Import-Substituting Industrialization:
From World War II until the 1970s many developing countries attempted to accelerate
their development by limiting imports of manufactured goods to substitute a
manufacturing sector serving the domestic market. This strategy became popular for a
number of reasons, but theoretical economic arguments for import substitution played an
important role in its rise. Probably the most important of these arguments was the infant
industry argument.
The Infant Industry Argument:
According to the infant industry argument, developing countries have a potential
comparative advantage in manufacturing, but new manufacturing industries in developing
countries cannot initially compete with well-established manufacturing in developed
countries. To allow manufacturing to get a grip, governments should temporarily support
new industries, until they have grown strong enough to meet international competition.
Thus, it makes sense, according to this argument, to use tariffs or import quotas as
temporary measures to get industrialization started. It is a historical fact that the world's
three largest market economies United States, Germany and Japan began their
industrialization behind trade barriers.
Problems with the Infant Industry Argument:
The infant industry argument seems highly reasonable, and in fact it has been convincing
to many governments. Yet economists have pointed out many drawbacks in the argument,
suggesting that it must be used cautiously
First, it is not always good to try to move today into the industries that will have a
comparative advantage in the future. Suppose that a country that is currently labor
abundant is in the process of accumulating capital: When it accumulates enough capital,
it will have a comparative advantage in capital-intensive industries. That does not mean it
should try to develop these industries immediately.
Second, protecting manufacturing does no good unless the protection itself helps make
industry competitive. Pakistan and India have protected their manufacturing sectors for
decades and have recently begun to develop significant exports of manufactured goods.
The goods they export, however, are light manufactures like textiles, not the heavy
manufactures that they protected. Some economists have warned of the case of the
"pseudo infant industry," where industry is initially protected, then becomes competitive
for reasons that have nothing to do with the protection. In this case infant industry
protection ends up looking like a success but may actually have been a net cost to the
economy.
Market Failure Justifications for Infant Industry Protection:
To justify the infant industry argument, it is necessary to go beyond the plausible but
questionable view that industries always need to be sheltered when they are new. The argument for protecting an industry in its early growth must be related to some particular
set of market failures that prevent private markets from developing the industry as rapidly
as they should. Supporters of the infant industry argument have identified two market
failures as reasons why infant industry protection may be a good idea:
i. imperfect capital markets
ii. problem of appropriability
The imperfect capital markets:
The imperfect capital markets justification for infant industry protection is as follows. If
a developing country does not have a set of financial institutions that would allow savings
from traditional sectors (agriculture) to be used to finance investment in new sectors
(manufacturing), then growth of new industries will be restricted by the ability of firms in
these industries to earn profits. Thus, low initial profits will be an obstacle to investment
even if the long-term returns on this investment are high. The first-best policy is to create
a better capital market, but protection of new industries, which would raise profits and
thus allow more rapid growth, can be justified as a second-best policy option.
The appropriability argument:
The appropriability argument for infant industry protection can take many forms, but all
have in common the idea that firms in a new industry generate social benefits for which
they are not compensated. For example, the firms that first enter an industry may have to
incur "start-up" costs of adapting technology to local circumstances or of opening new
markets. If other firms are able to follow their lead without incurring these start-up costs,
the pioneers will be prevented from reaping any returns from these outlays. Thus,
pioneering firms may, in addition to producing physical output, create immaterial benefits
(knowledge) in which they are unable to establish property rights. Both the imperfect
capital markets argument and the appropriability case for infant industry protection are
clearly special cases of the market failures justification for interfering with free trade.
Promoting Manufacturing Through Protection:
Although there are doubts about the infant industry argument, many developing countries
have seen this argument as a compelling reason to provide special support for the
development of manufacturing industries. In most developing countries, however, the
basic strategy for industrialization has been to develop industries oriented toward the
domestic market by using trade restrictions such as tariffs and quotas to encourage the
replacement of imported manufactures by domestic products. The strategy of encouraging
domestic industry by limiting imports of manufactured goods is known as the strategy of
import-substituting industrialization. By protecting import-substituting industries,
countries draw resources away from actual or potential export sectors. So, a country's
choice to seek to substitute for imports is also a choice to discourage export growth. The reasons why import substitution rather than export growth has usually been chosen as an
industrialization strategy are a mixture of economics and politics.
