Chapter 4: Contemporary
Models of Development and
Underdevelopment
ECON 460: Development Economics
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4.1 Underdevelopment as a Coordination Failure
• A newer school of thought on problems of economic
development
• Coordination failures occur when agents’ inability to
coordinate their actions leads to an outcome that makes
all agents worse off
• This can occur when actions are complementary
• Actions taken by one agent reinforces incentives for
others to take similar actions
• This circumstance can, under some circumstances, lead to
multiple equilibria
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Examples of complementarity and
coordination failure
• Firms and workers
• Firms will not enter a market if workers in that market do not possess the
necessary skills.
• Workers will not gain the skills if there are no firms to employ them.
• If there is no coordination the economy may be stuck and trapped in poverty.
• Even though all agents will be better off if workers acquired the skills and
firms invested, it may not be possible to achieve this desired status without
government intervention.
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Examples of complementarity and
coordination failure
• Subsistence agriculture
• Farmers will continue to produce for personal consumption unless there is some
mechanism for their goods to be distributed to a broader market.
• A distributor will only get involved with the farmers if they can vouch for the quality
and quantity of the good.
• Firm adopting a new technology
• It may have to wait a while before reaping the gains.
• In time, other firms can copy this technology from the first firm and avoid any initial
learning problems and hence reap gains immediately.
• Investment in infrastructure
• Initially, there is a massive outlay required in terms of investment.
• If firms adopt a wait and see attitude, then no firm is willing (at least initially) to
contribute and the entire economy suffers.
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Coordination and Complementarity Summary
• Investments must occur at the same time through coordination.
• An important role for the government policy in coordinating joint
investments.
• In the examples, neither parties may take the first step, as each is
waiting for the other
• Progress is delayed
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4.2 Multiple Equilibria: A Diagrammatic Approach
• Often, these models can be
diagrammed by graphing an S-
shaped function and the 45º
line
• Equilibria are
• Stable: function crosses the 45º
line from above
• Unstable: function crosses the
45º line from below
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Starting Economic Development: The Big Push
• Sometimes market failures lead to a need for public policy intervention
• The Big Push: A Graphical Model
• To draw the graph, 6 assumptions are needed
• One factor of production
• Two sectors (in the sense of modern and traditional production
techniques)
• Same production functions (modern and traditional) for each
activity
• Consumers spend an equal amount on each good
• Closed economy
• Perfect competition with traditional firms operating, limit pricing
monopolist with a modern firm operating
• Use the graph to examine conditions for multiple equilibria
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The Big Push
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Big Push Model Equilibria-Summary of Figure
• With a wage bill line like W1, passing below point A, it is profitable for a modern
firm to enter even one sector, with all other sectors continuing traditional
“cottage” production, so industrialization is the only equilibrium.
• With a wage bill line like W3, passing above point B, even if a modern producer
entered in all product sectors, all of these firms would still lose money, so only the
traditional technique would be used.
• The steeper (i.e., more efficient) the modern-sector production technique, and/or
the lower the fixed costs, the more likely it is that the wage bill will pass below the
corresponding point A.
• But if the wage line passes between points A and B, it is efficient to industrialize;
but in general the market will not achieve this on its own.
• Thus, with a wage bill line like W2, passing between A and B, there are two
equilibria: one in which there is industrialization and the society is better off
(point B) and one without industrialization (point A).
• The market will not move the economy to point B because of coordination failure
– a type of large-scale market failure
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The Big Push Model: Some Points to Keep in Mind
• The three wage levels are examples of what might prevail in a given
economy: They are NOT a succession of three wages over time
• The diagram is only one easy-to-depict illustration among several reasons why a Big
Push might be needed
• The point is NOT that the problem of industrialization is commonly that
workers demand too high wages
• it is used as an illustration because it is easy to describe graphically
• Other causes of multiple equilibria in the context of this model include
fixed costs that are lower for later-entering firms than for pioneers, a
technological externality such as “learning by watching” (the phrase being
a contrast with “learning by doing”)
• Moreover, other models discussed in the chapter show multiple equilibria
can arise from additional causes
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Other examples of coordination failures
• Inter-temporal effects
• Multiple equilibria can occur if investment must be undertaken in the current
period to get a more efficient production process in the next period.
