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Contemporary Models of Development

This document discusses several models of coordination failure that can lead to underdevelopment. It summarizes key coordination failure models including: 1) Technological transfer which illustrates multiple equilibria and how public policy incentives are needed to encourage investment coordination. 2) The Big Push theory showing how simultaneous investment is required across firms to achieve industrialization. 3) The O-Ring theory emphasizing strong complementarities between inputs that require coordination between skilled labor and modern firms. The document analyzes the conditions and problems that make a Big Push necessary to overcome coordination failures blocking development.

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Harsh Shah
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4K views27 pages

Contemporary Models of Development

This document discusses several models of coordination failure that can lead to underdevelopment. It summarizes key coordination failure models including: 1) Technological transfer which illustrates multiple equilibria and how public policy incentives are needed to encourage investment coordination. 2) The Big Push theory showing how simultaneous investment is required across firms to achieve industrialization. 3) The O-Ring theory emphasizing strong complementarities between inputs that require coordination between skilled labor and modern firms. The document analyzes the conditions and problems that make a Big Push necessary to overcome coordination failures blocking development.

Uploaded by

Harsh Shah
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 27

Contemporary Models of

Development and Underdevelopment

1
Outline of the Presentation

• Underdevelopment as Coordination Failure


• Models of Coordination failure
• Technological transfer for modernization
• Multiple equilibria: Graphical Illustrations
• Big-push theory
• Kremer’s O-Ring Theory of Economic Development
• Concluding remarks

3-2
Underdevelopment as Coordination Failure

• Economic development is difficult to achieve.


– It has been impossible for some countries (e.g., Nigeria,
Sudan), but accomplished by others (e.g., S. Korea,
Singapore)

• Principal-agent” model
– The success or failure of economic development policies can be
explained by the “principal-agent” model.
• Underdevelopment trap
– A region remains stuck in substance agriculture

4-3
Underdevelopment as Coordination Failure

• Principal:
– Government

• Agents:
– Households
– Private-sector firms
– Public agencies
– Government-owned enterprises
– International companies
4-4
Underdevelopment as Coordination Failure

• An effective principal
– It is needed to coordinate actions taken by agents and
achieve an optimal outcome, making all agents better-off.

• Coordination failure
– It occurs when the principal fails to induce agents to
coordinate their actions, which leads to an outcome that
makes all agents worse-off.

4-5
Models of Coordination Failure

Technological Transfer for Modernization

The Big Bush to Industrialization

The O-Ring Theory of Economic Development

The Growth Diagnostics Framework

4-6
Technological Transfer for Modernization

• Multiple Equilibria
– The model is explained by the privately rational decision
function, an S-shaped curve. The intersection of this curve
with the 45º line is the point of equilibrium (A stable
equilibrium)

• At equilibrium,
– The expected outcome of an action equals its actual outcome
– Expected outcome = Actual outcome

4-7
Multiple Equilibria: Graphical Illustration

4-8
Technological Transfer for Modernization

• Stable equilibrium:
– The S-shaped function crosses the 45º line from above (points D1
and D3).
– Here firms adjust their investment decisions in coordination with
average investment in the industry.

• Unstable equilibrium:
– The S-shaped function crosses the 45º line from below (point D2).
– As firms coordinate their investment decisions, equilibrium moves
to D1 (decrease investment) or D3 (increase investment).

4-9
Technological Transfer for Modernization

• How to achieve equilibrium


– Firms must be able to coordinate their investment decisions such
that all firms benefit from each other’s investment.

• Public policy
– Creating incentives for investment is the key for successful
coordination.
– The government must establish inclusive incentives to encourage
business investment.

