Chapter 4AContemporary Models of Development and

Underdevelopment

4.1 Underdevelopment as a Coordination Failure0A newer school of thought on problems of economic development0Coordination failures occur when agents’ inability to coordinate their actions leads to an outcome that makes all agents worse off.0This can occur when actions are complementary, i.e., 0Actions taken by one agent reinforces incentives for others to take similar actions

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4.2 Multiple Equilibria: A Diagrammatic Approach

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

0 Equilibria are0 Stable: function crosses the 45º line from above0 Unstable: function crosses the 45º line from below

Figure 4.1 Multiple Equilibria

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4.3 Starting Economic Development: The Big Push

0 Sometimes market failures lead to a need for public policy intervention

0 The Big Push: A Graphical Model, 6 assumptions0 One factor of production0 Two sectors 0 Same production function for each sector0 Consumers spend an equal amount on each good0 Closed economy0 Perfect competition with traditional firms operating, limit pricing monopolist with a

modern firm operating

0 Conditions for Multiple Equilibria0 A big push may also be necessary when there are:

0 Intertemporal effects0 Urbanization effects0 Infrastructure effects0 Training effects

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Figure 4.2 The Big Push

Why the Problem Cannot be Solved by a Super-EntrepreneurSuper 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

0Raising total demand0Reducing fixed costs of later entrants0Redistributing demand to later periods when other

industrializing firms sell0Shifting demand toward manufacturing goods (usually

produced in urban areas)0Help 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

0 Inefficient Advantages of Incumbency0Behavior and Norms0Linkages0 Inequality, Multiple Equilibria, and Growth

4.5 Michael Kremer’s O-Ring Theory of Economic Development0The O-Ring Model

0 Production is modeled with strong complementarities among inputs0 Positive assortative matching in production

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

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4.6 Economic Development as Self-Discovery0 Hausmann and Rodrik: A Problem of Information0 Not enough to say developing countries should produce “labor intensive

products,” because there are thousands of them0 Industrial policy may help to identify true direct and indirect domestic

costs of potential products to specialize in, by:0 Encouraging exploration in first stage0 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

0Three building blocks of the theory; and case examples of their reasonableness in practice:0 Uncertainty about products can produce 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)

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

0 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

0Focus on a country’s most binding constraints on economic growth

0No “one size fits all” in development policy0Requires careful research to determine the most likely

binding constraint

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The Hausmann-Rodrik-Velasco Growth Diagnostics Framework;1

1. Specialization – specifics beyond comparative advantage, i.e. labor-intensive activities is hardly enough. The idea behind “self-discovery” --- figuring out what the impediments to growth are.

2. The building towards self-discovery recognizes 3 building blocks:

a. Uncertainty about what a developing country can produce cost-effectively and also profitably.

b. Need for the local adaption of imported technology to prevent easy entry – might require local reverse engineering.

c. With (a) and (b) in place, “imitation” is very rapid. It shows as many countries who are labor-intensive will produce different labor intensive products.

3. Growth Diagnostics (GD)– once efficient investment & entrepreneurship are accepted for economic growth & development, there is need for country-specific binding constraints. GD is a decision tree for identifying the most binding constraints for each country currently and in future.

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The Hausmann-Rodrik-Velasco Growth Diagnostics Framework;2

1. Focus on a country’s most binding constraints on economic growth & alleviating pressing constraints.

2. Suppose a country is constrained by low level of private investment & entrepreneurship. The decision tree identifies the-how-to-solve the problem. The initial causes could be (a) low return to economic activity and (b) high cost of finance.

3. Not that the solution to these binding constraints are so many and multi-dimensional. This shows that No “one size fits all” in development policy, i.e. GD is a much more broader approach to development policy that complements econometric modelling.

0Not simple to find the binding constraint. Uncertainty leads to probabilistic assessments

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Figure :Hausmann-Rodrik-Velasco Growth Diagnostics Decision Tree

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The Hausmann-Rodrik-Velasco Growth Diagnostics Framework;3

Growth diagnostics1. Key constraint is inadequacy of public goods especially on 2 emerging

sectors (tourism & light manufacturing).

2. Financial sector constraints –credit and loans

SignalsProblem of “arriving late” for public eventsIllustrates the idea of multiple equilibria --- moving from one inferior equilibrium to a superior one