A model of diversification and growth in open developing economies

We build and calibrate the model of an artificial economy that resembles the situation of developing countries with small domestic markets: they are far from the world technological frontier, and they have a comparative advantage in one or a few primary commodities. Their growth is by imitation and addition of goods not previously produced, rather than by innovation or productivity growth in existing sectors. Starting new sectors from scratch is hampered by two market failures. In the first place, entrepreneurs must be willing to invest in discovering production technologies abroad and adapting them to local conditions. This process has information externalities: the “pioneers” have to undertake investments in information that can easily be copied by others who have not made the investment (“copycats”). In turn, the latter are essential for the scaling up of production in new sectors. Second, there is a coordination problem. Success in establishing new industries is dependent on the availability of non-tradable inputs (“infrastructure”) serving not only the good in question but several other goods that use a similar set of non-tradable inputs. We call “families” the sectors that use the same infrastructure. The model introduces a fiscal sector, with a planner who seeks to maximize growth. We simulate a large number of combinations of tax rates on the traditional sector and on pioneers and copycats, spending on subsidizing information search, and options for building sector-specific infrastructure. The objective is to find the combinations of policies that maximize growth. After calibrating the model and obtaining two scenarios that maximize growth, one without and one with productivity growth, we compare them to the growth trajectories of South Korea and Chile. We also describe the growth policies of Korea, Taiwan, Singapore and Chile, and contrast them to the key features of the model.