CHAPTER 4: CONTEMPORARY

MODELS OF DEVELOPMENT
AND UNDERDEVELOPMENT
DEGUIT, KHRYSS LIN
RUALES, CHABELITA
4.1 Underdevelopment as a
Coordination Failure
◦ Many newer theories of economic development that became influential in
the 1990s and the early years of the twenty-first century have emphasized
complementarities between several conditions necessary for successful
development. These theories often highlight the problem that several things
must work well enough, at the same time, to get sustainable development
under way.
◦ Models of development that stress complementarities are related to some of
the models used in the endogenous growth approach, but the coordination
failure approach has evolved relatively independently and offers some
significant and distinct insights. Put simply, a coordination failure is a state of
affairs in which agents’ inability to coordinate their behavior (choices) leads to
an outcome (equilibrium) that leaves all agents worse off than in an
alternative situation that is also an equilibrium.
◦ When complementarities are present, an action taken by one firm, worker,
organization, or government increases the incentives for other agents to take
similar actions. In particular, these complementarities often involve investments
whose return depends on other investments being made by other agents.

◦ In development economics, such network effects are common, and we

consider some important examples later in this chapter, including the model of
the big push, in which production decisions by modern-sector firms are
mutually reinforcing, and the O-ring model, in which the value of upgrading
skills or quality depends on similar upgrading by other agents. Curiously, such
effects are also common in analyses of frontier technologies in developed
countries, particularly information technologies, in which the value of using an
operating system, word-processing program, spreadsheet program, instant
messaging, and other software or product standard depends on how many
other users also adopt it. In both cases, the circular causation of positive
feedback is common. This framework may also be used in analyses of the
middle-income trap, in which countries develop to a degree but chronically
fail to reach high-income status, often due to lack of innovation capacity.
Government itself is increasingly analyzed in contemporary development models as one
of the components of the development process that may contribute to the problem as
well as to the solution.

Deep intervention
A government policy that can move the economy to a preferred equilibrium
or even to a higher permanent rate of growth, which can then be self-
sustaining so that the policy need no longer be enforced because the better
equilibrium will then prevail without further intervention.
4.2 MULTIPLE EQUILIBRIA: A
Diagrammatic Approach

Multiple equilibria
- A condition in which more than one equilibrium exists. These
equilibria sometimes may be ranked, in the sense that one is
preferred over another, but the unaided market will not move the
economy to the preferred outcome.
The basic idea
reflected in the S-
shaped function of
Figure 4.1 is that 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.
How do we find the equilibria in this
type of problem?

◦ In the Marshallian supply- ◦ In the multiple-equilibria

and-demand scissors diagram, equilibrium is found
diagram, equilibrium is found where the “privately rational
where the supply and decision function” crosses the
demand curves cross. 45-degree line.
◦ Firms would have to revise their expectations, matching their
expectations to the level of investment they actually would see.
This process of adjustment of expectations would continue until
the level of actual investment would just equal the level of
expected investment.

◦ So the general idea of an equilibrium in such cases is one in

which all participants are doing what is best for them, given what
they expect others to do, which in turn matches what others are
actually doing. This happens when the function crosses the 45-
degree line. At these points, the values on the x-axis and y-axis
are equal, implying in our example that the level of investment
expected is equal to the level that all agents find best (e.g., the
profit-maximizing level).
Pareto improvement
A situation in which one or more persons may be made
better off without making anyone worse off.
4.3 Starting Economic Development:
The Big Push
The big push is a model of how the presence of market failures can lead
to a need for a concerted economy-wide and probably public-policy-
led effort to get the long process of economic development under way
or to accelerate it. Put differently, coordination failure problems work
against successful industrialization, a counterweight to the push for
development. A big push may not always be needed, but it is helpful to
find ways to characterize cases in which it will be. Rosenstein-Rodan’s
arguments became a major part of the way development economists
thought about development problems in the 1950s and 1960s, and they
have continued to be taught in development courses.
 Key points:

◦ Minimum scale of savings, investment, and demand.

