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Trade and the Bottom Billion

Will recent trends in development economics ever benefit the bottom billion?

November 22, 2007

Will recent trends in development economics ever benefit the bottom billion?

International trade has taken place for several thousand years. However, the most dramatic transformation of the size and composition of trade has been during the past 25 years.

For the first time in history, developing countries have broken into global markets for goods and services other than just primary commodities. Until around 1980, the role of developing countries was to export raw materials. Now, 80% of developing countries’ exports are manufactured goods and service exports are also mushrooming.

The production of primary commodities is basically land-using, and exporting them is most likely to benefit the people who own the land.

Sometimes the land is owned by peasant farmers, but often the key beneficiaries are mining companies and big landowners.

So trade based on primary commodity exporting is likely to generate quite a lot of income inequality. And its scope is inherently limited by the size of the market: As exports grow, prices turn against exporters.

By contrast, manufactures and services offer much better prospects of equitable and rapid development. They use labor rather than land — and the opportunity to export raises the demand for labor.

Since the defining characteristic of developing countries is that they have a lot of unproductive labor, these exports are likely to spread the benefits of development more widely.

And because the world market in manufactures and services is huge and was initially dominated by the rich countries, the scope for expansion by developing countries is massive.

However, before getting starry-eyed about this transformation in developing countries’ trade, let us ask why it took so long.

In the 1960s and 1970s, the rich world dominated global manufacturing despite having wages that were around 40 times as high as those in the developing world. Why did this massive wage gap not make developing countries competitive?

Part of the answer is that the rich world imposed trade restrictions on the poor world. Another part of the answer is that the poor world shot itself in the foot with its own trade restrictions, which made exporting into a competitive world market unprofitable.

But trade restrictions are only part of the explanation for the persistence of the wage gap. The more important explanation is that the rich world could get away with a big wage gap because there are spatial economies of scale in manufacturing. That is, if other firms are producing manufactures in the same location, that tends to lower the costs for your firm.

For example, with lots of firms doing the same thing, there will be a pool of workers with the skills that your firm needs. And there will be plenty of firms producing the services and inputs that you need to function efficiently. Try moving to someplace where there are no other firms, and these costs are going to be much higher — even if raw labor is much cheaper.

The professional term for this is “economies of agglomeration.” It was the key building block for the big insight of Paul Krugman and Tony Venables. They asked what would happen if the wage gap widened until it became big enough to offset this advantage from scale economies.

Imagine yourself as the first firm successfully to jump the wage gap — that is, you relocate from the high-wage world to the low-wage world. At first you do not make a fortune. You just about break even. After all, if by moving it was possible to instantly make a fortune, someone else would already have done so.

You are the first to move and not go bankrupt, and you just get by. It is lonely being the first firm. There are no other firms around to generate those agglomeration economies, but you just hang on.

And now here comes the important step. How do things look to a second firm that is thinking of relocating?

Well, for the second firm it all looks a bit better than it did for the first firm because there is already another firm there. So the second firm relocates. And that also helps the first firm. They both start to do better than just getting by.

And the third firm? Better still. What happens is an explosive shift of manufacturing to the new location. Does this sound familiar — like the shift of manufacturing from the United States and Europe to Asia?

The change has been explosive because once activity started to relocate, agglomerations grew in low-wage Asia. In the process, wages are being driven up in Asia, but the gap was initially enormous — and there is a huge amount of cheap labor in Asia, and so this process of convergence is going to run for many more years.

This can be described as firms relocating. Sometimes this is precisely what happens — outsourcing, or “delocalization.” But it need not be, and you do not stop it by banning firms from moving.

It could equally well be that new firms set up in the low-wage locations and outcompete the existing firms in the high-wage locations. Firms do not have to move in order for industrial activity to shift location, since birth of firms in one place and deaths of firms in another come to the same thing.

In effect, in order to break into global markets for manufactures, it is necessary to get over a threshold of cost-competitiveness. If only a country can get over the threshold, it enjoys virtually infinite possibilities of expansion. If the first firm is profitable, so are its imitators.

This expansion creates jobs, especially for youth. Admittedly, the jobs are far from wonderful, but they are an improvement on the drudgery and boredom of a small farm, or of hanging around on a street corner trying to sell cigarettes.

As jobs become plentiful, they provide a degree of economic security not just for the people who get them, but for the families behind the workers.

And gradually, as jobs expand, the labor market tightens and wages start to rise.

This started to happen in Madagascar in the late 1990s.

The government established an export processing zone and created policies good enough that firms were sufficiently cost-competitive to take advantage of a U.S. trade arrangement called the Africa Growth and Opportunity Act. Almost overnight, the zone grew from very few jobs to 300,000 jobs.

That is a lot of jobs in a country with only 15 million people. The jobs would probably have kept on growing, but politics got in the way. When the president, Admiral Didier Ratsiraka, lost the election he refused to step down, and he got his cronies to blockade the port — a city his supporters controlled.

For eight months, the worthy admiral attempted to get his job back through economic strangulation of the wayward electorate. Unsurprisingly, by then the export processing zone had been decimated. By the time it restarted there were only 40,000 jobs — and firms were wary of returning.

A manager of a U.S. garment company said in disbelief that the former president had chosen to wreck his own country. He said, “If it’s like that, then count us out. We’ll stick to Asia.”

Editor’s Note: This feature is adapted from THE BOTTOM BILLION by Paul Collier. Copyright 2007 by Oxford University Press. Reprinted with permission of the publisher.