Import-Substituting Industrialization
From World War II until the 1970s, many developing countries attempted to accelerate their
development by limiting imports of manufactured goods, in order to foster a manufacturing
sector serving the domestic market. This strategy became popular for a number of reasons,
but theoretical economic arguments for import substitution played an important role in its
rise. Probably the most important of these arguments was the infant industry argument,
which we mentioned in Chapter 7.
258 PART TWO International Trade Policy
The Infant Industry Argument
According to the infant industry argument, developing countries have a potential comparative
advantage in manufacturing, but new manufacturing industries in developing countries
cannot initially compete with well-established manufacturing in developed countries. To
allow manufacturing to get a toehold, then, governments should temporarily support new
industries until they have grown strong enough to meet international competition. Thus it
makes sense, according to this argument, to use tariffs or import quotas as temporary
measures to get industrialization started. It is a historical fact that some of the world’s
largest market economies began their industrialization behind trade barriers: The United
States had high tariff rates on manufacturing in the 19th century, while Japan had extensive
import controls until the 1970s.
Problems with the Infant Industry Argument The infant industry argument seems
highly plausible, and in fact it has been persuasive to many governments. Yet economists
have pointed out many pitfalls in the argument, suggesting that it must be used cautiously.
First, it is not always a good idea to try to move today into the industries that will have a
comparative advantage in the future. Suppose that a country that is currently labor-abundant
is in the process of accumulating capital. When it accumulates enough capital, it will have a
comparative advantage in capital-intensive industries. However, that does not mean it
should try to develop these industries immediately. In the 1980s, for example, South Korea
became an exporter of automobiles; it would probably not have been a good idea for South
Korea to have tried to develop its auto industry in the 1960s, when capital and skilled labor
were still very scarce.
Second, protecting manufacturing does no good unless the protection itself helps make
industry competitive. For example, Pakistan and India have protected their manufacturing
sectors for decades and have recently begun to develop significant exports of manufactured
goods. The goods they export, however, are light manufactures like textiles, not the heavy
manufactures that they protected; a good case can be made that they would have developed
their manufactured exports even if they had never protected manufacturing. Some economists
have warned of the case of the “pseudoinfant industry,” in which an industry is initially
protected, then becomes competitive for reasons that have nothing to do with the protection.
In this case infant industry protection ends up looking like a success, but may actually have
been a net cost to the economy.
More generally, the fact that it is costly and time-consuming to build up an industry is not
an argument for government intervention unless there is some domestic market failure. If an
industry is supposed to be able to earn high enough returns for capital, labor, and other factors
of production to be worth developing, then why don’t private investors develop the industry
without government help? Sometimes it is argued that private investors take into account only
the current returns in an industry and fail to take account of the future prospects, but this
argument is not consistent with market behavior. In advanced countries at least, investors
often back projects whose returns are uncertain and lie far in the future. (Consider, for
example, the U.S. biotechnology industry, which attracted hundreds of millions of dollars of
capital years before it made even a single commercial sale.)
Market Failure Justifications for Infant Industry Protection To justify the infant
industry argument, it is necessary to go beyond the plausible but questionable view that
industries always need to be sheltered when they are new. Whether infant industry
protection is justified depends on an analysis of the kind we discussed in Chapter 10. That
is, the argument for protecting an industry in its early growth must be related to some
particular set of market failures that prevent private markets from developing the industry
CHAPTER 11 Trade Policy in Developing Countries 259
as rapidly as they should. Sophisticated proponents of the infant industry argument have
identified two market failures as reasons why infant industry protection may be a good
idea: imperfect capital markets and the problem of appropriability.
The imperfect capital markets justification for infant industry protection is as
follows: If a developing country does not have a set of financial institutions (such
as efficient stock markets and banks) that would allow savings from traditional sectors
(such as agriculture) to be used to finance investment in new sectors (such as manufacturing),
then growth of new industries will be restricted by the ability of firms in these
industries to earn current profits. Thus low initial profits will be an obstacle to
investment even if the long-term returns on the investment will be high. The first-best
policy is to create a better capital market, but protection of new industries, which
would raise profits and thus allow more rapid growth, can be justified as a second-best
policy option.