◦ How to push the economy into growth?
◦ Government investment
◦ Infrastructure
◦ Think and plan big
◦ Open trade
 ◦ Indivisibilities in the production
function, i.e., lumpiness of capital,
especially in the creation of social
Main overhead capital.

Components:
◦ Indivisibility of demand, i.e.,
complementarity of demand.

◦ Indivisibility of savings, i.e., kink in the

supply of savings.
4.4 Further Problems of Multiple
Equilibria
Inefficient Advantages of Incumbency
The presence of increasing returns in modern industries can also create another
kind of bad equilibrium. Once a modern firm has entered, it has an advantage
over any rivals because its large output gives it low average costs. So if an even
better modern technology becomes available to a potential rival, it may not be
easy for the new technology to supplant the old. Even though the new
technique has a lower per-unit cost for any given level of output, the firm with
the old technique has an advantage because its large output lets it produce at
a lower per-unit cost than that of the new technique, which starts out with a
small customer base and a large fixed cost. As a result, firms may need access
to significant amounts of capital to cover losses while they build their customer
base. If capital markets do not work well, as they often do not in developing
countries, the economy may be stuck with backward, less cost-effective
industries.
Behavior and Norms
Movement to a better equilibrium is especially difficult when it
involves many individuals changing their behavior from one of rent
seeking or corruption to honesty and the value of building a
reputation to reap the gains from cooperation (e.g., with business
partners). Your choice of partner may determine much.
Linkages
Connections between firms based on sales. A backward linkage is
one in which a firm buys a good from another firm to use as an
input; a forward linkage is one in which a firm sells to another firm.
Such linkages are especially significant for industrialization strategy
when one or more of the industries (product areas) involved have
increasing returns to scale that a larger market takes advantage
of.
The theory of linkages stresses that when certain industries are
developed first, their interconnections or linkages with other
industries will induce or at least facilitate the development of new
industries. Backward linkages raise demand for an activity, while
forward linkages lower the costs of using an industry’s output; both
may involve interactions between the size of the market and
increasing returns to scale and hence pecuniary externalities.
Inequality, Multiple Equilibria, and Growth
Other important work being done on growth and multiple equilibria addresses
the impact of inequality on growth. The traditional view has been that some
inequality may enhance growth because the savings of the rich are higher than
those of the poor. If at least some savings to be mobilized for investment
purposes must come from within a country, then according to this view, too high
a degree of equality could compromise growth. However, the poor save at
much higher rates than previously believed, when savings are properly
measured to include expenditures on health, children’s education, and
improvements on a home. Moreover, where inequality is great, the poor may
not be able to obtain loans because they lack collateral; indeed, one definition
of what it means to be poor is to be entirely or mostly lacking in a source of
collateral. Poor persons unable to get a loan to start a business due to such
capital market imperfections may get stuck in subsistence or wage
employment, although they (and perhaps potential employees) could do much
better if they had access to financing or if there were a more even distribution
of income.
4.5 Michael Kremer’s O-Ring Theory of
Economic Development
Another innovative and influential model that provides important insights into
low-level equilibrium traps was provided by Michael Kremer. The notion is that
modern production (especially in contrast to traditional crafts production)
requires that many activities be done well together in order for any of them to
amount to a high value. This is a form of strong complementarity and is a natural
way of thinking about specialization and the division of labor, which along with
economies of scale is another hallmark of developed economies in general and
industrial production in particular.
The result in the business world 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.
If a firm can increase quality in percentage terms at constant marginal cost or
even a not too quickly rising cost, there is a virtuous circle in that the more the
firm upgrades overall, the more value it obtains by doing so. Accordingly,
wages will increase at an increasing rate as skill is steadily raised. As Kremer
shows, the O-ring model is consistent with competitive equilibrium.

The O-ring result of positive assortative matching relies on some rather strong
assumptions. How important are each of these, and how much can they be
relaxed?
Two points are crucial:
(1)Workers must be sufficiently imperfect substitutes for each other, and
(2)we must have sufficient complementarity of tasks.

As long as these conditions hold, the basic results will follow.

