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Export Promotion, SectoralUnemployment and NationalWelfareChi-Chur Cho a & Eden S. H. Yu ba The Chinese University of Hong Kong , Oregon StateUniversityb The Chinese University of Hong KongPublished online: 23 Aug 2006.

To cite this article: Chi-Chur Cho & Eden S. H. Yu (1999) Export Promotion, SectoralUnemployment and National Welfare, International Economic Journal, 13:4, 1-13, DOI:10.1080/10168739900000041

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INTERNATIONAL ECONOMIC JOURNAL Volume 13, Number 4, Winter 1999

EXPORT PROMOTION, SECTORAL UNEMPLOYMENT, AND NATIONAL WELFARE

CHI-CHUR CHAO The Chinese University of Hong Kong, Oregon State University

EDEN S. H. YU The Chinese University of Hong Kong

A competitive, general equilibrium model is developed to analyze the effectiveness of export-promotion policy. We show that the employment and welfare effects of export promotion crucially depend on the foreign import demand elasticity and the home country's propensity to consume its export commodity. Our result is that export promotion hurts the economy in the long run but it may improve the short-run welfare under certain plausible conditions. [Fll, 0381

1. INTRODUCTION

The policy of export promotion has been adopted by a fairly large number of countries. Export promotion involves favorable loans and subsidies for domestic export sectors, providing services at overseas offices, organizing trade fairs and exhibitions, carrying out overseas missions, andlor government decrees especially by newly industrialized economies (NIEs) and planned economies. Two notable examples are the Hong Kong Trade Development Council (TDC) and the Singapore Trade Development Board (TDB). The objective of TDC is to adopt trade promotion strategies that enable companies in Hong Kong to position themselves for new business opportunities, whereas the TDB aims to promote Singapore's export as well as developing new markets.'

Export promotion has been considered a major instrument to achieve economic growth. The hypothesis of export-led growth has been tested extensively in the empirical literature. Supports for the hypothesis have been provided by, for instance, Beckerman (1965), Michaely (1977) and more recently by Chow (1987) and Chen and Tang (1990). Meanwhile, several recent empirical studies have casted doubt about the hypothesis, e.g., Jung and Marshall (1985), Darrat (1987), and Hsiao (1987), among others.

*We are indebted to an anonymous referee for insightful comments. The usual disclaimer applies.

'The TDC of Hong Kong is a quasi-government organization, whereas the Singapore TDB is a government body and has the authority to commit to trade agreements.

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2 CHI-CHUR CHAO AND EDEN S. H. YU

In sharp contrast to the voluminous empirical investigations, theoretical treatment on export-led policy in the Heckscher-Ohlin trade framework remains, to our knowledge, largely s ~ a n t y . ~ The purpose of this paper is to fill the void in the literature by constructing a general-equilibrium trade model with sectoral unemployment to study the welfare impact of an export-led policy. We focus in the present analysis on the welfare impact of export-promotion policy in the form of fiat observed in NIEs and planned economies. For example, failure to fulfil minimum export quotas by state-owned trading companies in China can result in penalties upon the managers in the form of loss of bonuses or even demotion. Other distinct features of most NIEs regarding rural-urban migration flows as well as the existence of sector- specific unemployment are also incorporated in the framework. In addition, we distinguish the short run from the long run based upon whether capital is intersectorally immobile or m ~ b i l e . ~

Using the model, we are able to derive several interesting results in the context of four cases: short and long run, and small and large country. In particular, export promotion in general can reduce the urban unemployment ratio in the short run, but it raises the unemployment ratio in the long run. Noteworthy is that this result is completely reversed under the Metzler paradox condition. Furthermore, using welfare as a measure for economic performance, we obtain a variety of conditions which give rise to export-led growth in the short run versus the long run.

2. THE URBAN UNEMPLOYMENT MODEL

A two-sector, general equilibrium model a la Harris and Todaro (1970) is succinctly ~ut l ined .~ Let the economy consist of two sectors: urban manufacturing, X, and rural agriculture, Y. Labor and capital are transformed into X and Y, utilizing constant returns-to-scale technology; each factor exhibits positive but diminishing marginal productivity. Let X and Y also denote the output levels of manufacturing and agriculture, respectively. Production functions in the urban and rural sectors can be expressed as

ZIn the theoretical arena, the impact of exports on income has been studied mainly in the standard Keynesian macroeconomic models.

