Development Economics 1

Introduction to Development Economics II

Week002 – Introduction to
Development Economics II
Welcome to the second module of this course on Development Economics! For this
lesson, you will learn more of the other terms and concepts related to development
as a definition in terms of field and variation.
At the end of this module, you are expected to:
1. Define the basic terms of the field in development as well the inequalities in
Development Economics.
2. Differentiate and distinguish the various fields in development.
3. Explain the factors affecting the inequalities of Development Economics.

Defining Development
Most development economists today would agree that “development” involves
sustained improvement in well-being for a country’s many people, with special
emphasis on improvements for poor people (i.e. people living at low levels of well-
being), and that “well-being” is an overall assessment of how good or bad a person’s
life circumstances are along multiple dimensions. Decades of thoughtful empirical
research suggest that a person’s well-being depends, at a minimum, on the
quantities and qualities of goods and services she consumes, the pleasures and pains
of the activities to which she devotes time, her vulnerability to shocks, her sense of
power or powerlessness, and her expectations regarding how her family’s living
conditions will tend to improve, hold steady, or decline in coming years. The levels
and rates of change in well-being for a country’s many people are determined within
a socioeconomic system.

For economists, the fundamental moving parts of the system are the people
themselves. Together with other members of their households they make inter-
related choices regarding consumption, time allocation, production, saving, lending,
investment, gift giving, and more, seeking to achieve as much as possible of what
matters to them, given the constraints they face. Households interact with one
another in many important forums, including not only markets for goods, services,
labor, credit, savings instruments, and insurance, but also many non-market forums,
such as communities, irrigation system user groups, ethnic networks, and society at
large. While their interactions in markets involve buying and selling, lending and
borrowing, their interactions in non-market settings may involve cooperation,
communication, respect of property rights, fulfillment of promises, and dispensation
of rewards and punishments. Within households, too, members engage in non-
market interactions such as cooperating, bargaining, sharing, and showing
deference.

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Development economists now recognize that non-market interactions are at least as

important as market interactions in determining the level and distribution of well-
being in a society. People’s interactions in market and non-market settings are
governed by “institutions,” a theoretical construct that greatly re-shapes and
enriches economists’ understanding of socioeconomic systems. An institution is the
set of formal rules and informal norms that constrain people’s choices regarding
how they interact in a particular setting, together with the enforcement mechanisms
that cause people to comply with those rules and norms. Some institutions are
entirely informal, defined only by shared understanding within neighborhoods or
networks. Some are more formal, involving codified rules and punishments, though
typically also shaped by informal norms.

Formal institutions on a small scale may be connected to local governments or local

membership organizations. Formal institutions on a macro scale include laws,
regulations, the rules defining government programs, and the rules and norms
shaping legal and law enforcement systems. Historically, many institutions have
been “extractive,” allowing powerful people to exploit the powerless (Acemoglu and
Robinson, 2012). Healthy institutions, by contrast, are sustained by and help sustain
mutually beneficial cooperation and trust. Economists now recognize that healthy
institutions are essential to well-functioning markets and constructive non-market
interactions.

Within this framework, households’ well-being and choices are determined by the
types and quantities of assets they own or have access to and their needs, together
with the market and non-market opportunities they face, and the institutions that
govern their intra- and inter-household interactions. Assets include any long-lasting
resources or attributes that raise a household’s effectiveness in pursuing well-being.
They include land, livestock, machines and other business assets, infrastructure,
education, job training, and technological ideas and practices, as well as systems
that deliver clean water or health care.

The focus on assets is significant, because people care about the future. Two
households may achieve the same income and living standards today, but one may
enjoy greater well-being because its greater asset stock implies higher expected
living standards in the future (Carter and Barrett, 2006). The system is dynamic.
The average level and distribution of wellbeing change over time as people invest in
creating or re-deploying assets, as external conditions evolve, and as the system is
hit by shocks. Endogenous changes in assets, and exogenous changes and shocks,
lead to system-wide change in market conditions and institutions. Development is
successful when changes in assets, markets, and institutions are raising well-being
sustainably for many people. Most economists would agree that economic growth is
necessary for fully successful development. Without growth, average income
remains constant, and resource flows that raise well-being for some groups along

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some dimensions must reduce well-being for other groups or along other
dimensions, and quickly reach their limits.