First, until the 1970s many developing countries were skeptical about the possibility of
exporting manufactured goods (although this skepticism also calls into question the infant
industry argument for manufacturing protection). They believed that industrialization was
necessarily based on a substitution of domestic industry for imports rather than on a
growth of manufactured exports.
Second, in many cases import-substituting industrialization policies merged naturally
with existing political biases.
It is also worth pointing out that some advocates of a policy of import substitution believed
that the world economy was rigged against new entrants, that the advantages of established
industrial nations were simply too great to be overcome by newly industrializing
economies. Extreme proponents of this view called for a general policy of delinking
developing countries from advanced nations; but even among milder advocates of
protectionist development strategies the view that the international economic system
systematically works against the interests of developing countries remained common until
the 1980s.
In most developing economies, the import-substitution drive stopped short of its logical
limit: Sophisticated manufactured goods such as computers, precision machine tools, and
so on continued to be imported. Nonetheless, the larger countries pursuing importsubstituting industrialization reduced their imports to remarkably low levels. Usually, the
smaller a country's economic size the larger will be the share of imports and exports in
national income.
Problems of Import-Substituting Industrialization:
The attack on import-substituting industrialization starts from the fact that many countries
that have pursued import substitution have not shown any signs of catching up with the
advanced countries. In some cases, the development of a domestic manufacturing base
seems to have led to a stagnation of per capita income instead of an economic takeoff..
Only a few developing countries really seem to have moved dramatically upward on the
income scale—and these countries either have never pursued import substitution or have
moved sharply away from it.
Why didn't import-substituting industrialization work the way it was supposed to? The
most important reason seems to be that the infant industry argument was not as universally
valid as many people assumed. A period of protection will not create a competitive
manufacturing sector if there are fundamental reasons why a country lacks a comparative
advantage in manufacturing. Experience has shown that the reasons for failure to develop
often run deeper than a simple lack of experience with manufacturing. Poor countries lack
skilled labor, entrepreneurs, and managerial competence and have problems of social organization that make it difficult to maintain reliable supplies of everything from spare
parts to electricity.
These problems may not be beyond the reach of economic policy, but they cannot be
solved by trade policy: An import quota can allow an inefficient manufacturing sector to
survive, but it cannot directly make that sector more efficient. The infant industry
argument is that, given the temporary shelter of tariffs or quotas, the manufacturing
industries of less-developed nations will learn to be efficient. In practice, this is not
always, or even usually, true. With import substitution failing to deliver the promised
benefits, attention has turned to the costs of the policies used to promote industry. On this
issue, a growing body of evidence shows that the protectionist policies of many lessdeveloped countries have badly distorted incentives. Part of the problem has been that
many countries have used excessively complex methods to promote their infant industries.
That is, they have used elaborate and often overlapping import quotas, exchange controls,
and domestic content rules instead of simple tariffs. It is often difficult to determine how
much protection an administrative regulation is actually providing, and studies show that
the degree of protection is often both higher and more variable across industries than the
government planned.
A further cost that has received considerable attention is the tendency of import
restrictions to promote production at an inefficiently small scale. The domestic markets of
even the largest developing countries are only a small fraction of the size of that of the
United States or the European Union. Often, the whole domestic market is not large
enough to allow an efficient-scale production facility.
By the late 1980s, the critique of import-substituting industrialization had been widely
accepted, not only by economists but by international organizations like the World Bank
and even by policymakers in the developing countries themselves. Statistical evidence
appeared to suggest that developing countries that followed relatively free trade policies
had on average grown more rapidly than those that followed protectionist policies.
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Problems of the Dual Economy:
While the trade policy of less-developed countries is partly a response to their relative
backwardness as compared with advanced nations, it is also a response to uneven
development within the country. Often a relatively modern, capital-intensive, high-wage
industrial sector exists in the same country as a very poor traditional agricultural sector.
The division of a single economy into two sectors that appear to be at very different levels
of development is referred to as economic dualism, and an economy that looks like this is
referred to as a dual economy. Why does dualism have anything to do with trade policy?
One answer is that dualism is probably a sign of markets working poorly: In an efficient
economy, for example, workers would not earn hugely different wages in different sectors.
Whenever markets are working badly, there may be a market failure case for deviating
from free trade. The presence of economic dualism is often used to justify tariffs that
protect the apparently more efficient manufacturing sector. A second reason for linking
dualism to trade policy is that trade policy may itself have a great deal to do with dualism.
