International Economics: Import Substitution and Export Promotion

FACULTY OF ECONOMICS
Kardan University
International Economics
Chapter 8: Import Substitution and Export Promotion
Book by: Dominick Salvatore
John Wiley & Sons, Inc.
Ahsanullah Mohsen M.Sc.
a.mohsen@Kardan.edu.af
Ahsanullah.Mohsen@rub.de
Kardan.edu.af
Chapter Outlines..
• Introduction
• Concept of Dual Economy
• Problems of the Dual Economy
• Import-Substituting
• Critical analysis of IS Strategy
• Export-Promotion
• The East Asian Miracle
• Conclusion
Introduction
• In the 30 years after world war II developing
countries were under the assumption that:
• The key to development
• Creation of strong manufacturing sector
• Protecting domestic markets from foreign imports
• Protectionism,
• 1980s the idea that free trade promotes growth got
momentum.
3
Introduction
• There is a great diversity among the developing countries in terms of their
income per capita.
• Is this variation in per capita income related to variation in trade policies?
• Import-substituting Industrialization
• Export-oriented Industrialization
Introduction
• Which countries are “developing countries”?
• The term “developing countries” does not have a
precise definition, but it is a name given to many
low and middle income countries.
Copyright © 2006 Pearson Addison-

Wesley. All rights reserved.
Introduction

Import Substituting Industrialization

• Import substituting industrialization was a trade
policy adopted by many low and middle income
countries before the 1980s.
• The policy aimed to encourage domestic industries
by limiting competing imports.
• It was often accompanied with the belief that poor
countries would be exploited by rich countries
through international financial markets and trade.
Import Substituting Industrialization (cont.)

Import-Substituting Policy
• From World War II until the 1970s many developing countries
attempted to accelerate their development by limiting imports of
manufactured goods to promote a manufacturing sector serving
the domestic market.
• The most important economic argument for protecting

manufacturing industries is the infant industry argument.
• This argument suggested that trade may be good for rich

countries but bad for poor countries.
Import-substituting Policy
• IS: is a trade and economics policy that advocates replacing imports
with domestic production.
• To reduce its foreign dependency through the local production of
industrialized products.
10
Import Substituting Industrialization (cont.)

• The principal justification of this policy is the infant
industry argument:
• Countries may have a potential comparative advantage in
some industries, but these industries can not initially
compete with well-established industries in other
countries.
• To allow these industries to establish themselves,
governments should temporarily support them
until they have grown strong enough to compete
internationally.

Problems With the

Infant Industry Argument
1. It may be wasteful to support industries now that will have
a comparative advantage in the future.
2. With protection, infant industries may never “grow up” or
become competitive.
3. It is difficult to remove the protection measures once in
place because of two reasons:
1. Corporate influence over bureaucrats
2. Govt gets benefit from Tariffs
4. Trade protection benefits producers and harms consumers

Valid Arguments for Infant Industry

Argument
• Lack of Know-How
• Small level of Output
• To achieve economies of scale
• Temporary Trade protection is justified
• For developing nations only
13
Import-Substituting Industrialization
•Problems with the Infant Industry
Argument
• It is not always good to try to move today
into the industries that will have a
comparative advantage in the future.
• Example: In the 1980s South Korea became an exporter of
automobiles. At that time it was well-endowed with capital,
which is important for comparative advantage in car
manufacturing. In the 1960s its capital and skilled labor were
still very scarce. Therefore, if the Korean government had not
used protection in the 1960s to start a domestic automobile
industry, it would have made a mistake.
• Problems with the Infant Industry Argument
• Protecting manufacturing does no good unless the
protection itself make industry competitive.
• Indeed, protection from foreign competition may
take away the pressure to improve
competitiveness.
• Example: Pakistan and India have protected their heavy
manufacturing sectors for decades and have recently begun to
develop significant exports of light manufactures like textiles, not the
heavy manufactures that they had protected.
• Problems with the Infant Industry Argument
• Government intervention becomes needed only when there
exists some market failure (Specially in Advanced Countries).
• The infant industry argument for protection does not identify
any market failure that the protection is meant to address.
• It is implicitly assumed that the capital market fails to see the
bright future in an infant industry that the government can
see. But,
• In the advanced countries at least, private lenders often
sustain infant industries for long periods of time. So, the
better approach in poor countries may be to fix the capital
markets.
Result of Import-Substituting Industrialization

•Many countries that have pursued import substitution have not
shown any signs of catching up with the advanced countries.
Example: In India, after 20 years of economic plans between the early 1950s and the early 1970s, its per
capita income was only a few percent higher than before.
17
Why didn’t import-substituting

industrialization work the way it was
supposed to?
The infant industry argument was not as universally valid as
many people assumed.
18
From Trade Theory to Trade Policy
1. Export Promotion – use of export subsidies,

directed credit and their effects on Welfare
2. Import Substitution – use of tariffs and quotas to

restrict imports, their effects on exchange rates and
welfare.
The practice of strict import-substitution by many

countries has been reduced as more countries switch to
export promotion.
19
Export-oriented Industrialization (EOI)
• E.O also called export substitution industrialization
(ESI) is trade and economic policy aiming to speed
up the industrialization process of a country
by exporting goods for which the nation has
a comparative advantage.
• Export-led growth implies opening domestic
markets to foreign competition in exchange for
market access in other countries.
20
Export Oriented Industrialization

• Instead of import substituting industrialization,
several countries in East Asia adopted
trade policies that promoted exports in targeted
industries.
• Japan, Hong Kong, Taiwan, South Korea, Singapore,
Malaysia, Thailand, Indonesia and China are countries
that have experienced rapid growth in various export
sectors and rapid economic growth in general.
• These economies or a subset of them are sometimes
called “high performance Asian economies”.

