May 3, 2024
Economic Development
Thirteenth Edition
Chapter 4
Contemporary Models of
Development and
Underdevelopment
Dr. Moeen ud Din
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
2 4.1 Underdevelopment as a Coordination Failure
• A newer school of thought on problems of economic development
• Coordination failures occur when agents’ inability to coordinate
their actions leads to an outcome that makes all agents worse off
• This can occur when actions are complementary, i.e.,
• Actions taken by one agent reinforces incentives for others to take
similar actions
• This circumstance can, under some circumstances, lead to multiple equilibria
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
3 4.2 Multiple Equilibria: A Diagrammatic Approach
• Often, these models can be diagrammed by graphing an
S-shaped function and the 45º line
• Equilibria are
• Stable: Function crosses the 45º line from above
• Unstable: Function crosses the 45º line from below
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
4 Stable
Unstable
Figure 4.1
Multiple Stable
Equilibria
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
Rodan`s Big-Push
Theory of
Economic Development
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
6 Starting Economic Development: The Big Push
• The Big Push:
• A big comprehensive package can be helpful to bring economic
development
• A certain minimum quantity of resources must be devoted for
developmental programs, if the success of programs is required
• Through bit-by-bit allocation no economy can move on the path of
economic development, rather specific amount of investment is
considered something necessary for economic development
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
7 Starting Economic Development: The Big Push
• Sometimes market failures lead to a need for public policy intervention
• The Big Push: A Graphical Model
• Assumptions
• One factor of production
• Two sectors (in the sense of modern and traditional production techniques)
• Same production functions (modern and traditional) for each activity
• Consumers spend an equal amount on each good
• Closed Economy ( X = M = 0 )
• Perfect competition with traditional firms operating, limit pricing
monopolist with a modern firm operating
• Use the graph to examine conditions for multiple equilibria
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
Figure 4.2
The Big Push
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
9 Big Push Model Equilibria
• With a wage bill line like W1, passing below point A, it is profitable for a
modern firm to enter even one sector, with all other sectors continuing
traditional “cottage” production, so industrialization is the only
equilibrium
• With a wage bill line like W3, passing above point B, even if a modern
producer entered in all product sectors, all these firms would still lose
money, so only the traditional technique would be used.
• The steeper (i.e., more efficient) the modern-sector production technique,
and/or the lower the fixed costs, the more likely it is that the wage bill
will pass below the corresponding point A.
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
10 Big Push Model Equilibria
• But if the wage line passes between points A and B, it is efficient to
industrialize; but in general, the market will not achieve this on its own.
• Thus, with a wage bill line like W2, passing between A and B, there are
two equilibria: one in which there is industrialization, and the society is
better off (point B) and one without industrialization (point A).
• The market will not move the economy to point B because of
coordination failure – a type of large-scale market failure
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
11
Figure 4.3
The Big Push
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
12 The Big Push Model:
Some Points to Keep in Mind
• The three wage levels are examples of what might prevail in the
economy: They are NOT a chain of three wages over time
• The diagram is only one easy-to-depict illustration among several
reasons why a Big Push might be needed
• The point is NOT that the problem of industrialization is commonly that
workers demand too high wages – that might be unusual; it is used as an
illustration because it is easy to describe graphically
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
13 The Big Push Model:
Some Points to Keep in Mind (Continued)
• In this regard, note that other causes of multiple equilibria are discussed in
the context of this model, such as fixed costs that are lower for later-entering
firms than for pioneers, a technological externality such as …..“learning by
watching” the phrase being a contrast with “learning by doing”.
• Moreover, other models discussed in the chapter show multiple equilibria
can arise from additional causes
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
14 Why the Problem Cannot be Solved by a
“Super-Entrepreneur”
• Capital market failures
• Cost of monitoring managers- Asymmetric (uneven) Information
• Communication failures
• Limits to knowledge
• Lack of any empirical evidence that would suggest this is possible
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
15 In a Nutshell: Big Push Mechanisms
• Raising total demand
• Reducing fixed costs of later entrants
• Redistributing demand to later periods when other industrializing
firms sell
• Shifting demand toward manufacturing goods
(usually produced in urban areas)
• Help to meet costs of essential infrastructure
(a similar mechanism can hold when there are costs of training, and other shared
intermediate inputs)
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
16 4.4 Further Problems of Multiple Equilibria
• Inefficient Advantages of Incumbency (Tenure/Position)
• Behavior
• Norms / Standards
• Linkages
• Inequality
• Growth
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
17
Michael Kremer`s O-Ring
Theory of
Economic Development
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
18 4.5 Michael Kremer’s O-Ring
Theory of Economic Development
• The O-Ring Model
• Production is modeled with strong complementarities among inputs
• Positive assortative matching in production
• Why rich countries produce more complicated products, have larger
firms, and much higher worker productivity than poor countries?
