Industrial Development and Convergence

Goodfriend, Marvin, and John McDermott. 1998. "Industrial Development and the Convergence Question." American Economic Review 88, no. 5 (December): 1277-1289.

Marvin Goodfriend was an economist with broad interests. He is well known for his contributions to macroeconomics and monetary economics. But he was also an avid reader of economic history and a student of the forces that drive economic growth.

Goodfriend wrote two papers on growth with his Brown University classmate John McDermott: "Early Development" and "Industrial Development and the Convergence Question," published in the American Economic Review in 1995 and 1998, respectively.

Early Development (Goodfriend and McDermott, 1995) examines the transition from a traditional, stagnant economy to a modern, growing economy. This work is part of an extensive literature on poverty traps and industrialization that includes Murphy and Shleifer (1989), Becker, Murphy, and Tamura (1990), Galor and Weil (2000), and Lucas (2002).

Industrial Development (Goodfriend and McDermott, 1998) highlights the importance of familiarity with the technologies of other countries in the returns to human capital accumulation and the growth process. This work is part of a large literature on the connections between trade and growth.¹

In this essay, we describe the Industrial Development model and ponder its lessons for contemporary policy discussions.

Model structure

Goodfriend and McDermott (1998) develop a model in which human capital accumulation is the engine of growth, as in Lucas (1988). The novel dimension is an interaction between the size of the population and the technology for human capital accumulation.

Final output is produced by combining efficiency units of labor with a continuum of differentiated goods produced by monopolists. There is free entry into the production of differentiated goods, so profits are zero in equilibrium. But, unlike Romer (1990), Goodfriend and McDermott assume in both of their papers that firms do not have to incur research and development costs to produce a new differentiated good.

The key mechanism is that a larger population results in higher demand for differentiated goods. The prospects of higher sales and profits induce entry so that a rise in population increases the number of differentiated-good producers. In turn, the number of differentiated goods produced has a positive impact on the ability of workers to accumulate human capital. Goodfriend and McDermott (1998) assume that this driver of human capital accumulation depends on how many goods are produced at home and how many of the goods produced abroad are familiar to domestic agents.

Ultimately, the setup is one in which countries that are open to the rest of the world, and familiar with technologies used or developed elsewhere, find it easier to accumulate know-how. As a result, these countries develop at a rate that allows them to catch up and even overtake the per capita output levels of more advanced trading partners. By contrast, countries that are less inclined to promote openness, and are less familiar with technologies used elsewhere, fall persistently behind the leading countries and potentially never catch up.

Context and contributions

In thinking about the broader arch of economic history, from the eve of the Industrial Revolution to recent times, Goodfriend and McDermott (1998) sought to identify key mechanisms underlying economic development that would not necessarily be evident over a shorter time period or in an individual country. They also recognized that these mechanisms needed to be consistent with periods of both divergence and convergence across countries during the process of world growth.

Goodfriend and McDermott (1998) isolates one of the potential ingredients responsible for the Japanese, South Korean, and Chinese growth miracles. In the context of their model, the familiarity of firms and workers in these economies with goods produced in the US increased the returns to human capital accumulation, fostering a period of fast growth. The concept of familiarity with foreign economies, in particular, which plays a central role in Goodfriend and McDermott (1998), now seems prescient given the explosion of information-sharing that the information technology revolution was about to make possible.

The Goodfriend and McDermott (1998) model can be used to think about some grand experiments implemented in the 20th century: Japan, South Korea, and other Asian countries chose export promotion as their development strategy in the 1970s and, starting in 1979, China also went this route. By contrast, India, Latin America, and Africa chose import substitution as their development policy.

Import substitution had the appeal of combining economic growth with political independence from the US and other large economies. In particular, Latin American countries hoped that import substitution would be a solution to the problem of being, in the words of the Mexican president Porfirio Dias, "too far from God, too close to the United States." After becoming independent in 1947, India hoped that import substitution would allow it to achieve "swadeshi," i.e., a genuine self-reliance that would make India independent of both communist and capitalist countries.

Import substitution produced some early wins. In 1954, Hindustan Motors, a state-owned Indian company, started producing automobiles. Imposing high tariffs on foreign goods and fostering the development of a domestic industry helped create a fast-growth decade in Brazil during the 1970s.

But these successes proved ephemeral. The Ambassador, the car first produced in India in 1954, remained almost unchanged for 50 years. Import substitution turned Brazil into one of the world's most closed economies. By protecting its computer industry, Brazil made the domestic price of computers much higher than the international price,² reducing the productivity benefits from adopting information technologies in a wide range of industries. The success of Brazil in the 1970s was followed by decades of stagnation that lent credence to the famous quip by the writer Stefan Zweig: "Brazil is the land of the future and always will be."

There are many aspects of import substitution regimes that might have contributed to their poor performance. The extensive government involvement in the economy gave entrepreneurs an incentive to invest in political connections rather than learning new technologies or adopting from abroad. At the same time, the protection from competition reduced incentives to be efficient and invest in new technologies.

