Contemporary Models Of Development And Underdevelopment

CONTEMPORARY MODELS OF DEVELOPMENT

Binding constraints – the one limiting factor that if relaxed would be the item that accelerates growth (or that allows a larger amount of some other targeted outcome). Economic agent - an economic actor- usually a firm, worker, consumer, or government officialthat chooses actions as to maximize an object; often referred to as “agents”

UNDERDEVELOPMENT AS A COORDINATION FAILURE • Complementarities between several conditions necessary for successful development are now frequent among the new and recent theories of economic development. • Complementarities - an action taken by one firm, worker, or organization that increases the incentives for other agents to take similar actions. Complementarities often involve investments whose return depends on other investments being made by other agents.

• These new theories also emphasize that in many important situations, investments must be undertaken by many agents in order for the results to be profitable for any individual agent.

• Coordination failure – a state of affairs in which the inability of agents to coordinate their behavior(choices) leads to an outcome (equilibrium) that leaves all agents worse off than in an alternative situation that is also an equilibrium. This does not imply that they do not know the desired equilibrium, it is just difficult to reach. • When complementarities are present, an action take by one firm, worker, organization, or government increases the incentives for other agents to take similar actions.

• Middle income trap – a condition in which an economy begins development to reach middle-income status but it 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. • Specialization and a detailed division of labor are hallmarks of an advanced economy. But we can specialize only if we can trade for the other goods and services we need. • The absence of motives for specialization can result in the underdevelopment trap.

• Underdevelopment trap - a poverty trap at the regional or national level in which underdevelopment tends to perpetuate itself over time.

• Sometimes they fail to find equilibrium by failing to figure out who shall take the first step. The answer to this is most of the times that both measures should be taken in the same time with coordination. • Many economists nowadays, look actively for vases in which government policy can still help, even when government is imperfect, by pushing the economy toward a self-sustaining, better equilibrium. Such deep intervention moves an economy to a preferred equilibrium.

• Deep intervention – a government policy that can move the economy to a preferred equilibrium or even to a higher permanent rate of growth that can then be self-sustaining so that the policy need no longer be enforced because the better equilibrium will then prevail without further intervention. • Congestion – the opposite of a complementarity; an action taken by one agent that decreases the incentives for other agents to take similar actions. • In real economic problems, the people who need to coordinate investments do not even know the identity of the other key agents.

MULTIPLE EQUILIBRIA: A DIAGRAMMATIC APPROACH • Multiple equilibria – a condition in which more than one equilibrium exists. These equilibria may sometimes be ranked, in the sense hat one is preferred to another, but the unaided market will not move the economy to the preferred outcome. • In this model, one invests based on his expectation of the average level of investment. • D1 represents a stable equilibrium with a coordination failure, D2 an unstable equilibrium, D3 a stable equilibrium with a higher level of investments; the equilibrium is stable when the Scurve intersects from above.

• The S-shaped curved simply explains the positive relationship between the benefits of an agent depending on the actions of other agents; it is the privately rational decision function. • The general idea of an equilibrium in such case, is one in which participants are doing what is the best for them, given what they expect others to do, which in turn matches what others are actually doing.

• The curve does not rise quickly first because of the lack of coordination and inaccurate expectations. But after enough investment, many agents begin to provide spill over benefits to neighboring agents, and the curve increases at a much faster rate. Finally after most potential investors have been positively affected and the most important gains have been realized, the rate of increase starts to slow down.

• Changing expectations may not be sufficient if it is more profitable for a firm to wait for others to invest rather that to be a pioneer investor.

• Market forces can generally bring us to one of the equilibria, but they are not sufficient to ensure that the best equilibrium will be achieved, and they offer no mechanism to become unstuck from a bad equilibrium and move toward a better one. • When jointly profitable investments may not be made without coordination, equilibria may exist in which the same individuals with access to the same resources and technologies could find themselves in either a good or a bad situation.

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 1. Factors - One factor of production (Labor) 2. Factor payments - Two sectors of labor markets 3. Technology - Same production function for each sector 4. Domestic demand- Consumers spend an equal amount on each good 5. International supply and demand - Closed economy

6. Market Structure - Perfect competition with traditional firms operating, limit 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

FURTHER PROBLEMS OF MULTIPLE EQUILIBRIUM • Inefficient Advantages of Incumbency • Behavior and Norms

• Linkages – connections between firms based on sales. A backward linkage is one in which a firm buys good from another firm to use as an input; a forward linkage is one in which a firm sells to another firm • Inequality, Multiple Equilibria, and Growth

KREMER’S O-RING THEORY OF ECONOMIC DEVELOPMENT • The O-Ring Model - Production is modeled with strong complementarities among inputs - Positive assortative matching in production • Implications of strong complementarities for economic development and the distribution of income across countries.

The “O-Ring” Theory: A Simple Illustration of the basic idea • HR Department has 4 workers- 2 H-types and 2 L-types; 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

ECONOMIC DEVELOPMENT AS SELF DISCOVERY • Hausmann and Rodrik: A Problem of Information • Not enough to say developing countries should produce “labor intensive products,” because there are thousands of them • 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

• 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 Growth diagnostics – A decision tree framework for 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