• Implications of strong complementarities among inputs for economic
development and the distribution of income across countries
• People with similar skills work to gather
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
19 Kremer’s O-Ring Theory: A Numerical Illustration
• Suppose a Human Resources (HR) Department has four workers -
two H-types and two L-types
• Strong complementarities are present when output “Q” is determined
by the product of the qualities, i.e., Q = qi*qj
• How to allocate for efficiency: {HL, LH} or {HH, LL} ?
• That is: Mix or Match ?
• We know that H2 + L2 > 2HL because: (H–L)2 > 0
• This illustrates that with strong complementarity it is more efficient to
match, i.e., produce using positive matching
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
20
O-ring production analysis setup: details
• Kremer’s concept of “q” is quite flexible.
Interpretations may include a quality index for characteristics of the
good:
• For example, suppose, q = 0.95
• Among other interpretations this can mean:
a) There is a 95% chance that the task is completed perfectly
so the product keeps maximum value,
5% chance that it is completed so poorly
that it has no value
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
21
O-ring production analysis setup: details
a) The task is always completed well enough that it keeps 95% of its
maximum value; or
b) The product has a 50% chance of having full value and a
50% chance of error reducing product
value to 95%.
c) The higher the skill, the higher probability the task is successfully
completed
(for example, the part created in this task will not fail)
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
22
O-Ring Model: Bottleneck Effects
• Following Kremer, consider a simple illustration of bottleneck effects
• Suppose that “n” tasks are required to produce a good
• Let “q” be a “standard” skill level of these “n” tasks
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
23
O-Ring Model: Bottleneck Effects
• But now, let the actual skill level of two workers be cut in half in all
firms:
• Production would fall 75%
(the result of cutting output in half once, then cutting it in half again)
• But then the marginal product of quality also falls by 75% for the other
n-2 tasks, thus, so does the incentive to invest in increasing skill
• As workers reduce their (planned) skill investments, they further reduce
level of skill in the economy, and thereby lower further the incentive to
invest in skill
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
24 Kremer’s “O-Ring theory”: Implications
• Firms tend to employ workers of similar skills for tasks
• Workers performing the same task at a high skill firm، earn higher
wages than in a low skill firm
• Explains why a worker of given skill moving from a developing to a
developed country receives a higher wage using the same skills
• In the model, wages increase with “q” at an increasing rate, so wages
will be more than proportionally higher in developed countries
• When co-workers or others doing complementary work have higher
skills, greater incentive to acquire more skills
• This type of income externality is by now a familiar condition in which
multiple equilibria can emerge
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
25
O-Ring Effects Across Firms
• Economy-wide low-level quality of production traps may occur when
there are O-ring effects across firms as well as within firms
• Such externalities can create a case for industrial policy to encourage
quality upgrading, as in some East Asian countries
• This magnifies effects of local production bottlenecks, because they
have a multiplicative effect on other firms’ production
• Bottlenecks reduce worker incentives, by lowering the expected return
to investment in skills
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
26
O-Ring Effects Across Firms
• Such bottlenecks could be upgraded with an alternative source of inputs,
through international trade and investment
• This is one explanation why economies cut off from international
economy generally performed less well those more integrated
• The O-ring theory also helps to explain:
‒ Why rich countries have larger firms; specialize in complex products?
‒ Why firm size and wages are positively correlated within and across
countries?
