Many recent studies have sought to explain differences in development patterns and performance of developing countries by whether they have chosen a strategy of export-led growth (ELG) or of import-substitution industrialization (ISI). Countries pursuing ELG strategies have typically experienced rapid but unbalanced growth, and the contributions of capital accumulation and total factor productivity (TFP) growth to their total output growth are typically higher than for other developing countries. Major problems arise, however, in attempts to explain their performance using standard neo-classical growth models that ignore the effects of trade externalities.
In Discussion Paper No. 400, Research Fellow Jaime de Melo and Sherman Robinson develop two simple models with pecuniary externalities that require the government either to coordinate activities or to subsidize activities that would otherwise take place at sub-optimal levels. They first develop a simple ELG model in which two domestic goods one an imperfect substitute for an imported good and the other for export only are produced in combinations defined by a production possibility frontier, subject to fixed total production and a balance-of-trade constraint. This model displays an export externality, since producers do not see the benefits of exporting beyond the competitively determined level, and therefore do not take into account any increases in productivity that may stem from the effects of increased exports on the production function.
They then expand this model to include four sectors (agriculture, light manufacturing, heavy manufacturing and services), in order to capture the major observed differences between the patterns of industrialization associated with ISI and ELG development strategies. Final demand includes both consumer and capital goods, and government collects indirect taxes and tariffs, pays subsidies, and finances any difference through lump-sum transfers. The balance of trade is also fixed exogenously, with the real exchange rate serving as the equilibrating variable. Export externalities enter as previously in light and heavy manufacturing, but not at all in agriculture and services. Also, an import externality is introduced since imported capital goods are assumed to be more productive than domestic capital goods, so there is a link between the import ratio in heavy manufacturing and the size of the `effective' capital stock.
Applying their model to Korea, they show the existence of export externalities in light and in heavy manufacturing and an import externality that works through the acquisition of foreign technology via imported capital goods. This simple model captures relatively well the major stylized outcomes of Korea's ELG strategy.
De Melo and Robinson argue that these models overcome a major shortcoming of the neo-classical theory by linking TFP growth to changes in economic structure. They thus provide both a first step towards endogenizing the determinants of TFP growth and a better framework for analysing the links between aggregate economic performance, structural change and policy choices. Further, the presence of externalities makes many of the simple policy rules derived from the neo-classical general equilibrium model invalid, since it is now necessary to take account of the trade-offs between static efficiency costs and the dynamic gains from exploiting these externalities. The empirical results from both models support this view and suggest that policy-makers should pursue aggressively any exploitable externalities. They should not be too concerned about the precise choice of policy instruments.

Productivity and Externalities: Models of Export-Led Growth
Jaime de Melo and Sherman Robinson

Discussion Paper No. 400, April 1990 (IT)