World Development Report 2024: The Middle-Income Trap

Key messages

• In an economy, both entrants and incumbents can add value. Entrants bring change in the form of enterprises with new products or production processes, workers with new skills and ideas, or energy sources such as renewables that embody new technologies. Incumbents bring scale—and can compete with entrants in the market to jointly expand a country’s technological capabilities—moving the country closer to the global technology frontier.

• In most middle-income countries, too few entrants disrupt because the majority of entrepreneurs start businesses driven by necessity, not business opportunity. And too few incumbents infuse global technologies and know-how. Instead, they abuse their dominance to block entry, resist innovation, and capture political institutions.

• Government policies in middle-income countries are often based on the size of firms rather than their ability to create value. As a result, policies tend to favor small firms and reduce the incentives of firms to grow.

• Governments will need more reliable diagnostics to implement effective policies, including microlevel data on firms, a more comprehensive approach to examining business dynamism, and greater analytical expertise.

Creation: The protagonist of economic growth, where incumbents create value alongside entrants

In the 1960s, the Tata Business Group, a major conglomerate based in India, needed computers for its various businesses, but they were difficult to purchase and import because the government had enacted import restrictions to protect state-owned enterprises (SOEs). To allow foreign hardware to be imported, the government required Indian companies to commit to exporting products or services. This challenge inspired the conglomerate to create a new business, Tata Consultancy Services (TCS). Tapping into talent from its various businesses and India’s elite technical institutions, TCS became the first Indian exporter of computing services to the United States. As part of a large conglomerate, TCS could have stifled creativity and misused its import allowance. In practice, however, TCS opened the world’s eyes to the high-quality, lower-cost talent that India’s software development had to offer. Many entrants took advantage of this opportunity. Among them, Infosys, a company founded by former IBM engineers and financed by their own savings, dramatically increasing the value it created, has become a global leader in information technology consulting (figure 4.1).

The gales of creative destruction carry new ideas, products, processes, and practices to the shores of middle-income economies. The term creative destruction was popularized by Austrian economist Joseph A. Schumpeter in his book Capitalism, Socialism and Democracy (1942). Schumpeter was concerned by the growing concentration of wealth in market economies where dominant incumbents colluded to preserve the status quo. He argued that economic and social improvements arise from new products and technologies introduced by entrepreneurs with talent and vision.

The forces of creation, preservation, and destruction interact to shape the growth of nations through technological advancement. This chapter examines how the forces of creation play out in middle-income countries to create value. Chapters 5 and 6 examine the forces of preservation and destruction. To shed light on the potency of creation in middle-income countries, this chapter examines three questions:

• Who creates value? Schumpeter highlighted that entrants bring change, and incumbents collude to preserve their dominance (figure 4.2, panel a) in the form of enterprises with new products or production processes, workers with new skills and ideas, or energy sources, such as renewables, that embody new technologies. In the process, they expand a country’s technology frontier. Interactions among firms, workers, and energy/technology underpin creative destruction (see box P2.1). In the current environment, Schumpeter’s view is reflected in the competition between high- and low-carbon energy. Fossil fuels have been the dominant incumbent technology for over 300 years. Technical progress, complementary public and private investment, individual preferences, and powerful interest groups interact to preserve a high-carbon status quo. Schumpeter’s ideas inspired the formal models of creative destruction developed by Philippe Aghion and Peter Howitt, who make a strong case that the entirety of growth stems from entrants and that incumbents assume the primary task of producing goods until they are replaced by these new players (figure 4.2, panel b). Their approach is particularly useful in highlighting the value added by investing in the talents of women and enabling women to seek the most rewarding opportunities. But must a new entrant always drive creation and displace incumbents? Although Schumpeter and his immediate followers celebrated entrants and downplayed the role of incumbents, Tata Consultancy Services’ journey reveals that incumbents can also create value (figure 4.2, panel c). Incumbents bring scale, which enables them to invest in upgrading products, hire and reward skilled workers, and effectively use large amounts of capital. They can compete with entrants in the market jointly to expand a country’s technological capabilities, advancing the country closer to the global frontier. The symbiotic view is most applicable to the modern enterprise. Regardless of whether they are entrants or established companies, firms that create value must be able to expand their operations, hire more workers, and displace enterprises that fail to generate additional value. This approach ensures that capital and labor are not held captive by unproductive firms but are utilized more efficiently by growing enterprises. In fact, 50–70 percent of productivity growth stems from successful resource reallocation among firms—whether incumbents or entrants.

• Are entrants and incumbents creating value in middle-income countries? Too few entrants disrupt, and too few incumbents infuse global technologies and know-how. The majority of entrepreneurs start businesses driven by necessity, not business opportunity. Incumbents that create value are unable to expand, limiting their potential for infusing technologies. Dominant incumbents can be vanguards for infusing global technologies and exporting globally. But, too often, they abuse their dominance to capture political institutions.

• Are middle-income country governments strengthening the forces of creation? Governments often use outdated rules of thumb to regulate and lack the information and capabilities needed to identify key constraints impeding the growth of firms. Over the last three decades, economists have developed modern techniques to provide calibrated assessments of what is enabling or suppressing the growth of firms. These techniques include better measurement of business dynamics that includes market concentration, markups, productivity dispersion, firm entry and exit rates, and job reallocation.

This chapter examines the forces of creation from the perspective of firms with an emphasis on the process in middle-income countries. A broader treatment that includes talent and energy sources appears in part 3 of this Report.

