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.
The most striking example of the effect of protectionist trade policies is that which is now ensuing as a result of the United States new tariffs on imported steel. In March, President Bush ratified a bill that would place as much as a 30% tariff on steel being imported to the United States. This is an attempt to give the domestic steel industry in the United States time to recover and restructure after a devastating last three years. Competition from foreign companies, who have lower wages and production costs than U.S. manufacturers, have driven U.S. steel prices down. In light of increasing production costs and lower revenues, this has caused many former giants in the steel industry to file for bankruptcy. The European Union is threatening to place tariffs on goods imported from the U.S. To their countries as well. China is threatening to place tariffs on its imported products as well. This is the type of retaliation that results from protectionist trade policies.
Placing tariffs on imported goods raises their price as compared to similar goods produced domestically. This theoretically causes the consumer to switch to the lower priced domestic goods, thus increasing demand for that product and therefore higher prices and increased production of the domestic goods. This is the theory, at least behind President Bush's steel tariffs.
Where there is no substitute, there is no foreign competition. Import Substitution only works where several countries produce the same goods, such as steel, which is produced in Europe, South America, and China. Europe does not export a high percentage of its steel to the United States and will not be effected by the Tariffs. Most of the steel from the EU goes to South America and very little goes to and from the United States. China, on the other hand is relatively new into the steel industry and has not established an economy of scale as of yet. It is likely to be hurt by the tariffs. It may have to attempt to increase imports to countries other than the United States.
Import substitution is a good way to hedge against the negative actions of a country. If a country has four sources for a product and one source decides to raise its prices or engage in protectionist tariffs, the country can simply switch suppliers. The availability of substitution of a product makes an import tariff less effective. China, has been one of the most protectionist countries for many years, and are famous for wanting one way trade deals. For commodities of which they were the only producer, these policies were rather effective, however, as more foreign producers began to produce the same goods, they were no longer effective and China had to become more trade friendly or risk losing its market all together.
Import substitution makes a more fair marketing arena. It prevents the formation of monopolies and works to keep prices competitive. In this way everyone sells more goods and the markets of all countries expand. Without import substitution, an unfair pricing advantage is created which drives prices up and in the end decreases demand and therefore decreases output as well.
It is yet to be seen whether the tariffs imposed by the United States on imported steel will have the desired effect of selling more domestically produced steel at higher prices to prop up the industry, or if the higher prices will only encourage manufacturers to turn to cheaper alternatives. The tariffs will only be effective if they are sufficient to raise the price of foreign steel to that above domestic steel. This will have an additional effect of raising the prices of the goods produced with this steel, as no matter from where the steel is obtained, the cost will go up. This will theoretically have the effect of decreasing demand for the products made from steel and therefore steel demand, ultimately driving the price down again.
Question #4: Education.
The theory behind developing countries pouring large amounts of money into secondary education is that a higher educated person gets higher paying jobs and therefore raises the per capita income of the country and causes economic expansion and industrial growth. This makes several assumptions, there is enough demand for the higher paying technological jobs, usually associated with manufacturing and that everything happens simultaneously so that everything remains in equilibrium.
There are however a few flaws in this theory, first of all the switch of a major portion of the population into higher paying jobs could leave a gap in the unskilled labor sector, such as was the case for Egypt. Secondly, the rise in education will indicate a shift from agriculture to manufacturing, which requires more capital than agriculture. There is also a case that the wage increase is not equal for both genders.
The switch from an agrarian economy to a manufacturing one must happen slowly. The promise of higher wages creates a mass exodus from farming and into manufacturing, and creates a hole in the agricultural sector. If the manufacturing sector is not ready to fill the gap, this could lead to higher unemployment rates.…