Industry to Aggregate Labor Productivity Growth since the 1990s

Contribution of Within-Sector Change Looking at three broad sectors—agriculture, industry, and services—across a large cross-section of LMICs between 1995 and 2018, we find that within-sector increases explain at least two-thirds of labor productivity growth, on average, in every region of the world (figure 1.5).8 This finding reinforces other evidence that highlights opportunities to enhance productivity growth within sectors. For example, Herrendorf, Rogerson, and Valentinyi (2013) show that, for most high-income and transition economies, productivity growth has largely occurred within sectors. McMillan, Rodrik, and Verduzco-Gallo (2014) also support this finding, concluding that growth accelerations in Latin American, Asian, and Sub-Saharan African countries were based on rapid within-sector labor productivity growth.

Strikingly, except in East Asia and the Pacific, productivity growth within the services sector contributes more than productivity growth within industry to aggregate productivity growth. In South Asia, the percentage contribution of productivity increases within the services sector (34 percent) was more than double that of industry. Similarly, in Sub-Saharan Africa, the percentage contribution of productivity increases within the services sector (33 percent) was four times that of industry (figure 1.5). This is not entirely surprising because, despite higher rates of industrial labor productivity

FIGURE 1.5 Among LMICs in Most Regions, Services Have Contributed More Than Industry to Aggregate Labor Productivity Growth since the 1990s

Decomposition of aggregate productivity growth “within” and “between” sectors in LMICs, by region and relative to high-income countries, 1995–2018

CAGR of value added per worker (%) 3.0

2.5

2.0

1.5

1.0

0.5

0

–0.5

High-income East Asia and Pacific Europe and Central Asia Latin America and the Caribbean Middle East and North Africa South Asia Sub-Saharan Africa

Within services Within agriculture Within industry Between agriculture and industry Between agriculture and services Source: Calculations based on World Development Indicators database. Note: Data for the “industry” sector include not only manufacturing but also mining and construction. “Low- and middle-income countries” (LMICs), by World Bank income group classifications, had 1994 gross national income (GNI) of less than US$8,955. “High-income countries” had GNI exceeding US$8,955 in 1994. CAGR = compound annual growth rate. For the underlying methodology of the decomposition analysis, see annex 1B.

growth, its contribution to overall productivity growth is stunted by its low share in total employment across regions at the beginning of the period (in 1995).

Contribution of Between-Sector Change As a corollary, structural change across LMICs between 1995 and 2018, on average, contributed no more than one-third to overall labor productivity growth in any region (figure 1.5). Its contribution ranged from 14 percent in Eastern Europe and Central Asia and 19 percent in Latin America and the Caribbean to 25 percent in East Asia and the Pacific, 32 percent in Sub-Saharan Africa, and 34 percent in South Asia.9 This positive but relatively small contribution of structural change reinforces the findings of McMillan, Rodrik, and Verduzco-Gallo (2014)—that overall productivity accelerations in several regions were based on rapid within-sector productivity growth—although the magnitude of the contributions shown here is somewhat larger.

We further disaggregate this “between” component to distinguish between the movement of labor in and out of industry and services.10 Although the literature has emphasized structural transformation from agriculture to manufacturing as the central dynamic to understanding productivity growth in LMICs, we find that the increasing share of services in total employment accounts for the bulk of the contribution of structural change in each region (figure 1.5).

This finding reinforces evidence from recent case studies showing that when productivity-enhancing structural change kicked in during the 2000s in Sub-Saharan Africa (specifically in Botswana, Ghana, Nigeria, and Zambia), the bulk of this contribution was accounted for by the movement of labor from agriculture into services (McMillan, Rodrik, and Sepúlveda 2017). In fact, the contribution of structural transformation from agriculture into industry to overall labor productivity growth was close to zero in Eastern Europe and Central Asia and even negative in Latin America and the Caribbean (figure 1.5). This is not surprising given the patterns of structural change described earlier. Despite positive productivity growth within industry in these regions, there was a negligible increase or even a decline in industry’s share of employment.

This implies two things: First, industry has played a special, dominant role in East Asia (and to a smaller extent in Eastern Europe), whereas LMICs in other regions, on average, have not benefited as much from industry as a central driver of their development. Second, it is not the case that industry inherently outperforms services. For many LMICs, therefore, the choice between manufacturing- and services-led development is not of dire importance. The data show that services can deliver productivity growth— in several cases, growth that is higher than that of industry. What matters for the longerterm potential of services-led development is whether the features of industrialization that have enabled scale, innovation, and spillovers along with job creation for unskilled labor—as in East Asia—are increasingly shared by the services sector.

