Category Archives: Member Contributions

(When) Do Anti-poverty Programs Reduce Violence? India’s Rural Employment Guarantee and Maoist Conflict

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Aditya Dasgupta (University of California, Merced), Kishore Gawande (University of Texas, Austin), and Devesh Kapur (Johns Hopkins University – SAIS)

More than half of all nations have experienced a violent civil conflict since 1960.[1] One of the best predictors of conflict outbreak in a country is a low level of economic development and whether it has experienced a civil conflict in the past, suggesting the existence of “conflict trap” in which poverty and violence reinforce one another over time. This begs the question: how do nations break out of the vicious cycle of poverty and violence?

Poverty encourages participation in armed civil conflict in at least two ways. First, it creates economic and political grievances among impoverished groups, providing fertile ground for rebel groups to draw support from those who feel neglected by the state. Second, a lack of employment opportunities and stable livelihoods reduces the opportunity costs of participating in violent conflict, making it easier for rebel groups to recruit fighters.

If poverty fuels violence, then anti-poverty programs ought to play an important role in pacifying violent civil conflict. A large and growing scholarly literature has examined this policy implication, coming to surprisingly mixed conclusions. One randomized study of Afghanistan’s largest development program finds that the program contributed to a modest reduction in violence.[2] Another important randomized study in Liberia found that a combination of cash payments and therapy produced a durable reduction of participation in crime and violence among at-risk young men.[3] Other studies, especially those that examine the roll-out of large-scale government programs and not pilot experiments, have found that foreign aid and development programs are sometimes associated with increases in violence.[4]

How do we reconcile the conflicting evidence, especially the disjuncture between micro-level randomized studies by researchers and the program evaluation literature? We argue that state capacity, or the bureaucratic capacity of a government to successfully implement programs, may play an important role in actuating the pacifying effects of anti-poverty programs. In conditions of low state capacity, program funds are unlikely to pass through to local populations and corruption may even reinforce local grievances with the state and provide opportunities for rebel financing. When local state capacity is strong, however, antipoverty programs have a better chance of actually reducing poverty, improving perceptions of the state, and dis-incentivizing participation in deadly conflict.

To examine this hypothesis, we empirically examine how the roll-out of India’s National Rural Employment Guarantee Scheme (NREGS), a large-scale anti-poverty program which guarantees every rural household in India up to 100 days of public works employment, affected the intensity of the Maoist conflict, a protracted conflict between a Maoist insurgency concentrated in eastern India and the Indian government. Because the roll-out of NREGS was staggered in three phases between 2006 and 2008, we can employ a difference in differences research design. If NREGS reduced violence, we should observe a reduction in violence in districts adopting the program relative to districts experiencing no change in their program adoption status. Moreover, if these pacifying effects depended on state capacity, we should observe that these effects are mainly concentrated in districts with a high level of state capacity, which varies quite substantially across regions and districts of India.

To measure the intensity of the Maoist conflict, we assemble a new panel dataset of violent incidents and deaths at the district level, drawing on the archives of local language newspapers, which ensures that we get adequate temporal and spatial coverage of a long-simmering conflict that occurs mainly in rural areas; existing datasets that draw exclusively on English language sources are heavily biased toward more recent conflict events and those that are close to urban areas. To measure district-level state capacity, we average the ranking of districts across four indicators of basic service provision according to the 2001 census based on the share of villages with: (1) a paved road; (2) a primary school; (3) a primary health center; and (4) an agricultural credit cooperative (the lowest tier of the Indian government’s agricultural credit network).

Using these data, we come to two main findings. First, overall the adoption of NREGS was associated with a large reduction violent incidents and deaths, especially over the long run. To provide a back-of-the-envelope calculation of the size of the pacifying effects, consider the total levels of violence observed in 2008: 619 violent incidents resulting in 751 deaths. According to our regression estimates, counter-factually without the adoption of NREGS across districts, levels of total violence would have been 1,440 violent incidents resulting in 2,030 deaths suggesting that the program eliminated roughly 821 potential violent incidents and 1,279 casualties across districts in that year.

Second, these effects were concentrated in districts with high levels of state capacity. Our analysis of heterogeneous effects suggests that the violence-reducing effects of NREGS were concentrated almost entirely in the top two quartiles of districts in terms of state capacity. In the districts in the bottom two quartiles of state capacity, the program had essentially no impact on violence at all.

What conclusions do we draw? First, NREGS has probably played an important role in the long-term pacification of the Maoist conflict in India. Second, one reason for the mixed evidence from the program evaluation literature on the impact of development programs on violence is that the pacifying effects of anti-poverty programs depend heavily on state capacity, which can vary considerably across and within countries. Indeed, other recent studies have come to similar conclusions – that development programs can reduce violence, but primarily in areas where the state possesses a monopoly of violence and has the capacity to carry out its developmental activities without rebel subversion.[5]

To reduce violence, therefore, policymakers need to encourage not only development through anti-poverty programs, but also the strengthening of bureaucratic and state capacity.

References

Beath, A., F. Christia, and R. Enikolopov, (2013); “Winning Hearts and Minds Through Development: Evidence from a Field Experiment in Afghanistan.” Paper presented at the 110th Annual Meeting of the American Political Science Association, August, Chicago.

Blattman, C., J.C. Jamison, and M. Sheridan, (2017); “Reducing Crime and Violence: Experimental Evidence from Cognitive Behavioral Therapy in Liberia.” American Economic Review 107(4): 1165-1206.

Blattman, C., and E. Miguel, (2010); “Civil war.” Journal of Economic Literature 48(1): 3-57.

Crost, B., J. Felter, and P. Johnston, (2014); “Aid Under Fire: Development Projects and Civil Conflict.” American Economic Review 104(6): 1833-56.

Sexton, R., (2016); “Aid as a Tool Against Insurgency: Evidence from Contested and Controlled Territory in Afghanistan.” American Political Science Review 110(4): 731-749.

Endnotes

[1] Blattman and Miguel (2010).

[2] Beath, Christia, and Enikolopov (2013).

[3] Blattman, Jamison, and Sheridan (2017).

[4] Crost, Felter, and Johnston (2014).

[5] Sexton (2016).

 

Heterogeneous Effects of Economic Integration Agreements

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By Scott L. Baier (Clemson University), Jeffrey H. Bergstrand (University of Notre Dame), and Matthew W. Clance (University of Pretoria)

It is now widely accepted that economic integration agreements (EIAs) and other trade-policy liberalizations contribute to nations’ economic growth and development. EIAs have proliferated among North-North (N-N), North-South (N-S), and South-South (S-S) country-pairs. While such agreements inevitably alter distributions of income within countries, for the most part EIAs are believed to raise economic welfare. A major recent advance in the international trade literature — in the wake of and building upon theoretical developments associated with firm heterogeneity and export fixed costs — is the development of the “new quantitative trade models.”[1] These models provide calculations of general equilibrium trade and welfare effects of trade liberalizations using exogenous (variable-cost) “trade elasticities” estimated from structural gravity equations combined with aggregate bilateral trade data. Moreover, estimates of welfare effects of EIAs can be computed once one has partial treatment effects from a properly specified gravity equation with EIA dummy variables and an exogenous trade-elasticity (parameter) value.[2]

However, an important unresolved and hardly explored issue is whether — and by what factors — trade elasticities with respect to trade-policy changes vary across time and space, that is, are sensitive to “particular settings”; this is particularly important in contrasting trade elasticities for N-N, N-S, and S-S EIAs. In a recent study, we address three particular questions related to this issue.[3] First, how are trade elasticities — fixed-cost-trade-policy trade elasticities as well as variable-cost ones — theoretically related to levels of fixed and variable trade-cost variables, which vary dramatically between N-N, N-S, and S-S pairs? Second, is there convincing empirical evidence supporting these theoretical interactions? Third, how important quantitatively is the heterogeneity in partial equilibrium trade impacts in determining the general equilibrium welfare impacts of trade-policy liberalizations?