• But investment will be undertaken only if it is deemed to be profitable. If
demand is high enough in the second period, this requires that many sectors
investment simultaneously (in the first period). If this happens then it
represents one equilibrium where everyone is better off.
• However, the market cannot ensure that this is the outcome because if
everyone adopts a wait and see attitude then there is coordination failure.
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Other examples, continued
• Infrastructure effects
• Infrastructure helps firms lower their cost once the infrastructure is in place.
• If firms invest in infrastructure, they are also lowering the costs of other firms
as well.
• Infrastructure is not tradeable hence it is only profitable for a firm to do so if
other firms set up in the area which the infrastructural projects have been
built.
• Urbanisation effects
• Training effects
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Why the Problem Cannot be Solved by a “Super-Entrepreneur”
• Super Entrepreneur?
• Capital market failures
• Cost of monitoring managers- Asymmetric Information
• Communication failures
• Limits to knowledge
• Lack of empirical evidence that would suggest this is possible
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In a Nutshell: Big Push Mechanisms
• Raising total demand
• Reducing fixed costs of later entrants
• Redistributing demand to later periods when other industrializing
firms sell
• Shifting demand toward manufacturing goods (usually produced in
urban areas)
• Help defray costs of essential infrastructure (a similar mechanism
can hold when there are costs of training, and other shared
intermediate inputs)
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Further Problems of Multiple Equilibria
• Inefficient Advantages of Incumbency
• Behavior and Norms
• Linkages
• Inequality, Multiple Equilibria, and Growth
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4.5 Michael 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
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Kremer’s O-Ring Theory: A Numerical Illustration
• Production modeled with strong complementarities among inputs
• Positive assortative matching in production
• Suppose a Human Resources (HR) Department has four workers -
two H-types and two L-types;
• Strong complementarities are present when output Q is determined by the
product of the qualities, i.e. Q = qi*qj
• How to allocate for efficiency: {HL, LH} or {HH, LL}? (Mix or Match?)
• We know that H2 + L2 > 2HL because: (H–L)2 > 0
• This illustrates that with strong complementarity it is more efficient
to match, i.e. produce using positive assortative matching
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O-ring production analysis setup: details
• Kremer’s concept of q is flexible.
• Interpretations may include a quality index for characteristics of the good:
• For example, suppose q=.95. Among other interpretations this can mean:
a) There is a 95% chance that the task is completed perfectly so the
product keeps maximum value, and a 5% chance that it is completed so
poorly that it has no value;
b) The task is always completed well enough that it keeps 95% of its
maximum value; or
c) The product has a 50% chance of having full value and a 50% chance of
error reducing product value to 90%.
d) The higher the skill, the higher probability the task is successfully
completed (for example, the part created in this task will not fail)
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O-Ring Model: Bottleneck Effects
• Following Kremer, consider a simple illustration of bottleneck effects
• Suppose that n tasks are required to produce a good.
