​ECO 310 Economics Development​

​A.Y. 2025-2026​ ​ECO 310​

​L4. Contemporary Models of Development and​ ​Coordination Failure​

​Underdevelopment​ ​●​ ​A​ ​state​ ​of​ ​affairs​ ​in​ ​which​ ​the​ ​inability​ ​of​
a​ gents​ ​to​ ​coordinate​ ​their​ ​behavior​
​Economic agent​
​(choices)​​leads​​to​​an​​outcome​​(equilibrium)​
​●​ ​An​ ​economic​ ​actor—usually​​a​​firm,​​worker,​ ​that​ ​leaves​ ​all​ ​agents​ ​worse​ ​off​ ​than​ ​in​ ​an​
c​ onsumer​ ​or​ ​government​ o ​ fficial—that​
​alternative​ ​situation​ ​that​ ​is​ ​also​ ​an​
​chooses​ ​actions​ ​so​ ​as​ ​to​ ​maximize​ ​an​
​equilibrium.​
​objective.​
​●​ ​They​ ​simply​ ​cannot​ ​get​ ​there​ ​because​ ​of​
​difficulties​ ​of​ ​coordination,​ ​sometimes​
​4.1 Underdevelopment as a Coordination Failure​
​because​ ​people​ ​hold​​different​​expectations​
​and​ ​sometimes​ ​because​ ​everyone​​is​​better​
​Complementarity​
​off​ ​waiting​ ​for​ ​someone​ ​else​ ​to​ ​make​ ​the​
​●​ ​An​ ​action​ ​taken​ ​by​ ​one​ ​firm,​ ​worker,​ ​or​
​first move.​
​organization​ ​that​ ​increases​ ​the​ ​incentives​
​ ​ ​This​ ​section​ ​spells​ ​out​ ​the​ ​meaning​ ​and​
●
f​ or other agents to take similar actions.​
​implications​ ​of​ ​these​​perspectives​​in​​detail,​
​●​ ​Complementarities​ ​often​ ​involve​
​through both simple models and examples.​
​investments​ ​whose​ ​return​ ​depends​ ​on​
​●​ ​These​ ​complementarities​ ​often​ ​involve​
​other​ ​investments​ ​being​ ​made​ ​by​ ​other​
​investments​ ​whose​ ​return​ ​depends​ ​on​
​agents.​
​other​ ​investments​ ​being​ ​made​ ​by​ ​other​
​ ​ ​Investments​ ​must​ ​be​ ​undertaken​ ​by​ ​many​
●
​agents.​
​agents​ ​in​ ​order​ ​for​ ​the​ ​results​ ​to​ ​be​
​profitable for any individual agent.​
​Big Push​
​Examples:​ ​●​ ​A​ ​concerted,​ ​economywide,​ ​and​ ​typically​
​ ublic​ ​policy–led​ ​effort​ ​to​ ​initiate​ ​or​
p
​●​ F​ irms​ ​needing​ ​skilled​ ​labor​ ​and​ ​workers​ ​accelerate​ ​economic​ ​development​ ​across​​a​
​needing firms to employ them.​ ​broad spectrum of new industries and skills.​
​●​ ​Middlemen​ ​in​ ​agricultural​​markets​​needing​
​concentrated​ ​producers​ ​and​ ​farmers​ ​O-ring Model​
​needing​ ​middlemen​ ​to​ ​sell​ ​specialized​
​●​ ​An​ ​economic​ ​model​ ​in​ ​which​ ​production​
​crops.​
f​ unctions​ ​exhibit​ ​strong​ ​complementarities​
​●​ ​Network​ ​effects​ ​in​ ​technology​ ​adoption​
​among​ ​inputs​ ​and​ ​which​ ​has​ ​broader​
​(e.g., software, social media).​
​implications​ ​for​ ​impediments​ ​to​ ​achieving​
​economic development.​
​Chicken and Egg Problem​
​●​ ​Complementarities​ ​often​ ​create​ ​situations​ ​Middle-income trap​
​ here​​investment​​is​​needed​​for​​returns,​​but​
w
​●​ ​A​ ​condition​ ​in​ ​which​ ​an​ ​economy​ ​begins​
​returns​ ​are​ ​not​ ​realized​ ​without​ ​prior​
​ evelopment​​to​​reach​​middle-income​​status​
d
​investment.​
​but​ ​is​ ​chronically​ ​unable​ ​to​ ​progress​ ​to​
​ ​ ​Role​ ​of​ ​Government:​ ​Government​
●
​high-income status.​
​intervention​ ​can​ ​be​ ​crucial​ ​to​ ​break​
​ ​ ​Often​ ​related​ ​to​ ​low​ ​capacity​ ​for​ ​original​
●
​coordination​ ​failures​ ​by​ ​facilitating​
​innovation​ ​or​ ​for​ ​absorption​ ​of​ ​advanced​
​simultaneous,​ ​joint​ ​investments​ ​or​ ​by​
​technology,​ ​and​ ​may​ ​be​ ​compounded​ ​by​
​pushing​ ​the​ ​economy​ ​towards​ ​a​ ​better​
​high inequality.​
​equilibrium (deep intervention).​
​ECO 310 Economics Development​
​A.Y. 2025-2026​ ​ECO 310​

