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Econ 313 Chapter 4- Contemporary Models of Development and
Underdevelopment
-
new models show that development harder to achieve, facing more barriers than
previously
- broadened scope of modeling market economy in a developing-country context
- one major theme is problems of coordination among agents\other themes: formal
exploration of situations in which increasing returns to scale, finer division of
labor, availability of new economic ideas or knowledge, learning by doing, and
monopolistic competition or other forms of industrial organzation other than
perfect competition predominate and special long-run growth (not just static
efficiency) are separately or jointly important
- includes economics of imperfect information
New Growth Theory: Endogenous Growth
Motivation for new growth theory
- no real ‘growth’ in traditional theory, just converge to zero growth without
‘shocks’, any growth is temporary phenomema
- GNI increases not in labor or capital are in 3rd category: Solow residual
- This residual responsible for 50% growth in industrializaed nations
- Neoclassicalists credit exogenous independent technological process
o However impossible to analize determinant of technological advance
because independent of economic decisions and doesn’t explain
discrepancies in residuals across countries with similar technology
- Neoclassical free market approach failed in developing country economic growth
- Developing world capital flows (from poor to rich) prompted endogenous growth
theory or new growth theory
- Models hold GNI growth to be a natural consequence of long-run equilibrium and
determined by system governing the production process
- Seek to explain factors that determine the size of ‘Y’, the rate of growth of the
GDP
- Differs from neoclassical by discarding assumption of diminishing marginal
returns to capital investments, permitting increasing returns to scale in aggregate
production, and frequently focusing on the role of externalities in determining rate
of return on capital investments
- Possibility exists that investments in physical and human capital can generate
external ecnomies and productivity improvements that excees private gains by an
amount sufficient to offset diminishing returns
- Direct implications for growth in conflict with traditional theory
o No force leading to equilibration of growth rates across closed economies;
national growth rates remain constant and differ across countries
depending on national savings rates and technology levels
o Per capita income levels in poor need not catch up with rich countries
o Prolonged recession in one country can lead to permanent increase in
income gap
- Endogenous help explain anomalous international flows of capital that exacerbate
wealth disparities between developed and developing countries
-
Developing countries get low levels of complementary investments such as
education, infrastructure, R&D
- Unlike Solow model, new growth theories explain technological change as
endogenous outcome of public and private investments in human capital and
knowledge-intensive industries
- Suggest active role in public policy in promoting econ dev through direct and
indirect investments in education and knowledge industries (software and
telecom)
Romer Model
- addresses technological spillovers in process of industrialization
- assumes growth processes derive from firm or industry level
- industry individually produces with constant returns to scale so model is
consistent with perfect competition but departs from solow by assuming that
economy wide capital stock ‘K’ posiytively affects output at the industry level, so
may be increasing returns to scale at economywide level
- ‘knowledge’ in firm’s capital stock is a public good
- model treats learning by doing as ‘learning by investing’
- spells out reason why growth might depend on rate of investment
- Formula:
each industry uses same level of capital and labor
A is constant rather than rising over time (assume no technological progress)
resulting growth rate for per capita income in the economy would be
where ‘g’ is output growth rate and ‘n’ is population growth rate, without
spillovers as in solow model with constant returns to scale ‘B=0”, and so per
capita growth would be zero (without technological progress)
- Look back at equation please!!
Criticisms of the New Growth Theory
- remains dependent on traditional assumptions that are inappropriate for LDC
rconomis
o e.g. assumes no single sector of production/all sectors symmetrical\
- LDC economic growth impeded by poor infrastructure, inadequate institutional
structures, imperfect capital and goods markets
- Fails to explain low rates of factory capacity utilization in low income countries
where capital is scarce
- Allocational inefficiencies common in transition from traditional to
commercialized markets
- Theory over-emphasizes long-term growth rate
- Empirical studies offer only limited support
Underdevelopment as a Coordination Failure
- newer theories emphasize complementarities btwn conditions necessary for
successful dev: several factors must work well at same time to get sustainable dev
- when present, an action by one party increases incentives for other agents to take
similar action
- coordination failure: agents’ inability to coordinate behavior leads to outcome
where all agents worse off than in alternative situation
- complementaries involved investments whose return depends on other
investments being made by other agents
- big push where production decisions by firms are mutually reinforcing
- O-ring model where value of upgrading skills depends on other agents’ upgrading
- Example is presence of firms using specialized skills and availability of workers
with these skill;s
- Coordination problem leaves economies stuck in bad equilibrium and also
behaviour to modern ‘way of life’
- Commercialization of agriculture include specialization and fine div of labour, but
cant achieve either fast enough in LDC without effective middleman to sell
distant markets the country’s product
- Without this there is little incentive to specialize and need subsistence agri
underdevelopment trap
- Complementaries=chicken and egg problem “skills or demand for skills?”
