A NEW THEORY OF INDUSTRIALIZATION

Heling Shi and Xiaokai Yang

Department of Economics
Monash University
Clayton, Victoria 3168
Australia

Abstract

This paper constructs an equilibrium model with consumer-producers, economies of speciali-zation and transaction costs. The comparative statics of equilibrium can be used to predict several concurrent phenomena associated with an industrialization process: an increase in productivity, an increase in trade dependence, increases in the division of labor and speciali-zation, the emergence of new producer goods at a layer of the hierarchy of goods, and an increase in the number of layers of the hierarchy, increases in the diversity of the economic structure and in the degree of integration of the economy, and an increase in capital goods.

Journal of Economic Literature Classification: L10, O14, M13

1. Introduction

Casual observation indicates a positive correlation between the level of specialization, the degree of the roundaboutness of production, and the variety of available goods in an econ-omy. The variety of available goods is small and the degree of production roundaboutness is low in a less developed and autarkic economy where the level of division of labor and spe-cialization is extremely low and everybody self-provides the goods he needs. In contrast, the variety of available goods is great and the degree of production roundaboutness is high in a developed economy where the division of labor and specialization is extremely high. This positive correlation may reflect some important mechanism that is essential for the theory of industrialization and that has not been well understood by economists. Two recent lines of research treat two aspects of the mechanism in isolation.

The first line, developed by Dixit-Stiglitz [1977], Ethier [1982], Krugman [1981], Romer [1986], and Grossman and Helpman [1989] endogenizes the variety of goods by for-malizing a tradeoff between the distortions arising from economies of scale and preferences for diverse consumption or economies of complementarity in production. The crucial ele-ment of the models is the CES utility or production function in which all goods are not neces-sities individually, so that the number of goods can be endogenized. However, these models cannot endogenize the level of specialization for each individual. To endogenize the level of specialization, the degree of self-sufficiency of consumers and the range of production of each individual have to be endogenized.

Rosen [1978], Baumgardner [1988], Kim [1989], Locay [1990], Yang [1990], Yang and Wills [1990], and Yang and Borland [1991] have endogenized the level of specialization, leaving the number of goods exogenously fixed. Yang's [1990], Yang and Wills' [1990], and

Yang and Borland's [1991] static and dynamic equilibrium models have endogenized the level of specialization by formalizing a tradeoff between economies of specialization and transaction costs. However, the variety of available goods is not endogenized in their models because the Cobb-Douglas utility function assumed in their models entails an exogenously fixed number of goods2. Yang and Shi [1992] have endogenized the variety of consumer goods, the number of traded goods, and the level of specialization by specifying a CES utility function in an equilibrium model with transaction costs, economies of specialization, and consumer-producers. The number of producer goods and the length of the roundabout pro-duction chain is not endogenized in their model because producer goods and the CES produc-tion function are absent. A natural conjecture is that a synthesis of the thinking along these two lines may enable us to decipher the mechanism behind the concurrent increases in spe-cialization, production roundaboutness, product diversity, and productivity. This idea moti-vates the paper.

According to Smith [1776] and Young [1928], there are three aspects of the division of labor: the level of specialization of individuals, the degree of diversity of professions, and what was referred to by Young as the degree of roundaboutness.3 Roundaboutness may be related to the vertical division of labor between up-stream and down-stream sectors in a long production chain and the second aspect, diversity of professions, may be related to the hori-zontal division of labor between professional sectors at the same level in this chain. Suppose there is a hierarchical structure of goods and factors, a production chain. At a down-stream layer of the hierarchy there are many consumer goods and, at an up-stream layer, there are many producer goods. The endogenization of level of specialization in Baumgardner [1988], Locay [1990], Yang [1990], and Yang and Borland [1991] captures the first aspect of the division of labor. The endogenization of the number of consumer goods by employing the CES utility function in Dixit and Stiglitz [1977] and Yang and Shi [1992] captures the second aspect of the division of labor at the down-stream layer of the hierarchy. However, the third aspect of the division of labor and the second aspect of the division of labor at the up-stream layer of the hierarchy does not seem to have been captured in previous studies. In order to endogenize roundaboutness we have to endogenize the number of layers of the hierarchy of goods or the length of production chain in a general equilibrium model. The number of pro-ducer goods as well as the level of specialization can be endogenized by introducing the CES production function and producer goods into the Yang model [1990]. This is pursued in this paper.

