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Import Substitution in Leontief Models

Author(s): Kenneth J. Arrow
Source: Econometrica, Vol. 22, No. 4 (Oct., 1954), pp. 481-492
Published by: The Econometric Society
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All use subject to . though it is. The outstanding relevant features of the present model are the presence of unemployed labor and the imperfect competition on the market for exports due to import quotas in foreign countries. First of all. and John Fei.7 on Mon. The procedure actually used by Chenery is. These assumptions will now be stated i a more precise way. at least. there is a unique method of production for each product. The purpose of the pres- ent note is to demonstrate that his procedure is correct under a wide variety of circumstances. there being no possibilities of substitution. it is assumed that at least some industries have short-run capacity limitations. that each commodity can be produced in just one way. for many helpful com- ments. however. It is further assumed that the domes- tic production system can be described by a Leontief model. Professor Chenery. C. University of Chic and the Cowles Commission. T. 2 I wish to thank my colleague H.. with what domestic prices would be under competitive conditions. Finally. in a contribution to a study of the industrial structure of the Italian economy ([1]. that is. 481 This content downloaded from 202. choice among them is to be made on the basis of minimizing the cost of imports in foreign currency. Chapter II. Section E). the output of each in- dustry is uniquely determined. 1. it is hoped. B.93. which.43. Hence. It is assumed that foreign relative prices are not grossly out of line. The aim of planning is to minimize the drain on foreign exchange. there are n commodities. Some. I think. each producible by a unique process 1 Work partly supported by the Office of Naval Research. a rough approximation to the condi- tion of Italy and certain other European countries. 25 Sep 2017 02:53:36 UTC All use subject to http://about. the optimal choice is independent of relative prices. if a given bill of final goods is specified. IMPORT SUBSTITUTION IN LEONTIEF MODELS' BY KENNETH J. ARROW2 INTRODUCTION IN A TYPICAL Leontief model. Chenery. the inputs being proportional to the scale of the output. I will not argue its realism. however. has considered a model more general in that each commodity may be either produced domestically by a unique process or imported. One would expect that the choice of production and import program would depend upon the relative prices of imports. is the analytic contribution.jstor. Harvard University. in a sense to be made more exact below. Koopmans. that in spite of the presence of a substitution possibility. There are then alternative ways of producing a given bill of goods. of the domestic industries operate under capacity limitations. independent of these prices. The main purpose of this paper.e. which involves a drain on foreign exchange. BASIC ASSUMPTIONS OF THE MODEL I will briefly sketch the characteristics of the economy being analyzed. may be capable of further extension.

p. . and the net domestic output of commodity i. Let aij be the amount of commodity i used in pro- ducing one unit of commodity j. From the discussions in the previous paragraph. Some such assumption is certainly widely made by planning authorities. 6 By this notation is meant. which is total domestic output less derived demand by other industries. It will be assumed that exports can be sold at world prices freely up to a maximum beyond which none can be sold. in view of widespread quantitative restrictions on imports.5 In symbols.jstor.(7re)l ye. and x the vector of domestic outputs. > ." It will also be assumed that commodities can be imported in unlimited quantities at fixed prices. 4 All vectors are considered to be column vectors unless a prime is attached to the symbol.DL. 482 KENNETH J.. Since we are considering only commodities that are produced. for all i. 7r! the export price. and. In vector notation.x. Let ri be the final demand (consumption plus in modity. that y. and 7ri be the vectors of exports. may have a certain degree of realism.4 respectively. -< v. the vector of net domestic outp A)x.Te The net drain on foreign currency is given by. let ye. ai < 1. we measure the quantities in dollars of some fixed base year. as usual. and import prices. see Koopmans [3]. This is an approximation to a declining demand curve. so that labor and capital are excluded. The world prices in question are the prices in foreign markets less transport cost (in foreign currency). . xi the dom modity. (1) aij > 0. which are equal to foreign prices plus transport costs.43. Correspondingly. let ye be the export of the ith commodity. and 7ri the import price of the ith commodity. ai. (4) (Oi)l yi . For analytic convenience. maximum possible exports. in which case the transpose is taken.93. 45. i7j the maximum possible export of the ith commodity. the price of a unit produced must exceed the cost of the produced commodities used in production. is xi. y' the import of the ith commodity. The demand by industry j for commodity i is then aijx .7 on Mon. This content downloaded from 202. yi. are. These prices will be referred to as "export prices. (3) 7r. it is assumed that (2) ye < v 5 From the definitions of import and export . As usual (see Leontief [2]). export prices. r the vector of final demands. the assumption that exports cannot be expanded indefinitely at fixed prices will be stated in an extreme form. where I is the identity matrix of order n and A is the matrix (ai1 8 I am indebted to a referee for stressing the distinction between export and im prices. imports. 25 Sep 2017 02:53:36 UTC All use subject to http://about. aii = 0. ARROW which has only one output.

