Although a country’s fundamentals – its endowments of physical and human capital, labor, and natural resources along with the overall quality of its institutions – are important in shaping its specialization patterns, they do not determine what a country will produce and export. In addition, not all goods are alike in terms of their consequences for economic performance. Specialization in some products yields a higher growth than specialization in others. As such, government policies that are appropriately targeted on the market failure in question assist in moulding the production structure.
The framework of this paper builds on the idea that countries become what they produce. Rich countries are those that have latched on to "rich-country products," while countries that continue to produce "poor-country" goods remain poor. What is different with the framework of this paper is that it establishes a hierarchy in the goods space that is both open to empirical measurement and has determinate growth implications.
To model this process, the mechanism of cost discovery is discussed. An entrepreneur who ventures in the production of a new good faces cost uncertainty. If the project is successful, other entrepreneurs benefit by emulating the entrepreneur. Otherwise, the entrepreneur bears all the losses. In this situation, the larger the number of entrepreneurs that engage in cost discovery in the modern sectors of the economy, the closer the economy gets to its productivity frontier.
The Model
To determine the production structure of an economy and discover its underlying cost structure of the economy, a general-equilibrium model with two sectors is proposed. This model consists of a modern sector which can produce a variety of goods and a traditional sector which produces a single homogenous good.
Every good is identified by a certain productivity level that is uniformly distributed. However, investors only discover the productivity level of a project only after the investment is sunk. By then, this level becomes common knowledge and subsequent producers will be able to produce the same good without incurring additional discovery cost. They would most likely emulate the project if the productivity of the most valuable discovered good is greater than their current productivity.
Expected productivity is determined both by skills and by the number of investors engaged in cost discovery. Productivity in the modern sector increases as investors multiply. Note that increasing returns to scale in the modern sector arises from cost information spillovers rather than technological externalities.
In the long-run equilibrium, the number of entrants in the modern sector is endogenous and is determined by the condition that excess profits are driven to zero. Wages are determined by setting the economy’s total labor demand equal to the fixed labor supply. The traditional sector produces a single homogenous good using labor as the sole factor of production. In the short-run equilibrium, on the other hand, labor markets are required to be strong but the number of entrants to the modern sector is fixed.
On the transition to long-term equilibrium, both the number of entrants and the wage rate will rise. The rise in the number of entrants implies that productivity will be higher in the future than it is today. Holding all other factors equal, this will delay the decision to invest in the modern sector. The rise in the wage rate, on the other hand, implies that investment will be more costly in the future than it is today. This factor is seen to encourage investment. Wages increase faster than the rate of productivity benefits and investors would opt to invest today than wait.
At labor-market equilibrium, lower wages induce firms to enter the modern sector and take part in cost discovery. This increases wages up to a point where new equilibrium is reached. Once the modern sector expands, productivity increases, and zero profits can be restored only if wages go up. Increases in the world price of a good and the economy’s maximum range of goods result in higher wage rates and yield more entrants, while an increase in the fixed cost of entry into the modern sector brings these two measures down.
The model of this paper is related to models in the endogenous-growth tradition. But what is unique with it is that it identifies a potentially empirically verifiable relationship between the type of goods that an economy specializes in and its rate of economic growth.
Empirics
The model shows that productivity in the modern sector is driven by the productivity of the most valuable discovered good, which depends on the number of investors engaged in self-discovery[1]. In this paper, the proxy for the productivity of the most valuable discovered good is called EXPY.
To show that some traded goods are associated with higher productivity levels than others and that countries that produce higher productivity goods perform better, a quantitative index which ranks traded goods in terms of their implied productivity must be constructed. This is done by taking a weighted average of the per-capita GDPs of the countries exporting a product, where the weights reflect the revealed comparative advantage of each country in that product. The generated income/productivity level for each good is called PRODY. Then, EXPY, the income/productivity level that corresponds to a country’s export basket is constructed by calculating the export-weighted average of the PRODY for that country. Trade data are drawn from the United Nations Commodity Trade Statistics Database (COMTRADE) covering over 5000 products at the Harmonized System 6-digit level for the years 1992 to 2003.
Results show that EXPY is highly correlated with per-capita GDPs. Rich (poor) countries export products that tend to be exported by other rich (poor) countries. It was also observed that EXPY exhibits a downward trend over time.
High EXPY values were detected on Mozambique, Swaziland, Armenia, India, and China. For Mozambique and Swaziland, this was driven by a specific commodity with a high PRODY value. For Armenia, India, and China, the result was induced by a portfolio of high PRODY exports, and not by specific items. China and India also had observed EXPY levels that are much higher than what would be predicted based on their income levels.
Apart from per-capita GDP, EXPY was noted to be also influenced by fundamentals such as human capital and the size of the labor force. However, even if a causal role to these factors is established, a lot is still unexplained in the determination of EXPY. Fundamentals are just part of the story.
Using a set of cross-national regressions that regress growth on EXPY, it was observed that EXPY is a strong and robust predictor of economic growth, controlling for standard covariates. To check the robustness of findings against COMTRADE’s short time-span and limited coverage of countries, the World Trade Flows dataset which has recently been updated to extend coverage back to 1962 was used and the results were comparable to the COMTRADE findings.
Discussion
Results show that countries that export goods associated with higher productivity levels grow more rapidly, even if initial income per head, human capital levels, and time-invariant country characteristics are controlled. This kind of growth happens when a country transfers from low productivity activities to higher productivity goods after they were identified by the cost discovery process. Countries are able to export them without adverse terms-of-trade effects because there is elastic demand for these goods in the world market.
Under this result, economic convergence can be achieved by fostering an environment that promotes entrepreneurship and investment in new activities. Such activities generate information spillovers for emulators. The necessary policy would then be to subsidize new entrants in new activities.
The type of goods in which a country specializes has important implications for subsequent economic performance. Ceteris paribus, an economy is better off producing goods that richer countries export. Countries sometimes get stuck with lower-income goods because entrepreneurship in cost discovery requires important externalities. They can overcome such externalities and enjoy higher economic growth by enacting policies that encourage entrepreneurs to venture into new activities.
Source:
Haussman, Ricardo, Jason Hwang, Dani Rodrik, “What You Export Matters” Harvard University (October 2006).
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