contemporary theories of development Flashcards
common threads between contemporary theories of development
▪ Complementarities between economic activities or sectors
▪ Low-level equilibria traps or constraints
▪ Less emphasis of a single prescriptive model of economic development
concept of underdevelopment as a coordination failure
o The concept of underdevelopment as a coordination failure stresses the importance of complementarity in agents’ actions
▪ Actions by one agent increases the incentive for other agents to engage in similar actions
▪ For example, investment must be undertaken by many agents simultaneously for the returns to be positive for any economic agents
o Coordination failure may occur due to agents’ inability to coordinate their action leading to a low-level equilibrium where all agents are worse off
o Models of coordination failure often considers the existence of multiple equilibria
example of complementaries - Specialized firms and specialized labour
o Firms will not locate to an area if workers do not have the skills the firm needs, even if the firm would be highly profitable if those skills existed
o Hence, workers in the area do not acquire those skills as there are no firms in the local area to employ them
o Everyone would be better off if firms invested in the area and workers acquired skills…but unless firms coordinate, the economy can be stuck at a ‘bad’ equilibrium with low growth and widespread poverty
o Escaping this bad equilibrium requires coordinated joint investments by firms (e.g., in training)
o Potentially a ‘one-time’ fix to move the economy to a better, self-sustaining equilibrium
Multiple Equilibria Diagram – Convergence to Low-Level Equilibrium
refer back to slides
o If firm i expects the average investment to be below 𝐷2investment will converge to the low-level equilibrium𝐷1. To see this, consider i’s investment over time
At t=1:
▪ Firm i expects average investment to be at 𝐷𝐴
▪ This implies firm i will invest 𝐼𝐴
▪ As this portion of the S-shaped function is below the 45° line, this implies 𝐼𝐴 < 𝐷𝐴
At t=2:
▪ Because firm i invested less than the average at t=1, the average has fallen to 𝐷𝐵
▪ At 𝐷𝐵 firm i will invest only 𝐼𝐵, so again, 𝐼𝐵 < 𝐷𝐵and average investment falls
This process continues until equilibrium is reached at 𝐷1
Multiple Equilibria Diagram – Convergence to High-Level Equilibrium
refer back to slides
o If firm i expects the average investment to be above 𝐷2investment will converge to the high-level equilibrium
At t=1:
▪ Firm i expects average investment to be at 𝐷𝑐
▪ This implies firm i will invest 𝐼𝑐
▪ As this portion of the S-shaped function is above the 45° line, this implies 𝐼𝑐 > 𝐷𝑐
At t=2:
▪ Because firm i invested more than the average at t=1, the average has increased to 𝐷𝐷
▪ At 𝐷𝐷 firm i will invest 𝐼𝐷, but 𝐼𝐷 > 𝐷𝐷 and average investment increases further
This process continues until equilibrium is reached at 𝐷3
simple example of underdevelopment trap
o Consider a closed, subsistence economy – i.e., no trade and no disposable income
o In this economy, there will be no demand for the goods produced by any modern firm choosing to start production – the subsistence population has no income to spare!
o A modern firm could sell some of its output to its own workers (assuming modern sector wages are higher than subsistence income) – but to sell all of the new output requires the existence of other modern firms
o Because the profits of the first modern firm requires the existence of other modern firms, no modern firm will ever start production!
o A large-scale investment in modernisation across multiple firms (e.g., by Government)could solve this coordination failure
positive assortative matching
o A key implication of the O-ring model is positive assortative matching: high skilled workers will seek to work with other high skilled workers
o Hence, workers with low skills will have no option but to work together
o Suppose a firm has four workers - two H-types and two L-types
o Production of Q requires two tasks, so the four workers must separate into pairs
o An example of a production function with strong complementarities would be:Q = 𝑞𝑖𝑞𝑗
o We can prove that:
𝑞𝐻2 + 𝑞𝐿2 generates more output than 2𝑞𝐻𝑞𝐿
o To see this - if 𝑞𝐻 ≠ 𝑞𝐿, it follows that:
(𝑞𝐻−𝑞𝐿)2 > 0𝑞𝐻2 − 𝑞𝐻𝑞𝐿 − 𝑞𝐻𝑞𝐿 + 𝑞𝐿2 > 0𝑞𝐻2 + 𝑞𝐿2 > 2𝑞𝐻𝑞𝐿
o This illustrates that - with strong complementarity in production - it is more efficient to match, i.e. produce using positive assortative matching
Multiple Equilibria
- diagram
- implications
- evidence
- criticisms
diagram on slides
implications
o Small improvements will have no structural effect: It is difficult to escape the low-level equilibria
o Only Transfers sufficiently large to overcome saddle point will they be effective in the long run
o Vulnerability – as uninsured shocks might push a household over the threshold
evidence
o Lybbert et al (2004) avoid the issue of multiple assets by focussing on an economy is characterised by a single asset (livestock) and climatic risk
o They look at pastoralists in Southern Ethiopia
o Rich are more able to cope with mortality risk, while poor move to the low-stable equilibrium
criticisms
o Lack of Evidence: While models with multiple equilibria are theoretically elegant, there is a lack of Empirical Evidence supporting the existence in real-world economies
