Friday, November 28, 2014

The Specialization Myth

CAMBRIDGE – Some ideas are intuitive. Others sound so obvious after they are expressed that it is hard to deny their truth. They are powerful, because they have many nonobvious implications. They put one in a different frame of mind when looking at the world and deciding how to act on it.

One such idea is the notion that cities, regions, and countries should specialize. Because they cannot be good at everything, they must concentrate on what they are best at – that is, on their comparative advantage. They should make a few things very well and exchange them for other goods that are made better elsewhere, thus exploiting the gains from trade.

But, while some ideas are intuitive or obvious, they can also be wrong and dangerous. As is often the case, it is not what you don’t know, but what you mistakenly think you know, that hurts you. And the idea that cities and countries actually do specialize, and that therefore they should specialize, is one of those very wrong and dangerous ideas.

When an idea is both intuitively true and actually false, it is often because it is true on one level but not on the level at which it is being applied. Yes, people do specialize, and they should specialize, too. Everyone benefits from each of us becoming good at different things and exchanging our knowhow with others. It is not efficient for a dentist and a lawyer, for example, to be the same person.

But specialization at the individual level actually leads to diversification at a higher level. It is precisely because individuals and firms specialize that cities and countries diversify.

Consider a rural medical facility and a major city hospital. The former probably has a single general practitioner who is able to provide a limited suite of services. In the latter, doctors specialize in different areas (oncology, cardiology, neurology, and so on), which enables the hospital to offer a more diverse set of interventions. Specialization of doctors leads to diversification of hospital services.

The scale at which specialization of individuals leads to diversification is the city. Larger cities are more diversified than smaller cities. Among cities with similar populations – say, Salvador and Curitiba in Brazil, or Guadalajara and Monterrey in Mexico – more diversified cities are richer than less diversified cities. They tend to grow faster and become even more diversified, not only because they have a larger internal market, but also because they are more diversified in terms of what they can sell to other cities and countries.

What is true at the level of cities is even more applicable at the level of states and countries. The Netherlands, Chile, and Cameroon have a similar population size, but the Netherlands is twice as rich as Chile, which is 10 times richer than Cameroon. Looking at their exports shows that the Netherlands is three times more diversified than Chile, which is three times more diversified than Cameroon.

As my colleagues and I recently argued, one way to understand this is to think of industries as stitching together complementary bits of knowhow, just as words are made by putting together letters. With a greater diversity of letters, the variety of words that can be made increases, as does their length. Likewise, the more bits of knowhow that are available, the more industries can be supported and the greater their complexity can be.

Cities are the places where people that have specialized in different areas congregate, allowing industries to combine their knowhow. Rich cities are characterized by a more diverse set of skills that support a more diverse and complex set of industries – and thus provide more job opportunities to the different specialists.

In the process of development, cities, states, and countries do not specialize; they diversify. They evolve from supporting a few simple industries to sustaining an increasingly diverse set of more complex industries. Achieving this implies solving important coordination problems, because an industry that is new to a city will not find workers with industry experience or specialized suppliers. But policymakers can do a lot to solve these coordination problems.

This is why the idea that cities, states, or countries should specialize in their current areas of comparative advantage is so dangerous. Focusing on the limited activities at which they currently excel would merely reduce the variety of capabilities – or “letters” – that they have. The challenge is not to pick a few winners among the existing industries, but rather to facilitate the emergence of more winners by broadening the business ecosystem and enabling it to nurture new activities.

This is all the more important today, because the globalization of value chains is delocalizing supplier-customer relations. Cities and countries would be ill-advised to focus on a few “clusters” and consolidate the value chains in their location, as is so often recommended. Instead, they should worry about being a node in many different value chains, which requires finding other industries that can use their existing capabilities if they were somehow expanded and adjusted to new needs.

Competition inevitably tends to winnow out the less efficient firms and industries. It is not the policymakers’ role to hasten their death. Their task is to identify productivity-enhancing interventions that can harness economies of agglomeration by adding new activities and productive capabilities, making the whole bigger than the sum of the parts.

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    1. CommentedAndrzej Żurawski

      It's an interesting article, however - in my opinion - there is the same mistake, that is criticised. The author states, that "people do specialize, and they should specialize, too." I believe, that it is the same "truth" as specialization of countries and cities.

      Obviously, "it is not efficient for a dentist and a lawyer to be the same person". But it doesn't mean, that we should expand our specialization to infinity. A lawyer who expertises in freshwater ship transport won't be "better" than simply "lawyer". There is tendency in modern world to do such narrow specializations, and I think it is a dead end.

