Why incomes might converge or diverge

There are two main arguments for why incomes across countries should converge over time.

Technology spillover. One argument is that innovations and technologies that are developed in the rich countries soon become available in the poor countries. This happens, for example, through foreign direct investment as companies from the rich countries bring new technologies to the poor countries. When the same technology is available everywhere, then incomes would also tend to become equal over time because technology is an important ingredient of economic development.

Based on that argument, incomes would converge faster if a poor country is ready to use the advanced technology. If it has an educated work force and stable political and economic conditions, the technological spillover is more likely to occur.

Divergence. Conversely, if its education system and institutions are not well developed, the new technology cannot be adopted. The income of the country will lag behind the income of countries with better education and institutions.

Diminishing returns. The second argument is that investments in the rich countries are less profitable than investments in the poor countries. Think of it as follows. If an accounting firm in a rich country has 10 computers, one more computer will make little difference. If an accounting firm in a poor country has no computers at all, then buying one computer would make a big difference. The investment in that first computer would pay off handsomely.

Therefore, international investment would flow primarily from the rich countries to the poor countries where profits are greater. This inflow of investment will make poor countries richer.

Divergence. However, returns could also be increasing, instead of diminishing. In the example above, if the firm has many computers and much experience using them, an additional computer will be put to good use. If it has only one computer, then it may not know what to do with it.

In this version of the story, adding investments to already rich firms or countries is more profitable. Then, investment flows to them and makes them even richer. Incomes around the world diverge instead of converging.

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