This content explores the historical trade policy of import substitution industrialization (ISI) in developing countries, examining its theoretical underpinnings, practical outcomes, and its complex relationship with economic dualism.
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Hello everyone. This is a tutorial about
trade policies in developing countries
and mainly dealing with import
substitution, industrialization and
economic dualism and link between these
two. There has been a belief that key to
economic development is really having a
strong manufacturing sector and one way
to have a strong manufacturing sector is
to really protect your industry at the
expense of imports. You expect your
industry to have a potential comparative
advantage that the industry would reach
sometime in the future. But right now it
is in the infancy stage and needs to be
protected and nurtured. There has been a
success with infant industry argument
mainly with US and Germany that adopted
this in the 19th century. Also, Japan
had extensive import controls for a long
time as well. And seeing the success of
these two countries, a lot of developing
countries started protecting their
manufacturing sectors.
Right. So there have been um arguments
in favor of infant industry production.
Uh one such argument is that you know
there are certain market failures that
prevents an industry from reaching its
comparative advantage. A sector has the
potential to uh reach a uh a high level
of productivity such that it might have
a comparative the country might have a
comparative advantage in the future. But
at this point in time it is being
constrained and restricted by other
sectors and one might be imperfect
capital markets. It's not easy for this
exporting sector to uh avail uh capital
or borrow money uh at uh at a uh at the
market interest rate and it might just
be that there are no banks in those
rural areas where these exporting
sectors might be now. Because of the
growth of the industry is might be
restricted because of imperfect capital
markets or a probability argument where
you have certain goods that have a large
proportion of uh benefits occurring to
the society not to the private sector
that might invest in it. So you might
have low levels of investment in those
sectors and then other uh adjoining
sectors as well like transportation
sector you might not have uh decent
roads uh for to transport the goods from
the place where it's being produced to
where it needs to be shipped to and this
might just be uh leading to a higher
cost. You need to protect these
industries till the other sectors also
develop and you'll have a competitive
advantage in the future. If you allow
for imports to come in at this point in
time, what's going to happen is that uh
your own industry will not be able to
compete with these imports not because
it is not product but because it has
other sectors that are pulling it down,
right? And um but but what we've
observed is that this import
substitution utilization has not really
worked the way it was supposed to, the
way that it worked for the US uh and for
Germany. There are some problems with
the infant industry argument that uh had
been ignored earlier. One is industry
might have a comparative advantage in
the future. But how much further in the
future do you think you might have that
advantage and would it make sense to
protect the industry right now if after
20 years you might have comparative
advantage? One example that is offered
is of South Korea which protected its
industry for 20 years and it it's only
now that we see Kia uh trying to compete
with other uh automobiles. And uh number
two, some of these industries that these
countries are trying to protect might
not really have a competitive advantage
even in the future. So there might be
wrong assumption about which industries
might have a competitive advantage.
Right? And here we talk about Pakistan
and India that have had protection for
its industry for a long time and it's uh
once uh India had to lower its uh tariff
rates the protection that it was
offering its import competing sectors in
the '90s we observed that the industries
could not really compete with the
outside world and it's still the light
manufacturing sectors that are uh able
to really compete and we have the
pharmaceutical sector as well now and uh
then the third is well what if you do
protect your industry and the industry
is producing for the domestic market but
the domestic demand is too small. It's
so small that you're actually producing
at an inefficient scale of production.
That means you're producing such a small
amount that you can't really avail of
economies of scale that might exist in the
the
industry. Right? And in that sense
you'll never really drive down the
average cost. you never bring down the
cost of producing the good because of uh
the the restricted demand that exists in
your uh country. So in that case you'll
never have the comparative advantage
because you'll never ever produce at a
scale uh to bring down your cost right
now. So what has been the result of
adopting import substitution
industrialization in these countries?
Well, there has been higher rates of uh
effective production and inefficient
scale of production in these
industries. And the main one that we'll
discuss uh in this lecture is high in
income inequality and
unemployment in these
countries. Um this is a table which
shows the effective rate of protection
for various countries at various points
in time. And what we we you see for
Pakistan uh
271% of tariffs being imposed on imports
whereas for Mexico you see only 26%. So
really different countries were are um
adopting different kinds of uh trade
policies. Some very protective measures,
some not so protective measures and
India hovers around 300% as
well, right? Um so where are we going
with this? Well, we want to look at
economic dualism. What is economic
dualism? It's exactly what this picture
shows you. There is a modern sector that
exists exists with a whole slum area
around it. Right? So you have high
levels of unemployment in the city and this
this
unemployment is arising because you have
a traditional sector which is offering
them a very lower wage compared to the
modern sector and people are migrating
from rural areas to urban areas. Right?
