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Driven by productivity gaps, absolute income gaps between developing and developed economies have remained persistent hindering catch-up. Export products mostly consisting of low value-added products; developing countries suffer even when they are part of global value chains. The so-called Fourth Industrial Revolution may further exacerbate their position. As a result, many developing countries have been in low- or middle-income traps for decades and this is likely to persist. So, why has the traditional productivity explanation not been able to explain the no-catch-up phenomenon? To explain lack of catch-up, we decompose productivity into price and technical efficiency components. Adopting a product differentiation strategy, the developed countries focus on price, while developing countries focus on technical efficiency; prices of products of advanced firms in developed countries are determined not in perfectly competitive markets but rather in monopolistically competitive markets granting them with pricing power through three tools: technology (R&amp;D), design, and branding. By virtue of this pricing power, advanced firms generate non-zero economic profits and “pseudo-productivities” which drive the income gaps. We suggest key lines of industrial policy sets such as focusing on design, branding, and product differentiation strategies, fast cycle technologies, and development-based public procurement coupled with educational policies.

Why Income Gaps Persist: Productivity Gaps, (No-)Catch-up and Industrial Policies in Developing Countries