By Dani Rodrik and Rohan Sandhu for the NBER , July 2024
ABSTRACT
Manufacturing generates very little employment in the developing world. Urban jobs are predominantly informal, unproductive, and in services. It seems unlikely that manufacturing will be able to absorb the new increments to the labor force or create more productive jobs for those that are already stuck in petty services. Raising productivity in services has been traditionally difficult, but is now necessary to achieve long-term growth in the standard of living. We discuss and provide evidence for four broad strategies: (a) incentivizing large, productive firms to expand their employment; (b) enhancing productive capabilities of smaller firms through the provision of public inputs; (c) providing workers or firms technologies that explicitly complement low-skill labor; (d) vocational training with “wrap-around” services to enhance job seekers’ employability, job retention, and eventual promotion.
I.Introduction
The future of developing countries lies in services. Enhancing productivity in labor-absorbing services is necessary both to ensure economic growth and to achieve a more equitable distribution of income. In this paper we provide a broad overview of what such a strategy might look like, drawing on a wide range of existing programs on which it might build. Emphasizing a services-driven model may seem odd in view of the phenomenal success that countries such as Soth Korea, Taiwan, and China have had with the strategy of export-oriented industrialization. Indeed, historically industrialization has been the main vehicle for modern economic growth. The aptly-named Industrial Revolution in Britain was itself the product of the application of new technologies to manufactures such as cotton textiles. Almost all subsequent and sustained cases of economic catch-up, from the United States to Japan, were the result of industrialization. The conventional recipe for low-income countries such as those of SubSaharan Africa is to replicate these experiences, by removing obstacles to (or actively promoting) rapid industrialization so their firms can plug into global manufacturing value chains. Today, even advanced economies are engaged in industrial and other policies to reinvigorate their manufacturing sectors, weakened by decades of competition with China.
There are good reasons why manufacturing is distinctive and may deserve special attention. In advanced economies, manufacturing contributes a disproportionate share of R&D and innovation, and therefore plays a particularly important role in driving economy-wide productivity growth. In developing countries, formal manufacturing sectors reliably exhibit “unconditional” labor productivity convergence to the technological frontier. Manufacturing establishments that are very far from the frontier experience especially rapid productivity growth, even in economic environments characterized by bad policies or disadvantageous external conditions (Rodrik 2013). Moreover, manufacturing is tradable, meaning that firms do not face domestic demand constraints; for smaller economies, and especially developing countries, this means that their manufacturing firms can expand virtually without limit, driving economic growth.
Historically, manufacturing presented an additional advantage for developing economies – and this one was critical in enabling rapid economic growth through industrialization. Many if not most segments of manufacturing did not demand significant skills from production workers, beyond some manual dexterity, punctuality, learning on the job, and ability to work with others. Machinery and equipment could be imported from abroad (and eventually produced at home with the requisite capabilities in place). Governance and regulatory requirements from the state were either similarly minimal, or when more extensive, could be provided in a targeted manner (through special zones or customized policy regimes, for example) without requiring economywide institutional improvements. In short, industrialization needed resources which were plentiful in poor countries (cheap, unskilled labor) and economized on resources that were scarce (education, physical capital, high-quality institutions). This in turn meant that industrialization faced few constraints on the supply side either: manufactures could expand rapidly without driving costs up and profitability down, at least until countries reached middleincome stage.
The features summarized in the previous paragraph no longer describe the realities of today’s manufacturing (Rodrik 2016). It is well documented that innovation in manufacturing has taken a predominantly skill-biased form, reducing demand for workers with relatively low levels of education (Acemoglu and Restrepo 2022). In many manufacturing segments, new technologies such as automation, robots, and 3D printing serve to directly substitute physical capital for labor. Of course, given their relative factor prices, firms in developing countries have the incentive to use more labor-intensive techniques. But they face a limited range of factor substitution possibilities. Competing in the global marketplace requires employing production techniques that cannot differ significantly from those employed in the frontier countries, because the productivity penalty would be otherwise too high. The need to produce according to the exacting quality standards set by global value chains restricts how much unskilled labor can substitute for physical capital and skilled labor (Rodrik 2022). The rising skill- and capitalintensity of manufacturing in turn means that globally competitive, formal segments of manufacturing in developing countries have lost the ability to absorb significant amounts of labor. They have effectively become “enclave” sectors, not too different from mining, with limited growth potential and few positive effects on the supply side of the rest of the economy.
