Chapter 5

Contemporary Models of Development and Underdevelopment

Instructor: Izzah Taimur THE NEW GROWTH THEORY:ENDOGENOUS GROWTH Poor performance of neo classical theories in illuminating the sources of long-term growth has led to widespread dissatisfaction with traditional theory Traditional theory: there are no intrinsic characteristics of economies that cause them to grow over an extended period of time SOLOW RESIDUAL: Any increase in GNP that cant be attributed to short term adjustments in stock of either labor or capital are attributed to this third category Solow Residual is responsible for at least 50% of historic growth in the industrialized nations According to Neo Classical Theory: Low capital labor ratios of developing countries promise high rates of return on Investment Free Market reforms (IMF& World Bank) promote higher Investmentincrease productivityimproved standard of living Developing countries experienced little or no growth + failed to attract new foreign investment Domestic Capital flight NEW GROWTH THEORY/ENDOGENOUS GROWTH New Growth Theory/Endogenous Growth: persistent growth is determined by system governing the production process rather than the forces outside the system Explain factors that determine the size of capital stock+ Growth rate of GDP Public + Private Investments in Human & Capital Economies of Scale & productivity Improvements Increasing returns too sale long term growth Technology plays a role in the long term growth Emphasizes the importance of saving in achieving long term economic growth IMPLICATIONS OF GROWTH No force leading to the equilibrium of growth rates across closed economies National growth rates remain constant & differ across countries depending on national saving rates & technology levels There is no tendency for per capita income levels in capital poor countries to catch up with those rich countries with similar saving & population growth rates poor countries benefit less High rates of return on investment offered by developing countries with low capital labor ratios are eroded by low levels of COMPLEMENTARY INVESTMENTS (human capital, R& D , infrastructure) Government can provide public goods, & play an active role in promoting economic development Technology change is endogenous outcome of public & private investments in human capital THE ROMER MODEL Romer endogenous growth model addresses the technological spillovers that may be present in the process of industrialization Assumptions: Growth processes derive from the firm or industry level, where each industry individually produces with constant returns to scale _ Secondly, it assumes that the economy wide capital stock, K, positively effects output at the industry level, so that there maybe increasing returns to scale at the economy wide level. Romer model treats learning by doing as learning by investing Endogenizing the reason why growth might depend on the rate of investment -1-

Chapter 5 A property of the model is that with an investment (or technology) spillover, the model avoids diminishing returns to capital. An important shortcoming of the new growth theory is that it remains dependant on a number of traditional neoclassical assumptions that are often inappropriate for the LDC economies. Economic growth in developing countries is frequently impeded by inefficiencies arising from the poor infrastructure, inadequate institutional structures and imperfect capital and goods markets. As endogenous growth theory overlooks the above-mentioned influential factors, its applicability for the study of economic development is limited. Allocational inefficiencies are common in economies undergoing the transition from traditional to commercialized markets. However, their impact on short and medium term growth has been neglected due to the new theorys over emphasis on the determinants of the long-term growth rates.

UNDERDEVELOPMENT AS A COORDINATION FAILURE Complementarities between several conditions necessary for successful development Investment must be undertaken by many agents in order for the results to be profitable for any individual agent Coordination failure is a state of affairs in which agents inability to coordinate their behavior (choices) leads to an outcome(equilibrium) that leaves all agents worse of than in an alternative situation that is also an equilibrium This may occur even if all the agents are fully informed about the preferred alternative equilibrium They simply cannot get there because of difficulties of coordination, sometimes because people hold different expectations, sometimes because everyone is better off waiting for someone else to make the first move Incase of the complementarities being present they often involve investments whose return depends on other investments being made by other agents An important example of complementarity is the presence of firms using specialized skills and the availability of workers that have acquired those skills. Firms will not enter a market or locate in an area if workers do not possess skills the firms need, but workers will not acquire the skills if there are no firms to employ them Coordination problem can leave an economy stuck in a bad equilibrium low average income or growth rate Rural developing areas concerns the commercialization of agriculture Adam Smith already understood , specialization is one of the sources of high productivity In the development of agricultural markets, middlemen play a key role by effectively vouching for the quality of the products they sell In order for a specialized market to emerge, there needs to be a sufficient number of concentrated producers with whom a middleman can work effectively. But without available middlemen to whom the farmers can sell, they will have little incentive to specialize in the first place and will prefer to continue producing their staple crop or a range of goods primarily for personal consumption or sales within the village The result can be an underdevelopment trap in which region remains stuck in the subsistence agriculture.

