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ECON 313
Chapter 4 – Contemporary Models of Development and Underdevelopment
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Development = possible; but = difficult to achieve
One problem: coordidnation among agents (e.g. groups of firms, workers, or workers and firms)
Not just about static efficiency, also about long-term growth
Key themes:
 Increasing returns to scale
 Finer division of labour
 Availability of new economic ideas/knowledge
 Learning by doing (experience curve)
 Imperfect competition (e.g. monopolies)
Depart from neoclassical economic assumptions
o “new institutional economics:
 Perfect information
 Relative insignificance of externalities
 Uniqueness and optimality of equilibrium
The New Growth Theory: Endogenous Growth
Motivations – Counter Neo-Classical Growth Theory
= neoclassical theories failure of illuminating sources of long-term growth

Credits the bulk of economic growth to EXOGENOUS/INDEPENDENT process of technological
progress.

In absence of external shocks OR technological advancement, all economies will converge to 0
economic growth = economic growth equilibrium.

Therefore, economic growth is TEMPORARY, and is a result exogenous change in technology OR
shocks (equilibrating process due to short-term adjustments of stocks of either labour or capital)

Note: shocks and technological advancement  EXOGENOUS (and not explained in tranditional
theory)

How do we get to long-run equilibrium levels???? Dynaimic process of capital-labour ratios
approaching the long-run equilibrium level. (NOT INTRINSIC CHARACTERISITIC OF COUNTRY)

Any increase in GNI not due to either technology OR shocks  Solow residual

2 Problem with this Neo-Classical Approach
Responsible for nearly 50% of growth in
industrial nations
1. Impossible to analyse technological advancements (because considered independent
from actions of economic agents)
2. Does not explain large differences in residuals amongst countries with similar
technologies
Failure
*** low labour-capital ratios in LDCS promised very high rates of return on investment.
PLUS...the free-market reforms imposed the highly indebted countries SHOULD HAVE LED TO:
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Higher investment
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Greater productivity
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Raised standards of living
BUT IT DIDN’T!!!!!!!!! – didn’t attract foreign investment AND – couldn’t stop flight of dom. Capital
New Growth Theory
Def. Endogenous Growth:
persistent GNI growth that is governed by the system governing
production process RATHER than by forces outside that system.
GOALS:
A) Differences in growth rates across countries
B) More explanation of the growth observed
***Endogenous growth tehoriest seek to explain te factors that determine the size of λ – the rate of
growth of GDP that is left un explained and exogenously determined in the Solow neoclassical growth
equation
i.e. the explain the SOLOW RESIDUAL.***
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Unlike neo-classical, they hold GNI growth to be a natural consequence of long-run
equilibrium.
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Differ in ASSUMPTIONS and CONCLUSIONS
o
Discard dimishing marginal reurn to capital investments; sustained long term growth is
possible!!!!

Permit increasing returns to scale in aggregate production

Focus on externalities in determining rate of return on capital investments.
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
Explains increasing returns to scale AND divergent long-term growth patterns
among countries; HOW: public and private investments in human capital 
external economies and productivity improvements that offset natural tendency
for diminishing returns

Technology is still important, but unnecessary to explain long-run growth
As in Harrod-Domar growth model, many endogenous growth theories can be explained by:
o
o
Y = AK

A  any factors that affect technology

K  physical and human capital
Remphasises importance of SAVINGS and HUMAN CAPITAL INVESTMENTS for achieving
rapid growth, also leads to implications re: growth that conflict with traditional theory:

no force leading to equilibration of growth rates across closed economies

national growth rates remain constant; differ across coutrnies depending on
national savings rates AND technology levels

no tendency for per capita income levels in capital-poor countries to catch up
with those in rich countries with similar savings AND population rates.
 Recession in one country can  permanent increase in income gap b/t
them and wealthier countries
o
Helpds explain int’l flows of capital (from poor to rich) that exacerbate wealth disparities
b/t North and South

Notion of complementary investments (human capital – education,
infrastructure, R&D)

