World Development Report 2024: The Middle-Income Trap

The shifts from 1i to 2i to 3i strategies are neither smooth nor linear. They require a mix of economic, social, and political change that Karl Marx and other philosophers considered impossible under capitalism. They reasoned instead that market-based economies would be riddled with a growing concentration of wealth and wracked by crises until capitalism was replaced by communism. Joseph Schumpeter changed this debate with his 1942 treatise Capitalism, Socialism and Democracy and the phenomenon of “creative destruction.” For Schumpeter, the crises in capitalist economies could be simultaneously painful and restorative.

Nearly a century later, many of Schumpeter’s insights appear to have been confirmed. Indeed, his admonitions and insights have been used by modern Schumpeterian theorists—most notably, Aghion and Howitt (1992) and Akcigit and Kerr (2018)—to construct formal frameworks. These advances in growth theory are useful in helping solve the hardest problem facing the global economy today: how should the 108 middle-income countries with 75 percent of the world’s people, 60 percent of global emissions, but just 40 percent of global output correct these imbalances while converging toward the living standards of advanced economies?

Schumpeterian ideas provide helpful clues. Success seems to come most quickly to societies that balance the economic forces of creation, preservation, and destruction.

Energy: Incumbents can collude (Schumpeter’s view)

Joseph Schumpeter (1942) wrote that society benefits when entrepreneurs with talent and vision introduce new products and technologies, displacing old products and business models and generating ever-higher productivity and growth. Often, however, incumbents collude to preserve the status quo (figure O.8, panel a). In today’s environment, Schumpeter’s view is perhaps best reflected in the contest between high- and low-carbon energy. High-carbon energy, particularly coal, has been an incumbent technology for over 300 years (box O.1). Technical progress has followed a path over which the efficiency with which fossil fuels are extracted and burned has increased, urban infrastructure has been built around the private motor vehicle, social attitudes and personal preferences are supportive of high carbon consumption, and political pressure groups represent carbon-intensive interests. The result is that the returns to investing in high-carbon activities are large because of all the complementary high-carbon investments that have been made.

Box O.1 Who and what are incumbents? Leading firms, technologies, nations, elites—and men

Incumbents are firms that usually have well-established brand names recognized and trusted by consumers. They often have better access to financial resources, such as capital for investment and technological infusion, and human resources, such as experienced employees. They also may have established relationships with suppliers and distributors, which can be leveraged to maintain a competitive edge. And they have resources to invest in research and development and to invent products and processes they can protect with patents.

Incumbents are well-established energy sources such as fossil fuels. Since 1709 when Abraham Darby, a British ironmaster, first smelted iron ore with coke, coal has been the fuel of choice around the world. In the more than 300 years since Darby’s innovation, coal has become the largest source of electricity generation worldwide, producing more than one-third of global electricity in 2022.a Cities and economies have been built on cheap coal-powered energy, fueling their prosperity. However, the widespread use of coal generates the highest energy-related carbon dioxide emissions—15.5 gigatons—representing 42 percent of total emissions in 2022.

Incumbents are technologically advanced nations. They can share technologies with emerging economies through investing in, licensing, training, and hosting foreign students. For decades, they were instrumental in supporting the growth of emerging economies. But today, they are erecting walls to subsidize their domestic firms, blocking others from joining their value chains.

Finally, incumbents are elites in society. They are always powerful, generally wealthy, and—in middle-income economies—mostly men. But they are not all against progress. Elites can have the education and resources to accelerate growth by infusing their -economies with global technologies. For a middle-income country seeking to infuse and innovate, elites may serve as the go-to pool of trained professionals, managers, entrepreneurs, and innovators. Men are also incumbents, for centuries enjoying better education and job opportunities than women and defining laws and institutions, often to buy social, economic, and political power. Such power has given them an outsize say in deciding who studies where and what, who gets a well-paid job, and who gets to start a business. Meanwhile, misogyny may keep women out of the market or at least the most desired jobs and business opportunities.

