Econ 313 Chapter 4-Contemporary Models of Development and Underdevelopment
Econ 313 Chapter 4-Contemporary Models of Development and Underdevelopment
Econ 313 Chapter 4-Contemporary Models of Development and Underdevelopment
Underdevelopment
- new models show that development harder to achieve, facing more barriers than
previously
- broadened scope of modeling market economy in a developing-country context
- one major theme is problems of coordination among agents\other themes: formal
exploration of situations in which increasing returns to scale, finer division of
labor, availability of new economic ideas or knowledge, learning by doing, and
monopolistic competition or other forms of industrial organzation other than
perfect competition predominate and special long-run growth (not just static
efficiency) are separately or jointly important
- includes economics of imperfect information
New Growth Theory: Endogenous Growth
Motivation for new growth theory
- no real ‘growth’ in traditional theory, just converge to zero growth without
‘shocks’, any growth is temporary phenomema
- GNI increases not in labor or capital are in 3rd category: Solow residual
- This residual responsible for 50% growth in industrializaed nations
- Neoclassicalists credit exogenous independent technological process
o However impossible to analize determinant of technological advance
because independent of economic decisions and doesn’t explain
discrepancies in residuals across countries with similar technology
- Neoclassical free market approach failed in developing country economic growth
- Developing world capital flows (from poor to rich) prompted endogenous growth
theory or new growth theory
- Models hold GNI growth to be a natural consequence of long-run equilibrium and
determined by system governing the production process
- Seek to explain factors that determine the size of ‘Y’, the rate of growth of the
GDP
- Differs from neoclassical by discarding assumption of diminishing marginal
returns to capital investments, permitting increasing returns to scale in aggregate
production, and frequently focusing on the role of externalities in determining rate
of return on capital investments
- Possibility exists that investments in physical and human capital can generate
external ecnomies and productivity improvements that excees private gains by an
amount sufficient to offset diminishing returns
- Direct implications for growth in conflict with traditional theory
o No force leading to equilibration of growth rates across closed economies;
national growth rates remain constant and differ across countries
depending on national savings rates and technology levels
o Per capita income levels in poor need not catch up with rich countries
o Prolonged recession in one country can lead to permanent increase in
income gap
- Endogenous help explain anomalous international flows of capital that exacerbate
wealth disparities between developed and developing countries
- Developing countries get low levels of complementary investments such as
education, infrastructure, R&D
- Unlike Solow model, new growth theories explain technological change as
endogenous outcome of public and private investments in human capital and
knowledge-intensive industries
- Suggest active role in public policy in promoting econ dev through direct and
indirect investments in education and knowledge industries (software and
telecom)
Romer Model
- addresses technological spillovers in process of industrialization
- assumes growth processes derive from firm or industry level
- industry individually produces with constant returns to scale so model is
consistent with perfect competition but departs from solow by assuming that
economy wide capital stock ‘K’ posiytively affects output at the industry level, so
may be increasing returns to scale at economywide level
- ‘knowledge’ in firm’s capital stock is a public good
- model treats learning by doing as ‘learning by investing’
- spells out reason why growth might depend on rate of investment
- Formula:
resulting growth rate for per capita income in the economy would be
where ‘g’ is output growth rate and ‘n’ is population growth rate, without
spillovers as in solow model with constant returns to scale ‘B=0”, and so per
capita growth would be zero (without technological progress)
- Look back at equation please!!
Criticisms of the New Growth Theory
- remains dependent on traditional assumptions that are inappropriate for LDC
rconomis
o e.g. assumes no single sector of production/all sectors symmetrical\
- LDC economic growth impeded by poor infrastructure, inadequate institutional
structures, imperfect capital and goods markets
- Fails to explain low rates of factory capacity utilization in low income countries
where capital is scarce
- Allocational inefficiencies common in transition from traditional to
commercialized markets
- Theory over-emphasizes long-term growth rate
- Empirical studies offer only limited support
Underdevelopment as a Coordination Failure
- newer theories emphasize complementarities btwn conditions necessary for
successful dev: several factors must work well at same time to get sustainable dev
- when present, an action by one party increases incentives for other agents to take
similar action
- coordination failure: agents’ inability to coordinate behavior leads to outcome
where all agents worse off than in alternative situation
- complementaries involved investments whose return depends on other
investments being made by other agents
- big push where production decisions by firms are mutually reinforcing
- O-ring model where value of upgrading skills depends on other agents’ upgrading
- Example is presence of firms using specialized skills and availability of workers
with these skill;s
- Coordination problem leaves economies stuck in bad equilibrium and also
behaviour to modern ‘way of life’
- Commercialization of agriculture include specialization and fine div of labour, but
cant achieve either fast enough in LDC without effective middleman to sell
distant markets the country’s product
- Without this there is little incentive to specialize and need subsistence agri
underdevelopment trap
- Complementaries=chicken and egg problem “skills or demand for skills?”
