The Source of Increasing Return to Scale Could Be External Or Internal

JESP Vol. 1, No. 2, 2009

The Importance of Positive Externalities and Intersectoral Linkages in Determining Growth Path of Developing Economies

Deden Dinar Iskandar

______Abstract This paper is intended to explore the significance of intersectoral linkage in determining the growth path of developing economies. It is commonly believed that intersectoral linkages among firms and industries is importance since it provides the positive externalities that enables firms or industries to gain the increasing return to scale. Increasing return to scale is the characteristic that drives the process of growth. The paper describes the source of increasing return to scale, the relation between externalities and sectoral linkages, and the link between sectoral linkages and growth path in developing economies. The analysis of the paper is based on the literatures review. All the models reviewed suggest the importance of sectoral linkages from various points of view, and come to the similar conclusion that the weak or absence of sectoral linkages could lead developing economies to be trapped in low equilibrium economy and low growth path. The conclusion is how the government able to release the developing economies from the historical trap of low equilibrium economy and low growth path by establishing a rational policy.

Keywords: increasing return to scale, externalities, sectoral linkages, growth path ______

The aim of this paper is to explain the increasing returns, and illustrates a few importance of intersectoral linkage in deter- relevant models that provide the link be- mining the growth path of developing econ- tween intersectoral linkages and growth omies and to build the rationale of how it path. This section aims to put a theoretical may release the developing economies from framework. The forth section analyzes in- the historical trap of low equilibrium econ- tersectoral linkage and growth path in de- omy and low growth path. According to the veloping economies based on the theo- new growth theory, economic growth retical framework. In this section I will results from increasing returns to scale make a general theoretical observation where a proportional increase in labor and based on the alleged characteristic of devel- capital as input of production would rise oping economies rather than go on details more than proportional yield in output. to analysis countries' cases, such as in These increasing returns drive the process Autant-Barnard, 2001; Combes, 2000; Hen- of growth (Cortright, 2001). The increasing derson, et al., 1995; Kim, 2008; and Vena- returns to scale could be driven by exter- bles, 1995). The fifth section briefly nalities aroused from interdependence a- describes the policy that could be beneficial mong firms within industry and economy. to overcome the historical growth path in The structure of the paper is ordered as developing economies. The last section is follows. The first section is introduction, the conclusion. followed by the second which is briefly explaining the source of increasing returns to scale. The third section briefly describes the types of externalities that generate the ______Alamat korespondensi: Deden Dinar Iskandar. Fakultas Ekonomi, Universitas Diponegoro. E-mail: [email protected] JESP Vol. 1, No. 2, 2009

THE SOURCE OF INCREASING productivity, which could be applied to RETURNS TO SCALE mass-production by capitalist sector. In the absence of externalities from economy The source of increasing returns to expansion, the cost of providing trained and scale could be external or internal to the skillful worker would be much higher for firm. The internal increasing returns to any firm to acquire. scale of particular firm could be resulted from its huge fixed cost and volume of Rosenstein-Rodan model enables multi- production. It is the characteristic of firm or ple equilibrium to exist since capital stock industry that apply modern technology. The increase when market wage of trained and external source of increasing returns to skillful worker provided by the economy is scale could occur from interdependence lower than the required wage to enable firm where the progress in one firm creates generating the steady capital accumulation. beneficial externalities for others firms On the other hand, steady capital accumu- within industry simultaneously. Therefore lation would decrease if market wage provided by economy greater than the firms producing individually with constant 1 returns to scale could acquire increasing required wage. returns to scale at the sector or economy If the market wage is lower than the level if activities of firms collectively affect required wage, firm would get more profit their production conditions. Although and the rate of capital accumulation would production of the firm exhibits constant be higher over time. Capital intensity within return to scale, the externalities of industry economy would increase over time and growth would encourage the return to scale reach the high level of equilibrium at stable to increase (Ross, 2000). steady state point with high real wage and high capital intensity. On the contrary, at THE EXTERNALITIES AND the low level of capital stock where the INTERSECTORAL LINKAGES market wage is higher than the real wage required to generate the steady state of Externalities could be specified into accumulation, the rate of accumulation is technological and pecuniary externalities. less than depreciation and the size of Technological externalities are emerged capitalist sector would be narrower over from direct interdependence among pro- time. The capital intensity within economy ducers, and related to the production would declines and the equilibrium would function. While pecuniary externalities are reach the low equilibrium at subsistent in which the interdependence between level. producers occur through the market mechanism, providing lower cost, larger Pecuniary Externalities market size and higher demand for their Pecuniary externalities are externalities goods (Ross, 2000). in which interdependence between pro- Technological Externalities ducers occurs through the market mechanism, where the firms expand the market size The model of Rosenstein-Rodan (1943) and give benefit for other firms reci- states that externalities generate increasing procally. As a result, firms gain returns not return to scale is resulted from activities only by its own expansion but also with the such as industrial training. Arrow (1962) growth of industry and the whole economy. added further that these effects are emerged from learning by doing process which increase the stock of experience accrued 1 with the production activities. The expan- The required wage to enable firm generating the steady capital accumulation is a constant increasing function of capital stock. sion of economy that increases the re- The market wage of trained and skillful worker could be lower or sources of trained and skillful workers is higher than the required wage. This is due to the elasticity of labor supply and additional effect of capital stock caused by increasing beneficial for the firms. It improves the returns to scale due to expansion of economy.