Large firms, social elites, powerful men, and advanced economies have, however, also helped new entrants. The size and ownership of enterprises and the socioeconomic status and gender of individuals are not reliable attributes on which to base policy.

In many middle-income countries, power markets are still a monopoly: an SOE operating under a vertically integrated utility remains in charge of generation, transmission, distribution, and the retail supply. This arrangement hinders competition and results in the inefficient use of resources. In addition, in many middle-income countries the first generators dispatched are often not those with the lower marginal prices (that is, power dispatch often does not follow merit order), serving as a barrier to the expansion of renewables with rapidly declining costs. In countries that include Pakistan, Poland, South Africa, and Türkiye, SOEs account for 84 percent of total installed capacity. By contrast, the private sector owns about an equal share (80 percent) of the installed capacity of renewable energy.

Although advances in low-carbon energy can help to decouple economic growth from carbon emissions, the diffusion of low-carbon technologies in middle-income countries is patchy, reflecting a landscape of legacy policies that preserve a high-carbon economy. Middle-income countries have a greenhouse gas (GHG) intensity of GDP that is 3.5 times higher than that of high-income countries. This difference reflects both the misallocation in the use of energy (with the energy intensity of GDP also 2.5 times higher than in high-income countries) and the lower diffusion of low-carbon energy technologies (figure O.9, panel a).

Talent: Entrants create value and displace incumbents (Aghion and Howitt’s view)

Schumpeter’s ideas on creative destruction served as the inspiration for one of the most influential papers in economics that emerged from a fortuitous collaboration between two economists. In the summer of 1987, Philippe Aghion, a new professor at the Massachusetts Institute of Technology (MIT), and Peter Howitt, a Canadian economist, formalized a theory of creative destruction in which economies expand mainly through innovation by entrants. Entrants challenge incumbents and become the protagonists of economic growth (figure O.8, panel b).

This formulation of creative destruction emphasizes the importance of both creating ever-larger reservoirs of talent and improving the allocation of talent to tasks. Not investing in the talents of women and minorities, keeping them out of the most rewarding activities, and adopting unfair compensation practices are surely the most self-defeating attributes of middle-income economies, where skills are already scarce. When these practices are discouraged, the payoff can be immense. In the United States between 1960 and 2010, the decline in gender and racial discrimination in education and work explains up to 40 percent of the observed growth during that period.

As they grow, middle-income countries will need skilled workers such as engineers, technicians, and managers, but they have smaller reservoirs of skilled talent than advanced economies. And yet preservation forces discourage the acquisition of talent. Talent is wasted wherever that acquired through education, training, and work experience is allocated not by merit, but according to other factors outside the control of individuals. Gender, family background, ethnic and cultural identity—none of these factors should matter for school enrollment or career prospects in a country aspiring to grow rapidly through infusion and innovation. But for the average child in a middle-income country today, they matter all too much.

Economically and socially mobile societies are better at developing skills and utilizing talent, but social mobility in middle-income countries is about 40 percent lower than that in advanced economies. Middle-income countries will need to ensure that more individuals, regardless of their parents’ circumstances, have better opportunities to become skilled workers. And social mobility matters much more in middle-income countries than in low-income countries simply because the former need more skilled workers to invest, infuse, innovate, and grow (figure O.9, panel b).

Why do preservation forces persist in constraining the opportunities for so many people? Part of the answer is that preservation insulates members of social elites from the forces of destruction that, in a more open society with meritocratic institutions, might dissipate their advantages in wealth and privilege. The same forces ensure that, beyond elites, few children will get the chance to climb to a higher rung on a country’s income ladder than that occupied by their parents. So, income inequality remains high and social mobility remains low, transmitting inequality across generations, exacerbating the inequality of opportunity.