Low levels of these erode LDC potential gains from low capital-labour ratios
N.B. Unlike Solow, new growth theory explain technological change as an
ENDOGENOUS outcome of public and private investments in human capital
and knowledge-intensive industries.
VS. Neo-classical counter-revolution theory: suggests ACTIVE ROLE FOR PUBLIC POLICY in promoting
eoncomic development:
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Investment in human capital
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Encouragement of FDI in knowledge-intensive industries (e.g. software, telecommunications)
Romer Model
Romer Endogenous Growth Model
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Addresses ‘technological spillovers’ that may be present in industrialization
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Models them without presenting uncessary details of SAVINGS determination and other
equilibrium issues.
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Growth process derives from: FIRM or INDUSTRY LEVEL (match Solow)
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Consisten w/ perfect competition – each industry produces with constant returns to scale
(matches Solow)
DEPART FROM SOLOW:
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Economy wide capital stock (Ќ) positively affects output at industry level – therefore, may be
increasing returns to scale at ECONOMY LEVEL
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Recognize knowledge as part of capital stock (= a public good) that spills over instantly into the
other firms in the economy
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Learning by doing, in this case, becomes “learning by investing”: explains why growth might
depend on rate of investment (as in Harrod-Domar)
Criticisms of New Growth Theory
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Remains dependent on several neo-classical assumptions that are often inappropriate for LDC
economies
o
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E.g. assumes all sector of production are symmetrical – this disallows for the growth
from structural change, that can take place by reallocating labour and capital among
sectors.
Overlooks important factours
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Poor infrastructure
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Inadequate institutional structures
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Imperfect capial and goods markets
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Poor incentive structures
Over emphasis on LONG-TERM growth rates overlooks SHORT and MEDIUM-TERM growth that
can be hindered by allocation inefficiencies during transistion from traditional to
commercialized markets.
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Little empirical support as of now.
Underdevelopment as Coordination Failure (circular causation)
Def. Coordination Failure:
a state of affairs in which agents’ inability to coordinate their behaviour
(= choices) leads to an outcome (= equilibrium) that leaves all agents
worse off than in an alternative equilibrium situation.
WHY DOES IT EXIST (even when ppl are fully informed)
o
Ppl hold different expectations
o
Waiting for someone else to make the first move
N.B. Emphasizes importance of Complementaries: when present, they increase the incentives for other
agents to take similar actions.
i.e. investments whose return depends on other investments being made by other agents.
Theories: Big-Push (production decisions by modern-sector firms are mutually reinforcing) abd O-ring
Model (the value of upgrading skills or quality depends on similar upgrading by other agents.)
 Circular causation of positive feedback.
Def. Bad Equilibrium:
at a low average income or growth rate OR trapped in extreme poverty
e.g. Firms needing specialized skills will not locate in areas where the availability of labour with these
skills is not available. HOWEVER, people will not gain these specialized skills if there are no firms to
employ them.  coordination problem  bad equilibrium trap.
- common in initial industrialization
- often cannot fix w/out government aid
Def. Underdevelopment Trap: region remains stuck in subsistence agriculture.
e.g. In order to specialize, farmers must be able to sell their products in distant markets. This requires
an effective middleman who can profit, and to whom the farmers can sell. Without this link to foreign
markets, the farmer will prefer not to specialize, and to continue producing variety which he consumes
or sells within the village.
Chicken and egg problem; what comes first: skills or demand for skills? Must come at same time
through coordination.
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often not in best ‘self-interest’ to take the first step;
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important role for gov’t policy in coordinating joint ventures AND easing the time b/t investing
and realizing the return on that investment
e.g. Modernizing firm using new technologies provides spill-over benefits to other firms that they do not
receive: this reduces incentive to modernize unless all the other firms are doing it too.
SOLUTION: raise demand for key industries, increase incentives
Government Policies
Government can play either a GOOD or a BAD role  increasingly analyzed in modern theories
NOTE: government policy can also be understood endogenously ( determined by underdeveloped
economy)
BAD: Mobutu in Congo: kept country in underdeveloped trap b/c if it developed, he would lose power.
GOOD: push economy toward self-sustaining, better equilibrium
= Deep Interventions: push economy to better equilibrium OR higher permanent rate of
growth, in which there is no incentive to go back to the old pattern of behaviour.
= one-time fix of multiple-equilibrium problem
Where-to-meet Dilemma
(illustrates Coordination Problem)
 same as farmers’ situation: know they will all benefit from specialization, but what one thing do
they choose to specialize in?
 Sure the friends could ahve had cell phones or internet BUT for farmers, with
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A) no formal leader
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B) a large number of participants
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C) high-cost communication

