Monday, May 11, 2009

How does a country build economic competitiveness?

Countries across the world from the US to Europe, Japan, China, East Asia, India, Australia and the Middle East are constantly trying to increase their economic competitiveness. Different countries have pursued different policies and strategies over time in the quest for competitive advantage in one or more sectors. These policies and strategies have included infant industry protection, trade liberalization, privatization, public sector enterprises, export subsidies, investment in education, provision of cheap finance to domestic industries, promotion of FDI, building of economic cities and special economic zones, etc. Sometimes these policies have worked to enhance economic competitiveness, at other times not. There is an abundance of literature that has tried to understand which policies and strategies work, when and why.

In this essay, I dwell on this question of what a country can do to increase its economic competitiveness. However, rather than identifying which policies work, or building an argument for sets of policies (it is all about free markets, or all about free trade or all about export promotion, or all about fixing institutions, etc.), I propose a modest yet powerful meta-level framework to think about this question and help understand which policies and strategies work in increasing economic competitiveness, when and why. Using this framework, I will argue that a pragmatic approach works better than a dogmatic one - not a very original insight, nevertheless an important one that needs to be restated and argued if we are to progress. But this is not the only insight that this framework offers as we will discover later in this essay.

I introduced this framework in a previous essay as a guide to help us think about planning for the future instead of planning for the past. I reproduce this framework below in Exhibit 1. It shows four different possible states of knowledge - the known known, the unknown known, the known unknown and the unknown unknown. In this essay, I use this four states of knowledge (4SoK) framework, to think about how a country (or a state or region, for that matter) can build economic competitiveness.

For the purposes of this essay, I assume that a country has competitive advantage in an economic sector (using sector to mean either an industry or class of economic activity within an industry or class of economic activities common to more than one industry), if it meets one of the following three conditions:
  1. It can deliver same or higher quantity of good or service at a lower price
  2. It can deliver better quality of good or service at the same or lower price
  3. It is the only country with the technology to produce a unique good or service or an existing good or service of unique quality (can be one of few countries, if the demand cannot be met by one country only)
Economic competitiveness can be seen as a function of three things - knowledge, cost of factor inputs, and cost of getting products and services to international markets. This last cost includes transportation costs, communications costs, and other costs that are not determined by the exporting country (such as tariffs and non-tariff barriers in receiving countries).

If EC is economic competitiveness in a sector in a given country, K is the set of knowledge relevant to that sector held in that country, FP is the set of factor prices relevant to the sector in the country, and OC other costs in getting goods and services to market, then economic competitiveness in that country can be expressed as

EC = f(K) + f(FP) + f(OC)

Economic competitiveness will be expected to increase with increases in knowledge, decrease with increase in prices of factor inputs relative to other countries, and decrease with increase in other costs. In this essay, I will solely focus on the role of knowledge in determining a country's economic competitiveness. I will leave the discussion of the impact of factor prices and other costs for later essays. However, I will point out here that these two sets of variables are also at least partly a function of knowledge held by the different countries.

The rest of this essay is presented in four parts. First, I will discuss the 4SoK framework in detail and elaborate what each of the four quadrants contain. Second, I will divide the world into three sets of countries - least developed countries (LDCs), emerging markets, and developed countries - and present the 4SoK framework as it applies to each of these sets of countries. Third, I will discuss how this framework informs the strategies and policies that each of these three sets of countries should pursue to enhance economic competitiveness. Finally, I conclude with some thoughts on how this analysis can be taken forward further. This essay will be posted in two separate blogs - sections 1 and 2 in the first blog, and sections 3 and 4 in the second.

1. The 4SoK framework

Exhibit II shows the components in each of the four states of knowledge in the 4SoK framework. It distinguishes the knowledge we have into two types - first, knowledge of the state of the world and how it works, and second, the knowledge that enables us to change the state of world. One could call the first science, and the second, technology. But I will avoid using these terms here as a catch all, and instead focus in more specific detail on what these two types of knowledge mean and how they are differently manifested in each of the four quadrants in the 4SoK framework.

In the known known quadrant, our knowledge about the state of the world include our observations about the present, our known record of the past, and our current understanding of how the world works. By the last, I mean our understanding of the relationships between different variables, especially our understanding of cause and effect relationships. This includes all the knowledge that we have in the different disciplines such as physics, chemistry, biology, mathematics, social science, anthropology, medicine, psychology, etc. So this category of knowledge can contain a wide variety of things from an understanding of the DNA sequence to the understanding of customer preferences for different types of toothpaste. The more we have of this knowledge, the more the opportunities are to convert this knowledge into an economic good or service.

This conversion is possible due to the second knowledge that we possess, that of how to change the state of the world. This includes both technological knowledge such as how to make a car, and business knowledge of how to get the cars one makes to millions of customers through thousands of dealers in a country. And similar to the first type of knowledge, the more we have of this knowledge, the more goods and services we can produce, as well as the more we can produce competitively. So in the case of our car example, if we have more technological knowledge, not only can we produce cars, but we can make better or cheaper cars. And the more business knowledge we have have, we can market the car to more customers more effectively.

second quadrant, the unknown known, contains all the knowledge that exists in the world but of which we are unaware or to which we don't have access. For a country, this can include knowledge that exists in a country in reports, libraries, that no one is aware of, or knowledge that is held in other countries but not in the country in question. The third quadrant, the known unknown contains two types of known unknowns. The first are the future states of variables that we know about and track, such as inflation, GDP per capita, etc. The second are the known gaps in our knowledge about the state of the world as well as in our technological and business knowledge. For example, if we take the case of alternative energies, scientists, engineers and policymakers in the United States are aware of the different possible sources such as nuclear, clean coal, biofuels, solar, wind etc., and they are also aware of different technologies being pursued within each of these, but they do not know which one will be successful in the future. In many cases, the scientists and engineers also know the bottlenecks and technological hurdles they face, but have not figured out the solutions to these yet. The last quadrant the unknown unknown contains knowledge about the state of the world and how we can transform it that does not exist and that we are completely unaware of. For example, this would have been knowledge of the internet in 1950.

