Lahore School of Economics BSC IV (2017)

Contemporary Models of Development and

Underdevelopment

Chapter 4
M. P. Todaro & S. C. Smith
Lahore School of Economics BSC IV (2017)

Underdevelopment as a Coordination Failure

• A newer school of thought on problems of
economic development
• Coordination failures: inability of agents to
coordinate their actions leads to an outcome
that makes all agents worse off.
• This can occur when complementarities (opp.
congestion) are present, i.e.,
– Actions taken by one agent reinforces incentives for
others to take similar actions (e.g. firms using
specialized skills availability of workers with skills)
– Examples: Big Push Model and O-Ring Model
Lahore School of Economics BSC IV (2017)

Multiple Equilibria: A Diagrammatic Approach

• Equilibria may be ranked (i.e. one is preferred
to the another, but unaided market won’t
move the economy to preferred outcome)
• Often, these models can be diagrammed by
graphing an S-shaped function and the 45º
line
Lahore School of Economics BSC IV (2017)

Participants
Figure 4.1 Multiple Equilibria
are doing
what is best
for them,
given what
they expect
others to
do, which in
turn
matches
what others
are actually
doing
Lahore School of Economics BSC IV (2017)

Starting Economic Development: The Big Push

• A economy-wide public –policy led effort to accelerate
economic development across a broad spectrum of
new industries and skill.
• Sometimes market failures lead to a need for public
policy intervention
• The Big Push: A Graphical Model, 6 assumptions
– One factor of production (Labor)
– Two sectors: traditional (w=1) and modern (w>1)
– Same production function for each sector (constant returns in
traditional and increasing returns in modern sector)
– Consumers spend an equal amount on each good
– Closed economy
– Perfect competition in traditional sector, limit pricing
monopolist with a modern sector
Lahore School of Economics BSC IV (2017)

Figure 4.2
The Big Push
Lahore School of Economics BSC IV (2017)

Why the Problem Cannot be Solved by a Super-

Entrepreneur

• Super Entrepreneur?
– Capital market failures
– Cost of monitoring managers- Asymmetric
Information
– Communication failures
– Limits to knowledge
Lahore School of Economics BSC IV (2017)

In a Nutshell: Big Push

Mechanisms
• Raising total demand
• Reducing fixed costs of later entrants
• Redistributing demand to later periods when other
industrializing firms sell
• Shifting demand toward manufacturing goods
(usually produced in urban areas)
• Help defray (pay for) costs of essential infrastructure
Lahore School of Economics BSC IV (2017)

4.5 Michael 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
Lahore School of Economics BSC IV (2017)

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 to
specialize in, by:
– Encouraging exploration in first stage
– Encouraging movement out of inefficient sectors and into
more efficient sectors in the second stage
Lahore School of Economics BSC IV (2017)

Economic Development as Self-Discovery

• Three building blocks of the theory; and case
examples of their reasonableness in practice:
– Uncertainty about what products country can
produce 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 western technology
(evidence: seen in cases such as shipbuilding in South
Korea)
– Rapid diffusion of new product and techniques in
economy
Lahore School of Economics BSC IV (2017)

4.7 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
Lahore School of Economics BSC IV (2017)

Figure 4.3 Hausmann-Rodrik-Velasco Growth Diagnostics

Decision Tree