Sunday, December 26, 2010

The path to prosperity: How countries become rich?

Becoming a rich country requires the ability to produce and export commodities that embody certain characteristics. We classify 779 exported commodities according to two dimensions: (1) sophistication (measured by the income content of the products exported); and (2) connectivity to other products (a well-connected export basket is one that allows an easy jump to other potential exports). We identify 352 “good” products and 427 “bad” products. Based on this, we categorize 154 countries into four groups according to these two characteristics. There are 34 countries whose export basket contains a significant share of good products. We find 28 countries in a “middle product” trap. These are countries whose export baskets contain a significant share of products that are in the middle of the sophistication and connectivity spectra. We also find 17 countries that are in a “middle-low” product trap, and 75 countries that are in a difficult and precarious “low product” trap. These are countries whose export baskets contain a significant share of unsophisticated products that are poorly connected to other products. To escape this situation, these countries need to implement policies that would help them accumulate the capabilities needed to manufacture and export more sophisticated and better connected products.

Here is a paper by Felipe, Kumar and Abdon. Their analysis is based on Hidalgo et al. (2007) and Hausmann et al. (2007)’s concept of product space, which is an application of network theory that yields a graphical representation of all products exported in the world. Products are linked through lines that represent their proximity, defined as the conditional probability of exporting one products given that they also export the other one. Countries change their export mix by jumping to products that are nearby, in the sense that these other products use similar capabilities to those used by the products in which they excel (those products in which they have revealed comparative advantage [RCA]). A country’s position within the product space signals its capacity to expand to more sophisticated products, thereby laying the groundwork for future growth. Countries that export products that have few linkages with other products or countries that have not accumulated sufficient capabilities to jump to other products cannot generate sustained long-term growth.

The focus is on manufacture and export of sophisticated and better connected products (PRODY) so that structural transformation-- whereby the economy moves from traditional, low wage sector to sophisticated, high wage sector—takes place in the developing countries. Here is more on their ranking of countries based on an “index of opportunities”. Here is a blog about Nepal’s export sophistication. The basic idea behind the whole analysis is that what countries products and export determines who they are in the world. Countries with a more sophisticated export basket growth faster.

So how does structural transformation occur? Basically, the major determinant of a country’s comparative advantage, and its trade pattern, is the relative factor endowment. Changing comparative advantage based on factor accumulation dictates a country’s export basket. If prices are right for the various factors of production so that firms select the most appropriate techniques for production, then factor accumulation leads to factor price changes, leading to changes in the techniques of production.  Countries growth by accumulating physical or human capital or by improving the way various factors of production are mixed (TFP). This brings about a change in the composition of export basket. So, structural transformation is the results of changes in underlying fundamentals such as education, financial resources, and overall productivity. That said, export diversification is not easy.

Those firms that engage in “self discovery” face cost of discovery, leading to a situation where there might be high social returns but high private costs. If new products discovery fails, then the firm incurs the cost. But, if it succeeds, then other enter the market following the discovery. This is where government intervention might be required to offset private costs if there is high social return from any venture. Similarly, export diversification requires large initial investments (high fixed costs), which the government should own up. The government could facilitate information and coordination externalities.

Here are few recommendations (adapted from the same paper) for countries with low product sophistication to escape “low-product trap” :

  • Many of the products exported by these countries are nature-made and subject to decreasing returns. Only industrialization can create an effective agricultural sector. None of these countries will ever get rich without an industrial and an advanced service sector.
  • In the traditional trap literature (à la Nelson and Myrdal) there were two ways to escape from the low-level equilibrium trap. First, per capita income must be raised, in one go, to the point where the trap would not force income per capita down again to the subsistence level. Second, the growth rate of population must decline (e.g., reduction in the birth rate or emigration), and/or that of national income increase (e.g., through technical progress or capital from abroad).Industrialization greatly increases a country’s ability to sustain a large population.
  • To a certain extent and under this view, some of these countries may need a “big push,” that is, a planned large-scale expansion of a wide range of economic activities and achieve a “critical minimum effort” (investment requirements to raise per capita income to the level beyond which the further growth of per capita income will not be associated with income-depressing forces exceeding income raising forces).
  • The above will not be enough: simply “pumping money” will not help unless a critical mass in an increasing returns sector is created. These countries will need their governments to take “strategic bets” by getting directly involved in the development of new sectors (big leaps). This, however, will be difficult for many countries in this group, as, by definition, they lack the required capabilities. These capabilities are: (i) human and physical capital, the legal system, institutions, etc. that are needed to produce a product (hence, they are product-specific, not just a set of amorphous factor inputs); (ii) at the firm level, they are the “know-how” and working practices held collectively by the group of individuals comprising the firm; and (iii) the organizational abilities that provide the capacity to form, manage, and operate activities that involve large numbers of people.
  • For this reason, it is imperative that these countries focus their efforts on accumulating new capabilities. This will require: (i) human capital to acquire skills, technology, and knowledge (in many cases, basic management, accounting, and record keeping); (ii) a higher drive to diversify and to increase sophistication by embracing a realistic industrial vision; and (iii) improvement in organizational abilities (e.g., firm-level organization).