Economic Growth in the Developing World: What Explains the Stubborn Refusal of Many LDC’S To Perform Up to Their Potential? Prof. G. Anderson/ CSUN/ Fall 2003 LECTURE NOTES 2

A Parable for Development Economics: the Two Koreas Consider the case of North and South Korea. The two share the same people, with the same pro-growth cultural characteristics (e.g., strong work ethic, respect for education, high savings rate), similar resource endowments [although in a number of respects the North is significantly better endowed*] Yet the two countries have had radically different development experiences. After recovering from the virtual obliteration of its domestic infrastructure during the war South Korea has emerged as one of the richest, most productive, and fastest growing economies in the world.

A Parable of the Two Koreas [continued] Meanwhile, the North remains mired in almost unimaginable grinding poverty– that is, for the lucky ones who don’t die in the annually recurring famines. And it appears to be getting worse. This economic state cannot be attributed to the lasting damages sustained during the Korean War; the South, not the North, suffered the brunt of “collateral damage”, yet the South has transformed itself into a dynamic powerhouse while its’ neighbor to the north remains a stagnant sump. The main objective of his course is to explain this ‘Korean problem’. The key element in this comparison that produces the differential outcome is the role of property rights, and how these effect the incentives that determine choice.

Why does economic growth occur? Economic growth is an extremely important issue. A percentage point added to the growth rate can make a huge difference There is a possibility of change with extraordinarily beneficial consequences How do we increase economic growth? Theories of economic growth take us quite far in understanding the development process At least it teaches us to ask the right questions

Modern economic growth: Basic features Modern economic growth was born after the Industrial Revolution in Britain A number of countries managed the take-off into sustained growth (Rostow) For many developing countries growth experience only began after the post-World War II area The developing nations not only need to grow they must grow at rates that far exceed historical experiences Increased perception of global inequalities requires sustained and high growth rates

Economic growth requires investment New investments add to the capital stock in the economy and endow it with a larger capacity for production Economic growth is positive when investment exceeds the amount necessary to replace depreciated capital Thus, savings and investment is an important determinant of the growth rate of an economy

The endogeneity of savings There are several reasons to believe that savings may itself be influenced by the overall level of per capita income, and the distribution of incomes Economies where the majority of the citizens are poor are unlikely of have a high savings rate. Growth efforts must then rely on external credit or foreign aid. Some tendency for the savings rate to significantly to rise as wee move from very poor to middle-income levels both within a country and across countries. The saving rate will change, which creates a tendency over time for the growth rate of a country to alter. Neutrality is lost: a pattern linking per capita income to growth rates is created

The endogeneity of population growth Population growth rates do change with the level of per capita income In poor countries death rates, especially among children, are very high. It is not surprising that birth rates are high as well. As long as death rate and birth rates are high the net population growth rate remains at a low level Increased living standards imply that death rates are falling while birth rates adjust more slowly. This causes the population growth rate to shoot up (referred to in the literature as the ‘reversed U- shape’).

History, Expectations and Development What we are looking for is an explanation of why investment rates differs or why a given a rate of savings translates into different growth rates under different circumstances. How does history and expectations shape the overall economic pattern shaped by a country or region.

What about population ? “Overpopulation” can’t be an absolute impediment to development in the long run, given that it represents a decision variable; family size is the outcome of choice Population size and growth rate are both important, but at the margin. Other factors also play a significant role in development (or nondevelopment, as the case might be)

Complementarities Look at the keyboard on your computer: Left top row, q,w,e,r,t,y…..Why this particular order? In part to reduce the frequency of jams. In no way the best keyboard for a computer. The Dvorak system introduced 1932 won repeatedly speed-typing contests. There are alternative today but why does the QWERTY still exist?

Complementarities Long ago firms were hiring QWERTY-trained typists, would be too costly to re-train them into Dvorak-style keyboards. We have then a self- fulfilling situation that is difficult for any individual to get out of, because the return to each person depends on what everybody else is doing. This divergence between individual cost and social gain occurs whenever a system of production, or organizational form, exhibits externalities, so that the cost or benefit of adopting that new system by an individual depends on how many other individuals have adopted that system.

Complementarities In the case of QWERTY the creation of typing schools and a pool of typists trained in a particular way lowered the cost of new individuals adopting the same system. But it is possible that QWERTY has a higher cost curve compared to an alternative product. History creates look-in effect that is difficult to get out of.