31t is now common to refer to the intersectorally immobile (mobile) capital case as the short (long) run. In the present analysis, we disregard capital accumulation and population growth. Thus, the long run may be more appropriately referred to as the intermediate run in the present paper.

4The original Hanis-Todaro (1970) framework is a two-sector model with sector-specific unemployment. For extensions and refinements of the framework, see Khan (1982), Beladi (1988), Beladi and Ingenue (1996), Beladi and Marjit (1996), and Chao and Yu (1993, 1997), among others.

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EXPORT PROMOTION AND UNEMPLOYMENT 3

where L, and Ki denote the employment of labor and capital of sector i, i = X, Y, respectively.

We assume that the home country exports good X and imports good Y. The assumption of the exports of manufacturing goods may be suitable in describing the pattern of trade for NIEs. Let S and E denote the domestic supply and the export of good X, respectively. Then we have X = S + E. By choosing good Y as numeraire, the domestic price ratio of good X is denoted by p. Note that the foreign price of good X is p*, with p* I p in equilibri~m.~

Consider first the labor market. While workers can move freely between the urban and the rural area, the urban wage (w,), however, is institutionally set at a level higher than the market clearing wage, and hence urban unemployment emerges. Following Harris and Todaro (1970), it is hypothesized that in the labor-market equilibrium, the rural wage, w , is equal to the expected urban wage, which is wx times the probability of employment in the urban area:

W, = w d l + A), (3)

where A = LJL, is the urban unemployment ratio and 1/(1 + A) serves as an index for the probability of finding a job. Here L, represents the level of urban unemployment. Under perfect competition labor is paid according to the value of its marginal product:

Denoting the total endowment of labor by L, we can write

With regard to capital, it is sector-specific in the short run; that is, capital in each sector is a fixed factor, and so its rental, paid according to the marginal value product of capital, differs between the two sectors:

51f p* > p, all domestic output of good X would be sold abroad

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4 CHI-CHUR CHAO AND EDEN S. H. YU

I where ri (i = X, Y) is the rental rate. Denoting the short-run endowment of capital in

I the ith sector by I?, and with full employment of capital

However, capital will flow between two sectors in the long run in response to capital rental differentials. Eventually the rentals will be equalized:

I and sector's capital employment will satisfy

where f? denotes the economy's total capital endowment. This completes the task of specifying the production side of the model.

The above model can be analyzed easily through its duality. Let C A W , r,) and Cdw, r,) be the unit cost functions for sector X and Y, respectively. By Shephard's lemma, the demand for a factor can be obtained as the partial derivative of the unit cost function. For example, the demand for labor in sector X is simply Cxw(wx, rx)X, where the second subscript in the unit cost function indicates the partial derivative.

Eqs. (11) and (12) below reflect the assumption of constant returns to scale and perfect competition in sectors X and Y, so that unit cost equals output price in equilibrium. Eq. (13) denotes the Harris-Todaro labor market equilibrium condition. The employment condition of labor is presented in (14). Eqs. (15s) and (151) denote the short-run and the long-run capital employment condition, respectively. Eq. (16) states that good X is either sold in the domestic (S) or the foreign market (E):

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EXPORT PROMOTION AND UNEMPLOYMENT 5

Eqs. (11) through (16) complete the description of the supply side of the economy. The domestic goods price ratio, p, is momentarily treated as given here (it will be determined later in a complete model consisting of the above production model coupled with the demand-side conditions.) Hence, the endogenous variables are function of E and p; namely, A = A(E, p), etc. However, from (1 1) to (15), the variables, X, Y, ?L, wy, rx and ry, can be solved as functions of p alone. Adding the export-market condition (16) to the production model generates a block recursive structure; (16) would not affect the solution of (1 1) - (15). This implies that aX/aE = aYhE = aw,hE = ar@E = ar#E = 0, but aShE < 0 from (16). Nevertheless, these variables will be affected by E through the changes in p, as presented in Appendix. Of particular interest is a m p < 0 for the short run but a m p > 0 in the long run. The reasons are as follows. An increase in p leads to an expansion in the urban output at the expanse of the rural production. This makes the demand for labor in the urban to rise but the rural labor demand to fall. In the short run with the sectorally fixed amount of capital, the increase in urban employment outweighs the fall in rural employment. This lowers the urban unemployment ratio in the short run. In contrast, in the long run, the movement of capital from the rural to the urban further shrinks the rural sector and, thus, worsens the urban unemployment ratio.

