Chapter 4 Contemporary Models of Development and Underdevelopment

Chapter 4 Contemporary Models of Development and Underdevelopment Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 2

Underdevelopment as Coordination Failure • Principal: – Government • Agents: – Households – Private-sector firms – Public agencies – Government-owned enterprises – International companies Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3

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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 4

Models of Coordination Failure • Technological Transfer for Modernization • The Big Bush to Industrialization • The O-Ring Theory of Economic Development • The Growth Diagnostics Framework Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 5

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6

Multiple Equilibria: Graphical Illustration Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 7

Technological Transfer for Modernization • Stable equilibrium: The S-shaped function crosses the 45º line from above (points D 1 and D 3). 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 D 2). As firms coordinate their investment decisions, equilibrium moves to D 1 (decrease investment) or D 3 (increase investment). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 8

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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 9

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 modernsector firms are mutually reinforcing and public policy intervention is needed to correct market failure Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 10

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 11

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) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 12

The Big Push: Graphical Illustration Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 13

The Big Push: Coordination Failure • At a low wage rate like W 1, a new firm will enter the modern sector after paying the fixed labor cost (F). With high demand (Q 2), the firm makes profit and invests in modern technology • As W 2 > W 1, other firms enter the modern sector to share the profit. Coordination between these firms is now needed for the economy to adopt modern technology 14 Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

The Big Push: Coordination Failure • At W 2, 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 W 3, investment in modern technology is not profitable Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 15

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) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 16

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 17

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 18

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 superentrepreneur to do so Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 19

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 20

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 21

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 22

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 24

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 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 25

The Growth Diagnostics Framework Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 26