The Development Path of Economies

Anand’s comment in response to a past posting prompts this one. He wrote:

The fact that manufacturing accounts for such a small percentage of India’s GDP is not a minus but a plus. All the industrialized nations have seen manufacturing as a percentage of GDP shrink.

There is much misunderstanding about the process of development and it may be worthwhile to start thinking about development. (What follows is partly from another article I had written some time ago.)

Countries, especially large countries such as the US and India, follow a very predictable development path: from agriculture, to manufacturing, to service, and finally to information technology. Large countries cannot jump any of these intermediate stages any more than an elephant can leap across a creek. Small countries are more nimble on their feet and can skip across sometimes.

So India with 70% of its population in rural areas (largely agricultural) cannot become an information technology superpower however pretty a song you sing about the internet and the world wide web. India has to have a nuts-and-bolt manufacturing base which can only exist if labor moves from agriculture to industry. Then with increased productivity of manufacturing, incomes rise and therefore consumption of services rise relative to basic consumption and so the economy moves to a service economy.

Why do countries have to go through the manufacturing stage before getting to the service economy?

Consider a large economy such as the US. Without going into the numbers, we can safely say that international trade forms a very small part of it, something of the order of single-digit percentage points. That means that most of what the economy consumes is produced within the economy— agricultural, manufactures, services—nearly all of it is domestically produced and consumed.

Any large economy when it starts off on its developmental trajectory, it is largely agricultural. Say 80% of the labor force is engaged in producing food and only 20% in manufacture and services. (It helps to consider the whole world as a large economy.)

This economy has little surplus food and therefore can only support a small service sector. Services, after all, are a sort of a luxury good. When you are poor, you don’t get fancy haircuts, don’t go to too many concerts, you don’t produce too many plays, or write too many novels, or consume too much education and art.

As agricultural productivity increases, labor moves to produce manufactures that go to increase the quality of life, which in turn produces capital goods that are invested that further increase agricultural productivity which in turn leaves more labor free to produce investment goods.

A virtuous cycle begins.

The investment in capital goods makes manufacturing more productive. Eventually you have something like 2% of the labor producing food, about 20% producing manufactures, and the rest providing services. Afterall, if 2% of the population can produce food for the rest, and if only 20% of the labor produce all the manufactures due to automation, then the rest have to produce concerts, novels, movies, provide dentistry, education, insurance, banking, and pornography.

A modern efficient large economy is a service economy only because it is also a very efficient agricultural and manufacturing economy too. Its sustainability derives from the productivity of the two older activities.

(To be continued in Part 2)

Author: Atanu Dey


4 thoughts on “The Development Path of Economies”

  1. In fact, the WSJ and Bloomberg news have been running stories on India’s new-found success in maufacturing, especially in the auto sector, steel sector and so on.

    The WSJ, in particular, seems to be more optimistic about India’s chances than you or Prof Bardhan are. Of course,it could simply be that, as a conservative mouthpiece, they have an axe to grind with China But it does seem to me that its more than that and that there’s some truth to this manufacturing story that Ive been hearing about from more than one source.


  2. First the point that is to be noted is that India has a decent base in manufacturing which is indeed rapidly growing.

    Second fact to be noted in India’s case is that like the US, in India, imports & exports constitute a low percentage of the GDP. Indeed, if you take out Oil, the rest of the imports as a percentage of GDP is dimnished to a large extent. This indicates that India has a fair amount of self sufficiency ( in manufacturing ) and domestic orientation in its markets.

    Now comes the route that we will take in the future. Certainly, nobogy is saying that let us all jump into services. But the fact a reasonable majority will go into services is fairly certain.

    Now is this a bad thing ? Most certainly not.

    Take manufacturing. Today, I can start a factory, pull people from the streets, teach them how to use the machines and the next month, my products will be on the market.

    In case of services, it is knowledge that matters. It takes far more time to attain this.

    The guy who designs the chip will always have the upper hand over the guy who produces the chip. Basically, this stems from the fact that the guy who designs the chip can produce it himself if the need arises. But the other way around is fairly difficult.

    The main advantage of manufacturing is ofcourse the fact that it provides easy ( low barrier to entry for the worker ) and mass emplyment. This ofcourse is the primary argument for manufacturing for which services has not much of an answer except saying that ancillary services ( for example the BPO ancillary services is slated to touch $2 Billion soon ) may provide this route.

    As long as manufacturing shows a decent growth in India and services grows much faster, we are on the right track.


  3. I agree with Antanu that we can’t leapfrog on services industry without having set up the manufacturing/heavy/infrastructure based industy, which i think India has to do a lot inn.
    Service industry in India has a very small share of global business on the lines of 1 or 2% i think (Plz correct me if i’m wrong, not good in keeping stats.). It’s a very small part of what we are getting business inn, it is good to have revenue coming from these sectors but not the way to move forwads for a robust economy, u need heavy industries because that are the engines for services, if u don’t have that, then the services as such what we are getting is a very risky proposition, because from a business men’s point of view its a very easy process to make money. Ex Call centre industry needs only few computers a rented place, and few people who knows how to talk in englisg roughly and u are up and running with the growth propsects of business from 100% to 200% to 300%, and when u think the cost advantage is not good here, it is far better in places like Phillipines South africa or Italy move there, then he can move esaily because his investment was minimal where as heavay based industry cant be moved easily requires more resourcess, more skills to set up initially and returns comes in long term, but that creates a robust economic model as compared to one in call centre based, which is very risky.
    I think we should use our Forex reserve which we are getting to be used properly(efficiently) in the heavy/infrastucture/defence based industries.
    Currently it’s costing us money to mainatin that, so why dont we utilise it.

    On the other side, keep watching the prices of oil which is touching 55-6O USD/Barrel, migh be putting a huge pressue on the government.



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