2. Applying the 4SoK framework to understand economic competitiveness in different sets of countries.

In this section, I will apply the 4SoK framework to understand the differences in economic competitiveness between the LDCs, emerging markets and developed countries from the perspective of knowledge held in those countries. Before we get to these three sets of countries, let us first look at the 4SoK framework as applied to the entire world as shown in Exhibit III.

The length of the lower red bar represents the set of knowledge that exists in the world. The share of the length of this red bar that is in the first quadrant represents the share of the knowledge that exists in the world that is known. As our reference in this case is the entire world, the first quadrant contains the entire length of the bar, as the entire world holds all the knowledge that exists in it. The length of the upper red bar represents the set of unknown knowledge that is known by the entire world. The length of this red bar expressed in the known unknown quadrant is the share of this global known unknown set held in the reference country or region. As in this case, the reference is the entire world, the known unknown quadrant contains 100% of the length of this bar.

Now let us turn to LDCs in Exhibit IV. As shown in the known known quadrant by the length of the red bar in that quadrant, the share of the total known in the world held in the LDC is relatively small. The rest of the red bar is in the unknown known quadrant, as this existing knowledge is mostly held outside the LDC (there may be some codified knowledge in the LDC that the LDC is not aware of in this quadrant, but the size of this is probably very small). Similarly, the share of the world's known unknowns known in the LDC would be small too, in fact this is likely to be even smaller than the known knowns.

Now let us to turn to the green bar and what it represents. This is critical to understanding the state of development in a country and the barriers it faces in increasing economic competitiveness. Just because some knowledge exists in the country - in books and documents, in other media and in the minds of citizens - does not mean that the country is acting on that knowledge to increase economic competitiveness. Let me explain what I mean with the example of women in Saudi Arabia. There are many people in Saudi Arabia who know that female participation in the labour force is key to increasing the country's economic competitiveness. However, they are not able to act on that knowledge because of other reasons such as culture and values, which define particular roles for women in the Saudi society.

In an LDC, there may be several barriers to their ability to act on the relatively little knowledge they possess - culture and values, institutions and legacy regulations that hinder enterprises taking advantage of existing knowledge, lack of resources or investment to exploit the knowledge the country has, the rule by the majority or other groups that don't possess this knowledge, or if the rulers possess the knowledge, the conflict their best interests have with the country's best interests, etc. For similar reasons, they also take relatively little action to increase knowledge transfer from other countries as shown by the relatively thin column of green in the bottom right quadrant.

As in the known known and unknown known quadrants, the green in the known unknown quadrant is a negligible share of the already little amount of the known unknowns that the LDC knows, for the same reasons discussed in the previous paragraph. In addition to that, the small amount of knowledge they have also inhibits them from acting on the unknown knowns or the known unknowns, as the approaches to tackle these also require sophisticated knowledge that may not exist in the LDC. I do not discuss the unknown unknowns here as that is even more inaccessible to the LDCs.

Therefore, there are many reasons why in an LDC, the share of knowledge they act upon to increase competitiveness is a small share of the small amount of knowledge they possess in the first place or why they do not do better at accessing more of the world's stock of knowledge. This is important to understand, especially if internal policy makers or external agencies want to intervene to help LDCs develop and build economic competitiveness. I will talk about how they can do this in the next section. Here I restrict the discussion to characterising the situation in the different sets of countries.

Now let us move to the next step in the hierarchy of development and look at emerging markets such as China, India, Brazil and Eastern Europe in Exhibit V. Here, the known known quadrant contains a larger share of the known knowledge as seen by the longer red share in this quadrant. Similarly, they also contain larger shares of the known unknowns too as seen in the top left quadrant. The greens are also relatively bigger as they are able to act on a bigger share of the known knowns to increase economic competitiveness. They also do a better job of learning from other countries, and therefore overtime increasing the share of the world's knowledge they access. The red is shifted more to the left over time.

The primary efforts at increasing competitiveness in emerging markets comes from these two actions - increasing the actioned share of knowledge they possess, and increasing the knowledge they possess by learning from other countries. There is less of creating new knowledge by converting known unknowns to known knowns and even less of drawing knowledge out of the unknown unknowns.

On the other hand, in the developed countries, as seen in Exhibit VI, the scope to increase economic competitiveness from increasing the actioned share of knowledge they possess or increasing the share of the world's knowledge they possess by learning from others is smaller than in emerging markets. In the most advanced countries, the scope to increase economic competitiveness comes from being the first or one of the first to transfer knowledge from the upper two quadrants into the bottom left quadrant. In this endeavour, they also have the advantage of having a large amount of existing knowledge that they have actioned, as the more you know, the higher your ability to capture more from the unknown. The policies and strategies they must pursue to keep ahead of the curve, therefore, are different from that of the emerging markets.

It is to those policies that I turn to in the next section, which is the most fun section of this essay. But for that, you will have to wait for the next edition of my blog, which should be available in the next few days. But in the meantime, digest this, and send me questions you have, if any.

© Raja Shankar: This essay may be copied or referred to freely, as long as it is sourced to the author

No comments:

Post a Comment