As import-substituting industrialization has come under attack, some economists have
argued that import-substitution policies have actually helped to create the dual economy
or at least aggravate some of its symptoms.
The Symptoms of Dualism:
There is no precise definition of a dual economy, but in general a dual economy is one in
which there is a "modern" sector that contrasts sharply with the rest of the economy in a
number of ways:
1. The value of output per worker is much higher in the modern sector than in the rest of
the economy. In most developing countries, the goods produced by a worker in the
manufacturing sector carry a price several times that of the goods produced by an
agricultural worker. Sometimes this difference runs as high as 15 to 1.
2. Accompanying the high value of output per worker is a higher wage rate. Industrial
workers may earn ten times what agricultural laborers make.
3. Although wages are high in the manufacturing sector, however, returns on capital are
not necessarily higher. In fact, it often seems to be the case that capital earns lower returns
in the industrial sector.
4. The high value of output per worker in the modern sector is at least partly due to a
higher capital intensity of production. Manufacturing in less-developed countries typically
has much higher capital intensity than agriculture. In the developing world, agricultural
workers often work with primitive tools, while industrial facilities are not much different
from those in advanced nations.
5. Many less-developed countries have a persistent unemployment problem. Especially in
urban areas, there are large numbers of people either without jobs or with only occasional,
extremely low-wage employment. These urban unemployed coexist with the relatively
well-paid urban industrial workers.
Trade Policy as a Cause of Economic Dualism:
Trade policy has been accused both of widening the wage differential between
manufacturing and agriculture and of fostering excessive capital intensity. The reasons for
huge wage differentials between agriculture and industry are not well understood. Some
economists believe these differentials are a natural market response. Firms, so the
argument goes, offer high wages to ensure low turnover and high work effort in countries
not used to the discipline of industrial work. Other economists argue, however, that the
wage differentials also reflect the monopoly power of unions whose industries are sheltered by import quotas from foreign competition. With freer trade, they argue,
industrial wages would be lower and agricultural wages higher. If so, dualism and
unemployment may be worsened by import restrictions, especially those undertaken in the
name of import substitution. The excessive capital intensity of manufacturing is partly due
to relatively high wages, which give firms an incentive to substitute capital for labor. To
the extent that trade restrictions are responsible for these high wages, they are to blame.
Also, in some countries a controlled banking system in effect provides subsidized credit
to industrial firms, making capital-labor substitution cheap. The most direct channel,
however, has been through selective import control. In many cases, imports of capital
goods enter without tariff or other restriction, and sometimes with actual import subsidies.
This policy further encourages the use of capital-intensive techniques.
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Export-Oriented Industrialization:
The East Asian Miracle
In the 1950s and 1960s it was widely believed that developing countries could create
industrial bases only by substituting domestic manufactured goods for imports. From the
mid-1960s onward, however, it became increasingly apparent that there was another
possible path to industrialization: via exports of manufactured goods, primarily to
advanced nations. Moreover, the countries that developed in this manner, a group that the
World Bank now refers to as the high-performance Asian economies (HPAEs)—achieved
spectacular economic growth, in some cases at more than 10 percent per year. The
economies of the HPAEs were severely affected by the financial crisis that began in 1997;
nonetheless, their achievements up to that point were remarkable. While the achievement
of the HPAEs is not in doubt, and while there is also no question that their success refutes
the previous conventional wisdom that industrial development must take place via import
substitution, there remain major controversies about the implications of the "East Asian
miracle." In particular, different observers place very different interpretations on the role
of government policies, including trade policy, in fostering economic growth.
The Facts of Asian Growth:
The World Bank's definition of HPAEs contains three groups of countries, whose
"miracles" began at different times.
First is Japan, which began rapid economic growth soon after World War II and now has
per capita income comparable to the United States and Western Europe, which presents
trade and industrial policy in advanced countries. In the 1960s rapid economic growth
began in four smaller Asian economies, often known as the four "tigers": Hong Kong,
Taiwan, South Korea, and Singapore.6 Finally, in the late 1970s and the 1980s rapid
growth began in Malaysia, Thailand, Indonesia, and, most spectacularly, in China. Each
group achieved very high growth rates. Real gross domestic product in the "tiger"
economies grew at an average of 8-9 percent from the mid-1960s until the 1997 Asian crisis, compared with 2-3 percent in the United States and Western Europe. Recent growth
rates in the other Asian economies have been comparable, and China has reported growth
rates of more than 10. In addition to their very high growth rates, the HPAEs have another
distinguishing feature: They are very open to international trade and have become more
so over time. In fact, the rapidly growing Asian economies are much more export oriented
than other developing countries, particularly in Latin America and South Asia. Gross
domestic product represents the value added by an economy, not the total sales. Because
modern manufacturing often consists of adding a relatively small amount of value to
imported inputs, exports can easily exceed total national output.
