Question

answer the following questions in regard to developing country trade policies:

a) explain the theoretical rationale for important substitution policy . provide three weaknesses of this policy in practice

Answer 1

Import Substitution refers to a policy where import of a good from other country is substituted by producing it domestically by an economy. According to the theory, this policy helps in adjusting the balance of payments. When we substitute import of good we are also reducing the pressure on the foreign exchange reserves and correspondingly the balance of trade becomes favorable. On the other hand, when the good is produced domestically it provides employment opportunities in an economy along with increased circulation of money, thus, increases the rate of economic growth.

There are three weaknesses of this policy:

1) Fall in Efficiency- Due to lack of comparative advantage in producing a good domestically, a country prefers importing a good but when it is produced domestically it may be produced with lesser efficiency due to lack of technology and resources.

2) Inflation: Import substitution leads to a rise in the price of a product to the extent that due to inefficient production, costs of production rise even though the good may be less competitive globally.

3) Increase in Exchange rate: An economy carrying out import substitution may reach a balance in its trade but over a period of time there will be an over-accumulation of foreign currency which put pressure on dmoestic currency to appreciate. Therefore, this may lead to reduction in export demand as after appreciation of currency dmoestic goods becomes expensive to be imported by other countries.