CONTEMPORARY MODELS

OF DEVELOPMENT
Binding constraints – the one limiting factor that if
relaxed would be the item that accelerates
growth (or that allows a larger amount of some
other targeted outcome).

Economic agent - an economic actor- usually a

firm, worker, consumer, or government official-
that chooses actions as to maximize an object;
often referred to as “agents”
 UNDERDEVELOPMENT AS A
COORDINATION FAILURE
• Complementarities between several conditions necessary for
successful development are now frequent among the new and
recent theories of economic development.

• Complementarities - an action taken by one firm, worker, or

organization that increases the incentives for other agents to take
similar actions. Complementarities often involve investments whose
return depends on other investments being made by other agents.

• These new theories also emphasize that in many important

situations, investments must be undertaken by many agents in order
for the results to be profitable for any individual agent.
• Coordination failure – a state of affairs in which the
inability of agents to coordinate their behavior(choices)
leads to an outcome (equilibrium) that leaves all agents
worse off than in an alternative
situation that is also an equilibrium. This does not imply that
they do not know the desired equilibrium, it is just difficult to
reach.

• When complementarities are present, an action take by

one firm, worker, organization, or government increases the
incentives for other agents to take similar actions.
• Middle income trap – a condition in which an economy begins
development to reach middle-income status but it is chronically
unable to progress to high-income status. Often related to low
capacity for original innovation or for absorption of advanced
technology, and may be compounded by high inequality.

• Specialization and a detailed division of labor are hallmarks of

an advanced economy. But we can specialize only if we can
trade for the other goods and services we need.

• The absence of motives for specialization can result in the

underdevelopment trap.
• Underdevelopment trap - a poverty trap at the regional or national
level in which underdevelopment tends to perpetuate itself over time.

• Sometimes they fail to find equilibrium by failing to figure out who

shall take the first step. The answer to this is most of the times that both
measures should be taken in the same time with coordination.

• Many economists nowadays, look actively for vases in which

government policy can still help, even when government is imperfect,
by pushing the economy toward a self-sustaining, better equilibrium.
Such deep intervention moves an economy to a preferred
equilibrium.
• Deep intervention – a government policy that can move the
economy to a preferred equilibrium or even to a higher permanent
rate of growth that can then be self-sustaining so that the policy
need no longer be enforced because the better equilibrium will then
prevail without further intervention.

• Congestion – the opposite of a complementarity; an action taken

by one agent that decreases the incentives for other agents to take
similar actions.

• In real economic problems, the people who need to coordinate

investments do not even know the identity of the other key agents.
 MULTIPLE EQUILIBRIA: A
DIAGRAMMATIC APPROACH
• Multiple equilibria – a condition in which more than one
equilibrium exists. These equilibria may sometimes be ranked, in
the sense hat one is preferred to another, but the unaided
market will not move the economy to the preferred outcome.

• In this model, one invests based on his expectation of the

average level of investment.

• D1 represents a stable equilibrium with a coordination failure,

D2 an unstable equilibrium, D3 a stable equilibrium with a
higher level of investments; the equilibrium is stable when the S-
curve intersects from above.
• The S-shaped curved simply explains the positive
relationship between the benefits of an agent depending
on the actions of other agents; it is the privately rational
decision function.

• The general idea of an equilibrium in such case, is one in

which participants are doing what is the best for them, given
what they expect others to do, which in turn matches what
others are actually doing.
• The curve does not rise quickly first because of the lack of
coordination and inaccurate expectations. But after enough
investment, many agents begin to provide spill over benefits to
neighboring agents, and the curve increases at a much faster rate.
Finally after most potential investors have been positively affected
and the most important gains have been realized, the rate of
increase starts to slow down.

• Changing expectations may not be sufficient if it is more profitable

for a firm to wait for others to invest rather that to be a pioneer
investor.
• Market forces can generally bring us to one of the
equilibria, but they are not sufficient to ensure that the best
equilibrium will be achieved, and they offer no mechanism
to become unstuck from a bad equilibrium and move
toward a better one.

• When jointly profitable investments may not be made

without coordination, equilibria may exist in which the same
individuals with access to the same resources and
technologies could find themselves in either a good or a
bad situation.
 STARTING ECONOMIC DEVELOPMENT:
THE BIG PUSH
• Sometimes market failures lead to a need for public policy
intervention.

• The Big Push: A Graphical Model, 6 assumptions

1. Factors - One factor of production (Labor)
2. Factor payments - Two sectors of labor markets
3. Technology - Same production function for each sector
4. Domestic demand- Consumers spend an equal amount
on each good
5. International supply and demand - Closed economy
6. Market Structure - Perfect competition with traditional
firms operating, limit pricing monopolist with a modern
firm operating

• Conditions for Multiple Equilibria

• A big push may also be necessary when there are:
- Intertemporal effects
- Urbanization effects
- Infrastructure effects
- Training effects
 FURTHER PROBLEMS OF MULTIPLE
EQUILIBRIUM
• Inefficient Advantages of Incumbency

• Behavior and Norms

• Linkages – connections between firms based on

sales. A backward linkage is one in which a firm
buys good from another firm to use as an input; a
forward linkage is one in which a firm sells to
another firm

• Inequality, Multiple Equilibria, and Growth

 KREMER’S O-RING THEORY OF
ECONOMIC DEVELOPMENT
• The O-Ring Model
- Production is modeled with strong
complementarities among inputs
- Positive assortative matching in production

• Implications of strong complementarities for economic

development and the distribution of income across
countries.
 The “O-Ring” Theory: A Simple Illustration of the basic idea

• HR Department has 4 workers- 2 H-types and 2 L-types; In a

simplified model let Q = qiqj

• How to allocate? {HH, LL}; or {HL, LH}? We know that H2 +

L2 > 2HL because: (H–L)2 > 0

• So with strong complementarity it always pays to do

assortative matching
 ECONOMIC DEVELOPMENT AS SELF
DISCOVERY
• Hausmann and Rodrik: A Problem of Information

• Not enough to say developing countries should produce

“labor intensive products,” because there are thousands of
them

• Industrial policy may help to identify true direct and indirect

domestic costs of potential products in which to specialize by:
- Encouraging exploration in the first stage
- Encouraging movement out of inefficient sectors and
into more efficient sectors in the second stage
• Three building blocks of the theory; and case examples of their
reasonableness in practice:

- Uncertainty about what products can be produced

efficiently (evidence: India’s success in information technology
was unexpected; reasons for Bangladesh’s efficiency in hats vs
Pakistan’s in bedsheets is not clear)

- Need for local adaptation of foreign technology

(evidence: seen in cases such as shipbuilding in South Korea)

- Imitation can be rapid (e.g. the spread of cut flower

exporting in Colombia)
 THE HAUSMANN-RODRIK-VELASCO
GROWTH DIAGNOSTICS FRAMEWORK
• Focus on a country’s most binding constraints on economic
growth

• No “one size fits all” in development policy

• Requires careful research to determine the most likely binding

constraint

Growth diagnostics – A decision tree framework for identifying a

country’s most binding constraints on economic growth

Social returns – the profitability of an investment in which both costs

and benefits are accounted for from the perspective of the society
as a whole