Chapter 3-4: Contemporary Models of Development and Underdevelopment

After over half a century of development initiatives, it has become clear that while development is achievable, it is also immensely
complex. Some nations, such as those in East Asia, have seen massive progress, while others, like parts of Sub-Saharan Africa,
continue to struggle. The modern challenge is to understand why development occurs in some contexts and fails in others.
Contemporary models provide a more nuanced, realistic framework to interpret these varied outcomes.

I. Key Economic Concepts

1. Binding Constraints
Binding constraints are the most binding or limiting factors in an economy that hinder progress and growth. If addressed, these
constraints can unlock substantial improvements in development outcomes. These constraints differ across countries, regions, and
sectors, depending on the stage of development.

Examples of Common Binding Constraints:

Country/Region Binding Constraint Explanation

Philippines (rural) Poor infrastructure (roads, electricity) Limits access to markets and services, raises transport costs
Sub-Saharan Africa Limited access to finance Hinders entrepreneurship and investment
Argentina Macroeconomic instability Unpredictable inflation discourages long-term planning
Bangladesh Low human capital (health, education) Affects labor productivity and innovation capacity
Venezuela Policy uncertainty and corruption Reduces investor confidence and capital inflow

Diagnostic Tool:
The Growth Diagnostics Framework by Hausmann, Rodrik, and Velasco helps policymakers identify the most binding constraint
using a decision-tree approach.

2. Economic Agent
An economic agent is any individual, firm, organization, or government body that makes economic decisions—usually to maximize
an objective, such as:

 Consumers – maximize utility (satisfaction)

 Firms – maximize profit
 Governments – maximize social welfare, growth, or political stability

Why Agents Matter in Development:

The success of development policies depends on how these agents respond to incentives.

Example:

 A subsidy for solar panels will only increase usage if consumers trust the technology and have access to installation
services.
 A new school building will only improve education if parents send children to school and teachers show up and
teach effectively.

Categories of Economic Agents and Their Roles:

Agent Type Objective Role in Development Example

Provide labor, consume goods, invest in human
Households Maximize utility Family deciding to send children to school
capital
Firms Maximize profit Invest in production, create jobs, innovate Startups in fintech or agritech
Set regulations, invest in infrastructure and public
Government Maximize welfare Implementing universal health care
goods
Microfinance for rural women
NGOs & Donors Maximize impact Fill gaps in service delivery
entrepreneurs

Additional Insights: Interaction Between Agents and Constraints

The interaction between agents and binding constraints can result in coordination failures or virtuous cycles depending on policy
environments.

Example:
In regions with poor roads (binding constraint), farmers (agents) cannot sell their produce efficiently → low income → no incentive
to invest in productivity → cycle of underdevelopment.

II. Underdevelopment as a Coordination Failure

What Is Coordination Failure?

Coordination failure occurs when individuals, firms, or institutions do not take actions that would lead to mutual benefit—not
because those actions are irrational, but because they are waiting on others to act first. This lack of trust, poor communication, or
misaligned incentives can trap an economy in a low-level equilibrium, where development stalls despite potential.

Complementarity in Action

Complementarity means that the actions of one agent increase the returns for others to act.

Example of Complementarity How It Works

Education investment by workers Makes it worthwhile for firms to invest in high-tech industries
Infrastructure development by government Encourages private investment in logistics, tourism, and manufacturing
Technology adoption by farmers Creates economies of scale for suppliers and buyers in agribusiness
Banking penetration in rural areas Increases financial inclusion, makes entrepreneurship viable

If no one acts first, development remains stagnant.

The Low-Level Equilibrium Trap

Coined by Richard R. Nelson, this concept describes a self-reinforcing situation where:

 Productivity stays low

 Incomes remain stagnant
 Investment and innovation are minimal
 Human capital formation is weak

Even if better outcomes are possible, no one moves because each agent depends on others acting first.

Example of the Trap:

In a remote province in the Philippines:

 Firms don’t build factories because roads are bad.

 Government won’t improve roads without tax revenues or jobs from businesses.
 Workers migrate to cities, worsening rural underdevelopment.

