Growth and Development Economics Quiz 2B

Lahore School of Economics

Spring Semester, 2013

Development and Growth Economics

BSc IV Section C

Quiz 2B Total Points: 35 Suggested Solutions

Instructions: Answer all questions in the spaces provided. For full marks, make sure you write
all relevant points and formulate coherent and concrete answers. Pencils, pens, rulers, etc.
cannot be shared and cell phones cannot be used during the session.

Question 1

Discuss the complementarities and multiple equilibria problems emerging in the Big Push to
Industrialization model. (10 points)

Rosenstain-Rodan introduced Big Push to industrialization model. Think of a poor economy

where there are no factories. Apart from agriculture, other consumer items are produced by
village artisans using low productivity cottage industry technologies. Suppose one person
decides to set up a big shoe factory using a modern factory technology which has some set up
costs, so that it can earn profits only if sales exceed some minimum level. In the process of
setting up this factory all the construction work, the wages and salaries paid to employees will
generate a lot of demand in the village. But, and this is a key assumption, if the shoe factory is
restricted to sell its shoes only within the village then only a small fraction of all the output can
be sold. The end result will be losses for the shoe factory as sales are never enough. However, if
instead other industrialists simultaneously set up factories to produce food, clothing and every
other consumer good, then they will expand each others demand for goods. In that case the
village economy will become industrialized.

Notice that simultaneous investment in different products can expand economys output and
income but this will require a coordinated behavior among the economic agents. Since the first
ones investing can incur losses because of pecuniary externalities, they may never invest.
Hence, government intervenes by sharing or incurring the cost of industrialization. Consider the
following diagram with current wage line as W2.

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 Growth and Development Economics Quiz 2B

If only one modern investor invests, it will produce Q1 at Point A. The cost of workers (wage) is
higher than revenues at that point. Since costs exceed revenues, the firm will not invest making
Q1 an eventual (stable) equilibrium. But simultaneous investment in various products of the
underdeveloped economy will raise the employment, output and income to Point B! At this
point, revenues exceed costs and hence, reflect an (unstable) equilibrium which doesnt come
by itself. Rather, it is achieved by the government via coordinating behavior of economic
agents. There is a role for policy in starting economic development. The moment minimum
level of profits is gained, other investors will be attracted automatically (complementarities).

Question 2 (10 points each = 20 points)

It is said that complementary investments produce social and private benefits because of
which government intervention is inevitable. How do endogenous growth models illustrate
this problem?

Consider the following endogenous growth model: Y = AK; whereby A represents any factor
that affects technology and K includes both human and physical capital. Any increase in human
capital can generate external economies and social gains that exceed the private gains by an
amount sufficient to realize increasing or at least constant returns to scale.

Implications:

There is no external force to equilibrate the growth rates across economies; national growth
rates are determined by national savings rate and technology levels

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 Growth and Development Economics Quiz 2B

There is no tendency for low income countries to catch up with the growth rates of high income
countries with similar savings and population growth rates

The potentially high rates of return promised by low capital/labor ratios are offset by low levels
of complementary investment. Such alternative forms of capital expenditures have positive
externalities and thus investors are waiting for others to start. The result is a market failure
whereby there is underinvestment. Hence, government has to intervene for more efficient
resource allocation. New growth models (endogenous growth theory) suggest a promising and
active role of public and industrial policy in promoting development through higher A and K.

How does Romer Model of endogenous growth explain the occurrence of consistent
economic growth in the economy? You have to make use of the output growth equation,
assuming no technological progress.

Romer Model addresses technological spillovers in which one firms productivity gains lead to
productivity gains in other firms in the process of industrialization. Simplified version of the
model is:

Y = AK+L1 ; whereby K is a type of technology with as its rate of return and K is the
conventional type of capital. Since K acts as a public good or has technological externalities, higher
use of K reflects increasing returns to scale at the economywide level. Put differently, if K and L,
both increase by one unit each, output will increase by more than one unit as + + 1 > 1. For
example, the knowledge gained by a firm about the capital stock can spill over to other firms or
other firms can learn by watching others invest. Thus, when we implement our own investment idea,
the costs are lower as we have learnt by others mistakes making use of knowledge spillovers. As
more and more firms learn, the more they become efficient and the higher is the output at the
economywide level reflecting increasing returns to scale. In this model, higher K will increase the
economy output by the return to the firm because of using more technology and by the
return to other firms because of learning and making use of knowledge spillovers. Specifically,

dY/dK = (+)(A)(K+ 1)(L1 ) = (+)(A) (L1 )(K+)/K = (+)Y/K

dY/dL = (1 )(L1 1) (A)(K+) = (1 )(A)(L1 )(K+)/L = (1 )Y/L

dY/dt = dY/dK x dK/dt + dY/dL x dL/dt; dY/dt = Y and dK/dt = K

Y = (+)Y/K x K + (1 )Y/L x L

Y = Y [(+)K/K + (1 )L/L]

Y/Y = K/K = g and L/L = n

g = (+) g + (1 ) n g - (+) g = (1 ) n g (1 ) = (1 ) n

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 Growth and Development Economics Quiz 2B

g = (1 ) n / (1 )

If n is subtracted from each side to get growth rate per capita:

g - n = [(1 ) n / (1 )] n

g n = n n n + n + n / (1 )

g n = n / (1 )

If we have Solow model with constant returns to scale, = 0 and g n = 0 (assuming no

technological progress)

With Romers assumption of a positive capital externality, ( > 0), we have that g n > 0 and
Y/L or g n keeps on growing even without technological progress.

Question 3

In HRV diagnostic growth framework, what could be termed as binding constraints on growth
rates of various economies? (5 points)

Students can refer to any four (or more than four) variables in HRV framework. These can
include low returns to economic activity because of low human capital, poor infrastructure and
government failure of unable to coordinate economic activities among the agents, market
failure due to pecuniary externalities, etc.

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