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Market Led Industrialization and Globalization Jeffrey Sachs and Xiaokai Yang
We are grateful to Francisco Rodriguez for
stimulating discussion and to the participants of the seminar at the
Harvard Center for International Development and of 1999 Conference
of Development Economics for comments. Also, comments from an anonymous
referee are appreciated. We are solely responsible for the remaining
errors. The paper introduces asymmetric production
conditions between firms and asymmetric transaction conditions between
countries into the Murphy-Shleifer-Vishny model of industrialization.
It explores a general equilibrium mechanism that generates circular
causation loop that each firm's profitability and its decision of
involvement in a network of industrial linkages is determined by the
size of the network, while the network size is in turn determined
by all firms' decisions of participation. It shows that the very function
of the market is to network relevant self-interested decision-makers
and to utilize the network effects of industrialization, though this
function is not perfect. Hence, market led industrialization will
gradually spread until the whole world economy is integrated in a
single network of trade and industrial linkages as trading efficiency
is improved. This paper devises a new approach to specifying zero
profit condition for a marginal modern firm, while keeping original
feedback loop between positive profit and the extent of the market
of the MSV model. Hence, this new method and the trade off between
economies of scale and transaction costs can be used to endogenize
the number of modern sectors, thereby increasing applicability of
this type of models. Since the end of the 1980s, many general equilibrium
models with increasing returns have been developed to formalize what
is called by Krugman (1995) "high development economics."
There are two different views in high development economics. One is
referred to as the theory of big push and balanced industrialization,
represented by Rosenstein-Rodan (1943) and Nurkse (1952). The other
is referred to as the theory of unbalanced industrialization, represented
by Fleming (1954) and Hirschman (1958). When economists were not familiar
with technical substance of general equilibrium models, they can only
use vague words to address general equilibrium phenomena, such as
circular causation, interdependent decisions in different industries,
pecuniary externality of industrial linkages, and so on. In essence, Rosenstein-Rodan's idea (1943)
about big push industrialization is to advocate for state led industrialization
because of coordination failure in exploiting network effects of industrial
linkages in a decentralized market. This idea is formalized by the
MSV model with the feedback loop between the extent of the market
and economies of scale that can be exploited. Hirschman's idea (1958)
about pecuniary externality of industrial linkages relates more or
less to market led industrialization since the network effects of
industrial linkages are pecuniary (which can be exploited by the price
system). Term "balanced vs. unbalanced industrialization"
may be misleading. Unbalanced industrialization strategy may be associated
with specialization of a country in a particular sector and international
division of labor between countries. Hence, from a view of the world
market, such a strategy is a balanced industrialization strategy,
although it is not balanced within a single country (Sheahan, 1958).
We shall extend the MSV model to formalize Hirschman's idea on market
led spread of industrialization. Casual observation indicates that industrialization
was gradually spread from the UK to Netherlands and France, then to
Germany and other Central and Northern European countries, and finally
reached Southern Europe and the rest of the world. In Asia, industrialization
started in Japan in the end of 19th century, then gradually spread
to Hong Kong, Singapore, Taiwan, South Korea, and other Asian countries. The observed spread of industrialization is
affected by transaction conditions. There are three major determinants
of transaction conditions: institutions, geography, and technology.
Industrialization started in the island countries, then spread to
coastal regions of the continent, then to hinterland countries. It
was so in Europe in the 18th and 19th century (the UK is an island
country, Netherlands and France are in coastal region, and Germany
and other central European countries are hinterland countries) and
in Asia in the 19th and 20th century (Japan and Taiwan are island
countries, Singapore, Hong Kong, and South Korea are in coastal region,
China and India are continental countries with vast hinterland areas).
Effects of institutions on transaction conditions
and thereby on economic development have been investigated by North
(1981), North and Weingast (1989), Mokyr (1990, 1993), and others.
Gallup and Sachs (1998) provide empirical evidence for effects of
geography on transportation conditions and thereby on economic development.
They use cross country data to show that the population share of coast
region and distance from the major international market have very
significant impact on per capital income. Institutions and geography are not independent
of each other. Baechler (1976, pp. 78-80) notes that geographical
conditions of Europe created a variety of polity and rivalry between
hostile sovereignties within the same cultural whole in Europe, which
encouraged many different institutional experiments. A particular
geographical condition ensured that Britain could avoid war with other
countries at low defense expenses and had transportation advantage
for trade. Pursuit of riches was legitimated under the prevailing
ideology, so that talents were diverted from military, religious,
and bureaucratic careers to business activities prior to and during
the Industrial Revolution. In the paper, we will introduce asymmetric
production conditions between firms and asymmetric transaction conditions
between countries into the MSV model of industrialization (1989).
In the MSV model market prices are determined by the zero profit condition
in the traditional sector with constant returns to scale technology
and therefore its algebra is easy to manage. The feedback loops between
the extent of the market, dividend earnings, economies of scale that
can be exploited, and quantities demanded nicely formalize a general
equilibrium mechanism that can talk to circular causation, network
effects of industrial linkages, and interdependence between production
and market conditions and decisions in different sectors, which concerned
high development economists. In this paper, we develop an analytical approach
to specifying a zero profit condition for a marginal modern firm,
while keeping positive profit for other active modern firms. Following
Kelly, we specify the trade off between economies of scale and transaction
costs to endogenize the numbers of active modern and traditional firms.
This approach keeps the original flavor of the MSV model: interdependence
between the extent of the market and economies of scale, and compatibility
between price taking and global economies of scale. A key ingredient
that makes this approach work is asymmetry of production conditions
between different modern firms and asymmetry of transaction conditions
between countries. This new approach to handling the MSV model will
make this model more applicable to the analysis of many problems in
economic development, trade, urbanization, and industrial organization. The introduction of the trade off between
economies of scale that can be exploited and transaction costs can
accommodate empirical evidence that is at odds with the MSV model.
The MSV model predicts that a large population size has a positive
effect on industrialization. But the first country that was industrialized
(UK) was not the most populous country (which was China). Empirical
evidence provided in National Research Council (1986) and Dasgupta
(1995) rejects this type of scale effect. Murphy, Shleifer, and Vishny
(1989) suggest introducing transaction costs to counteract the scale
effect. Our model will substantiate their idea and show that there
exists substitution between population size and trading efficiency
in promoting industrialization and economic development and that a
large country can be locked in the development trap if its transaction
efficiency is low. In section 2, equilibrium and comparative
statics of the extended MSV model are solved. We then extend the model
to the case with many countries to endogenize a dual structure between
integrated developed world and autarkic less developed world in section
3. In addition, a dynamic version of the model is considered. The
final section concludes the paper. Inframarginal Economics Society www.inframarginal.com
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