Import substitution versus

What have we learned from the experience of developing countries? Anne O. Krueger

In the 1950s and 1960s, there was consid- the economies and did not merely produce obtained by reducing the output of A by
erable debate among academics and policy static gains from improved allocation of one unit.)
makers on the relative advantages of resources. In principle, a government could protect
inward-oriented (or import substitution) This article examines the links between some industries in the domestic market
policies and outward-oriented (or export export orientation and general economic while providing sizable export subsidies to
promotion) policies, and on the effects of performance by contrasting inward- and other industries. In practice, however, the
such policies on economic growth in de- outward-oriented strategies and attempts scope for such two-way protection is lim-
veloping countries. Essentially the argu- to explain the reasons for differences in ited, for a number of reasons: (1) protective
ment for protection and inward orientation performance of economies that adopted devices or export subsidies are meaningful
of the economy rested on the presence of each strategy. only if they discriminate against some other
imperfections in the market mechanism Defining export-led growth activities; (2) protection of a large number
that made it difficult for developing econ- of activities is generally inconsistent with
omies to compete and to develop. Propo- The terms "export-led growth," "out- encouraging exports, because exporters of
nents of outward-oriented policies pointed ward oriented," "export promotion," and manufactured goods require relatively easy
to the costs associated with protectionist "export substitution" are all used to define access to international markets for their
policies. Meanwhile, a number of devel- policies of countries that have been suc- inputs of raw materials and intermediate
oping countries proceeded either to aban- cessful in developing their export markets. and capital goods; and (3) protection at the
don or substantially reduce their trade bar- While different countries have had different levels deemed necessary to induce import
riers and other controls on economic activity. policies, their common features are that substitution usually requires a great degree
The result was a spectacular growth of their there is at least as much incentive to earn of control (to prevent smuggling, false in-
economies, leading to the conclusion that as to save foreign exchange and that incen- voicing, etc.) to ensure that the domestic
outward-oriented policies had a dynamic tives to export are fairly uniform and not market is profitable enough, and to prevent
effect on the domestic economy and helped discriminatory across commodity groups. export of the protected goods.
accelerate growth rates (see table). An export-oriented set of policies could Thus most analysts would agree that an
Three main points have emerged from be no more than the absence of policies export-oriented strategy is one in which
the experience of the countries that opted that discriminate in favor of sales in the there is no bias of incentives toward pro-
for export-led growth. First, their remark- domestic market. The criterion for optimal duction of import substitutes. Whatever
able rates of growth were associated with allocation of resources is that the marginal incentives exist must favor production for
the rapid growth of exports; second, for all rate of transformation of domestic produc- export as much as, if not more than, pro-
countries where it was possible to contrast tion should equal the international mar- duction for the domestic market. Such a
performance before and after the policy ginal rate of transformation, in the absence strategy generally entails less of a departure
changes, the growth rate clearly jumped of monopoly power in trade. One must from free trade and equalized incentives
sharply after adoption of the export- bear in mind that developing countries, than does an inward-oriented strategy.
oriented strategies; and third, the sustained with their relatively smaller economies, are A glance at some countries and territories
high growth rates indicated that outward- unlikely to have monopoly power in im- that have been successful as exporters (at
oriented policies created dynamic effects in porting manufactured goods, which are certain periods or consistently) indicates
most often the subject of protection. (The the range of policies followed. Singapore
marginal rate of transformation is defined appears to have followed interventionist
as the amount of one commodity that must policies, while Hong Kong was genuinely
be forgone in order to free resources to laissez-faire, with Brazil, Korea, and Taiwan
This article is based on a chapter entitled "Compar-
produce a specified amount of another Province of China lying somewhere in be-
ative Advantage and Development Policy Twenty commodity. One good (A) can be "trans- tween. Interventions generally were in the
Years Later," included in Economic Structure formed" into another (B), if production of form of incentives rather than imposition
and Performance: Essays in Honor of Hollis B. the first is reduced and resources trans- of direct controls. Most successful exporters
Chenery (M. Syrquin, L. Taylor, and L. VJest- ferred to the production of the second good. also provided incentives across-the-board
phal, editors, Academic Press, New York, 1984). The marginal rate of transformation shows instead of differentiating by commodity
how much extra output of B could be groups.

