What Price Domestic Industry?

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What Price Domestic Industry? // an industry in a developing country can produce goods that are cheaper than the equivalent imports, should the government encourage that industry? The author says: "Not necessarily/' and suggests better criteria. George B, Baldwin

F YOU ASK BUSINESSMEN whether they The doctrine of "comparative costs" is about I think governments should encourage indus- as important a piece of advice as economic tries that have a comparative advantage with theory has to offer governments which want to respect to their costs, and should discourage push economic development in sensible direc- those that hold a comparative disadvantage, tions. The advice applies to all sectors of the nine out of ten will say "yes." But if you then economy—agriculture, mining, industry, tour- ask them what they mean by an industry that ism, fishing, forestry, the whole lot. Here we has a "comparative advantage," nine out of will deal only with industry, the glamour sector ten will flunk the course. They will tell you of development and the one where the question of protection is most vigorously debated. What that governments should help those industries I want to do is to present a simple and straight- whose costs compare favorably with the cost of forward explanation of the doctrine of com- imports—"industries that have a comparative parative costs (or "comparative advantage"), advantage." That is the obvious answer, but to show its relevance for development policy it is also the wrong one. Even if you go among and decision making, and to translate the a gathering of economists and government theoretical concept into operational terms. policymakers, wherever ten are gathered to- gether five will get it wrong. If Morocco can Not all governments have a policy, a formal make cement at a cost of 100 and nobody else sense of direction, about the kinds of industries can land it at Casablanca under a price of 115, they want to see develop. They prefer to re- this does not mean that Morocco has a "com- spond to ad hoc pressures, perhaps intending to parative advantage" in the making of cement. look back some day to see what their policy It may have. It may not. If Nigeria can brew has been. But the governments of most devel- beer at a cost of 100 and European beer can oping countries do have some general ideas of be landed in Lagos at 80, it does not follow what they would like to see happen. At one that Nigeria is at a comparative disadvantage extreme is the fairly common policy of self- in brewing beer. It may be. It may not be. sufficiency, a policy that leads to protection for

©International Monetary Fund. Not for Redistribution Domestic Industry almost every project that asks for it. Any- production (including a normal profit) were thing short of self-sufficiency must rest on some M$35, that particular industry would be repre- set of principles that forms the basis of a more sented by industry No. 1, where domestic pro- selective policy. Self-sufficiency may look at- duction costs are only 70 per cent of the c.i.f. tractive for many reasons, some sensible, some price of imported cement. If we compile such foolish. One of the strongest motivations is the ratios for a large number of industries and ar- hope of saving foreign exchange by the es- range the ratios in ascending order from left to tablishment of industries to manufacture goods right, we arrive at the picture shown for coun- that were formerly imported. However, there try A. All the industries which lie above the is not much evidence that industrialization for "equality line" have production costs higher the sake of import substitution does in fact than the c.i.f. price of imported goods. Each of reduce the demand for imports. More often these industries is at an absolute disadvantage than not such a policy only raises the price of with respect to imports, but inside the country industrial goods in the economy and distorts each holds a comparative advantage over all the pattern of investment away from the lines domestic industries that fall to its right. of comparative advantage. An industrialization The "Law of Comparative Costs" says policy guided by correctly applied tests of com- that the last point—where a given project parative costs is far more likely to help the falls in this ranking of all domestic pos- balance of payments than one guided primarily sibilities—is the only thing that counts. by a desire for import substitution without A country will be better off in every way paying attention to costs. The latter test has —its living standards and its balance of much too narrow a basis and covers too short payments—if it encourages activities that a period of time for making decisions about lie toward the left-hand end of the scale how resources should be allocated. "Compara- and discourages those that lie to the right. tive costs" provides a much safer lead. If a country were limited to establishing only The Law of Comparative Costs those industries in which it enjoyed an absolute advantage, its opportunities might be narrowly The theory of comparative costs can be restricted. For example, the lower half of the understood easily from the chart on page 27. chart shows the extreme case of a country This chart represents a ranking of a country's where, under existing exchange rates, no in- present or proposed industries according to a comparison of domestic production costs and dustry enjoys an absolute advantage—it cannot 1 find any modern industry whose costs will be the c.i.f. price of the imported good. Thus, if the top diagram referred to-Malaysia, and if below the cost of imports. The theory of com- the c.i.f. price of cement at Malaysian ports parative advantage relieves a country from the were M$50 and the domestic ex-factory cost of bleak prospect of not having any industries to start. Some industries will have costs that come 1 "Cost insurance freight"—i.e., the delivered cost at much closer to imported goods than other in- the point of import but excluding all tariff duties or dustries. If we compare the international cost other taxes, or subsidies, of either the importing or exporting country. position of the industries at the left of the

