Development and accumulation of new capabilities: The Index of Opportunities

Jesus Felipe, Utsav Kumar, Arnelyn Abdon

22 July 2010

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Development is about structural transformation. This can be defined as the process by which countries change what they produce and how they do it. It involves a shift in the output and employment structures away move from low-productivity and low-wage activities into high-productivity and high-wage activities; and the upgrading and diversification of the production and export baskets. This process generates sustained growth and enables countries to increase their income per capita. The idea that structural change (in particular the importance of industrialisation) is the engine of growth goes back to Kaldor (1967).

More recently, Hidalgo et al. (2007) and Hausmann et al. (2007) have developed a Capabilities Theory and revived Kaldor’s ideas. They argue that while growth and development are the result of structural transformation, not all activities have the same consequences for a country’s growth prospects. The implication is that a sustainable growth trajectory must involve the introduction of new goods and not merely involve continual learning on a fixed set of goods. A country’s ability to foray into new products depends on whether the set of existing capabilities necessary to produce these products can be easily redeployed for the production and export of new products.

What are these capabilities? They are human and physical capital, the legal system, institutions, etc... that are needed to produce a product. At the firm level, they are the “know-how” or working practices held collectively by the group of individuals comprising the firm. These existing capabilities reflect the package that the country produces and exports with revealed comparative advantage. In the simple theory of comparative advantage Pakistan might not produce Mercedes cars because the opportunity cost would be too high. In capabilities theory, however, Pakistan cannot produce and export Mercedes cars simply because it does not have the necessary capabilities.

The Index of Opportunities

In recent research (Felipe et al. 2010a) we develop a new Index of Opportunities based on a country's accumulated capabilities to undergo structural transformation. The Index captures the potential for further upgrading, growth, and development. The idea underlying the Index is that, in the long run, a country's income is determined by the variety and sophistication of the products it makes and exports, and by the accumulation of new capabilities. The Index of Opportunities has the following dimensions, all related to a country's export basket:

  • Overall sophistication (EXPY)

The level of sophistication of the export basket captures its income content. It is calculated as a weighted average of the income level of the products exported, where the latter is calculated as a weighted average of the GDP per capita of the countries that export a given product. Figure 1 shows the level of sophistication for a group of countries.

Figure 1. Export sophistication (2001-2007 average)

Source: Felipe et al. (2010a)

  • Sophistication of the core

We also look at the sophistication level of the "core" products. Core commodities are machinery, chemicals and metals (see Appendix Table 1 in Felipe et al. 2010a for details).

  • Overall diversification

The diversification of a country’s export basket is measured by the number of products in which the country has acquired revealed comparative advantage. It measures the country’s ability to compete in a wider range of products. Figure 2 shows the level of diversification for a group of countries.

Figure 2. Diversification (2001-2007 average)

Source: Felipe et al. (2010a)

  • Diversification of the core

This is the number of core products in which the country has acquired revealed comparative advantage.1

  • Share of Complex Capabilities

This is the ratio of the number of core commodities with revealed comparative advantage to the total number of commodities with revealed comparative advantage.

  • Standardness

Another aspect of the export basket that the index captures is uniqueness, i.e., how many countries export the same product. This measure of uniqueness of the export basket has been called “standardness” (Hidalgo and Hausmann 2009). A lower value of standardness represents a more unique and therefore better export package. Figure 3 shows the relationship between standardness and diversification.

Figure 3. Standardness and diversification (2001-2007 average)

Source: Felipe et al. (2010a)

  • Open Forest

This is a measure of the potential for further structural change. This variable provides a measure of the (expected) value of the goods that a country could potentially export, i.e., the products that it currently does not export with revealed comparative advantage (see Figure 4).

Figure 4. Open Forest (2001-2007 average)

Source: Felipe et al. (2010a)

Construction of the Index of Opportunities

We estimate cross-country regressions of each of the seven indicators on the level of GDP per capita. Each indicator has two components that enter the construction of the Index. One is the actual value of the indicator, which captures the actual capabilities. The other one is the residual from the regression of the indicator on GDP per capita. This shows whether a country is a positive or a negative outlier given its income per capita. The residual obtained in each case is considered a “reward” or a “penalty”, respectively. A lower value of standardness is considered better. In this case, therefore, a negative residual corresponds to a reward and a positive residual to a penalty. We use highly disaggregated trade data covering 779 products for the years 2001-2007.

