1 12/2/07ARE 253/PP 253, Fall 2007 Alain de Janvry & Elisabeth SadouletTrade and industrialization strategiesHandout #8Part I. Trade and industrialization strategiesI. ISI (import substitution industrialization) vs. EOI (export orientedindustrialization) vs. OEI (open economy industrialization)Three contrasted strategies:ISI: protect sectors of industry until competitive and then open (ISTE: import substitute then export).EOI: open the economy and subsidize selected firms until they are competitive.OEI: open the economy, create “investment climate”, and call on FDI.Economies of scale in production and learning-by-doing AC Infant industry Protection(ISI) OEIWorld market price =AC in MDC Subsidy (EOI)AC AC - SubsidyProduce for domestic market (ISI) Produce for international OutputProduce for international market (EOI) market (all)II. ISI (sector protection)1. Why protect? Arguments for protection- History: 1850s-1930s: Liberal period, open economy models. Primary export-led growth strategy(ag., mines) LDC against imports of manufactures from MDC. 1930s-1970s: Depression and WWII, ISI strategy in East Asia, Latin America.- Arguments: Infant industry: economies of scale, learning-by-doing, entry costs. New entrants, infant industries not competitive: need temporary protection to achieve competitiveness.- Phases of ISI: 1st phase of ISI: protect finished products (consumer goods). 2d phase of ISI: protect intermediate and capital goods.2. ISI is a strategy that can failInstruments: import tariffs, import quotas, overvalued exchange rate (fixed exchange rate and foreignexchange rationing), appreciated real exchange rate (decline in demand for foreign exchange due to importtariffs and import quotas).• Short run impact: raises prices of protected tradables, creates inefficiencies through protection,redistributes income from consumers to producers of protected goods, produce for domestic market tosubstitute for imports.Bias against agriculture: industry protected but not agriculture: high industrial input costs;overvalued exchange rate: low prices for tradables (ag goods).Bias against employment: imported capital goods cheap through overvalued exchange rate.• Long run impact: AC falls, can decrease protection, ISTE.• Strategy can fail: (i) If AC does not fall: no competitive pressures (as no foreign competition, domestic monopolies),domestic market too small (insufficient opportunities for economies of scale).(ii) If protection is not removed: successful lobbying and rent seeking by entrepreneurs and workersin protected industries not to remove protection. Political pressures for protection are high if: industry isconcentrated; small entrepreneurial class; limited democratic checks by farmers and consumers; strongorganized labor in formal sector.• Conditions for success: Needs good/strong/credible governance that protection will be removed.Needs large domestic market: large countries, income redistribution (e.g., land reform) to expand thedomestic market.III. Trade policy1. Definitionsp$ = international market price in foreign currency ($).pb = border price in local currency units (LCU).pd = domestic price.e = nominal exchange rate in LCU/$.QR = quantity restriction on imports or exports.Tradable goods: price determined by border price and by trade and exchange rate policiesNon-tradable goods: price determined by supply = demand.Tradable good: pd= pb(1 + t), pb= ep$t = tM = import tariff ratet = -tE = export tax ratet = s = domestic subsidy (+) or tax (-) rate Domestic price Trade policy Border price Exchange rate policy World market price Border pd= pb1 + tM( ) tM,QR pb= ep$Nominal ep$Example India: 4000*1.3 = 5200 tM= 0.3 40*100 = 4000 e = 40 RS/$ 100$/MT2. Indicators of protection(1) Nominal protection coefficient = NPC NPC =pdpb= 1 + t.If NPC > 1, producers are protected, consumers (users) are disprotected.If NPC < 1, producers are disprotected, consumers (users) are protected.(2) Effective protection coefficient = EPCDefine:p = price = unit value of output.c = cost of intermediate goods used in production per unit of output (purchased inputs from otherindustries).VA = value added = cost of primary factors such as labor, land, and financial capital per unit of output.p = c + VA. Hence: VA = p – c. EPC =VAdVAb=pd− cdpb− cb.If EPC > 1, producers are protected, consumers (users) are disprotected.If EPC < 1, producers are disprotected, consumers (users) are protected.Note: EPC a better measure of protection than NPC since product may be protected but inputs alsoprotected, in which case effective protection is less than nominal protection.(3) Real protectionImported goods or import substitutes: pd= ep$1+ tM( ).Exported good: pd= ep$1− tE( ).Can protect tradables through exchange rate policy: devaluation or depreciation raises e.Can protect tradables through trade policy: raise import tariffs or lower export taxes.2 12/2/07Exchange rate and trade policies can be substitutes or complements in protecting. For example,when there is a devaluation in Argentina, typically the country raises export taxes on agriculture toredistribute income from agriculture to the urban sectors.3. Who gains and who loses from protection?Recall definitions of consumer surplus (CS) and producer surplus (PS)i) Import tariffs vs. free trade $ S Δ = change inCompared to free trade:ΔCS = – a – b – c – dΔPS = aΔB (Gvt budget) = cpd = pb(1+tM) M NSG (net social gain) = – b – d a b c d ISI: c invested?pb D SR loss LR gain? qii) Quantity restrictions: import quotas (licenses) vs. free tradeNote: this remains a non-tradable in spite of trade (licenses). Price determined by S = D afteradministered trade. $ S M Compared to free trade:DCS = – a – b – c – dDPS = aD importers’ rent = c pd M NSG = – b – d a b c d If auction of M : DB = cpb D qiii) Advantages of tariffs over quantity restrictions: tariffication (WTO, NAFTA)Rent goes to government (c).Easier to administer.Use uniform tariffs on protected sectors: easy signal, easier to resist rent seeking.iv) Example: U.S. sugar quotasProduction = 6.3 million tonsImport quotas = 2.1 million tons (25% of domestic supply)pd = 466 $/tonpb = 280
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