Economics 281 Chapter 4 PDF

**[Economics 281]** **[Chapter 4]** **[Contemporary Models of development and Underdevelopment:]** - **[Economic development]** is the process of improving the standard of living in a country through economic growth and structural change. - **[Impediments to economic development]** include poverty, inequality, corruption, lack of education and skills, poor infrastructure, and conflict. - **[Catalysts for economic development]** include sound economic policies, foreign investment, technological innovation, and social entrepreneurship. - **[Economic models]** are simplified representations of the economy that help us to understand how it works. - **[Newer economic models]** emphasize coordination problems among economic agents and factors that can influence development, such as increasing returns to scale, division of labour, availability of new economic ideas, information externalities, and various forms of industrial organization beyond perfect competition. - **[Binding constraints]** are the limiting factors that, if addressed, can accelerate growth and development. - **[Economic agents]** are the actors (such as firms, workers, consumers, and government officials) who make decisions to maximize their objectives. Key dates: - The late 1980s: The development of newer economic models that emphasize coordination problems among economic agents and factors that can influence development. Key names: - **[Paul Romer]**: An economist who developed a new economic model that emphasizes the importance of technological innovation in driving economic growth. - **[Douglass North]**: An economist who developed a new economic model that emphasizes the importance of institutions in shaping economic development. **[Definitions:]** - **[Binding constraints:]** - are the specific factors that are preventing an economy from growing or achieving its full potential. These factors can include things like lack of access to capital, poor infrastructure, or inadequate education. When these constraints are addressed, it can lead to significant economic growth and development. - **[Economic agents: ]** - are the individuals and organizations that make up the economy. They include businesses, workers, consumers, and government officials. Economic agents make decisions about how to allocate their resources in order to achieve their goals. These decisions can have a big impact on the overall health of the economy. Here are some additional ways to rewrite the definitions: - **[Binding constraints]** are the bottlenecks that are holding back economic growth. - **[Economic agents]** are the players in the economy who make decisions about how to use resources. [4.1 Underdevelopment as a coordination failure:] ============================================================= **[Key Terms]** - **[Complementarities:]** The condition where multiple factors need to work together simultaneously to achieve sustainable development. - **[Coordination Failure]**: A situation where agents are unable to coordinate their actions, leading to an outcome that leaves all parties worse off than an alternative equilibrium. - **[Endogenous Growth]**: A theory of economic growth that emphasizes the role of innovation and knowledge accumulation in driving economic expansion. - **[Government Policy]**: The actions taken by governments to influence the economy. - **[Modern Communication Technologies]**: Technologies that facilitate communication between individuals and groups, such as the internet, cell phones, and social media. - **[Peasant Farmers]**: Farmers who own or operate small farms and rely on manual labor. - **[Sustainable Development]**: Economic development that meets the needs of the present without compromising the ability of future generations to meet their own needs. **[Definitions]** - **[Complementarities:]** Complementarities exist when two or more factors work together to produce a desired outcome. For example, the development of a new technology may require the training of workers in new skills and the construction of new infrastructure. In this case, the technology, the workers, and the infrastructure are all complements. - **[Coordination Failure]**: Coordination failure occurs when agents are unable to coordinate their actions in a way that produces a mutually beneficial outcome. For example, consider a situation where two firms are both considering investing in a new technology. If both firms invest, they will both benefit from the new technology. However, if only one firm invests, it will not be able to recoup its costs and will be worse off. In this case, there is a coordination failure because the two firms are unable to agree on who should invest first. - **[Endogenous Growth]**: Endogenous growth theory argues that economic growth is not just driven by exogenous factors, such as technological progress, but can also be influenced by endogenous factors, such as government policy and investment in human capital. - **[Government Policy]**: Government policy can have a significant impact on economic development. For example, government policies that promote investment in education and infrastructure can help to boost economic growth. - **[Modern Communication Technologies]**: Modern communication technologies can help to improve coordination and cooperation, which can lead to faster and more sustainable economic growth. For example, cell phones and the internet can be used to connect farmers with markets, workers with jobs, and businesses with customers. - **[Peasant Farmers]**: Peasant farmers are an important part of the agricultural sector in many developing countries. They often face challenges such as limited access to land, credit, and technology. Government policies can help to address these challenges and improve the productivity of peasant farmers. - **[Sustainable Development]**: Sustainable development is a concept that emphasizes the need to meet the needs of the present without compromising the ability of future generations to meet their own needs. This means that economic development must be balanced with environmental protection and social equity. **[Explanations]** - **[Complementarities]**: Complementarities are important in economic development because they can lead to positive feedback loops. For example, when a government invests in education, it can lead to a more skilled workforce, which can then lead to higher productivity and economic growth. This can then lead to further investment in education, and so on. - **[Coordination Failure]**: Coordination failure can be a major obstacle to economic development. For example, if a country has a number of small firms that are all competing in the same market, they may be unable to coordinate their investments in new technology. This can lead to a situation where no firm is able to invest in the new technology, and the country as a whole misses out on the potential benefits of technological innovation. - **[Endogenous Growth]**: Endogenous growth theory has important implications for economic development policy. For example, it suggests that government policies that promote investment in human capital can be an effective way to boost economic growth. - **[Government Policy]**: Government policy can play a variety of roles in economic development. These roles include: - Providing the legal and regulatory framework that allows markets to function effectively - Investing in physical and human capital - Providing social safety nets to protect the poor and vulnerable - Promoting trade and investment - Managing the economy to achieve macroeconomic stability - **[Modern Communication Technologies]**: Modern communication technologies can have a significant impact on economic development in a number of ways. These include: - Improving coordination and cooperation between economic agents - Reducing the costs of information and communication - Expanding access to markets and services - Promoting innovation and entrepreneurship - **[Peasant Farmers]**: Peasant farmers are an important part of the agricultural sector in many developing countries. They often face challenges such as limited access to land, credit, and technology. Government policies can help to address **[Definitions:]** - **[Complementarities:]** Actions taken by different agents that make each other\'s actions more valuable. For example, if one firm invests in a new technology, it will be more valuable to other firms that can use that technology. - **[Coordination failure:]** A situation in which agents are unable to agree on a course of action that would be beneficial to all of them. For example, if a group of firms are all considering investing in a new technology, they may be unable to agree on which firm should make the first move. - **[Big push:]** A government-led effort to promote economic development by investing in a wide range of industries and technologies. - **[O-ring model:]** An economic model that suggests that economic development is often dependent on the coordinated investment of multiple agents. For example, the development of a new aircraft may require the coordinated investment of firms in the aerospace, electronics, and manufacturing industries. - **[Middle-income trap:]** A situation in which an economy has reached middle-income status but is unable to progress to high-income status. This may be due to a number of factors, such as low levels of innovation, poor infrastructure, or high inequality. - **[Underdevelopment trap]**: A situation in which a country is unable to escape poverty. This may be due to a number of factors, such as lack of access to education and healthcare, poor governance, or conflict. - Deep interventions: Government policies that are designed to promote economic development by addressing the underlying causes of underdevelopment. For example, deep interventions may include investments in education, healthcare, and infrastructure, as well as reforms to the legal and regulatory system. - **[Congestion]**: A situation in which too many agents are competing for the same resources. This can lead to a decrease in the value of each agent\'s actions. For example, if too many people are trying to use a public transportation system, it can lead to delays and overcrowding. - **[Where-to-meet dilemma:]** A situation in which two or more parties need to agree on a meeting place, but they cannot communicate with each other. This can lead to a stalemate, as neither party knows where to go. - **[Prisoners\' dilemma]**: A situation in which two prisoners are offered a deal: if they both confess, they will both be sentenced to a shorter prison term. However, if one prisoner confesses and the other does not, the prisoner who confesses will be released, while the other prisoner will be sentenced to a longer prison term. [4.2 Multiple Equilibria: a Diagrammatic approach:] =============================================================== - Multiple equilibria: - Multiple equilibria exist when there are two or more possible outcomes for an economy, depending on the expectations of economic agents. For example, an economy could be stuck in a low-growth equilibrium if agents expect other agents to not invest. - Coordination failures: - Coordination failures occur when economic agents are unable to coordinate their actions, even though it would be in their best interest to do so. For example, investors may be reluctant to invest in a country if they believe that other investors will not invest. - The 45-degree line: - The 45-degree line in the graph represents the point at which expectations match actual outcomes. An equilibrium occurs when the S-shaped curve intersects the 45-degree line. - Stable and unstable equilibria: - Stable equilibria are those that will remain in place even if there are small changes in expectations. Unstable equilibria are those that will shift to another equilibrium if there are even small changes in expectations. - The importance of government policy: - Government policy can play a role in overcoming coordination failures and ensuring that economies achieve the best possible equilibrium. For example, the government can offer incentives for investors to invest, or it can provide information and support to help investors make informed investment decisions. Key points to the graph: - The S-shaped curve represents the \"privately rational decision function.