Lecture 7 - Trade with Developing Countries

Core theme: How can preferential trade policy, particularly the Generalised System of Preferences (GSP), promote development in poorer countries within the framework of EU and UK trade policy?

1. Trade Policy as Development Policy

The Policy Question

How can trade policy help the development of poor countries?

The EU treats development policy as a cornerstone of European integration. Trade policy is not merely about efficiency or consumer welfare; it is also a tool for structural transformation in low-income countries.

Policy instruments include:

  • Aid and technical assistance
  • Preferential market access
  • Less strict enforcement of certain trade measures
  • Trade facilitation and reform of trade-related rules

The central mechanism is simple:

Trade → Growth → Poverty reduction

However, trade may also create:

  • Labour exploitation risks via MNEs
  • Adjustment costs and inequality
  • Sectoral dislocation

Visual Framing of the Trade–Development Debate

ECON1014_EconomicIntegrationII/ECON1014_images/EI II_L7/Slide6.png

The image frames the optimistic narrative: trade promotes growth and growth reduces poverty. However, it explicitly acknowledges the tension that multinational enterprises may exploit low-skilled workers.

This captures a fundamental development trade-off:

  • Aggregate gains from specialisation
  • Distributional and institutional vulnerabilities
Economic Intuition

Trade increases market size and allows countries to specialise according to comparative advantage. Poor countries often specialise in labour-intensive goods, increasing demand for unskilled labour and potentially raising wages. However, weak labour institutions may allow rents to accrue disproportionately to capital.

2. The Common Trade Policy and Development

Examples of EU development-oriented trade agreements:

  • Cotonou Agreement with ACP countries
  • Negotiations with ASEAN

These illustrate the EU’s use of non-reciprocal or asymmetrically structured agreements to integrate developing countries into global markets.

Theoretical Interpretation

Preferential access alters relative prices facing exporting firms in developing countries. This increases expected profitability of export activity, triggering entry, technology upgrading, and scale expansion in heterogeneous-firm models.

3. What is the Generalised System of Preferences?

Definition

The Generalised System of Preferences (GSP) is a preferential tariff system allowing lower or zero tariffs on imports from selected developing countries without extending the same treatment to developed countries.

WTO Context

Under WTO rules:

  • The Most Favoured Nation (MFN) principle requires equal tariff treatment across members.
  • GSP is a formal exemption allowing differentiated treatment for development purposes.

This is a key institutional innovation: development-oriented discrimination within a rules-based multilateral system.

4. Advantages of GSP

4.1 Export Productivity Effects

Mechanisms:

  • Ex-ante effect: Higher expected profits → Investment in R&D and quality upgrading
  • Access to high-income markets → Incentives to improve standards
  • Ex-post learning: Firms absorb foreign knowledge

Evidence: Mercosur case

  • Brazilian tariffs on Argentine goods fell from 29% to zero (1991–1995)
  • Exports quadrupled
  • Industries with larger tariff cuts were more likely to:
    • Enter export markets
    • Upgrade technology
    • Increase skill intensity
Theoretical Interpretation

In Melitz-type models, trade liberalisation increases the productivity threshold for survival. More productive firms expand, less productive exit. GSP can therefore induce reallocation towards higher-productivity exporters.

4.2 Economies of Scale

Access to the EU market:

  • Vastly larger than domestic markets in poor countries
  • Reduces average costs
  • Enables fixed-cost recovery in export industries
Economic Intuition

If fixed export costs are high, small domestic markets cannot sustain modern industry. Preferential access effectively increases market size and allows firms to exploit scale economies.

4.3 Export Diversification

  • Reduces dependence on primary commodities
  • Encourages structural transformation
  • Promotes resilience to external shocks

4.4 Spillovers and Skill Upgrading

Exporting firms:

  • Demand more skilled labour
  • Induce upgrading in non-export sectors via spillovers

4.5 Infant Industry Argument

Definition

The Infant industry argument states that emerging industries may require temporary protection to achieve scale and productivity sufficient to compete internationally.

However:

Common Mistake

Not all industries justify protection. The industry must plausibly develop comparative advantage, and protection must be temporary.

5. Arguments Against GSP

5.1 Trade Diversion

  • Preferences may replace more efficient suppliers
  • Leads to inefficient global resource allocation

This is a core welfare concern.

5.2 Limited Impact

  • EU tariffs are already low
  • Marginal gains may be small

5.3 Political Motivations

  • Selective country inclusion
  • Suspension of preferences for political reasons

5.4 Undermining Multilateralism

  • Countries may focus on maintaining preferences rather than supporting global liberalisation

6. Graphical Analysis of GSP

ECON1014_EconomicIntegrationII/ECON1014_images/EI II_L7/Slide15.png

The diagram shows:

  • Two foreign supply curves:
    • (rest of world)
    • (GSP countries)
  • Initial uniform tariff
  • Removal of tariff on GSP suppliers

Before GSP

  • EU price:
  • Imports from rest of world only
  • Tariff revenue:

After GSP

  • Consumers still pay
  • GSP exports increase to
  • Rest of world exports fall

Effects:

  • EU loses tariff revenue:
  • GSP gains producer surplus:
  • Deadweight loss from diversion:
Theoretical Interpretation

GSP can generate welfare losses for the importing bloc due to tariff revenue loss and trade diversion, even if developing country exporters gain. The policy redistributes surplus internationally.