3. EXPORT PROMOTION AND URBAN UNEMPLOYMENT

We begin our analysis by considering the large country case in which home exports can affect the foreign goods price. The foreign goods-market equilibrium requires that the home exports (E) equal the foreign imports (M*):

where M* is a function of p". That is, under an export target which is set above the

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6 CHI-CHUR CHAO AND EDEN S. H. YU

equilibrium amount of foreign import demand, the terms of trade is exclusively determined by the foreign offer curve.

~ The effect of an increase in exports due to government decree on the foreign price ratio can be obtained by differentiating (17) as

where E* = - (dW/W)l(dp*/p*) > 0, being the foreign country's price elasticity of import demand. A small country is simply a special case in which E* = w. It follows immediately that dp*/dE = 0.

To determine the impact of export promotion on the domestic goods price, we need to specify the demand-side condition, which can be represented by an expenditure function:

e(p, u) = min (pDx + Dy), (19)

with respect to the demand for the two final goods, Dx and D , subject to a strictly quasi-concave utility function, u(Dx, Dy) 2 U . ~

Turn to the home country's budget constraint:

where p I p* in the presence of export promotion. Eq. (20) states that national expenditure equals national income, which is the values of goods X and Y minus the cost from the concerted effort to sell abroad. It is worthy mentioning that exports are purchased by foreign importers at the world price p*. It turns out that export promotion by fiat is analytically equivalent to an export subsidy with the amount of p - P * . ~ Note that the country's budget constraint in (20) is consistent with the trade- balance condition.

The goods market equilibrium condition requires that the demand for good X equals the domestic availability of good X: I

I

where e, = d e b , u)ldp = Dx. ~ 5 e e Rodrik (1997) for a discussion of export subsidy in a general-equilibrium model.

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EXPORT PROMOTION AND UNEMPLOYMENT 7

The basic system of the model can be represented by (20) and (21) with two endogenous variables, p and u, and the exogenous policy variable, E. The impact of export promotion, identified with an exogenous increase in E, on national welfare (u) and the domestic goods price ratio (p) can be obtained.

Totally differentiating (20) provides the welfare expression as

e,du = pdX + dY + Edp* - (p - p")dE.

By utilizing (1) through ( l o ) , we can rewrite (22) as

e,du = - wyL&L + ~ d p * - O, - p * ) d ~ , (23)

which reveals the welfare impact of export promotion via the employment effect, the terms-of-trade effect and the direct loss of selling abroad.

Next, totally differentiating (21) and then utilizing aX/dE = 0, we have:

where e,, = = aD,/au > 0, c = - (p/E>(ae#p) > 0 describes the price-caused consumption substitution for a given utility, and s = (p/E)(dX/ap) > 0 represents the substitution in production of good X in response to a change in p.7

By solving (23) and (24), the effect of export promotion on the domestic goods price can be obtained:

where m = pepJe, and A = E(c + s) + mwyL&liVap). Since the expenditure function e(p, u ) is homogeneous of degree one in goods prices, m (= pepJe,) expresses the marginal propensity to consume good X and lies in (0, I ) , assuming both goods are normal. To facilitate our exposition, we define the unemployment-distortion parameter, b, as

'By imposing the Khan-Neary stability condition (shown in Appendix) for the mobile-capital Hanis-Todaro model, we have the normal price-output responses: aX&p > 0 and JYhp < 0.