\" This means that the benefits an agent receives from taking an action depend on the actions taken by others. - The 45-degree line represents the point at which expectations match actual outcomes. - The graph shows three possible equilibria: D1, D2, and D3. - D1 and D3 are stable equilibria, while D2 is an unstable equilibrium. - The shape of the S-shaped curve reflects the nature of complementarities. Complementarities occur when the benefits of one agent\'s actions increase with the number of other agents taking similar actions. 1. **[Standard Diagram for Multiple Equilibria:]** - The text introduces a diagram (Figure 4.1) commonly used to illustrate the concept of multiple equilibria and coordination failures in economic development. - This diagram is compared to the well-known supply-and-demand diagram. 2. **[S-Shaped Privately Rational Decision Function:]** - The diagram portrays an S-shaped curve representing the \"privately rational decision function.\" - The benefits an agent receives from taking an action depend on the actions taken by others. - For instance, a farmer\'s selling price depends on the number of middlemen and other farmers participating. 3. **[Equilibrium Points and 45-Degree Line:]** - Equilibrium in this scenario occurs where the S-shaped curve intersects the 45-degree line. - At equilibrium, agents\' expectations match actual outcomes. - Equilibrium is established when participants act in their best interest given what they expect others to do. 4. **[Identifying Equilibria:]** - The diagram\'s S-shaped curve intersects the 45-degree line at three points---D1, D2, and D3---each representing a potential equilibrium. - Of these, D1 and D3 are \"stable\" equilibria, meaning expectations would adjust to maintain these equilibria. 5. **[Stable and Unstable Equilibria:]** - D1 and D3 are stable equilibria because slight changes in expectations would lead to behavioural adjustments that restore the original equilibrium. - D2, the middle equilibrium, is unstable as minor changes in expectations could shift the equilibrium to either D1 or D3. 6. **[Function Shape and Complementarities:]** - The shape of the S-shaped curve reflects the nature of complementarities. - Initially, a few agents\' actions have minimal spill over effects, causing the curve to rise slowly. - As more agents take the action, spill overs increase, and the curve steepens. Eventually, the curve\'s increase slows down as the most important gains are realized. 7. **[Importance of Government Policy:]** - The text emphasizes that coordination problems related to investment decisions with spill overs require government intervention to shift an economy from a less productive to a more productive equilibrium. - Market forces alone may not ensure the best equilibrium. 8. **[Implications for Development:]** - Multiple equilibria and coordination failures are significant challenges in economic development. - These issues can prevent economies from transitioning to higher growth rates or more productive states. - Strategies to overcome these challenges often require government-led efforts to coordinate investments and expectations. 3. [Starting Economic Development: The Big Push ] ========================================================== - Market failures and circular causation: - Market failures occur when the market does not allocate resources efficiently. Circular causation is the idea that the actions of one firm affect the actions of others. In the context of economic development, market failures and circular causation can hinder the initiation of economic development. - Need for a concerted effort and public policy: - The \"big push\" model suggests that market failures and circular causation necessitate an economy-wide and possibly government-led effort to initiate or accelerate economic development. Coordination failure impedes industrialization, and a concerted push is needed to overcome this challenge. - Applicability and recent relevance: - Rosenstein-Rodan\'s model influenced development economics in the 1950s and 1960s. It remains relevant today, especially in explaining the success of East Asian economies like South Korea. Formal models help determine when coordination issues are likely to pose significant challenges. - Modern development theories and coordination failures: - The text mentions the model by Kevin Murphy, Andrei Shleifer, and Robert Vishny, as well as Paul Krugman\'s simplification and popularization of their work. These contributions form the basis for modern development theories addressing coordination failures. - Market failures: Market failures can occur in a variety of ways, including: - Monopolies: When a single firm controls the market for a particular good or service, it can charge higher prices and reduce output. - Externalities: When the production or consumption of a good or service generates costs or benefits that are not reflected in the market price, this is known as an externality. Negative externalities can lead to overproduction, while positive externalities can lead to underproduction. - Information asymmetry: When one party to a transaction has more information than the other party, this can lead to market failures. For example, if a seller knows more about the quality of a product than the buyer, the buyer may be willing to pay more for the product than it is worth. - Circular causation: - Circular causation is the idea that the actions of one firm affect the actions of others. For example, if one factory opens, it may create demand for workers who can then be trained to work in other factories. This can lead to a virtuous circle of economic growth. - Government policy: The government can play a role in overcoming market failures and coordination failures in a number of ways, including: - Regulation: The government can regulate the market to prevent monopolies and externalities. - Subsidies: The government can provide subsidies to firms to encourage investment and production. - Public investment: The government can invest in infrastructure and other public goods that can help to promote economic growth. 1. [The Big Push: a Graphical model] --------------------------------------------- - Assumptions - development has something significant to do with increasing returns to scale, then we will have to sacrifice some generality to address it. We will make six types of assumptions 1. Factors: - Assume there is only one factor of production - Labour - Has a fixed total supply - L 2. **[Factor payments:]** - Labour market has two sectors - Traditional sector: - Worker receive wage of 1 - Wage = numeraire - If wage is 19 pesos per day = amount is called 1 - Morden sector: - Workers receive a wage = W \> 1 - **[Context:]** - The excerpt is situated within broader discussions around economic development issues prevalent in developing countries - It specifically centers around analysing the wage differential typically observed between the traditional and modern sectors in these economies - The aim is to explore the reasons behind this wage differential and its implications for development - **[The Nature of the Wage Differential:]** - A consistent pattern seen in developing countries is a significant wage gap between traditional agricultural/crafts-based work and modern industrialized jobs - Jobs in the modern manufacturing and services sectors tend to offer substantially higher wages compared to traditional subsistence farming or artisanal trades - However, modern sector jobs are also perceived as less desirable and more labour-intensive, yet the wage differential persists - **[Underlying Reasons for the Wage Differential:]** - The higher wages in the modern sector partly compensate workers for the disutility and hardships associated with modern industrialized employment - Features that make modern factory jobs less preferable than traditional work include challenging physical working conditions, highly regimented and repetitive tasks, long or inflexible hours, and an abrupt departure from accustomed rural lifestyles - The wage premium thus provides an economic incentive for workers to shift from traditional occupations to the modern sector as countries industrialize - **[Market Equilibrium and Utility Trade-offs:]** - In a hypothetical scenario of market equilibrium, workers would not gain any net utility benefits from switching from traditional to modern sectors - This is because the disutility and lost utility from taking up industrialized employment would fully offset any advantages from higher modern sector wages - At equilibrium, workers would be indifferent between remaining in the traditional sector or shifting to the modern sector - **[Potential for Pareto Improvements: ]** - However, if economic profits are generated within the modern sector, it can lead to an overall Pareto improvement for society - Investors and business owners benefit from the additional profits created in the modern sector - Since no one is made worse off, while some become better off, there is an increase in total welfare and average incomes rise - Appropriate income redistribution policies could further enhance these Pareto improvements - **[Role of Surplus Labour and Opportunity Costs:]** - The presence of surplus labour and under-employment in the traditional sector also amplifies the potential social benefits of industrialization - Modern sector wages that exceed the opportunity costs of labour in the subsistence agricultural or artisanal trades provide an added incentive to transition - Absorbing this surplus labour into the higher productivity modern sector contributes to overall economic development - **[Beyond High Modern Sector Wages:]** - The model focuses specifically on a scenario where high modern sector wages cause coordination problems that result in underdevelopment traps - However, high modern wages are just one particular circumstance that can precipitate coordination failures - Even in cases where modern sector wages are on par with traditional