The appropriability argument for infant industry protection can take many forms,
but all have in common the idea that firms in a new industry generate social benefits for
which they are not compensated. For example, the firms that first enter an industry may
have to incur “start-up” costs of adapting technology to local circumstances or of
opening new markets. If other firms are able to follow their lead without incurring
these start-up costs, the pioneers will be prevented from reaping any returns from
these outlays. Thus, pioneering firms may, in addition to producing physical output,
create intangible benefits (such as knowledge or new markets) in which they are unable
to establish property rights. In some cases the social benefits from creation of a new
industry will exceed its costs, yet because of the problem of appropriability, no private
entrepreneurs will be willing to enter. The first-best answer is to compensate
firms for their intangible contributions. When this is not possible, however, there is a
second-best case for encouraging entry into a new industry by using tariffs or other
trade policies.
Both the imperfect capital markets argument and the appropriability case for infant
industry protection are clearly special cases of the market failure justification for
interfering with free trade. The difference is that in this case, the arguments apply
specifically to new industries rather than to any industry. The general problems with
the market failure approach remain, however. In practice it is difficult to evaluate
which industries really warrant special treatment, and there are risks that a policy
intended to promote development will end up being captured by special interests.
There are many stories of infant industries that have never grown up and remain
dependent on protection.
Promoting Manufacturing Through Protection
Although there are doubts about the infant industry argument, many developing countries
have seen this argument as a compelling reason to provide special support for the
development of manufacturing industries. In principle such support could be provided
in a variety of ways. For example, countries could provide subsidies to manufacturing
production in general, or they could focus their efforts on subsidies for the export of
some manufactured goods in which they believe they can develop a comparative
advantage. In most developing countries, however, the basic strategy for industrialization
has been to develop industries oriented toward the domestic market by using
trade restrictions such as tariffs and quotas to encourage the replacement of imported
manufactures by domestic products. The strategy of encouraging domestic industry by
limiting imports of manufactured goods is known as the strategy of import-substituting
industrialization.
260 PART TWO International Trade Policy
One might ask why a choice needs to be made. Why not encourage both import substitution
and exports? The answer goes back to the general equilibrium analysis of tariffs in
Chapter 6: A tariff that reduces imports also necessarily reduces exports. By protecting
import-substituting industries, countries draw resources away from actual or potential
export sectors. So a country’s choice to seek to substitute for imports is also a choice to
discourage export growth.
The reasons why import substitution rather than export growth has usually been chosen
as an industrialization strategy are a mixture of economics and politics. First, until the
1970s many developing countries were skeptical about the possibility of exporting
manufactured goods (although this skepticism also calls into question the infant industry
argument for manufacturing protection). They believed that industrialization was necessarily
based on a substitution of domestic industry for imports rather than on a growth of
manufactured exports. Second, in many cases, import-substituting industrialization policies
dovetailed naturally with existing political biases. We have already noted the case of
Latin American nations that were compelled to develop substitutes for imports during the
1930s because of the Great Depression, and also during the first half of the 1940s because
of the wartime disruption of trade (Chapter 10). In these countries, import substitution
directly benefited powerful, established interest groups, while export promotion had no
natural constituency.
It is also worth pointing out that some advocates of a policy of import substitution
believed that the world economy was rigged against new entrants—that the advantages of
established industrial nations were simply too great to be overcome by newly industrializing
economies. Extreme proponents of this view called for a general policy of delinking developing
countries from advanced nations; but even among milder advocates of protectionist
development strategies, the view that the international economic system systematically
works against the interests of developing countries remained common until the 1980s.
The 1950s and 1960s saw the high tide of import-substituting industrialization.
