Results of Favoring Manufacturing: Problems
of Import-Substituting Industrialization
Import-substituting industrialization began to lose favor when it became clear that
countries pursuing import substitution were not catching up with advanced countries.
In fact, some developing countries lagged further behind advanced countries even as
they developed a domestic manufacturing base. India was poorer relative to the United
States in 1980 than it had been in 1950, the first year after it achieved independence.
Why didn’t import-substituting industrialization work the way it was supposed to? The
most important reason seems to be that the infant industry argument is not as universally
valid as many people had assumed. A period of protection will not create a competitive
manufacturing sector if there are fundamental reasons why a country lacks a comparative
advantage in manufacturing. Experience has shown that the reasons for failure to develop
often run deeper than a simple lack of experience with manufacturing. Poor countries lack
skilled labor, entrepreneurs, and managerial competence and have problems of social
organization that make it difficult for these countries to maintain reliable supplies of
everything from spare parts to electricity. These problems may not be beyond the reach of
economic policy, but they cannot be solved by trade policy: An import quota can allow an
inefficient manufacturing sector to survive, but it cannot directly make that sector more
efficient. The infant industry argument is that, given the temporary shelter of tariffs or
quotas, the manufacturing industries of less-developed nations will learn to be efficient. In
practice, this is not always, or even usually, true.
With import substitution failing to deliver the promised benefits, attention turned to
the costs of the policies used to promote industry. On this issue, a growing body of
evidence showed that the protectionist policies of many less-developed countries badly
distorted incentives. Part of the problem was that many countries used excessively
complex methods to promote their infant industries. That is, they used elaborate and
often overlapping import quotas, exchange controls, and domestic content rules instead
of simple tariffs. It is often difficult to determine how much protection an administrative
regulation is actually providing, and studies show that the degree of protection is
often both higher and more variable across industries than the government intended. As
Table 11-2 shows, some industries in Latin America and South Asia were protected by
regulations that were the equivalent of tariff rates of 200 percent or more. These high
rates of effective protection allowed industries to exist even when their cost of production
was three or four times the price of the imports they replaced. Even the most
enthusiastic advocates of market failure arguments for protection find rates of effective
protection that high difficult to defend.
TABLE 11-2 Effective Protection of Manufacturing
in Some Developing Countries (percent)
Mexico (1960) 26
Philippines (1965) 61
Brazil (1966) 113
Chile (1961) 182
Pakistan (1963) 271
Source: Bela Balassa, The Structure of Protection in Developing
Countries (Baltimore: Johns Hopkins Press, 1971), p. 82.
CHAPTER 11 Trade Policy in Developing Countries 263
A further cost that has received considerable attention is the tendency of import
restrictions to promote production at an inefficiently small scale. The domestic markets
of even the largest developing countries are only a small fraction of the size of that
of the United States or the European Union. Often, the whole domestic market is not
large enough to allow an efficient-scale production facility. Yet when this small market
is protected, say, by an import quota, if only a single firm were to enter the market, it
could earn monopoly profits. The competition for these profits typically leads several
firms to enter a market that does not really have enough room even for one, and
production is carried out at a highly inefficient scale. The answer to the problem of
scale for small countries is, as noted in Chapter 8, to specialize in the production and
export of a limited range of products and to import other goods. Import-substituting
industrialization eliminates this option by focusing industrial production on the domestic
market.
Those who criticize import-substituting industrialization also argue that it has aggravated
other problems, such as income inequality and unemployment.
By the late 1980s, the critique of import-substituting industrialization had been widely
accepted, not only by economists but also by international organizations like the World
Bank—and even by policy makers in the developing countries themselves. Statistical
evidence appeared to suggest that developing countries that followed relatively free trade
policies had, on average, grown more rapidly than those that followed protectionist policies
(although this statistical evidence has been challenged by some economists).2 This intellectual
sea change led to a considerable shift in actual policies, as many developing countries
removed import quotas and lowered tariff rates.
of Import-Substituting Industrialization
Import-substituting industrialization began to lose favor when it became clear that
countries pursuing import substitution were not catching up with advanced countries.
