Document Type : Causal

Authors

• Alireza Kashfi ¹
• Ali Salmanpur ²
• Sima Eskandari ¹

¹ Department of Economics, Mi.C., Islamic Azad University, Miyaneh, Iran.

² Department of Economics, Mi.C., Islamic Azad University, Marand, Iran.

Abstract

Introduction
The quest for sustained economic development remains the central preoccupation of policymakers in developing nations. Traditional neoclassical growth models, such as the Solow-Swan framework, primarily attribute economic growth to factor accumulation—specifically capital and labor inputs. However, contemporary evolutionary and endogenous growth theories have shifted the focus toward the “composition” of production. In this paradigm, economic complexity—defined as the diversity and sophistication of a country’s export basket and production capabilities—is identified as a critical determinant of long-term prosperity. A nation’s ability to export complex products reflects the underlying collective knowledge, skills, and organizational capabilities embedded within its economic system.
Despite the proven relationship between economic complexity and growth, recent empirical discourse has identified a “missing link”: the institutional environment. It is argued that production complexity cannot yield its full potential in a vacuum. Effective government institutions—encompassing regulatory quality, the rule of law, control of corruption, and political stability—are necessary to provide the predictable environment required for high-tech industrial activity. Without sound institutions, complex economic structures may remain fragile or fail to generate positive spillovers.
This study seeks to bridge this gap by investigating the interplay between economic complexity and government institutions. Specifically, it tests the hypothesis that the relationship between economic complexity and economic growth is not linear but conditioned by the quality of a country’s institutional framework. Using a Panel Smooth Transition Regression (PSTR) model, this research examines whether government institutions serve as a threshold that determines the efficacy of economic complexity as a growth driver in developing countries from 2008 to 2023.
 
 
Methodology
To rigorously evaluate these complex, non-linear dynamics, the study employs the Panel Smooth Transition Regression (PSTR) approach. Unlike standard linear panel models, PSTR is uniquely suited for this research because it allows for the coefficients of the explanatory variables to change continuously as a function of a “threshold variable.” In this model, the threshold variable is represented by the index of Government Institutional Quality.
The dataset comprises a selection of developing countries over the period 2008–2023, ensuring sufficient temporal coverage to observe structural economic changes. The dependent variable is the rate of real GDP per capita growth, representing sustained economic expansion. The core independent variables are
 
Economic Complexity Index (ECI): A measure of the diversity and ubiquity of products in a country’s export basket.
 
Institutional Quality Indices: An aggregate measure derived from standardized international datasets reflecting government effectiveness, regulatory quality, and the rule of law.
The PSTR methodology enables the model to identify “regimes.” By estimating a transition function, the research determines the threshold level of institutional quality required for economic complexity to become an effective engine of growth. This econometric technique effectively addresses endogeneity issues and accounts for the heterogeneous nature of developing economies, where some nations possess the capacity to absorb complex technologies while others struggle due to institutional bottlenecks.
 
Findings
The empirical results derived from the PSTR model provide compelling evidence of a non-linear, threshold-dependent relationship. The findings are summarized as follows:
First, the analysis confirms that economic complexity is a positive predictor of growth, but its impact is significantly mediated by the quality of state institutions. In environments characterized by low institutional quality, the marginal effect of economic complexity on economic growth is observed to be negligible or statistically weak. This suggests that in the absence of a stable regulatory and legal environment, the introduction of complex production activities fails to generate the desired growth trajectories.
Second, the model identifies a clear institutional threshold. Once a country’s institutional quality crosses a critical “tipping point,” the growth-enhancing impact of economic complexity increases substantially. Beyond this threshold, the “spillover effects” of complex knowledge become more pronounced, as high-quality institutions facilitate the flow of capital, protect intellectual property, and incentivize technological innovation.
Third, the findings indicate that for developing nations, a strategy of industrial diversification is incomplete without concurrent institutional reform. Countries that attempted to increase their economic complexity without addressing systemic institutional weaknesses experienced lower-than-expected growth outcomes. Conversely, nations that prioritized institutional stability were able to leverage their production capabilities far more efficiently, resulting in faster structural transformation and resilient growth.
 
Discussion and Conclusion
The results of this study carry profound policy implications. The central conclusion is that economic complexity and government institutions are complements, not substitutes. Policymakers in developing countries often pursue industrial policies focused solely on export diversification or technology adoption. However, this research demonstrates that such efforts may yield suboptimal results if the underlying “rules of the game”—the institutional framework—are not robust.
 
Policy Recommendations:
Institutional Sequencing: Governments should prioritize institutional reforms—specifically enhancing regulatory quality and the rule of law—as a prerequisite for or alongside industrial policy initiatives. Strengthening these “soft” infrastructures is essential to make “hard” investments in industrial complexity effective.
Capacity Building: Developing nations must foster a regulatory envirnment that reduces transaction costs and minimizes corruption, as these are the primary factors that dampen the growth-promoting effects of economic complexity.
Holistic Development: Development strategies should transition from being purely sectoral (focusing on specific industries) to being institutional (focusing on the governance capacity to support those industries).
In conclusion, this research provides a nuanced understanding of the mechanics of economic growth in developing nations. By demonstrating that institutional quality acts as a threshold that dictates the success of economic complexity, the study offers a roadmap for more effective development strategies. Future research should further investigate the role of human capital in this institutional-complexity nexus to determine how educational infrastructure interacts with these dynamics to drive long-term prosperity.

Keywords

• Economic Complexity
• State Institutions
• Economic Growth
• Panel Smooth Transition Regression (PSTR)
• Developing Countries

Main Subjects

• Regression