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Furthermore, Ross (2000) makes a profit, provides the large market size for the distinction between horizontal and vertical firm in first sector (Sachs & Warner, 1999). pecuniary externalities. Horizontal means This would lead to industrialized equilib- that the interdependence occurs horizontally rium, when modern technology production through the interrelated market of final in each sector produces at a full level of goods industries, where pecuniary exter- employment. This high level of equilibrium nalities entails demand spillover across would display higher output, wage, and final goods industries. Vertical means that profit in economy (Ross, 2000). the industry acts as supplier and costumer, However, if fixed labor input to initiate where firms provide the intermediate input the modern technology production is so to others firms. Horizontal interdependence large that the total wage cost of applying could be described by Big Push model from modern technology is higher than sales Murphy, et al (1989), while vertical inter- accrued by modernized firm at level of full dependence could be explained by model employment, the market is not profitable to from Venables (1996). apply modern technology. Therefore the industrialization would not emerge; econo- Big Push Model my would be set at low-income equilibrium There is multisectoral economy produc- with traditional technology. ing different final goods. There are two Here we have multiple equilibriums. The techniques in the production of each sector: economy equilibrium would be set at stable traditional technology with constant return high equilibrium or stable low equilibrium. to scale and modern technology with in- The temporary equilibrium beside those creasing return to scale. The modern tech- two would be temporary and moving to nology relates with industrialization and either stable high or stable low equilibrium. would be more productive at higher level of output but less productive at lower level. Venables Model Individual producer in the perfect compe- Venables (1996) illustrates that there tition market use traditional technology. On are two industries in economy, upstream the contrary, a single firm in each sector has industries and downstream industries. Up- access to modern technology (Ross, 2000), stream industries supply intermediate goods although they are not necessarily able to as input of production for downstream utilize it. Utilization of modern technology industry producing final goods. Domestic requires the firm to set a premium wage, upstream industry operates in imperfect higher than the wage that is paid in tra- market while downstream industry with ditional technology to draw the labor from constant return to scale is price taker in both traditional technology. input market and output market. The indus- Utilization of modern technology by try uses intermediate goods and labor as firm in particular sector would only be input production. Both final goods and profitable if its level of employment re- intermediate goods are tradable. The price quired selling as much as the traditional do of imported goods is the world market price at its full employment is higher than total plus tariff. With the expansion of economy, wage cost as function of labor input of higher volume final goods would increase applying modern technology. By replacing the demand for intermediate goods from traditional producer, the firm would gain a upstream industry. It would encourage more larger market to be profitable and sales are entry into upstream industry, therefore the higher than wage cost. The similar result industry would be more competitive and would apply to utilization of modern lowering its average cost and its price. technology by firm in others sectors. The Here Venables model demonstrates the utilization of modern technology would pecuniary externalities between firms, generate the higher wage paid and more which are operating trough demand link-

