Demand and structural transformation: theory and evidence

Structural transformation refers to the interrelated processes of structural change that accompany economic development. In addition, the principal changes in structure emphasized in economic literature includes increases in the rate of accumulation (investment), shifts in the sectoral composition of economic activities (industrialization) and changes in the location of economic activity (urbanization), along with other aspects of industrialization, such as demographic transition and income distribution. The accumulation of human and physical capital and shifts in the composition of demand, trade, production and employment are described as the economic core of the transformation process. Countries that manage to pull out of poverty and become richer are those that are able to diversify away from agriculture and other traditional products. As labour and other resources move from agriculture into modern economic activities, overall productivity rises, and incomes expand (McMillan, Rodrik and Verduzco-Gallo, 2014).

Structural transformation literature builds on the long-standing empirical observation that the composition of economies differs systematically by stage of development (Herrendorf, Rogerson and Valentinyi, 2014). In its initial form, composition was mainly understood as the relative size of the broad sectors – agriculture, industry and services. The process entails a declining share of agriculture in total output and employment, the rise of a modern industrial and service economy; rapid urbanization as people migrate from rural to urban areas; and a demographic transition from high birth and death rates to low birth and death rates.

The literature proposed specific models of development that explained structural transformation as an endogenous process in response to factor accumulation, increasing wealth, and sector-specific properties of demand and production functions. With a steady decline of agriculture’s share of both employment and GDP, a pattern emerged that strongly associated with income growth, urbanization, poverty reduction, and a demographic transition from high birth and death rates common in rural ones associated with better health standards. The outcome of structural transformation is an economy with well-functioning sectors and output markets that equalize the capital and labour productivity between agriculture and non-farm industrialservice and other sectors, leading to inclusive economic growth (Barret and others, 2015).

Structural change in the economy implies that some industries or sectors experience faster long-term growth, compared with others, leading to shifts of the shares of these industries or sectors in total aggregate (Kruger, 2008). The differential impact of technological innovations on the production sectors, the differences in income elasticities of domestic demand for various goods, and the changing comparative advantage in foreign trade leads to rapid changes in production structures (Kuznets, 1973). This emphasizes the two central causes of structural change of varying income elasticities of demand and the differential impact of technological progress on the sectors.

7 Structural change leads to a characteristic pattern of change among the three sectors of the economy, along with changes in the industry composition of these sectors. Supply and demand factors closely interact in shaping the process of structural change. On the supply side, production technologies allow for producing the same goods with lower unit costs leading to productivity improvements. On the demand side, factors such as prices and quality influence the quality and composition of demand. The interaction of these factors gives structural change a specific direction and influences the speed at which this process takes place. This affects the growth of aggregate output, employment and productivity.

Theoretical literature has proposed several channels as drivers of structural change. The most prominent are the differences throughout the sectors in productivity growth (Ngai and Pissarides, 2007) or in capital intensity (Melck, 2002; Acemoglu and Guerrieri, 2008) on the supply side, and income effect on the demand side.³ At present, literature has mainly emphasized supply-side sources, such as technology, innovation, human and physical capital and exchange rate policies (through the Dutch disease models). Productivity improvements resulting from innovation and technological change are considered as one of the major driving forces of structural changes. Conversely, less attention has been devoted to demand-side factors (typical of the post-Keynesian approach) that are crucial for defining the extent of the market, the division of labour and the dynamics of productivity in the economic system.

Most of the theories are based on the tenet that technological progress drives structural change, but it is frequently the demand side that is crucial for determining the industry that grows faster and the one that shrinks, which therefore shapes the direction of structural change.

Changes in the structure of production and employment results either from sectoral differences in productivity growth or from sectoral differences in income elasticities of demand. Here, the fundamental cause of structural change is the hierarchical nature of needs.

During the process of economic growth, consumers are saturated with existing products, so in order to sustain growth new goods have to be continuously introduced. This nature of demand implies that structural change takes the form of the re-allocation of resources from old to new industries (Foellmi and Zweimüller, 2005).

