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Contemporary Models of Contemporary Models of Development and Development and

UnderdevelopmentUnderdevelopment

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Contemporary Models of Development Contemporary Models of Development

and Underdevelopmentand Underdevelopment New theories that help us understand

the barriers to development include

– Endogenous growth– Coordination failures– Multiple equilibria– The Big Push– O-Ring theory

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Contemporary Models of Development Contemporary Models of Development

and Underdevelopmentand Underdevelopment The new models of economic The new models of economic

development have broadened the development have broadened the scope for modeling a market in a scope for modeling a market in a developing countrydeveloping country

Departs from neoclassical economics Departs from neoclassical economics in its assumptions of perfect in its assumptions of perfect information, the relative insignificance information, the relative insignificance of externalities, and the uniqueness of externalities, and the uniqueness and optimality of equilibriaand optimality of equilibria

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The New Growth Theory: Endogenous The New Growth Theory: Endogenous

GrowthGrowth Endogenous growth theory explains

TFP “endogenously” Advances in explaining growth rate Advances in explaining growth rate

differentials across countriesdifferentials across countries New growth theories assume increasing New growth theories assume increasing

returns to capital, permit increasing returns returns to capital, permit increasing returns to scale and focus on the role of to scale and focus on the role of externalities in determining rate of return on externalities in determining rate of return on capital investmentscapital investments

Suggest an active role for public policy in Suggest an active role for public policy in increasing complementary investmentsincreasing complementary investments

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Endogenous Growth ModelsEndogenous Growth Models The models imply that a country’s LR The models imply that a country’s LR

growth rate depends on its rate of savings growth rate depends on its rate of savings and investment, not only on exogenous and investment, not only on exogenous productivity growthproductivity growth

The models use the aggregate production The models use the aggregate production

Y=AKY=AK Assume that marginal productivity of Assume that marginal productivity of

capital is constant as a result of capital is constant as a result of concurrent investment in human capital concurrent investment in human capital and R & D and R & D

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The Romer Endogenous Growth ModelThe Romer Endogenous Growth Model The model addresses technological The model addresses technological

spillovers that may be present in the spillovers that may be present in the process of industrializationprocess of industrialization

The aggregate production function is similar The aggregate production function is similar to that of Harrod-Domar model and to that of Harrod-Domar model and endogenises why growth might depend on endogenises why growth might depend on investmentinvestment

As a result of saving, investment As a result of saving, investment (knowledge/ know-how) spillovers occur (knowledge/ know-how) spillovers occur leading to higher rates of growth leading to higher rates of growth

Drawbacks of the theory/modelDrawbacks of the theory/model

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Underdevelopment as a Coordination Underdevelopment as a Coordination

FailureFailure Influential during 1990- early 2000Influential during 1990- early 2000 Emphasizes that Emphasizes that complementaritiescomplementarities between between

several conditions is necessary for economic several conditions is necessary for economic development development

Complementarities versus congestionsComplementarities versus congestions Coordination failuresCoordination failures results in (bad) results in (bad)

equilibrium in which agents are worse-off than equilibrium in which agents are worse-off than in alternative (situation of) equilibriumin alternative (situation of) equilibrium

Deep interventionsDeep interventions by the government can by the government can move an economy to a preferred equilibriummove an economy to a preferred equilibrium

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Illustration of Coordination FailureIllustration of Coordination Failure : : Multiple equilibriaMultiple equilibria

Equilibrium occurs when agents do what is best Equilibrium occurs when agents do what is best for them and when agents observe what they for them and when agents observe what they expected to observeexpected to observe

Multiple equilibria is illustrated using a S-shaped Multiple equilibria is illustrated using a S-shaped curve intersecting a 45 degree linecurve intersecting a 45 degree line

When there is multiple equilibria, we usually have a– lower stable equilibrium– higher stable equilibrium

Examples: Coordinating investment decisions in Examples: Coordinating investment decisions in a economy and Malthus population trap a economy and Malthus population trap

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Illustration of Coordination FailureIllustration of Coordination Failure : : Multiple equilibriaMultiple equilibria

Lower stable equilibrium occurs when only a few agents take a complementary action and spillovers are minimal

Higher stable equilibrium occurs at a stage when many agents have taken the complementary action that they all enjoy the positive benefits of the spillovers

Government intervention can change expectations of individuals and thus move the economy from low to high stable equilibrium

Technological availability is a necessary but not a Technological availability is a necessary but not a sufficient condition for development sufficient condition for development

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The Big Push Model Of Development The Big Push Model Of Development The big push model shows how market The big push model shows how market

failures can be mitigated by concerted public failures can be mitigated by concerted public policy policy

It is the most famous model of coordination It is the most famous model of coordination failures and it emphasizes the existence offailures and it emphasizes the existence of

increasing returns in the modern, increasing returns in the modern, industrialized sectorindustrialized sector