20 Finance & Development/June 1985

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export promotion
Salient characteristics
The characteristics of import-substitution
and export-oriented regimes vary widely
according to local conditions, especially
those prevailing in factor markets. None-
theless, there are some fairly uniform
features, and for present purposes a
few stylized facts can be presented to high-
light the differences between import-
substitution and export-oriented regimes.
• Import-substitution regimes generally
have strict and time-consuming licens-
ing procedures for imports of manufac-
tured producer goods; export-oriented re-
gimes permit ready access to imports of
intermediate and capital goods, at least to
exporters.
• Import-substitution regimes are charac-
terized, inter alia, by overvalued exchange
rates (fostering excess demand for foreign
exchange, which is held in check by the
licensing process). Since domestic produc-
ers of import substitutes would receive a
substantially lower price for their products
in the world market than they do behind
the wall of protection under the import-
substitution regime, it rarely pays them
to expand production beyond the demand
of the domestic market; export-oriented
regimes have fairly realistic exchange rates
and provide at least as much, if not
more, incentive to sell abroad as to sell
domestically.
• Generally, virtual prohibition of im-
ports is needed to sustain import substitu-
tion; either imports are prohibited, or a
wide range of tariffs is imposed on different
products at a level high enough to make
their import uneconomic. Under export pro-
motion most incentives apply uniformly to
all exporters and are based on either the
value or value added of export sales.
• Import-substitution regimes are charac-
terized by quantitative restrictions or pro-
hibitive tariffs for many commodities;
export-oriented policies normally avoid
©International Monetary Fund. Not for Redistribution
Experiences of the successful exporters
Annual rate of growth of:
Dollar
Real value of
Country/territory Period GDP exports Exports Investment
(In percent) (As percentage of GDP) '
Brazil 1960-67 4.1 3.7 7 14
1968-73 11.5 16.5 8 23
Hong Kong 1963-78 8.2 9.2 99 28
Korea 1953-60 5.2 5.7 3 11
1960-78 9.6 28,4 29 35
Singapore 1965-78 8.6 8.7 187 39
Taiwan Province of China 1960-76 8.7 20.9 47 28
Sources: United Nations, Yearbook of National Accounts Statistics 1 966, 1 975, and 1 979; and World Bank, World
Development
1
Report 1978 (for Taiwan Province of China) and 1981.
In the last year of the period indicated.
quantitative restrictions and use (generally grow rapidly, markets become increasing-
low) tariffs with relatively simple proce- ly diverse and the economy increasingly
dures to permit exporters access to the flexible.
international market at international prices It is relatively easy to launch an import-
for their inputs. substitution policy; initially simple and ad-
The chief rationale for import substitu- ministratively straightforward regulations
tion in many developing countries is to offering protection and prohibiting com-
stimulate industrial growth. The rate of petitive imports provide adequate incen-
industrial growth normally exceeds that of tives for the few new investments. As
the rest of the economy under both import- investments multiply it becomes increas-
substitution and export-oriented trade ingly difficult and costly to monitor and
strategies. However, the industrial growth sustain this strategy. On the other hand,
rate appears to be higher and output of starting an export-oriented growth strategy
primary commodities seems to grow more is difficult and requires a combination of
rapidly under export promotion than under policies and determination on the part of
import substitution. the government that is politically difficult
Import substitution, which is rationalized to achieve. However, once started, an
in many countries as a means of reducing export-oriented growth strategy is more
dependence on the international economy, likely to be self-sustaining and gather mo-
actually seems to increase it as import- mentum. The increasing supply of foreign
substitution activities are import-intensive exchange permits additional liberalization
and require both intermediate and capital of the import regime. This strengthens the
goods from abroad to sustain production bias of the regime toward exports.
and growth. Thus, the economy becomes
vulnerable to declines in availability of What affects performance?
foreign exchange. By contrast, export pro- Three sets of factors account for the
motion seems to reduce dependence, in difference in performance of economies
the sense that foreign exchange earnings under inward- and outward-oriented re-
Finance & Development/June 1985 21
gimes. Their relative and absolute impor-
tance probably varies considerably between
countries, depending on local circum-
stances (such as size and resource endow-
ment), and political and cultural differences
that affect both the behavior of politicians
and bureaucrats and the relations between
government and business.
