Chapter 4

Contemporary Models of Development and Underdevelopment

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Underdevelopment as Coordination Failure

Economic development is difficult to achieve. It has been impossible for some countries (e.g., Nigeria, Sudan), but accomplished by others (e.g., S. Korea, Singapore)
The success or failure of economic development policies can be explained by the principal-agent model.
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Underdevelopment as Coordination Failure

Principal:
Government

Agents:
Households Private-sector firms Public agencies Government-owned enterprises International companies
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Copyright 2009 Pearson Addison-Wesley. All rights reserved.

Underdevelopment as Coordination Failure

An effective principal is needed to coordinate actions taken by agents and achieve an optimal outcome, making all agents better-off.
Coordination failure occurs when the principal fails to induce agents to coordinate their actions, which leads to an outcome that makes all agents worse-off.
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Models of Coordination Failure

Technological Transfer for Modernization The Big Bush to Industrialization The O-Ring Theory of Economic Development

The Growth Diagnostics Framework

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Technological Transfer for Modernization

The model is explained by the privately rational decision function, an S-shaped curve. The intersection of this curve with the 45 line is the point of equilibrium.
At equilibrium, the expected outcome of an action equals its actual outcome

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Multiple Equilibria: Graphical Illustration

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Technological Transfer for Modernization

Stable equilibrium: The S-shaped function crosses the 45 line from above (points D1 and D3). Here firms adjust their investment decisions in coordination with average investment in the industry. Unstable equilibrium: The S-shaped function crosses the 45 line from below (point D2). As firms coordinate their investment decisions, equilibrium moves to D1 (decrease investment) or D3 (increase investment).
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Technological Transfer for Modernization

To achieve stable equilibrium, firms must be able to coordinate their investment decisions such that all firms benefit from each others investment. Public policy creating incentives for investment is the key for successful coordination. The government must establish inclusive incentives to encourage business investment.
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The Big Push to Industrialization

A big push to industrialization requires a set of leading firms to investment in productive activities and transfer of modern technology
Investment decisions made by modernsector firms are mutually reinforcing and public policy intervention is needed to correct market failure
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The Big Push to Industrialization

Assumptions: One factor of production: labor Two economic sectors: traditional vs. modern Same production function for each sector Consumers spend an equal amount on each product they buy Closed economy Perfect competition
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The Big Push: Coordination Failure

A firm is deciding to invest in new technology
It faces a production function in the traditional sector that passes through the origin as output increases with labor employment It faces a production function in the modern sector that requires some labor employment before initiating production (point F)
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The Big Push: Graphical Illustration

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The Big Push: Coordination Failure

At a low wage rate like W1, a new firm will enter the modern sector after paying the fixed labor cost (F). With high demand (Q2), the firm makes profit and invests in modern technology
As W2 > W1, other firms enter the modern sector to share the profit. Coordination between these firms is now needed for the economy to adopt modern technology 4-14
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The Big Push: Coordination Failure

At W2, investment becomes profitable if all firms invest in modern technology to industrialize the economy. High demand for manufactured products makes workers and firms benefit from capital investment At a high wage like W3, investment in modern technology is not profitable
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The Big Push: Coordination Failure

Point A is a stable equilibrium as low profits discourage firms to invest in modern technology (no industrialization)
Point B is an unstable equilibrium because it requires the principal to provide incentive to invest and agents to coordinate their decision of investment in modern technology (industrialization)
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Conditions Making The Big Push Necessary

Intertemporal effects: investment in the modern sector becomes profitable overtime as the market size increases
Urbanization effects: demand for manufactured goods increases with urban population growth
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Conditions Making The Big Push Necessary

Infrastructural effects: improvement in transportation, communication, and distribution systems reduces the cost of investment
Training effects: the labor force becomes more productive and skilled with education
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Coordination Problem Cannot Be Solved by a Super-Entrepreneur

Capital market failure: bankers are unwilling to provide loans to a single firm
Cost of monitoring managers: expensive agency costs to ensure compliance of employees Communication failure: agents wanting to share profit cannot convince the superentrepreneur to do so
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Coordination Problem Cannot Be Solved by a Super-Entrepreneur

Limited knowledge: agents do not have sufficient information about the importance of industrialization Lack of empirical evidence: agents do not know that other firms are investing in modern technology

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Further Problems of Multiple Equilibria

Linkages: underdeveloped backward and forward linkages to support industrialization
Inequality and growth: trickle-up growth, resulting in increased inequality and poverty, reduces the buying power of workers and their demand for manufactured goods

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Further Problems of Multiple Equilibria

Inefficient advantages of incumbency: existing firm have lower production cost
Behavior and norms: agents may be corrupt and bribery may be the standard method of doing business internationally

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The O-Ring Theory of Economic Development

Production is modeled with strong complementarities of inputs (labor & capital) and interdependencies among firms (output of one firm is input of another)
Positive assortative matching in production: skilled labor works with its peers; profitable and modernizing firms coordinate with their counterparts
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The O-Ring Theory of Economic Development

Implications of strong complementarities for economic development and the distribution of income across countries will induce countries at the same level of development to coordinate their actions
MDCs cooperate and coordinate with each other in the development and transfer of modern technology
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The Growth Diagnostics Framework

Focus on a countrys most binding constraints of economic development: low rate of return on investment and high cost of financing No one size fits all in development policy of market coordination Insufficient investment in physical, social, environmental, and human capital
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The Growth Diagnostics Framework

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