The Structural Dynamics of Economic Development
What
policies and factors make it possible for some countries to attain sustained
and inclusive growth, while others languish? To answer this question, which is
at the heart of development economics, it is useful to start from the
observation that, throughout history, modern economies have moved successively
from subsistence agriculture to light industry, then to heavy industry,
high-tech industry, and eventually to the post industrialization phase. This
evolution proves the basis for an understanding of economic development as:
(i)
a process of continuous technical innovation leading to improved quality and/or
lower production costs of the same goods; and
(ii)
a dynamic process of industrial upgrading and structural change with new and,
different goods and services produced continuously.
The
economic literature has devoted a lot of attention to the analysis of
technological innovation, but not enough to the equally important issue of
industrial upgrading and its corollary, structural change. While no economist
believes that all rich countries are alike and all poor countries are alike,
growth models feature only minimal differences between countries. Some models
focus on only one sector and completely overlook the industrial differences
between developed and developing countries. Even the well-known Kuznets
three-sector model assumes that all countries produce the same goods, with only
differences in their relative weight. Clearly it is a modelling choice to
introduce a suitable level of abstraction. Nevertheless, it can have misleading
implications for growth analysis.
One
consequence of such modelling choices is that they pay little heed to
structural factors. These structures and the differences they imply between
countries should be the starting point for the enquiry of economic development.
It is crucial to consider the fact that countries at different stages of
development tend to have different economic structures due to differences in
their endowments. An economy’s factor endowments at any given time determine
budget levels and relative factor prices – the two most important economic
parameters at any given time. Thus, given preferences and available
technologies in an economy, the structure of its factor endowments determines
endogenously its optimal industrial structure and the economy’s production
possibility frontier. When the endowment structure is upgraded, the country’s
industrial structure must be upgraded too. And, these changes in industrial
structure necessitate changes in the social and economic structure so as to
reduce transaction costs (such as transportation or financial costs) for production
and exchanges.
The
analysis of growth dynamics should, therefore, begin with an economy’s
endowments, and its evolution over time. Following classical thinking,
economists tend to consider a country’s endowments as consisting only of its
land (or natural resources), labour, and capital (both physical and human).
These are simply factor endowments, which firms can use for production.
Conceptually, it is useful to add infrastructure as one more component of an
economy’s endowments.2 Infrastructure can be hard (tangible) or soft
(intangible). Examples of hard infrastructure are highways, port facilities,
airports, telecommunication systems, electricity grids and other public
utilities. Soft infrastructure consists of institutions (legal, regulatory, political,
security etc.), laws and regulations, social capital, culture, value systems,
and other social and economic arrangements. Both of these types of
infrastructures are critical to the viability of domestic firms: they affect
individual firm’s transaction costs and the marginal rate of return on
investments. Most hard infrastructure and almost all soft infrastructure- is
exogenously provided to individual firms and cannot be internalized in their
production decisions.
As
industrial structure is endogenous to an economy’s endowment structure, for the
developing countries to upgrade their industrial structure, they must first
upgrade their endowment structures, especially in terms of physical and human
capital.3 For instance, developing countries can upgrade by increasing their
relative share of physical and human capital. The best way to do this is for
developing countries to develop industries and adopt technologies that are
consistent with their comparative advantage and their level of economic
development. This is because when firms choose their industries and
technologies according to comparative advantages determined by local factor
endowments, the economy is most competitive. 4 As competitive industries and
firms grow, they claim a larger market share and create the greatest possible
economic surplus, in the form of profits and salaries. Furthermore, reinvested
surpluses earn the highest return possible, because the industrial structure is
optimally organized given the endowment structure. Over time, this strategy
allows the economy to accumulate physical and human capital and upgrade the
factor endowment structure as quickly as possible. As capital becomes more
abundant and hence relatively cheaper, production shifts to more
capital-intensive goods and labour-intensive goods are gradually displaced.
This
process generates perpetual V-shaped industrial dynamics - the so-called
“flying geese” pattern of economic development.
For
firms to follow the economy’s comparative advantage in their choices of
industries and technologies in the manner outlined above, a price system is
required whereby the relative factor prices reflect the relative abundance of
endowment factors. Only a competitive market can have a price system with such
characteristics. Therefore, only by embracing the market and its resource
allocation mechanisms can a developing country ensure that the right price
signals are in place to encourage firms to promote those industries whose
development is optimal for the country.
As
capital accumulates and as the endowment structure is upgraded and the country
climbs up the industrial and technological ladder, many other changes must take
place as well. First, the technology needed by firms becomes more sophisticated
and riskier as they move closer to the global frontier. Second, capital
requirements become more important, just like the scale of production and the
size of markets. Third, market exchanges increasingly take place at arm’s
length. It then becomes clear that a flexible and smooth process of industrial
and technological upgrading also requires simultaneous improvements in
education, financial, and legal institutions, as well as other infrastructures.
Yet, individual firms cannot internalize all these changes cost-effectively,
and coordination among many firms to achieve these changes will often be
impossible.
At
that point, the only entity that can coordinate the desirable investment or
change is the state. It has to play a facilitating role in dealing with market
externalities. Despite their insights on issues of market failures, old
structuralist economists treated industrial structure as exogenous and
recommended that developing countries change their industrial structure through
direct intervention and other administrative measures.
This
caused all kinds of distortions. Neoclassical critics rightly highlighted the
importance of government failures. However, by treating the distortions
introduced previously under the structuralist policies to protect nonviable firms
in designated priority sectors as exogenous, they recommended an approach to
eliminate those distortions without sufficient consideration of the endogeneity
of those distortions. They also ignored the structural differences between the
developed and developing countries and missed the specific responsibilities of
a facilitating state in the process of industrial upgrading and structural
changes.