India, Free Trade, Productivity and Sectoral Shifts

This is what I was talking about when thinking about the EU/India Free Trade deal. Will it help India shift workers from low productivity activities to high productivity industries? This doesn’t necessarily happen automatically. Look at a graph of Dani’s on Growth reducing structural change

The representative Latin America country has experienced faster productivity growth in its individual economic sectors than the representative Asian economy. (China is not included in this data set.) Why then did Latin America do so much worse overall? Because the reallocation terms have contributed negatively to overall economic growth. Note in particular the hugely negative “cross” term for Latin America (the green bar). In Latin America, labor has moved from sectors with high productivity growth to sectors with low (or negative) productivity growth, offsetting to a large extent the large “within” effect and the much smaller (but still positive) “between” effect.

This should be the worry for countries like India entering Free Trade deals with Europe. Will the trade help poor countries restructure their economies in productive ways or will it retard or reverse that process.

I’m tempted to believe it will with respect to India’s already well established services sectors. Demand from Europe should swell employment in the relatively high productivity service sector, which is what we want to see. A positive sectoral shift from high productivity to low productivity employment as a result of trade.

However, investment in agriculture will probably become depressed in India as competition from subsidised European crops depresses returns in this sector. This could increase low-investment subsistence farming and decrease large scale efficient farming methods. A negative sectoral shift from high productivity to low productivity employment as a result of trade.

Opening up to trade will induce all sorts of competitive pressures on all sorts of industries. It will cause relatively uncompetitive firms to close down. In an efficient economy more efficient firms will expand or new more efficient firms will be created to stake that market share.

Competition and the exit and entry of new firms are good ways of making a country more wealthy. However, it will not necessarily happen automatically, and a country like India, with very poor quality institutions need to be careful which policies they adopt.


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