- Answer is complementary investments need to come at same time (coordination)
- Governments may contribute to problem as well as solution with corrupt leaders
- Deep interventions move an economy to a preferred equilibrium or higher
permanent rate of growth
- Much of economics, complementaries not present and have pressure and
counterpressure like congestion
o Too many people fishing in a lake, more fishers try to move to another
lake
- However, economic development has joint externalities: underdev begets
underdev, while sustainable dev stimulates further dev
- Where to meet dilemma illustrates coordination problems. (communication poor)
Multiple Equilibria : A Diagrammatic Approach

Multiple equilibria-a condition in which more than one equilibrium exists however
the market can not move to the preferred one without government aid ( in forms of
policies and reforms)
 In a situation of multiple equilibria the benefits an agent receives by taking an action
depends on how many other agents are expected to follow that action. (reflected by
the S shaped function)
 In a multiple equilibria diagram the equilibriums are found at the intersection points
between the S shaped curve ( privately rational decision function) and the 45° line.
o Because at each of these points agents observe what they had expected. There
is no reason for firms to adjust their expectations any more as all agents are
doing what is best for them. This is point can be considered as the profit
maximizing level.
 The S function and the 45° line intersect various times:
o Stable equilibria: a stable equilibrium can be identified when the S function
intersect the 45° line from above. (D1 and D3 on figure 4.1) These are stable
because if any expectations were changed, agents would increase or decrease
their investment levels in a way that would bring the equilibrium back to its
original point, ( back to D1 or D3).
o Unstable equilibria: can be identified when S function intersect the 45° line
from below. ( the middle point D2 on figure 4.1). This point is unstable
because if expectations were to change, agents would change their levels of
investment, however the new equilibrium would not return to its original point
(D2) but will move to D1 if levels of investment decreased, or move to D3 if
levels of investment increased.
 The rate of the S shaped curve depend on the agents taking action. When enough
agents have invested, the snowball effect takes action, and many agents provide
spillover benefits to other participants; the effect is an increasing rate of the S curve.
 Consequently once most investors have obtained their most important gains, the rate
of increase starts to slow down.
 Pareto improvement- is when moving to a higher ranked equilibrium giving higher
utility to everyone, rather than the equilibrium with fewer users
 A problem in economic development concerns coordinating investment decisions
when rate of return of an investment depends on the presence of other investments.
o All are better off with more investments, but the market may not be able to get
to that situation without any gov policies.
o This issue with investment coordination gives rise to gov-led strategies for
industrialization.
 Market forces can bring us to one of the multiple equilibria, but does not assure the
best equilibria is achieved and they don’t offer mechanisms to leave the bad equilibria
for a better one.
Starting Economic Development: The Big Push
- people do not have enough incentives to put new tech to work.