Scale, Innovation, Spillovers, and Job Creation: Revisiting the “Uniqueness” of Manufacturing

The patterns presented in the previous section show that industry’s share of output and employment across LMICs since 1990 has stagnated and that the industrial and services sectors have experienced comparable productivity growth. Does this imply that the countries that have not yet industrialized will be unable to replicate East Asia’s success in manufacturing-led development?

This question risks misplacing the emphasis of what is important. It is not necessarily the production of “goods” or ‘“services” per se that matters but how these are produced. Expanding a sector with potential for growth or for positive spillovers does not necessarily imply that the growth or spillovers will automatically occur (Baldwin 1969; De Ferranti et al. 2002; Lederman and Maloney 2010; RodríguezClare 2007). Countries have expanded manufacturing production but without significant contributions to productivity or longer-term growth, as in the case of Latin America’s import substitution efforts (further discussed below). So, what made manufacturing special in the case of East Asia? And does the services sector have similar underlying features?

Key Features of Manufacturing

Manufacturing-led development, particularly as exemplified by East Asia’s success in export-led growth, has highlighted how a sector’s key characteristics shape its potential to drive development. The experience with manufacturing underscores the sector’s contributions from (a) access to larger markets; (b) the scope to augment labor with capital and technology; and (c) linkages with other sectors—that is, the contributions of economies of scale, innovation, and spillovers.

“Kaldor’s growth laws,” based on data from present-day high-income economies in the 1960s, reflect these contributions of innovation, scale, and spillovers in delineating the manufacturing sector as the main engine of growth for an economy (Kaldor 1966). These laws document three positive associations: (a) between growth of manufacturing output and average GDP growth (explained via a transfer of surplus labor from agriculture to manufacturing, where it can be combined with capital and technology); (b) between growth of manufacturing output and manufacturing productivity (attributable to static and dynamic economies of scale); and (c) between growth of manufacturing output and overall productivity of the economy (owing to spillover effects).

Based on data from LMICs between 1995 and 2018, Kaldor’s three growth laws remain valid for the broad industrial sector.11 These dynamics, as further described below, have led to productivity growth and substantial job creation for unskilled workers.

Economies of scale. Manufactured goods are storable and transferable, so that production can be separated from consumption. This enabled the manufacturing sector to achieve enormous gains from scale, particularly when goods were traded and thus able to access demand beyond the domestic market. Although the agriculture sector was also traded, it typically faced price volatility in international markets.

Demand-side dynamics also underlie the global expansion of markets for manufactured goods (Szirmai 2012): as per capita incomes rise, the share of agricultural products in total expenditure declines, while the share of manufactured goods increases in accordance with a hierarchy of needs (Engel’s law). The production of tradable manufactured goods facilitates scale economies, technology diffusion, and greater competition which, in turn, underlie the “catch-up” that labor productivity in (formal) manufacturing exhibits across countries (Rodrik 2012).12

Innovation. The movement of surplus labor from (rural) agriculture to (urban) manufacturing and capital accumulation in the latter (Lewis 1954) was integral to innovation dynamics in the manufacturing-led development model. Much of the innovation was focused on improving and deepening capital investment—most of which raises labor productivity (although automation can serve to replace labor, too, beyond a threshold) while also providing the benefits of scale economies.

This innovation through labor-augmenting capital accumulation is reflected in large, systematic differences in labor productivity between the agriculture and manufacturing sectors, and these intersectoral labor productivity gaps are wider in the poorest countries (Caselli 2006; Herrendorf, Rogerson, and Valentinyi 2013; Restuccia, Yang, and Zhu 2008).13

Spillovers. Linkages between manufacturing subsectors also helped expand the productivity and growth dynamics of manufacturing through spillovers—for example, from basic metals to machinery and equipment—whereby manufactured goods could in turn help make more, and more sophisticated, goods.

Job creation. The production process in the manufacturing sector has therefore typically absorbed large numbers of relatively unskilled workers from agriculture at a substantial productivity premium and subsequently placed that labor on a productivity path that rises up to the global frontier (Rodrik 2012) owing to opportunities for scale, innovation, and spillovers.

However, the contrast between the industrialization experiences in East Asia and Latin America is important here. Labor-intensive, export-oriented industrialization in East Asia integrated the countries with world markets, enabling them to achieve scale, face competition, and acquire foreign technology while creating jobs for unskilled labor. In contrast, import substitution industrialization in Latin American countries— an inward-oriented strategy in the mid-twentieth century that used trade barriers to strengthen local producers and often employed capital-intensive techniques that did

not conform with a country’s comparative advantage—did not deliver similar growth benefits (Gereffi and Wyman 2014).

