Publications

1. Prices of Goods and Factors of Production

5. The most immediate effect of trade liberalization is to lower the prices of imported goods, which affects the consumption and income patterns of the rich and the poor. The poor are particularly vulnerable to price changes, as their consumption-to-income ratio is high and their capacity to protect themselves from adverse price changes through the selling of assets or other defense mechanisms is small.

6. On the consumption side, benefits to the poor will be higher the higher the proportion of their expenditure on imported goods. On the income side, trade liberalization will affect the relative price of goods in different sectors and result in the reallocation of resources. To the extent that the poor receive income from (i.e. work in) sectors or industries that are negatively affected (for example, import-competing sectors that were previously protected) they may suffer a decline in income. However, if the poor work in sectors or industries that benefit from liberalization (for example, sectors that use imported intermediate inputs) their incomes and employment opportunities will rise. Thus, the net effect of a liberalization of trade on the poor will depend on the balance of consumption and income effects.

7. On aggregate, declining prices on the consumption side can offset reduced incomes of the poor caused by lower prices for goods they produce. However, at the household level the capacity of poor producers to compensate for price changes may be limited, particularly when households are dependent on a small number of income sources with slim profit margins. In the extreme, poor producers might not remain in the market, if their traditional products compete with imported goods of cheaper price and/or better quality. If poor producers do leave the market, there could be efficiency gains from a national or global perspective, but such a change in the economy could entail adjustment costs for poor households, who might not be able to switch easily to other forms of income generation.

8. The effects of trade liberalization on prices, availability and quality of imported goods (including intermediate inputs and capital goods) can have a beneficial effect on the competitiveness of exports by enhancing economic efficiency. To the extent that poor producers participate in such exporting sectors, they may benefit from increased competitiveness in international markets.

9. The impact of trade liberalization on factor prices depends on the direct price effects, the location and flexibility of labor, and the initial pattern of protection, which determines the winners and losers of liberalization (ODI, 1999). Whenever trade liberalization results in higher demand for products from unskilled-labor intensive agriculture and industries, demand for this type of labor and employment will increase. The final effect on wages will depend on conditions in the labor market. Changes in factor prices can also induce changes in factor use. For instance, the removal of protection on capital goods may lead to greater investment and higher returns to skilled labor, which is a complementary input to more capital intensive production. 10. The transmission of price effects depends on institutions and on the functioning of and linkages between markets, agents, and distribution services. Imperfections in the functioning of markets (and agents) will affect the extent to which price changes are transmitted throughout the economy, including to non-traded goods. This illustrates the importance of concomitant reforms of institutions and domestic markets, as advocated by a number of researchers and development practitioners.

2. Government Revenue

11. Trade liberalization can affect government revenues in several ways. For example, reductions in tariffs could reduce government revenues and thus have an adverse impact on governments’ capacities to deliver social services and antipoverty programs (even assuming that given adequate resources these services and programs are delivered effectively).

12. However, the effects of trade liberalization on government revenue are not necessarily negative. Trade liberalization may have positive effects on government revenue when: (i) unduly high tariffs have curbed the import of goods, and the lowering of these tariffs increases the import volume by more than the decline in tariff rates; (ii) the removal of tariff exemptions, often granted to the non-poor, increase revenues and reduces inequality in the structure of taxes; and (iii) quotas, licenses, quantitative restrictions, and other barriers are replaced by more transparent tariffs; and (iv) the simplification of tariff structures increases efficiency, thus freeing public resources for better use elsewhere. On the negative side, as protection is progressively lowered revenues may be reduced, with might limit or reduce government spending on social services delivery and antipoverty programs. This can be prevented if public expenditure is prioritized toward benefiting disadvantaged segments of society and minimizing spending in unproductive areas. More importantly, tax reform can replace tariffs with less distortionary and more efficient across-the-board instruments such as the value-added tax, so that trade reform, even at the extreme, need not result in a loss of revenue.

3. Economic Growth Effects from Trade

13. While the precise quantitative impact of economic growth on the income of the poor depends on country-specific factors, there is now overwhelming evidence that growth is good for poverty reduction (World Bank, 2000a). Trade liberalization can lead to higher growth rates in a number of ways. It can lower the cost of capital and increase the efficiency of investment (for example through economies of scale), leading to higher rates of investment, and can facilitate the adoption or creation of new technologies that lead to the establishment of new firms and industries. This will often take place through increased foreign direct investment, which is usually closely linked to trade flows.¹ However, for economic growth effects to materialize, trade liberalization must be accompanied by other structural and institutional reforms (for example, investment in infrastructure, education and labor market reform), in addition to macroeconomic stability and an appropriate exchange rate regime, to assure an adequate supply response that leads to growth (IMF, 2001).

14. The poor can gain from growth through employment in expanding sectors, particularly when new markets become available to the agriculture sector, generating jobs for the rural poor, and through indirect employment effects of growth-induced investments in other sectors such as infrastructure. However, direct employment opportunities vary across sectors. They depend on input-output coefficients and quality standards of the target market (including the domestic market challenged by international competition), which determine production and technology choices and, crucially, skills requirements. Technological changes in many sectors may reduce the advantage of cheap labor with lowest skill levels, and non-tariff trade barriers may require certain production standards be met to qualify for import certification. Both of these factors can work in favor of a higher capital-intensity of investments, and increase the demand for a minimum of education and skills that could be beyond that of the poor with limited or no basic education. However, whenever opportunities exist for an expansion of labor-intensive sectors, the poor are bound to benefit.

15. For small-scale producers, a critical aspect is whether they can withstand international competition when they compete for the same customers. Economies of scale, quality and prices, customer preference, and the capacity of local small-scale producers to diversify production and customer bases will affect the extent to which they may maintain their market share. A shrinking of this business sector would affect the poor as employment opportunities decline, and would place small-scale producers, who may not be poor today, at risk of falling into poverty.

16. For economic growth to translate into poverty reduction, the degree of existing inequality matters. A study has shown that “in East Asia, for each percentage point of growth, the number of people in poverty was reduced by 3 percent. In Sub-Saharan Africa, the figure is slightly above 1 percent, while in Latin America it is below 1 percent. As a result, economies in the latter 2 regions would need to grow faster in order to reduce poverty at the same rate as East Asia” (OXFAM, 1997).