Chapter 4 - Todaro & Smith (2015)

Chapter 9 – De Janvry & Sadoulet (2016)

Contemporary Models of Development

and Underdevelopment

Lucia Piscitello, 23 March, 2021

Dipartimento di Ingegneria Gestionale

 Contemporary models

• Behavioural determinants of growth: the production,

availability and use of technology are significantly influenced by
structural considerations, but, ultimately, it is human behaviour
that determines innovation, adoption and diffusion.

• The new research has broadened considerably the scope for

modeling a market economy in a developing country context:

– Formation of expectations

– Coordination among economic agents

 Expectations
• Expectations about the behaviour of others can strongly
influence individual investment decisions (e.g. when one is
confident about the market potential for the development or use
of a technology, one is more likely to move forward, accepting
risks in anticipation of likely rewards)

• How expectations are determined and how they influence

behaviour remains incompletely understood

• The assumption of pure rationality in the formation of

expectations, so fashionable before the entry of psychology in
economics, is insufficient to explain decisions (consumption,
investment, saving)
 Basu K., Weibull J. (2003): Punctuality: A
cultural trait as equilibrium

Estimates suggested that

Ecuador lost between 4% and
10% of its GDP due to chronic
lateness
• If a social movement to
change expectations about
punctuality can be made to
work, something similar
might be tried around the
world for fixing even more
pernicious problems, e.g.
public corruption
 Basu K., Weibull J. (2003): Punctuality: A
cultural trait as equilibrium
• A newspaper was publishing a
list each day of officiales who • A popular notice for meeting
rooms. On the one side:
are late for public events
• «Come in: you are on time».
• A popular poster for the
campaign against lateness • When the meeting begins at
the scheduled time, it is
described the disease and said
turned around to the other
«Treatement: inject yourself side:
each morning with a dose of • «Do not enter: The meeting
began on time»
responsibility and discipline.
Recommendation: plan,
organize activities and repair
your watches
Underdevelopment as a Coordination
Failure

• Many newer theories in the 1990s and early 2000s have

emphasized complementarities between several conditions
necessary for successful development

• Several things should work well enough at the same time

• In many important situations, investments must be undertaken

by many agents to get results that are profitable for any agent
 Underdevelopment as a Coordination
Failure
• Coordination problems are illustrated by the where-to-meet
dilemma: a situation in which all parties would be better off
cooperating than competing but lack information about how to
do so. If cooperation can be achieved, there is no subsequent
incentive to defeat or cheat.
• Prisoners’ dilemma: a situation in which all parties would be
better off cooperating than competing but once cooperation has
been achieved, each party would gain the most by cheating,
provided that others stick to cooperative agreements – thus
causing any agreement to unravel
• https://www.youtube.com/watch?v=t9Lo2fgxWHw
 The Prisoners’ Dilemma

Red\Blue Not confess Betray

Not confess 1,1 3,0

Betray 0,3 2,2

Nash
equilibrium
Outcomes = years in prison
Pareto
equilibrium
 Underdevelopment as a Coordination
Failure

• Coordination failure is a state of affairs in which agents’ inability

to coordinate their behavior (choices) leads to an outcome
(equilibrium) that leaves all agents worse off than in alternative
situation that is also an equilibrium.

• Even when all agents are fully informed about the preferred
alternative equilibrium (they simply cannot get there because of
difficulties of coordination)
 The multi-industry investment game

3 sectors: coal, steel, railroads

- Each industry is composed of one firm, with identical costs,
prices, and capacity
- Fixed investment cost of 100 LCU (local currency units) which is
wasted if any of the other industries do not invest
- The payoff for each industry, if the other two invest, is 50LCU.
In this case:
Steel Steel

Invest Withhold Invest Withhold

Coal

Invest 50,50,50 -100,0,-100 Invest -100,-100,0 -100,0,0

Withhold 0,-100,-100 0,0,-100 Withhold 0,-100,0 0,0,0

Railroad invest Railroad withhold investment

 The multi-industry investment game

2 equilibria: three-way mutual investment (50,50,50), or no

investment (0,0,0)

