reason that at its fourth world conference, held in Nairobi, Kenya, in May 1976, the
United Nations Conference on Trade and Development (UNCTAD) advocated the
establishment of an $11 billion common fund to finance "buffer stocks" to support the prices
of some 19 primary commodities (including sugar, coffee, tea, bauxite, jute, cotton, tin, and
vegetable oil) produced by various Third World nations. Unfortunately for LDC exporters,
there has been little progress on the UNCTAD proposal, and most existing non-oil
commodity agreements have either failed (tin) or been largely ignored by producers (coffee
and sugar).
The fourth and fifth factors working against the long-run expansion of LDC primary-product
export earnings - the development of synthetic substitutes and the growth of agricultural
protection in the developed countries-are perhaps the most important. Synthetic substitutes

for commodities like cotton, rubber, sisal, jute, hide, skins, and recently even copper (with
glass fibers for communication networks) act both as a brake against higher commodity
prices and as a direct source of competition in world export markets. The synthetic share of
world market export earnings has steadily risen over time while the share of natural products
has fallen.
In the case of agricultural protection, which usually takes the form of tariffs, quotas, and non-
tariff barriers such as sanitary laws regulating food and fiber imports, the effects can be
devastating to Third World export earnings. The common agricultural policy of the European
Union, for example, is much more discriminatory against LDC food exports than the policies
that had formerly prevailed in the individual member nations.
Supply Side
On the supply side, a number of factors also work against the rapid expansion of primary-
product export earnings. The most important is the structural rigidity of many Third World
rural production systems. These rigidities include limited resources; poor climate; bad soils;
antiquated rural institutional, social, and economic structures; and nonproductive patterns of
land tenure. Whatever the international demand situation for particular commodities (and
these will certainly differ from commodity to commodity), little export expansion can be
expected when rural economic and social structures militate against positive supply responses
from peasant farmers who are averse to risk.
Furthermore, in developing nations with markedly dualistic farming structures (i.e., large
corporate capital-intensive farms existing side by side with thousands of fragmented, low-
productivity peasant holdings), any growth in export earnings is likely to be distributed very
unevenly among the rural population. Small farmers are further, disadvantaged in countries
(mostly in Africa) in which agricultural marketing boards act as middlemen between the
farmers and export markets. Marketing boards often constrain export expansion by forcing
cultivators to sell their goods at a fixed price-usually well below world market prices. They
thereby remove the incentive to increase output.
Finally, we should mention here the pernicious effects of developed-country trade policies
(such as the United States' sugar quota) and foreign aid policies that depress agricultural
prices in LDCs and discourage production. For example, the European Union's policy of
selling subsidized beef to the nations of West Africa in the guise of foreign assistance has
devastated cattle prices in those countries.

We may conclude, therefore, that the successful promotion of primary-product exports
cannot occur unless there is a reorganization of rural social and economic structures to raise
total agricultural productivity and distribute the benefits more widely. The primary objective
of any Third World rural development strategy must be to provide sufficient food to feed the
indigenous people first and only then be concerned about export expansion.
But having accomplished this most difficult internal development task, LDCs may be able to
realize the potential benefits of their comparative advantage in world primary commodity
markets only if they can
 cooperate with one another,
 be assisted by developed nations in formulating and carrying out workable inter-
national commodity agreements, and
 Secure greater access to developed country markets.
Unfortunately, given the structure of world demands for primary products, the threat of local
food shortages and thus the desire for agricultural self-sufficiency, the inevitability of the
development of further synthetic substitutes, and the unlikelihood of significantly lower
levels of agricultural protection among developed nations, the real scope for primary-product
export expansion in individual LDCs seems limited.
Expanding Exports of Manufactured Goods: Some Successes, Many Barriers
The expansion of LDC manufactured exports has been given great stimulus by the
spectacular export performances of countries like South Korea, Singapore, Hong Kong,
Taiwan, Mexico, and Brazil over the past four decades. For example, Taiwan's total exports
grew at an annual rate of over 20%, and exports from South Korea grew even faster. In both
cases, this export growth was led by manufactured goods, which contributed over 80% of
both nations' foreign exchange earnings. For the Third World as a whole, manufactured
exports grew from 6% of total merchandise exports in 1950 to almost 45% by 1990. How-
ever, in 1990 South Korea, Taiwan, Singapore, and Hong Kong accounted for 82.8% of these
exports. Despite this growth, therefore, the LDC share of total world trade in manufactures
has remained relatively small, even though it did grow from 7% in 1965 to 18% in 1990.
The export successes of recent decades, especially among the Four Asian Tigers have
provided the primary impetus for arguments by neoclassical counterrevolutionaries -
particularly those at the World Bank and the IMF. According to them, LDC economic growth
is best served by allowing market forces, free enterprise, and open economies to prevail while
minimizing government intervention. Unfortunately, the reality of the East Asian cases does

not support this view of how their export success was achieved. In South Korea, Taiwan, and
Singapore (as in Japan earlier), the production and composition of exports was not left to the
market but resulted as much from carefully planned intervention by the government.
The demand problems for LDC export expansion of manufactured goods, though different in
basic economic content from those for primary products, are nonetheless similar. Although
income and price elasticities of international demand for manufactured goods in the aggregate
are higher than for primary commodities, they afforded little relief to many developing
nations bent on expanding their exports. For many years there was widespread protection in
developed nations against the manufactured exports of LDCs-which was in part the direct
result of the successful penetration of low-cost labor-intensive manufactures from countries
like Taiwan, Hong Kong, and South Korea during the 1960s and 1970s.
Different sources indicate that industrial-nation trade barriers have been pervasive. During
the 1980s, for example, 20 of the 24 industrial countries increased their protection against
LDC manufactured or processed products. Moreover, their rates of protection were
considerably higher against LDC exports than against those of other industrial nations.
Making matters worse, MDC protection often increased with the level of processing.
Example, the tariff on processed cacao, is twice that of raw cacao, so chocolate imports are
discouraged; raw sugar faces tariffs below 2% while processed sugar products are blocked by
20% tariffs.
Then there are the non-tariff barriers, which now form the main protection against Third
World manufactured exports, affecting at least one-third of them. The most significant is the
Multi-Fiber Arrangement (MFA), a complex system of mostly bilateral quotas against LDC
exports of cotton, wool, and synthetic fiber products. The United Nation Development
Program estimates that the MFA costs the Third World $24 billion a year is lost textile and
clothing export earnings.
All in all trade restrictions by developed countries cost LDCs at least $40 billion a year in
foreign exports and lowers their GNP by more than 3%. If these barriers were dropped-for
example, if the 1995 Uruguay Round of multilateral GATT negotiations can effectively be
implemented-developing-country manufactured exports could grow by $30 to $40 billion
annually.
As in the case of agricultural and other primary production, the uncertain export outlook
should be no cause for curtailing the needed expansion of manufacturing production to

serve local LDC markets. There is great scope for mutually beneficial trade in
manufactures among developing countries themselves within the context of the gradual
economic integration of their national economies. Too much emphasis has been placed on
the analysis of trade prospects of individual LDCs with the developed nations (North-
South trade) and not enough on the prospects for mutually beneficial trade with one
another (South-South trade).
5.4.2. Import Substitution Industrialization Strategy
During the 1950s and 1960s, developing countries experienced a decline in world markets for
their primary products and growing balance of payments deficits on their current accounts.
Given a general belief in the magic of industrialization as well as the terms of trade
arguments of the Prebisch-Singer hypothesis, they turned to an import substitution strategy of
urban industrial development.
Some countries still follow this strategy for both economic and political reasons, although
pressure from the IMF and the World Bank lay heavy opportunity costs on such endeavors.
As we noted earlier, import substitution entails an attempt to replace commodities that are
being imported, usually manufactured consumer goods, with domestic sources of production
and supply.
The typical strategy is first to erect tariff barriers or quotas on certain imported commodities,
then to try to set up a local industry to produce these goods-items such as radios, bicycles, or
household electrical appliances. Typically, this involves joint ventures with foreign
companies, which are encouraged to set up their plants behind the wall of tariff protection
and given all kinds of tax and investment incentives.
Although initial costs of production may be higher than former import prices, the economic
rationale put forward for the establishment of import-substituting manufacturing operations is
either that the industry will eventually be able to reap the benefits of large-scale production
and lower costs (the so-called infant industry argument for tariff protection) or that the
balance of payments will be improved as fewer consumer goods are imported. Often a
combination of both arguments is advanced. Eventually, it is hoped that infant industry will
grow up and be able to compete in world markets. It will then be able to generate net foreign-
exchange earnings once it has lowered its average costs of production. Let us see how the
theory of protection can be used to demonstrate this process.
5.4.2.1 Tariffs, Infant Industries, and the Theory of Protection
A principal mechanism of the import substitution strategy is the erection of protective tariffs

(taxes on imports) or quotas (limits on the quantity of imports) behind which IS industries
are permitted to operate. The basic economic rationale, for such protection is the infant
industry argument mentioned earlier. Tariff protection against the imported commodity is
needed so the argument goes, in order to allow the now higher-priced domestic producers
enough time to learn the business and to achieve the economies of scale in production and the
external economies of learning by doing that are necessary to lower unit costs and prices.
With enough time and sufficient protection, the infant will eventually grow up, be directly
competitive with developed country producers, and no longer need this protection.
Ultimately, as in the case of many formerly protected IS industries in South Korea and
Taiwan, domestic LDC producers will be able to produce not only for the domestic market
without a tariff wall or government subsidies but also to export their now lower-cost
manufactured goods to the rest of the world. Thus for many Third World industries, in
theory, an IS strategy becomes the prerequisite for an EP strategy. It is for this reason,
among others (including the desire to reduce dependence and attain greater self-reliance,
the need to build a domestic industrial base, and the ease of raising substantial tax revenue
from tariff collections), that import substitution appealed to so many LDC governments.
The basic theory of protection is an old and controversial issue in the field of international
trade. It is relatively simple to demonstrate. Consider Figure 4.1 The top portion of the
figure shows standard domestic supply and demand curves for the industry in question
(say, shoes) if there were no international trade-that is, in a closed economy. The
equilibrium home price and quantity would be P1 and Q1.
If this LDC then were to open its economy to world trade, its small size in relation to the
world market would mean that it would face a horizontal, perfectly elastic demand curve.
In other words, it could sell (or buy) all it wanted at a lower world price, P 2. Domestic
consumers would benefit from the lower price of imports and the resultant greater quantity
purchased, while domestic producers and their employees would clearly suffer as they lose
business to lower-cost foreign suppliers. Thus at the lower world price, P2, quantity
demanded rises from Q1 to Q3 whereas the quantity supplied by domestic producers falls
from Q1 to Q2. The difference between what domestic producers are willing to supply at
the lower P2 world price (Q2) and what consumers want to buy (Q3) is the amount that will
be imported-shown as line ab in Figure 5.1
Facing the potential loss of domestic production and jobs as a result of free trade and desiring
to obtain infant industry protection, local LDC producers will seek tariff relief from the

government. The effects of a tariff (equal to t0) are shown in the lower half of Figure 4.1. The
tariff causes the domestic price of shoes to rise from P2 to Pt that is, Pt = P2 (1 + to). Local
consumers now have to pay the higher price and will reduce their quantity demanded from Q 3
to Q5. Domestic producers can now expand production (and employment) up to quantity Q4
from Q2. The rectangular area cdef measures the amount of the tariff revenue collected by the
government on imported shoes.
Clearly, the higher the tariff, the closer to the domestic price will be the sum of the world
price plus the import tax. In the classic infant-industry IS scenario, the tariff may be so high
that it raises the price of the imported produce above P1 to, say, P3 in the upper diagram of
Figure 5.1, so that imports are effectively prohibited and the local industry is allowed to
operate behind a fully protective tariff wall, once again selling Q1 output at P1 price.
In the short run, it is clear that the impact of such a prohibitive tariff is to penalize consumers,
who are in effect subsidizing domestic producers and their employees through higher prices
and lower consumption. Alternatively, we can say that a tariff redistributes income from
consumers to producers. However, in the longer run, advocates of IS protection for LDC
infant industries argue that everyone will benefit as domestic and other shoe manufacturers
reap the benefits of economies of scale and learning by doing so that ultimately the domestic
price falls below P2 (the world price). Production will then occur for both the domestic and
the world market, domestic consumers as well as domestic producers and their employees
will benefit, protective tariffs can be removed, and the government will be able to replace any
lost tariff revenue with taxes on the now very much higher incomes of domestic
manufactures. It all sounds logical and persuasive in theory. But how has it performed in
practice?

