1. 1 Trade & Growth “Welfare impact of growth in an open economy could be reduced because the primary gain from growth might be offset by the secondary loss from a possible deterioration in terms of trade” (Bhagwati, J. et. al; 1998).

2. 2 Outline 1)Immiserizing growth3 2) Capital accumulation and growth8 3) Capital accumulation and trade11 A)Efficiency gain11 B)Capital accumulation13 C)Capital and or productivity improvements 14 C.1) New Capital14 C.2) Imported capital14 C.3) Externalities among firms which make them more productive 15 Notes and puzzles16 Further Topics 19

3. 3 How can growth be immiserizing? 1.1. The “large” country case The fact that large countries can affect international prices and it’s terms of trade gives rise to the possibility that biased productivity growth towards exportable goods can lead to immiserizing growth: prices falling more than output grows. We can see this through the diagram of production and consumption of importable and exportable goods. Initially, at the given international prices the country produces at point P (tangency point between budget constraint and production possibility frontier) and consumes at C (tangency point between budget constraint and utility function). 1) Immiserizing growth

4. 4 References: Bhagwati, J; Panagariya, A. and Srinivasan, T. (1998) “Lectures in International Trade”, (2nd Ed) MIT Press: Chap. 29. "On the presentation of tariffs in the two goods space used here, see a clear presentation in ETHIER, W. (1988) "Modern International Economics" (2nd Ed.) New-York: Norton : Chap.4 sec. 3 (pp. 163-165). An increase in production biased towards the exportable good increases the quantity of X produced, which we can see in the movement of the production possibility frontier. Despite the fact that production of exportable goods has increased, the satisfaction derived from aggregate consumption has decreased. The large country production increase of exportable goods affects their international prices. A reduction of p X affects the terms of trade of the country, seen on the movement of the budget constraint that is now flatter.

5. 5 C C’ P’ P qXqX qMqM Consumption decrease on importable goods Production increase on importable goods Consumption decrease on exportable goods (possible but not necessary) Production increase on exportable goods Worsening of terms of trade : p’ X /p M < p X /p M

6. 6 There is an increase in the production and exports of good X, but the income from these exports decreases as well as the purchasing power in terms of imports. This is why growth is immiserizing in this case, it reduces earnings because the decrease in prices is higher than the increase in quantities produced. The consumption point, at the tangency between the new budget line and the highest possible indifference curve is on a lower indifference curve. Immiserizing growth requires that the demand elasticity to price is inelastic, that is when small movements on supply of goods produces big changes on prices. Large countries which are afraid of this growth trap will control their production or charge the “optimal tariff” (see trade policy courses).

7. 7 1.2. Immiserizing growth in “small” countries In the case of small countries the immiserizing growth can take place by the establishment of a tariff. Tariff is a distortion that gives rise to a bias in production towards imported goods and in consumption towards exported goods. Biased growth in favor of imported goods plus the tariff will worsen this country’s situation, it will produce even more of the importable but will earn less from the exportable in the world market: hence a lower satisfaction level from consumption. Making efforts for the production of goods that are “badly” produced locally can lead to immiserizing growth. Here we assume balanced trade, but the long run effect is worse in the case of debt finance. (This is one of the arguments against “import substitution policies”. Compare this with Krugman’s argument for learning in the Ricardian model).

8. 8 Why capital accumulation? Accumulating capital allows firms to produce more. For a given production function a capital increase leads to production increase and consumption increase, which is the final objective. 2) Capital accumulation and growth Production function: Investment needs to be made to maintain capital (K): Maintaining existing capital: depreciation (d) Maintain capital per capita with increasing population at rate n and The price of maintaining capital is a constant saving out of output. The price of increasing capital is a temporary reduction in consumption, an extra saving.

9. 9 How much capital accumulation should take place? Example: Period  0 1 2  A Production 100 102 BCapital=K200 220 C Depreciation 5%*B 10 11 D Additional investment 0200 E Consumption A-C-D 907091

10. 10 The investment done in period 1 reduces the consumption substantially in the same period. However, it causes that from period 2 on, the consumption level is higher than at the beginning. Is this final increase in consumption enough to make the investment? This will depend on people’s preferences. An their willingness to suffer from the consumption reduction in period 1. Investment rate of the project: cost 20, return 1 forever: Minimum conditions needed for the investment: increase in consumption and maintain capital. We will accumulate capital according to the golden rule. Golden rule of capital accumulation

11. 11 3) Capital accumulation and trade Trade can affect production possibilities either by improving production possibilities or by higher investment. Even more, new capital is usually better, and when it is imported it permit firms to take advantage of innovation made abroad. Reference : Baldwin, R. (1989). The growth effects of 1992 (No. w3119). National Bureau of Economic Research. A) Efficiency gain Static effect of trade : better use of resources, e.g. different labour division. Upward shift of the aggregate production function. If we assume that capital has decreasing returns to scale, the first effect can be seen by a movement of the production possibilities frontier: for given levels of capital, the marginal productivity of capital turns out to be higher, as we can see in graph 1. As we can see the marginal productivity of capital is higher for F’ than for F at the capital level K 0.