- Perfect comp does not hold under conditions of increasing returns-to-scale but
industrial revolutions, taking advantage of returns to scale is key
- Conclude that market failures work to make economic development difficult to
initiate: Pecuniary externalities which are spillover effects on costs/revenues
-
Big push coordination model assumes economy not able to exportsubsistence
industriesworkers have no money to buy goods
- Profitability of 1 factory depends on opening of another (circular causation)
- Need to for a concerted economywide and probably public-policy led effort
The Big Push: a Graphical Model
- assumptions
o factors- only one factor of production, labor
o factor payments
 traditional sector receive a wage of ‘1’ and modern sector receive
wage > ‘1’
 may be a compensation for disutility of modern factory types of
work, if so in equilibriu workers would reveice no net itulity
benefits from switching sectores during industrialization, but if
economic profits generated= Perato Improvement (avg income
rise)
o technology
 ‘N’ types of product
 traditional sector, one worker=one unit of output and constant
returns to scale
 modern sector has increasing returns to scale
 fixed cost= number of workers ‘F’, there is a linear production
function in which workers are more productive than in traditional
sector, labor requirements in any sector take the form L=F+cQ
where c<1 is the marginal labor required for an extra unit of
output, modern workers are more productive but only if a
signigicant cost is paid up front. Fixed cost is amortized over more
units of output, avg cost declines
o domestic demand
 assume each good receives constant and equal share of
consumptionout of national income
o international supply and demand
 assume economy is closed
 conclusions will remain when trade is allowed, advantages to
having a domestic market: initial economies of scale and learning
to achieve sufficient quality
o market structure
 assume perfect competition in traditional sector
 free entry and no economic profits, price of each good is 1
 at most, one modern sector firm can enter each market, limitation
is a consequence of increasing return to scale,
 as they face unit elastic demands the monopolist will also charge a
price of 1 if it decides to enter the market
 they will monopolize entire market but will also produce same
queantity that was produced by the traditional producers because
firm is the only one using modern technique
Conditions of Multiple Equilibria
 If in a traditional economy with no modern production, a potential producer with
modern technology (fixed cost and increasing returns) considers entering the market
he will pay attention to 2 considerations:
1. How much more efficient the modern sector is than the traditional sector
2. how much higher wages are in the modern sector than in the traditional sector
 By assumption all sectors are symmetrical. So if a modern firm finds it profitable to
enter in a sector, the same incentive will be present in all sectors. The whole economy
will than industrialize through market forces.
 With a relatively low modern wage ( W1 in figure 4.2), revenues exceed costs (seeing
that W1 is below A in figure 4.2, A= the output the modern firm will produce if it
enters the market), and the modern firm will pay its fixed cost (F) and enter the
market.
o In general modern firms will enter the market if they encounter themselves
with lower fixed cost, or lower marginal labor requirements, or if it pays
lower wages.
o With the increase in the number of firm investment there is also an increase in
demand. This increase in demand is high enough that production increases
from point A to B.
 If the wage bill line is W2, in between point A and B, a modern firm would not enter
on its own in the market because it would encounter losses (W2 is above point A).
However if modern firms enter in each market then wages are increased to the
modern wage in all markets, and income expands (now at point B).
 At wage W2, point B is profitable after industrialization as it stands above W2.
o these modern firms cant rise their prices higher than 1 because traditional
techniques still exist and would be more profitable with a price higher than 1.
 At wage W2, there are 2 equilibria:
1. When producers with modern techniques enter all markets, and profit, wages
and output are higher than before (from point A to B in figure 4.2)
2. When no modern producer enters and wages and output remain lower. (stays
at point A)
o Equilibrium 1 is better however the market will not get there on its own. State
policies will be needed.
 It is not necessary for all sectors to industrialize to get the sufficient push for some to
do so. Only necessary that a sufficient number industrialize to generate enough
National Income to make industrialization minimally profitable.
 There are cases of semi-industrialization in which benefits or costs accumulate in
different proportions to different sectors.
o This can happen if the level of foxed cost decreases the more sectors
industrialize, as there are local examples from which to learn, “Learn by
watching”.
Further Problems of Multiple Equilibria
 Inefficient advantage of Incumbency
o Presence of increasing returns in modern industries can also create a bad
equilibria
o Once a modern firm enters, it has an advantage over rivals because its large
output gives it a low average cost.
o If an even more modern technology appears, it may not be able to displace the
old one.
o Even though the newer one has a lower average cost for any given level of
output, the older technique has an advantage because its large output is
produced at a lower per unit cost than the new technique which starts out with
a small customer base and large fixed cost.
 Behavior and Norms
o This approach assumes that people have rent-seeking and corrupt behavior.
Saying that it is difficult to change such behavior to honesty and the value of
building a reputation to reap the gains of cooperation.
o Only by cooperating with other good-willed cooperators may you reach the
best outcome. Only once cooperative relationship become a norm, more
people will change their behavior to fit such a norm.
 Linkages
o One strategy for solving coordination problems is to focus gov policies on
developing sectors with key backward or forward linkages.
o Backward linkage- when a firm buys a product from another firm to use as
input
o Forward linkage- when a firm sells to another firm
o Exs of different strategies:
I. Subsidies for domestic industries to enter these key sectors
II. Establishing a few key public enterprises to act as pioneers in an industry
o The Linkage theory- When certain industries are developed first, their
linkages with other sectors will induce and ease the development of new
industries.
o In choosing a sector with strong linkages, it would be best to choose the ones
with least private –sector investments, because they tend to have the most
bottlenecks.
