Contemporary Models of Development and Underdevelopment

1
Contemporary Models of Development and
Underdevelopment

• Reading Todaro Chapter 4

2
Overview

• Endogenous Growth
• Coordination Failure
• Multiple Equilibria
• The Big Push
• Kremers ORing Theory

3
Contemporary Models

• These theories highlight the fact that
  development is much harder to achieve than had
  been previously thought.
• The new models incorporate
• Coordination problems
• Alternative market structures
• Increasing returns to scale
• Imperfect Information
• Multiple Equilibria
• Externalities

4
Endogenous Growth Models

• Born out of dissatisfaction with traditional
  growth theory.
• According to traditional models, in the absence
  of external shocks and technological change, all
  economies will converge to zero growth. This
  leaves no explanation for sustained growth. All
  unexplained growth is attributed to the Solow
  Residual. Growth for the most part is the result
  of an exogenous process. It is impossible to
  analyze the determinants of technological change.
• New growth theory provides a framework for
  analyzing persistent growth in national income
  that is determined within the system rather than
  by external forces.
• Exogenous changes in technology still play a role
  but they are no longer needed to explain long-run
  growth.

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Goals of New Growth Theory

• Explain growth rate differentials across
  countries
• Explain a greater portion of the growth observed

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Implications

• Re-emphasize the importance of savings and human
  capital investments in achieving rapid growth
• No force leading to convergence in growth rates
  across closed economies as national growth rates
  remain constant and differ across countries
  depending on saving rates and technology levels.
• No tendency for per capita incomes in poor
  countries to catch up and a prolonged recession
  in one country can lead to increases in the
  income gap between wealthy and poor nations.

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• An explanation is given for the inconsistent
  international flows of capital that help to
  exacerbate the wealth disparities between
  developed and developing countries.
• The attraction of relatively high rate of return
  of investment offered by developing countries due
  to their low capital-labout ratios is eroded by
  lower levels of complementary investments in
  education, infrastructure and RD. The low levels
  of complementary investment are due to positive
  externalities/spillovers.
• An explanation is also given for the rate of
  technological change as an endogenous outcome of
  public and private investment in human capital
  and knowledge-intensive industries, suggesting an
  active role for public policy.

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The Romer Model

• Seminal model of endogenous growth in which
  technology spillovers that may be present in the
  industrialization process drive growth.

The economy-wide capital stock. Although each
firm produces with CRS, total capital stock
affects output at the industry level. Knowledge
spillovers and Learning by investing
Firm output also depends on the industry-wide
capital stock
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• If we assume that all firms are symmetric, that
  is they choose the same level of capital and
  labour then aggregate production

Aggregate production exhibits increasing returns
to scale.
Assuming that there is no exogenous technological
change (i.e. A is constant), then our growth rate
for per capita income is
10
We return to the Solow model with its prediction
of convergence to zero growth.
Romers assumption means that per capita output
is growing.
11
Criticism of New Growth Theory

• It either assumes a single sector for production
  or that all sectors are symmetrical, not allowing
  for growth-generating reallocation of labour and
  capital between sectors that are transforming due
  to structural change.
• Overlooks inefficiencies brought about by poor
  infrastructure, inadequate institutional
  structures and imperfect capital and goods
  markets.
• Since the focus is on steady-state growth rates,
  the theory places most of its emphasis on
  explaining long term growth rates and not on
  short or medium-term growth.

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Coordination Failure

• Complementarities are present when an action
  taken by one agent increases the incentives for
  other agents to take similar actions. The
  decisions are mutually reinforcing.
• A coordination failure occurs when agents
  inability to coordinate their behaviour results
  in an equilibrium that leaves all agents worse
  off than in an alternative equilibrium.

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Coordination failure models highlight the fact
that in order to get sustainable development
underway, several things must work well enough
simultaneously. In order for investment to be
profitable for an individual agent, a significant
number of other agents must undertake
investment. Whether we are in advanced capitalist
economies or in traditional subsistence
developing economies, we will find many examples
of this circular causation of positive
feedback. The inability to coordinate investment
efforts can leave an economy stuck in a bad
equilibrium. Often coordination problems are
exacerbated by other market failures such as
those affecting capital markets.
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Underdevelopment trap A region remains stuck at
the subsistence level due to coordination
failure. No one invests in new products or skills
because the demand is not there. The demand for
new products and skills is not developed because
the new products and skills are not
available. Role of Government Clearly there is a
role for government in coordinating joint
investments. Often there is a lag between making
the investment and the realization of the return.
So each agent waits for someone else to make the
first move and a bad equilibrium results. Deep
government intervention is needed to move the
economy to the preferred equilibrium. On the
other side, bad government policy could result in
the economy moving to a bad equlibrium. Underinves
tment in New Technologies This is another example
of coordination failure. The benefit to adopting
a new technology for an individual firm is
contingent on the adoption of this technology by
other firms, so each firm invests less than the
socially optimal level.
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Joint Externalities Normally in economics we
think of self-interested individuals responding
to incentives such as market prices in order to
determine their actions. These mechanisms impose
counter-pressures in order to restore balance.
Often in development economics, joint
externalities in which behaviour is mutually
reinforced exist so that a state of
underdevelopment results in further
underdevelopment, while on the other hand,
processes of sustainable development, one
underway, tend to beget further development.
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Coordination Game

