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Compare the relative merits of export promotion vs. import substitution as development strategies. Why do these trade policies of the developing countries need to be reformed? Developing countries can pursue two main approaches of trade, namely import substitution and export promotion. In simple words, the two terms can be defined in the following way:
From figure 1, it can be seen that domestic consumers gain as they have access to a larger quantity of goods, Q1Q3 at a lower price P2, while domestic producers suffer, as they are substituted away by cheaper foreign producers, since they want to supply Q2 at P2, but Q2Q3 is supplied by foreign producers. In the second figure, domestic industries receive tariff protection from the government that causes prices to rise from P1 to P2 which the consumers suffer through higher prices in the short run and lower consumption, Q3Q5. However, in this case the domestic producers sell at higher prices, Pt and supply increase, Q2Q4. Hence, it causes a redistribution of income. However in the long run, IS is believed to help domestics firms to achieve EOS and ultimately prices to fall below world price of P2, and that is tariffs can be removed. Food for thought LDCs typically face huge balance of payments deficits. However, IS brings this deficit down, as imports fall. Another important benefit is the increase in tax revenues, which can be ploughed back by the government into infrastructure building or other development schemes. However it comes with its share of shortcomings which include, among others: Exchange rates have to be overvalued artificially in order to protect the domestic industries. However, this means that the domestic goods are relatively more expensive to the foreign buyers, thus might lead to worsening of the current account. It has been seen in the past, allocation of resources were often distorted due to monopolization.
With EP, domestic firms get to specialize in industries in which they enjoy comparative advantage and hence can bring down unemployment. Since EP also results in intense competition, resources are more equally distributed. However, there are other factors that need to be considered too. Price elasticity of demand for most primary goods is quite low, which indicates that even when price falls significantly, demand will only increase slightly. The innovation of synthetic substitutes mean that there is increased competition in the market of primary goods for developing countries, for which developing countries are facing fall in export earnings from them. World population growth has been slowing down too, and to expect export demand to increase due to increasing population is not quite feasible. From the factors listed above, it can be seen that both IS and EP come with the shares of advantages and disadvantages. But it is quite difficult to say which strategy is more useful, since there are other factors that determine the usefulness of each, which include the global economy and external sources. Therefore, it cannot be concluded which is the superior strategy, but a combination of both seems most appealing. Reasons why the trade policies of developing countries need to be reformed: Protectionist measures, as in IS, erode the benefits of the comparative advantage theory and hence the gains that can be derived are lost. Therefore, if such tariff protection is removed, it will lead to an overall improvement, since there can be a more vibrant trade system so that the developing countries can enjoy the benefits of free trade. It is often seen that trade protection methods like tariffs remain permanently, often leading to inefficiencies and inequitable income distribution. Inefficiencies because with IS, domestic firms tend to lack any incentive to find cheaper or more efficient production methods due to the protection they receive from local governments. Therefore domestic firms produce at higher costs, transferring this as higher prices to consumers. With higher prices and lower quantities and hence lower choices, consumers are thus exploited. Here is creates an inequitable distribution of income, redistributing income from the consumers to producers. One consequence of the above mentioned inefficiency and the need to keep them permanently means is the administrative costs incurred by the government during this process. In order to fund these costs, the government needs to tax the citizens, which may lead to reducing the welfare of the economy as a whole. Another unfavorable outcome is that, when LDCs continue to be stuck at producing low value goods, and thus create very few, and at times no. employment opportunities.