Picking winners

Concepts derived from structural-change theory are being revived and debated in exciting new ways, as evidenced in a recent conference at the World Bank earlier this month on ‘Structural Transformation and Economic Growth.’ Top researchers presented new papers and new ongoing work that covered globalization and structural transformation, sectoral diversification and human capital, industrial policy, and country case studies. 

The conference revealed an important emerging consensus about the role of the government in providing both soft infrastructure (for example a conducive business environment, regulations, and legal system) and hard infrastructure (such as port facilities, highways, telecommunications, and power).  Indeed, few dispute that broad-based interventions to support industrial upgrading and diversification are crucial to facilitating structural transformation and to spurring sustainable growth. 
 
I find this emerging consensus to be encouraging: As I had argued in earlier writings about New Structural Economics, structural differences between developed and developing countries are endogenous to their endowment structure. A given economy’s structure of factor endowment -- defined as the relative composition of natural resources, labor, human capital and physical capital – is innately different at each level of development. Because of this, for any given economy, its comparative advantage and optimal industrial structure will be different at different levels of development. But to move from one level to another smoothly and quickly, the government needs to provide or coordinate the improvement in hard and soft infrastructure.

What is more controversial is the notion that broad-based interventions are not sufficient and that government’s facilitation should be sector-specific.  Let me elaborate on why it is important for the government to pick winners: 

First, no matter its success or failure, a pioneer firm in industrial upgrading and diversification provides information externalities to other firms. If it fails, the firm needs to bear all the costs of failure. If it succeeds, other competitive firms will enter and the pioneer firm will not be able to earn extra profits. Due to the asymmetry between the cost of failure and the gain of success, a firm’s incentive to be the pioneer will be low. A broad based intervention cannot solve the need for compensating pioneer firms.

Second, the required infrastructure improvements are often industry-specific. The cut flowers and textile industries require different infrastructure for their exports. Since a developing country’s fiscal resources and implementation capacity are limited, its government has to prioritize the infrastructure improvement according to the targeted industries.

Third, to compete in the globalized world, a new industry not only must align with the country’s comparative advantage so that its factor costs of production can be at the lowest possible level, but also the industry needs to have the lowest possible transaction related costs.  Suppose a country’s infrastructure and business environment are good and industrial upgrading and diversification happen spontaneously. Without the government’s coordination, firms may enter into too many different industries that are all consistent with the country’s comparative advantage. As a result, most industries may not form large  enough clusters in the country and may not be competitive in the domestic and international market.  Only in the wake of many failures may a few clusters may emerge eventually. Such a “trial and error” is likely to be a long and costly process, reducing the individual firms’ expected returns and incentives to upgrade or diversify to new industries. This in turn can slow down a country’s economic development.

Whether the government plays the sector-specific identification and facilitation role to support a country’s upgrading to new industries that are consistent with changes in the country’s comparative advantage determined by changes in its endowment structure may explain why some developing countries can grow at 8 percent or more for several decades and most others fail to have a similar performance. The Growth Identification and Facilitation framework, proposed by Celestin Monga and me, provides the government in developing countries with a pragmatic approach to pick the right winners.