Contemporary Models of Development

Contemporary Models
These theories highlight the fact that development is much harder to achieve than had been previously thought. The new models incorporate:
Coordination problems Alternative market structures Increasing returns to scale Imperfect Information Multiple Equilibria Externalities

Endogenous Growth Models

According to traditional models, in the absence of external shocks and technological change, all economies will converge to zero growth. This leaves no explanation for sustained growth. All unexplained growth is attributed to the Solow Residual. Growth for the most part is the result of an exogenous process. It is impossible to analyze the determinants of technological change.

 New growth theory provides a framework for analyzing persistent growth in national income that is determined within the system rather than by external forces. Exogenous changes in technology still play a role but they are no longer needed to explain longrun growth. Explain growth rate differentials across countries Explain a greater portion of the growth observed

New growth theory

GNP growth is determined by the system governing the production process rather than by forces outside that system Endogenous growth theorists seek to explain the factors that determine the size of Solow residual Discarding the assumption of diminishing marginal returns to factors introduced the assumption of increasing returns to scale

 It assumes that investments in human capital generate positive externalities and result in increasing returns spillover effect learning by doing, learning by investing creativity is the expression of mind power: It is the capacity to produce new ideas such as inventions and innovations and creativity is the main driver for economic development.

 Investment in knowledge and R&D is a kind of capital and is not subject to diminishing returns. The new growth theory assumes that people invest in human capital which results in inventions and innovations in turn increases the level of consumption and investment

 Romer model This model addresses technological spillovers that may be present in the process of industrialization. The model begins by assuming that growth processes derive from firm or industry level. Each industry individually produces with constant returns to scale so consistent with perfect competition up to this point matches up to the solow model. This model departs from the Solow model by assuming increasing returns to scale to K at industry wide level. It is valuable to think of each firms capital stock as including its knowledge The knowledge part of the firms capital stock is essentially a public good like A in the Solow model that is spilling over instantly to other firms in the economy. The model treats learning by doing as learning by investing The reason why growth might be dependant on investment.

 The model may be explained as Yi =AK L 1-K There is assumption of symmetry among industry so each industry will use the same amount of capital and labor then we have aggregate production function Y = AK+ L1- Where A represents technology and assume that there is no technical progress over time so A is constant
1 2

 With a little calculus it can be shown that the growth rate for per capita income is g- n = / 1-- If is positive ( human capital) then growth rate is greater than n and if is zero this growth rate is equal to n to like in Solow model. This model shows that we have endogenous growth depending on the level of savings and investment undertaken in the model not driven exogenously by increases in productivity. These models ward off diminishing returns

Criticism of New Growth Theory

It either assumes a single sector for production or that all sectors are symmetrical, not allowing for growth-generating reallocation of labour and capital between sectors that are transforming due to structural change. Overlooks inefficiencies brought about by poor infrastructure, inadequate institutional structures and imperfect capital and goods markets. Since the focus is on steady-state growth rates, the theory places most of its emphasis on explaining long term growth rates and not on short or medium-term growth

Underdevelopment as a Coordination Failure

Complementarities are present when an action taken by one agent increases the incentives for other agents to take similar actions. The decisions are mutually reinforcing. A coordination failure occurs when agents inability to coordinate their behaviour results in an equilibrium that leaves all agents worse off than in an alternative equilibrium.

Coordination failure models highlight the fact that in order to get sustainable development underway, several things must work well enough simultaneously. In order for investment to be profitable for an individual agent, a significant number of other agents must undertake investment. Whether we are in advanced capitalist economies or in traditional subsistence developing economies, we will find many examples of this circular causation of positive feedback. The inability to coordinate investment efforts can leave an economy stuck in a bad equilibrium.