​Underdevelopment trap​ ​●​ ​These​​equilibria​​may​​sometimes​​be​​ranked,​

i​n​ ​the​ ​sense​ ​that​ ​one​ ​is​ ​preferred​ ​to​
​●​ ​A​ ​poverty​ ​trap​ ​at​ ​the​ ​regional​ ​or​ ​national​
​another,​ ​but​ ​the​ ​unaided​ ​market​ ​will​ ​not​
​level​ ​in​ ​which​ ​underdevelopment​ ​tends​ ​to​
​move​ ​the​ ​economy​ ​to​ ​the​ ​preferred​
​ erpetuate itself over time.​
p
​outcome.​
​ ​ ​Region​ ​remains​ ​stuck​ ​in​ ​subsistence​
●
​●​ ​This​​diagram,​​in​​one​​version​​or​​another,​​has​
​agriculture​
​become​​almost​​as​​ubiquitous​​in​​discussions​
​of​ ​multiple​ ​equilibria​ ​as​ ​the​ ​famous​
​Deep intervention​
​supply-and-demand​​(“Marshallian​​scissors”)​
​●​ ​A​ ​government​ ​policy​ ​that​ ​can​ ​move​ ​the​ ​diagram​​in​​discussions​​of​​single​​equilibrium​
e​ conomy​​to​​a​​preferred​​equilibrium​​or​​even​ ​analysis.​
​to​ ​a​ ​higher​ ​permanent​ ​rate​ ​of​​growth​​that​ ​ ​ ​Occur​ ​when​ ​an​ ​economy​ ​can​ ​settle​ ​into​
●
​can​ ​then​ ​be​ ​self-sustaining​ ​so​ ​that​ ​the​ ​either​ ​a​ ​high-growth​ ​(good)​ ​or​ ​low-growth​
​policy​ ​need​ ​no​​longer​​be​​enforced​​because​ ​(bad/trap)​ ​state​ ​based​​on​​expectations​​and​
​the​ ​better​ ​equilibrium​ ​will​ ​then​ ​prevail​ ​coordination,​ ​rather​ ​than​ ​just​ ​market​
​without further intervention.​ ​fundamentals.​

​Congestion​
​●​ ​The​ ​opposite​ ​of​ ​a​ ​complementarity;​ ​an​
a​ ction​ ​taken​ ​by​ ​one​ ​agent​ ​that​ ​decreases​
​the​ ​incentives​ ​for​ ​other​ ​agents​ ​to​ ​take​
​similar actions.​

​Where to meet dilemma​

​●​ ​A​ ​situation​ ​in​ ​which​ ​all​ ​parties​ ​would​ ​be​
​ etter​ ​off​ ​cooperating​ ​than​ ​competing​ ​but​
b
​lack information about how to do so.​
​ ​ ​If​ ​cooperation​ ​can​ ​be​​achieved,​​there​​is​​no​
●
​subsequent incentive to defect or cheat.​
​Axes​
​Prisoners’ dilemma​ ​●​ ​The​ ​x-axis​ ​represents​ ​the​ ​expected​
​●​ ​A​ ​situation​ ​in​ ​which​ ​all​ ​parties​ ​would​ ​be​ ​ ecision/action​ ​of​ ​other​ ​agents​ ​(e.g.,​
d
​ etter​ ​off​ ​cooperating​ ​than​ ​competing​ ​but​
b ​average​ ​investment​ ​level),​ ​and​ ​the​ ​y-axis​
​once​ ​cooperation​ ​has​ ​been​ ​achieved,​ ​each​ ​represents​ ​an​ ​individual​ ​agent's​ ​privately​
​party​ ​would​ ​gain​ ​the​ ​most​ ​by​ ​cheating,​ ​rational​​decision​​(e.g.,​​individual​​investment​
​provided​ ​that​ ​others​ ​stick​ ​to​ ​cooperative​ ​level).​
​agreements—thus​ ​causing​ ​any​ ​agreement​
​to unravel.​ ​S-shaped curve​
​●​ ​This​ ​represents​ ​the​ ​"privately​ ​rational​
​4.2 Multiple Equilibria: A Diagrammatic Approach​ ​ ecision​​function."​​It​​shows​​how​​an​​agent's​
d
​optimal​ ​action​ ​changes​ ​based​ ​on​ ​their​
​Multiple equilibria​
​expectations of others' actions.​
​●​ ​A​ ​condition​ ​in​ ​which​ ​more​ ​than​ ​one​
​equilibrium exists.​
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​A.Y. 2025-2026​ ​ECO 310​