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
27 4.6 Economic Development as “Self-Discovery”
• No person is born knowing their comparative advantage; specific
comparative advantage of an economy also not obvious; no alternative to
trial and error…
• Hausmann and Rodrik: A Problem of Information
• Not enough to say developing countries should produce “labor intensive
products”, because there are thousands of such products
• The problem is “information externalities”, associated with the need to search
for comparative advantage in efficient production opportunities
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
28
4.6 Economic Development as “Self-Discovery”
• There is limited incentive to search for, because knowledge gained
“spills over” to other entrepreneurs, limiting the opportunity to capture
profits
• Industrial policy may help to identify true direct and indirect domestic
costs of potential products to specialize in, by:
1. Encouraging exploration in first stage
2. Encouraging movement out of inefficient sectors and into
more efficient sectors in the second stage
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
29 Economic Development as “Self-Discovery”
• Three building blocks of the theory:
(Authors’ case examples of the reasonableness of these assumptions in practice)
1. Uncertainty about products can be produced efficiently.
Authors’ examples:
• India’s widely unexpected success in information technology
• Reasons for Bangladesh’s efficiency in hats vs Pakistan’s in
bedsheets is unclear
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
30
Economic Development as “Self-Discovery”
2. Need for local adaptation of foreign technology
• Authors’ example: Shipbuilding in South Korea
3. Imitation can be rapid
• Authors’ example: The spread of cut flower exporting in
Colombia
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
31
Hausmann-Rodrik-Velasco
Growth Diagnostics
Framework
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
32 4.7 The Hausmann-Rodrik-Velasco
Growth Diagnostics Framework
• Focus on a country’s most binding constraints on economic growth
• No “one size fits all” in development policy
• Requires careful research to determine the most likely binding constraint
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
33 Figure 4.3 Hausmann-Rodrik-Velasco
Growth Diagnostics Decision Tree
Source: Hausmann, Ricardo, Rodrik, Dani and Velasco, Andrés (2006), ‘Getting the diagnosis right,’ Finance and Development 43. Reprinted with permission.
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
34 Growth Diagnostics: Categories of
“most binding constraints” in the “decision tree”
• Constraint categories are the boxes from which no further arrows arise
– 10 are included
• These 10 are comprehensive; many specific constraints fit well within
these categories
• Example: Natural disasters pose immediate constraints,
but if extended problems for the growth follow,
government failure is likely the root problem -
not the initial shock of the disaster
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
35 Growth Diagnostics: Categories of
“most binding constraints” in the “decision tree”
• But potential additional independent “boxes” for constraint types that
have been raised for consideration but are debatable could include:
• Environment: if climate change and ecological collapse threaten food
security, or domestic degradation leads to near un-livability of the
major cities (lowering productivity, stopping investment…)
• Inability to resolve conflict
• Social capital (or “cultural”) dimensions such as lack of trust
(e.g., in forming business relationships, etc.)
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
36
Doing Growth Diagnostics in Practice*
Careful research is required to determine most likely binding constraint:
• In practice, growth diagnostics involves “Economic Detective Work”
• To evaluate whether a proposed constraint is mandatory,
a growth diagnostician looks for evidence on its implications
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
37
Doing Growth Diagnostics in Practice*
• If the constraint is
• Excessive Taxation: we would expect high movement into the informal
sector or underground economy
• Infrastructure: we would expect significant congestion
• Education: expect high rates of return to education
• In general, the analyst will look for economic behavior consistent with agents trying
to get around a constraint
*Draws from Ricardo Hausmann, Bailey Klinger, Rodrigo Wagner, Doing Growth Diagnostics in Practice:
A ‘Mindbook,’ CID Working Paper No. 177, 2008
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
38 Hausman et al’s* “Principles of a Differential Diagnosis”
If a constraint is binding, then…
1) The (shadow) price of the constraint should be high
2) Movements in the constraint should produce significant movements in
the objective function
3) Agents in the economy should be attempting to overcome or bypass
the constraint
4) Agents less intensive in that constraint should be more likely to
survive and thrive, and vice versa
*Ricardo Hausmann, Bailey Klinger, Rodrigo Wagner, Doing Growth Diagnostics in Practice: A ‘Mindbook,’
CID Working Paper No. 177, 2008:
http://siteresources.worldbank.org/INTDEBTDEPT/Resources/468980-1218567884549/mindbook.pdf
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
May 3, 2024
39
THANKS
dr.moeenuddin
Copyright © 2020, 2015 Michael P. Todaro and Stephen C. Smith