 Inequality, Multiple Equilibria, and Growth
o Traditional view- Some inequality can enhance growth because the savings of
the rich are higher than those of the poor. This is valid if savings for
investment purposes must come from within the country, then too much
equality could compromise growth.
o However, where inequality is high, poor people may not be able to take out
loans due to lack of collateral. Several consequences can come from this; for
example a poor person will not be able to get credit to finance productive
schooling. If schooling could be achieved, the families could escape a poverty
trap.
o There is a large jump in the return of human capital when an individual passes
primary school, secondary school and so on.
 This is because the degree obtained proves that the individual in question has
met his entire requirement. Hence the importance of offering education to all,
and that keeping a high degree of inequality ill not necessarily help economic
growth.
Kremer’s O-Ring Theory of Economic Development
- Micheal Kremer
- Another insight into low-level equilibrium traps
- Notion that modern production requires many activities to be done well together
in order for any of them to amount to high value
o Form of strong complementarity
o Natural way of thinking about specialization and division of labor
- The theory explains the existence of poverty traps and the reasons that countries
caught in such traps might have such exceptionally low incomes comparatively
The O-Ring Model
- Key feature is the way it models production with strong complementarities among
inputs
- Provides valuable insights into the complementarities across firms or sectors of
the economy
 A production process is broken down into n tasks
 We use skill required to complete these tasks for simplicity sake, q (although there are
many ways to carry out the tasks), where 0 ≤ q ≤ 1.
 The higher the skill the higher the probability the task will be “successfully
completed”
 Kremer’s concept of q is quite flexible (could also be quality index for characteristics
of the good: consumers would be willing to pay more for higher-quality characteristics)
- Suppose the q=0.95 this could mean, among other interpretations:
o That there is a 95% chance that the task is completely perfectly, thus the
product keeps max value, and a 5% chance that it is completed so poorly
that it has no value
o That the task is always completed well enough that is keeps 95% of its
max value
o That the product has a 50% chance of having full value and a 50% chance
of an error reducing the value of the product to 90%
 The production function assumed is a simple one: Output is given by multiplying the q
values of each of the n tasks together, in turn multiplied by a term, say B, that depends on
the characteristics of the firm and is generally larger with a larger number of tasks
 Assume that the probability of mistakes by different workers is independent
 Suppose the firm hires only two works, then the O-ring production function looks like
this: BF(qiqj)=qiqj
 To make things simple we let the multiplier, B, equal 1
 Three other types of simplifying assumptions:
- (1) firms are risk neutral
- (2) labor markets are competitive
- (3) workers supply labor inelastically (they work regardless of their wage)
 For now, we also assume the economy is close
-
One of the most prominent features of this type of production function is called
positive assortative matching
-
EX:
-
o Meaning workers with high skills will work with others with high skills
and those will low will work with others will low skill
o When used to compare economies the model dictates that high value
products will be concentrated in countries with high-value skills
o This can be seen if we imagine a four person economy
 Supposed this economy has two high-skill workers (qh) and two
low-skill workers (ql)
 The 4 workers can be arranged either as matched skill pairs or
unmatched
 Total output will always be higher under a matching scheme
because qh2 + ql2 > 2qhql
 (see top of 181 if further explanation is required)
This generalized to larger number of workers in the firms and the economy
Result: workers sort out by skill level
Because the total value is higher when skilled matching takes place, the firm that
starts with high-productivity workers can affords to bid more to get additional
high-productivity workers (profitable to do so)
The high-productivity workers pair off (it is more advantageous for them to work
together), are out of the picture and the less productive workers are then stuck
with each other
The result is that some firms and workers, even an entire low-income economy,
can fall into a trap of low skill and low productivity, while others escape into
higher productivity
Suppose there are 6 workers
o 3 have q=0.4 and are grouped together in equilibrium
o the other 3 have q=0.8
o Now suppose that the q of one of the workers in the first firm rises from
0.4 to 0.5 (result of training)
o And suppose the q of one of the workers in the second firm rises from 0.8
to 1.0
o In each case we have a 25% increase in the quality of the worker
o You might expect that a 25% increase in the quality of one worker leads to
a 25% increase in output quality in both cases
o BUT when starting from a higher quality level, that 25% clearly translates
into a much larger point increase
 The first firm goes from (0.4)(0.4)(0.4) = 0.064 to (0.4)(0.4)(0.5) =
0.80,
 a difference of 0.016 (25%)
 The second firm we move from (0.8)(0.8)(0.8) = 0.512 to
(0.8)(0.8)(1) = 0.64,
 the change in this case is 0.128 (again 25%)
 The point value, however, is eight times greater for the second firm
-
If a firm can increase quality in percentage terms at contact marginal cost, or even
not too quickly rising cost, there is a virtuous circle in that the more you upgrade
overall the more value you obtain by doing so
This model is consistent with competitive equilibrium
The positive assortative matching relies on rather strong assumptions. Two points
of the model are crucial:
o (1) Workers must be sufficiently imperfect substitutes for each other.
