Deindustrialization: Definition, Causes and Effects

Indonesia is facing deindustrialization. We see the contribution of its manufacturing output to gross domestic product continues to fall, from 28% in 2008 to only 17% in 2019. The chart above shows you how severe the decline is.

The turning point was during the 1998 crisis, after which the percentage continued to fall. What is deindustrialization? How did that happen? What is the impact on the economy and society? Let’s discuss them one by one.

What is the definition of deindustrialization?

What’s it: Deindustrialization is a phenomenon in which an economy evolves from a manufacturing-based to a service-based one. In other words, the economy is transitioning from relying on the secondary sector to the tertiary sector. However, what is even worse is when the economy transitions back to the primary sector (as opposed to industrialization).

How can we observe this transition? First, we can see it from the gross domestic product (GDP) data by sector. It details the economic structure of a country. In it, GDP data is broken down into sectors based on the monetary value of their final output.

Then, we divide the manufacturing sector’s output value to GDP. When deindustrialization occurs, the manufacturing sector no longer contributes dominantly to the economy. As a result, the percentage of its output to GDP shows a decline.

The next impact is on employment. Employment in the manufacturing sector contributed to a decline in absorbing new workers. The creation of new jobs in this sector is less rapid than in the service sector. Thus, the manufacturing sector no longer dominates in absorbing labor in an economy.

Contribution of the manufacturing sector’s output to GDP (%)

What causes deindustrialization?

Several reasons explain why deindustrialization occurred. We can see it as a natural phenomenon but also as a phenomenon resulting from structural problems of the economy.

An increasingly advanced economy

We can view deindustrialization as a natural phenomenon of the development of an economy. An economy is evolving from agriculture-based to manufacturing-based – known as industrialization.

In subsequent developments, it expanded to a service base, and the manufacturing sector contributed lower than before (deindustrialization). Thus, when the economy has matured and reached full industrialization, as in developed countries, deindustrialization will occur.

The above phenomenon brings prosperity to the economy. The population has a high per capita income, prompting more consumer spending on services.

On the other hand, the increase in productivity in the manufacturing sector – due to advances in production methods and technology – makes the price of goods cheaper. In addition, they also get cheap goods from imports. As a result, the additional dollars spent on manufactured goods are less than those spent on services.

Structural problems of the economy

Deindustrialization can take place due to structural problems. Economists call this negative or premature deindustrialization.

Manufacturing sector output grew at a slower pace than economic growth or even fell before reaching maturity. In contrast, the non-manufacturing sector, usually the service sector, grew higher and became a new engine for economic growth.

Such a phenomenon occurs for a long period, not a year or two. As a result, industrialization did not achieve the same prosperity as developed countries produced during industrialization – causing a middle-income trap.

Then, due to declining competitiveness, low innovation, and investment, the manufacturing sector no longer creates many jobs. As a result, its contribution to % of GDP is also slowly decreasing.

Causes of deindustrialization in a nutshell

Well, here are the factors causing deindustrialization, both from a positive and a negative point of view:

Decreased competitiveness. For example, rising wages or poor infrastructure for logistics increases the cost of doing business. Low research and development can also weaken competitiveness due to low innovation.

• As a result, the cost of producing manufactured goods becomes more expensive. On the other hand, their quality is also less competitive compared to goods from other countries.

Competitive pressure is increasing. Trade liberalization and globalization increase the flow of international trade. It makes foreign goods enter abundantly into the domestic market. On the other hand, consumers are easier to get imported goods than before.

• High imports threaten domestic manufacturers. Due to not competing, some eventually went out of business.

Capital flight took place on a massive scale. Many manufacturers withdrew their investment. It may be caused by political shocks or unsupportive government policies, which last for a long time.

New investment is low. Fewer factories are built, and fewer new jobs are created. On the other hand, new investment in the service sector increased significantly.

• Low new investment causes output in the manufacturing sector to grow at a slow pace. Accumulated capital goods do not grow, and eventually, the economy relies on old, low-productivity capital goods.

The government is promoting an economic transformation program. The government directs the economy to rely on a higher value-added service sector (quaternary) rather than labor-intensive manufacturing.

• Such an initiative does not mean sacrificing the manufacturing sector at all. Instead, the government directed the economy towards deindustrialization as a natural phenomenon. Therefore, to support the program, the government also builds strategic supporting manufacturing such as high-tech industries, ultimately increasing overall manufacturing productivity. “Made in China 2025” is a good example you can dive into.

Consumer spending patterns are changing. Industrialization – which occurred during the previous period – brought more prosperity, leading to high per capita incomes. People spend more extra dollars on services than on goods. It encourages the service sector to develop rapidly.

• On the other hand, increased productivity makes the price of manufactured goods cheaper. Thus, people only need to spend an additional dollar less to buy them than to buy services.

Offshoring increased. Manufacturers relocate their production facilities overseas and choose to focus on service. An example is Apple’s decision to outsource production to countries outside the United States.

• Such relocation leads to a decline in manufacturing sector output. For example, labor-intensive companies, such as textiles, move their production facilities from developed countries to developing countries like Vietnam and Bangladesh.
• The destination country offers lower labor wages than the home country. Because textiles are labor-intensive, low wages allow for low production costs. This business strategy keeps the prices of textile products cheap and competitive in the global market.

What is the effect of deindustrialization?

Deindustrialization brings positive and negative impacts on the economy and society. It affects jobs, people’s incomes, and the environment.

Here are the positive impacts:

• More income. The transition from the manufacturing sector to the service sector reflects higher welfare and income. In addition, the service sector also has a higher added value for the economy. This shift in economic structure ultimately leads to a higher standard of living.
• Higher productivity. As it produces more value-added, output per worker also increases.
• Reduced environmental degradation. Manufacturing businesses emit substantial carbon emissions, which are damaging to the environment. Reduced manufacturing activity means a less negative impact on the environment.
• More cheap stuff. Trade specialization leads to cheaper goods. For example, global companies in developed countries have increased profits by shifting production to low-cost locations in other countries. Finally, they export their products back to their home countries more cheaply.
• Less hazardous work. Working in factories often leads to accidents and causes lifelong disability.

On the other hand, deindustrialization also causes negative impacts, such as:

• Increased structural unemployment. Jobs in certain manufacturing are lost, and unemployed people cannot switch to the service sector due to inadequate skills. Factors such as specialization hinder labor mobility. Workers do not have alternative skills to apply for jobs in the service sector when their employers go bankrupt or relocate their factories overseas.
• Persistent current account deficit. As manufacturing output decreases, the economy relies on imported goods, buying from abroad to meet domestic consumption. On the other hand, product exports tend to shrink as manufacturing output decreases.
• Taxpayer reduction. Higher unemployment and reduced manufacturing activity reduce potential sources for government tax collections.
• Increasing environmental pressures in manufacturing investment destinations. When manufacturers relocate their factories overseas, it means they transfer potential carbon emissions to the destination country, which is usually a developing country.

• What are the Factors Causing Deindustrialization?
• What Are the Positive and Negative Impacts of Deindustrialization?
• What Are the Effects of Industrialization? [Positive and Negative Impacts]
• Dutch Disease: Definition, Examples, Causes, and Possible Solutions
• Industrialization: Definition and Causing Factors