Import substitution refers to making products to replace those being imported, notably by the less developed countries from advanced counterparts. It is a theory of economics of developing industries in less-developed countries. Notably, import substitution became a preferred approach for developing industrial economies in post-colonial time. The underlying reason is that during the first and second industrial revolutions, UK-led European colonial powers treated their colonies as suppliers of natural resources and buyers of industrial products. After independence, one of the development priorities was to pursue an import substitution strategy for developing an industrial economy. Despite the initial success of locally made-in products, sustaining and scaling import substitution have remained elusive.
Eroding labour-based value addition scope -- in the 1930s, as high as 85 per cent of automobile manufacturing work used to be performed by humans. The scene in the 2020s is quite the opposite. Similarly, over 30 years, labour requirements in apparel-making have been reduced by more than 60 per cent. Even in modern furniture-making units in less developed countries, the labour cost has dropped to as low as 6.0 per cent of the total cost of production. Besides, in the technology sector, the role of labour has been substantially reduced, reaching as low as 2.0 per cent at the final production stage-assembling. Despite wage differential and high labour content, in the 1960s and 1970s, import substitution was a less costly alternative. It is no longer valid now.
There has been a growing role of capital investment need in producing all kinds of products, starting from potato chips to silicon microchips. Knowledge and ideas in the form of capital machinery have been offering the option of improving the quality and reducing the cost -- while lowering labour content. The purpose of increasing the role of machines in production is far more than saving labour. Significant benefits are derived from higher accuracy, less wastage, and more efficiency. Automation guarantees bigger profits. But less developed countries have to import capital machinery from advanced ones.
Value addition through knowledge and ideas in production contributes to total factor productivity (TFP). Of course, education, training, and experience play a positive role in TFP. To increase that part of TFP, less developed countries have been pursuing education and training. Unfortunately, capital machinery advancement has been reducing the scope of adding value through knowledge and ideas during production. Besides, the advancement of machinery, which demands increasing capital investment, has expanded the scale of advantage. As a result, the minimum efficiency scale of many products has been exceeding the domestic market size of a growing number of less developed countries. Therefore, the sustainability of import substitution has been facing increased challenges.
Due to decreasing role of labour, increasing capital investment, diminishing TFP contribution, and growing scale of advantage, the import substitution as a less costly option has been losing its appeal. However, less developed countries are still after import substitution to show visible progress in developing industrial economies. Hence from the 1980s, they started applying tariff differentials to offer profit-making protection to sustain import substitution. However, at the dawn of the 21st century, tariff differential started facing limits. In such a situation, they started investing in infrastructure, offering free land and other incentives. Upon exhausting them, they are now offering subsidies as high as 75 per cent in capital investment and sweetening it further by providing production-linked cash incentives. In certain instances, surprisingly, such as foreign firms assembling smartphones for the local market have been getting more production-linked incentives than the salaries they are paying to the local labour force.
The extent of subsidies has reached such a stage that in many cases import substitution has become a loss-making and foreign currency-draining proposition. Does it mean that there have been no success stories? Fortunately, there are with countries like Japan and South Korea shining.
The rise of Canon from the humble beginning of making local replicas of Leica's cameras is well known. There have been many such examples in Japan and South Korea. However, how did they succeed in sustaining, more importantly, scaling up the phase of building an industrial economy through import substitution? Yes, in many cases, they began the journey of making copies through reverse engineering. But unlike many less developed countries, they focused on advancing features of products, tinkering with production processes, and capital machinery. They created the path of sustaining and scaling up industrial economy development through a blend of ideas. In many cases, notably Japanese firms recreated once-imported industrial products by changing the technology.
Thus import substitution offers an entry window for less developed countries in developing industrial economies. Besides, tariff differential, infrastructure development, TFP and subsidies or incentives no longer offer sustaining options, let alone scaling up. However, all industrial products have been evolving through incremental advancement and reinvention. Lessons from Japan and South Korea indicate that it's feasible to outperform the inventors and innovators of exporting countries in the advancement race. By winning the innovation race, less developed countries may expand the market of their import substitutions outside of their domestic market.
There has been no natural tendency to win the innovation race through increasing investment in education and research. Besides, all the indicators used in global innovation rankings are also insufficient for sustaining and scaling up import substitution. Instead, increased investment in education and R&D (research and development) for producing graduates, publications, rankings, and patents tends to have a natural tendency to get wasted. For sustaining and scaling up import substitutions, focus should be on collaborative, synchronized and timely strategic response in creating a snowball effect of value creation for winning innovation race through cumulative effect of knowledge and idea.
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