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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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