Trade adjustment costs in developing countries

Bernard Hoekman, Guido Porto 18 June 2010

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Integration into the global economy offers an enormous opportunity for increasing economic growth and reducing poverty. Increasing competition on the domestic market can lower prices, increase choices for consumers and improve access to new knowledge, products and technologies. But the gains from trade openness are not guaranteed. They are conditional on various factors, such as a sound investment climate, a sufficiently large “absorptive capacity” (e.g., human capital) and an absence of major domestic distortions (Freund and Bolaky 2008).

Globalisation also generates costs. Trade liberalisation will result in a re-allocation of factors of production within and between firms and sectors. This is the source of the efficiency improvements that underpin the gains from trade, but it also brings with it adjustment costs. There are winners and losers. Attenuating the negative effects of integration for disadvantaged groups is an important task for governments. In principle, the gains from trade generate the resources that can be used by governments to do so. The design of public policies to facilitate the transition and smooth the adjustment process needs to be informed by an understanding of the impacts of trade reforms and the responses by firms, workers and households.

Stylised facts

As is well known, there has been a significant increase in the wage premium for skilled labour around the world, a rise in the ratio of skilled-to-unskilled employment in all sectors, and rising relative inequality between the skilled and unskilled. While typically skilled-biased technical change is seen as the main driver, recent research by Galiani and Porto (2010) shows that barriers to factor mobility and unions can also play a role.

Basic trade theory predicts that trade reforms will result in labour reallocation across sectors. Surprisingly, much of the empirical research on this question does not find strong evidence for this using available data for developing countries. For example, Wacziarg and Wallack (2004) conclude that liberalisation episodes are followed by a reduction in the extent of inter-sectoral labour shifts at the economy-wide one-digit level of disaggregation. This somewhat counter-intuitive result in part reflects the relatively short time frame of many empirical analyses, and the fact that many tend to focus on the formal manufacturing sector, on which there is generally much better data. In a longer-run perspective, by definition economic development entails significant structural change, with large numbers of people leaving agriculture and finding employment in manufacturing and services industries.

A new compilation of research results

In a series of short papers compiled in our recent report (Porto and Hoekman 2010), some two dozen leading researchers have analysed what is known about how agents in developing countries adjust to new trading opportunities, what they do to adjust to reforms, and the factors that drive adjustment. Papers include assessments of the magnitude of trade adjustment costs, the nature of labour reallocation, the consequences of offshoring and migration on labour markets, the role of labour income risk, impacts of trade on child labour and schooling, the consequences of increased FDI, and the impact of various types of fixed and variable costs and market failures.

The contributions make clear that domestic distortions and transactions costs can be major impediments to adjustment. Government policies therefore can play an important role in the adjustment process, ranging from a focus on overcoming market failures to the realisation of equity (distributional) objectives.

Opportunity costs matter

A recurring theme of the contributions is that the focus of policy should not be limited to attenuating the negative impacts of reforms – issues that have tended to attract much of the attention in the empirical and policy literature. Instead efforts are also needed to reduce the transactions and other costs that limit desirable adjustment and reduce the aggregate gains from trade. Adjustment costs may be so high that the potential benefits of trade are only partially realised, if at all, or are distributed asymmetrically, e.g., accruing primarily to higher income, urban households.

In addition to the business environment broadly defined, the research focusing on adjustment to trade identifies a number of specific areas for government policy or action. These centre on the functioning of factor markets, rural product markets and other input markets – reducing fixed costs of entry and exit, and enhancing the productivity of firms and farmers.

Taking advantage of the opportunities created by trade and investment liberalisation often requires substantial effort and investment in upgrading the production process. At a general level, neither theory nor experience provides unambiguous guidance regarding the design of policies to support such investments. Much depends on whether there are spillovers, whether these are international or intra-national, and on the capacities of firms and workers to absorb and adapt new technologies.

Facilitating entry into new activities

Exit by low performers and entry of new firms with incomplete information on their “capacity” is a major channel for the efficiency gains from trade reform. An implication is that governments should promote entry by new firms and remove barriers to exit, which may include restrictive labour market regulation. Measures to promote innovation (R&D) and to assist upgrading of existing firms can include policies that encourage the use of new technology to improve performance. Many of the chapters in Porto and Hoekman (2010) suggest that taking action to reduce transactions costs, improve access to credit, and enhance access to information through trade support services can be very beneficial from a poverty reduction and trade expansion perspective.

