Is there a direction in economic development? Pier Paolo Saviotti, INRA GAEL, Grenoble, and CNRS GREDEG I2C, Sophia Antipolis, France.

Econ Dev, Stylised facts STF1) Economic development is characterised by qualitative change. STF2) The efficiency of existing processes increases in the course of economic development. STF3) The diversity/variety of the economic system rises during the process of economic development.

Efficiency vs diversity Efficiency grows when a constant output is produced with (a) decreasing quantities of all inputs or (b) decreasing costs of all inputs Efficiency at constant quality Qualitative change: emergence of new entities, qualitatively different (distinguishable) from the pre-existing ones. N° distinguishable entities  Diversity

Development as system transformation Structural change: change in the structure of the economic system (components + linkages/interactions). Defined at the level of aggregation of industrial sectors. But: structural change can occur at lower levels of aggregation. Structural change can occur for activities and actors as well as for outputs, thus also for knowledge, and institutions.

Importance of qualitative/structural change. They affect the composition of the economic system. They are determinants of system performance. Economic development is a process of transformation, involving both quantitative/efficiency change at constant composition and qualitative change.

Development vs Growth Need to measure = need to transform qualitative differences into quantitative measurements (conventions, approximations) Changes in efficiency can be easily measured, qualitative changes are much more difficult to measure

Diversity/variety Definition(PPS): number of actors, activities and objects required to describe the economic system at a given time Variable to represent analytically changes in composition = N° distinguishable economic species in system But: also (I) extent of diffusion of new entities in the economic system (balance), and (ii) intrinsic difference between economic species (Disparity) (Stirling)

Modern phenomena Most people could only purchase the bare essentials to survive until the end of the XIXth century, and many people still do today Diversity existed only for the rich But in the XXth century diversity became available for many people in developed societies

Diversity for most

Efficiency and Diversity Two complementary forces/trajectories :  growing efficiency  growing diversity Hypothesis 1: The growth in diversity is a necessary requirement for long-term economic development. Hypothesis 2: Diversity growth, leading to new sectors, and efficiency growth in pre- existing sectors, are complementary and not independent aspects of economic development.

Compensation At constant output  growing efficiency + saturating demand  possibility to produce all demanded output with declining fraction of resources (labour force)  Marxian trap Emergence of new sectors compensates for the falling capacity of existing sectors to create employment Growing diversity avoids Marxian trap. Supply side: surplus old sectors  search activities  new goods & services + creation of demand for new goods & services needs income

Family expenditure Workers UK

Necessities and higher goods/ services The efficiency in the production of necessities had to increase to leave room for the purchase of higher goods/services During the XIXth century the share of family expenditures allocated to necessities increased and it started to fall only at the beginning of the XXth century Necessary condition for social stability and for economic growth

Economic development by the creation of new sectors A model in which the number of new sectors varies endogenously during economic development Sector created by an important innovation establishing an adjustment gap (size of the potential market)‏

Intra sector dynamics First entrepreneur enters the market (expectation of a temporary monopoly) imitators enter  rising intensity of competition  inducement for further entry falls until exit starts dominating entry. Innovation has become part of the ‘circular flow’ (Schumpeter, ) Sector  oligopoly or monopoly

Demand dynamics Demand dynamics: Adjustment gap (distance from saturation) is gradually closed leading to a saturated market, but the product/service is improved by means of search activities The joint dynamics of competition and of demand gives rise to an industry life cycle (ILC)‏

Creation of new sectors The decline of mature sectors induces entrepreneurs to look for new opportunities of temporary monopoly, to be found by exploiting new important innovations leading to new niches and sectors.

Competition Competition both intra- and inter-sector: Intra- sector:  density of product/output population. Entrepreneur induced by expectation of temporary monopoly to enter. If innovation successful  imitation  increasing intensity of competition  decreasing inducement to enter  exit

Inter-sector competition Inter- sector: different sectors can provide comparable services. Important component of contestable markets Total intensity of competition perceived within each sector = intra + inter Limits the extent of oligopoly/monopoly that could be achieved within individual isolated sectors

Search activities Activities by means of which one scans the external environment looking for alternatives to existing routines (Nelson, Winter, 1982) Generalized analogue of Research and Development All economic activities can be divided into routines and search activities

Model equation

Number of firms Life cycle: in each sector N i first increases rapidly, reaches a maximum, and then falls (oligopoly, monopoly)‏ But, life cycle driven purely by dynamics of competition and demand (See ILC models). Shape of life cycle affected by several variables (AG i, D i etc).

Adjustment gap

Demand

Search activities

Competition

Employment l i = k i /Q ia = k i /Q i /N i = (k i *N i )/Q i l i = L i /Q i

Aggregate employment

Demand function D i 0 = initial demand for the output of the new sector I D disp,i = the disposable income for new good or service I Y i and Δy i = level of services supplied by the new product/service and degree of product differentiation, p i = the price of the new product/service D disp,i can be calculated by subtracting from total income the expenditures on all previous goods or services. Evolution of demand constrained by the creation of disposable income

Demand, disposable income Demand, new function (left); Demand, old function (right)

Effects of (low-high) product quality Product quality in the low (pink) and high (blue) case Effect of product quality on sectoral demand, low (pink) and high (blue) case Effect of product quality on output, low (pink) and high (blue) case Effect of product quality on wages, low (pink) and high (blue) case

Effects of (low-high) product quality (2) Quantity of Human capitalHuman capital/output ratio Quality of human capital

Effects of (low-high) product quality (3) Disposable income (low product quality) Disposable income (high product quality) Aggregate income (low product quality, pink, high product quality blue) Aggregate employment (low product quality, pink, high product quality blue)

Model summary The model shows that if diversity/variety grows economic development can continue in the long run Many experiments can be carried out with the model by assessing the effect of varying its parameters on system behaviour and performance Experiments: micro-macro dynamics, competition and growth, industry life cycles, Emergence of bubbles, etc.