Growth happens when people invest in the creation of assets that raise labor
productivity, and when they increase the efficiency with which the economy’s
productive assets are deployed by, for example, migrating or giving up rent seeking.
The asset changes that underlie growth have the potential to raise the well-being of
many households, including many poor households, through diverse channels. Poor
and vulnerable households might participate directly in the creation of assets, and
even if the new assets underlying growth are owned by non-poor households, poor
households might benefit indirectly when changes in the behavior of the assets’
owners induce change in markets and institutions. More specifically, poor
households might benefit if they are net sellers in markets for goods or labor where
prices rise, if they are net buyers in markets where prices fall, if they benefit from
public goods and government services financed by growing tax revenue, or if they
receive transfers made by the assets’ owners in compliance with private or public
safety net institutions.

The framework offers no logical guarantee, however, that rapid economic growth
will adequately raise well-being for all poor and vulnerable households. The initial
conditions and policies that support a particular growth episode might, for example,
concentrate new assets in the hands of the non-poor, do little to raise the demands
for goods or labor supplied by poor households, and direct government services
primarily to the non-poor. And even when growth is relatively pro-poor, specific
groups among the poor may be excluded for many reasons. Thus the framework
leaves plenty of room for disagreement about how inevitably the policy packages
that underlie rapid growth will also yield rapid poverty reduction. All this suggests
the importance for development policymaking of careful research on how
households, markets, and institutions work, and especially on the frictions and
imperfections that might slow growth or prevent the benefits of growth from
generating widespread and sustained improvements in well-being in the absence of
intervention.

Where such frictions and imperfections prevent people from making socially
desirable choices, governments and NGOs may be able to improve development
outcomes by intervening. Where such frictions and imperfections are lacking,
policies and programs inherited from the past may require careful reform or
elimination. Unfortunately, the public sector institutions governing policy design
and implementation can also fail in diverse ways. Interventions and reforms
improve development outcomes only when policymakers’ choices are governed by
healthy political institutions; and when the policies and reforms are well-designed
and well-implemented responses to correctly-diagnosed market and institutional
failures. Thus, in addition to studying household choices, markets, and private
institutions, development economists also study the governance of policy

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implementation within public sector institutions and how political institutions

shape policy choices.
In simple models with perfect information, it is assumed that firms, and developing
economies as a whole, already know their comparative advantage. But individuals
must discover their own comparative advantage in labor markets; for example, no
one is born knowing they are well suited to become an economist or international
development specialist. Somewhat analogously, nations must learn what activities
are most advantageous to specialize in. As Ricardo Hausmann and Dani Rodrik
show, this is a complex task—and one prone to market failure. It is not enough to
tell a developing nation to specialize in “labor-intensive products,” because even if
this were always true, there are a vast number of such products in the world
economy of today, and underlying costs of production of specific products can differ
greatly from country to country. So it is socially valuable to discover that the true
direct and indirect domestic costs of producing a particular product or service in a
given country are low or can be brought down to a low level.

It is valuable in part because once an activity is shown to be profitable, it can usually

be imitated, at least after some lag, spawning a new domestic industry. An example
is the ready-made garment industry in Bangladesh, which spread from the first
pioneers as dozens of entrepreneurs entered the market. But as markets are
eventually open to competing firms, they will take away potential profits from the
original innovator. And since due to this information externality innovators do not
reap the full returns generated by their search for profitable activities, there will be
too little searching for the nation’s comparative advantage—too much time carrying
on with business as usual and too little time devoted to “self-discovery.” The term
self-discovery somewhat whimsically expresses the assumption that the products in
question have already been discovered by someone else (either long ago, or recently
in a developed economy); what remains to be discovered is which of these products
a local economy is relatively good at making itself.

Hausmann and Rodrik also point out another market failure. There can be too much
diversification after the point where the nation discovers its most advantageous
products to specialize in. This is because there may be an extended period in which
entry into the new activity is limited. Hausmann and Rodrik conclude that in the
face of these market failures, government policy should counteract the distortions
by encouraging broad investments in the modern sector in the discovery phase. In
fact, they also argue that policy should in some cases work to rationalize production
afterward, encouraging movement out of higher-cost activities and into the lower-
cost activities, and paring down industries to the ones with the most potential for
the economy.

