Udviklingsøkonomi - grundfag

Lecture 19

Trade and development: Import substitution

1

2

Introduction

Trade protection is Tariffs Quotas Other measures

quality standards, Sanitary standardsAnti-dumping rulesLabour & environmental standards

coming into WTO???

Other ways to support industry Subsidies Infrastructure investment Training and education etc

Develop country protectionism: Agriculture

Import restrictions

Export subsidies

Textiles

(Multifiber agreement)

General arguments for trade protection

Infant industry

increasing returns Public revenue from tariffs

Positive externalities

Learning-by-doing, etc.

Imperfekt competition

Rent-snatching

Better terms of trade

Other effects

Income improvement

Effects on factor composiiton etc

But often trade protection/tariff is not “first-best” policy

Rent-seeking: protection hard to remove

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Import substitutionPhase 1

Replace import of non-durable consumption goods (leather, textiles, shoes, etc)

May not need much protection (natural comparative advantages).

Possibly need weak protection if there are externalities in training, education etc)

Phase 2

Replace import of capital goods and durable consumer goods

Need high protection as these are capital intensive and have increasing returns and high gains from specialisation with a sizeable “minimum efficient scale”.

Phase 3

Remove protection (!?)

Participate in the world economy on an equal footing

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C

The case for import substitution

A

World market prices

Export goods

Impo

r go

ods

After introduction of protection, for example a subsidy that shifts production towards importables

Production at B and consumption at D.

Domestic Prices, 1965B

D

Production possibility frontier

Small country that cannot affect world market prices

Starting situation, 1965, without protection:

Production at A, consumption at C.

Consume less of both goods than before the intervention

welfare lower Import and export lower,

but what happends over time?

Indifference curve

5

IS argument 6

B I

A

F

Domestic prices 1990

C

H

World terms of trade

Production frontier 1965

Production frontier 1990

Exportable goods

Imp

orta

ble

good

s

Import Substitution after Twenty-five Years of Rapid Growth, 1990. After twenty-five years of successful import substitution, the production frontier has been shifted outwardsufficiently to enable the country to produce at point F and to consume at point H, on a higher indifference curve than at point C before the imposition of a tariff.

Anti IS argument 7

B

J

A

Domestic prices 1990

M

L

World terms of trade

Production frontier 1965

Production frontier 1990

Exportable goods

Imp

orta

ble

good

s

C

Import Substitution after Twenty-five Years of Slow Growth, 1990. If, instead, import substitution does not move the production frontier outward as substantially as in last slide,production will take place at a point like J and consumption, at L, will remain on an indifference curve lowerthan at the starting point C.

Welfare loss of a tariffIntroduce a tariff so that :

Quantity

Price

Domestic demand

Domestic supply

pw

q2 q1

p p td w 1 0

pd

q4 q3

M2

M1

a b c d

a+b+c+d : Fall in consumer surplus

a : Rise in producer surplus

c : Tariff revenue to government

b+d : Deadweigth loss (Harberger triangles)

8

Overvalued exchange ratesTariffs reduce the demand for foreign exchangeIn addition, governments have often fixed official nominal exchange rates at unrealistic

(appreciated) levels

Foreign exchange

exch

ange

rat

e (p

eso

per

dolla

r)

Demand(importers)

Supply(exporters)

re

Xs Md

r0

rt

Demand with tariffs

re Equilibrium exchange rate

rc Equilibrium exchange rate with tariffs

ro Official and over valued exchange

rate High import demand Md

Export supply low: Xs

Deficit on the balance of trade

Devaluation often opposed by strong lobby groups

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Negative effects of import substitution1. Static deadweight losses

2. From “infant industry protection” to “senile industry protection” Inefficient production and lack of productivity gains Small markets result in lack of competition (monopolies, oligopolies) Cannot realise scale economies.

3. Overvalued exchange rates Negative bias against export sectors Lack of foreign exchange due to bias against exports and increasing need for imports

of capital goods, production inputs etc General negative bias against agriculture

4. Financial repression Often negative real interest rates and government-managed credit allcoation Lack of incentives to save

5. Political economy effects Rent-seeking Lobbying and corruption

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IS – success or failure?

Depends on:

Magnitude and structure of protection

Small countries/markets versus large countries/markets

Basic consumer goods verus capital and technology intensive goods

Effektive and honest bureaucracy versus widespread corruption and rent seeking

Export collapse versus export incentives were maintained

Permanent or temporary protection

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Concluding question

Can the government, credibly, promise temporary infant industry protection?