Productivity as a guide for industrial policies

This blog post is the second in a series that is bringing the latest research to bear on the potential role industrial policy can, should, or shouldn’t play in government economic policy in low- and middle-income countries. The first blog looked at the track record of micro-industrial policies.
 

Industrial policies, government efforts to modify economic activity across sectors, face a critical initial question: Which sectors do you want to grow?   For governments aiming at economic development, Penny Goldberg and I have a paper that provides high-level guidance. We highlight that growth in exports has been a key driver of poverty reduction in low-income countries over the last four decades. Thus, enhancing the export sector is a viable path to development.

The Dilemma of Choosing Exports

What remains challenging is identifying which exports a government should prioritize. The conventional economic wisdom suggests focusing on industries that are held back by market failures, where the individual rationality of entrepreneurs doesn't align with the societal good.  A classic example is the learning-by-doing process, which might require initial government subsidies to kickstart production and learning. Examples like subsidies for pharmaceuticals research and solar panel development demonstrate this approach.

However, market failures are nuanced and idiosyncratic, making it very difficult to generalize this strategy across many industries. Through intensive study one can document the market failures in a particular industry and propose corrections. But, as my World Bank colleagues have concluded in the past, literature gives “no confident policy guidance” about which export goods have larger externalities in a specific country context.

Even with a clear understanding of market failures and strategies to address them, success isn't guaranteed due to international competition. An industry, despite being freed from internal market failures, might still struggle to compete globally if other countries have natural advantages or more effective industrial policies.

High Productivity Industries are Low Risk

Rather than externalities, one simpler and more universal metric to compare across industries is productivity. The measure is based on the economist David Ricardo’s theory, confirmed in the data, that countries tend to export more from industries where they are relatively more productive. As a result, we can determine an industry’s productivity by looking at its exports. In this model, productivity is the combination of access to low-cost inputs and the ability to transform them into output efficiently.

The measure works as follows. Recently, 2.4 percent of exports from Guatemala were of “business services”, which include outsourced business activities like customer support. In contrast, only 1.7 percent of exports by all countries are of “business services”. Since Guatemala is more specialized in business services compared to the rest of the world, it is said to have a revealed comparative advantage in that industry. As a result, one can infer that, within Guatemala, firms in business services are relatively more productive than firms in industries that export less.

Nonetheless, even productive industries might still be impeded by market failures. In the business services example, firms may still underinvest in worker training, new entrants may lack knowledge about the standards of international customers, and international customers may not have information about which service providers can best meet their needs. In these situations, government intervention may still be warranted, despite the industry’s success.

Low Productivity Industries are High Risk

Targeting development in new, low productivity industries carries higher risk. Efforts to transition from traditional commodity exports to more value-added industries are challenging and uncertain. Industry-level strategies, like targeting markets with growing demand or leveraging technological similarities with existing industries, can mitigate some risks.  Looking at individual firms, a McKinsey & Company study found that 50 percent of a company’s profit growth could be explained by the industry the company was in. The same logic can be applied to a country’s exports, which are often concentrated in a few “superstar” firms anyway. The concept of “product space density” proposed by Bailey Klinger and Ricardo Hausmann offers insights into likely successful diversifications. This measure is highly predictive of the new products countries move into as they diversify over time, even controlling for other factors.

Tailoring Industry Policy to Country Context

These benchmarks are most useful for excluding industries from industrial policy. There is no shortage of theories about products that are inherently beneficial for development—for instance upstream products, labor intensive products, green products, or products rich countries export. Not all globally beneficial industries might suit a particular country’s technological capabilities or market trends. A strategic exclusion of certain industries from policy support is as crucial as the inclusion of others.

Beyond targeting industries, each government needs to calibrate its tolerance for risk, and the balance of high and low productivity industries to target.  Historically, most countries have preferred a low-risk strategy: use of industrial policy is highly concentrated in industries where countries have a revealed comparative advantage. Evidence suggests that such interventions can be effective: In Peru, attention from an export promotion agency helped already successful exporters increase “the number of products exported and the number of countries served.”

Key Takeaways

Despite the allure of high-risk interventions to create new industries or revive declining ones, especially in places with high unemployment, it's crucial to first exhaust low-risk options.  Today, low-income, and middle-income countries invest less in export promotion compared to high-income countries. Given that export growth remains a proven path to rapid economic development, addressing this gap in industrial policy could be a critical step towards sustainable economic growth.