Trade & Development I:
Import Substitution Industrialization
International Political Economy
Prof. Tyson Roberts
Brief history globalization &
development
• Mercantilism (1500s-1700s)
– Globalization through empire
– Imperial goal: amass the most gold
– Subsidize exports, tax imports
• Classical liberalism (1800s– early 1900s )
– Increasing free trade promoted by Britain
hegemon
– Continued promotion of trade within empires
How globalization helps developing countries
according to classical liberalism
1st Age of Globalization
• Free trade: poor countries specialize in comparative
advantage (e.g., agriculture) & import other products
(e.g., manufactures)
• Free flow of labor: workers move from laborabundant to labor-scarce economies => wages 
• Free flow of capital: capital flows freely from capitalrich to capital scarce countries => investment,
development
Example 1: Argentina in 1800s
• Economically backward compared to Britain
• Land abundant
• Labor scarce
What should we predict regarding policy preferences of
each group, and the resulting political coalitions?
Commerce and Coalitions
1st Age of Globalization (increasing free trade)
Labor scarce
relative to Land
Labor abundant
relative to Land
Capital rich
(Developed countries)
Capitalists & Landowners
for trade
Labor against
Capital & Labor for trade
Landowners against
Capital scarce
(LDCs)
Landowners for trade
Labor & Capitalists against
Labor for trade
Landowners & Capitalists
against
5
Commerce and Coalitions
1st Age of Globalization (increasing free trade)
Labor scarce
relative to Land
Labor abundant
relative to Land
Capital rich
(Developed countries)
Capitalists & Landowners
for trade
Labor against
Capital & Labor for trade
Landowners against
Capital scarce
(LDCs)
Landowners for trade
Labor & Capitalists against
Labor for trade
Landowners & Capitalists
against
Argentina
6
In 1800s, Latin America ruled by landowners;
much of Asia & Africa ruled by empires
Collective Action Cost
High
Factors Mobile &
Majoritarian Inst. (e.g.,
democracy, not oligarchy)
Rampant free riding
No trade policy coalitions
Exit (?)
Low
Rogowski
Rampant free riding
Trade policy coalitions
Exit (?)
Class-based coalitions possible,
but not necessary for victory
Factors Specific &
Majoritarian Inst.
Individual interest groups unable
to affect trade policy
Consumer groups inactive
Universalistic logroll (?)
Cross sector coalitions
(logrolling) or coalitions with
labor
Consumer groups active
Factor Specific &
Non-maj. Inst.
Standard trade policy
Model (Pareto,Olson, etc)
Lobbying for protection
Consumer groups inactive
Cross sector coalitions
(logrolling) or coalitions with
labor possible, but not
necessary for victory
Consumer groups active
Factors Mobile &
Non-maj. Inst. (e.g.,
oligarchy)
Brief history globalization &
development
• Mercantilism (1500s-1700s)
– Globalization through empire
– Imperial goal: amass the most gold
– Subsidize exports, tax imports
• Classical liberalism (1800s– early 1900s )
– Increasing free trade promoted by Britain
hegemon
– Continued promotion of trade within empires
• World Wars & interwar period (1914-1945)
– Breakdown of free trade system, nationalist, fascist &
communist movements
Crisis: WWI & Great Depression
• War => increased demand for labor => increased
power of labor in economics (unions) and politics
(votes) (esp. in sovereign nations)
• British Navy no longer strong enough to enforce
free trade policies in developing countries
• Rich and poor countries respond to crisis by
imposing controls on trade, capital, immigration
• Communists & Fascists extremely protectionist
War => increased demand for labor => increased
power of labor in economics and politics (votes)
Collective Action Cost
High
Factors Mobile &
Majoritarian Inst. (e.g.,
democracy, not oligarchy)
Rampant free riding
No trade policy coalitions
Exit (?)
Low
Rogowski
Rampant free riding
Trade policy coalitions
Exit (?)
Class-based coalitions possible,
but not necessary for victory
Factors Specific &
Majoritarian Inst.
Individual interest groups unable
to affect trade policy
Consumer groups inactive
Universalistic logroll (?)
Cross sector coalitions
(logrolling) or coalitions with
labor
Consumer groups active
Factor Specific &
Non-maj. Inst.
Standard trade policy
Model (Pareto,Olson, etc)
Lobbying for protection
Consumer groups inactive
Cross sector coalitions
(logrolling) or coalitions with
labor possible, but not
necessary for victory
Consumer groups active
Factors Mobile &
Non-maj. Inst. (e.g.,
oligarchy)
Example 2: Argentina in 1930s
• Economically backward compared to Britain
• Land abundant
• Labor scarce
What should we predict regarding policy preferences of
each group, and the resulting political coalitions?
