International Trade Theory and Export Promotion
The two graphs represent the production outputs of two countries. The first graph represents a developed country, which specializes in the production of machines, which is capital intensive.
The second graph represents a developing country which specializes in textiles, which is labor intensive. The factor endowments model of international trade is based on the concept that each country has a certain specialty that they are skilled at producing and that there are not enough resources or skills in every country to produce everything that is needed. Each country specializes what it is good at producing and trades for goods that it cannot product itself.
In perfect trade equilibrium, the production and consumption of both items would be increased. When the value of exports and the value of imports for both countries are equal, then both countries are at maximum consumption of both goods. In this scenario prices would equalize as well. The factor endowment theory argues that capital-abundant countries, such as the United States will tend to specialize in sophisticated machinery such as automobiles, aircraft and technology. They will export some of these capital intensive products to developing countries which have abundance in labor and land. This model concludes that all countries gain from trade and the entire world output is increased.
This theory makes several assumptions, which are not valid in the real world. The first assumption is that productive resources are fixed in quantity and are of equal quality. It also assumes that the technology of production is fixed. It also assumes that consumers' tastes are fixed. It also assumes that the factors of production are perfectly mobile between different production activities. It also does not take in to account the role of National Governments in influencing trade policies. This also assumes that only one country produces a particular good. In this situation, free trade should be good to help expand the production and overall economy of a developing country.
It should be quite obvious that these theories are not realistic in a real world scenario. First of all, the per capita income in the developed country is typically higher than in that of a developing country. Real wages are higher and the average person has more money to spend on the goods produced by the developing country. However, with lower per capita income and lower real wages, in the developing country, the people in the developing country have less to spend on technological goods, which are typically higher priced than agricultural goods. This makes the demand for the machines decrease, and therefore lowers the price. Meanwhile the revenue from the machines decreases and the people in the developed country have less to spend on agricultural goods. This creates a trade imbalance and in the real world decreases the output of both the developed and developing countries.
Let us look at Kenya, who produces cotton as a major export and the United States trying to sell them computers. The per capita income in Kenya is much lower than that of the United States. This brings up another dilemma in this trade scenario, Kenyans, with lower per capita income, do not have electricity needed to run the computers. They will therefore not buy the computers that the United States is selling. This creates a trade imbalance, which only hurts both countries. Instead of increasing output as endowment theory would suggest, it instead causes a contraction in both economies. Therefore, in this scenario, free trade does not help the developing country. In contrast, however, Taiwan showed more efficient use of its resources and was able to increase production of technology in lieu of agricultural products and free-trade helped the economy of Taiwan. The effective use of land and labor resources in a developing country is the key to whether free trade will help or be a further hindrance.
Question #2. Import Substitution.
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