1. Udviklingsøkonomi - grundfag Lecture 19 Trade and development: Import substitution 1

2. 2 Introduction Trade protection is Tariffs Quotas Other measures quality standards, Sanitary standards Anti-dumping rules Labour & 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)

3. 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 3

4. Import substitution Phase 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 4

5. C The case for import substitution A World market prices Export goods Impor goods After introduction of protection, for example a subsidy that shifts production towards importables Production at B and consumption at D. Domestic Prices, 1965 B 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

6. IS argument 6 BI A F Domestic prices 1990 C H World terms of trade Production frontier 1965 Production frontier 1990 Exportable goods Importable goods Import Substitution after Twenty-five Years of Rapid Growth, 1990. After twenty-five years of successful import substitution, the production frontier has been shifted outward sufficiently 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.

7. Anti IS argument 7 B J A Domestic prices 1990 M L World terms of trade Production frontier 1965 Production frontier 1990 Exportable goods Importable goods 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 lower than at the starting point C.

8. Welfare loss of a tariff Introduce a tariff so that : Quantity Price Domestic demand Domestic supply pwpw q2q2 q1q1 pdpd q4q4 q3q3 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

9. Overvalued exchange rates Tariffs reduce the demand for foreign exchange In addition, governments have often fixed official nominal exchange rates at unrealistic (appreciated) levels Foreign exchange exchange rate (peso per dollar) Demand (importers) Supply (exporters) rere XsXs MdMd r0r0 rtrt Demand with tariffs r e Equilibrium exchange rate r c Equilibrium exchange rate with tariffs r o Official and over valued exchange rate  High import demand M d  Export supply low: X s  Deficit on the balance of trade Devaluation often opposed by strong lobby groups 9

10. Negative effects of import substitution 1.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 10

11. 11 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

12. 12 Concluding question Can the government, credibly, promise temporary infant industry protection?