So you see a slum right next to a big city
city
here and really all
countries while while they develop go
through this period of duality. Okay.
Because development really proceeds
unevenly and you have dual economy where
modern sector starts performing much
better than a traditional sector.
traditional sector lags behind and you
have dualism and then countries develop
further and this duality disappears.
Right? Now the what is what are the
symptoms of dualism? How do you define
or how do you characterize uh economic
duality? Well, you have two sectors
coexisting with very different uh
characteristics. You have a modern
industrial sector which has a higher
high value of output per worker. So
productivity, labor productivity is
really high in these sectors compared to
agriculture sector. There's a huge wage
differential. Wages are much higher in
the modern sector compared to the
agriculture or the traditional sector.
higher capital intensity in the
manufacturing se in the modern sector
further increasing the labor
productivity and and then you have
persistent unemployment around the urban
areas that those were the slums that we
saw in that picture and this is the high
level of unemployment that exists in the
urban areas right now how are how are
import substitution industization
economic tourism linked well if you have
this high levels of unemployment around
your urban areas That means the modern
sector is not able
to absorb these people that are
migrating from rural to urban areas.
Right? Uh so the believers in ISI really
think that the ISI can ease dualism.
uh and if there is economic duality then
maybe what uh policies developing
countries should be following is one of
protection import subs industalization
they protect their manufacturing sector
or the modern sector from
imports the prices in these sectors
rise and production would increase and
hence employment increases and you deal
with a decreasing unemployment right so
that's really what their argument is in
favor of ISI. Now the other argument the
counterargument is that actually you
know what the dualism has been worsened
by import substitution industization. So
it's actually a cause of these severe
levels of dualism found in developing
countries these days not a solution. So
these are the arguments and the counter
arguments for whether you should use ISI
when you have economic dualism. So let's
look at the first argument. Um as uh I mentioned
mentioned
earlier import substitute
industalization can ease
rism by reducing
unemployment. You protect the import
substitution substit uh import competing
sectors your manufacturing sectors your
modern sectors from imports. You block
out imports. The production takes place
at home. There's increase in production.
There's increase in uh manufacturing
goods. employment increases and you can
deal with these slum areas these high
levels of unemployment in urban
areas. The second the counter argument
is well not
really what has been observed in some
developing countries is that there has
been an increase in economic duality as
a result of import substitution
industalization. Right? So it's actually
causing it not
helping. And uh the ones to come up with
were Harris and Daro. They came up with
this model which links they explain this
um counterargument by linking the rural
to urban migration and unemployment in urban
urban
cities. And the it undermines the
migration undermines the case of
favoring manufacturing
employment. Right? So really what we are
what they were suggesting is that right
you do if you protect the manufacturing
sectors and the prices are increasing
these sectors the wages are also
increasing these sectors. So increasing
this wage disparity between traditional
sector and the urban sector and their
argument is really based on this
evidence that we uh see that highly
dualistic economies also have a high
level of urban unemployment. Right? And
so the main link that they are making is
between the rural to urban migration uh
which is so large that the increase in
urban employment cannot keep up with
this migration and urban unemployment
actually rises. Now that that would
happen because you're protecting the
manufacturing sector, the modern sector,
right? The prices are going up, the
wages are going up, it has higher
returns and so you see capital moving
more towards uh the modern sector is
becoming more productive. The wages are
increasing. At the same time, the
traditional sector is lagging behind.
The productivity isn't increasing at the
same pace. The wages aren't going up. Uh
there is a huge disparity now that wage
disparity between modern sector and
traditional sector. So more people are
going to be dissatisfied in the rural
areas and move towards urban areas. So
really the problem is your uh
traditional sector that is not really
able to increase productivity. Okay. So
these are pictures of um some
traditional sectors in India and what we
see here is really that uh there hasn't
been any improvement in technology being
used in the agriculture sector. The
labor productivity is really low. As a
result you see the wages lower uh in
these traditional sectors and modern
sectors. Trade policy has really been
accused of widening this wage
differential as well as fostering excess
capital intensity in the capital in the
modern sector. By uh imposing high
tariffs, you're keeping the prices in
the manufacturing sectors artificially
high which then increases the capital
intensity in these sectors because it's
more profitable to invest in these
sectors because of higher prices. Is
resources moving away from agriculture
towards a modern sector? To deal with
economic dualism, you really have to
attack the problem the problem of rural
to urban migration. You have to deal
with this wage inequality by increasing
the labor productivity in the
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