30 March 2014


Kankesu Jayanthakumaran*
Import-substitution policy creates biases in the incentive structure and lowers the
growth of potential exports in the long run. Trade reforms in this respect are likely to
reduce the gap between domestic and border prices. The expectation is to bring better
industrial performance on the lines of comparative advantages. This paper examines
the import-substitution policy and the effect and impact of trade liberalisation.
Neoclassical economic theory focuses on the market or exchange with the assumption
that the price mechanism works well and allocates resources efficiently. A focus on
the effectiveness of the market mechanism in allocating resources is a core theme of
this approach. Promoting foreign trade to access the potential static and dynamic gains
and removing the widespread inefficiencies in developing countries due to higher
level of protection are some of the issues that the supporters of the market mechanism
focus on. In the light of the above argument during the 1980s many developing
countries initiated economic adjustment programmes and focused on export
promotion along the lines of comparative advantage.
Economic adjustment package includes reducing public sector activity, reforming
markets such as international trade, labour, financial and other microeconomic
activities. For a majority of countries the general picture is that the price system has
been highly distorted through government intervention. In other words, there was a
divergence between shadow prices and market prices. It is well established in the
literature on shadow pricing that the world price will represent the market price. The
economic adjustment package has been oriented to shifting resources into the export
sectors by bringing market prices more in line with opportunity costs. Bringing
opportunity costs more in line with world prices was felt necessary in shifting
resources into the export sector.
In recent years neo-classical theory has come to be linked with stabilisation and
adjustment programmes by world organisations and applied in many developing
countries. Trade reform has been given a prominent role under stabilisation
programmes in the expectation that it would promote growth performance and
efficiency along the lines of comparative advantage; it would also reduce
monopolistic conditions in domestic markets and reduce price markups. The objective
of this paper is to study the role of trade strategies in industrialisation. The first three
sections of this paper deal with trade strategies, government interventions and importsubstituting
industrialisation. The rest of the sections deal with export-orientation,
trade efficiency and conclusion.
Government intervention in foreign trade is often associated with the concepts
"Import Substitution" (IS) and ‘Export Promotion’ (EP). The former entails higher
intervention, the latter less intervention. It is difficult to have a precise definition for
the concepts IS and EP. Two basic approaches measuring the intensity of intervention
may be distinguished. One was a single-criterion based on the underlying incentive
structure; the other is multiple-criteria using choice of trade policy variables.
Little, Scitovsky and Scott (1970), Balassa (1971), Bhagwati (1978) and Krueger
(1978) measured trade strategy by use of an almost identical single criterion. For
example Bhagwati (1978) treated export promotion as the situation in which
where X EER and M EER indicate the effective exchange rate for exports and for
imports respectively. The EER incorporates all form of incentives and disincentives
offered to the economy (for details see P.15, export orientation: trade liberalisation).
Greenaway and Num (1988) adopted a multiple criteria approach. They argued that a
single criterion approach is not appropriate for a number of reasons. First,
classification into import and export sectors is difficult as industries produce a range
of products. Second, the actual and intended effects of policies may be entirely
different in developing countries. Third, the evidence suggests that only a few
economies persistently pursue a strategy through time. The authors noticed that the
initial stages of industrialisation are characterised by import substitution and that it is
only after some ‘take off’ point that resources need to be mobilised into higher valueadded
activities through export promotion.
Michaely, Papageorgiou and Choksi (1991) adopted multiple criteria and introduced
liberalisation indices for each country in a study of nineteen countries and twenty-nine
episodes. The liberalisation indices were constructed for each episodes annually
during the period studied and were assigned a value ranging from 1 (for the highest
possible degree of trade intervention) to 20 (for complete trade liberalisation). For
each episodes intensity was derived based on strength and speed and their
sustainability1. Various quantitative and qualitative factors were taken into account.
The difficulties in defining trade strategies are reflected in the vast variation in
approaches to measurement. Between the two extremes, stringent import control and
export-orientation policy, there exist various degrees of combinations. In brief, trade
strategy can be defined in terms of changes to incentive structure using a singlecriterion
and changes in the choice of trade policy instrument using multiple criteria2.
However, the single criterion definition is used in most of the literature.
There are static and dynamic gains of free trade. As a result of exchange of goods and
services and specialisation there will be more production and income in the line of
comparative advantages. There will be an increase in saving as a result of rise in
income, which in turn allows resources to be relocated from the production of
consumption goods to the capital goods.
National governments do often intervene in foreign trade in number of ways. These
include tariffs, quotas, export barriers, anti dumping duties, local content requirements
and administrative policies. Among the other reasons, interventions are intended to
protect domestic industries from foreign competition. It was widely noted that these
interventions introduce widespread distortions in the pricing system and they pose
some of the most intriguing policy problems.
Interventions in Import
A tariff is a tax on importing a good or service into a country, gathered by customs
officials at the place of entry. Tariffs fall into two categories. A specific tariff is a
money amount per physical unit of import. For example a $ per ton of textiles. An ad
valorem tariff is a percentage of the estimated market value of the goods imported.
For example a 25 per cent of the value of textiles imported. In general, as a result of a
tariff consumers will end up paying higher prices, buying less of the product or both.
A tariff brings gains for domestic producers who face import competition.
It is likely that tariffs of importing country result in retaliation from exporting country
and both countries end up losing most of the gains from trade. Suppose we assume
that the terms of trade of the nation imposing the tariff improve and those of the trade
partner deteriorate. Facing both a lower volume of exports and deteriorating terms of
trade, the trade partner’s welfare declines. As a result the trade partner is likely to
retaliate and impose a tariff of its own. The volume of trade further declines. If the
process continues, all nations end up losing most of the gains from trade.
