Charter Cities, Exogenous Institutional Development and Technological Imitation

Jos D. Sierra Castillo Duke University December, 2012

Abstract This paper presents a modified version of the traditional technological imitation model. It is assumed that the economy has a carrying capacity for the imitation of new technology, which implies that the process of technological transfer follows a logistic path. The process can be accelerated or slowed down by the institutions of the imitating country. This implies that one valid method for spurring growth in a technologically backwards country is to improve its institutions. After that, growth will happen at a faster rate until the following country catches up to the leading country.

I.

Introduction Throwing water into the ocean; reiteratively. Throughout the world, poor countries keep pouring resources into figuring out how to grow, yet they fail to catch up to their superior counterparts. Economists agree that one of the fundamental causes for this problem is a deficient level of institutional development in poor countries (Acemoglu 2009). In that sense, this paper proposes a simple model that shows how the lack of proper institutions affects technological imitation given a logistic function for the growth of technology in the poor country. Consequently, the model also shows how an institutional shock affects the transition dynamics of the poor country towards its steady state. The model is motivated by Paul Romers idea of charter cities. Romer argues that these cities could be created to bring a new set of rules and institutions into a country, thus accelerating the north-south transmission of knowledge and technology. In that sense, the conclusions presented in this paper can be taken as interpretations of what the creation of a charter city would mean for a country. To show this, the paper is structured in the following way: It first shows how technology is created in the leading country. Afterwards, it presents how the economy in country 2 works; making emphasis on how technology is transmitted into the country. This last part is the heart of the model. Subsequently, the model is closed by concentrating on the transition dynamics and on how institutional development affects country twos growth. A brief discussion is also carried on how the follower can become a leader. The paper comes to a close with some short concluding remarks about its main findings.

II.

Creation of technology in the leading country Following1 Barro and Sala-i-Martins (2004) model for the diffusion of technology, it is convenient to first establish how the economy in the leading country (the country with the technological advantage) works. First assume that country one has the following production function: 1. where is labor and a constant, A1 represents total factor productivity and X1 of

the j type represents an specialized intermediate good. At any moment in time the economy has N1 goods X; this variety of goods represents the level of technological development of the country. Furthermore, it is assumed that the intermediate goods, X, are produced by monopolists. This implies that these firms will charge the price for any good noticing that . Normalizing the cost of producing these goods to 1, and assures that the producers of the intermediate goods will will

have extra ordinary profits, which will drive the discovery of new goods ( increase) in country 1 Equaling the marginal product of

.with the price and

assuming all j intermediate goods are identical and are employed in the same quantity, gives the demand for intermediate goods in the economy: 2. Plugging (2) into (1) and dividing by L gives income per capita: 3.
1

In fact the model is based entirely on Barro and Sala-i-Martins approach towards modeling technological diffusion.

From here it can be seen that the marginal product of labor equals: 4. ( )

Assuming a non-arbitrage condition, free entry into the market, and a fixed cost of innovation called , the instantaneous rate of return for the innovating firms in the market can be written as: 5. Where , is profit for the firm. Rewriting profit in terms labor, and the

productivity factor, and plugging it into (5) gives: ( ) ( )

6.

For the consumption side of the economy, assume consumers maximize their lifetime utility subject to the budget constraint: ( ) s.t.

7.

Where p is the discount rate, c is consumption per person, assets,

is income from

is income from work, and theta is the inverse of the elasticity of

substitution for utility. The higher this value is, the higher the premium consumers will demand to sacrifice consumption today for consumption tomorrow. By solving the previous optimization problem and plugging in (6) into the resulting Euler equation it can be shown that:

8.

(( ) (

This last equation gives the steady state growth for consumption, as well as for the number of new goods in the economy, and for output. The economy in country one was modeled in such a simple way because that is all that is necessary to see what happens during countrys two technological catch up, which is this papers objective. From now on, the growth rate of country one will be called III. Behavior of the follower country

The economy in the following country has many similarities with the economy described for the innovating country. For example, it is assumed that after an agent pays the cost of imitation, , it will have a monopoly over the imitated good. Because of this, the demand for intermediate goods will have the same form as the demand for intermediate goods in country 1 (given that the output function has the same form as in equation 1):

9. Just as before this implies that income per capita has the following form: 10. Note from this last equation that the growth rate of per capita income in country two will equal the growth rate of technology in country two. This highlights the fact that to accelerate growth country 2 should attempt to increase its stock of technology

(as reflected by the number of intermediate goods it has). The process by which country two can accomplish this goal is discussed further ahead. Continuing with the similarities between economies, profits also have the same form:

11.

