World Development Report 2024: The Middle-Income Trap

Key messages

• By promoting contestable markets, middle-income countries can strike a balance between supporting incumbents and ensuring that they do not abuse their market power.

• Middle-income countries will need to update their institutional arrangements that favor incumbents, including by retracting the government’s direct involvement in productive enterprises, challenging state-owned incumbents in the electricity industry, and weakening the norms that discriminate against women and other marginalized groups.

• Middle-income countries can encourage incumbents to strengthen creation through policies that enhance trade openness, support upgrading firm capabilities, and incentivize the free movement of ideas and people, including highly skilled talent.

• Middle-income countries can ensure the effectiveness of competition authorities to rein in errant incumbents and use fiscal policy to make elites contestable.

Balancing incumbents’ innovation and abuse of dominance

Part 2 of this Report highlighted that incumbent firms, especially market leaders, can be the vanguards of technical progress. But they can also use their incumbency advantage to block other firms from entering the market and competing, thereby resisting progress. In designing policies to facilitate investment alongside infusion and innovation, middle-income countries will need to strike a balance between supporting the growth of market leaders and ensuring that these firms do not abuse the market power that comes with their larger scale in their market. For example, in Italy labor productivity has stagnated for more than two decades. Recent research has highlighted how incumbents use their dominance to hold back progress. Market leaders tend to bolster political connections by hiring more local politicians as they gain larger market shares; at the same time, they reduce their efforts to innovate (figure 7.1).

The challenges of incumbency extend beyond firms. The economic elite has grown rapidly in many middle-income countries. In 2004, only 20 percent of the billionaires in the Forbes list were from emerging markets. By 2014, this share had risen to 43 percent and by 2023 to 48 percent. China ranks second in the number of billionaires (496) after the United States (735). The recent surge of billionaire wealth in emerging markets can be traced to the creation and management of new companies. Some company founders and executives are likened to superstar billionaires by creating popular products known by millions or introducing innovative production methods that expand consumer choices and reduce prices. Examples include Jack Ma (Alibaba) and Narayana Murthy (Infosys). Many in the economic elite have amassed their fortunes through their innovative work—a reward for their ability, grit, risk-taking, and ingenuity. But others have inherited wealth or thrived in environments where business regulations, government patronage, and limited international competition have protected them.

Dominant incumbents can block the policy reforms needed to promote social mobility and talent development. In early 2013, Mexican president Enrique Peña Nieto tried to take on one of the world’s most powerful teacher unions, the National Union of Workers in Education (Sindicato Nacional de Trabajadores de la Educación, SNTE). The union was so large and powerful that it operated as a political machine. Hundreds of members held administrative positions in the education system (including at the highest levels), and the union exercised control locally over hiring decisions and, in some states, over teacher payroll. Reforming teachers’ career paths and replacing underperforming teachers with those needed to promote children’s achievement were enormous challenges under those circumstances.

State-owned enterprises (SOEs) are the dominant incumbents in fossil fuel power generation. As a result, they block entry of new players in renewables using their outsize market share, control of the grid, and influence on regulation.

Contestable markets—and the policies that enable them—are vital for middle-income countries to discipline incumbents. Contestability means that incumbents feel pressure to compete and upgrade because their existing products and processes can be displaced by technologically sophisticated producers within their own country or from other countries. Such contestability is central to creative destruction. Contestability is fostered by three sets of policies: (1) institutions that weaken the forces of preservation; (2) incentives that strengthen the forces of creation; and (3) interventions that target errant incumbents to destroy harmful arrangements (figure 7.2).

Targeted interventions, often focusing on specific firms or individuals, are used as instruments of first resort by policy makers. But these instruments end up being ineffective and can hinder innovation if not designed with care. Policy makers should recalibrate their strategies by first strengthening the institutions that weaken the forces of preservation and then aligning the incentives to strengthen forces of creation. Targeted interventions are effective when they follow institutions and incentives.

Updating institutions to weaken the forces of preservation

Institutions—formal rules and informal norms—are often well intentioned when they are designed in their specific contexts. But they may end up persisting beyond their usefulness, protecting the status quo. Such persistence hurts the economic prospects of middle-income countries that need to rapidly change their growth model by adding infusion and innovation to investment. Institutional arrangements that favor incumbents will then need updating.

Retracting protection of incumbents, including state-owned enterprises

In middle-income countries, institutional inertia protects incumbents, strengthening the forces of preservation. Turnover, especially among market leaders, is low. In many middle-income countries, a small number of companies dominate markets, a survey suggest (figure 7.3).

