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Sadia Shehzeen Matric No.

U083381r W2
Compare the relative merits of export promotion vs. import substitution as development strategies. Why do these trade policies of the developing countries need to be reformed? Developing countries can pursue two main approaches of trade, namely import substitution and export promotion. In simple words, the two terms can be defined in the following way:

Import substitution (IS) refers to a strategy within a nation to curtail


imports of manufactures in order to save valuable foreign exchange and instead promoting the emergence and expansion of domestic industries. It helps provide job protection to the residents of the country and also helps create new jobs. All these result in reduced dependency on other countries, accelerated industrial growth and hence aid in economic development. Import substitution is much favored by inward looking protectionists. Export promotion (EP) refers to incentive programs designed to entice more firms into exporting through various mechanisms like assisting in product and market identification and development, pre-shipment and postshipment financing, training, payment guarantee schemes, trade fairs, trade visits, foreign representation, etc. Export promotion is preferred by outward looking free traders who believe free trade and increased competition lead to more efficiency in production and hence improvement in current account and balance of payments. These strategies are targeted towards the developing countries, but they cannot be successfully carried out without the co-operation of the developed countries. The developed countries need to design their policies in such a way that they do not hinder development of the LDCs. Comparing the relative merits of Import Substitution vs. Export Promotion Put simply, import substitution means replacing imported goods with locally produced goods. For this to be possible, the government needs to intervene in the market in order to protect domestic firms from foreign rivals. The strategy for import substitution can be implemented in stages. First-stage IS refers to substituting domestic production of previously imported simple consumer goods. Second-stage IS refers to moving on to substituting for more sophisticated and manufactured items. The basic instruments for import substitution are import controls, namely high tariffs, quotas (ban being an extreme form of quota), etc. Here, the first merit of import substitution comes up, its contribution to the industrialization process of a developing country, and this point arises from infant industry argument. Import controls make imports relatively more expensive. This provides protection to the high priced domestic industry from fierce competition from firms worldwide and the underlying target is to mainly shield the infant industries so that they can grow and attain a level of competence so that they can survive in the world market. Other advantages that maybe gained include economies of scale, low labor costs, spillover effects of learning by doing, i.e. resultant positive externalities. However, when

Sadia Shehzeen Matric No. U083381r W2


infant industries get this guaranteed protection, they tend to remain high cost. Such inefficient IS firms, in most cases, hinder the industrialization process. Quite opposite to this case, export promotion applies only to industries that have the capability, thus preparing them to compete in global markets. To aid in the industrial progress, EP exposes the domestic industries to competition from foreign firms. In doing so, domestic firms can flourish by specializing in the production of goods that use the most efficient or abundant resources, and survive in the world market. Moving on to the second merit would be that of the associated productivity gains. With IS, protection from competition is provided to allow domestic firms to thrive and ultimately reap the benefits of economies of trade. However, as is often seen, IS does the necessarily apply to the most efficient firms and hence, the protection often is permanent, i.e. the protection continues to be in place even over the long run. On the other hand, EP drives domestic exporting firms to gain efficiency in order to lower costs in the face of fierce global competition. While IS allows inefficient firms to operate, EP only allows the most efficient firms to continue production. The next comparable merit could be that of the gains in technology and knowledge. Since LDCs lack proper proficiency, with IS, industries often start to merge with foreign companies. These domestic firms can then gain useful expertise from them, and through learning-by-doing, they can increase their efficiency. This gradually enhances the progress of technology and knowledge, which then results more diversified and value-added production. Furthermore, this also increases industry profits which can be ploughed back, resulting in accelerated growth. EP works in a similar way, but through learning-by-trading, as foreign investors are enticed into the country. Exporters themselves have the urge to find better, cheaper and more efficient modes of production which continually result in research and development. In IS, however, firms usually face no competition and get complacent and have no incentive to invest in R&D. Both, IS and EP result in reduced dependency on other countries. When the strategy of IS is implemented, domestic industry, through protection from international competition, can boom the industries in general, building a strong base and thereby reducing its dependency on the world market for imports. Thus, IS results in self-sufficiency. With EP, the country has a larger market when compared to a restricted domestic market. Therefore, in case of any external shock on the economy of a country, the domestic country can always turn to alternate markets to restore the lost demand. The best example is that of Singapore, who boasts of having diverse markets- from the U.S. to the Middle East. All the above merits boil down to the key merit: economic growth. IS encourages domestic production which is an engine for economic growth. This leads to an overall increase in standard of living, but it is not equally distributed. We can see it from the graph below.