12. 12 Graph 1Graph 2

13. 13 B) Capital accumulation Temporary growth effect: capital accumulation is stimulated by the higher rates of return due to the efficiency gain (of point A). Capital accumulation ceases (according to neoclassical growth theory) once capital reaches again the golden rule rate of return. By investing, the firm can increase capital and expand production function. We can see in graph 2 that for the previous marginal productivity of capital the production possibility leads to an even higher production level. Then, there is an incentive to invest until the marginal productivity of capital gives a normal return.

14. 14 C) Capital and or productivity improvements (Endogenous growth theories) C.1) New capital is more productive than old capital. Further upward shift of the production function. Much debated effect. C.2) At the same time, imported capital goods are more productive than autarky ones. Trade and FDI make it possible to import more productive capital goods and know-how, which contribute to faster catch-up growth. This is temporary, once the equipment and organization of the most advanced country is fully acquired, the catch-up country grows at the pace of the leader. See e.g.: LEE, Jong-Wha (1994) "Capital Goods Imports and Long-Rung Growth" Journal of Development Economics 48, 91-110.

15. 15 Trade can facilitate the transmission of know-how, the access to specific inputs, and hence reduce the cost of innovation. These cost-reducing externalities can accelerate growth and lead to a permanently higher (but not growing) rate of growth than before and than the one of countries less open to trade. Trade also increases competition between all firms. This erodes the margins. It eliminates some deadweight losses of monopoly power but it may also slow growth in some cases, by lowering the rewards to innovation. This last effect is problematic when it dominates the effect of the cost-reducing externalities. Trade increases diversity and satisfaction, hence demand for such goods. Cost-reducing externalities carried through trade, input-improving trade, scale economies on a global market  “new” trade and growth theories. Cost-reducing externalities can sometimes be local instead of global. They are then strengthened by agglomeration of externality-sensitive activities.  “new” geography and trade theories (see Geography and Trade chapter). C.3) There are externalities among firms which make them more productive Reference : Grossman, G. M. and Helpman, E. (1991). Innovation and Growth in the Global Economy. MIT press.

16. 16 Evidence on Trade and Growth ? Levine and Renelt (1992, p. 953-954) : They find : - In growth regressions : X/GDP is not strongly significant and has a coefficient similar to M/GDP or to (X+M)/GDP, other trade variables measuring distorsions are not significant either. - Strong positive correlation between X/GDP and I/GDP - Investment/GDP has a positive and significant coefficient in growth rate regressions.  They conclude that trade affects growth trough investment more than through other efficiency gains (See also Lee, Jong-Wha (1994) on the quality of the investment goods). Source : Levine, R. & Renelt, D. (1992) « A sensitivity analysis of cross-country growth regressions » American Economic Review 82, 4 (Sept.) 942-963. Variations ? -Granger causality : Openness and Investment ? What causes what ? -Export (trade) growth (instead of export level) and GDP growth versus import substitution ? Industries different from aggregate ?

17. 17 Note on the Capital accumulation effect and factor prices : There may be a puzzle to reconcile the capital accumulation induced by the efficiency gains of trade liberalization with the Heckscher-Ohlin relative price effects of trade liberalization. In this last model, the Stolper-Samuelson theorem predicts an increase in the return to capital in the capital-rich country, and hence a less capital-intensive production. There is also a puzzle in the capital-poor country where Stolper and Samuelson predict a fall in the interest rate, which doesn’t seem to be an incentive to accumulate capital. Actually, these are different issues. The Heckscher-Ohlin model deals with fixed endowments and relative prices, while the growth model deals with endowment changes after a shock. Notes and puzzles

18. 18 Note on Capital accumulation and specialization pessimism Some authors fear that capital accumulation may lead to overproduction of low price-elasticity goods (and lead to immiserizing growth, especially in developing countries which would specialize in the “wrong” goods according to Heckscher- Ohlin). This doesn’t hold as soon as there are more than two goods. Specialization is then indeterminate in the two-factor model. The model only says that the capital rich country will on average export more capital-intensive goods, but it doesn’t say which ones. Note on Cost-reducing externalities and periphery-development pessimism Localized production externalities, global competition externalities: risk for periphery to be unable to compete in such goods and to specialize in raw- materials and other land-bound output. Slower growth, slower absorption of labor: out-migration at constant birth rate. There are solutions like a multi-polar agglomeration system and facilitation of the transmission of learning and of other cost reducing externalities (See Martin 1999 in chap. 7 slides).

