Global general equilibrium consequences ofimport substitution: a new trade theory perspective
Toshihiro Atsumi
Faculty of Economics, Meiji Gakuin UniversityDiscussion Paper No.23-02
2024 ᖺ 3 ᭶

Global general equilibrium consequences of import substitution: a new trade theory
perspective
Abstract
This paper offers a simple theoretical account of import substitution by applying the basic
framework of new economic geography based on the tradition of new trade theory, which
introduces monopolistic competition to explain differentiated goods trade. The global
consequences of import substitution policy are explained. When a developing country blocks
imports of the modern sector to establish its own modern sector to supply domestically and replace
imports, it requires resource reallocation from the traditional sector to the modern sector within thedeveloping country, resulting in a contraction of the traditional sector. In turn, international tradein the traditional sector induces the rest of the world to increase production of traditional goods,
which is accompanied by a contraction of the modern sector. Welfare loss due to this global
decoupling of the modern sector is mostly borne by the developing country, but welfare is also
reduced in the rest of the world.

1. Introduction
Import substitution as a development strategy is a topic covered not only in development economics
but also in the field of international trade. For example, the textbook on international trade byKrugman, Obstfeld, and Melitz (2018) devotes a chapter to trade policy in developing countries,
where import-substituting industrialization is reviewed.
During the post-WWII era, particularly in the 1950s and 1960s, industrialization through importsubstitution was one basic component of economic development strategy. For example, Chenery(1955, p. 51) comments “Industrialization consists primarily in the substitution of domestic
production of manufactured goods for imports,” and Bruton (1998, p. 907) explains that “manystudents and policy makers in much of the world believed that the appropriate strategy fordevelopment was to replace imports from the rich North with their own domestic production.”
Krueger (1997, p. 12) points out that “the premises underlying import substitution policies were so
widely accepted that developing country exceptions were even incorporated into the GATTarticles.”What was import substitution? Essentially, it involved countries prioritizing domestic productionof manufactured goods over reliance on imports. In this article, I aim to provide a straightforward
theoretical explanation of import substitution to enhance understanding of its consequences. To
elucidate the impact of import substitution, I employ a theoretical framework based on new
economic geography, as outlined by Krugman (1991), drawing from the principles of new trade
theory, which incorporates monopolistic competition to explain trade in differentiated goods.
Specifically, import substitution is conceptualized as a scenario wherein a country, typically adeveloping nation, impedes imports of modern goods with increasing returns to scale, while
establishing its own modern sector to meet domestic demand and replace imports.
Through formal analysis, this process is shown to necessitate a reallocation of resources from thetraditional sector to the modern one within the developing country, resulting in a contraction of theformer. As highlighted by Bruton (1998, p. 914), import substitution often entails the "squeezing"of agriculture to finance burgeoning manufacturing activities. Consequently, international tradedynamics in the traditional sector stimulate increased production of traditional goods elsewhere in
the world, leading to a concomitant contraction of the modern sector and impacting global welfare.
In the next section, I present a two-sector international trade model with a modern, increasing
returns to scale sector and a traditional sector producing a homogeneous good, characterized by thefollowing asymmetry: the developing country exports the homogeneous good while importing
differentiated goods from the modern sector in the rest of the world. In section 3, I analyze theglobal general equilibrium effect of the developing country turning to import substitution, followedby concluding comments.
2. Trading equilibrium of a developing country and the rest of the world
2.1 Assumptions
The developing country
The developing country produces only a homogeneous good in the traditional sector. It exports thehomogeneous good to the rest of the world to import differentiated goods produced by the modern
sector in the rest of the world.
1