©International Monetary Fund. Not for Redistribution Finance and Development scale with those on the right, they are ob- duction costs have time to be affected by these viously in a much less disadvantageous posi- higher import costs, the devaluation has the tion. If the government had to decide which effect of extending the number of industries industries to start, it would encourage those at that enjoy an absolute advantage. Since these the left and discourage those at the right. Of industries differ greatly in the extent to which course, if there were some way by which con- they rely on imported capital goods, spare sumers could buy these goods at world prices, parts, supplies, fuels, and raw materials, the this would be much better than starting up the devaluation will quite quickly produce second- "least disadvantageous" industries. If the coun- ary changes in the domestic cost structure try had very favorable mineral or agricultural which will lead to some reshuffling of the resources, it might do its theoretical "best" if ordering of industries. Thus, comparative ad- it started few if any industries and concen- vantage does not depend wholly on a country's trated heavily on mining or oil or agriculture. endowment of resources—natural, human, and Kuwait probably conies close to such an institutional. It depends partly on the relative extreme. shares of domestic and foreign exchange costs A somewhat more realistic way out of the in total costs. Since the share of foreign ex- high-cost situation pictured in the chart is to change costs will usually change somewhat devalue the currency. This tends to make the when the exchange rate changes, the ranking price of imports rise more than the price of of industries by comparative costs will also domestic goods, i.e., it gives rise to some cases change. of absolute advantage. But while devaluation may put a country into a more realistic rela- What Gives an Industry Comparative tionship to world prices, the country should Advantage? still worry about "comparative costs" in decid- If an industry falls to the left in the chart ing which industries to start. it is mainly because of the following: Effect of Devaluation Raw materials: the existence of a domestic raw material that is efficiently produced and The chart also shows the effect of devalua- which constitutes a relatively large part of final tion (in country A). The original "equality product costs. Cement, bricks, oil, mining, line" was fixed by calculating the price of im- timber extraction, and food processing are ported goods using a given exchange rate. The common examples. higher "equality line" shows the effect of a 20 per cent devaluation of the currency. The im- Transport costs: the effect of transport costs mediate effect is to make all imports more ex- that are high in comparison to the value of the pensive by 25 per cent.2 Unless domestic pro- product. This makes it hard for imports com- ing from a long way off to compete with prod- 2 If the exchange rate changed from $1.00 to $0.80, ucts made near the market. foreigners could then buy a unit of currency for 20 per cent less. But importers who wanted to buy $1.00 Wages: high labor productivity, especially would have to pay 25 per cent more, i.e., enough to buy $0.80 plus $0.20. if wages are high.

©International Monetary Fund. Not for Redistribution WHICH IS CHEAPER: DOMESTIC PRODUCTION OR IMPORTS?

Economies of scale: a market large enough everyday world of practical decision making by to permit establishment of economically sized ministries and tariff commissions and develop- plants in industries where economies of scale ment banks nobody pays much attention to are important. comparative costs, only to absolute costs. This is because most people think in terms of how Acquired skill: the existence of experience individual producers will measure up to compe- and know-how based on historical speciali- tition, not in terms of how to allocate resources zation. This is Adam Smith's famous explana- for the good of the country. Since the main tion of why certain firms, industries (and even business of economics is to help people im- individuals) become more efficient than others prove their use of resources, it is worth seeing even though all have equal access to the same if comparative advantage can make more of a raw materials. Of course, specialization in a contribution to this objective than it has in the country has to be based on a sensible use of past. I suspect it can. resources—a bad project should not get protection simply because the promoters promise There are plenty of difficulties in compiling to specialize! The specialties of country A usable data for ranking industrial proposals open up other production opportunities in according to their comparative costs. But these countries B, C, D, etc., where all trading part- difficulties can be overcome at least to the ners benefit by not trying to establish all in- extent1 of permitting a rough classification of dustries and by filling some of their needs at industries into, say, three groups, e.g., "com- lower cost through trade. paratively advantageous," "comparatively disadvantageous," and "borderline." In any coun- Where, on balance, these characteristics are try at any moment in time it would certainly present, industries will tend to fall on the left not be necessary to compile an exhaustive list side of the chart; where their opposites are of every conceivable industry that might be present, we have right-hand industries. proposed or to fit each industry studied into its The ordering of a country's industries in re- exact, unambiguous position on the chart. All lation to the price of imported goods is not we need is approximate information sufficient static. The chart would have to be kept under to permit broad classifications. A country continual revision. As management and labor could develop such standards with only a acquire (or lose) specialized skills, and as modest investment of time and energy by a sources of raw materials, fuels, and energy are handful of people. developed (or exhausted), and as technology Let us review some of the difficulties in changes, both comparative and absolute ad- gathering the necessary data, beginning with vantages will change. the domestic costs of production. The purpose is to collect cost figures for as many existing But Is it Practical? or proposed domestic industries as feasible. The theory of comparative advantage is Even for existing industries figures may be hard traditionally presented in terms which seem to to get, since firms are often secretive about pro- make it "only theory." When it comes to the duction costs. However, unless an industry is