​45-degree Line​ ​●​ ​A​​concerted,​​economy-wide​​effort,​​often​​led​

​ y​ ​public​ ​policy,​ ​to​ ​initiate​ ​or​ a​ ccelerate​
b
​●​ ​Represents​ ​the​ ​condition​ ​where​ ​expected​
​development​ ​across​ ​many​ ​industries​
​actions equal actual actions.​
​simultaneously.​

​Equilibria​ ​ roblem​ ​Addressed:​ ​Difficulty​ ​in​ ​initiating​

P
​●​ ​Occur​ ​where​ ​the​ ​S-shaped​ ​curve​​intersects​ ​industrialization​ ​in​ ​subsistence​ ​economies​ ​due​ ​to​
​the 45-degree line.​ ​market​ ​failures,​ ​particularly​ ​pecuniary​ ​externalities​
​and coordination failures.​
​Stable Equilibria (D₁ and D₃)​
​●​ ​Occur​ ​where​ ​the​ ​S-shaped​ ​curve​ ​cuts​ ​the​ ​Rosenstein-Rodan's Insight​
​ 5-degree​​line​​from​​above.​​Small​​deviations​
4 ​●​ ​The​ ​first​ ​firm​ ​to​ ​industrialize​ ​faces​ ​a​
​from​ ​these​ ​points​ ​lead​ ​agents'​ ​actions​ ​to​ c​ oordination​ ​problem:​ ​who​ ​will​ ​buy​ ​its​
​push​ ​the​ ​economy​ ​back​ ​towards​ ​products?​
​equilibrium.​ ​●​ ​Workers​ ​in​ ​a​ ​subsistence​ ​economy​ ​lack​
​purchasing power.​
​Unstable Equilibrium (D₂)​ ​ ​ ​Profitability​ ​depends​ ​on​ ​other​ ​firms​ ​also​
●
​●​ ​Occurs​ ​where​ ​the​ ​S-shaped​ ​curve​ ​cuts​ ​the​ ​industrializing.​
​ 5-degree​​line​​from​​below.​​Small​​deviations​
4
​lead​ ​the​ ​economy​ ​to​ ​one​ ​of​ ​the​ ​stable​ ​Key Issues​
​equilibria.​ ​1.​ D ​ emand​ ​Spillovers:​ ​One​ ​firm's​ ​production​
​ ​ ​It acts as a threshold.​
● ​creates demand for another's.​
​2.​ ​Training​ ​Costs:​ ​Initial​ ​firms​ ​bear​ ​training​
​Shape of the S-curve​ ​costs,​ ​but​ ​subsequent​ ​firms​ ​can​ ​poach​
​●​ ​Reflects​ ​complementarities.​ ​Initially,​ ​the​ ​trained​ ​workers​ ​without​ ​incurring​ ​these​
c​ urve​ ​rises​ ​slowly​ ​(few​ ​spillovers),​ ​then​ ​costs, disincentivizing training.​
​accelerates​ ​(snowball​ ​effect),​ ​and​ ​finally​ ​3.​ ​Increasing​ ​Returns​ ​to​ ​Scale:​ ​Modern​
​slows down as gains diminish.​ ​industries​ ​often​ ​have​ ​high​ ​fixed​ ​costs​ ​and​
​declining​ ​average​ ​costs,​ ​making​ ​it​ ​hard​ ​to​
​start without sufficient scale.​
​Pareto Improvement​
​●​ ​A​ ​situation​ ​in​ ​which​ ​one​ ​or​ ​more​ ​persons​ ​Former Model Assumptions​
​ ay​ ​be​ ​made​ ​better​ ​off​ ​without​ ​making​
m
​anyone worse off.​ ​Labor​
​●​ ​One factor of production.​
​Policy Relevance​
​●​ ​Market​ ​forces​ ​may​ ​lead​ ​to​ ​an​ ​equilibrium,​ ​Wages​
​but not necessarily the best equilibrium.​ ​●​ ​Traditional​ ​sector​ ​wage​​=​​1;​​Modern​​sector​
​●​ ​Government​ ​intervention​ ​might​ ​be​​needed​ ​wage = W > 1​
t​ o​ ​shift​ ​the​ ​economy​ ​to​ ​a​ ​preferred​
​outcome.​ ​Technology​
​●​ ​Traditional:​ ​1​ ​worker​ ​produces​ ​1​ ​unit​
​4.3 Starting Economic Development: The Big Push​ ​(constant returns).​