Just as before, due to non-arbitrage and free entry conditions, the instantaneous rate of return for imitation has to equal the markets rate of return. However, country 2 is not innovating, it is imitating. Fixed innovating costs were assumed for country 1. This assumption cant be made for country 2, since it can be argued that the number of goods to be imitated is limited. If country 2 is lagging behind country 1 by a wide margin, it will be relatively easy for it to imitate rudimentary technologies without incurring in major costs. Analogously, as country two catches up to country 1, it will deplete the stock of rudimentary ideas to copy, and only more sophisticated technologies such as satellites or robotics will be left. Understandably, the cost of learning how to build and operate a satellite is higher than the cost of learning how to process chicken meat at an industrial level. As the technological gap closes, so will the cost of imitation increase. The rate of return would be:

12.

For simplicity, the following imitation cost function is assumed ( ):

13.

This simple equation implies that, as the ratio between technology in country 2 and technology in country one approaches 1, the cost to imitate will approach the cost to innovate in country 2. For simplicity it is assumed that never reaches one; the

cost of imitation will always be below the cost of innovation and country 2 will not have an incentive to innovate. Differentiating 13 with respect to time, and plugging it into 12 gives: 14. ,

Where

= .

Finally, the law of motion for consumption in country 2 is: 15.

The steady state in country two will be reached when country two catches up to country one technologically. Since one of the previous assumptions states this will never happen, it can be said that in the limit the results will be close enough. At this point, under the binding assumption that country 2 wont innovate, it can only imitate the new goods created by country 1 at the speed of state growth rate for country 2. ; this will also be the steady

IV.

Imitation: Effort and institutions So far it has been stated that the growth rate of country 2 will depend on how successfully it copies technology from country 1, however nothing has been said about the process through which this takes place. At first glance it is tempting to observe technological differences between countries and simply assume that the transfusion of technology from the superior country to the inferior country should be carried out in an unencumbered fashion. Besides the obvious monetary cost of imitating the technology, there should not exist any other big obstacle for north - south technological diffusion. Poor countries without universal electric grids, public sanitation, or access to water prove this is not always true. Even countries that share the same historic, geographic, cultural, and economic backgrounds present big differences in their levels of technological and economic growth. For example, the Central American countries are all remarkably similar; nevertheless Costa Rica and El Salvador customarily outperform the other countries in the region. After noticing that this is a common occurrence among several groups of countries that share a common background, economists asked themselves what differentiated these countries in such a way as to provoke such differences in secular growth. So far, it seems that the differentiating element is institutions. Countless models have shown how an inadequate level of institutional development can hinder economic growth by stopping endogenous innovation in key areas of economic activity. If institutions are defined as the set of rules that facilitate doing business in a country it can easily be seen that bad institutions can also get in the way of technological imitation. After all, imitation has a cost. Any rational agent would

invest in imitation only if it can profit from said imitation. If the legal and economic environment of a country dont guarantee this profit, or increases this cost, imitation would be slowed down. Another argument on how bad institutions could slow down progress lies in diffusion. If a firms profits or property rights are not guaranteed, it is possible that the firm will try to imitate and keep the innovation for itself. It will try its best to avoid diffusing this new technology throughout the economy as a way of securing profits that would otherwise be guaranteed by the countrys institutions. Using either of the previous two arguments, it can be said that, given a sufficiently low level of institutional development, an investment in imitation would have a minimum marginal benefit for the countrys technological development in relation to the superior country. The effect of the imitation would be similar to that of a bucket of water thrown into the ocean. Combining the argument that a low level of institutional development hinders technological imitation (and therefore growth), with the previous argument on how the cost to imitate increases as the technological frontier is reached, leads one to expect an s shaped trajectory for the evolution of technology in country 2.
2

The

lack of institutional development would make the trajectory of technological growth flat at first. On the other end of the spectrum, running out of the stock of ideas would make the trajectory flat once again at the end of the time horizon. In between these two extremes an upwards trajectory would be present where momentarily an increase in technology would make copying other technologies easier, countering the negative effect of the other two forces. Mathematically all of these can be shown by:

It has been shown that endogenous innovation can also follow this shape (Peretto and Connolly 2007) under similar arguments to the ones just exposed; a limited carrying capacity controls the evolution of technology.

