The implications of this framework for research are challenging. One needs to better understand the roles of the market and the state and how they interact to strengthen the private sector in the process of economic development. This poses several important questions: How can a successful development approach be designed and implemented to facilitate the smooth diversification and upgrading from one industrial structure to another? Where distortions exist because of excessive or insufficient interventions by governments, how can countries move to a first-best, distortion-free world? How can policymakers ensure that transitions work smoothly?

The remainder of the paper is organized as follows: Section 2 examines the evolution of development thinking and offers a critical review of some of its main schools of thought. Section 3 outlines the basic principles and conceptual framework of the new structural economics, the function of the market, the four roles of a facilitating state, and the exit strategy from distortions. Section 4 highlights similarities and differences between old and new structural economics, and discusses some preliminary insights on major policy issues based on this new approach. Section 5 concludes with new structural economics’ implications for World Bank research.

# **2. A SHORT REVIEW OF DEVELOPMENT THINKING AND EXPERIENCES**<sup>**6**</sup>

The process of sustainable per capita income increase and economic growth, characterized by continuous technological innovation and industrial upgrading, is a modern phenomenon. Before the modern era, most countries were in the development stage of a relatively backward agrarian economy—disturbed from time to time by war and natural calamities, and afflicted by the Malthusian trap. Except for the ruling classes, craftsmen and merchants—who represented a minority of the population—most people worked in subsistence agriculture, animal husbandry, or fishery. Given the technologies and industries prevalent at the time, the allocation of resources, developed through generations of practice in such economies, was close to optimal. Therefore, the gains from improvement in the allocation of resources were small (Schultz 1964). Further economic development was feasible only with some technological innovations, as an exogenous shock or an improvement based on experience, to the system.<sup>7</sup> In this pre-modern era, economic development was manifested mainly in the form of population increase and the aggregate size of the economy. There was extensive growth, but per capita income did not change much (Clark 2007; Kuznets 1966; Perkins 1969).

The income gap between areas that today would be considered developed and those that would be considered developing was relatively small from today’s viewpoint—estimated to be at most 50 percent (Maddison 2006; Bairoch 1993). Indeed, some of today’s developing countries—such as China and part of India—were believed to be richer than Europe at that time (Cipolla 1980; Pomeranz 2000; Smith 1776). Until the late eighteenth century, the overall performance of markets—in terms of integration—in China and Western Europe was comparable (Shiue and Keller 2007).

> 6 These first four paragraphs draw heavily on Lin (2009a).

> 7 A few technological innovations before the modern times, such as the introduction of corn and sweet potato from America to the rest of the world, which were byproducts of the discovery of the new continent, can be analyzed as exogenous technological shocks. Most other technological innovations before modern times were the by-products from the daily practices of craftsmen or farmers.

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