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Development Economics

Debraj Ray

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Copyright © 1998 by Princeton University Press Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, Chichester, West Sussex

All rights reserved

Library of Congress Cataloging-in-Publication Data Ray, Debraj.

Development economics / Debraj Ray. p. cm.

Includes bibliographical references and index. ISBN 0-691-01706-9 (cl : alk. paper) 1. Development economics. I. Title.

HD75.R39 1998 338.9--dc21 97-33459

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ISBN-13: 978-0-691-01706-8 (cloth)

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http://pup.princeton.edu/
For my parents, Radha and Kalyan

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Contents

Preface

Chapter 1: Introduction

Chapter 2: Economic Development: Overview 2.1. Introduction 2.2. Income and growth 2.2.1. Measurement issues

2.2.2. Historical experience

2.3. Income distribution in developing countries 2.4. The many faces of underdevelopment 2.4.1. Human development

2.4.2. An index of human development

2.4.3. Per capita income and human development

2.5. Some structural features 2.5.1. Demographic characteristics

2.5.2. Occupational and production structure

2.5.3. Rapid rural–urban migration

2.5.4. International trade

2.6. Summary Exercises

Chapter 3: Economic Growth 3.1. Introduction 3.2. Modern economic growth: Basic features 3.3. Theories of economic growth 3.3.1. The Harrod–Domar model

3.3.2. Beyond Harrod–Domar: Other considerations

3.3.3. The Solow model

3.4. Technical progress 3.5. Convergence? 3.5.1. Introduction

3.5.2. Unconditional convergence

3.5.3. Unconditional convergence: Evidence or lack thereof

3.5.4. Unconditional convergence: A summary

3.5.5. Conditional convergence

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3.5.6. Reexamining the data

3.6. Summary Appendix 3.A.1. The Harrod–Domar equations

3.A.2. Production functions and per capita magnitudes

Exercises

Chapter 4: The New Growth Theories 4.1. Introduction 4.2. Human capital and growth 4.3. Another look at conditional convergence 4.4. Technical progress again 4.4.1. Introduction

4.4.2. Technological progress and human decisions

4.4.3. A model of deliberate technical progress

4.4.4. Externalities, technical progress, and growth

4.4.5. Total factor productivity

4.5. Total factor productivity and the East Asian miracle 4.6. Summary Appendix: Human capital and growth Exercises

Chapter 5: History, Expectations, and Development 5.1. Introduction 5.2. Complementarities 5.2.1. Introduction: QWERTY

5.2.2. Coordination failure

5.2.3. Linkages and policy

5.2.4. History versus expectations

5.3. Increasing returns 5.3.1. Introduction

5.3.2. Increasing returns and entry into markets

5.3.3. Increasing returns and market size: Interaction

5.4. Competition, multiplicity, and international trade 5.5. Other roles for history 5.5.1. Social norms

5.5.2. The status quo

5.6. Summary Exercises

Chapter 6: Economic Inequality 6.1. Introduction 6.2. What is economic inequality? 6.2.1. The context

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6.2.2. Economic inequality: Preliminary observations

6.3. Measuring economic inequality 6.3.1. Introduction

6.3.2. Four criteria for inequality measurement

6.3.3. The Lorenz curve

6.3.4. Complete measures of inequality

6.4. Summary Exercises

Chapter 7: Inequality and Development: Interconnections 7.1. Introduction 7.2. Inequality, income, and growth 7.2.1. The inverted-U hypothesis

7.2.2. Testing the inverted-U hypothesis

7.2.3. Income and inequality: Uneven and compensatory changes

7.2.4. Inequality, savings, income, and growth

7.2.5. Inequality, political redistribution, and growth

7.2.6. Inequality and growth: Evidence

7.2.7. Inequality and demand composition

7.2.8. Inequality, capital markets, and development

7.2.9. Inequality and development: Human capital

7.3. Summary Appendix: Multiple steady states with imperfect capital markets Exercises

Chapter 8: Poverty and Undernutrition 8.1. Introduction 8.2. Poverty: First principles 8.2.1. Conceptual issues

8.2.2. Poverty measures

8.3. Poverty: Empirical observations 8.3.1. Demographic features

8.3.2. Rural and urban poverty

8.3.3. Assets

8.3.4. Nutrition

8.4. The functional impact of poverty 8.4.1. Poverty, credit, and insurance

8.4.2. Poverty, nutrition, and labor markets

8.4.3. Poverty and the household

8.5. Summary Appendix: More on poverty measures Exercises

Chapter 9: Population Growth and Economic Development 9.1. Introduction

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9.2. Population: Some basic concepts 9.2.1. Birth and death rates

9.2.2. Age distributions

9.3. From economic development to population growth 9.3.1. The demographic transition

9.3.2. Historical trends in developed and developing countries

9.3.3. The adjustment of birth rates

9.3.4. Is fertility too high?

9.4. From population growth to economic development 9.4.1. Some negative effects

9.4.2. Some positive effects

9.5. Summary Exercises

Chapter 10: Rural and Urban 10.1. Overview 10.1.1. The structural viewpoint

10.1.2. Formal and informal urban sectors

10.1.3. Agriculture

10.1.4. The ICRISAT villages

10.2. Rural–urban interaction 10.2.1. Two fundamental resource flows

10.2.2. The Lewis model

10.3. Rural–urban migration 10.3.1. Introduction

10.3.2. The basic model

10.3.3. Floors on formal wages and the Harris–Todaro equilibrium

10.3.4. Government policy

10.3.5. Comments and extensions

10.4. Summary Exercises

Chapter 11: Markets in Agriculture: An Introduction 11.1. Introduction 11.2. Some examples 11.3. Land, labor, capital, and credit 11.3.1. Land and labor