Why?
 Suppose they were perfect substitutes
 ie: two skills levels, ql and qh=2ql, so every qh worker can be
replaces by two ql workers with no change
 Thus the qh workers will be paid twice the amount the ql workers
are paid
 We can not predict what combination of worker skills a
firm/economy will use so we learn nothing about low-skill level
equilibrium traps
o (2) We must have sufficient complementarity of tasks. Why?
 Suppose there are two tasks indexed by g and h but with no
complementarity between them.
 Suppose that our qh worker is hired for g task, and ql worked is
hired for h task then,
 F(qhqL) = g(qh) + h(ql)
 Here skills are imperfect substition (only one type of worker can
be hired for each task)
 BUT because tasks are not complementary the optimal choice of
skill for g task is independent of that of h task, and not strategic
complementaries are present
Implications of the O-Ring Theory
- Firms tend to employ workers with similar skills for their several tasks
- Workers performing the same task earn higher wages in a high skill firm that in a
low skill firm
- Because wages increase in q at an increasing rate, wages will be more than
proportionally higher in developed countries than would be predicted from
standard measures of skill
- Workers will consider the level of human capital investments made by other
workers as a component of their decision in how much skill to acquire. Ie:
Workers will have greater incentive to acquire more skills (this type of
complementarity should now be a familiar condition in which multiple equilibrai
can emerge) – parallels the issues raised in our analysis of the big push model
- One can get caught in economywide low-production-quality traps (across and
within firms). Because there is an externatility at work, there could thus be a case
for industrial policy to encourage quality upgrading
- O-Ring effects magnify the impact of local production bottlenecks because such
bottlenecks have a multiplicative effect on other production
-
Bottlenecks also reduce the incentive for workers to invest in skills by lowering
the expected return to these skills
Consider a simple illustration of these bottleneck effects
- Suppose that n tasks are required to produce a good. Let q be the standard skill
level of these n tasks
- Now let the actual skill level of two workers be cut in half all firms
- With O-ring production function output would fall 75% (result of cutting output
in half once and then again)
- Marginal product of quality would also fall by 75% for all the remaining n-2 tasks
- Therefore the incentive to invest in increasing skill does as well
- As workers reduce their skill investment, they further reduce the level of skill in
the economy and thereby lower further the incentive to invest in skill
- The O-ring analysis helps to understand why the impacts of the failure to take
advantage of foreign investments or inputs may be so great
- Also helps explain why trade can play a key role as part of an industrialization
strategy
- Model has implications for the choice of technology
o EX: when skill is scarce a firm is less likely to choose a technique with
higher value but complicated production technology
o Mistakes are costly to firms with large numbers of workers and production
steps; therefore such firms place exceptional value on high quality skilled
workers who are unlikely to make mistakes
o It also helps explain why firm size and wages are positively correlated
within and across countries
- Model can also help explain the brain drain
o Observed that a worker with any given skill that moves from LDC to
developed country is often paid more for using that same skill
- O-Ring Model points out many of the implications of strong complementarities
for economic development and the distribution of incomes across countries
Economic Development As Self Discovery
-
Similar to individuals, nations must learn what activities are most advantageous to
specialize in
o This is complex task and one prone to market failure
It is socially valuable to discover that the true direct and indirect domestic costs of
producing a particular product or service in a given country are low or can be
brought down to a low level
o Because once an activity is shown to be profitable it can usually be
imitated spawning a new domestic industry
o As markets are eventually open to competing firms, they will take away
potential profits from the original innovator thus (the innovator) does not
reap the full returns generated by their search for profitable activities,
there will be too little time searching for the nation’s competitive
-
advantage (too much time carrying on business as usual and too little time
devoted to self discovery)
Hausmann and Rodrik also point out another market failure: there can be too
much diversifications after the point where the nation discovers its most
advantageous products to specialize in
o They also argue that policy should in some cases work to rationalize
production afterward, encouraging movement out of higher cost sectors
and into lover sectors, paring down industries to the ones with the most
potential for the economy
o Building blocks of their theory:
 There is uncertainty about what products a country can products a