Big Push Theory (Rosenstein-Rodan, 1943)

Big Push Theory proposes that simultaneous, large-scale investments in various sectors can help break out of coordination failures.

Key Features:

 Requires government intervention or strong planning

 Involves public-private partnerships
 Targets multiple complementary sectors at once (e.g., transport + education + energy)
 South Korea Case Study:
In the 1960s, the South Korean government:

 Built nationwide infrastructure (roads, ports)

 Subsidized key industries (e.g., steel, shipbuilding)
 Reformed education to supply skilled labor
 Directed banks to fund export-oriented firms

Result: Rapid industrialization and transition from a poor agrarian economy to a high-tech exporter.

Visual Framework: Coordination Failure Cycle vs. Big Push Success

Without Coordination (Failure Trap) With Coordination (Big Push)

Firms wait for infrastructure Firms invest alongside infrastructure
Government waits for private investment Government initiates targeted investments
Workers remain unskilled Skills development programs align with industry needs
No innovation or productivity growth Rapid industrial growth and rising incomes

When Is a Big Push Justified?

Use cost-benefit analysis or growth diagnostics to assess:

 If there’s complementarity between sectors

 If market failures are systemic
 If isolated policies won’t work unless done together

Summary Points

 Coordination failure is not about incompetence, but about strategic interdependence.

 Complementarity explains why agents might hesitate to act alone.
 The Big Push shows how government-led coordination can break the trap and accelerate growth.
 Modern relevance: Still seen today in infrastructure gaps, digital divide, and environmental cooperation (e.g., climate
finance).

III. Multiple Equilibria and the Role of Policy

What Are Multiple Equilibria?

In development economics, multiple equilibria means that an economy can stabilize in different long-term outcomes depending on
initial conditions and decisions. These outcomes can either be:

 Low-income, low-growth equilibrium (poverty trap)

 High-income, high-growth equilibrium (prosperity)

Each state tends to reinforce itself. Once a country or region falls into one of these, it often stays there—unless something major (like
government policy or external aid) pushes it toward a better path.

Example:
Two regions start out at the same level.

 Region A builds irrigation and improves roads to access markets.

 Region B doesn’t invest in infrastructure.
After 10 years, Region A thrives, while Region B remains poor.

This shows how small differences in coordination or investment can lead to very different outcomes.
Pareto Improvement

A Pareto Improvement is a change where at least one person benefits without making anyone else worse off. These are ideal in
policy—but in real life, they can be hard to achieve without coordination or trade-offs.

Example Pareto-Improving? Why?

Clean water access ✅ Yes Health improves; no one is harmed
Removing energy subsidies ❌ No May raise prices and hurt low-income consumers
Universal education ✅ Potentially Boosts long-term growth; short-term costs may vary

Why Policy Matters

Government intervention can:

 Help coordinate investments across sectors and regions

 Break the poverty trap by crossing the critical threshold
 Create the conditions needed for sustainable, shared prosperity

Without well-planned policy, economies may remain stuck in low-growth equilibria—even when better outcomes are possible.

The S-Curve of Multiple Equilibria (Poverty Trap)

The S-curve illustrates how low levels of investment keep an economy stuck in poverty, while high levels of coordinated investment
can shift it toward sustained growth.

Here is the improved graph showing the S-Curve of Multiple Equilibria using a smoother and more realistic curve. It highlights:

 Low-Level Equilibrium (Poverty Trap) on the left side where low investment leads to low income/output.
 High-Level Equilibrium (Prosperity) on the right side where high investment leads to sustained growth.

Game Theory Concepts in Development

1. Prisoner’s Dilemma

This classic game-theory problem illustrates why rational individuals may not cooperate, even when it’s in their best interest to do
so.

In development:

 Firms may under-invest in R&D if others can free-ride on the innovation

 Countries may not cut emissions, hoping others do while they continue polluting
 Workers avoid joining unions, even though collective bargaining benefits all
 Actor Choice Individual Incentive Collective Outcome
Country A Continue pollution Lower cost today Climate damage
Country B Reduce emissions Higher cost today Better environment

Policy Role: Government or international agreements can enforce cooperation (e.g., Paris Agreement).