. is certainly positive and usually fairly considerable.( . the second. 7r.)r.93. It is assumed that. A)x + y_ ye> . while the first term.EsiZ bij7ri) . let {i be the total capacity.7rj) -EsL aij(7r . the first term.43. Now.) + Stn (bi1 -a. so that labor is a This content downloaded from 202. (6) 0 ? x < t. i. {j can be regarded as equal to infinity. we assume that the only factor of production other than the pro- duced commodities is labor and that there is unemployment.e. aijr.7r. The negligibility of transport costs and the identity of foreign and domestic production structures are. it suffices to take care of final demands and exports. the fourth term will be small because the bij's will be close to the aii's. (5) (I. To see why this assumption may be reasonable. Let ir be the vector of prices in the foreign country. Let t be the vector of capacities. the amount of commodity i used in producing one unit of commodity j in the foreign world. Next. purely as an identity... if the inputs (other than labor) are imported and the product then exported at the going import and export prices. aijt Finally. consider the excess of the export price over the import cost of the produced inputs for the jth product. there will be a net gain in foreign exchange. third.7 on Mon. If we can assume that transport costs are relatively small. Let bij be the foreign input-output coefficient. Then. Then. standard assumptions of foreign trade theory. r. The "export surplus" obtainable by producing commodity j out of foreign com- ponents is thus expressed as the value added abroad less the transport cost of the final product less the transport cost of the inputs needed for the product plus a term which depends upon the difference between the foreign and domes- tic technologies.L. Then we can write it as. for each product. For an industry in which there are no capacity limitations. of . and fourth terms will be small. > E!. which is value added per unit output abroad. i.ajj7ri = (7ri . must be defi- nitely positive. the value added. 25 Sep 2017 02:53:36 UTC All use subject to http://about. we will make a critically important assumption on import and export prices. while if the technology abroad does not differ too greatly from that domestically. 7rJ -E. For each industry. together with imports. If this be accepted. where even in the short run output can be in- creased by a proportional increase in all inputs. Hence we can assume that the export surplus must be positive. . since labor certainly enters into the costs of production abroad and there are normally profit elements also. the second and third terms will be small. IMPORT SUBSTITUTION IN LEONTIEF MODELS 483 net domestic output vector must be such that.e.

as we would expect if transport costs are significant. 484 KENNETH . In the condition (5) that the given final demands be at least met. even when applicable. First of all. and (6) is of course a problem in linear programming. Hence. ARROW free good from the national point of view. and we reduced both exports and imports of that commodity slightly by the same amount. any triplet of vectors x. THEOREM: Under the above assumptions (1). To avoid misapprehension. 2.1 and 2.jstor. the new program is still feasible. it should be remarked that the theorem does not imply. Under these conditions. (5). (5) and (6). Among the feasible programs. so (5) is still satisfied. The theorem permits a considerable simplification of the planning process in that. MATHEMATICAL ANALYSIS The problem of minimizing the linear form (7ri)' yi . yi. but there is never any loss in restricting oneself to such programs. In the present case. only the difference between exports and imports enters. (3).3. the optimal one is that which minimizes the drain upon foreign currency. given by (4). 25 Sep 2017 02:53:36 UTC All use subject to http://about. the minimum-cost import program for a given set of final demands can be determined in a fairly simple manner. The theoremn is demonstrated in the next section. from (3). ye. 2. In (6). 6 Under certain unimportant circumstances as good (in terms of minimizing the adver (2).7 on Mon. In view of (8) we can simplify the formulation of the vector. the optimal program has the following properties: (1) no commodity is both imported and exported.(7re)' ye subject to (2). and (7) on the technology and the import and export prices. which states that import prices are at least as high as export prices. that relative import and export prices are of no relevance for the planner. we can assume without loss that in an optimal program. This content downloaded from 202. so that the optimal program is independent of import and export prices so long as they satisfy (3) and (7). The upper bound (2) on exports would certainly be main- tained. see below in 2. there is no commodity which is both exported and imported. (2) there is no industry such that simultaneously the domestic industry has excess capacity and the exports are less than the maximum possible.93. (9) y = X + yi _ ye. For suppose there were. Further. some preliminary considerations lead to a relatively simple solution. the exports and imports do not enter explicitly. adverse trade balance cannot be increased and will in fact be reduced if the import price is actually greater than the export price. we can assume with- out loss of generality that. (8) for anyj. so that the choice among alternative bills of final demands will still depend upon those prices. For the circum- stances. within the limits of the theorem's validity.6 There is precisely one feasible program satisfying these conditions. is feasible if it satisfies (2). But the cost itself depends upon import and export prices.1.43. Hence. either y} = 0 or y =0.