19. 19 Note on the Productivity of new capital Some growth theorists went even as far as claiming that this productivity gain would overcome the declining returns to capital and lead to constant returns and never-ending growth. The constant returns assumption brings them actually close to Harrod-Domar growth fully based on capital accumulation with fixed coefficients. Empirically, the evidence of a relatively constant capital/output ratio is no proof of constant returns to capital. This constant ratio is also compatible with declining returns to capital and exogenous technological progress. This last has the effect mentioned on point 2 and then the capital-output ratio can remain constant.

20. 20 Further Topics Differentiated products and growth Remember Externalities with differentiated products : New varieties have general external effects (on the demand side): - Decrease profit of existing firms (increased competition, reduced demand), - Increase satisfaction when consumers love variety. They can have an additional external effect (on the production side): - Increase know-how in the sector hence reduce cost (Grossman & Helpman, 1991, endogenous growth effect) and facilitate creation. This last effect may be a source of constant positive growth rate through constant innovation. Source : Grossman, G. & Helpman E. (1991) Innovation and Growth in the Global Economy, MIT Press.

21. 21 The convergence issue Low capital endowments and high marginal return to capital on a common knowledge production function should lead to capital accumulation in and capital flows to poor countries. Faster capital accumulation should lead to income convergence. Non-convergence may be due to : High risk premium, Lack of complementary factors like human capital (growth regressions show the importance of education variables) or infrastructure, Monopoly power on the local market, and/or absence of scale economies on the local market. Sources : Lucas, R. (1988) “Why doesn’t capital flow from rich to poor countries?” American Economic Review. Export promotion and growth

22. Further readings and applications http://www.nber.org/digest/aug13/w19033.html Exporting and Plant-Level Efficiency Gains Marginal costs within plant-product categories drop by approximately 15-25 percent during the first three years after export entry. Trade competition has led to aggregate productivity gains, but some research suggests that those gains come only from selection of the most productive plants into exporting, rather than from efficiency gains within plants. That finding is rather surprising, because exporters can learn from international buyers, and by exporting will have access to larger markets and therefore incentives to innovate or invest in productive technology. In Exporting and Plant-Level Efficiency Gains: It's in the Measure (NBER Working Paper No. 19033) Alvaro Garcia Marin and Nico Voigtländer use a cost-based measure of productivity and find that within-plant efficiency gains do occur after plants begin exporting. They suggest that other studies failed to find such gains because they used a revenue-based productivity measure, which is affected by changes in prices. Garcia and Voigtländer instead calculate plant-product-level marginal costs for a panel of Chilean establishments and show that those costs drop significantly for new exporters -- that is, a within-plant productivity gain.19033Alvaro Garcia MarinNico Voigtländer The gains are substantial: marginal costs within plant-product categories drop by approximately 15-25 percent during the first three years after export entry. At the same time, new exporters pass on most of the efficiency gains to customers in the form of lower prices (around 20 percent), which are accompanied by a strong increase in export volumes. The fact that plants pass on the gains in physical productivity to buyers in the form of lower prices explains why studies that look at revenue- based productivity measures typically do not find evidence of within-plant efficiency gains. In the data, export entry goes hand-in-hand with a decline in marginal costs in the entry period, which is not driven by productivity shocks before export entry. And marginal costs drop particularly steeply for plants that are initially less productive. Those two facts suggest that investment complementarity – the fact that investment opportunities in new technologies become profitable in combination with access to larger markets – is important. Moreover, marginal costs keep falling in the years after entry, which suggests that learning-by-exporting is also an important driver of the result. Although the results suggest within-plant productivity improvements, selection into exporting based on revenue productivity is significant. In fact, the exporter revenue-productivity premium is 17 percent in this sample of Chilean firms. The within- plant productivity gains reflect efficiency gains in addition to the typically documented selection effect. Within-plant gains are of roughly the same magnitude as the between-plant differences. --Claire Brunel The Digest is not copyrighted and may be reproduced freely with appropriate attribution of source. 22