Import Quotas and Voluntary Export Restraints
The government gives out a limited number of licences to import items legally and
prohibits importing without a license. A quota gives government officials greater
administrative flexibility and power. A quota is a shelter against further increases in
import spending when foreign competition is becoming severe. The quota cuts the
quantity imported and derives the domestic price of the good up above the world price
at which the licence holders buy the good abroad.
The way in which a quota is allocated will have impact on consumer welfare.
Competitive auction is the best way. The competitive auction is likely to yield a price
for the import licences that roughly equals the difference between the foreign price of
the imports and the highest home price at which all the licensed imports can be sold.
In the case of a public auction, the quota system does not cost the nation any more
than an equivalent tariff. Allocating quota on a fixed favouritism is the most illogical
way. In this method the government allocates fixed shares to already established firms
without competition. A third method is resource-using application procedures. This is
considered the least efficient way and a non-price method of allocation. For example,
the quota may be allocated on a first-come first-served basis (Lindert 1996).
A voluntary export restraint is a kind of quota on trade imposed by the exporting
countries, at the request of the importing countries3. For example, textiles, clothing
and footwear were subject to voluntary export restraints during the last four decades in
which importing countries requested the exporting countries to limit their exports to
them. By agreeing to export restraints, foreign producers/exporters secure their
minimum export and avoid far more damaging tariffs or quotas by importing
countries. The Uruguay Round agreement called for the elimination of restraints on
exports of textiles, clothing and footwear.
The Japanese automobile industry was subject to voluntary export restraints in the
1980s. USA automobile producers were running low on profit and workers were
subject to massive job layoffs. There were two options to address the protectionist
pressure available to USA Congress: imposing quota restrictions on automobile
imports from Japan, and imposing voluntary export restraints. The first option was out
of favour as USA leads global progress towards freer trade. Instead, Japan agreed to
limit its exports to the United States of America. In this case the importing country is
a powerful country having trouble with facing rising import competition, and forces
the exporting country to deserve so-called "voluntary" export restraints. Voluntary
export restraints may benefit Japanese producers by reducing import competition in
the importing country and raising their price-markup profits. USA consumers do not
benefit as a result of increase in the prices of imported goods. When imports are
limited, this bids the prices up for that limited foreign supply. The world as a whole
loses as voluntary export restraints limit trade between nations (Hill 1999).
Anti dumping
The governments of importing countries levy antidumping tariffs against dumping.
Dumping is a form of international price discrimination in which an exporting firm
sells its product at a lower price in a foreign market than it charges in its homecountry
market. Dumping is considered a method by which firms unload excess
production in foreign markets. There are two types of dumping. Predatory dumping
occurs when the firm temporarily discriminates in favour of some foreign buyers with
the purpose of eliminating some competitors with the intention of later raising its
prices after the competition is over. Persistent dumping occurs when price
discrimination goes on forever.
Dumping by an exporting country is often subject to retaliation by the importing
country. The governments of importing countries levy antidumping tariffs. In a way,
antidumping policies are designed to punish foreign firms that engaged in dumping.
The objective is to protect domestic producers from so called “unfair” competition.
Usually domestic producers file a petition with the appropriate government agencies.
The government agencies investigate the complaint and, if appropriate, impose the
antidumping tariff. Such duties are prohibited under the International Antidumping
Code signed by most parties to the GATT. However, current GATT practices permit
retaliation against dumping.
An antidumping duty is likely to lower world welfare. It is possible uncompetitive
domestic producers can call for antidumping duties from firms that may not be
dumping. In a way this is an excuse for protectionism. In this case antidumping duties
are like usual tariffs and generate costs to the world and to the importing nation as
Local Content Requirements
National governments can require firms to use a specific minimum proportion of
inputs of a good to be sourced domestically. For example, it was a practice in
Australia that 85 per cent of component parts for automobiles, or 85 per cent of the
value of automobiles must be produced locally. Canada forced the radio and television
stations to give a certain share of their airtime for local songs and shows. Developing
countries frequently use this method as a device for promoting local manufactured
products and components. For example Colombia once allowed the free import of the
world's best steel on the condition that the buyers should show that they bought
certain amount of finished steel from Colombian mills.
By limiting foreign competition the producers of local content benefits. Restrictions
on imports raise the prices of imported contents. Higher prices for imported contents
raise the cost of the final products produced locally and in turn raise the prices.
Overall this scheme tend to benefit producers but not consumers.
Administrative Policies
Some times a range of administrative trade policies or bureaucratic rules can restrict
imports and boost exports. The resulting delays due to bureaucratic rules can have
direct impact on imports. Bureaucratic rules benefit producers and harm consumers by
denying access to superior and lower cost foreign products.
Interventions in Export
Export interventions are export quotas, export tax and export subsidy. Export quotas
are rarer, but tend to be more severe, than import quotas. For example to avoid
national famines governments used to control exports in the past. In the extreme they
can take the form of an export ban or export embargo, both refers to complete bans or
economic sanctions. For example United States impose export bans and quotas more
often than other industrial nations4. Export tax is common, which has effects that are
symmetrical to those of an import tax. An export tax, in the face of a fixed world
price, discourages exports and directs supplies back onto the home market, pushing
down the domestic price.
Exports are often subsidised. For example, governments use taxpayers’ money to give
low-interest loans to exporters, engage in advertising and export promotion on behalf
of exporters and give tax relief based on the value of goods or services each firm
exports. Lower prices of exports due to subsidy likely to benefit consumers and harm
producers of importing countries. The governments of importing countries have a
good reason to protect their producers from unfair competition. They do retaliate by
imposing a tariff against exporters which is widely known as countervailing duties.
