What Price Domestic Industry?

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 24 ©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 25 ©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.

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