Lesson 4: Contemporary Models of Development and Underdevelopment

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. They also stress that in many
important situations, investments must be undertaken by many agents in order for the results to be
profitable for any individual agent. Generally, when complementarities are present, an action taken by
one firm, worker, or organization increases the incentives for other agents to take similar actions.

Models of development that stress complementarities are related to some of the models used in the
endogenous growth approach, the coordination failure approach has evolved relatively independently
and offers some significant and distinct insights. Simply put, 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. Agents of
development cannot get there because of difficulties on coordination, sometimes because people hold
different expectations and sometimes because everyone is better off waiting for someone else to make
the first move.

When complementarities are present, an action taken by one firm, worker, organization, or government
increases the incentives for other agents to take similar actions.

An important example of a complementarity is the presence of firms using specialized skills and the
availability of workers who have acquired those skills. Firms will not enter a market or locate in an area if
workers do not possess the skills the firms need, but workers will not acquire the skills if there are no
firms to employ them. This coordination problem can leave an economy stuck in a bad equilibrium—that
is, at a low average income or growth rate or with a class of citizens trapped in extreme poverty. Even
though all agents would be better off if workers acquired skills and firms invested, it might not be
possible to get to this better equilibrium without the aid of government. Such coordination problems are
also common in initial industrialization, as well as in upgrading skills and technologies, and may extend
to issues as broad as changing behavior to modern “ways of doing things.” Such problems are further
compounded by other market failures, particularly those affecting capital markets.

Another example typical of rural developing areas concerns the commercialization of agriculture. As
Adam Smith already understood, specialization is one of the sources of high productivity. Indeed,
specialization and a detailed division of labor are hallmarks of an advanced economy. But we can
specialize only if we can trade for the other goods and services we need.

A case of Coordination Problem

Coordination problems are illustrated by the where-to-meet dilemma: Several friends know that they
will all be in Metro Manila on a certain day but have neglected to settle on a specific location within the
city. Now they are out of communication and can arrive at a common meeting point only by chance or by
very clever guessing. They want to meet and consider themselves better off if they can do so; there is no
incentive to “cheat.” Thus, the where-to-meet problem is quite different from that of prisoners’
dilemma, another problem often encountered in theories of economic development. But the fact that all
gain from coordination does not make the where-to-meet dilemma easy to solve.

There are many famous places in Metro Manila alone; Only with luck would the friends end up making
the same guesses and meeting in the same place. If someone from the group drifts then the possibility
of not meeting is extremely high.

Complementarity - An action taken by one firm, worker, or organization that increases the incentives for
other agents to take similar actions. Complementarities often involve investments whose return depends
on other investments being made by other agents.

Economic agent/ economic actor—usually a firm, worker, consumer, or government official— that
chooses actions so as to maximize an objective; often referred to as “agents.”

Coordination failure - A situation in which the inability of agents 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.

Big push - A concerted, economy-wide, and typically public policy–led effort to initiate or accelerate
economic development across a broad spectrum of new industries and skills.

O-ring model - An economic model in which production functions exhibit strong complementarities
among inputs and which has broader implications for impediments to achieving economic development.

Middle-income trap - A condition in which an economy begins development to reach middle-income

status but is chronically unable to progress to high-income status. Often related to low capacity for
original innovation or for absorption of advanced technology, and may be compounded by high
inequality.

Underdevelopment trap - A poverty trap at the regional or national level in which underdevelopment
tends to perpetuate itself over time. (paulit ulit)

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.

Congestion - The opposite of a complementarity; an action taken by one agent that decreases the
incentives for other agents to take similar actions.

Where-to-meet dilemma – A situation in which all parties would be better off cooperating than
competing but lack information about how to do so. If cooperation can be achieved, there is no
subsequent incentive to defect or cheat.

Prisoners’ dilemma – A situation in which all parties would be better off cooperating than competing,
but once cooperation has been achieved, each party would gain the most by cheating provided that
others stick to cooperative agreements—thus causing any agreement to unravel.

The Big Push

The Big Push pointed out several problems associated with initiating industrialization in a subsistence
economy. The problem is easiest to perceive by a simplifying assumption that the economy is not able to
export. In this case, the question becomes one of who will buy the goods produced by the first firm to
industrialize. Starting from a subsistence economy, no workers have the money to buy the new goods.
The first factory can sell some of its goods to its own workers, but no one spends all of one’s income on a
single good. Each time an entrepreneur opens a factory, the workers spend some of their wages on other
products.

So the profitability of one factory depends on whether another one opens, which in turn depends on its
own potential profitability, and that in turn depends on the profitability of still other factories.

Such circular causation should now be a familiar pattern of a coordination failure problem. Moreover,
the first factory has to train its workers, who are accustomed to a subsistence way of life. The cost of
training puts a limit on how high a wage the factory can pay and still remain profitable. But once the first
firm trains its workers, other entrepreneurs, not having to recoup training costs, can offer a slightly
higher wage to attract the trained workers to their own new factories. However, the first entrepreneur,
anticipating this likelihood, does not pay for training in the first place. No one is trained, and
industrialization never gets under way.

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.

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.

