“Import Substitution Industrialization”: Reconsidering American Economic Policy

Shortfalls in protective equipment as well as other materials during the coronavirus pandemic taught us that even a country as advanced as the United States can further strengthen and develop industries by shifting industrial strategy to a mode which is known as “Import Substitution Industrialization” (ISI). The aim of adopting ISI is to allow for less dependence on foreign exports, especially from China, and in turn generate greater domestic production. Albeit an industrial strategy adopted mostly by developing countries, ISI can be adopted by the United States primarily to achieve two objectives: coping with external trade imbalances and promoting domestic industrialization.[1]Right now, the United States is in need of achieving both objectives in order to stimulate its economy and can do so by adopting the ISI strategy used by developing countries to further industrialize, increase domestic production, and reduce trade imbalances by making its exports competitive once again in the international market. Also, tax cuts and subsidies will be instrumental in recovering businesses and industries that have largely been lost to the Middle East and Asia.

Sustained long-run economic growth requires industrialization and manufacturing. The best way to further industrialize is to place limits on specific imports to encourage their development domestically. Once developed, profits made by the substitution of imports can be used for further investment.[2] Developing an industry can be best achieved by the imposition of tariffs, which is a mode of protection despite their political incorrectness. Initially, however, the country must revert to the basic intent of developing domestic industries and manufacturing capabilities. Once the intent is there, tariff protection could then be used to carry the industry through its phases of development up to the economies of scale level. Not only will consumer goods result from intending to revert to an infant industry model approach to broadening America’s economic base, but eventually intermediate goods and capital goods will also result as both classic and traditional as well as new and innovative industries develop. The result of intermediate and capital goods will broaden the potential of development in budding sectors of the overall economy.

Ultimately, the objective of adopting an ISI strategy is to “transform into producing for export markets to earn foreign exchange.”[3]At a time when the terms of trade are deteriorating for the United States vis-à-vis China, regaining an edge in terms of trade by attempting to meet the ultimate objective of ISI becomes important. Improving terms of trade would inject vitality into American business and manufacturing. Furthermore, protected industries are able to develop in the sense that they acquire “technological mastery,” which leads to an increase in productivity and efficiency. As a result, “a strong case can thus be made that the promotion of infant industry exports provides an effective means to hasten the achievement of international competitiveness.”[4]After all, infant industry exports are an important factor in determining an infant industry’s ability to reduce costs and to become competitive internationally.

The infant industry approach may also improve efficiency and allow for a business or a set of businesses to achieve economies of scale, despite claims that an infant industry approach leads to a monopolistic market structure and thus a deteriorated quality of products due to lack of competition, and lack of competition in essence creates a disincentive to improve technical and product standards since the focus obviously becomes to solely make profits when the need to compete is absent. In a sense, heavy investments in an industry once an infant industry approach is adopted become secure since protection for the firms are provided, either through subsidies or tariffs. Firms can thus achieve economies of scale without interference by competitors and with protection firms can actually achieve high levels of efficiency and productivity. As Benjamin Franklin wrote, the basis for wealth consists of two things: productivity and savings. Once firms secure their domestic markets, the firms can then turn outward toward foreign markets and achieve optimal export targets through prudent plans and strategies.[5]

After ISI is implemented and manufacturing is developed, established, and secured, America can then design and implement a strategy that promotes exports by using domestic profits to subsidize exports. Government intervention is needed to foster the success of any export promotion strategy, for it fosters an environment –via protection – in which a firm or set of firms can attain and utilize the essential ingredients needed to shift to a strategy of export promotion: technological mastery, technical progress, supportive monetary policies, high levels of efficiency and high levels of productivity. Once a firm or set of firms shift to an export-oriented strategy, tariffs on imported inputs can then be reduced or removed in order to make the production of exports less expensive. After all, the goal of exports is to retain the power of purchasing imports. Reducing costs of production through achieving economies of scale in manufacturing as well as other industries can then lead to increased profitability and as a result more effective export promotion strategies by enabling firms to pursue rent-seeking behavior in foreign markets. In a sense, adopting an export promotion strategy allows for firms to allocate their resources in a smarter way, and smarter allocation of resources can in turn enable firms to realize increasing profits both domestically and abroad. Many countries – among them being South Korea and Japan – have in fact pursued a dual method of imposing import barriers while implementing export promotion policies and in the process businesses, industries, and governments have taken advantage of the incentives offered by both trade methods.[6]

Initially, infant industries are at such a disadvantage relative to other “adult” industries that have developed and are competitive on an international stage that justifying protection for infant industries seems unfeasible. There usually exists a gap between the average cost of production for the domestic producers and that of world competitors.[7] However, government intervention is never usually justified by economists, and the only time government intervention is justified is in the context of the following two cases:

  1. When a country invests in an infant industry that will seek to develop and become competitive relative to other firms of the same industry in other industrialized countries, and
  2. When a government seeks to impose optimal tariff protection for an industry.

