The document discusses several models of economic development and underdevelopment: 1) Underdevelopment can be seen as a coordination failure where agents cannot coordinate actions to escape a low-income equilibrium. Government policy can help coordinate investment to reach a better outcome. 2) Kremer's O-Ring Theory models how even small failures can bring down complex systems, similar to an economy. Strong complementarities mean all tasks must be done well together for high value production. This can trap countries in a low-quality, low-income equilibrium. 3) The Hausmann-Rodrik-Velasco Growth Diagnostics Framework takes a country-specific approach, using a decision tree to identify the most pressing binding constraint limiting growth in

1. Chapter 3:3
Contemporary Models of
Development and
Underdevelopment

2. Introduction:
• development is possible and extremely difficult.
• The new research has broaden the scope of
modeling market economy in developing country
context by incorporating the problem of
coordination among economic agents.
• And, it considers increasing return to scale,
learning by doing, information externalities,
monopolistic competitions other than perfect
competition dominance.

3. Underdevelopment as a Coordination Failure
• Coordination failures occur when agents’ inability to
coordinate their actions leads to an outcome that makes all
agents worse off.
• This can occur when actions are complementary, i.e., New
models have emphasized complementarities between several
conditions necessary for successful development.
• Complementarity means actions taken by one agent reinforces
incentives for others to take similar actions, meaning
investment return depends on other investment taken by others.
• Congestion: The opposite of Complementarity, an action taken
by one agent that decrease the incentive for other agents to take
similar actions.

4. • The coordination problems can leave the economy stuck in bad
equilibrium-that is a low average income of growth rate with a
class of citizen trapped in extreme poverty.
• In many cases, the presence of Complementarity creates a classic
“ chicken and egg” problem: which comes first, the skills or the
demand for the skills: Often the answer is that the
Complementarity investment must come at the same time through
coordination.
• As result, every economic agents expect a change to a better
equilibrium, they will wait until other parties have made their
investment.
• This can be an important role of government policy in coordinating
joint investment
• Deep intervention: a government policy that can move the
economy to a preferred equilibrium that can then be self-sustaining
so that the policy need no longer be enforced because the better
equilibrium will then prevail without further intervention.

5. Michael Kremer’s O-Ring
Theory of Economic
Development

6. •The name of the theory comes from the cause of the Challenger
space shuttle explosion. In that case, a highly complex machine
with thousands of components failed because one minor part, an
O-ring, failed in the cold conditions. This is despite the remaining
components being in order.
• Kremer saw a similarity between what occurred in the
Challenger case and what may happen in production in the
economy. A company with a great product and service may fail
due to bad marketing. An otherwise functional good may sell at a
much reduced price due to a single defect., what does this imply
for economic development?
• Kremer pictured firms that engage in production involving a
series of tasks. Workers have different skill levels, which is
represented by a probability that they properly perform the task.
Even if workers have relatively high completion rates, small

7. Michael Kremer’s O-Ring Theory of Economic Development
• He created the well-known economic theory regarding skill
complementarities called O-Ring Theory of Economic Development.
• It is another innovative and influential model that provides
important insights into low-level equilibrium trap.
• The modern production requires that many activities be done
well together on order for any of them to amount high value.
• The O-Ring Model
– Production is modeled with strong complementarities
among inputs
– Positive assortative matching in production
• He proposes that tasks of production must be executed
proficiently together in order for any of them to be of high
value. The key feature of this model is positive assortative,
whereby people with similar skill levels work together

8. • Implications of strong complementarities for economic
development and the distribution of income across countries:
1. Firms tend to employ workers with similar skills for their various tasks
2. Workers performing the same task earn higher wages in high-skill form than in
a low-skill firm
3. Because wages increase in q at an increasing rate, wages will be more than
proportionally higher in developed countries than would be predicted from the
standard measures of skill
4. Higher average skill causes a greater incentive to acquire more skills, building
a human capital
5. Once country trapped in low quality production, this will occur when there are
O-rings effect across firms and within firms. Industrial policy in favor of quality
upgrading helps country to escape out from the middle-income trap.
6. O-ring effects magnify the impact of local production bottlenecks because such
bottleneck have a multiplicative effects on other production.
7. Bottlenecks also reduce the incentive for workers to invest in skills by
lowering the expected return to these skills.

9. The Hausmann-Rodrik-Velasco Growth
Diagnostics Framework

10. The Hausmann-Rodrik-Velasco Growth
Diagnostics Framework
• Focus on a country’s most binding
constraints on economic growth.
• No “one size fits all” in development policy
• Requires careful research to determine the
most likely binding constraint

11. The Hausmann-Rodrik-Velasco Growth
Diagnostics Framework: 1
1.Specialization – specifics beyond comparative advantage, i.e. labor-
intensive activities is hardly enough. The idea behind “self-discovery”
--- figuring out what the impediments to growth are.
2.The building towards self-discovery recognizes 3 building blocks:
a.Uncertainty about what a developing country can produce cost-
effectively and also profitably.
b.Need for the local adaption of imported technology to prevent
easy entry – might require local reverse engineering.
c.With (a) and (b) in place, “imitation” is very rapid. It shows as many
countries who are labor-intensive will produce different labor
intensive products.
3. Growth Diagnostics (GD)– once efficient investment &
entrepreneurship are accepted for economic growth & development,
there is need for country-specific binding constraints. GD is a
decision tree for identifying the most binding constraints for each
country currently and in future.

12. The Hausmann-Rodrik-Velasco Growth Diagnostics
Framework: 2
1. Focus on a country’s most binding constraints on
economic growth & alleviating pressing constraints.
2. Suppose a country is constrained by low level of private
investment & entrepreneurship. The decision tree
identifies the-how-to-solve the problem. The initial causes
could be (a) low return to economic activity and (b) high
cost of finance.
3. Note that the solution to these binding constraints are so
many and multi-dimensional. This shows that No “one size
fits all” in development policy, i.e. GD is a much more
broader approach to development policy that
complements econometric modelling.
Not simple to find the binding constraint. Uncertainty leads to
probabilistic assessments

13. Figure 3 Hausmann-Rodrik-Velasco Growth
Diagnostics Decision Tree

14. The Hausmann-Rodrik-Velasco Growth Diagnostics
Framework;3
Growth diagnostics
1. Key constraint is inadequacy of public goods especially on
2 emerging sectors (tourism & light manufacturing).
2. Financial sector constraints –credit and loans
Signals
Problem of “arriving late” for public events
Illustrates the idea of multiple equilibria --- moving from one inferior equilibrium
to a superior one

15. Thank you