• Example
• Many wireless phone providers have calling plans
  in which calling someone with the same wireless
  plan or on the same network is costless to the
  consumer. It is also very costly to switch
  wireless providers.
• It would be beneficial to an individual wireless
  consumer if all of his friends and relatives were
  on the same network. The larger the number of
  people on the network, the larger the savings.
• It would be socially improving if everyone could
  find a way to coordinate their wireless provider
  decisions.

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Multiple Equilibria

• Privately Rational Decision Function
• An individuals investment level is a function of
  his expectations of the economy-wide or
  industry-wide average level of investment.

Individual investment level
Expected average investment level
Actual average investment level
Privately Rational Decision Function
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• Rational Expectations Equilibrium
• The actual average investment level is a function
  of the sum of individual investment decisions.

If we assume that agents are identical.
Rational Expectations Equilibrium
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• Adjusting Expectations and Stable vs. Unstable
  Equilibria
• Starting out of equilibrium, the expectations
  adjustment process would continue until agents
  observe what they expected to see.
• An equilibrium is stable if when we start
  slightly away from it, the adjustment process
  brings us back to that equilibrium
• An equilibrium is unstable if starting slightly
  away from it, pulls us further away from it.
• Shape of S-curve and Number of Equilibria
• If the privately rational decision function
  increases at an increasing rate this means that
  the value of taking action steadily increases as
  the number of others taking action increases. In
  this case, there could only be one equilibrium
  (if any).
• However, if the rate at which taking action
  increases with the number of other agents taking
  action varies, there could be multiple
  equilibria.

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• Welfare and Pareto-ranking Equilibria
• Technology Spillovers and the Romer Model
• Changes in Expectations
• Market Mechanism
• Hindrances to switching from Bad Equlibria
• Technology Transfer and Sufficiency

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The Big Push

• Main insight here is that it is harder to get
  growth underway than to maintain it
• Market failures make initializing growth
  difficult.
• Low initial demand
• High set-up costs
• Increasing Returns to Scale
• Spillovers and underinvestment
• A concerted economy-wide effort is needed.

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• Model
• One factor of production, Labour (L), is in
  fixed supply
• Wage in the traditional sector is the numeraire,
  wT 1.
• Workers in the modern sector receive a wage wM gt
  1.
• N types of products are produced, where N is a
  large number.
• In the traditional sector, one worker produces
  one unit of output (CRS production), while there
  is IRS in the modern sector. Zero output is
  produced unless at least F workers are employed.
• Labor Required in traditional sector LTQT
• Labor Required in modern sector LM F cQM

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c is the marginal labor required for an
additional unit of output. c lt1, reflecting the
higher productivity of workers in the modern
sector. Average cost is decreasing in output in
the modern sector IRS, while it is constant in
the traditional sector. Cost and Average cost in
the traditional sector CT wTLT(QT)
QT ACT1 Cost and Average cost in the modern
sector CM wMF cQM ACM wMF/QM
wMc Consumers spend an equal share of national
income on the consumption of each good, so that
domestic demand for the output of the traditional
and modern sector is Y/N.
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A perfectly competitive traditional sector means
that price is equal to marginal cost so that PT
MC(QT) 1. Due to increasing returns to scale in
production of the modern sector, at most one firm
can enter each market natural monopolies.
Competition from the traditional sector forces
the monopolist in the modern sector to charge a
price of 1 if it chooses entry (limit pricing
monopolist). Since this is the only firm using
modern techniques and the workers from other
sectors receive a wage of 1, national income
remains essentially the same (the income effect
of higher wages in the modern sector is very
small), so no more units of the output of either
sector can be sold low demand. Whether or not
entry occurs depends on how much more efficient
the modern sector is and how much higher the
modern sector wage is relative to the traditional
sector.
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• The need for the Big Push can also stem from
• Intertemporal effects
• Urbanization effects
• Infrastructure effects
• Training effects

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Super-Entrepreneur?

