Industrial development program based on the protection of local infant industries through protective tariffs, import quotas, exchange rate controls, special preferential licensing for capital goods imports, subsidized loans to local infant industries, etc.
“A deliberate effort to replace major consumer
imports by promoting the emergence and expansion of domestic industries such as
textiles, shoes, household appliances,” usually requiring the imposition of
protective tariffs and quotas to protect new or infant industries. From Michael
Todaro 1994, Economic Development, p. 681.
In the “old economic order”, the “international division of labor” was such that industrialized , higher income countries specialized in the production of manufactured goods, while the low income non-industrialized countries specialized in the production of “primary” (agricultural, mineral, forests) products. In this way, it was reasoned, different countries specialize in the production of those commodities with which each enjoys a “comparative advantage” i.e. an abundant resource or factor endowment (e.g. labor, land, technology,). Countries then trade those commodities they produce for those they consume but do not produce. This meant that the low income countries would have to trade their own relatively low value-added primary sector products for the more expensive, higher-value added products in which the industrialized higher income countries specialized.
Two developments beginning around World War II made
this international division of labor untenable for the low-income developing
countries. First, the War itself forced the industrialized countries to shift
production from a civilian consumer market to a wartime military market. Tanks
and guns were produced in place of automobiles and bread toasters. This left
many developing countries which had come to depend upon foreign manufactured
consumer goods imports vulnerable to shortages of those goods. Second, a
long-term trend of declining “real prices” (prices adjusted for inflation) for
primary commodities began after World War II. This development meant that low
income countries specializing in primary commodity production received less and
less “foreign exchange” (US$) through trade, and therefore had to pay relatively
more for the manufactured goods from trade with the industrialized countries.
These “deteriorating terms of trade” meant developing countries dependent upon
the manufactured imports from the industrialized countries had to spend more
and more money to purchase those imports. Both of these developments made many
Third World leaders, especially in Latin America, to decide to promote domestic
industrialization to reduce their country’s economic dependence and
vulnerability to the First World economies. ISI became the policy strategy they
pursued to gain this economic independence.
(a)
Forward and Backward Linkages in Industrialization Processes. The goal of ISI was to
promote native/local industries to replace the foreign produced manufactured
products that were consumed as imports. A few principles of manufacturing need
to be understood: First, every industrial or manufacturing process involves
several stages of production. The number of stages in the production process is
a reflection and function of the complexity of the final product. For example,
the manufacturing process that transforms alumina into soft-drink containers
entails about 5 stages. The manufacturing process that transforms about 17
primary metals into the structure that ultimately becomes an automobile
requires over 120 stages. Note also that the “density” (number of stages) of
the manufacturing process also influences the “value added” of the final
product, and hence the final price that industrialized countries can secure for
complex manufactured products.
Generally, we classify these stages of production into 4 inter-related industrial goods sectors:
(1)
Consumer
non-durable goods sector (foods, beverages, clothes, pharmaceuticals);
(2)
Consumer
durable goods sector (appliances, autos,etc.)
(3)
Intermediate
goods sector (pressed steel, sawnwood, prefabricated plastic structures with
versatile end uses)
(4)
Capital
goods sector (e.g. blast furnaces,
pressure molds, robotic assembly devices).
For any truly autonomous manufacturing process to be
free of foreign dependency it would need to develop industries in all 4 sectors
to some degree. ISI envisaged that the “backward linkages” from the consumer
goods sectors would generate demand for the products that intermediate and
capital goods sectors would produce. Ultimately, the goal was to develop a
vertically integrated industrial economy in which a few (high capital/output)
capital goods manufacturers supplied the entire economy with the basic
components for producing intermediate goods. Then, a broader range of
intermediate goods manufacturers produced an even broader range of intermediate
goods that consumer (durable and non-durable) sectors could shape into final
consumer products.
(b)
“Economies of Scale”
The key to success in industrialization requires that individual factories achieve “economies of scale” of production.
In most manufacturing processes a point of output is
reached after which the cost of producing every additional unit of output
diminishes. Different types of industries, given their different production
functions (combinations of capital and labor, etc.) obtain different scale
thresholds or minimum levels of output necessarily to begin accruing cost
savings from large-scale output. For
example, a mechanical pencil factory may need to sell 5 million units of output
(pencils) each year before it can achieve economies of scale of production –
efficient level of production. An automobile industry may need to sell 100,000
units of output (cars) to achieve the same level of efficiency.
