A Model of Diversification and Growth in Open Developing Economies

We build a growth model that resembles the situation of many poor countries with small domestic markets: they are far from the world technological frontier and they have a comparative advantage in one (or a few) primary commodity. Their great challenge is to introduce into the domestic economy goods that are produced elsewhere in the world economy. Starting new sectors from scratch is hampered by two market failures. In the first place, entrepreneurs must be willing to invest in discovering production technologies abroad and adapting them to local conditions. This process has information externalities: the pioneers have to undertake investments in information that cannot be patented and that can easily be copied by others who haven’t made the investment (copycats). Second, there is a coordination problem. Success in establishing new industries is dependent on non-traded inputs that serves a variety of sectors (“infrastructure”). A simple model allows us to simulate the conditions under which a planner that balances her budget can succeed in maximizing growth. The solution involves erecting infrastructure and subsidizing information investments of pioneers and taxing both a traditional sector and copycats induced to invest by the discoveries of pioneers.