Contemporary Models of Development and Underdevelopment

1. Contemporary Models of Development and Underdevelopment Todaro: Chapter 4 Part II

2. Overview Multiple Equilibria and Coordination Failure Incumbency and Barriers to Entry Behaviour and Norms Linkages Inequality and Capital Market Imperfections Kremer�s O-ring Theory Strong Complementarities and Positive Assortative Matching

3. Positive Externalities Raising demand for other industries� products Shifting demand towards manufactured goods Redistributing demand towards future periods Helping to lower the fixed cost of an essential infrastructure

4. Incumbency and Barriers to Entry Sometimes due to the advantages of incumbency, new firms with more productive technology are discouraged from entry. New entrants face large fixed costs at the beginning and initially small demand for their products.

5. Behaviour and Norms Sometimes the incentives provided by social norms and even laws and regulations reward dishonest and corrupt behaviour, driving out honest efforts.

6. Linkages Backward Linkages raise demand for an activity Forward Linkages lower the costs of using an industries output When certain industries are established first, their linkages with other sectors can facilitate the development of new industries. Target investment in key industries with strong linkages that are less likely to draw private investment.

7. Inequality and Capital Market Imperfections The traditional view is that a small amount of inequality is needed to enhance growth because some funds need to be pooled in order to increase savings and investment. However, high inequality could retard growth as the inability to access credit markets due to lack of collateral is part of the definition of poverty.

8. Kremer�s O-ring Theory Features Strong Complementarities in production which results in the positive assortative matching of the factors of production by productivity.

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

10. Assumptions Firms are risk-neutral Labour markets are competitive and labour supply is inelastic So, workers are paid according to their productivity. Strong complementarities in production Workers are imperfect substitutes for each other. Closed economy (inputs cannot be imported)

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

12. Notes The coordination failure and multiple equilibria result with agents behaving rationally The potential benefit of the active role of government is emphasized After the big push, the need for an active government in the economy is reduced. Bad policies can reinforce the bad equilibrium and even drive the economy to a worse equilibrium. The benefits to outside development assistance goes beyond capital provision.