Dani Rodrik of the Harvard Kennedy School of Government was on Econtalk two months ago. Rodrik did a study recently on why some emerging markets like China and India have greatly benefited from globalization whereas other countries, particularly in Latin America and Sub-Saharan Africa have not. His argument has many layers but the main point was that the classical view of how closed economies should open up can lead to market failures. In the latter part of the twentieth century when globalization revved up, the traditional view as preached by the United States and the World Bank was that developing nations with closed economies should drop trade barriers and let their sheltered companies compete on the world market. This would cause the inefficient industries to shrink or disappear, which would free labour to move into more productive industries where they had a comparative advantage. However, what happened was that after these old companies shrank, the newly unemployed workers ended up moving into less productive areas like petty trade, such as street vending, because the supposed new industries never materialized as expected. The end result was that there was no great increase in economic growth from globalization and in some cases even a decline.
Rodrik’s explanation for why new companies didn’t develop was because they weren’t able to collect what is known as Schumpeterian rents. Rent is an economic term for a payment that is beyond what the costs of production and normal profits would entail. Schumpeterian rent is the extra payment an innovator would receive for bringing something new to the market. For example, patent laws ensure that if you invent something, you are protected from competition for a number of years to recoup your investment. This encourages innovation and risk taking. Now, in an advanced country, new companies are generally formed because of some innovation that allows for Schumpeterian rent. Either by law or some first mover advantage, there is a barrier to entry for competing companies. Thus we have companies like Amazon.com or Google. I still don’t know what advantage Facebook had (credibility with adults perhaps?).
However, in developing countries, new industries form because of a cost advantage and not an idea advantage. So a toy manufacturer in China or a call center in India has an advantage over the United States because labour costs are lower. However, in an emerging economy, the person who moves first has a disadvantage because by navigating bureaucratic and other hurdles to get started, they would provide free information to future competitors. Rodrik uses the example of setting up a call center in Jamaica. If someone were to set one up, just the fact that they succeeded would bring in competitors who could do so with lower cost and risk. Hence, there is no incentive to start companies. It is always better to be second. Rodrik thus proposed that this market failure could be corrected with government policy that subsidizes first movers but not subsequent ones. This would then encourage innovation.
According to Rodrik, China did not use the classical model. They did not stop protecting their inefficient state-run companies but instead started special economic zones where new companies would be subsidized to compete on the world economy. This allowed for an influx of previously unproductive rural workers to become urbanized and more productive. Employees in state-run companies, although more inefficient compared to those in the new companies were still more productive than their rural comrades. Thus by protecting new companies, in part by keeping their currency under valued, China was able to sustain rapid growth. Rodrik has many other very interesting things to say so I recommend listening to the entire podcast.