Economic development CH 4

Chapter 4: Contemporary Models of Development and .

. Underdevelopment

Coordination failure A
situation in which the inability
1. Underdevelopment as a Coordination Failure of agents to coordinate their
• A newer school of thought on problem of economic development. behavior (choices) leads to an
• Coordination failures occur when agents’ inability to coordinate their outcome (equilibrium) that
actions leads to an outcome that makes all agents worse off. leaves all agents worse off
• This can occur when actions are complementary. than in an alternative situation
• Actions taken by one agent reinforces incentives for others to take that is also an equilibrium.
similar actions .

2. Multiple Equilibria: A Diagrammatic Approach

• Often, these models can be diagrammed by graphing an S-shaped function and the 45º line.
• Equilibria are:
Complementarity An action
- Stable: function crosses the 45º line from above.
taken by one firm, worker, or
- Unstable: function crosses the 45º line from below.
organization that increases the
For example, the price a farmer can hope to receive for his produce incentives for other agents to
depends on the number of middlemen who are active in the region, which take similar actions.
in turn depends on the number of other farmers who specialize in the same Complementarities often involve
product. investments whose return
depends on other investments
being made by other agents.

By Dalia Elaraby
Economic development CH 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
Big push A concerted,
1- One factor of production.
economy-wide, and typically
2- Two sectors.
public policy–led effort to
3- Same production function for each sector.
initiate or accelerate economic
4- Consumers spend an equal amount on each good.
development across a broad
5- Closed economy.
spectrum of new industries and
6- Perfect competition with traditional firms operating, limit
skills.
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.

Middle-income trap A condition in

which an economy begins
development to reach middle-
income status but is chronically
unable to progress to high-income
status. Often related to low
capacity for original innovation or
for absorption of advanced
technology, and may be
compounded by high inequality.

Asymmetric information
• Why the Problem Cannot be Solved by a Super- Entrepreneur
A situation in which one
Super Entrepreneur? party to a potential
transaction (often a
- Capital market failures. buyer, seller, lender, or
- Cost of monitoring managers Asymmetric Information. borrower) has more
- Communication failures. information than another
- Limits to knowledge. party.
- Lack of any empirical evidence that would suggest this is possible.

By Dalia Elaraby
Economic development CH 4

4. Further Problems of Multiple Equilibria Multiple equilibria A condition in

• Inefficient Advantages of Incumbency. which more than one equilibrium
• Behavior and Norms. exists. These equilibria sometimes
• Linkages. may be ranked, in the sense that
• Inequality, Multiple Equilibria, and Growth. one is preferred over another, but
the unaided market will not move
the economy to the preferred
outcome.
5. Michael Kremer’s O-Ring Theory of Economic
Development O-ring model An economic
• The O-ring midel: model in which production
- Production is modeled with strong complementarities among functions exhibit strong
inputs. complementarities among
- Positive assortative matching in production. inputs and which has
• Implications of strong complementarities for economic development broader implications for
and the distribution of income across countries. impediments to achieving
• The O-ring theory places emphasis on skill complementarities. economic development.

Poverty trap A bad equilibrium

6. Economic Development as Self-Discovery for a family, community, or
• Hausmann and Rodrik: A Problem of Information. nation, involving a vicious circle
• Not enough to say developing countries should produce “labor in which poverty and
intensive products,” because there are thousands of them. underdevelopment lead to
• Industrial policy may help to identify true direct and indirect more poverty and
domestic costs of potential products to specialize in, by: underdevelopment, often from
- Encouraging exploration in first stage. one generation to the next
- Encouraging movement out of inefficient sectors and into
more efficient sectors in the second stage.
• Three building blocks of the theory; and case examples of their reasonableness in practice:
1- Uncertainty about products can produce efficiently.
- (evidence: India ’ s success in information technology was unexpected; reasons for Bangladesh ’
in hats vs Pakistan ’ s efficiency s in bedsheets is not clear)
2- Need for local adaptation.
- (evidence: seen in cases such as shipbuilding in South Korea).
3- Imitation can be rapid.
- (e.g. the spread of cut flower exporting in Colombia).

By Dalia Elaraby
Economic development CH 4

7. The Hausmann-Rodrik-Velasco Growth Diagnostics Framework

• Focus on a country’s most binding constraints on economic growth.
Growth diagnostics A
• No “one size fits all” in development policy.
decision tree framework for
• Requires careful research to determine the most likely binding constraint
identifying a country’s most
binding constraints on
economic growth.

Social returns The profitability of

an investment in which both costs
and benefits are accounted for
from the perspective of the
society as a whole.

By Dalia Elaraby
Economic development CH 4

Revision questions

1. A subsistence economy is
a. A very low income economy.
b. An economy in which people make what they consume.
c. An economy in which people receive food for pay.
d. All of the above.
2. A good definition of the meaning of development is the
a. Elimination of absolute poverty.
b. Improvement in the quality of life.
c. fulfillment of the potential of individuals
d. all of the above.
3. An example of an upper-middle income country is
a. India.
b. Brazil.
c. Indonesia.
d. Nigeria.
4. The number of units of developing country currency required to purchase a basket of goods and
services in a developing country that costs one dollar in the U.S. is given by
a. GNP price deflator.
b. Human Development Index ranking.
c. Purchasing power parity.
d. The exchange rate.
5. The false paradigm model attributes lack of development to
a. Inadequate attention to price iincentives
b. inappropriate advice from rich country economists.
c. low levels of savings and investment.
d. A lack of government regulation.
6. A situation in which government intervention in the economy worsens the economic
a. Neoclassical failure.
b. socialism.
c. government failure.
d. dependency revolution.
7. The big-push theory argues that coordination failures may arise because of
a. externalities.
b. technological externalities.
c. lack of human capital.
d. all of the above.
8. The O-ring theory places emphasis on
a. of the labor force.
b. skill complementarities.
c. purchases of machinery and equipment by firms.
d. none of the above.

By Dalia Elaraby