Higher domestic prices of importing countries as a result of countervailing duties
suppose to protect the domestic producers. GATT/WTO do proscribe export subsidies
as “unfair competition” and allow importing countries to retaliate with protectionist
countervailing duties. The net effect of the subsidy plus countervailing duty together
determines the world welfare.
Advocates of strategic trade policy support granting subsidies to strategic
industries/firms5. This form of subsidy is different from the infant industry argument
for protection. Countries may predominate in the export of certain products because
they had firms that were foremost in technology and able to attain first-mover
advantages in industries that would support only a few firms because of substantial
economies of scale. Government should use subsidies to support promising firms in
emerging industries and should provide this support until the domestic firms establish
first-mover advantage in the world market. Both home market protection and export
subsidies are advocated. For example the United States of America supports Boeing
and a number of European countries support Airbus.
Development economists justify import substituting industrial policies on a number of
grounds. Given the low productivity and low income elasticity of demand for the
primary goods mainly produced by developing nations known as periphery underwent
long term deterioration of prices and short-term export revenue instability (Prebisch
1984). Given the high productivity and high income elasticity of demand for the
manufacturing goods produced by rich countries known as centre received
continuously higher prices for their products6. If a secular decline of terms of trade of
periphery is true forecast for future trends, long-lasting expansion of traditional
exports cannot be relied upon for sustained long-run growth. It was felt that switching
into import-substitution industrialisation was the only option for periphery to grow
with the given export pessimism case7. Switching into import substituting industries
was also perceive as a means of reducing the income elasticity of demand in the
periphery for its manufacturing imports from the centre.
The classical economists and later structuralists brand the manufacturing sector as an
engine of growth8. This sector relatively generates increasing returns in the long-run
not only within the sector itself but also in the other major sectors, that is rising
productivity as output expands. Manufacturing sector has the potential of interrelated
branches of activities and generates greater linkages and externalities. Agricultural
and service sectors do generate linkages. However, the expansion of these sectors
does not offer specialisation and division of labour within the sectors as like
manufacturing sector. Productivity gains and technical change arising in
manufacturing sector pass on to these sectors through purchase of capital and
intermediate goods.
Switching into domestic production satisfying domestic demand replaces the imports.
The government interventions in foreign trade and the price distortions arise due to
that is to protect the import substituting manufacturing industries. Price distortions are
expected to shelter the higher-cost local producers by allowing the domestic
production more profitable. The above process can be an important strategy in raising
manufacturing sector through foreign exchange savings and the generation of
externalities and learning effects.
The danger is that this strategy targets the internal demand and neglects the external
demand from export sector. Weiss (1988) has noted developing countries failed to
lower their imports, while reducing the exports below its long-run potential for many
cases. One can look at various explanations for this. First the composition of imports
may change but not overall imports that includes capital and intermediate goods.
Second the growing income inequalities can lead to shifts in consumer demand
towards import-intensive commodities. Finally there is also a tendency that importsubstitution
policy creates biases in the incentive structure, lower the growth of
potential exports. It is inevitable to call for an export-oriented policy at this stage
which demand removal of biases in the incentive structure.
Externalities and Linkages
Generation of externalities and linkages are vital step for import-substituting
industrialisation process. Externalities are generally defined as the effects created by
individual producers/consumers that are felt elsewhere in the economy not reflected in
the cost and revenue of the originator of the effect. Technological externalities and
pecuniary externalities are two types of externalities. For example 'Firm A' incurs cost
for their worker training for future needs. Suppose the worker leaves from 'Firm A'
and joins 'Firm B' then these potential benefits are lost and 'Firm A' is left with
bearing cost. The expectation is that protected firms, in this case 'Firm A', can have
the ability to expand their expenditure including expenditure on training; the rest of
the firms benefit by workers with no cost. The above direct interdependence among
producers can be referred as technological externalities.
Figure 1: Pecuniary Externalities
Figure 1 indicates some of the possible pecuniary externalities. Pecuniary externalities
are defined as the effects that revealed in price terms through market mechanism.
Suppose if expansion of textiles production by 'Firm B' is subject to increasing returns
of scale then there will be cost reductions. So that garment producer of 'Firm C'
generates higher profit. Growth of textile production by 'Firm B' will create a demand
for cotton production by 'Firm A' and will create higher profits in 'Firm C'. These are
positive pecuniary externalities. In case if output of textiles by 'Firm B' is higher cost
or lower quality than the competitors, and 'Firm C' is compelled to use the textiles
from 'Firm B' rather than alternatives then this situation generates negative pecuniary
externalities. Economic planners usually target broad economic perspective and higher
existence of positive externalities.
There are number of scepticism over externalities. First, one can argue that it would
be less costly for the government to directly subsidise such worker training rather than
blindly protecting the industry. Direct subsidisation for worker training avoids the
consumer welfare loss arises from protection. Second, by definition import
substituting industries focuses limited small domestic market and this is major
constraint of achieving economies-of-scale in the process of industrialisation.
Linkages are closely related with externalities and some times synonymous. It is
narrowly defined as a series of production relationships in an intra-industry
framework. Hirschman (1958) introduced backward and forward linkages reflect
production interdependence. Backward linkage is from particular industry to its input
suppliers. Forward linkage is from particular industry to its users.