Policy makers will need to retract government’s direct involvement in productive enterprise, while removing outdated regulations that favor and protect incumbents. Often, incumbents are protected by licenses that limit the number of market participants or directly restrict market entry. Standards and minimum firm sizes can further protect incumbent interests. These dangers should be weighed against benefits, such as the incentives to improve quality that standards provide. For example, the standard connector (SC), a fiber-optic connector developed by Tyco Electronics (now known as TE Connectivity Ltd) used in data networking and telecommunications, has become the dominant international standard. How? By joining national standardization organizations in many countries, the company influenced the standard-making process, with the result that European and international standards refer to the SC connector. Tyco thus gained a significant global market share, earning an additional US$50–$100 million in profits between 1995 and 2004.

India’s License Raj—a system of central controls introduced in 1951 regulating entry and production activity in the registered manufacturing sector—is another example. The system favored incumbents and stifled Indian entrepreneurs for more than four decades. Its dismantlement during the 1980s and 1990s amplified entry and business dynamism, and the effects were most prominent in states with labor market institutions that favored employers.

Often, dominant incumbents in local markets lobby local authorities to erect ad hoc entry barriers. In Italy, such local entry regulations in the retail market increased price margins by 8 percent and reduced the productivity of incumbent firms by 3 percent in the early 2000s. In Peru, when the national competition agency (Indecopi) strengthened its powers to dismantle local and sector-specific regulatory and administrative entry barriers in 2013, productivity increased significantly, including for firms operating in downstream sectors or in the same municipality.

Product market regulations (PMRs), intentionally or inadvertently, protect incumbents and constrain competition (figure 7.4). These regulations include regulatory barriers to firm entry and competition in a broad range of key policy areas, ranging from licensing and public procurement to governance of SOEs, price controls, evaluation of new and existing regulations, and foreign trade. They also include restrictive regulations in key network and services sectors (figure 7.5). Regulations tend to become less restrictive as country incomes rise.

Regulatory restrictions in critical input sectors can lead to adverse effects that constrain firm performance, job creation, and productivity in downstream industries. Anticompetitive regulations in key upstream sectors such as energy, transport, and communications, as well as professional services such as legal and accounting, hinder productivity growth and export performance in manufacturing firms. This effect is more pronounced in sectors heavily reliant on these inputs and those closer to the productivity frontier. Reforms in services sectors can positively influence the productivity of manufacturing firms, emphasizing the importance of regulatory reform in enhancing overall economic performance.

Public ownership and its weak governance are significant entry barriers. Businesses of the state (BOSs)—enterprises with majority or minority state shareholdings—act as powerful incumbents in many middle-income countries. Several middle-income countries score much higher than the Organisation for Economic Co-operation and Development (OECD) average on the presence and weak governance of SOEs in the economy (figure 7.6). Recent research presented in the World Bank’s The Business of the State report reveals that a doubling of states’ market share in a given sector is associated with 5–35 percent lower entry (figure 7.7, panel a). BOSs’ operational and financial performance lags behind that of their private peers, and they, on average, have lower labor productivity, profitability, and return on investments, while operating with higher levels of debt vis-à-vis private counterparts. Advantages such as subsidies, exclusion from competition laws, preferential access to finance, restrictions on foreign direct investment (FDI), and import bans in sectors dominated by SOEs are more prevalent in lower-middle-income countries compared to upper-middle-income countries (figure 7.7, panel b). Mechanisms to improve SOE governance and efficiency are still limited in many countries, including separation of ownership from regulation, as well as transparent and reliable information on performance-based measures.

Challenging state-owned incumbents in the electricity industry

Disciplining the incumbency advantage of public ownership is most pressing in the electricity industry. Although the cost of lower-carbon energy is declining rapidly, private providers in many countries face major barriers to entry. SOEs dominate fossil fuel power generation, mainly in coal-fueled power plants, where they account for 84 percent of total installed capacity (figure 7.8). By contrast, the private sector owns about an equal share (80 percent) of the installed capacity of renewable energy.

Historically, the electricity industry was considered to be a “natural monopoly” with one dominant firm due to economies of scale in transmission and distribution (networks) and the need to coordinate generation with the grid. Arguments related to economies of scale became obsolete when smaller co-generators and gas-fired power plants became competitive with larger, utility-owned power plants. Arguments calling for economies of scope no longer hold because advances in communication technology have reduced coordination costs, enabling competition in bulk (wholesale) power markets and then in retail sales. The retail choice is similar to how consumers choose a cell phone plan; consumers can buy electricity from any supplier just as they would purchase mobile phone services from a telecom provider. However, as of 2020 in 125 developing countries 60 percent of consumers still relied on a public distribution utility for electricity.

