Economic Development
Thirteenth Edition
Chapter 4
Contemporary Models of
Development and
Underdevelopment
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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, i.e.,
• Actions taken by one agent reinforces incentives for
others to take similar actions
– This circumstance can, under some circumstances, lead to
multiple equilibria
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Figure 4.1
Multiple Equilibria
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Figure 4.2
The Big Push
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Big Push Model Equilibria
• 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 W 2, 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
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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 – that might be unusual; it is
used as an illustration because it is easy to describe graphically
• In this regard, note that other causes of multiple equilibria are
discussed in the context of this model, such as 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
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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 any empirical evidence that would suggest
this is possible
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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)
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
4.4 Further Problems of Multiple Equilibria
• Inefficient Advantages of Incumbency
• Behavior and Norms
• Linkages
• Inequality, Multiple Equilibria, and Growth
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Kremer’s O-Ring Theory: A Numerical
Illustration
• The O-Ring Model
– Production modeled with strong complementarities among inputs
– Positive assortative matching in production
• Simple Illustration of the basic idea
• 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}?
• That is: 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
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
O-ring production analysis setup: details
• Kremer’s concept of q is quite 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)
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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% (the 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
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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:
• This is one explanation why economies cut off from international economy
generally performed less well those more integrated
• The O-ring theory also helps explain:
‒ Why rich countries have larger firms; specialize in complex products;
‒ Why firm size and wages are positively correlated within and across
countries
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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
• 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 Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Economic Development as “Self-Discovery,”
continued
• 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. Authors’
examples:
– India’s widely unexpected success in information technology
– Reasons for Bangladesh’s efficiency in hats vs Pakistan’s in bed
sheets is unclear
2. Need for local adaptation of foreign technology
– Authors’ example: Shipbuilding in South Korea
3. Imitation can be rapid
– Authors’ example: The spread of cut flower exporting in
Colombia
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
4.7 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
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Figure 4.3
Hausmann-Rodrik-Velasco Growth Diagnostics
Decision Tree
Source: Hausmann, Ricardo, Rodrik, Dani and Velasco, Andrés (2006), ‘Getting the diagnosis right,’ Finance and Development 43. Reprinted with permission.
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Growth Diagnostics: Categories of “most
binding constraints” in the “decision tree”
• Constraint categories are the boxes from which no further arrows emanate –
10 are included
• 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)
– Suggested discussion exercise: Identifying other possible final boxes
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Doing Growth Diagnostics in Practice*
• Careful research is required to determine most likely binding constraint:
• In practice, 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
*Draws from Ricardo Hausmann, Bailey Klinger, Rodrigo Wagner, Doing Growth Diagnostics in Practice: A ‘Mindbook,’
CID Working Paper No. 177, 2008
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
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
*Ricardo Hausmann, Bailey Klinger, Rodrigo Wagner, Doing Growth Diagnostics in Practice: A ‘Mindbook,’ CID
Working Paper No. 177, 2008:
[Link]
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Findings. Inclusive Growth Diagnostics:
The Case of Bangladesh*
• Growth diagnostics methods were used to identify the binding
constraint(s) for growth in Bangladesh
• A study goal: beyond growth as a general objective; consider
inclusive growth in the context of opportunities for women.
• General review ruled out some potential constraints, narrowed
focus to five plausible ones. Candidate binding constraints:
‒ Finance: Not a strong case, but recommended the finance
sector would need attention looking ahead
‒ Market failure (particularly coordination and information
externalities): Found market failures important concerns, but
unlikely currently binding given severity of other problems
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Findings. Inclusive Growth Diagnostics:
The Case of Bangladesh* (Continued)
• Human capital:
– Progress including girls’ education noted;
– Returns to education not particularly high;
– Firms did not cite education levels as a problem;
– Education does not explain international migration patterns;
– No clear relationship between labor intensity and growth by industry
– While education not now binding, the study argued that its low
average quality and high variance could make it a possible emerging
constraint going forward
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Inclusive Growth Diagnostics: Bangladesh
(Continued)
• Government failure?
– Evidence for contract enforcement as binding was inconclusive
– Corruption: Authors termed it “a most binding constraint”;
“close to binding” in some sectors; likely not binding on growth
at this time, based on benchmark indexes and firm surveys
– Note: Amount of bribes paid substantial, but around the
middle of comparator countries- far below Cambodia and
Philippines; no clear relationship between corruption and
investment.
• Infrastructure?
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Inclusive Growth Diagnostics: Bangladesh
(Continued)
• The authors termed electricity infrastructure “The most binding constraint”
– Regarding a high shadow price, the team reported that the cost of non-grid
electricity is several times that of bulk electricity tariff rates
– Regarding movements in the constraint shifts objective, they found that electricity
availability has been followed (likely causally) by higher electricity-using investment
– Regarding bypassing constraints, firms – and government – using expensive private
generators; also connected to the building of export processing zones
– (Regarding whether less-intensive users of electricity thrive, evidence less clear)
– Argued greater electricity capacity and reliability would likely lead to increased
formal sector employment
• Authors conclusion: electricity capacity investment would have largest impact
on growth, with favorable impacts on employment and incomes for women
Source: USAID-UKAID: Bangladesh Inclusive Growth Diagnostic, June 2014: [Link]
%20Inclusive%20Growth%20Diagnostic%20-%20Final%[Link]
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Findings Box 4.2: Village Coordination and
Monitoring for Better Health Outcomes
• The problem: poor health outcomes, low public health care provision in rural
Uganda
• Villagers have access to public “dispensaries” – but use levels and satisfaction
are low; government oversight has been ineffective
• A program intervention provided villagers with the knowledge and resources
to enable them to monitor health workers, both individually and through their
community organization
• 50 villages selected; 25 for the “treatment,” and 25 for the control group
• Surveys were conducted of all households on health outcomes and satisfaction
with the health care providers; Data also collected from health care providers
• A randomized controlled trial (RCT) used to identify causal impacts of the
intervention
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Findings Box 4.2: Village Coordination and
Monitoring for Better Health Outcomes
(Continued)
• Purpose of an RCT: It is impossible to observe the same person with and
without treatment…
• Next best: Find the average effect on a group of people randomly selected for
treatment, from a broader, randomly selected pool. Those not selected
become the control group
• Treatment: Using household survey data, a report card for each health care
provider was developed and presented at community meetings, with health
care providers present
• Goal: giving information to users about overall and relative outcomes enables
them to more effectively monitor their health care providers
• Effects: significant improvements in health outcomes
Source: M. Bjorkman and J. Svensson, “Village Coordination and Monitoring for Better Health Outcomes, Quarterly
Journal of Economics, 124 (2), pp 735–769, May 2009
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Concepts for Review
• Agency costs • Information externality
• Asymmetric information • Linkage
• Big push • Middle-income trap
• Complementarity • Multiple equilibria
• Congestion • O-ring model
• Coordination failure • O-ring production function
• Deep intervention • Pareto improvement
• Economic agent • Pecuniary externalities
• Growth diagnostics • Poverty trap
• Prisoners’ dilemma
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
Concepts for Review (Continued)
• Social returns
• Technological externality
• Underdevelopment trap
• Where-to-meet dilemma
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
