Policies for Growth
Multiple equilibria

Poor countries benefit from trade by specializing in standardized commodities that use abundant unskilled labour, but middle-income countries with higher-skilled labour forces may exploit a wider range of options. In Discussion Paper No. 862, Research Fellow Dani Rodrik considers a small open economy that produces two tradable final goods under constant returns to scale. The low-tech sector uses labour and capital, while the high-tech sector also uses a range of differentiated, non-tradable intermediates (producer services and specialized inputs), whose production under increasing returns to scale requires skilled labour.

Rodrik identifies two possible equilibria. With initial specialization concentrated in the low-tech sector, no single firm can profitably enter the high-tech (or intermediate) sector at prevailing factor prices, since sufficient demand for intermediates will exist only if enough other firms already produce them. This coordination problem can be overcome, however, by imposing a minimum wage which subsidizes the incipient high-tech sector, thus promoting new entry that allows the achievement of a superior equilibrium at a higher level of real income. Maintaining a low-wage policy, in contrast, may crowd out potentially viable medium- and high-tech sectors.

Rodrik relates his model to the transition in Eastern Europe, where many countries that are well-endowed with human capital are maintaining cheap currency policies and therefore risk attracting investment on the basis of low labour costs instead. Eastern Germany, in contrast, should be able to sustain Western levels of labour productivity in the longer term, and its high current wages may draw resources into high-tech industries that can utilize its educated and skilled labour force. East Asian countries have also long recognized the potential trade-off between low wages and industrial upgrading. Singapore, in particular, has promoted high-tech industries by raising minimum wages and discouraging immigration. Rodrik cautions, however, that the empirical relevance of these ideas remains to be demonstrated.

Do Low-Income Countries Have a High-Wage Option?
Dani Rodrik

Discussion Paper No. 862, January 1994 (IM)