What are the three key variables in the gravity model? Why are they important in explaining bilateral trade flows? In addition to these key variables, what are the additional factors that are important in explaining bilateral trade flows?
The gravity model of international trade has achieved its name because it resembles Isaac Newton’s formula for calculating the force of gravity between two objects. According to the gravity model, the trade flow between two countries (or other entities) can be statistically predicted from the size of their economies and the geographical distance between the countries:
- F = (G × M1 × M2) / D,
where F is the trade flow between countries, M1 and M2 are the sizes of the economies of the countries (usually measured in GDP), D is the geographical distance between the countries, G is a coefficient.
Thus, the three key variables in the gravity models are the two sizes of the economies of the countries (or other entities that engage in trading) and the geographical distance between them. The sizes of the economies are important because upon these sizes depends how much a country will be able to sell or buy, whereas the distance is important because the shorter it is, the lower are the logistics expenditures, and the more profitable the trade is.
For example, the U.S. and Canada may have large trade flow, because the countries are located nearby, and their economies are large. On the other hand, Lesotho and Panama are unlikely to have large trade flows, because their economies are small, and it is expensive to transport goods from one country to the other due to the long distance.
Some other factors that influence the trade flows are the level of development of countries (for instance, countries at different stages of development will have more trade, e.g., the less developed country will sell minerals, the more developed country will sell hi-tech products); the customs policies of the countries (this directly affects the size of profits; e.g., large customs will make imported goods very expensive in the market, decreasing the demand for them), currency exchange rates (£10 may be a large sum of money in some countries, so British beverages will be very expensive in Madagascar), etc.
Developing countries in the 20th century mainly adopted two trade policies. What are they? Which is less successful? For the less successful one, what are the potential problems of the policy which may have contributed to its failure?
The two main types of trade policies mainly adopted by developed countries in the 20th century are the 1) export-oriented industrialization and 2) import substitution industrialization. Both of them are aimed at stimulating the country’s development and industrialization but in different ways.
Export-oriented industrialization is aimed at stimulating the industrialization of a country by exporting goods for which the country has an advantage in comparison to other countries, and focusing on the production of such goods, simultaneously opening the country’s market to competitors from other countries.
On the contrary, import substitution industrialization is aimed at stimulating the industrialization by providing beneficent conditions for home manufacturers. The country closes its market to foreign competitors (e.g., by implementing customs policies), and relies mainly on home businesses to produce goods and services; these businesses, thus, do not have to compete with foreign manufacturers and exist in a less competitive environment. This should allow more of them to better develop and grow, simultaneously providing more workplaces for employees. At the same time, this is supposed to reduce the country’s dependence on imported goods.
Historically, export-oriented industrialization was more effective because it allows a country to specialize in an industry in which it has a competitive advantage, retaining that advantage and using it. Simultaneously, import substitution industrialization, while lowering competition in the home market, decreases the stimulus for home manufacturers to make their goods cheaper and of higher quality; these manufacturers, therefore, have a lower incentive to develop. The country does not gain benefits from specialization and imports.
Simultaneously, there also exist limitations of export-oriented industrialization. For instance, a country with a specialized economy and strongly dependent upon foreign exports may be more sensitive to external factors such as political relationships with its trade partner countries.
What is ‘infant industry policy’? Discuss the assumptions of this policy. Two market failures are identified to justify this theory. What are they? Why did the policy fail?
Infant industry policy is a protectionist trade policy aimed at helping a country’s home industry which is currently at an early stage of development to advance by removing competition from foreign manufacturers until the home industry achieves a similar economy of scale (i.e., the advantages achieved thanks to the size, the volume of output, etc.). Import substitution industrialization is an example of an infant industry policy.
An infant industry policy, it is assumed, for example, that the home industry will develop without the (foreign) competitors prompting it to do so, and that this industry will not be able to survive and develop in stiff competition. The first assumption may be doubted because, without the competition, a company will often have few stimuli to develop. The second assumption may be true for particular companies, but if a company is able to gain a sustainable advantage, it should be able to survive and develop.
Two market failures are used to justify an infant industry policy. They are the 1) imperfect capital markets and 2) appropriability argument. According to the imperfect capital markets argument, in the case when in a developing country there are no financial organizations which would permit for investing the savings from traditional sectors (such as agriculture or mining) into new industries (such as manufacturing), the development of the new industries will be limited by the ability of new firms to obtain profits, and thus should be additionally stimulated. According to the appropriability argument, companies in a new industry create new social benefits that are not compensated in the market properly.
The infant industry policy often may fail because companies are placed in an environment where they can make profits without the need to develop further. In addition, if a country closes its markets to foreign industries, it may often face retaliatory obstacles and thus be unable to sell its goods in foreign markets.