CHAPTER 4: CONTEMPORARY MODELS OF information about how to do so.
If cooperation can be
DEVELOPMENT AND UNDERDEVELOPMENT achieved, there is no subsequent incentive to defect or
cheat.
Prisoners’ dilemma - A situation in which all parties
Binding constraint - The one limiting factor that if relaxed would be better off cooperating than competing, but once
would be the item that accelerates growth (or that allows a cooperation has been achieved, each party would gain the
larger amount of some other targeted outcome). most by cheating, provided that others stick to cooperative
binding constraints - on the ability of a developing nation agreements—thus causing any agreement to unravel.
to further close the gap with the developed world.
Economic agent - An economic actor—usually a firm, 4.2 Multiple Equilibria: A Diagrammatic Approach
worker, consumer, or government official—that chooses
actions so as to maximize an objective; often referred to as Multiple equilibria - A condition in which more than one
“agents.” equilibrium exists. These equilibria sometimes may be
ranked, in the sense that one is preferred over another, but
the unaided market will not move the economy to the
4.1 Underdevelopment as a Coordination Failure preferred outcome.
Many newer theories of economic development that Pareto improvement - A situation in which one or more
became influential in the 1990s and the early years of the persons may be made better off without making anyone
twenty-first century have emphasized complementarities worse off.
between several conditions necessary for successful 4.3 Starting Economic Development: The Big Push
development.
Pecuniary externality - A positive or negative spillover
Complementarity - An action taken by one firm, worker, effect on an agent’s costs or revenues.
or organization that increases the incentives for other
agents to take similar actions. Complementarities often The Big Push: A Graphical Model
involve investments whose return depends on other
investments being made by other agents. Assumptions - In any model (indeed, in any careful
thinking), we need to make some assumptions, sometimes
Coordination failure - A situation in which the inability of seemingly large assumptions, to make any progress in our
agents to coordinate their behavior (choices) leads to an understanding.
outcome (equilibrium) that leaves all agents worse off than
in an alternative situation that is also an equilibrium. six types of assumptions
Big push - A concerted, economy-wide, and typically 1. Factors. We assume that there is only one factor
public policy–led effort to initiate or accelerate economic of production—labor. It has a fixed total supply,
development across a broad spectrum of new industries and L.
skills. 2. Factor payments. The labor market has two
sectors. We assume that workers in the
O-ring model - An economic model in which production traditional sector receive a wage of 1 (or
functions exhibit strong complementarities among inputs normalized to 1, treating the wage as the
and which has broader implications for impediments to numeraire; that is, if the wage is 19 pesos per
achieving economic development. day, we simply call this amount of money “1” to
Middle-income trap - A condition in which an economy facilitate analysis using the geometry in Figure
begins development to reach middle-income status but is 4.2). Workers in the modern sector receive a
chronically unable to progress to high-income status. Often wage W 7 1 (that is,some wage that is greater
related to low capacity for original innovation or for than 1).
absorption of advanced technology, and may be 3. Technology. We assume that there are N types
compounded by high inequality. of products, where N is a large number.16 For
each product in the traditional sector, one worker
Underdevelopment trap - A poverty trap at the regional
produces one unit of output (this is a less
or national level in which underdevelopment tends to
perpetuate itself over time.
stringent assumption than it appears because
again we have a certain freedom in
Deep intervention - A government policy that can move choosing our unit of measurement; if a
the economy to a preferred equilibrium or even to a higher worker produces three pairs of shoes per
permanent rate of growth, which can then be self-sustaining day, we call this quantity one unit).
so that the policy need no longer be enforced because the 4. Domestic demand. We assume that each good
better equilibrium will then prevail without further receives a constant and equal share of
intervention. consumption out of national income. The model
has only one period and no assets; thus there is
Congestion - The opposite of a complementarity; an action
no saving in the conventional sense.
taken by one agent that decreases the incentives for other
5. International supply and demand. We assume
agents to take similar actions.
that the economy is closed. This makes the
Where-to-meet dilemma - A situation in which all parties model easy to develop. The most important
would be better off cooperating than competing but lack conclusions will remain when trade is allowed,
provided that there are advantages to having a also too little demand by workers for training
domestic market. because they do not know what skills to acquire.