Some economists have tried to tell a simple story that attributes the success of East Asian
economies to an "outward-oriented" trade policy. In this view, the high ratios of exports
and imports to GDP in Asian nations are the consequences of trade policies that, while
they might not correspond precisely to free trade, nonetheless leave trade much freer than
in developing countries that have tried to develop through import substitution. And high
growth rates are the payoff to this relatively open trade regime. Unfortunately, the
evidence for this story is not as strong as its advocates would like. In the first place, it is
unclear to what extent the high trade ratios in the HPAEs can really be attributed to free
trade policies. With the exception of Hong Kong, the HPAEs have in fact not had anything
very close to free trade: All of them continue to have fairly substantial tariffs, import
quotas, export subsidies, and other policies that manage their trade. Are the HPAEs
following policies that are closer to free trade than those of other developing countries?
Probably, although the complexity of the trade policies followed by developing countries
in general makes comparisons difficult.
Industrial Policy in the HPAEs:
Some commentators believe that the success of the HPAEs, far from demonstrating the
effectiveness of free trade policies, actually represents a payoff to sophisticated
interventionism. It is in fact the case that several of the highly successful economies have
pursued policies that favor particular industries over others; such industrial policies
included not only tariffs, import restrictions, and export subsidies, but also more complex
policies such as low-interest loans and government support for research and development.
Here, we just need to note that most economists studying this issue have been skeptical
about the importance of such policies, for at least three reasons.
First, HPAEs have followed a wide variety of policies, ranging from detailed government
direction of the economy in Singapore to virtual laissez-faire in Hong Kong. South Korea
deliberately promoted the formation of very large industrial firms; Taiwan's economy
remains dominated by small, family-run companies. Yet all of these economies have
achieved similarly high growth rates.
Second, despite considerable publicity given to industrial policies, the actual impact on industrial structure may not have been large. The World Bank, in its study of the Asian
miracle, found surprisingly little evidence that countries with explicit industrial policies
have moved into the targeted industries any faster than those which have not.
Finally, there have been some notable failures of industrial policy even in otherwise highly
successful economies. For example, from 1973 to 1979 South Korea followed a policy of
promoting "heavy and chemical" industries, chemicals, steel, automobiles, and so on. This
policy proved extremely costly and was eventually judged to be premature and was
abandoned.
Other Factors in Growth:
In the last few years several researchers have suggested that the whole focus on trade and
industrial policy in Asian growth may have been misplaced. After all, international trade
and trade policy are only part of the story for any economy, even one with a high ratio of
exports to national income. Other aspects of the economy may well have been more
important determinants of success.
And in fact, the fast-growing Asian economies are distinctive in ways other than their high
trade shares. Almost all of these economies, it turns out, have very high savings rates,
which means that they are able to finance very high rates of investment. Almost all of
them have also made great strides in public education. Several recent estimates suggest
that the combination of high investment rates and rapidly improving educational levels
explains a large fraction, perhaps almost all, of the rapid growth in East Asia. If this is
true, the whole focus on trade and industrial policy is largely misplaced. Perhaps one can
argue that the Asian economies have had trade policy that is good in the sense that it has
permitted rapid growth, but it is greatly overstating the importance of that policy to say
that it caused growth. One thing is, however, certain about the East Asian experience.
Whatever else one may say about it, it definitely refutes some assumptions about economic
development that used to be widely accepted.
First, the presumption that industrialization and development must be based on an inward-looking strategy of import substitution is clearly false. On the contrary, the success stories
of development have all involved an outward-looking industrialization based on exports
of manufactured goods.
Second, the pessimistic view that the world market is rigged against new entrants,
preventing poor countries from becoming rich, has turned out to be spectacularly wrong:
Never in human history have so many people seen their standard of living rise so rapidly.
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