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Globalization, Dual
Economy, and Economic Development Jeffrey Sachs, Xiaokai Yang Dingsheng Zhang This Version: June 2000 Abstract: This paper applies the infra-marginal analysis,
which is a combination of marginal and total cost-benefit analysis,
to a model with both constant returns and increasing returns in production.
It demonstrates that as transaction conditions are improved, the general
equilibrium discontinuously jumps from autarky to partial division
of labor with a dual structure, then to the complete division of labor
where dual structure disappears. Two types of dual structure may occur
in the transitional stage of economic development and globalization.
One of them involves the division of labor in the developed economy
and autarky in the less developed economy, generating increasing disparity
of per capita real income between the two types of economies. The
other involves a domestic dual structure in the less developed economy,
where the population is divided between commercialized sector which
trades with foreign country and self-sufficient sector which is not
involved in trade. All gains from trade go to the developed economy.
This paper shows that deterioration of a country's terms of trade
and an increase of gains that this country receives from trade may
concur, provided productivity progress from an expanded network of
division of labor outpaces the deterioration of terms of trade. In
the model with both endogenous and exogenous comparative advantages,
a country may export a good with exogenous comparative disadvantage
if endogenous comparative advantage dominates this exogenous comparative
disadvantage. Implications of the findings for China's WTO membership
and China's trade policy are explored. Second, we use inframarginal analysis, which is total
cost-benefit analysis across corner solutions in addition to marginal
analysis of each corner solution, to show that deteriorated terms
of trade for a country may be associated with increasing gains that
this country receives from trade if productivity gains generated by
expanding network of division of labor more than compensate the deteriorated
terms of trade. Finally, we will examine implications of the coexistence
of exogenous and endogenous comparative advantages for China's pattern
of trade. Let us motivate the three tasks one by one. Yang (1994) and Yang and Borland (1991) have drawn
the distinction between David Ricardo's exogenous comparative advantage
(Ricardo, 1817) and Adam Smith's endogenous comparative advantage
(Smith, 1776). There is an extensive literature on exogenous comparative
advantage in trade theory (see, for instance, Dixit and Norman, 1980).
Separately, there are many models of endogenous comparative advantage
in the growing literature on endogenous specialization (see Yang and
Ng, 1998 for a recent survey on this literature and references there).
The current paper develops a general equilibrium model with both endogenous
and exogenous comparative advantages. The coexistence of endogenous
and exogenous comparative advantage may provide a general equilibrium
mechanism for explaining phenomena of underdevelopment and dual structure
with underemployment in a transitional stage of economic development.
Lewis (1955) noted development implications of dual
structure of commercialized versus noncommercialized sectors and evolution
of commercialization. Therefore, Ranis (1988, p. 80) emphasizes that
really guiding principle of organizational dualism is "commercialized"
versus "noncommercialized" rather than "agricultural"
versus "nonagricultural". But Lewis could not find a right
way to model evolution of division of labor which is associated with
the reallocation of resources from the noncommercialized and self-sufficient
sector to commercialized modern sector. He did not know how to use
general equilibrium model with increasing returns to describe evolution
of dual structure, nor he could command inframarginal analysis of
division of labor which is associated with corner solutions. Hence,
he used neoclassical marginal analysis of a model with constant returns
to scale and disequilibrium in labor market to investigate development
implications of evolution in division of labor. Chenery (1979) used
market disequilibrium to explain structural changes to avoid a general
equilibrium analysis of structural changes. Recently, general equilibrium
models are used to study dual structure. In some of these models,
such as in Khandker and Rashid's equilibrium model (1995), dual structure
is exogenously assumed. They cannot predict the emergence and evolution
of dual structure. In a recent literature of formal equilibrium models
of high development economics, evolution of dual structure between
the manufacturing sector with economies of scale in production and
the agricultural sector with constant returns to scale can be predicted
(see Krugman and Vanables, 1995, 1996, and Fujita and Krugman, 1995).
The equilibrium models with endogenous geographical location of economic
activities of Krugman and Venables (1995) and Baldwin and Venables
(1995) attribute the emergence of dual structure to the geographical
concentration of economic activities in economic development that
marginalizes peripheral areas. Kelly (1997), based on Murphy, Shleifer,
and Vishny (1989), develops a dynamic general equilibrium model that
predicts spontaneous evolution of a dual structure between the modern
sector with economies of scale and the traditional sector with constant
returns technology. As transaction conditions are sufficiently improved,
the level of division of labor increases and dual structure disappears.
Our model in this paper is complementary to these general equilibrium
models that predict the emergence and evolution of dual structure.