Three kinds of preservation forces perpetuate social immobility in middle-income countries, shutting out talent from economic creation. The first force is norms—biases that foreclose or limit opportunity for women and other members of marginalized groups. Next are networks—above all, family connections. And the last force is neighborhoods—regional and local disparities in access to education and jobs. Although all three factors can have positive impacts on talent creation—filling voids left by missing markets and services—they become forces of preservation when they block the disadvantaged from accessing opportunity.

Enterprise: Incumbents and entrants add value (Akcigit and Kerr’s view)

The original Schumpeterian premise that new entrants drive change and create new economic potential while incumbents are inert runs counter to the latest empirical evidence on enterprises. Globally, larger and more established firms are infusing new knowledge into their businesses at a higher rate than smaller firms. In middle-income countries, it is the large firms that are employing the majority of highly skilled workers. Throughout the twentieth century, the United States effectively transitioned its innovation focus from individuals working in their garages to established firms, leveraging advantages such as risk management, market access, brand reputation, and collaboration. These firms now account for over 75 percent of patents filed at the United States Patent and Trademark Office.

A third generation of Schumpeterian economists have formalized the idea that both incumbent enterprises and entrants can create value (Figure O.8, panel c). Market leaders—successful incumbents—can bring scale and advance domestic industry by investing in upgraded products and business practices, as well as technology for new markets. Scale allows for adopting modern management practices, for hiring and rewarding skilled workers, and for making the most productive use of large amounts of capital. In other words, scale gives incumbents the power to boost their efficiency, whether in the expectation of competition from other incumbents or from entrants or in response to it. Scale also allows incumbents to specialize in multiple product lines, changing course to parry the new offerings of competitors.

However, the forces of creation are weak in middle-income countries. In India, Mexico, and Peru, for example, if a firm operates for 40 years, it will roughly double in size. In the United States, the average firm that survives that long will grow sevenfold (figure O.9, panel c). For firms in middle-income countries, this implies a “flat and stay” dynamic: firms that fail to grow substantially can still survive for decades. By contrast, for US firms the dynamic is “up or out”: facing intense competitive pressure, a few entrepreneurs will expand their businesses rapidly, while most others will exit quickly. Among the majority who exit the market, many will become wage earners at the most flourishing firms.

In keeping with the flat and stay dynamics, firms in India, Mexico, and Peru tend to remain microenterprises: nearly nine-tenths of firms have fewer than five employees, and only a tiny minority have 10 or more. The longevity of undersize firms—many of them informal—points to market distortions that keep enterprises small while keeping too many in business. For example, a high regulatory cost attached to formal business growth may inhibit an efficient firm from gaining market share and driving out inefficient competitors. Such policy-induced distortions in middle-income countries result in misallocated resources, hampering creation and infusion at scale.

Balancing the three forces

Looked at it this way, middle-income countries face common challenges in balancing the three forces:

• Creation—the primary protagonist of economic growth—is a weak force in many middle-income countries. Large incumbents are slow to develop new products and processes, and, although small firms are continually entering various markets, most of them do not create or disrupt. Periods of growth are also times of creation, and thus of structural change.

• Preservation—the arch antagonist of creation—is the strongest force in middle-income countries. The same market leaders who could enable middle-income countries to speed up the infusion of global knowledge are too often slowing down the process. Incumbent firms and elites are often successful in keeping things as they are whether through market power and collusion, through capture of policies and regulations, or through education systems and labor markets that place more importance on socioeconomic status than on talent or merit.

• Destruction—a necessary evil that clears the way for creation by freeing up misallocated resources and sweeping away outdated institutions—is kept weak in middle-income countries by opposition from those with market power or government influence. A growing economy that requires new arrangements in capital, labor, and energy markets needs to release itself from less efficient ones. To the extent that weak institutions and policies preserve outdated arrangements, creative destruction is stifled. However, this opposition tends to weaken during crises—whether economic, political, or ecological. When crises place intense pressure on governments to act, a window opens for reforms.