Trade, Foreign Investment, and Industrial Policy for Developing Countries 4091

shares, and tariffs. In countries with low barriers to entry, there is a positive relationship
between openness to trade and growth; in regulated economies, there is a negative
relationship. The importance of other policies—in this case, low entry barriers—
provides one explanation for why it is so difficult to find a robust relationship between
openness to trade and good performance. There is simply too much heterogeneity in
outcomes, in large part because other types of policies are so different. The necessity
for openness to trade to be accompanied by low barriers to entry and exit can be
understood in light of new trade theories that emphasize firm heterogeneity, as illu-
strated by Melitz (2003). In his model, gains from trade occur through reallocation
of market share from less productive to more productive firms. If firms cannot easily
expand or exit, this important source of productivity gains through trade reforms is
lost.
Two other studies also find that gains from trade are contingent on other policies.
Chang et al. (2005) use panel data instead of a cross section and trade shares corrected
for country size are their measure of openness. In their work, the key complementary
policies for ensuring that openness to trade is associated with growth include infra-
structure development, labor market flexibility, and low barriers to entry. Given
the current levels of those variables, they conclude that “there are many countries
that currently stand to lose from opening their markets.” Chang et al. argue that
other types of reforms are not so critical for ensuring growth gains from openness,
including educational attainment, financial depth, and good governance. DeJong
and Ripoll (2006), using tariffs as a measure of openness, also find that the effect of
openness on growth is conditional on the level of income. In particular, using
cross-country data for 1975-2000, they find a positive relationship between tariffs
and growth rates for the world’s poorest countries, but a negative relationship for rich
countries.
These three papers have several implications for trade policy. When eliminating
both trade and other distortions simultaneously is not possible, these papers suggest
that the benefits of trade reform depend on the existence and the degree of nontrade
distortions and the feasibility of removing them. Packages tailored to the specific cir-
cumstances of each country may be more appropriate than a “one size fits all” policy.
Another implication is that opening up to trade is not enough to ensure growth; in
particular, key complementary reforms include lowering barriers to new firm entry,
encouraging more flexible labor markets, and improving infrastructure.

4.3 What can the different effects of trade volumes versus trade
policy tell us about the success of IP?
Our review of recent evidence on trade policies, trade volumes, and growth suggests
that researchers face several challenges. In particular, measuring openness to trade,
identifying the direction of causality between openness and growth, and adding