we can easily find the vectors yi and ye from which it was derived. (12) (I. (10). Suppose the vectors x. 25 Sep 2017 02:53:36 UTC All use subject to http://about. Assume then that (11) holds with an inequality in at least one component. will be at least as good from the viewpoint of minimizing loss of foreign exchange. (11) (I. i. Any principal minor A of A (formed by de- leting rows and corresponding columns) also enjoys the properties (1). where both latter vectors are nonnegative. A feasible program can then ing (6).3. If we consider a matrix A having the properties stated in (1). Solow [41. and will involve equality in all components of (11). i. production plus imports exceeds required final demand plus exports for at least one commodity. imports being taken as negative exports. If a program is optimal.e. while ye can be obtained from y .. where u 0. (13) (I-A)x + y = + + u. then it follows from (8) that yi can be obtained by replacing all negative components of y . so that (6).jstor. This content downloaded from 202. (2) is equivalent to the condition that. where u and v are vectors. (10) y > 0. then each negative component of y . 45.* 7 (12) can also be written. so that ye < a. (2) is satisfied. See Koopmans. In particular. for a decrease in one component of y ports or a decrease in imports. it follows from (9) that y _ 0. at least one i. then it is well known that the matrix I . p.A)x + y '2 + .e. 37). no excess production. so that (I. 2. A new program will be constructed which will also be feasible.. since y - X) = y . either of which 7 By the symbol u > v. We will make use of a fundamental property of Leontief matrices.7 on Mon. there cannot be another y 2 9.93.2. Conversely. (11) may be satisfied with the in- equality holding for at least one component.43. IMPORT SUBSTITUTION IN LEONTIEF MODELS 485 The vector y may be interpreted as the excess of maximum possible exports over actual exports. Condition (5) can be written. 2. . and (11). y constitute an optimal program. Hence.A)-' are all nonnegative (see for example. p.q by replacing all positive components by 0 and changing the sign of all negative components. and (11) are satisfied.-7 will be greater than or equal to the corresponding com- ponent of -a.q by 0. [3]. Given the vector y. For each export vectors yi and ye can exchange evaluated from (4). that is. if (2) is satis- fied. A)x +y2 + +. If y _ 0. (10). a nonnegative matrix whose column sums are all less than one. that is.A is non-singular and the elements of (I . by u > v is meant us > vi for all i.A)-' is also defined and consists of nonnegative elements.