Figure 5.1 Import Substitution and the Theory of Protection
5.4.2.2. The IS Industrialization Strategy and Results

Most observers agree that the import-substituting strategy of industrialization has been
largely unsuccessful. Specifically, there have been five undesirable outcomes. First,
secured behind protective tariff walls and immune from competitive pressures, many IS
industries (both publicly and privately owned) remain inefficient and costly to operate.

Second, the main beneficiaries of the import substitution process have been the foreign
firms that were able to locate behind tariff walls and take advantage of liberal tax and
investment incentives. After deducting interest, profits, and royalty and management
fees, most of which are remitted abroad, the little that may be left over usually accrues to
the wealthy local industrialists with whom foreign manufacturers cooperate and who
provide their political and economic cover.
Third, most import substitution has been made possible by the heavy and often
government-subsidized importation of capital goods and intermediate products by foreign
and domestic companies. In the case of foreign companies, much of this is purchased
from parent and sister companies abroad. There are two immediate results. First, capital-
intensive industries are set up, usually catering to the consumption habits of the rich
while having a minimal employment effect. Second, far from improving the LDCs'
balance of payments situation and alleviating the debt problem, indiscriminate import
substitution often worsens the situation by increasing a need for imported capital-good
inputs and intermediate products while, as we have just seen, a good part of the profits is
remitted abroad in the form of private transfer payments.
A fourth detrimental effect of many import substitution strategies has been their impact
on traditional primary-product exports. To encourage local manufacturing through the
importation of cheap capital and intermediate goods, exchange rates (the rate at which the
central bank of a nation is prepared to purchase foreign currencies) are often artificially
overvalued. This has the effect of raising the price of exports and lowering the price of
imports in terms of the local currency. For example, if the free market exchange rate
between Pakistani rupees and U.S. dollars was 20 to 1 but the official exchange rate was
10 to 1, an item that cost $10 in the United States could be imported into Pakistan for 100
rupees (excluding transport costs and other service charges).
Table 5.3. Degree of Currency Overvaluation in Selected LDCs, 1980-1989 (median values
of annual end-of-year premium)
Country Overvaluation Premium Premium during
1980-1989a the Period
Low premium 3.4 15.5
Indonesia 17.7 66.0
Mexico 75.2 213.0
Venezuela
Moderate premium
Kenya 15.2 44.9
Brazil 43.1 173.0
Bolivia 17.6 293.1

High premium
Peru 27.0 278.9
Tanzania 214.3 809.1
Ghana 142.0 4,263.7
If the free-market exchange rate (the exchange rate determined by the supply and demand
for Pakistani rupees in terms of dollars) prevailed, that item would cost 200 rupees. Thus by
means of an overvalued exchange rate, LDC governments are able effectively to lower the
domestic currency price of their imports. At the same time, their export prices are increased-
for example, at an exchange rate of 10 to 1, U.S. importers would have to pay 10 cents for
every 1-rupee item rather than the 5 cents they would pay if the hypothetical free-market ratio
of 20 to 1 were in effect. Table 4.1 provides rough estimates of the extent of currency
overvaluation in nine developing countries during the 1980s.
The net effect of overvaluing exchange rates in the context of import substitution policies is
to encourage capital-intensive production methods still further (because the price of imported
capital goods is artificially lowered) and to penalize the traditional primary-product export
sector - by artificially raising the price of exports in terms of foreign currencies. This
overvaluation, then, causes local farmers to be less competitive in world markets.
In terms of its income distribution effects, the outcome of such government policies may be
to penalize the small farmer and the self-employed while improving the profits of the owners
of capital, both foreign and domestic. Industrial protection thus has the effect of taxing agri-
cultural goods in the home market as well as discouraging agricultural exports. Import
substitution policies have in practice often worsened the local distribution of income by
favoring the urban sector and higher-income groups while discriminating against the rural
sector and lower-income groups.
Fifth, and finally, import substitution, which may have been conceived with the idea of
stimulating infant industry growth and self-sustained industrialization by creating "forward"
and "backward" linkages with the rest of the economy, has often inhibited that
industrialization. Many infants never grow up content to hide behind protective tariffs, and
governments loath to force them to be more competitive by lowering tariffs. In fact, LDC
governments themselves often operate protected industries as state-owned enterprises.
Moreover, by increasing the costs of inputs to potentially forward-linked industries (those
that purchase the output of the protected firm as inputs or intermediate products in their own
productive process, such as a printer's purchase of paper from a locally protected paper mill)
and by purchasing their own inputs from overseas sources of supply rather than through

backward linkages to domestic suppliers, inefficient import-substituting firms may in fact
block the hoped-for process of self-reliant integrated industrialization.
A consideration of patterns of import substitution leads to conclusions such as those of
Gerald Helleiner, whose views seem to reflect a consensus among development economists:
It is difficult to find any rationale for the pattern of import substituting
industrialization which has, whether consciously or not, actually been promoted. It
has given undue emphasis to consumer goods in most countries; it has given
insufficient attention to potential long-run comparative advantages, i.e., resource
endowments and learning possibilities; and it has employed alien and unsuitable, i.e.,
capital-intensive technologies to an extraordinary and unnecessary degree. If a
selective approach to import substitution is to be pursued at all, and there is a strong
case to be made for a more generalized approach, the selection actually employed in
recent years has left a great deal to be desired. The consequence has too frequently
been the creation of an inefficient industrial sector operating far below capacity, and
creating very little employment, very little foreign exchange saving, and little prospect
of further productivity growth. The object of policy must now be gradually to bring
incentive structures and thus the relative efficiencies of various industrial activities
into some sort of balance, thereby encouraging domestic manufacture of intermediate
and capital goods at the expense of importable consumer goods and the development
eventually of manufacture for export.
5.4.3. Tariff Structures and Effective Protection
Because import substitution programs are based on the protection of local industries against
competing imports primarily through the use of tariffs and physical quotas, we need to
analyze the role and limitations of these commercial policy instruments in developing
nations. As we have already discussed, governments impose tariffs and physical quotas on
imports for a variety of reasons. For example, tariff barriers may be erected to raise public
revenue. In fact, given the administrative and political difficulties of collecting local income
taxes, fixed percentage taxes on imports collected at a relatively few ports or border posts
often constitute one of the cheapest and most efficient ways to raise government revenue. In
many LDCs, these foreign trade taxes are thus a central feature of the overall fiscal system.
Physical quotas on imports like automobiles and other luxury consumer goods, though more
difficult to administer and more subject to delay, inefficiency, and rent-seeking corruption
(e.g., with regard to the granting of import licenses), provide an effective means of restricting

the entry of particularly troublesome commodities. Tariffs, too, may serve to restrict the
importation of non-necessity products (usually expensive consumer goods). By restricting
imports, both quotas and tariffs can improve the balance of payments. And like overvaluing
the official rate of foreign exchange, tariffs may be used to improve a nation's terms of trade.
However, in a small country unable to influence world prices of its exports or imports (in
other words, most LDCs), this argument for tariffs (or devaluation) has little validity. Finally,
as we have just seen, tariffs may form an integral component of an import substitution policy
of industrialization.
Whatever the means used to restrict imports, such restriction always protects domestic firms
from competition with producers from other countries. To measure the degree of protection,
we need to ask by how much these restrictions cause the domestic prices of imports to exceed
what their prices would be if there were no protection. There are two basic measures of
protection: the nominal rate and the effective rate.The nominal rate of protection shows the
extent, in percentages, to which the domestic price of imported goods exceeds what their
price would be in the absence of protection. Thus the nominal (ad valorem) tariff rate (t)
refers to the final prices of commodities and can be defined simply as where p' and p are the
unit prices of industry's output with and without tariffs, respectively.
p ' p
t
p
For example, if the domestic price (p') of an imported automobile is $5,000 whereas the CIF
(cost plus insurance and freight) price (p) when the automobile arrives at the port of entry is
$4,000, the nominal rate of tariff protection (t) would be 25%.
v ' v
g
v
By contrast, the effective rate of protection shows the percentage by which the value added at
a particular stage of processing in a domestic industry can exceed what it would be without
protection. In other words, it shows by what percentage the sum of wages, interest, profits,
and depreciation allowances payable by local firms can, as a result of protection, exceed what
this sum would be if-these same firms had to face unrestricted competition (no tariff
protection) from foreign producers.
The effective rate (g) can therefore be defined as the difference between value added (percent
of output) in domestic prices and value added in world prices, expressed as a percentage of
the latter, so that where v' and v are the value added per unit of output with and without
protection, respectively. The result can be either positive or negative, depending on whether

v' is greater or less than v. For most LDCs, it is highly positive. Table 5.4. provides some
estimates of effective protection in selected Third World countries. In general, IS countries
like Pakistan and Uruguay by definition have much higher rates of protection than EP
countries like South Korea and Singapore.
The important difference between nominal and effective rates of protection can be illustrated
by means of an example. Consider a nation without tariffs in which automobiles are produced
and sold at the international or world price of $10,000. The value added by labor in the final
assembly process is assumed to be $2,000, and the total value of the remaining inputs is
$8,000. Assume for simplicity that the prices of these non-labor inputs are equal to their
world prices.
Suppose that a nominal tariff of 10% is now imposed on imported automobiles, which raises
the domestic price of cars to $11,000 but leaves the prices of all the other importable
intermediate units unchanged. The domestic process of automobile production can now spend
$3,000 per unit of output on labor inputs, as contrasted with $2,000 per unit before the tariff.
The theory of effective protection therefore implies that under these conditions, the nominal
tariff of 10% on the final product (automobiles) has resulted in an effective rate of protection
of 50% for the local assembly process in terms of its value added per unit of output. It
follows that for any given nominal tariff rate, the effective rate is greater the smaller the value
added of the process; that is, g= t/(1- a), where t is the nominal rate on final product and a is
the proportionate value of the importable inputs in a free market where these inputs are
assumed to enter the country duty-free.
Table 5.4. Effective Protection Rate in Selected Third World Countries
Country Average Effective Protection Rate (%)