Thus, when a country employs government intervention for the sake of protecting an infant industry, it is a justified economic act for the sake of expanding the industrial base of a country and as a result adding to the economic development of a country or society. The application of the infant industry theory and the protection thereof can be justified by three specific propositions:

  1. The industry must have positive and fast productivity growth
  2. The productivity growth of the protected industry must be faster than world producers or, in other words, reaching international competitiveness
  3. The long-run benefits of establishing the industry must be able to recoup the costs incurred during the learning period

By adapting to technological changes that occur in a society, investing in research and development, and simply learning by doing while being under government protection, an industry can grow out of infancy and reach adulthood in the sense that the industry becomes efficient, productive, and internationally competitive by reducing the costs associated with growth over the long-run.

Calling for infant industry protection, as has been done in this essay, has many implications which come in the form of “dynamic externalities.” By definition, “dynamic externalities” are any changes in the environment that affect a firm which result from the activity of other firms and affect a firm’s production function.[8] Infant industry protection not only impacts existing externalities which affect a firm, but also create further externalities which may shape the destiny of the entire industry, either domestically or internationally. For example, research and development – aided by the government – along with the improvement of the education system and infrastructure could positively impact the learning curve associated with the production function of firms and as a result could render a full-blown revolution in the way production takes place within an industry, not just in an internal economy but also in external economies as telecommunications, the internet, and technology advance and people communicate on an international scale. Thus, when considering infant industry protection, one must also take into account the broader yet positive implications – or dynamic externalities – which essentially shape the entire environment within which an industry can function.

            It is through the presence of dynamic externalities which makes evident that “private activity will not generate the optimal development of infant industries in a market-oriented economy.”[9] Without government intervention, industries cannot meet the first proposition associated with the theory of infant industry protection, which is fast growth. Government intervention basically promotes an investment which would otherwise be unprofitable if undertaken privately, and it also renders an investment as being socially profitable by the altering and creation of dynamic externalities that would not have been pertinent had the investment been done privately. Infant industries cannot mature without some sort of government intervention, with “mature” meaning the attainment of international competitiveness. An industry becomes mature once it has reached productivity levels equal to or higher than that of international competitors.

Also, productivity increases when the cost of production decreases. Making production less costly for firms in an industry is an instrumental operation of government intervention and protection. It helps close the initial productivity gap that exists between domestic startups in an industry and those firms and individuals that are already established in other countries. An infant may become mature and competitive on the international stage even with slow productivity growth. Thus, even with slow productivity growth, infant industry protection becomes justifiable in certain cases. Nevertheless, time is of immense value when investing in an infant industry. Only with time can costs of production fall and render the price of a product competitive in world markets. Depending on the slope of the domestic and international productivity growth patterns, the net benefit of an investment in an infant industry can be negative or positive. The level of efficiency and productivity of a domestic producer must be such that domestic prices match the competitiveness of international prices. Optimal protection is such that cost reduction occurs as a result of protection. Therefore, enough time and enough patience must be afforded to an investment in an infant industry in order to make it beneficial not only to the investors, but also to consumers as well as the international economy.[10]

The point is that successful infant industry protection cannot take place without the role of government and its strategic intervention. Carlos Asilis and Martin Richardson, in an essay titled “Infant Industry Policy and Information Revelation,” contend that governments reign superior over firms in any active policy that promotes infant industry protection due to the advantage they have over firms in information possession and as a result government’s role in any infant industry policy implementation becomes crucial to the short-term and long-term success of firms. Asilis and Richardson also argue that there are two types of governments, one which is myopic and does not take into account firm density success, whereas the other type of government is “far-sighted” and is interested in sending the kind of shocks into the industry which would filter out bad firms and in the end shape the industry to prevail both domestically and in the international market. Government’s role in the implementation of an infant industry policy cannot be underestimated, and it must be understood that government intervention through the implementation of infant industry protection actually shapes the nature of an industry either into a successful and competitive one, or one which shapes the industry to become a disappointing failure when the government is inactive in the implementation of a far-sighted policy that promotes the broadening and diversification of a country’s economic portfolio.[11]