To address these questions, we provided three contributions. First, we extended a standard Melitz model of trade to show theoretically how extensive-margin, intensive-margin, and trade elasticities are endogenous to the levels of theoretical bilateral variable and fixed, policy and non-policy trade costs — even with CES preferences and with an untruncated Pareto productivity distribution.[4] Among several theoretical results, we note three. While the intensive-margin elasticity of tariff rates is sensitive only to the relative levels of variable policy and non-policy trade costs, the extensive-margin elasticity is sensitive also to the relative importance of bilateral endogenous export fixed costs (via network effects) in total bilateral export fixed costs. While the intensive-margin elasticity of policy export fixed costs is zero, the extensive-margin elasticity of policy export fixed costs is sensitive to the relative importance of bilateral endogenous export fixed costs in total bilateral export fixed costs as well as the relative importance of exogenous policy export fixed costs to exogenous non-policy export fixed costs. The theoretical comparative statics provide numerous predictions about how proxies for (time-invariant exogenous) natural variable trade costs and policy and non-policy export fixed costs influence the expected partial effects of EIAs on intensive margins, extensive margins, and bilateral trade.

Second, we evaluated empirically our theoretical hypotheses. We provided empirical evidence confirming our theory and demonstrated the heterogeneity of EIAs’ trade effects depending upon country-pairs’ geographic, cultural, institutional, and development characteristics. Extending earlier work, this is the first study to show evidence that extensive-margin, intensive-margin, and trade-flow EIA elasticities are indeed sensitive to levels of (observable) bilateral variable and fixed, policy and non-policy trade costs in a manner consistent with theoretical comparative statics.[5] Trade elasticities with respect to trade-policy changes do vary across “particular settings.” Geographic, cultural, institutional, and development country-pair characteristics all significantly influence the extensive margin elasticity, whereas primarily geographic variables (distance and adjacency) influence the intensive margin elasticity, consistent with our theory.

Finally, our framework allows us to put to ex ante use the partial effects of EIAs. By explaining the heterogeneity of EIAs’ effects according to theoretically-motivated factors, one can use the heterogeneous partial (treatment) effects for ex ante predictions and we demonstrate empirically that the partial effect of an EIA tends to be much larger for a pair of developing economies. Moreover, in the context of the new quantitative trade models, we demonstrate empirically using two approaches how sensitive quantitatively general equilibrium welfare effects of EIA liberalizations are to the bilaterally heterogeneous (partial) trade elasticities. In one approach, we calculate the general equilibrium welfare effects for importers of 1,358 bilateral EIA liberalizations among N-N, N-S, and S-S country-pairs. Consistent with theory, we show that 98-99 percent of the variation in these 1,358 welfare changes can be explained by the variation in two statistics: the estimated pair-specific bilateral EIA partial (treatment) effect and the share of the importer’s national expenditures on exports from the EIA partner. In the other approach, we show that the probability of two countries having an EIA — which in the context of a theoretical model is related to the net welfare gain from such EIA — is highly correlated with the heterogeneous EIA coefficients and the trade shares.[6] Our results suggest that a 10 percent lower average per capita income of a country-pair is associated with a 60 percent higher partial (trade) effect of an EIA. We close our study by demonstrating the relevance of our findings to the current trade-policy debate, analyzing the partial effect of “Brexit” from the European Union (EU), as well the potential effects of two EU members that are developing economies exiting the EU.

References

Arkolakis, C., A. Costinot, A. Rodriguez-Clare, (2012); “New Trade Models, Same Old Gains?” American Economic Review, 102 (1), 94-130.

Baier, S., and J. Bergstrand, (2004); “Economic Determinants of Free Trade Agreements.” Journal of International Economics, 64 (1), 29-63.

Baier, S., J. Bergstrand, and M. Clance, (2018); “Heterogeneous Effects of Economic Integration Agreements.” Journal of Development Economics, 135, 587-608.

Baier, S., J. Bergstrand, and M. Feng, (2014); “Economic Integration Agreements and the Margins of International Trade.” Journal of International Economics, 93 (2), 339-350.

Costinot, A., and A. Rodriguez-Clare, (2014); “Trade Theory with Numbers.” In Handbook of International Economics, Volume 4, edited by G. Gopinath, E. Helpman, and K. Rogoff. Elsevier Science: Amsterdam.

Head, K., and T. Mayer, (2014); “Gravity Equations: Workhorse, Toolkit, and Cookbook.” In Handbook of International Economics, Volume 4, edited by G. Gopinath, E. Helpman, and K. Rogoff. Elsevier Science: Amsterdam.

Melitz, M., and S. Redding, (2015); “New Trade Models, New Welfare Implications,” American Economic Review, 105 (3), 1105-1146.

Novy, D., (2013); “International Trade without CES: Estimating Translog Gravity,” Journal of International Economics, 89 (2), 271-282.

Endnotes

[1] See Arkolakis, Costinot, and Rodriguez-Clare (2012), Head and Mayer (2014), and Costinot and Rodriguez-Clare (2014).

[2] See Head and Mayer (2014).

[3] See Baier, Bergstrand, and Clance (2018).

[4] Novy (2013) generated endogenous trade elasticities by assuming transcendental logarithmic preferences and Melitz and Redding (2015) generated endogenous trade elasticities by assuming a truncated Pareto productivity distribution.

[5] See Baier, Bergstrand, and Feng (2014) and Head and Mayer (2014) for earlier work.

[6] See Baier and Bergstrand (2004) for underpinnings on this methodology.

Community-Based Action to Fight Corruption

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By Avinash Dixit (Princeton University)

How should a country fight corruption? Most people would answer that the government should make and enforce strong laws against it. But further thinking should show that this approach won’t get far. The politicians who make laws, and the officials who enforce them, all stand to benefit from the prevailing corrupt system. One cannot expect them to go against their strong self-interest. They will make weak laws with loopholes; their enforcement will be lax and itself riddled with corruption. At a minimum, formal legal avenues must be supplemented by participatory and organized efforts of the losers – citizens. Participatory because mere voting is not enough; even if a corrupt government is voted out, the new one will act with the implicit motto: “It is now our turn to eat”. Organized because any one citizen or firm is helpless when a politician or official demands a bribe, but collectively they have a lot of power. The question is how to harness it effectively.

This is a prisoners’ dilemma for consumers and businesses. If no one else is giving bribes, you improve your chances by bribery; if everyone else is complicit in bribery, you will only hurt yourself if you refrain. So bribery is the dominant strategy for all. But when everyone chooses it, in the aggregate they merely cancel one another’s actions and transfer money to politicians and officials. Social scientists have observed and theorized about numerous ways to resolve prisoners’ dilemmas using bottom-up, self-enforcing strategies. We can deploy this knowledge and experience to devise community-based action against corruption.

