Chapter 1
Economics, Institutions, and Development:
A Global Perspective
Economic Development
• Development = Growth plus Change
• Growth: sustained improvement in the level of
per capita income
• Change: sustained improvement in institutions
and organizations that support growth
Growth
• Gross Domestic Product (GDP): Market value
of all final goods and services an economy
produces in one year
• Real GDP: GDP in constant prices
• GDP Per Capita = (Real GDP / Population) or
income per person
• Economic Growth = percentage change in Real
GDP per capita
Institutions
• Family: respect the authority & share resources
• Culture: propensity to save & invest
• Religion: ability to bring about change
• Law: protect property rights and civil liberties
and enforce contracts
Organizations
• Government: produce public goods and
regulate economic activities
• Education: increase productivity and expand the
range of economic and social opportunities
• Health: enable proactive participation in
economic and social activities
• Business: provide incentive for profit making,
resulting in growth and expansion
Happiness and Development
• There is not a perfect correlation between
happiness and per capita income: people could
be poor, but happy; rich, but unhappy
• Once per capita income increases above $10,000
to $20,000, the percentage of people who say
they are happy tends to increase
Factors affecting happiness:
• Family relationships
• Financial conditions
• Work satisfaction
• Community and friends
• Health and health-care services
• Personal freedom
• Personal values
Three Core Values of Development
• Sustenance: The ability to meet basic human
needs including shelter, food, health, education,
safety
• Self-Esteem: To be a person with a sense of
self-respect and self-worth. To live with dignity,
respect, and honor
• Freedom from Servitude: To be able to choose
the path to prosperity and have the opportunity
to improve
Objectives of Development
• To increase the availability and distribution of
basic human necessities
• To improve the standard of living for the
majority of the people
• To expand the range of economic and social
choices and opportunities
Millennium Development: Goals and Targets for 2015
1. Eradicate Extreme Poverty and Hunger
2. Achieve Universal Primary Education
3. Promote Gender Equality and Empower Women
4. Reduce Child Mortality
5. Improve Maternal Health
6. Combat HIV/AIDS, Malaria and Other Diseases
7. Ensure Environmental Sustainability
8. Develop a Global Partnership for Development
Economic Development
• Inclusion of non-economic variables in
designing development strategies
• Achieving the Millennium Development Goals
• “…One future-or none at all”
Chapter 2
Comparative Economic Development
Common Characteristics of Developing Countries
These features in common are on average and with
great diversity, in comparison with developed countries:
– Lower levels of living and productivity
– Lower levels of human capital
– Higher levels of inequality and absolute poverty
– Higher population growth rates
– Greater social fractionalization
– Larger rural population - rapid migration to cities
– Lower levels of industrialization and manufactured
exports
– Adverse geography
– Underdeveloped financial and other markets
– Colonial Legacies - poor institutions etc.
2.1 Defining the Developing World
• World Bank Scheme- ranks countries on
GNP/capita
2.2 Basic Indicators of Development: Real Income,
Health, and Education
• Gross National Income (GNI)
• Gross Domestic Product (GDP)
• PPP method instead of exchange rates as
conversion factors
2.3 Holistic Measures of Living Levels and Capabilities
• Health
• Life Expectancy
• Education
• HDI as a holistic measure of living levels
•
• HDI can be calculated for groups and regions in
a country
HDI varies among groups within countries
HDI varies across regions in a country
HDI varies between rural and urban areas
• The New Human Development Index
• Introduced by UNDP in November 2010
What is new in the New HDI?