The authors draw parallels with some of the successful export and industrial policy
experiences of East Asia. The authors note three “building blocks” of their theory;
there is uncertainty about what products a country can produce efficiently; there is
a need for local adaptation of imported technology so that it cannot be used

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productively “off the shelf”, and once these two obstacles have been overcome,
imitation is often rapid (reducing the profitability of pioneers). They present a
number of case examples that show the reasonableness of each of these
assumptions in practice, such as the unexpected emergence of the information
technology industry in India and the surprising differences in the exports from
various countries with similar apparent comparative advantages, such as
Bangladesh (hats but not bedsheets) and Pakistan (bedsheets but not hats); the
history of local adaptations of various types of Western technology in East Asia
(such as shipbuilding in South Korea); and the rapid diffusion of new products and
techniques in the local economy (often facilitated by the movement of personnel
across firms), as seen in the growth of the cut-flower export industry in Colombia.

Development as a Field
Why is development economics a separate field? Pessimism? To some extent this
stems from a belief that orthodox economics inappropriate. Why? Pervasiveness of
market failure? Poor countries are different? Structural constraints? How relevant is
the western experience for developing countries? Notice that for the former, the key
breakthrough was institutional innovation. These societies had to develop new
systems of organization that would foster innovation. This led to important
breakthroughs. In the developing countries the primary factor is also institutional;
were it not, then capital flows would suffice to make these countries grow faster.

To some extent this is a function of the view on convergence. If the world is

explained by Solow-type growth models, then we should expect poor countries to
converge to the per-capita incomes of the rich. The question is how long will this
process take. This could seem to suggest that little needs to be done, in a policy
sense, to initiate the growth process. But this is almost certainly too sanguine a
view. Besides, the fact of convergence does not indicate that pace. Simple catch-up
may take an incredibly long time. Moreover, there is some evidence that
convergence is, at best, conditional, and a lot of evidence that divergence is the
actual norm. The experience of countries in transition is informative in this regard.
If transition were relatively costless and painless, then one could argue that
institutions are not important to economic development. Why? Because institutions
are precisely what transition economies lack.

Transition economies have already experienced the rural-urban transition, with

large shifts of workers from agriculture to industry. They typically have large
manufacturing sectors; often very large when we control for per-capita income.
What is lacking in these economies are the institutions common to developed
countries (DCs). The fact that the transition to a market economy is rocky suggests
that developing these institutions is tricky. One of the central tenets of classical
development theory is the view that developing countries face a different situation
than DC’s did. I will discuss one aspect of this below (export pessimism).

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One reason is a view of the development process that is due to Gershenkron. His
central tenet was that, in a number of important historical instances of
industrialization processes. When launched at length in a backward country,
showed considerable differences, as compared with more advanced countries, not
only with regard to the speed of the development (the rate of industrial growth) but
also with regard to the productive and organizational structures of industry which
emerged from those processes. Furthermore, these differences in the speed and
character of industrial development were to a considerable extent the result of
application of institutional instruments for which there was little or no counterpart
in an established industrial country (Gershenkron 1962). The idea is that Germany’s
industrialization would be different from Britain’s due to timing.

Gershenkron (1962) argued that “the more backward a country’s economy (on the
eve of industrialization) the greater was the part played by special institutional
factors (banks, the State) designed to increase the supply of capital to the nascent
industries”. The implication for LDC’s was that they would have to follow a different
path as well. A modern application of this view is in Amsden’s analysis of Korea.
There are, of course, advantages as well as disadvantages in a later start. The late
industrializers can import technology rather than invent it themselves. Facing a
portfolio of modern techniques the key problem seems to be that of applying
technology, although experience suggests that there is an extra organizational
problem of getting advanced techniques to work well in backwards countries.
Development economics is clearly more than just growth theory. In the latter we
deal with balanced growth paths; expanding economies where the structure of the
economy is unchanged.

One view of development economics is that it is precisely structural change which is

the defining characteristic. Structural change here refers to changes in the relative
importance of sectors in the economy. Development is the transformation of the
economy via these changes that are the key elements to economic growth. What are
these structural changes? The principal changes that are identified are: increases in
the rates of accumulation (Rostow, Lewis); shifts in the sectoral composition of
economic activity, whether output or employment or factor use (Kuznets, Chenery);
often called industrialization; changes in the location of economic activity
(urbanization); and such changes as the demographic transition and changes in
income distribution.