​Big Push​
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​A.Y. 2025-2026​ ​ECO 310​

​●​ ​Modern:​ ​Requires​ ​a​ ​fixed​ ​number​ ​of​ ​Scenario 2 (W₂ line between A and B):​
​workers​ ​(F)​ ​to​ ​start,​​then​​linear​​production​ ​●​ ​If​ ​only​ ​one​ ​firm​ ​considers​​entering,​​it's​​not​
(​ L=F+cQ)​ ​ rofitable (loss at A).​
p
​ ​ ​Exhibits​ ​increasing​ ​returns​ ​to​​scale​​as​​fixed​
● ​●​ ​If​ ​all​ ​firms​ ​enter,​ ​demand​ ​rises,​ ​wages​ ​rise​
​cost is spread over output.​ ​to​ ​W,​​and​​it​​becomes​​profitable​​to​​produce​
​at B.​
​Domestic Demand​ ​ ​ ​This​ ​creates​​two​​equilibria:​​industrialization​
●
​●​ ​Each​ ​good​ ​receives​ ​an​​equal​​share​​(Y/N)​​of​ ​(B) and no industrialization (A).​
​national income (Y).​ ​●​ ​The​ ​market​ ​may​ ​fail​ ​to​ ​reach​ ​the​ ​better​
​equilibrium (B).​
​Closed Economy​
​●​ ​Simplifies​ a​ nalysis;​ ​open​ ​economy​ ​Scenario 3 (W₃ line above B)​
​considerations​ ​are​ ​discussed​ ​but​ ​the​ ​core​ ​●​ ​Even​ ​with​ ​full​ ​industrialization,​ ​modern​
​logic holds.​ ​ rms​ ​would​ ​still​ ​lose​ ​money.​ ​Traditional​
fi
​methods persist.​
​Market Structure​
​ ​ T​ raditional sector​​is perfectly competitive.​
● ​Technological externality​
​●​ ​Modern​​sector​​is​​monopolistic​​(at​​most​​one​ ​●​ ​A​ ​positive​ ​or​ ​negative​ ​spillover​ ​effect​ ​on​ ​a​
​ rm per product due to increasing returns).​
fi ​ rm’s​ ​production​ ​function​ ​through​ ​some​
fi
​ ​ ​Modern​ ​firms​ ​price​ ​at​ ​marginal​ ​cost​ ​(1)​ ​to​
● ​means other than market exchange.​
​avoid​ ​competition​ ​from​ ​traditional​
​producers.​ ​Other Conditions Requiring a Big Push​

​Intertemporal Effects​
​Conditions for Multiple Equilibria​
​●​ ​Investment​ ​today​ ​lowers​ ​costs/increases​
​Wage Bill Line​ ​demand tomorrow.​
​●​ ​Represents​ ​the​ ​cost​ ​of​ ​labor​ ​for​ ​a​ ​modern​
​firm.​ ​Urbanization Effects​
​●​ ​Concentrated​ ​urban​ ​demand​ ​for​
​Point A​ ​manufactured goods.​
​●​ ​Represents​ ​the​ ​output​ ​level​ ​for​ ​a​ ​modern​
​ rm​ ​if​ ​it​ ​enters​ ​alone​ ​(considering​ ​fixed​
fi ​Infrastructure Effects​
​costs and marginal labor).​ ​●​ ​Investing​ ​firms​ ​benefit​ ​from​ ​and​ ​help​
​finance shared infrastructure (roads, ports).​
​Point B​
​●​ ​Represents​​the​​profitable​​output​​level​​if​​the​ ​Training Effects​
​economy​ ​industrializes​ ​widely​ ​(higher​ ​●​ ​Underinvestment​ ​in​ ​training​ ​due​ ​to​ ​fear​​of​
​ emand, higher wages).​
d ​poaching.​

​Scenario 1 (W₁ line below A)​ ​ hy​ ​the​ ​Problem​ ​Cannot​ ​Be​ ​Solved​ ​by​ ​a​
W
​​ M
● ​ odern firm enters profitably.​ ​Super-Entrepreneur​
​●​ ​Economy industrializes automatically.​ ​1.​ C
​ apital​​market​​failures​​(difficulty​​assembling​
​huge capital).​
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​A.Y. 2025-2026​ ​ECO 310​