63 JESP Vol. 1, No. 2, 2009 ages and cost linkages. The demand link- Rosenstein-Rodan model views econo- ages occur when the increasing operation mies growth as a process of learning-by- scales in downstream industries give ad- doing within a firm, industry and economy. vantage to upstream industry. The cost link- As economy expands, there is spreading in ages emerge when the expansion of up- learning across industry and the industry as stream industry lower the price and give whole with get benefit from it. The pre- benefit for downstream industry. sence of technological externalities is very These externalities would establish much linked with interdependence among multiple stable equilibriums; high level firms in different sector. These externalities equilibrium and low level equilibrium. provide the trained and skillful worker in a High level of equilibrium characterized by lower cost beneficial for firm in each sector low intermediate goods price that enable the to apply capital intensive technology and high volume of downstream output, se- mass production with increasing return to quentially attract many upstream firms to scale. emerge in the market of intermediate goods However, firm in developing econo- that create more intense competition. The mies faces the huge fixed cost to generate economy at this equilibrium is featured by capital accumulation. Simultaneous with high output and low cost. low productivity, this condition discourages On the contrary, low level equilibrium the utilization of capital-intensive technol- is characterized by narrow downstream ogy with increasing returns. The firms in industry. The price of intermediate goods different sectors also face the same thing. set at the price of imported goods. The Therefore no firm are willing to initiate the quantity of firm in upstream industry deter- expansion to drive the externalities (in term mined by the ability to cover cost at the of technology spillover and learning-by- price level of imported intermediate goods.2 doing) spreading across economy. It would Therefore, the volume of upstream industry lead to the absence of capital intensive is narrow and the competition in upstream technology with increasing return to scale industry is not intense enough to provide in economy. Therefore growth path would lower intermediate goods price. The econo- be steady set at a low-level equilibrium my at this equilibrium is characterized by with low capital intensity, low wage and high cost and low output. low per capita income. According to the Big Push model INTERSECTORAL LINKAGES AND framework, externalities aroused from in- GROWTH PATH OF DEVELOPING tersectoral linkages are pecuniary exter- ECONOMIES nalities. Utilization of modern technology Developing economies is historically with increasing returns to scale in industrial characterized by highly imperfect domestic sector would generate higher wage and industrial market, huge fixed cost, low profit; provide larger market for other firm worker productivity in industrial sector, and from other. It leads to industrialization dependence of imported intermediate goods where firms in each sector apply modern (Bardhan & Urdy, 1999). Given these char- technology with increasing return to scale acteristics, we can adopt theoretical frame- and produce at full employment level. work of models mentioned earlier to ob- This would generate higher output, wage, serve the intersectoral linkage and the and profit in economy as a whole. growth path in developing economies. However, fixed cost of applying modern technology in developing economies is

2 too high for individual firm to produce in Since the intermediate goods are tradable, downstream industries could get intermediate goods from domestic downstream profitable level since output demand and industries or imported from foreign countries. Provided narrow market size is not large enough. Demand and high cost of domestic upstream industry, intermediate goods would be imported and domestic upstream industry should set the for output is too low and market size is too price at the same level as imported price.

