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What Price Domestic Industry?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1966
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George B. Baldwin

IF YOU ASK BUSINESSMEN whether they think governments should encourage industries that have a comparative advantage with respect to their costs, and should discourage those that hold a comparative disadvantage, nine out of ten will say “yes.” But if you then ask them what they mean by an industry that has a “comparative advantage,” nine out of ten will flunk the course. They will tell you that governments should help those industries whose costs compare favorably with the cost of imports—”industries that have a comparative advantage.” That is the obvious answer, but it is also the wrong one. Even if you go among a gathering of economists and government policymakers, wherever ten are gathered together five will get it wrong. If Morocco can make cement at a cost of 100 and nobody else can land it at Casablanca under a price of 115, this does not mean that Morocco has a “comparative advantage” in the making of cement. It may have. It may not. If Nigeria can brew beer at a cost of 100 and European beer can be landed in Lagos at 80, it does not follow that Nigeria is at a comparative disadvantage in brewing beer. It may be. It may not be.

The doctrine of “comparative costs” is about as important a piece of advice as economic theory has to offer governments which want to push economic development in sensible directions. The advice applies to all sectors of the economy—agriculture, mining, industry, tourism, fishing, forestry, the whole lot. Here we will deal only with industry, the glamour sector of development and the one where the question of protection is most vigorously debated. What I want to do is to present a simple and straightforward explanation of the doctrine of comparative costs (or “comparative advantage”), to show its relevance for development policy and decision making, and to translate the theoretical concept into operational terms.

Not all governments have a policy, a formal sense of direction, about the kinds of industries they want to see develop. They prefer to respond to ad hoc pressures, perhaps intending to look back some day to see what their policy has been. But the governments of most developing countries do have some general ideas of what they would like to see happen. At one extreme is the fairly common policy of self-sufficiency, a policy that leads to protection for almost every project that asks for it. Anything short of self-sufficiency must rest on some set of principles that forms the basis of a more selective policy. Self-sufficiency may look attractive for many reasons, some sensible, some foolish. One of the strongest motivations is the hope of saving foreign exchange by the establishment of industries to manufacture goods that were formerly imported. However, there is not much evidence that industrialization for the sake of import substitution does in fact reduce the demand for imports. More often than not such a policy only raises the price of industrial goods in the economy and distorts the pattern of investment away from the lines of comparative advantage. An industrialization policy guided by correctly applied tests of comparative costs is far more likely to help the balance of payments than one guided primarily by a desire for import substitution without paying attention to costs. The latter test has much too narrow a basis and covers too short a period of time for making decisions about how resources should be allocated. “Comparative costs” provides a much safer lead.

The Law of Comparative Costs

The theory of comparative costs can be understood easily from the chart on page 27. This chart represents a ranking of a country’s present or proposed industries according to a comparison of domestic production costs and the c.i.f. price 1 of the imported good. Thus, if the top diagram referred to Malaysia, and if the c.i.f. price of cement at Malaysian ports were M$50 and the domestic ex-factory cost of production (including a normal profit) were M$35, that particular industry would be represented by industry No. 1, where domestic production costs are only 70 per cent of the c.i.f. price of imported cement. If we compile such ratios for a large number of industries and arrange the ratios in ascending order from left to right, we arrive at the picture shown for country A. All the industries which lie above the “equality line” have production costs higher than the c.i.f. price of imported goods. Each of these industries is at an absolute disadvantage with respect to imports, but inside the country each holds a comparative advantage over all domestic industries that fall to its right.

The “Law of Comparative Costs” says that the last point—where a given project falls in this ranking of all domestic possibilities—is the only thing that counts. A country will be better off in every way—its living standards and its balance of payments—if it encourages activities that lie toward the left-hand end of the scale and discourages those that lie to the right.

If a country were limited to establishing only those industries in which it enjoyed an absolute advantage, its opportunities might be narrowly restricted. For example, the lower half of the chart shows the extreme case of a country where, under existing exchange rates, no industry enjoys an absolute advantage—it cannot find any modern industry whose costs will be below the cost of imports. The theory of comparative advantage relieves a country from the bleak prospect of not having any industries to start. Some industries will have costs that come much closer to imported goods than other industries. If we compare the international cost position of the industries at the left of the scale with those on the right, they are obviously in a much less disadvantageous position. If the government had to decide which industries to start, it would encourage those at the left and discourage those at the right. Of course, if there were some way by which consumers could buy these goods at world prices, this would be much better than starting up the “least disadvantageous” industries. If the country had very favorable mineral or agricultural resources, it might do its theoretical “best” if it started few if any industries and concentrated heavily on mining or oil or agriculture. Kuwait probably comes close to such an extreme.