Goodfriend and McDermott (1998) add two important factors to this standard list of the perils of import substitution. The first factor is scale. In many countries, the internal market is too small. According to Scitovsky (1969), the 1960s saw 90 Latin American companies in eight countries producing cars and trucks with a combined volume of about 600,000 vehicles. Yet, he documents that during this period, the efficient scale for an automobile plant was estimated to require a minimal annual production of 250,000 vehicles. In the Goodfriend and McDermott (1998) model, scale matters indirectly: it affects the returns to human capital accumulation and the associated growth prospects. In earlier work, Goodfriend and McDermott (1995) argued that a large enough scale, achieved through population growth, was key to increased specialization, which eventually raised learning productivity enough to kick start a period of self-sustaining technological progress.

The second factor highlighted by Goodfriend and McDermott is familiarity with foreign goods and technologies. Countries that close their doors to trade also shut their doors to foreign technologies. In the Goodfriend and McDermott (1998) model, low familiarity with foreign goods depresses the returns to human capital accumulation and dims growth prospects. Here, familiarity is envisioned as stemming in part from active commercial relations, but also from a more pervasive knowledge of foreign cultures and commodities.

Reading this paper brings to mind themes that are very relevant today. Just as the information technology revolution was about to hit its stride, Goodfriend and McDermott (1998) wrote that "... it is easy to see that familiarity would grow over time with the economy. Nations become more familiar with each other as technological progress lowers transports costs and communication costs." After achieving remarkable success with export promotion, China is now turning to import substitution with its campaign "Made in China 2025." Goodfriend and McDermott's (1998) model predicts that this choice will penalize China's growth prospects. But will progress in information technology allow China to stay inside its great walls and maintain familiarity with the technological world outside?

As it turns out, forces that contributed to familiarity with the outside world also brought to the fore new vulnerabilities such as cybercrime and intellectual property theft. Intellectual property products, in particular, are now a key component of investment goods in the US National Income Accounts following, in part, a reclassification of industries in 1999 and again in 2013. Therefore, will the ease with which information can be obtained increase the incentive to accumulate human capital in countries that are still relatively closed to foreign trade? In Goodfriend and McDermott (1998), world growth is maximized when all countries are perfectly familiar with each other. Would they still see the world in this way 25 years later?

These are fascinating topics that can be discussed in the context of the Goodfriend and McDermott (1998) model. We only wish that Marvin could be here to debate them with us, as he would have undoubtedly done enthusiastically.

References

Becker, G.S., K.M. Murphy, and R. Tamura. 1990. "Human Capital, Fertility, and Economic Growth." Journal of Political Economy 98, no. 5, part 2 (October): S12-S37.

Eaton, Jonathan, and Samuel Kortum. 2001. "Technology, Trade, and Growth: A Unified Framework." European Economic Review 45, no. 4-6 (May): 742-755.

Galor, Oded, and David N. Weil. 2000. "Population, Technology, and Growth: From Malthusian Stagnation to the Demographic Transition and Beyond." American Economic Review 90, no. 4 (September): 806-828.

Goodfriend, Marvin, and John McDermott. 1995. "Early Development." American Economic Review 85, no. 1 (March): 116-133.

Goodfriend, Marvin, and John McDermott. 1998. "Industrial Development and the Convergence Question." American Economic Review 88, no. 5 (December): 1277-1289.

Grossman, Gene M., and Elhanan Helpman. 1991. "Trade, Knowledge Spillovers, and Growth." European Economic Review 35, no. 2-3 (April): 517-526.

Grossman, Gene M., and Elhanan Helpman. 2015. "Globalization and Growth." American Economic Review 105, no. 5 (May): 100-104.

Lucas Jr., Robert E. 1988. "On the Mechanics of Economic Development." Journal of Monetary Economics 22, no. 1 (July): 3-42.

Lucas Jr., Robert E. 2002. "The Industrial Revolution: Past and Future." In Lectures on Economic Growth, 109-188. Cambridge: Harvard University Press.

Luzio, Eduardo, and Shane Greenstein. 1995. "Measuring the Performance of a Protected Infant Industry: The Case of Brazilian Microcomputers." Review of Economics and Statistics 77, no. 4. (November): 622-633.

Murphy, Kevin M., Andrei Shleifer, and Robert W. Vishny. 1989. "Industrialization and the Big Push." Journal of Political Economy 97, no. 5 (October): 1003-1026.

Romer, Paul M. 1990. "Endogenous Technological Change." Journal of Political Economy 98, no. 5, Part 2 (October): S71-S102.

Scitovsky, Tibor. 1969. The Process of Industrialization in Latin America: Round Table, Inter-American Development Bank. Guatemala: Inter-American Development Bank.

Cite as: Rebelo, Sergio T., and Pierre-Daniel G. Sarte. 2022. "Industrial Development and Convergence." In Essays in Honor of Marvin Goodfriend: Economist and Central Banker, edited by Robert G. King and Alexander L. Wolman. Richmond, Va.: Federal Reserve Bank of Richmond.