Chapter 4
Contemporary
Models of
Development and
Underdevelopment
Dr. Syed Hassan Raza
4.1 Underdevelopment as a
Coordination Failure
• A newer school of thought on problems of economic
development (Contemporary as opposed to traditional
models like the Harrod-Domar or Lewis models).
• These newer theories emphasize interactions
between economic agents and the role of institutions,
incentives, and expectations in development.
• They recognize that poor countries might be stuck in
low-level equilibria not just because of lack of capital
or technology, but due to coordination issues among
different players in the economy.
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4.1 Underdevelopment as a
Coordination Failure
• Coordination failures occur when agents’ inability to
coordinate their actions leads to an outcome that
makes all agents worse off.
• An agent refers to any economic actor this could
be individuals, firms, governments, or institutions.
• If agents don’t act together in a complementary
way, they may all end up in a worse-off state.
• For example, a firm may not want to invest in a
region unless there's infrastructure, but the
government might not build infrastructure unless
firms show interest a classic coordination problem.
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4.1 Underdevelopment as a
Coordination Failure
• This can occur when actions are complementary,
i.e., Actions taken by one agent reinforces
incentives for others to take similar actions.
• Complementarity means the benefit of one
agent’s action increases if others also act.
• Example: If multiple firms invest in a new industrial
zone, they create a market for suppliers, services,
and workers making everyone better off.
• But if none act, fearing others won’t act either, no
one moves, and development stalls.
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4.1 Underdevelopment as a
Coordination Failure
• This circumstance can, under some
circumstances, lead to multiple equilibria
• The idea is that an economy might be stuck
in a bad equilibrium (low investment, low
productivity, low income).
• But there's also a better equilibrium (high
investment, high productivity, high income).
• Which equilibrium the economy reaches
depends on expectations and coordination.
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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
• This model shows how coordination failures can lead to
more than one equilibrium some of which may trap a
country in underdevelopment.
• Equilibria are
– Stable: function crosses the 45º line from above
– Unstable: function crosses the 45º line from below
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Figure 4.1 Multiple Equilibria
45° line:
represents points
where an agent’s
expectations
match actual
outcomes (i.e., S-shaped curve
expectations = (nonlinear): shows how
reality). much an individual
agent
(e.g., a firm or
household) chooses to
invest based on what
they
expect others to do.
D1 is Stable, but it If slightly more or less investment is D3 is Stable, Stable and
reflects expected, desirable outcome
underdevelopment agents change behavior reflects successful
or low-level equilibrium. significantly. Hence D2 is unstable. coordination.
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4.3 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
– One factor of production
– Two sectors
– Same production function for each sector
– Consumers spend an equal amount on each good
– Closed economy
– 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
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Figure 4.2 The Big Push
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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 any 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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4.4 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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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 =
qi qj
• 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
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4.6 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
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4.6 Economic Development as Self-
Discovery
• 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)
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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
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Figure 4.3 Hausmann-Rodrik-Velasco Growth
Diagnostics Decision Tree
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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
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Concepts for Review (cont’d)
• Social returns
• Technological externality
• Underdevelopment trap
• Where-to-meet dilemma
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