Tuesday, October 14, 2014

Manufacturing-led growth is still more powerful than services-led growth in low-income countries

Dani Rodrik is skeptical that “a services-led model can deliver rapid growth and good jobs in the way that manufacturing once did”. Excerpts from a recent article on why productivity gains in services sector activities are self-limiting and mostly lower than in manufacturing sector. It has to do with the nature of services activities, which are mostly low value added, low productivity and non-tradable type in low-income countries.

Two things make services different from manufacturing. First, while some segments of services are tradable and are becoming more important in global commerce, these typically are highly skill-intensive sectors that employ comparatively few ordinary workers.
Banking, finance, insurance, and other business services, along with information and communications technology (ICT), are all high-productivity activities that pay high wages. They could act as growth escalators in economies where the work force is adequately trained. But developing economies typically have predominantly low-skilled labor forces. In such economies, tradable services cannot absorb more than a fraction of the labor supply.
That is why, for all of its success, the ICT sector in India has not been a primary driver of economic growth. By contrast, traditional manufacturing could offer a large number of jobs to workers straight off the farm, at productivity levels three to four times that in agriculture.
In today’s developing countries, the bulk of excess labor is absorbed in non-tradable services operating at very low levels of productivity, in activities such as retail trade and housework. In principle, many of these activities could benefit from better technologies, improved organization, and greater formalization. But here the second difference between services and manufacturing comes into play.
Partial productivity gains in non-tradable activities are ultimately self-limiting, because individual service activities cannot expand without turning their terms of trade against themselves – pushing down their own prices (and profitability). In manufacturing, small developing countries could thrive on the basis of a few export successes and diversify sequentially through time – t-shirts now, followed by the assembly of televisions and microwave ovens, and on up the chain of skill and value.
By contrast, in services, where market size is limited by domestic demand, continued success requires complementary and simultaneous gains in productivity in the rest of the economy. Focusing on a few sectors yields no quick winning opportunities. Growth therefore must rely on the much slower accumulation of economy-wide capabilities in the form of human capital and institutions.

2014 Noble Prize in Economic Sciences for Jean Tirole

The 2014 Noble Prize in Economic Sciences is awarded to French economist Jean Tirole of Universit√© Toulouse 1 Capitole “for his analysis of market power and regulation”.

Here is the Nobel committee’s brief on his work and here is the detailed explanation. His main theoretical contributions is related to the understanding and regulation of industries with a few powerful firms (oligopoly), which influence prices, volume and quality. His research has helped governments to design regulations "so that large and mighty firms will act in society's best interest" and that there is a need to ensure that different industries may require different regulations. Other important issues that has Triole’s contributions in microeconomics are market failures, oligopoly, asymmetric information, game theory, competition regulation and industrial organization, procurement theory and optimal contracts. More on the depth and breadth of his work is outlined here and here.

Excerpts from the Nobel committee's brief:

Price caps can provide dominant firms with strong motives to reduce costs – a good thing for society – but may also permit excessive profits – a bad thing for society. Cooperation on price setting within a market is usually harmful, but cooperation regarding patent pools can benefit everyone involved. The merger of a firm and its supplier may lead to more rapid innovation, but it may also distort competition.
To arrive at these results, a new theory was needed for oligopoly markets, because not even extensive privatization creates enough space for more than a small number of firms. There was also a need for a new theory of regulation in situations of assymetric information, because regulators often have poor knowledge of firms’ conditions.
Tirole’s research would come to build upon new scientific methods, particularly in game theory and contract theory. There were great hopes that these methods would contribute to practical policy. Game theory would aid the systematic study of how firms react to different conditions and to each other’s behavior. The next step would be to propose appropriate regulation based on the new theory of incentive contracts between parties with different information. However, even though many people could see the research questions, they were difficult to solve.
Jean Tirole’s research contributions are characterised by thorough studies, respect for the peculiarities of different markets, and the skilful use of new analytical methods in economics. He has penetrated deep into the most central issues of oligopolies and assymetric information, but he has also managed to bring together his own and other’s results into a coherent framework for teaching, practical application, and continued research. Tirole’s emphasis on normative theories of regulation and competition policy has given his contributions great practical significance.