Consumer preferences
There are two types of goods. Differentiated goods and a homogenous good. All consumers areassumed to have the same preferences. These preferences are described by the following two-tierstructure:(1a)ܷ = ‫ܯ‬௠ ܶ ଵି௠ (0 < ݉ < 1)భ௡
‫ = ܯ‬ൣ‫׬‬଴ ‫)݅(ݖ‬ఘ ݀݅ ൧ഐ(0 < ߩ < 1)(1b)(1a) is a Cobb-Douglass function of the consumption of an aggregate of differentiated varieties (‫)ܯ‬
and the homogeneous good (ܶ). (1b) then defines ‫ ܯ‬as a constant elasticity of substitution (CES)
function, and ‫ )݅(ݖ‬is the consumption of each variety ݅, and ݊ is the total mass of variety. Theelasticity of substitution between any variety is 1Τ(1 െ ߩ) ‫ > ߪ( ߪ ؠ‬1).
Production technology and market structure
On the production side, a firm in the modern sector producing a particular variety requires a unitof resource and ܿ units of resource per unit output. 1 The firm thus faces increasing returns to scale.
Its total cost for producing a given amount, ‫ ݍ‬is then(2a)‫ܥ‬ெ (‫ ݎ = )ݍ‬+ ܿ‫ݍݎ‬,
where ‫ ݎ‬is the return for the resource. It is assumed that this industry is monopolisticallycompetitive.
The traditional sector is a constant returns to scale sector also using the same resource as a factorof production. A unit of the resource produces a unit of the homogeneous good. Therefore, the total
cost of producing a given amount of the homogeneous good (‫ ) ் ݍ‬is(2b)‫ ் ݍݎ = ) ் ݍ( ்ܥ‬.
Factor endowment
Total world resource for production is ܴ. A fraction, ‫( ܴݏ‬0 < ‫ < ݏ‬1), exists in the developing
country and (1 െ ‫ ܴ)ݏ‬exists in the rest of the world. The resource is not mobile internationally.
2.2 Consumer behavior
For a given income ܻ, a given price for the traditional good ‫ ்݌‬and a given price ‫ )݅(݌‬for each
modern-sector variety, the consumers problem is to maximize her utility, subject to the budget
constraint௡(3)‫׬‬଴ ‫ ݅݀)݅(ݖ)݅(݌‬+ ‫ܻ = ܶ ்݌‬.
The standard results for the demand for differentiated varieties and the homogeneous good are‫ି)݆(݌݉ = )݆(ݖ‬ఙ ‫ ܩ‬ఙିଵ ܻ(4)and(ଵି௠)(5)ܶ = ೅ ܻ,௣respectively. ߪ is the price elasticity of demand and ‫ ܩ‬is called the price index:ഐഐషభഐ௡‫ ؠ ܩ‬൤‫׬‬଴ ‫)݅(݌‬ഐషభ ݀݅ ൨1௡భ= ൣ‫׬‬଴ ‫)݅(݌‬ଵିఙ ݀݅ ൧భష഑ .

Resource here includes labor and other factors of production.

2(6)2.3 Firm behavior in the modern sector
Because of the infinite number of potential varieties and increasing returns to scale at the firm level,
each firm becomes a sole producer of a differentiated variety. The first-order condition of profit
maximization is then the equalization of marginal revenue and marginal costs. Since the demand
elasticity that each firm faces is ߪ, firms will exhibit the following mark-up pricing behavior
ଵ(7)‫ ݌‬ቀ1 െ ఙቁ = ܿ‫ݎ‬,and the price index of differentiated goods isభభ‫݌݊( = ܩ‬ଵିఙ )భష഑ = ݊భష഑ ‫݌‬.
Hereafter (݅) is dropped to focus on a typical firm.

(8)

2.4 Equilibrium
Equilibrium requires market clearing in the goods and factor markets, and zero profit of firms as aresult of free entry.
Traditional sector
Because perfect competition leads to marginal cost pricing in the traditional sector,‫ݎ = ்݌‬.
(9)
Choosing the traditional good as the numeraire and setting the return to resource equal to 1,(10)‫ = ݎ = ்݌‬1.
Modern sector
In the modern sector, zero profit due to free entry requires operating profits to equal fixed cost.
That is,‫ ݍ݌‬െ ܿ‫ݎ = ݍݎ‬.
(11)
Then, because there are no profits in equilibrium, given (10),ܻ = ܴ.
(12)
Market clearing conditions
The market clearing conditions for the differentiated goods and the homogeneous good are(13)‫ି݌݉ = ݍ‬ఙ ‫ ܩ‬ఙିଵ ܴ.
and(1 െ ݉)ܴ = ܴ െ ݊ܿ‫ ݍ‬െ ݊,(14)respectively. The left-hand-side of (14) is world demand for the homogeneous good and the righthand-side of (14) is the resource available for the traditional sector, which is equal to world supplyof the homogeneous good. Therefore, (14) is also the full employment condition of resources.
Equilibrium firm size, firm mass and real return
Using (10) and (11), we haveఙିଵ(15)
‫ =ݍ‬௖ ,and using (7), (8), (13) and (15), we have
௠ோ
݊= ఙ.
(16)
It can be confirmed that (15) and (16) satisfy condition (14). Then, equilibrium real return forresource (ߛ) is3

