Technological innovation versus import substitution

M Rokonuzzaman | Published: February 12, 2019 20:43:17 | Updated: February 16, 2019 20:58:43

With the growth in domestic consumption of electronic devices like smartphones, televisions, and refrigerators, the obvious strategy for developing countries is to go for local production. Import substitution has been intended to rapidly industrialise and reduce dependence on costly imported manufactured goods.  To leverage this opportunity, diverse incentives are given starting from the duty-free import of capital machinery, high import duty differential on the import of inputs and finished products, to subsidised availability of utilities as well as infrastructure. In developing countries, basically low skilled labour and limited raw materials are added to further process imported inputs with imported capital machinery to produce outputs, as a substitute to import of finished products. But does such a strategy succeed in creating net benefits? By pursuing this strategy, is it possible to develop sustainable industrial economy? In retrospect, developing countries could not succeed in crafting a sustainable growth path out of this strategy. Rather some countries like Argentina have become poorer. Argentina has slipped from among top 10 richest countries in the 1930s to the 87th position-based on per capita income, as reported by recent Heritage Foundation Research. Moreover, technological progress has weakened the import substitution strategy further. Here are a few areas that can be considered to assess cost-benefit analysis of import substitution strategy:

i) SOFTWARE-INTENSIVE TECHNOLOGY IS GETTING BETTER THUS SUBSTITUTING LABOUR: More software installed into machines for their operations are making capital machineries smart. As a result, the substitution of labour with technology is contributing to quality improvement and cost reduction. To leverage this potential, producers are adopting labour as well as cognitive capability saving capital machinery to consequentially and rapidly reduce the labour content in production. Moreover, a growing number of industrial products are seeing increasing volumes of software content. For example, almost 30 per cent cost of a mid-priced model of any smartphone brand in the market is because of the phone's software content. The local labour requirement of building (basically, copying) this software content in products is virtually zero. As a result, the labour-centric comparative advantage of developing countries in support of import substitution has been eroding very rapidly

ii) ECONOMIES OF SCALE AND SCOPE ADVANTAGE MAKE IMPORT SUBSTITUTION LESS ATTRACTIVE: Due to the increasing role of software in capital machinery, and in some industrial products, the economies of scale and scope have been rapidly increasing. As a result, low volume production for meeting domestic demand only does not allow full exploitation of the scale and scope advantages. Additionally, the cost of import substitution often exceeds the international cost levels. This is one of the reasons behind Apple not producing all the physical components of the iPhone. Instead, Apple encourages some of the component suppliers to sell the same component to competitors in order to benefit from scale. Producers manufacturing a family of products as opposed to just one or couple of them often befit from the scope, as some of the components or software assets are reused in multiple products thus reducing the cost. On the other hand, the purpose of producing just for meeting the local demand does not offer the same advantage to import substitution producers.

iii) LIMITS INNOVATION CAPACITY DEVELOPMENT: Import substitution strategy for leveraging low-cost labour often discourages governments of developing countries to invest in technology development and innovation. As technological development invariably kills jobs, developing countries shy away from investing in research and development (R&D). Unfortunately, they fail to succeed to protect their workforce in the long run as imported technology eventually kills job opportunities. 

iv) INCREASES INEQUALITY: Often tax incentives ensure profitable replication of industrial products to meet domestic demand. This provides few producers with an easy path to accumulate wealth. For example, many developing countries are getting into mobile phone assembling as they are targeting a large domestic market. Tax differentials such as 32 per cent on import of finished handsets and 18 per cent on locally assembled ones are attractive enough to drive local assembling of the mobile phone handsets. But, local value addition through labour in such an assembling process is often less than five percent of the price of the handset. As a result, often the government's tax proceeds to the hands of a few. Such a strategy has been one of the root causes of a disproportionate rise in the segment of rich people in developing countries. This is leading to growing inequality in developing countries.

As reported in the media, recent research has found that import substitution strategies pursued by many developing countries have led to high cost and low quality of delivery. Consumers in some developing countries are even paying more than 60 per cent over the international price level for many locally-produced import substitutions. By pursuing import substitution strategy over the last 50 years, most of the developing countries could neither succeed to make their domestic industrial capacity globally competitive nor open new export windows. Often they could not sustain the early success of the industrial economy through import substitution. As a result, in many situations, they suffered premature deindustrialisation. Along the way, citizens paid a higher price than the international level for locally produced inferior quality products. Once subsidies could no longer offset inefficiency, entrepreneurs often ended up becoming bank loan defaulters while governments were deprived of tax revenue. On the flip side, the said government's debt burden kept increasing as they continued to offer cash incentives to support the strategy of developing an industrial economy.

But there is no denial that import substitution can be leveraged as an entry opportunity to global industries. Through intelligently drawn up regulatory and ecosystem enrichment steps, producers can be encouraged to focus on learning, knowledge accumulation, and innovation to keep increasing internal capacity to drive up the quality and reduce the cost. In the process, the market of turning the mental capacity of a growing number of university graduates into knowledge creation driving innovation economy can be created. But, in retrospect, it was found that most of the developing countries failed to leverage import substitution to develop globally competitive, sustainable industrial capacity and create high-paying positions with focus on innovation. Instead of giving conventional incentives to acquire replication capacity out of imported capital machinery, it's time that developing countries leveraged import substitution as an opportunity to enter into innovation economy, as opposed to forcing citizens to buy lower quality locally produced industrial products at higher prices. 

M Rokonuzzaman Ph.D is academic and researcher on technology, innovation and policy.


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