In any other situation, at least one party will opt out of investment,
driving the solution to the no-investment equilibrium

Solving a coordination game (with 2 sectors):

Steel
Invest Withhold
Coal

Invest 50,50 -100,0

Withhold 0,-100 0,0
 Underdevelopment as a Coordination
Failure

• When complementarities are present:

– Actions taken by one agent reinforces incentives for others to

take similar actions
– Investments’ returns may depend on other investments
being made by other agents (e.g. Model of Big Push, in which
production decisions by modern-sector firms are mutually
reinforcing; O-ring model, in which the value of upgrading
skills depend on similar upgrading by other agents)
– “Chicken and egg” problem: which comes first, the skills or
the demand for skills?
 Underdevelopment as a Coordination
Failure
• As another example, a firm using new technologies (or training
employees) may provide benefits to the other firms (spillovers);
thus, each firm has an incentive to underinvest in the new
technology (or training), unless a sufficient number of others
invest.

• Important role for government policy in coordinating

joint investments
• Deep intervention: a policy that can move the economy to a
preferred equilibrium or even to a higher permanent rate of
growth, which can then be self-sustaining so that the policy is
not needed any more
 Multiple Equilibria in development

• These models can be diagrammed by an S-shaped function

and the 45º line

• The basic idea: the benefits an agent receives from taking an

action depend positively on how many other agents are
expected to take the action or on the extent of those actions

• Equilibrium = where the «privately rational decision

function» (the S-shaped curve) crosses the 45-degree line,
i.e. where agents observe what they expect to observe
 Multiple Equilibria

• Multiple equilibria: a condition in which more than one

equilibrium exists. These equilibria sometimes may be ranked
(e.g. one is preferred over another), but the unaided market
will not move the market to the preferred outcome

• Equilibria are
– Stable: function crosses the 45º line from above
– Unstable: function crosses the 45º line from below
 Multiple Equilibria

High level
equilibrium Investment Reaction
Function
(representative firm)

Unstable
equilibrium

Low level
equilibrium

Underdevelopment
trap
Need to call on coordination to move from the low- to the high-level
equilibrium, as opposed to reliance on market forces

The Big Push

(coordinated investment effort)

Rosenstein-Rodan (1943); Leibenstein (1957); Hirschman (1958)

- The shoe factory example

- Indivisibilities in infrastructure (e.g. power, transport, and
communications)
- Indivisibilities in demand (workers need other goods, not only shoes)
 The Big Push - The shoe factory example

- If 100 workers (with marginal productivity of L = 0) in an

underdeveloped country were put into a shoe factory, they
could spend all their additional income in shoes they produce.
The shoes will find a market
- However, as they need to buy something else (!), the shoe
factory will not have enough market (unless we allow
exports) and the project of the shoe factory will be
abandoned.
- If instead we put thousands of workers in one hundred of
factories and farms….
- The new producers will be each others’ customers (and
create additional markets)
- They all need infrastructures
Starting Economic Development: The Big
Push (Paul Rosenstein-Rodan, 1943)
• Several problems associated with initiating industrialization in
a subsistence economy (Simplifying assumption: no exports)
• Who will buy the goods produced by the first firm to
industrialize?
• The first factory has to train its workers, who are accustomed
to a subsistence way of life. However... Due to spillovers and
opportunisms.. No one is trained and industrialization never
gets under way.
• Need for public policy intervention
• International trade reduces the size of the minimum push, as
the world market can be a substitute for additional domestic
market required in a closed economy
The Big Push Model: In development you cannot do
anything until you can do everything
“IMAGINE you run a poor agricultural economy. Your farmers want to
improve their soil but have no fertilisers, so you must either build a
fertiliser factory or import the stuff. You will therefore need a port, dock
workers, accountants and lawyers, roads and trucks to transport it,
bankers to extend credit, and plastic bags to put the fertiliser in,
necessitating plastics and packaging factories, too. Your farmers then
need seeds and livestock, so you must have vets, market traders,
construction companies to build barns and refrigeration systems. And you
will need all this before your farmers put a seed in the ground.”

