Chapter 4:

CONTEMPORARY
MODELS
of development and
underdevelopment
ALIDO.BERTE.ESLAO.INTIA
AC2Y1- 2
ECONOMIC
AGENT
An, economic actor- usually a firm,
worker, government official,
consumer that choses actions as to
maximize an objective.
 4.1
UNDERDEVELOPM
ENT AS A
COORDINATION
FAILURE
 COMPLEMENTA
RY
An action taken by one firm, worker, or
organization that increases the incentives for
other agents to take similar actions.
 COORDINATION
FAILURE
A state of affairs in which the inability of agents
to coordinate their behavior (choices) leads to
an outcome (equilibrium) that leaves all agents
worse off than in an alternative situation that is
also an equilibrium
 Big push
A concerted, economywide, and typically public
policy–led effort to initiate or accelerate
economic development across a broad spectrum
of new industries and skills.

O-ring model
An economic model in which production
functions exhibit strong complementarities
among inputs and which has broader
implications for impediments to achieving
economic development
 Middle-income trap
A condition in which an economy begins
development to reach middle-income status but
is chronically unable to progress to high-income
status
 Deep intervention
A government policy that can move the
economy to a preferred equilibrium or even to a
higher permanent rate of growth that can then
be self-sustaining so that the policy need no
longer be enforced because the better
equilibrium will then prevail without further
intervention
 Congestion
The opposite of a complementarity; an action
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 better
off cooperating than competing but lack
information about how to do so
 Prisoners’dilemma
A situation in which all parties would be better
off cooperating than competing but once
cooperation has been achieved, each party
would gain the most by cheating, provided that
others stick to cooperative agreements— thus
causing any agreement to unravel
 4.2 MULTIPLE
EQUILIBRIA:
A DIAGRAMATIC
APPROACH
 Multiple
equilibria
A condition in which more than one
equilibrium exists.
• The basic idea reflected in the S-shaped
function of Figure 4.1 is that the benefits
an agent receives from taking an action
depend positively on how many other
agents are expected to take the action or
on the extent of those actions.
• In the Marshallian supply-and-demand
scissors diagram, equilibrium is found
where the supply and demand curves
cross.
• In the multiple-equilibrium diagram,
equilibrium is found where the “privately
rational decision function” (the S-shaped
curve in Figure 4.1) crosses the 45-
degree line.
Pareto improvement-
A situation in which one or more persons
may be made better off without making
anyone worse off.
 4. 3 Starting economic
development: the big push
Pecuniary externality- A positive or
negative spillover effect on an agent’s costs
or revenues.
 The Big Push: A Graphical
Model
is a concept in development economics or
welfare economics that emphasizes that a
firm's decision whether to industrialize or
not depends on its expectation of what
other firms will do.
 ASSUMPTIONS
• we need to make some assumptions,
sometimes seemingly large assumptions, to
make any progress in our understanding. The
six type of assumptions are;
1. FACTORS
2. Factors payment
3. Technology
4. Domestic demand
5. International supply and demand
6. Market structure
In Figure 4.2, production functions are represented for
the two types of firms for any industry.23 The traditional
producers use a linear technique with slope 1, with each
worker producing one unit of output. The modern firm
requires F workers before it can produce anything, but
after that, it has a linear technique with slope 1/c 7 1.
Price is 1, so revenues PQ can be read off the Q axis. For
the traditional firm, the wage bill line lies coincident with
the production line (both start at the origin and have a
slope of 1). For the modern firm, the wage bill line has
slope W 7 1. At point A, we see the output that the
modern firm will produce if it enters, provided there are
traditional firms operating in the rest of the economy.
Whether the modern firm enters depends, of course, on
whether it is profitable to do so.
Technological externality- A positive or
negative spillover effect on a firm’s production
function through some means other than
market exchange.
The need for a big push can result from
four conditions;

1. INTERTEMPORAL EFFECTS
2. URBANIZATION EFFECTS
3. INFRASTRUCTURE EFFECTS
4. TRAINING EFFECTS
• Agency costs -Costs of monitoring managers
and other employees and of designing and
implementing schemes to ensure compliance
or provide incentives to follow the wishes of
the employer.
• Asymmetric information- A situation in
which one party to a potential transaction
(often a buyer, seller, lender, or borrower) has
more information than another party.
4.4 Further Problems of Multiple
Equilibria
Linkages Connections between firms based on
sales.
Poverty trap- A bad equilibrium for a family,
community, or nation, involving a vicious circle
in which poverty and underdevelopment lead to
more poverty and underdevelopment, often
from one generation to the next.
 4.5 Michael
Kremer’s O-
Ring Theory of
Economic
Development
 THE O-RING MODEL
it models production with strong
complementarities among inputs.
O-ring production function- A production
function with strong complementarities among
inputs, based on the products of the input
qualities.
3 OTHER TYPES OF SIMPLIFYING
ASSUMPTIONS
1. Firms are risk neutral
2. Labor markets are competitive
3. Workers supply labor inelastically
POSITIVE ASSORTATIVE MATCHING- This
means that workers with high skills will
work together and workers with low skills
will work together.
 IMPLICATIONS OF THE O-RING THEORY
1. Firms tend to employ workers with similar skills for
their various tasks.
2. Workers performing the same task earn higher wages
in a high-skill firm than in a low-skill firm.
3. Because wages increase in q at an increasing rate,
wages will be more than proportionally higher in
developed countries than would be predicted from
standard measures of skill.
4. If workers can improve their skill level and make such
investments, and if it is in their interests to do so, they
will consider the level of human capital investments
made by other workers as a component of their own
decision about how much skill to acquire.
1. One can get caught in economywide low-
production-quality traps. This will occur when
there are (quite plausibly) O-ring effects across
firms as well as within firms.
2. O-ring effects magnify the impact of local
production bottlenecks because such
bottlenecks have a multiplicative effect on other
production.
3. Bottlenecks also reduce the incentive for
workers to invest in skills by lowering the
expected return to these skills.
4.6 Economic Development as
Self-Discovery
• Information externality- The spillover
of information— such as knowledge of a
production process—from one agent to
another, without intermediation of a
market transaction; reflects the public
good characteristic of information (and
susceptibility to free riding)—it is neither
fully excludable from other uses, nor
non-rival (one agent’s use of information
does not prevent others from using it).
4.7 The Hausmann-Rodrik-Velasco
Growth Diagnostics Framework
• Social returns- The profitability of an
investment in which both costs and benefits
are accounted for from the perspective of the
society as a whole
• Growth diagnostics- A decision tree
framework for identifying a country’s most
binding constraints on economic growth.
 4.8 CONCLUSION
• The purpose of economic development theory
is not only to understand underdevelopment
but also to devise effective policies to redress
it.
• people keep doing inefficient things because
it is rational to keep doing them, and it will
remain rational as long as others keep doing
inefficient things.
• the analysis shows that the potential for
market failure, especially as it affects the
prospects for economic development