One can see the Chenery approach as producing stylized facts of structural change in
development. We observe the shift in sector shares, the demographic transition;
changes in the nature of trade, and other changes that occur as the economy
becomes richer. This analysis gives us a picture of the normal development process.
Of course there is a question if there is a “normal” process. And if there is, what are
the causes that make this common across countries? In addition, one can always add
the questions of whether these changes need to be pushed by planners, or whether

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market forces will bring them about themselves. To what extent are developing
countries different? Some argue that a different type of economics is needed
because of structural constraints that are different from western economies.

One structural constraint that early development economists focused on was the
presence of developed economies. The idea is that the terms of trade hurt the
prospects of the developing economies. Of course, similar arguments were made a
century-and-a-half ago when economies that are now developed were just
beginning to industrialize. It is not clear, however, that these constraints are
significant, over and above the policies of the respective governments. Another
example would be rural-urban migration (Harris-Todaro effects) and limitations on
relative price flexibility. One aspect of structural constraints that is important is
missing markets. Credit markets, in particular, are underdeveloped, and this has
dramatic effects on development. We would want to know how critical financial
markets to development are. This is interesting from the transition perspective,
because these economies are underdeveloped in this sense, despite being
industrialized. It could be quite useful in gauging the importance of these factors.
Development economics has typically ignored institutional and organizational
development.

How does organizational development affect the ability to contract? Consider the
investment decisions of a rural household. Without secure financial markets, the
best way to invest for the future may be to have more children, since they can
provide for retirement. With social security systems and with secure financial
markets, however, the family may invest in physical capital, which may have a
potent effect on productivity. Underdeveloped financial markets may thus play a
large role in underdevelopment traps. The contrast between development and
transition economics is easy to characterize. Development economics takes
structural constraints as given. Transition economics assumes that things are
elastic, and that the major problems are allocation-related. Structural
transformation is relatively ignored. In transition, economics initial conditions are
important, but much of the literature has applied insufficient focus on this.

Why is development economics so concerned with growth? It is largely the belief

that growth is the surest way to alleviate poverty. That is not a perfect correlation.
But it seems to be a key channel. Early development economics focused on capital
formation as the key to growth. The key problem was that investment had failed to
materialize in poor economies. Arthur Lewis has stressed that “the central problem
in the theory of economic development is to understand the process by which a
community which was previously saving 4 or 5 per cent of its national income or
less converts itself into an economy where voluntary savings is running at about 12
to 15 per cent of national income or more. This is the central problem because the
central fact of economic development is rapid capital accumulation (including
knowledge and skills with capital). We cannot explain any industrial revolution (as

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the economic historians pretend to do) until we can explain why saving increased
relatively to national income." Rostow emphasized the sharp increase in capital
accumulation as one of the key structural elements of development.

The key task was then to start the development process. But how? Two views: in the
Rosenstein-Rodan version, balanced growth, the problem was what we would now
call a coordination problem. Entrepreneurs failed to invest because, in isolation,
there was no assurance that others would simultaneously invest. Hence, where
would the demand for output come from? Coordinated investments were the key.
The critique of this view, by Hirschman, shared the major diagnosis that capital
formation was the problem. The difference was how to create the inducements to
invest. The unbalanced growth view saw these incentives coming from the forward
and backward linkages in the process. But it also gave assurance to the import-
substitution view, since resulting shortages would be inducements for
entrepreneurs to invest. There was also a notion of "hidden resources" available to
be tapped that was important here. This was important, for it implied that increased
investment would not involve sacrifice of other aims. There were again two strands.