16.

Where

can be interpreted as the carrying capacity of the economy (country 2 represents the effort country two makes to

cannot grow beyond this point), and

imitate technology given the economys budget constraint:

17.

This budget constraint states that country two will use its resources to consume, to produce intermediate goods or to imitate new technology at a cost of . Note that the

cost of imitation is scaled down by the parameter phi, which represents institutional development. Solving for and using equations 9 and 10 gives: ( ) ( )

18.

By plugging 18 in 16, and dividing by

it is obtained that: ]( ) ( )

19.

Where

. Equation 19 shows how technology grows in country 2.

Furthermore, if it is assumed for simplicity that the term inside the keys is a constant, Z, equation 19 can be solved in the following way: ( )

which can be solved by integration to give: ( ) ( )

From here it can be easily shown that:

20.
Initializing equation 10 at time 0:

21.

Equation 21 gives a better perspective on how technological evolution in country behaves. Graphically it can be seen that this growth does have an S shaped path for low levels of Z, while a steeper path for high levels of Z. Going back to the original equation, remember that Z represents a constant level of effort to imitate technology; it becomes clear that a country can accelerate its growth rate by sacrificing consumption to put more effort into imitation. It also becomes clear, from equation 18, that the level of institutional development has a positive scaling effect on effort. The higher this parameter is, the bigger effort will be exerted by a country at any level of investment. As the graph illustrates, this level of effort becomes the main determinant in how long it would take country 2 to catch up to country 1, assuming country 1 is not moving farther away. When the level of effort is extremely low, it can take more than 100 periods, when the level of effort is higher, the process is presents a considerable degree of acceleration. In the sense, improving the quality of their institutions becomes a viable option for cash strapped countries that wouldnt otherwise increase their investment in acquiring new technology. Romers idea of charter cities would operate in this way, shocking countries out of natural slow growth paths into a faster track where technology and GDP per capita reach their steady state levels in less time. .

Figure 1: Technological imitation through time

0.8

0.6

N2/N1
0.4 0.2 0 0

10

20

30

40

50 time

60

70

80

90

100

The previous example, although illustrative, has too many simplifications to properly show the process of technological imitation followed by country 2. This process is better appreciated in a 2 variable phase diagram, using the variables as control and state variables respectively. Concentrating first on rate is: and

its growth

22.

The growth rate of

was obtained in equation 19, while the growth rate of : combining these two gives the first equation of the

technology in country 1 equals

system of differential equations that describes the economy:

23.

=[

]( )(

Using equation 23, equaling to 0, and solving for f gives:

24.

) ( ).

The growth rate of f is:

25.

Plugging in equations 15, 19, and 23 into in to equation 25 gives: 3

26.

( )[

( (

( )( ) ](

) )

)(

Equation 26 is the second equation of the system of autonomous differential equations that describe the economy. Equaling to 0, and solving for f gives:

27.
Note that:

)(

)( )(

)(

Graphically, equations 24 and 27 can be plotted in the following phase diagram:

For simplicity it is assumed that theta is between 0 and 1. This implies that people in country two are indifferent to the timing of consumption as long as they are compensated with at least their intertemporal rate.

