C ONTEMPORARY M ODELS OF D EVELOPMENT AND U NDERDEVELOPMENT 1

C ONTEMPORARY MODELS OF D EVELOPMENT Is Development possible? Development is possible but extremely difficult! It has been impossible for some countries (e.g., Nigeria, Sudan, or even Pakistan), but accomplished by others (e.g., S. Korea, Singapore). Thus an improved understanding of barrier and catalysts of development is the utmost important. Does it happen automatically? It happens systematically! 2

C ONTEMPORARY M ODELS OF D EVELOPMENT AND U NDERDEVELOPMENT New theories that help us understand the barriers to development include Endogenous growth Coordination failures Multiple equilibria The Big Push O-Ring theory 3

The new models of economic development have broadened the scope for modeling a market in a developing country. Neoclassical assumption of diminishing marginal return to capital investments, permitting increasing return to scale in aggregate production. Departs from neoclassical economics in its assumptions of perfect information, the relative insignificance of externalities, and the uniqueness and optimality of equilibrium. 4 C ONT..

T HE N EW G ROWTH T HEORY : E NDOGENOUS G ROWTH The new growth provides a theoretical framework for analyzing endogenous growth, persistent GNP growth that is determined by the system governing the production process rather than by the forces outside the system. Endogenous growth theory explains TFP “endogenously” Advances in explaining growth rate differentials across countries. New growth theories assume increasing returns to capital, permit increasing returns to scale and focus on the role of externalities in determining rate of return on capital investments. Suggest an active role for public policy in increasing complementary investments 5

E NDOGENOUS G ROWTH M ODELS Structural resemblance, however, differ considerably in their assumption and conclusions drawn. The models imply that a country’s LR growth rate depends on its rate of savings and investment, not only on exogenous productivity growth The models use the aggregate production Y=AK Assume that marginal productivity of capital is constant as a result of concurrent investment in human capital and R & D 6

C ONT.. Complementary investment produced social and private benefits. Govt. should improve the efficiency of resource allocation by providing public good and or encouraging private investment. Human capital accumulation subsequently can generate increasing return to scale. So such growth theory models explain technological change as endogenous outcome of public and private investment in human capital and knowledge-intensive industries. 7

C ONT.. Endogenous growth theory holds that economic growth is primarily the result of endogenous and not external forces.economic growthendogenous Endogenous growth theory holds that investment in human capital, innovation, and knowledge are significant contributors to economic growth.human capitalinnovation The theory also focuses on positive externalities and spillover effects of a knowledge- based economy which will lead to economic development. positive externalitiesspillover effects 8

N EW A PPROACHES TO G ROWTH New research reveals that GDP growth in many of the technologically advanced countries has had to do largely, even principally, with TFP growth (i.e., increases in productivity). Furthermore, research has been conducted on why productivity growth has such a major impact? And one explanation is that there are i ncreasing returns to investment in knowledge. This may be a result of p ositive externalities (spillovers). 9

T HE R OMER E NDOGENOUS G ROWTH M ODEL To demonstrate the endogenous growth models: let us examine the simplified form of Romer endogenous growth models. endogenous The model addresses technological spillovers that may be present in the process of industrialization The aggregate production function is similar to that of Harrod-Domar model and endogenises why growth might depend on investment As a result of saving, investment (knowledge/ know-how) spillovers occur leading to higher rates of growth DrawbacksDrawbacks of the theory/model 10

C OMPARISON OF S OLOW AND R OMER MODELS Assumption: growth process derive from the firm or industry level, each industry produces individually produces with constant returns to scale, so the model is consistent with perfect competition. (matches assumptions of Solow ) Economy wide capital stock positively affect output at the industry level so that there may be IRS at the economy wide level. Knowledge is included in the capital stock of each firm, (Public good) that is spilling over instantly to the other firms in the economy. 11 Back

C RITICISMS Assumptions, that often inappropriate for LDC. Single sector of production and all sectors are symmetrical. Does not permit the crucial growth-generating reallocation of labor and capital among the sectors that are transformed during the process of structural change. Overlook the very influential factors of the LDC, such as, poor infrastructural, inadequate institutional structures, and imperfect capital and goods markets. Its applicability for the study of economic development is limited. 12 Back

U NDERDEVELOPMENT AS A C OORDINATION F AILURE Influential during early 2000 Emphasizes that complementarities between several conditions is necessary for economic development.(skill or demand for skill) Coordination failures results in (bad) equilibrium in which agents are worse-off than in alternative (situation of) equilibrium Deep interventions by the government can move an economy to a preferred equilibrium. Then govt. has no need to continue the intervention because the better equilibrium will be maintained automatically. 13