Uruguay 384
Pakistan 356
India 69
Brazil 63
Ivory Coast 41
Thailand 27
Singapore 22
Colombia 19
South Korea -1
Most economists argue that the effective rate is the more useful concept (even though the
nominal or ad valorem rate is simpler to measure) for ascertaining the degree of protection
and encouragement afforded to local manufacturers by a given country's tariff structure. This

is because effective rates of protection show the net effect on a firm or industry of restrictions
on the imports of both its outputs and its inputs.
For most countries, developing and developed, the effective rate normally exceeds the
nominal rate, sometimes by as much as 200%. For example, Little, Scitovsky, and Scott
found that average levels of effective protection during the early 1960s exceeded 200% for
India and Pakistan, 100% for Argentina and Brazil, 50% for the Philippines, 33% for Taiwan,
and 25% for Mexico.
Among the many implications of analyzing effective versus nominal tariff structures with
regard to developing countries, two stand out as particularly noteworthy. First, most
developing countries, as we have seen, have pursued import substituting programs of
industrialization with emphasis on the local production of final consumer goods for which a
ready market was presumed to exist. Moreover, final goods production is generally less
technically sophisticated than intermediate capital-goods production. The expectation was
that in time, rising demand and economies of scale in finished-goods production would create
strong backward linkages leading to the creation of domestic intermediate-goods industries.
The record of performance, as we have also seen, has been disappointing for most developing
countries.
Part of the reason for this lack of success has been that developing-country tariff structures
have afforded exceedingly high rates of effective protection to final-goods industries while
intermediate and capital goods have received considerably less effective protection. The net
result is an attraction of scarce resources away from intermediate-goods production and
toward the often inefficient production of highly protected final consumer goods. Backward
linkages do not develop, intermediate-good import costs rise, and, perhaps most important in
the long run, the development of an indigenous capital goods industry focusing on efficient,
low-cost, labor-intensive techniques is severely impeded.
Second, even though nominal rates of protection in developed countries on imports from the
developing countries may seem relatively low, effective protection rates can be quite
substantial. As we saw earlier in the cases of cacao and sugar, raw materials are usually
imported duty-free whereas processed products such as roasted and powdered coffee, coconut
oil, and cocoa butter appear to have low nominal tariffs.
The theory of effective protection suggests that in combination with zero tariffs on imported
raw materials, low nominal tariffs on processed products can represent substantially higher
effective rates of protection. For example, if a tariff of 10% is levied on processed coconut

oil, whereas copra (dried coconut) can be imported duty-free, and if the value added making
oil from copra is 5% of the total value of coconut oil, the process is actually being protected
at 200%. This greatly inhibits the development of food and other raw-material-processing
industries in developing nations and ultimately cuts back on their potential earnings of
foreign exchange.
Effective rates of protection are considerably higher than nominal rates in the developed
countries. For example, the effective rate on thread and yarn, textile fabrics, clothing, wood
products, leather, and rubber goods averages more than twice the nominal rate on these same
items in the United States and the members of the European Union. In the EU, effective rates
on coconut oil are 10 times the nominal rate (150% compared with 15%), and those on
processed soybeans are 16 times the nominal rate (160% as opposed to 10%).
To sum up, the standard argument for tariff protection in developing countries has four major
components:
 Duties on trade are the major source of government revenue in most LDCs because
they are a relatively easy form of taxation to impose and even easier to collect.
 Import restrictions represent an obvious response to chronic balance of payments and
debt problems.
 Protection against imports is one of the most appropriate means for fostering
economies of scale, positive externalities, and industrial self-reliance as well as
overcoming the pervasive state of economic dependence in which most Third World
countries find themselves.
 By pursuing policies of import restriction, developing countries can gain greater
control over their economic destinies while encouraging foreign business interests to
invest in local import-substituting industries, generating high profits and thus the
potential for greater saving and future growth. They can also obtain imported
equipment at relatively favorable prices and reserve an already established domestic
market for local or locally controlled producers. Eventually, they may even become
competitive enough to export to the world market.
Although these arguments can sound convincing and some protective policies have proved
highly beneficial to the developing world, as we discovered, many have failed to bring about
their desired results. Protection can have an important role to play in the development of the
Third World, for both economic and non economic reasons, but it is a tool of economic

policy that must be employed selectively and wisely, not as a panacea to be applied
indiscriminately and without reference to both short- and long-term ramifications.
5.4.4. Foreign-Exchange Rates, Exchange Controls, and the Devaluation Decision
We have already briefly discussed the question of foreign-exchange rates. Remember that a
country's official exchange rate is the rate at which its central bank is prepared to transact
exchanges of its local currency for other currencies in approved foreign-exchange markets.
Official exchange rates are usually quoted in terms of U.S. dollars-so many pesos, reals,
pounds, shillings, rupees, bhat, or yen per dollar.
For example, the official exchange rate of the South African rand for U.S. dollars in 1998
was approximately 5 rand per dollar, and the Indian rupee was officially valued at
approximately 40 rupees per dollar. If a South African manufacturer wished to import fabrics
from an Indian textile exporter at a cost of 40,000 rupees, he would need 5000 rand to make
the purchase. However, since almost all foreign-exchange transactions are conducted in U.S.
dollars, the South African importer would need to purchase $1,000 worth of foreign exchange
from the central bank of South Africa for his 5000 rand and then transmit these dollars
through official channels to the Indian exporter.
Official foreign-exchange rates are not necessarily set at or near the economic equilibrium
price for foreign exchange-that is, the rate at which the domestic demand for a foreign
currency such as dollars would just equal its supply in the absence of governmental
regulation or intervention. In fact, as we saw in Table 5.2, the currencies of most developing
countries are usually overvalued by the exchange rate. Whenever the official price of foreign
exchange is established at a level that, in the absence of any governmental restrictions or
controls, would result in an excess of local demand over the available supply of foreign
exchange, the domestic currency in question is said to be overvalued.
In situations of excess demand, LDC central banks have three basic policy options to
maintain the official rate of exchange. First, they can attempt to accommodate the excess
demand by running down their reserves of foreign exchange (as Mexico did from 1991 to
1994 and Thailand, Malaysia, Indonesia and the Philippines did from 1995 to 1997) or by
borrowing additional foreign exchange abroad and thereby incurring further debts (as many
African countries did in the 1980s and Indonesia and South Korea did in the 1990s).
Second, they can attempt to curtail the excess demand for foreign exchange by pursuing
commercial policies and tax measures designed to lessen the demand for imports (e.g., tariffs,
physical quotas, licensing). Third, they can regulate and intervene in the foreign exchange

market by rationing the limited supply of available foreign exchange to "preferred"
customers. Such rationing is more commonly known as exchange control. The policy is in
wide use throughout the Third World and is probably the major financial mechanism for
preserving the level of foreign-exchange reserves at the prevailing official exchange rate.
The mechanism and operation of exchange control can be illustrated diagrammatically with
the aid of Figure 4.2. Under free-market conditions, the equilibrium price of foreign exchange
would be Pe, with a total of M units of foreign exchange demanded and supplied. If,
however, the government maintains an artificially low price of foreign exchange (ie., an
overvaluation of its domestic currency) at Pa, the supply of foreign exchange will amount to
only M' units because exports are overpriced. But at price Pa the demand for foreign
exchange will be M" units, with the result that there is an "excess demand" equal to M" - M'
units. Some mechanism will therefore have to be devised to ration the available supply of M'.
If the government were to auction this supply, importers would be willing to pay a price-of
Pb for the foreign exchange. In such a case, the government would make a profit of Pb - Pa
per unit. However, such open auctions are rarely carried out, and limited supplies of foreign
exchange are allocated through some administrative quota or licensing device. Opportunities
for corruption, evasion, and the emergence of black markets are thus made possible because
Figure
importers
5.2are
Free-Market
willing to pay
and as
Controlled
much as Rates
Pb perofunit
Foreign
of foreign
Exchange
exchange
S
Prices of foreign exchanges (units
Pb
of domestic currency per unit of
Pe
foreign currency)
Pa
Why have most LDC governments opted for an overvalued official

D exchange rate? Basically,
as we have seen, they have done so as part of widespread programs of rapid industrialization
and import substitution. Overvalued exchange rates reduce the domestic currency price of
M’ M M’’
imports below the level that would exist in a .free market for foreign exchange (i.e., by the
Quantity
forces of supply and demand). Cheaper of foreign
imports, exchange
especially capital and intermediate producer

goods, are needed to fuel the industrialization process.
But overvalued exchange rates also lower the domestic currency price of imported consumer
goods, especially expensive luxury products. Third World nations wishing to limit such
unnecessary and costly imports often need to establish import controls (mostly physical
quotas) or to set up a dual or parallel exchange rate system with one rate, usually highly
overvalued and legally fixed, applied to capital and intermediate-good imports and the other,
much lower and illegal (or freely floating), for luxury consumption-good imports. Such dual
exchange-rate systems make the domestic price of imported luxury goods very high while
maintaining the artificially low and thus subsidized price of producer-good imports. Needless
to say, dual exchange-rate systems, like exchange controls and import licenses, present
serious problems of administration and can promote black-markets, corruption, evasion, and
rent seeking.
However, overvalued currencies reduce the return to local exporters and to import-
competing industries that are not protected by heavy tariffs or physical quotas. Exporters
receive less domestic currency for their products than would be forthcoming if the free-
market exchange rate prevailed. Moreover, in the absence of export subsidies to reduce the
foreign-currency price of an LDC's exports, exporters, mostly farmers, become less
competitive in world markets because the price of their produce has been artificially elevated
by the overvalued exchange rate. In the case of import-competing but unprotected local
industries, the overvalued rate artificially lowers the domestic currency price of foreign
imports of the same product (e.g., radios, tires, bicycles, or household utensils).
Hence in the absence of effective government intervention and regulation of the foreign-
exchange dealings of its nationals, overvalued exchange rates have a tendency to exacerbate
balance of payments and foreign-debt problems simply because they cheapen imports while
making exports more costly. Chronic payments deficits resulting primarily from current
account transactions (exports and imports) can possibly be ameliorated by a currency
devaluation. Simply defined, a country's currency is devalued when the official rate at
which its central bank is prepared to exchange the local currency for dollars is abruptly
increased. Currency depreciation, by contrast, refers to a gradual decrease in the purchasing
power of a domestic currency in foreign markets relative to domestic markets; appreciation
refers to a gradual increase.
For example, a devaluation of the South African rand and the Indian rupee would occur if
their official exchange rates of approximately 5 rand and 40 rupees to the dollar were

changed to, say, 8 rand and 50 rupees per dollar. Following these devaluations, U.S.
importers of South African and Indian goods would pay fewer dollars to obtain the same
products. But U.S. exports to South Africa and India would become more expensive, requir-
ing more rand or rupees to purchase than before.
In short, by lowering the foreign currency price of its exports (and thereby generating more
foreign demand) while raising the domestic-currency price of its imports (and thereby
lowering domestic demand), Third World nations that devalue their currency hope to
improve their trade balance vis-à-vis the rest of the world. This is a principal reason why
devaluation is always a key component of IMF stabilization policies.
An alternative to currency devaluation would be to allow foreign-exchange rates to fluctuate
freely in accordance with changing conditions of international demand and supply. Freely
fluctuating or flexible exchange rates in the past were not thought to be desirable, especially
in developing nations heavily dependent on exports and imports, because they are extremely
unpredictable, subject to Wide and uncontrollable fluctuations, and susceptible to foreign and
domestic currency speculation. Such unpredictable fluctuations can wreak havoc with both
shorter and long-range development plans.
Nevertheless, during the global balance of payments and debt crises of the 1980s, a number
of developing countries, including Mexico, Argentina, Chile, and the Philippines, were forced
by the IMF to let their exchange rates float freely in order to correct sizable payments
imbalances and to prevent continued capital flight. The same phenomenon occurred again for
Mexico in 1994 and for Thailand, the Philippines, South Korea, Malaysia, and Indonesia in
1997 and 1998 during the Asian currency crisis. In a matter of several months during 1997,
the Thai baht lost one-third of its value against the dollar and the Philippine peso, South
Korean won, Malaysian ringgit, and Indonesian rupiah fell by almost 30%.
The present international system of floating exchange rates, formally legalized at the 1976
Jamaica IMF meeting, represents a compromise between a fixed (artificially "pegged") and a
fully flexible exchange rate system. Under this "managed" floating system, major
international currencies are permitted to fluctuate freely, but erratic swings are limited
through central bank intervention. Most developing countries, however, have decided to
continue to peg their currencies to those of developed countries. Some, like Kenya, have gone
further and decided to tie their currencies to the movements of a weighted index of the
world's major currencies rather than to tie them to a particular currency, like the U.S. dollar
or the pound sterling.