 Underdevelopment trap
A region remains stuck at the subsistence level due to coordination failure. No one invests in new products or skills because the demand is not there. The demand for new products and skills is not developed because the new products and skills are not available

 Role of Government
Clearly there is a role for government in coordinating joint investments. Often there is a lag between making the investment and the realization of the return. So each agent waits for someone else to make the first move and a bad equilibrium results. Deep government intervention is needed to move the economy to the preferred equilibrium. On the other side, bad government policy could result in the economy moving to a bad equlibrium

 Underinvestment in New Technologies

This is another example of coordination failure. The benefit to adopting a new technology for an individual firm is contingent on the adoption of this technology by other firms, so each firm invests less than the socially optimal level

 Joint Externalities
Normally in economics we think of self-interested individuals responding to incentives such as market prices in order to determine their actions. These mechanisms impose counter-pressures in order to restore balance. Often in development economics, joint externalities in which behaviour is mutually reinforced exist so that a state of underdevelopment results in further underdevelopment, while on the other hand, processes of sustainable development, one underway, tend to beget further development.

Coordination Game
Many wireless phone providers have calling plans in which calling someone with the same wireless plan or on the same network is costless to the consumer. It is also very costly to switch wireless providers. It would be beneficial to an individual wireless consumer if all of his friends and relatives were on the same network. The larger the number of people on the network, the larger the savings. It would be socially improving if everyone could find a way to coordinate their wireless provider decisions.

Multiple Equilibria

Multiple Equilibria: A Diagrammatic Approach

Generally, these models can be diagrammed by graphing an S-shaped function and the 45 line Equilibria are
stable when the function crosses the 45 line from above unstable when the function crosses the 45 line from below

Multiple Equilibria

 In above mentioned diagram we suppose that X-axis shows the number of friends expected to sign up for an instant messaging service while Y-axis show how many will sign up. Some people might sign up even none of their friends sign up. It give positive intercept on Yaxis but after that the slope of the curve is positive as more friends expected to sign up more there will be who want to do so.

 Starting out of equilibrium, the expectations adjustment process would continue until agents observe what they expected to see. An equilibrium is stable if when we start slightly away from it, the adjustment process brings us back to that equilibrium An equilibrium is unstable if starting slightly away from it, pulls us further away from it.

The Big Push

Market failures make initializing growth difficult.
Low initial demand High set-up costs Increasing Returns to Scale Spillovers and underinvestment A concerted economy-wide effort is needed.

Model
One factor of production, Labour (L), is in fixed supply Wage in the traditional sector is assumed as 1 wT = 1. T represent traditional sector Workers in the modern sector receive a wage wM > 1.M represents modern sector

N types of products are produced, where N is a large number

 In the traditional sector, constant returns to scale while in modern sector increasing returns to scale. one worker produces one unit of output in traditional sector. At least F workers are employed to produce output in modern sector. Labour Required in traditional sector: LT=QT Labour Required in modern sector: LM = F + cQM c is the marginal labor required for an additional unit of output. c <1, reflecting the higher productivity of workers in the modern sector.

 Average cost is decreasing in output in the modern sector , while it is constant in the traditional sector.
Cost and Average cost in the traditional sector:

CT = wTLT(QT) = QT
In modern sector CM = wM[F + cQM]

ACT=1
ACM= wMF/QM + wMc

Consumers spend an equal share of national income on the consumption of each good, so that domestic demand for the output of the traditional and modern sector is Y/N.

As assumed perfect competition in traditional sector means P= MC so that PT = MC(QT) = 1. At most one firm can enter each market of the modern sector due to increasing returns to scale in production (natural monopolies).

The monopolist in the modern sector charges a price not more than 1 due to competition by traditional sector because if it charges a price above 1 competition from the traditional sector produces will cause the modern sector firm to loose all of its profits. We also assume that the monopolist will choose to produce at least as much output as the traditional producers for the same level of labor otherwise it would make no sense to switch out of traditional techniques.