Figure 2: Backward and Forward Linkages
Figure 2 shows the backward and forward linkages. The garment industry needs
textiles; these links are referred to as direct backward linkages. Textiles generate the
need for cotton and fertiliser; these are known as indirect linkages. Users can be final
consumers, retailers, and wholesalers; these are known as forward linkages. The
Leontief inverse of an input and output table incorporates total linkages, both direct
and indirect. The expectation here is that the higher the total linkages, the greater will
be the inducement to expansion.
It is often argued that it is the manufacturing sector that generates higher linkages and
having potential for generating higher externalities. Within manufacturing one should
give main concern to the activities that form the maximum linkages. However, not all
linkages create economically desirable outcomes, for example, establishing a garment
production creates a demand for textiles and encourage establishing higher capacity.
If the domestic market is not adequate or the cost of production of textiles is relatively
high then the cost of garment product is more than the world standard. If the garment
industry is protected, leaving the industry profitable, then still the linkages can be
justifiable. Linkages of this type will result in the establishment of a number of high
cost supplying industries.
Infant Industry
A number of government interventions in foreign trade have the intention to promote
infant industries. Imposing tariffs is one example, but this is not an effective method
for a number of reasons. First, tariffs may not be an effective tool to target the specific
industry. Second, tariffs are not easily removed once they are written into legislation
and there is a danger that an infant never becomes efficient. Finally, tariffs generate
both misallocation of resources and consumer welfare loss due to misalignment of
domestic and world prices. A subsidy to an import substituting industry is an effective
tool to target a specific industry9. Subsidising production can promote infant
industries more cheaply compared to tariffs on imports. A subsidy can still lead to
misallocation of resources but avoid consumer welfare loss due to the alignment of
domestic and world prices. The other option is low-interest loans. If an industry’s
current high costs are outweighed by the later cost reductions, then the industry can
borrow against its own future profits.
Advocates of protectionism promote the infant industry argument. This states that a
temporary tariff is justified because it cuts down on imports while the infant-domestic
industry learns how to produce at low enough costs to compete without the help of
tariffs. Central to the argument is that new industries cannot be expected to compete
on equal terms with established overseas producers. These industries need a limited
period of protection from import competition while learning. The expectation is that,
over time, costs of production will fall to international standards.
Figure3: Infant Industry: Learning and Externalities
Weiss (1991) has depicted the infant industry arguments using diagrams that relate
costs of production of infants at a point of time. This is shown in Figure 3. The
vertical and horizontal axes represent costs/prices and time respectively. The real
average cost curve of an individual producer is falling as learning takes place over
time and represented by the curve 'AA'. The Cost, Insurance and Fright (CIF) price of
comparable imports remains constant in real terms and represented by 'MM". At the
time of 't' the infant reached the international standards. If costs fall beyond 't' the firm
can compete in the export market. The curve 'EE' represents externalities. This curve
is derived from the infant's own cost curve 'AA' minus the external benefits per unit of
output that are created for others. With the inclusion of 'EE' curve the maturity occurs
at time 't''; the learning costs are lower; the gains after 't'' are greater.
Figure 3 demonstrates that infant-industry protection generates more benefits
wherever there are positive externalities. But to be realistic it is important that one
should show more than the costs fall to international standard. First, this can be done
by a detailed cost-benefit evaluation of the infant. Over the lifetime of the investment
of an infant the discounted value of the later benefits should offset the discounted
value of the initial costs. Second, the assumption that international prices remain
constant is unrealistic. International prices can fall with the improvement in
productivity. Finally, only firms which are prepared to understand, adapt and
technologically active can be successful infants, not all the firms that are given
The import substitution approach is subject to a number of criticisms. First, a real
possibility of government failures and the costs associated with resulting from the
attitudes of bureaucrats, influence of powerful pressure groups and substituting private
interests on the expense of public interests by politicians and employees needs to be
addressed. Second, prevailing foreign exchange controls may tend to promote the use
of more inappropriate capital-intensive techniques of production. Third, exchange
controls and protections together may result in a vast increase in rent-seeking
activities. Forth, a forgoing view is that infant industries in developing countries have
had a tendency never to grow up10. Finally, import-substitution policy creates biases in
the incentive structure and lowers the growth of potential exports in the long term.
This necessitates the need of export-oriented policy over time11.
The concept ‘trade liberalisation’ does not mean complete free trade, but fewer trade
barriers or a neutral trade regime. The process of removal of quota and tariff may
continue until a neutral trade regime appears. A neutral trade regime may be defined
as a situation with equal incentives to domestic sales and exports. Trade protection
instruments such as tariffs and non-tariff barriers tend to discriminate between
domestic and border prices. Trade reforms in this respect are likely to reduce the gap
between domestic and border prices and tends to narrow the market prices with
opportunity costs. Bhagwati (1978) defined a neutral trade regime as in equation (1)
X M EER = EER (1)
where X EER and M EER indicate the effective exchange rate for exports and for
imports respectively. The former refers to the number of units of domestic currency
that can be obtained for a dollar worth of exports by considering all factors that affect
the price of exports, such as export duties and subsidies. The latter refers to the
number of units of domestic currency that would be paid for a dollar worth of
imports by considering all factors that affect the price of imports such as tariffs and
surcharges. It is assumed that M EER determines the nominal protection for importcompeting
firms selling in the domestic market. In a situation where:
X M EER < EER (2)
the policies are directed toward import substitution, and where
X M EER > EER (3)
the policies are directed towards over-subsidization of exports. The process of moving
towards a neutral trade regime may be defined as trade liberalisation.