Coordination failure Pervasive complementarities might lead to a situation where an economy is stuck in a “low- level equilibrium trap” while at the same time there is another better equilibrium, if only all agents could coordinate their actions to reach it. Rosenstein-Rodan: Economic underdevelop- ment is the outcome of a massive coordination failure. Investments do not occur because other complementary investments are not made and these latter investments are not forthcoming because the former are missing.

Coordination failure Coordination failure emerges from complementarities and the situation that creates it it is often known as a coordination game. The failure manifests itself in the ability of a group of economic agents, whose actions are complementary to achieve a desirable equilibrium. Notion of coordination is closely linked with the concept of linkages.

Linkages and policy Linkages are important and have an impact on policy. Suppose that an economy is in a depressed equilibrium; how should policies be formulated to take the economy to a better equilibrium? Rosenstein-Rodan introduced the idea of the big-push, a policy that simultaneously creates a coordinated investment in many different sectors of the economy (balanced growth).Two features: First, requires a massive investment in many different sectors at once. Second, need to know the quantitative allocation of investment across different sectors.

Linkages and policy A problem with a balanced growth strategy is that it requires a lot of resources and information. The policy does not exploit the fact that the desirable outcome is also an equilibrium. We can rely on the market to correct this coordination failure. Selectively promote a few key sectors in the economy which would through the linkages with the rest of the economy stimulate other sectors as well (unbalanced growth).

Linkages and policy How do we choose key sectors? The number of linkages a certain sector possesses is important. The characteristics of the economy. Does it matter if forward or backward linkages are promoted? Yes, a backward linkage directly raises the price of its output and a forward linkage reduces the price on one of its inputs of production. Forward linkage has international implications as well. It is also important to look at the “intrinsic profitability” in each sector. It might be the case that the government maximizes the chances of overcoming coordination failure by investing in the least profitable activity.

History versus expectations Problem: The case of several sectors simultaneously functioning at a suboptimal level requires a policy that assists the economy to move from a suboptimal outcome to one that is more efficient. Assumption: History makes it difficult for firms, individuals or sectors to move out from the low- level equilibrium trap. If expectations of agents could be changed movement would occur from one equilibrium to another What prevents expectations from changing?

History versus expectations In the case of an economic coordination failure, going first means taking economic losses. Expectation plays a role when there is some advantage to going first. For example congestion increases the cost of moving later, perhaps because of difficulties in finding housing. In such cases economic agents might trade-off the lower current returns from moving now with the higher costs of moving in the future.

History versus expectations Another important factor is increasing returns A production activity displays increasing returns to scale if an expansion in the scale lowers the unit cost of operation. The role of increasing returns in development: The ability to realize the gains from increasing returns depends on the size of the available market for the product. The size of the market may itself depend on the ability to exploit increasing returns, expand production and pay out income to employees.

History versus expectations Increasing returns and entry into markets: Assume that a developing country has a small domestic market for automobiles that is currently serviced by imports. Now assume that a local manufacturer designs a car that is particularly suitable for domestic conditions. Production of automobiles involves increasing returns to scale, which imply that large volumes have to be produced to reduce unit cost

History versus expectations This leads to the following dilemma: during the transitional period where customers are progressively switching to the new product our producer must function at a loss. Losses would not be a problem if capital markets were perfect. If not the whole project may be scuttled. Three things caused this problem: Increasing returns in production Credit markets are missing Customers switch slowly

Increasing returns and market size: Interaction Construction industry: In developing countries construction is a labour-intensive industry. In developed countries automated process (cranes and fabricated walls). Final production of a house is reduced to a large series of automated steps requiring the provision of many intermediate inputs. These inputs can be extremely costly and requires a larger market. In other words intermediate inputs are often produced under conditions of increasing returns to scale. This means that increased varieties of inputs would increase output.

Increasing returns and market size: Interaction Assume a poor country with low demand for the final product. This means that intermediate production is constrained (implies a high price). Firms substitute away from intermediates to labour, which reduce productivity and income. Low income in turn generates lower demand and the vicious circle is complete. The opposite occurs in a virtuous circle. High demand for the final consumption good increased the demand for intermediates, which lower the price of intermediates. Falling prices give incentives of substitution away from labour towards intermediates, which has a positive impact on productivity and on income in the economy.

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