It is argued that the demand side determinants of productivity performance entail that the division of labour enhances workers’ skills and know-how, induces the introduction of technological innovation and changes the sectoral structure of the economy as new industries emerge leading to further specialization and productivity growth (Crespi and Pianta, 2008). It is important to note that these factors eventually form the supply-side factors that affect the structural transformation process.

Among the most uniform of changes in demand affecting industrialization and structural transformation is the decline in the share of food consumption and the rise in the share of resources allocated to investment. Literature, however, reveal that the share of consumption (food and private) declines over time, while that of non-food consumption and investment rises,

3 It should be noted that the authors are following some trends evident in the literature, for example, use of the term “manufacturing” in the present context to refer to all activity that falls outside of agriculture and services. It is more appropriate to refer to the category as “industry”, because in the case of African countries, the industry sector data include the mining sector, a category that is not included in the present study.

8 implying a shift in demand away from agricultural goods to industrial commodities and non-tradables (Syrquin, 1988b).

Consumption habits that emanate from a rise in standards of living can also initiate structural change, as consumers’ opportunities for satisfying their needs increase in tandem with their incomes. Shifts in consumption patterns will therefore have an impact on the structure of an economy due to its effect on resource allocation and consumer’s demand changes. In this regard, structural change is driven by a non-homothetic household utility function and differences in the income elasticity of demand in goods, with a lower income elasticity on agricultural goods than on non-agricultural goods. As capital accumulates and income rises throughout the development process, these differences shift demand and therefore resources and production, from goods with low demand elasticity (such as food or other necessities) to high demand elasticity goods (such as services or luxuries) fostering a relative agricultural decline in the economy (Matsuyama, 1992; Laitner, 2000; Kongsamut, Rebelo and Xie, 2001; Gollin, Parente and Rogerson, 2007; Foellmi and Zweimüller, 2008; and Gollin and Rogerson, 2014). The decline of the food consumption share is consistent with one key feature of structural change: the decline of the agriculture sector, in terms of both employment and value added, during economic development. The subsistence demand of agriculture products plays a central role to model the structural transformation.⁴ In addition, the service consumption will continue to rise, driven by the demand for skill intensive services, which coincides with a period of rising relative wages and quantities of high-skilled workers (Buera and Kaboski, 2012a).

Recent research has examined alternative explanations for structural transformation, including barriers to labour reallocation and adoption of modern agricultural inputs (Restuccia, Yang and Zhu, 2008); scale economies (Buera and Kaboski, 2012a); human capital (Buera and Kaboski, 2012b); education and training costs (Caselli and Coleman, 2001); tax changes (Rogerson, 2008); transportation improvement (Herrendorf, Schmitz and Teixeira, 2012b);

international trade (Uy et al. 2013); and population growth (Echevarria, 1997; Acemoglu and Guerrieri, 2008).

Aggregate demand generally plays a small role in modern growth theory, but it could have significant implications for structural transformation, mainly in developing countries.

This could be through these countries’ increasing growth, urbanization, trade, capital accumulation, through their economic policies and other factors, having implications for aggregate demand that has been one of the driving forces of these economies, in particular those in Africa (ERA, 2017).

Urbanization stemming out of industrialization and including the wake of modernization, have significant effects on structural change, although, indirectly in the long run. As economies develop, the share of agriculture in employment falls and workers migrate to cities to look for employment in the industrial and service sectors (Clark, 1940; Lewis, 1954; Kuznets, 1957).

The economic history of every country reveals a close correlation between industrialization and urbanization and many countries have attained structural transformation while experiencing urban change (Bose, 1961). Modern large-scale industries cannot develop unless there are adequate economic and social overheads and economies of scale, which will only be available in big towns and cities as they stimulate trade and commerce through their increased

4 See, for example, Echevarria (1997); Laitner (2000); Kongsamut, Rebelo, and Xie (2001); Gollin, Parente and Rogerson (2007); Restuccia, Yang and Zhu (2008); Duarte and Restuccia (2010); and Alvarez Cuadrado and Poschke (2011).

9 demand for goods and services. The growth in the number and size of towns invariably redistributes the labour force into the manufacturing and service sectors, which was initially absorbed in primary activities such as the agricultural sector.