Developing countries typically began by protecting final stages of industry, such as food
processing and automobile assembly. In the larger developing countries, domestic products
almost completely replaced imported consumer goods (although the manufacturing
was often carried out by foreign multinational firms). Once the possibilities for replacing
consumer goods imports had been exhausted, these countries turned to protection of intermediate
goods, such as automobile bodies, steel, and petrochemicals.
In most developing economies, the import-substitution drive stopped short of its logical
limit: Sophisticated manufactured goods such as computers, precision machine tools,
and so on continued to be imported. Nonetheless, the larger countries pursuing importsubstituting
industrialization reduced their imports to remarkably low levels. The most
extreme case was India: In the early 1970s, India’s imports of products other than oil
were only about 3 percent of GDP.
As a strategy for encouraging growth of manufacturing, import-substituting industrialization
clearly worked. Latin American economies began generating almost as large a share
of their output from manufacturing as advanced nations. (India generated less, but only
because its poorer population continued to spend a high proportion of its income on food.)
For these countries, however, the encouragement of manufacturing was not a goal in itself;
rather, it was a means to the end goal of economic development. Did import-substituting
industrialization promote economic development? Here serious doubts appeared. Although
many economists approved of import-substitution measures in the 1950s and early 1960s,
since the 1960s, import-substituting industrialization has come under increasingly harsh
criticism. Indeed, much of the focus of economic analysts and of policy makers has shifted
from trying to encourage import substitution to trying to correct the damage done by bad
import-substitution policies.
CHAPTER 11 Trade Policy in Developing Countries 261
Case Study
Mexico Abandons Import-Substituting Industrialization
In 1994 Mexico, along with Canada and the United States, signed the North
American Free Trade Agreement—an agreement that, as we explain in Chapter 12,
has become highly controversial. But Mexico’s turn from import-substituting industrialization
to relatively free trade actually began almost a decade before the country
joined NAFTA.
Mexico’s turn toward free trade reversed a half-century of history. Like many
developing countries, Mexico turned protectionist during the Great Depression of
the 1930s. After World War II, the policy of industrialization to serve a protected
domestic market became explicit. Throughout the 1950s and 1960s, trade barriers
were raised higher, as Mexican industry became increasingly self-sufficient. By
the 1970s, Mexico had largely restricted imports of manufactured goods to such
items as sophisticated machinery that could not be produced domestically except at
prohibitive cost.
Mexican industry produced very little for export; the country’s foreign earnings
came largely from oil and tourism, with the only significant manufacturing exports
coming from maquiladoras, special factories located near the U.S. border that were
exempt from some trade restrictions.
By the late 1970s, however, Mexico was experiencing economic difficulties, including
rising inflation and growing foreign debt. The problems came to a head in 1982, when
the country found itself unable to make full payments on its foreign debt. This led to a
prolonged economic crisis—and to a radical change in policy.
Between 1985 and 1988, Mexico drastically reduced tariffs and removed most of
the import quotas that had previously protected its industry. The new policy goal
was to make Mexico a major exporter of manufactured goods closely integrated
with the U.S. economy. The coming of NAFTA in the 1990s did little to reduce trade
barriers, because Mexico had already done the heavy lifting of trade liberalization in
the 1980s. NAFTA did, however, assure investors that the change in policy would
not be reversed.
So how did the policy change work? Exports did indeed boom. In 1980, Mexican
exports were only 10.7 percent of GDP—and much of that was oil. By 2008, exports
were up to 28.3 percent of GDP, primarily manufactures. Today, Mexican manufacturing,
rather than being devoted to serving the small domestic market, is very much part
of an integrated North American manufacturing system.
The results for the overall Mexican economy have, however, been somewhat
disappointing. Per-capita income has risen over the past 25 years, but the rate of
growth has actually been lower than that achieved when Mexico was pursuing a
policy of import-substituting industrialization.
Does this mean that trade liberalization was a mistake? Not necessarily. Most
(but not all) economists who have looked at Mexican performance blame the
relatively low growth on such factors as poor education. But the fact is that
Mexico’s turn away from import substitution, while highly successful at making
Mexico an exporting nation, has not delivered as much as hoped in terms of broader
economic progress.
