Answer to Question #125080 in Economics for Joseph Danso

Question

Discuss the relative merits of import substitution versus export promotion in developing countries

Answer 1

Foreign trade strategy is not a technical concept, characterized by whether the goods are produced for the domestic market or for export. It is a set of measures of the entire economic policy, which together creates incentives for either expanding exports and integrating the economy into the world economy, or to reduce imports and isolate the economy from the outside world.

The main characteristic of the import substitution policy is the creation of artificial incentives for the development of individual sectors of domestic industry in order to increase their competitiveness in the domestic market.

During import substitution, incentives are distorted in favor of imported goods, i.e., the totality of all instruments of economic policy creates a situation where business entities receive more profit from the sale of their goods on the domestic market than from their export. Such a shift in incentives towards import substitution is, as a rule, a consequence of the establishment of high import tariffs, quotas for imports, currency control, and massive subsidies for import-substituting industries through tax, credit, customs and other benefits. In carrying out the policy of import substitution in practice, all these tools are most often used at the same time.

The policy of export promotion involves the industrialization of the economy by increasing the country's export potential. In practice, the implementation of this policy does not boil down to a strong shift in incentives towards exports and massive subsidies. Massive subsidizing of exports cannot lead to an increase in the country's exports, since a decrease in the prices of exported goods and an increase in demand for them in the world market as a result of subsidies will lead to an increase in the exchange rate of the national currency.

The latter, in turn, will restrain exports, since domestic goods will cost more to foreign buyers (or exporters' income from exports in national currency will decrease), and stimulate imports, since imported goods will be cheaper for domestic consumers. As a result, the effect of export subsidies is nullified.

However, in order to have a comparative advantage in the production of goods that require high qualifications for their production and have a capital-intensive nature, the relative provision of the country with qualified labor and capital should be higher than that of the main trading partners. As the relative security of the country with qualified labor and capital per worker increases compared with the trading partner countries, the country's comparative advantages change, and the economy begins to shift from the production of low-value goods to high-value-added goods.

It is no accident that countries that have chosen an export promotion strategy have had a faster pace of structural adjustment of the economy: in terms of economic diversification and an increase in the share of finished products with high added value in the structure of production and exports, they are significantly ahead of countries that have chosen an import substitution strategy.