As a result of liberalisation, some activities may contract while others may expand. As
resources in the contracting activities are likely to be affected, this would involve
some political implications. Macroeconomic imbalances such as higher inflation and
severe balance of payments problems are likely with liberalisation. To avoid
uncertainties Michaely (1986) suggested an optimal path to trade liberalisation.
Michaely recommended a multi-stage implementation, as being superior to a onestage
implementation on the grounds that one-stage implementation is not feasible
politically or socially, as this would lead to greater unemployment and larger changes
in income distribution.
Michaely further argues that the desirable first step is to eliminate all forms of
quantitative restrictions. Further he suggested a uniform treatment of activities as far
as tariff reductions are concerned. Three alternative “uniform” paths can be looked
into. First, equiproportional(across-the board) reduction of protection of various
activities. This would lead to a gradual reduction of the protection system. Second,
equally large absolute reductions between various activities. The third method is
named the ‘concertina method’. In the initial stage of the policy, all protection rates
above a certain ceiling are lowered to that ceiling, with no changes in other rates. The
next step is that all rates are again brought to the lower ceiling and so on. This would
allow consistency in the lowering of the variance in the protection system. This tends
now to be the approach used as bringing highest net benefit.
It is recognised within the Neoclassical literature that effective trade liberalisation
requires the effective operation of all inter-related and inter-dependent markets, such
as those for foreign exchange, finance, labour and capital market. In the absence of
free movements in related markets, the benefits that accrue from liberalisation may be
significantly reduced. Macroeconomic policies appear to be important in determining
the survivability of trade liberalisation. Trade liberalisation may not be effective in
countries with growing fiscal deficits, worsening external balance and rising inflation.
For example, with the liberalisation, inflationary pressures lead to appreciation in the
real exchange rate and worsen the current account deficit. High real lending and
excessive debt-burden rate due to inflationary pressures lead to lower investment.
Adjustment assistance is the policy of compensating those jobs and investments that
are displaced by import competition. Greater import competition entails displacement
costs, in terms of worker, capital and other resources. Job losses need to be addressed
in order to avoid the social and political unrest. Who pays this cost? One can argue
that as long as the free-trade policy brings net gains to the nation, the gainers can
compensate the injured while still retain the net gains from the free trade. The
Government can play the mediator role between gainers and losers. This is referred to
as adjustment assistance. This assistance can be used to relocate and retrain workers
(and firms) for reemployment in sectors where employment is expanding.
Economy as a whole
Government intervention in the form of foreign trade protection creates direct and
indirect costs to the economy as a whole. The misallocation of resources in production
and the reduction in consumer welfare because of the misalignment of domestic and
foreign prices generate direct costs to the economy. Indirect costs derive from
unproductive activities associated with protection such as evading tariffs, undercapacity
utilisation and smuggling.
Kirkpatrick and Weiss (1992) explained some of the above impacts diagrammatically
using the standard production possibility frontier in a two good model of cloth and
rice. It is assumed in ‘Figure 4’ that protection creates costs, not benefits. The
production frontier QQ signifies the maximum output of the economy in a situation
where resources and technology are limited. WW and DD indicate international and
domestic price lines respectively with DD incorporating some form of protection for
cloth. In a free trade situation, ‘A’ is the efficient production point on the frontier,
whilst trade along WW allows the combination of goods ‘X’ to be attained. In the
situation of protection, ‘B’ is the production point and trade under these restricted
conditions along WW will allow a lower combination of goods ‘X1’ to be obtained.
‘R1W’ is the allocative efficiency loss measured in terms of rice along the horizontal
axis due to protection.
Apart from allocative inefficiency, protection generates ‘X- inefficiency’, either by
encouraging rent-seeking behaviour in order to receive preferential treatment from
protection or by creating negative incentive effects. These processes raise unit costs.
This can be illustrated by shifting the production possibility frontier to the left to
Q1Q1(Figure 5). Under protection, point ‘C’ is the production point now, and trade
along ‘PW’ allows the combination of goods ‘X2’. Now ‘R2W’ is the loss due to
protection which is higher than the loss in Figure 1.
If the assumption that protection creates costs but no benefits is removed, then there is
a possibility that the frontier can shift outward relative to the free trade position. The
possibility arises when there are dynamic benefits from trade protection. In figure 6, a
new frontier Q2Q2 is drawn, which as a result of protection is skewed towards greater
cloth production compared to the original frontier QQ. In this figure, production under
protection is at point ‘E’, and trading along ‘PW’ allows a combination of goods ‘X3’,
which is above the original free trade combination of ‘X’. The gain in terms of rice is
R3W. These are alternative views on the merits of trade liberalisation. Kirkpatrick and
Weiss (1992) argue that these alternative perceptions still need to be demonstrated
Sector/Industry level
The neo-classical literature on industrialisation noted that the level of protection was
high in developing countries and this, in turn, led to discriminatory impacts not only
on import-competing industries but also various other branches and sectors. Export19
oriented industries need to be competitive in the world market to progress. To be
competitive, the economy should move to an export promotion strategy which
encourages greater competition and associated productivity gains, technological
know-how and knowledge of international standards. Protectionist policies allow and
maintain an exchange rate well above the free trade situation and result in local
exporters receiving less local currency for a given unit of exports than the free trade
situation. In addition, import controls raise domestic prices. Exporters are forced to
use domestically produced inputs, which are relatively expensive and possibly inferior
to that those available in foreign markets.