​2.​ A ​ gency​ ​costs​ ​(monitoring​ ​managers​ ​in​ ​a​ ​●​ ​Norms​ ​are​ ​inertial​ ​and​ ​can​ ​persist​ ​even​
​massive conglomerate).​ ​ hen​ ​dysfunctional​ ​(e.g.,​ ​large​ ​families,​
w
​3.​ ​Communication​ ​failures​ ​(identifying​ ​the​ ​distrust of outsiders).​
​"right" coordinator).​
​4.​ ​Limits​ ​to​ ​knowledge​​(one​​individual​​cannot​ ​Linkages​
​master all aspects).​ ​ ​ C​ onnections between firms based on sales.​
●
​5.​ ​Empirical​ ​observation:​ ​No​ ​such​ ​single​ ​●​ ​A​ ​backward​ ​linkage​ ​is​ ​one​ ​in​ ​which​ ​a​ ​firm​
​private agent has emerged.​ ​ uys​​a​​good​​from​​another​​firm​​to​​use​​as​​an​
b
​input;​ ​a​ ​forward​ ​linkage​ ​is​ ​one​ ​in​ ​which​ ​a​
​Agency costs​ ​firm sells to another firm.​
​●​ ​Costs​ ​of​ ​monitoring​ ​managers​ ​and​ ​other​ ​●​ ​Such​ ​linkages​ ​are​ ​especially​ ​significant​ ​for​
e​ mployees​ ​and​ ​of​ ​designing​ ​and​ ​industrialization​​strategy​​when​​one​​or​​more​
​implementing​ ​schemes​ ​to​ ​ensure​ ​of​ ​the​ ​industries​ ​(product​ ​areas)​ ​involved​
​compliance​ ​or​ ​provide​ ​incentives​ ​to​ ​follow​ ​have​​increasing​​returns​​to​​scale​​that​​a​​larger​
​the wishes of the employer.​ ​market takes advantage of.​
​●​ ​Strategy:​ ​Focusing​​policy​​on​​industries​​with​
​Asymmetric information​ ​strong​ ​backward​ ​or​ ​forward​ ​linkages​ ​can​
​●​ ​A​​situation​​in​​which​​one​​party​​to​​a​​potential​ ​initiate​ ​development​ ​by​ ​creating​ ​spillovers​
t​ ransaction​ ​(often​ ​a​​buyer,​​seller,​​lender,​​or​ ​and inducing development in other sectors.​
​borrower)​ ​has​ ​more​ ​information​ ​than​ ​●​ ​Pecuniary​ ​Externalities:​ ​Linkages​ ​often​
​another party.​ ​involve​ ​pecuniary​ ​externalities,​ ​where​
​developing​ ​one​ ​industry​ ​lowers​ ​costs​ ​or​
​4.4 Further Problems of Multiple Equilibria​ ​raises​ ​demand​ ​for​ ​linked​ ​industries,​
​especially​ ​significant​ ​with​ ​increasing​
​Further Problems of Multiple Equilibria​ ​returns.​
​●​ ​Government​ ​Role:​ ​Government​ ​may​ ​need​
​Inefficient Advantages of Incumbency​ ​to​ ​invest​ ​in​ ​vital​ ​but​ ​less​ ​profitable​
​●​ ​Firms​ ​with​ ​increasing​ ​returns​ ​can​​entrench​ ​industries​ ​with​ ​strong​ ​linkages,​ ​even​ ​if​
t​ hemselves.​ ​private investors don't see immediate profit.​
​ ​ ​A​ ​new,​ ​better​ ​technology​​might​​struggle​​to​
●
​compete​​if​​the​​incumbent​​can​​produce​​at​​a​ ​Inequality, Multiple Equilibria, and Growth​
​lower​ ​average​ ​cost​ ​due​ ​to​ ​existing​ ​scale,​ ​●​ ​Traditional​ ​View:​ ​Inequality​ ​might​ ​boost​
​especially if capital markets are weak.​ g​ rowth via higher savings from the rich.​
​●​ ​Modern​​View:​​Imperfect​​credit​​markets​​can​
​Behavior and Norms​ ​trap​ ​the​ ​poor.​ ​Lack​ ​of​ ​collateral​ ​prevents​
​●​ ​Shifting​ ​from​ ​rent-seeking/corruption​ ​to​ ​loans for entrepreneurship or education.​
​ roductive behavior is difficult.​
p ​ ​ ​Multiple​ ​Equilibria:​ ​Can​ ​arise​ ​from​ ​credit​
●
​●​ ​Past​ ​negative​ ​experiences​ ​can​ ​create​ ​market​ ​imperfections,​ ​leading​ ​to​​outcomes​
​expectations of dishonesty, encouraging it.​ ​with​ ​either​ ​widespread​ ​high​ ​incomes​ ​or​
​ ​ ​Equilibria​ ​can​ ​exist​ ​with​ ​high​ ​corruption​​or​
● ​persistent low incomes.​
​low​ ​corruption,​ ​depending​​on​​enforcement​ ​●​ ​Human​ ​Capital:​ ​Indivisibilities​ ​in​ ​human​
​of norms.​ ​capital​ ​investment​ ​(e.g.,​ ​a​ ​full​ ​year​ ​of​
​●​ ​Institutional​ ​reform​ ​is​ ​itself​ ​subject​ ​to​ ​schooling)​ ​combined​ ​with​ ​imperfect​ ​credit​
​coordination failure.​ ​markets​ ​create​ ​increasing​ ​returns​ ​and​ ​can​
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​A.Y. 2025-2026​ ​ECO 310​