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Chapter 5 There can be an important role for government policy in coordinating joint investments, such as between the workers who want skills that employers can use and the employers who want equipment that workers can use Deep interventions move an economy to a preferred equilibrium, or even to a higher permanent rate of growth, in which there is no incentive to go back to the behavior associated with the bad equilibrium. In these cases government has no need to continue the interventions, because the better equilibrium will be maintained automatically Congestion may be present Underdevelopment begets underdevelopment, while processes of suitable development, once underway, tend to stimulate further development Coordination problems are illustrated by the where-to-meet problem There may be several perfectly good products from which to choose, but the critical problem is for all the farmers to choose one, so the middleman may profitably bring the villages produce to market A complex problem of coordination is a simple one of communication. Anyone who has tried to establish a meeting among a large number of participants with no formal leader knows that this is a slow and cumbersome process Real economic problems, the people who need to meet__ perhaps to coordinate investmentsdo not even know the identity of the other key agents

MULTIPLE EQUILIBRIA: A DIAGRAMMATIC APPROACH Multiple Equilibria S- shaped function reflects the benefits an agent receives from taking an action depend positively on the number of agents expected to take the action, or on the extent of those actions For example, the price a farmer can hope to receive for his produce depends on the number of middlemen who are active in this region, which in turn depends on the number of other farmers who specialize in the same product Coordination is not really much of a problem when the group to be coordinated is small The solutions to coordination problems are far more difficult In case of the multiple equilibrium diagram, equilibrium is found where the privately rational decision function ( the S-shaped curve) crosses the 45- degree line. This is because, in these cases, agents observe what they expected to observe The functions cuts the 45-degrees line three times Possibility of multiple equilibria D 1 and D 3 are stable equilibria D2 cuts the function from below and so it is unstable This shape reflects what is ought to be the typical nature of complementarities The classical example of this problem in economic development concerns coordinating investment decisions when the value (rate of return) of one investment depends on the presence or extent of other investments All are better off with more investors, or higher rates of investment, but the market may well not get us there without the influence of certain type of govt. policy -3-

Chapter 5 The investment coordination perspective helps to clarify the nature and extent of problems posed when the technology spillovers are present, such as seen in the Romer model

STARTING ECONOMIC DEVELOPMENT: THE BIG PUSH Whether an economy has already been growing sustainably for some time or has been stagnant seems to make a very big difference for subsequent development. If growth can be sustained for a substantial time, say, a generation or more, it is much rarer for economic development to later get off track for long A century ago Argentina, along with the emerging United States was seen in Europe as a future powerhouse of the world economy Why should it be so difficult to start modern growth? Human capital developed Technology present Government provides essential services Several market failures work to make economic development difficult to initiate. Economy is not able to export Who will buy the goods produced by the first firm to industrialze? Starting from a subsistence economy, no workers have the money to buy the new goods The first factory can sell some of its goods to its own workers, but no one spends Each time an entrepreneur opens a factory, the workers spend some of their wages on products of other factories. So the profitability of one factory depends on whether another one opens First factory has to train Slightly higher wage to attract them to their own new factories No one is trained, and industrialization never gets underway The Big push is a model of how the presence of market failures can lead to need for a concentrated economy wide and probably public policy led effort to get the long process of economic development underway, or to accelerate it. Put differently, coordination failure problems work against successful industrialization

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