Sunday, 22 May 2016

The Importance of Manufacturing: Productivity Growth or Trade?

In a recent article, Ha-Joon Chang highlights the decline of manufacturing as a source of stagnating living standards in the UK.  I would agree that Britain's manufacturing decline is a cause for concern, but what interested me in the article was the discussion of the role of productivity growth.

The basic argument here is: 1) there is greater scope for productivity growth in manufacturing than in services; 2) greater concentration of economic production in activities with high productivity growth means higher aggregate productivity growth; 3) the higher a country's overall productivity growth, the higher its per capita real income growth.  In fact, for a small open economy like the UK, I think the latter point is a bit more complicated than that.

To help see why, imagine that you were about to choose your future career and had the choice between going to work on a production line making TVs - an area with scope for high future productivity growth - or becoming a hairdresser - an area with little scope for productivity growth.  Now, obviously, there are lots of considerations here.  However, the argument that you could expect to see much higher personal income growth as a production line worker than as a hairdresser because of the productivity issue should sound a little suspect.

What in fact is likely to happen is that, over time, TVs become cheaper relative to haircuts.  The productivity growth in TV production benefits both the production line worker and the hairdresser.  Exactly how much each benefits depends on how the terms of trade develop between the two which depends on various demand and supply elasticities.

In a world with significant global trade, the same point applies to whole economies.  Productivity gains in one country are to the benefit of all countries, even those which are themselves seeing no productivity growth.  Exactly which countries benefit depends on their trading positions - the elasticities in the goods they export and import.

Now, this does not mean that the UK's decline in manufacturing does not matter.  It does matter, but the point is that it matters as much because of the role of manufacturing in providing exports and import substitutes as it does in providing productivity growth.  To benefit from global productivity growth, a country has to be well positioned in traded markets.  Cutting hair is a useful activity, but has limited export potential.  Of course some services can act as exports and, in principle, it is possible for a country which exports the right services to see substantial growth in living standards without any material domestic productivity growth.  But this is probably not an option for the UK.