Trade, Foreign Investment, and Industrial Policy for Developing Countries 4059
could be a useful measure for IP. In particular, countries could consider inducing col- lective action in sectors with a high “adjusted income level.”
2.4 Self-discovery and diversification
The notion of IP that we have emphasized so far is that there are “special industries,” and that countries can increase welfare by reallocating resources to those industries. An alternative idea that we now explore is to think of a policy to increase diversification. This has been a particular concern in countries that specialize in natural-resource inten- sive industries (see CAF, 2007; De Ferranti, 2001, for recent treatments focusing on Latin America). Diversification could be desirable as a way to reduce volatility, or as a way to increase productivity. Here we focus on the later. To think about the connection between diversification and productivity, consider the Eaton and Kortum (2002) model of trade. As explained above, Eaton and Kortum model productivities as being drawn from a distribution that is common across countries except for a technology parameter T. This technology parameter determines the location of the productivity distribution: countries with a higher T have “better” distributions in the sense that, on average, productivity draws will be higher (formally, this entails first-order stochastic dominance). Apart from T, countries also differ in size, L. Assuming away trading costs for simplicity, wages are determined by the ratio of technology to size, T/L. A high T/L means that the country would have many sectors in which it has absolute advantage relative to its size, leading to a high equilibrium wage. Moreover, given L, a higher T implies the production (and export) of more goods, or more diversification. Of course, higher productivity and higher wages may not go together with diver- sification. For example, high productivity in a sector that is not “diversified” or “differ- entiated” would draw resources away from the diversified sector and reduce overall diversification even as it increases overall productivity and wages. It is also important to recall that the data reveal that after a certain level of development, higher income goes together with less, not more diversification (see Imbs & Wacziarg, 2003). An interesting way to think about diversification is via what Hausmann and Rodrik (2003) call “self-discovery.” They argue that countries do not really know their cost structure, and hence they do not know the goods in which they have comparative advantage. This must be discovered through costly experimentation, which is plagued by information spillovers that render its private benefits low relative to its social bene- fits. The following model shows a simple way to capture the connection between diversification and productivity, and then between self-discovery and diversification. Consider an economy with labor as the only factor of production and two sectors: agriculture and manufactures. Agriculture is a homogenous good, produced with decreasing marginal returns to labor, with QA ¼ lF(LA). There are a continuum of manufacturing goods indexed with j e [0, 1] that are produced from an input H ¼ eL