Direction of development Reversal? Growing efficiency and growing diversity/variety If the efficiency of basic functions (e.g. Food, housing etc.) were to fall the resources of the system could be concentrated on these functions thus reducing diversity Possible examples: (I) fall of earth temperature of 50 degrees; (ii) increased environmental fluctuations We live in a fairly benign environment

Implications for development Countries at different levels of economic development. Catching up. How? If world diversity/variety grows then national diversity/variety should grow in parallel  keep (national/world) diversity/variety ratio approximately constant But, short run exceptions : specialization strategies compensating narrow range with increased competitiveness within range, but only viable in short run

Trends and systems General trends (e.g. towards growing diversity) not followed in exactly the same way by all countries, but interpreted. Two types of persistent asymmetries:  In output structure  In institutional and organisational configurations National Innovation Systems

Heterogeneity vs homogenization Innovations created at particular places and times  asymmetric distribution of in world economic system  raise heterogeneity Diffusive forces (trade, technology transfer etc) tend to homogenize technologies, capabilities etc. Dynamic steady state where complete homogeneity unthinkable

Catch-up strategies

Variety based interpretation of past policies  Two extreme choices: a) only natural resource based sectors; b) add manufacturing (ISI) ‏  a) leads to relative decline in national variety, b) can lead to increasing or constant share of world variety

Empirical studies  Test: calculate output variety/diversity in the course of time for different countries and compare with GDP Growth, labour productivity growth, etc.  But comparable and disaggregated output statistics generally not available  Netherlands study (Frenken et al, 2007): output variety of regions determinant of labour productivity growth & of output growth

Variety and the entropy function  Entropy can measure variety because the greater the number of distinguishable entities there are in the system, the greater the amount of information required to describe it.  Decomposable nature of entropy: variety at several digit levels can enter a regression analysis without necessarily causing collinearity.

Related vs unrelated variety.  Related variety (RV): measured at a lower level of aggregation where any two sectors are likely to show greater similarity (intra-group variety) ‏  Unrelated variety(UV): measured at a higher level of aggregation where two sectors are very different (inter-group variety)  Given the properties of the informational entropy function RV and UV can be combined in the same econometric equation

Variety growth and trade Netherlands, only related variety is a determinant of employment growth in the regions of the Netherlands in the period considered Meaning: in order to grow you have to diversify your economy but remaining in the vicinity of your previous production structure

Variety growth & trade (2)‏ OECD countries ( ): related export variety( 3 digits) short run determinant of economic growth, unrelated variety(1 digit) and semi related variety(2 digits) not short run determinant of economic growth unrelated variety(1 digit) long run determinant of economic growth

Real GDP growth rate vs Export variety, UN data data

Real GDP per capita growth rate vs Export variety, UN data data

Related vs unrelated variety, Short vs Long run

Related vs unrelated variety, Short vs Long run (2)

Variety, Proximity

Results  Related export variety determinant of the growth of GDP and of GDP per head in the short run  Unrelated export variety determinant of the growth of GDP and of GDP per head in the long(er) run  Confirmation of previous study of OECD countries (Saviotti, Frenken, JEE 2008)

Interpretation Countries need to diversify their exports to keep growing, but in the short run they need to do it in the vicinity (similarity), in knowledge and product space, of their previous outputs.(See also Hidalgo et al 2007) But, diminishing returns to related variety and need to start preparing more radically different types of exports to keep growing in the long(er) run

Trajectories and interpretations In general we can say that related export variety is a determinant of economic growth However, within this general trend there can be many interpretations or deviations The strategies of individual countries are not identical (see previous strategies for catching up)

Export variety of Latin American countries

Export variety of Asian countries

Export variety of small or expanding countries

Export variety of developed market economies

Development periods

Role of export variety In general we can say that related export variety is a short run determinant of economic growth (requires further testing) Unrelated and semi-related export variety are not short run determinants of growth Unrelated export variety long run determinant of economic growth

Diminishing returns - Emergence of new technologies However, local or incremental modifications leading to an increase in related variety are likely to lead to diminishing returns. Creation of unrelated variety required for long run but The period preceding economic returns for unrelated variety is a long term investment but without it economic growth would slow down or cease

Secular trends & National variations Two long term, secular, trends (laws, forces, trajectories) in economic development (i) growing efficiency & (ii) growing diversity However, within the general trend described above there can be many national (local) interpretations or deviations

 The strategies of individual countries are not identical (see previous strategies for catching up)‏  Prevalence of related export variety (short run)  path dependence (the near future of an economic system depends on what it has done in the recent past)‏  Long run change must be prepared Secular trends & National variations(2)‏

Changing development mechanisms In P1( ) related export variety is not a significant determinant of growth but it becomes a determinant in P2 ( )‏ Related export variety is not a significant determinant of growth in the transition from low to middle income but it is in the transition from middle to high income Mechanisms of economic development and of catching up changed from P1 to P2 & for different income ranges

Changing development mechanisms (2) In P1 it was possible to catch up by simple imitation, in P2 the countries which caught up managed to construct their national innovation system Different mechanisms required for the transitions low to middle and middle to high income per capita