In the model to be considered, each individual is assumed to be a consumer-producer and to derive utility from a single consumption good, called food, which uses as inputs labor and either one or two producer goods. One of the two producer goods, called a hoe, can be produced out of labor and the other, called a tractor, needs as inputs labor and another pro-ducer good, called a machine tool. Finally a machine tool can be produced out of labor. Each individual is endowed with fixed amount of labor and has a system of individual-specific Cobb-Douglas-CES production functions for producing the producer and consumption goods. The relationship between labor and producer goods is specified by a Cobb-Douglas function. The relationship between hoes and tractors is specified by a CES function. In producing a tractor, machine tools are needed. In producing a machine tool, only labor is needed. Owing to the property of the CES function, hoes and tractors are not individually necessities for the production of food. Hence, if tractors are not employed, then machine tools will not be pro-duced.

Where there are economies of specialization, economies of complementarity between producer goods in producing the final good, and transaction costs, a tradeoff exists. A greater degree of horizontal division of labor between the production of hoes and the production of tractors may generate more opportunities for the vertical division of labor between the pro-duction of tractors and the production of machine tools, which is associated with a larger number of layers of the hierarchy. This implies higher productivity, generated by a greater variety of sophisticated professional equipment and machines, but, at the same time, greater transaction costs.

If transaction efficiency is extremely low, then the gains to introducing more layers of the hierarchy and further horizontal and vertical division of labor are outweighed by transac-tion costs. In this case, each individual will choose autarky, that is, he will self-provide all producer goods and consumer goods. A tradeoff still exists in autarky between economies of specialization and increasing returns to a variety of producer goods. If a large number of producer goods are produced in autarky, a person's level of specialization in producing each good must be low. Thus, in autarky the foregone economies of specialization due to the production of many producer goods at many layers of the hierarchy of goods outweigh the gains to a variety of producer goods. Therefore, in autarky, each individual will choose a hierarchy of goods with a small number of layers and a small number of producer goods at each layer, so that he can capture more economies of specialization by concentrating his limited labor in a few activities. This implies that some sophisticated producer goods based on a large number of layers of the hierarchy are unlikely to exist in autarky. For example, it is likely that only hoes will be produced but no tractors and machine tools will be produced in autarky.
If transaction efficiency is extremely high, then people may choose a greater degree of horizontal as well as vertical division of labor and in the meantime maintain each individual's level of specialization at a high level through the division of labor between many different specialists. Therefore, a high transaction efficiency may bring out some new layers in the hierarchy of goods and new producer goods at each layer in the hierarchy. For example, tractors and hoes are produced if a higher transaction efficiency generates a higher level of horizontal division of labor in producing tractors and hoes. The higher level of horizontal division of labor will create scope for the vertical division of labor in producing both down-stream goods, tractors, and up-stream goods, machine tools. The emergence of the new layers and new producer goods implies new technology and new industries that are associated with an industrialization process. Hence, a general equilibrium model may be used to predict concurrent increases in the number of producer goods at each layer, in the level of specializa-tion, and in the number of layers of the hierarchy of goods.

We will show that, for a sufficiently large elasticity of substitution between producer goods, the number of producer goods at each layer and the number of layers of the hierarchy of goods increase as transaction efficiency is improved. Further, trade dependence, produc-tivity, and the level of specialization for individuals increase with improvements in transac-tion efficiency.

In section 2, a model with consumer-producers, increasing returns to specialization, and transaction costs is specified. Section 3 investigates individuals' decisions and equilibrium. The final section concludes the paper.

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