64 JESP-Vol. 1, No. 1, 2009 narrow as other firm in others sector do not and technological spillover across industry apply modern technology for the same is believed as the cause of low growth path, reason. Therefore the growth path would government should provide the knowledge be steady set in low-income equilibrium and industrial training that beneficial for without industrialization. each firm in utilizing modern technology. Venables model emphasizes the impor- Therefore government should emphasize tance of intersectoral linkage between up- the education sector and promote industrial stream industries supplying intermediate training as well as research and develop- goods, with downstream industries that ment. produce final goods using labor input and Big Push model suggests that govern- intermediate goods. With the expansion of ment provide policy to generate a larger economy, intersectoral linkage would gen- market to overcome huge fixed cost of erate pecuniary externalities that are bene- modern technology utilization in industrial ficial for both industries. Demand linkage is sector. This policy could be a large spend- beneficial for upstream industry since the ing program that generates more income downstream industry demand more inter- and lead to larger demand for industrial mediate goods. Meanwhile cost linkage sector. Given initial large market due to would give benefit for downstream indus- government spending program, the progress try, since the increasing demand for inter- of industrialization in one sector would mediate goods generates the competition in generate a larger market demand for upstream industry resulted in lower inter- industrialization in other sectors, therefore mediate goods price and lead to lower cost the industrialization in economy would of downstream industry. emerge. However, the upstream industry in According to Venables, the cause of developing is producing at high fixed cost low growth path is high cost of intermediate level. Therefore most of intermediate input input that prevents the downstream industry for downstream industry is imported and to expand and reciprocally shrink the intermediate goods price is set at world- demand for domestic upstream industry. market price plus tariff. Consequently it Therefore the policy of government should would prevent the expansion of down- be directed to reduce the high cost of inter- stream industry since they would face a mediate input and provide larger market for relatively high intermediate goods price. domestic final goods. Government could The growth path would be set at low-level provide subsidy to lower the cost of up- equilibrium with low output and high cost stream industry rather than protect the of production. intermediate goods trade. On the contrary All the model above explain the the protection on final goods is consider- importance of sectoral linkages from a ably beneficial. different views, and come to the similar Summarized from all explanation conclusion that the weak or absence of above, good and suitable government policy sectoral linkages could lead developing could move the developing economies from economies to be trapped in low equilibrium historically low growth path toward a high- economy and low growth path. er level of growth path. In general, institutional is significant to overcome history. RELEASING THE DEVELOPING Institutions matter because it shape the ECONOMIESS FROM LOW environment for larger market and applying GROWTH TRAP modern technology in production that lead There are several initial ways to release to industrialization. the developing economies from low growth trap. According to Rosenstein-Rodan model, since the absence of learning-by-doing

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CONCLUSION Corthright, J. 2001. New Growth Theory, Technology and Learning: A Practitioner’s Intersectoral linkage is important in Guide. Washington, D.C.: EDA. determining a growth path of developing Henderson, V., Kuncoro, A. & Turner, M. 1995. economies. Economies growth result from Industrial Development in Cities. Journal of increasing return to scale, and increasing Political Economy, 103: 1067-1090. return to scale could be driven by exter- Kim, S. 2008. Spatial Inequality and Economic nalities aroused from interdependence a- Development: Theories, Facts, and Policies. mong firm within industry and economy. Working Paper No. 16, Commission on Growth Developing economies is historically and Development. characterized by highly imperfect domestic Murphy, K., Shleifer, A. & Vishny, R. 1989. market in industrial market, huge fixed cost, Industrialization and the Big Push. Journal of low worker productivity in industrial sector, Political Economy, 97: 1003–1026. and dependence of imported intermediate Ross, J. 2000. Development Theory and the goods. The weak or absence of sectoral Economics of Growth. Ann Arbor, Michigan: linkages in developing economies would U.P., Chapters 3-5. prevent the externalities in term of techno- Rossenstein-Rodan, P. 1943. Problems of logical spillover, demand spillover and cost Industrialization of Eastern and Southeastern spillover. The absence of externalities e- Europe. The Economic Journal, 53: 202-211. vades increasing return to scale and leads Sachs, J., & Warner, A. 1999. The Big Push, Natural the developing economies to be trapped in Resource Booms and Growth. Journal of low growth path. Development Economics, 59: 43-76. Institutional matter is significant to Venables, A.J. 1995. Economies Integration and the overcome historical low growth path in Location of Firm. American Economic Review, 85(2): 296–300. developing economies. Its significance a- roused from its capacity to shape the envi- ______. 1996. Equilibrium Locations of ronment for larger market and application Vertically Linked Industries. International Economic Review, 37: 341-359. of modern technology in production with increasing return to scale that lead to industrialization. The government could establish policy on promoting education sector and research development activities, reducing cost and generating a larger market for industrial sector.

REFERENCES

Arrow, K.J. 1962. The Economies Implications of Learning by Doing. Review of Economics Studies, 29(3):155-173. Autant-Barnard, C. 2001. The Geography of Knowledge Spillovers and Technological Proximity. Economics of Innovation and New Technology, 10(4): 237-254.

Bardhan, P. & Udry. C. 1999). Development Microeconomics. Oxford & New York: OUP, Chapter 14. Combes, Pierre-Philippe. 2000. Marshall-Arrow- Romer Externalities and City Growth. Working Paper No. 99-06, CERAS.