We pay more attention to the effects of evolution of individuals'
levels of specialization and the coexistence of exogenous and endogenous
comparative advantages on the emergence and evolution of dual structure.
In our model endogenous and exogenous comparative advantages
generate pecuniary positive network effects of division of labor on
aggregate productivity. The trade off between the network effects
and transaction costs implies that if a transaction cost coefficient
for a unit of goods traded is large, total transaction cost outweighs
economies of division of labor, so that autarky, where aggregate productivity
is lower than the PPF, is equilibrium. As transaction conditions are
improved, the equilibrium network of trade expands. In the transitional
stage from a low to a high level of domestic and international division
of labor, the country with lower transaction efficiency is partly
involved in the division of labor. Some residents trade with foreign
country and the rest of the population are in autarky. This underemployed
labor looks like labor surplus that forces down terms of trade of
this country, so that all gains from international trade go to the
developed country that has a better transaction condition and is completely
involved in the division of labor. As the transaction condition in
the less developed country is further improved, the equilibrium network
of division of labor expands further, the equilibrium aggregate productivity
reaches the PPF, and gains from trade are shared by all individuals,
so that dual structure disappears. We shall show that in the process of moving to a high
level of division of labor, a country may receive more gains from
trade even if its terms of trade deteriorate. This is because an expansion
of the network of division of labor can generate productivity gains
that outweigh the adverse effect of the terms of trade deterioration.
Many economists try to find empirical evidence for or against the
claim that terms of trade are worsening for developing economies or
to measure adverse effects of worsening terms of trade on economic
development (see, for instance, Morgan, 1970 and Kohli and Werner,
1998). Recent empirical evidence provided by Sen (1998) shows that
economic development and deteriorated terms of trade may concur. Sen
uses a partial equilibrium model with monopolistic competition, where
prices in the world market are exogenously given, to predict this
phenomenon. Hence, his model cannot explore feedback loops between
the network size of international division of labor, the extent of
the market, aggregate productivity, and terms of trade. There are two separate literatures on pattern of trade.
Standard trade theory explains trade pattern by exogenous technological
and endowment advantages in the Ricardo and Heckscher-Ohlin models
with constant returns to scale in production. The literature of trade
models with economies of scale are silent about which country exports
which good since this makes no difference due to the symmetry assumed
in these models (see Krugman, 1980 and Ethier 1982). In the literature
of endogenous specialization, trade pattern is explained by endogenous
comparative advantage. Individuals trade those goods which have greater
economies of specialization, better transaction condition, and/or
are more desirable if not all goods are traded (see Yang, 1991). But
who sells which good is indeterminate in the models too because of
the assumption that all individuals are ex ante identical. In the current paper, individuals' characteristics
might be ex ante different, while endogenous comparative advantage
can be acquired via the decisions in choosing a pattern of specialization
and a network of trade partners. Both increasing returns and constant
returns are allowed. We then show that if a country has endogenous
comparative advantage and exogenous comparative disadvantage in producing
a good, it may export the good with exogenous comparative disadvantage
if the endogenous comparative advantage dominates exogenous comparative
disadvantage. Our findings have the following implications for China's
policy debate on WTO access. In the debate, some argue that China's
access to the WTO will generate a dual structure in which capitalist
core exploits peripheral China. Others contend that China's WTO membership
will initiate a new round of reforms and China can gain from globalization.
Our model shows that if China's transaction efficiency is very low,
then China cannot gain from globalization in a dual structure where
some Chinese are involved in international trade and others are in
autarky since low income in autarchic part forces terms of trade against
China, bring all gains from trade to the developed country with a
higher transaction efficiency. If China's further reforms can significantly
raise transaction efficiency, China can then gain from globalization
from a high level of international and domestic division of labor
and a fairer division of gains from the division of labor. Many Chinese economists argue that China's trade policy
should utilize its exogenous comparative advantages. Our findings
in this paper show that China should push further institutional reforms
to increase trading efficiency rather than promoting export of goods
in which China has exogenous comparative advantages. For instance,
China has exogenous comparative advantage in labor intensive sector.
However, China may export capital intensive satellite launching if
China's endogenous comparative advantages outweigh its exogenous comparative
disadvantages in satellite launching. The rest of this paper is organized as follows. Section 2 presents the 2x2 Ricardian model with transaction costs and endogenous and exogenous comparative advantages. Section 3 solves for general equilibrium and its inframarginal comparative statics. Section 4 extends the analysis to different combinations of endogenous and exogenous comparative advantages for the two countries and two goods. The concluding section summarizes the findings of the paper and suggests possible extensions. Inframarginal Economics
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