Protecting the industrial sector may harm the agricultural sector and generate price
distortions in factor markets. Supporting the industrial sector at the expense of the
agricultural sector can result in the agricultural sector suffering from an anti-export
bias. A protectionist policy is just one among a range of government interventions that
introduce distortions in factor prices. It is widely recognised that there is a divergence
between the opportunity cost of wages and interest rates and the market price of wages
and interest rates in developing countries. The need to introduce shadow price
estimates of labour and capital into calculations of investment viability is essential in
this circumstance. Therefore, it is argued that removal of protection is essential to
promote efficient resource allocation among branches and sectors of the economy.
At the industry level the removal of trade protection generates efficiency in a number
of ways. First, by eliminating foreign exchange constraints it increases the importing
capacity of the economy. Second, by removing quantitative restrictions, it reduces the
wastefulness from the stockpiling of goods in expectation of later shortages. In
addition, it reduces the forced inactivity of resources due to the shortages of matching
import components. Third, by eliminating X-inefficiency it raises the efficiency level
in an industry and by eliminating monopoly profits it allows optimum resource
allocation in an industry. Thus, it is expected that the process can lead to
specialisation along the lines of the economy's comparative advantages.
Market level
It is argued in welfare economics that monopoly leads to inefficiency in pricing.
Profit-maximising behaviour will ensure economic efficiency only in the context of a
perfectly competitive market. Since protection allows domestic firms to operate under
either monopoly or monopolistic competition, a rise in profits may represent the
exercise of the firm’s monopoly power in the market, rather than an improvement in
Figure 7 compares the firm in perfect competition and in monopoly. In perfect
competition, the firm faces a perfectly elastic demand curve, where average revenue
(AR) is equal to marginal revenue (MR). In equilibrium, the firm is earning normal
profits and the average total cost (ATC) is tangent to the demand curve. With profit
maximisation, marginal revenue (MR) is equal marginal cost (MC), this leads to the
efficient price P, where P = MC. In monopoly, the firm/industry faces a down-ward
sloping demand curve. Profit maximisation behaviour (MC = MR) results in the price
and output combination ‘PQ’, where efficiency pricing (P = MC) requires the
combination P’Q’.
At the market level it is expected that with the opening to trade, domestic prices have
to equate with the average cost of the firms in operation, since they cannot make
excess profits. The protection factor is included in the present prices and cost structure
of the firms. Thus liberalisation is expected to reduce domestic prices and this will
induce some of the inefficient firms to leave the industry. Thus liberalisation will
reduce the average cost of operating firms. This process will go on until price equals
marginal cost.
Firm level
A key argument behind trade liberalisation and an Export Promotion (EP) policy is
that export expansion increases international competition and forces domestic firms to
achieve international standards. At the firm level export expansion and import
liberalisation creates an implicit ‘Challenge Response’ mechanism among domestic
firms and this, it is argued, will eventually increase domestic efficiency.
‘Best practice’ production frontiers illustrate three types of technical advance which
trade can promote12. Figure 8 illustrates the optimum point at the present state of
technology. The vertical axis shows unit labour requirement and the horizontal axis
shows unit capital requirement. PPo is the ‘Best Practice’ production frontier
estimated from a sample of firms and represents the firm’s existing state of
technology. The efficient decision lies at the point where the relative factor price line
is tangent to the production frontier PPo. F1, F2 and F3 are the factor price lines and
represent the relative prices of a unit of labour and a unit of capital. Point B is
technically efficient since it is on the frontier but point ‘C’ is technically inefficient.
The overall inefficiency of point C is OD/OC. This can be divided into allocative
(OD/OB) and technical (OB/OC) components. Point ‘A’ is the least cost techniqe in
terms of factor prices and the existing state of technology. When a firm moves from
point ‘B’ to point ‘A’ it regains its allocative efficiency. In other words, the already
existing inefficiency, perhaps due to misallocation of resources has now been
removed. Firms that are at point ‘C’ or point ‘B’ are inefficient and this may be partly
the result of using labour biased technology due to prevailing import substituting
It is also expected that investment by enterprises in respect to trade liberalisation may
promote research and development activities, movement of relative factor prices,
quality control and staff training and move the firm to the new frontier PP1, towards
the origin. The proponents of liberal trade regimes agree that, in the long-run, further
gains from improved allocative efficiency will not remain and only benefits from
improved technical efficiency will continue. Pack (1988: 364) argued that
liberalisation may have a substantial initial impact but not yield any steady-state
benefits. However, since all the elements are subject to change in the long-term, as a
result of foreign or domestic technical change and of changing prices both
internationally and domestically, the concept of long-term productivity growth is
ambiguous. We need further evidence in this regard.
Static measures of efficiency
The impact of trade policy on static efficiency is widely measured in terms of
Nominal Protection Coefficient (NPC), Effective Rate of Protection (ERP), Cost-
Benefit (CB) and Domestic Resource Cost (DRC) estimates.
Nominal protection coefficient (NPC)
Protection in the form of quota, tariff, taxes and subsidies on inputs and outputs
generates drastic changes in resource allocation and output levels. This necessitates an
awareness of the end result of protection. The Nominal Protection Coefficient (NPC)
can be defined as the ratio of the domestic price to the world price for a comparable
commodity. The estimates of NPC will not capture the entire effects of protection.
NPC represents the price rising effect of tariffs on a product and can be defined as
NPC = d W P / P (4)
where d P is domestic price and w P is world price. If NPC is greater than one then
government protects producers.