= coordination in specialization is slow and difficult!
Multiple Equilibria: A Diagrammatic Approach
(with possible coordination failure)
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S-shaped function
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Positive slope
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X-axis: expected decision by other agents; Y-axis: privately rational decisions
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The benefits an agent receives from taking an action depend positively on how many other
agents are expected to take the action or on the extent of those actions.
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The more agents do it, the greater the benefit
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To the greater extent that other agents do it, the greater the benefit.
Equilibrium? = where the ‘privately rational decision function’ meets the 45° line
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Some ppl are going to sign up even they don’t expect any of their friends to sign up.
Once this happens, we have to adjust expected signups to reflect the fact that some ppl
have, and this would motivate others to sign up, and so on.

= have to revise expectations upward to match the actual number of
participants  process of adjusting expectations continues until ‘number
observed equal number expected.’

Equilibrium: a situation in which everyone is doing what is best for them, given
what they expect other to so, which in turn matches what others are actually
doing.
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D1 and D3 are stable equilibria
 Cut 45° line from above
 If slight changes in expectations, ppl would adjust behaviour to bring it
back to the equilibrium

D2 is an unstable equilibrium
 Could be equilibrium only by chance (if move in either direction they
would go to either D1 or D3 equilibrium)
 A way of dividing ranges of expectations over which a higher or lower
equilibrium will hold sway.
S-shape
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Increases first at an INCREASING rate...
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Snowball effects
... and then at a DECRESING rate.
o
After most potential investors have joined and most important gains have been realized
The value (=utility) of multiple equilibria are generally not the same.
e.g. investment coordination: better of at higher equilirbia with more investors and higher rate
of return.
Re: investments
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Equilibrium investment rates
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X-axis: expected investments from other key firms
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Assume possible relation between investments and growth
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= an economy can get stuck in a low frowth rate largely b/c the economy is expected to have a
low investment rate.
REMEDIES
a) Change expectations (may not always be enoughif more profitable not to be the pioneer, in
which case...)
b) Government policy
**Market Forces YES can bring us back to equilibrium, but not necessarily the optimal
equilibrium!!!!**
- same individuals, same technology, same resources: drastically different situations
depending on equilibrium
SHOWS that better technology is NECESSARY but NOT SUFFICIENT to achieve devl.
N.B. Come across multiple equilibrium situation in Malthus’ population trap in Ch. 6
Starting Economic Development: The Big Push
= encouraging the simultaneous expansion of the modern sector in many industries
Disagree with Rostow: one development underway, it is not impossible to stop it.
Agree with Rostow:
a) difficult to get modern economic growth underway
b) Much easier to maintain once a track record has been established
a)
under perfect competition, it WOULD be easy to get growth underway, as long as
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Adequate human capital development
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Technology transfer problem addressed (not only need technology, need incentive to use new
technology)
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Gov’t provides other essential services
But, perfect competition does not hold under increasing returns to scale (taking advantage of this has
been key to growth in the past.)
Pecuniary Externalities  Multiple Equilibria
= spillover effects on costs of revenues
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Market failure that works to make economic development difficult to initiate
Big Push
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Paul Rosenstein-Rodan re: coordination issues
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Shows how market failures (= coordination problems) work against industrialization
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Problems associate with initiating industrialization in a susbsistence economy
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Assumption: economy is not able to export
a) Question: who will buy goods produces to industrialize?
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In susbsistence, no workers have the money to buy the new goods; firms own workers can buy it,
but not going to spend all money on one product
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THEREOFRE.. profitability depends on whether another firm opens with workers to spend
money, which in turn relies on another firm to poen, and so on.
b) High modern wages:
First firm will have to pay to train employees, which limits how
high of wages they can offer; another firm w/out training costs can scoop them up with
higher wages.
= no one is trained
= no industrialization
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Big push not always needed; characterizes cases where it is
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Explains East Asian miracle economies
The Big Push: A Graphical Model
6 Types of Assumptions