Increasing f in

reduces said growth rate, while decreasing f has the

opposite effect; the direction to the right of the plot of equation 24 goes left, while the direction to the left of the plot goes right. Similarly, increasing makes this growth rate go down, while decreasing in

has the opposite effect; the

direction to the left of the plot goes up, while the direction to the right of the plot goes down. As shown in the phase diagram, the stable point corresponds to begins below its steady state value, will grow at a faster rate than . If until

country two catches up with country one. Note that

by assumption;

country two is bounded from surpassing country 1. Finally, points outside the

stable path are ruled out because they lead to negative values of consumption (or zero consumption) with infinite values of technology, or infinite levels of consumption. None of these are economically correct. The dotted lines show the effects of a positive institutional shock (like the c e io of Rome s ch e ci ies) i he sys em The shock displaces the curves The increase in

in such a way that it increases the steady state value of

institutional development lowers the cost of imitation at any level, which allows cou cou y o i ch c ose o cou y s ech o ogic i e y highe i y i e e This implies that he e s e dy s e

y s pe c pi

i come

i be e

( he fi

e e of f is u c e

f om he

hich he cu es mo e)

However, while country two transitions towards its new steady state, co sump io o rise as fast as technology, since it will be lowered to pay for

this higher level of technology. Finally, once the new steady state is reached country two will go back to growing at the same rate as country 1, albeit enjoying a relatively higher living standard than before thanks to it closing the technological gap with country 1 even more.

V.

From Imitator to Innovator The mode s de e oped up o his poi c be used o exp i

mathematically the process of technological leapfrogging. As the model is s uc u ed ech o ogy i cou he eco omy cou y c g o e e beyo d he c yi g c p ci y of

y o es ech o ogic

However, it can be used to make a brief non-technical comment on how the follower can become an innovator. So far, the growth of the following country has been bounded by the assumption that it can never truly catch up to the leading country. This assumption implies that the following country is inferior to the leading country in factor productivity, factor endowments, or in other parameters not determined by the model. If it were to happen that, for example, technological process in country 2 gives the country enough know how to lower its innovation cost to the point where it is below the steady state cost of imitation, the no catching up assumption would no longer hold. Without this assumption a scenario could be created in which improving country twos p me e s (i c udi g i s e e of i s i u io de e opme ) cou d

displace the curves in the phase diagram to a new steady state where the ratio of technology between country two and country one is more than or equal to one. If the cost of innovation for country 2 is normalized to one, at the new steady state innovation becomes a real and viable option for growth; this would push country 2 to become the new technological leader. Once the switch takes place, the dynamics of the system and all elements so far discussed will be the same, except changing the roles of country 2, now the innovator, with country 1, now the follower.

VI.

Concluding remarks Technology, the main source of growth in modern economies, can be either created endogenously through innovation or brought from outside through imitation. Since imitation is cheaper than innovation, less developed countries should acquire new technology at a faster rate than it is created by innovators, thus promoting faster growth and an eventual catch up. However, there are situations in which this does not happen (or in which the process is significantly slowed). This paper argues that one of these situations is when the imitating country has bad institutions. The level of institutional development becomes one of the main determinants of the speed of technological catch up, slowing or accelerating the process according to its movements. Under this light, it becomes apparent that exogenous shocks that aim to improve the quality and level of institutions in a country have the potential to accelerate short run growth. In some cases, for countries with abyssal i s i u io s hese shocks o jus cce e eg o h hey i i i i e i by

bringing the country out of low growth slumps caused by the institutional b ock de The mode b cks up Rome s ide bou he c e io of ch e ci ies

References

Acemoglu, Daron. 2009. Introduction to modern economic growth. Princeton: Princeton University Press. Barro, Robert J, and Xavier Sala-i-Martin. 2004. Economic growth. Cambridge, Mass.: MIT Press. Findlay, Ronald. 1978. Relative Backwardness, Direct Foreign Investment, and the Transfer of Technology: A Simple Dynamic Model. MLI. 2012. Success and the City: How Charter Cities Could Transform the Developing World. Peretto, Pietro, and Michelle Connolly. 2007. The Manhattan Metaphor. Peretto, Pietro, Michelle Connolly, and Nelson S. 2006. Sustaining the Goose That Lays the Golden Egg: A Continuous Treatment of Technological Transfer. Sandefur, Justin, and Milan Vaishnav. 2012. Imagine Theres No Country: Three Questions About a New Charter City in Honduras. http://www.cgdev.org/files/1426274_file_Sandefur_Vaishnav_charter_cities_FINAL.pdf.