The Nurkse-Lewis view was that surplus labor, residing in the countryside, could be
used to work on investment projects. If labor were surplus in the countryside, then
shifting this labor to the cities would not affect total output. Moreover, since the
marginal product of agricultural labor was unchanged, factor payments to
agriculture need not change. Hence, if consumption did not increase among the
remaining rural labor force, an untapped potential was available to work on
investment. This was a net increase, for these workers were consuming anyway,
even though their marginal products were zero. Of course, there were a lot of ifs in
this. The second strand of the disguised potential view, again associated with
Hirschman, focused on latent entrepreneurship. Creative disequilibria would pose
challenges and generate responses. Latent entrepreneurship would emerge,
technological breakthroughs would occur, and shortages would be ameliorated. This
is a sort of decentralized disguised resources, as opposed to the Nurkse-Lewis
model, which was much more suited to planning. This all combined to present
certain optimism about development. An important element of the development
orthodoxy was the notion of multiple equilibria. LDC’s were viewed as being stuck in
a low-level equilibrium trap. The key problem was to attain the take-off to self-
sustained economic growth, as Rostow termed it. This trap could be due to
problems with demography. Or it could be due to pecuniary externalities and
increasing returns, ala Rosenstein-Rodan.

In any event, the idea was that LDC’s needed was a "Big Push" or a critical minimum
effort to escape the trap. These ideas are returning in economics. Paul Krugman
refers to this as a counter-counter-revolution in development economics. He has
suggested that these ideas lost their force in the early 60’s due to the inadequate
modeling of the period. A non-market failure refers to the inefficiencies of non-

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market institutions. These are due, in large part, to the weak incentives associated
with hierarchy. The prevalence of non-market failures in socialist economies has
become accepted wisdom. It leads to distortions that are often orders of magnitude
greater than any market failures. It also leads to rent-seeking behavior, which has
become a problem that dominates LDC’s. One interesting line of inquiry, that this
analysis suggests, is to study the relative importance of market versus non-market
failure in developed versus underdeveloped economies. That is, how does economic
development affect the relative importance of the two types of failures. One might
argue that in LDC’s, the competence of government officials is relatively low, so that
non-market failures may be high. But one must also note that the underdeveloped
state of credit and labor markets may be important too. It seems that development
economics has focused heavily on the latter, while comparative economics has
focused on the former. Although the hidden resources view reflected a good deal of
optimism, there was a pessimistic side to the picture shared by the classical
development theorists. This dealt, almost exclusively, with the external
environment.

Nurkse argued that the "era of export-led growth" was over, and that trade could
not act as an engine of growth for developing countries. This was primarily due to
the fact that the demand for the tropical products of the developing countries was
income inelastic. Prebisch and Singer completed the argument with their thesis that
the commodity terms of trade for developing countries inexorably declined, and
would continue to decline, over time. This occurs because the foreign demand for
LDC exports was lower than for imports. Essentially, LDC exports were exogenous.
Devaluation would not increase revenues. Hence, controlling imports would not
hurt the volume of trade. This led to the prescription of import-substitution policies.
One sees in this a preference for quantitative controls. The typical neoclassical
response to these problems, if they existed, would be to impose a tariff or subsidy.
But the reflexive policy seemed to focus on quantitative restrictions. This reflects, to
some extent, the view of human behavior in developing countries; what we may
term the structuralist view.

The final piece in the puzzle is the two-gap model, associated with Chenery, among
others. The essence of the two-gap model is the notion that foreign exchange is a key
bottleneck. Start with a Harrod-Domar model, where growth is the ratio of the
savings rate to the marginal capital-output ratio. If the latter were 3, then to achieve
a respectable growth rate of output of say, 5%, would require an investment rate of
15%. Hence the focus on increasing savings. Now add to this a dependence of
growth on key imported inputs. Imagine a Leontief production function with
imported inputs that have no domestic substitutes. This implies that increased
domestic savings will not have a positive effect on growth unless sufficient foreign
exchange can be earned to finance the necessary imports. But here the foreign
exchange bottleneck enters the picture. Due to elasticity pessimism the LDC faces an
inelastic demand for its exports.

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These cannot be augmented; hence to increase growth foreign exchange must be

augmented by foreign aid, and by restrictions on imports. Notice how this easily fit
with the preference for planning and the pessimism about the external
environment. Needless to say, this anti-export bias in development economics did
not last. The basic flaw was the lack of concordance with the facts. The successes of
countries that pursued export promoting strategies, combined with the costs
associated with import-substitution (e.g., rent-seeking) played a critical role.

A series of important studies of actual experience played an important role as well.