Effective rate of protection (ERP)
Effective Rate of Protection (ERP) is defined in the literature as the percentage excess
of domestic value-added obtainable by reason of the imposition of tariffs and other
protective measures on the product and its inputs over value-added at world prices. In
other words ERP is the percentage of domestic price value-added to world price
i i
v* - v
where *
i V is value-added at domestic prices in activity ‘i’ and i V is value-added at
world prices in activity ‘i’, under liberal trade. Other things being equal, it is expected
that the higher the ERP level in an activity ‘i’ the greater will be output as compared
with what its output would be in the absence of protection. The higher the anti-exports
bias the greater the incentive to domestic production. The following situations tend to
increase the ERP, (a) high import duty on output and low import duty on inputs, (b)
low export tax on output and high export tax on inputs, and © imposition of licensing
on output. The ERP is not strictly a measure of the efficiency with which resources are
employed, but rather of the incentive to shift resources into particular activities.
Cost-benefit analysis
It is widely believed that market prices often fail to represent national opportunity
costs, so that an alternative basis of valuation of an investment or project is required.
Price distortions arise for various reasons such as state intervention in economic
activities and lack of resource mobility. Where distortions are important shadow
prices should be used for commodities or factors instead of prevailing market prices.
Cost benefit analysis is a commonly used technique for appraising new investments in
public projects by incorporating economic prices. It is used for measuring the
efficiency of existing projects. To decide whether an existing project continuously
requires government support through either protection or subsidy this analysis can be
used. In addition, this technique can be employed as part of an interventionist policy
that attempts to direct private sector activity.
An investment or a project may be beneficial to the country if NPV > 0 and IRR > d
are satisfied:
where NPV = r t
(1+ )
å (6)
and NPV, NB and IRR refer to “net present value”, “net benefit” and “internal rate of
return” respectively. One can derive NPV by using the appropriate discount rate (r).
When NPV > 0, it means that in today’s value terms, the stream of economic net
benefits would be positive. The higher the r, is the lower the NPV. The IRR criterion
focuses on the rate of discount (d) at which the NPV becomes zero:
(1 )
= å
d t
NPV (7)
In other words, one can accept a project as feasible if it has an IRR greater than the
interest rate (d > r). If one invests in this particular project, then one receives ‘d’
whilst elsewhere one receives a rate of return of ‘r’.
Domestic resource cost
The Domestic Resource Cost (DRC) is an estimate of the opportunity cost in terms of
domestic resources of generating a net marginal unit of foreign exchange. It gives the
cost of domestic resources that are necessary to save or earn one unit of foreign
exchange by producing a unit of value-added, for a particular plant or enterprise. In
empirical research, DRC can be defined in the following notation13,
å å å
+ +
( )
* * * * * *
i Ti t
Li L Ki K Ni N
i P a P
a L CF a K CF a N CF
DRC (8)
where Li Ki Ni a ,a anda refer to the units of labour, capital and non-traded goods
respectively required per unit of output ‘i’. L, K and N indicate the unit market prices
of labour, capital and non-traded goods respectively. L K N CF ,CF andCF represent the
conversion factors of labour, capital and non-traded costs respectively14. i t PandP are
the world prices of output ‘i’ and traded input ‘t’ respectively. Ti a represents the unit
of input ‘T’ per unit of ‘i’. å refers to summation.
In the algebraic notation of the DRC ratio, non-tradables are in the numerator and
tradables in the denominator. To determine whether or not a good falls into the
tradable or non-tradable category, one must look at its ultimate impact on exports and
imports and this often depends on judgement. If extra demand that arises in the
domestic economy is met by imports or exports then the item falls into the tradable
category. For consistency it is suggested that non-traded goods should be decomposed
into non-traded and traded components and traded inputs be included in the
denominator of the DRC ratio (Bruno 1972). The same treatment is appropriate to the
annualised capital stock used in the calculations. The part of capital that is itself
imported should be included in denominator while keeping domestically produced
capital in the numerator (Bruno 1972).
The DRC criterion is an explicit expression of the comparative cost principle in
international trade. A country has a comparative cost advantage if DRC < SER, where
SER is the shadow exchange rate. This is the situation in which a country experiences
a positive net foreign exchange impact. If DRC > SER, then it reflects comparative
disadvantage and a negative net foreign exchange benefit.
Two types of DRCs can be distinguished, one ex-ante and the other ex-post. The
former is often used in micro level project evaluation and the latter for industry level
cost of protection studies. DRCs at the ex-ante level can be made equivalent to
conventional CB ratios or IRR15. DRCs at the ex-post level have two wings of which
one includes only short-run variable cost (short-run DRCs) and the other includes past
investment costs (long-run DRCs). The long-run DRCs incorporate the annualised
replacement costs in the prices of the base year. Still, if ex-post long-run DRCs are
static single year measure, they are inferior to the CB ratio of IRR which cover the
whole life of an activity.
The main differences that can be identified between ERP and DRC measures is that in
the case of the DRC shadow prices are used, whilst the ERP is based on market prices.
In the absent of shadow pricing these two measures are same provided equivalent
assumptions are adopted.
Dynamic measures of efficiency
Productivity growth
The impact of trade reform can also be assessed in dynamic terms. There can be three
possible links between trade liberalisation and productivity growth. First, opening to
trade encourages foreign competition and ‘challenge response’ and hence affects
domestic efficiency. Second, the availability of imported inputs may lead to cost
reductions partly due to improved capacity utilisation. Third, expansion of output due
to opening to trade reduces the production costs and hence leads to better productivity
Labour productivity and total factor productivity growth measures indicate the change
in technology in the production function as well as a number of other effects such as
changes in allocative and technical efficiency and in capacity utilisation rates. Labour
productivity may be defined as,
- output per worker
- output per manhour, and
- value-added per worker
Total factor productivity is often referred as the ‘residual’ or the index of ‘technical
progress’. In other words this part of the changes in output cannot be explained by the
changes of total inputs. The interpretation of the changes in total factor productivity
differs according to the way in which inputs are measured and specified. When there
is error in measurement it is wrong to conclude that the residual is productivity
growth. Total factor productivity may be defined as
TFP = VA a L a K 1 2 - - (9)
where VA refers the growth of value-added at constant prices, L refers the growth of
labour inputs in number of workers, K indicates the growth of capital inputs at
constant prices and 1 a and 2 a the mean shares of labour and capital respectively.