If one naively cooperates with an opportunistic, predator type, it be worse off than by going it alone.
Only by cooperating with other good-willed cooperators may you reach the best outcome. Moreover,
past experience may lead people to expect opportunistic behavior at least among certain groups of
potential business partners, which in turn raises the incentives for the potential partners to actually act
that way. If there is nothing to be gained and something to be lost by being honest, the incentives lie in
being dishonest. On the other hand, in some settings, individuals take it on themselves to enforce norms
rather than leaving this task to government. If many people work to enforce a norm such as honesty,
each individual’s enforcement burden is relatively low.

You can have equilibria where most people resist corruption, and so corruption is rare; and you can have
equilibria where few resist corruption, and corruption is common.

One cannot rely on good organizations to prevail in competition if the rules of the game tend to reward
the bad organizations. Rather, the critical importance of policies for developing or reforming institutions
is highlighted, such as reform of the framework of property rights, antitrust, clean government rules, and
other laws, regulations, and industry association norms that set the rules of the game for economic life.
Once the new behavior assumes the status of a norm, it is much easier to maintain. Some neoclassical
theorists have at times implied that good institutions would be developed through the market
mechanism. Bad institutions would be outcompeted by good institutions. But reform of institutions
aiding and abetting coordination failure—for example, by permitting or encouraging corruption—is itself
subject to coordination failure.

Once cooperative relationships (e.g., in business) become a norm, more people may adopt cooperative
behavior. But norms of all kinds are subject to inertia. Although norms may have been adaptive when
they originated, they are hard to change, even when they become dysfunctional. An example is a value
such as that to be a good citizen one must have a large number of children. This value may have been
adaptive at a premodern stage, but today it inhibits development.

Linkages

There are several ways to undertake a big push, encouraging the simultaneous expansion of the modern
sector in many industries. One strategy for solving coordination problems is to focus government policy
on encouraging the development of industries with key backward or forward linkages. This could mean
subsidies or quid pro quos for domestic industries to enter these key industries, it could mean incentives
for multinational firms to enter in key industries and provide advanced training, a policy followed in
Singapore; or it could mean establishing a few key public enterprises to act as pioneers in an industry
(that could later be sold).

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. In other words, linkages are especially significant for
industrialization strategy when one or more of the industries involved have increasing returns to scale, of
which a larger market may take advantage.

When increased demand for chemicals used in textile manufacture causes expansion of the chemical
industry that enables it to produce at a larger scale and hence lower cost, a backward linkage can occur.
Both examples illustrate a pecuniary externality effect (a lowering of cost) when there are increasing
returns in the linked industry.
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.

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.

Similarly, if the poor lack access to credit, they may not be able to obtain loans to finance otherwise very
productive schooling. If the poor are unable to bequeath much to their next generation, families can be
trapped in poverty from generation to generation; however, if schooling could somehow be achieved,
they could escape from this poverty trap. It is best to keep in mind a rather expansive definition of what
is meant by a transfer from parents to be used for human capital accumulation by their children. It is
more than tuition and more than forgone wages or work on the farm to help the family because it goes
well beyond the cost of formal schooling and may be thought of as the building of a whole array of
“capabilities” that one acquires almost as a simple by-product of growing up in an affluent, educated
family.

Poverty trap - A bad equilibrium for a family, community, or nation, involving a vicious circle in which
poverty and underdevelopment lead to more poverty and underdevelopment, often from one
generation to the next.

The O-Ring Model

The key feature of the O-ring model is the way it models production with strong complementarities
among inputs. We start by thinking of the model as describing what is going on inside a firm, but as we
will see, this model also provides valuable insights into the impact of complementarities across firms or
industrial (product) sectors of the economy.

One of the most prominent features of this type of production function is what is termed positive
assortative matching. This means that workers with high skills will work together and workers with low
skills will work together. When we use the model to compare economies, this type of matching means
that high-value products will be concentrated in countries with high-value skills.
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. Put differently, when those
around you have higher average skills, you have a greater incentive to acquire more skills. This
type of complementarity should by now be a familiar condition in which multiple equilibria can
emerge.
 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. Because there is an
externality at work, there could thus be a case for an industrial policy to encourage quality
upgrading This could be relevant for a country trying to escape the middle-income trap. 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.

O-ring production function - A production function with strong complementarities among inputs, based
on the products (i.e., multiplying) of the input qualities.

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; for example, no one is born knowing they are well suited to become an
economist or international development specialist. Somewhat analogously, nations must learn what
activities are most advantageous to specialize in.

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. So 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. It is valuable in part
because once an activity is shown to be profitable, it can usually be imitated, at least after some lag,
spawning a new domestic industry. As markets are eventually open to competing firms, they will take
away potential profits from the original innovator. And since, due to this information externality,
innovators do not reap the full returns generated by their search for profitable activities, there will be
too little searching for the nation’s comparative advantage—too much time carrying on with business as
usual and too little time devoted to “self-discovery.” The term self-discovery somewhat whimsically
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.
Information externality - The spillover of information - such as knowledge of a production process—
from one agent to another, without intermediation of a market transaction; reflects the public good
characteristic of information (and susceptibility to free riding)—it is neither fully excludable from other
uses, nor nonrival (one agent’s use of information does not prevent others from using it).