- Answer is complementary investments need to come at same time (coordination)
- Governments may contribute to problem as well as solution with corrupt leaders
- Deep interventions move an economy to a preferred equilibrium or higher
permanent rate of growth
- Much of economics, complementaries not present and have pressure and
counterpressure like congestion
o Too many people fishing in a lake, more fishers try to move to another
lake
- However, economic development has joint externalities: underdev begets
underdev, while sustainable dev stimulates further dev
- Where to meet dilemma illustrates coordination problems. (communication poor)
Multiple Equilibria : A Diagrammatic Approach
Multiple equilibria-a condition in which more than one equilibrium exists however
the market can not move to the preferred one without government aid ( in forms of
policies and reforms)
In a situation of multiple equilibria the benefits an agent receives by taking an action
depends on how many other agents are expected to follow that action. (reflected by
the S shaped function)
In a multiple equilibria diagram the equilibriums are found at the intersection points
between the S shaped curve ( privately rational decision function) and the 45° line.
o Because at each of these points agents observe what they had expected. There
is no reason for firms to adjust their expectations any more as all agents are
doing what is best for them. This is point can be considered as the profit
maximizing level.
The S function and the 45° line intersect various times:
o Stable equilibria: a stable equilibrium can be identified when the S function
intersect the 45° line from above. (D1 and D3 on figure 4.1) These are stable
because if any expectations were changed, agents would increase or decrease
their investment levels in a way that would bring the equilibrium back to its
original point, ( back to D1 or D3).
o Unstable equilibria: can be identified when S function intersect the 45° line
from below. ( the middle point D2 on figure 4.1). This point is unstable
because if expectations were to change, agents would change their levels of
investment, however the new equilibrium would not return to its original point
(D2) but will move to D1 if levels of investment decreased, or move to D3 if
levels of investment increased.
The rate of the S shaped curve depend on the agents taking action. When enough
agents have invested, the snowball effect takes action, and many agents provide
spillover benefits to other participants; the effect is an increasing rate of the S curve.
Consequently once most investors have obtained their most important gains, the rate
of increase starts to slow down.
Pareto improvement- is when moving to a higher ranked equilibrium giving higher
utility to everyone, rather than the equilibrium with fewer users
A problem in economic development concerns coordinating investment decisions
when rate of return of an investment depends on the presence of other investments.
o All are better off with more investments, but the market may not be able to get
to that situation without any gov policies.
o This issue with investment coordination gives rise to gov-led strategies for
industrialization.
Market forces can bring us to one of the multiple equilibria, but does not assure the
best equilibria is achieved and they don’t offer mechanisms to leave the bad equilibria
for a better one.
Starting Economic Development: The Big Push
- people do not have enough incentives to put new tech to work.
