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«Policy Research Working Paper 5313 Public Disclosure Authorized Growth Identification and Facilitation The Role of the State in the Dynamics of ...»

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The difference between factors of production and infrastructure is that the supply and demand of the former are determined individually by households and firms, whereas the latter in most cases are supplied by the community or governments in a form that cannot be internalized in the decisions of individual households or firms, as they require collective actions.

5    achieve that, it must first close its endowment gap with that of the advanced countries. The strategy to get there is to follow its comparative advantage in each stage of its development.

When firms choose to enter industries and adopt technologies that are consistent with the country’s comparative advantage, the economy is most competitive. These firms will claim largest possible market shares and create the greatest possible economic surplus in the form of profits and salaries. Because of the competitiveness of its industries, re-invested surpluses earn the highest return, which allows the economy to accumulate even more physical and human capital over time. This dynamics can lead to a virtuous circle: it can upgrade the country’s factor endowment structure as well as the industrial structure, and also make domestic firms more competitive in more capital and skill-intensive products over time.

A firm’s objective is to maximize profit, not to exploit the economy’s comparative advantage. It will follow the economy’s comparative advantage in choosing its industry and technology in the development process only if the relative factor prices in the economy reflect the relative abundances of factors in the economy (Lin 2009, Lin, and Chang 2009). The relative factor prices with such nature will exist only in a competitive market system. An efficient market mechanism is therefore a required institution for the economy to follow its comparative advantage in the process of dynamic development.

However, in spite of the importance of the market mechanism, for the following information, coordination, and externality reasons, it is also desirable for the government to play a pro-active

role in facilitating industrial upgrading and diversification in the development process:

First, the decision to upgrade to an industry or to diversify business toward an activity that is consistent with a country’s latent comparative advantage is never an obvious choice. A pioneer firm may fail due to the lack of complementary inputs or adequate infrastructure for the new industry or simply the targeted industry may not be consistent with the economy’s comparative advantage. Industrial upgrading and diversification are therefore likely to be a costly trial-anderror exercise of discovery even with the advantage of backwardness (Hausmann and Rodrik 2003). In order to be successful in a competitive market, firms in a developing country need information about which industries within the global industrial frontier align with the country’s latent comparative advantage.

Information has the same properties as public goods. The costs of collecting and processing information are substantial. However, the marginal cost of allowing one more firm to share the information is almost zero once the information is generated. Therefore, the government can play a facilitating role by investing in information collection and processing and making information about the new industries that are consistent with the country’s latent comparative advantage freely available to firms. In addition, the choice of a new industry may also shape the economy’s future growth potential in a path-dependent way through the accumulation of specific human and social capital. The government is better than individual private firms at analyzing information about how each new industry may shape the economy’s future growth path and making that information available to the public.

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in their market scope and infrastructure needs due to the evolving nature of production that is embodied in the process. In other words, industrial upgrading and diversification are typically accompanied by changes in hard and soft infrastructure requirements. For example, with the change from agrarian production to manufacturing and from simple manufacturing to advanced manufacturing in the development process, the scale of production and market scope become increasingly large. The demand for transportation, roads, and power increase accordingly.

Individual firms are not capable of internalizing those provisions or deploying the kind of coordination efforts among firms in different sectors needed to meet those increasing demands. 8 Even if some large single companies were willing to finance a national road or a power network, coordination through the public sector would be needed to ensure consistency, efficiency, and prevention of natural monopolies when the national economy grows. In addition to the hard infrastructure, in a low-income country firms in small-scale, labor-intensive agriculture and manufacturing industries only need an unskilled labor force and an unsophisticated informal financial and marketing system. But when the economy expands into modern manufacturing industries, firms need high-skilled labor, large funds for lump-sum investments in equipment, working capital and/or export financing, as well as new marketing arrangements. However, individual firms are usually not capable of internalizing the needed changes in soft infrastructure.

Here again, there is a need for the state to provide or coordinate some of those changes in different sectors of the economy so as to facilitate the individual firms’ upgrading and diversification.9 Third, innovation, which underlies the industrial upgrading and diversification process, is by nature a very risky endeavor. Even when governments are willing and capable of helping by providing the necessary information and coordination to firms, success is not guaranteed. Firms can succeed or fail in their attempt to upgrade their activities in new industries. They can fail because the targeted industry is too ambitious, or the market too small, or the coordination inadequate. But even such cases of failure offer useful information to other firms: the failures indicate that the targeted industries are inappropriate and should be re-examined. Therefore, firms that are first movers pay the cost of failure and produce valuable information for other firms. When the first movers succeed, their experience also provides information externalities to other firms: their success proves that the new industry aligns with the economy’s new


For example, the application of chemical fertilizers in rice and wheat require modern semi-dwarf varieties to avoid the lodging problem, and the use of modern seeds often requires timely irrigation. Individual farmers will not be able to develop the new seeds or improve the irrigation system by themselves. The applications of chemical fertilizers and modern seeds also increase the needs for access to credits. The change in financial system to meet the needs is beyond individual farmers’ capacity. Similarly, the diversification from farm to non-farm industries or from small-scale traditional industries to modern industries also requires the provision of many new inputs and improvements in hard and soft infrastructure, which cannot be internalized in any individual firm’s decision.