Let v be defined by sides of (13). Partition the vectors x. each compo of x(l)(t) must be nonincreasing as t increases. Partition the matrix A correspondingly. (18) x(0) = x.7(1) + UM (16) -A21x'l) + (I.A)x + (y . x(l)(t) > 0.43. The expression in brackets in the first equation of (17) is composed of nonnega- tive elements.v) > + n.A1)x(l) . ARROW change. as assumed. Further. as follows: x (l)(t (I. since u _ v. Since x. y(O) = y. then y .A12X(2) = t(1) + .(I . By solving for x(l) in the first equation of (16) and for y(2) in the second. y is optimal. so that.v _ 0. which is impossible if. (15) y(l) = 0. Hence. y(t) of the real variable t over the interval from 0 to 1. y and u so that all the positive components of y are in y(2) and the zero components in y(l). the expression in brackets is decreasing in at least o component as t increases. y(2) > o u(1) > 0? U(2) = 0.All)-' has only nonnegative elements. x < by (6).93. both as to rows and as to columns.jstor. This content downloaded from 202. that is.v is f any component .All)-' [A 12XA (2) + r (1) + 7(l) + (1 -t)0 1)] X(2)(t) x(2) (17) (1) y(l)(t) _ 0. (14) if y.A22)x(2) + r(2) + Xi(2). As also y . v = 0. y was feasible.v) = +n+ (u . it is easily verified that. then. since u(1) > 0. y(2)(t) = A2ix(l)(t) . the program x. (19) 0 ! x(t) <_ for O < t < 1.A22)x(2) + y(2) = r(2) + q(2). from the nonnegativity of (I . (I . > 0. If we multiply through the first equation in (17) by I .All and perform some obvious transpositions. (20)n ( h f\I .)-'.v < y. Then (13) can be written. y . it is easily seen that. Ui = 0. the pro- gram x. (I .7 on Mon.A1. Define vector functions x(t). since (I . With the aid of (14). 486 KENNETH J. 25 Sep 2017 02:53:36 UTC All use subject to http://about.A)t f y(t = r I _I + 1 -A t)u > + (O :! t 1).

so that y(l) = y > 0. how can it happen that there is more than one optimal program. x(1) < t. it is clear that the program x(1). Since (I . property (2) in the statement of the Theorem. i.e. the program x(t). If t is set equal to 1 in (20). 25 Sep 2017 02:53:36 UTC All use subject to http://about. in conjunction with (19) and (20). if it is possible to satisfy all final demands and export the maximum possible of every commodity without any imports and without reaching capacity in any industry. We shall now make use of (7) to establish the basic property of an optimal program. (22) (I-A)x(1) + y = + q. subtract (21) from (13). all components of y(2) are also nonincreasing. then y > y(t). it appears that starting with an optimal program we can find another as good by imposing the restriction that equality hold in every component in (11). y is feasible. the problem is reduced to selecting a pair of vectors x. y can be optimal only if y = 0. and (15). That is.7 on Mon. by the last line of (17). y(t) is feasible. Multiply both sides by (I . Then. we may replace (11) by the stronger conditions. which is impossible since it was assumed that x. (I .x(l)] = u.43.93. a detailed analysis of these cases does not seem worthwhile. and (22) so as to minimize (4). That is. A)x(l) + y = + a With the aid of (19).A)-' has only nonnegative el- ements and u > 0 (that is. This content downloaded from 202. so that. More complicated cases where optimal programs with excess production also exist with some industries at capacity and even with imports in some industries. x(1) ? x ? {. not all satisfying (22)? To answer this question. x . 2. It will appear in the next section that under these circumstances the program x(1). in searching for an optimal program.jstor. Hence each component of y(t) is neither increasing nor . That is. IMPORT SUBSTITUTION IN LEONTIEF MODELS 487 The matrix A2. y is optimal. has only nonnegative components. One special case is that in which the strict inequality holds.x(1)= (I . (10). From (17).A)[x . Since the net drain on foreign exchange depends only on y. then there exist alternative optimal programs with excess production in some industries. If y(t) had one component which is strictly decreasing in t.A)-lu > 0. y(t) ? 0.4. It may be interesting to inquire to what extent the condition (22) is actually essential for an optimum. then. (21) (I.. since all components of x(l)(t) are nonincreasing. y satisfying (6). u has at least one positive element). (18). As a result of the last section. for t sufficiently small but positive.A)-'.