The Changing Nature of Services

The simultaneity of consumption and production, the intrinsic role of labor, and limited linkages to other activities have typically affected the services sector’s potential for scale, innovation, and spillovers. These salient characteristics that distinguished services from manufactured goods have thus traditionally led many to question the sector’s potential to lead productivity growth and enable LMICs to catch up, especially when compared with manufacturing. However, the advent of digital technologies and increased tradability suggests that this potential has been changing.

Analog Services (Pre-ICT Era) The “simultaneity of production and consumption” and “nonstorability and perishability” that traditionally characterized services emphasized the physical proximity between producers and consumers (Griliches 1992; Hill 1977). This importance of face-to-face interactions, in turn, constrained service providers from achieving scale by accessing demand beyond the local market, including through international trade. This meant that producers in lower-income countries could not exploit the rising demand for services in higher-income countries.14 Unlike goods, the consumption of services could not be detached from their production because they cannot be stored.15

Subsequent to this early conceptualization, however, many studies have highlighted the restrictiveness of this definition with a view that not all services are same. For instance, many “noncontact” services allow for the separation of production and consumption across space (Bhagwati 1984; Kohn 1989). Similarly, that services cannot be put into stock may have little to do with their physical durability; many services such as education are not only permanent but also irreversible (Hill 1977).

Early characterizations of the services sector also outlined the “intrinsic role of labor” as a constraint to labor-augmenting capital accumulation and technology adoption. Baumol (1967) argued that the productivity of many services sector activities cannot be readily increased through capital accumulation, innovation, or economies of scale because of their relatively labor-intensive nature: whereas labor was simply an incidental requisite for the attainment of the final product in manufacturing, it was an important end in itself for services.

Baumol’s classic example of this is that although it took a string quartet exactly the same amount of time to play a piece in 1965 as it did when Mozart wrote it in 1865, musicians in 1965 made a lot more money than musicians in 1865. Rising worker productivity in the manufacturing sector allowed factories to cut prices and raise wages at the same time. But when wages rise, live music venues have no alternative but to raise ticket prices to cover the higher costs of labor-intensive orchestra performances.16

The increasing share of services in total output may therefore be attributable to the increasing relative prices of services.

This argument became known as Baumol’s “cost disease” hypothesis and had implications far beyond the arts. It implies that in a world of rapid technological progress, we should expect the cost of manufactured goods (cars, smartphones, T-shirts, bananas, and so forth) to fall and the cost of labor-intensive services (schooling, health care, childcare, haircuts, legal services, and so forth) to rise.

Last but not least, the potential role of providing spillovers—defined as the multiplier effects of linkages across sectors—applied to only a limited number of services (such as transportation and distribution) that were closely linked to the production of agricultural commodities and manufactured goods. This point abstracts from a larger literature on spillovers that looks at broader sources of externalities and market failures that have often resulted in the public provision of many services, such as telecommunications, finance, education, and health care.17

Digitally Enhanced Services The features of manufacturing that were once considered uniquely special for productivity growth might be increasingly shared by some service sectors, especially given the advent of ICT (table 1.1). There is now greater scope for services firms to achieve efficiency gains through scale, labor-augmenting innovation, and backward or forward linkages with other sectors.

Gaining scale through access to international markets. Digital electronic content has made services more storable, codifiable, and transferable, which in turn has meant that physical proximity between consumers and producers no longer constrains the scaling-up of many services-related transactions—telephone and online banking, computer programming, and education services being cases in point (Ghani and Kharas 2010). Freund and Weinhold (2002) provided the earliest assessment of this relationship between digital technologies and scale in services, finding that the growth in US service exports and imports increased by 1.1 percentage points as internet penetration in a partner country increased by 10 percent.

Many services now have trade costs comparable to manufacturing industries (Gervais and Jensen 2019). In fact, compound annual growth in world exports has been higher in services than in manufacturing since 2000, with the highest rates in modern, more digitally enabled, services (Loungani et al. 2017).

Accumulating capital and adopting technologies for labor-augmenting innova-

tion. Capital accumulation that augments labor is not uncommon to transportation and telecommunications services. Take the example of data centers, which require high levels of fixed assets and for which costs rapidly decrease with scale (Fontagné, Mohnen, and Wolff 2014).