Even the simplest activity requires a network of other activities and that
individual firms cannot organise such a large network, so the state or
some other giant agency must step in.

The Economist, 2011

The Big Push model

– Rosestein-Rodan’s arguments became a major part of the

way economists thought about development problems in
the ’50s and ’60s.

– However, the approach received a huge boost following the

publication of a technical paper by Murphy, Shleifer and
Vishny in 1989, which demonstrated the formal logic of this
approach more clearly.
Michael Kremer’s O-Ring Theory of Economic
Development (1993)

– Production is modeled with strong complementarities

among inputs:
BF(qiqj) = qiqj

– Positive assortative matching in production (i.e.

workers with high skills will work together, and workers
with low skills will work together)
– When the model is used to compare economies, this
matching means that high-value products will be
concentrated in countries with high-value skills
* From the 1986 Challenger disaster
The “O-Ring” Theory: A Simple
Illustration of the basic idea

• 4-person economy: 2 H-skill and 2 L-skill; In a simplified

model let Q = qiqj
• How to allocate?
{HH, LL}; or {HL, LH}?
• We know that H2 + L2 > 2HL because: (H–L)2 > 0
• So with strong complementarity it always pays to do
assortative matching

• Nobel laureate (1992) Gary Becker’s famous “marriage

market” model
 The “O-Ring” Theory

• Thus, poor countries will have more workers in production

that is simpler, i.e. requires less tasks (if only one task goes
wrong it could destroy everything)

• Virtuous vs. vicious circle

• http://www.mruniversity.com/courses/development-
economics/o-ring-model

(Try also to answer the Practice Questions)

Economic Development as Self-Discovery

• Hausmann and Rodrik: A Problem of Information (i.e.

countries do not know their comparative advantage; instead,
traditional models assume perfect information)

• Industrial policy may help to identify true direct and indirect

domestic costs of potential products in which to specialize by:
– Encouraging exploration in the first stage
– Encouraging movement out of inefficient sectors and into
more efficient sectors in the second stage
Economic Development as Self-Discovery

• Three building blocks of the theory; and case examples of

their reasonableness in practice:
– Uncertainty about what products can be produced
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)
– Need for local adaptation of foreign technology (evidence:
seen in cases such as shipbuilding in South Korea)
– Imitation can be rapid (e.g. the spread of cut flower
exporting in Colombia)
The Hausmann-Rodrik-Velasco Growth
Diagnostics Framework

• Focus on a country’s most binding constraints on economic

growth

• No “one size fits all” in development policy

• Requires careful research to determine the most likely

binding constraint
Figure 4.3 Hausmann-Rodrik-Velasco Growth
Diagnostics Decision Tree
 Hausman, Rodik and Velasco (2007):
country case studies

El Salvador: the economy is constrained by a lack of productive

ideas. The binding constrain is a lack of innovation and demand
for investment to replace the traditional cotton, coffee, and
sugar sectors.

The best strategy focus for El Salvador would be to encourage

more entrepreneurship and development of new business
opportunities
Hausman, Rodik and Velasco (2007):
country case studies

Brazil: The binding constrain is a lack of sufficient funds to

invest despite an abundance of productive ideas.
Although Brazil could increase national savings (i.e. investments)
by reducing government expenditures, this may be not politically
feasible.

HRV suggest that higher taxes and lower infrastructure and

human capital subsidies can work
 Take home messages

• Contemporary models introduce behavioural aspects in the

study of development economics

• Underdevelopment as a coordinational failure

• Multiple equilibria are possible

• No “one size fits all” in development policy