CHAPTER 4: CONTEMPORARY MODELS OF Congestion - The opposite of a complementarity; an

DEVELOPMENT AND UNDERDEVELOPMENT action taken by one agent that decreases the incentives
for other agents to take similar actions.
Where-to-meet dilemma - A situation in which all
Binding constraint - The one limiting factor that if
parties would be better off cooperating than competing
relaxed would be the item that accelerates growth (or
but lack information about how to do so. If cooperation
that allows a larger amount of some other targeted
can be achieved, there is no subsequent incentive to
outcome).
defect or cheat.
binding constraints - on the ability of a developing
Prisoners’ dilemma - A situation in which all parties
nation to further close the gap with the developed world.
would be better off cooperating than competing, but
Economic agent - An economic actor—usually a firm, once cooperation has been achieved, each party would
worker, consumer, or government official—that chooses gain the most by cheating, provided that others stick to
actions so as to maximize an objective; often referred to cooperative agreements—thus causing any agreement to
as “agents.” unravel.

4.1 Underdevelopment as a Coordination Failure 4.2 Multiple Equilibria: A Diagrammatic Approach

Many newer theories of economic development that Multiple equilibria - A condition in which more than
became influential in the 1990s and the early years of one equilibrium exists. These equilibria sometimes may
the twenty-first century have emphasized be ranked, in the sense that one is preferred over another,
complementarities between several conditions but the unaided market will not move the economy to the
necessary for successful development. preferred outcome.