for each commodity j.) A 'X2(2) + yl= ( + 71 Solve for x(l) in the first equation and for x(l) in the second. as that in the second. Since (I . (10). (25) y(l) = 0. In an optimal program. and take account of (25). so that (24) x(l) < x(l) x(2) > x(2) Since x(1) < t(1). we may suppose xi < Xi for at least one i. we must have x $ x. it has been shown that there can be only one program which satis- fies all the conditions (6). by (22). (10). 25 Sep 2017 02:53:36 UTC All use subject to http://about. any optimal program must satisfy these conditions. and importing all the in- puts needed for the increase. (22). g.jstor. in each component. the conditions do not involve the import and export prices. In (22). then y = y. by (10). For it will be shown that there can be only one program satisfying (6). under the present assumptions.93. since also y(l) > 0. Partition the vectors x. For bhe right-hand side gives the cost in for- eign exchange of a unit increase in production. the bracketed expres- sion in the first equation is at least as large. and on the other hand. (10). = b or yj = 0. according to (7). (22). denote them by x. Without loss of gen- erality. and (23) simultaneously. respectiv x = x. it follows that x(l) > x(l). applied to the two programs in question. (22). (23) either x. there will be. ARROW Suppose some industry is not operating at full capacity and at the same time is exporting less than the maximum possible. (I-Ali)x(l) A12X (2) + y(l) = (I) + qi (IAii)x. x. That is. an improvement in the foreign exchange position. which contradicts the first half of (24). x(l) < t(1). y. and x. hence. exporting the increase. and (23) . consider only those equations corresponding to elements of y(l).5. it follows from the second half of (24) that A12X(2) > A12x(2). Suppose there were two different programs which satisfied (6).2xV(2) + r(l) + 17(1)_8() Since A12 contains only nonnegative elements. x(l) = (I-All)-' [A=X(2) + r(l) + c(1)i Vl1) = (IAll)-' [A. and (23). This content downloaded from 202. y. Partition the matrix A correspondingly.All)-' has only nonnegative elements.7 on Mon. y. Then by increasing the out- put of the industry slightly. But on the one hand. it is the critical one. 488 KENNETH J. while the left-hand side gives the additional receipts of foreign exchange. 2. by (23). Simple as this step is.

IMPORT SUBSTITUTION IN LEONTIEF MODELS 489 so long as they satisfy the conditions (3) and (7).(11 + 72?2). that is5. as before. (28) -yi = xi . the Theorem has been demonstrated. lri(Xi .a2iXi . The choice of xi and X2 is further restricted by the cap (31) 0 ? xi _ ?1 . as given by (4).71) + 7r2(Y2 . each commodity can be produced at a profit in terms of foreign prices. which can be solved for yi and Y2.jstor. Hence. The condition (22). (29) (7ri . which is considerably simplified from John Fei. we let y repre- sent the extent to which exports fall short of the maximum possible. where ir stands for the common value of export and import price vectors. 7r2.al27r)X2 . The aim of minimizing the drain on foreign exchange.712).93. that net domestic output plus net imports equals given final demands. is then simplified to that of minimizing gr'(ye .a12x2 .ai2X2 . A simple diagram may illustrate the reasoning of the last section. From (28) and (26).a217r2)X1 + (7r2 . (26) 7rl(yl . which is expressed by the condi of (28).org/terms .ai271 > 0. 0 _ X2 < t2.yi). x1-al2X2 + yi-71 = ?1.ti) + ir2(x2.7 on Mon. the optimal program is that feasible program which maximizes.6.(t2 + 772).43.12)Xl + (r2. 25 Sep 2017 02:53:36 UTC All use subject to http://about. Since the last term is a constant uninfluenced by the choice of program.8 2. where imports are counted as negative exports. X2-a21x1 + Y2-772 = 2. The net drain on foreign exchange is thus given by. 8 This proof. in the special case of two commodities where export and import prices are equal. If. X2 -a2iXi <2 + 772.a2172 > O. the optimal program can be characterized as maximizing.a2ixi -2) = (7ri .( + 71) Y2 = X2 .v represents net imports. these may be expressed as the following restrictions on xi and X2: (30) xi-ai2X2 <`+ 71i + . These conditions say that if labor costs are disregarded.a2. This content downloaded from 202. -e = 7xi.al22Jl)X2 A basic restriction on the choice of a program is th a certain quota a7. can be written. then y . The restriction (7) on prices can be written. or -e yi. (27) ri.