©International Monetary Fund. Not for Redistribution Domestic Industry monopolistic, so that prices are well above they reflect less than full costs. Once again, costs, one can take prices as a reasonable ap- there is considerable room for the exercise of proximation of "costs plus normal profit." judgment. Price quotations often involve ambiguities and Such uncertainties mean that comparisons of variations, but it is almost always feasible to domestic and import costs often do not have a arrive at usable figures. high degree of objective accuracy. Compari- Proposals for new industries present a differ- sons become most useful when they point to ent set of problems. Cost figures have to be extreme results, i.e., to exceptionally high or based on estimates. The feasibility studies on exceptionally low ratios of domestic to im- which major projects are based usually assume ported costs. In the great middle ground where operating rates and levels of managerial and the figures do not speak loudly there is much labor efficiency similar to those found in in- room for decisions based on judgment and dustrialized countries. Such levels are not qualitative considerations. likely to be reached for a few years, perhaps It would be entirely feasible to build up and many, so that initial production costs are maintain a file of comparative advantage almost always higher than those presented in figures as an aid to decision making by govern- feasibility studies. It would clearly be incor- ment agencies, development banks, tariff com- rect to make decisions on the basis of high missions, and other bodies. One could begin short-term costs if there were reasonable pros- by collecting c.i.f. price quotations for a man- pects that the industry would reach a lower ageable list of commonly imported items. level of costs within a reasonable period (2 Within a few months one or two energetic and years? 5 years? 10 years? 30 years? In short, resourceful junior research officers could set up how long does "infancy" last?). There is thus files on-perhaps 50-75 products. Most of the considerable room for judgment in determining information would have to be collected by what level of production costs should be used talking with importers, foreign sales repre- in comparing domestic and foreign goods. sentatives in the country, and government pur- Similarly there are often difficulties in meas- chasing officers. The research department of a uring the cost of imported goods. One problem development bank is probably the most prom- is that of short-run price changes, which make ising place to have this work done, though it difficult to tell just what a representative certainly not the only one. At the start there price is. An even more difficult problem occurs would need to be central direction to assure when imports are being sold at prices that do reasonable standardization of the classification not reflect full costs—the familiar problem of system, the data to be collected, and so forth. "dumping." This may occur even without any The gathering of "numerator" information government subsidies in the exporting country: (domestic production costs) can be undertaken manufacturers often quote export prices below by similar methods, mainly by building up data full costs in order to gain business and keep on production costs and selling prices of in- their plants busy. It is often difficult to tell dustries already in existence and then adding when c.i.f. prices represent full costs and when estimated costs for new industry proposals as

©International Monetary Fund. Not for Redistribution Finance and Development they come along. If no existing agency in a price quotations that it is better not to publish country had the manpower or budget to do the them. But whenever important projects are initial data collection necessary to set up the proposed in any country, a considerable effort initial rankings, the job could be given to a has to be made to establish the international consultant or research institution. prices against which domestic production costs will have to be measured. This effort has to be From such an effort there would emerge, duplicated in many countries, by many insti- quite quickly, a rough standard for judging tutions, on many different occasions. With the whether or not a particular industry looked like pace and breadth of industrialization bound to an attractive use of the country's resources. accelerate over the years ahead, would it not be useful to establish a regular price-reporting A Proposal service for the more standardized manufactured As noted, c.i.f. price data available in in- goods that move in international trade? dividual importing countries do not reveal A start on such an effort had indeed already much about the validity of the prices—whether been made in recent work done by the (priv- or not they are "fair" prices or may represent ate) National Bureau of Economic Research in "dumping." The only way to judge this issue New York.3 The time is ripe to build on these for any large number of goods is to compare beginnings. The resulting information would sales prices in different markets. If there are help businessmen judge their absolute advan- gross inequalities for similar goods that cannot tage (how their costs compare with the de- be explained by transport costs, then the prices livered cost of imports) and would help at the lower end of the scale may be presumed development agencies judge the vital matter of to reflect sales below full costs. comparative advantage—i.e., discovering the At the present time international price in- direction in which national resources should be formation is much better organized for raw pushed to move the country up to higher levels materials than for manufactured goods. It is of living. time to push for an improvement in the avail- ability of price information for manufactured 3 See the NBER's study, Measuring International goods. There will be the usual objections that Price Competitiveness: A Preliminary Report, Oc- casional Paper No. 94, by I. B. Kravis, R. E. Lipsey, there are so many difficulties in interpreting and P. J, Bourque (New York, 1965), 37 pp.