Reviewing contemporary models on economic development:

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Lecture 5

• Reviewing contemporary models on economic
  development
• New (endogenous) growth theory
• Models based on
• Coordination problems between agents and/or
• Imperfect competition
• Externalities
• Multiple equilibria

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New growth theory

• Explains (long-run) per capita income growth
  within the model.
• Is therefore called endogenous growth theory.
• The new growth theory was developed to remedy two
  main drawbacks of neoclassical growth theory
• A large share of economic GNI/cap growth was left
  unexplained by the Solow model.
• There was little evidence of a convergence of
  GNI/cap growth rates, which the Solow model
  predicted.

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The Romer model

• The aggregate production function is
• Y AK??L1-?
• Y is total output
• A represents technological change
• K is the capital stock
• L is the labour force
• ?gt0 expands the contribution of capital to
  output.
• There is a positive capital externality (formally
  a spillover effect across producers in the
  detailed version of the model).

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The Romer model

• The positive external effect is increasing with
  the capital stock.
• This implies that there is (long-term) per capita
  income growth even if A is constant.
• Since there is a growth-generating capital
  externality, investments will be below socially
  optimal levels.
• This implies that there is scope for government
  intervention that (directly or indirectly)
  increases the domestic capital accumulation.

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The Romer model

• Main criticisms
• There is only one type of production in the
  model, so it abstains from explaining structural
  changes.
• Imperfectly functioning markets due to
  institutional constraints etc.
• Has received limited empirical support.

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Coordination

• Everyone is better off from moving into another
  equilibrium.
• These gains can only be attained if agents
  coordinate their actions.
• Coordination failure can be due to
• Lack of information of true conditions
• Different expectations on part of agents.
• Smaller gains from taking action for first mover.

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Coordination failure and economic development

• Based on complementarities between several
  conditions necessary for succesful development.
• Adoption of product techniques characterised by
  network economies (such as communication
  technologies).
• The use and supply of specialised labour skills.
• The demand and supply of modern, highly
  specialised agricultural markets.
• Production of final and intermediate goods in new
  commodity markets.

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Coordination failure models

• Models suggest that there is scope for government
  intervention to assist agents in overcoming
  coordination failures and reach pareto-efficient
  improvements.
• In particular, short-term policies can lead to a
  substantial, permanent, increase in the countrys
  level of economic development.
• Coordination failure between producers often
  takes place in markets characterised by imperfect
  competition and/or externalities.
• Coordination failure models can also explain the
  functioning and persistence of economic and
  political institutions.

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The big push approach

• Development economists often emphasise the role
  of pecuniary externalities in explaining
  underdevelopment.
• Pecuniary externalities are spillover effects on
  costs and revenues.
• The interplay between supply and demand create
  pecuniary externalities.
• Final goods markets.
• Intermediate goods markets.

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The big push approach

• Modern, industrialised, sectors are often
  characterised by increasing returns to scale in
  production.
• Cost-efficient production in the sector hinges on
  a large enough domestic market size.
• The domestic demand for goods produced in the
  sector depends on the number of high-productivity
  workers in the economy.
• The expansion of a modern sector requires a
  larger domestic demand base, but a larger
  domestic demand base requires an expanded modern
  sector.

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The big push approach

• To start up modern final goods production a
  sufficient supply of specialised intermediate
  inputs and services is required.
• Specialised suppliers of intermediate inputs and
  services needs a large enough demand base for
  their products to start up production.
• These effects are strengthened by increasing
  returns to scale in production and/or production
  externalities.

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Coordination failure and institutions

• People form expectations about the interaction
  with others on the basis of past experience.
• This means that institutional systems tend to be
  self-preserving and hard to change.
• In a corrupt society, it is rational to expect
  others to be corrupt.
• Well-functioning political institutions needs
  time to become established because the adoption
  of new norms is a learning-by-doing process.

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The o-ring theory

• Models production with strong complementarities
  between inputs.
• The quality of inputs are jointly reinforcing.
• High-productivity inputs tend to be used together
  by firms that can pay the highest wages.
• This leaves low productivity inputs to be used in
  combination by other firms.

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The o-ring theory

• The production process contains n tasks.
• These tasks are ordered by level of skill
  required q, 0 q 1.
• The higher the skill, the larger the probability
  that the task is succesfully completed.
• The probability of mistakes by different workers
  is strictly independent.

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The o-ring theory

• The o-ring production function is
• E(y) Bqjqk
• E(y) is expected output
• B captures firm characteristics
• There are two production tasks, which are
  performed by worker j and k.
• The skill of one worker reinforces the expected
  output of the other worker.

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The o-ring theory

• A firm with a high-skilled worker can afford to
  pay that worker higher wages and hire another
  high-skilled worker.
• There is a matching of workers according to
  skill.
• Due to the reinforcement effect, the expected
  output of all producers is maximised with
  matching.

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The o-ring theory

• Example There are 2 firms, 2 high-skilled
  workers (qH) and 2 low-skilled workers (qL) B1.
• Expected output without matching
• qLqH qLqH 2 qLqH
• Expected output with matching
• qLqL qHqH qL2 qH2
• If qH0.5 and qL0.1,
• 2 qLqH(20.10.5)0.1
• qL2 qH2 (0.120.52)0.26

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The o-ring theory and economic development

• Low productivity in one sector can obstruct the
  growth process in other sectors.
• Reduces the incentive for private investment.
• Public investment may be required to acheive a
  production shift in the economy.
• The wage premium of education and training tend
  to be much lower in developing countries.
• Leads to so-called brain drain where
  well-educated citizens move to rich developed
  countries.