We know that successful collective action to resolve prisoners’ dilemmas requires: (1) a group with stable ongoing relationships, (2) common knowledge of what constitutes cooperation and cheating, (3) common knowledge of the sanctions to be imposed on cheaters, (4) good detection of cheating, (5) good communication of incidents of cheating to all participants, (6) incentives for members to take their designated action to punish a cheater.[1]

A business community can establish a “no bribery” norm and enforce it using the sanction that anyone found violating it would be ostracized by the others, which would cut him/her off from all the interactions – contracts, supply chains, finance and so on – that any business needs to function in today’s economies.

Let us see how this meets the desiderata listed above.[2]

(1) The community should have some organized structure such as a Chamber of Commerce, which a business is required to join in order to benefit from networking and trade relations, or be on a list qualified to bid for government business.

(2) Members must pledge not to attempt bribery to win any government contracts or licenses or to influence the decisions of regulators, legislators, and courts.

(3) Any member found violating the norm is subject to ostracism by others. This means cutting off business contacts, but can also include social ostracism if the Chamber has a social branch where the families of businesspeople meet. No one wants their spouses and children excluded from social activities of friends, so this threat can be very effective. But experience shows that sanctions should be graduated, not drastic ones triggered by small infractions; therefore violations especially by new and small members should be met first with warnings, and escalate to full ostracism only if they persist.

(4) The Chamber should have a good gossip network, and contacts with media and officials, that enable it to sniff out corruption, and a tribunal that can investigate suspicions or allegations of corruption. This can be supplemented by a more formal research unit that gives ratings to firms for their clean or corrupt behavior, similar to the Michelin star ratings for restaurants. It is extremely important to avoid false accusations, under severe penalties against anyone found making them. It is also important that the tribunal is not perceived as an insiders’ club that serves to exclude newcomers. A broad outside representation of respected senior retired businesspeople, public figures, media personnel, and academics should oversee the working of the tribunal.

(5) The name and picture of anyone convicted of violating the norms should be publicized widely, as done by the famous New York Diamond Merchants’ Club.[3]

(6) A system like the Honor Codes against cheating that exist in some universities, where refusing to report a violation is itself a violation requiring similar sanction, can create an incentive to take part in the ostracism of a convicted briber. But more than that: If A is ostracized by everyone and invites B to deal with him, B knows that A has nothing worse to fear by cheating in their interaction, and therefore that he must give up a bigger share of the available joint profit or rent to A to keep him honest. In other words, it is more costly to deal with a convicted briber than with someone who has a clean record.

The prisoners’ dilemma view of corruption can be supplemented by a coordination game.[4] Societies have two kinds of equilibria, one where everyone is corrupt and that is just an accepted state of affairs, and another with a clean culture where corruption is shameful and rare. How to shift from a corrupt to a clean equilibrium? Try harnessing the idealism of youth. Everywhere the young, especially the best educated and most enterprising, want their country to be modern and corruption-free. Other things reasonably equal, they prefer to work for, and buy from, firms with good governance and ethical behavior. A movement that channels these preferences into action can create an environment in which such clean firms attract the best talent, are favored by consumers, and therefore are more profitable; this builds momentum for more and more firms to eschew corruption. Indeed, such an organization is having some success in Sicily to fight the Mafia’s extortion; bureaucrats should be easier to counter.[5]

I am not claiming that such organizations or movements will successfully eliminate corruption everywhere, or quickly, or completely. But corruption is such an obstacle to development that even a little success is worth having. Nothing else has worked at all well. Waiting for a 100% effective solution only ensures getting 0% progress.[6]

Suggestions for further reading

Transparency International, (2016); The Benefits of Anti-Corruption and Corporate Transparency.  Working Paper #01/2016.

Mungiu-Pippidi, A. (2015); The Quest for Good Governance: How Societies Develop Control of Corruption. Cambridge University Press.

Basu, K., and T. Cordella (eds). (2018); Institutions, Governance, and the Control of Corruption, Palgrave Macmillan.

References

Bernstein, L., (1992); “Opting out of the legal system: Extralegal contractual relations in the diamond industry.” Journal of Legal Studies, 21(1), 115–57.

Dixit, A., (2004); Lawlessness and Economics: Alternative Modes of Governance, Princeton University Press.

Dixit, A., (2017); “Fighting corruption by altering the equilibrium in an assurance game.” working paper, November 2017, available at http://www.princeton.edu/~dixitak/home/wrkps.html

Dixit, A., (2018); “Anti-Corruption Institutions: Some History and Theory.” Published in K. Basu and T. Cordella, (eds.) Institutions, Governance, and the Control of Corruption, Palgrave Macmillan, pp. 15-49.

Dixit, A. and R. Mankar (2018); “New ideas for fighting corruption in India,” LiveMint, April 23, 2018, https://www.livemint.com/Opinion/mxVdMVeQUBEfoJWmY0scRL/New-ideas-for-fighting-corruption-in-India.html .

Dugatkin, L., (1999); Cheating Monkeys and Citizen Bees: The Nature of Cooperation in Animals and Humans, Harvard University Press, 1999

Greif, A., (2006); Institutions and the Path to the Modern Economy: Lessons from Medieval Trade, Cambridge University Press.

Jacobson, P., (2014); “Addiopizzo: The Grassroots Campaign Making Life Hell for the Sicilian Mafia,” Newsweek, September 17, 2014.

Ostrom, E., (2015); Governing the Commons: Evolution of Institutions for Collective Action, Cambridge University Press, Canto Classics reissue.

Superti, C., (2009); “Addiopizzo: Can a Label Defeat the Mafia?” Journal of International Policy Solutions, 11, Spring 2009 3-11.

Endnotes

[1] This list derives from studies and meta-analyses of many prisoners’ dilemmas of collective action: common resource pool problems (most notably Ostrom 2015), contract enforcement (for example Greif 2006, and Dixit 2004), and socio-biology (for example Dugatkin, 1999), to cite just a few.

[2] For more detailed arguments see Dixit (2018).

[3] See Bernstein (1992).

[4] A model with supporting evidence is in Dixit (2017).

[5] See Superti (2009) and Jacobson (2014).

[6] An OpEd offers a starter attempt to implement these ideas in India: Dixit and Mankar (2018).

 

 

Institutional and Organizational Analysis: Concepts and Applications

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By Eric Alston (University of Colorado Boulder), Lee Alston (Indiana University Bloomington), Bernardo Mueller (University of Brasilia), and Tomas Nonnenmacher (Allegheny College, Pennsylvania)

Today, the notion that “institutions matter” is broadly accepted.  Scholars have generated a rich literature on the causes and effects of institutions spanning from the micro to the macro level. The pioneering work of Buchanan, Coase, North, Ostrom, Williamson, and many others is the fertile soil in which the literature in Institutional and Organizational Analysis (IOA) has taken root and blossomed. There is a wealth of institutional scholarship that now spans disciplines, decades, and continents. Our 2018 book with Cambridge University Press, Institutional and Organizational Analysis: Concepts and Applications, expands on many of the major contributions in this area, organized within a framework that explains both the effects and determinants of institutions and norms.