From World War II until the 1970s, many developing countries attempted to accelerate their
development by limiting imports of manufactured goods, in order to foster a manufacturing
sector serving the domestic market. This strategy became popular for a number of reasons,
but theoretical economic arguments for import substitution played an important role in its
rise. Probably the most important of these arguments was the infant industry argument,
which we mentioned in Chapter 7.
258 PART TWO International Trade Policy
The Infant Industry Argument
According to the infant industry argument, developing countries have a potential comparative
advantage in manufacturing, but new manufacturing industries in developing countries
cannot initially compete with well-established manufacturing in developed countries. To
allow manufacturing to get a toehold, then, governments should temporarily support new
industries until they have grown strong enough to meet international competition. Thus it
makes sense, according to this argument, to use tariffs or import quotas as temporary
measures to get industrialization started. It is a historical fact that some of the world’s
largest market economies began their industrialization behind trade barriers: The United
States had high tariff rates on manufacturing in the 19th century, while Japan had extensive
import controls until the 1970s.
Problems with the Infant Industry Argument The infant industry argument seems
highly plausible, and in fact it has been persuasive to many governments. Yet economists
have pointed out many pitfalls in the argument, suggesting that it must be used cautiously.
First, it is not always a good idea to try to move today into the industries that will have a
comparative advantage in the future. Suppose that a country that is currently labor-abundant
is in the process of accumulating capital. When it accumulates enough capital, it will have a
comparative advantage in capital-intensive industries. However, that does not mean it
should try to develop these industries immediately. In the 1980s, for example, South Korea
became an exporter of automobiles; it would probably not have been a good idea for South
Korea to have tried to develop its auto industry in the 1960s, when capital and skilled labor
were still very scarce.
Second, protecting manufacturing does no good unless the protection itself helps make
industry competitive. For example, Pakistan and India have protected their manufacturing
sectors for decades and have recently begun to develop significant exports of manufactured
goods. The goods they export, however, are light manufactures like textiles, not the heavy
manufactures that they protected; a good case can be made that they would have developed
their manufactured exports even if they had never protected manufacturing. Some economists
have warned of the case of the “pseudoinfant industry,” in which an industry is initially
protected, then becomes competitive for reasons that have nothing to do with the protection.
In this case infant industry protection ends up looking like a success, but may actually have
been a net cost to the economy.
More generally, the fact that it is costly and time-consuming to build up an industry is not
an argument for government intervention unless there is some domestic market failure. If an
industry is supposed to be able to earn high enough returns for capital, labor, and other factors
of production to be worth developing, then why don’t private investors develop the industry
without government help? Sometimes it is argued that private investors take into account only
the current returns in an industry and fail to take account of the future prospects, but this
argument is not consistent with market behavior. In advanced countries at least, investors
often back projects whose returns are uncertain and lie far in the future. (Consider, for
example, the U.S. biotechnology industry, which attracted hundreds of millions of dollars of
capital years before it made even a single commercial sale.)
Market Failure Justifications for Infant Industry Protection To justify the infant
industry argument, it is necessary to go beyond the plausible but questionable view that
industries always need to be sheltered when they are new. Whether infant industry
protection is justified depends on an analysis of the kind we discussed in Chapter 10. That
is, the argument for protecting an industry in its early growth must be related to some
particular set of market failures that prevent private markets from developing the industry
CHAPTER 11 Trade Policy in Developing Countries 259
as rapidly as they should. Sophisticated proponents of the infant industry argument have
identified two market failures as reasons why infant industry protection may be a good
idea: imperfect capital markets and the problem of appropriability.
The imperfect capital markets justification for infant industry protection is as
follows: If a developing country does not have a set of financial institutions (such
as efficient stock markets and banks) that would allow savings from traditional sectors
(such as agriculture) to be used to finance investment in new sectors (such as manufacturing),
then growth of new industries will be restricted by the ability of firms in these
industries to earn current profits. Thus low initial profits will be an obstacle to
investment even if the long-term returns on the investment will be high. The first-best
policy is to create a better capital market, but protection of new industries, which
would raise profits and thus allow more rapid growth, can be justified as a second-best
policy option.