o Assumption of Homogeneity: Multiple equilibria models often assume homogeneity among agents within the economy, disregarding the heterogeneity that exists in real-world economies
poverty trap
- definition
- mechanisms
o Poverty trap: Individuals are unable to generate high enough income to maintain wealth, and become poorer over time, until they reach a low-income equilibrium
o Once in this vicious circle it may be impossible to escape - used in ME theory
mechanisms
o Credit Constraints
No assets ⟹ no credit ⟹ no investment ⟹ low productivity ⟹ low income ⟹ No assets
o Lack of Insurance
No insurance ⟹ income smoothing ⟹ lower productivity ⟹ can’t afford insurance ⟹ No insurance
o Nutrition and Efficiency Wages
Low nutrition ⟹ poor health ⟹ low productivity ⟹ can’t afford nutritious food ⟹ Low nutrition
big push theory/Rosenstein-Rodan’s theory 1943
- definition
- criticisms
o The Rosenstein-Rodan’s theory suggests a circle of poverty in underdeveloped regions
▪ Low productivity in one sector ⟹ low income ⟹ limits on the demand for goods and services from other sectors ⟹ perpetuates underdevelopment
o If all sectors become more productive simultaneously, then the increase in income due to the increases in wages/profits will create the demand for new goods produced
criticisms
o Assumption of Simultaneous Investment: The theory assumes simultaneous investment. It neglects the possibility of prioritizing investments in sectors with higher potential for growth
o Coordination Challenges: Implementing coordinated investment in contexts with weak institutions and governance leaves the Big Push approach unfeasible
o Neglect of Structural Transformation: Critics argue that development requires not only increased investment but also structural change
o ring theory
- definition
- implications
- criticisms
o The Kremer (1993) theory stresses the importance of complementarities in production and the consequences of ‘small’ failures in the production process
o A simplified version of the O-ring production function for a single good Q
Q = 𝑓(𝑞1, 𝑞2, 𝑞3, . . . 𝑞𝑛)
𝑞𝑖 = skill level of the worker completing task i
o 𝑞 = probability to correctly complete each task in a production process – 𝑞𝑖= 0.5 there is only a 50% chance that task i in the production process will be completed correctly
o The model assumes strong complementarities among inputs
o A single ‘weak link’ in the production process lowers the probability that the output will be produced – even if all other tasks are completed correctly 100% of the time
implications
o High value production will be concentrated in countries with higher skills
o Similar workers performing similar tasks in high-skill countries earn higher wages than in low-skill countries
o Productivity and wage increase in 𝑞 at an increasing rate - the wage gap is more than proportionally higher than the skill gap would suggest
o The model stresses the importance of bottlenecks, which multiplicatively affect others’ production … and reduce individual incentives for investment in skills
o The incentive to acquire skills depends on the average skill of labour in the economy –another example of multiple equilibria?
criticisms
o Limited Applicability: The O-ring theory may have limited applicability beyond certain sectors or industries characterized by high interdependence among tasks
o Static View of Technology: The theory assumes a static view of technology, where the quality of output is solely determined by the successful completion of individual tasks
o Neglect of Institutional and Organizational Factors: The theory overlooks the role of institutional and organizational factors in shaping production processes and outcomes
o Implications for Development Policy: Critics caution against drawing direct policy implications from the O-ring theory without considering the broader socioeconomic context, e.g.,infrastructure, institutions, and access to markets
HRV growth diagnostics
- examples
- criticisms
o The Hausmann-Rodrik-Velasco (HRV) Growth Diagnostics approach focusses on finding and addressing a country’s most binding constraints to growth
o Country-specific constraints should be implemented - No one size fits all policy
o The approach requires careful research to determine the most likely binding constraint
For example:
▪ If the constraint is high taxation, we would expect to see a large informal sector
▪ If the constraint is infrastructure, we would expect significant congestion
▪ If the constraint is education, we would expect high rates of return to education
examples
o The Inter-American Development Bank (IADB) has commissioned growth diagnostic studies of many of its member countries
o The World Bank has also applied the method in several studies to identify the binding constraints to development
criticisms
o Subjectivity in Diagnostic Process: The HRV approach relies heavily on judgments inidentifying the binding constraints to growth. Different analysts may prioritize different variables or interpret data differently
o Neglect of Political Economy Factors: The framework may neglect the political economy factors that influence policymaking and implementation in developing countries, e.g.,institutional constraints may limit the feasibility of the recommended reforms
o Limited Policy Prescription: While the theory is effective at diagnosing constraints to growth, it provides limited guidance on specific policy interventions