1)
Factors
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Only one factor of production – Labour
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Fixed total supply: L
2) Factor Payments
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Labour market has 2 sectors
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Traditional sector wage: 1
o
Modern sector wage: w > 1
3) Technology
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N types of products (N is a large number)
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Trad. Market: one worker = one unit of output ( constant-returns-to-scale)
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Modern Market: one worker  increasing returns to scale
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Fixed costs – nothing can be produced without at least F workers  must be paid up
front
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Workers are more productive than in trad. Market
o
Therefore, labor requirements: L = F + cQ
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C<1 is marginal labor required for an extra unit of output
Fixed cost is paid back over more units of output  average cost goes down the more
you produce = increasing returns to scale!
4) Domestic Demand
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Each good receives CONSTANT and EQUAL share of consumption out of national income
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No assets; no savings
5) International Supply and Demand
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Economy is closed
6) Market Structure
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Assume perfect competition in TRAD. Sector
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Free-entry
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N oeconomic profits
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Price = 1 (marginal cost of production – labour)
One modern-sector firm can enter each market
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Can’t charge higher than 1 b/c lose business to trad. Sector
o
At same time, only having one means no more units of output will be sold  national
income constant
Conditions for Multiple Equilibria: When does a Case need a Big Push
Depends on
a) how much more efficient the modern sector is
b) how much higher wages are in the modern sector
- traditional sector graph is linear with slope of 1 (1 input labour, one unit output) and begins in origin)
- modern sector graph input (labour) starts at certain amount, but then has a greater slope (more than 1
unit output for 1 unit input – labour)
re above: Coordination failure depends on 2 things: 1) TECHNOLOGY and 2) PRICES (including wages)
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If ‘wage bill line’ passes below A (output) then market will lead economy to mordernize; if above,
then it will not because a firm would incur losses.
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If above point B – it makes no sense to modernize
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if between B and A  efficient to industrialize (page 156)
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even when technology available, market forces alone cannot get us from point A (no
indsutrlization) to point B (with industrialization)  need POLICIES
NOTE:
Not all sectors HAVE to industrialize for big push; just enough to generate enough national income
(through wages and profits)
NOTE AGAIN!!!
Model DOES NOT ASSUME technological externalities (“learning by watching” other firms’ production
methods  spillovers that can raise other firms’ productivities AND lower cost)
 can lead to inefficiently low investment; no one wants to give other firms advantage
Need For Big Push comes from 4 other conditions
1) Intertemporal effects
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Multiple equilibria can occur even when modern wages are SAME as traditional (1)
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IF INVESTMENT MUST BE UNDERTAKEN to get more efficient production process in next period
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Indsutrialization still preferred b/c 1st-period income decreased by fixed cost, BUT second-period
income increased by WAGE and PROFITS more.
2) Urbanization effects
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?
3) Infrastructure Effects
4) Training Effects
Why the Problem Cannot be Solves by a Super-Entrepreneur
1) May be capital market failures
a. How could one agent get all the needed capital????
2) Agency Costs: Costs of monitoring managers and other agents AND designing and implementing
schemes to ensure compliance OR provide incentives to follow their wishes.
3) Communication failures
a. How do you know who to follow; that someone will be the one to make you money?
4) Limits to Knowledge
a. One individual cannot gain sufficient knowledge to industrialize (or whom to hire, etc.)
5) EMPIRICAL: No private agent has been observed playing the role of super-entrepreneur
Further Problems of Multiple Equilibria
Inefficient Advantages of Incumbency: due to presence of increasing returns to scale
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A large firm with a huge customer base can take advantage of increasing returns to scale 
LOWER COSTS
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Rival with smaller customer base may gain access to more cost efficient technology, but still not
enough to get to huge firm’s low prices
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Costs lots of capital to implement technology and cover losses while they build their customer
base
o
LDC capital markets often not very good
 Sector stuck in BACKWARD, but cost-effective TRAP!!!!
Behaviour and Norms
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Movement to better equilibrium HARDER when: involves individuals moving from corruption
honesty;
