Economic development as self-discovery

In the presence of uncertainty about what a country can be good at producing, there can be great social value to discovering costs of domestic activities because such discoveries can be easily imitated. We develop a general-equilibrium framework for a small open economy to clarify the analytical and normative issues. We highlight two failures of the laissez-faire outcome: there is too little investment and entrepreneurship ex ante, and too much production diversification ex post. Optimal policy consists of counteracting these distortions: to encourage investments in the modem sector ex ante, but to rationalize production ex post. We provide some informal evidence on the building blocks of our model. (C) 2003 Elsevier B.V. All rights reserved.