Session 7 Import Substitution-

Industrialization (ISI)

1. What is ISI

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.

2. Rationale for ISI

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.
 3. Logic Behind ISI.

(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.
Two concepts of protection: nominal and effective rates of
tariff
(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.

2. Quotas. Limits on the number of units of a foreign product that may be

imported into a country. Sometimes quotas are auctioned to the highest foreign
bidder.

3. Foreign Currency Exchange Rate Adjustments. In an unregulated currency

market the domestic price of a foreign currency is determined by the rate at
which the demand for that currency would just equal supply (“equilibrium
price”). When we speak of exchange rate adjustments we are usually referring
to the domestic currency value of the US dollar (US$), the principal currency
of foreign trade (e.g. how many Mexican pesos exchange for US$ 1.00?). The
higher the exchange rate for the US$ the more expensive it will be to purchase
foreign product imports. The lower the exchange rate, the cheaper those
imports become. To adjust exchange rates governments must first accumulate
enough foreign exchange to affect the domestic supply. Governments do this
by regulating foreign trade. For example, the government of Brazil requires
that all letters of credit (i.e. purchase orders) for Brazilian exports be payable
in US$. The government deposits these US$ in the Central Bank and pays local
exporters in the Brazilian currency (Reais). The government can then use these
accumulated foreign exchange earnings to pay down the external debt or adjust
the dollar exchange rate to make imported goods more expensive. If the
government wishes to “overvalue” the Dollar relative to the Real, and thereby
make foreign imports more expensive in domestic market, it withholds US$
from domestic circulation. For example, suppose the domestic market demands
US$ 1 billion in foreign exchange but the government releases only US$ 500
million into the economy. Obviously the price of Dollars would increase since
supply exceeds demand. This situation would make the U.S. Dollar overvalued
relative to the Brazilian Real. Conversely, if the government sells more dollars
in the local currency market than are demanded, this undervaluing of the
Dollar and overvaluing of the Real would make foreign goods more
inexpensive.

(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.
Growth of Urban Industrial Employment and Labor Force in Latin
America during ISI

Period Percent Growth in Urban Percent Growth in Urban

Industrial Employment 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 Prevailing Industrial

Investment Policy
as % of Total
Investment
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%