Commerce and Coalitions
Depression of the 1930s (increasing protectionism)
Labor scarce
relative to Land
Labor abundant
relative to Land
Capital rich
(Developed countries)
Capitalists & Landowners
for trade
Labor against
Capital & Labor for trade
Landowners against
Capital scarce
(LDCs)
Landowners for trade
Labor & Capitalists against
Labor for trade
Landowners & Capitalists
against
12
Commerce and Coalitions
Depression of the 1930s (increasing protectionism)
W. European Fasicism
United States: New Deal
Labor scarce
relative to Land
Labor abundant
relative to Land
Capital rich
(Developed countries)
Capitalists & Landowners
for trade
Labor against
Capital & Labor for trade
Landowners against
Capital scarce
(LDCs)
Landowners for trade
Labor & Capitalists against
Labor for trade
Landowners & Capitalists
against
South American Populism
Asian & East
European Fascism
13
Argentina 1940s-1950s
• Juan Peron rises to power
with support of labor,
industrialists (import
competing sectors) and
military
• Implements import
substitution
industrialization policies
• http://www.youtube.com/watch?v=WxnaZ0S
ANr8
Structuralist Critique of Economic
Liberalism
• Market imperfections in developing countries
– Industrialization in modern era requires
coordination
• Complementary demand: need critical mass of wage
workers to buy manufactured products
• Pecuniary external demand: need related industries to
invest simultaneously
Coordination Problem
Electricity Firm
Manufacturer
Invest in factory
Don’t invest
Invest in Dam
Don’t invest
10, 10
-5, 0
0, -5
0, 0
Coordination Problem
Electricity Firm
Manufacturer
Invest in factory
Don’t invest
Invest in Dam
Don’t invest
10, 10
-5, 0
0, -5
0, 0
Solution to coordination problem:
“Big Push” by Government
Volta Dam, Ghana
Major electricity producer
Valco aluminum smelter
Major electricity user
Structuralist Critique of Economic
Liberalism
• Market imperfections in developing countries
– Industrialization in modern era requires
coordination
– Declining terms of trade
• Imported manufactures prices rise
• Export commodity prices fall
• Result: core country real incomes rise, periphery
country real incomes fall
Solution to Declining Terms of Trade
Problem: ISI
1. Easy ISI:
– Promote local production of consumer goods
• Sufficient local demand to enable economies of scale
• Sufficient local labor for labor intensive production
• Necessary technology available for import (in part in
form of foreign capital: machines, etc.)
• Benefits: wage-based employment, human capital
Solution to Declining Terms of Trade
Problem: ISI
1. Easy ISI
2. Second step options
– Secondary ISI
•
•
Move up to consumer durables (cars, etc.),
intermediate inputs (steel, etc.), and capital goods
(machines, etc.)
Common in Latin America, South Asia, etc.
– Export substitution
•
•
Expand consumer good production for export
Common in some East Asian countries
ISI Policies
• Government planning (5-year plans, etc.)
• Government investment
– Roads, rail, electricity, telecom, etc.
– State-owned & mixed-ownership enterprises
• Trade barriers
– Tariffs (on manufactured goods)
– Import quotas (on manufactured goods)
– Overvalued and/or multitiered exchange rates to
enable import of capital goods
Sources of funds for investment
• Foreign aid
• Foreign borrowing
• Taxes on agricultural exports (marketing
boards)
• Tariffs on imports
$2
$1
$1
Winners & Losers from ISI Policies
Winners
• Workers & firms in importcompeting industries
– Higher market share & prices
for produced goods
• Government
– Jobs, opportunities for rentseeking
• Urban residents
– Subsidized government
services
Losers
• Export-oriented farmers
– Lower producer prices =>
reduced production
• Consumers
– Higher prices for
manufactured goods
• Manufacturers in exportoriented industries (if any)
– Overvalued exchange rates
increase price of exports, etc.
Assume the world equilibrium price for cocoa is $2. How much
would Ghana cocoa farmers be willing to produce?
Price of
cocoa
3
SC
2
DC
1
2
4
6
Quantity of
Ghanaian Cocoa
Assume the world equilibrium price for cocoa is $2. How much
would Ghana cocoa farmers be willing to produce?
Price of
cocoa
3
SC
2
DC
1
2
4
6
Quantity of
Ghanaian Cocoa
How would cocoa farmers respond if the
government sets the producer price at $1?
Price of
cocoa
3
SC
2
DC
1
2
4
6
Quantity of Cocoa
How would cocoa farmers respond if the
government sets the producer price at $1?
Price of
cocoa
3
SC
2
DC
1
2
4
6
Quantity of Cocoa
ISI policies successfully promoted
industrialization & GDP growth in 60s & 70s
GDP/capita growth
1960s & 70s
Latin America
2.3%
Sub-Saharan Africa
1.4%
Middle East & N. Africa
3.7%
East Asia
5.2 %
South Asia
1.2%
Southeast Asia
3.1%
But for most countries (all but East Asia), those growth rates would not prove sustainable…
Conclusions
• International and domestic developments and
new belief systems => ISI Policies
– World Wars & Depression strengthened relatively
scarce factor owners
– Political changes strengthened workers, domestic
industrialists, urban voters, etc.
– Marxism, Structuralist critique of economic
liberalism, etc.
Conclusions
• ISI policies increased industrialization & GDP
growth, but …
• Urban workers & industrialists benefitted to
detriment of export-oriented farmers
• Governments (esp. in “weak states”) took
advantage of rent-seeking opportunities to overextend protection of inefficient manufacturers
• Budget & trade deficits left countries exposed to
global downturn