Clearly, the more units of anything manufactured you
can sell the better the chances that your factories (consumer goods and
intermediate, and ultimately capital goods) will achieve economies of scale,
efficient production.
In a free market global economy, industries that
produce inefficiently (without obtaining economies of scale of production)
under the protections of ISI have been subject to criticism from more efficient
foreign industries – a force driving the neo-liberal campaign for open markets.
What determines whether a country obtains efficiency
– economies of scale in production?
Market size (number of consumers, population) and purchasing power
(usually but unreliably indicated by GNP/capita). Hence, larger, richer economies were more likely to make ISI
succeed efficiently, whereas smaller countries with lower per capita incomes
were less likely to succeed with ISI.
(c)
3 ISI Strategies
Countries pursuing industrial independence all wanted complete manufacturing autonomy. In reality, hard choices forced development planners toward one of three ISI strategies:
(1)
Complete
vertical integration – All stages, all sectors (virtually impossible in most
countries over a reasonably 20-year industrialization time-line);
(2)
Selected
vertical integration- All stages, but selected sectors.
(3)
Selected
horizontal integration – multiple consumer durable/non-durable sectors serving
different markets support a single intermediate goods sector.
(d) ISI Policy Instruments.
1. Tariffs: Ad valorem taxes imposed on imported products to make them relatively more expensive than comparable domestically produced goods. Such taxes serve to protect local companies from foreign competition in the domestic consumer market.
(a)
Nominal tariff rate: Percentage difference between the price of a good with and without
protection. We can calculated the nominal tariff rate as follows:
t = p1 – p
Where t = nominal tariff rate,
p p = market price of an imported good
p1 = price of imported good with
tariff
e.g. p = 10, p1 = 12
12-10/10 = .2 or 20% tariff rate.
(b)
Effective tariff rate: When the
nominal rates of tariff for a final product and its component parts or inputs
are different can effectively increase the protection of the domestic product
beyond the nominal tariff rate. We
calculate the effective tariff rate as follows:
ERP = (Pw)(t) – (Cw)(t1)
Pw-Cw
Where, ERP = Effective Rate of Protection
Pw = Price without the tariff
t
= Nominal tariff on imported final product
Cw = Cost of the final product inputs
without the tariff
t1 = Nominal tariff on imported inputs.
For example, Consider a pair of imported Nike shoes
with market price of $ 100 (Pw). There are two different nominal tariff rates,
one for the pair of shoes itself (t,) say taxed at 50% and another for the shoe
laces, one of the shoes component parts (t1), say taxed at 10%. Assume that the
cost of producing the shoes without the tariff (Cw) is $50. Plug in the numbers
as follows:
ERP = 100(.5) – 50(.1) = 50-5/50 = .9 or 90%
100-50
Effective tariff rates vary widely between countries
and between products. For example Mexico used to have a 25% nominal rate of
tariff on many manufactured goods, while India imposed a 200% nominal rate. The
consequence of tariff protection is that the higher the effective tariff rate
the greater the difficulty for foreign manufactures to compete with protected
domestic manufactures in the final consumer goods market. Protected
industrialization between trading partners generally reduces opportunities for
export.
(d)
Effects of ISI.
While several of the large developing countries (e.g. Brazil, Mexico, India) were reasonably successful in fomenting industrialization through ISI strategies, this approach did have several negative impacts as well.
1.
Sectoral Disparities. Not all sectors of industry benefited equally. By
protecting infant industries from competition, many sectors could produce
inefficiently and survive, charging customers higher prices than foreign
counterpart suppliers. Many times those industries already established founded
domestically production intermediate production inputs more expensive than the foreign inputs that they
were buying before ISI. Either such customers successfully pressured
governments for exemptions to the import restrictions or absorbed higher costs
of their own production. Thus one sector in a final manufacturing process
sometimes benefited by discouraging the development of a domestic intermediate
input sector.
2.