One final point that should be made about Third World currency devaluations, particularly in
the light of previous discussions, concerns their probable effect on domestic prices.
Devaluation has the immediate effect of raising prices of imported goods in terms of the local
currency. Imported shirts, shoes, radios, records, foodstuffs, and bicycles that formerly cost x
rupees now cost (1 + d)x rupees, depending on the percentage magnitude of the devaluation,
d. If, as a result of these higher prices, domestic workers seek to preserve the real value of
their purchasing power, they are likely to initiate increased wage and salary demands. Such
increases, if granted, will raise production costs and tend to push local prices up even higher.
A wage-price spiral of domestic inflation is thereby set in motion. In fact, a vicious cycle of
devaluation-domestic could result wage and price increases, higher export prices, and
worsened balance of trade. Thus the devaluation decision could simply exacerbate the
external balance of payments problem while generating increased inflation domestically. For
example, following the widespread IMF-induced currency devaluations during the 1997
Asian crisis, rates of inflation shot up in 1998 from 11% to 35% in Indonesia, from 6% to
12% in Thailand, and from 5% to 10% in the Philippines. Unemployment rates doubled, and
workers took to the streets, demanding an end to the layoffs and a rise in wages to offset their
lost purchasing power.
As for the distributional effects of devaluation, it is clear that by altering the domestic price
and returns of "tradable" goods (exports and imports) and creating incentives for the
production of exports as opposed to domestic goods, devaluation will benefit certain groups
at the expense of others. In general, urban wage earners, people with fixed incomes, the
unemployed, and the small farmers and rural and urban small-scale producers and suppliers
of services who do not participate in the export sector stand to be financially hurt by the
domestic inflation that typically follows devaluation.
Conversely, large exporters (usually large landowners and foreign-owned corporations) and
medium-sized local businesses engaged in foreign trade stand to benefit the most. Although
we cannot categorically assert that (devaluation tends to worsen income distribution, we may
conclude that the more that ownership of and control over the export sector is concentrated in
private rather than public hands, the greater is the likelihood that devaluation will have an
adverse effect on income distribution. For this reason, among others, international
commercial and financial problems (e.g., chronic balance of payments deficits) cannot be
divorced from domestic problems (e.g., poverty and inequality) in Third World nations.
Policy responses to alleviate one problem can either improve or worsen others.

5.5. Summary and Conclusions: Trade Optimists and Trade Pessimists
We are now in a position to summarize the major issues and arguments in the great ongoing
debate between advocates of free-trade, outward -looking development and export promotion
policies-the trade optimists-and advocates of greater protection, more inward-looking
strategies, and greater import substitution-the trade pessimists. Let us begin with the latter
school of thought.
5.4.1 Trade Pessimist Arguments
Trade pessimists tend to focus on three basic themes:
1. the limited growth of world demand for primary exports,
2. the secular deterioration in the terms of trade for primary producing nations, and
3. the rise of "new protectionism," against the exports of LDC manufactured and
processed agricultural goods.
LDC exports grow slowly because of
1. a shift in developed countries from low technology, material-intensive goods to
high-technology, skill-intensive products, which decreases the demand for Third
World raw materials;
2. increased efficiency in industrial uses of raw materials;
3. the substitution of synthetics for natural raw materials like rubber, copper, and
cotton;
4. the low income elasticity of demand for primary products and light manufactured
goods;
5. the rising productivity of agriculture in developed countries; and
6. the rising tide of protectionism for both agriculture and labor-intensive
developed-country industries.
The terms of trade deteriorate because of
1. oligopolistic control of factor and commodity markets in developed countries
combined with increasing competitive sources of supply of LDC export tables and
2. a generally lower level of the income elasticity of demand for LDC exports.
The rise of new protectionism in the developed world results from the very success of a
growing number of LDCs in producing a wider range of both primary and secondary
products at competitive world market prices, combined with the quite natural fears of
workers in higher-cost developed- country industries that their jobs will be lost. They
pressure their governments in North America, Europe, and Japan to curtail or prohibit

competitive imports from the developing world.
The trade pessimists therefore conclude that trade hurts Third World development
because
1. the slow growth in demand for their traditional exports means that export
expansion results in lower export prices and a transfer of income from poor to rich
nations;
2. without import restrictions, the high elasticity of LDC demand for imports
combined with the low elasticity for their exports means that developing countries
must grow slowly to avoid chronic balance of payments and foreign-exchange
crises; and
3. because developing nations have their "static" comparative advantage in primary
products, export-promoting free-trade policies tend to inhibit industrialization,
which is in turn the major vehicle for the accumulation of technical skills and
entrepreneurial talents.
5.5.2 Trade Optimist Arguments

Trade optimists tend to underplay the role of international demand in determining the gains'
from trade. Instead, they focus on the relationship between LDC trade policy, export
performance, and economic growth. They argue that trade liberalization (including export
promotion, currency devaluation, removal of trade restrictions, and generally "getting prices
right") generates rapid export and economic growth because free trade provides a number of
benefits:
1. It promotes competition, improved resource allocation, and economies of scale in
areas where LDCs have comparative advantage. Costs of production are consequently
lowered.
2. It generates pressures for increased efficiencies, product improvement, and technical
change, thus raising factor productivity and further lowering costs of production.
3. It accelerates overall economic growth, which raises profits and promotes greater
saving and investment and thus furthers growth.
4. It attracts foreign capital and expertise, which are in scarce supply in LDCs.
5. It generates needed foreign exchange that can be used to import food if the
agricultural sector lags behind or suffers droughts or other natural catastrophes.
6. It eliminates costly economic distortions caused by government interventions in both

the export and foreign-exchange markets and substitutes market allocation for the
corruption and rent-seeking activities that usually result from an overactive
government sector.
7. It promotes more equal access to scarce resources, which improves overall resource
allocation
Trade optimists argue, finally, that even though export promotion may at first be difficult
with limited gains-especially in comparison with the easy gains of first -stage import
substitution-over the longer run the economic benefits tend to build up momentum, whereas
import substitution faces rapidly diminishing returns.
5.5.3. Reconciling the Arguments: The Data and the Consensus
We can evaluate the debate on two levels, the empirical and the philosophical. In his study of
the experience of developing countries over the past three decades, Rostam M. Kavopssi
argues that the empirical evidence demonstrates quite clearly that neither the trade optimists
nor the trade pessimists are correct at all times. It all depends on fluctuations in the world
economy. Thus when the world economy was expanding rapidly during the period from 1960
to 1973, the more open economy LDCs clearly outperformed (in terms of aggregate export
and economic growth) the more closed-economy nations. The trade optimists' arguments
appear validated during this period of rapid world growth. But when the world economy
slowed down between 1973 and 1977, the more open economies (with the notable exception
of the four Asian NICs) had a more difficult time and the trade pessimists fared better. A
follow-up 1988 study by Hans W Singer and Patricia Gray, which extended Kavoussi's
empirical analysis for the period 1977-1983, when world economic conditions were even
more unfavorable, supports the finding that high growth rates of export earnings occur only
when external demand is strong. Changes in trade policy appear to have little or no effect.
Furthermore, low-income countries were found to fare worse across all time periods. Singer
and Gray argue that contrary to the position of the World Bank and other trade optimists, an
outward-oriented policy is not necessarily valid for all LDCs. To conclude, therefore, that
either export promotion or import substitution is always an unambiguously better strategy-
even for promoting economic growth narrowly conceived, let alone our broader definition of
development-is to miss a key conceptual and empirical insight that a growing number of
development economists are beginning to recognize.
In the final analysis, it is not a developing country's inward- or outward-looking stance vis-
à-vis the rest of the world that will determine whether or not it develops along the lines

described in different parts of this course. Inward-looking, protectionist policies such as
tariffs, quotas, and exchange-rate adjustments do not necessarily guarantee more jobs,
higher incomes that are more equitably distributed, adequate nutrition and health, clean
water, or relevant education any more than outward-looking, noninterventionist policies do.
Policies of export promotion appear to have contributed more to GNP growth than import
substitution did during the 1960s and 1970s. Similar results were not forthcoming in the
slow-growth 1980s. Moreover, the success of export promotion in the 1990s globalization
era varied widely from region to region and country to country. Some prospered, others
stagnated, and some Asian economies that had prospered earlier through more open trade
and financial liberalization policies (e.g., Thailand, Indonesia, Malaysia, and South Korea)
found themselves in serious trouble when their currencies collapsed and foreign investors
and speculators quickly withdrew their funds.
In terms of our broadened definition of development, therefore, the results of the past four
decades are largely ambiguous. Much depended on the structure of both the domestic LDC
economy and the world economy. In fact, as Paul Streeten skillfully pointed out:
A curious paradox came out of the discussion [of the effects of trade on LDC inequalities].
It seemed that both inward-looking, import-substituting, protectionist, interventionist
policies and outward-looking; market-orientated, noninterventionist policies) tend to
increase market imperfections and monopolies and reduce the demand for labour-intensive
processes, the latter because the market rewards most those factors that are relatively
scarce (capital, management, professional skills) and penalizes those in abundant supply
and because the market strengthens the ability to accumulate of those who have against
those who have not. But though it is paradoxical that both a protectionist "distorted"
system of prices, interest rates, wages and exchange rates and a market-determined one
should increase inequalities, there is no contradiction. It is plausible that within a certain
social and political framework, both export-orientated market policies and import-
substitution-orientated, interventionist, "distorting" policies should aggravate inequalities,
though one set may do this somewhat more than the other. Perhaps economists have been
barking up the wrong tree when disputing which set of price policies contributes more to
equality. In an egalitarian power structure, both make for inequality; in an egalitarian
power structure, both may make for equality.
In short, the current consensus leans toward an eclectic view that attempts to fit the relevant
arguments of both the free-trade and protectionist models to the specific economic,

institutional, and political realities of diverse nations at different stages of development. What
works for one may not work for another. For example, the pre-1997 East Asian success
stories may have little relevance for other developing nations beyond the important
conclusion reached by Colin L Bradford:
What seems to distinguish the East Asian development experiences is not the dominance of
market forces, free enterprise, and internal liberalization, but effective, highly interactive
relationships between the public and private sectors characterized by shared goals and
commitments embodied in the development strategy and economic policy of the government.
The dichotomy between market forces and government intervention is not only overdrawn: it
misconceives the fundamental dynamic at work. It is the degree of consistency between the
two sectors-rather than the extent of implicit or explicit conflict-that has been important in the
successful development cases. A coherent development strategy was not only formulated but
followed by both the government and the private sector in providing an unusual degree of
common direction to national energies in these cases.
Finally, all of the foregoing discussion has left out perhaps one of the most viable long-run
trade policies for small and medium-sized developing economies, one that is oriented
simultaneously outward and inward in an area that has shown slow but steady growth over
the past few decades. This is the expansion of trade among the developing countries-South-
South rather than North-South trade and the possibilities of economic integration in Third
World regions.
5.6. South-South Trade and Economic Integration: Looking Outward and Inward
5.6.1. The Growth of Trade among Developing Countries
Although trade among the LDCs still represents a meager 7% of total world trade, twice its
share in 70s, it grew rapidly during the 1980s. By 1990, South-South trade represented almost
33% of all Third World exports. Trade in manufactures has risen from only 5% in 1960 to
almost 35% of all exports in the 1990s. Much of the growth of these inter-LDC exports
helped to compensate for weak demand and growing protectionism in the developed world.
Many development economists have argued that Third World countries should therefore
orient their trade more toward one another. Their arguments usually entail four basic points:
1. There are relative comparative-advantage changes to South-South as opposed to

North-South trade.
2. There are greater dynamic gains to be realized from such trade.