Creative destruction: Three decades of increasingly refined analysis

A first look: Entrants create value

When Canadian economist Peter Howitt visited the Massachusetts Institute of Technology (MIT) in the summer of 1987, he crossed paths with Philippe Aghion, an assistant professor at MIT. Their collaboration gave birth to the formal theory of creative destruction, and their paper “A Model of Growth through Creative Destruction,” published in Econometrica in 1992, became one of the most influential papers in economics. Their main insight was that economies expand organically through innovation driven by new entrants. Aghion and Howitt attributed innovation and growth exclusively to newcomers (figure 4.3).

Such models of creative destruction, that is, quality ladder models, depict a hierarchical structure with multiple rungs in which each innovation adds a new rung to the ladder and elevates the prospects for all future producers—a phenomenon known as intertemporal spillovers. This hierarchy suggests that there may be underinvestment in innovation because innovators often fail to consider the height of each rung, which determines the long-term benefits of their creative endeavors for society. On the other hand, there may be an overinvestment in entry. Entrants primarily focus on displacing incumbents, and so more entry is associated with shorter durations of monopoly for incumbents, discouraging innovations by future entrants. This motive—called “business stealing”—carries the risk that a society could end up overinvesting in research and development (R&D) and creating too much entry. Whether equilibrium results in an excess or deficiency of R&D depends on the varying magnitudes of spillovers and business stealing, which can differ significantly from one sector to another and from one country to another. This novel framework has opened the door to a more nuanced and realistic discourse on innovation policy.

A recent view: Incumbents also create value

Schumpeter’s ideas, as well as the framework presented in Aghion and Howitt’s seminal 1992 paper, focused predominantly on entrants and small businesses, downplaying the role of incumbents (often larger firms) in fostering infusion and innovation. In fact, the theory of creative destruction highlights an important tension between the incumbent currently in production and the new entrant that endeavors to replace the incumbent with a superior product or technology.

In 2004, Tor Klette and Sam Kortum refined the framework by reimagining each firm as a conglomerate of production units in different sectors. Within this framework, firms are able to expand their products or services into new markets and compete with other incumbents, but not scale up their existing products or services. In essence, this framework indicated that, within each narrow sector, all innovations originate from external sources and never from incumbents within the production unit.

In 2018, Ufuk Akcigit and William Kerr further advanced the framework to enable a more accurate description of innovation and growth. In their framework, incumbents not only expand into new markets through external R&D, but also enhance their existing products through internal R&D without directly displacing other producers. In fact, upon venturing into new markets, many established incumbents allocate a significant portion of their resources to refining and elevating their current products and technologies. The significant insight is that creative destruction can be instigated not only by entrants but also by incumbents. Moreover, not every innovation introduced by incumbents inevitably results in creative destruction through the dismantling of others in their ”ecosystem” (figure 4.4).

The United States and Germany are contrasting cases of creative destruction. In Germany, companies established before 1950 constitute a substantial 70 percent of publicly traded companies—a figure that diverges markedly from that for the United States, where the equivalent proportion is approximately 50 percent. Furthermore, although the annual rate of new firm creation is about 8 percent in the United States, it is 3 percent in Germany. Despite these pronounced disparities in terms of incumbent longevity and the pace of firm entry, there is a striking symmetry in the number of patents per capita between the two economies. This convergence in patent output underscores a noteworthy distinction: innovation in Germany is primarily championed by long-standing incumbents, whereas in the United States it is shouldered to a greater extent by emerging young entrants (figure 4.5).

A more nuanced view of incumbents: Incumbents’ power can drive or suppress creation

The turn of the twentieth century witnessed a rapid transformation in the typical manufacturing enterprise in the United States. Characterized until the early 1900s by single-unit firms with one or a small number of owners, the modern multiunit enterprise, administered by salaried middle and top managers overseeing complex layers of production, became the typical business model by World War I. Recordkeeping, accounting, and inventory control were all tasks required by the ”visible hand” managing a firm.

This transformation of business proved to be fertile ground for the emergence of what became a powerhouse of corporate innovation, the Computing-Tabulating-Recording-Company, later IBM. In 1939, when William Hewlett and David Packard created their company in a rented garage in Palo Alto, California, IBM was already a well-established company with more than 10,000 employees. Herman Hollerith, founder of one of the companies consolidated into IBM in 1911, could not anticipate that his invention, the electromechanical tabulation of punched card data, would become the backbone of a computer hardware and software company. Similarly, Hewlett and Packard did not envision that their frequency oscillator would pave the way for their small firm to become a leading manufacturer of personal computers that would compete with a giant like IBM. Yet both companies found themselves competing against each other for decades. It was only later that many others, such as Dell and Microsoft, entered the market to compete.

On the surface, the forces of creation are more apparent than the forces of destruction in the Schumpeterian view of forces of innovation. In the US business services industry, as HP, Dell, Microsoft, and Oracle entered various branches of the hardware, software, and computing services markets, the pace of growth of IBM (as the incumbent) slowed—but not to the level of shutting down the company (figure 4.6). Destruction still occurs within firms as they replace older products and tap into newer markets.

But dominant firms can also use their incumbency advantage to block entry and resist innovation. They can collude, with the most significant players coordinating price-setting to outbid smaller competitors, while avoiding price wars against one another. For example, in 2013 the US Department of Justice uncovered a decade-long cartel of Japanese auto part makers conspiring against the United States car industry (figure 4.7). Mitsuba Corporation, a prominent cartel member, increased its sales relative to the average performance of publicly listed companies in the same industry. However, this growth was not fueled by innovation but rather by suppressing competition, partly reflected in the decline in the number of public firms in the same industry.

When incumbents respond to competition by upgrading technologies and business practices either to defend existing market positions or to tap into newer ones, they drive progress, as in the United States (box 4.1). When incumbents resist competition by enacting barriers to entry, it not only stalls infusion and innovation but also can entirely prevent them.