Disappointing Industrial Employment Results. In Latin America anyway ISI
failed to generate the high levels of employment that government policy-makers
had hoped for (Table):
Average Percent Increase per Year
|
Decade |
Urban
Industrial Jobs |
Urban
Labor Force |
|
1950-60 |
2.6% |
3.5% |
|
1960-70 |
3.2% |
3.5% |
|
1970-80 |
3.0% |
4.3% |
In all 3 decades when ISI was the prevailing national development strategy in Latin America, the urban labor force increased at higher rates than urban industrial employment (new job creation), due to combined effects of internal migration and use of modern capital-intensive (and labor-saving) production technology .
3.
Balance of Payments. Instead of improving the situation of the old economic order based on
the trade of cheap raw materials (e.g. iron ore) for expensive finished
products (e.g. automobiles), ISI, in some cases, aggravated the balance of
payments dilemma. Why? New infant industries specializing in final consumer durable
and non-durable goods created a demand for intermediate and capital goods which
could only be purchased from abroad. As long as final goods themselves were
imported the demand for these expensive industrial suppliers did not exist. So,
while the structure of imports shifted, from consumer goods to intermediate and
capital goods, the total import bill often stayed about the same or even
worsened.
Moreover, new heavy industries created new demand for industrial fuels, especially petroleum, which for many countries had to be imported from OPEC. Indeed, oil as a percent of total imports increased from 8.7% in 1960 to 27.4% in 1983 in Latin America. The oil shock in 1973 set in motion the debt crisis of the 1980s. (see Sessions 18 and 19).
Additionally, the ISI process became highly dependent on foreign capital and expensive production technologies. Foreign direct investment in Latin America as a percent of total gross investment increased from –1.1% in 1950 to 18.1% in 1982 before the global recession (Table)
Foreign Direct Investment in Latin America
(% of total gross investment)
|
1950 |
-1.1% |
Early ISI |
|
1960 |
6.0% |
ISI |
|
1970 |
7.2% |
ISI |
|
1980 |
10.3% |
ISI |
|
1982 |
18.1% |
Early post-ISI |
|
1984 |
-0.3% |
Post ISI decapitalization |
4. Dependent Industrialization. Although intended to promote economic autonomy and independence, many of the successful industries that were created under ISI were subsequently acquired by foreign investors remitting corporate profits abroad rather than investing them in new domestic industries. Moreover, imported technologies were patented. Their use in newly formed industries required royalty payments. In consequence, a large proportion of the profits from industrialization were paid-out to foreign income remittances (Table):
Foreign Income Remittances from Latin America
(Percent of FOB Latin American Exports.)
|
1960 |
13.2% |
|
1970 |
18.1% |
|
1980 |
26.6% |
|
1982 |
48.2% |
|
|
|
5. Urbanization. Industries tend to locate in urban centers where they can achieve both “urbanization” and “agglomeration” savings. Concentrating in existing cities, ISI promoted an urban population explosion, drawing workers from other locations in search of jobs in the newly expanding industrial sector (see Session 10).
6. Inefficient Industrialization. Many (especially smaller) countries embarked on ISI strategies without having sufficient domestic market to efficiently support the production of many manufactured products. For example, every country wanted an auto industry and all of the dense backward linkages such an industry generates. However, few countries could produce and sell enough automobiles to make such production profitable. This limited market size problem constrained the effectiveness of ISI.
|
Period |
Percent
Growth in Urban Industrial Employment |
Percent
Growth in Urban Labor Force |
|
1950-60 |
2.6% |
3.5% |
|
1960-70 |
3.2% |
3.5% |
|
1970-80 |
3.0% |
4.3% |
Foreign Investment as Percent of Total Gross Domestic Investment in Latin America During ISI Years
Year |
Foreign Investmentas
% of Total Investment |
Prevailing Industrial Policy |
|
1950 |
-1.1% |
Pre-ISI
decapitalization |
|
1960 |
6.0% |
ISI |
|
1970 |
7.2% |
ISI |
|
1980 |
10.3% |
ISI |
|
1982 |
18.1% |
Global
recession/early post-ISI |
|
1984 |
-0.3% |
Post-ISI
decapitalization |
Foreign
Corporate Profit Repatriation as Percentage of Export Earnings in Latin America
During ISI
|
1960 |
13.2% |
|
1970 |
18.1% |
|
1980 |
26.6% |
|
1982 |
48.2% |