Labour market frictions are a key feature of many of the models that are used to assess the magnitude of adjustment costs. For instance, displaced workers cannot easily find jobs in expanding sectors because the new jobs require specific skills that need to be acquired – a process that takes time. Adjustment costs can be substantial: Davidson and Matusz (2010) argue they can range from one third to 80% of the gross benefits from trade reforms; Artuc and McLaren (2010) conclude that in the case of Turkey wages in the formerly protected sector may have declined by as much as 20%.

Fixed costs and trade costs

In the case of African economies, potential gains from reforms are greatly reduced as a result of feeble supply responses in agriculture, reflecting barriers to exit from subsistence. High fixed (sunk) costs can greatly constrain adjustment of capital and non-labour inputs like trees (vanilla, coffee, cashews), seeds, machinery, pesticides, etc. In the case of Madagascar, Cadot et al. (2010) estimate that subsistence farmers could increase household income by over 40% by selling for the market, but are impeded from doing so by missing markets and high sunk costs. While various transaction, information and transport costs are significant, ranging from 30% to over 80%, the sunk costs of shifting to market agriculture is most important, ranging from 120% to 150% of the value of annual output at market prices. These high costs effectively exclude farmers from benefitting from the price changes associated with trade liberalisation.

Understanding the nature and effects of trade costs faced by exporters is a rapidly expanding area for research, with the standard notion of sunk and fixed costs of exporting now being extended to assess market penetration costs, learning effects, search costs, and coordination between buyers and sellers. Among the findings are that trade costs are endogenous – responding to changes in trade policies, the characteristics of export markets, and the composition of trade – and that that product differentiation matters for the duration of trade relationships.

Research gaps and priorities

The contributions in Porto and Hoekman (2010) suggest a policy focus on factor market distortions, credit constraints and transactions costs, as well as domestic and export market-specific barriers to entry.

Two areas stand out where more research is needed. One is the nature of adjustment in factor markets in low-income developing countries. The research on labour reallocation typically focuses on more advanced, middle-income economies, as well as developed countries. Much less is known regarding adjustment in low-income countries where the share of manufacturing is generally small and issues of agricultural adjustment at the smallholder level are much more relevant.

Another priority area for research is the role of domestic institutions. While the term “institutions’’ is often too broad to generate specific policy insights or guidance, a deeper understanding of how a given economy adjusts to trade requires deep knowledge of the setting that characterises the functioning of the economy. This depends heavily on the institutional context that governs incentives and therefore drives the adjustment process.

Conclusion

Our collection of papers on adjustment to trade in developing countries suggests that for developing countries – especially low-income economies with large informal and agricultural sectors – the key issues go beyond adjustment by workers to a new equilibrium and the transitional costs of unemployment, job search and so on – the current focus in much of the trade and labour literature. The development community should also aim to identify and address the constraints that impede the ability of households to leave subsistence and the informal sector, and that limit the scope for firms, farmers and communities to benefit from greater trade opportunities. Indeed, this should be a research priority.

This note draws on research supported by the UK-funded Global Trade and Financial Architecture project. The views expressed are personal and should not be attributed to the World Bank.

References

Artuc, E and J MacLaren (2010), “A Structural Empirical Approach to Trade Shocks and Labor Adjustment: An Application to Turkey”, in G Porto and B Hoekman (eds.), Trade Adjustment Costs in Developing Countries: Impacts, Determinants and Policy Responses, CEPR and World Bank.

Cadot, O, L Dutoit and M Olarreaga (2010) “Barriers to Exit from Subsistence Agriculture,” in G Porto and B Hoekman (eds.), Trade Adjustment Costs in Developing Countries: Impacts, Determinants and Policy Responses, CEPR and World Bank.

Davidson, C and S Matusz (2010), “Modeling, Measuring, and Compensating the Adjustment Costs Associated with Trade Reforms”, in G Porto and B Hoekman (eds.), Trade Adjustment Costs in Developing Countries: Impacts, Determinants and Policy Responses, CEPR and World Bank.

Freund, C and B Bolaky (2008), “Trade, regulations, and income”, Journal of Development Economics, 87(2):309-321.

Galiani, S and G Porto (2010) “Trends in Tariff Reforms and in the Structure of Wages”, The Review of Economics and Statistics, 92(3).

Porto, G.and B Hoekman (eds) (2010), Trade Adjustment Costs in Developing Countries: Impacts, Determinants and Policy Responses, CEPR and World Bank.

Wacziarg, R and J Seddon Wallack (2004), “Trade Liberalization and Intersectoral Labour Movements”, Journal of International Economics, 64:411-439.
 

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Topics:  Development International trade

Tags:  globalisation, developing countries, adjustment costs

Professor and Director of Global Economics, Robert Schuman Centre for Advanced Studies, European University Institute; Research Fellow, CEPR

Associate Professor of Economics at the University of La Plata

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