ECONOMIC DEVELOPMENT (MIDTERM) to progress to high-income status that is often due to low capacity for

innovation or absorption of advanced technology or compounded by

Prelim Lecture Notes 16 high inequality. Examples of complementarity is the presence of firms
using specialized skills and availability of workers who have acquired
Contemporary Models of Development and Underdevelopment
those skills. However, firms will not enter a market if workers do not
Development is both possible and difficult to achieve as possess the skills the firm needed and workers will not acquire the
such improved understanding of the impediments and catalysts of skills if there is no firm that will employ them.
development is of utmost importance. In some cases, ideas of classic
Coordination problem can be illustrated by Where-to-meet
theories of development have been formalized and, in the process,
Dilemma a situation in which all parties would be better off
their logical structure and their significance for policy have been
cooperating than competing but lack information about how to do so.
clarified and refined and the analysis has also led to entirely new
If cooperation can be achieved, there is no subsequent incentive to
insights into what makes development so hard to achieve but also
defect or cheat.
possible to achieve that makes the study of economic development
important. Theory, indeed, guides us to think systematically about
how to organize our efforts to achieve development.
Prelim Lecture Notes 17
The new models of economic development show that
development is harder to achieve since it faces more barriers than Big Push Model
had been recognized previously. The new models have already
One of the best-known coordination failures model in the
influenced development policy and modes of international assistance.
development literature is Big Push model pioneered by Paul
The contemporary models of development and underdevelopment
Rosenstein-Rodan, who first raised some of the basic coordination
concludes with a framework for appraising the locally binding
issues.
constraints (the one limiting factor that if relaxed would be the item
that accelerates growth or that allows a larger amount of some other The big push is a model of how the presence of market
targeted outcome) on the ability of a developing nation to close the failures can lead to a need for a concerted economy-wide and
gap with the developed countries. probably public-policy-led effort to get the long process of economic
development under way or to accelerate it. Coordination failure
Newer theories in 1990s and early 20th, have emphasized
problems work against successful industrialization, a counterweight
complementarities (an action taken by one firm, worker, or
to the push for development. A big push may not always be needed,
organization that increases the incentives for other economic agents
but it is helpful to find ways to characterize cases in which it will be.
to take similar action – often it involves investments whose return
Many development economists have concluded that several market
depends on other investments being made by other economic agents)
failures work to make economic development difficult to initiate, like
between several conditions necessary for successful development.
pecuniary externalities which are spillover effects on cost or
Economic agents are those economic actor such as firm, worker,
revenues.
consumer, government that chooses actions so as to maximize an
objective. These newer theories often highlight the problem that Market Failures arises because it is not possible for the
several things must work well enough, at the same time, to get market to correctly weigh costs and benefits in a situation in which
sustainable development underway. Models of development that some of the costs are completely unaccounted for.
stress complementaries are related to some of the models used in the
endogenous growth approach but the coordination failure approach Demand-side market failures arise because it is impossible
though evolved relatively independently and offers some significant in certain cases to charge consumers what they are willing to pay for
and distinct insights. Coordination failure is situation or a state of the product. (ex. Benefits from fireworks display)
affairs in which the ability of agents to coordinate their behavior
Supply-side market failures arise in situations in which a
(choices) leads to an outcome (equilibrium) that leaves all agents
firm does not have to pay the full cost of producing its output. (ex.
worse off than in an alternative situation that is also an equilibrium.
cost of smoke pollution from factory machines)
Coordination failure may occur even when all agents are fully
informed about the alternative equilibrium: they cannot get there An externality occurs when some of the costs or the
because of coordination difficulties, sometimes because people benefits of a good or service are passed onto or spill over to someone
different expectations and sometimes because everyone is better off other than the immediate buyer or seller.
waiting for someone else to make the first move.
Pecuniary externality is a negative or positive spillover
Complementaries in which an action taken by one firm, effect on an agent’s costs or revenue.
worker, organization, or government increases the incentives for
other agents to take similar action such network effects are common. Negative externalities cause supply-side market failures,
Such network effects are also common in analyses of frontier these failures happen because producers do not take into account the
technologies in developed countries, in particular in information costs that their negative externalities impose on others.
technologies such as the use of operating system, word processing
Positive externalities cause demand-side market failures,
program, instant messaging, and other software depends how many
these failures happen because market demand curves in such cases
users also adopt it. This framework can also be used in analyses of
fail to include the willingness to pay of the third parties who receive
Middle-income trap which is a condition in which an economy begins
the external benefits caused by the positive externalities.
development to reach middle-income status but is chronically unable
 so, because the value of output will be higher with two productive
workers than with one low and one high-productivity worker. Skill
Some conditions that the need for a big push can result from: matching is more advantageous than skill mixing.
a. Urbanization effect- when some traditional cottage Some implications of the O-ring theory:
industry is rural and the increasing-returns-to-scale
manufacturing, urban dwellers’ demand may be more 1. Firms tend to employ workers with similar skills for their
concentrated in manufactured goods. As such, one needs a various tasks.
big push to urbanization to achieve industrialization.
2. Workers performing the same task earn higher wages in a
b. Infrastructure effects – in using infrastructure, such as high skills firm than in low-skill firm.
bridges, roads, airports, ports, an investing firm modern
firm helps defray the large fixed cost of that infrastructure. 3. If workers can improve their skill level and make such
The existence of infrastructure helps investing firms lower investments, and if it is in their interest to do so, they will
their own costs. Then investing firms thereby contribute consider the level of human capital investments made by
indirectly to lowering the cost of other firms like lowering other workers as a component of their own decision about
the average cost of infrastructure use. As such, there is a how much skill to acquire.
need for a big push for infrastructure. 4. O-ring effects magnify the impact of local production
c. Training effects- the presence of underinvestment in bottlenecks because such bottlenecks have a multiplicative
training facilities because entrepreneurs know that workers effect on other production.
they train may be enticed away with higher wages offered 5. Bottlenecks also reduce the incentive for workers to invest
by rival firms refused to pay these training costs. There is in skills by lowering the expected return to these skills.
also less demand for workers to undergo training because
of not knowing which skills are they going to acquire. In this
case, a big push for mandatory public education is
necessary.

Prelim Lecture Notes 18

O-Ring Theory

An innovative and influential model that provides important

insights into low level equilibrium traps was provided by Michael
Kremer. The notion is that modern production requires that many
activities be done well together for any of them to amount to a high
value. It is a form of strong complementarities and is a natural way of
thinking about specialization and the division of labor which along
with economies of scale is a hallmark of developed economies in
general and particularly industrial. Michael Kremer’s O-Ring theory
key feature is it models production with strong complementarities
among inputs. The O-ring models explains not only the existence of
poverty traps but also the reasons countries in such traps may have
exceptionally low incomes compared with high income countries.

O-ring production function is a production function with strong

complementarities among inputs, based on the products of the input
qualities.

Example: positive assortative matching

It means that workers with high skills will work together and
workers with low skills will work together. If to compare countries
using the model, this type of matching means that high-value
products will be concentrated in countries with high-value skills. In
this model, everyone would like to work with the more productive
workers because if your efforts are multiplied by those of someone
else, you will be more productive when working with a more
productive worker. A firm with a higher-productivity worker can
afford to pay a higher wage and has the incentive to bid higher to do