3. Export instability resulting from fluctuations in developed-country economic activity
can be reduced.
4. Greater collective self-reliance will be fostered.
5.6.2. Economic Integration: Theory and Practice
One strong variant of the South-South trade hypothesis is that LDCs should go beyond
greater trade with one another and move in the direction of economic integration. Economic
integration occurs whenever a group of nations in the same region, ideally of relatively equal
size and at equal stages of development, join together to form an economic union or regional
trading bloc by raising a common tariff wall against the products of nonmember countries
while freeing internal trade among members.
In the terminology of integration literature, nations that levy common external tariffs while
freeing internal trade are said to have formed a customs union. If external tariffs against
outside countries differ among member nations while internal trade is free, the nations are
said to have formed a free-trade area. Finally, a common market possesses all the attributes of
a customs union (common external tariffs and free internal trade) plus the free movement of
labor and capital among the partner states.
The theory of customs unions and economic integration is associated primarily with the work
of Jacob Viner of Princeton University in the 1940s. The traditional core idea of this theory,
which focuses on the static resource and production reallocation effects within highly
integrated and flexible industrialized nations, is of limited value to contemporary developing
nations intent on building up their industrial base. Yet many concepts of the theory of
integration provide valid criteria on which to evaluate the probable short-run success or
failure of economic cooperation among Third World countries.
The basic economic rationale for the gradual integration of less developed economies is a
long-term dynamic one: Integration provides the opportunity for industries that have not yet
been established as well as for those that have to take advantage of economies of large-scale
production made possible by expanded markets. Integration therefore needs to be viewed as a
mechanism to encourage a rational division of labor among a group of countries, each of
which is too small to benefit from such a division by itself. In the absence of integration, each
separate country may not provide a sufficiently large domestic market to enable local
industries to lower their production costs through economies of scale.
In such cases, import-substituting industrialization will typically result, as we have seen, in
the establishment of high-cost, inefficient local industries. Moreover, in the absence of

integration, the same industry (e.g., textiles or shoes) may be set up in two or more adjoining
small nations. Each will be operating at less than optimal capacity but will be protected
against the imports of the other by high tariff or quota barriers. Not only does such
duplication result in wasted scarce resources, but it also means that consumers are forced to
pay a higher price for the product than if the market were large enough for high - volume,
low-cost production to take place at a single location.
This leads to a second dynamic rationale for LDC economic integration. By removing
barriers to trade among member states, the possibility of coordinated industrial planning is
created, especially in industries where economies of scale are likely to exist. Examples
include fertilizer and petrochemical plants, heavy industry like iron and steel, capital goods
and machine tool industries, and small farm mechanical equipment. But the coordinated
planning of industrial expansion that enables all member states to accelerate their rates of
industrial growth by assigning given industries to different members takes the partners that
much closer to full economic and eventual political union.
Problems of sovereignty and national self-interest impinge at this stage. To date they have
overwhelmed the economic logic of a close and coordinated union. However, as Third World
nations, especially small ones, continue to experience the futility of either development in
isolation (autarchy) or full participation in the highly unequal world economy, it is likely that
interest will increase in the coming decades in the long run benefits of some form of
economic (and perhaps political) cooperation. In addition to these two long-term dynamic
arguments for integration, there are also the standard static evaluative criteria known as trade
creation and trade diversion.
Trade creation is said to occur when common external barriers and internal free trade lead to
a shift in production from high- to low-cost member states. For example, before integration,
both country A and country B may produce textiles for their respective local markets.
Country A may be a lower-cost producer, but its exports to country B are blocked by the
latter's high tariffs. If A and B form a customs union by eliminating all barriers to internal
trade, country A's more efficient low-cost textile industry will service both markets. Trade
will have been created in the sense that the removal of barriers has led to a shift in country
B's consumption from its own relatively high cost textiles to the lower-cost textiles of country
A.
Similarly, trade diversion is said to occur when the erection of external tariff barriers causes
production and consumption of one or more member states to shift from lower-cost

nonmember sources of supply (e.g., a developed country) to higher-cost member producers.
Trade diversion is normally considered undesirable because both the world and member
states are perceived to be worse off as a result of diversion of production from more efficient
foreign suppliers to the less efficient domestic industries of member states.
But this static argument against economic integration ignores two basic facts. First, because
of potential economies of scale, the creation of local jobs, and the circular flow of income
within the integrated region, static trade diversion may turn out to be dynamic trade creation.
This is simply a variant of the standard infant industry argument for protection, but with the
more likely possibility that the infant will grow up as a result of the larger market in which it
now operates.
Second, if in the absence of integration, each member state were to protect its local import-
substituting industry against all lower-cost foreign suppliers, the common external tariff of
member states would cause no more trade diversion than would have happened anyway. But
as we just saw, if there are scale _economies, the possibility of dynamic trade creation can
emerge. Hence we conclude that static concepts like trade creation and trade diversion are
useful. However, it is important that they be analyzed in the dynamic context of growth and
development and based on the realities of current commercial policies of developing nations,
rather than in the theoretical vacuum of traditional free- trade models.
5.7 Regional Trading Blocs and Trade Globalization

We may conclude, therefore, that developing countries at relatively equal stages of
industrial development with similar market sizes and with a strong interest in coordinating
and rationalizing their joint industrial growth patterns stand to benefit most from the
combined inward- and outward-looking trade policies represented by economic
integration. In particular, regional groupings of small nations like those of Central
America and Southern and Western Africa can create the economic conditions (mainly in
the form of large internal markets) for accelerating their joint development efforts.
Such groupings can also promote long-run development by enabling nations to block
certain forms of trade with the more powerful developed nations and perhaps also to
restrict or prohibit the deep penetration of multinational corporations into their industrial
sectors. In any event, integration is crucial: Without cooperation and integration, the
prospects for sustained economic progress by most low- and middle-income LDCs will be
greatly diminished.

But even if such an integration strategy may seem economically logical and persuasive on
paper (and may in fact be the only long-run solution to the economic problems of small
nations), in practice it requires a degree of statesmanship and a regional rather than
nationalistic orientation that is often lacking in many countries. The unfortunate demise of
the East African Community in the 1970s demonstrates how political and ideological
conflict-in this case among Kenya, Tanzania, and Uganda-can more than offset the
economic logic of regional cooperation.
But prospects for the future are much more positive. As trade becomes increasingly
globalized, even the largest industrialized nations now realize that they cannot go alone. In
Europe, a single economic market became a reality at the end of 1992 as all internal trade
barriers were removed. Now the European Union has a single currency, requiring close
monetary coordination and in effect creating the largest economic entity in the world.
Similar efforts are under way in North America, where the North American Free Trade
Agreement (NAFTA) represents a unique arrangement in that a developing country,
Mexico, has joined a developed-country trading bloc, Canada and the United States.
(Chile, a NIC is also seeking membership.)
Two major trading blocs now exist in Latin America. Argentina, Brazil, Paraguay, and
Uruguay in 1994 finalized arrangements for a free-trade area called the Southern Cone
Common Market, also known as Mercosur. In the six years after the original treaty was
signed in 1990, regional trade in Mercosur more than quadrupled to $17.1 billion, and
Brazil replaced the United States as Argentina's largest trading partner (once Brazil and
Argentina were bitter rivals). Mercosur is taking advantage of sizable economies of scale
and a new expanded market of 180 million people and $800 billion of economic activity.
The other Latin American bloc, the Andeah Group (consisting of Bolivia, Colombia,
Ecuador, Peru, and Venezuela), established a full-fledged common market in 1995. Its
intra-union trade expanded by 370% between 1990 and 1996. In Africa, moves are under
way. To promote regional economic integration, the most promising is the newly formed
South African Development Community (SADC). Thanks to well-developed railroad and
air links, the 10 members of SADC-Angola, Botswana, Lesotho, Malawi, Mozambique,
Namibia, South Africa, Swaziland, Zambia, and Zimbabwe-anticipate new and much
greater trading opportunities. In SADC's intra-union trade grew by 450% in the 1990s.
The critical question about all these new regional trading blocs is not whether they will
promote greater internal growth (which they likely will) but whether such regional groupings

will fragment the world economy and run counter to the recent globalization of trade. Most
economists believe that globalization is here to stay, particularly as multinational
corporations set up subsidiaries throughout the world. For LDCs, effective regional blocs can
provide a buffer against the negative effects of globalization while still permitting the
dynamic benefits of intra-union specialization and greater equality among members to take
place.
5.8 .Trade Policies of Developed Countries: The Need for Reform
We have seen that a major obstacle to LDC export expansion, whether in the area of primary
products or manufactures, has been the various trade barriers erected by developed nations
against the principal commodity exports of developing countries. In the absence of economic
integration or even in support of that effort, the prospects for future LDC trade and foreign-
exchange expansion depend largely on the domestic and international economic policies of
developed nations. Although internal structural and economic reform may be essential to
economic and social progress, an improvement in the competitive position of industries in
which LDCs do have a dynamic comparative advantage will be of little benefit to them or the
world as a whole so long as their access to major world markets is restricted by rich-country
commercial policies.
Developed countries' economic and commercial policies are most important from the
perspective of future Third World foreign-exchange earnings in three major areas:
1. Tariff and non tariff barriers to LDC exports
2. Adjustment assistance for displaced workers in developed-country industries hurt by
freer access of labor-intensive, low-cost LDC exports
3. The general impact of rich-country domestic economic policies on developing
economies
Rich-Nations Tariff and Non-tariff Trade Barriers and the 1995 Uruguay Round GATT
Agreement
Until 1995, the new-protectionist tariff and non-tariff trade barriers (e.g, excise taxes, quotas,
"voluntary" export restraints, sanitary regulations) imposed by rich nations on the commodity
exports of poor ones were the most significant obstacle to the expansion of the 'latter's export-
earning capacities. Moreover, as we have seen, many of these tariffs increased with the
degree of product processing. This means these tariffs were higher for processed foodstuffs
than for basic foodstuffs, higher for, say, shirts than for raw cotton. These high effective
tariffs inhibited LDCs from developing and diversifying their own secondary-export

industries and thus acted to restrain their industrial expansion.
The overall effect of developed-country tariffs, quotas, and non-tariff barriers had been to
lower the effective price received by LDCs for their exports, reduce the quantity exported,
and diminish foreign-exchange earnings. Although the burdens that developed-country
tariffs imposed on LDC primary- and secondary product exports varied from commodity to
commodity, it has been estimated that the net impact of trade barriers on all products has
reduced Third World foreign exchange earnings by more than $40 billion per year.
However, the final act of the Uruguay Round agreement that was signed in April 1994 and
became effective in 1995 after passage by 124 national legislatures substantially reduced
tariff and non-tariff trade barriers in many sectors. It also established the World Trade
Organization (WTO) to replace the 47-year-old General Agreement on Tariffs and
Trade (GATT). The Geneva-based WTO is intended to oversee the trade agreements and
settle trade disputes. The three major provisions of the accord, from the perspective of
Third World nations, are the following:
1. Developed countries will cut tariffs on manufactures by an average of 40% in five
equal annual reductions. Tariffs will be eliminated in 10 major sectors (beer,
construction equipment, distilled spirits, farm machinery, furniture, medical
equipment, paper, pharmaceuticals, steel, and toys). Developing countries in turn
agreed to not raise tariffs by "binding" in recent trade reforms. Despite these
reductions, developing countries still face tariffs that are 10% higher than the global
average while the least developed countries face tariffs that are 30% higher.
2. Trade in agricultural products will come under the authority of the WTO and be
progressively liberalized. Developed-country non-tariff barriers were to be converted
into tariffs and reduced to 36% of the 1986-1988 level by the year 2000. Agricultural
subsidies will also be reduced, but only by 21 % in the volume of subsidized exports.
3. For textiles and apparel, the Multi-Fiber Arrangement (MFA) quotas, which have long
penalized exports of developing countries, will be phased out by 2005, with most of
the reductions taking effect toward the end of the period. But tariffs on textile imports
will be reduced only to an average of 12%- three times the average level of tariffs on
other MDC imports.
One optimistic study that attempted to assess the quantitative impact of the agreement on

developing-country economies concluded that the Third World's real income could grow by
as much as $78 billion (in 1992 dollars). But even if this is correct, the gains would be very
unevenly distributed. Many of the poorest LDCs-especially those that are net food importers
and will face higher import prices as MDC agriculture subsidies are removed-are likely to
lose. LDCs in Africa currently enjoying trade preferences may also be harmed.
Finally, environmental groups have been critical of the agreement for its exclusive focus on
growth and its lack of attention to the preservation of sensitive and threatened environmental
resources. In short, while many analysts are optimistic that the new GATT accord represents
a major transition to a more liberal world trading system that will inevitable help the majority
of developing countries, it remains to be seen whether the least developed countries will in
fact benefit or whether the Uruguay Round Agreement will further widen the gap between
rich and poor nations. To date, the gap appears to be widening for most LDCs. An evaluation
by the UNDP in its 1997 Human Development Report led its authors to the following
conclusion:
Poor countries often lose out because the rules of the game are biased against them -
particularly those relating to international trade. The Uruguay Round hardly changed
the picture. Developing countries, with three-quarters of the world's people, will get
only a quarter to a third of the income gains generated-and most of that will go to a
few powerful exporters in Asia and Latin America.
The Problem of Adjustment Assistance
One of the major obstacles to lowering tariff barriers of rich countries against the
manufactured exports of poorer nations is the political pressure exerted by traditional light
manufacturing industries that find their products under-priced by low-cost, labor-intensive
foreign goods. Not only can this cause economic disruption for these higher-cost domestic
industries, but it can also lead to a loss of employment for their workers. In classical trade
theory, the answer to this dilemma would be simple: Merely shift these rich-country workers
with their complementary resources to the other more capital-intensive industries where a
comparative advantage still exists. Everybody will be better off as a result.
Unfortunately, even in the most industrialized and economically integrated societies of the
world, the process of adjustment is not so simple. More important, the political power of
many of these older industries is such that whenever they feel threatened by low-cost foreign
imports, they are able to muster enough support effectively to block competition from the
LDCs.

