Ecomomics evelopment 10th y p todaro and smith chapter 04

Chapter 4
Contemporary
Models of
Development and
Underdevelopment

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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)

•

The success or failure of economic development policies can be explained by the “principal-agent” model.

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Underdevelopment as
Coordination Failure
•

Principal:

–

•

Government

Agents:

–

Households

–

Private-sector firms

–

Public agencies

–

Government-owned enterprises

–

International companies

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Underdevelopment as
Coordination Failure
•

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

•

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

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Models of Coordination Failure
• Technological Transfer for Modernization
• The Big Bush to Industrialization
• The O-Ring Theory of Economic Development
• The Growth Diagnostics Framework
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Technological Transfer for
Modernization
•

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.

•

At equilibrium, the expected outcome of an action equals its actual outcome

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Multiple Equilibria:
Graphical Illustration

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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
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Technological Transfer for
Modernization
•

To achieve stable 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.

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The Big Push to Industrialization

•

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

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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
•
•
•
•

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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)

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The Big Push:
Graphical Illustration

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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
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The Big Push:
Coordination Failure
• 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
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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)

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Conditions Making
The Big Push Necessary
• Intertemporal effects: investment in the
modern sector becomes profitable overtime as the market size increases
• Urbanization effects: demand for
manufactured goods increases with
urban population growth
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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
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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

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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

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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

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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

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The O-Ring Theory of
Economic Development
•

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

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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

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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

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