Exam Insight

When analysing GSP graphically:

  1. Identify consumer price
  2. Identify tariff revenue changes
  3. Identify trade diversion area
  4. Separate domestic welfare from global welfare

7. Perceptions of Trade

ECON1014_EconomicIntegrationII/ECON1014_images/EI II_L7/Slide18.png

The chart shows:

  • Majority in surveyed countries view trade positively
  • Decline in strong pro-trade sentiment between 2002 and 2014
  • Particularly among lower-income countries

This highlights a political economy constraint: trade policy must be socially legitimate.

ECON1014_EconomicIntegrationII/ECON1014_images/EI II_L7/Slide19.png

This figure shows perceptions of trade’s effects on:

  • Wages
  • Job destruction
  • Job creation

There is heterogeneity across countries and income levels.

Theoretical Interpretation

Stolper-Samuelson predicts trade raises returns to a country’s abundant factor. However, imperfect labour mobility, regional concentration of industries, and firm heterogeneity complicate distributional outcomes.

8. Trade, Employment and Inequality

Mechanisms:

  • Poor countries abundant in unskilled labour
  • Trade increases relative demand for unskilled labour
  • Raises earnings under perfect mobility

However:

  • Industry-specific skills
  • Rigid labour markets
  • Geographic concentration

More productive firms survive import competition and tend to employ more skilled workers.

→ Potential increase in inequality.

Economic Intuition

Trade increases average income but redistributes within countries. Adjustment costs and mobility constraints determine who gains.

9. The EU’s GSP

Key Features

  • Started in 1971
  • Covers 88 developing countries
  • Accounts for ~5.5% of EU imports
  • €93bn imports receive GSP treatment

Variants:

  1. Standard GSP
  2. GSP+: Conditional on human rights, labour and governance conventions
  3. Everything But Arms (EBA): Duty-free, quota-free access for LDCs

Product graduation:

  • If country exceeds 15% of EU GSP imports in a product → loses eligibility
Institutional Logic

Graduation prevents competitive exporters from capturing preferences indefinitely and preserves developmental targeting.

Utilisation Constraints

  • Only ~8% of DC products actually receive zero or reduced tariffs
  • Reasons:
    • Administrative burdens
    • Rules of origin requirements
Common Mistake

Preference eligibility does not equal utilisation. Compliance costs reduce effective impact.

10. The UK After Brexit

ECON1014_EconomicIntegrationII/ECON1014_images/EI II_L7/Slide26.png

The UK replicates the EU structure:

  • Least Developed Countries Framework
  • General Framework
  • Enhanced Framework

Conditionality includes:

  • Human rights
  • Labour standards
  • Environmental commitments

This reflects continuity in development-oriented trade policy.

11. Empirical Evidence

  • GSP increases eligible trade by ~4% (€5.5bn)
  • Displaces EU production and rest-of-world imports
  • Producer surplus in DCs increased ~10%

Herz & Wagner (2011):

  • Short-run export gains
  • Long-run potential export dependence and reduced diversification

Persson & Wilhelmsson (2015):

  • Positive effects on export diversification under GSP and GSP+
Key Takeaways
  • GSP generates modest but positive trade effects
  • Short-run gains may reflect trade diversion
  • Long-run effects depend on diversification and structural transformation
  • Distributional and political economy effects matter
  • Non-tariff barriers increasingly constrain development

Overall Conceptual Summary

The Generalised System of Preferences represents a targeted deviation from MFN principles to promote development through trade.

Its effects operate through:

  • Productivity upgrading
  • Economies of scale
  • Export diversification
  • Skill reallocation

However:

  • Trade diversion creates inefficiency
  • Gains are modest in magnitude
  • Political conditionality matters
  • Administrative barriers reduce utilisation
  • Distributional consequences affect legitimacy

Exam trigger: When asked to evaluate GSP, structure answer as:

  1. Definition and WTO context
  2. Theoretical benefits
  3. Graphical welfare analysis
  4. Empirical evidence
  5. Political economy and limitations

Bibliography

Feenstra, R.C. and Taylor, A.M. (2008) International Economics. New York: Worth Publishers.

Herz, B. and Wagner, M. (2011) ‘The dark side of the Generalized System of Preferences’, Review of International Economics, 19(4), pp. 763–775.

Persson, M. and Wilhelmsson, F. (2015) ‘EU Trade Preferences and Export Diversification’, The World Economy, 39(1), pp. 16–53.

Pavcnik, N. (2017) ‘The Impact of Trade on Inequality in Developing Countries’, Journal of Economic Perspectives, 31(3), pp. 119–140.