In South Africa, the vertically integrated power company Eskom dominates the power market with a 90 percent market share. In Poland, four companies—Polska Grupa Energetyczna (PGE), Tauron Polska Energia, Energa, and Enea—control nearly three-fourths of the market share in electricity production, with PGE holding 40 percent. Poland’s transmission grid is owned and operated by state-owned Polskie Sieci Elektroenergetyczne. SOEs use their dominant position to thwart entrants and protect their markets by blocking technological change.

SOEs are also significant investors in energy, contributing 36 percent of global energy investment. In low- and middle-income countries, SOEs are the largest providers of energy finance—accounting for 60 percent of energy investment (figure 7.9). A concern is that SOEs account for 50 percent of fossil fuel power investment globally, notably due to expanding coal plants in India and South Africa and gas plants in the Middle East and North Africa.

SOEs can block entry of new market players using their outsize market share and control of the grid. To compete for customers, rival firms need access to the grid controlled by a large incumbent. Thus access pricing becomes important. Access prices are set by the sectoral regulator. To set a fair access price, the regulator may need the incumbent utility to reveal information about its cost function. The incumbent has an incentive to overstate the cost of supplying the input to its competitors in order to raise the access price and try to eliminate the competition—that is, “foreclose” the downstream market. Concerns about anticompetitive foreclosure—through high prices, discriminatory conditions, and low quality of service—are an important incentive for regulation of access in network industries such as energy supply and telecommunications that rely on networks to transmit and distribute their services (network industries).

Incumbents can collude to block new entrants. Price collusion and other forms of collusion in wholesale markets are frequent in small power systems and illiquid markets and are difficult to detect in advance by sectoral regulators and after the fact by competition agencies. Various market analyses are employed to capture the strategic aspects of competition in this industry and avoid focusing only on simplistic concentration measures. These include examining

• The incentives of producers. In the near term, it is likely that electricity markets will feature a diverse set of firms, including publicly owned utilities, unregulated generation companies, and traditional vertically integrated regulated utilities. Each type of firm is likely to respond differently to a given competitive environment.

• The price responsiveness (elasticity) of demand. In markets in which customers can easily choose not to consume a product or to consume a substitute instead, producers cannot raise their prices far above costs without significantly reducing sales. Conversely, a producer that knows that buyers find its product essential can profitably raise prices to very high levels.

• The potential for expansion of output by competitors and potential competitors. Just as a producer with very price-responsive customers cannot exercise much market power, neither can a producer faced with many price-responsive competitors. Transmission capacity in a region and available competitive generation capacity are the main factors determining the potential for short-term competitive entry or output expansion.

Incumbents can be disciplined using less restrictive PMRs. Ex ante rules on access to essential infrastructure and open wholesale and retail electricity markets can enable entry by private providers, avoiding cases of “curtailment,” respecting the merit order (chapter 8), and encouraging entry through global competition.

Weakening patriarchal gender norms

Norms that discriminate against women perpetuate the hold of men (the incumbents) in the workplace. In the labor market, women remain an underused resource, particularly in the Middle East and North Africa and in South Asia, where female labor force participation is only half the level expected given these regions’ income levels. However, some factors have contributed to an ongoing rise in female labor force participation: an increase in the kinds of jobs requiring brains rather than brawn (such as professional positions); the increase in part-time jobs; the adoption of labor-saving household technologies; the growing number of educated women; the availability of contraceptives; the elimination of policies that punished married women; and the decline in social stigma against women working outside the home. In the United States, for example, the gender gap in labor force participation has nearly been eliminated. Countries with strong preferences for male children, such as China, Japan, and the Republic of Korea, have experienced similar increases in female labor force participation as their economies have grown.

Equal treatment of women in the law is associated with higher female labor force participation, smaller gender wage gaps, and more successful careers for women as employees and entrepreneurs. However, women still lack basic legal rights in many countries related to running a business, such as to sign a contract, register a business, and open a bank account. In Papua New Guinea, social norms that hinder female labor force participation and productivity are estimated to cost the economy about 0.5 percent of the gross domestic product (GDP) a year. Legal reforms that grant better property and inheritance rights also improve women’s social and economic outcomes. For example, in India the 2005 Hindu Succession (Amendment) Act, which increased a daughter’s share of land inheritance from 8 percent to 16 percent, led to an increase in women’s education rates, labor force participation, entrepreneurship, and autonomy within their marriages. The starting point to bringing more women into the labor force is implementing institutional reforms that grant women rights to property ownership, inheritance, and other basic rights to access economic opportunities.