C ONT.. Complementarities versus congestions In the absence of complementarities, such as in competitive markets; when there is excess demand there is counter-pressure for the prices to rise, restoring the equilibrium. Whenever, congestions may be present, these counter-pressures are very strong. Furthermore, in the process of economic development, joint externalities are common: underdevelopment begets underdevelopment, while the process of sustainable development, once underway, tend to stimulate further development. 14

I LLUSTRATION OF C OORDINATION F AILURE : M ULTIPLE EQUILIBRIA Equilibrium occurs when agents do what is best for them and when agents observe what they expected to observe MultipleMultiple equilibria is illustrated using a S- shaped curve intersecting a 45 degree line When there is multiple equilibria, we usually have a lower stable equilibrium higher stable equilibrium Examples: Coordinating investment decisions in a economy and Malthus population trapMalthus 15

C ONT C ONT.. 16 Unstable equilibrium: The S-shaped function crosses the45º line from below (point D2). As firms coordinate theirinvestment decisions, equilibrium moves to D1 (decreaseinvestment) or D3 (increase investment). Economic development concerns coordinating investment decisions: when the value(rate of return) of one investment depends on the presence or extend of other investments

Malthusian Population Trap- The population threshold at which life-sustaining resources would no longer be able to support the human population, according to Malthus. Also known as the low-level equilibrium trap.trap 17

I LLUSTRATION OF C OORDINATION F AILURE : M ULTIPLE EQUILIBRIA Lower stable equilibrium occurs when only a few agents take a complementary action and spillovers are minimal Higher stable equilibrium occurs at a stage when many agents have taken the complementary action that they all enjoy the positive benefits of the spillovers Government intervention can change expectations of individuals and thus move the economy from low to high stable equilibrium Technological availability is a necessary but not a sufficient condition for development 18

T HE B IG P USH M ODEL O F D EVELOPMENT The big push model shows how market failures can be mitigated by serious public policy –led efforts to get the long process of economic development underway or to accelerate it. It is the most famous model of coordination failures and it emphasizes the existence of increasing returns in the modern, industrialized sector A look at the record, however, allows us to agree with Rostow at least in that it is very difficult to get modern eco­nomic growth under way in the first place and much easier to maintain it once a track record has been established. 19

C ONT.. Why should it be so difficult to start modern growth? Under perfect competition, it is not clear why starting development would be so difficult, provided at least that the needed human capital is developed, the technology transfer problem is adequately addressed, and government provides other essential services. But development seems hard to initiate even when better technologies are available—they often go unused. 20

C ONT.. Rosenstein-Rodan's arguments became a major part of the way development economists thought about development problems in the 1950s and 1960s, and they have continued to be taught in development courses. But while some of the basic insight has thus been around for decades, the approach received a huge boost following the 1989 publication of a technical paper by Kevin Murphy, Andrei Shleifer, and Robert Vishny, which for the first time demonstrated the formal logic of this approach more clearly. Its recent appeal is also due in part to its perceived value in explaining the success of the East Asian miracle economies, notably that of South Korea 21

T HE B IG P USH M ODEL O F D EVELOPMENT Assumptions: 1. Factors 2. Factor payments 3. Technology 4. Domestic demand 5. International supply and demand 6. Market structure 22

T HE B IG P USH M ODEL O F D EVELOPMENT 23

T HE B IG P USH M ODEL O F D EVELOPMENT Other cases in which a big push may be 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 Infrastructure 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 24

C OORDINATION P ROBLEM C ANNOT B E S OLVED BY A S UPER -E NTREPRENEUR Why the problem cannot be solved by a super- entrepreneur? Capital market failures; bankers are unwilling to provide loans to a single firm Agency costs; expensive agency costs to ensure compliance of employees Asymmetric information; agents do not know that other firms are investing in modern technology Communication failures; agents wanting to share profit cannot convince the super-entrepreneur to do so Limits to knowledge; agents do not have sufficient information about the importance of industrialization 25

F URTHER PROBLEMS OF MULTIPLE EQUILIBRIA The presence of increasing returns in modern industries can create bad equilibrium Inefficient advantages of incumbency Behavior and norms of individuals in an economy Public policy identifying linkages (forward and backward) and targeting investment in these industries could be a solution. 26

K REMER ’ S O-R ING T HEORY OF E CONOMIC D EVELOPMENT Provides insights into low-level equilibrium traps and explains the reasons for the existence of poverty traps and why countries with low- income are caught in these traps The theory models production with strong complementarities among inputs The production function assumes that output is derived by multiplying level of skill required for completing a task by the total number of tasks 27