Unless some scheme of adjustment assistance is established whereby the governments of
developed nations assist industries and their workers financially in the transition to alternative
and more profitable activities, trade barriers against competitive Third World exports will be
difficult to remove. Many such schemes have been proposed. To date, none has been really
effective in persuading threatened industries and industrial workers to forgo their private
interests in the interest of maximum world welfare. This is not surprising. In fact, the typical
response of developed-country governments has been to subsidize new investment in
threatened industries to keep them afloat.
Nevertheless, continuous efforts must be made to search for an acceptable program of
adjustment assistance that will not unduly penalize displaced workers, who themselves often
come from the lower income bracket. Without the introduction of such programs in
developed nations, the world market for Third World manufactured exports will always
remain restricted, both for new entrants and for the growth of existing suppliers.
Although it is beyond the scope of this chapter to examine the myriad ways in which the
economic welfare of many export -oriented poor nations is tied to the domestic fiscal and
monetary macroeconomic policies of rich nations, the importance of this link must not be
overlooked. The major factor determining the level and growth of Third World export
earnings has been the ability of rich nations to sustain high rates of economic growth without
inflation. This was clearly confirmed by their relatively good performance in the 1960s and
1990s and their sharp decline during the recessions of the 1970s and 1980s. Even a low
income elasticity of demand for LDC exports can be compensated for by a high rate of
income growth in a developed country. It follows that under present international economic
relationships, Third World export performance is directly related to the growth and price
stability of developed-country economies.
But just as the poor are often said to be the last to be hired and the first to be fired, so too,
when international economic disruptions occur, the world's poor nations feel the effects much
sooner and more substantially than the rich nations do. The worldwide inflationary spiral of
the 1970s caused by a combination of Keynesian-type excess aggregate demand pull and
natural resource, especially petroleum, cost push factors provide a classic example of this
phenomenon. Facing rampant inflation at home, developed countries were able to call on
traditional macroeconomic policies designed to restrict aggregate demand (e.g., lower
government expenditure, higher taxes, higher interest rates, a slower-growing money supply)
while attempting to control wage and price rises.

When rapid inflation is accompanied by growing balance of payments deficits and rising
domestic unemployment as in the 1970s, these deflationary domestic fiscal and monetary
policies tend to be reinforced by specific government actions to curtail imports and control
the outflow of foreign exchange. The nations hit the hardest by these belt-tightening measures
are usually the weakest, most vulnerable, and most dependent of the world, the 40 or so
poorest LDCs. Although they are not the intended victims of such domestic economic
policies, the fact remains that they are the main victims.
Clearly, we cannot blame the developed nations for looking first after their own domestic
economic interests. Nevertheless, it would not seem unreasonable to ask them to try to ease
the burden of their spending cutbacks on the poorest nations by giving the exports of these
nations some form of preferential treatment. But the lesson is clear. As long as developing
nations, either individually or as a group, whether willingly or unwillingly, permit their
economies to be linked too closely to the economic policies of rich nations, they will remain
the chief, albeit innocent victims in times of stress and but minimally rewarded in times of
prosperity. Even more disturbing is the loss of their capacity to control their own economic
and social destinies.
The lessons of the past 40 years thus revealed to developing nations, as no economic model
could, their need to make every effort to reduce their individual and joint economic
vulnerabilities. One method of achieving this goal is to pursue policies of greater collective
self-reliance within the context of mutual economic cooperation. Though not denying their
interdependence with developed nations and their need for growing export markets, many
developing countries now realize that in the absence of major reforms of the international
economic order, a concerted effort at reducing their current economic dependence and
vulnerability is essential to any successful development strategy.
CHAPTER 6
INTERNATIONAL CAPITAL MOVEMENT
Looking in to the sources of finance is compulsory in dealing with development. As
Economic development can be financed from domestic sources as well as external sources.
Learning Objectives
At the end of this chapter, Students are expected to know:
 The international flow of finical resources
 Basic concepts and definition of private foreign investment

 The between Private and public development assistance
 The cost and benefit of foreign direct investment, and
 The concept of foreign aid
 And explain the rationales of aid in general and complex human society
6.1. Introduction
The aim of this chapter is to introduce you with the basic concepts of international capital
flow. As it is known shortage of capital is one big problem of all developing countries and to
overcome this problem the flow of finance is assumed to fill this gap but the final outcome
this financial flow may not be satisfactory as it is expected, as a result scholarly treatment of
foreign capital flow is necessary to internalize the benefit and reduce its cost. In this chapter
the various types of international financial flows and private and public development
assistance are given focus. The costs and benefits of different types of financial flow are
discussed in detail so that you will be able to analyze the overall nature of capital movement.
As many indicate the flow of finance from developed countries is only for their own sake like
increasing of the demand for the product they are producing and increasing the dependence of
LDCs on developed countries. As far as foreign aid is concerned, it meaning, nature and
significance is given focus since the rationale behind motives of foreign aid may give hint
regarding the lack of trust in aiding countries and hidden objective which may be achieved in
the name of foreign aid in particular and movement of international capital in general
6.1.1. The International Flow of Financial Resources

“This increased capital flow reflected greater confidence in the economic prospects of
several developing countries. Countries are benefiting from improved global market
conditions and investment climates, while closer global financial integration is posing
difficult challenges to policy makers in both developed and developing countries to sustain
economic growth and financial stability.
Francois Bourguignon, Senior Vice president and Chief Economist, the World Bank
A summery international capital flow
In this section we are concerned with autonomous international capital flows, which could be
summarized as follows:

International Autonomous Financial Flows
Private Foreign Investment Public Development Assistance
Long Term Capital Short Term Capital

NGOS Foreign Aid
Direct Investment Portfolio Investment Debt Flows
Commercial Bank Loan Bonds Others
The overall surplus or deficit in the balance of payments is the results of two kinds of
financial flows:
 Induced financial flows, that arise due to commodity flows (import and export)
 Autonomous financial flows i.e. short-term and long - term investment and foreign
aid.
That is, a country’s international financial situation as reflected in its balance of payment
and its level of monetary reserves depends not only on its current account (it commodity
trade) but also on its capital account (outflow and inflow of private and public financial
resources).
Since almost all non- oil exporting developing nations incur deficits on their current
account balances, a continuous net inflow at foreign financial resources represents an
important ingredient in their long run development strategies.
The international flow of financial resources takes two forms:
1. Private foreign Direct Investment and Portfolio Investment
It consists
a) Private foreign Direct Investment by large MNCs ( Multinational
Corporations) with head quarters in the developed nations and

b) Foreign portfolio investment
o Stocks
o Bonds and
o Notes s
2. Public and Private development assistance(foreign aid)
a) Individual national governments, and Multinational donor agencies and
increasingly.
b) Private non – governmental organizations (NGOs) most working directly with
developing nations at the local level.
In this chapter we examine the nature, significance and controversy regarding private direct
and portfolio investment and foreign aid in the context of the changing world economy.
6.2. Net long – term Resource flows to Developing Nations
“These increased capital flow reflected greater confidence in the economic prospects of
several developing countries. Countries are benefiting from improved global market
conditions and investment climates, while closer global financial integration is posing
difficult challenges to policymakers in both developed and developing countries to sustain
economic growth and financial stability”
Francois Bourguignon, senior Vice President and Chief Economist, the world bank
Total resource flow (official & private) has almost continuously increased since 1990. It has
increased from $98.3 billion in 1990 to $300.36 billion in 1997. The table below presents the
1990s scenario of net long-term resource flows of different categories.
According to the table the share of official Development Finance has a declining trend where
as private foreign investment has an increasing trend since 1990. Of the private foreign
investment, foreign private direct investment accounted for the largest proportion (47%) in
1997 followed by private debt capital (40%)

Table 6.1 Net long – term Resource flows to Developing countries* 1990-1997.
Types of Flow 1990 1991 1992 1993 1994 1995 1996 1997
1. Official Development 56.4 62.7 53.8 53.6 45.5 54.0 34.7 44.2
Finance (ODF)
Grants 29.2 35.1 30.5 28.4 32.7 32.6 29.2 25.1
Loans 27.2 27.6 23.3 25.1 12.9 21.4 5.4 19.1
Bilateral 11.6 13.3 11.1 10.0 2.5 10.0 7.2 1.8
Multilateral 15.6 14.4 12.24 15.2 19.4 13.3 12.6 17.4
2. Total Private Flows 41.9 53.6 90.1 154.6 160.6 189.1 246.9 256.0
Debt Flows 15.0 13.5 33.8 44.0 41.1 55.1 82.2 103.2
Commercial Bank loan 3.8 3.4 13.1 2.8 8.9 29.3 34.2 41.1
Bonds 0.1 7.4 8.3 31.8 27.5 23.8 45.7 53.8
Others 11.1 2.7 12.4 9.4 4.7 2.0 2.3 8.3
Foreign Direct Investment 23.7 32.9 45.3 65.6 86.9 101.5 119.0 120.4
Portfolio equity Flows 3.2 7.2 11.0 45.0 32.6 32.5 45.8 32.5
Total (1+2) 98.3 116.3 143.9 208.1 206.2 243.1 281.6 300.3
*Including low – and middle income countries with 1995 per capita income of $765(low) and
$9385 (middle) Source: World Bank, Global Development Finance, 1998, Page 3
In 2005, net private capital flows to developing countries reached a record high of $491
billion, driven by privatization, mergers and acquisitions, external debt refinancing, as well as
strong investor interest in local – currency bond markets in Asia and Latin America, says the
world Bank’s annual 2006 Global Development Finance reports.
The sharp rise in private flows to developing countries came despite uncertainties caused by
high oil prices, rising global interest rates and growing global payments imbalances, Private
debt flows to developing countries rose to an estimated $192 billion, up from $ 85 billion in
2003, driven by abundant global liquidity, steady improvement in developing – country credit
quality, lower yields in rich countries, and expansion of investor interest in emerging market
assets.
Multi National Companies are corporations or enterprise that conducts and controls
productive activities in more than one country. These huge firms present a unique opportunity
and a host of serious problems for the many developing countries in which they operate.