10-21
Export Oriented Industrialization (cont.)

• These high performance Asian economies have
generated a high volume of exports and imports
relative to total production.
• By this standard, these economies are
“open economies”.
• But it is debatable to what degree these economies
established “free trade”.
• Although evidence suggests that these economies did have
less restricted trade than other low and middle income
countries, some trade restrictions were still in effect during
different times.

10-22

10-23

• It is also unclear if the high volume of exports and
imports caused rapid economic growth or was
merely correlated with rapid economic growth.
• Some economists argue that the cause of rapid economic
growth was high saving and investment rates, leading to
both rapid economic growth in general and rapid
economic growth in export sectors.
• In addition, almost all of the high performance Asian
economies have experienced rapid growth in education,
leading to high literacy and numeracy rates important for
a productive labor force.

10-24
Export-Oriented Industrialization: the

• 1. Introduction
East Asian Miracle
It was the export promotion (EP) strategy that accounted for
East Asian's states' success of economic development. Meanwhile,
many other developing countries such as Latin America countries
had committed to an alternative strategy, import substitution (IS).
• The IS strategy yielded disappointing results: most of these
countries did not succeed in either industrialization or economic
growth while export-oriented industrializations (EOIs) sustained
fast economic development.
• Empirical Data showed that the real GDP of EOIs grew faster than
IS countries during last two decade. There is no doubt that EOIs
outperformed countries that adopted IS strategy in terms of
economic development.
25
Export-Oriented Industrialization:
The East Asian Miracle
From the mid-1960s onward, exports of manufactured goods,
primarily to advanced nations, was another possible path to
industrialization for the developing countries.
High performance Asian economies (HPAEs)

•A group of countries that achieved spectacular economic
growth. In some cases, they achieved economic growth of
more than 10% per year.
26
the East Asian Miracle
• Industrial Policy in the HPAEs
• Several of the highly successful economies have pursued
industrial policies (from tariffs to government support for
research and development) that favor particular industries
over others.
• Most economists have been skeptical about the importance of
such policies because:
• HPAEs have followed a wide variety of policies, but achieved similarly high
growth rates.
• The actual impact on industrial structure may not have been large.
• There have been some notable failures of industrial policy.
the East Asian Miracle
• Other Factors in Growth
• Two factors can explain the rapid growth in East
Asia:
• High saving rates
• Rapid improvement in public education
• The East Asian experience refutes (disprove) that:
• Industrialization and development must be based on an inward-
looking strategy of import substitution.
• The world market is rigged against new entrants, preventing poor
countries from becoming rich.
Strategies of Industrialisation: Eight East Asian countries

Hong Kong Export-led growth
1963: Import-substitution (abandoned shortly after),
Singapore 1965: Export-oriented industrialisation.
Import-substitution in early 1960 rapidly followed by export-oriented
South Korea industrialization.
Taiwan Import-substitution, 1965 export-led growth
Philippines Import-substitution, 1972 export-led growth

Export diversification and import-substitution in 1970 onwards;
Malaysia Export-oriented industrialisation
1960: Import-substitution;
Thailand 1985: Export- Oriented industrialisation
Late 1960: Import-substitution;
Indonesia 1979: promotion of exports by giving incentives to foreign investors.
29
Two Serious Disadvantages:

(1) It may be very difficult for developing nations to set up
export industries because of the competition from the
more established and efficient industries in developed
nations.
(2) Developed nations often provide a high level of

effective protection for their industries producing
simple labor-intensive commodities in which
developing nations already have or can soon acquire a
comparative advantage.
Conclusion
Import substitution may be of some benefit in the
early stages of development (especially for larger
developing nations), while an export orientation becomes
an absolute necessity only later in the development
process.
Thus, rather than being alternatives, policies of

import substitution and export orientation could
profitably be applied to some extent sequentially,
especially in the larger developing nations.

International Economics: Import Substitution and Export Promotion

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FACULTY OF ECONOMICS

• Is this variation in per capita income related to variation in trade policies?

Copyright © 2006 Pearson Addison-

Copyright © 2006 Pearson Addison-

Import Substituting Industrialization

Import Substituting Industrialization (cont.)

Copyright © 2006 Pearson Addison-

• The most important economic argument for protecting

• This argument suggested that trade may be good for rich

Import Substituting Industrialization (cont.)

Copyright © 2006 Pearson Addison-

Problems With the

Copyright © 2006 Pearson Addison-

Valid Arguments for Infant Industry

Result of Import-Substituting Industrialization

Why didn’t import-substituting

From Trade Theory to Trade Policy

1. Export Promotion – use of export subsidies,

2. Import Substitution – use of tariffs and quotas to

The practice of strict import-substitution by many

Export Oriented Industrialization

Copyright © 2006 Pearson Addison-

Export Oriented Industrialization (cont.)

Copyright © 2006 Pearson Addison-

Export Oriented Industrialization (cont.)

Copyright © 2006 Pearson Addison-

Export Oriented Industrialization (cont.)

Copyright © 2006 Pearson Addison-

Export-Oriented Industrialization: the

High performance Asian economies (HPAEs)

Strategies of Industrialisation: Eight East Asian countries

Taiwan Import-substitution, 1965 export-led growth

Philippines Import-substitution, 1972 export-led growth

Two Serious Disadvantages:

(2) Developed nations often provide a high level of

Thus, rather than being alternatives, policies of

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