Some ideas are intuitive. Others sound so obvious after they are expressed that it is hard to deny their truth. They are powerful because they have many nonobvious implications. They put people in a different frame of mind when looking at the world and deciding how to act on it.
One such idea is the notion that cities, regions and countries should specialize. Since they cannot be good at everything, they must concentrate on what they are best at — that is, on their comparative advantage.
They should make a few things very well and exchange them for other goods that are made better elsewhere, thus exploiting the gains from trade.
However, while some ideas are intuitive or obvious, they can also be wrong and dangerous. As is often the case, it is not what you do not know, but what you mistakenly think you know, that hurts you. The idea that cities and countries actually do specialize, and that therefore they should specialize, is one of those very wrong and dangerous ideas.
When an idea is both intuitively true and actually false, it is often because it is true on one level, but not on the level at which it is being applied. Yes, people do specialize, and they should specialize, too. Everyone benefits from each of us becoming good at different things and exchanging our know-how with others. It is not efficient for a dentist and a lawyer, for example, to be the same person.
However, specialization at the individual level actually leads to diversification at a higher level. It is precisely because individuals and firms specialize that cities and countries diversify.
Consider a rural medical facility and a major city hospital. The former probably has a single general practitioner who is able to provide a limited suite of services. In the latter, doctors specialize in different areas (oncology, cardiology, neurology and so on), which enables the hospital to offer a more diverse set of interventions. Specialization of doctors leads to diversification of hospital services.
The scale at which specialization of individuals leads to diversification is the city.
Larger cities are more diversified than smaller cities. Among cities with similar populations — say, Salvador and Curitiba in Brazil, or Guadalajara and Monterrey in Mexico — more diversified cities are richer than less diversified cities. They tend to grow faster and become even more diversified, not only because they have a larger internal market, but also because they are more diversified in terms of what they can sell to other cities and countries.
What is true at the level of cities is even more applicable at the level of states and countries. The Netherlands, Chile and Cameroon have a similar population size, but the Netherlands is twice as rich as Chile, which is 10 times richer than Cameroon. Looking at their exports shows that the Netherlands is three times more diversified than Chile, which is three times more diversified than Cameroon.
As my colleagues and I recently argued, one way to understand this is to think of industries as stitching together complementary bits of know-how, just as words are made by putting together letters.
With a greater diversity of letters, the variety of words that can be made increases, as does their length. Likewise, the more bits of know-how that are available, the more industries can be supported and the greater their complexity can be.