Whether or not entry occurs depends on how much more efficient the modern sector is and how much higher the modern sector wage is relative to the traditional sector. With relatively low modern wages it is profitable for a firm to enter in modern sector. If many firms enter in different sectors labor earn high wages and can purchase increased production. The whole economy will industrialize. Demand is now high enough that we end up with point B in each sector

The Big Push

Multiple Equilibria and Coordination Failure

Incumbency and Barriers to Entry Behaviour and Norms Linkages Inequality and Capital Market Imperfections

Incumbency and Barriers to Entry

Sometimes due to the advantages of incumbency, new firm with more productive technology is discouraged from entry. Incumbents are able to take advantage of increasing returns to scale in their own production processes, with lower average costs at higher output levels due to established and large markets for their products

 New entrants face large fixed costs at the beginning and initially small demand for their products. With increasing returns to scale they start out with higher average costs and are not able to price competitively with the incumbent and so entry is not attractive

Behaviour and Norms

Sometimes the incentives provided by social norms and even laws and regulations reward dishonest and corrupt behaviour, driving out honest efforts. Removing social norms that encourage bad behaviour or creating social norms that encourage good behaviour can themselves be subject to coordination failure

Linkages
Backward Linkages raise demand for an activity Forward Linkages lower the costs of using an industries output Forward linkage occurs when the products of one industry is used as the raw material of another industry. It can involve an industry in primary production linking with an industry in secondary production. Forward linkage is when one industry is producing the raw material for another industry. The relationship between a firm or industry and the suppliers of its inputs, or raw materials. An increase in the output of the firm or industry is transmitted backward, yielding an increase in the demand for inputs. Development planners usually prefer to target industries with significant backward linkages, so that investments have additional multiplier effects in generating benefits for other sectors and in helping to further growth in input industries. When certain industries are established first, their linkages with other sectors can facilitate the development of new industries. Target investment in key industries with strong linkages that are less likely to be draw private investment

Inequality and Capital Market Imperfections

The traditional view is that a small amount of inequality is needed to enhance growth because some funds need to be pooled in order to increase savings and investment. However, high inequality could retard growth as the inability to access credit markets due to lack of collateral is part of the definition of poverty. Too few people have the ability to become entrepreneurs because of imperfect credit markets and the indivisible nature of some of the investments

Kremers O-ring Theory

Attempts to explain the existence of poverty traps and why countries caught in poverty traps can have such extremely low incomes compared to richer countries. Features Strong Complementarities in production which results in the positive assortative matching of the factors of production by productivity.

 Production of a single product is broken down into n tasks. 0 < qi < 1, is the skill level with which each component is produced. qi can be interpreted as a measure of quality of the component or the probability that the component will function properly. The total quality of the final product is given by multiplying the quality of the n components. Y = q1 x q2 x q3 xx qn

 Firms are risk-neutral Labour markets are competitive and labour supply is inelastic
So, workers are paid according to their productivity.

Strong complementarities in production Workers are imperfect substitutes for each other. Closed economy (inputs cannot be imported)

Positive Assortative Matching

High productivity firms have the means to attract high productivity workers. High productivity workers prefer to work with high productivity firms because their pay is based on how productive they are and their productivity is affected by the skill level of the workers around them So all the high productivity workers will be grouped together, leaving the low productivity workers to work with other low productivity workers

 It is also socially efficient to group workers together by productivity Suppose that there are 4 workers producing two components to the production of a product and also two types of workers low productivity workers with skill level qL and high productivity workers with skill level qH. So Y = q1q2 Output is higher if we group the workers by skill qH2 + qL2 > 2qHqL

Implications
Firms tend to employ workers with matching skill levels Income is higher for workers in higher-skilled firms so all workers prefer to work in higherskilled firms Wages increase at an increasing rate in quality, explaining the large disparity between wages in developed and developing countries

 Individual decisions to invest in training and education are based on the average skill level of others around you. Multiple equilibria can exist in which everyone invests at a high level or in which every invests at a minimal level leading to lower product quality. Strategic complementarities can result in low-skill equilibria An industrial policy to promote economy-wide quality improvement could result in tremendous growth

 O-ring effects magnify the impact of local production bottlenecks which reduce the incentive of workers to invest in skills. International trade and investment could improve product quality with the importation of higherquality inputs and high-productivity technology. When the availability of high-skilled workers is limited, firms will choose less complicated technology and specialize in the production of simple goods. Large firms that specialize in complex products place a premium on highquality, skilled workers. So the model has predictions on choice of technology given the available skill level.

 The model can also explain international brain drain as highly-skilled workers in developing countries emigrate to developed countries where they can receive higher wages for their skills.