 Implications of the O-Ring Theory

The analysis has several important implications:

◦ Firms tend to employ workers with similar skills for their various tasks.
◦ Workers performing the same task earn higher wages in a high-skill firm than 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.
◦ If workers can improve their skill level and make such investments, and if it is in their interests to do so, they
will consider the level of human capital investments made by other workers as a component of their own
decision about how much skill to acquire.
◦ One can get caught in economy-wide, low-production-quality traps. This will occur when there are (quite
plausibly) O-ring effects across firms as well as within firms.
◦ 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.
4.6 Economic Development as Self-
Discovery
In simple models with perfect information, it is assumed that firms, and
developing economies as a whole, already know their comparative
advantage. But individuals must discover their own comparative advantage in
labor markets; nations must learn what activities are most advantageous to
specialize in.

Ricardo Hausmann and Dani Rodrik

- As Ricardo Hausmann and Dani Rodrik show, this is a complex task—and one
prone to market failure.49 It is not enough to tell a developing nation to
specialize in “labor-intensive products,” because even if this were always true,
there are a vast number of such products in the world economy of today, and
underlying costs of production of specific products can differ greatly from
country to country.
Self-discovery - expresses the assumption that the products in question have
already been discovered by someone else (either long ago, or recently in a
developed economy); what remains to be discovered is which of these
products a local economy is relatively good at making.

Ricardo Hausmann and Dani Rodrik

- There can be too much diversification after the point where the nation
discovers its most advantageous products to specialize in.
Three “building blocks” of their theory:
a) There is uncertainty about what products a country can produce efficiently
b) there is a need for local adaptation of imported technology so that it cannot
be used productively “off the shelf”
c) and once these two obstacles have been overcome, imitation is often rapid
(reducing the profitability of pioneers).
4.7 The Hausmann-Rodrik-Velasco
Growth Diagnostics Framework
Different countries face different binding constraints on achieving faster rates of growth
and economic development. A key mission for economic development specialists is to
help determine the nature of the constraints for each country. Ricardo Hausmann, Dani
Rodrik, and Andrés Velasco (HRV) propose a growth diagnostics decision tree framework
for zeroing in on a country’s most binding constraints on economic growth. HRV explain
that targeting the most binding constraint has important advantages over other
approaches to policy selection.
If a developing nation experiences a relatively low level of private investment and
entrepreneurship, what steps should it take? The basic decision tree for addressing this
question is seen in Figure 4.3.
Low returns to investors may be due to the fact that there are intrinsically low underlying
social returns to economic activities. Alternatively, low returns may be caused by what is
termed low private appropriability, meaning limited ability of investors to reap an
adequate share of the rewards of their otherwise profitable investments. Considering
these cases in turn, low social returns may be caused by one of three factors.
◦ First, poor geography such as tropical pests, mountains, and other physical barriers,
distance to world markets, and landlocked status (which may render port access
politically dubious or economically costly) may limit the ability of a low-income country
to initiate and sustain economic development, especially when other compounding
factors are present. When these constraints are most binding, development policy must
initially focus on strategies for overcoming them.

◦ Second, low human capital—skills and education as well as health of workers—are

complementary with other factors in production, affecting the returns to economic
activity. For example, if economic returns are most affected by lack of literacy and
numeracy, this becomes a development policy priority.