incomes, coordination problems could still arise and hamper development - **[Interactions Between Key Variables: ]** - The passage highlights the complex interrelationships between the wage differential, disutility of modern work, economic profits, surplus labour, and coordination failures - It utilizes a simplified model to illustrate the dynamics at play in initiating economic development and industrialization - But in reality, coordination failures and barriers to development arise through many other mechanisms beyond just wage differentials 3. **[Technology:]** - Product Diversity and Quantity: - The model considers N different types of products, where N is a large number, allowing for a wide variety of potential goods to be produced. - This diversity in product types reflects the reality that developing countries often have a large number of small-scale producers, each specializing in a particular product or service. - The model also assumes that each product can be produced in a variety of quantities, from small-scale production for local consumption to large-scale production for export. - Flexible Output Units: - The model introduces flexibility in defining output units by using an example: a worker producing 3 pairs of shoes per day is counted as 1 unit of output. - This flexibility accommodates various real-world scenarios where output units might not directly correspond to the individual worker\'s effort. - For example, a worker in the agricultural sector might produce a certain quantity of crops, while a worker in the manufacturing sector might produce a certain quantity of manufactured goods. - Increasing Returns to Scale in Modern Sector: - The modern sector of the economy exhibits increasing returns to scale, which implies that larger production leads to lower average costs. - This effect is introduced through the presence of a fixed cost denoted as F. - F represents the minimum number of workers required to produce any product in the modern sector. - By imposing a fixed labour requirement, the model introduces a fixed cost element similar to a setup cost. - The presence of increasing returns to scale in the modern sector means that there are significant economies of scale to be reaped from larger production. - Fixed Cost and Labour: - Given the absence of capital in the model, the fixed cost F is specified in terms of labour requirements. - The model assumes that beyond the fixed labour cost F, there is a linear production function with marginal labour requirement c, where c \< 1. - In essence, modern sector workers are more productive than their traditional sector counterparts. - This means that each additional unit of output requires fewer additional workers in the modern sector than in the traditional sector. - Total Labour Requirement: - The total labour needed to produce Q units of output in the modern sector is given by L = F + cQ. - This formulation captures the fixed labour cost F and the additional labour required to produce Q units. - As output (Q) increases, the fixed cost F is spread over more units, leading to a reduction in average costs due to increasing returns to scale. - Trade-off and Increasing Marginal Productivity: - The model presents a trade-off: a higher upfront fixed cost F is associated with greater marginal productivity of modern sector workers. - This means that there is a balance to be struck between the costs and benefits of investing in the modern sector. - If the fixed cost F is too high, it may not be worthwhile to invest in the modern sector, even though the marginal productivity of modern sector workers is higher. - However, if the fixed cost F is too low, then there may not be enough economies of scale to reap the benefits of investing in the modern sector. - Symmetric Production Function: - The same production function with fixed labour requirement F and marginal labour requirement c applies to all products in the modern sector. - This assumption of symmetry simplifies the model\'s representation while capturing the key dynamics of increasing returns to scale. - It also implies that there is no difference in the productivity of workers across different products in the modern sector. 4. **[Domestic demand:]** - Each of the N goods receives an equal share of consumption spending out of total national income Y. - The model has a single time period, with no assets or saving. - Therefore, all national income Y is spent on consumption in the same period. - With N different goods, and total spending of Y, the amount spent on each individual good is Y/N. - So if there are 100 goods (N=100) and national income is \$1000 (Y=\$1000), then \$10 (1000/100) is spent on each good. - This assumes consumers evenly distribute their total spending across all available goods in the economy. - With no saving or assets, the lack of intertemporal decision making simplifies the single-period model. - In summary, the model assumes consumers spend an equal fraction of national income on each good, distributing their consumption evenly across all products in the economy within the same time period. This captures consumer behaviours in a simple way without modelling saving or asset accumulation. 5. **[International supply and demand:]** - The economy is assumed to be closed, with no international trade. - This simplifying assumption makes the model easier to develop and analyse. - The main conclusions will remain valid even when trade is allowed, as long as there are advantages to having a domestic market. - Such advantages include: - Economies of scale and learning effects to achieve sufficient quality before exporting - Favourable product characteristics tailored to domestic consumers - Better customer service and support for a known domestic market - Evidence shows export success in countries like South Korea has been built on first establishing a sizable domestic market. - Export-led economies have also benefited from industrial policies aimed at overcoming coordination failures. - Even with a fully open global economy, the conclusions can hold if: - Some necessary inputs are non-tradable services - Infrastructure investment models imply the need for a concerted \'big push\' 6. **[Market structure:]** - The traditional cottage industry sector has perfect competition, free entry, and no economic profits. - Therefore, the price of each traditional good is 1, equal to the marginal cost of labour (the only input). - In the modern sector, at most one firm can enter and produce each good, due to increasing returns to scale. - This creates a monopoly for whichever modern firm enters a market. - Given the demand assumptions, the modern monopolist faces unit elastic demand. - If the monopolist tried to charge a price above 1, it would be profitable. - However, any price above 1 would allow traditional sector producers to undercut the monopolist and capture the entire market. - So the profit-maximizing price for a modern monopolist is also 1. - At this price, the monopolist will supply the entire market demand if it enters. - But the quantity supplied will be the same as under perfect competition. - With the wage rate at 1 in other sectors, national income stays essentially unchanged. - So demand remains the same, and more output cannot be sold at the profit-maximizing monopoly price. - It is assumed modern firms can produce at least as much output with the same labour as traditional firms. Otherwise, there is no incentive to adopt modern production techniques. ### **[Conditions for Multiple equilibria:]** - Consider a potential modern firm deciding whether to enter a market consisting only of traditional firms. - **[Profitability of entry depends on:]** - Efficiency of modern vs. traditional production - Wage differential between modern and traditional sectors - **[Figure 4.2 shows]** production functions for traditional (slope=1) and modern (slope=1/c) firms. - With wage line W1 below point A, the modern firm enters and makes profits. The whole economy industrializes. - With wage line W2 between A and B, the modern firm does not enter alone, but if all markets industrialize, output and income expand, making entry profitable at point B. - With wage line W3 above point B, losses occur even with full industrialization. Traditional techniques continue. - If wage line is below A, industrialization happens automatically. If above B, it does not happen. - Between A and B, industrialization is efficient but won\'t occur through markets alone due to coordination failure. - Problematic cases have two equilibria: - No industrialization at A - Efficient industrialization at B - Markets won\'t move economy from A to B due to coordination failure. Policy can play a role. - Where a specific economy lies on this continuum is unclear. But it explains why development stalls even when technology exists. - Figure 4.2 shows potential for multiple equilibria more precisely than Figure 4.1. - Reasons beyond wage premiums can cause need for big push. Various coordination failures are possible. - Complete industrialization across all sectors not needed. Sufficient sectors industrializing can provide the \"push.\" - **[The Graph:]** - Plots output Q on the horizontal axis and wages/costs on the vertical axis - Shows production functions for traditional and modern firms - Traditional function is linear with slope 1 - Modern function has fixed cost F as minimum labour requirement, then linear portion with slope 1/c \< 1 - Wage lines W1, W2, W3 depict potential wage rates - **[The Key Points:]** - If wage line is below point A (e.g. W1), modern firm enters and makes profit - If wage line is between A and B (e.g. W2), modern firm won\'t enter alone but will if whole economy industrializes - If wage line is above point B (e.g. W3), losses even with full industrialization - Below A: automatic industrialization - Above B: no industrialization - Between A and B: coordination failure prevents shift from A to efficient B - The Variables: - F - Fixed cost (minimum labour for modern firm) - c - Marginal labour requirement for modern firm - W - Wage rate - Q - Output - Relative levels of F, c, W determine position of wage line - Wage line position affects feasibility and incentives for industrialization 2. [Other cases in which a Big Push may be necessary:] --------------------------------------------------------------- **[Intertemporal Effects]** - When investment in the present period leads to higher profits in the future, but depresses current profits, then there may be multiple equilibria. - In this case, a big push may be necessary to ensure that enough investment takes place in the current period to generate higher profits in the future. - For example, if a country needs to invest in education and training in order to industrialize, then the benefits of this investment will not be realized immediately. There will be a short-term cost in terms of lost output, but this cost will be outweighed by the long-term benefits of a more skilled workforce. **[Urbanization Effects]** - If industrialization is concentrated in urban areas, then there may be multiple equilibria. - In this case, a big push may be necessary to ensure that enough people migrate to