Competing in product space and economic complexity

by: Prof. Yeah Kim Leng, Director of Economic Studies Program at Jeffrey Cheah In­stitute on Southeast Asia

A long-standing and dominant idea about how industries prosper and countries become rich is they are able to transfer resources from activities which are low in productivity to ones that have high productivity.

The higher productivity activities are usually characterised by increasing returns to scale whereby output increases by a greater proportion than the increase in inputs during the production process.

Products associated with higher productivity activities also have higher income elasticities whereby demand rises at a faster rate as income increases.

More recently, these ideas have been articulated in the form of product space and economic complexity. The key idea is that a country’s growth structural transformation is determined by its capacity to accumulate the capabilities that are necessary to produce a greater variety and more complex goods.

A major implication arising from this economic complexity perspective is that while specialisation is a key driver of competitive advantage at the firm and industry levels, at the national level it is the country’s ability to diversify into more complex products that explains why some countries outperform others.

The most complex products belong to machinery, chemicals, and metal products while the least complex products are mostly raw materials and commodities.

Turnaround in Malaysia’s economic complexity ranking

The latest global ranking on economic complexity for 2014 published by Harvard Center for International Development shows that Malaysia gained 5 places from the previous year to 28th out of 124 countries.

The improvement marked a steady climb up the ladder since its ranking had dropped to 42nd in 2009. It was then relatively unchanged from the 45th position in 1995, the earliest year for which the global ranking is available.

While the improved ranking augurs well for the country’s growth prospects, it is seen that both China and Thailand are ranked ahead at 19th and 26th, respectively.

Both countries were ranked below Malaysia up to 2006. From then on, they recorded steady strides up the ranking.

With the significant five-place jump in 2014 to 28th position, Malaysia is poised to pull ahead of Thailand if it is able to sustain the expansion of its product space, diversify into more sophisticated products and produce higher value products.

Nurturing more complex capabilities

To sustain growth through acquisition of production knowledge and capabilities, policy makers, industry captains and entrepreneurs will not only have to improve on their existing production of the same set of goods, but also acquire more complex sets of capabilities that enable them to move towards new activities associated with higher levels of productivity.

To expand upon the capabilities, firm managers will need to codify and improve upon the “know-how” or working practices held collectively by their employees.

These also encompass the organizational abilities that provide the capacity to form, manage, and operate activities that involve large numbers of people.

It is not surprising therefore that “bringing out the best in employees” contributes to the availability of capabilities that are needed to broaden the country’s production structure.

Fine-tuning industrial strategies

Faster development results from having a more complex productive structure where firms engage in high productivity activities. Given that complexity of production structure matters to economic growth and development, it is crucial for industry leaders to focus on the accumulation of capabilities and promote the development of new more complex products.

Investments in capital upgrading, research and development, technology licensing and hiring of foreign technical experts should be part of the capability-building strategies.

For policy makers, implementing policies that not only fosters the accumulation of capabilities but also encourages the diversification of the development of complex products and services will be key to sustaining the sophistication of the country’s production structure.

The accumulation of capabilities is often hindered by information and lack of coordination between the private sector and the government as well as between government agencies, leading to inadequate action by the private sector.

While there is no easy solution to this problem, there is merit to consider more aggressive industrial policies to accelerate the rapid accumulation of relevant capabilities since no country has become rich without creating an advanced industrial and service sector.

By Prof. Yeah Kim Leng | 16 June 2017

Professor Yeah Kim Leng is the Director of Economic Studies Program at Jeffrey Cheah In­stitute on Southeast Asia at Sunway University and Professor of Eco­nomics at Sunway University Business School. He is also an external member of Bank Negara Malaysia’s Monetary Policy Committee. The views expressed in this article are his own.

First appeared in the New Straits Times

Modified by Low Wai Sern