A somewhat more realistic way out of the high-cost situation pictured in the chart is to devalue the currency. This tends to make the price of imports rise more than the price of domestic goods, i.e., it gives rise to some cases of absolute advantage. But while devaluation may put a country into a more realistic relationship to world prices, the country should still worry about “comparative costs” in deciding which industries to start.

Effect of Devaluation

The chart also shows the effect of devaluation (in country A). The original “equality line” was fixed by calculating the price of imported goods using a given exchange rate. The higher “equality line” shows the effect of a 20 per cent devaluation of the currency. The immediate effect is to make all imports more expensive by 25 per cent. 2 Unless domestic production costs have time to be affected by these higher import costs, the devaluation has the effect of extending the number of industries that enjoy an absolute advantage. Since these industries differ greatly in the extent to which they rely on imported capital goods, spare parts, supplies, fuels, and raw materials, the devaluation will quite quickly produce secondary changes in the domestic cost structure which will lead to some reshuffling of the ordering of industries. Thus, comparative advantage does not depend wholly on a country’s endowment of resources—natural, human, and institutional. It depends partly on the relative shares of domestic and foreign exchange costs in total costs. Since the share of foreign exchange costs will usually change somewhat when the exchange rate changes, the ranking of industries by comparative costs will also change.

What Gives an Industry Comparative Advantage?

If an industry falls to the left in the chart it is mainly because of the following:

Raw materials: the existence of a domestic raw material that is efficiently produced and which constitutes a relatively large part of final product costs. Cement, bricks, oil, mining, timber extraction, and food processing are common examples.

Transport costs: the effect of transport costs that are high in comparison to the value of the product. This makes it hard for imports coming from a long way off to compete with products made near the market.

Wages: high labor productivity, especially if wages are high.

WHICH IS CHEAPER: DOMESTIC PRODUCTION OR IMPORTS?

Economies of scale: a market large enough to permit establishment of economically sized plants in industries where economies of scale are important.

Acquired skill: the existence of experience and know-how based on historical specialization. This is Adam Smith’s famous explanation of why certain firms, industries (and even individuals) become more efficient than others even though all have equal access to the same raw materials. Of course, specialization in a country has to be based on a sensible use of resources—a bad project should not get protection simply because the promoters promise to specialize! The specialties of country A open up other production opportunities in countries B, C, D, etc., where all trading partners benefit by not trying to establish all industries and by filling some of their needs at lower cost through trade.

Where, on balance, these characteristics are present, industries will tend to fall on the left side of the chart; where their opposites are present, we have right-hand industries.

The ordering of a country’s industries in relation to the price of imported goods is not static. The chart would have to be kept under continual revision. As management and labor acquire (or lose) specialized skills, and as sources of raw materials, fuels, and energy are developed (or exhausted), and as technology changes, both comparative and absolute advantages will change.

But Is it Practical?

The theory of comparative advantage is traditionally presented in terms which seem to make it “only theory.” When it comes to the everyday world of practical decision making by ministries and tariff commissions and development banks nobody pays much attention to comparative costs, only to absolute costs. This is because most people think in terms of how individual producers will measure up to competition, not in terms of how to allocate resources for the good of the country. Since the main business of economics is to help people improve their use of resources, it is worth seeing if comparative advantage can make more of a contribution to this objective than it has in the past. I suspect it can.

There are plenty of difficulties in compiling usable data for ranking industrial proposals according to their comparative costs. But these difficulties can be overcome at least to the extent of permitting a rough classification of industries into, say, three groups, e.g., “comparatively advantageous,” “comparatively disadvantageous,” and “borderline.” In any country at any moment in time it would certainly not be necessary to compile an exhaustive list of every conceivable industry that might be proposed or to fit each industry studied into its exact, unambiguous position on the chart. All we need is approximate information sufficient to permit broad classifications. A country could develop such standards with only a modest investment of time and energy by a handful of people.

Let us review some of the difficulties in gathering the necessary data, beginning with the domestic costs of production. The purpose is to collect cost figures for as many existing or proposed domestic industries as feasible. Even for existing industries figures may be hard to get, since firms are often secretive about production costs. However, unless an industry is monopolistic, so that prices are well above costs, one can take prices as a reasonable approximation of “costs plus normal profit.” Price quotations often involve ambiguities and variations, but it is almost always feasible to arrive at usable figures.