​lead​ ​to​ ​multiple​ ​equilibria​ ​(e.g.,​ ​poverty​ l​ow-skill​ ​worker​ ​(qL).​ ​In​ ​competitive​
t​ raps across generations).​ ​markets,​​higher​​productivity​​leads​​to​​higher​
​ ​ ​Empirical​​Evidence:​​Often​​shows​​a​​negative​
● ​wages.​
​impact​ ​of​ ​inequality​ ​on​ ​growth,​ ​especially​ ​ ​ ​Analogy​​:​​Marriage​​market​​model​​(Becker)​​–​
●
​post-1980.​ ​most​ ​attractive​ ​people​ ​pair​ ​up,​ ​then​ ​the​
​next most attractive, etc.​
​Poverty trap​
​Implications​
​●​ ​A​ ​bad​ ​equilibrium​ ​for​ ​a​​family,​​community,​
​ r​​nation,​​involving​​a​​vicious​​circle​​in​​which​
o ​Wage Differences​
​poverty​ ​and​ ​underdevelopment​ ​lead​ ​to​ ​●​ ​Wages​ ​increase​ ​more​ ​than​ ​proportionally​
​more​​poverty​​and​​underdevelopment,​​often​ ​ ith skill level.​
w
​from one generation to the next.​
​ ​ ​Developed​​countries​​with​​high-skill​​workers​
●
​have​ ​higher​​wages​​than​​standard​​measures​
​4.5 Michael Kremer’s O-Ring Theory of Economic​
​might predict.​
​Development​
​●​ M ​ odern​ ​production​ ​requires​ ​many​​tasks​​to​ ​Skill Investment Complementarity​
​be done well simultaneously.​ ​●​ ​Higher​ ​average​ ​skills​ ​in​ ​the​ ​economy​
​●​ ​The​ ​failure​ ​of​ ​one​ ​small​ ​component​ ​can​ i​ncrease​ ​individual​ ​incentives​ ​to​ ​acquire​
​doom the entire process.​ ​more skills.​
​●​ ​This​ ​explains​ ​exceptionally​ ​low​ ​incomes​ ​in​ ​ ​ ​This​ ​can​ ​lead​ ​to​ ​multiple​ ​equilibria​ ​in​ ​skill​
●
​some countries.​ ​levels.​