43. The solutions of the equations.93. It is immediately apparent that the point 0 domi'nates any other feasible point. xi . For two vectors u and v.. yo = ~+ . the feasible set is the horizontally shaded area in Figure 1. implies that yi = 0. It is on the line xi . i. must lie in the positive quadrant since 0 < a12.a2X2. 25 Sep 2017 02:53:36 UTC All use subject to http://about. 3. from (28).+71 X2-a21X= . they can be described as follows.490 KENNETH J.7 on Mon. in the sense that each coordinate of 0 is at least as large as any other feasible point and at least one coordinate is actually large. Hence. COMPUTATIONAL METHODS This section will justify the computational methods used by Chenery. Define sequencesWnv. v) be the vector whose ith component is min (ui. That is. vi). point 0 must be better than any other feasible point for any set of prices. which is the main content of the theorem. On the other hand. Mathe- matically. It is further to be noted that point 0 uses the full capacity of in- dustry 2 but is below capacity in industry 1. the commodity which is being produced domestically below capacity is being exported to the maximum possible extent.al2X2 = ~1 + t71.jstor.xo. so long as they satisfy (27).e. let mmn ( . This content downloaded from 202. ARROW X2 42 Xi FIGURE 1 The problem is to choose xi and X2 satisfying (30) and (31) so as to m (29). the objec- tive is that of maximnizing a positively-weighted sum of xi and X2 among all feasible points. that exports are at the maximum possible. wh2ich. Hence. if (27) and (29) are compared.2 + t2. Xn ynl by the following recursive formulas: (32) w = X0= min(% + 1). a21 < 1.

xn is a monotone increasing sequence. and (22). It will be shown that the sequences xn. With the aid of (32). from (34).x* + x? = y. From (33). including maximum possible ex- ports.xn + x?. Also.93. then.. (37) Xn < t for all n. it follows from (34) that W +l < 3. the output of each in- dustry is expanded to meet the derived demand of the previous round until capacity limits are reached. at the initial stage.xn. yfn > 0 for all n. Xn+1 = Xn + wn+1 < xn + t . hence. (40) y* > 0. n =Ei-l (y4+1 . any remaining derived demand is met from im- ports.x-') + Aw? . Suppose wn > 0. the Wn+l > 0. Suppose for some j tha by n + 1. xn is monotone increasing.xn = Hence. Let y* = lim. yn converge to the optimal pro- gram.. (39) (I-A) + y* + q. wn+l . (36) yn is monotone increasing. wn 2 0 for all n. Xn = X* exists. w? ? 0.(I . At each subsequent stage. we set the output of each industry equal to its capacity or the final demand for its product.43. . From (32). But (37) implies that Xn is bounded.Ax? + Aw? .. y* = yO + Ax* .wn+- In words. (38) limn. y? _ 0. whichever is smaller. w"+1 < Awn.-Ax0 + Aw? . From (38-40). Ws = y? + A Z=51 (xi .A)x* + x?. From (33). from (35). the progr (10). -x) (34) Xn+l _ Xn + wn+l (35) yn+l = yn + Awn . 0 < x* < t. Therefore. Therefore. yn+l y". Hence. IMPORT SUBSTITUTION IN LEONTIEF MODELS 491 (33) Wn+1 = min (Awn. We seek to that it satisfies (23). Let n approach infinity.Ei-. 25 Sep 2017 02:53:36 UTC All use subject to . From (36).jstor.7 on Mon. yn.l (xi-x = yO + Axn.X7 This content downloaded from 202.yi) + y? = y? + A i=0 oW.

It has been shown that for all industries which xs < t. n1+1 y+l= Y for all n.. W. W. 33-97. New York: John Wiley and Sons. x? = j + nj. This content downloaded from 202.: The Structure of the American Economy. C. from (33). andthereforey* = y?. 29-46. Stanford University REFERENCES [1] The Structure and Growth of the Italian Economy.43. Special Mission to Italy for Economic Cooperation. 25 Sep 2017 02:53:36 UTC All use subject to http://about.jstor. and y? = 0. [2] LEONTIEF. pp. y7 = 0. Cowles Commission Monograph No. United States Government. [4] SOLOW. From (35). T. 1951. ARROW and therefore. C. Butsince x < X.: "On the Structure of Linear Models. 13. 1953 (mimeographed).org/terms .) Activity Analysis of Production and Allocation.93. prepared by the Program Division. Vol. Second edition. New York: Oxford University Press. then. R.7 on Mon. for all n." EcONOMETRICA.: "Analysis of Production as an Efficient Combination of Activities. The limiting program obtained from the iterative procedure (32-35) is then the optimal program so long as import prices satisfy condition (7).n*n or = y? forhrfr y00Btsnex all n. [3] KOOPMANS. Koopmans (ed. 1951. 20 (1952).492 KENNETH J. which is precisely (23). that wa7w = a . pp. Mutual Security Agency." in T.