It is important to understand how this view of the development problem arose out
of a particular approach to the problems of LDC’s; what is called the structuralist
view. The essence of the structuralist view is inflexibility. The structuralist sees
obstacle, bottlenecks, and constraints everywhere. Essentially the world is inelastic.
This general inflexibility is exacerbated in LDC’s, where the peculiarities of peasant
behavior inhibit adjustment. People are ruled by custom and tradition, not self-
interest. There is a lack of entrepreneurial ability. The structuralist view is
consistent with a general distrust of the price mechanism. When the world is
inelastic, very large price increases are needed to achieve even small quantitative
changes. Large price changes are, however, disturbing to the social order, primarily
because they result in changes in income distribution. This may lead to political
reactions that overturn the policies.

Administrative and quantitative controls are thus the best way to achieve results. It
is hard not to see the connection between the structuralist view and the standard
ideology of planning. The view that the world is inelastic, and the general distrust of
the price mechanism is the characteristic view of Soviet economic man. It is
interesting to note that the Soviet planning model developed with a view to
achieving large scale change. It too was a development model. And it was a
development model designed to achieve a maximum of change in a minimum of
time. Gregory Grossman termed this the "Economics of Virtuous Haste."
Mobilization is the key notion of the Soviet planning model, along with a strong
tendency to dismiss notions of economic efficiency. The massive changes that this
system succeeded in producing in the Soviet Union, and other economies, were a
strong example for many developing countries. Nehru seems, for example, to have
been a great admirer of the Soviet Union, and this admiration explains the adoption
of many of the features of early Indian planning. There has, of course, occurred a
counter-revolution to the development orthodoxy.

The current wisdom emphasizes the value of export-promoting strategies rather

than the inward-looking policies. Moreover, it treats agents in developing countries
as rational, and tries to explain why they behave the way they do. That is, what is the
nature of market incompleteness that leads to imperfect outcomes? In general the
new orthodoxy is more neo-classical. It is also less optimistic. The current view
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treats the development process as more complex than did the development
orthodoxy. This is due, in large part, to the fact that modern development
economists tend to eschew uni-causal theories of development. Development is seen
as a complex multi-factor process; consequently there are no simple answers.
Recent analyses have also dropped the notion of irrational peasants. Today the focus
is on how rational agents adapt their institutions to cope with the problems they
face. For example, how does an Indian village cope with uncertainty over climate in
the absence of futures markets and formal insurance? Today the emphasis is on the
role of institutions in coping with missing markets. Constraints come not from
irrationality, but rather from path dependence.

Extreme Inequality in Defining Development Economics

Throughout this part we are assuming that social welfare depends positively on the
level of income per capita but negatively on poverty and negatively on the level of
inequality, as these terms have just been defined. The problem of absolute poverty
is obvious. No civilized people can feel satisfied with a state of affairs in which their
fellow humans exist in conditions of such absolute human misery, which is probably
why every major religion has emphasized the importance of working to alleviate
poverty and is at least one of the reasons why international development assistance
has the nearly universal support of every democratic nation. But it may reasonably
be asked, if our top priority is the alleviation of absolute poverty, why should
relative inequality be a concern?

We have seen that inequality among the poor is a critical factor in understanding the
severity of poverty and the impact of market and policy changes on the poor, but
why should we be concerned with inequality among those above the poverty line?
There are three major answers to this question. First, extreme income inequality
leads to economic inefficiency. This is partly because at any given average income,
the higher the inequality, the smaller the fraction of the population that qualifies for
a loan or other credit. Indeed, one definition of relative poverty is the lack of
collateral. When low-income individuals (whether they are absolutely poor or not)
cannot borrow money, they generally cannot adequately educate their children or
start and expand a business.

Moreover, with high inequality, the overall rate of saving in the economy tends to be
lower, because the highest rate of marginal savings is usually found among the
middle classes. Although the rich may save a larger dollar amount, they typically
save a smaller fraction of their incomes, and they almost always save a smaller
fraction of their marginal incomes. Landlords, business leaders, politicians, and
other rich elites are known to spend much of their incomes on imported luxury
goods, gold, jewelry, expensive houses, and foreign travel or to seek safe havens
abroad for their savings in what is known as capital flight. Such savings and

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investments do not add to the nation’s productive resources; in fact, they represent
substantial drains on these resources.

