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.