​O-Ring Production Function​ ​Economy-wide Traps​

​●​ ​A​ ​ roduction​ ​function​ ​with​ ​strong​
p ​●​ ​O-ring​ ​effects​ ​across​ ​firms​ ​can​ ​create​
​complementarities​ ​among​​inputs,​​based​​on​ ​low-production-quality traps.​
​the products of the input qualities.​
​●​ ​Output​ ​depends​ ​on​ ​multiplying​ ​the​ ​Bottlenecks​
​"quality" (q of each task.​
​●​ ​Local​ ​production​ ​bottlenecks​ ​have​
​ ​ ​Example:​​If​​a​​process​​has​​n​​tasks,​​and​​qi​ ​is​
●
​ ultiplicative​ ​effects​ ​due​ ​to​ ​the​ ​nature​ ​of​
m
​the​ ​quality​ ​of​​task​ ​i​,​​total​​output​​might​​be​
​the production function.​
​proportional to​​
​ ​ ​They​ ​also​ ​reduce​ ​incentives​ ​for​ ​skill​
●
​●​ ​Quality​ ​(q)​ ​can​ ​represent​ ​probability​ ​of​
​investment.​
​success,​ ​a​ ​quality​ ​index,​ ​or​ ​a​ ​fraction​ ​of​
​maximum value.​
​Technology Choice​
​●​ ​Firms​ ​in​ ​high-skill​ ​economies​ ​may​ ​adopt​
​Positive Assortative Matching​
​ ore​ ​complex​ ​technologies​ ​with​ ​more​
m
​●​ ​Workers​ ​with​ ​high​ ​skills​ ​tend​ ​to​ ​work​
​tasks, as the cost of mistakes is magnified.​
​together,​​and​​workers​​with​​low​​skills​​tend​​to​
​ ork together.​
w
​Brain Drain​
​ ​ ​Reasoning:​ ​If​ ​output​ ​is​ ​a​ ​product​ ​of​
●
​individual​ ​efforts​ ​(qi​​×​​qj),​ ​then​​a​​high-skill​ ​●​ ​Can​ ​help​ ​explain​ ​why​ ​skilled​ ​workers​ ​earn​
​worker​​(qH)​​is​​more​​productive​​when​​paired​ ​more in developed countries.​
​with​ ​another​ ​high-skill​ ​worker​ ​than​ ​with​ ​a​
​Key Assumptions for Assortative Matching:​
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​●​ W ​ orkers​ ​are​ ​sufficiently​ ​imperfect​ i​nformation​ ​(and​ ​susceptibility​ ​to​ ​free​
​substitutes.​ ​riding)​
​●​ ​Tasks exhibit sufficient complementarity.​ ​ ​ ​it​ ​is​ ​neither​ ​fully​ ​excludable​ ​from​ ​other​
●
​uses,​ ​nor​ ​non-rival​ ​(one​ ​agent’s​ ​use​ ​of​
​4.6 Economic Development as Self-Discovery​ ​information​ ​does​ ​not​ ​prevent​ ​others​ ​from​
​●​ C ​ oncept:​ ​Nations,​ ​like​ ​individuals,​ ​must​ ​using it).​
​discover​​their​​comparative​​advantages.​​This​
​process is prone to market failure.​ ​4.7 The Hausmann-Rodrik-Velasco (HRV) Growth​
​●​ ​The​ ​Problem:​ ​It's​ ​not​ ​enough​ ​to​ ​know​ ​a​ ​Diagnostics Framework​
​general​ ​category​ ​(e.g.,​ ​"labor-intensive").​ ​●​ G
​ oal​​:​ ​Identify​ a​ ​ ​country's​ ​most​ b
​ inding​
​Discovering​ ​the​ ​specific​ ​products​​a​​country​ ​constraints​ ​on​ ​economic​ ​growth,​ ​moving​
​is​ ​relatively​ ​good​ ​at​ ​producing​​efficiently​​is​ ​away​ ​from​ ​"one-size-fits-all"​ ​policy​
​socially valuable.​ ​prescriptions.​

​Market Failure​ ​Decision Tree Approach​

​ ​ I​nformation externality.​
● ​​ A
● ​ structured way to diagnose problems.​
​●​ ​Pioneers​ ​who​ ​discover​ ​profitable​ ​activities​ ​●​ ​Starting​ ​Point:​ ​Low​ ​levels​ ​of​ ​private​
​bear the costs of search and adaptation.​ ​investment and entrepreneurship.​
​●​ ​Once​​discovered,​​others​​can​​imitate​​rapidly,​
r​ educing the pioneer's profits.​ ​Two Main Branches​
​ ​ ​This​ ​leads​ ​to​ ​underinvestment​ ​in​
● ​1.​ L​ ow​ ​Return​ ​to​ ​Economic​​Activity:​​Why​​are​
​"self-discovery"​ ​because​ ​individuals​ ​do​ ​not​ ​activities not profitable enough?​
​capture the full social return.​
​Low Social Returns​
​Government Role​ ​●​ P ​ oor​ ​Geography​ ​(e.g.,​ ​landlocked,​ ​tropical​
​●​ ​Policy​ ​should​ ​encourage​ ​broad​ ​investment​ ​diseases).​
i​n​ ​the​ ​modern​ ​sector​ ​during​ ​the​ ​discovery​ ​●​ ​Low​ ​Human​ ​Capital​ ​(education,​ ​skills,​
​phase​​and​​potentially​​rationalize​​production​ ​health).​
​afterward.​ ​●​ ​Bad​ ​Infrastructure​ ​(transport,​
​communication, utilities).​
​Building Blocks​
​​ U
● ​ ncertainty about efficient products.​ ​Low Appropriability​
​●​ ​Need​ ​for​ ​local​ ​adaptation​ ​of​ ​imported​ ​ ​ I​nvestors cannot capture returns.​
●
t​ echnology.​ ​●​ ​Government Failures:​
​ ​ ​Rapid​ ​imitation​
● ​once​ ​obstacles​ ​are​ ​-​ ​Micro​ ​Risks:​ ​Weak​​property​​rights,​
​overcome.​ ​corruption, high effective taxes.​
​-​ ​Macro​ ​Risks:​ ​Financial,​ ​monetary,​
​fiscal instability.​
​Information externality​
​●​ ​Market Failures:​
​●​ ​The​ ​spillover​ ​of​ ​information​ ​such​ ​as​
​-​ ​Information​ ​Externalities​
k​ nowledge​ ​of​ ​a​ ​production​ ​process—from​
​(self-discovery problems).​
​one​ ​agent​ ​to​ ​another,​ ​without​
​-​ ​Coordination​ ​Problems​ ​(e.g.,​ ​big​
​intermediation​ ​of​ ​a​ ​market​ ​transaction;​
​push).​
​reflects​ ​the​ ​public​ ​good​ ​characteristic​ ​of​
​ECO 310 Economics Development​
​A.Y. 2025-2026​ ​ECO 310​