1. Calculating with a geometric mean
• Probably most consequential: The index is now
computed with a geometric mean, instead of an
arithmetic mean
• A geometric mean is also used to build up the
overall education index from its two components
 • Traditional HDI added the three components and • But there is increasing evidence of “per capita
divided by 3 income convergence,” weighting changes in per
• New HDI takes the cube root of the product of capita income by population size
the three component indexes 2.7 Long-Run Causes of Comparative Development
• The traditional HDI calculation assumed one • Schematic Representation
component traded off against another as perfect  Geography
substitutes, a strong assumption  Institutional quality- colonial and post-colonial
• The reformulation now allows for imperfect  Colonial legacy- pre-colonial comparative advantage
substitutability  Evolution and timing of European development
What is new in the New HDI?  Inequality- human capital
2. Other key changes:  Type of colonial regime
• Gross national income per capita replaces gross Nature and Role of Economic Institutions
domestic product per capita • Institutions provide “rules of the game” of
• Revised education components: now using the economic life
average actual educational attainment of the • Provide underpinning of a market economy
whole population, and the expected attainment • Include property rights; contract enforcement
of today’s children • Can work for improving coordination,
• The maximum values in each dimension have • Restricting coercive, fraudulent and anti-
been increased to the observed maximum rather competitive behavior
than given a predefined cutoff • Providing access to opportunities for the broad
• The lower goalpost for income has been reduced population-
due to new evidence on lower possible income • Constraining the power of elites, and managing
levels conflict
2.4 Characteristics of the Developing World: Diversity • Provision of social insurance
within Commonality • Provision of predictable macroeconomic
1. Lower levels of living and productivity stability
2. Lower levels of human capital (health, education,
skills) Chapter 3
3. Higher Levels of Inequality and Absolute Poverty Classic Theories of Economic Growth and
– Absolute Poverty Development
– World Poverty
4. Higher Population Growth Rates Class Theories of Economic Development – Four
– Crude Birth rates Approaches
5. Greater Social Fractionalization
6. Larger Rural Populations but Rapid Rural-to-Urban 1. Structural change model
Migration Linear stages of growth
7. Lower Levels of Industrialization and Manufactured Saving-investment
Exports Rural-urban migration
8. Adverse Geography 2. Neocolonial dependence theory
– Resource endowments Dependence: Center vs. Periphery
9. Underdeveloped Financial and Other markets False Paradigm
– Imperfect markets 3. Neoclassical theory
– Incomplete information Market friendly approach
10. Colonial Legacy and External Dependence Dualistic approach
– Institutions Public choice approach
– Private property
– Personal taxation Rostow’s Linear-Stages Model
– Taxes in cash rather than in kind  Traditional society
2.5 How Low-Income Countries Today Differ from  Pre-condition to take-off
Developed Countries in Their Earlier Stages  Take-off
• Eight differences  Drive to maturity
 Age of high mass consumption
 Physical and human resource endowments
 Per capita incomes and levels of GDP in relation to Harrod-Domar Growth Model
the rest of the world The source of growth is saving and investment in
 Climate production of goods and services
 Population size, distribution, and growth
 Historic role of international migration The Lewis Development Model
 International trade benefits  Rural agricultural sector
 Basic scientific/technological research and Low or even zero Marginal Product of Labor so
development capabilities that labor is a redundant factor and wage rate is
 Efficacy of domestic institutions at the subsistence level
 Urban industrial sector
2.6 Are Living Standards of Developing and Devolved Rising demand for unskilled labor to be trained
Nations Converging? for industrial growth results in greater
• Evidence of unconditional convergence is hard employment and more profits and higher wages
to find  Rural-Urban migration
To find jobs and earn higher wages

Neocolonial Dependence Model
 MDCs form the “center” of global economic
relations and technological advancement
 LDCs serving as the “periphery” are dominated by:
unequal trade and finance relations
domestic politico-economic elite
multinational corporations
Under these conditions economic development is
impossible
False Paradigm Model
 Economic development relies heavily on funds from
international donor agencies such as the World Bank
and IMF
 The policy of these agencies is to support urban
industrial growth and impose capitalistic austerity
measures
 They reinforce the pattern of “dependent
development”
Dualistic Development Model
 Structural transformation models create a “dualistic”
pattern of development, resulting in an ever-
increasing degree of economic inequality both
nationally and internationally:
urban vs. rural
industrial vs. agricultural
modern vs. traditional
rich vs. poor
Approaches To Development
 Free-market approach: rely of the allocation role of
markets and limited government involvement in
economics. But, there are several areas in which
markets fail to achieve efficient outcomes:
income distribution
public goods
externalities
market power
 Market-friendly approach: improve market operation
through “nonselective” interventions such as
income redistribution system
investment in social and human capital
environmental protection policy
anti-trust laws
 Public-choice approach: public officials and
bureaucrats in the position of authority are “rent-
seeking” citizens acting on self-interest rather than
public-interest
 Need a system of checks and balances to monitor the
behavior of public officials and bureaucrats
 Need a democratic system to let people choose
public officials and bureaucrats for limited duration
of authority
Components of Economic Growth
 Capital Formation
1. Physical capital formation: investment
in tools, equipment, machinery, buildings
2. Social capital formation: investment in
roads, dams, airports, railroads, bridges
3. Human capital formation: investment in
education, training, health, nutrition
4. Political capital formation: investment is
creating a secular and democratic government and
free mass media
Determinants of Economic Growth
 Physical Capital Formation
Increase in the amount of physical capital per
unit of labor
 Technological Advancement
Increase factor productivity (labor, land, capital)
Production Possibilities Curve
 Maximum quantities of two good and services the
economy can produce, assuming:
full employment / efficiency
fixed resources
constant technology
Chapter 4
Contemporary Models of Development and
Underdevelopment
Underdevelopment as Coordination Failure
 Economic development is difficult to achieve. It has
been impossible for some countries (e.g., Nigeria,
Sudan), but accomplished by others (e.g., S. Korea,
Singapore)
 The success or failure of economic development
policies can be explained by the “principal-agent”
model.