Our book is centered on the insight that institutions and norms are fundamental determinants of economic and political development. Institutions are rules that recognized authorities create, and choose whether or not to enforce. Norms are long-standing patterns of behavior, shared by a subset of people in a society or organization. Institutions and norms play a role in all organizations, including governments, firms, churches, universities, gangs, and even families. In our book, we (1) present a set of concepts—for example, institutions, norms, property rights, and transaction costs—used in IOA that link institutions and norms to economic performance; (2) use the same set of concepts to better understand political organizations and performance; and (3) build a framework based on those concepts for understanding divergent developmental trajectories of nations around the world. In Parts I and II, we define the concepts needed to understand how economic activity is organized and how institutions and norms shape economic and political outcomes. In Part III, we add the comparatively recent work on beliefs and leadership to better understand the fundamental question of why there has not been convergence in economic and political performance across countries. In the following paragraphs, we summarize the three parts of our book in greater detail, which is intended as a useful reference for advanced students and scholars alike.

In Part I of the book, we link institutions to property rights, transaction costs, and economic performance. In Chapter 1, we examine how institutions and norms shape property rights. Property is a social construct; that is, property rights define our ability to use different aspects of an asset. In Chapter 2, we define transaction costs as the costs of “transfer, capture, and protection” of property rights. Transaction costs are a key determinant of organizational and contractual choice. In Chapter 3, we analyze how different types of transaction costs shape the structure of contracts and organizations. The price mechanism and hierarchies can be thought of as endpoints on a spectrum of contractual choices, and we provide a theoretical justification for and examples of different intermediary forms.

In Part II, we explain the determinants of institutions taking as fixed the basic constitutional rules and current economic performance. In the four chapters, we analyze the process through which groups and individuals lobby and government supplies laws and regulations. In Chapter 4, we address the role and impact of interest groups on government policy. Every policy is potentially redistributive, so firms and individuals organize to influence redistribution in their favor. In Chapter 5, we assess the roles of the legislature and the executive as the organizations in charge of creating and implementing legislation. In Chapter 6, we address the role of the bureaucracy and its impacts on the content, quality, and effectiveness of the outcomes of laws. In Chapter 7, we analyze how institutions can influence the structure and output of the judiciary. We also examine the impact that judiciaries have on institutions and norms.

Simple economics suggest that countries should have converged in terms of economic and political development. Moreover, scholars in the IOA have spilled a lot of ink in showing the socially beneficial institutions that accompany development. But despite an increasingly well-known institutional template, countries have not converged in terms of economic and political development and, in many cases, have outright declined. A number of explanations to this puzzle have emerged: (1) it is not in the interest of those in power to have economic and political development; (2) poorer countries have not converged because the volatility of their growth rates means such economies are as likely to shrink as grow; and (3) a change in fundamental core beliefs about how institutions affect outcomes is required to break out of the status quo. In Part III, we discuss the role of core beliefs and leadership in bringing about changes to constitutional-level institutions. Though we do not directly analyze culture or ideas as a determinant, we recognize their importance as background conditions that determine which belief changes take place. We stress leadership for its coordinative function within a dominant network that is negotiating how to respond to either an existing shock or a foreseeable crisis that could be attenuated or avoided, provided sufficient institutional change occurs.

Further, we identify fruitful avenues for research within each of our referential frames of institutional and organizational analysis, from the economic to the political to the constitutional. Our text provides useful background for the future areas of research we suggest by laying out many of the foundational contributions of the emerging discipline. It is our hope that the text will serve as a resource in helping to define the still emerging field of IOA. Our book is relevant for advanced undergraduates, as well as a valuable reference for graduate students and scholars. The analysis of the emergence and evolution of complex rule sets has proven to be one of the most illuminating areas of economic study over the course of the past century, and we accordingly describe how much more we think the field has to contribute.

Protection in Government Procurement Auctions

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By Matthew T. Cole (California Polytechnic State University), Ronald B. Davies (University College Dublin), and Todd Kaplan (University of Exeter Business School and University of Haifa)

Government procurement contracts are a large part of many economies, often accounting for 15-20% of GDP.[1] Given the significant size of these contracts and their public-sector nature, it is unsurprising that there is a long-standing tradition of protecting domestic bidders from foreign ones. A standard method of doing so has been to use a “price preference”, that is, awarding the contract to the lowest domestic bidder even if there are lower foreign bids, just so long as that domestic bid is not too much higher than the lowest foreign bid.  For example, under the European Community’s rules, contracts were awarded to a member firm so long as its bid was no more than 3% higher than the lowest non-member-bid.[2] Obviously, this is not the only method of discriminating against foreigners with tariffs being but one alternative. Despite this history, in step with the overall drive towards trade liberalization, efforts have been taken towards reducing the use of price preferences. Chief among these was the 1996 Government Procurement Agreement (GPA) which would have enforced non-discrimination in contract bidding among participating countries.[3] Importantly, this agreement which covers a subset of WTO members primarily addresses price preferences and not other discrimination mechanisms, with tariffs still being permitted as per other WTO regulations. Thus, there is a need to understand how different methods of protectionism in procurement contract auctions compare with one another. This is especially true in the current international climate where there appears to be a marked shift towards protectionism. Comparing these policies is the goal of our analysis.[4]

To do so, we modify a standard auction model in which two firms, one domestic and one foreign, are each endowed with a privately-known cost. Armed with this knowledge, the firms simultaneously submit expected profit-maximizing bids to the government under one of two policy settings. In the first, consistent with practice, we impose a price preference where the contract is awarded to the domestic firm so long as its bid is no more than a fixed percentage p higher than that of the foreign firm. The other is an ad valorem tariff t which is applied to the foreigner’s bid should it win. Note that this latter is equivalent to a tariff on the foreigner’s cost since there is a one-to-one mapping between winning bids and firm costs.

From the firms’ perspectives, there is an equivalence across the two policies, that is, for each price preference level p there is a tariff t = p that is equivalent both in terms of the probability of winning and expected profits. Intuitively, this happens because if the government replaces the price preference with a tariff of the same level, when the foreign firm increases its bid so that after-tariff profits are the same, this does not alter the bidding behaviour of the domestic firm, meaning that the probability of winning and expected after-tariff profits remain the same.

Turning to the government, we assume that it chooses its policy to maximize the expected sum of three things: the surplus generated from the contract (i.e. minimize the expected bid), expected tariff revenues (which may be costly to collect), and, given the inherently political nature of trade policy, the weighted profits of the domestic firm (where the weight represents the value of private profits relative to public revenues). When tariffs are costless to collect, the equivalence for firms holds for the government as well. This occurs because, even though a shift from a price preference p to a tariff of the same rate increases the expected cost of the contract (since the winning firm sets a higher bid), this increase is exactly offset by the rise in expected tariff revenue. In addition, with costless tariffs the government’s preferred policy is one that discriminates against foreign bidders, often to the detriment of global welfare (the sum of all players’ payoffs). Thus, under this condition, at its worst the GPA would have no impact on the level of protection between members in procurement contests. Further, if tariffs are constrained below the equivalence level under the WTO so that GPA signatories could not use their equivalent tariffs, the agreement would result in a more level playing field.

These results, however, assume that tariffs are costless to collect, something that runs counter to the empirical evidence.[5] When there are, for example, enforcement and administration costs associated with tariffs, switching from a price preference to the firm-equivalent tariff results in lower expected government welfare since the foreign firm’s bid goes up by more than the after-collection cost tariff revenue. Because of this, so long as expected tariff revenues are rising in the tariff, the government finds protection less attractive when using a tariff and, if forced to abandon the price preference, it would set it such that protection is smaller than under its preferred price preference. Thus, in this setting, even if the tariff is unconstrained by WTO regulations, one would expect the introduction of the GPA to be efficiency-improving.

