Trade, Foreign Investment, and Industrial Policy for Developing Countries 4059

could be a useful measure for IP. In particular, countries could consider inducing col-
lective action in sectors with a high “adjusted income level.”

2.4 Self-discovery and diversification

The notion of IP that we have emphasized so far is that there are “special industries,”
and that countries can increase welfare by reallocating resources to those industries. An
alternative idea that we now explore is to think of a policy to increase diversification.
This has been a particular concern in countries that specialize in natural-resource inten-
sive industries (see CAF, 2007; De Ferranti, 2001, for recent treatments focusing on
Latin America). Diversification could be desirable as a way to reduce volatility, or as
a way to increase productivity. Here we focus on the later.
To think about the connection between diversification and productivity, consider
the Eaton and Kortum (2002) model of trade. As explained above, Eaton and Kortum
model productivities as being drawn from a distribution that is common across
countries except for a technology parameter T. This technology parameter determines
the location of the productivity distribution: countries with a higher T have “better”
distributions in the sense that, on average, productivity draws will be higher (formally,
this entails first-order stochastic dominance). Apart from T, countries also differ in size,
L. Assuming away trading costs for simplicity, wages are determined by the ratio of
technology to size, T/L. A high T/L means that the country would have many sectors
in which it has absolute advantage relative to its size, leading to a high equilibrium
wage. Moreover, given L, a higher T implies the production (and export) of more
goods, or more diversification.
Of course, higher productivity and higher wages may not go together with diver-
sification. For example, high productivity in a sector that is not “diversified” or “differ-
entiated” would draw resources away from the diversified sector and reduce overall
diversification even as it increases overall productivity and wages. It is also important
to recall that the data reveal that after a certain level of development, higher income
goes together with less, not more diversification (see Imbs & Wacziarg, 2003).
An interesting way to think about diversification is via what Hausmann and Rodrik
(2003) call “self-discovery.” They argue that countries do not really know their cost
structure, and hence they do not know the goods in which they have comparative
advantage. This must be discovered through costly experimentation, which is plagued
by information spillovers that render its private benefits low relative to its social bene-
fits. The following model shows a simple way to capture the connection between
diversification and productivity, and then between self-discovery and diversification.
Consider an economy with labor as the only factor of production and two sectors:
agriculture and manufactures. Agriculture is a homogenous good, produced
with decreasing marginal returns to labor, with QA ¼ lF(LA). There are a continuum
of manufacturing goods indexed with j e [0, 1] that are produced from an input H ¼ eL