ߛ=௥ீ ೘ ௣೅

భష೘=቎(ఙିଵ)ቀ

భ೘ೃ ഑షభቁ
഑ఙ௖௠

቏ .

(17)

This level of ߛ is achieved globally because there are no trade costs.
3. Import substitution by the developing country
3.1 Assumptions
Import substitution is modeled in the following way: the developing country blocks imports ofdifferentiated goods from the rest of the world. The isolated local market allows infant modern
firms to supply the domestic market using local resources. The modern sector of the developing
country is technologically disadvantaged. Specifically, it is assumed that ܿǁ > ܿ , where ܿǁ 
represents the marginal input requirement of resources in the developing country. Hereafter,variables with tildes represent those of the developing country. The newly created modern firms inthe developing country are unable to export, which could be due to factors such as lack of marketing
and/or sales channels or higher production costs.
3.2 Trading equilibrium under import substitution
Traditional sector
The homogeneous good is still tradable between the developing country and the rest of the world.
Therefore, (9) and (10) still hold.
Modern sector
Analogous to the modern firms in the rest of the world, pricing behavior of the modern firms in thedeveloping country isଵ(18)‫݌‬෤ ቀ1 െ ఙቁ = ܿǁ ‫ݎ‬,and the corresponding price index of differentiated goods in the developing country becomesభభ‫ܩ‬෨ = (݊෤‫݌‬෤ଵିఙ )భష഑ = ݊෤భష഑ ‫݌‬෤.
(19)
Now that the modern sector exists both in the developing country and the rest of the world,‫݌‬෤‫ݍ‬෤ െ ܿǁ ‫ݍݎ‬෤ = ‫ݎ‬.
(20)is required in addition to (9).
Market clearing conditions
Market clearing in the homogeneous good requires(1 െ ݉)ܴ = ܴ െ ݊෤ܿǁ ‫ݍ‬෤ െ ݊෤ െ ݊ܿ‫ ݍ‬െ ݊.
Market clearing in the differentiated goods in the rest of the world requires‫ି݌݉ = ݍ‬ఙ ‫ ܩ‬ఙିଵ (1 െ ‫ܴ)ݏ‬,and in the developing country‫ݍ‬෤ = ݉‫݌‬෤ିఙ ‫ܩ‬෨ ఙିଵ ‫ܴݏ‬is required.

(21)
(22a)
(22b)

Equilibrium firm size, firm mass and real returns
Because (10) and (11) still hold, size of a typical firm in the modern sector in the rest of the world
remains unchanged, that is, ‫ ߪ( = ݍ‬െ 1)Τܿ. Using (10) and (20), we have4

ఙିଵ

(23)
‫ݍ‬෤ = ௖ǁ ,meaning that modern sector firms are smaller in the developing country. Substituting ‫ ݍ‬and ‫ݍ‬෤ into(22a) and using (7) and (8), we obtain௠(ଵି௦)ோ
.
(24a)
݊=
ఙ
Similarly, substituting (23) into (22b) using (18) and (19) respectively, we have௠௦ோ݊෤ = ఙ .
(24b)
Finally, using (15) and (24a) the real return in the rest of the world is expressed as
ߛ=௥ீ ೘ ௣೅భష೘=቎(ఙିଵ)ቂ

భ೘(భషೞ)ೃ ഑షభ
ቃ
഑ఙ௖௠

቏ .