◦ Third, every developing nation must provide the vital infrastructure needed to achieve
and sustain a modern economy, beginning with basic physical structures such as roads,
bridges, railroads, ports, telecommunications, and other utilities. With bad infrastructure,
otherwise high-return economic activities may prove unprofitable. In some countries,
inadequate and imbalanced infrastructure is the main factor preventing an
acceleration of growth, and in such cases, policies focusing on providing it would
boost investment and growth the most.
But the problem may lie not with the underlying social return to economic activities but with low
appropriability, meaning that investors cannot reap an adequate share of returns to investment. In turn,
appropriability problems can be due to either government failures or market failures.
The fundamental problem may also be large-scale market failures of the type stressed in this chapter.
These may include the self-discovery problems pointed up by Hausmann and Rodrik and reviewed in
section 4.6. They may also take the form of coordination externalities, such as seen in the big push model
of underdevelopment, examined in section 4.3.
In yet other cases, the main problem may not be underlying low rates of return but rather an abnormally
high cost of finance.
Here the problem may be bad international finance—inadequate access to foreign sources of capital or
problems with debt, examined in Chapter 13; or the problem may reside in bad local finance, due either
to low availability of loanable funds through domestic financial markets, traced to low domestic saving, 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.
It is often difficult to observe a binding constraint directly. In practice, growth diagnostics usually involves
some economic detective work. To evaluate whether a proposed constraint is binding, a growth
diagnostician looks for evidence on its implications.
Clearly, identifying and addressing constraints that are likely to become binding in the future is even more
challenging than targeting today’s more visible bottlenecks.
Although growth diagnostics might be criticized as “more art than science,” at the very least this new
approach forces the analyst to focus on country-specific circumstances and thus to get to know the
individual country very well. This is one of the reasons that growth diagnostics offers a valuable
complement to econometric studies.
4.8 CONCLUSIONS
 CASE STUDY
UNDERSTANDING A
DEVELOPMENT MIRACLE: CHINA
An Extraordinary Performance
From 1978 to 2011, the economy of China grew at an average rate of close to 9% a year,
an unprecedented achievement for any economy in history, let alone the world’s most
populous nation, with over 19% of global population. China’s income per capita by 2012
was approaching six times what it was in 1978, when reforms began. Growth was three
times the rate that would be considered respectable by the recent standards of most
low-income countries. China has also experienced the world’s most dramatic reductions
in poverty. The World Bank’s most recent estimate is that just 12% of China’s population
lives on less than $1.25 per day (27% below $2 per day). This means that hundreds of
millions fewer people were living in extreme poverty in a span of just three decades.
Reductions in extreme poverty in China are far faster and greater than anywhere else in
the world.
 China is hailed as an example of the benefits of markets, trade, and globalization. Yet
by conventional measures, institutions in China remain quite weak. For example, the
World Bank’s 2013 “Ease of Doing Business” index ranks China poorly, at No. 96—worse
than Russia, Mongolia, Zambia, or Serbia.
Manufactured exports are a key to China’s growth, and market incentives have played
a primary motivational role in business decisions. But China has also adopted activist
industrial policies, pushing exports of increasingly higher skill and technology content,
and it embarked on its period of rapid growth around 1980, more than a decade before
significant trade liberalization.
But often overlooked is that China’s agricultural productivity growth was also very high.
Moreover, much of China’s growth in the 1980s and early 1990s was due to rural
township and village enterprises, which had a quasi-cooperative and quasi-municipally
owned character.
Sources of Success
◦ Regional “Demonstrations.” The presence of regional “demonstration” models has
been crucial. Japan was emulated by other countries in the East Asian region. Hong
Kong provided an additional example for China, as did China’s archrival Taiwan.
Taiwan, Hong Kong, and South Korea focused on export-oriented industrialization
strategy at a time when world trade was growing rapidly.

◦ Leveraging the Lure of a Billion Consumers By the late 1980s, the locus of regional
growth shifted to China as investors began to pour investments into China in large part
because of the allure of its eventual market of more than 1.3 billion consumers.
◦ Export-Led Investment and Growth Once early investments built up a sufficient critical
mass, agglomeration benefits of concentrated economic activity kicked in. The more
producers located in China, the greater the benefits for an increasing number of
suppliers to operate there.
◦ Health and Education Investments The central planning of China’s first decades after its
1949 Communist revolution were by most measures a failure. Industry was highly
inefficient. As many as 30 million people died in a late-1950s famine caused by poor
central planning decisions and political pressures that led party and government
officials to regularly overstate the harvest prospects.
◦ Such disasters were only partly offset by the early and ongoing emphasis on basic
health and education in China and then on reductions of fertility through China’s one
child policy. These basic first steps on education, health, and eventually fertility helped
set the stage for growth and poverty reduction when later combined with market
incentives. One of the results is the apparently higher educational and skill level of
factory workers for given wages in China in comparison to its competitor countries.
◦ Productivity Growth There has been considerable debate about whether rapid growth
in other East Asian countries is the result of capital accumulation or productivity gains.
◦ Most of China’s growth came from the reallocation of labor, particularly from
agriculture to other activities, and that sustainable total factor productivity progress
was much lower, on the order of 2% per year.
 China has introduced new and transitional institutions that exist side by side with previous
institutions of central planning for extended periods.