The success of Ecuador’s cut flowers export in the 1980s is a good example. The fact that Ecuador had latent comparative advantages in producing and exporting cut flowers to the US market was known in the 1970s.

However, the industry did not expand and exports did not take off until the government helped arrange regular flights and investment of cooling facilities near airport in the 1980s (Harrison and Rodriguez-Clare 2010). A similar story applied to Ethiopia’s cut flowers’ export to European market. In the issues related the provision of skilled labor, Germany’s dual system of vocational education and training, involving both in-company training and education at vocational schools, has been a major factor in Germany’s economic success over the past six decades.

7    comparative advantage. Such information prompts many new firms to enter into the industry.10 The subsequent large entry of new firms eliminates the possible rents that the first mover may enjoy. From the perspective of an individual firm, the incentive to be a pioneer firm is repressed because of the asymmetry between the high cost of failure and the limited advantage of success.

Unless there is compensation for the information externalities that the pioneer firm creates, few firms will have incentives to be the first movers and thus the process of industrial upgrading and diversification as well as economic growth will be impeded (Aghion 2009; Romer 1990). In a developed country located at global-frontier industries, a successful first mover in general can be rewarded with a patent and enjoys the rent created by a period of monopoly for its innovation.

For a developing country, its new industry is most likely to be a matured industry located within the global industrial frontier. Therefore, the first mover will not be able to obtain a patent for its entry into a new industry in its economy. Some form of government’s direct support to pioneer firms that are willing to take the risk to move to new industries is justifiable.11 Compared with developed countries whose industries are located on the global frontier and their industrial upgrading and diversification rely on their own generation of new knowledge through the process of trial and error, developing countries in the catching-up process move within the global industrial frontier and have an advantage of backwardness. That is, developing countries can rely on borrowing the existing technology and industrial ideas from the advanced countries.

That method of acquiring innovation has a lower cost and is less risky than the one used by firms in developed countries (Krugman 1979).12 Therefore, in a market-based developing country, if firms know how to tap into the potential of the advantage of backwardness and the government pro-actively provides information, coordination, and externality compensation in the process of industrial upgrading and diversification, the country can grow much faster than a developed country and achieve the goal of converging to high-income countries (Lin 2009). After all, this was the case for Britain before the 18th century; Germany, France, and the United States in the 19th century; and the Nordic countries, Japan, Korea, Taiwan-China, Singapore, Malaysia, and other East Asian economies in the 20th century (Amsden 1989; Chang 2003; Gerschenkron 1962;

and Wade 1990).


In a recent field study in Zambia, we find that a local entrepreneur successfully started the production of a construction material—corrugated roofing sheets. Within a year, more than 20 firms entered into the production such materials.

Precisely because of such positive information externalities, in addition to patents, governments in developed countries provide various forms of targeted supports to firms that are engaged in innovation. Commonly used measures include funding of basic research, preferential taxes, mandates, defense contracts, and procurement policies.

The possibility to borrow existing knowledge for industrial upgrading and diversification does not mean that a developing country need not engage in indigenous innovation. To be successful, developing countries need to undertake a process of innovation that makes the borrowed technology suitable to local conditions. They also need to carry out product innovation in sectors in which they are already world leaders, or not too far behind the world leader. For further discussions, see Lin and Ren (2007).


3. Picking Winners or Losers: Lessons from Experience

There is wide consensus among economic historians on the important role played by the state in facilitating structural change and helping sustain it across time and across developed countries.

However, except for a few successful cases post World War II, the governments in most developing countries have failed to play that desirable facilitating role. It is therefore essential to briefly review the historical and contemporary experiences of state intervention in the process of industrial upgrading and diversification, both in advanced economies and in developing countries, to draw lessons from the many failures and few successes.

The Role of the State in Structural Change in Advanced Economies

There is ample historical evidence that today’s most advanced economies heavily relied on government intervention to ignite and facilitate their take-off and catch-up process, which allowed them to build strong industrial bases and sustain their growth momentum over long periods. In his well-known survey of trade and industrial policies that led to early economic transformations in the Western world, List (1841) documented various policy instruments through which governments protected the domestic industries or even intervened to support the development of specific industries—many of which became successful and provided the bedrock for national industrial development.13 Likewise, Chang (2003) has reviewed economic developments during the period when most of the currently advanced economies went through their industrial revolutions (between the end of the Napoleonic Wars in 1815 and the beginning of World War I in 1914). He has documented various patterns of state interventions that have allowed these countries to successfully implement their catch-up strategies. Contrary to conventional wisdom that often attributes the industrial successes of Western economies to laissez-faire and free-market policies, the historical evidence shows that the use of industrial, trade, and technology policies was the main ingredient to their successful structural transformations. This intervention ranged from the frequent use of import duties or even import bans for infant industry protection to industrial promotion through monopoly grants and cheap supplies from government factories, various subsidies, public-private partnerships, and direct state investment, especially in Britain and in the U.S. (Trebilcok 1981).

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