Proposals for new industries present a different set of problems. Cost figures have to be based on estimates. The feasibility studies on which major projects are based usually assume operating rates and levels of managerial and labor efficiency similar to those found in industrialized countries. Such levels are not likely to be reached for a few years, perhaps many, so that initial production costs are almost always higher than those presented in feasibility studies. It would clearly be incorrect to make decisions on the basis of high short-term costs if there were reasonable prospects that the industry would reach a lower level of costs within a reasonable period (2 years? 5 years? 10 years? 30 years? In short, how long does “infancy” last?). There is thus considerable room for judgment in determining what level of production costs should be used in comparing domestic and foreign goods.

Similarly there are often difficulties in measuring the cost of imported goods. One problem is that of short-run price changes, which make it difficult to tell just what a representative price is. An even more difficult problem occurs when imports are being sold at prices that do not reflect full costs—the familiar problem of “dumping.” This may occur even without any government subsidies in the exporting country: manufacturers often quote export prices below full costs in order to gain business and keep their plants busy. It is often difficult to tell when c.i.f. prices represent full costs and when they reflect less than full costs. Once again, there is considerable room for the exercise of judgment.

Such uncertainties mean that comparisons of domestic and import costs often do not have a high degree of objective accuracy. Comparisons become most useful when they point to extreme results, i.e., to exceptionally high or exceptionally low ratios of domestic to imported costs. In the great middle ground where the figures do not speak loudly there is much room for decisions based on judgment and qualitative considerations.

It would be entirely feasible to build up and maintain a file of comparative advantage figures as an aid to decision making by government agencies, development banks, tariff commissions, and other bodies. One could begin by collecting c.i.f. price quotations for a manageable list of commonly imported items. Within a few months one or two energetic and resourceful junior research officers could set up files on perhaps 50-75 products. Most of the information would have to be collected by talking with importers, foreign sales representatives in the country, and government purchasing officers. The research department of a development bank is probably the most promising place to have this work done, though certainly not the only one. At the start there would need to be central direction to assure reasonable standardization of the classification system, the data to be collected, and so forth. The gathering of “numerator” information (domestic production costs) can be undertaken by similar methods, mainly by building up data on production costs and selling prices of industries already in existence and then adding estimated costs for new industry proposals as they come along. If no existing agency in a country had the manpower or budget to do the initial data collection necessary to set up the initial rankings, the job could be given to a consultant or research institution.

From such an effort there would emerge, quite quickly, a rough standard for judging whether or not a particular industry looked like an attractive use of the country’s resources.

A Proposal

As noted, c.i.f. price data available in individual importing countries do not reveal much about the validity of the prices—whether or not they are “fair” prices or may represent “dumping.” The only way to judge this issue for any large number of goods is to compare sales prices in different markets. If there are gross inequalities for similar goods that cannot be explained by transport costs, then the prices at the lower end of the scale may be presumed to reflect sales below full costs.

At the present time international price information is much better organized for raw materials than for manufactured goods. It is time to push for an improvement in the availability of price information for manufactured goods. There will be the usual objections that there are so many difficulties in interpreting price quotations that it is better not to publish them. But whenever important projects are proposed in any country, a considerable effort has to be made to establish the international prices against which domestic production costs will have to be measured. This effort has to be duplicated in many countries, by many institutions, on many different occasions. With the pace and breadth of industrialization bound to accelerate over the years ahead, would it not be useful to establish a regular price-reporting service for the more standardized manufactured goods that move in international trade?

A start on such an effort had indeed already been made in recent work done by the (private) National Bureau of Economic Research in New York.3 The time is ripe to build on these beginnings. The resulting information would help businessmen judge their absolute advantage (how their costs compare with the delivered cost of imports) and would help development agencies judge the vital matter of comparative advantage—i.e., discovering the direction in which national resources should be pushed to move the country up to higher levels of living.

“Cost insurance freight”—i.e., the delivered cost at the point of import but excluding all tariff duties or other taxes, or subsidies, of either the importing or exporting country.

If the exchange rate changed from $1.00 to $0.80, foreigners could then buy a unit of currency for 20 per cent less. But importers who wanted to buy $1.00 would have to pay 25 per cent more, i.e., enough to buy $0.80 plus $0.20.

See the NBER’s study. Measuring International Price Competitiveness: A Preliminary Report, Occasional Paper No. 94, by I. B. Kravis, R. E. Lipsey, and P. J. Bourque (New York, 1965), 37 pp.

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