Development Economics

GS F234
Leela Rani, PhD
Associate Professor, Management
BITS Pilani Email: leela_r@pilani.bits-pilani.ac.in
Pilani Campus
 BITS Pilani
Pilani | Dubai | Goa | Hyderabad

Development Economics
Chap 08: Market and state
The most appropriate economic systems for economic growth and development

1. Traditionally there has been difference between institutions and organizations

Institutions were considered => rules in society
Organizations were considered=> formal establishments in the form of govt, firms, or any group of
individuals with the common focus

2. These two are inseparable, and also used interchangeably today

Therefore for our purpose,
3. We will consider organizations/ institutions as functional bodies which are governed by a
set of rules and policies
4. The “set of rules and policies” = institutions
5. In this context, market is an organization that coordinates the production and
consumption of goods and services amongst buyers and sellers
6. One must differentiate between two types of market in any economy
=>> Goods market & factor market
1. Transactions in the markets are based on free will
2. Information of different types about quantities, prices and terms and conditions at which transactions can
happen is widely and reliability available to participants in the market…= competitive market
3. Therefore transactions happen only when participants gain something
4. Several organizations co-ordinate people's activities of buying and selling resulting in satisfaction of self
interest and economic welfare mutually
1. The state here refers to the government
2. The government in any country is a special organization
3. It has legal and coercive powers
4. Its main aim is to co-ordinate people's activities according to constitutional rules regulations
5. For the purpose of welfare, economic growth and development
6. State can enforce different systems under legal umbrella, like:
7. Property laws, taxes, regulations for almost any industry (TRAI)
8. Its chief responsibilities are to provide national defence, courts, police, roads, schools, basic resources
for sustainable like water, minimum livelihood, basic security and protection
9. Markets are run on a more commercial basis than state organizations
10. While these two are separate they do reinforce each other
11. For example, if the state does not make property laws, then market participants will find it difficult to run
their economic transactions efficiently
12. Similarly if the state does not give legal power for enforcing contracts, economic transactions can come to
a standstill
13. More of dominance from either of these parties- state or market- it is detrimental for the optimum level of
economic growth and therefore economic development
Efficiency of the competitive market
1. Classical economists like Adam Smith favored competition in a free market way
2. They said that free market participants, will be able to decide their own best welfare,
• of what to produce
• What price to charge and pay,
• about profit margins

1. That they will be able to do it best without unnecessary government interventions

2. This he called the invisible hand
3. The invisible hand will automatically lead to the greatest value for the nation
4. They also advocated removal of trade restrictions
5. This will improve static efficiency=> allocation of resources
6. Also dynamic effect => increased division of labour, R&D etc
7. In the same market the concept of efficiency also meant that
8. It all stakeholders are able to get maximum value in a deal from the market
9. Where there is no wastage or and productive input for time, effort or money
1. Equilibrium between demand and supply in a free market, it represents efficient resource
allocation…. See this in a graph
2. This has no demand surplus and no supply surplus
3. The extent to which real world conditions diverge from this equilibrium, represents inefficiency
4. Efficient allocation means that no participate in market transaction can increase the
economic welfare without decreasing welfare of others - as everyone is getting the most
optimum desired for him or her
https://www.youtube.com/watch?v=cT3DcuZnsGs

This optimality is called Pareto optimality

5. Market failures happen when Pareto optimality is not met
This can happen frequently for public goods
but it can also happen for private goods

Broadly wherever one stakeholder is taking more than his or her fair share of benefits because of
6. Lack of information
7. Fraudulent behaviour practices
8. Monopolizing power of anyone participant
1. In all such cases to establish optimality, ideally government or industry boards/ unions, consumer unions,
would need to intervene to establish fair practices and acceptable norms and conditions for transactions
2. In reality perfection is normally never achieved, but still citizens aim at achieving it.
3. So one can list several reasons why market failures and why government failures happen
4. While market failures are limited in their scope and impact, as they can be more quickly located and weeded
out
5. Government failures are more tricky issue to solve
6. Government have approved vote of citizens at least at some point of time
7. Which brings them to office with power and money
8. This helps them to work on their selfish aims not only as a powerful entity,
9. but also against whom information gathering to prove corruption is very difficult
10. Governments don't only misuse budgets but also power.
11. They also make policies to favour their own people
12. Have network with judiciary, police, business and other groups in a more in legitimate way
13. These are the major reasons why government failures not only happen but they also persist
How much problems are happening from governments side to create such failures,
would depend on:
1. Cultural heritage of the country
2. Level of information transparency and infrastructure
3. Stage of economic development