K REMER ’ S O-R ING T HEORY OF E CONOMIC D EVELOPMENT The production function is characterized by positive assortative matching and therefore total output will always be high under a matching scheme Positive assortative matching relies on two strong assumptions Workers are imperfect substitutes for one another There is sufficient complementarity of tasks 28

I MPLICATIONS OF THE K REMER ’ S O-R ING T HEORY Firms tend to employ workers with similar skills for their several tasks Workers performing the same task at a high- skill firm earn higher wages Wages are proportionally higher in developed countries because wages increase at an increasing rate Levels of human capital investment made by other workers is an important determinant of worker’s decision to improve her skill level 29

I MPLICATIONS OF THE K REMER ’ S O-R ING T HEORY Firms would worry about their productivity only if other firms are trying to increase their quality Due to O-ring effects across firms, economy could be caught in low-production-quality traps O-ring effects magnify the impact of production bottlenecks Bottlenecks reduce worker’s expected return to investment in her skills 30

I MPLICATIONS OF THE K REMER ’ S O-R ING T HEORY Trade could mitigate bottlenecks and low levels of skills. The choice of technology depends on skill level of workers. Developed countries have high skilled workers and therefore large specialized production processes. International brain drain occurs because a worker from a developing country receives a higher wage for the same skills. 31

D OMESTIC P ROBLEMS AND P OLICIES Statement of the problem Relative importance of the problem in developing countries Possible development goals and objectives- equity vs growth Role of economics and economic principles Policy alternatives and consequences- open for discussion 32

E CONOMIC D EVELOPMENT AS S ELF - D ISCOVERY Hausmann and Rodrik: A Problem of Information Not enough to say developing countries should produce “labor intensive products,” because there are thousands of them Industrial policy may help to identify true direct and indirect domestic costs of potential products to specialize in, by: Encouraging exploration in first stage Encouraging movement out of inefficient sectors and into more efficient sectors in the second stage 33

T HE G ROWTH D IAGNOSTICS F RAMEWORK 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 34

4-35 T HE G ROWTH D IAGNOSTICS F RAMEWORK 35

© 2011 South-Western, a part of Cengage Learning 36

Neo-liberal / Capitalist Marxist/ SocialistPopulistGrassroots China, Asian Tigers Cuba, Kerala (India) Venezuela / Latin America Community based Market led development, following the ‘Modernisation Theory’ of WW Rostow Stressing industry and infrastructure, free trade and attracting foreign direct investment to create jobs and raise incomes. Breaking free of capitalism and profit. State ownership and planning so that profits from industry and uses for health and education; usually involves wholesale land reform. State control and limited involvement in world trade and TNCs Charismatic ‘man of the people’ leaders create a ‘them and us’ discourse promising social equality and using policies that appeal to the pockets of ordinary people Critics state populism is directionless and leads to poor economic decision-making Small-scale, community focussed development often aiming to meet basic needs rather than hugely improve incomes Often involves local or international NGOs who provide some funding and other support. Political Viewpoint Approaches 37

Bottom upTop Down Scale Small; based on one community or area e.g. a valley Large; often part of national planning aims Leadership Community and NGOs; partnership arrangements Government and government agencies; construction and engineering TNCs Funding source Local people and NGOs; donations or earned income recycled into the community Government, via multilateral aid (WB / IMF) or bilateral aid; private investment Aims Meeting basic needs of food, health, education and water; small improvements in income Meeting national needs in terms of energy or water supply, or transport; profit Technology Intermediate / appropriateHi-Tech Types of project Food production, water supply, small scale renewable energy Electricity, transport, industry and infrastructure Winners Local people; the environmentIndustry, urban dwellers, TNCs Losers Usually are noneEnvironment, rural people Strategies 38

PlayerRole World Bank / IMFThese two IGOs lend money to the developing world – essentially funding development, and as part of this process guide economic policy (the IMF). Much of the developing world’s debt is owed to the IMF and WB. TNCsInvest in the developing world e.g. building factories; Foreign Direct Investment tends to flow to low cost locations, but where people are educated and skilled; Africa’s share of FDI is therefore small. United NationsMonitors the MDG, but has many component organisation which focus on development (UNDP), health (WHO), food and farming (FAO) and environmental issues (UNEP); often involved in disaster relief as well as longer term aid. GovernmentsDeveloped world governments provide funding for the UN, IMF and WB. They also provide bi-lateral aid the developing world in the form of Official Development Assistance (ODA). Developing World governments manage their countries path to development. NGOsCharities and not-for-profit organisations provide aid to the developing world, often in a smaller, more localised way compared to Governments and IGOs. Some NGOs receive government funding IndividualsAs consumers and voters, individuals can alter government policy both in the developed and developing world; community led development in becoming more common; developed world consumers may support fair trade. Global Players 39

40

41 Thanks