Chapter Contemporary Models of Development and Underdevelopment Copyright © 2009 Pearson Addison-Wesley All rights reserved 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-2 Underdevelopment as Coordination Failure • Principal: – • Government Agents: – Households – Private-sector firms – Public agencies – Government-owned enterprises – International companies Copyright © 2009 Pearson AddisonWesley All rights reserved 4-3 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-4 Models of Coordination Failure • Technological Transfer for Modernization • The Big Bush to Industrialization • The O-Ring Theory of Economic Development • The Growth Diagnostics Framework Copyright © 2009 Pearson AddisonWesley All rights reserved 4-5 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-6 Multiple Equilibria: Graphical Illustration Copyright © 2009 Pearson AddisonWesley All rights reserved 4-7 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 Copyright © 2009 Pearson Addisoninvestment) Wesley All rights reserved 4-8 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-9 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-10 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) Copyright © 2009 Pearson AddisonWesley All rights reserved 4-12 The Big Push: Graphical Illustration Copyright © 2009 Pearson AddisonWesley All rights reserved 4-13 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 Copyright © 2009 Pearson Addisoneconomy toreserved adopt modern technology 4-14 Wesley All rights 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-15 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) Copyright © 2009 Pearson AddisonWesley All rights reserved 4-16 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-17 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-18 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 so Copyright © 2009 Pearson AddisonWesley All rights reserved 4-19 Coordination Problem Cannot Be Solved by a Super-Entrepreneur • Limited knowledge: agents not have sufficient information about the importance of industrialization • Lack of empirical evidence: agents not know that other firms are investing in modern technology Copyright © 2009 Pearson AddisonWesley All rights reserved 4-20 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-21 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-22 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-23 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-24 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 Copyright © 2009 Pearson AddisonWesley All rights reserved 4-25 The Growth Diagnostics Framework Copyright © 2009 Pearson AddisonWesley All rights reserved 4-26 ... 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 Copyright © 2009 Pearson... be corrupt and bribery may be the standard method of doing business internationally Copyright © 2009 Pearson AddisonWesley All rights reserved 4-22 The O-Ring Theory of Economic Development •... technology • Investment decisions made by modern-sector firms are mutually reinforcing and public policy intervention is needed to correct market failure Copyright © 2009 Pearson AddisonWesley All