Sadia Shehzeen Matric No. U083381r W2

From figure 1, it can be seen that domestic consumers gain as they have access to a larger quantity of goods, Q1Q3 at a lower price P2, while domestic producers suffer, as they are substituted away by cheaper foreign producers, since they want to supply Q2 at P2, but Q2Q3 is supplied by foreign producers. In the second figure, domestic industries receive tariff protection from the government that causes prices to rise from P1 to P2 which the consumers suffer through higher prices in the short run and lower consumption, Q3Q5. However, in this case the domestic producers sell at higher prices, Pt and supply increase, Q2Q4. Hence, it causes a redistribution of income. However in the long run, IS is believed to help domestics firms to achieve EOS and ultimately prices to fall below world price of P2, and that is tariffs can be removed. Food for thought LDCs typically face huge balance of payments deficits. However, IS brings this deficit down, as imports fall. Another important benefit is the increase in tax revenues, which can be ploughed back by the government into infrastructure building or other development schemes. However it comes with its share of shortcomings which include, among others: Exchange rates have to be overvalued artificially in order to protect the domestic industries. However, this means that the domestic goods are relatively more expensive to the foreign buyers, thus might lead to worsening of the current account. It has been seen in the past, allocation of resources were often distorted due to monopolization.

Sadia Shehzeen Matric No. U083381r W2


It has also been seen that tariffs and quotas dampen incentives of domestic firms to invest in R&D and become efficient. Thus they remain inefficient forever, which means protection is sometimes permanent.

With EP, domestic firms get to specialize in industries in which they enjoy comparative advantage and hence can bring down unemployment. Since EP also results in intense competition, resources are more equally distributed. However, there are other factors that need to be considered too. Price elasticity of demand for most primary goods is quite low, which indicates that even when price falls significantly, demand will only increase slightly. The innovation of synthetic substitutes mean that there is increased competition in the market of primary goods for developing countries, for which developing countries are facing fall in export earnings from them. World population growth has been slowing down too, and to expect export demand to increase due to increasing population is not quite feasible. From the factors listed above, it can be seen that both IS and EP come with the shares of advantages and disadvantages. But it is quite difficult to say which strategy is more useful, since there are other factors that determine the usefulness of each, which include the global economy and external sources. Therefore, it cannot be concluded which is the superior strategy, but a combination of both seems most appealing. Reasons why the trade policies of developing countries need to be reformed: Protectionist measures, as in IS, erode the benefits of the comparative advantage theory and hence the gains that can be derived are lost. Therefore, if such tariff protection is removed, it will lead to an overall improvement, since there can be a more vibrant trade system so that the developing countries can enjoy the benefits of free trade. It is often seen that trade protection methods like tariffs remain permanently, often leading to inefficiencies and inequitable income distribution. Inefficiencies because with IS, domestic firms tend to lack any incentive to find cheaper or more efficient production methods due to the protection they receive from local governments. Therefore domestic firms produce at higher costs, transferring this as higher prices to consumers. With higher prices and lower quantities and hence lower choices, consumers are thus exploited. Here is creates an inequitable distribution of income, redistributing income from the consumers to producers. One consequence of the above mentioned inefficiency and the need to keep them permanently means is the administrative costs incurred by the government during this process. In order to fund these costs, the government needs to tax the citizens, which may lead to reducing the welfare of the economy as a whole. Another unfavorable outcome is that, when LDCs continue to be stuck at producing low value goods, and thus create very few, and at times no. employment opportunities.

Sadia Shehzeen Matric No. U083381r W2


With higher unemployment, developing countries remain in the vicious cycle of poverty. When these barriers to trade are imposed, the MDCs may resort to adopting retaliatory measures against the LDCs. LDCs, with already very limited resources, may suffer if MDCs increase their trade protection levels against particular countries. Thus, in such cases these LDCs have to import certain goods, at even higher costs, that may lead to possible worsening of the balance of payments of the domestic country. Another key factor is that, LDCs get to produce at very low costs, since labor costs are very high and this basically applies to primary products. Since there is abundance, they resort to dumping in the MDCs. Dumping at artificially low prices destroy the market mechanism and thus MDCs might end up with retaliatory measures including bans being placed against these countries. This might result in loss of markets for the LDCs. They can alternately choose to export away these primary products at the start of season since perishable items also incur costs during the time they need to be stored before they are dumped. Conclusion: IS and EP are both important strategies, necessary for the growth of the developing countries, but the benefits and costs of each strategy in accordance to the domestic economic condition should be considered before they can be used an a universal cure strategy. The relative merits of IS vs. EP discussed in the first half of the essay may sound very convincing theoretically, but empirical evidence shows otherwise; since impact of each strategy on different countries at different points of time tend to be quite varied. As the world is getting more and more globalised, the trade policies of LDCs impact the MDCs, and vice versa. Therefore, domestic as well as global consequences need to be considered when policies are made, and once made if they fail to meet their targets, should be reformed. Bibliography: Todaro, M.P. and Smith, S.C. (10th edition) Chapter: 12. International Trade Theory and Development Strategy. Todaro, M.P. and Smith, S.C. (10th edition) Chapter: 13. Balance of Payments, Developing-Country Debt, and the Macroeconomic Stabilization Controversary. BusinessDirectory.Com http://www.businessdictionary.com/definition/exportpromotion.html Accessed at 1200 hours on April 1, 2010 Answers.Com http://www.answers.com/topic/import-substitution Accessed at 1200 hours on April 1, 2010 Joseph Stiglitz. Globalisation and its discontents. Chapter:6 Unfair Trade Laws and Other Mischief.

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