      Consequently, it might be the case of countries too. I agree that none country should ever specialize in smartphones, but if it be generally electronics of all sorts, the conclusions could be different.

    2. CommentedEnrique Fleischmann

      Comparing countries at different stages of development could be somewhat misleading. Holland, for example has a 400 plus years of Capitalist tradition ( and very close to three of the most important economies France, England and above all Germany) , while Cameroon was until the 60 a French colony. Therefore the analysis must incorporate a time dimension i.e. countries at a similar level of development.

      Generally speaking countries at the first steps of development with high growing rates are export led ( US is an exemption, as it is its size, though the civil war was precisely about that question ) and in many cases quite specialized in a few products ( Even Flanders or UK in the early development phases specialized in cloths) . That is related to economies of scale ( small market does not allow to develop the scale) . In a second phase, the country can or better put, should diversify. First, it (should ) become rich enough to be less dependent on foreign countries and more internal consumption oriented . Second , specialization is a double edged sword. It may bring prosperity as the country is more competitive, but it also creates a deep dependence on the specific activity. Therefore, the second phase is normally diversification and as it is mentioned in the article, related to prosperity.

    3. CommentedClaudio Migliore

      As I reflect on partial truths, I would advise the Author to reread his own writing, third paragraph, second sentence, together with fourth paragraph, first sentence.
      Specialization is not a myth. Government ability, and probably the mandate to successfully enforce economic success through any recipe (diversification or monoculture) is probably a greater myth.
      I think it is a valid point that diversified economies are better off than specialized ones, but to assume a casual link there is the classic "post hoc ergo propter hoc" mistake. I would posit it is more likely that the Dutch, or Guadalajara, become large and prosperous before and then have the opportunity to diversify. In fact, the country clinic won't get bigger by having a brain surgeon and an oncologist on the payroll (I know you can find counterexamples, but only to play word games). The fact is that most ill advised over diversification is driven by bad policy and probably corruption, while monoculture in most cases resolves itself by internal incentives whenever it is dysfunctional.
      Most generally, I enjoyed reading this article, though, particularly in conjunction with "Free Trade and Costly Love" by Robert Skidelsky. A little diversified truth with a grain of salt goes a long way.

    4. CommentedMax Volmar

      Perhaps the author misses the aspect of intl competition in specialisation. Take the German car industry. The benefit that Germany gets from this industry is not only from carmakers like Daimler but mainly their being interwoven with smaller suppliers. Had the German economy not focused so strongly on automotives, but, say, on agriculture (like France) the overall benefit would be way smaller (like in France). The point is that through specialisation the competitive advantage increases.

        Portrait of Ricardo Hausmann

        CommentedRicardo Hausmann

        To Max Volmar: It is funny that you use the example of Germany to exemplify specialization when Germany is actually the most diversified country in the world. Look at its export structure here:
        I do not doubt that the car industry has done wonders for Germany but it has also developed capabilities that has allowed it to dominate the market for machinery, chemicals and many other activities. As the article argues, it is this kind of specialization at one level that leads to diversification at the regional and country level.

    5. CommentedGabriel Nagy

      I can'think of any city specializing in a single economic field. Cities evolve and develop as a diverse organism with some competitive advantages that they wold do wrong not exploiting them.

    6. CommentedBrahm Prakash

      It is advisable to be aware about particular levels of specialization involved in development. Cities, regions and countries indeed specialize in providing infrastructure, banking and financial services, and governance while certain other skills reside at the organizational and individual levels.

    7. CommentedDaryl stevens

      While true, at the national level globally, it should be noted that there are stages in industrialization. Steps through certain industries, commonly. Perhaps, most appropriately to the tenor of this argument, is that the space becomes very crowded, as education outpaces opportunity, in a global economic system, that experiences great overcapacity due to the heavy-handed nature of the Asian Development model, and states within that process. Such, will be one of the great issues moving forward, in the first half of the 21st century, while some are preoccupied with the rise of this or another, primarily, Asian power, the truth, is that there is a rise of participation, and a need for recognition that more demand need be captured domestically in the future,as so many attempting to industrialize under system institutions at present (Africa, Central America, South Asian, Central Asia, MENA, etc...) Let alone that NIE's, SEA tigers, and others are still considered emerging economies, when Kenya, Tanzania, Nigeria, Egypt, Bangladesh, Cambodia, Vietnam, Guatemala and others are toward committed to industrialize,, each with a different set of challenges, but different is the ability to capture demand from advanced countries, as the EU seeks to surplus its way through crisis, demand has lessened in US, and China's CCP bears considerable weight and ownership of its Non-Market Economy, under the auspices of the global free trading system and its institutions. This is the big story of the first half f the 21st century.