In short, the rich do not generally save and invest significantly larger proportions of
their incomes (in the real economic sense of productive domestic saving and
investment) than the middle class or even the poor. Furthermore, inequality may
lead to an inefficient allocation of assets. High inequality leads to an overemphasis
on higher education at the expense of quality universal primary education, and this
in turn begets still more inequality in incomes. Moreover, high inequality of land
ownership—characterized by the presence of huge latifundios (plantations)
alongside tiny minifundios that are incapable of supporting even a single family—
also leads to inefficiency because the most efficient scales for farming are family and
medium-size farms. The result of these factors can be a lower average income and a
lower rate of economic growth when inequality is high. The second reason to be
concerned with inequality above the poverty line is that extreme income disparities
undermine social stability and solidarity.

Also, high inequality strengthens the political power of the rich and hence their
economic bargaining power. Usually this power will be used to encourage outcomes
favorable to them. High inequality facilitates rent seeking, including actions such as
excessive lobbying, large political donations, bribery, and cronyism. When resources
are allocated to such rent-seeking behaviors, they are diverted from productive
purposes that could lead to faster growth. Even worse, high inequality makes poor
institutions very difficult to improve, because the few with money and power are
likely to view themselves as worse off from socially efficient reform, and so they
have the motive and the means to resist it. Of course, high inequality may also lead
the poor to support populist policies that can be self-defeating.

Countries with extreme inequality, such as El Salvador and Iran, have undergone
upheavals or extended civil strife that have cost countless lives and set back
development progress by decades. In sum, with high inequality, the focus of politics
often tends to be on supporting or resisting the redistribution of the existing
economic pie rather than on policies to increase its size. Finally, extreme inequality
is generally viewed as unfair. The philosopher John Rawls proposed a thought
experiment to help clarify why this is so. Suppose that before you were born into
this world, you had a chance to select the overall level of inequality among the
earth’s people but not your own identity. That is, you might be born as Bill Gates,
but you might be born as the most wretchedly poor person in rural Ethiopia with
equal probability. Rawls calls this uncertainty the “veil of ignorance.”

The question is, facing this kind of risk; would you vote for an income distribution
that was more equal or less equal than the one you see around you? If the degree of
equality had no effect on the level of income or rate of growth, most people would
vote for nearly perfect equality. Of course, if everyone had the same income no
matter what, there would be little incentive to work hard, gain skills, or innovate. As

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Introduction to Development Economics II

a result, most people vote for some inequality of income outcomes, to the extent that
these correspond to incentives for hard work or innovation. But even so, most vote
for less inequality than is seen in the world (or in virtually any country) today. This
is because much of the inequality we observe in the world is based on luck or
extraneous factors, such as the inborn ability to kick a football or the identity of
one’s great-grandparents.

Glossary
Balanced growth is a dynamic process with the path which is a trajectory such that
all variables grow at a constant rate.

Capital flight occurs when assets or money rapidly flow out of a country, due to an
event of economic consequence.

Capital formation is a term used to describe the net capital accumulation during an
accounting period for a particular country, and the term refers to additions of
capital stock, such as equipment, tools, transportation assets and electricity.

Coordination problem is a concept that can explain recessions through the failure
of firms and other price setters to coordinate.

Credit market refers to the market through which companies and governments
issue debt to investors, such as investment-grade bonds, junk bonds and short-term
commercial paper.

Demographic transition refers to the transition from high birth and death rates to
lower birth and death rates as a country or region develops from a pre-industrial to
an industrialized economic system.

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Introduction to Development Economics II

Labor-intensive products were determined by the amount of capital needed to

produce the goods and services. It refers to a process or industry that requires a
large amount of labor to produce its goods or services.

Marginal product is the change in output resulting from employing one more unit
of a particular input (for instance, the change in output when a firm's labor is
increased from five to six units), assuming that the quantities of other inputs are
kept constant.

Non-market failure or other term is government failure is imperfection in

government performance. The phrase emerged as a term of art in the early 1960s
with the rise of intellectual and political criticism of regulation.

Savings instruments is a traceable asset or negotiable item to be kept on hold for

the time being such as security, commodity, derivative, index or any by which
something of value is transferred, held or accomplished.

Veil of ignorance is a concept or a thought experiment to recognize an individual

and to accept that it’s not possible to choose where and whom he will be born.

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