urban areas to support industrialization. - For example, if a country has a large rural population, then it may need to invest in infrastructure and other services to make urban areas more attractive to migrants. **[Infrastructure Effects]** - If infrastructure investments are necessary for industrialization, but are not profitable for private investors, then there may be multiple equilibria. - In this case, a big push may be necessary to ensure that these infrastructure investments are made. - For example, if a country needs to build roads and railways in order to connect its markets, then the private sector may not be willing to make these investments on its own. **[Training Effects]** - If firms do not invest in training workers because they fear that the workers will be poached by other firms, then there may be multiple equilibria. - In this case, a big push may be necessary to ensure that enough workers are trained. - For example, if a country wants to develop a skilled workforce, then it may need to provide subsidies or tax breaks to firms that invest in training. **[Limitations of a Super-Entrepreneur Solution]** - The idea of a single super-entrepreneur coordinating and profiting from multiple markets is theoretically challenged. - Capital market failures, agency costs, communication failures, limits to knowledge, and other diseconomies of scope hinder the feasibility of such a solution. - For example, it would be difficult for a single entrepreneur to raise the capital needed to invest in multiple industries. Additionally, it would be difficult for an entrepreneur to monitor and manage multiple businesses effectively. **[Empirical Evidence]** - Empirically, no private agent has been observed acting as a super-entrepreneur. - Large firms aren\'t necessarily the solution, as the problems of monitoring, knowledge, and capital markets persist. - Direct government production, as seen in the Soviet Union, also hasn\'t resolved the problem effectively. **[Role of Public Coordination]** - Solving the coordination failure generally requires public coordination of private investors, often through industrial policy. - Successful cases of development, particularly in East Asia, are often attributed to effective public coordination. - For example, the East Asian governments played a key role in coordinating investment and providing support to key industries. - In conclusion, the need for a big push policy arises due to multiple equilibria caused by external effects and coordination failures. Various factors like intertemporal effects, urbanization, infrastructure, and training contribute to these failures, and a super-entrepreneur solution is unlikely due to practical challenges and empirical evidence. Public coordination through industrial policy emerges as a more viable solution. **[Additional Information:]** 1. **[Intertemporal Effects]** - With investment in period 1 lowering demand then but raising it in period 2, multiple equilibria can occur even if wages are equal across sectors - Investment in period 1 only undertaken if profitable based on expected demand in period 2 - This requires coordinated investment across many sectors - Market does not ensure efficient industrialization due to pecuniary externalities 2. **[Urbanization Effects]** - If traditional sector is rural and modern sector is urban, urban demand may favour manufactured goods - Urbanization \"push\" may be needed to spur industrialization 3. **[Infrastructure Effects ]** - Investing modern firms help cover fixed costs of infrastructure like railroads or ports - This lowers costs for other firms, an externality not captured - Critical that one sector\'s investment increases market size for infrastructure used by other sectors 4. **[Training Effects]** - Underinvestment in training due to poaching of trained workers (labour market failure) - Lack of worker demand for skills when firms\' investment plans unclear - Public coordination may be needed to solve training coordination failures - In each case, the external benefits of one firm\'s investment for other firms leads to a coordination failure without concerted public action. **[Definitions:]** - **[Pecuniary externality:]** A positive or negative spill over effect on an agents costs or revenue. - **[Technological externality:]** A positive or negative spill over effect on a firms production function through some means other than the market exchange. - **[Agency Cost:]** Costs of monitoring managers and other employees and of designing and implementing schemes to ensure compliance or provide incentives to follow the wishes of the employer. **[-Asymmetric information:]** A situation in which one party to a potential transaction has more information than another party. 4. [further problems of Multiple equilibria:] ====================================================== 3. [inefficient Advantages of Incumbency:] --------------------------------------------------- **[Introduction:]** - Increasing returns to scale in modern industries can lead to another detrimental equilibrium. - Established modern firms have an advantage due to lower average costs resulting from economies of scale. - New technology might struggle to replace older technology even if it offers lower per-unit costs. - Advantage of established firms comes from a larger customer base and amortization of fixed costs. **[Challenge of New Technology Adoption:]** - New and improved technology may emerge, promising lower per-unit costs. - However, existing firms with economies of scale can maintain a competitive edge. - Established firms can produce at lower per-unit costs due to their large output, while new entrants start with small customer bases and high fixed costs. - New entrants may struggle to attract customers and bear high initial fixed costs. **[Capital Markets and Capital Access:]** - Successful transition to advanced technology requires substantial capital. - New entrants need resources to build customer base and overcome initial cost disadvantage. - Effective capital markets are crucial for providing necessary funds during the transition. - Inadequate capital markets, common in developing countries, hinder technology transition. - Capital markets facilitate access to financing, allowing firms to absorb initial losses and cover high fixed costs. **[Consequences of Inadequate Capital Markets:]** - Without functional capital markets, transitioning firms might face difficulties. - Firms could remain entrenched in less cost-effective technologies. - Economic progress towards efficiency could be hampered. - Unfavourable equilibrium could persist, preventing the adoption of better technologies. **[Importance of Functional Capital Markets:]** - Functional capital markets enable firms to transition to advanced technologies. - Access to capital helps firms overcome initial challenges and achieve economies of scale. - Allows new technologies to compete effectively against established ones. - Promotes economic growth by facilitating technological progress and industry transformation. **[Conclusion:]** - The presence of increasing returns in modern industries creates challenges for technology adoption. - Established firms have advantages due to economies of scale, making it difficult for new technologies to displace old ones. - Effective capital markets are essential for enabling firms to transition successfully and achieve economies of scale with new technologies. - Inadequate capital markets can perpetuate unfavourable equilibria, hindering economic development and progress. 4. [Behaviour and Norms ] ---------------------------------- - **[Transitioning Behaviour: ]** - Shifting from unfavourable equilibria to better ones can be challenging. This is because it often requires individuals to abandon rent-seeking or corrupt practices in favour of cooperation and honesty. This can be difficult, especially if individuals have a history of engaging in these behaviours and have come to expect rewards for doing so. - Additionally, cooperation and honesty become more valuable for reaping long-term gains. This is because cooperation can lead to the development of trust and reputation, which can then be used to build stronger relationships and achieve greater success in the future. - **[Cooperation Dynamics: ]** - The choice of business partners becomes crucial for successful transition. If individuals cooperate with opportunistic partners, they may be taken advantage of and suffer negative outcomes. On the other hand, if individuals cooperate with genuinely cooperative partners, they can reap the benefits of cooperation and build stronger relationships. - The optimal outcome requires cooperation among genuinely cooperative individuals. This is because cooperation is a two-way street and requires that both parties be willing to trust and sacrifice for the benefit of the other. If one party is not cooperative, the other party is likely to suffer negative consequences. - Cooperative behaviour promotes positive outcomes, but past experiences can shape expectations. If individuals have had negative experiences with cooperation in the past, they may be less likely to cooperate in the future. This can create a self-fulfilling prophecy, as individuals who are less likely to cooperate are less likely to reap the benefits of cooperation. - **[Incentives for Dishonesty: ]** - In settings where dishonesty is common, incentives lie in being dishonest. This is because dishonesty can offer gains, while honesty may result in losses. For example, if it is common for businesses to bribe government officials in order to get favourable treatment, then businesses that do not bribe may be at a disadvantage. - This can create a self-perpetuating cycle of dishonesty, as individuals and businesses are incentivized to engage in dishonest behaviour in order to compete. This can make it difficult to transition to a more honest equilibrium. - **[Norm Enforcement and Institutions: ]** - In some contexts, individuals take on the role of enforcing norms instead of relying solely on government. This can be done through social sanctions, such as ostracism or shunning. Collaborative norm enforcement keeps the burden low for each individual, as the costs of enforcing norms are shared among many people. - Equilibrium can shift between resisting corruption (rare) and embracing corruption (common). This is because the equilibrium that emerges depends on the prevailing norms and the incentives that individuals face. If norms favour honesty and cooperation, then individuals are more likely to behave honestly and cooperate with each other. However, if norms favour dishonesty and competition, then individuals are more likely to behave dishonestly and compete with each other. - **[Role of Institutions: ]** - Institutions play a fundamental role in long-term economic development. This is because institutions shape the incentives that individuals and businesses face. Strong institutions that promote honesty, cooperation, and competition can create an environment that is conducive to economic growth. - Good organizations cannot succeed if the rules of the game reward bad ones. This is because organizations are