China has a large population, a vast territory, and a complex situation. This is why Deng
Xiaoping adopted a strategy of “feeling out the stones to cross the river.” He
encouraged all types of trial reforms, such as the creation of Special Economic Zones
(SEZs).
China’s reforms are progressing in the following order: first the countryside and then the
cities; first coastal areas and then inland areas; first predominantly economic reforms and
then political reforms; first relatively easy reforms followed by more difficult reforms. The
advantage of this approach is that the experiences gained in the first phase of reform
may be used to lay down the foundations for the later stages of reform. This approach is
influenced by the Chinese tradition of integrated thinking. Back in the 1980s, Deng
Xiaoping devised a 70 year-strategy to turn China into a developed country, and this
strategy is still being implemented to this very day.
China’s Coming Challenges
China’s successes do need to be kept in perspective. Since 1980, China has grown
about 4½ times faster than the United States, as measured by per capita output. As a
result, China has been closing the relative gap in living standards. In 1980, China’s
income per person was only 2% of that in the United States, but by 2012, it had grown to
over 15%. But even if China’s output per person continued to grow at its unprecedented
recent rate of 8.4% and the United States at its long-run rate of just 1.9%, China would still
not catch up until close to 2040. A high rate of domestic saving is associated with a trade
surplus. Savings have been extremely high and rising in China. As of 2011, China was
saving nearly half of its national income—an astounding and unprecedented rate
compared to the country’s own past rates (already a high 35% in 1990) and in relation to
the high rates that have generally prevailed in East Asia. Such high rates are not
consistent with the pivot toward increasing local consumption as an engine of growth.
◦ Poverty and Vulnerability - Life can indeed be harder than ever for the millions remaining in
extreme poverty, such as rural peasants in some parts of the country facing the loss of
security; official corruption, including reports of official land grabs from peasants; rising local
taxes; and minimal improvements in technology or skills.

◦ Environment and Pollution - A majority of the most polluted cities in the world are located in
China, and health problems are growing.

◦ Product and worker safety- China’s regulatory institutions will need to catch up with the
progress made in other aspects of national economic development.

◦ Avoiding the Middle-Income Trap - The question for China will be how it can maintain
somewhat more modest but historically still high growth, of perhaps 6.5%, sustainably over
the next three decades.

◦ Addressing Structural Imbalances- China’s very large export surplus has come under great
criticism, as this was widely argued to be one of the underlying causes of the global financial
crisis. One cause of the surpluses is probably the undervaluation of China’s exchange rate,
estimated to be at least 20%.
Demographic Challenges
China also has a rapidly aging population. For the last decade of the twentieth century and
first decade and a half of the twenty-first century, China has benefited from a demographic
dividend, in which by global standards an unusually large fraction of its population has been
of working age (neither too young nor too old to be active in the workforce). This “dividend”
occurs in the process of economic development after the drop in births per woman but
before the previous larger cohorts retire, allowing for rapid income growth. China is now
entering a phase in which a large fraction of its working population will begin to retire. One
challenge is the need to implement a modern pension system. Another is to respond to a
shrinking workforce and the need to support a large retired population. It is a challenge
common to many modern societies but may be particularly acute in China due to its one-
child policy that has been in effect since about 1980, which has greatly accelerated the
demographic transition. There was a slight relaxation of this policy at the Third Plenum in
November 2013, to allow urban families for which either husband or wife is an only child to
have a second child (previously this was allowed only if each was an only child). But this
change may have very limited impact on fertility because of the high cost of raising children
in China’s cities. The very high ratio of males to females remains another serious demographic
challenge that may lead to continued distortions.
Comparison between China and
Philippines
Similarities Differences

High labor supply Industrialization

Low cost of labor Special Economic Zones
Government intervention Export
Mixed market economy People’s attitude
Allocation of surplus resources
Lack of innovation capability (Philippines)
Exports are much greater than imports in
China