​2.​ H​ igh​ ​Cost​ ​of​ ​Finance:​ ​Why​ ​is​ ​capital​ ​whole.​

​expensive?​
​Conclusions​
​Bad International Finance​ ​●​ C ​ entral​ ​Problem:​ ​Coordination​ ​failures,​
​●​ ​Problems with foreign borrowing or debt.​ ​driven​ ​by​ ​complementarities​ ​and​
​externalities,​ ​mean​ ​that​ ​rational​ ​individual​
​Bad Local Finance​ ​behavior​ ​can​ ​lead​ ​to​ ​inefficient​ ​collective​
​ ​ L​ ow Domestic Saving.​
● ​outcomes (poverty traps).​
​●​ ​Poor​ ​Financial​ ​Intermediation​ ​(weak​ ​●​ ​Role​​of​​Policy:​​Government​​intervention​​can​
​banking system)​ ​be​ ​crucial​ ​("deep​ ​interventions")​ ​to​ ​shift​
​economies​ ​to​ ​better,​ ​self-sustaining​
​equilibria.​
​●​ ​"Onetime-Fix"​ ​Potential:​ ​Some​
​Policy Implications​ ​interventions,​ ​like​ ​a​ ​successful​ ​"big​ ​push,"​
​●​ T​ argeting​​the​​identified​​binding​​constraint​​is​ ​might​ ​move​ ​an​ ​economy​ ​to​ ​a​ ​better​
​more​ ​effective​ ​than​ ​a​ ​broad​ ​laundry​​list​​of​ ​equilibrium​​that​​it​​can​​maintain​​on​​its​​own,​
​reforms.​ ​reducing​ ​the​ ​need​​for​​ongoing​​government​
​intervention.​
​Examples​ ​●​ ​Risks​​of​​Policy:​​Poorly​​designed​​policies​​can​
​●​ E​ l​ ​Salvador:​ ​Constrained​ ​by​ ​a​ ​lack​ ​of​ ​also​ ​push​ ​an​ ​economy​ ​into​ ​a​ ​bad​
​productive​ ​ideas​ ​("self-discovery").​ ​Focus:​ ​equilibrium,​ ​with​ ​significant​ ​long-term​
​Encourage entrepreneurship.​ ​costs.​ ​Government​ ​itself​​can​​be​​part​​of​​the​
​●​ ​Brazil:​ ​Constrained​ ​by​ ​insufficient​ ​funds​ ​to​ ​problem​ ​(e.g.,​ ​corruption​ ​perpetuating​​bad​
​invest​​despite​​ideas.​​Focus:​​Mobilize​​savings​ ​equilibria).​
​(domestic/foreign)​ ​and​ ​potentially​ ​adjust​ ​●​ ​Balanced​​Approach:​​Recognize​​both​​market​
​fiscal policy.​ ​failures​ ​(coordination,​ ​information​
​●​ ​Dominican​ ​Republic:​ ​Constrained​ ​by​ ​core​ ​externalities)​ ​and​ ​government​ ​failures.​
​public​​goods​​(infrastructure,​​security)​​in​​key​ ​Foster​ ​collaboration​ ​between​ ​public​ ​and​
​sectors.​ ​Focus:​ ​Invest​ ​in​ ​essential​ ​public​ ​private sectors.​
​goods.​ ​●​ ​Growth​ ​Diagnostics:​ ​A​ ​valuable​ ​tool​ ​for​
​identifying​ ​specific,​ ​binding​ ​constraints​ ​to​
​ ey​ ​Takeaway:​ ​Development​ ​strategies​ ​must​ ​be​
K ​guide policy priorities.​
​tailored to country-specific binding constraints.​ ​●​ ​Contemporary​ ​models​ ​offer​ ​a​ ​richer​
​understanding​ ​of​ ​development's​ ​difficulty​
​Growth Diagnostics​ ​and​​the​​potential​​for​​targeted​​interventions,​
​●​ A​ ​ ​decision​ ​tree​​framework​​for​​identifying​​a​ ​emphasizing context-specific solutions.​
​country’s​ ​most​ ​binding​ ​constraints​ ​on​
​economic growth.​

​Social Returns​
​●​ T​ he​ ​profitability​ ​of​ ​an​ ​investment​ ​in​​which​
​both​ ​costs​ ​and​ ​benefits​ ​are​ ​accounted​ ​for​
​from the perspective of the society as a​