SMU SOE Seminar (Apr 3, 2017): Industrial Upgrading, Structural Change, and Middle Income Trap

As intermediate input, upstream production service is more intensively used in the production of sophisticated manufacturing and consumption service than the 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 (nontradable) 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. International trade may help a country to escape the mid-income trap by inducing structural change, but further liberalization in the production service sector or increases in consumption service productivity may result in being caught in the mid-income trap. Welfare-enhancing government interventions are proposed.

 

Keywords: Industrial Upgrading, Structural Change, Middle-Income Trap, Labor Market, Chinese Economy, Economic Growth, Industrial Policies