In economic literature, one often stumbles across the term “structural change”, which refers to the process by which the economy’s composition changes over the long term, from low value-added activities, such as subsistence farming, to more modern and productive ones, such as industry and services1. Structural change thus entails a progressively faster diversification of those products the economy has an edge on and can competitively trade in the global economy. The majority of low-income countries produce a limited variety of manufacturing goods while their economies are heavily concentrated in a small number of basic agricultural commodities, energy sources or unprocessed minerals (see figure below) because they lack the capabilities, i.e. the skills and assets, needed to drive production capacity in manufacturing industries.
The challenge for many developing countries is deciding which new activities and industries to add and which products to promote to gain a competitive edge. More than a decade ago, César Hidalgo and Ricardo Hausmann proposed a solution to this dilemma starting from the realization that “new products that a country develops depends substantially on the capabilities available in the country2”. Accordingly, the most suitable products to promote are those “which balance the desire to increase the diversification and complexity of production, while not over-stretching existing capabilities3”. Based on this, they pioneered the concept of the so-called “product space”, which can be used as a ready-made map for countries keen to pursue structural change.
A recent study commissioned by UNIDO examined countries’ diversification experiences over the last 20 years (see next figure) to empirically test whether the majority of “jumps” observed in the product space were indeed short and had only marginally expanded the countries’ existing capabilities (high relatedness), or whether these jumps were in fact longer than the countries’ initial set of capabilities would have led one to believe (low relatedness). The study finds that the latter, which are referred to as long jumps, accounted for at least 39 per cent of all jumps in the product space.
The implication of this finding for decision-makers is that the product space can be used as a map for slightly longer and more ambitious excursions than initially presumed. It can be used to distinguish between products that can be exported competitively, independently of a country’s initial capabilities (low path-dependence products), and products that countries have succeeded in exporting based on their pre-existing capabilities (high path-dependence products).
Longer jumps towards the former group of products, namely products with a low path-dependence, challenge the traditional approach that countries should not “overstretch” their existing capabilities by choosing products that are at a distance from their current export baskets. Pursuing products without encountering any significant resource and capability constraints and that a relevant number of other countries have already successfully started exporting (high frequency of new entries) is certainly an attractive option.
Although longer jumps towards the second group (of high path-dependence products) correspond to Hidalgo and Hausmann’s predictions, UNIDO’s recent study yields some interesting insights. First, a product that is “close” to the country’s current export basket may not prove a particularly attractive option in case of strong international competition due to market saturation, i.e. entering a market that already has many competitors, and/or the product lies even “closer” to many other countries’ current export baskets, in particular countries with the same or lower income level and consequently, lower labour costs (i.e. when other country competitors have a relatedness advantage).
Secondly, a product that lies at a distance from the country’s current export basket could be an attractive option if: it is even “farther away” from the current export baskets of other countries that belong to the same or to a lower income group (i.e. when a country has a relatedness advantage), and if a reasonable number of other countries that belong to the same income group and have a similar endowment of capabilities has managed to successfully export the respective product over time.
UNIDO is currently developing a tool (DIVE) to help decision-makers more effectively navigate through the set of possible diversification options drawing on the above insights. The tool can be used to identify four types of products within a country’s potential diversification space:
Short jumps with high path-dependence and many competitors
These are products with a high degree of path-dependence for which a country’s initial capabilities do matter and that are “close” (have high relatedness) to the country’s current export basket. Two additional criteria are used to determine a product’s attractiveness, namely: i) a relatedness advantage to ensure that the country’s capabilities are more closely related to the product than the capabilities of countries that have reached a similar level of development, and ii) a large number of countries specialized in producing the respective good (above the 75th percentile) could flag market saturation.
Short jumps with high path-dependence and only few competitors
These are products that share the same features as those described above, but only a limited number of competitors or countries have a comparative advantage in producing the respective good.
Long jumps with low path-dependence, high frequency of new entries and few competitors
The combination of these features in a product suggest that low relatedness does not necessarily thwart structural change. In fact, many countries—even those with an unrelated initial specialization in producing the respective good—managed to start exporting it competitively in a non-saturated international market (few competitors). Products with low path-dependence likely hinge on the existence of a set of productive capabilities that can be relatively easily acquired or are universally available. Such products might be particularly interesting as targets in a diversification strategy if they include other attractive features (such as complexity, potential spillovers or strategic priorities).
Long jumps with high path-dependence and relatedness advantage
These products have a high degree of path-dependence for which a country’s initial capabilities do matter and which lie at a distance (low relatedness) to the country’s current export basket. A narrow interpretation of the product space would not endorse such products as delivering a comparative advantage, and pursuing them would therefore be unwarranted. Given the inherent risks, such products are only selected: i) in case of a relatedness advantage, which signifies that the country is more closely related to the respective product compared to other countries at a similar level of development, and in case these products are already being exported by countries with similar income characteristics, indicating a reasonable risk when targeting these products.
Whereas Hidalgo and Hausmann’s approach focuses on prioritization of products characterized by “short jumps”, DIVE differentiates short jumps between those that have many and those that have only few country competitors. Most importantly, DIVE re-introduces “long jumps” into the debate on product prioritization, both in terms of products that do not depend heavily on existing capabilities and those that although constrained by their existing capabilities, are already present in the export baskets of countries with similar income characteristics (i.e. suggesting that such long jumps are not necessarily destined to fail). DIVE can be applied in all countries with existing trade data to identify product prioritization for diversification opportunities.
Disclaimer: The views expressed in this article are those of the authors based on their experience and on prior research and do not necessarily reflect the views of UNIDO (read more).
Have your say
What is your opinion on the IAP?