Here we must recognize that MNCs are not in the development business: there objective is to
maximize their return on capital. This is why over 90% of global FDI goes to other industrial
countries and the fastest growing third world Nations. MNCs seek out the best profit
opportunities and are largely unconcerned with issues such as poverty, inequality, and
unemployment alleviation.
People sometimes compare the economic magnitude of the world’s largest corporations to
various mid- sized national economies. A commonly – quoted report notes that of the world’s
100 largest economies, 51 are companies while only 49 are countries.
To put this in perspective, General Motors is now bigger than Denmark; Daimler Chrysler is
bigger than Poland; Royal Dutch/shell is bigger than Venezuela; IBM is bigger than
Singapore; and Sony is bigger than Pakistan”.
6.2.1. Kinds of private Foreign Investment
Private or non – official foreign investment refer to all long and short – term investment by
the citizen of a country into income yielding assets of another country.
Foreign private investment is generally classified on the bases of
 The maturity period of the assets and
 Owner ship, control and management
On the base of maturity period, the Foreign private investment is categorized as:
i. short – term investment, and
ii. long term investment
On the bases of control and management, it is classified as:
a) portfolio investment, and
b) Direct investment
i. Short – term and long – term investment
Short term investments are those with a maturity period of less than one year.
 Short-term assets include
- Demand deposits in foreign bank
- Treasury bills.
- Government bonds
- Commercial papers, etc.
 Long – term investment include:
- Common equity
- Plant and building

- Real estate ( which never mature)
- Mortgage
- Long – term bonds, etc.
The distinction between short and long term is only conventional: in reality a short – term
investment may be rolled over again and again as it matures, and can be converted into a long
– term one: similarly a long – term investment may be converted into a short – term one by
selling the assets within a year.
Long – term private foreign investment can be further classified as:
a) portfolio investment, and
b) Direct investment
a) Foreign portfolio investment refers to the investment in common stock and bonds of a
corporation. By so doing an investor becomes a part owner of the corporation and has
the right to share the profit, whereas an investment in bonds gives the right to interest
only.
b) Foreign direct corporation setting up their subsidiaries in a foreign country and
* Multinational corporation setting up their subsidiaries in a foreign country, and
* Buying majority (51%) shares in a domestic company
In case of FDI ownership, control, and management go together.
What can be done to attract FDI in LDCs?
Recipient countries can provide different incentives for attracting FDI. Some of these are:
* Providing information on investment opportunities
* Providing supplementary capital
* Availing infrastructural facilities
* Imposition of protective tariffs on competing imports
* Exempting capital import from import duty
* Granting exchange guarantee
* Removing administrative obstacles
* Tax incentives and subsides
* Providing facility for repatriation of profits and capital
* Granting control management and control power to the foreign investors
6.2.2. Benefits and costs of Foreign Direct Investment
Few areas in the economics of development arouse so much controversy and are subject to
such varying interpretations regarding with the benefits and costs of private foreign

investment. Thus, understanding the benefits and the drawbacks of FDI is imperative to
formulate a sound policy. Even if, in recent time, a policy that favors FDI dominates, there
are two opposing views as to the role of FDI in developing economies. On the one hand, it is
argued that FDI benefits the host country, for instance by creating employment opportunities
and bringing new technologies. In contrast, the other groups argue that the adverse effects of
FDI outweigh its benefits.
6.2.2.1. Benefits of Foreign Direct Investment
FDI benefits developing economy as it offers the possibility for channeling resources to
developing countries. According to this argument, FDI is becoming an important source of
funds at a time when access to other means of financing is dwindling, particularly in the
aftermath of the international debt crisis that emerged in the early 1980s. Lipsey (1999)
argues that FDI has been the most dependable source of foreign capital for developing
countries.
FDI can also help to fill the gap in the balance of payment by reducing part or the entire
deficit. This is because; multi-national companies assemble products which are exported to
international markets and able to generate net positive export earnings.
FDI can also play important role by creating employment opportunities and by integrating the
host-countries economy in to the world economy (OECD, 2002). Moreover, FDI is important
in this sense not only because it entails the movement of financial capital but also because it
is normally associated with the provision of technology as well as managerial, technical and
marketing skills.
Summarizing the idea of proponents view FDI is typically seen as growth stimulants by
filling saving and investment gaps, foreign exchange gap(trade gap),revenue gap and lastly
but not least filling gaps in management, entrepreneurship, technology and skill presumed to
be filled partly or wholly by local operation of private foreign investment.
6.2.2.2. Costs of FDI
A group of scholars in many countries show an ambivalent attitude towards FDI. Inward FDI
is said to have negative employment effect, retard home-grown technological progress and
worsen the trade balance. A substantial foreign ownership often brings the rise in concerns
related to loss of sovereignty and compromise over national security. Outward FDI is
sometimes blamed for the export of employment, and for giving foreigners access to
domestic technology. Certainly, initial investment of foreign firms improves the current and
the capital account of the host country. However, in the long run, substantial import of

intermediate and capital goods, repatriation of profit, interest, royalties and management fees
may harmfully affect the foreign exchange position of the host countries.
Trans-national companies contribute to close the gap between locally collected tax and
targeted revenue. However, governments often enter in to exclusive agreements with foreign
firms and provide tax holidays, tariff protections, and investment allowances. Due to these
reasons, the taxes that can be collected become quite small. Moreover, these firms can avoid
local taxation by transferring pricing techniques as a method used to reduce local profit level
and by paying artificially inflated prices to the intermediate products purchased from foreign
subsidiaries.
In general, the arguments of both for and against private foreign direct investment are still far
from being settled empirically and may never be, as they ultimately reflect important
differences in value judgments and political perceptions concerning desirable development
strategies.
6.2.2. 3.Effects of Foreign Direct Investments: Pro-development effects
Though there is a fundamental disagreement on what constitutes the costs and benefits of the
perspectives of the countries, the possible way to explain the effect of FDI is to use
conventional multiplier process. Hence, the fact why investors are undertaking FDI projects
in the host country is that, it creates economic, political and social effects that impinge the
costs and benefits of FDI.
Economic growth depends on the rate of investment which in turn largely depends on
savings. However, gross domestic savings are too low in the least developed countries in
general and Ethiopia in particular. Foreign direct investment is an alternative source to fill the
gap between savings and the required investment. Foreign firms bring not only financial
capital but also managerial techniques as well as, entrepreneurial and technological skills that
lack in LDCs and these skills can be transferred to domestic firms through different channels.
The government’s budget deficits can also be filled by profit-tax may be collected from
transnational companies (Todaro, 1992).
The total amount of foreign exchange that can be obtained from export and net public foreign
aid falls short of foreign exchange that is required by LDCs. FDI can help to fill this gap by
reducing part or the entire deficit in the balance-of-payments. Moreover, multinational
companies manufacture products that can be exported and are able to generate net positive
export earnings (Ibid).

Foreign direct investment plays an extraordinary and growing role in global business
interaction of Ethiopia. It can also provide a firm with new markets and marketing channels,
cheaper production facilities, access to new technology, products, skills and financing. For a
host country or the foreign firm which receives the investment, it can provide a source of new
technologies, capital, processes, products, organizational technologies and management
skills, and as such can provide a strong impetus to economic development.
FDI can also play important role by creating employment opportunities and by integrating
the host-country economy in to the world economy (OECD, 2002). Recently, Ethiopia need
massive inflows of foreign direct investment to even approach its ambitious GTP goals. This
will be successful by treating foreign investors who do face unfavorable tax treatment, denial
of licenses, discriminatory import or export policies, or inequitable tariff and non-tariff
barriers (EIA, 2008).
Based on neoclassical economics principle which postulates FDI raises income and social
welfare in the host country unless the optimum conditions are distorted significantly by
protections, monopoly and externalities, the effects of FDI in the host country can be
classified in to economic, political and social effects. The conceptual framework of these
effects captures the conventional wisdom of FDI. Thus, by mean economic effects of FDI it
includes implications (macro and micro) of economic variables such as output, balance of
payments and market structures. The political effects include the question of national
sovereignty, as a sheer size of investing multinational companies may jeopardize national
independence. The social issues are concerned mainly with creation of enclaves and foreign
elite in the host country as well as the cultural effects on local populations (Markusen, 2003).
Earlier work had put political effects and social effects in their literature to deal with
desirability of FDI by host country. In this study a detail review of economic effects
considered to understand the positive effects of FDI on economic development of host
country.
6.3. Foreign Aid and Economic Development
In this section we shall see:
 Historical Background of aid
 What foreign aid is
 Motives behind foreign aid,
 Effects of foreign aid on economic development.

Developing countries are characterized by deteriorating economic performance, mainly due
to their dependence on agricultural sector, stagnant per capita income, low level of living
condition of the people, etc. Thus, they are forced to look for external assistance from
developed countries, with the hope to change the prevailing nature of their economy.
While foreign private investment is a commercial financial flow foreign aid is a non-
commercial financial flow. Private foreign investment is based on profit and foreign aid is
based on non profit motive. But Aid is not a cure for all developing world’s problems but it
has often been effective in reducing suffering and assisting developments.
Foreign aid cannot be traced to an exact starting point because its origins are diverse. It is
essentially a post war phenomenon.
According to E.K.Hawkins,” … the idea of one country granting assistance to another is as
old as the history of nation – states. The role of economic aid as now understood, however,
dates back only to the Second World War.”
During WWII, extensive preparations were made for an orderly transaction from wartime to
peace time condition. Policy makers of the time foresaw three types of post war economic
problems: relief, reconstruction, and long term growth & stability. Foreign aid was one of the
foreign policy instrument adopted to attack all three problems.
Relief aid in the form of food, clothing and shelter on a grant basis was aimed at preventing
the famine disease and general chaos that are so likely to occur in the wake of war. The
policy makers realized that beyond the immediate need for relief aid, there was the need for
reconstructing the war torn economies of Europe. In addition to the short run planning for
relief and reconstruction, plans were laid for the promotion of lone term growth and stability.
After WWII, in general, the following reasons increase the inflow of aid:
 An agreement has been signed to bring the UN and its family organization. They
become the basis of multinational aid.
 The “ Marshal plan” by USA to reconstruct the war torn economies of Europe
 The accession to independence of the colonized nation and the growing constituency
of aid receiving nation.
 USA has been giving aid in order to control the spread of communism from the
former Soviet Union.
In Africa, the share of foreign Aid to GDP has significantly increased over the last decades.
6.3.1. The concept of foreign Aid

Foreign aid, also called official development assistance (ODA), has been an important feature
in the international economy. Foreign resources have played an important role in the
economic development of many advanced countries of today. In Principle all resource
transfers from one country to another should be included in the definition of foreign aid.
However, we shouldn't include all transfer of capital to LDCs, particularly the capital flows
of private foreign investors.
Economists defined foreign aid, therefore, as any flow of capital that meets two criteria:
1. Its objective should be non-commercial from the point of view of the donors.
2. It should be characterized by concessional terms, i.e., the interest rate and
repayment period of borrowed capital should be softer (less significant) than
commercial terms.
Foreign resources have played an important role in the economic development of many
advanced countries of today, likewise, the LDCS of today are more or less in the same stage
of economic development as the DCs used to occupy on the 18th and 19th centuries.
Therefore, foreign resources could play a vital role in promoting economic development
where there is the savings gap and the foreign exchange gap on developing countries.
Most developing countries, especially, Sub-Saharan African are dependent on foreign aid to
finance their development. For low income countries where most of the world poor lives,
foreign aid represents close to 70% of net external finance. In any of these countries, aid is
much more important source of foreign exchange than export earnings. Like any other
developing countries, Ethiopia has been taking a large portion of foreign resources from
bilateral and multilateral sources in order to minimize the after-effect of natural disaster.
With the help of foreign aid, Ethiopia like many African countries has been designing and
implementing programs or projects in almost all sectors with the aim of improving economic
and social conditions. For instance, in the agricultural sector, a number of aid financed
development projects and programs have been initiated and executed as part of agricultural
and rural development strategies. Most of these projects or programs have been aimed at the
provision of agricultural inputs and establishing and improving agricultural and rural
infrastructures, like rural roads, storage facilities, water supply and agricultural resource
conservation and management.
According J. N Bhagwati: Foreign aid is defined as the flow of capital from developed
countries that meets two criteria:
a) It has non – commercial motive from the donor – country’s point of view, and

