Contemporary Models of

Development and Underdevelopment

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 Outline of the Presentation

• Underdevelopment as Coordination Failure

• Models of Coordination failure
• Technological transfer for modernization
• Multiple equilibria: Graphical Illustrations
• Big-push theory
• Kremer’s O-Ring Theory of Economic Development
• Concluding remarks

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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)

• Principal-agent” model
– The success or failure of economic development policies can be
explained by the “principal-agent” model.
• Underdevelopment trap
– A region remains stuck in substance agriculture

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Underdevelopment as Coordination Failure

• Principal:
– Government

• Agents:
– Households
– Private-sector firms
– Public agencies
– Government-owned enterprises
– International companies
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Underdevelopment as Coordination Failure

• An effective principal
– It is needed to coordinate actions taken by agents and
achieve an optimal outcome, making all agents better-off.

• Coordination failure
– It occurs when the principal fails to induce agents to
coordinate their actions, which leads to an outcome that
makes all agents worse-off.

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 Models of Coordination Failure

Technological Transfer for Modernization

The Big Bush to Industrialization

The O-Ring Theory of Economic Development

The Growth Diagnostics Framework

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 Technological Transfer for Modernization

• Multiple Equilibria
– 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 (A stable
equilibrium)

• At equilibrium,
– The expected outcome of an action equals its actual outcome
– Expected outcome = Actual outcome

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Multiple Equilibria: Graphical Illustration

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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 investment).

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 Technological Transfer for Modernization

• How to achieve 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.

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 The Big Push: Coordination Failure

• Starting from a subsistence economy, no workers have the

money to buy the new goods
• The first factor sells some of its goods to its own workers
• No one spends all of their income on a single good
• Profitability of one factory depends on whether another one
opens
• Circular causation is a familiar pattern of a coordination failure
problem
• The first factory needs to train its workers
• The second firm pays a slightly higher wages

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 The Big Push to Industrialization

• Paul Rosenstein-Rodan
• 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

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 The Big Push to Industrialization

Assumptions:

• One factor of production: labor

• Two economic sectors: traditional vs. modern
• Same production function for each sector
• Consumers spend an equal amount on each
product they buy
• Closed economy
• Perfect competition
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 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)
– Modern firm will pay the fixed cost F and enter the market
• g

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The Big Push: Graphical Illustration

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 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 economy to adopt
modern technology
• 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
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 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)
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Conditions Making The Big Push Necessary

• Intertemporal effects:
– Investment in the modern sector becomes
profitable over-time as the market size
increases

• Urbanization effects:
– Demand for manufactured goods increases
with urban population growth

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 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

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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 do so
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Coordination Problem Cannot Be Solved by
a Super-Entrepreneur

• Limited knowledge: agents do not have

sufficient information about the importance
of industrialization

• Lack of empirical evidence: agents do not

know that other firms are investing in
modern technology

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 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

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 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

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 The O-Ring Theory of
Economic Development

• A model of economic development put forward by

Michael Kremer in 1993
• 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
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 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
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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
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The Growth Diagnostics Framework

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