This is why countries, such as Ethiopia, that were not so long ago touted as the next manufacturing miracles, have been unable to experience manufacturing-led growth. While overall manufacturing output and employment shares have increased in Ethiopia, the aggregate statistics hide a discomforting productive dualism: the productive and mostly large firms are essentially not creating any employment, while the manufacturing firms that are absorbing labor are predominantly small, informal, and productively stagnant (Diao et al. 2024). It is also the reason why countries such as Bangladesh that have done exceptionally well in certain manufacturing segments, such as ready-made garments, are now finding it very difficult to diversify and move into more sophisticated segments (as East Asian countries eventually did). As virtually every report on Bangladesh argues, the country requires a significant investment in skills and new technologies if it is to continue building on its manufacturing success. True as far as it goes, this recommendation is also an implicit acknowledgement that manufacturing is no longer the growth escalator it once was: what made industrialization special in the first instance was that it allowed productive upgrading within the limited resource endowments of lowincome countries.2
2 Vietnam stands out as a possible exception, a country that has managed to rapidly expand output, exports, and employment in manufacturing, replicating many of the features of earlier East Asian experiences. As we argue in Rodrik and Stiglitz (2024), Vietnam had several distinctive advantages. The country’s geographical proximity to China and other East Asian exporters made it a natural landing spot for firms from those countries when their labor costs began to rise. This positioned the country as the leading beneficiary of the Trump tariffs on China, and eventually the U.S. emphasis on “friend-shoring.” But in Vietnam too, integration into the world economy through inward direct investment has made increasing demand on skills. “Skill shortages” (and consequent problems of “job hopping” and “employer poaching”) are reported to be among the most important constraints export-oriented foreign investors such as Samsung face.
More broadly, all over the developing world we now see a pattern of structural change that is very different from what the usual process of economic development is supposed to look like. As young workers flock to urban areas from the countryside, they find very little employment in manufacturing (unlike earlier eras, whether under Latin American-style import-substitution or East-Asian style export-promotion). The urban jobs that are created to employ them are predominantly informal, precarious, unproductive, and in services. While we might be tempted to argue that this reflects errors in government policy, the considerations above suggest there is something more structural, beyond the government’s ability to control, that is at play. In the years ahead, manufacturing will neither be able to absorb the new increments to the labor force, where the labor force is still growing rapidly (as in the low-income countries of subSaharan Africa), nor create more productive jobs for those that are already stuck in petty services.
This brings us back to the opening sentence of this paper. The future of developing countries is in services in the sense that that is where the jobs will be. Those jobs need to be productive ones, for reasons of both economic growth and equity. Economic growth requires that we move people from less productive to more productive activities. If services are the preponderant source of new employment, they have to be more productive than the rest of the economy in order for aggregate incomes to rise. And as for equity, the only sustainable way to lift people at the bottom of the income distribution is to provide them with better paying jobs. Those jobs will have to be in services, whether we like it or not (Rodrik and Stiglitz 2024).
Here we face a conundrum though. We do not know much about how to raise productivity in labor-absorbing services. While some services, such as banking, IT, and business process outsourcing (BPO) are both productively dynamic and tradable, they are not going to be labor absorbing for the same reason that manufacturing is not. These are relatively skill-intensive services which, even under the best of circumstances, will not provide the answer to the challenge of productive job creation. In India and the Philippines, two countries where these types of services have been successful (IT in India and BPO in Philippines), the bulk of employment continues to be generated by informal services. The challenge is to increase productivity in labor-absorbing services, such as retail, care, personal and public services, where we have had limited success, in part because such services have never been an explicit target of productive development policies. Industrial policies, as the name makes clear, typically focus on fostering innovation, investment, and productivity in manufacturing. But if developing countries are going get richer under present conditions, they will have to adapt these policies to laborabsorbing services.
Services have traditionally been the laggards of productivity. Will Baumol’s (2012) famous “cost disease” argument is predicated on slow productivity growth in services and explains why the relative prices of services rises as the rest of the economy become more productive. In manufacturing, the labor units required to produce steel or cars has been slashed drastically over time, especially if we adjust for quality improvements. But it takes just as long today for a barber to cut a customer’s hair or a conductor to lead the orchestra through a Beethoven symphony as it did centuries ago. As we mentioned previously, technological catch-up has been far easier for developing countries in manufacturing than in labor-absorbing services. The broad historical record suggests it will be difficult to achieve comparable rates of productivity growth in areas such as care, education, retail, or public services. But if we are right about the eroding power of industrialization as a growth strategy, there is no alternative other than making services productivity an explicit government priority.
The literature on this paper’s themes is not large, in part because the term productive upgrading is not typically associated with services. It tends to be used in connection with tradable sectors of the economy, such as manufacturing or agricultural supply chains. The recent survey by Verhoogen (2023) on firm-level upgrading focuses almost entirely on manufacturing firms. Magruder (2018) surveys experimental evidence on technology adoption in agriculture. But there is other work that, while not explicitly focused on services, covers some aspects of the approaches described above, such as training or fostering entrepreneurship. McKenzie and Woodruff (2014) and Quinn and Woodruff (2019) survey experimental interventions – such as the provision of grants or management training – aimed at improving entrepreneurship among smaller firms, including microenterprises. Many of the firms covered in these experiments are in services. Carranza and McKenzie (2024) discuss job training policies in developing countries. Kremer et al. (2021) present a compendium of interventions, some in services, that have been evaluated that hold promise for scaling up. We have drawn on this literature in selecting our cases.