Principal: Government
Agents: Households
Private-sector firms
Public agencies
Government-owned enterprises
International companies
 An effective principal is needed to coordinate
actions taken by agents and achieve an optimal
outcome, making all agents better-off.
 Coordination failure occurs when the principal fails
to induce agents to coordinate their actions, which
leads to an outcome that makes all agents worse-off.
Models of Coordination Failure
 Technological Transfer for Modernization
 The Big Push to Industrialization
 The O-Ring Theory of Economic Development
 The Growth Diagnostics Framework
Technological Transfer for Modernization
 Stable equilibrium: The S-shaped function crosses
the 45º line from above.
 Unstable equilibrium: The S-shaped function crosses
the 45º line from below.
 To achieve stable equilibrium, firms must be able to
coordinate their investment decisions such that all
firms benefit from each other’s investment.
 Public policy creating incentives for investment is
the key for successful coordination. The government
must establish inclusive incentives to encourage
business investment.
The Big Push to Industrialization
 A big push to industrialization requires a set of
leading firms to investment in productive activities
and transfer of modern technology
 Investment decisions made by modern-sector firms
are mutually reinforcing and public policy
intervention is needed to correct market failure
Assumptions:
 One factor of production: labor
 Two economic sectors: traditional vs.
modern
 Same production function for each
sector
 Consumers spend an equal amount on each
product they buy
 Closed economy
  Perfect competition  No “one size fits all” in development policy of
market coordination
 Insufficient investment in physical, social,
environmental, and human capital
The Big Push: Coordination Failure
 A firm is deciding to invest in new technology
 It faces a production function in the traditional sector
that passes through the origin as output increases
with labor employment
 It faces a production function in the modern sector
that requires some labor employment before
initiating production
Conditions Making The Big Push Necessary
 Intertemporal effects: investment in the modern
sector becomes profitable over-time as the market
size increases
 Urbanization effects: demand for manufactured
goods increases with urban population growth
 Infrastructural effects: improvement in
transportation, communication, and distribution
systems reduces the cost of investment
 Training effects: the labor force becomes more
productive and skilled with education
Coordination Problem Cannot Be Solved by a Super-
Entrepreneur
 Capital market failure: bankers are unwilling to
provide loans to a single firm
 Cost of monitoring managers: expensive agency
costs to ensure compliance of employees
 Communication failure: agents wanting to share
profit cannot convince the super-entrepreneur to do
so
 Limited knowledge: agents do not have sufficient
information about the importance of industrialization
 Lack of empirical evidence: agents do not know that
other firms are investing in modern technology
Further Problems of Multiple Equilibria
 Linkages: underdeveloped backward and forward
linkages to support industrialization
 Inequality and growth: trickle-up growth, resulting
in increased inequality and poverty, reduces the
buying power of workers and their demand for
manufactured goods
 Inefficient advantages of incumbency: existing firm
have lower production cost
 Behavior and norms: agents may be corrupt and
bribery may be the standard method of doing
business internationally
The O-Ring Theory of Economic Development
 Production is modeled with strong
complementarities of inputs (labor & capital) and
interdependencies among firms (output of one firm
is input of another)
 Positive assortative matching in production: skilled
labor works with its peers; profitable and
modernizing firms coordinate with their counterparts
 Implications of strong complementarities for
economic development and the distribution of
income across countries will induce countries at the
same level of development to coordinate their
actions
 MDCs cooperate and coordinate with each other in
the development and transfer of modern technology
The Growth Diagnostics Framework
 Focus on a country’s most binding constraints of
economic development: low rate of return on
investment and high cost of financing