The three sets are: (1) technological fac-
tors; (2) economic factors; and (3) politico-
economic considerations. Technological
factors cover the nature of production func-
tions including the extent of indivisibilities
and economies of scale, and the capital
intensity of import-competing domestic
production. Economic factors refer to such
phenomena as people's responses to in-
centives and direct controls, the impact
of industry structure on behavior, and
the flexibility of the economy. Politico-
economic considerations relate to the fac-
tors that influence decision makers in mak-
ing or altering economic policies.
Technological factors
Size of markets. The small size of do-
mestic markets in developing countries
constrains their economic growth under
import-substitution policies. Even some of
the populous developing countries have
markets, however measured, that are rel-
atively small in contrast with the developed
countries. Bangladesh, for example, has a
nonagricultural income approximately 3
percent that of Sweden and less than 2
percent that of Canada, neither of which
is regarded as an economy large enough
to forgo the benefits of specialization and
international trade. Despite a large popu-
lation, the Indian market is estimated to be
less than one quarter that of Germany's,
based on the value of industrial output.
Import substitution policies inherently
tend to encourage expansion of any indus-
try only up to the size of the domestic
market (which itself may be smaller when
commodities are higher priced), and the
expansion of an activity beyond the amount
sold in the domestic market is seldom
profitable under import substitution. In an
outward-oriented economy, efficient activ-
ities can expand well beyond that point.
Indivisibilities and economies of scale.
For processes and activities that are highly
divisible and have constant returns to scale,
the size of the production unit does not
matter. There are other processes, how-
ever, where one or more indivisibilities are
important, or where there are sizable econ-
omies of scale. Capital equipment (e.g.,
heavy presses) requires a substantial vol-
ume of production if it is to be fully utilized.
Likewise, many processes or industries
(e.g., fertilizer and tires) demand a mini-
22 Finance & Development/June 1985
©International Monetary Fund. Not for Redistribution
mum size for a plant to be efficient. Other they can—indeed should—be expanded well
processes do not allow production to be beyond the size of the domestic market.
divided into numerous steps that can easily Restriction of their output levels to the
be changed. In most metal casting, press- quantities demanded in the domestic mar-
ing, and shaping activities, for example, ket would necessarily reduce the dynamic
the die or mold has to be changed whenever gains from development of the industry to
a new shape or form is to be produced. No far smaller magnitudes than would be pos-
intermediate alteration is possible. The sible if the industry could be induced to
longer the length of the production run for export. Viewed in this light, there is noth-
a given metal product, the smaller the fixed ing in the infant industry argument that
costs relative to variable costs. indicates that import substitution, or more
Import substitution policies, because they generally protection, is preferable to an
generally restrict local industries to reliance unbiased or export-oriented trade-and-
upon sales in the domestic market, lead to growth strategy.
short production runs and high average Interdependence and quality. Efficient
variable costs. An export-oriented strategy, production of most manufactured goods
however, permits a developing country, entails the use of a wide variety of inputs.
regardless of the size of its domestic market, As mentioned earlier, countries adopting
to establish plants of economically efficient inward-oriented trade strategies have gen-
size and to maintain long production runs. erally (because of foreign exchange short-
Thus, the limitations of a small size of age and in order to enforce a degree of
domestic market can be largely overcome, protection) required producers to obtain
at least for traded goods, in an export- their intermediate inputs from protected
oriented economy. Under such a regime, domestic producers, if at all possible. When
producers in a small developing country such protected producers have not main-
can obtain specialized products, which are tained satisfactory standards of quality con-
not produced domestically, at internation- trol, because of lack of competition, use of
ally competitive prices. By contrast, under their products has raised costs and lowered
import-substitution regimes, either there the quality of output in other firms.
