Economic development is unavoidably a series of wagers. Investments in physical, human and knowledge capital (R&D) are made with an expectation of return, but with cognizance of the accompanying risk. A recent literature (Acemoglu and Zilibotti 1997) has moved the inability of poor countries to diversify this risk combined with the indivisibility of many projects, as the central explanation for the perverse phenomenon of both low growth and high volatility.1 However, the issue remains germane for advanced countries: ongoing growth is thought to depend on investments in supplying specialized, hence inherently risky production inputs (see, for example Romer 1990 and Grossman and Helpman 1991).
Several factors have been forwarded as impeding countries from taking on riskier projects. The financial sector is seen as central. Greenwood and Jovanovic (1990) argue that financial intermediates encourage high-yield investments and growth by performing dual roles: pooling idiosyncratic investment risks and eliminating ex-ante downside uncertainty about rates of return. Obstfeld (1994) sees international asset trade as encouraging all countries to shift from low-return, safe investments toward high return, risky investments. Grossman and Razin (1985) argue that that multinational corporations may take on more risky production techniques within a country because they are more diversified internationally than locals firms. In the area of trade, Baldwin (1985) argues that the differential ability of investors to diversify leads the country with better capital markets to exports the ‘risky’, and hence higher return, good.2 However, finance need not be the only barrier to countries taking on riskier projects. To the degree that Pasteur is right that “chance favors the prepared mind,” an inability to resolve the well-known market failures and again, indivisibilities surrounding innovation and R&D would leave poorer countries restricted to less complex, and less risky products (For a recent application that emphasizes appropriation externalities over finance, see Hausmann, Hwang and Rodrik 2007). Further, as Acemoglu. Johnson and Robinson (2002) and Levchenko (2007) argue, weak supporting institutions that either exclude entrepreneurs, create additional uncertainty in the rules of the game, or make managing the implications of loss (for instance, bankruptcy law) would also cause countries to specialize in lower risk.
To date, the evidence of these effects, while compelling, has been largely historical and anecdotal. This paper studies the dynamics of product quality changes in US imports to explore the tradeoff between risk and return in quality improvements in the exporting countries.3,4 Across one decade, 1990-2001 the paper documents how the first two moments of quality growth vary across countries and products. Both dimensions are central to the development debate. On the one hand, the literature above suggests that distinct country contexts will lead to different investment choices. On the other, a long and continuing literature stresses the importance of the type of goods countries produce and export. In particular, natural resource based goods have been seen as being intrinsically more volatile, yet with fewer possibilities for growth overall (see, for instance, Matsuyama on the latter). Hausmann, Hwang and Rodrik (2007) have led a resurgence of interest on the qualities of different products and their development impact more generally. The dichotomy is clearly overdrawn since country characteristics also inform the composition of the export basket, however parsing out the contribution of each is important to the debate.