• Capital Market Failures
• Asymmetric information and Agency costs
• Communication failures
• Knowledge Limitations

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Other Models

• Multiple Equilibria and Coordination Failure
• Incumbency and Barriers to Entry
• Behaviour and Norms
• Linkages
• Inequality and Capital Market Imperfections
• Kremers O-ring Theory
• Strong Complementarities and Positive Assortative
  Matching

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Positive Externalities

• Raising demand for other industries products
• Shifting demand towards manufactured goods
• Redistributing demand towards future periods
• Helping to lower the fixed cost of an essential
  infrastructure

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Incumbency and Barriers to Entry

• Sometimes due to the advantages of incumbency,
  new firm with more productive technology is
  discouraged from entry. Incumbents are able to
  take advantage of increasing returns to scale in
  their own production processes, with lower
  average costs at higher output levels due to
  established and large markets for their products.
• New entrants face large fixed costs at the
  beginning and initially small demand for their
  products. With increasing returns to scale they
  start out with higher average costs and are not
  able to price competitively with the incumbent
  and so entry is not attractive.

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Behaviour and Norms

• Sometimes the incentives provided by social norms
  and even laws and regulations reward dishonest
  and corrupt behaviour, driving out honest
  efforts.
• Removing social norms that encourage bad
  behaviour or creating social norms that encourage
  good behaviour can themselves be subject to
  coordination failure.

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Linkages

• Backward Linkages raise demand for an activity
• Forward Linkages lower the costs of using an
  industries output
• When certain industries are established first,
  their linkages with other sectors can facilitate
  the development of new industries.
• Target investment in key industries with strong
  linkages that are less likely to be draw private
  investment.

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Inequality and Capital Market Imperfections

• The traditional view is that a small amount of
  inequality is needed to enhance growth because
  some funds need to be pooled in order to increase
  savings and investment.
• However, high inequality could retard growth as
  the inability to access credit markets due to
  lack of collateral is part of the definition of
  poverty. Too few people have the ability to
  become entrepreneurs because of imperfect credit
  markets and the indivisible nature of some of the
  investments.

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Kremers O-ring Theory

• Attempts to explain the existence of poverty
  traps and why countries caught in poverty traps
  can have such extremely low incomes compared to
  richer countries.
• Features Strong Complementarities in production
  which results in the positive assortative
  matching of the factors of production by
  productivity.

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O-Ring Model

• Production of a single product is broken down
  into n tasks.
• 0 lt qi lt 1, is the skill level with which each
  component is produced. qi can be interpreted as a
  measure of quality of the component or the
  probability that the component will function
  properly.
• The total quality of the final product is given
  by multiplying the quality of the n components.
• Y q1 x q2 x q3 xx qn

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Assumptions

• Firms are risk-neutral
• Labour markets are competitive and labour supply
  is inelastic
• So, workers are paid according to their
  productivity.
• Strong complementarities in production
• Workers are imperfect substitutes for each other.
• Closed economy (inputs cannot be imported)

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Positive Assortative Matching

• High productivity firms have the means to attract
  high productivity workers.
• High productivity workers prefer to work with
  high productivity firms because their pay is
  based on how productive they are and their
  productivity is affected by the skill level of
  the workers around them
• So all the high productivity workers will be
  grouped together, leaving the low productivity
  workers to work with other low productivity
  workers.
• It is also socially efficient to group workers
  together by productivity
• Suppose that there are 4 workers producing two
  components to the production of a product and
  also two types of workers low productivity
  workers with skill level qL and high productivity
  workers with skill level qH.
• So Y q1q2
• Output is higher if we group the workers by skill
• qH2 qL2 gt 2qHqL

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Implications

• Firms tend to employ workers with matching skill
  levels
• Income is higher for workers in higher-skilled
  firms so all workers prefer to work in
  higher-skilled firms
• Wages increase at an increasing rate in quality,
  explaining the large disparity between wages in
  developed and developing countries.
• Individual decisions to invest in training and
  education are based on the average skill level of
  others around you. Multiple equilibria can exist
  in which everyone invests at a high level or in
  which every invests at a minimal level leading to
  lower product quality. Strategic
  complementarities can result in low-skill
  equilibria.

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Implications (contd)

• An industrial policy to promote economy-wide
  quality improvement could result in tremendous
  growth.
• O-ring effects magnify the impact of local
  production bottlenecks which reduce the incentive
  of workers to invest in skills.
• International trade and investment could improve
  product quality with the importation of
  higher-quality inputs and high-productivity
  technology.
• When the availability of high-skilled workers is
  limited, firms will choose less complicated
  technology and specialize in the production of
  simple goods. Large firms that specialize in
  complex products place a premium on high-quality,
  skilled workers. So the model has predictions on
  choice of technology given the available skill
  level.
• The model can also explain international brain
  drain as highly-skilled workers in developing
  countries emigrate to developed countries where
  they can receive higher wages for their skills.

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Notes

• The coordination failure and multiple equilibria
  result with agents behaving rationally
• The potential benefit of the active role of
  government is emphasized
• After the big push, the need for an active
  government in the economy is reduced.
• Bad policies can reinforce the bad equilibrium
  and even drive the economy to a worse
  equilibrium.
• The benefits to outside development assistance
  goes beyond capital provision.