- Perfect comp does not hold under conditions of increasing returns-to-scale but
industrial revolutions, taking advantage of returns to scale is key
- Conclude that market failures work to make economic development difficult to
initiate: Pecuniary externalities which are spillover effects on costs/revenues
- Big push coordination model assumes economy not able to exportsubsistence
industriesworkers have no money to buy goods
- Profitability of 1 factory depends on opening of another (circular causation)
- Need to for a concerted economywide and probably public-policy led effort
The Big Push: a Graphical Model
- assumptions
o factors- only one factor of production, labor
o factor payments
traditional sector receive a wage of ‘1’ and modern sector receive
wage > ‘1’
may be a compensation for disutility of modern factory types of
work, if so in equilibriu workers would reveice no net itulity
benefits from switching sectores during industrialization, but if
economic profits generated= Perato Improvement (avg income
rise)
o technology
‘N’ types of product
traditional sector, one worker=one unit of output and constant
returns to scale
modern sector has increasing returns to scale
fixed cost= number of workers ‘F’, there is a linear production
function in which workers are more productive than in traditional
sector, labor requirements in any sector take the form L=F+cQ
where c<1 is the marginal labor required for an extra unit of
output, modern workers are more productive but only if a
signigicant cost is paid up front. Fixed cost is amortized over more
units of output, avg cost declines
o domestic demand
assume each good receives constant and equal share of
consumptionout of national income
o international supply and demand
assume economy is closed
conclusions will remain when trade is allowed, advantages to
having a domestic market: initial economies of scale and learning
to achieve sufficient quality
o market structure
assume perfect competition in traditional sector
free entry and no economic profits, price of each good is 1
at most, one modern sector firm can enter each market, limitation
is a consequence of increasing return to scale,
as they face unit elastic demands the monopolist will also charge a
price of 1 if it decides to enter the market
they will monopolize entire market but will also produce same
queantity that was produced by the traditional producers because
firm is the only one using modern technique
Conditions of Multiple Equilibria
If in a traditional economy with no modern production, a potential producer with
modern technology (fixed cost and increasing returns) considers entering the market
he will pay attention to 2 considerations:
1. How much more efficient the modern sector is than the traditional sector
2. how much higher wages are in the modern sector than in the traditional sector
By assumption all sectors are symmetrical. So if a modern firm finds it profitable to
enter in a sector, the same incentive will be present in all sectors. The whole economy
will than industrialize through market forces.
With a relatively low modern wage ( W1 in figure 4.2), revenues exceed costs (seeing
that W1 is below A in figure 4.2, A= the output the modern firm will produce if it
enters the market), and the modern firm will pay its fixed cost (F) and enter the
market.
o In general modern firms will enter the market if they encounter themselves
with lower fixed cost, or lower marginal labor requirements, or if it pays
lower wages.
o With the increase in the number of firm investment there is also an increase in
demand. This increase in demand is high enough that production increases
from point A to B.
If the wage bill line is W2, in between point A and B, a modern firm would not enter
on its own in the market because it would encounter losses (W2 is above point A).
However if modern firms enter in each market then wages are increased to the
modern wage in all markets, and income expands (now at point B).
At wage W2, point B is profitable after industrialization as it stands above W2.
o these modern firms cant rise their prices higher than 1 because traditional
techniques still exist and would be more profitable with a price higher than 1.
At wage W2, there are 2 equilibria:
1. When producers with modern techniques enter all markets, and profit, wages
and output are higher than before (from point A to B in figure 4.2)
2. When no modern producer enters and wages and output remain lower. (stays
at point A)
o Equilibrium 1 is better however the market will not get there on its own. State
policies will be needed.
It is not necessary for all sectors to industrialize to get the sufficient push for some to
do so. Only necessary that a sufficient number industrialize to generate enough
National Income to make industrialization minimally profitable.
There are cases of semi-industrialization in which benefits or costs accumulate in
different proportions to different sectors.
o This can happen if the level of foxed cost decreases the more sectors
industrialize, as there are local examples from which to learn, “Learn by
watching”.