2. Where-to-Meet Dilemma (Coordination Problem)

Also known as the “Stag Hunt” or “focal point” problem, this situation arises when:

 All players want to cooperate

 But they lack information, communication, or leadership
 As a result, no action happens—even though everyone agrees it should

Example:

 All countries want to build inter-country infrastructure (e.g., ASEAN highway)

 No one starts construction until another does
 The project never begins due to uncertainty

Policy Role: A credible coordinator (e.g., national government, regional body, international donor) can signal the location and
timing of cooperation, solving the “where-to-meet” problem.

Role of Policy in Moving Toward a Better Equilibrium

Policy Tool How It Helps Solve Coordination/Multiple Equilibria

Public investment Signals confidence and encourages private sector follow-up (e.g., roads, telecom)
Subsidies or tax incentives Reduces cost of first movers in risky industries
Information campaigns Helps agents recognize shared goals (e.g., health drives, financial literacy)
Institutions and regulations Align individual incentives with collective goals (e.g., pollution taxes, anti-cartel laws)

Case Example:
The Philippines’ Public-Private Partnership (PPP) Program created a policy framework to attract private investment in
infrastructure—reducing the “wait-and-see” problem for investors.

V. Development Traps

Development traps are situations where countries or regions are stuck at a certain level of development due to self-reinforcing
problems. Escaping these traps usually requires external intervention or coordinated policy efforts.

1. Underdevelopment Trap

 A vicious cycle where poverty prevents investment, which in turn leads to poor infrastructure, low productivity, low tax
revenue, and weak public services.
 Key features:
o Poor education → low human capital → unskilled workforce.
o Weak infrastructure → high costs for firms → low FDI inflow.
o Government lacks capacity or funds for public investment.

Visual Aid – Underdevelopment Trap Cycle:

[Low Income] → [Low Investment] → [Poor Infrastructure] → [Low Productivity] → [Low Tax Revenue] → [Low
Public Investment] → back to [Low Income]

2. Middle-Income Trap
  Occurs when a country graduates from low-income status (through manufacturing and exports) but fails to become a high-
income economy.
 Reasons:
o Lack of innovation capacity.
o Weak institutions and corruption.
o Rising labor costs make low-skill exports uncompetitive.
 Examples: Malaysia, Brazil, South Africa.

World Bank Insight (2020):

Fewer than 20 of the 100+ middle-income countries in 1960 became high-income by 2008.

How to escape:
 Invest in education and R&D.
 Strengthen institutions.
 Develop high-value industries (e.g., IT, green tech).

VI. The O-Ring Theory of Development (Michael Kremer)

This theory stresses the importance of complementary skills and reliability in production processes.

Main Concept:
 O-Ring analogy: Like the failed O-ring in the Challenger disaster, a single failure in a complex task ruins the whole product.
 Production Function: Quality of output depends on the weakest task in the chain.
o Q=q1×q2×...×q
 Implication:
o High-skill workers prefer to work with others of similar skill (skill matching).
o Low-skill economies get trapped producing low-quality outputs.
Policy Implication:
 Invest in broad-based education and training.
 Encourage cluster development and quality control systems.

Graphical Representation:

Country Group Task Quality Output Quality Wage Level

High-Skill Cluster High High High
Low-Skill Cluster Low Low Low

VII. Economic Development as Self-Discovery (Hausmann & Rodrik)

Core Idea:
 Countries don’t know what they’re good at producing until someone tries.
 Entrepreneurs experiment, but if successful, others imitate without sharing initial costs.
Key Concept:
 Information Externalities: The benefits of discovery spill over to others.
 Entrepreneurs face high risk with little reward if copied too easily.
Policy Solutions:
 Support infant industries through:
o R&D subsidies.
o Export promotion.
o Temporary tariffs or protection.
 Provide public goods like infrastructure, information, and skills training.
VIII. Growth Diagnostics Framework (Hausmann, Rodrik, Velasco)

A step-by-step method to identify a country's most binding constraint on growth, rather than applying a one-size-fits-all policy.