ultimately made up of individuals, and individuals will behave in accordance with the incentives that they face. If the rules of the game reward dishonesty and corruption, then organizations are more likely to engage in these behaviours. - Policies for developing or reforming institutions are crucial. These policies can help to create an environment that is conducive to honest and cooperative behaviour. For example, policies that promote property rights, antitrust, clean government, and industry norms can help to create an environment that is supportive of economic development. - **[Inertia of Norms: ]** - Norms exhibit inertia and are challenging to change. This is because norms are often deeply embedded in a society\'s culture and history. Even once-adaptive norms can become dysfunctional as conditions evolve. For example, norms that favour large families may have been adaptive in the past, when land was abundant and labour was scarce. However, these norms may be dysfunctional in the modern era, when land is scarce and labour is abundant. - Examples include outdated values of citizenship or excessive family trust that hinder modern business partnerships. These norms can make it difficult to transition to a more modern and efficient economic system. **[Transitioning to Better Equilibria]** - **[Behavioural challenges: ]** - Individuals must abandon rent-seeking or corrupt practices in favour of cooperation and honesty. - Cooperation and honesty are more valuable for long-term gains. - **[Cooperation dynamics: ]** - Choosing business partners carefully is crucial for successful transition. - Cooperating with opportunistic partners can lead to negative outcomes. - Optimal outcome requires cooperation among genuinely cooperative individuals. - Cooperative behaviour promotes positive outcomes, but past experiences can shape expectations. - **[Incentives for dishonesty: ]** - In settings where dishonesty is common, incentives lie in being dishonest. - If being honest leads to losses while dishonesty offers gains, dishonesty prevails. - Behaviour and incentives can create a self-perpetuating cycle of dishonesty. - **[Norm enforcement and institutions: ]** - In some cases, individuals take responsibility to enforce norms rather than relying on government. - Many people working together to enforce norms keeps enforcement burden low. - Equilibrium can shift between resisting corruption (rare) and embracing corruption (common). - **[Role of institutions: ]** - Institutions play a fundamental role in long-term economic development. - Good organizations can\'t succeed if rules of the game reward bad ones. - Policies for developing or reforming institutions are crucial. - Reforms involve property rights, antitrust, clean government rules, regulations, and industry norms. - Transitioning to new norms is challenging but once established, it\'s easier to maintain. - **[Inertia of norms: ]** - Norms are subject to inertia and can be hard to change. - Even adaptive norms can become dysfunctional as conditions evolve. - Examples include outdated values of citizenship or excessive family trust that hinder modern business partnerships. **[Conclusion:]** - Shifting to better equilibria involves overcoming challenges related to behaviour, cooperation, incentives, and norms. - Institutions and policies play a crucial role in facilitating these transitions. - Norms are powerful but can be difficult to change even when they become counterproductive. 5. [Linkages:] ----------------------- **[Strategies for Implementing a Big Push]** - **[Linkage-Based Strategy: ]** - Government policy can focus on developing industries with essential linkages to other sectors. - This can be done through subsidies, incentives, attracting multinational firms, or establishing public enterprises. - **[Linkages and Industrialization: ]** - Linkages are connections between firms based on sales, involving backward and forward links. - Backward linkages are when a firm buys goods from another firm as inputs. - Forward linkages are when a firm sells goods to another firm. - Linkages are crucial for industrialization strategy, especially when industries have increasing returns to scale. - Increasing returns to scale means that the cost of producing each unit of output falls as the total output produced increases. - A larger market size can exploit increasing returns to scale in linked industries. - Linkages can also create cost reductions due to increasing returns in linked industries. - **[Effective Linkage Strategies: ]** - Select industries with strong linkages and a higher number of links to other sectors. - Prioritize industries with stronger and more numerous links. - Target industries with less private investment likelihood, addressing critical bottlenecks. - Justify strategic government entry into less profitable industries due to their developmental benefits. - Consider the roles of state-owned and private enterprises in developmental linkages when comparing their efficiency. - **[Government Intervention and Enterprise Efficiency: ]** - State-owned enterprises (SOEs) are often compared to private enterprises in terms of efficiency. - Government entering strategic but less profitable industries is justifiable for development. - Efficiency comparisons should consider strategic complementarities and linkages. - A blanket statement against government production is not always reasonable considering linkages. **[Conclusion:]** - Implementing a big push involves focusing on industries with key linkages to overcome coordination failures. - Strategies include subsidies, incentives, multinational firm involvement, and public enterprises. - Linkages are essential for successful industrialization, especially in industries with increasing returns to scale. - Government intervention in less profitable industries is justified for developmental benefits and addressing bottlenecks. - Efficiency debates between state-owned and private enterprises need contextual considerations. **[Linkage-Focused Policies for Development]** - Linkage-focused policies aim to encourage simultaneous expansion across multiple interconnected industries. - **[Examples include: ]** - Subsidies or incentives for domestic firms to enter key linkage industries. - Attracting multinationals to invest in key industries and provide training. - Establishing pioneering public enterprises in key industries. - Linkage theory stresses how developing certain industries first can facilitate development of new industries through interconnections. - Backward linkages raise demand for an activity. - Forward linkages lower costs of using an output. - Linkages are especially important when industries involved have increasing returns to scale. - Linkage policies target investment in key linkage industries to overcome coordination failures and generate positive feedback. - Industries with more and stronger links to others, and less private investment, are priorities. - This provides a rationale for state-owned enterprises in some vital but less profitable industries. - While state enterprises are often less efficient, a blanket stance against any state production role fails to consider strategic complementarities. **[Conclusion]** - Linkage-focused policies, including strategic roles for state enterprises, can help coordinate expansion across interdependent industries as part of a big push for development. **[Definitions:]** - **[Linkages:]** a. Connections between firms based on sales. b. A backward linkage: - Is one in which a firm buys a good from another firm to use as an input c. A forward linkage: - Is one in which a firm sells to another firm d. Such linkages are especially significant: I. For industrialisation strategy when one or more of the industries involved has increasing returns to scale that a larger market takes advantage of. 6. [Inequality, Multiple Equilibria, and Growth:] ---------------------------------------------------------- **[Traditional View on Inequality and Growth:]** - Inequality and Savings: Traditional view suggests some inequality might enhance growth due to higher savings by the rich. - Savings for Investment: Rich\'s savings contribute to investment, crucial for economic growth. - Degree of Equality and Growth: Excessive equality might hinder growth as it limits investment potential. **[Reassessment of Poor\'s Savings:]** - Higher Poor Savings: Poor save more than believed when including expenditures on health, education, and home improvements. - Inequality Impact on Loans: High inequality can prevent poor from obtaining loans due to lack of collateral. - Poor and Capital Market Imperfections: Lack of collateral can trap poor in subsistence or wage employment. - Credit Market Imperfections: Imperfect credit markets lead to equilibria where few can become entrepreneurs. **[Impact on Education:]** - Access to Credit and Schooling: Lack of credit access can prevent poor from financing productive schooling. - Poverty Trap: Poor without credit access can stay trapped in poverty across generations. - Human Capital Accumulation: Transfer from parents for human capital goes beyond tuition or forgone wages. **[Formal Model by Galor and Zeira:]** - Endogenous Growth Model: Developed by Oded Galor and Joseph Zeira. - Importance of Human Capital and Distribution:\*Emphasizes the role of human capital, distribution, and their interaction in growth and development. - Critical Assumptions: Imperfect capital markets and indivisibilities in human capital investment. - Indivisibilities in Investment: Human capital investment treated as discrete packages (e.g., years of schooling). - Increasing Returns to Scale: Indivisibilities lead to increasing returns, similar to the big push model. - Sheepskin Effect: Jump in returns when passing certain education milestones due to proving completion of requirements. - Role of Increasing Returns: Increasing returns contribute to generating multiple equilibria. - Empirical Findings: Many studies show negative inequality-growth relationship, especially after 1980. **[Conclusion:]** - Inequality and Savings Reconsidered: Poor savings, credit market imperfections, and education impact inequality\'s effect on growth. - Indivisibilities and Increasing Returns: Indivisibilities in investment and increasing returns play pivotal roles in generating equilibria. - Empirical Trends: Studies reveal a negative relationship between inequality and growth, particularly post-1980. **[Definitions:]** - **[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 5. [Michael Kremer's O-ring theory of Economic development] ==================================================================== Applications and Policy Implications - **[Education]**: Investment in education is essential for breaking out of poverty traps. Education can help to improve productivity, develop skills, and create a more skilled workforce. It can also help to promote innovation and entrepreneurship. - **[Healthcare]**: Investment in healthcare is also essential for breaking out of poverty traps. Healthcare can help to improve the health of the population, reduce mortality rates, and increase life expectancy. It can also help to reduce the