            The economist Eric W. Bond also argues that subsidies to an infant sector are “desirable,” for they shape and form the level of entry such that it assumes the socially optimal level. Furthermore, Bond argues for government’s direct intervention into capital markets in the form of subsidized loans as opposed to indirect interventions in the form of production subsidies or tariffs mainly because direct intervention allows for moving toward the objective of maintaining entry into the industry at optimal levels whereas indirect interventions in the form of subsidies or tariffs actually create distortions in the market that may prove costly to the entire industry as well as consumers.[12]Bond also touches upon the issue of information, and implies that the asymmetry of information between firms and governments in favor of governments actually allow for governments to separate efficient firms from inefficient firms and as a result allow for the industry to reach optimal levels of efficiency and production. Governments must intervene in the development of an industry in order to obtain two pieces of private information which it otherwise would not have:

  1. The type of entrant into the industry, which may be either an entrepreneur or non-entrepreneur, and
  2. The actual probability of success of an entrepreneur after the initial period of heavy losses.

By having these two pieces of information, governments can prevent potential entrants such as non-entrepreneurs who have almost zero probability of success from entering the industry while keeping individuals with higher probabilities of success inside the industry by adjusting the incentives for staying in the industry through the initial intervention. One particular way in which governments can adjust the incentives is by adjusting the penalties associated with leaving the industry. Lowering the penalties for those with lower probabilities of success can help drive poor performers out of the industry and good performers into the industry. In any case, higher penalties for leaving the industry will keep individuals with higher rates of success from leaving the industry. Information spurs the potential for the success of an industry, and this is why information fuels the drive for governments to have the qualitative edge over the private sector in almost every regard. Informational asymmetries in favor of the private sector can give rise to capital market imperfections and as a result can lead to industry inefficiency and imperfection by allowing inefficient and underproductive individuals and firms to enter into the industry. Thus, it requires substantial knowledge on the part of governments to overcome capital market imperfections and to intervene in markets in order to drive infant industry success.[13]

            The United States of America has the potential to invest in a profitable and beneficial undertaking of an infant industry which will meet and exceed the quality of international competitors in the area of manufacturing as well as other industries. For one, the United States offers an environment that is safe and prosperous and would allow for greater services to take root. Services actually represent an investment in human capital.[14]When service capabilities increase, the likelihood for an infant industry to thrive increases as well. Services and the industries they serve can then be taken abroad, and the potency of U.S. services is evinced by the fear foreign countries have of their services sector collapsing in the face of U.S. competition.[15]That is why many countries, especially developing countries, resist U.S. entry into their markets.

Last but not least, the United States enjoys the privilege of not having a cultural policy in addition to not having to worry about making “sectoral reciprocity” commitments to its competitors. “Sectoral reciprocity” is defined by agreements between two or more countries that reduce or eliminate trade barriers for certain goods and products. The United States, due to its strong institutions and lack of cultural policy, can effectively intervene into its own economy in order to correct shortfalls that exist vis-à-vis the economies of other nations. France, which has a cultural policy, has often lamented about U.S. success in captivating the French market. Also, in negotiations on sectoral reciprocity, the United States will benefit from the outset in any arrangement, given that it is the world’s largest market.

In the end, the focus will have to be on government intervention and investment in industries such as manufacturing as well as the up and coming green industry which China is focusing on in order to undergird its superior position in the global economy. Competing with China in areas such as manufacturing and the “green economy” would be in accordance with an economic concept known as the “Kuznet’s Curve,” which suggests that economic growth in the end reduces pollution because logically economic prosperity enables the freedom of a society to proactively address an existential issue and a “collective end” pertaining to all nations and individuals, namely, climate change and environmental sustainability. After all, economics is defined as the ability to freely pursue one’s ends in life, according to Ludwig Von Mises. Without addressing the existential threat of climate change as well as other threats through a superior economic position, economies will ultimately collapse, as we saw with the current coronavirus pandemic.

[1] Alavi, Pg. 3

[2] Alavi, Pg. 5

[3] Alavi, 12

[4] Alavi, 13

[5] Alavi, 18

[6] Alavi, 26

[7] Alavi, 101

[8] Alavi, 105

[9] Alavi, 106

[10] Alavi, 107-112

[11] Asilis and Richardson

[12] Bond, 192

[13] Bond, 207-208

[14] Dam, 113.

[15] Dam, 121.

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