country can produce efficiently
 There is a need for local adaptation of imported technology so that
is cannot be used productively “off the shelf”
 Once these two obstacles have been overcomes, imitations is often
rapid (reducing profitability of pioneers)
The Hausmann-Rodrik-Velasco Growth Diagnostics Framework
-
Different countries face different binding constraints on achieving fasted rates of
growth and economic development
Hausmann-Rodrik-Velasco propose a growth diagnostics tree framework for
zeroing in on a country’s most binding constraints on economic growth
HRV explains that targeting the most binding constraint has important advantages
over other approaches to policy selection
Figure 4.3 page 186
The analyst seeks to dividing countries between those for which the mammon
problem is a low underlying rate of retun and those for which the problem is an
abnormally high cost of finance
o Low returns to investors may be due to the fact that there are intrinsically
low underlying social returns to economic activities
o May be caused by low private appropriability (limited ability of investors
to reap an adequate share of the rewards of their otherwise profitable
investments)
o Low social returns may be caused by
 Poor geography
 Low human capital
 Bad infrastructure
o Appropriablity problems could be due to either govt failures or market
failures
 Fundamental problem may also be large-scale market failures
which may include
 The self discovery problems
 Coordination problems
o Other cases may not be due to low rates of return but rather an abnormally
high cost of finance

-
-
-
Bad international finance (inadequate access to foreign sources of
capital or problems with debt)
 Bad local finance (due either to low availability of loanable funds
through domestic financial markets,
 traced to low domestic savings
 or to poor intermediation owing to an inadequate
 or overregulated banking system that is unable or unwilling
to channel funds to the economic activities with high
returns
One size does not fit all in development policy
Economic development strategies focusing on resource mobilization through
foreign assistance and other capital flows along with increased domestic national
saving can be most effective when domestic returns are both high and privately
appropriable
Strategies focusing on market liberalization and opening up the economy can be
most effective when
o social returns are high
o the most serious obstacle to private appropriation is govt-imposed
excessive taxes and restrictions
Strategies focusing on industrial policy can be most effective when private returns
are low not because of what a govt does (errors of commission) but because of
what they don’t do (error of omission)
The fact that a constraint is not binding does not mean we can neglect it as it may
become binding in the future
Growth diagnostics has already had an effect on the world of development
agencies
EX: Three Country Case Study Applications of Growth Diagnostics
o Box 4.2 pg 189
Conclusion
- Sometimes firms and other econ agents will be able to coordinate to achieve a
better equilibrium on their own, but in many cases govt policy and aid will be
necessary to overcome the cycles of underdevelopment
- The analysis of coordination failure problems shows that the potential for market
failure, especially as it affects the prospects for economic development is broader
and deeper than had been fully appreciated in the past
o Coordination failures that may arise in the presence of complementarities
highlight potential policies for deep interventions that move the economy
to a preferred equilibrium, or permanent rate of growth that can be selfsustaining
o The prospect of deep interventions can mean that the costs of
implementing policy can be reduced and that carefully targeted
development assistance could have more effective results
- With deep interventions, the potential costs of a public role become much larger
o Bad policy can even initiate a move to a worse equilibrium than a country
began with
-
Both govt failure and market failure (including coordination problems and
information externalities) are real, but public and private sector contributions to
development are also vital
Thus we need to work toward the development of institutions in which actors in
the public and private sectors have incentives to work productively together
The Growth diagnostics tool is useful for domestics and intl analysts who start
with a detailed understanding of a developing country (helpful in indentifying
binding constraints on national growth and the policy priorities to address them)
Case Study
Understanding a Development Miracle: China
-
From 1978 to 2006 the economy of China grew at an average rate (approx 9% a
year)
China’s capita per income by 2006 was more than 5 times higher than 1978
Also experienced one of the worlds most dramatic decrease in poverty (number of
poor falling from 53% in 1981 to 8% in 2001)
The roots of this success remain disputed
Hailed as an exampled of the benefits of markets, trade and globalization
Manufacturing exports are key to China’s success
Also adopted active industrial policies pushing exports of increasingly higher skill
and tech. content