Complementarity - An action taken by one firm, Pareto improvement - A situation in which one or more
worker, or organization that increases the incentives for persons may be made better off without making anyone
other agents to take similar actions. Complementarities worse off.
often involve investments whose return depends on other
4.3 Starting Economic Development: The Big Push
investments being made by other agents.
Pecuniary externality - A positive or negative spillover
Coordination failure - A situation in which the inability
effect on an agent’s costs or revenues.
of agents to coordinate their behavior (choices) leads to
an outcome (equilibrium) that leaves all agents worse off The Big Push: A Graphical Model
than in an alternative situation that is also an
Assumptions - In any model (indeed, in any careful
equilibrium.
thinking), we need to make some assumptions,
Big push - A concerted, economy-wide, and typically sometimes seemingly large assumptions, to make any
public policy–led effort to initiate or accelerate progress in our understanding.
economic development across a broad spectrum of new
six types of assumptions
industries and skills.
1. Factors. We assume that there is only one factor
O-ring model - An economic model in which
of production—labor. It has a fixed total supply,
production functions exhibit strong complementarities
L.
among inputs and which has broader implications for
2. Factor payments. The labor market has two
impediments to achieving economic development.
sectors. We assume that workers in the
Middle-income trap - A condition in which an traditional sector receive a wage of 1 (or
economy begins development to reach middle-income normalized to 1, treating the wage as the
status but is chronically unable to progress to high- numeraire; that is, if the wage is 19 pesos per
income status. Often related to low capacity for original day, we simply call this amount of money “1” to
innovation or for absorption of advanced technology, and facilitate analysis using the geometry in Figure
may be compounded by high inequality. 4.2). Workers in the modern sector receive a
wage W 7 1 (that is,some wage that is greater
Underdevelopment trap - A poverty trap at the
than 1).
regional or national level in which underdevelopment
3. Technology. We assume that there are N types
tends to perpetuate itself over time.
of products, where N is a large number.16 For
Deep intervention - A government policy that can move each product in the traditional sector, one worker
the economy to a preferred equilibrium or even to a produces one unit of output (this is a less
higher permanent rate of growth, which can then be self- stringent assumption than it appears because
sustaining so that the policy need no longer be enforced again we have a certain freedom in
because the better equilibrium will then prevail without choosing our unit of measurement; if a
worker produces three pairs of shoes per
further intervention.
day, we call this quantity one unit).
 4. Domestic demand. We assume that each good investing firms thereby contribute indirectly to
receives a constant and equal share of lowering the costs of other firms (by lowering
consumption out of national income. The model the average cost of infrastructure use).
has only one period and no assets; thus there is 4. Training effects. There is underinvestment in
no saving in the conventional sense. training facilities because entrepreneurs know
5. International supply and demand. We assume that the workers they train may be enticed away
that the economy is closed. This makes the with higher wages offered by rival firms that do
model easy to develop. The most important not have to pay these training costs. There is also
conclusions will remain when trade is allowed, too little demand by workers for training
provided that there are advantages to having a because they do not know what skills to acquire.
domestic market.
6. Market structure. We assume perfect
competition in the traditional (cottage industry) Agency costs - Costs of monitoring managers and other
sector, with free entry and no economic profits. employees and of designing and implementing schemes
Therefore, the price of each good will be 1, the to ensure compliance or provide incentives to follow the
marginal cost of labor (which is the only input). wishes of the employer.
We assume that at most, one modern-sector firm
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
economy with no modern production in any market. A 4.4 Further Problems of Multiple Equilibria
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
profitable to enter the market. Given the size of the fixed can also create another kind of bad equilibrium. Once a
cost, the answer depends on two considerations: modern 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 sector
than in the traditional sector. Movement to a better equilibrium is especially difficult
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
Technological externality - A positive or negative
gains from 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
Other Cases in Which a Big Push May Be Necessary one in which a firm sells to another firm. Such linkages
are especially significant for industrialization strategy
The need for a big push can result from four conditions when one or more of the industries (product areas)
beyond those described previously. involved have increasing returns to scale that a larger
1. Intertemporal effects. Even if the industrial market takes advantage of.
wage rate is 1 (i.e., the same as the traditional- Inequality, Multiple Equilibria, and Growth
sector wage), multiple equilibria can occur if
investment must be undertaken in the current Other important work being done on growth and
period to get a more efficient production process multiple equilibria addresses the impact of inequality on
in the next period. growth. The traditional view has been that some
2. Urbanization effects. If some of the traditional inequality may enhance growth because the savings of
cottage industry is rural and the increasing- the rich are higher than those of the poor. If at least some
returns-to-scale manufacturing is urban, urban savings to be mobilized for investment purposes must
dwellers’ demand may be more concentrated in come from within a country, then according to this view,
manufactured goods (e.g., foods must be too high a degree of equality could compromise growth.
processed to prevent spoilage due to the time However, the poor save at much higher rates than
needed for transportation and distribution). previously believed, when savings are properly
3. Infrastructure effects. By using infrastructure, measured to include expenditures on health, children’s
such as a railroad or a port, an investing modern education, and improvements on a home.
firm helps defray the large fixed costs of that
Poverty trap - A bad equilibrium for a family,
infrastructure. The existence of the infrastructure
community, or nation, involving a vicious circle in which
helps investing firms lower their own costs. But
poverty and underdevelopment lead to more poverty and should by now be a familiar condition in which
underdevelopment, often from one generation to the multiple equilibria can emerge; it parallels issues
next. raised in our analysis of the big push model.
Kremer shows that a graph like Figure 4.1 can
apply to choices about how much skill to
4.5 Michael Kremer’s O-Ring Theory of Economic acquire.
Development  One can get caught in economy-wide, low-
production-quality traps. This will occur when
Another innovative and influential model that provides there are (quite plausibly) O-ring effects across
important insights into low-level equilibrium traps was firms as well as within firms. Because there is an
provided by Michael Kremer. The notion is that modern externality at work, there could thus be a case
production (especially in contrast to traditional crafts for an industrial policy to encourage quality
production) requires that many activities be done well upgrading, as some East Asian countries have
together in order for any of them to amount to a high undertaken in the past (see Chapter 12, section
value. This is a form of strong complementarity and is a 12.6, and its end-of-chapter case study of South
natural way of thinking about specialization and the Korea). This could be relevant for a country
division of labor, which along with economies of scale is trying to escape the middle-income trap.
another hallmark of developed economies in general and  O-ring effects magnify the impact of local
industrial production in particular. The name for production bottlenecks because such bottlenecks
Kremer’s model is taken from the 1986 Challenger have a multiplicative effect on other production.
disaster, in which the failure of one small, inexpensive  Bottlenecks also reduce the incentive for
part caused the space shuttle to explode. The O-ring workers to invest in skills by lowering the
theory is interesting in part because it explains not only expected return to these skills.
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
4.6 Economic Development as Self-Discovery
countries.
In simple models with perfect information, it is assumed
The O-Ring Model
that firms, and developing economies as a whole,
The key feature of the O-ring model is the way it models already know their comparative advantage. But
production with strong complementarities among inputs. individuals must discover their own comparative
We start by thinking of the model as describing what is advantage in labor markets; for example, no one is born
going on inside a firm, but as we will see, this model knowing they are well suited to become an economist or
also provides valuable insights into the impact of international development specialist.
complementarities across firms or industrial (product)
sectors of the economy.
Information externality - The spillover of information
O-ring production function
— such as knowledge of a production process—from
A production function with strong complementarities one agent to another, without intermediation of a market
among inputs, based on the products (i.e., multiplying) transaction; reflects the public good characteristic of
of the input qualities. information (and susceptibility to free riding)—it is
neither fully excludable from other uses, nor nonrival
Implications of the O-Ring Theory (one agent’s use of information does not prevent others
The analysis has several important implications: from using it).

 Firms tend to employ workers with similar

skills for their various tasks.
4.7 The Hausmann-Rodrik-Velasco Growth Diagnostics
 Workers performing the same task earn higher Framework
wages in a high-skill firm than in a low-skill
firm. Encouraging efficient investment and widespread
 Because wages increase in q at an increasing entrepreneurship plays a prominent role in accelerating
rate, wages will be more than proportionally growth and promoting development more broadly. But
higher in developed countries than would be the once popular idea of finding a “one size fits all”
predicted from standard measures of skill. policy for economic development is now generally
 If workers can improve their skill level and recognized as a myth. Different countries face different
make such investments, and if it is in their binding constraints on achieving faster rates of growth
interests to do so, they will consider the level of and economic development. A key mission for economic
human capital investments made by other development specialists is to help determine the nature
workers as a component of their own decision of the constraints for each country. Ricardo Hausmann,
about how much skill to acquire. Put differently, Dani Rodrik, and Andrés Velasco (HRV) propose a
when those around you have higher average growth diagnostics decision tree framework for zeroing
skills, you have a greater incentive to acquire in on a country’s most binding constraints on economic
more skills. This type of complementarity growth. HRV explain that targeting the most binding
constraint has important advantages over other
approaches to policy selection.
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.