Share of labour is the average of the ratio of wages divided by value-added at the
beginning and the end of the period under study. Share of capital is the average of the
ratio of non-wage value-added divided by value-added divided by value-added at the
beginning and end of the period of study.
Price-cost margins
There are links between price-cost margins and trade liberalisation. First, foreign
competition and free entry restrain the exercise of market power by domestic firms in
the domestic market. In other words, import competition may weaken the collusive
agreements of domestic firms. This eventually leads them to cut their prices in order
to avoid their loss of market share. Second, foreign competition improves the
productive efficiency of inefficient producers and allows them to cut their prices.
Third, as oligopolistic export firms tend to face greater difficulties in achieving tacit
collusion with importers, largely because of communication, they are forced to cut
their prices to compete in the export market. Finally, there is a possibility that an
import competition induces mergers among domestic firms, as long as imports are
close substitutes for domestic products.
The monopolistic profit maximisation model best explains the theoretical aspect
of the price cost margin (PCM) measure. The model can be written as
MC = MR = P(1 - 1/n) (10)
where n is the price elasticity of demand. Rearranging equation gives:
- =
The left hand side of the equation gives PCM and that is equal to the inverse of the
elasticity of demand. Also, if MC equals average variable cost, then one can show that
the ratio of profit to sales revenue (thus multiplying the numerator and denominator of
PCM by output) is equal to the reciprocal of the demand elasticity. This is a version of
Structure-Conduct-Performance (SCP) models, where performance (PCM) is
determined by structure (n) and conduct is monopolistic.
Export growth
Export growth of a country may be an alternative measure of competitiveness. Trade
liberalisation eliminates restricted markets due to protection allows domestic
producers to access inputs cheaper than the earlier protected system. Growth in
exports is likely by enhancing price competitiveness, increase in external demand and
reductions in internal demand.
Structuralists, who believe in government involvement in foreign trade, hold the
strong view that import-substituting industrialisation can be an important strategy for
raising earnings and savings of foreign exchange, generating externalities and learning
effects. In general, misallocation of resources and consumer welfare loss due to
misalignment of domestic and world prices and rent-seeking activities are costs
associated with protectionism. Import-substituting strategy creates biases in the
incentive structure and likely to reduce the potential exports. Focus is also on limited
domestic market where industry unlikely to reap the benefits of economies-of-scale.
The expectation of the trade reforms is to generate trade efficiency in the short-run by
eliminating allocative and technical inefficiency that possibly arises from trade
protection. Long-run productivity growth is ambiguous one as there is vast range of
changes in technical conditions and prices both internationally and domestically. It is
possible to capture the short-run effects of trade reforms by using static and dynamic
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*Department of Economics, University of Wollongong, NSW 2522. I wish to thank
Dr.Boon-Chye Lee for helpful comments.
1 Seven of the entire episodes experienced a relaxation of quantitative restrictions. Seven
other episodes had low quantitative restrictions to begin with. The rest experienced tariff
cuts. Authors found that there appears to be not a single case in which higher tariffs were
consciously used to improve neutrality.
2 For a comprehensive account, see Helleiner (1990).
3 Voluntary export restraints mean that the importing country gives exporters monopoly
power, forces them to take it, and calls their compliance "voluntary" (Lindert 1996, p.140).
4 The United States was the originator of about 54 out of the world's 89 major embargo
occurrence between 1945 and 1983.
5 New trade theorists introduced strategic trade policy argument. For review, see P.R.
Krugman (1992).
6 Development economists in the 1950s and 1960s, for example Prebisch, Nurkse, Lewis and
Myrdal, shared the view of 'export pessimism' regarding traditional primary exports from
developing countries.
7 Export pessimism case was not completely acceptable as developing countries had the
capabilities of expanding non-traditional exports or expanding south-south customs unions as
a means of widening their markets.
8 Structuralists are pessimistic in their view of how markets perform, but optimistic
concerning the government's involvement in problem solving. Weiss (1988 pp107-16) argues
for and against the industrial specialisation and dynamic increasing returns suggested by
9 Lindert (1996) pp.159-62 argues that production subsidy is preferable to the tariff in an
import substituting industry since it achieves any given expansion of output or jobs at lower
social costs. If the priority is to promote jobs then a subsidy tied to the number of workers
employed might be better than a subsidy tied to output.
10 For details Grabowski (1994) and Weiss (1988).
11 Prebisch (1984) has shown his dissatisfaction of policies which create excessive biases
against exporting.
12 Farrell (1957) has used the term ‘best practice’ for the production frontier and has shown
technical efficiency and allocative efficiency in a systematic manner.
13 See for example Weiss (1991) for a detailed derivation of DRC.
14 A conversion factor may be defined as the ratio of the shadow to the market price of any
activity in an economy.
15 Warr (1983) concludes that the DRC criterion is capable of distinguishing between projects
generating positive and negative net present value. He found that all three criteria – CB ratio,
IRR and DRC – are helpful in distinguishing desirable from undesirable projects but, none of
them can be relied upon to rank a set of mutually exclusive projects correctly.
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