Industrial Upgrading, Structural Change, and Middle Income Trap

Cross-country empirical evidence suggests that the production-service share in countries stuck in the middle-income trap is lower than that in those which have escaped the trap, but the opposite is true for their counterparts inside and outside the low-income trap. Why? To address these questions, we develop a multi-sector growth model which highlights the asymmetric importance of production service at different development stages. 

As intermediate input, upstream production service is more intensively used in the production of sophisticated manufacturing and consumption service than basic manufacturing. At the low income level, basic manufacturing is the main employment sector. When labor productivity increases, the rising wage results in a shift in the aggregate demand disproportionately toward sophisticated manufacturing and consumption service, so labors are reallocated from the basic manufacturing sector into the service sector (structural change) and the sophisticated manufacturing sector (industrial upgrading).    

 We show that laissez faire market equilibrium is not necessarily Pareto efficient because of two sources of pecuniary externality. One is the vertical input-output externality in production, which may lead to multiple equilibria because of coordination failure in upstream production-service sector with entry barriers; and the other is the horizontal demand complementarity between (non-tradable) consumption service and (tradable) sophisticated manufacturing consumption, which are asymmetrically affected by international trade.  As a result, the market induces premature industrial upgrading and structural change in some cases, but hampers industrial upgrading and structural change in other cases.  Lowering entry barriers to the production service sector in a developing country may facilitate, or hamper, or have no effect on its convergence to the developed country, depending on their trade specialization pattern, which is in turn determined by their comparative advantages associated with their development stages. For sufficiently developed middle-income countries, liberalizing the production service sector is crucial in avoiding the middle-income trap.  Welfare-enhancing government interventions are proposed.