Since the bulk of firms in services is informal, this paper also relates to the extensive literature on informality (Chen 2012; La Porta and Shleifer 2014; Portes and Haller 2008). This literature scrutinizes the reasons for informality and its consequences for economic performance. In general, there is a two-way relationship between informality and productivity. Firms with little opportunity to expand may not be able to afford the costs of formality, such as registration and taxes. But barriers to formality may also serve as obstacles to firm expansion and productive upgrading, by hindering access to credit markets, technology, and new markets for example. So informality can be both a cause and a consequence of low productivity. In this paper, we sidestep these questions, focusing directly on strategies that enhance productivity regardless of firms’ formality status.
The plan of the paper is as follows. In the next section we provide a typology of different strategies for creating productive employment in services. Section III briefly summarizes our cases. Section IV provides more details on four of the cases, as illustrations of the four strategies in our typology. Section V presents a discussion and some preliminary conclusions.
II. A typology of strategies
There are four broad strategies for expanding productive employment in services. The first focuses on established, large, and relatively productive incumbent firms, and entails working with them to incentivize them to expand their employment, either directly or through their local supply chains. These firms could be large retailers, platforms such as ride-sharing services, or even manufacturing exporters (with potential to generate upstream linkages with service providers). The second strategy focuses on smaller firms (which constitute the bulk of firms in developing countries) and aims to enhance their productive capabilities through the provision of specific public inputs. These inputs could be management training, loans or grants, customized worker skills, specific infrastructure, or technology assistance. Given the heterogeneity of firms in this segment, ranging from micro-enterprises and self-proprietorships to mid-size firms, policies in this domain require a differentiated approach, to respond to the distinct needs of firms of different size. Given the numbers involved, often they also require a mechanism for selecting among the most promising, since most such firms are unlikely to become dynamic and successful.
The third strategy focuses on the provision, to workers directly or firms, of digital tools or other forms of new technologies that explicitly complement low-skill labor. The objective here is to enable less educated workers to do (some of) the jobs traditionally reserved for more skilled professionals and to increase the range of tasks they can perform. The fourth and final strategy is centered on less-educated workers and combines vocational training with “wrap-around” services, a range of additional assistance programs for job seekers to enhance their employability, job retention, and eventual promotion. Modeled after Project Quest and other similar sectoral workforce development schemes (Katz et al. 2022), these training programs typically work closely with employers, both to understand their needs and to reshape their human resource practices to maximize employment potential. In different ways, these strategies all aim to increase productivity and/or employment possibilities in services for workers with limited skills.
We want to explore the potential of these kinds of programs to address the productive service jobs conundrum. To that end, this paper centers around twenty different initiatives from around the developing world, encompassing illustrations from each of the four strategies we just described. Our cases do not constitute a random sample. They have been selected among those that are well-documented to indicate the range of programs that is already in place. Our goal is to highlight the richness of experimentation and to suggest that there is already a reservoir of practice on what might be called productive development policies for labor-absorbing services on which future efforts can build and expand. We shall draw some provisional conclusions from our cases at the end of the paper
Not all of the programs we will summarize have been formally or rigorously evaluated; and among those that have, not all have been successful. We are more interested in suggesting a general direction for future development policy than to pass judgement on what kind of programs work best. We suspect that local context matters greatly — as it does in general, but even more so when it comes to the kind of service activities that are our focus. Even programs that produce superlative results in one setting may prove difficult to replicate in others.
Moreover, regardless of the success of individual programs, it is important to bear in mind the scale of the challenge a services-oriented development strategy faces. A randomized policy intervention that increased earnings of low-income workers by, say, 20 percent would normally be judged a great success (assuming reasonable program costs). Even if it were successfully scaled up to the economy at large, this gain would not make up even 1 percent of the income gap that currently exists between a country like Ethiopia and the U.S. Real success will require greater ambition, continuous experimentation, and the cumulation of a very wide range of different programs.
III.A brief description of cases
We catalogued twenty initiatives from around the world to study their respective approaches, experiences, and results. Table 1 provides a summary. These are initiatives that have been welldocumented in the academic and/or policy literature. Our cases represent a range of geographies: eight of these initiatives are from Africa, eight from South and East Asia, four from Latin America, and one from Europe. The initiatives vary based on the type of implementer, the goals of the program, and nature of intervention. Not all of them have been formally evaluated. Several of these initiatives are administered by multistakeholder coalitions, with actors from government, social enterprises, and multilateral or bilateral funders. In eleven cases, the lead implementer is an international development actor, including multilateral agencies such as the World Bank and UNICEF or large non-profit organizations such as Plan International and Swisscontact. In seven cases, the government (either national or subnational) was a lead player; in four, a social enterprise was a lead implementing agent.
We distinguish programs in the table according to whether they target (a) employment creation, (b) productivity improvement, or (c) both. We have tried to identify interventions on both the demand and supply sides of the labor market, to unpack their mechanisms and approaches. The specific approaches include business competitions, training, technology tools, financial assistance, internships, and addressing policy barriers. In many cases, partnership between different stakeholders – as opposed to policy or “innovation” – was the primary value add of the initiative.
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