Transcript A Parable for Development Economics: the Two Koreas

Economic Growth in the Developing World:
What Explains the Stubborn Refusal of Many LDC’S
To Perform Up to Their Potential?
Prof. G. Anderson/ CSUN/ Fall 2003
LECTURE NOTES 2
A Parable for Development Economics: the Two Koreas
Consider the case of North and South Korea. The
two share the same people, with the same pro-growth
cultural characteristics (e.g., strong work ethic,
respect for education, high savings rate), similar
resource endowments [although in a number of
respects the North is significantly better endowed*]
Yet the two countries have had radically different
development experiences. After recovering from the
virtual obliteration of its domestic infrastructure
during the 1950-53 war South Korea has emerged as
one of the richest, most productive, and fastest
growing economies in the world.
A Parable of the Two Koreas
[continued]
Meanwhile, the North remains mired in almost unimaginable grinding
poverty– that is, for the lucky ones who don’t die in the annually recurring
famines. And it appears to be getting worse. This economic state cannot
be attributed to the lasting damages sustained during the Korean War; the
South, not the North, suffered the brunt of “collateral damage”, yet the
South has transformed itself into a dynamic powerhouse while its’
neighbor to the north remains a stagnant sump.
The main objective of his course is to explain this ‘Korean problem’. The
key element in this comparison that produces the differential outcome is
the role of property rights, and how these effect the incentives that
determine choice.
Why does economic growth
occur?
Economic growth is an extremely important issue.
A percentage point added to the growth rate can
make a huge difference
There is a possibility of change with
extraordinarily beneficial consequences
How do we increase economic growth?
Theories of economic growth take us quite far in
understanding the development process
At least it teaches us to ask the right questions
Modern economic growth: Basic
features
Modern economic growth was born after the
Industrial Revolution in Britain
A number of countries managed the take-off into
sustained growth (Rostow)
For many developing countries growth experience
only began after the post-World War II area
The developing nations not only need to grow they
must grow at rates that far exceed historical
experiences
Increased perception of global inequalities
requires sustained and high growth rates
Economic growth requires
investment
New investments add to the capital stock in the
economy and endow it with a larger capacity for
production
Economic growth is positive when investment
exceeds the amount necessary to replace
depreciated capital
Thus, savings and investment is an important
determinant of the growth rate of an economy
The endogeneity of savings
There are several reasons to believe that savings may itself be
influenced by the overall level of per capita income, and the
distribution of incomes
Economies where the majority of the citizens are poor are unlikely
of have a high savings rate. Growth efforts must then rely on
external credit or foreign aid.
Some tendency for the savings rate to significantly to rise as wee
move from very poor to middle-income levels both within a
country and across countries.
The saving rate will change, which creates a tendency over time
for the growth rate of a country to alter. Neutrality is lost: a pattern
linking per capita income to growth rates is created
The endogeneity of population
growth
Population growth rates do change with the level
of per capita income
In poor countries death rates, especially among
children, are very high. It is not surprising that
birth rates are high as well. As long as death rate
and birth rates are high the net population growth
rate remains at a low level
Increased living standards imply that death rates
are falling while birth rates adjust more slowly.
This causes the population growth rate to shoot up
(referred to in the literature as the ‘reversed U-
History, Expectations and
Development
What we are looking for is an explanation
of why investment rates differs or why a
given a rate of savings translates into
different growth rates under different
circumstances. How does history and
expectations shape the overall economic
pattern shaped by a country or region.
• What about population?
“Overpopulation” can’t be an absolute impediment
to development in the long run, given that it
represents a decision variable; family size is the
outcome of choice
Population size and growth rate are both
important, but at the margin. Other factors also
play a significant role in development (or
nondevelopment, as the case might be)
Complementarities
Look at the keyboard on your computer:
Left top row, q,w,e,r,t,y…..Why this
particular order? In part to reduce the
frequency of jams. In no way the best
keyboard for a computer. The Dvorak
system introduced 1932 won repeatedly
speed-typing contests. There are
alternative today but why does the
QWERTY still exist?
Complementarities
Long ago firms were hiring QWERTY-trained
typists, would be too costly to re-train them into
Dvorak-style keyboards. We have then a selffulfilling situation that is difficult for any
individual to get out of, because the return to
each person depends on what everybody else is
doing.
This divergence between individual cost and
social gain occurs whenever a system of
production, or organizational form, exhibits
externalities, so that the cost or benefit of
adopting that new system by an individual
depends on how many other individuals have
adopted that system.
Complementarities
In the case of QWERTY the creation of typing
schools and a pool of typists trained in a
particular way lowered the cost of new
individuals adopting the same system. But it is
possible that QWERTY has a higher cost curve
compared to an alternative product.
