Together with the process of economic development and the changes in the structure of production, there is also a transformation of the economy, which both involves major social changes and induces greater (and perhaps more “complex”) coordination of economic activities.
Loosely speaking, we can think of a society that is relatively developed as functioning along (or at any rate, nearer) the frontier of its production possibilities set, while a less-developed economy is in the interior of its “notional” production possibilities set.
This may be caused by the fact that certain arrangements necessary for an economy to reach the frontier of its production possibility set require a large amount of capital or some specific technological advances (in which case, even though we may think of the society as functioning in the interior of its production possibility set, this may not be the outcome of market failure, thus the qualifier “notional” in the previous sentence). Alternatively, less developed economies may be in the interior of their production possibility set because these societies are sub ject to severe market failures. In this chapter, I will discuss both types of models.I first focus on structural transformations and how these may be limited by amount of capital or technology available in a society. The main economic issues are most simply and effectively illustrated by a simple model in which economic development is accompanied with financial development, enabling better risk sharing and thus investment in higher productivity activities. This model, presented in Section 21.1, has certain clear similarities to the model we studied in Section 17.6 in Chapter 17, though it focuses on the sharing of idiosyncratic risks rather than diversification of aggregate risks. Section 21.2 is less explicitly about the economy moving from the interior of its production possibilities set towards the frontier. Nevertheless, it discusses a major aspect of the structural transformation of the economy during the development process—the demographic transition. In particular, this section discusses how population and fertility change over the process of development and emphasizes how these structural transformations may be linked to investments in human capital.
This model provides a brief introduction to the rich literature on the demographic transition and its role in economic growth. Section 21.3 discusses another important structural change, the increase in the population living in urban areas via migration from the countryside to the cities. This model illustrates both how development is associated with a process of allocating workers to activities in which their marginal product is higher and also how a dual economy structure can emerge in equilibrium and slow down this reallocation process. All three of these sections are meant to give a flavor of vast literatures dealing with issues of financial development, the demographic transition, population growth, fertility, migration, urbanization, and other social changes taking place in the course of the development process. Some of these areas are at the forefront of current research in economic growth (and economic development!) but space restrictions preclude me from spending more than a few sections on these important topics.In Section 21.4 I present a model that is complementary to those in Sections 21.1-21.3, where the stage of development is captured by the distance of an economy’s technology to the world technology frontier. This model shows how the distance to the frontier measure of the stage of development influences how production is and should be organized. More specifically, it focuses on whether entrepreneurs that are unsuccessful will be immediately replaced by new entrepreneurs or whether the equilibrium will feature long-term relationships and the survival of experienced entrepreneurs even when they are not very productive early on. The simple framework presented in this section can be used for modeling a range of decisions related to the structure of production and the internal organization of firms over the process of development, which is another aspect of the sweeping structural changes suggested by Kuznets.
The models presented in Sections 21.1-21.4 focus on structural transformations.
Part of the focus of these models is on the structural transformation that is an essential part of the process of economic development and the common theme is an investigation of the factors that help or hinder this structural transformation as well as the impact of this transformation on aggregate productivity. Some of these models feature market failures, though the focus is not on market failures per se.A central question of economic development (and economic growth) is why so many societies have failed to take advantage of new and improve their technologies over the past 200 years. The perspective that emphasizes potential differences in efficiency and in the extent of market failures also suggests that some less-developed economies might be suffering disproportionately from market failures. In the extreme, some economists might interpret the implications of these models as stating that less-developed economies are “stuck” in a potential “development trap,” that is, an equilibrium or a steady state where efficiency is low and market failures sustain this low efficiency equilibrium, though a different type of steady state (or equilibrium) with a higher level of income and/or a higher growth rate is also possible. The rest of this chapter turns to an investigation of some of the role of various different types of market failures in economic development and in particular, in causing poverty traps. Section 21.5 emphasizes the possibility of multiple equilibria due to aggregate
demand externalities. In the model presented in this section, one of the multiple equilibria approximates a situation without industrialization and growth. Section 21.6 investigates the importance of income inequality for economic development and shows how the interaction of imperfect capital markets with income inequality can lead to multiple steady states, again with different levels of efficiency and productivity. I also use the models in this section to emphasize the difference between multiple equilibria and multiple steady states, and I provide a brief discussion of richer models of income inequality dynamics and their implications for economic development.
Finally, Section 21.7 provides a reduced-form model that emphasizes some of the common themes in the approaches covered in this chapter. While each model in this chapter makes quite different assumptions, there are sufficiently many common elements that my hope is that an attempt to bring out the similarities, even if in a highly reduced-form way, will provide additional insights.The topics covered in this chapter are part of a large and diverse literature. My purpose is not to do justice to this literature but to emphasize how certain ma jor structural transformations take place as part of the process of economic development and also highlight the potential importance of market failures in this process. Given this objective and the large number of potential models, my choice of models is selective and my treatment will be more informal than the rest of the book. In addition, I will often make reduced-form assumptions in order to keep the exposition brief and simple, while communicating the main ideas.
21.1.