6. Market structure. We assume perfect
competition in the traditional (cottage industry)
sector, with free entry and no economic profits. Agency costs - Costs of monitoring managers and other
Therefore, the price of each good will be 1, the employees and of designing and implementing schemes to
marginal cost of labor (which is the only input). ensure compliance or provide incentives to follow the
We assume that at most, one modern-sector firm wishes of the employer.
can enter each market.
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.
Conditions for Multiple Equilibria With these six
assumptions, we can characterize cases that will require a
big push. To begin, suppose that we have a traditional
4.4 Further Problems of Multiple Equilibria
economy with no modern production in any market. A
potential producer with modern technology (i.e., a Inefficient Advantages of Incumbency
technology like the one described previously, with fixed
costs and increasing returns) considers whether it is The presence of increasing returns in modern industries can
profitable to enter the market. Given the size of the fixed also create another kind of bad equilibrium. Once a modern
cost, the answer depends on two considerations: firm has entered, it has an advantage over any rivals
because its large output gives it low average costs.
1. how much more efficient the modern
sector is than the traditional sector and Behavior and Norms
2. how much higher wages are in the modern Movement to a better equilibrium is especially difficult
sector than in the traditional sector. when it involves many individuals changing their behavior
from one of rent seeking or corruption to honesty and the
value of building a reputation to reap the gains from
Technological externality - A positive or negative cooperation (e.g., with business partners).
spillover effect on a firm’s production function through
some means other than market exchange. Linkages - Connections between firms based on sales. A
backward linkage is one in which a firm buys a good from
another firm to use as an input; a forward linkage is one in
which a firm sells to another firm. Such linkages are
Other Cases in Which a Big Push May Be Necessary
especially significant for industrialization strategy when
The need for a big push can result from four conditions one or more of the industries (product areas) involved have
beyond those described previously. increasing returns to scale that a larger market takes
advantage of.
1. Intertemporal effects. Even if the industrial
wage rate is 1 (i.e., the same as the traditional- Inequality, Multiple Equilibria, and Growth
sector wage), multiple equilibria can occur if Other important work being done on growth and multiple
investment must be undertaken in the current equilibria addresses the impact of inequality on growth.
period to get a more efficient production process The traditional view has been that some inequality may
in the next period. enhance growth because the savings of the rich are higher
2. Urbanization effects. If some of the traditional than those of the poor. If at least some savings to be
cottage industry is rural and the increasing- mobilized for investment purposes must come from within
returns-to-scale manufacturing is urban, urban a country, then according to this view, too high a degree of
dwellers’ demand may be more concentrated in equality could compromise growth. However, the poor save
manufactured goods (e.g., foods must be at much higher rates than previously believed, when
processed to prevent spoilage due to the time savings are properly measured to include expenditures on
needed for transportation and distribution). health, children’s education, and improvements on a home.
3. Infrastructure effects. By using infrastructure,
Poverty trap - A bad equilibrium for a family, community,
such as a railroad or a port, an investing modern or nation, involving a vicious circle in which poverty and
firm helps defray the large fixed costs of that underdevelopment lead to more poverty and
infrastructure. The existence of the infrastructure underdevelopment, often from one generation to the next.
helps investing firms lower their own costs. But
investing firms thereby contribute indirectly to
lowering the costs of other firms (by lowering 4.5 Michael Kremer’s O-Ring Theory of Economic
the average cost of infrastructure use). Development
4. Training effects. There is underinvestment in
training facilities because entrepreneurs know Another innovative and influential model that provides
that the workers they train may be enticed away important insights into low-level equilibrium traps was
with higher wages offered by rival firms that do provided by Michael Kremer. The notion is that modern
not have to pay these training costs. There is production (especially in contrast to traditional crafts
production) requires that many activities be done well
together in order for any of them to amount to a high value.
