PPS603 Microeconomics of International Development Policy

1. PPS603Microeconomics of International Development Policy 1. Introduction

3. What Is Development Microeconomics? “A study of least developed countries is to economics what the study of pathology is to medicine: by understanding what happens when things do not work well, we gain insight into how they work when they do function as designed. The difference is that in economics, pathology is the rule: less than a quarter of mankind lives in the developed economies.” – Joseph E. Stiglitz (1989)

4. What Is Development Microeconomics? Development microeconomics is the study of individual, household, and firm behavior in developing countries. Development microeconomics is standard microeconomic analysis (e.g., utility and profit maximization, choice under uncertainty, public goods and externalities, market power, principal—agent models; etc.) – just that it’s applied to developing countries.

5. Why Study Development Microeconomics? Bill Easterly noted in The White Man’s Burden that as of 2006, industrialized countries (the “West”) had spent over $2.3 trillion in foreign aid since 1949. This began with Rosenstein-Rodan(1943), who advocated a “Big Push” for developing countries. This was the logic behind the Marshall Plan for European reconstruction after World War II.

6. Why Study Development Microeconomics? More than six decades later, large portions of the developing world are still not on the path toward self-sustaining growth. Some aren’t even on the path toward growth, although in fairness, things are getting better in some places (Kenny, 2011). This points to a failure of macroeconomic policies. That is, of Big Push-type, economy-wide, sectoral, or structural adjustment, policies.

7. Why Study Development Microeconomics? Yet, in The End of Poverty, Jeff Sachs (2005) advocated a supposedly novel idea – a Big Push for developing countries. The idea is to throw as much money as we can at the problem. With enough money, developing countries will climb out of poverty. That is presumably the idea behind Sachs’ ill-conceived Millennium Villages Project.

8. Poverty Traps: An Old Idea The literature on poverty traps started out with Rosenstein-Rodan (1943), a Polish (as in nationality) Austrian (as in Hayek) economist. In a paper looking at the development problems of Eastern and Southeastern Europe, he laid the foundation for the study of poverty traps. Rosenstein-Rodansaw underdevelopment as a coordination failure.

9. Solow Growth Model: Well-Behaved Aggregate Production Function y = Y/L (n+d)k A sy k = K/L

10. Solow Growth Model It is likely that the aggregate production function does not have that nice (i.e., strictly concave) shape usually assumed by neoclassical economists. What if the aggregate production function is S-shaped? In other words, what if there are increasing returns to scale on a portion of the aggregate production function?

11. Solow Growth Model: Ill-Behaved Aggregate Production Function (n+d)k y = Y/L G sy U k = K/L B

12. Solow Growth Model The relationship between population growth and deprecation on the one hand, and savings rate on the other hand, remains unchanged. What does change is the fact that there are now multiple equilibria. But to get that, we had to move away from neoclassical (i.e., diminishing returns to scale) assumptions.

13. Solow Growth Model In the good equilibrium (G), the economy remains stable at a high level; in the bad equilibrium (B), the economy remains stable at a low level. In the unstable equilibrium (U), it can go both ways, depending on the slightest perturbation. The Solow growth model can be extended to incorporate additional inputs. Mankiw et al. (1992) famously added human capital (i.e., education, experience, etc.)

14. “Big Push” Theories of Development Questions to answer with the Solow growth model: 1. How does this last graph embody the idea of a Big Push theory of development? 2. What could a Big Push look like concretely in terms of policy? 3. Do we know better? Why or why not?

15. Why Study Development Microeconomics? Well-targeted, evidence-based micro projects have been shown to work better than macro projects. This favors a “bottom-up” rather than a “top-down” approach. Easterly (2006) talks about “Searchers” vs. “Planners.” The debate between Sachs and Easterly is summarized by Paul Collier (2007) in The Bottom Billion.

