The impact of trade liberalization on economic growth and income distribution.

The impact of trade liberalization on economic growth and income distribution.

1. Introduction

Trade liberalization refers to a set of activities or policies that are intended to increase overall economic performance by reducing restrictions on international trade. These restrictions can be in the forms of tariffs, non-tariff barriers such as licensing regulations or quotas, and other measures used to discriminate against foreign goods and services. Free trade is a policy in which a country does not discriminate against imports or exports. This can be achieved through the removal of trade barriers. It is argued that it is the unrestricted flow of goods and services across international borders that has been the driver of world economic growth since the end of World War II. Free trade produces economic growth more effectively than protectionism. This first diagnosis will allow for a better understanding of the current trend of countries to enter into regional trade agreements which is another form of trade liberalization. It is thought that trade between member countries of a Regional Trade Agreement will be increased by the agreement itself between the countries, and it is generally thought that removing trade barriers among a select group of countries will shift or skew the distribution of national and international income.

2. Theoretical background

In an attempt to move beyond the inconclusive results produced through simple regression analysis, some empirical research has used techniques to identify a causal link between trade policy and growth. This is often done through a set of theoretically derived equations, known as structural equations, which are used to conduct 2SLS IV regression analysis techniques. Unfortunately, these empirical works relying on 2SLS IV have also been subject to criticism and have still not provided a consistent stance on the relationship between trade policy and growth.

In a survey of empirical work, Frankel and Romer (1999) found an overwhelming discrepancy in the interaction of trade policy and economic growth. They note that a significant indictment on the empirical growth literature is the severe lack of robustness in finding consistent results. This is primarily due to the endogeneity of trade policy and institutions.

Empirical work identifying the relationship between trade openness and growth has been inconclusive. Most of the cross-country work uses regression analysis to estimate the effect of trade policy on levels or growth rates of real per capita income. Most studies have used openness as a measure of trade policy influenced by the neoclassical belief that open economies are more conducive to growth. However, the wide range of empirical methods and differing measures of openness have produced quite varying results.

Theories provide a medium through which information is interpreted and understood. The pure free trade model assumes a situation in which there are no taxes applied to imported or exported goods, and no restrictions are applied to the flow of goods and services across borders. In the Heckscher-Ohlin model, an elegant theorem shows the gains from trade and those who are likely to benefit. Stolper and Samuelson, in 1941, developed a theorem which carries their name, looking at how factor incomes are affected relative to product prices.

3. Empirical evidence

Methods of empirical investigation. Conceptual issues in the relationship between trade and economic growth. The relationship between trade and economic growth has been one of the most contentious issues in the last three decades. While some economists have attributed positive impacts (and some even negative impacts) on growth to increased levels of trade, others have found no conclusive evidence of any impact. One recent survey notes that the literature on the relationship between trade and growth can be divided into three lines of inquiry: whether trade leads to higher growth rates over the long term; whether an increase in the level of trade openness is associated with an improvement in the growth performance of countries; and whether trade liberalization has a more immediate impact on the growth process. The survey concludes that in the first two cases, it can be said that the relationship between trade and growth is inconclusive and varies with the country sample and methodology used. Nevertheless, in this extensive debate, a huge array of empirical tools have been employed to test the various links between trade and growth. Static models have been concerned with identifying the relationship between the volume of trade and growth rates in cross-sectional data. Early tests of the exogenous growth models expounded by Romer (1990) and Lucas (1988) made use of gravity-type models derived from the neoclassical growth model; regressing the growth rate of per capita GDP on a measure of trade openness, controlling for initial income and a vector of other explanatory variables. Subsequently, a number of endogenous growth models have tested the prediction that trade raises the economy’s growth rate by increasing investment in R&D and human capital. Empirical tests of these models have employed two-stage least squares estimation to identify the causal relationship between trade and growth using an index of instrumental variables, while controlling for the effects of reverse causality and omitted variable bias. Finally, recent research has employed panel cointegration and causality tests in an attempt to identify the short and long run relationships between trade and growth, whilst addressing concerns that past studies have failed to deal with issues of parameter heterogeneity and omitted variable bias.

4. Challenges and limitations

Another form of inequality will arise through the difference in consumer welfare, as the price of imports will rise and the price of exports will fall. This will have a regressive effect on income groups. Import-competing and export sectors are drawn from different income groups. The increase in inequality between income groups within a country and between developing and developed countries can lead governments and the public to demand another round of trade restriction measures to offset the effects of liberalization. This has the potential to lead to a trade war and/or an increase in the use of CSVs. Thus, the effects of unequal distribution of gains from liberalization can lead to the reversal of liberalization measures and undermine the IT hegemony in the DDA.

However, the reality is that the marginal cost of readjustment is great, and it is rare for winners to compensate losers. This will lead to an increase in the wage rate in industries where comparative advantage has been lost and a fall in the wage rate in industries where comparative advantage has been gained. This will result in inequality in wage earnings. Workers and owners of factors in import and non-competitive industries will be worse off compared to the pre-liberalization era. This will also have adverse effects on income distribution between skilled and unskilled workers, with an increase in wage earnings inequality between them.

There is a fear that trade liberalization may worsen inequality between income groups within a country and also between developing and developed countries. Theories of trade and empirical evidence suggest that trade liberalization will shift resources from the production of goods in which a country does not have a comparative advantage into industries in which it does have a comparative advantage. This, in turn, will increase the aggregate welfare of the country if the winners from trade liberalization compensate the losers and the marginal cost of readjustment is not great.

Trade liberalization faces a plethora of challenges and criticisms. One of the principal criticisms of trade liberalization is the issue of unequal distribution of the gains from trade. This has been a considerable concern not only for policymakers but also for economists.

5. Conclusion

A more radical approach is taken in the second chapter, as it is argued that the negative perception of trade liberalization is a result of special interest group activities within nations, and although the removal of import tariffs promotes efficiency, there is a lost equity in the movement of resources. This contrasts the first argument and shows that the effects of free trade are not the same in all sectors of the economy. To simplify, an industry in a given nation that does not have a comparative advantage in producing a good will have a decreased demand for factors of production, and in turn lower wage rates for this sector. Although liberalized trade increases the global efficiency of this good, the result is more unemployment and unequal distribution of income in this sector.

The work focuses on both the positive and negative effects of trade liberalization and takes into consideration different aspects of global welfare. The first chapter introduces the current state of trade liberalization and poses a hypothesis that a more liberalized global economy will foster efficiency and equity in developed and developing nations. Using a simple static model with two countries and two goods, it is shown that free trade between two nations increases efficiency and equality of income amongst the nations. This model provides the foundation for the rest of the paper and stresses that free trade is essential for the economic betterment of nations.

In this paper, we have seen that the changes in policy regimes and economic strategies lead to enhancing the global welfare, income, and access to food in a more open and liberalized trading world. Trade liberalization has always been an issue in international economic relations with regards to its detrimental effects on national and global welfare. Some feel that it is a necessary evil, as the short-run costs are great but the long-run efficiency of the world economy is increased. Only in recent years following the Uruguay Round of GATT has the world economy begun to see more liberal trade policies being put into place. With the establishment of such organizations as the WTO, an increasingly more liberal global economy is becoming a realized objective.

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