- One of the most prominent features of this type of production function is called
positive assortative matching
o Meaning workers with high skills will work with others with high skills
and those will low will work with others will low skill
o When used to compare economies the model dictates that high value
products will be concentrated in countries with high-value skills
o This can be seen if we imagine a four person economy
Supposed this economy has two high-skill workers (qh) and two
low-skill workers (ql)
The 4 workers can be arranged either as matched skill pairs or
unmatched
Total output will always be higher under a matching scheme
because qh2 + ql2 > 2qhql
(see top of 181 if further explanation is required)
- This generalized to larger number of workers in the firms and the economy
- Result: workers sort out by skill level
- Because the total value is higher when skilled matching takes place, the firm that
starts with high-productivity workers can affords to bid more to get additional
high-productivity workers (profitable to do so)
- The high-productivity workers pair off (it is more advantageous for them to work
together), are out of the picture and the less productive workers are then stuck
with each other
- The result is that some firms and workers, even an entire low-income economy,
can fall into a trap of low skill and low productivity, while others escape into
higher productivity
EX:
- Suppose there are 6 workers
o 3 have q=0.4 and are grouped together in equilibrium
o the other 3 have q=0.8
o Now suppose that the q of one of the workers in the first firm rises from
0.4 to 0.5 (result of training)
o And suppose the q of one of the workers in the second firm rises from 0.8
to 1.0
o In each case we have a 25% increase in the quality of the worker
o You might expect that a 25% increase in the quality of one worker leads to
a 25% increase in output quality in both cases
o BUT when starting from a higher quality level, that 25% clearly translates
into a much larger point increase
The first firm goes from (0.4)(0.4)(0.4) = 0.064 to (0.4)(0.4)(0.5) =
0.80,
a difference of 0.016 (25%)
The second firm we move from (0.8)(0.8)(0.8) = 0.512 to (0.8)
(0.8)(1) = 0.64,
the change in this case is 0.128 (again 25%)
The point value, however, is eight times greater for the second firm
- If a firm can increase quality in percentage terms at contact marginal cost, or even
not too quickly rising cost, there is a virtuous circle in that the more you upgrade
overall the more value you obtain by doing so
- This model is consistent with competitive equilibrium
- The positive assortative matching relies on rather strong assumptions. Two points
of the model are crucial:
o (1) Workers must be sufficiently imperfect substitutes for each other.
Why?
Suppose they were perfect substitutes
ie: two skills levels, ql and qh=2ql, so every qh worker can be
replaces by two ql workers with no change
Thus the qh workers will be paid twice the amount the ql workers
are paid
We can not predict what combination of worker skills a
firm/economy will use so we learn nothing about low-skill level
equilibrium traps
o (2) We must have sufficient complementarity of tasks. Why?
Suppose there are two tasks indexed by g and h but with no
complementarity between them.
Suppose that our qh worker is hired for g task, and ql worked is
hired for h task then,
F(qhqL) = g(qh) + h(ql)
Here skills are imperfect substition (only one type of worker can
be hired for each task)
BUT because tasks are not complementary the optimal choice of
skill for g task is independent of that of h task, and not strategic
complementaries are present
Conclusion
- Sometimes firms and other econ agents will be able to coordinate to achieve a
better equilibrium on their own, but in many cases govt policy and aid will be
necessary to overcome the cycles of underdevelopment
- The analysis of coordination failure problems shows that the potential for market
failure, especially as it affects the prospects for economic development is broader
and deeper than had been fully appreciated in the past
o Coordination failures that may arise in the presence of complementarities
highlight potential policies for deep interventions that move the economy
to a preferred equilibrium, or permanent rate of growth that can be self-
sustaining
o The prospect of deep interventions can mean that the costs of
implementing policy can be reduced and that carefully targeted
development assistance could have more effective results
- With deep interventions, the potential costs of a public role become much larger
o Bad policy can even initiate a move to a worse equilibrium than a country
began with
- Both govt failure and market failure (including coordination problems and
information externalities) are real, but public and private sector contributions to
development are also vital
- Thus we need to work toward the development of institutions in which actors in
the public and private sectors have incentives to work productively together
- The Growth diagnostics tool is useful for domestics and intl analysts who start
with a detailed understanding of a developing country (helpful in indentifying
binding constraints on national growth and the policy priorities to address them)
Case Study
- From 1978 to 2006 the economy of China grew at an average rate (approx 9% a
year)
- China’s capita per income by 2006 was more than 5 times higher than 1978
- Also experienced one of the worlds most dramatic decrease in poverty (number of
poor falling from 53% in 1981 to 8% in 2001)
- The roots of this success remain disputed
- Hailed as an exampled of the benefits of markets, trade and globalization
- Manufacturing exports are key to China’s success
- Also adopted active industrial policies pushing exports of increasingly higher skill
and tech. content
- Started its rapid growth around 1980, a decade before significant trade
liberalization
- Less privatization of state owned enterprises than in most developing countries