burden of disease and disability, which can free up resources for other investments. - **[Infrastructure]**: Investment in infrastructure is also important for breaking out of poverty traps. Infrastructure can help to improve transportation, communication, and energy systems. It can also help to connect rural areas to markets and create jobs. - **[Other sectors]**: There are also a number of other sectors that are important for breaking out of poverty traps, such as agriculture, manufacturing, and finance. Investment in these sectors can help to increase productivity, create jobs, and promote economic growth. Critiques and Further Research - **[Criticisms]**: Some critics of the O-ring theory argue that it is too simplistic and does not take into account the full complexity of development. They argue that there are a number of other factors that can also contribute to poverty traps, such as political instability, institutional weakness, and unfavourable global market conditions. - **[Further research]**: Further research is needed to refine the O-ring theory and consider its interaction with other economic and social factors. This research could help to identify more effective ways to break out of poverty traps and promote sustained development. Global Development Context - **[Challenges]**: The O-ring theory highlights the challenges faced by developing countries striving to overcome poverty and achieve sustainable growth. These challenges include: - Low levels of investment in education, healthcare, and infrastructure - Political instability and weak institutions - Unfavourable global market conditions - **[Opportunities]**: The O-ring theory also highlights the opportunities for development. By understanding the interconnectedness of various factors that contribute to economic growth, policymakers and development practitioners can work towards breaking the cycle of poverty and promoting sustained development. **[Conclusion]** - The O-ring theory is a valuable tool for understanding the dynamics of development and designing effective development strategies. - By understanding the role of strong complementarities and coordination failures, policymakers and development practitioners can work towards breaking the cycle of poverty and promoting sustained development. - **[The O-ring theory: ]** - The O-ring theory is a development economics theory that explains how countries can get stuck in poverty traps. The theory argues that economic growth requires coordinated investment in a wide range of complementary activities. If any one of these activities is not adequately developed, the entire system can fail. - **[Applications and policy implications:]** - The O-ring theory has a number of applications and policy implications. It can be used to design effective development strategies, identify areas where investment is needed, and coordinate efforts between different sectors. - **[Critiques and further research:]** - The O-ring theory has been criticized for being too simplistic. Critics argue that it does not take into account the full complexity of development. However, the theory has also been praised for its insights into the importance of coordination and complementarities for economic growth. - **[Global development context:]** - The O-ring theory is particularly relevant to developing countries. These countries often face challenges such as low levels of investment, political instability, and weak institutions. The O-ring theory can help policymakers and development practitioners to understand these challenges and design effective strategies for overcoming them. 7. [The O-Ring Model:] ------------------------------- **[O-Ring Production Function]** - Models production as n complementary tasks, each with quality level qi where 0 ≤ qi ≤ 1. - B is a multiplier term depending on number of tasks. - With 2 workers per firm, output is: BF(qi, qj) = qi \* qj - More generally with n workers and tasks: Output = B \* Π qi for i = 1 to n **[Key Features and Assumptions]** - Firms are risk-neutral. - Competitive labour markets. - Workers supply labour inelastically. - Competitive capital markets. - Closed economy. **[Positive Assortative Matching]** - High skill workers match with each other, low skill match with each other. - In a 4 worker example with qH and qL: qH\^2 + qL\^2 ≥ 2qHqL - This generalizes to larger economies - workers sort by skill level. - Firms with high q workers can pay more to attract other high q workers. **[Imperfect Substitutability and Task Complementarity]** - Model relies on: - Imperfect substitutability of workers. - Complementarity of tasks. - With perfect substitutes, no prediction on skill combinations. - With no task complementarity and production function: F(qH, qL) = g(qH) + h(qL) - There is no interdependence between tasks, so no strategic complementarity. **[Introduction to the O-Ring Theory: Strong Complementarities in Production:]** - Michael Kremer\'s O-Ring theory explains the role of strong complementarities in modern production. - Strong complementarities refer to the interconnectedness of tasks in a production process. - This theory offers insights into how successful completion of multiple tasks together leads to high-value production, similar to specialization and division of labour in developed economies. **[Model Basics and Skill Levels (q):]** - The model breaks down a production process into n tasks, indexed by q, representing skill level. - Skills are ordered as 0 ≤ q ≤ 1, with higher q indicating higher skill. - The theory focuses on successful task completion to achieve high productivity. **[Production Function:]** - The production function represents the value of output. - It multiplies the q values of tasks together and is characterized by strong complementarities. - The output formula, ignoring other factors, is given by: Output = q1 \* q2 \* q3 \* \... \* qn. **[Positive Assortative Matching and Skill Sorting:]** - Positive assortative matching refers to high-skill workers tending to work together. - This leads to higher productivity as the output benefits from the combined high skills. - Skill sorting is a consequence of this matching, concentrating high-value products in skill-intensive countries. **[Competitive Markets and Wage Incentives:]** - In competitive markets, wages are determined by productivity. - High-skill workers have a higher incentive to work together due to the productivity gains. - Firms are motivated to bid more for high-skill workers to increase their overall output. **[Implications for Economic Development:]** - Low-skill firms or economies can become trapped in low skill and productivity due to complementarity effects. - High-skill firms engage in continuous skill upgrading, driving economic growth. - Increasing skill levels lead to higher wages, contributing to a cycle of development. **[Conditions for Positive Assortative Matching:]** - Imperfect substitutability among workers is necessary for the O-ring effect. - Workers cannot be perfect substitutes; otherwise, skill sorting wouldn\'t occur. - Complementarity of tasks is essential; tasks must interact and support each other. **[Numerical Example: Skill Upgrading:]** - A numerical example demonstrates the impact of skill upgrading on output. - A 25% increase in skill leads to a proportional increase in output, but the actual value increase is higher for higher initial skills. - High-skill firms continuously upgrading skills create a virtuous cycle of increasing output and wages. **[Extensions and Real-World Considerations:]** - The O-ring model\'s assumptions may oversimplify real-world complexities. - Empirical evidence supports imperfect substitutability among worker types in firms. - Complementarity of tasks is crucial for the model\'s predictions. 8. [Implication of The O-Ring theory:] ----------------------------------------------- Implications of the O-Ring Theory for Economic Development Skill-Matching in Firms: - Firms tend to hire workers with similar skills for their tasks. - Skill assortative matching is essential for the O-ring effects to occur. Wage Disparities within Firms: - Workers performing the same tasks earn higher wages in high-skill firms compared to low-skill firms. - Wages increase at an increasing rate with skill levels due to the O-ring effect. - Developed countries witness wages that are disproportionately higher than predicted by standard skill measures. Skill Investments and Interdependence: - Workers consider the skill levels of others as they make their own skill investments. - Higher average skills in the environment encourage individuals to acquire more skills. - This interdependence creates conditions for multiple equilibria to emerge, similar to the big push model. Economy-Wide Traps and Industrial Policy: - Low-production-quality traps can emerge across the economy due to O-ring effects across firms. - Industrial policies may be needed to encourage quality upgrading and escape from low-level equilibria. - Countries trapped in middle-income levels might benefit from strategies to overcome these traps. Amplification of Production Bottlenecks: - O-ring effects magnify the impact of local production bottlenecks. - Bottlenecks reduce the incentive for workers to invest in skills due to lower expected returns. Trade, Investment, and Bottlenecks: - International trade and investment can alleviate production bottlenecks by providing alternative sources of inputs. - Countries with limited international integration might face more significant challenges due to lack of foreign inputs. Technology Choice and Firm Size: - Firms are less likely to choose complex production technologies with many tasks when skills are scarce. - Firms value high-quality, skilled workers more when products or technologies require large-scale deployment or many steps. - Rich countries with high-skill workers tend to have larger firms and specialize in complex products. International Brain Drain: - The model can explain the phenomenon of the brain drain, where workers moving from developing to developed countries experience immediate wage increases. - O-ring effects and skill interdependence contribute to this wage disparity. O-Ring Production Function - Models production as complementary tasks, each with quality level qi. - Output is the multiplicative product of all qi. - Exhibits increasing returns to scale. Key Features and Assumptions - Firms are risk-neutral. - Competitive labour and capital markets. - Inelastic labour supply. - Closed economy. Positive Assortative Matching - High-skill workers match with each other, low-skill workers match with each other. - Sorting raises total output and wages compared to skill mixing. - Follows from the multiplicative O-ring production function. - Analogous to \"marriage market\" sorting by attractiveness. Development Traps - Can get caught in a low-skill/low-productivity equilibrium. - A raise in any worker\'s skill has a much bigger impact when starting from a higher base. - High-skill firms are incentivized to invest more in upgrading skills. - Complementarities lead to inertia and bad path dependence. Multiple Equilibria - Choices about skill acquisition can exhibit strategic complementarity. - Individual skill investments depend on economy-wide skill levels. - Can have high-skill and low-skill economy equilibria. Implications - Wage premiums in high-skill firms and economies. - Discourages advanced technologies in low-skill economies. - Magnifies bottlenecks - reduces incentives for skill everywhere. - Rationale for industrial policies to encourage skill/quality upgrades. - Explains larger firms and wage premiums in high-skill countries. - Contributes to international brain drain. 