This is a form of strong complementarity and is a natural Korea). This could be relevant for a country
way of thinking about specialization and the division of trying to escape the middle-income trap.
labor, which along with economies of scale is another ● O-ring effects magnify the impact of local
hallmark of developed economies in general and industrial production bottlenecks because such bottlenecks
production in particular. The name for Kremer’s model is have a multiplicative effect on other production.
taken from the 1986 Challenger disaster, in which the ● Bottlenecks also reduce the incentive for
failure of one small, inexpensive part caused the space workers to invest in skills by lowering the
shuttle to explode. The O-ring theory is interesting in part expected return to these skills.
because it explains not only the existence of poverty traps
but also the reasons that countries caught in such traps may
have such exceptionally low incomes compared with high-
income countries. 4.6 Economic Development as Self-Discovery
The O-Ring Model In simple models with perfect information, it is assumed
that firms, and developing economies as a whole, already
The key feature of the O-ring model is the way it models know their comparative advantage. But individuals must
production with strong complementarities among inputs. discover their own comparative advantage in labor markets;
We start by thinking of the model as describing what is for example, no one is born knowing they are well suited to
going on inside a firm, but as we will see, this model also become an economist or international development
provides valuable insights into the impact of specialist.
complementarities across firms or industrial (product)
sectors of the economy.
O-ring production function Information externality - The spillover of information—
such as knowledge of a production process—from one
A production function with strong complementarities agent to another, without intermediation of a market
among inputs, based on the products (i.e., multiplying) of transaction; reflects the public good characteristic of
the input qualities. information (and susceptibility to free riding)—it is neither
fully excludable from other uses, nor nonrival (one agent’s
Implications of the O-Ring Theory use of information does not prevent others from using it).
The analysis has several important implications:
● Firms tend to employ workers with 4.7 The Hausmann-Rodrik-Velasco Growth Diagnostics
similar skills for their various tasks.
Framework
● Workers performing the same task earn higher
wages in a high-skill firm than in a low-skill Encouraging efficient investment and widespread
firm. entrepreneurship plays a prominent role in accelerating
● Because wages increase in q at an increasing growth and promoting development more broadly. But the
rate, wages will be more than proportionally once popular idea of finding a “one size fits all” policy for
higher in developed countries than would be economic development is now generally recognized as a
predicted from standard measures of skill. myth. Different countries face different binding constraints
● If workers can improve their skill level and on achieving faster rates of growth and economic
development. A key mission for economic development
make such investments, and if it is in their
specialists is to help determine the nature of the constraints
interests to do so, they will consider the level of
for each country. Ricardo Hausmann, Dani Rodrik, and
human capital investments made by other
Andrés Velasco (HRV) propose a growth diagnostics
workers as a component of their own decision decision tree framework for zeroing in on a country’s most
about how much skill to acquire. Put differently, binding constraints on economic growth. HRV explain that
when those around you have higher average targeting the most binding constraint has important
skills, you have a greater incentive to acquire advantages over other approaches to policy selection.
more skills. This type of complementarity
should by now be a familiar condition in which Growth diagnostics - A decision tree framework for
multiple equilibria can emerge; it parallels issues identifying a country’s most binding constraints on
raised in our analysis of the big push model. economic growth.
Kremer shows that a graph like Figure 4.1 can Social returns - The profitability of an investment in which
apply to choices about how much skill to both costs and benefits are accounted for from the
acquire. perspective of the society as a whole.
● One can get caught in economy-wide, low-
production-quality traps. This will occur when
there are (quite plausibly) O-ring effects across
firms as well as within firms. Because there is an
externality at work, there could thus be a case
for an industrial policy to encourage quality
upgrading, as some East Asian countries have
undertaken in the past (see Chapter 12, section
12.6, and its end-of-chapter case study of South
