Cause, Effect, and Misallocation

In preparation for a price theory book I am writing, I am re-reading George Stigler’s classic 1966 text The Theory of Price.  The following is found on page 19 (3rd edition):

[I]t has become a major task demanded of all economies: they are required (as soverigns use this word) to provide technological advances, capital accumulations, improved labor forces, and larger incomes.  So strong is this demand, that sometimes a method by wich western nations become richer–industrialization–is confused with the growth itself, and inappropiate industries that reduce a nations’s income are adopted to increase it.

Confusing cause with effect is a major problem facing all analysts.  This becomes doubly true when discussing economic growth when policy is involved.

Industrialized nations are wealthy, but it doesn’t necessarily mean such industrialization is the cause of wealth.  Rather, industrialization is itself a symptom of a deeper cause, that is the division of labor.  “Industrialization” is a term without definition, as it can refer to many kinds of industries.  Comparative advantage is what tells us what kind of industrialization is needed to foster growth.

The United States has a comparative advantage in high tech industries; we are an extremely intelligent people with lots of capital (both human and machine) at our disposal.  China, however, has a comparative advantage in low tech industries; they have lots of unskilled labor at their disposal.  It makes sense for the US to industrialize in high tech industries and China to industrialize in low tech industries.

But even within countries, industrialization is varied.  In the US, the vast middle of the country has some of the most fertile farmland in the world.  It makes sense for those states to be agriculturally-based and other places, like Texas, to be resource-based, and others, like Massachusetts, to be tech-based.

A scheme based on the mistaken notion that “industrialization = progress” will lead to misallocation of resources.  Resources, such as labor, capital, time, will be diverted into less productive and more costly areas.  This, in turn, leads to a net decline in wealth compared to where it otherwise would have been.  An example of this is China during the “Great Leap Forward.”  Industrialization, specifically of steel, was all the rage of the Communist Party.  All production was geared toward steel production.  This inherently meant a rapid decline in production of other items–like food.  China’s poverty deepened.

The Great Leap Forward is an extreme example, but other historical cases of misallocation of resources due to the mistaken belief of “industrialization = wealth” include the USSR, modern Venezuela, and North Korea.

When examining the causes of economic growth, one must be very careful in determining cause and effect.  This is where price theory really shines.