6. [ Economic Development as Self-Discovery:] ====================================================== Economic Development as Self-Discovery - Challenges of Comparative Advantage: - Individuals must identify their optimal career paths in labour markets. - Nations need to determine the most advantageous activities to specialize in. - Specifying \"labour-intensive products\" is insufficient due to vast product diversity and varying production costs. - Value of Self-Discovery: - Self-discovery involves recognizing products with low domestic production costs. - Discovering profitable activities leads to imitation and the birth of new domestic industries. - The term \"self-discovery\" humorously implies that the products have been discovered by others; what remains is determining a local economy\'s proficiency in making them. - Market Failures in Self-Discovery: - Under-Searching for Comparative Advantage: - Innovators don\'t capture full returns due to information externality (others benefit from their discoveries). - This results in inadequate searching for the nation\'s comparative advantage. - Too much time spent on existing activities and too little on \"self-discovery.\" - Excessive Diversification: - After identifying advantageous products, excessive diversification can occur. - Entry into the new activity is limited, leading to too many firms entering. - Government policy should encourage investments in the modern sector and rationalize production afterward. - Building Blocks of Theory: - Uncertainty about Efficient Products: - Countries are uncertain about which products they can produce efficiently. - Local Adaptation of Technology: - Imported technology needs adaptation to be productive, not just \"off the shelf.\" - Rapid Imitation: - Imitation of successful activities is quick, reducing pioneer profits. - Case Examples: - Emergence of the IT industry in India. - Differences in exports of similar countries with apparent comparative advantages. - Local adaptation of Western technology in East Asia. - Rapid diffusion of new products and techniques facilitated by personnel movement, like the cut-flower industry in Colombia. - Conclusion: - Hausmann and Rodrik\'s theory underscores the need for nations to strategically discover their comparative advantages, manage diversification, and implement supportive policies to foster economic development. Economic Development as Self-Discovery - Comparative Advantage - In models with perfect information, comparative advantage is known. - In reality, individuals and countries must discover their comparative advantage. - Nations must learn which activities are most advantageous to specialize in. - Market Failures - Hausmann & Rodrik argue that this process is complex and prone to market failures. - Innovators don\'t reap full returns due to information externalities. - This leads to too little search for comparative advantage and insufficient self-discovery. - There can also be excessive diversification after discovering key activities. - Industrial Policies - Hausmann & Rodrik recommend broad investments initially, followed by rationalization. - They draw parallels to industrial policies in East Asia. - Their theory is based on three key concepts: - Uncertainty about efficient production - The need for local adaptation - Rapid imitation after obstacles are overcome - Conclusion - The self-discovery view sees development as a process of learning comparative advantage through innovation and adaptation. - It provides a rationale for industrial policies to facilitate discovery and specialization. Here are some additional details that you may find helpful: - Uncertainty about efficient production: Countries are often uncertain about which products they can produce efficiently. This is because there are many factors that can affect production costs, such as the availability of natural resources, the skills of the workforce, and the level of technology. - The need for local adaptation: Even if a country has the potential to produce a particular product efficiently, it may still need to adapt imported technology to local conditions. This can be a costly and time-consuming process. - Rapid imitation: Once a country has developed a successful industry, other countries can quickly imitate its products and production methods. This can make it difficult for the original country to maintain its competitive advantage. - The self-discovery view of economic development suggests that governments can play a role in helping countries to overcome these challenges. By providing broad investments in education and infrastructure, governments can help to create an environment that is conducive to innovation and adaptation. They can also use industrial policies to target specific industries and help them to achieve economies of scale. **[Definitions:]** - **[Information externality:]** - The spill over of information such as knowledge of a production process from one agent to another, without intermediation of a market transaction. - Reflects on the public good characteristic of information. - It is neither fully excludable from other users, nor nontrivial. 7. [ The Hausmann -- Rodrik -- Velsaco growth Diagnosis Framework:] ============================================================================ HRV Growth Diagnostics Framework - Identifying the binding constraint: - The HRV framework is a decision tree approach to identify the most binding constraint on economic growth in a country. - The first step is to assess whether the constraint is due to low returns or high costs of finance. - If the constraint is due to low returns, then the following factors are considered: - Government failures: poor policies, corruption - Market failures: information/coordination externalities - Low appropriability: weak property rights, contract enforcement - If the constraint is due to high costs of finance, then the following factors are considered: - Low human capital - Poor infrastructure - Low intertemporal returns - Poor geography - Bad international finance - Micro risks: property rights, taxes, regulations - Macro risks: financial, monetary, fiscal instability - Advantages: - The HRV framework is superior to universal policies because it targets the most binding constraint on growth. - It provides a systematic framework to dig into country-specific growth obstacles. - It helps design tailored reforms that focus on the biggest bottlenecks. HRV Growth Diagnostics Framework - Problem: Countries face diverse binding constraints on growth. - Solution: Identify the most binding constraint and target policies accordingly. - Methodology: - Decision tree approach - Assess if low returns or high cost of finance - If low returns, consider government failures, market failures, low appropriability - If high cost of finance, consider micro risks and macro risks - Advantages: - Superior to universal policies - Systematic framework to dig into country-specific growth obstacles - Tailored reforms focusing on the biggest bottlenecks In summary, the HRV diagnostic methodology is a systematic framework for identifying the most binding constraint on growth in a given country context. This allows for developing bespoke, high-return policy reforms. Here are some additional details about the HRV framework: - The decision tree approach is a systematic way of thinking about the different possible constraints on growth. It helps to identify the most likely constraint by asking a series of questions about the country\'s economic situation. - The framework considers a wide range of possible constraints, including both government failures and market failures. This is important because it recognizes that there is no single solution to the problem of low growth. - The framework also helps to identify specific factors that may be contributing to the constraint. This can help policymakers to design more targeted reforms. Growth Diagnostics - Problem: Countries face different constraints on achieving economic growth. - Solution: Identify the most binding constraint and target policies accordingly. - Framework: Growth diagnostics decision tree - Assess if low returns or high cost of finance - If low returns, consider government failures, market failures, low appropriability - If high cost of finance, consider micro risks and macro risks - Advantages: - Superior to universal policies - Systematic framework to dig into country-specific growth obstacles - Tailored reforms focusing on the biggest bottlenecks Customized Development Policies - Challenge: Different countries face unique constraints that hinder their growth and development. - Solution: Employ tailored strategies and recognize diverse constraints. - Framework: Growth diagnostics decision tree - Identify the most binding constraint and target policies accordingly. - Advantages: - More effective and efficient outcomes - Context-specific development Growth Diagnostics - Problem: Countries face different constraints on economic growth. - Solution: Growth diagnostics can help identify the most binding constraint and target policies accordingly. - Methodology: - Decision tree approach - Assess if low returns or high cost of finance - If low returns, consider government failures, market failures, low appropriability - If high cost of finance, consider micro risks and macro risks - Advantages: - Superior to universal policies - Systematic framework to dig into country-specific growth obstacles - Tailored reforms focusing on the biggest bottlenecks Conclusion: Growth diagnostics is a valuable tool for policymakers who are trying to promote economic growth. It can help to identify the most binding constraint on growth and to design policies that are tailored to the specific needs of the country. Here are some additional details about growth diagnostics: - The decision tree approach is a systematic way of thinking about the different possible constraints on growth. It helps to identify the most likely constraint by asking a series of questions about the country\'s economic situation. - The framework considers a wide range of possible constraints, including both government failures and market failures. This is important because it recognizes that there is no single solution to the problem of low growth. - The framework also helps to identify specific factors that may be contributing to the constraint. This can help policymakers to design more targeted reforms. **[Definitions:]** - **[Growth diagnostics:]** A decision tree framework for identifying a country's most binding constraints on economic growth. ![](media/image2.png) - **[Social Returns:]** The profitability of an investment in which both costs