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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 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
45º 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 45º 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 45º 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 other’s
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 modern-

sector 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 over-
time 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 super-
entrepreneur 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 country’s 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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