Balance-of-Payments Constrained Growth — Dual Gap Analysis

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Writes Thirlwall in Growth and Development (2006), p. 444 pp;

Trade theory and dual-gap analysis

Another dimension to the protectionist argument draws explicitly on dual-gap analysis. The crucial question is whether a developing country's economic potential can be fully utilised at the same time as equilibrium is maintained externally. Free trade may not lead to the full employment of resources for two reasons: because of factor immobility; and because certain imports may be required to achieve full utilisation of resources, and these import requirements may exceed the availability of foreign exchange. 

In our discussion of dual-gap analysis in Chapter 15 we saw that if the import-export gap is dominant and foreign exchange is scarce, domestic resources may go unutilised in the absence of development policies to equate the import-export gap and the investment-savings gap ex ante. Potential domestic saving will fall either through a fall in the potential level of output or through a fall in the propensity to save through a redirection of expenditure. One solution, however, is to devote more domestic resources to import substitution or export promotion.

Linder (1967) has argued that in developing countries it may not be possible to solve the problem of the domestic underutilisation of resources through trade because of an export maximum. Classical trade theory, however, does not admit this. 

The notion of an export maximum is related to what Linder calls the theory of 'representative demand', which determines the relative price structure for goods. The theory of representative demand states that the production function for a commodity will be the more advantageous in a country the more the demand for a commodity is typical of the economic structure of a country compared with other countries. 

The chief determinant of demand structure is per capita income, so that goods in demand in advanced countries have unfavourable production functions in developing countries, and vice versa. The developing countries therefore face severe marketing problems if they decide to develop by trade. The goods they are best at producing are not demanded in developed countries, and they are inefficient at producing the goods that are demanded in developed countries. Productivity may not be high enough to support resources in the production of these goods, and imported inputs for export production might absorb more foreign exchange than the exports eventually yield.

These circumstances provide a case for protection to save foreign exchange and enable the full utilisation of domestic resources. This contrasts with conventional theory, which does not allow for protection for balance-of-payments reasons or to increase the effective demand for domestic products in order to eliminate underemployment.

Moreover protection in this model involves no allocation losses, because if foreign exchange is required to utilise domestic resources fully, the opportunity cost of using resources is zero. The only qualification Linder makes to his argument for development based on import substitution and the expansion of domestic demand is if value-added is negative; that is, if imported inputs for domestic production involve a higher foreign exchange cost than the importation of the end-products themselves.

Except in these circumstances, there is no conflict between allocation and capacity considerations or allocative efficiency and import substitution as long as a foreign exchange gap exists. Import substitution frees foreign exchange for imported inputs that allow the full utilisation of domestic resources.