Case Study 2.0

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Chapter 4 Contemporary Models of Development and Underdevelopment

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4.1 Underdevelopment as a Coordination Failure

A newer school of thought on problems of economic development

Coordination failures occur when agents’ inability to coordinate their actions leads to an outcome that makes all agents worse off.

This can occur when actions are complementary, i.e.,

Actions taken by one agent reinforces incentives for others to take similar actions

This circumstance can, under some circumstances, lead to multiple equilibria

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4.2 Multiple Equilibria: A Diagrammatic Approach

Often, these models can be diagrammed by graphing an S-shaped function and the 45º line

Equilibria are

Stable: function crosses the 45º line from above

Unstable: function crosses the 45º line from below

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Figure 4.1 Multiple Equilibria

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4.3 Starting Economic Development: The Big Push

Sometimes market failures lead to a need for public policy intervention

The Big Push: A Graphical Model, 6 assumptions

One factor of production

Two sectors

Same production function for each sector

Consumers spend an equal amount on each good

Closed economy

Perfect competition with traditional firms operating, limit pricing monopolist with a modern firm operating

Conditions for Multiple Equilibria

A big push may also be necessary when there are:

Intertemporal effects

Urbanization effects

Infrastructure effects

Training effects

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Figure 4.2 The Big Push

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Why the Problem Cannot be Solved by a Super-Entrepreneur

Super Entrepreneur?

Capital market failures

Cost of monitoring managers- Asymmetric Information

Communication failures

Limits to knowledge

Lack of any empirical evidence that would suggest this is possible

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In a Nutshell: Big Push Mechanisms

Raising total demand

Reducing fixed costs of later entrants

Redistributing demand to later periods when other industrializing firms sell

Shifting demand toward manufacturing goods (usually produced in urban areas)

Help defray costs of essential infrastructure (a similar mechanism can hold when there are costs of training, and other shared intermediate inputs)

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4.4 Further Problems of Multiple Equilibria

Inefficient Advantages of Incumbency

Behavior and Norms

Linkages

Inequality, Multiple Equilibria, and Growth

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4.5 Michael Kremer’s O-Ring Theory of Economic Development

The O-Ring Model

Production is modeled with strong complementarities among inputs

Positive assortative matching in production

Implications of strong complementarities for economic development and the distribution of income across countries

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The “O-Ring” Theory: A Simple Illustration of the basic idea

HR Department has 4 workers- 2 H-types and 2 L-types; In a simplified model let Q = qiqj

How to allocate? {HH, LL}; or {HL, LH}?

We know that H2 + L2 > 2HL because: (H–L)2 > 0

So with strong complementarity it always pays to do assortative matching

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4.6 Economic Development as Self-Discovery

Hausmann and Rodrik: A Problem of Information

Not enough to say developing countries should produce “labor intensive products,” because there are thousands of them

Industrial policy may help to identify true direct and indirect domestic costs of potential products in which to specialize by:

Encouraging exploration in the first stage

Encouraging movement out of inefficient sectors and into more efficient sectors in the second stage

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4.6 Economic Development as Self-Discovery

Three building blocks of the theory; and case examples of their reasonableness in practice:

Uncertainty about what products can be produced efficiently (evidence: India’s success in information technology was unexpected; reasons for Bangladesh’s efficiency in hats vs Pakistan’s in bedsheets is not clear)

Need for local adaptation of foreign technology (evidence: seen in cases such as shipbuilding in South Korea)

Imitation can be rapid (e.g. the spread of cut flower exporting in Colombia)

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4.7 The Hausmann-Rodrik-Velasco Growth Diagnostics Framework

Focus on a country’s most binding constraints on economic growth

No “one size fits all” in development policy

Requires careful research to determine the most likely binding constraint

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Figure 4.3 Hausmann-Rodrik-Velasco Growth Diagnostics Decision Tree

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Concepts for Review

Agency costs

Asymmetric information

Big push

Complementarity

Congestion

Coordination failure

Deep intervention

Economic agent

Growth diagnostics

Information externality

Linkage

Middle-income trap

Multiple equilibria

O-ring model

O-ring production function

Pareto improvement

Pecuniary externalities

Poverty trap

Prisoners’ dilemma

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Concepts for Review (cont’d)

Social returns

Technological externality

Underdevelopment trap

Where-to-meet dilemma

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