Together, these results suggest that the GPA, in particular with binding limits on tariffs under preferential trade agreements, can be expected to have lowered protection levels in government procurement auctions and increase global welfare. This has important lessons for the current trade negotiation situation. First, with threats to exit various trade agreements rising rapidly, our findings indicate that if countries were to quit the GPA this would result in rising protectionism with consequent welfare losses. Second, even if the GPA remains intact, if political pressures lead to rising tariffs even under the oversight of the WTO, this may serve to roll back the gains achieved by the GPA.

References

Branco, F., (1994); “Favoring Domestic Firms in Procurement Contracts.” Journal of International Economics, 37, 65-80.

Cole, M.T., R.B. Davies, and T. Kaplan, (2017); “Protection in Government Procurement Auctions,” Journal of International Economics, 106:134-142.

Riezman, R., and J. Slemrod, (1987); “Tariffs and Collection Costs.” Review of World Economics, 123, 545-549.

World Trade Organization, (2013); “Government Procurement.” Retrieved from http://www.wto.org/english/tratop_e/gproc_e/gproc_e.htm on July 31 2013.

Endnotes

[1] World Trade Organization (2013).

[2] Branco (1994).

[3] See WTO (2013) for details.

[4] For full analysis, see Cole, Davies and Kaplan (2017).

[5] See Riezman and Slemrod (1987).

Export Competitiveness of Developing Countries and US Trade Policy

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By Shushanik Hakobyan[1] (International Monetary Fund)

With rising US trade protectionism against its major trading partners, the Generalized System of Preferences or GSP, a long-running scheme of tariff exemptions meant to aid exporters in developing countries, may get less attention. While GSP imports account for about one percent of total US imports, they account for about ten percent of all imports from GSP beneficiaries with considerable heterogeneity across countries.[2] Since the early 1970s, the GSP has given a boost to these exporters by granting their products duty-free access to the US market thereby aiding the efforts to expand their industrial and exporting capacity. But as with any policy, the devil is in the details. Despite the benefits, uptake has been low due to a number of reasons, including a low margin of preference granted by GSP, uncertainty about the permanence of the GSP program, and the statutory caps on benefits designed to prevent “abuse” by successful exporters.[3] My research focuses on the latter and explores whether these caps are well-targeted and serve their designated purpose.[4]

One of the features of the US GSP, the so-called Competitive Needs Limits, or CNLs, act as caps on benefits by excluding exporters exceeding CNL thresholds. There are two criteria to identify country-product pairs that have exceeded CNLs: (1) imports exceeding a certain value threshold in a calendar year, set at $180 million in 2017, and increasing by $5 million every year; (2) import share of a country in a given product exceeding the percentage threshold set at 50 percent. Meeting either criteria triggers an automatic exclusion of a country-product pair from GSP in the following year. The range of imports that exceed these thresholds varies greatly in terms of value. For example, the eligibility of Indian exporters of gold necklaces and neck chains was revoked in 2008, following their exports reaching $266 million in the previous calendar year (the value threshold in 2007 was set at $130 million). Likewise, the Argentine exporters of green olives lost their GSP eligibility in 2008 after accounting for 66 percent of total imports of green olives into the US in 2007. It is worth noting that Argentina had not exported green olives in the previous five years prior to 2007.

There are three ways to avoid losing the GSP benefits due to the CNL. First, if total US imports of a given product are trivial, at most $23.5 million in 2017 (set to increase by $0.5 million every year), a de minimis waiver could be applicable. Second, the percentage threshold may be waived if a directly competitive product was not produced in the US on January 1, 1995 (504(d) waiver). Lastly, country-product pairs exceeding the value or percentage CNL may petition for a more “permanent” CNL waiver.

To evaluate the impact of these caps on exporters, I examine the universe of all country-product pairs that have been excluded for more than two years from GSP over the period of 1997-2010. There have been 202 country-product pairs that met the CNL criteria in this period and were excluded from the GSP, accounting for $7 billion in imports (in the pre-exclusion year) or about 31 percent of US imports claiming GSP on average over this period. I estimate country-product level regressions of the value and share of imports on a set of binary variables indicating the first, second and third year of exclusion.

I find that the CNL exclusions are associated with a continuous decline in exports and import shares for up to three years after the exclusion, leading to a 75 percent drop by the third year of exclusion relative to the pre-exclusion average. Similarly, import shares drop by 42 percentage points from an average of 63 percent prior to the exclusion. This drop is predominantly driven by exporters who meet the percentage threshold with lower valued exports. These results are robust to employing volume data instead of values. Furthermore, the effect is larger for products facing higher MFN tariff rates. By the third year of exclusion, the value of imports and import shares of exporters eligible for a de minimis waiver drop by 50 and 75 percent, respectively, relative to pre-exclusion averages. In contrast, the impact of CNLs on the largest country-product pairs that exceeded the value threshold is negligible.

A related question of interest is the potential impact of CNLs on imports from other GSP beneficiary countries. If CNL-affected countries are unable to continue exporting to the US, who fills the void — other GSP countries or non-GSP countries? I find that import shares rise considerably more for non-GSP countries. By the third year of exclusion, the share of imports from other GSP eligible countries increases by 7 percentage points from a pre-exclusion average of 7 percent, whereas the share of imports from non-GSP countries rises by 29 percentage points (pre-exclusion average share is 25 percent).

Arguably, CNLs do not serve their intended purpose of identifying exporters who no longer need the preferential market access and allowing other GSP beneficiary countries benefit more from the program. Instead, CNLs tend to target small exporters, forcing them to stop exporting to the U.S. altogether, and mostly benefit non-GSP exporters.

These findings call for tweaks to the design of the program. Two simple changes can be made to boost the utilization of the program. First, since percentage CNL fails to identify successful exporters, a more holistic approach that takes into account both the value of imports and market share is needed to accurately detect such exporters. Second, the analysis of exports over a longer period (instead of the statutory one year) could go in hand with the previous suggestion by capturing the export dynamics of given products. These simple changes would ensure a lasting market access for the countries whom the GSP scheme is intended to help.

References

Blanchard, E., and S. Hakobyan, (2015); “The U.S. Generalized System of Preferences in Principle and Practice,” The World Economy 38(3).

Hakobyan, S., (2015); “Accounting for Underutilization of Trade Preference Programs: U.S. Generalized System of Preferences,” Canadian Journal of Economics 48(2), 2015.

Hakobyan, S., (2017a); “Export Competitiveness of Developing Countries and U.S. Trade Policy,” The World Economy 40(7).

Hakobyan, S., (2017b); “GSP Expiration and Declining Exports from Developing Countries,” Working Paper, 2017.

Ornelas, E., (2016); “Special and Differential Treatment for Developing Countries,” in Handbook of Commercial Policy, Kyle Bagwell and Robert W. Staiger (eds.), Vol. 1B, Amsterdam, North-Holland: Elsevier.

Endnotes

[1] The views expressed in this column are those of the author and should not be attributed to the IMF, its Executive Board, its management, or its member country governments.

[2] See Ornelas (2016) for a general introduction to GSP, an aspect of special and differential treatment for developing countries under the World Trade Organization.