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8 CHI-CHUR CHAO AND EDEN S. H. YU

And recalling that w, =pX,l(I + A), we can simplify A = E[c + s(l + mb)] and its sign crucially depends upon the value of b. Since a m p > 0 in the long run, we have b > 0 and, hence, A > 0. On the other hand, a m p < 0 for the short run. However, A remains positive because -1 < b < 0 in the short run (shown in Appendix).

A careful inspection of (25) reveals that the numerator consists of two parts. The first part denotes the supply effect of export promotion; the increase in exports reduces domestic supply, thereby exerting a positive pressure on the relative goods price of X. The second part represents the demand effect through the negative income effect (via the marginal propensity to consume good X.)8 The negative income effect pushes down the relative goods price of X. In sum, combining these two conflicting forces of demand and supply, we obtain:

where v = mp*/[(I - m)p + mp*] < m. In view of (25'), we can state the following proposition:

PROPOSITION 1. Export promotion in the urban-unemployment economy raises (lowers) the domestic price ratio of the exportable good according to E* > (<) V.

Export promotion results in an increased portion of the supply of good X abroad. Thus, the domestic and foreign prices will change accordingly until the markets are in equilibrium. Export promotion, which directly reduces the domestic availability of the exportable good, is expected to raise the domestic price ratio of the exportable. Of particular interest is the paradoxical case in which dp/dE < 0 if E* < v. The drop in the domestic price ratio of the exportable good as a result of export promotion is similar to the well-known Metzler (1949) paradox, i.e., an increase in tariffs lowers the domestic price ratio of the importable good. Both paradoxes require that the foreign import elasticity is smaller than the home's propensity to consume its exportable good.

A distinguishing feature of the present model is the existence of urban unemployment. Since A = il(E, p), we obtain the change in the urban unemployment ratio as

where a m E = 0. Using (25'), we have dWdE < 0 if E* > (<) v for the short (long)

8Differentiating the income, I = pX + Y + (p* - p)E, with respect to E, we obtain: alhE =

- p[l - p*(e* - I)/pe*], which is negative because p* I p.

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EXPORT PROMOTION AND UNEMPLOYMENT 9

run, by recalling that a m p < (>) 0 in the short (long) run. The following proposition is immediate:

PROPOSITION 2. In the presence of urban unemployment, export promotion lowers the short-run urban unemployment ratio when E* > V; in contrast, export expansion reduces the long-run urban unemployment ratio when E* < V.

4. EXPORT PROMOTION AND WELFARE

We are now ready to examine the welfare effect of export promotion on domestic welfare. Denoting the change by dW = e,du, (23) can be used to identify the welfare consequence of an exogenous increase in exports:

I

I dW/dE = - wYLx(d?ddE) + E(dp*/dE) - (p - p*). (28)

The first term on the right-hand side of (28) captures the welfare effect of export promotion due to the change in employment resulting from the induced change in the domestic goods price. The second and third terms capture the losses from the terms- of-trade deterioration and direct sales abroad.

Consider the large country case (E* < w) in which the home country can affect the foreign goods-price ratio. It is clear that dp*/dE < 0 by (18) and dp/dE may display any sign depending upon the sign of ( E * - v) in (25'). Hence, dW/dE is indeterminate. We consider two cases:

(i) When E* > V , we have dp/dE > 0 by (25'). This implies that dWdE < (>) 0 for the short (long) run. Thus, dW/dE < 0 for the long run, whereas the short-run welfare effect is less cut and dry. If the favorable employment effect outweighs the losses from the terms-of-trade deterioration and the direct sale abroad, dW/dE will be positive in the short run. By solving (23) and (24) and using the definition of b, we can obtain:

It is clear that a sufficient condition for welfare-improving export promotion in the short run is:

1 A strong employment effect is necessary for export promotion to be welfare-

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10 CHI-CHUR CHAO AND EDEN S. H. YU

improving. The sufficient condition is likely to hold when s is large; the larger the value of s, the higher the employment level in the urban sector in the short run.

Notice that, for the small country (E* = 03)) the condition in (30) becomes (1 + c/s)(l - p*/p) < - b. Compared with (30), this condition is weaker because that dp*/dE = 0 when E* = win (18). Hence, in the short run, the policy of export promotion is more effective for the small country in raising national welfare.

