Factors causing deindustrialization occurred due to higher manufacturing productivity, pushing prices and job absorption to continue to fall. The change in the economic structure from a manufacturing-based to a service-based basis has become a natural phenomenon of economic development, as has happened in developed countries.
What is deindustrialization?
Deindustrialization refers to an economic phenomenon in which the contribution of the manufacturing sector continues to decline. Economists usually track it from historical trends in the value of manufacturing output as a % of gross domestic product (GDP). Another indicator they observe is the proportion of employment in the manufacturing sector to total employment.
Deindustrialization due to the natural development of the economy
At the beginning of economic development, developed countries switched from agriculture-based to manufacturing-based – referred to as industrialization. Then, economic progress encourages the service sector to grow. As a result, service sector output and employment began to take on an increasing contribution to the economy.
On the other hand, the manufacturing sector is increasingly productive, where advances in technology and production methods encourage manufacturers to produce goods at lower costs. As a result, it makes goods even cheaper.
Manufacturers are beginning to replace labor with machines and robots, enabling them to produce at a higher scale at lower costs. Some manufacturers then adopted a strategy to specialize in services and relocate their factories overseas.
Finally, the economy generates more income for the people. In addition, the standard of living in developed countries also increases, so people can access cheaper goods.
So, in other words, deindustrialization is a normal phenomenon of the development of an economy.
Deindustrialization due to structural problems
In some developing countries, the ideal transition does not occur. The contribution of the manufacturing sector fell due to being uncompetitive and unproductive. For example, new investment is low, so the economy relies on old, less productive capital goods. Economists call it negative or premature deindustrialization, where it occurs before it reaches a mature stage of economic development.
Due to premature deindustrialization, per capita income during industrialization did not reach as high as per capita income in developed countries during industrialization. It happened because of structural problems such as low investment and innovation. As a result, the economy does not achieve the same prosperity as in developed countries.
Factors causing deindustrialization
Various arguments explain the causes of deindustrialization. For example, some manufacturing firms in developed countries cannot compete with producers from developing countries because they bear higher labor costs, making their products uncompetitive. Consumers finally increase the demand for imported goods from developing countries such as China because they are cheaper. As a result, several manufacturers of developed countries went out of business.
Later, others relocated their factories to developing countries, where labor was cheaper and closer to sources of raw materials. They then focus on services, which have greater added value.
More sophisticated technology and production methods allow manufacturers to increase output at a more efficient cost. In other words, it makes the manufacturing sector more productive. As a result, manufacturers can sell their output at lower prices.
In contrast, labor productivity grew more slowly in the service sector than in the manufacturing sector. As a result, the prices of manufactured goods fall relatively faster than services. As a result, the value of manufacturing output as a % of GDP decreases, not because output declines, but because prices fall.
The fall in the prices of manufactured goods also brings more wealth into the economy. So, consumers have to spend fewer dollars to buy goods.
In addition, advances in technology and production methods in the manufacturing sector have led to less employment. Many manufacturers are reducing their workforce and relying more on automation through machines, robots, and computers. As a result, the number of employed also fell, making employment growth in the manufacturing sector slower than in the service sector.
International trade specialization
Deindustrialization also occurs as countries pursue specializations in which they have a competitive advantage. For example, developed countries specialize in the service sector and maintain strategic manufacturing, such as industrial goods and high technology. Meanwhile, developing countries are transitioning from agriculture-based to less capital-intensive manufacturing-based to process agricultural commodities into higher-value products.
On the other hand, businesses will look for production locations to reduce production costs because of the profit motive. So, for example, they relocate production facilities to low-wage countries such as Asia.
Such specialization ultimately shifts the long-term economic structure of developed countries. Their service sector is growing rapidly, supported by strategic domestic manufacturing. For other goods, they import from abroad because it is cheaper.
Changing consumer spending patterns
Industrialization brings prosperity to developed countries. With a higher standard of living, many consumers in developed countries spend most of their extra income on services rather than goods.
Demand for services such as tourism, restaurants, information technology, and financial services is increasing rapidly. But, on the other hand, they also enjoy cheaper manufactured goods due to increased productivity in the manufacturing sector and getting goods cheaper from imports.
As a result, spending on manufactured goods as a % of GDP declined. On the other hand, spending on services increased.
High prices can make manufacturers less competitive. As a result, their export sales declined because they could not compete with manufacturers from other countries who were more competitive in the international market. In the domestic market, they also have to face the pressure of cheaper imported goods. Finally, some went out of business.
Weakened competitiveness can occur for several reasons. First, high wages can increase production costs, especially labor-intensive manufacturing. Second, poor infrastructure for logistics also contributes to high costs.
Another cause is low research and development. As a result, innovation in the manufacturing sector is also low, making goods less attractive.
Increased competitive pressure
Trade liberalization opens up more competition for manufacturers, both in international and domestic markets. As a result, manufacturers in various countries such as China find it easier to market their products to international markets. As a result, it ended up destroying less competitive domestic manufacturers.
For example, labor-intensive manufacturing businesses such as textiles in developed countries face more competition from developing countries. Manufacturers in developing countries are more efficient because they use cheaper labor. Finally, consumers prefer imported goods over domestic goods because they are cheaper.
Capital flight and increased offshoring
Political shocks or unfavorable government and economic policies can force manufacturers to withdraw their investments. It causes capital flight. They relocated factories overseas.
Relocation can also occur as a business adopts a strategy to specialize. Today, global companies based in developed countries are also shifting their production overseas to be more competitive – known as offshoring. For example, General Motors closed a US plant in Michigan and opened a plant in Mexico. First, they increase profits by shifting production to low-cost countries. Then, they focus on service, which has higher value-added.
Destination countries may offer lower labor costs. Or they are close to the source of the raw material. These all contribute to lowering production costs.
Exchange rate acute appreciation
An acute and long-lasting appreciation of the exchange rate can threaten domestic manufacturers. In addition, domestic manufactured goods become more expensive when sold overseas. Finally, foreign buyers reduce the demand for them.
On the other hand, appreciation makes the price of imported goods cheaper. Domestic buyers then favor imports over domestic goods.
Such conditions encourage domestic consumers to shift their demand to imported manufactured goods. And it could destroy the domestic manufacturing business. So they ended up losing out on the competition and shutting down their operations.
Low new investment
The decline in new investment in the manufacturing sector is another factor causing deindustrialization. As a result, fewer production facilities are built, and fewer new jobs are created. Finally, accumulated capital goods grow slowly. And, manufacturers rely on old capital goods that are less productive.
Low new investment can occur due to various combinations such as:
- An unfavorable investment climate, such as no incentives from the government.
- Bad economic policies such as high-interest rates
- Poor business performance due to weakening competitiveness in domestic and international markets