[3] See Blanchard and Hakobyan (2015), Hakobyan (2015, 2017b).

[4] See Hakobyan (2017a).

Firm Productivity Differences from Factor Markets: New Evidence from China

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By Wenya Cheng (University of Glasgow) and John Morrow (Birkbeck, University of London)

Although firms may face radically different production conditions, this dimension of firm heterogeneity is often overlooked. A number of studies document large and persistent differences in productivity across both countries and firms.[1] However, these differences remain largely ‘some sort of measure of our ignorance’. It’s therefore worth inquiring to what extent the supply characteristics of regional input markets help explain such systematic productivity dispersion across firms, differences which remain a ‘black box’.[2] It would be surprising if disparate factor markets result in similar outcomes, when clearly the prices and quality of inputs available vary considerably, as when markets are thin, incomplete, distorted or highly heterogeneous: in short, in most developing country markets. Recent work has indicated imperfect factor mobility has sizable economic effects and that developing country distortions are large.[3] Our recent work models firm adaptation to such variation in a general equilibrium framework which microfounds these distortions and heterogeneity.[4] The structural equations of the model are simple to estimate and the estimation results quantify the importance of local factor markets for firm input use, productivity and welfare.

To better understand the environments that firms operate in, we model regional inputs markets with differing distributions of worker types, wages and regional input quality. Firms can hire different types of labor (e.g. education groups or occupations) and within each type, worker quality varies and incurs search costs. As the ease of finding higher quality workers increases with their regional supply, firm hiring depends on the joint distribution of worker types and wages. Our estimates indeed confirm that contrary to standard models with perfectly competitive labor markets, firm hiring responds to not only wages, but also the availability of worker types. Since each firm’s optimal workforce varies by industry and region, the comparative advantage of regions varies with its labor market characteristics. Since industries also differ in factor intensity, local capital and materials costs also influence the comparative advantage of a region. As the model also explicitly models entry, firms locate in proportion to the cost advantages available.

To quantify real world supply conditions, we use the model to derive estimating equations which fix: 1) hiring by wage and worker type distributions, 2) substitution into non-labor inputs and 3) firm location in response to local factor markets. The estimation strategy combines manufacturing and population census data for China in the mid-2000s, a setting which exhibits substantial local variation (see Figures 1, 2 a,b).

Figure 1 Chinese Prefectures Average Monthly Income of Employees (2005)

Figure 2 (a) % of Labor Force with less than or equal to Junior High School

Figure 2 (b) % of Labor Force with greater than or equal to Junior College

By revealing how firm demand for skills varies with local conditions, the model quantifies the unit costs for labor across China. The estimates based on within-firm hiring patterns imply interquartile differences in effective labor costs across prefectures which range from 30 to 80 percent (see Figure 3). Taking into account industry level production estimates of capital, labor and materials expenditure shares, these labor cost differences imply productivity differences of 3 to 12 percent. This helps explain the productivity difference ‘black box’ by reducing the variance of productivity residuals in every industry compared to a production function using counts of worker types or the wage bill. Extending this approach we also find that capital and materials frictions combined explain a similar range of productivity differences.

Figure 3: Geographic Dispersion of Unit Labor Costs: General Machines

The model has welfare implications for microeconomic changes in labor markets that shift regional comparative advantage and thereby the distribution of industry activity in general equilibrium. For instance, if the highly heterogenous distribution of workers and wages is due to regional frictions (e.g. the hukou system in China) then homogenizing worker distributions and wages across labor markets helps capture what the removal of these frictions might imply. In theory, this homogenization could lead to gains from variety being more evenly sourced across regions but could also lessen regional comparative advantages and gains from specialization. Ultimately these competing forces must be resolved quantitatively. Using Input-Output and population data, the model implies that homogenizing across factor markets would, on net, increase real incomes by 1.33 percent.

The importance of local factor markets for understanding firm behavior suggests new dimensions for policy analysis. For instance, regions with labor markets which generate lower unit labor costs for an industry attract higher levels industry activity. As unit labor costs depend on the distribution of wages and worker types that represent substitution options, this yields a deeper view of how educational policy or flows of different worker types impact firms. For this reason, work evaluating wage determination could be enriched by taking this approach. Taken as a whole, the results show that policy changes which influence the composition of regional labor markets will likely have sizeable effects on firm productivity and location. Finally, the substantial differences within industry suggest that at the regional level, inherent comparative advantages exist which policymakers might leverage.

In fact, relatively little is known about the dynamic relationships between labor markets and firm behavior, and this paper provides both a general equilibrium theory and structural estimation strategy to evaluate these linkages.[5] Having seen that cost and productivity differences inherent in local factor markets are potentially large, our approach could be of use in evaluating trade offs between regional policies or ongoing trends across regions. Further work could leverage or extend the approach of combining firm, census and geographic data to better understand the role of local factor markets on firm behavior.

References

Cheng, W. and J. Morrow, (2018); “Firm Productivity Differences from Factor Markets.” Journal of Industrial Economics, 66(1): 126–171.

Hsieh, C. T. and P. J. Klenow, (2009); “Misallocation and Manufacturing TFP in China and India.” Quarterly Journal of Economics, 124(4): 1403–1448.

Melitz, M.J. and S.J. Redding, (2014); “Heterogeneous Firms and Trade.” Handbook of International Economics, Vol. 4: 1–54.

Ottaviano, G., and G. Peri, (2013) “New Frontiers of Immigration Research: Cities and Firms.” Journal of Regional Science, 53(1): 1–7.

Syverson, C., (2011); “What Determines Productivity?” Journal of Economic Literature, 49(2): 326–365.

Topalova, P., (2010); “Factor Immobility and Regional Impacts of Trade Liberalization: Evidence on Poverty from India.” American Economic Journal: Applied Economics, 2(4): 1–41.

Endnotes

[1] See Syverson (2011).

[2] See Melitz and Redding (2014).

[3] See Topalova (2010) and Hsieh and Klenow (2009).

[4] See Cheng and Morrow (2018).

[5] See Ottaviano and Peri (2013).

Trade Liberalization and Intergenerational Occupational Mobility in Urban India

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By Reshad N Ahsan (University of Melbourne) and Arpita Chatterjee (University of New South Wales)

Economic globalization is currently under threat from a populist political backlash.  A common narrative is that this backlash is partly a result of a trade-induced increase in inequality.[1]  In our recent research, we show that the same mechanism that causes greater trade-induced inequality – a higher relative demand for skill – also allows an increasing number of Indian sons from underprivileged backgrounds to enter better occupations than their father.[2]  This suggests that, when thinking about the effects of trade on labour-market opportunities for the poor, we must keep in mind international trade’s ability to provide a pathway for children from underprivileged backgrounds to move up the occupational ladder.

Once regarded as one of Asia’s least open economies, India experienced a rapid increase in trade following its trade reforms in 1991.  These reforms led to a decrease in India’s average manufacturing tariffs from 149 percent in 1988 to 45 percent in 1998. This dramatic trade reform occurred in a country where occupations are highly persistent across generations.  This is vividly illustrated in Figure 1 below, where we show that conditional on having a father who is at the bottom decile of the fathers’ occupational distribution in 1999 there is a 57 percent chance that a son in 1999 is also in the bottom decile of the sons’ occupational distribution.  We also observe high levels of persistence at the other end of the occupational distribution.  In particular, we find that, conditional on having a father who is at the top decile of the fathers’ occupational distribution in 1999 there is a 39 percent chance that a son in 1999 is also in the top decile of the sons’ occupational distribution.

