How Poor Countries Get Rich

Economic development is not a gradual process with all the poor countries of the world converging on the rich countries. Rather, it involves the rapid industrialisation of poor countries in turn, as a consequence of changing incentives to industries to spread into low wage economies.

According to Diego Puga and Professor Tony Venables, writing in the latest issue of the Economic Journal, unilateral trade policy can play an important role in promoting such industrialisation. But while a policy of import substitution can be successful in attracting industry, a policy of trade liberalisation attracts different industrial sectors and generates higher levels of welfare.

The determinants of a country''s stage of economic development are usually seen in terms of their endowments of factors (physical and human resources), their technologies and their institutional structures. While international differences in these factors are clearly important, Puga and Venables explore a radically different view of economic development and underdevelopment, based on the idea that economic activity may tend to agglomerate spatially. In this case, it is possible that countries with similar or even identical underlying characteristics may nevertheless have very different economic structures and income levels.

This observation is not new, and has been formalised in recent work in economic geography. The goal of these researchers'' work is to draw out more fully the implications of this approach for the process of economic development:

  • What forces are conducive to agglomeration, and what to the spread of industry from country to country?
  • If industrialisation does spread, what form does development take?
  • What is the role of policy, particularly trade policy, in promoting industrialisation?
  • Agglomeration of manufacturing sectors may result from linkages between industrial firms, and this creates substantial real income differences between countries. Yet firms do not move to low wage economies because in doing so they would forego the benefits of proximity to suppliers of intermediate goods and to their industrial customers.

These researchers focus on two forces that can lead to economic development. The first is to suppose that in the world as a whole, the manufacturing sector is growing relatively faster than other tradable sectors. Economies where industry is agglomerated will experience increasing demand for labour, opening up a larger and larger wage gap between countries.

At some point, this wage gap becomes unsustainable, and industry starts to spill over to low wage economies. However, this will not lead to steady development of all low wage economies, but instead to rapid industrialisation of countries in turn.

According to this view, economic development does not take the form of smooth growth by developing countries converging on the developed countries. Instead, there is a rich group of countries and a poor group. Development takes the form of countries being drawn in turn out of the poor group, and taken through a process of rapid development into the rich group. This is an insightful way to think about the spread of industry in a number of contexts, for example, from Japan to its East Asian neighbours.

The second issue is the role of developing country trade policy in promoting or hindering industrialisation. Puga and Venables show that unilateral trade policy can be used to attract industry by import substitution. More surprisingly, unilateral trade liberalisation can also be successful in attracting industry, as lower cost intermediate goods remove a barrier to industrial development.

Comparison of import substitution and trade liberalisation indicates that trade liberalisation yields higher welfare. The researchers analyse this in an aggregate model and then in a multi-industry variant of the model, calibrated to South Korean input-output and demand data. They use the calibration to show the different sectoral impact of trade liberalisation and import substitution, and to confirm the difference in welfare generated by the two policies.

''Agglomeration and Economic Development: Import Substitution versus Trade Liberalisation'' by Diego Puga and Tony Venables is published in the April 1999 issue of the Economic Journal. Puga is at the University of Toronto; Venables at the London School of Economics.