(ii) When E* < v, we have dp/dE < 0 and, hence, dii/dE > (<) 0 for the short (long) run. It is assured that dW/dE < 0 for the short run. As for the long run, although there is a favorable long-run employment effect, its impact is, however, insufficient to offset the terms-of-trade and the direct sale loss. Hence, we still obtain dW/dE < 0, which can be confirmed from (29) by recalling that b > 0 in the long run.

By way of summary, we state the following proposition:

PROPOSITION 3. For both small and large countries with urban unemployment, export promotion always reduces welfare in the long run, but it may improve welfare in the short run when the employment effect is sufficiently large. Nevertheless, in the short run, export-led policy is more effective for small countries.

Foe ease of comparison, the main results on the goods-price ratio, the unemployment ratio and welfare are presented in Table 1 for the large country case when E* > v and in Table 2 for the large country case where E* < v.

Table 1. Effects of Export Promotion ( E * > v) - - - -- - - -

P* P a U --- -- -

Short Run - + - * Long Run - + + -

- -- -- --- - --

Table 2. Effects of Export Promotion (E* < v) -- -- - - - - - - -

a U --

P* --

P

Short Run - - + - Long Run - - - -

- - -

5. CONCLUDING REMARKS

In this paper we have developed a two-commodity, two-country general equilibrium trade model to analyze the effectiveness of export promotion policy

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EXPORT PROMOTION AND UNEMPLOYMENT 11

frequently adopted by many countries in promoting employment and welfare. We have shown that the employment and welfare effects of export promotion crucially depend on the foreign import demand elasticity and the home country's propensity to consume its export commodity. Our main result is that export promotion actually hurts the economy in the long run but it may improve the short-run welfare only under certain conditions. Our analysis casts some doubt the validity of the export-led growth hypothesis.

APPENDIX

1. The Short-Run Comparative Statics Results

Let 8, = wxCXJCX and eKX = rxCxJCx be the distributive share of labor and capital in sector X, and il, = CX$ULbe the fraction of labor employed in sector X and so on.

The short-run comparative statics results can be obtained by differentiating (1 1) - (16) and solving them ax9

where k = S/X and D = k8KX[~YALY + il,8KY(l + A)] > 0. Here ox and oy signify the factor substitution in sector X and Y, respectively.

By utilizing the above results, the unemployment-distortion parameter in the short run can be obtained as

9Jones (1965) provides a detailed discussion on the Jones algebra.

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12 CHI-CHUR CHAO AND EDEN S. H. YU

= - kAuOKy(l + A)l[oYALy + AuOKy(l + A)],

which is between -1 and 0.

2. The Long-Run Comparative Statics Results

Let OLX = wXCX+,/CX and OKX = rxCx/Cx be the distributive share of labor and

capital in sector X, and ALX = CXX/rand il, = CXX'Kbe the fraction of labor and capital employed in sector X. Note that rx = ry = r in the long run.

Following Chang (1981), the dynamic adjustment process is specified as follows:

where a dot over the variable is the time derivative and a, is the speed of the adjustment which is assumed to be positive.

Linearization of the differential equations around the equilibrium values gives

where sL, = oiAL,tlKi and SKi = qAKiG i = X, Y. The D-stability (for all speeds of adjustment) of the original nonlinear system

requires that every principal minor of the coefficient matrix of even order is nonnegative and every principle minor of odd order is nonpo~itive.'~ Denoting the

losee Quirk and Saposnik (1968).

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EXPORT PROMOTION AND UNEMPLOYMENT

principle minor by Ji (i = 1 to 4), the stability conditions require:

It should be remarked that AKx - (1 + A)ALy > 0, which is the stability condition for the mobile- capital Harris-Todaro model. See Khan (1980) and Neary (1981). Khan interpreted this condition as manufacturing sector being capital intensive in employment adjusted term. Neary called it the manufacturing sector being capital abundant relative to agriculture.

By imposing the stability conditions, the long-run comparative statics results can be obtained as:

REFERENCES

Beckerman, W., "Demand, Exports and Growth," in W. Beckerman and Associates, The British Economy in 1965, The National Institute of Economic and Social Research, 1965.

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