Started its rapid growth around 1980, a decade before significant trade
liberalization
Less privatization of state owned enterprises than in most developing countries
Some explanations for success
- The presence of regional “demostration” models has been crucial
o By late 1980s Investors began to pour investment into China mostly
because of the allure of its eventual market of more than 1 billion
customers
o Early investors found high incentives to export from several special
economic zones on the SE coast
 Discovered China offered cheap labor with unusually high skills
and work habits for their income level
o Once early investment built up a sufficient critical mass, benefits of
concentrated econ activity began to kick in
- After Tiananmen Square protests, 1989, there was considerable doubt about
whether the reforms would cont and therefore whether the investment and growth
would remain high
- The Central planning of Chinas first decades after the 1949 communist revolution
were by most measures a fail (industry was highly inefficient, famine)
o Such disasters were partly offset by the one child policy
o Basic first steps in education, health
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o One result was higher educational and skill level of factory workers for
wages in comparison to other countries
Role model lessons from S Korea and other E Asian countries benefited China
Productivity gains explained more than 42% of China’s growth in the 1979-1994
period
o Production has overtaken investment by the 1990s as the largest source of
growth
o Surprising because of the fast pace of capital investments in China
But rapid growth began in the 1970s in the areas close to Hong Kong while it was
clear that a large volume of investment funds were flowing into China (a barrier
that had long prevented the transfer of both capital and know how)
Widespread concern that China has now entered an investment bubble stage
(many investments are of dubious quality)
Mody and Wang of world bank stated: Industry-specific features (degree of
specialization and competition) had some influence on growth but much of the
action came from region-specific influences and regional spillover
China case also illuminates complementarities
Govt played off potential investors who wanted access to China’s consumers
demanding tech transfer, public and private Chinese business partnerships, local
content and other concessions
Wing Thye Woo concluded most of Chinas growth came from the reallocation of
labor (part from agriculture to other activities)
The way market incentives were introduced and used seemed almost as important
as the incentives themselves
Subtle move towards a free market economy: China has introduced new and
transitional institutions that exist side by side with previous institutions
Reform was introduced on the margin (kept central planning partially intact for an
extended period)
This dual track system simulated the allocational efficiency of a more competitive
market economy and created strong incentives for firms to improve
efficiency/increase output
State owned enterprises (SOEs) remained in govt hands for an extended period of
time but encouraged a new more efficient sector to grow up around them
From the 1970s to mid 1990s local level enterprises (TVEs) were encouraged and
accounted for a very large share of industrial output growth in China
o Majority of these privatized in the late 1990s
o Played a unique role in spurring growth and spreading the benefits of
development to rural areas
From late 1980s on, terms of trade shifted toward industry yet in 2004 over half
the pop was still involved in agriculture
China’s transitional institutions have served a dual purpose:
o To improve efficiency while compensating the losers (and thereby keeping
legitimacy or at least preventing some political back lash)
Under the reforms local govt continued to have responsibility to provide revenue
to the central govt but was allowed to keep a large share of collections on the
margin before local and central revenue collection was fully separated
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For peasants in parts of China where the rural sector has done well earlier land
reforms have been among the causes
The environmental crisis in China is reaching epic proportions
o Health problems are growing as a result
o Water resource problems, erosion and loss of habitat undermine the
prospects for sustainable development
Production safety standards are low and their regulation is lax
Foreign and local investors, and govt all share the blame
o Regulatory institutions will need to catch up with other aspects of
development
The huge indebtedness of the SOE sector and other public debt may lead to crisis
Clearly lacking many freedoms and the pop is very homogenous
Relatively poor endowment of natural resources (although can be viewed as more
of a benefit than drawback as it encourages political fighting)
Some E Asian countries have benefited largely from the growth in China: The
commodity price boom of recent years is significantly as result of the growth in
China
However, for many other developing countries, the growth of China appears to be
as much of a threat as it is an opportunity.