The economic advantages of urbanization are rooted in economies of scale, also known as agglomeration economies, which arise from the proximity of economic agents and their interaction in the factor and products markets (ERA, 2017), further enhancing structural changes in the country’s economy. Urbanization provides the infrastructure necessary for industrial development and increases the efficiency of labourers by providing them with suitable employment opportunities.

Countries that have succeeded in structural transformation are urbanized and they feature a consumption and production pattern driven by productive industrial and services sectors.

Those countries have relocated resources (including labour) from low to high-productivity sectors. A key element of structural transformation involves the movement of labour out of rural activities into urban ones. Historically, as economies develop and incomes rise, the share of income that people spend on food declines, and demand for manufactured products rises. At a later stage of development, a similar process of shifting demand takes place that favours services. Changes in economic structure accompany such changes in demand and trade, with the share of employment in agriculture declining and that of industry or urban-based services rising. This ` process is generally accompanied by increasing accumulation of human and physical capital and diversification (Chenery, 1982). The shift in sector employment from agriculture to industry and services is accompanied by productivity increases. In addition, in cities, knowledge and ideas generate increasing returns to scale. Firms invest in research and development to reap the benefits of productivity, increase their market share and maximize their profits.

Capital accumulation remains one of the main drivers of aggregate demand of any economy. Investment, especially if aimed at reducing unemployment and raising people’s living standards, will facilitate shifts in labour force from less productive to more productive sectors of the economy.

It has recently been argued that investment-specific technological change could be a new and fundamental force behind structural transformation, in particular the rise in services due to the decline in agriculture and manufacturing (Garcia-Santana, Pijoan-Mas and Villacorta, 2016; Guo Hang and Yan, 2017). For a long time, the literature on structural transformation had been built on the premise of balanced growth hypothesis (with constant investment rate).

Recent studies, however, have shown that changes in the sectoral composition of investment cannot be explained by the relative price of inputs alone, but also by investment rate and investment-specific technological change, that shifts the investment demand from agriculture and manufacturing to services. This challenges the recent growth literature on structural transformation, which postulates that changes in the sectoral composition of growing economies are associated with a balanced growth path. In explaining what has led to the rise in the services sector with a reduction in the agriculture and manufacturing sector in China, Guo, Hang and Yan (2017) argue that changes in sectoral composition of investment and investment rate affects sectoral shares of total value added. Changes in sectoral composition of investment could be attributed to a technological revolution based on the development and deployment of information technology, leading to structural transformation. For China, investment-specific technological change has shifted the demand for various categories of input producing investment goods leading to profound implications for structural transformation.

10 The composition of trade and the type of specialization are determined in large part on the availability of natural resources, traditional factor proportions and by policy. In practice, however, the evolution of comparative advantage and commercial policies have combined to create an export pattern that reinforces the shift from primary to industry, which is implicit in the pattern of domestic demand (Syrquin, 1988b).

The premise of endogenous growth theory and new trade theory is that knowledge and technology intensive commodities embody higher levels of productivity and sophistication that manifests itself in their added value. It is considered that knowledge, technology transfer and horizontal and vertical spillovers between firms and industries have beneficial effects on the structural transformation of exports and building international competitiveness (Stojcic and Orlic, 2016). This leads to export diversification through an increase in the number of export sectors (hence export earnings) and knowledge spillovers arising from improved production techniques, new management practices and skills training and improved productivity with profound implications for a country’s structural transformation.

Trade allows countries to specialize in areas where they have a comparative advantage, leading to an increase in economic activity and employment in the export sector. Specializing in areas of comparative advantage, shifts resources to their most productive use, increasing the value of aggregate production and income by facilitating an efficient allocation of production across and within economies. Developing countries have integrated more into the world economy and have been more open since the early 1990s. This has facilitated technology transfer and contributed to efficiencies in production leading to structural changes and growth in many countries; however, this has not led to the expected gains in Latin America and sub-Saharan African countries, as globalization and trade openness seem to have led to negative structural change effects. Labour has moved from high-productivity to low-productivity sectors and activities (McMillan and Harttgen, 2014). Empirical work on trade liberalization has also revealed that import competition has forced manufacturing industries in developing countries to become either more efficient or those that are least productive to exit the industry, leading to reallocation of labour and other resources.