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The Big Push Model Of Development The Big Push Model Of Development Assumptions: Assumptions:

1.1. FactorsFactors

2.2. Factor paymentsFactor payments

3.3. TechnologyTechnology

4.4. Domestic demandDomestic demand

5.5. International supply and demandInternational supply and demand

6.6. Market structureMarket structure

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The Big Push Model Of Development The Big Push Model Of Development

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The Big Push Model Of Development The Big Push Model Of Development Other cases in which a big push may be Other cases in which a big push may be

necessary: necessary: – Intertemporal effectsIntertemporal effects– Urbanization effectsUrbanization effects– Infrastructure effectsInfrastructure effects– Training effectsTraining effects

Why the problem cannot be solved by a Why the problem cannot be solved by a super-entrepreneur?super-entrepreneur?

– Capital market failuresCapital market failures– Agency costsAgency costs– Asymmetric informationAsymmetric information– Communication failuresCommunication failures– Limits to knowledge Limits to knowledge

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Further problems of multiple equilibriaFurther problems of multiple equilibria The presence of increasing returns in modern The presence of increasing returns in modern

industries can create bad equilibriumindustries can create bad equilibrium– Inefficient advantages of incumbencyInefficient advantages of incumbency

Behavior and norms of individuals in an Behavior and norms of individuals in an economy economy

Public policy identifying linkages (forward Public policy identifying linkages (forward and backward) and targeting investment in and backward) and targeting investment in these industries could be a solution these industries could be a solution

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Kremer’s O-Ring Theory of Economic Kremer’s O-Ring Theory of Economic

Development Development Provides insights into low-level equilibrium Provides insights into low-level equilibrium

traps and explains the reasons for the traps and explains the reasons for the existence of poverty traps and why countries existence of poverty traps and why countries with low-income are caught in these trapswith low-income are caught in these traps

The theory models production with strong The theory models production with strong complementarities among inputscomplementarities among inputs

The production function assumes that output The production function assumes that output is derived by multiplying level of skill is derived by multiplying level of skill required for completing a task by the total required for completing a task by the total number of tasks number of tasks

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Kremer’s O-Ring Theory of Economic Kremer’s O-Ring Theory of Economic

Development Development The production function is characterized by

positive assortative matching positive assortative matching and therefore total output will always be high under a matching scheme

Positive assortative matching relies on two strong assumptions

– Workers are imperfect substitutes for one anotherWorkers are imperfect substitutes for one another– There is sufficient complementarity of tasks There is sufficient complementarity of tasks

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Implications of the Kremer’s O-Ring Implications of the Kremer’s O-Ring TheoryTheory

Firms tend to employ workers with similar Firms tend to employ workers with similar skills for their several tasksskills for their several tasks

Workers performing the same task at a high-Workers performing the same task at a high-skill firm earn higher wagesskill firm earn higher wages

Wages are proportionally higher in developed Wages are proportionally higher in developed countries because wages increase at an countries because wages increase at an increasing rate increasing rate

Levels of human capital investment made by Levels of human capital investment made by other workers is an important determinant of other workers is an important determinant of worker’s decision to improve her skill levelworker’s decision to improve her skill level

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Implications of the Kremer’s O-Ring Implications of the Kremer’s O-Ring TheoryTheory

Firms would worry about their Firms would worry about their productivity only if other firms are productivity only if other firms are trying to increase their qualitytrying to increase their quality

Due to O-ring effects across firms, Due to O-ring effects across firms, economy could be caught in low-economy could be caught in low-production-quality trapsproduction-quality traps

O-ring effects magnify the impact of O-ring effects magnify the impact of production bottlenecks production bottlenecks

Bottlenecks reduce worker’s expected Bottlenecks reduce worker’s expected return to investment in her skills return to investment in her skills

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Implications of the Kremer’s O-Ring Implications of the Kremer’s O-Ring TheoryTheory

Trade could mitigate bottlenecks and low Trade could mitigate bottlenecks and low levels of skills.levels of skills.

The choice of technology depends on skill The choice of technology depends on skill level of workers. level of workers.

Developed countries have high skilled Developed countries have high skilled workers and therefore large specialized workers and therefore large specialized production processes.production processes.

International brain drain occurs because a International brain drain occurs because a worker from a developing country receives a worker from a developing country receives a higher wage for the same skills.higher wage for the same skills.

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Domestic Problems and Policies Domestic Problems and Policies

Statement of the problemStatement of the problem Relative importance of the problem in Relative importance of the problem in

developing countriesdeveloping countries Possible development goals and Possible development goals and

objectives- equity vs growth objectives- equity vs growth Role of economics and economic Role of economics and economic

principles principles Policy alternatives and consequences- Policy alternatives and consequences-

open for discussionopen for discussion