In fact, some developing countries lagged further behind advanced countries even as
they developed a domestic manufacturing base. India was poorer relative to the United
States in 1980 than it had been in 1950, the first year after it achieved independence.
Why didn’t import-substituting industrialization work the way it was supposed to? The
most important reason seems to be that the infant industry argument is not as universally
valid as many people had assumed. A period of protection will not create a competitive
manufacturing sector if there are fundamental reasons why a country lacks a comparative
advantage in manufacturing. Experience has shown that the reasons for failure to develop
often run deeper than a simple lack of experience with manufacturing. Poor countries lack
skilled labor, entrepreneurs, and managerial competence and have problems of social
organization that make it difficult for these countries to maintain reliable supplies of
everything from spare parts to electricity. These problems may not be beyond the reach of
economic policy, but they cannot be solved by trade policy: An import quota can allow an
inefficient manufacturing sector to survive, but it cannot directly make that sector more
efficient. The infant industry argument is that, given the temporary shelter of tariffs or
quotas, the manufacturing industries of less-developed nations will learn to be efficient. In
practice, this is not always, or even usually, true.
With import substitution failing to deliver the promised benefits, attention turned to
the costs of the policies used to promote industry. On this issue, a growing body of
evidence showed that the protectionist policies of many less-developed countries badly
distorted incentives. Part of the problem was that many countries used excessively
complex methods to promote their infant industries. That is, they used elaborate and
often overlapping import quotas, exchange controls, and domestic content rules instead
of simple tariffs. It is often difficult to determine how much protection an administrative
regulation is actually providing, and studies show that the degree of protection is
often both higher and more variable across industries than the government intended. As
Table 11-2 shows, some industries in Latin America and South Asia were protected by
regulations that were the equivalent of tariff rates of 200 percent or more. These high
rates of effective protection allowed industries to exist even when their cost of production
was three or four times the price of the imports they replaced. Even the most
enthusiastic advocates of market failure arguments for protection find rates of effective
protection that high difficult to defend.
TABLE 11-2 Effective Protection of Manufacturing
in Some Developing Countries (percent)
Mexico (1960) 26
Philippines (1965) 61
Brazil (1966) 113
Chile (1961) 182
Pakistan (1963) 271
Source: Bela Balassa, The Structure of Protection in Developing
Countries (Baltimore: Johns Hopkins Press, 1971), p. 82.
CHAPTER 11 Trade Policy in Developing Countries 263
A further cost that has received considerable attention is the tendency of import
restrictions to promote production at an inefficiently small scale. The domestic markets
of even the largest developing countries are only a small fraction of the size of that
of the United States or the European Union. Often, the whole domestic market is not
large enough to allow an efficient-scale production facility. Yet when this small market
is protected, say, by an import quota, if only a single firm were to enter the market, it
could earn monopoly profits. The competition for these profits typically leads several
firms to enter a market that does not really have enough room even for one, and
production is carried out at a highly inefficient scale. The answer to the problem of
scale for small countries is, as noted in Chapter 8, to specialize in the production and
export of a limited range of products and to import other goods. Import-substituting
industrialization eliminates this option by focusing industrial production on the domestic
market.
Those who criticize import-substituting industrialization also argue that it has aggravated
other problems, such as income inequality and unemployment.
By the late 1980s, the critique of import-substituting industrialization had been widely
accepted, not only by economists but also by international organizations like the World
Bank—and even by policy makers in the developing countries themselves. Statistical
evidence appeared to suggest that developing countries that followed relatively free trade
policies had, on average, grown more rapidly than those that followed protectionist policies
(although this statistical evidence has been challenged by some economists).2 This intellectual
sea change led to a considerable shift in actual policies, as many developing countries
removed import quotas and lowered tariff rates.
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