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About Sambriddhi Acharya

Sambriddhi is a researcher at Samriddhi Foundation.

Import Substitution: A Hindrance To Economic Development

As Nepal’s imports vis-à-vis exports continue to surge, more and more voices in favour of import substitution through import substitution industrialization (ISI) have been gaining ground. The fundamental logic is, instead of depending on imports, these (imported) goods should be produced domestically. While it may be tempting to defend this policy on the grounds of reduced reliance on imports and promotion of domestic market, there are quite a few explicit and implicit costs such policy entails.

Developing countries generally adopt ISI with the objective of stimulating economic growth, ironically by setting up trade barriers – imposition of tariffs and/or import restriction through quotas. Protectionist mechanism as such inflates the price of otherwise cheap imports, which in turn induces people to consume domestic alternatives they otherwise would not have in the absence of import tariffs or quotas. Consumers are compelled to bear substantial welfare loss for the sake of protecting few domestic jobs. New jobs replace old ones as a result of technological advancement under what we call the process of creative destruction. Hence, domestic jobs being lost due to foreign competition is a normal phenomenon of “economic evolution”. One way to look at it is as a release of human capital to take on something else where this capital can be employed. The question then would be are the economic policies of a country conducive enough to facilitate that transition?

ISI has proved to be counterproductive time and again. Latin American countries suffered severe ramifications – ranging from overvalued exchange rates to high level of foreign debt – upon adopting this policy. Furthermore, dependence on imported capital goods intensified as a result of attempting to substitute imported consumer goods with domestic goods. There was no improvement on trade deficits whatsoever and in some cases worsened as high exchange rates discouraged exports. And finally, ISI failed to alleviate unemployment in all respects.

Nepal has witnessed soaring trade deficits over the years. A recent finding has shown that Nepal’s imports amounted to Rs.893.09 billion while exports lagged behind at Rs.67.35 billion. Experts have pointed out the need to focus on promoting import substitution industrialization. However, is enforcing import restriction really going to help domestic markets to grow? Gorakhkali Rubber Industry, a domestic tire manufacturing company, was established in 1992 with the goal of reducing dependence on imported tires from India. The price of tires manufactured by this company was more expensive than the ones offered by Indian brands, which are of course levied custom duties. Evidently, Indian brands had comparative advantage over the production of tires as they were able to manufacture them at a lower opportunity cost. Gorakhkali Rubber Industry had to eventually halt production as it faced a supply glut since no one was willing to purchase overpriced tires. The basic principle of trade – countries engage in production of goods that they have comparative advantage over – is entirely disregarded under ISI as it was the case with Gorakhkali Rubber Industry.

Export oriented industrialization (EOI) approach could be more economically viable in generating sustainable growth. Rather than imposing import restriction to retain inefficient domestic industries, Nepal should divert its attention towards industries that actually have comparative advantage in the world market and incentivize these industries to export their products. On the other hand, Nepal is still not at par with foreign producers when it comes to manufacturing capital intensive commodities, say cars. Instead of attempting to manufacture cars on its own to bring down trade deficits, the government should formulate policies that would attract foreign direct investments to establish a plant for manufacturing foreign cars in the country. This significantly shrinks the import-export gap but more importantly, technology transfer that follows foreign direct investment contributes to the extensive development of domestic industries.

Nepal needs to analyze the trade-offs involved in each case and construct policies accordingly – ISI could save a few jobs in the short run at the expense of consumer welfare, and EOI might fail to save those jobs in the short run but enhances productivity and fosters growth eventually. All policies are carved with good intentions; however, good intentions of a policy do not necessarily yield good consequences in the long run. We therefore need to get our priorities right in the first place.

About Sambriddhi Acharya

Sambriddhi is a researcher at Samriddhi Foundation.

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Aftermath – The Unintended Consequences of Public Policies: Book Review

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Public policies can give rise to unintended consequences. It is needless to say that government forms policies with good intentions – usually to eliminate existing social or economic issues and to bring socially desirable changes within the country. However, when government adopts a certain policy with the shortsighted vision of positive impact it may generate without any regards to possible ramifications such a policy could have on a long term, the policy ultimately perpetuates and aggravates the very problem it was trying to mitigate in the first place.

This book—Aftermath— raises the question of efficacy of public policies by looking into several instances when they failed to carry out their fundamental function – enhancing social well-being. From minimum wage law to alcohol prohibition, Thomas E. Hall delves into inevitable repercussions the United States faced and is still facing due to hasty implementations of several policies by the government.

In a free market, wage rate is determined by the worker’s marginal productivity. There is a voluntary agreement between the employer and the employee regarding the amount the employee gets paid. However, when the government intervenes in this consensual relationship between the employer and the employee, by setting a minimum wage rate that mandates the employer to pay no less than the stipulated amount to the employee, adverse consequences can arise. According to Hall, minimum wage law, passed with the objective of giving every employee – mainly unskilled and teenage workers – enough wage to sustain a basic standard of living, has been proved to be counterproductive. When employers are forced to pay the employees more than what they originally used to pay or when the law is binding, they either lay off workers to reduce the cost or replace them with someone more skilled. This leaves unskilled and teenage workers bereft of employment. Hall further rebukes this law for encouraging discrimination by employers on the basis of race, sex, or physical appearance when selecting a potential candidate for a job, as evidenced by employment rate of white teenagers exceeding – by a large amount – that of black teenagers in the 1950s (minimum wage rate was increased from $0.75 to $1.00 per hour in 1956).

Hall talks at length about how minimum wage law increases cost for firms, which in turn induces these firms to layoff workers in order to maintain their profit margin. Nevertheless, he neglects to address the cost incurred by taxpayers for the public assistance programs implemented to financially support citizens earning below cost of living. The author’s assessment would have been more convincing if he had provided an analysis on how much the public would have to contribute in tax in the absence of minimum wage law (for such assistance programs) and if this cost to the public is higher/lower than the social cost of implementing minimum wage law.

The author also examines the effectiveness of cigarette tax. Revenue generation along with discouraging cigarette consumption was the primary purpose of cigarette taxation when it was first implemented in Iowa in the 1920s. However, what policymakers failed to take in account while pushing this agenda was the possible outbreak of illegal activities it could entail. Hall explains how the tax incentivizes people to engage in smuggling to make substantial profit by exploiting large price disparity in different countries. This leads to the rise in organized crimes and criminal groups resorting to violence to monopolize the profit generating trade of cigarettes. Furthermore, he illustrates how the government incurs revenue loss if the tax is increased beyond a certain threshold. He argues that the government will only increase tax to the point up to which there is positive revenue growth even after factoring for the people who give up smoking as a result of increased cost of smoking. Hall concludes that excessive tax on cigarettes leads to intensified smuggling along with diminished revenue.

In retrospect, inefficiency of these public policies is clear to the government as well as the public. Hall reasons that despite the evident social and economic costs they engender, large share of public and well defined interest groups support these policies making it difficult for the government to repeal them – middle and lower income groups are proponents of progressive income tax; labor unions are convinced minimum wage makes poor better off; and non-smokers want cigarette consumption to decline.

I personally gained profound insights from this book on the history of several public policies – how they came into existence – and how they have affected well-being of the country over the years. Aftermath is definitely a constructive read for those who have ever wondered why public policy matters spark controversies; it will make the readers critically reassess government’s role in the market and whether government intervention is always justified on the grounds of “enhanced social welfare” within the country.

About Sambriddhi Acharya

Sambriddhi is a researcher at Samriddhi Foundation.

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