The appropriability argument for infant industry protection can take many forms,
but all have in common the idea that firms in a new industry generate social benefits for
which they are not compensated. For example, the firms that first enter an industry may
have to incur “start-up” costs of adapting technology to local circumstances or of
opening new markets. If other firms are able to follow their lead without incurring
these start-up costs, the pioneers will be prevented from reaping any returns from
these outlays. Thus, pioneering firms may, in addition to producing physical output,
create intangible benefits (such as knowledge or new markets) in which they are unable
to establish property rights. In some cases the social benefits from creation of a new
industry will exceed its costs, yet because of the problem of appropriability, no private
entrepreneurs will be willing to enter. The first-best answer is to compensate
firms for their intangible contributions. When this is not possible, however, there is a
second-best case for encouraging entry into a new industry by using tariffs or other
trade policies.
Both the imperfect capital markets argument and the appropriability case for infant
industry protection are clearly special cases of the market failure justification for
interfering with free trade. The difference is that in this case, the arguments apply
specifically to new industries rather than to any industry. The general problems with
the market failure approach remain, however. In practice it is difficult to evaluate
which industries really warrant special treatment, and there are risks that a policy
intended to promote development will end up being captured by special interests.
There are many stories of infant industries that have never grown up and remain
dependent on protection.
Promoting Manufacturing Through Protection
Although there are doubts about the infant industry argument, many developing countries
have seen this argument as a compelling reason to provide special support for the
development of manufacturing industries. In principle such support could be provided
in a variety of ways. For example, countries could provide subsidies to manufacturing
production in general, or they could focus their efforts on subsidies for the export of
some manufactured goods in which they believe they can develop a comparative
advantage. In most developing countries, however, the basic strategy for industrialization
has been to develop industries oriented toward the domestic market by using
trade restrictions such as tariffs and quotas to encourage the replacement of imported
manufactures by domestic products. The strategy of encouraging domestic industry by
limiting imports of manufactured goods is known as the strategy of import-substituting
industrialization.
260 PART TWO International Trade Policy
One might ask why a choice needs to be made. Why not encourage both import substitution
and exports? The answer goes back to the general equilibrium analysis of tariffs in
Chapter 6: A tariff that reduces imports also necessarily reduces exports. By protecting
import-substituting industries, countries draw resources away from actual or potential
export sectors. So a country’s choice to seek to substitute for imports is also a choice to
discourage export growth.
The reasons why import substitution rather than export growth has usually been chosen
as an industrialization strategy are a mixture of economics and politics. First, until the
1970s many developing countries were skeptical about the possibility of exporting
manufactured goods (although this skepticism also calls into question the infant industry
argument for manufacturing protection). They believed that industrialization was necessarily
based on a substitution of domestic industry for imports rather than on a growth of
manufactured exports. Second, in many cases, import-substituting industrialization policies
dovetailed naturally with existing political biases. We have already noted the case of
Latin American nations that were compelled to develop substitutes for imports during the
1930s because of the Great Depression, and also during the first half of the 1940s because
of the wartime disruption of trade (Chapter 10). In these countries, import substitution
directly benefited powerful, established interest groups, while export promotion had no
natural constituency.
It is also worth pointing out that some advocates of a policy of import substitution
believed that the world economy was rigged against new entrants—that the advantages of
established industrial nations were simply too great to be overcome by newly industrializing
economies. Extreme proponents of this view called for a general policy of delinking developing
countries from advanced nations; but even among milder advocates of protectionist
development strategies, the view that the international economic system systematically
works against the interests of developing countries remained common until the 1980s.
The 1950s and 1960s saw the high tide of import-substituting industrialization.
Developing countries typically began by protecting final stages of industry, such as food
processing and automobile assembly. In the larger developing countries, domestic products
almost completely replaced imported consumer goods (although the manufacturing
was often carried out by foreign multinational firms). Once the possibilities for replacing
consumer goods imports had been exhausted, these countries turned to protection of intermediate
goods, such as automobile bodies, steel, and petrochemicals.