are substantial delays in obtaining items The demands for intermediate inputs are
not domestically produced because of im- generally fairly specialized. This, in turn,
port licensing procedures and restrictions, has implied that there were few domestic
or producers must obtain them from high- producers of any particular item. Conse-
cost (possibly monopolistic) domestic quently, production stoppages (or even
sources. inadequate quality of inputs) in one sector
Factor intensities. Developing countries of the economy very quickly affect other
are usually relatively well endowed with firms and industries. These phenomena,
unskilled labor. The rate of human and in turn, raise costs for users of the inter-
physical capital formation (broadly defined) mediate goods.
is the constraint upon expansion of the Under a liberal trade regime, exporters
industrial sector in these countries. When have access to international markets for
the proportions of the human and physical their intermediate inputs. Their freedom of
factors employed differ significantly among choice permits them to tap the cheapest
industrial sectors, export promotion per- and most reliable source, thus reducing
mits a more rapid growth of value added their own production costs. That this may
and employment of unskilled labor in in- be important is suggested by the fact that
dustry for the same rate of human and in Korea, even with its relatively labor-
physical capital formation. Under these intensive consumer goods exports in the
conditions, the larger size of the interna- 1960s, approximately 50 percent of the
tional market encourages expansion of ex- value of exports represented imports of
porting industries that use relatively un- intermediate goods and raw materials.
skilled labor. Import substitution, however,
limits the expansion of these industries to Economic behavior
the rate of growth of domestic demand The relatively small size of most domestic
once production has expanded sufficiently markets implies that, when industries are
to replace imports; thereafter growth of encouraged by protection, there will be
output is tied to increases in real income either very few firms producing a given
and demand (unless costs and prices are product or the firms will be very small.
falling). Any policy encouraging competition by
Infant industry. The infant industry ar- increasing the number of firms in a given
gument has long been used to justify pro- line of activity will result in the reduced
tection. Given the experience of the export- size of each firm and hence loss of econ-
oriented developing countries, there are omies of scale. Moreover, many import-
important grounds for believing that, if restricting mechanisms indeed preclude the
there are infant industries, once developed, entry of new firms and reduce the possi-
 bility of competition regardless of the num- tation for politicians to regulate economic is far smaller, as is the scope for doing so:
ber in the industry. To cite but one example, activity rather than to create incentives. surrender of foreign exchange proceeds is
a frequently encountered licensing mech- There are obvious limits to the extent to sufficient proof of exports.
anism allocates intermediate goods and raw which quantitative controls can be imposed Overview
material imports to firms in proportion to in an export-oriented regime. Since ex-
their share of industrial capacity or output. porters must have ready access to the The growth rates of the outward-oriented
To the extent that outputs and inputs are international market for their inputs, pro- countries certainly suggest that something
in more or less fixed proportions to each vision of that access substantially reduces more than the direct impact of exports was
other and resale of inputs is either costly the scope for quantitative restrictions upon at work in accounting for the superior
or prohibited, these mechanisms tend to any category of imports. If quantitative growth performance of these countries.
render market shares fairly rigid, thus in- restrictions are highly restrictive, the re- When one examines critically some of the
ducing a lack of competition among firms. ward for evading them will be substantial. bases upon which that superior perform-
That, together with the small size of market Their enforcement is possible only with ance may have rested, most of the factors
and the limitation of expansion of individ- fairly detailed scrutiny of all incoming goods. earlier thought to have justified protection-
ual industries to the rate of growth of the That scrutiny, in turn, is inconsistent with ist regimes in fact become arguments for
domestic market, generally implies that the ready access required for exporters. intervention supporting exports instead
growth rates of most firms and industries Thus, the fact that some imports are inter- of production for a protected domestic
will be fairly uniform. Hence, changes in mediate goods used by exporters imposes market.