We rescale all seven indicators and the residuals such that they lie between 0 (minimum value) and 1 (maximum value). With all the seven indicators (and their residuals) scaled to lie between 0 and 1, and an increasing value corresponding to an improvement, we averaged the fourteen components to obtain the Index of Opportunities.

Results

Table 1 shows the ranking for 96 non-high income countries (see Felipe et al. 2010a for high-income countries). China has the highest score, followed by India, Poland, Thailand, and Mexico. Brazil comes in 6th place and Russia in 18th (for in-depth analyses of China and India see Felipe et al. (2010b) and Felipe et al. (2010c), respectively).

Table 1. Index of Opportunities

Source: Felipe et al. (2010a)

To see how the Index performs as a predictor of future growth, we constructed the Index for 1980-86. Figure 5 shows that there is a positive and a statistically significant relationship between the capabilities that existed in the early 1980s and per capita GDP growth over the period 1980-2007 (Felipe et al. (2010d) provide growth forecasts for 2010-2030 for 147 countries).

Figure 5. Index of Opportunities (1980-1986) and per capita GDP growth (1980-2007)

Source: Felipe et al. (2010a)

Conclusion

Development is the result of the transformation of the economy and of nurturing the capabilities that support it. Accumulating capabilities is a long-term and path-dependent process that requires painstaking learning that cannot happen overnight. Leapfrogging is very difficult and unlikely.

Our results show that countries like China, India, Poland, Thailand, Mexico, and Brazil have accumulated a significant number of capabilities, which will allow them to do well in the long run. These countries diversified and increased the level of sophistication of their export baskets. At the other extreme, countries like Guinea, Malawi, Benin, Mauritania, and Haiti score very poorly in the Index of Opportunities because their export structures are neither diversified nor sophisticated, and they have accumulated very few and unsophisticated capabilities. The lesson for these countries is that they are in urgent need of implementing policies that lead to the accumulation of capabilities that facilitate economic transformation and that lead to higher diversification and sophistication of the export basket. “Soft” industrial policies (Harrison and Rodriguez Clare 2010) can play an important role.

This paper represents the views of the authors and not necessarily those of the Asian Development Bank, its Executive Directors, or those of the countries that they represent.

References

Balassa, B (1965), “Trade Liberalization and Revealed Comparative Advantage”, Manchester School of Economics and Social Studies, 33: 99-123.

Felipe, J, U Kumar and A Abdon (2010a), "As you sow so shall you reap: from capabilities to opportunities", Asian Development Bank mimeograph. Forthcoming as working paper of the Levy Economics Institute of Bard College.

Felipe, J, U Kumar, N Usui and A Abdon (2010b), "Why has China succeeded? An why it will continue to do so", Asian Development Bank mimeograph. Forthcoming as working paper of the Levy Economics Institute of Bard College.

Felipe, J, U Kumar and A Abdon (2010c), “Exports, Capabilities, and Industrial Policy in India”, Asian Development Bank mimeograph.

Felipe, J, U Kumar and A Abdon (2010d), “Using Capabilities to Project Growth 2010-2030”, Asian Development Bank mimeograph. Forthcoming as working paper of the Levy Economics Institute of Bard College.

Harrison, A, A Rodríguez-Clare (2010), “From hard to soft industrial policies in developing countries”, VoxEU.org, 27 June.

Hausmann, R, J Hwang, and D Rodrik (2007), "What you export matters", Journal of Economic Growth, 12(1):1-15.

Hidalgo, C and R Hausmann (2009), "The Building Blocks of Economic Complexity", Proceedings of the National Academy of Sciences 106(26):10570-10575.

Hidalgo, C, B Klinger, AL Barabasi, and R Hausmann (2007), "The Product Space Conditions the Development of Nations", Science, 317:482-487.

Kaldor, N (1967), Strategic Factors in Economic Development, New York State School of Industrial and Labour Relations, Cornell University.


1 We use the measure proposed by Balassa (1965), Algebraically:


A country c is said to have revealed comparative advantage in a commodity i if the above defined index, RCAci, is greater than 1. The index of revealed comparative advantage can be problematic, especially if used for comparison of different products. For example, a country very well endowed with a specific natural resource can have a RCA in the thousands. However, the highest RCA in automobiles is about 3.6.
 

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Topics:  Development International trade

Tags:  development, growth, international trade, comparative advantage, structural adjustment

Lead Economist with the Central and West Asia Department of the Asian Development Bank

Consultant with the Central and West Asia Department of the Asian Development Bank

Consultant with the Central and West Asia Department of the Asian Development Bank

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