International Trade: Issue 2

Over the last four decades, many developing countries initiated reforms that have lowered barriers to trade. Yet despite these reforms, developing countries still remain far less open than developed ones, both because of tariffs that remain high but also weak contract and regulatory enforcement, inadequate transport infrastructure, search frictions, and a plethora of other distortions that are more severe in the developing world. This survey summarises a broad set of empirical work that explores the impact of international trade in developing countries characterised by weak institutions, market failures and firm distortions. For each of these categories we ask how the effects of trade policy may differ in the presence of such frictions, how trade may moderate or exacerbate the friction itself, and how policies should respond in the light of the answers to the first two questions.

Key takeaways for international trade policy

No country has successfully developed its economy without integrating into global markets. At the same time, the mainstream result that there are gains from trade comes from analysing textbook economies where all resources are allocated to their best uses. For many developing countries, where we think there are pervasive distortions that prevent resources being used efficiently, the impacts of trade are more nuanced. For example, will tariff reforms generate substantial increases in trade if customs officials are routinely bribed? Does the presence of a large informal economy exacerbate or minimise the gains from trade? To what extent do the impacts of lower international trade costs propagate through an economy if intranational trade costs are high? Does trade liberalisation reduce the extent of distortions by allowing firms without connections to government to thrive?

An exciting wave of recent research lying at the intersection of trade and development economics addresses these questions, and more, and has given us a deeper understanding of how trade and globalisation interact with the myriad of distortions that typify developing countries.

This research comes at an important time. For decades, trade barriers have been declining thanks to both multilateral trade agreements and unilateral reductions as developing countries have systematically moved away from import substitution policies. In recent years, however, the direction of trade policy has become less certain. On the one hand, the US has returned to protectionism and other countries have retaliated, geopolitical tensions have raised the possibility of a return to a multi-polar world with supply chains starting to shift as a result, and Europe has begun to link environmental requirements to its tariff levels for polluting goods. On the other hand, many developing countries continue to pursue trade agreements and take steps towards deeper integration, particularly amongst each other. Even after decades of liberalisations, tariffs in low- and middle-income countries remain higher than tariffs in rich countries. Given all of these evolving factors, trade policy remains an extremely active area for policymakers across the globe.

This review emphasises three broad distortions—weak institutions, market failures, and firm-specific distortions—and how they interact with trade. The central takeaway is that, to maximise benefits from international trade, policymakers must consider complementary policy reforms that address domestic distortions. More specifically:

1. The ability to use tariffs as industrial policy or for revenue generation is only as good as a country’s ability to enforce revenue collection at the border.
2. Weak contract enforcement raises the cost of trade for firms, requiring firms to build a reputation for quality and reliability that is costly and takes time.
3. Weak regulatory enforcement may lead to reallocations of activity into polluting or low-labour standard sectors, but export-oriented firms typically adhere more strongly to regulations and cleaner technology.
4. Labour markets are disrupted by trade reforms, but the ultimate impacts and the adjustment path are context specific, determined by factors such as ability of the informal sector to absorb shocks, the speed at which labour and capital can reallocate across sectors or regions, and how investments in education adjust.
5. Financial market development matters, with credit constraints and a lack of physical capital limiting firms' ability to engage in trade.
6. Informational barriers to trade are large and reducing them through better communication technologies, and by lowering transportation costs, can have sizeable impacts both on trade flows, on how well markets equilibrate supply and demand, and on firm productivity through knowledge spillovers.
7. Large costs of internal trade also reduce the gains from international trade, particularly for households living far from ports and capital cities.
8. Firms of different sizes face different taxes, tariffs, credit constraints, labour regulations, political connections etc. that lead to factors being misallocated across uses. While trade can improve allocative efficiency by allowing more productive firms to expand, it can also worsen misallocation, for example, if a country has a comparative advantage in sectors that were already heavily favoured.
9. International trade can generate growth by improving management practices and productivity among domestic firms, through agglomerating lots of productive firms, through importing and then reverse-engineering knowledge-intensive inputs, and through transfers of knowledge from foreign partners.
10. Trade and trade policies can have significant effects on carbon emissions and environmental outcomes, but the relationship is complex and depends on factors like comparative advantage, technology adoption, and the stringency of environmental regulations.

International Trade: Presentation of key takeaways

For the launch event of Issue 1 in 2022, Senior Editors David Atkin and Amit Khandelwal joined us to outline the key takeaways from this VoxDevLit, highlighting policy relevant results from recent research at the intersection of international trade and development.

This survey is a collaborative effort to provide an up-to-date review of selected topics in trade and development. It is based on the article written by Atkin and Khandelwal, and is reproduced with permission from the Annual Review of Economics, Volume 12 © 2020 by Annual Reviews, http://www.annualreviews.org. Fatima Aqeel, Emily Gallagher, Paul-Robert Laliberte, Hesham Nawaz and Vishan Nigam provided excellent research assistance. Pinelopi K. Goldberg and Nina Pavcnik provided very helpful comments on the original ARE article. We are grateful for funding from Yale’s Institution for Social and Policy Studies.