b) It involves concessions in interest rates and terms of repayment.
According to Todaro, the concept of foreign aid encompasses all official grants and
concessional loan, in currency or in kind, that are broadly aimed at transferring resources
from developed to less developing nations- on development and income redistribution
grounds. Foreign aid includes also the resource transfer from OPEC to other developing
nations.
6.3.2. FOREIGN AID MOTIVATIONS
Because foreign aid is seen differently by donor and recipient counties, we must analyze the
giving and receiving process from these two often contradictory view points. One of the
major criticisms of the literature on foreign aid is that it has concentrated almost exclusively
on the motives and objectives of donor countries while devoting little attention to why LDCs
accept aid and what they believe it will accomplish.
6.3.2.1. Why Donors give Aid?
Some of the reason for donors to give aid as: "Donor countries give aid primarily because it is
in their political, strategic or economic self-interest to do so. Some development assistance
may be motivated by moral and humanitarian desires to assist the less fortune (e.g.
emergency food relief programs), but there is no historical evidence to suggest that over
longer periods of time, donor nations assist others without expecting some corresponding
benefits (political, economic, military, e.t.c) in return.
A. The moral case for Aid
What concerns here is the claim made by governments and supporters of aid that it should be
given for moral reasons. Since its inception, aid has been continuously provided on the
grounds of morality. With government asserting that there is a moral obligation to grant aid.
In some instances, for example, Sweden in the early 1960s, countries have maintained that
morality provides the exclusive reason for an aid program.
Still some writers say that since Africa helped Europe forcefully during colonization, it is the
turn of Western Europe to help Africa develop. The today’s national boundaries are artificial
boundaries and there is high income inequality in the distribution. There fore, redistribution
of income in the form of Aid is necessary.
i. Christian Faith and Theology
For some it is Christianity or the ethical implication derived from Christianity that provides
the basis for the obligation. For this group scriptural texts are a powerful force in confirming

obligation. Two quotations, selected from among many would appear to provide the proof for
these believers.
If one of your brothers or one of your sisters is in need of clothes and has not enough foot to
live on and one of you says to them, ‘ I wish you well: keep yourself warm and eat plenty’.
Without giving them the bare necessities of life, then what good is that? Faith is like that: if
good works do to go with it, it is quite dead.
James 2:15-16
In this way we distinguish the children of God from the children of the devil: anybody not
living a holy lie and not loving his brother is no child of God’s … if a man who was in need,
but closed his heart to him how could the love of God be living in him?
First E [istle of john 3:10 and 17
ii. The Human Good
The fundamental principle of the human good is based on an understanding of being human
and what is for human well being. There is a basic moral “right to life” and the condition
necessary for it. Hence, if one accepts the principle of human good, no distinction is to be
made between different people in different countries.
iii. Needs
It carries the idea that human beings have needs that has to be fulfilled in order to be human.
Advocates of this idea believe that there is an obligation to provide it. It has frequently based
those claims on a principle of justice captured in the phrase ‘to each according to his needs.’
An account of the theory of Justice based on need begins with thinking of the harm that
people will suffer through not having, or being provided with, what they need. Hence a sound
concept of need is the following:
“A needs X = A will suffer harm if he lacks X”
Here, what constitute harm are actions that hinder the development of a person’s ‘plan for
life’.
B. Non Moral case for Aid
Different writers criticize the moral obligation to aid. They contend that the fundamental
basis for government actions beyond national boundaries is national self interests. That is,
countries give aid primarily because it is in their political, strategic and /or economic self –
interest to do so.
According to Todaro

“Donor countries give aid primarily because it is their political, strategic, and/or economic
self interest. While some development assistance may be motivated by moral and
humanitarian desires to assist the less fortunate (e.g. Emergency food relief programs). There
is no historical evidence to suggest over longer periods of time donor nations assist others
without expecting some corresponding benefits (political, economic, military. etc) in return”
The foreign aid motivations of donor countries can be categorized into two broad, but often
interrelated categories: Political and Economic.
i. Political Motive
It is generally clear that aid will not be given to one’s enemy. This has been by far the
primary motivation of aid granting nations, especially the two major donor countries: the
United States and the Soviet Union. Most aid programs to developing countries were,
therefore, oriented towards purchasing their security and propping up their some times shaky
regions than promoting long – term social and economic development.
 During the cold war period it was a strategic action.
 To prevent the spread of communism
 The US Marshall Plan initialed in the 1940s after the war has the same motive.
ii. Economic Motive
Within the broad context of political and strategic priorities, foreign aid programs of the
developed nations have had a strong economic rational. One of the principal economic
arguments is to facilitate and accelerate the process of development by stimulating and
generating additional domestic savings because of the higher growth rates, which it presumed
to induce. Eventually, the need for aid disappears. Local resource there become sufficient to
make the development process self sustaining.
Within the broad context of political and strategic priorities foreign aid programs of the DCs
have had a strong economic rationale. These can be grouped in to two aspects.
a. Economic motives from the point of view of recipients
b. Economic motives from the point of view of donors
a. Economic motives from the point of view of recipients:
o Foreign exchange constraints: External finance (both grants & loans) can play a
critical role in supplementing domestic resources in order to relieve savings or foreign
exchange bottlenecks. This is the so-called two-gap analysis of foreign assistance.

Therefore, the LDCs require foreign aid to meet the deficits in their external balance
and to supplement domestic savings.
 Technological transfer
 Provision of economic and social infrastructure e.g. health, education, railways,
roads, communication etc.
b. Motives from the point of view of donors
DCs invest in LDC, not only to raise the growth rate of the LDCs, but also to improve their
own welfare.
Rate of interest: If the rate of interest on loans is higher than the productivity of capital in
developed donor country and lower than the productivity of capital in the developing
recipient country, both parties will gain.
Tied loans: most of the bilateral loans from DCs are tied loans. The recipient country
purchases the goods from the donor country at a higher price, higher than the competitive
market price.
Market: When an aid recipient country improves its economic conditions, its per capita
income improves and this creates a market for the products of DCs.
Economic Rational of Foreign Aid
 The two – Gap theory
 Focuses on the effects of foreign aid on two kinds of resource gaps in LDCs .i.e.
o The saving – investment gap, and
o The foreign exchange gap (import – export gap).
The theory states that LDCs are poor because of these two gaps.
iii. Historical Factors for Aid
The flow of foreign resources is sometimes guided by historical factors in the context of
former colonial powers. For example, British initiated colonial Development Act in 1929 in
the form of loan s and grants to the colonies. And even today some of the developed countries
give priorities to their former colonies while giving assistances.
6.3.2.2. Why LDC Recipients Accept Aid?
The reasons why third world nations, at least until recently, have been eager to accept aid,
even in its most stringent and restrictive forms, have been given much less attention than the
reasons why donors provide aid. Basically, we can identify three reasons, one major and two
minor why LDCs have sought foreign aid.

The major reason is economic. Third world countries have often tended to accept uncritically
the proposition-typically advanced by developed country economists, taught in all university
development courses and supported by reference to success cases like Taiwan, Israel and
South Korea to the exclusion of many more failures-- that aid is a crucial and essential
ingredient in the development process; it supplements scarce domestic resources; it helps
transform the economy structurally; and it contributes to the achievements of LDCs take offs
in to self-sustaining economic growth. Thus, the economic rationale for aid in LDCs is based
largely on their acceptance of the donors perceptions of what the poor countries require to
promote their economic development. Recipient countries consider foreign aid as one of the
major sources to raise their growth rate.
The two minor and still important motivations for LDCs to seek aid are political and moral.
There are moral, humanitarian motives to assist poor countries. The same arguments which
provided the basis for income redistribution with in nations can also be applied at the global
level, namely that absolute poverty is intolerable and that if the marginal utility of income
diminishes, total welfare will be increased by a redistribution of income from rich to poor.
From a moral and welfare point of view, national boundaries are quite artificial constructions.
Developing countries accept assistance with this concern in mind not only from national
government as part of their regular aid program, but also from many voluntary and charitable
organizations and from emergency & disaster relief funds.
As stated by Todaro (1994:547) whether on grounds of basic humanitarian responsibilities of
the rich toward the welfare of the poor or because of a belief that the rich nations owe the
poor national conscience money for past exploitations, many proponents of foreign aid in
both developed and developing countries believe that rich nations have an obligation to
support the economic and social development of the third world.
Finally, we come to political, military and historical motives for granting assistance.
Thirlwall explained that a large part of American aid program goes to her ally. Most
developing countries are willing to accept assistance on this basis, as an aid to their
development effort, particularly by governments threatened from hostile forces from within
or without . In some countries aid is seen by both donor and recipients as providing greater
political leverage to suppress opposition and maintain itself in power. In such instances,
assistance takes the form not only of financial resource transfers but of military and internal
security reinforcement as well.
6.3.2.3. Effects of Foreign Aid

Some argue that Aid has promoted growth and structural transformation in many LDCs.
Other argues that aid has aggravated the BOP problem of LDCs as a result of rising debt
repayment obligations and linking of Aid to donor – country exports.
 Assistance is mal distributed: there is no equal distribution in foreign aid. Foreign aid
does not reach poor people in the poor countries.
 Official aid is also criticized for focusing on the growth of the modern sector, thereby
increasing the gap in living standards.
 Foreign aid has failed due to its appropriation by corrupt bureaucrats.
 Recently foreign aid is liked to market reforms and the building of institutional
capacities and more effective forms of governance as preconditions for structural
adjustment.
 Poverty alleviations and environmental protection are also other areas of concern.
 It may lead to dependence on other and discourage self reliance.
 It reduce the domestic effort to save
 Tied aid reduces the leverage in the management of foreign aid
 It increase the debt burden
 Due to foreign aid some governments may take undue advantage of it and may
suppress opposition.
Rather than the inherent weaknesses of foreign aid, there are problems associated with
foreign aid administration, some says.

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RIFT VALLEY UNIVERSITY NEKEMTE CAMPUS-DEPARTMENT OF

ECONOMICS A.Y 2020/2012

Basic concepts related to population growth

International Economics –II Lecture Notes –For 2nd Year Page 1

International Economics –II Lecture Notes –For 2nd Year Page 2

International Economics –II Lecture Notes –For 2nd Year Page 3

International Economics –II Lecture Notes –For 2nd Year Page 4

The Demographic Transition

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International Economics –II Lecture Notes –For 2nd Year Page 6

Figure1.4. the Demographic Transition in Western Europe

International Economics –II Lecture Notes –For 2nd Year Page 7

Figure 1.5.The Demographic Transition in Developing Countries

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International Economics –II Lecture Notes –For 2nd Year Page 9

International Economics –II Lecture Notes –For 2nd Year Page 10

International Economics –II Lecture Notes –For 2nd Year Page 11

International Economics –II Lecture Notes –For 2nd Year Page 12

International Economics –II Lecture Notes –For 2nd Year Page 13

. Health and Education in developing countries

International Economics –II Lecture Notes –For 2nd Year Page 14

Improving Health and Education: Why Increasing Income Is Not

International Economics –II Lecture Notes –For 2nd Year Page 15

Educational Supply and Demand

International Economics –II Lecture Notes –For 2nd Year Page 16

Social versus Private Benefits and Costs

Education, Inequality, and Poverty

International Economics –II Lecture Notes –For 2nd Year Page 17

.The Gender Gap: Women and Education

International Economics –II Lecture Notes –For 2nd Year Page 18

International Economics –II Lecture Notes –For 2nd Year Page 19

Internal Migration, and the Brain Drain

Education and Rural Development

 The equitable distribution of the benefits of higher levels of living.

International Economics –II Lecture Notes –For 2nd Year Page 20

The Migration and Urbanization Dilemma

International Economics –II Lecture Notes –For 2nd Year Page 21

The Urban Informal Sector

The informal sector is characterized by:

International Economics –II Lecture Notes –For 2nd Year Page 22

Economic theory of Rural – Urban Migration

International Economics –II Lecture Notes –For 2nd Year Page 23

International Economics –II Lecture Notes –For 2nd Year Page 24

The Harris – Todaro Model

International Economics –II Lecture Notes –For 2nd Year Page 25

.Comprehensive Strategies for Employment and Migration

International Economics –II Lecture Notes –For 2nd Year Page 26

International Economics –II Lecture Notes –For 2nd Year Page 27

International Economics –II Lecture Notes –For 2nd Year Page 28

International Economics –II Lecture Notes –For 2nd Year Page 29

International Economics –II Lecture Notes –For 2nd Year Page 30

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International Economics –II Lecture Notes –For 2nd Year Page 33

Table 5. 2. Comparative Advantage Theory of David Ricardo

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International Economics –II Lecture Notes –For 2nd Year Page 37