Figure 1: The occupational deciles of sons who have fathers in the bottom decile of the fathers’ occupational distribution.

To identify the impact of trade on occupational mobility, we use nationally representative household surveys collected by the National Sample Survey Organisation (NSSO).  These data are for the year 1999 and allow us to categorize individuals in our sample in to 335 three-digit occupations.  With these data in hand, we examine whether, all else equal, a son residing in an urban district with greater exposure to trade liberalization is more likely to be in an occupation that is higher ranked than that of his father.[3]  We define a district’s exposure to trade liberalization as the change in the weighted average tariffs of all manufacturing industries located in that district between 1987 and 1998.  A key advantage of our context is the fact that India’s trade reforms were enacted under pressure from the International Monetary Fund and provides us with exogenous variation in tariffs in the post-reform period.[4]

Our analysis shows that greater exposure to trade liberalization allows an increasing number of sons from underprivileged backgrounds in India to enter better occupations than their father.  This result is both statistically significant and economically meaningful.  It suggests that differential exposure to trade explains 46 percent of the difference in upward occupational mobility between a district at the 25th percentile of upward mobility when compared to a district at the 75th percentile.

What explains this effect?  We show that sons residing in more liberalized districts in 1999 are more likely to be employed in skill-intensive industries. This is consistent with the idea that trade induces an increase in the relative share of skilled occupations.[5] While this effect goes hand-in-hand with a rise in the gap in skilled and unskilled wages, it also creates exactly the type of occupations that underprivileged sons need to move up the occupational ladder.  Interestingly, we also find evidence of spillover effects where manufacturing tariff liberalization leads to greater intergenerational occupational mobility amongst sons working in non-manufacturing industries.  We show that this result can be partly explained by the rising demand for skill in downstream manufacturing industries spilling over in to upstream non-manufacturing industries.

An alternate explanation for our results is that trade liberalization improved occupational mobility via its impact on educational mobility.  This means that households that invest more in their son’s education as a result of trade are the ones that experience greater upward intergenerational occupational mobility.  However, our results do not support this conjecture.  Interestingly, in a second new result, we show that greater investment in education only facilitates greater intergenerational occupational mobility in areas where we expect to see the largest increases in the employment share of high-skill occupations.  These results suggest that education can act as a harbinger of social mobility only if there is a sufficient increase in the demand for skill.

Our results offer a more nuanced perspective on the prevailing narrative that trade leads to adverse labour-market outcomes for underprivileged individuals. While trade may increase the skill premium, it also has longer-term effects that facilitate upward intergenerational mobility. For developing countries in particular, these longer-term effects of trade on occupational mobility have the potential to significantly improve the lives of underprivileged individuals.

References

Aghion, P., Blundell, R., Griffith, R., Howitt, P., and Prantl, S., 2009. “Online Supplement to The Effects of Entry on Incumbent Innovation and Productivity.” The Review of Economics and Statistics, 91(1): 20–32.

Ahsan, R.N., and Chatterjee, A., 2017. “Trade Liberalization and Intergenerational Occupational Mobility in Urban India.” Journal of International Economics, 109(1): 138-152.

Rodrik, D., 2017. “Populism and the Economics of Globalization.” NBER Working Paper Number 23559.

Topalova, P., 2010. “Factor Immobility and Regional Impacts of Trade Liberalization: Evidence on Poverty from India.” American Economic Journal: Applied Economics, 2(4), 1–41.

Endnotes

[1] See Rodrik (2017).

[2] See Ahsan and Chatterjee (2017).

[3] We rank occupations by calculating the average education of individuals in that occupation in 1987, which is prior to the trade reform of 1991.  Thus, we do not allow this ranking to change over time. Our results are robust to ranking occupations based on average wages instead.

[4] See Topalova (2010).

[5] We develop this idea more formally in an appendix to our paper. Following Aghion et al. (2009), we show that the threat of foreign entry encourages domestic firms that are relatively close to the technology frontier to increase their innovation effort, thereby leading to an increase in the share of high-skill occupations.

Growth, Import Dependence, and War

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By Roberto Bonfatti (University of Nottingham) and Kevin Hjortshøj O’Rourke  (University of Oxford)

World trade has increased tremendously in recent decades, driven by the rise of China and other emerging economies. The reliance of world trade on choke points (such as the Strait of Hormuz, the Malacca Strait and the South China Sea) creates the need for someone to guarantee the freedom of navigation. Traditionally, this role has been upheld by the naval hegemon of the day: Britain during the 19th century’s Pax Britannica, and the United States today. While the naval hegemon may in fact be providing a global public good by behaving in this manner, its activities may not always reassure everyone, especially if strategic tensions are gradually building up between itself and rising powers such as China.

Rising tension between the US and China is often analyzed in the context of the broader challenge that the rise of China poses to US military hegemony. Political scientists have long cautioned against the risks posed by shifts in relative power. In fact, in the eyes of some theorists, such shifts are the main reason why war can occur. Robert Powell shows, in the context of a two-country world, that if one of the two countries is catching up militarily on the other, it may be impossible to dissuade the established power from launching a pre-emptive war against the rising power.[1]

This is because from the perspective of the established power, not going to war carries a future cost: in the future, the rising power, having become more powerful, will be better able to impose its will on the established hegemon when it comes to disputes between the two. The follower has an incentive to forestall a pre-emptive war by the leader, by promising the leader a sufficiently big slice of the pie in the future. Since it cannot pre-commit to this, and has an incentive to use its greater power in the future to secure a greater share of the pie, the leader may choose to launch a pre-emptive war in order to lock in a higher share of the spoils while it still has the chance.

Applied to the case of industrial catching up, this model seems to have clear implications. Military power goes hand in hand with growth and industrial development; thus, an established industrial leader should be the one to consider launching a pre-emptive war against a catching-up, late industrializing, follower.

In our recent work, we show that, if international trade is taken into account, the implications of the model can be quite different.[2] Central to our analysis are the assumptions that the follower needs to import increasing amounts of raw materials from the rest of the world, as it undergoes structural change, and that the leader may be able to blockade the follower’s trade.

An industrial leader may well be losing out to a catching-up follower in terms of potential military power; however, this does not necessarily imply that it is actually becoming militarily weaker over time. Industrial catching up is a double-edged sword for the follower: while it makes its military apparatus potentially more powerful, rapid growth and structural change also makes it more dependent on imported raw materials. If the leader has the capacity to blockade these imports in case of war, the follower may actually become militarily weaker, rather than stronger, over time. In this case, it may be the follower who launches a pre-emptive war on the leader, and not the other way around.

By generalizing the model in this manner, we open up a rich menu of theoretical possibilities. For example, the follower may decide to attack resource-rich peripheral areas in an attempt to become more self-sufficient, or entirely self-sufficient, in raw materials. It may do so instead of, or prior to, launching an attack on the leader. The follower may even attack the resource-rich region in circumstances when it knows that this will provoke an attack upon it by the leader, when otherwise the two countries would not have gone to war.

