IMPORT SUBSTITUTION AND EXPORT PROMOTION

In the 30 years after ww2 developing countries were under the assumption that the key to development was the creation of strong manufacturing sector through protecting domestic markets from foreign imports through protection. 1980s idea that free trade promotes growth Main concern in developing countries is the low level of overall income also the case that many developing countries are characterised by large differentials in income between regions and sectors.

Import Substitution (for the purpose of industrialisation) Until the 70s developing countries tried to limit imported manufactured goods in order to help the development of local firms who were able to support the domestic markets. Most important argument for such policy was:

Infant industry argument Developing countries have a potential comparative advantage in manufacturing They need support for the initial start up existing industries in developed countries are too well established to compete with. This produces the argument for protection via tariffs, quotas etc.

Examples of success of the policy US, Germany (tariffs in 18th century on manufactures) and Japan (import controls until the 70s) Problems with the argument not always good to move into a potential advantage industry No good to protect unless the protection itself eventually makes the industry competitive Pseudoinfant industry industry becoming competitive for reasons unassociated with protection. This makes protection look like it is working deceiving results High cost and high time consumption is no reason for protection

Imperfect capital markets If financial institutions are inefficient e.g. savings are not efficiently used in investment, the ability to earn current profits decreases. This creates disincentives to invest. This case the solution would be to repair the institutions, and if not possible, protection is the alternative measure.

Appropriability argument Pioneer firms create intangible benefits such as knowledge and new markets and are unable to establish property rights follower firms will not be subjected to these costs. Solution compensate firms for initial costs if not possible then protection via quotas and other policies Problem with above 2 arguments - hard to assess industries which fall into the categories

Promoting manufacturing through Protection Most developing countries have tried to promote industry through orientation towards supplying the domestic market using quotas, tariffs.. Therefore replacing imports with domestically produced goods called import substituting industrialisation Problems with such policies trading partner countries may decide to retaliate with similar quotas and tariffs. Such policies employed due to belief that this is the way for growth to occur as opposed to export promoting and also political biases exist Others believed that the system was rigged to ensure developing countries remain poor

Method of protection protection of final stages of industry e.g. food processing. The larger countries tried to completely replace imported goods with domestically produced consumer goods but most of this production was undertaken by multinationals. The next step was to protect intermediate goods such as steel and petrochemicals Conclusions of the policy import sub has encouraged growth of manufactures but as some countries e.g. India tend to spend high proportions of income on food, the idea that it has promoted development is doubtful.

Problems with import substitution industrialisation countries have pursued the policy but show no sign of catching up. Also stagnation of per capita incomes was evident can be seen in India between 1950 70s as there was a very minute increase Mexico achieved growth but not narrowed the gap between themselves and other countries. If for fundamental reasons a country lacks a comparative advantage, a period of protection will not lead to competitive manufactures.

Poor countries lack skilled labour, entrepreneurs, managerial competence + reliable supplies such as electricity and spare parts. Such issues cant be resolved through trade policy. Protection would allow inefficient manufacturing to exist and does not necessarily mean efficiency will ensue. Often there is not enough scope for more than one producer as the domestic market is unable to handle it. Therefore the creation of a monopoly is imminent which leads to inefficiency and higher profits

Dual economy Economic dualism 1 economy but a division into sectors that appear to be at very differing levels of development e.g. poor agricultural sector and relatively wealthy industrial sector in terms of high capital intensity and high wages.

This dual economy is a bad sign as it shows the economy is working poorly (wage differentials) creates a case for intervention in the free market i.e. protection Symptoms of dualism General meaning modern sector that contrasts sharply with the rest of the economy in the following ways: 1. The value of output per worker is much higher in the modern sector then the rest of the economy 2. Accompanying high value of output per worker is a higher wage rate sometimes up to 10x 3. Wages may be high but returns on capital are not necessarily high 4. High value of output per worker is often due to higher capital intensity production.. Poor country farmers have primitive tools while developed countries have expensive machinery. 5. Many poor countries have a persistent problem of unemployment. These urban unemployed exist with the relatively well paid urban industrial workers Wage differential argument in terms of market failure Many firms employing an additional worker will create marginal social benefit for which it receives no reward therefore as wage increases workers move from agriculture to manufacturing If there were no wage differentials then there would be indifference between the 2 sectors and no marginal social benefit would exist other than profits earned by firms

The 2 curves represent value of marginal product of an additional worker in each sector Employers will hire workers up to the pint where the value of a workers marginal product = wage: thus employment in manufacture is OML1 (point B) while food is (point C). If labour could shift to manufacturing then food output would decrease while that of manufacturing would increase. The value of additional manufacturing output would be the wage rate WM while that of food would be lower at WF therefore total output of the economy would increase by WM - WF. As the value of output has increased it means labour is not efficiently allocated. However by setting labour = in both sectors OML2 is achieved (point A) therefore there is an increase in output is the area ABC. Conclusion wage differentials lead to misplacement of labour and employers in manufacturing would hire too few workers National welfare would increase if the government can move more labour Therefore the best policy would not be a trade policy but in fact a policy aimed at eradicating wage differentials. When not possible the alternative is a subsidy / quota scheme but this distorts demand and also capital does not receive a particularly high rate of return.

According to Harris and Todaro, wage differentials encourage immigration into urban sectors but does not necessarily lead to employment. This leaves an idle FOP and unemployment co-exists with the higher paid urban workers. Therefore it can be said

that the marginal social benefit created through partial employment is offset by the increase in unemployment. Higher performance Asian economies HPAEs These countries have grown through import substitution but have apparently been relatively more open to free trade and followed export oriented policy. This may be the key to their success. REGION HPAE Other Asian South America Sub Saharan Africa AVG rate of protection, 1985 (%) 24 42 46 34

However despite the data, HPAEs still have trade restrictions it terms of tariffs, quotas, policies etc Their higher trade ratios are as much effect as cause of their success. This is because countries such as Thailand became popular with multinationals that export but also import raw materials and the rest is accounted for by increased income of the population. Therefore these figures can be misleading. Imports and exports have increased as the economy is doing well and not the other way round. Finally, one must consider that other factors may be key in the growth of these countries. Higher savings leading to increased investment Higher education rates more abundant and skilled labour force easy to train and higher human capital value Conclusion the power of trade policy must not be overestimated.

REGION HPAE Other Asian South America Sub Saharan Africa

AVG rate of protection, 1985 (%) 24 42 46 34