Import substitution is a trade and economic policy based on the premise that a developing country should attempt to substitute products which it imports (mostly finished goods) with locally produced substitutes. This usually involves high tariff barriers to protect local industries and hence import substitution policies run contrary to the concept of free trade. In addition import substitution typically advocates an overvalued currency to allow more easier purchase of foreign goods and capital controls.
Import substitution policies were adopted by most nations in Latin America in the 1950s and 1960s. They were rejected by most nations in East Asia in the 1960s, and many economists attribute the superior performance of East Asia in the 1970s and 1980s to this difference in policies. Typically, import substitution policies would result in inefficient industries which created a drag on the economy. In addition the focus of import substitution in promoting industralization typically resulted in policies which benefited industrial workers at the expense of farmers which made up most of the population of the nations involved. For example to reduce the cost of industrialization, the cost of food was often fixed at an artificially low level. In addition the licensing schemes required for an import substitution strategy led also to rent seeking behaviors which increased economic inefficiency.
As a result of the East Asian experience, import substitution policies generally became unpopular by the mid-1980s and was largely rejected by the Washington consensus.
However many economists have pointed out that the failure of import substitution should not necessarily be taken as an endorsement of free trade. They note that most East Asian countries while rejecting import substitution also maintained high tariff barriers. The strategy followed by those countries was to focus industrialization on industries which would make goods for export. The focus on export markets allowed them to create competitive industries.
By the end of the 1990's, the Washington consensus was being severely questioned. Nevertheless, there has not been a return to import substitution as a developmental strategy.
See also: border friction