Social norms shape personal attitudes toward women’s participation in the labor force. The likelihood of a wife being employed increases if her husband’s mother worked during his childhood. Parents also have a major impact on their children’s attitudes toward gender (even more than their peers), with mothers exerting more influence than fathers. But personal attitudes tend to be more progressive than collective social expectations, leading to misconceptions about social norms themselves.

Broad-based education and information interventions can help address both personal attitudes and misperceptions about social attitudes. For example, a study in India found that two years of classroom discussions about gender equality led to improved attitudes toward gender equality among teenage boys and girls. An intervention that encouraged teenage girls to question restrictive social norms in India combined with connecting girls to changemakers in the wider community reduced school dropout rates and early marriage and improved mental health. In China, the Spring Bud Project, initiated in 1989, promotes equitable, inclusive, and quality education (primary to the higher education level) for girls by means of subsidies for those from low-income families, large-scale advocacy and awareness-raising, and skills building for adolescent girls, including digital competencies for income generation and employment. In Viet Nam, early exposure to female classmates led to more egalitarian gender attitudes in adulthood—even more so for men who grew up in conservative households.

The misperception about support for gender norms is widespread across the world: many people think social support for working women is much lower than it is. For example, in Saudi Arabia misperceptions about gender norms restrict women’s basic rights to work outside of the home, and yet most Saudi men privately support women working but underestimate the extent to which others share this view. Correcting this misperception can lead to a significant increase in female labor force participation. Saudi Arabia has experienced an unprecedented surge in female labor force participation since 2017 as a result of changing regulations and shifting social norms, the implementation of sound structural reforms, and effective government communications. Saudi Arabia’s success in increasing female labor force participation from 17.4 percent in 2017 to 36 percent in 2023 may contain important lessons for other countries and regions.

In Bangladesh, the robust growth of the garment manufacturing industry has generated more than 5 million jobs, amounting to 60 percent of female employment, one-quarter of industrial employment, and three-quarters of the country’s export earnings in recent years. Employment in the garment industry has enabled migrant women from rural areas to earn cash for their families back home and has had far-reaching positive effects on the welfare and empowerment of women in rural and urban areas.

Role models, including women who challenge traditional behavior, can change the behavior and aspirations of other women. Their actions have led to an increase in female participation in political positions in local village councils (panchayats) and assemblies in India, which, in turn, has increased female labor force participation. The rise in the number of female entrepreneurs has also boosted female labor force participation and the number of women in higher management positions. In addition, educating the public about the costs and benefits of working is an important way in which female labor force participation and other modern practices can spread through society.

Bringing women into labor markets will mean providing them with support services such as child and elderly care, safety in the workplace, and transport. Both men and women in Indonesia also cite harassment in public transport and commuting, as well as in the workplace, as important factors in women not wanting to work. For women, difficulty in finding childcare is the primary reason given for not working. A review of 22 studies across low- and middle-income countries reveals that increasing access to and reducing the cost of childcare can improve maternal labor market outcomes, including employment, hours worked, income, productivity, and job type. Governments can use various options that range from free state-provided care to offering providers and parents financial subsidies, tax incentives, or other forms of support. The challenge of accessing affordable childcare disproportionately affects poor families. Childcare subsidies in low-income countries can help make childcare more affordable. However, such targeted policies are not very common in lower-middle-income and upper-middle-income countries, where only 9 percent and 41 percent of countries, respectively, have a law that establishes some form of financial support for families for childcare services, compared with 80 percent of high-income countries.

In countries where women lack equal economic and social rights, support for them will increase their chances of contributing to the labor market, including through gender-based affirmative action policies in education or employment (box 7.1). Upskilling and training programs are more effective when complemented with other interventions that address social, family, and logistical constraints that women can face, such as household and childcare responsibilities.

Box 7.1 A digital tool helps female entrepreneurs obtain capital and training in rural Mexico

To improve opportunities for indigenous rural women in some of Mexico’s southeastern states, a local nongovernmental organization, Pro Mujer, partnered with Google to help women access capital and entrepreneurship training. In February 2023, they launched a joint initiative, “Women: Force of the Southeast,” which includes an online platform to provide female entrepreneurs with free, customized online training. By means of hybrid sessions, participating entrepreneurs learn how to use social media to sell their products, prepare a budget, handle their finances, and communicate effectively. The platform also offers small loans with minimum requirements and no collateral requirements, as well as other financial services. In this region of Mexico, where about 80 percent of women live in poverty, digital technologies offer the promise of boosting skills, entrepreneurship, and incomes. The program is expected to benefit 6,000 women through small loans and about 2,000 women through entrepreneurship and financial literacy training.