• Let q be a “standard” skill level of these n tasks
• But now, let the actual skill level of two workers be cut in half in all firms:
• Production would fall 75% (result of cutting output in half once, then cutting
it in half again)
• But then the marginal product of quality also falls by 75% for the other n-2
tasks, thus, so does the incentive to invest in increasing skill
• As workers reduce their (planned) skill investments, they further reduce
level of skill in the economy, and thereby lower further the incentive to
invest in skill
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Kremer’s “O-Ring theory”: Implications
• Firms tend to employ workers of similar skills for tasks
• Workers performing the same task at a high skill firm earn higher
wages than in a low skill firm
• Explains why a worker of given skill moving from a developing to a
developed country receives a higher wage using the same skills
• In the model, wages increase with q at an increasing rate, so wages
will be more than proportionally higher in developed countries
• When co-workers or others doing complementary work have higher
skills, greater incentive to acquire more skills
• This type of income externality is by now a familiar condition in
which multiple equilibria can emerge
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O-Ring Effects Across Firms
• Economy-wide low level quality of production traps may occur when there are
O-ring effects across firms as well as within firms
• Such externalities can create a case for industrial policy to encourage quality
upgrading, as in some East Asian countries
• This magnifies effects of local production bottlenecks, because they have a
multiplicative effect on other firms’ production
• Bottlenecks reduce worker incentives, by lowering the expected return to
investment in skills
• Such bottlenecks could be ameliorated with an alternative source of inputs,
through international trade and investment
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4.6 Economic Development as “Self-Discovery”
• No person is born knowing their comparative advantage; specific
comparative advantage of an economy also not obvious; no
alternative to trial and error…
• Hausmann and Rodrik: A Problem of Information
• Not enough to say developing countries should produce “labor intensive
products,” because there are thousands of such products
• The problem is “information externalities,” associated with the need to search
for comparative advantage in efficient production opportunities
• There is limited incentive to search for, because knowledge gained “spills over”
to other entrepreneurs, limiting the opportunity to capture profits
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Economic Development as “Self-Discovery,” continued
• Industrial policy may help to identify true direct and indirect
domestic costs of potential products to specialize in, by:
1. Encouraging exploration in first stage
2. Encouraging movement out of inefficient sectors and into
more efficient sectors in the second stage
• Three building blocks of the theory; and authors’ case examples
of the reasonableness of these assumptions in practice:
1. Uncertainty about products can be produced efficiently
2. Need for local adaptation of foreign technology
3. Imitation can be rapid
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4.7 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
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Hausmann-Rodrik-Velasco Growth Diagnostics Decision Tree
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Growth Diagnostics: Categories of “most
binding constraints” in the “decision tree”
• Constraint categories are the boxes from which no further arrows
emanate
• These 10 are fairly comprehensive; many specific constraints fit well
within these categories
• Example: natural disasters pose immediate constraints, but if extended problems
for the growth follow, government failure is likely the root problem - not the
initial shock of the disaster
• But potential additional independent “boxes” for constraint types that
have been raised for consideration but are debatable could include:
• Environment: if climate change and ecological collapse threaten food security, or
domestic degradation leads to near un-livability of the major cities (lowering
productivity, stopping investment…)
• Inability to resolve conflict
• Social capital (or “cultural”) dimensions such as lack of trust (e.g. in forming
business relationships, etc.) 26
Growth Diagnostics in Practice
• Careful research is required to determine most likely binding
constraint.
• Growth diagnostics involves “economic detective work.”
• To evaluate whether a proposed constraint is binding, a growth
diagnostician looks for evidence on its implications.
• If the constraint is excessive taxation, we would expect high
movement into the informal sector or underground economy.
• If the constraint is infrastructure, we would expect significant
congestion.
• If the constraint is education, expect high rates of return to education.
• In general, the analyst will look for economic behavior consistent with
agents trying to get around a constraint.
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Hausmann et al’s “Principles of a Differential Diagnosis”
If a constraint is binding, then…
1) The (shadow) price of the constraint should be high
2) Movements in the constraint should produce significant movements in
the objective function
3) Agents in the economy should be attempting to overcome or bypass the
constraint
4) Agents less intensive in that constraint should be more likely to survive
and thrive, and vice versa
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Discussion Question
• Modern economic models sometimes require strong assumptions.
What do you think are some of the trade-offs between a more
rigorous, logically cohesive model with strong assumptions but clear
inferences and a description of problems followed by a verbal
discussion of possible implications?
• Do you think the two approaches can be used together to inform
each other?