In most developing economies, the import-substitution drive stopped short of its logical
limit: Sophisticated manufactured goods such as computers, precision machine tools,
and so on continued to be imported. Nonetheless, the larger countries pursuing importsubstituting
industrialization reduced their imports to remarkably low levels. The most
extreme case was India: In the early 1970s, India’s imports of products other than oil
were only about 3 percent of GDP.
As a strategy for encouraging growth of manufacturing, import-substituting industrialization
clearly worked. Latin American economies began generating almost as large a share
of their output from manufacturing as advanced nations. (India generated less, but only
because its poorer population continued to spend a high proportion of its income on food.)
For these countries, however, the encouragement of manufacturing was not a goal in itself;
rather, it was a means to the end goal of economic development. Did import-substituting
industrialization promote economic development? Here serious doubts appeared. Although
many economists approved of import-substitution measures in the 1950s and early 1960s,
since the 1960s, import-substituting industrialization has come under increasingly harsh
criticism. Indeed, much of the focus of economic analysts and of policy makers has shifted
from trying to encourage import substitution to trying to correct the damage done by bad
import-substitution policies.
CHAPTER 11 Trade Policy in Developing Countries 261
Case Study
Mexico Abandons Import-Substituting Industrialization
In 1994 Mexico, along with Canada and the United States, signed the North
American Free Trade Agreement—an agreement that, as we explain in Chapter 12,
has become highly controversial. But Mexico’s turn from import-substituting industrialization
to relatively free trade actually began almost a decade before the country
joined NAFTA.
Mexico’s turn toward free trade reversed a half-century of history. Like many
developing countries, Mexico turned protectionist during the Great Depression of
the 1930s. After World War II, the policy of industrialization to serve a protected
domestic market became explicit. Throughout the 1950s and 1960s, trade barriers
were raised higher, as Mexican industry became increasingly self-sufficient. By
the 1970s, Mexico had largely restricted imports of manufactured goods to such
items as sophisticated machinery that could not be produced domestically except at
prohibitive cost.
Mexican industry produced very little for export; the country’s foreign earnings
came largely from oil and tourism, with the only significant manufacturing exports
coming from maquiladoras, special factories located near the U.S. border that were
exempt from some trade restrictions.
By the late 1970s, however, Mexico was experiencing economic difficulties, including
rising inflation and growing foreign debt. The problems came to a head in 1982, when
the country found itself unable to make full payments on its foreign debt. This led to a
prolonged economic crisis—and to a radical change in policy.
Between 1985 and 1988, Mexico drastically reduced tariffs and removed most of
the import quotas that had previously protected its industry. The new policy goal
was to make Mexico a major exporter of manufactured goods closely integrated
with the U.S. economy. The coming of NAFTA in the 1990s did little to reduce trade
barriers, because Mexico had already done the heavy lifting of trade liberalization in
the 1980s. NAFTA did, however, assure investors that the change in policy would
not be reversed.
So how did the policy change work? Exports did indeed boom. In 1980, Mexican
exports were only 10.7 percent of GDP—and much of that was oil. By 2008, exports
were up to 28.3 percent of GDP, primarily manufactures. Today, Mexican manufacturing,
rather than being devoted to serving the small domestic market, is very much part
of an integrated North American manufacturing system.
The results for the overall Mexican economy have, however, been somewhat
disappointing. Per-capita income has risen over the past 25 years, but the rate of
growth has actually been lower than that achieved when Mexico was pursuing a
policy of import-substituting industrialization.
Does this mean that trade liberalization was a mistake? Not necessarily. Most
(but not all) economists who have looked at Mexican performance blame the
relatively low growth on such factors as poor education. But the fact is that
Mexico’s turn away from import substitution, while highly successful at making
Mexico an exporting nation, has not delivered as much as hoped in terms of broader
economic progress.
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