History creates look-in effect that is difficult to
get out of.
Coordination failure
Pervasive complementarities might lead to a
situation where an economy is stuck in a “lowlevel equilibrium trap” while at the same time
there is another better equilibrium, if only all
agents could coordinate their actions to reach it.
Rosenstein-Rodan: Economic underdevelopment is the outcome of a massive coordination
failure. Investments do not occur because other
complementary investments are not made and
these latter investments are not forthcoming
because the former are missing.
Coordination failure
Coordination failure emerges from
complementarities and the situation that
creates it it is often known as a
coordination game. The failure manifests
itself in the ability of a group of economic
agents, whose actions are complementary
to achieve a desirable equilibrium. Notion
of coordination is closely linked with the
concept of linkages.
Linkages and policy
Linkages are important and have an impact on
policy. Suppose that an economy is in a
depressed equilibrium; how should policies be
formulated to take the economy to a better
equilibrium? Rosenstein-Rodan introduced the
idea of the big-push, a policy that simultaneously
creates a coordinated investment in many
different sectors of the economy (balanced
growth).Two features:
First, requires a massive investment in many different
sectors at once.
Second, need to know the quantitative allocation of
Linkages and policy
A problem with a balanced growth strategy is
that it requires a lot of resources and information.
The policy does not exploit the fact that the
desirable outcome is also an equilibrium. We can
rely on the market to correct this coordination
failure. Selectively promote a few key sectors in
the economy which would through the linkages
with the rest of the economy stimulate other
sectors as well (unbalanced growth).
Linkages and policy
How do we choose key sectors?
The number of linkages a certain sector possesses is
important. The characteristics of the economy.
Does it matter if forward or backward linkages are
promoted? Yes, a backward linkage directly raises the
price of its output and a forward linkage reduces the
price on one of its inputs of production. Forward
linkage has international implications as well.
It is also important to look at the “intrinsic
profitability” in each sector. It might be the case that
the government maximizes the chances of overcoming
coordination failure by investing in the least profitable
activity.
History versus expectations
Problem: The case of several sectors
simultaneously functioning at a suboptimal level
requires a policy that assists the economy to
move from a suboptimal outcome to one that is
more efficient.
Assumption: History makes it difficult for firms,
individuals or sectors to move out from the lowlevel equilibrium trap. If expectations of agents
could be changed movement would occur from
one equilibrium to another
History versus expectations
In the case of an economic coordination failure,
going first means taking economic losses.
Expectation plays a role when there is some
advantage to going first. For example congestion
increases the cost of moving later, perhaps
because of difficulties in finding housing. In such
cases economic agents might trade-off the lower
current returns from moving now with the higher
costs of moving in the future.
History versus expectations
Another important factor is increasing returns
A production activity displays increasing returns
to scale if an expansion in the scale lowers the
unit cost of operation. The role of increasing
returns in development:
The ability to realize the gains from increasing returns
depends on the size of the available market for the
product.
The size of the market may itself depend on the ability
to exploit increasing returns, expand production and
pay out income to employees.
History versus expectations
Increasing returns and entry into markets:
Assume that a developing country has a small
domestic market for automobiles that is
currently serviced by imports. Now assume
that a local manufacturer designs a car that is
particularly suitable for domestic conditions.
Production of automobiles involves increasing
returns to scale, which imply that large
volumes have to be produced to reduce unit
cost
History versus expectations
This leads to the following dilemma: during the
transitional period where customers are
progressively switching to the new product our
producer must function at a loss. Losses would
not be a problem if capital markets were perfect.
If not the whole project may be scuttled. Three
things caused this problem:
Increasing returns in production
Credit markets are missing
Customers switch slowly
Increasing returns and market
size: Interaction
Construction industry: In developing countries
construction is a labour-intensive industry. In
developed countries automated process (cranes
and fabricated walls). Final production of a
house is reduced to a large series of automated
steps requiring the provision of many
intermediate inputs. These inputs can be
extremely costly and requires a larger market. In
other words intermediate inputs are often
produced under conditions of increasing returns
to scale. This means that increased varieties of
inputs would increase output.
Increasing returns and market
size: Interaction
Assume a poor country with low demand for the
final product. This means that intermediate
production is constrained (implies a high price).
Firms substitute away from intermediates to
labour, which reduce productivity and income.
Low income in turn generates lower demand and
the vicious circle is complete. The opposite
occurs in a virtuous circle. High demand for the
final consumption good increased the demand for
intermediates, which lower the price of
intermediates. Falling prices give incentives of
substitution away from labour towards
intermediates, which has a positive impact on
productivity and on income in the economy.
[next up: population and
development]
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