Middle Income Trap

It is being argued that some economies, particularly amongst the hitherto fast growing ones in Asia, may stop growing beyond a point. This point may be such that the average incomes in these economies are well short of those in the developed economies of the west. Thus these economies may become ‘middle class’ and stay that way. This is what has been called as the Middle Income Trap.

Alternatively, it can also be put across as:

  • An economic development situation where a developing economy after attaining certain income growth, risks stagnation and is unable to continue its growth further and enter into the rank of a Developed economy.

Here, a developing economy might grow very fast initially before it gets stuck at a certain level (middle income level) and is then unable to grow further i.e. its growth plateaus.

A developing nation gets “trapped” when it reaches a certain, comparatively comfortable level of income but cannot appear to take that next big jump into the true major league of the developed world economy, with per capita wealth to match.

Following are the characteristics of countries trapped at the middle income level:

  • Low investment ratios
  • Slow manufacturing growth
  • Limited industrial diversification; and
  • Poor labour market conditions

The following are some of the causes that may lead to the Middle Income Trap:

  • Collapse in the growth of productivity, i.e. the ability for a given amount of labour and capital to produce ever-increasing amounts of output.
  • Beyond a point increases in labour and capital are not enough to drive growth rates higher due to diminishing returns.
  • Inadequate infrastructure
  • Weak institutions
  • Unfavourable macroeconomic conditions
  • Demographic disadvantages and slowing population growth. As fertility rates drop, fewer new workers join the population, leading to less labour supply and higher wages over time.

On these parameters, while India has demographic dividend and one of the few countries whose average population will actually get younger in years to come, other weaknesses persist. Among them infrastructure weaknesses and macroeconomic problems, can be potential causes of a growth slowdown in India. Skill shortages can also be a serious concern despite the working age population expected to see a substantial growth. Such skill shortages can push the wages and the cost of skilled labour up.

A middle income trap can be avoided in the following ways:

  • Identifying strategies to introduce new processes and find new markets to maintain export growth.
  • Ramping up domestic demand
  • Shifting from resource-driven growth (i.e. dependent on cheap labor and capital) to growth based on high productivity and innovation
  • Investments in infrastructure and education.
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