Chapter 10
One obvious difference among countries is the income level.
In this chapter, we focus on developing countries, not the “advanced” nations of North
American and Western Europe.
Recall Thai/Swiss watch example
(external economies of scale)
In 60s, economists and Less Developed Countries believed that “import substitution”
was best way to jump-start the manufacturing sectors in poor countries.
Infant Industry Argument
Use import restrictions (tariffs, quotas) to provide temporary protection to domestic
manufacturing industry. Historically, the world’s 3 largest market economies had high
tariff rates on manufacturing during their development.
Case for temporary infant industry protection (when there is a potential comparative
advantage) is basically one of market failure:
1) imperfect capital markets
Don’t have banks or stock market that permit savings from established sectors
(agriculture) to be transferred to budding industry. Possibly too much corruption
(a potentially serious problem now for the U.S., given the Enron and other
accounting fiascos).
 Best policy: fix capital markets
 2nd best: protect industry
2) External economies of scale
Benefits to incurring start up costs can’t be appropriated by first firm to operate.
 Best policy: subsidize (initial) production
 2nd best: protect industry
But there are problems with infant industry argument:
 generates grandfather industries
 if a firm knows that it will get protection so long as it is not fully competitive, then has
reduced incentives to invest
Types of investments: R&D, infrastructure development
Reason? cost-reductions will reduce duration of protection period.
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Why doesn’t import substituting industrialization work?
a) “A period of protection will not create a competitive manufacturing sector if there are
fundamental reasons why a country lacks a comparative advantage in manufacturing.”
(p.260)
Poor countries are likely to lack comparative advantage in manufacturing because they
lack
i) skilled labor
ii) entrepreneurs
iii) managerial competence
These problems cannot be solved by trade policy:
“An import quota can allow an inefficient manufacturing sector to survive, but it cannot
directly make that sector more efficient.” (p.260)
Finally, why not just rely on far-sighted investors to take into account the wonderful
future prospects and endure temporary losses. This type of investment is common in
developed countries.
Reasons for import substitution rather than export growth
First of all, there is a trade-off between these, so you can’t really do both at the same
time. Resources put into import substitution don’t go to exports.
The reasons combine economics and politics – there used to be a widespread belief that
the deck was stacked against new entrants in global markets. Given this belief, the only
way to industrialize was to protect manufacturing. (of course, the East Asian tigers tore
this belief to shreds).
Existing political biases also figured in; for example, the wartime disruption of trade
forced import substitution in some countries (particularly in South America), and a
political constituency developed.
India and Brazil (Table 2) reduced their imports to levels below the U.S. But this doesn’t
really seem to have helped these economies. Argentina is another case.
Table 10-3 Effective protection of manufacturing in some developing countries (tariff
equivalent)
Mexico (1960)
26
Philippines (1965)
61
Brazil (1961)
Chile (1961)
Pakistan (1963)
113
182
271
Read Chile Case Study (p.259)
By the end of the late 1980s, it had become clear that countries that pursued free trade
were doing better than countries that had followed protectionist policies.
Economic Dualism
definition of economic dualism:
division of a single economy into two sectors that appear to be at very different levels of
development. (p.262)
Symptoms:
1) value of output per worker in modern sector may be 10-15 times that in the rest of
the economy.
2) Corresponding higher wages
3) Excess pool of unskilled labor in urban areas. These folks co-exist with the wellpaid workers (although think about what this does to the fabric of society).
India is a primary case; see the Case Study, p. 263.
Example: wage differentials. Some have argued that a higher wage for manufacturing
labor generates a social benefit (higher wage for worker, more money in the society,
particularly if the employer is a foreign firm).
Figure 10-1
Suppose that, for some reason, wages do not equilibrate across sectors: (e.g. modern
sector union that pegs wage at wm.
We could increase the value of output by shifting workers to manufacturing, letting the
wages converge. Markets are misallocating labor.
wM > wA
 too few workers in manufacturing
 if could move another worker over to manufacturing, would gain by difference
of wM – wF (other changes would net out)
Economists argued that could use trade policy to induce this relocation of workers.
Ideally, governments should target employment directly, but this may not be practical.
So, in principle, a tariff on manufactures could be justified as a second-best alternative.
However, some dispute this:
Harris-Todaro model
In dual economy, workers incur migration cost in exchange for positive probability of
getting employment in modern sector.
Results in substantial urban unemployment
level depends on
a) size of wage differential
b) probability of modern sector employment
 The higher is (a) or (b),
the greater the migration to urban sector.
 So while protection reduces (a),
it raises (b),
may actually raise number of urban unemployed.
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What causes wage differential to begin with?
A) efficiency wages
(named for malnurished workers
– higher wage
 more calories available for work)
Now refers to firms offering above market wages
if get caught shirking,
run risk of unemployment
(sustained via higher-than-equilibrium-wages),
workers work harder.
B) Economic power of unions – enhanced in industries protected by import quotas (this
is where trade policy comes in)
Some contend that trade policy is actually a cause of economic dualism. What do you
think?
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Export-led Growth
3 groups of countries that experienced high levels of growth (High Performance Asian
economies – HPAEs):
 Japan
post WWII
 Tigers (Hong Kong, Taiwan, South Korea, Singapore)
mid 60’s to 1997 (Asian crisis)
 Malaysia, Thailand, Indonesia, China
late 70s to 1997
All characterized by free trade:
Table 10-4 Average rates of protection 1985 (percent)
High-performance Asian Economies
Other Asia
South America
Sub-Saharan Africa
24
42
46
34
But were these countries open during industrialization process?
Not all – several countries targeted certain industries for growth
E.g. South Korea
targeted chemicals, steel, automobiles
gave these sectors preferential credit rates, access to cheap imports of intermediate goods.
But this was costly, eventually abandoned.
Note: SKorea also got lots of aid from US to compensate for fight against North Korea.
Conclusion: openness to trade probably facilitated rapid economic growth; unclear that is
was actual cause of growth of HPAEs.
One important factor is/was the very high savings rates in these countries, allowing
investment. However, when these countries became too dependent on foreign investment
anyway, the rug was pulled out.