(25a)

Using (23) and (24b) the real return in the developing country is௥ߛ෤ = ෨ ೘ ೅ భష೘ = ቎(ఙିଵ)ቀ

భ೘ೞೃ ഑షభቁ
഑ఙ௖ǁீ ௣

௠

቏ .

(25b)

Comparison of (24a) and (24b) with (16) indicates that the global mass of modern firm remains
unchanged. That is, modern firms newly operate in the developing country but the modern firms
in the rest of the world is reduced by the same mass. Resource in the developing country moves
from its traditional sector to the modern sector, thereby reducing output of the homogeneous good.
(The reduction in homogeneous good output in the developing country is ݊෤ܿǁ ‫ݍ‬෤ െ ݊෤ = ݉‫ܴݏ‬.) The
reduced amount of the homogeneous good, ݉‫ܴݏ‬, needs to be produced in the rest of the world, byreducing use of resource in the modern sector.
A numerical example of the global consequence of import substitution is shown in Figure 1. In thisexample, when ‫ = ݏ‬0.025 (size of the developing country is 2.5% of the world), real return isreduced by 55.4% in the developing country, and the rest of the world experiences 0.32% real
return loss compared to the pre-import substitution situation. The cost of import substitution ismostly borne by the developing country, but it also harms the rest of the world because thetraditional sector in the developing country shrinks as resource is diverted from the traditional
sector to the modern sector, requiring the rest of the world to reduce the firm mass or differentiatedvarieties in the modern sector to increase production in the traditional sector.

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0.095

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0.085

0.08

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0.02

0.015

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0.005

0Note: graph drawn with ߪ = 5, ݉ = 0.5, ܴ = 1000, ܿ = 0.0001, ܿǁ = 0.0002
Figure 1: Numerical example of real return to resource, under various levels of ࢙
4. Concluding Comments
What does import substitution achieve? From the perspective of new trade theory, which focuseson differentiated goods trade, import substitution effectively entails an international decoupling of
the modern sector. Trade between the modern sectors in the developing country and the rest of theworld does not occur, while trade in the traditional sector induces the rest of the world to adjust to
the decreased output of the traditional sector in the developing country by reallocating resourcesfrom the modern sector to the traditional sector. This results in welfare losses not only in thedeveloping country but also in the rest of the world.
Advocates of import substitution industrialization supported the policy, particularly for developing
countries with large domestic markets. However, as the example shows, while a larger size of thedeveloping country may mitigate the loss from the decoupling of modern sectors, the loss fromstopping imports of modern-sector goods would usually be too significant to be compensated bylocal market size alone.
The infant industry argument for trade protection was well aware of such losses from importsubstitution. During the period of protection, welfare loss is unavoidable, but it was expected that6the modern sector would grow and later compensate for the loss incurred during protection.
However, empirical evidence has shown that such future development of the protected industry isdifficult to anticipate. Luzio and Greenstein (1995) illustrate this with the case of Brazilian
computers. While computer firms were established during protection in Brazil, they never caught
up with existing manufacturers in developed countries. More generally, theoretical considerations
by Baldwin (1969) do not support using import tariffs for local industrial development.
References
Baldwin, Robert E. 1969. “The Case against Infant-Industry Tariff Protection” Journal of Political
Economy, Vol.73 No.3.
Bruton, Henry J. 1998. “A reconsideration of import substitution” Journal of Economic Literature,
Vol.36. No.2.
Chenery, Hollis B. 1955. “The Role of Industrialization in Development Programs” American
Economic Review, Vol. 45, No. 2.
Krueger, Anne O. 1997. "Trade policy and economic development: how we learn" NBER WorkingPaper 5896.
Krugman, Paul. 1991. “Increasing Returns and Economic Geography” Journal of Political
Economy, Vol. 99, No. 3.
Krugman, Paul R., Maurice Obstfeld, and Marc J. Melitz. 2018. International Economics Theoryand Policy, Pearson.
Luzio, Eduardo, and Greenstein, Shane. 1995. “Measuring the performance of a protected infantindustry: the case of Brazilian microcomputers” The Review of Economics and Statistics, Vol.77,
No.4.

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