On the static and dynamic costs of trade restrictions for small developing countries

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Abstract

We analyze the costs of trade restrictions for a small developing economy (LDC). Intermediate goods invented elsewhere are only introduced on the LDC market if it is profitable to do so. The LDC economy evolves to a balanced growth path in which income, welfare, and the share of available goods increase if trade restrictions fall. The adjustment path is asymmetric: an increase in trade restrictions leads to a slow-down of economic growth, while a decrease may lead to a rapid catch-up process. The dynamic costs of trade restrictions are in general substantially larger than the static costs.

Introduction

Developing countries are largely dependent on R&D efforts undertaken in the high income countries for access to newly developed goods and services and the availability of quality improvements for existing goods and services, see e.g. Coe et al. (1997). A few years earlier, Romer (1994) already incorporated this fact in a static model, where he argued that the costs of unexpected increases in trade restrictions are smaller than the costs of expected increases in trade restrictions, because the latter affect the range of goods available in the economy. In essence, if some new goods or quality improvements are not imported because of the high trade restrictions, this deprives consumers from the market surplus created by new goods and producers from the efficiency gains associated with new intermediate goods or better ways to organize the production process, leading to large welfare losses. Romer (1994) discusses these welfare losses, which he refers to as “Dupuit triangles” (named after a 19th century French engineer) to distinguish them from the Harberger triangles normally used to estimate welfare costs of trade restrictions.

We provide a dynamic extension of Romer (1994) in an endogenous growth setting, see Romer, 1986, Romer, 1990, Grossman and Helpman (1991), and Aghion and Howitt (1992).1 Using the variety approach, we analyze a small developing economy (LDC) which does not affect the equilibrium in the Rest of the World (RoW). All R&D is undertaken in RoW, which leads to the steady invention and introduction of new varieties of intermediate goods in RoW (with positive production externalities). As in Romer (1990), the providers of intermediate goods have market power and are able to charge a mark-up over marginal costs. As in Romer (1994), there is a fixed (set-up) cost that must be incurred before a newly invented variety can be introduced on the LDC market. Since these set-up costs differ between the varieties, inventors of new varieties will only incur these extra costs if they think it is worthwhile to do so, that is if the (expected) discounted operating profits for the LDC market are larger than the set-up costs for their particular variety. At any point in time, therefore, not all varieties available in RoW will also be available on the LDC market. Deriving balanced growth paths and explicit transition dynamics, the key questions we address are: (i) what determines which intermediate goods are actually introduced on the LDC market and (ii) what are the static and dynamic welfare consequences of trade restrictions.

Two implications of our model are worth emphasizing from the start. First, the estimated static costs of trade restrictions for the LDC are smaller than the dynamic costs of trade restrictions if, and only if, the increase in trade restrictions reduces the share of invented intermediate goods introduced on the market. In this dynamic setting it is therefore not the fact that we ignore the Dupuit triangles of newly invented goods in estimating the effects of an increase in trade restrictions, but the fact that an increase in trade restrictions affects the share of goods introduced on the LDC market. Second, as a result of the sunk-cost nature of the set-up costs, there is an asymmetric adjustment path of the LDC economy after a change in trade restrictions. An increase in the level of trade restrictions will slow-down economic growth and put the economy on a transition path to a new balanced growth rate. If the new level of trade restrictions exceeds a critical value, the new growth rate will be zero and stagnation occurs. If trade restrictions fall, on the other hand, the LDC economy may embark on a rapid catch-up process of economic growth by benefiting from the backlog of previously-invented-but-not-yet-introduced intermediate goods which may now, as a result of increased profitability, be introduced on the LDC market. Section 6 discusses some empirical evidence supporting this asymmetric adjustment path.

After providing the structure of our model (Section 2), we analyze the fraction of intermediate goods introduced on the LDC market (Section 3) and balanced growth paths (Section 4). We then analyze policy changes and (asymmetric) adjustment dynamics (Section 5), followed by a general discussion (Section 6) and some conclusions (Section 7).

Section snippets

The model

Our analysis focuses on a small developing economy (LDC) which at time t uses labor L(t) and a range (indexed by i) of different types of intermediate goods x(i,t) to produce a final good Y(t), see Eq. (1). The set of available intermediate goods at time t is denoted by A(t). We use the term intermediate goods in a broad sense to refer to capital goods and services used in the production of final goods, see Ethier (1982) and Dixit and Stiglitz (1977). It is well-known that an increase in the

The range of introduced intermediate goods

We are now able to determine the range of intermediate goods introduced on the LDC market relative to the range of goods in RoW as a function of the trade restrictions T. At each point in time, the growth rate of intermediate goods in RoW is g, implying that gN(t) new goods become available for introduction on the LDC market. If the discounted value of operating profits π(T) / ρ is smaller than the minimum set-up cost a, it is clear that no new intermediate goods will be introduced on the LDC

Balanced growth and welfare

This section focuses on LDC welfare under the assumption that the same trade policy has been operative indefinitely. We therefore assume that the same fraction of intermediate goods as dictated by the function β(T) of Eq. (12) has also been introduced at time 0. The next section analyzes transitory dynamics if government policy is changed. Under the simplifying assumption above, the share of intermediate goods on the LDC market is constant over time; i.e. if M(.) is the measure of firms, it

Policy changes and transition dynamics

A crucial aspect of our model is the sunk cost nature of the set-up costs. This implies that once a good has been introduced on the LDC market it will continue to be supplied independently of subsequent changes in the level of trade restrictions. The income level is therefore path-dependent (hysteresis) and the economic response to changes in government policy is asymmetric, see van Marrewijk and Berden (2004) for further details on this section.

Discussion

We extended Romer's (1994) argument on the importance of endogenously determining the number of varieties available on the LDC market for a proper understanding of the potentially devastating consequences of imposing trade restrictions, to a simple dynamic setting which allowed us to derive balanced growth paths and explicit transition dynamics. The (short-run) static costs of trade restrictions take the number of varieties as given, whereas the (long-run) dynamic costs take the endogenous

Conclusion

We analyze the static and dynamic costs of a change in trade restrictions for a small developing economy (LDC) which combines labor and intermediate goods in its final goods production process. The LDC economy depends on successful R&D projects undertaken elsewhere (RoW) and introduced on the LDC market for an increase in the range of available intermediate goods. A new intermediate good is only introduced on the LDC market if the (expected) discounted value of operating profits is larger than

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    The studies noted above provide evidence to indicate that national economies cannot prosper unless they are open and integrated into the world economy and that trade does appear to positively impact growth. At the same time, it has also been shown that increase in trade restrictions can slow down economic growth (for example, Marrewijk and Berden, 2007). However, trade may not always have a direct positive effect on growth.

Part of this research was undertaken while we were visiting the University of Adelaide, Australia. We are grateful to the School of Economics and its staff for their hospitality. We would like to thank Joseph Francois, Maarten Goos, Justin Trogdon, an anonymous referee, the co-editor in charge, and seminar participants at the University of Adelaide for their useful comments and suggestions.

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