shares would come about more slowly than a limit on the level of protection accorded Whether that "something more" is be-
they would in a more competitive environ- to any productive activity through quanti- cause export-oriented regimes are de facto
ment. The absence of competition itself tative import restrictions. (Of course, im- closer to the optimal allocation of resources
probably cuts down the extent to which ports of luxury consumer goods do not fall under free trade or whether their superior
individual entrepreneurs concern them- in this category.) performance is the result of their ability
selves with engineering and economic Export-oriented policies by their nature to capture the dynamic gains associated
efficiency. reward those who export and do not dis- with an export-oriented strategy is still an
When industrial growth is based upon criminate among exportables. Since re- open question. What seems certain is that
the competitive international market, firms wards are based upon performance, which the existence of dynamic factors in no
can be of optimal economic size without in turn is highly correlated with the social way creates a presumption that growth in-
regard to the size or price and demand profitability of the activity, there is a greater duced via protection of the domestic mar-
characteristics of the domestic market. Low- inherent tendency toward less variability ket will be in any way superior to growth
cost firms in individual industries can ex- in incentives under export promotion than under neutral or outward-oriented trade
pand at their desired rate, unconstrained under import substitution. strategies.
by availability of raw material or the price The feedback to policy makers on the Insofar as the superior results achieved
elasticity of domestic demand for the prod- negative effects of policies is much stronger under export orientation have been the
uct. This leads to greater reduction of costs under an export-oriented policy stance than result of the behavioral differences rather
and expansion of output than that observed it is under import substitution. For exam- than the technological factors discussed
under protection. Moreover, industries with ple, an overvalued exchange rate is much earlier, the fact of openness itself, rather
comparative advantage can increase their more clearly reflected in lagging exports than of export growth, is a critical ingre-
shares of industrial output at a more rapid under an outward-oriented policy than dient for rapid increases in output and
rate when they can profitably export than would be evident through rising premiums productivity. This consideration is signifi-
when their growth is restricted to their for import licenses under import substitu- cant in evaluating the prospects for future
shares of the less dynamic domestic market. tion. It is quite possible that the constraints growth of developing countries in the con-
Thus, to the extent that competitive mar- upon the nature of policies that can be text of a potentially slower expansion of
kets induce lower-cost activities in individ- followed, and the quicker feedback to pol- world trade: if it is openness itself that
ual firms, there is a presumption that an icy makers on the effects of their policies, conveys benefits due to competition and
export-oriented trade strategy will induce are at least as important in explaining the the nature of policy instruments employed,
greater economic and engineering effi- success of outward-oriented regimes as are the gains from export orientation will be
ciency. For any given distribution of costs the economic and technological factors con- almost as great (provided the world econ-
within an industry, the possibility of ex- sidered above. However, quantifying their omy remains open) with slower growth of
porting permits more rapidly changing role would provide a significant research world trade as with more rapid growth.
market shares. Finally, changing individual challenge.
industries' shares of industrial output can One other potentially important, but
further accelerate the average rate of in- probably unmeasurable, aspect of feedback
crease of factor productivity and of the should be noted: under import substitution Anne O. Krueger
industrial sector. and direct controls over imports, firms have « US citizen, became Vice
built-in incentives to misrepresent their President, Economics and
Policy formulation activities in ways that will induce the receipt Research, of the Bank in
of more import licenses and other permis- 1982. She is on leave from
Government policy instruments that seek sions and privileges. Government officials the University of Minnesota,
where she is Professor of
to regulate and control through negative naturally suspect information presented to
Economics. She has
means (e.g., import restrictions) are less them, and thus require verification or check published extensively on
likely to achieve the intended results than producers' claims before acting on their development and trade
those that create incentives for particular applications. Under an export-oriented re- issues.
types of economic activities. Nonetheless, gime with a fairly realistic exchange rate,
there seems to be a widely present temp- the incentive to misrepresent performance

Finance & Development/June 1985 23

©International Monetary Fund. Not for Redistribution