Usually these are poor for developing economies

1. Infant industry protection or government

2. Import substitution industrialization policy
3. Develop mentalist models
4. Role of information and ideology
5. Old developmental market economies
6. Collapse of centrally planned economy
7. Trap of populism
8. Success and failure of new developmental market economies (notes)
Infant industry protection argument
1. A common debate is about the proportion of government it vs private intervention for
economic growth
This corresponds to:
 More of government intervention - tools like infant industry protection
 More of private intervention- tools like free trade
1. For less developed economies, the problem of imperfect information, capital accumulation
and technological progress - make production difficult
2. Availability of educated and trained citizens is also a challenge
3. All this makes the initial development of industry difficult
4. This is where the government is expected to play a larger role,
5. By pushing policies around, infant industry protection, import substitution etc
Many classical economists like Ricardo encouraged free trade
They showed how in cases of both absolute advantage and comparative advantage, countries
can gain from trade
We see this in a small example here

1. Later economist, , like List, said that free trade create a problems for the developing nations
2. They are forced to remain engaged with low value agricultural activities
3. While high value add manufacturing activities are always beyond their competitiveness

This happens because,

4. initially developed country is more competitive in manufacturing items,
5. while developing nations are better at agricultural items
6. So the trade happens like this: developed economies export manufactured items, and
developing economies export agricultural items
7. Developed countries get better and better at high value add manufacture items,
8. the developing countries are left out from rising up the ladder
What is the production
for each count
 USA is giving 30% L to
coffee and 70% to wheat

USA is giving 25% L to

coffee and 75% to wheat
1. List said that government should protect domestic Industries against competition from overseas so
that manufacturing can develop
2. He suggested such measures as protection in the form of tariff, quota, quality requirements to
restrict imports of manufactured items into developing countries
3. At the same time, government must give subsidies, soft loans, several other business enhancing
resources and facilities to promote home manufacturers

List did not contradict what Ricardo

4. He only emphasized that the initial static effect, must not make way for obscuring or removing the
dynamic effect of development
5. dynamic effect relates to the lowering of cost as one develops his or her industry
6. List was against Adam Smith’s free trade – former said avoid market failure, latter said avoid
government failure
7. List’s suggestions also lead to creation of further problems…called Listian trap
8. This can be seen in how government failure happened when to protect infant industries, govt.
implemented import substitution policy.

Why did these govt. measures fail in most nations and succeeded only in some?
The impact of import substitution industrialization policy

1. This policy was thought as super important to help developing countries achieve their convergence goal
2. It was highly supported by citizens of developing countries who had just come out of an oppressive colonial
system
3. This policy enabled and supported the substitution of manufactured items connected to all industrial sectors
to be manufactured at home
4. Instead of importing them from other developed countries
5. This was also supported by export pessimism for primary commodity
6. Export pessimism was based on the secular decline in terms of trade against developing countries
7. Terms of trade mean the ratio of primary to manufactured commodity prices
8. If prices of primary commodities is < prices of manufactured commodity
9. It means, that latter will generate more income and more margin of profits
10. Since developing country specializes in primary commodities, there will be a net income flow in favour of
developed countries
11. To undo this the import substitution Policy was established and favored by governments of developing
countries
 the Policy was implemented by border protection measures like tariffs, import quotas and other similar
restrictions
Additionally, developing countries kept an overvalued domestic currency …eg.
If the normal marker-driven exchange rate is 65Rs: 1 $, then Indian govt sets it at 60Rs: 1 $.
This makes imports cheaper and benefits those companies that import capital equipment for the production
process
They imposed quota on import purchases of these items so that domestic consumers will buy them from
domestic producers and cannot import them.
For example, take the production of a sewing machine. Its inputs will be cheap, citizens cannot buy these
finished products from other countries and
Also, if the price of domestic sewing machines is high then it also benefits the domestic production.

This will harm development of all other sectors/industries which are not protected.
The protected become less efficient and less productive at the expense of the non-protected.
The former do not have much incentive to produce globally competitive standard items
This is used by politicians and powerful businessmen to protect their own interests.
The limit of information and role of ideology
1. The major reason for market failure is future uncertainty
2. The assumption in promoting the role of government, is that, government will take care of of uncertainty
3. However with lack of information and vested interest, or role of certain ideology
4. It can often happen that government has less information, also wrong information, many times international, to decide
which are the best industries of processes to protect
5. What is the best level for currency valuation so that all sectors and industries of the economy that appropriate protection
from undue competition, as well as are challenged to be productive
6. In the absence, government interventions lead to major failures
7. Successful cases of import substitution in japan and Germany
8. But mainly result of, simple policies to protect their industries, without much interference in currency valuations
9. Later both the system's became overly complex and therefore allowed manipulation
10. This led to failure for many other developing countries

Why did developmental market economies succeed (Germany & Japan) and fail (other DE’)?...page 259
The collapse of the centrally planned economy……Self reading …………263
the Trap of populism……….bringing beneficial policies for a limited few based on ideologies, affiliations…..harmful for
several others……….reservations in India, election based populist moves , recent example is SriLanka
https://www.youtube.com/watch?v=dJvmlIxpf4s
page 267
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