Framework Process:

Step Guiding Question

1. Is low growth due to low returns to investment or lack of financing?
2. If low returns: Is it due to low social returns (e.g. human capital, infrastructure) or market failures (e.g. risk, appropriability)?
3. If financing is the issue: Are domestic savings too low? Are financial markets failing?
4. Look for signs of avoidance behavior: Are firms going informal? Are entrepreneurs investing abroad?
5. Tailor policy: Focus on the most binding constraint, not all problems at once.

Example:
In the Philippines, growth diagnostics may point to infrastructure and bureaucratic red tape as binding constraints, rather than
macroeconomic stability or financing.

Development Models

Model/Theory Core Concept Problem Addressed Key Policy Advice

Low investment and public Large-scale coordinated
Underdevelopment Trap Vicious cycle of poverty
capacity intervention
Middle-Income Trap Growth stagnation Failure to innovate and upgrade Innovation, education, governance
O-Ring Theory Weakest link matters Skill mismatch, low productivity Skill matching, clustering
Entrepreneurs learn by
Self-Discovery Risk of imitation, market failures Support for new industries
doing
Growth Diagnostics Framework Tailored constraint analysis Ineffective generic policy Target most binding constraint

Development is not automatic; it requires careful diagnosis, active coordination, and sustained effort. Contemporary theories
emphasize the importance of information, innovation, and institutions. Effective public policy, when backed by capable governance,
can overcome even deeply rooted development traps.

IX. Additional Barriers to Development

Beyond development traps and institutional weaknesses, several economic frictions can hinder a country’s progress. These barriers
often create inefficiencies, reduce investment, and prevent markets from functioning optimally.

1. Agency Costs

Costs that arise because agents (e.g., managers or government officials) may not act in the best interests of principals (e.g.,
shareholders or citizens).
Problem:
o In firms: Managers may prioritize personal perks or short-term goals.
o In government: Corruption or misallocation of public funds due to lack of accountability.
Example:
o A state-owned enterprise fails to innovate because managers fear disrupting their position.
o A mayor diverts public funds to win political favor instead of investing in education.
Policy Solutions:
o Strengthen corporate governance and performance audits.
o Implement transparent incentive structures and monitoring mechanisms.

2. Asymmetric Information

Occurs when one party in a transaction has more or better information than the other.
 Effects:
o Adverse Selection: Bad risks are more likely to be selected (e.g., in health insurance).
o Moral Hazard: One party takes more risks because they don't bear the full consequences.
Examples:
o Banks hesitate to lend to small firms due to lack of verifiable credit histories.
o Employers may avoid hiring unknown applicants due to skill uncertainty.
Policy Solutions:
o Develop credit bureaus, financial reporting standards.
o Use screening tools (e.g., skills certification, microfinance group lending).

3. Pecuniary and Technological Externalities

a. Pecuniary Externalities:
 Definition: When actions of firms or consumers affect others through changes in market prices.
 Example:
o A large firm moves into a region and drives up land prices, pushing out small farmers.
b. Technological Externalities:
 Definition: When knowledge or innovation by one firm spills over to benefit others without compensation.
 Example:
o A tech firm develops a new process, and neighboring firms copy it without R&D costs.
 Implication: These externalities mean individual firms may underinvest in innovation or market expansion because
they can’t capture all the benefits.
 Policy Solutions:
o Government support for R&D, subsidies for innovation.
o Infrastructure development that benefits multiple firms (e.g., science parks).

Summary Table: Additional Barriers

Barrier Core Issue Real-World Example Policy Recommendation

Government corruption, inefficient
Agency Costs Misaligned incentives Transparency, performance monitoring
SOEs
Asymmetric SME credit denial, risky insurance Credit bureaus, public disclosure, smart
Unequal access to information
Information markets contracts
Large investor crowds out small
Pecuniary Externalities Price-based spillovers Land-use regulation, zoning policies
players
Technological Knowledge spillovers without R&D subsidies, patent laws, innovation
Innovation copied without reward
Externalities payback clusters