Monday, January 19, 2009

Strategies For Development 1: Inward Or Outward Industrialisation?

“Outward-looking development policies encourage not only free trade but also the free movement of capital, workers, enterprises & student……the multinational enterprise & an open system of telecommunications”

“By contrast inward-looking policies stress the need for LDCs to develop their own style of development & to control their own destiny”

By Dr. Paul Streeten (professor emeritus at Boston University)

ISI (Import Substitution Industrialisation)/ Inward-looking strategies

During 1950s & 1960s, developing country experienced a sharp decline in world markets of their primary products & growing balance of payment deficit on their current accounts. It was thought that unavailability of manufacturing sector was always the cause. Thereby many countries such as Brasil, Mexico & Argentina etc increasingly embrace the idea of creating a local industrial base

Its main intention is to:

(1) Create employment. Local firms lose out to multinational corporations in many ways from management skills to professional workforce, amount of investment into operations & scale of productions. In order to help local industries to strive, import barriers such as tariffs & quotas were erected, making it more costly for consumers to purchase imported goods than locally made ones. By ‘supporting’ home-made substitute goods, producers will over time reap supernormal profit. They will be able to grow further thus creating more job opportunities. At same time, this is hopefully can eradicate poverty

(2) Improve BOP deficit. Balance of payment records the financial transaction between one country & the rest of the world. BOP normally runs into deficit due to the deficit in current account. It could be imports are growing, exports are falling or both. By operating behind government’s protection, it is hoped that local producers will be able to produce locally. These products can be exported, thus boosting exports. Meanwhile, as consumers substitute away from foreign goods, imports will fall. BOP deficit will be narrowed

(3) To build strong base for EP (export promotion). Barriers will stay as they are until local firms are able to compete in terms of size & have acquired the know-how techniques to be productively efficient. Good examples will be the East Asian economies such as Taiwan, Hong Kong, South Korea & Singapore which once operate behind protection. Now they are able to produce at competitive costs to the whole world. This is the strongest argument use by economists to defend the need of ISI

Is ISI really that good?

(1) Productively inefficient. In theory, local firms will eventually be more cost efficient once the industry reached maturity. However, that’s not the case in reality. These firms realised that they have their own ‘captive’ markets & yet being insulated from competition. So what’s the need to improve? As a result, they will never strive to be cost-efficient. Also in many cases, the products are of ill-quality & yet expensive. Consumer surplus falls

(2) Never removed. As mentioned, local producers will tend to slack ‘forever’ knowing that once they become more-able, protections will be removed & there is no guarantee that they are able to compete internationally & earn as much profit as now. So they tend to remain as they are. Furthermore, removal of protections is very politically unpopular & may cause resentment. Ruling government may lose its mandate (think of Proton, our so called pride for more than 20 years!)

(3) Capital-intensive. Even if there were improvements made in terms of cost efficiency, very often it is done at the expense of another. As infant industry grows, they may begin to capitalise & substituting manpower with machineries, giving rise to large scale unemployment

(4) BOP deficit. We must acknowledge that poor developing countries do not have the sufficient means to grow by themselves. To develop a strong local industrial base, other than human capital they also need capital goods such as specialise machineries which must be imported from abroad. Again, this represents an outflow in current account. Hence, improvement of BOP deficit is largely questionable here

How does an import tariff works?

Tariff is a tax imposed onto imported goods

Before tariff. The price at which the good can be imported from world markets is given by PW. So in the absence of tariff domestic demand is given by DF of which SF is supplied within the domestic economy & the remainder SFDF is imported

After tariff. When government introduces tariff, the domestic price rises to PW+T, where T is the amount of tariff. It has 2 effects. First, reducing demand for good from DF to DT. Secondly, is to encourage producers to expand their output from SF to ST. As a result, imports fall substantially to DTST. However, not all the effects of tariff are favourable. For instance higher price has reduced consumer surplus. There is also deadweight loss represented by the 2 triangles at the side. For government, the tax revenue can be channelled onto local industries

Outward looking

Export promotion requires a more dynamic & outward-looking approach, as domestic producers need to be able to compete with established producers in world markets. China & India are 2 rising stars in export-led growth


(1) Create employment. Many of these factories are located in urban areas & they are labour-intensive. It provides great employment opportunity to not only people in town but also to rural migrants. As a result, we will witness lesser urban slums which are disgust to sights. Also it reduces the level of absolute poverty

(2) Influence AD. We have learned this in Unit 3. An export-oriented economy will expect an increase in its exports over imports, thus creating net exports. This shall move the AD curve rightward resulting in an increase in real GDP. Through the multiplier effect, national income & employment will further increase

(3) Financing capital goods. An increase in exports over imports can improve its terms of trade. Terms of trade means ratio of export prices to import prices. In other word, the country need to export lesser to finance the same amount of imported goods e.g. machineries. Also there will be lesser danger that the economy will run into foreign exchange & foreign debt problems

(4) Exploit EOS. Since local manufacturers are producing on a large scale to world market, it is able to significantly exploit EOS. It could be any of the combination of purchasing EOS, marketing EOS, managerial EOS, technical EOS etc. This will give the particular developing countries an added advantage on top of its cheap labour. As such it will be able to compete easily at international scale given its cost competitiveness. China is a good example. It has successfully create a chaos in British, US & other Western European’s manufacturing industry

(5) Learn from rivals. By competing with multinational companies, local firms will be able to improve its competitiveness. There will be more efforts put into R&D. Marketing team will be more aggressive. Also they can learn the unique features of rivals’ product & perhaps make a large improvement over their existing ones to enlarge market share


(1) Dependent culture. Export-led growth is not without its problems too. Its level of success depends a lot on the pace of economic growth in rich Western countries. If say, US is hit by a recession, then third world countries could be the worst affected. Level of exports will slump. Unemployment will escalate & the demultiplier effect will feed into the whole system

(2) Rich countries erect protectionism. It is unlikely that Western manufacturing sectors are able to compete with low cost Asian economies. What’s more in manufacturing sector which is labour intensive. More often than not, labours form a large portion of total costs. That is also one of the major arguments as to why major Western economies are shifting their comparative advantage to services sector, except Germany. Others which still have manufacturing industry as their core economic activity began to erect unfair protectionism

(3) Environmental degradation. Developing countries are often accused by Western economies as the major contributors to global warming, especially China. This is true. Rich Western economies have already reached the desired level of income. As such living in a cleaner environment is now their priority. Meanwhile, for poor but booming countries they have to sacrifice environment at the expense of economic growth & development. Besides, industrialists in developing economies are not that well educated. As such their level of environmental awareness is very low

(4) Fall in export prices. This is assuming if all developing countries are trying to export their way out simultaneously. Due to flooding of manufactured goods into the world market, its prices will be forced to plunge, putting exporters in disadvantage

I'm very pro free-market & for that I fully support export-led growth. I actually do not believe that excessive governement protection will eventually turn 'an ugly frog into a handsome prince'. Furthermore, it's just too costly for persistent intervention


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