16. Why Study Development Microeconomics? Development microeconomics is about “bottom-up” solutions to poverty and underdevelopment. Instead of indulging in social engineering, development microeconomists focus on smaller, simpler problems. For example: How can we get kids to go to school? How can we get people to use bednets? What is the impact of food price volatility on household welfare?

17. Why Study Development Microeconomics? An example: Does participating in agricultural value chains (i.e., contract farming) make the households who participate better off? Even such simple questions are difficult to answer. First, what does “better off” mean? Welfare is difficult to measure. Second, participation is nonrandom, so one needs to come up with ways of making it as good as random.

18. Why Study Development Microeconomics? Another example: “Do changes in food prices cause social unrest?” This is also not an easy question to answer. Where do you find a good measure of social unrest? Also, there certainly is a correlation between food price increases and food riots, but this does not imply causation. Again, one needs to come up with ways to make a causal statement that can inform policy.

19. Why Study Development Microeconomics? This brings us to why we should be interested in development. Between 2006 and 2011, food prices nearly doubled. A total of 100 million poor rural and urban people were pushed into poverty. In 2050, world population is expected to attain 9 billion people. Feeding these people will require a 70-percent increase in global food production (IFAD, 2011).

20. Why Study Development Microeconomics? This is not to bring back the old Malthusian argument, but to illustrate the importance of agricultural development. Moreover, 3.1 billion individuals – 55 percent of the world population – live in rural areas and derive their livelihoods from agriculture. We will thus spend a good amount of time studying agricultural development.

21. What is Development Microeconomics? “Most of the people in the world are poor, so if we knew the economics of being poor, we would know much of the economics that really matters. Most of the world's poor people earn their living from agriculture, so if we knew the economics of agriculture, we would know much of the economics of being poor.” – Theodore W. Schultz (1979)

22. Why Study Development Microeconomics? The graphs we saw earlier represented a theoretical macroeconomic model. Good macroeconomics must have solid microeconomic foundations. Each module of this course looks at some micro aspect of the broader macro model of economic growth.

23. Why Study Development Microeconomics? Before anything, we will start next week by talking about the ideas and methods that are specific to or have originated from development microeconomics. This means a necessary digression into the epistemology of social science research. In other words: How can we uncover the truth? How do we know that what we know is true? How can we disentangle causality

24. Why Study Development Microeconomics? Next, we will consider the household, a new economic agent that combines the consumer and the firm –households in developing countries often produce the commodities they consume. We will put the household in relationship with markets and show that in many instances, market access is the issue.

25. Why Study Development Microeconomics? We will then look at the production function of the household by focusing on a major input – land. We will first look at agricultural productivity, at land rental markets, and finally at land rights.

26. Why Study Development Microeconomics? We will next look at another key input – labor – by looking at three aspects of what makes labor effective. First, we will look at food policy and nutrition. Second, we will look at health (e.g., HIV, malaria, worms, etc.) Third, we will look at education (e.g., teacher absenteeism, flip charts, textbooks, school subsidies, etc.)

27. Why Study Development Microeconomics? The last input we will look at in the household’s production function is capital. Although economists understand capital as encompassing physical capital (e.g., equipment, tools, etc.) as well as financial capital, we will focus on the latter. We will thus focus on credit rationing and microfinance (i.e., micro-loans, micro-savings, and micro-insurance).

28. Why Study Development Microeconomics? Finally, we will take a step back and look at the institutional and legal environments within which the household operates. We will first look at whether colonial origins; the legal system; the financial system; and other institutions determine economic development.

29. Why Study Development Microeconomics? We will also look at the impacts of corruption and governance on economic development. Although these last two topics are a priori more macro, we will study them using the tools of microeconomics.

30. Why Study Development Microeconomics? Before we start discussing these various aspects of development microeconomics, however, we need an accurate portrait of the people for whom we study development microeconomics. We need to know who the poor (< $2.50 PPP) and the extreme poor (< $1.25 PPP) are. Who the poor are and how they live will be the topic of some of this week’s readings.