and benefits are accounted for from the perspective of the society as a whole. Identifying Binding Constraints in Economic Development - Low Social Returns to Economic Activities - Low social returns can be attributed to: - Poor geography - Inadequate human capital - Insufficient infrastructure - Specific constraints within these factors need to be addressed for effective development policies. - Low Private Appropriability - If low returns are due to limited private appropriability, government and market failures become relevant. - Government failures encompass: - Micro risks (institutional weaknesses, corruption, high taxes) - Macro risks (financial, monetary, fiscal instability) - Market failures may involve: - Self-discovery problems - Coordination externalities - Failures to respond to complementarities of skills - High Cost of Finance: - High finance costs can stem from: - Bad international finance (limited access to foreign capital or debt issues) - Bad local finance - Bad local finance might arise from: - Low domestic saving - Poor intermediation within the domestic banking system - Principles of Differential Diagnosis: - Correct identification of binding constraints involves principles analogous to medical diagnosis. - Four principles include: - Specificity (clearly pinpointing the constraint) - Consistency (the diagnosis should match the symptoms) - Coherence (the diagnosis must align with the country\'s context) - Falsifiability (the diagnosis can be proven wrong if disproven by evidence) - Conclusion: - Identifying binding constraints is essential in economic development. - The growth diagnostics decision tree framework by Hausmann, Rodrik, and Velasco provides a structured approach to tackling constraints arising from low social returns, limited appropriability, or high finance costs. - Ensuring the accuracy of the diagnosis through principles of differential diagnosis enhances the effectiveness of development policies and accelerates sustainable growth. - Identifying Binding Constraints and Growth Diagnostics - Identifying the binding constraints that hinder economic growth is crucial for effective development policies. Ricardo Hausmann, Dani Rodrik, Andrés Velasco, Bailey Klinger, and Rodrigo Wagner propose a set of principles for conducting a differential diagnosis to correctly identify a country\'s binding constraint. This process can be likened to a doctor diagnosing a patient. Here are the key principles and approaches: 1. **[Four Principles of Differential Diagnosis:]** - These principles provide a framework for correctly identifying a country\'s binding constraint. - Accurate identification is vital for tailoring development policies to address specific obstacles. 2. **[Analogy to Medical Diagnosis:]** - The growth diagnostics process is analogous to how a doctor diagnoses a patient\'s health condition. - Just as doctors use various methods to identify medical issues, growth diagnosticians utilize multiple approaches to uncover economic constraints. 3. **[The Four Key Approaches:]** a. *[Symptoms and Clusters:]* - Growth diagnosticians observe symptoms and patterns in the economy to identify underlying constraints. - Clusters of issues can suggest the root cause of growth problems. b. *[Solving for the Equilibrium:]* - Diagnosticians analyse the economy as a set of interrelated equations. - By solving these equations, they can pinpoint the constraint that prevents the economy from reaching its potential equilibrium. c. *[Counterfactuals:]* - This approach involves comparing the current state of the economy with a hypothetical scenario where the binding constraint is removed. - Differences between the two scenarios reveal the constraint\'s impact. d. *[Quantitative Benchmarking:]* - Diagnosticians compare the country\'s performance with that of similar countries to identify outliers. - This helps reveal whether the country\'s growth constraints are significantly different from those of its peers. 4. **[Importance of Correct Diagnosis:]** - Accurate identification of the binding constraint is critical for effective policy formulation. - Policies that target the true constraint are more likely to lead to successful development outcomes. - **[Conclusion:]** - Identifying a country\'s binding constraints is akin to diagnosing a patient\'s health issues. Growth diagnosticians apply principles such as observing symptoms, analysing equilibrium conditions, using counterfactuals, and quantitative benchmarking. Accurate identification is essential for tailoring development policies to effectively address specific constraints and promote sustainable economic growth. Identifying Binding Constraints for Economic Growth - Analogy to Medical Diagnosis: - The process of growth diagnostics can be likened to a doctor diagnosing a patient\'s condition. - Just as a doctor needs to identify the underlying causes of symptoms, growth diagnosticians seek to identify the root causes of a country\'s development challenges. - Principles of Differential Diagnosis: - Hausmann, Klinger, and Wagner propose four principles that guide growth diagnosticians in identifying binding constraints: - Principle 1: Multiple Possible Diagnoses: - Like medical conditions, economic development challenges can have multiple potential causes. - Growth diagnosticians should consider various factors, such as geography, human capital, infrastructure, market and government failures, and macroeconomic risks. - Principle 2: Identifying Unique Symptoms: - Just as different illnesses manifest unique symptoms in patients, different constraints exhibit distinct symptoms in economies. - Diagnosticians should focus on the specific symptoms a country experiences, such as lack of private investment, low entrepreneurship, inadequate infrastructure, or unstable financial systems. - Principle 3: Specific Intervention for Each Diagnosis: - Effective medical treatment varies based on the diagnosed illness. Similarly, tailored policy interventions are required for specific constraints. - Growth diagnosticians must recommend policies that directly address the identified binding constraint to stimulate economic growth. - Principle 4: Testing the Diagnosis: - Medical practitioners test the accuracy of their diagnosis through observation and treatment outcomes. Similarly, growth diagnosticians need to assess the impact of policy interventions. - By monitoring the results of policy implementation, diagnosticians can refine their understanding of the binding constraints and adjust strategies accordingly. - Conclusion: - Identifying binding constraints for economic growth is essential for formulating effective development policies. - The principles of differential diagnosis proposed by Hausmann, Klinger, and Wagner draw parallels between growth diagnostics and medical diagnosis. - By understanding the unique symptoms of economic challenges, recommending tailored interventions, and monitoring policy outcomes, growth diagnosticians can guide countries toward sustainable economic development. Here are some additional key points from the passage: - Low returns to investors in developing countries may be due to low underlying social returns or low private appropriability of returns. - Low social returns can be caused by poor geography, low human capital, or inadequate infrastructure. - Low private appropriability of returns can be caused by government failures (micro risks like weak property rights or macro risks like financial instability) or market failures (like coordination externalities). - High cost of finance rather than low returns may be the problem. This could be due to issues with international finance, low domestic saving, or poor financial intermediation. - There is no one-size-fits-all policy. Growth diagnostic analysis is needed to identify the most binding constraint to growth in a particular country context in order to design the most effective policies. - Principles of a good growth diagnosis: identifies the most binding constraint, shows how relaxing that constraint will spur growth, finds that other constraints are not binding, and identifies policy remedies that target the binding constraint. Hausmann-Rodrik-Velasco Growth Diagnostics Framework - Identifies binding constraints on economic growth: These constraints hinder a country\'s ability to achieve higher rates of economic development. - Suggests several indicators and principles: To guide the diagnosis process, including: - High shadow price of the constraint: If the shadow price of a constraint is high, it indicates that the constraint significantly affects the overall economic performance. - Movement-objective relationship: Significant changes in the constraint should lead to noticeable shifts in the economic objective, such as investment or growth rates. - Attempts to overcome or bypass the constraint: Economic agents may develop strategies to overcome or bypass binding constraints. - Agents\' resilience in the face of constraints: Agents less affected by a binding constraint are more likely to thrive in the economy. - Five-step diagnostic process: - Describe the growth process and formulate a question: Define the context and issue at hand. Determine the central question for the diagnostics exercise. - Conduct a differential diagnosis: Examine multiple potential constraints and their symptoms. Consider a range of factors, including geography, human capital, infrastructure, market and government failures, and macroeconomic risks. - Formulate a syndrome of symptoms: Based on the differential diagnosis, create a syndrome that captures the symptoms associated with the most likely binding constraint. - Test further implications: Examine additional implications of the chosen syndrome. Look for evidence that corroborates the presence of the syndrome. - Reiterate steps three and four: If necessary, refine the syndrome and test implications iteratively until a clear conclusion can be reached about the binding constraint. Benefits of using the framework: - Systematic approach: The framework provides a systematic approach to identifying binding constraints, which can help analysts to be more objective and thorough in their analysis. - Considers multiple factors: The framework considers a range of factors that can contribute to binding constraints, which can help analysts to identify the root cause of the problem. - Flexible: The framework is flexible and can be adapted to different countries and contexts. Overall, the Hausmann-Rodrik-Velasco Growth Diagnostics Framework is a valuable tool for identifying binding constraints on economic growth. By following the framework, analysts can be more objective and thorough in their analysis, and they can identify the root cause of the problem in order to design effective policies. - **[Identifying Binding Constraints for Economic Growth: Hausmann-Rodrik-Velasco Framework]** The Hausmann-Rodrik-Velasco (HRV) framework offers a systematic approach to identifying binding constraints that hinder economic growth. This process involves analysing various clues and signals to determine the most significant obstacles to development. The foll

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