We argue that our model can shed light on why it was Japan who attacked the United States in 1941, and not the other way around.[3] This was unambiguously a case of an industrial follower catching up on the leader. And yet Japan was also becoming rapidly more dependent on imported raw materials. Japan’s invasions of resource-rich Manchuria, China, and Southeast Asia were attempts to break free from this pattern of increased dependence: they correspond to attacks on the resource-rich region in our model, prior to an eventual attack on the leader.

Like Japan, late 19th and early 20th century Germany had been rapidly catching up on the Britain and the United States. However, Germany had also become more dependent on imports of food and raw materials. While we do not argue that this strategic dependence explains the origins of either world war in Europe, Avner Offer has argued that it was a key factor explaining the Anglo-German naval rivalry which preceded World War I.[4] After World War I, Hitler was obsessed with German dependence on imports of food and strategic raw materials. The importance of securing the resources needed to fight his wars is a constant theme of Adam Tooze’s classic book on the Nazi economy.[5] One obvious solution was to attack Eastern Europe, which corresponded to the resource-rich peripheral region in our model, even though attacking Poland risked war with the UK and France. And in the long run, conquering Russia was seen as the only way to achieve complete self-sufficiency in raw materials.

Such theoretical and historical considerations suggest that it is Chinese vulnerability, rather than American, that we should be worried about. As long as the United States retains control over maritime choke points, it may be China, rather than the United States, that fears becoming more vulnerable over time. In that context, Chinese expansionism in the South China Sea, while potentially dangerous, may not be so surprising.

References

Barnhart, M.A. (1987). Japan Prepares for Total War: The Search for Economic Security, 1919-1941. Cornell University Press.

Bonfatti, R. and K.H. O’Rourke (forthcoming). “Growth, Import Dependence and War.” Economic Journal. An earlier version is available as CEPR Discussion Paper 10073.

Offer, A. (1989). The First World War: An Agrarian Interpretation. Clarendon Press.

Powell, R. (2006). “War as a Commitment Problem.” International Organization, vol. 60(1), pp. 169-203.

Tooze, A. (2006). The Wages of Destruction: The Making and Breaking of the Nazi Economy, Allen Lane.

Endnotes

[1] See Powell (2006).

[2] See Bonfatti and O’Rourke (forthcoming).

[3] See Barnhart (1987).

[4] See Offer (1989).

[5] See Tooze (2006).

Foreign Investment Boosts Sophistication of Domestic Manufacturing: New Evidence from Turkey

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By Beata Javorcik (University of Oxford), Alessia Lo Turco, (Marche Polytechnic University), Daniela Maggioni (University of Catania)

Recently, there has been a renewal of interest in industrial policy across the world. Advanced economies promise to use industrial policy to revive their declining manufacturing, while emerging markets hope that industrial policies will help them upgrade their production structure and in this way stimulate economic growth. Yet, little is known about the micro determinants of product upgrading.

The existing research suggests that inflows of foreign direct investment (FDI) can foster host countries’ production upgrading, where upgrading is measured in terms of the unit values of exports (Harding and Javorcik,  2012).[1]

In our recent work, we move away from unit values – a highly imperfect proxy for product quality –  and examine the link between FDI and product upgrading, as captured by complexity of new products introduced by domestic firms.[2] We focus on manufacturing firms in Turkey, a country that has experienced a spectacular surge in FDI inflows during the 2000s and dramatically increased the sophistication of its productive structure in the last decades.[3]

Anecdotal evidence

Anecdotal evidence suggests that foreign affiliates stimulate product upgrading among their suppliers. For example, Indesit Company, an Italian white good producer – recently acquired by Whirlpool – has produced refrigerators in Turkey since the 1990s. In 2012, Indesit built a new plant to produce washing machines. To become a supplier of this new plant, a local company purchased new presses and automated its production process. This allowed it to start producing a new and more sophisticated product, a washing machine flange, and to increase efficiency and production volumes. The flange is a very complex product as it needs to be produced with no aesthetic defects by an 800-1,000 tonne metal presses. It also needs to withstand the stress of between 1,000 and 1,400 revolutions per minute while remaining within a certain range of vibration and noisiness. Indesit has shared essential tacit knowledge, information processes, instructions and control procedures with the local company, thus stimulating and supporting the supplier’s complexity upgrading.

Inspired by the anecdotal evidence, our study examines the link between the presence of foreign affiliates and production upgrading by Turkish firms located in the same region and active in the input-supplying industries.

Measuring product complexity

To capture product complexity we use a measure proposed by César Hidalgo and Ricardo Hausmann, who relate the concept of product complexity to the extent and exclusivity of capabilities needed to produce a given product.[4] It is easiest to explain this measure using a Lego analogy. Think of a country as a bucket of Lego pieces with each piece representing the capabilities available there. The set of products (i.e., Lego models) a country can produce depends on the diversity and exclusiveness of the Lego pieces in the bucket. A Lego bucket that contains pieces that can only be used to build a toy bicycle probably does not contain the pieces to create a toy car. However, a Lego bucket that contains pieces that can build a toy car may also have the necessary pieces needed to build a toy bicycle.  While two Lego buckets may be capable of building the same number of models, these may be completely different sets of models. Thus, determining the complexity of an economy by looking at the products it produces amounts to determining the diversity and exclusivity of the pieces in a Lego bucket by simply looking at the Lego models it can build.

Our findings

Our analysis suggests that the presence of foreign affiliates does not affect the propensity of Turkish firms to innovate. However, the presence of foreign affiliates is positively correlated with the complexity level of products newly introduced by Turkish firms active in the supplying industries and located in the same region.

The estimated effect is economically meaningful. A 10 percentage point increase in foreign presence implies moving about half of the way from the production of pot scourers to producing stainless sinks. An increase of about 17 percentage points in FDI in the relevant sectors would be necessary in order to move from the production of stainless sinks to the production of the washing machine flanges.

Conclusion  

Our findings matter for policy. Dani Rodrik argues that enhancing an economy’s productive capabilities over an increasing range of manufactured goods can be considered an integral part of economic development.[5] As foreign affiliates facilitate the upgrading of the host country’s productive capabilities, our results, then, imply that FDI inflows can act as an important stimulus for economic growth. Thus, there is room for investment promotion activities, a policy that is quite effective in developing countries.[6] In contrast to many other industrial policies, investment promotion is relatively inexpensive and causes few distortions. Therefore, there is little downside when the government gets it wrong.

References

Harding, T. and Javorcik, B.S. (2011). ‘Roll out the red carpet and they will come: investment promotion and FDI inflows’, Economic Journal, vol. 121(557), pp. 1445–1476.

Harding, T. and Javorcik, B.S. (2012). ‘Foreign direct investment and export upgrading’, The Review of Economics and Statistics, vol. 94(4), pp. 964–980.

Hidalgo, C.A. and Hausmann, R.(2009). ‘The building blocks of economic complexity’, Proc. Natl. Acad. Sci., vol. 106, pp. 10570–10575.

Javorcik, B.S., Lo Turco, A., Maggioni, D. ‘New and Improved: Does FDI Boost Production Complexity in Host Countries?‘ Economic Journal, forthcoming.

Rodrik, D. (2006). ‘Industrial development: stylized facts and policies’, Kennedy School of Government.

Endnotes

[1] See Harding and Javorcik (2012).

[2] Javorcik, Lo Turco and Maggioni (forthcoming).

[3] See Hidalgo (2009).

[4] See Hidalgo and Hausmann (2009)

[5] See Rodrik (2006)

[6] Harding and Javorcik (2011)