This blog post explains the theory of Economic Complexity(EC). We detail the construct of EC by laying out its assumptions and predictions. We describe its operationalization by explicating the linear algebraic formulation of the ‘Method of Reflections’. Finally, we critique this rich theory by pointing out its inherent contradiction in lacking micro foundations.
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📚📚 This post is a literature review. There are no novel results here. 📚📚
⚠️⚠️ Given the content of this blog, it has not been rigorously peer reviewed. So all mistakes are my personal responsibility and not of the lab.⚠️⚠️
The ideas presented in this blog post come from reading existing literature on Economic Complexity(EC), a theory still in its infancy and should be looked upon with cautious optimism. We believe the ideas here could potentially help the ArtSciLab's (ASL) original research on a closely related topic. So we wrote this up to get feedback from subject matter experts and find potential collaborators. But we believe this will also be useful to anyone interested in economic growth theories (See The construct of Economic Complexity) or in the analysis of bipartite networks/graphs (See Method of reflections and its Linear Algebraic formulation).
The style of arguments here closely resemble what is presented by Hausmann et al. (2014) (hitherto called Atlas) and we direct the interested reader to read it. Any jargon you see in this post, comes from there. But we noticed some parts of the Atlas needed clarity (especially the mathematical details on the Linear Algebra of EC) and have provided that clarity here by citing other pieces of literature. We have also explored literature that readers who have already read the Atlas can look into to get a deeper understanding of EC. Finally, we have a section highlighting criticisms of the theory. We advise readers to read this section with skepticism and highly encourage critiques of our critique. While mathematical equations are included, we have ensured to explain the ideas enough such that it should be possible for readers to skip the equations and still get an overview. That said, if a section is too technical we have indicated explicitly that it can be skipped.
There are good reasons to believe that Economic growth is positively associated with human well being. To quote Roser (2013), "Economic growth has allowed us to break out of the conditions of the past when everyone was stuck in poor health, hard and monotonous work, and malnutrition." If one accepts this premise and realizes the importance of Economic Growth, then one's curiosity should lead one to ask questions as Lucas (1988) did:
"Within the advanced countries, growth rates tend to be very stable over long periods of time ... For poorer countries, ... there are many examples of sudden, large changes in growth rates, both up and down. ... I do not see how one can look at figures like these without seeing them as representing possibilities. Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia's or Egypt's? If so, what, exactly? If not, what is it about the 'nature of India' that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else."
Questions such as these have been the basis of the research endeavor in 'Growth accounting'. Growth accounting involves identifying possible factors that can account for the large observed variances in economic growth across nations of the world. Factors such as technology, externalities of human capital and coordination failures (For a discussion on these three interpretations see section 3 of Banerjee and Duflo (2005)) have so far been proposed.
A relatively new theory posits that the observed variance can be explained by a new construct called Economic Complexity (hitherto, EC). We deconstruct this theory in the passages that follow.
Sir Francis Bacon claimed "Knowledge is power". EC theory claims, "...productive knowledge is the key to prosperity". Productive knowledge refers to the knowledge a country holds that goes into the production of goods and services. Such knowledge can be of two types - Explicit or Tacit knowledge. Explicit knowledge can be written down and learnt by reading books. On the other hand, tacit knowledge refers to skills embedded in the professionals in a country that can be learnt only by work experience. It is not far fetched to assume that, more than explicit knowledge, it is the amount of tacit productive knowledge that can explain the production of goods and services in a country.
EC theory builds on another assumption - there is a limit to how much productive knowledge, especially the tacit kind, a given human being can hold. The Atlas call this limit a Personbyte. This assumption is not completely arbitrary. EC theory claims that the phenomena of specialization and division of labor (posited by Smith (2008)) can be interpreted as a result of the limits on how much knowledge each person in the economy can hold. This knowledge limit also means that individuals rely on others to provide them with products made from additional knowledge they can't possess. This demand for additional knowledge creates a market. To quote the Atlas, "Markets allow us to access the vast amounts of knowledge that are scattered among the people of the world".
The Personbyte each person holds constitutes a coherent set of tacit knowledge called a capability. For instance, by having the diverse knowledge set of predictive statistics, programming, and data visualization, a person can hold a data science capability. When persons with diverse capabilities come together and create a firm, a new capability emerges which each of them individually don't possess. Such a capability is called an organizational capability. Similarly, organizations with diverse capabilities coming together results in the emergence of another novel capability embedded in the network of such diverse organizations which each of the individual organizations in the network don't possess. Thus, markets have a mechanism to keep accumulating productive knowledge by developing new capabilities via networking the existing diverse capabilities of persons and, organizations. It is on the basis of this mechanism of markets that EC theory explains the large cross-country variances in economic growth.