    8. CommentedTony Phuah

      "Yes, people do specialize, and they should specialize, too." -- Aren't many people (experts) nowadays too specialized that they lose sight on the whole picture.

    9. CommentedKeshav Prasad Bhattarai

      Yes, I agree with Hausmann and think his logic and observation suits especially to those countries - that have not reached at a level of development. We have similar experiences with farming in Nepal. Some times farmers planted new cash crops when they received much profit. They stopped rice, corn or wheat farming and instead planted a new cash crop, but later when the demands for those crops got low and some times no buyer for them- they suffered much and no income to buy their daily food supply. therefore, diversification in agriculture and industry is a good idea- because if they do not find their buyers in international markets - the internal markets can save them. A good idea ! indeed .

    10. CommentedPaul A. Myers

      Re: "Their task is to identify productivity-enhancing interventions that can harness economies of agglomeration by adding new activities and productive capabilities, making the whole bigger than the sum of the parts."

      I love the last sentence. It is a real argument for imaginative investment in public infrastructure and productivity-enhancing social investment.

    11. CommentedUsamah Uthman

      The author makes the observation about greater diversification, but he does not explain it! A clinic in a small village does not enjoy the same amount and quality of resources as a Hospital in a large city. Cameroon, Cheli, and the Netherlands have equally- sized poulations, but the quality of labor is definitely not the same, not to mention the quantity and quality of land and capital. the theories of comparative advantage of ricardo and later Hecsher-ohlin are among the most important discoveries in economic science. The author is correct, however about the role of government policy in improving the quality of resources and thus enhacing the posibilities of productivity growth and further diversification.

    12. CommentedStephen Stanley

      Having grown up in an area that specialized, this article speaks to my past. Muhlenberg County, Kentucky, specialized in mining coal. The coal of the region is high in sulfur but in the 50's, 60's and 70's, no one worried about that, that is until someone realized the pH of northeastern lakes was higher than some industrial acids. Meanwhile, Muhlenberg County not only thrived on its industrial monoculture, it was proud of it, actively resisting industries settling there. We dug coal and were rich because of it, right up until the time the Clean Air Act made the coal more expensive to burn than competing products lower in sulfur from the West. It was literally less expensive to ship in low sulfur coal than to operate a mine-mouth power plant. The mines dried up, the livelihood left, the standard of living plummeted and today, with cheap natural gas, the mine mouth power plant my father supplied with coal is converting. The area is poor, even the small manufacturing plants of earlier are gone.
      Industrial monoculture can lead to brief bubbles of prosperity. Some day in the future, even Silicon Valley will fall to a different technology. Specialization is valuable at an individual level but as even diversified Denver has experienced, if you put all your eggs in one basket, you better hope the basket never falls.

    13. CommentedEdward Ponderer

      I'm forced to disagree--or rather, agree but at a higher level--the level of the global village.

      As human civilization evolves rapidly--and it is quite unstoppable--through global evolution--such specialization becomes evermore prominent. Indeed, cities, provinces, and countries need diversification -- but in the same way that our cells, tissue, and organs do. Liver cells, liver tissues, and the liver itself, must have their own (fractal) capabilities--internal specializations--for obtaining nutrients, digesting those nutrients, utilizing the same, eliminating waste, etc. Nonetheless, these cells, tissues, and organ have their higher-system raison d'etre as well.

      And like the case of the individual villagers who diversify, one will indeed damage the evolving body human if one pushes away from natural national talents and strengths based upon cultural history, perspective, climate and resources, and countless other factors. But worse--because the competitors goal is not to be "the best they can be" for the world at large unless that world is fully seen as family. Rather, it is to conquer the market and optimize profit and security. Therefore, competition, as compared to collaboration, tends to tremendous waste and destruction. Sales talk, hypnotic packaging, over-production, premature obsolescence, and armies of lawyers, are not their to make the world a better and happier place. Imagine, if you would having two hearts, at loggerheads, pumping in opposite directions, hoping to eliminate each other, and focusing their resources on this battle rather than the well-being of the body. -- And know that this is exactly the reason for the present global crisis!

      No, not global diversification per se (except for some level of necessary local diversification, per the earlier discussion), but rather integral education to fit our global tapestry together, and overcome our egoism in a manner of mutual responsibility through every media means of global self-help possible--this is the call of the hour.