4-10
The Big Push: Coordination Failure

• Starting from a subsistence economy, no workers have the


money to buy the new goods
• The first factor sells some of its goods to its own workers
• No one spends all of their income on a single good
• Profitability of one factory depends on whether another one
opens
• Circular causation is a familiar pattern of a coordination failure
problem
• The first factory needs to train its workers
• The second firm pays a slightly higher wages

4-11
The Big Push to Industrialization

• Paul Rosenstein-Rodan
• A big push to industrialization requires a set of leading
firms to investment in productive activities and transfer
of modern technology

• Investment decisions made by modern-sector firms are


mutually reinforcing and public policy intervention is
needed to correct market failure

4-12
The Big Push to Industrialization

Assumptions:

• One factor of production: labor


• Two economic sectors: traditional vs. modern
• Same production function for each sector
• Consumers spend an equal amount on each
product they buy
• Closed economy
• Perfect competition
4-13
The Big Push: Coordination Failure

• A firm is deciding to invest in new technology

• It faces a production function in the traditional sector that passes


through the origin as output increases with labor employment

• It faces a production function in the modern sector that requires


some labor employment before initiating production (point F)
– Modern firm will pay the fixed cost F and enter the market
• g

4-14
The Big Push: Graphical Illustration

4-15
The Big Push: Coordination Failure

• At a low wage rate like W1,


– A new firm will enter the modern sector after paying the fixed labor
cost (F). With high demand (Q2), the firm makes profit and invests in
modern technology
• As W2 > W1,
– Other firms enter the modern sector to share the profit. Coordination
between these firms is now needed for the economy to adopt
modern technology
• At W2,
– Investment becomes profitable if all firms invest in modern technology to
industrialize the economy.
• High demand for manufactured products makes workers and firms benefit from
capital investment
• At a high wage like W3, investment in modern technology is not profitable
4-16
The Big Push: Coordination Failure

• Point A is a stable equilibrium as low profits


discourage firms to invest in modern
technology (no industrialization)

• Point B is an unstable equilibrium because it


requires the principal to provide incentive to
invest and agents to coordinate their
decision of investment in modern
technology (industrialization)
4-17
Conditions Making The Big Push Necessary

• Intertemporal effects:
– Investment in the modern sector becomes
profitable over-time as the market size
increases

• Urbanization effects:
– Demand for manufactured goods increases
with urban population growth

4-18
Conditions Making The Big Push
Necessary

• Infrastructural effects:
– Improvement in transportation,
communication, and distribution systems
reduces the cost of investment

• Training effects:
– The labor force becomes more productive
and skilled with education

4-19
Coordination Problem Cannot Be Solved by
a Super-Entrepreneur

• Capital market failure: bankers are unwilling


to provide loans to a single firm
• Cost of monitoring managers: expensive
agency costs to ensure compliance of
employees

• Communication failure: agents wanting to


share profit cannot convince the super-
entrepreneur to do so
4-20
Coordination Problem Cannot Be Solved by
a Super-Entrepreneur

• Limited knowledge: agents do not have


sufficient information about the importance
of industrialization

• Lack of empirical evidence: agents do not


know that other firms are investing in
modern technology

4-21
Further Problems of Multiple Equilibria

• Linkages: underdeveloped backward and


forward linkages to support industrialization

• Inequality and growth: trickle-up growth,


resulting in increased inequality and poverty,
reduces the buying power of workers and
their demand for manufactured goods

4-22
Further Problems of
Multiple Equilibria
• Inefficient advantages of incumbency:
existing firm have lower production cost

• Behavior and norms: agents may be corrupt


and bribery may be the standard method of
doing business internationally

4-23
The O-Ring Theory of
Economic Development

• A model of economic development put forward by


Michael Kremer in 1993
• Production is modeled with strong complementarities of
inputs (labor & capital) and interdependencies among firms
(output of one firm is input of another)

• Positive assortative matching in production:


– Skilled labor works with its peers;
– Profitable and modernizing firms coordinate with
their counterparts
4-24
The O-Ring Theory of
Economic Development

• Implications of strong complementarities for


economic development and the distribution
of income across countries will induce
countries at the same level of development
to coordinate their actions

• MDCs cooperate and coordinate with each


other in the development and transfer of
modern technology
4-25
The Growth Diagnostics Framework

• Focus on a country’s most binding


constraints of economic development:
– Low rate of return on investment and high cost
of financing

• No “one size fits all” in development policy of market


coordination

• Insufficient investment in physical, social,


environmental, and human capital
4-26
The Growth Diagnostics Framework

4-27

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