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There is value in building reputation; more ppl do business with you
Linkages
One way to solve coordination problem: focus gov’t policy on encouraging devlp of sectors w/ key
backward or forward linkages i.e. subsidies for dom. Industries to enter these key industries.
i.e. incentives for MNCs to come into these key industries & train
i.e. establish a few public enterprises to be pioneers (later sell them)
Def. Theory of Linkages: when certain industries are developed first, their interconnections with other
sectors will induce or at least facilitate the development of new industries.
Backward Linkages:
raise demand for an activity
Forward Linkages:
lower the costs of using an industry’s output
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Made more significant with interaction b/t market size AND increasing returns-to-scale
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Hence, may involve pecuniary externalities effect (a lowering of costs)
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Investment in key linkages overcomes coordination failure AND generates positive feedback
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Focus on key linkages that will least likely be scooped up privately (least profitable)
Inequality, Multiple Equilibria, and Growth
Exists the idea that some income inequality is necessary for growth. (concentrated so some ppl ahve
money to invest)
BUT...
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Poor save at much higher rates than previously believed
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Poor can’t get loans if inequality is too great – no collateral; MISSIN GCREDIT MARKETS
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Can’t finance entrepreneurship or productive schooling to escape POVERTY TRAP
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Lowers “capabilities”
Implications of missing credit markets explored Galor and Zeira...assumptions:
a) Imperfect capital markets
b) Individisbilites in human capital investment
Kremer’s O-Ring Theory of Economic Development
Explains low-level income traps
modern production requires that many activities be done well together in order for any of them to
amount to high value
Strong complementarity among inputs
Natural way of thinking abt specialization & division of labour
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Production broken down into n tasks
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Level of skill required: q
o
Range of 0 to 1: higher it is, the higher the probability of it being performed successfully
Production function:
“out put is given by multiplying the q values of each of the n tasks together, and then multiplying that
my a term B that depends on the caractreistics of the firm AND usually larger than number of tasks.”
BF(q1q2) = q1q2
Simplifying assumptions
a) Firms are risk-neutral
b) Labor and capital markets are competitive
c) Supply of labour is inelastic (the same regardless of wage)
d) Economy in closed
Positive Assortative Matching: workers w/ same skill level will work together
= high-value products concentrated where ther is high-valued skill
Because your efforts are multiplied by the efforts of someone else.
Firms tend to pay more for more productive workers, meaning a productive person
needs a firm who can afford to pay their competitive wages.
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Good ones get picke dup until only the shit ones are left
RESULT:
low skill and low productivity trap; while other escape to high productivity
ASSUMPTIONS: a)
b)
workers must be sufficiently imperfect substitutes for each other
we must have sufficient complementarity of tasks
Implicatinos of O-ring Theory
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Firms tend to employ workers w/similar skills
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Earn higher wages in high-skill firm than low skill-firm
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b/c wages increase in q at an increasing rate wages more proportionally higher in higher
developed countries
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when those around you have higher skills, you have more incentive to invest, if you can, in your
own skills  complementarity
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can get caught in low productivity trap
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magnifies effects of bottlenecks in production
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bottlenecks reduce incentives for workers to invest in skills B/C LOWER expected return of these
skills.
Bottlenecks: workers start to reduce skill investment  lowers skill level in economy  further reduces
worker’s incentive to invest in skill

helps explain brain drain.
SUMMARY!!!!!!!!! OF CHAPTER 4 – MULTIPLE EQUILIBRIA AND COORDINATION FAILURES
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ppl keep doing inefficient things b/c it is RATIONAL to do so so long as others keep doing
inefficient things
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vicious circle of underdevelopment  needed is gov’t policy and aid
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presence of multiple equilibria increase the role of gov’t
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once big push has been undertaken, gov’t may no longer be needed  often market can
maintain industrialization, just not initiate it!
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On flip side, with deep interventions, increase chance of implementing a policy that will
absolutely fuck things up
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Public and private actors are also significant  we must develop institutions in which they have
incentives to work productively together to create conditions to creak out of poverty traps!
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International community  provide ideas/models to serve as catalyst for change AND aid.