Economic diversification and human development in Europe

Abstract

Economic diversification is recognized in literature as a strong determinant of economic development. The relationship between economic diversification and human development (social welfare), however, is not conclusive. High level of diversification can improve social welfare by providing a large range of alternatives to economic agents. On the contrary, it can also increase complexity of the decision making and hence negatively affecting social welfare. Using data for 20 European countries from 1996 to 2010, we found evidence for positive welfare effects of economic diversification in Central and Eastern European Countries suggesting that diversification is especially important for social welfare in transition economies. Our results hold for all three types of diversification indices (related, unrelated and overall diversification) and are robust to the selection of industries and lag specifications. For the full sample, variety only affects human development after a significant lag. More specifically, in the long run, overall variety improves social welfare while related variety reduces it. A negative relationship between related variety and human development is attributable to obsolescence of skills when new sectors replace existing ones. Such is not the case with unrelated variety as sectors are by definition unrelated to each other and therefore new sectors are less likely to replace old ones.