11.3.2. Capital and credit

Chapter 12: Land 12.1. Introduction 12.2. Ownership and tenancy 12.3. Land rental contracts 12.3.1. Contractual forms

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12.3.2. Contracts and incentives

12.3.3. Risk, tenancy, and sharecropping

12.3.4. Forms of tenancy: Other considerations

12.3.5. Land contracts, eviction, and use rights

12.4. Land ownership 12.4.1. A brief history of land inequality

12.4.2. Land size and productivity: Concepts

12.4.3. Land size and productivity: Empirical evidence

12.4.4. Land sales

12.4.5. Land reform

12.5. Summary Appendix 1: Principal–agent theory and applications 12.A.1. Risk, moral hazard, and the agency problem

12.A.2. Tenancy contracts revisited

Appendix 2: Screening and sharecropping Exercises

Chapter 13: Labor 13.1. Introduction 13.2. Labor categories 13.3. A familiar model 13.4. Poverty nutrition, and labor markets 13.4.1. The basic model

13.4.2. Nutrition, time, and casual labor markets

13.4.3. A model of nutritional status

13.5. Permanent labor markets 13.5.1. Types of permanent labor

13.5.2. Why study permanent labor?

13.5.3. Permanent labor: Nonmonitored tasks

13.5.4. Permanent labor: Casual tasks

13.6. Summary Exercises

Chapter 14: Credit 14.1. Introduction 14.1.1. The limits to credit and insurance

14.1.2. Sources of demand for credit

14.2. Rural credit markets 14.2.1. Who provides rural credit?

14.2.2. Some characteristics of rural credit markets

14.3. Theories of informal credit markets 14.3.1. Lender’s monopoly

14.3.2. The lender’s risk hypothesis

14.3.3. Default and fixed-capital loans

14.3.4. Default and collateral

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14.3.5. Default and credit rationing

14.3.6. Informational asymmetries and credit rationing

14.3.7. Default and enforcement

14.4. Interlinked transactions 14.4.1. Hidden interest

14.4.2. Interlinkages and information

14.4.3. Interlinkages and enforcement

14.4.4. Interlinkages and creation of efficient surplus

14.5. Alternative credit policies 14.5.1. Vertical formal–informal links

14.5.2. Microfinance

14.6. Summary Exercises

Chapter 15: Insurance 15.1. Basic concepts 15.2. The perfect insurance model 15.2.1. Theory

15.2.2. Testing the theory

15.3. Limits to insurance: Information 15.3.1. Limited information about the final outcome

15.3.2. Limited information about what led to the outcome

15.4. Limits to insurance: Enforcement 15.4.1. Enforcement-based limits to perfect insurance

15.4.2. Enforcement and imperfect insurance

15.5. Summary Exercises

Chapter 16: International Trade 16.1. World trading patterns 16.2. Comparative advantage 16.3. Sources of comparative advantage 16.3.1. Technology

16.3.2. Factor endowments

16.3.3. Preferences

16.3.4. Economies of scale

16.4. Summary Exercises

Chapter 17: Trade Policy 17.1. Gains from trade? 17.1.1. Overall gains and distributive effects

17.1.2. Overall losses from trade?

17.2. Trade policy: Import substitution

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17.2.1. Basic concepts

17.2.2. More detail

17.3. Export promotion 17.3.1. Basic concepts

17.3.2. Effect on the exchange rate

17.3.3. The instruments of export promotion: More detail

17.4. The move away from import substitution 17.4.1. Introduction

17.4.2. The eighties crisis

17.4.3. Structural adjustment

17.5. Summary Appendix: The International Monetary Fund and the World Bank Exercises

Chapter 18: Multilateral Approaches to Trade Policy 18.1. Introduction 18.2. Restricted trade 18.2.1. Second-best arguments for protection

18.2.2. Protectionist tendencies

18.2.3. Explaining protectionist tendencies

18.3. Issues in trade liberalization 18.3.1. Introduction

18.3.2. Regional agreements: Basic theory

18.3.3. Regional agreements among dissimilar countries

18.3.4. Regional agreements among similar countries

18.3.5. Multilateralism and regionalism

18.4. Summary Exercises

Appendix 1: Elementary Game Theory A1.1. Introduction A1.2. Basic concepts A1.3. Nash equilibrium A1.4. Games over time

Appendix 2: Elementary Statistical Methods A2.1. Introduction A2.2. Summary statistics A2.3. Regression

References

Author Index

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Subject Index

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Preface

This book provides an introduction to development economics, a subject that studies the economic transformation of developing countries. My objective is to make a large literature accessible, in a unified way, to a student or interested individual who has some training in basic economic theory. It is only fair to say that I am not fully satisfied with the final product: in attempting to provide a well-structured treatment of the subject, I have had to sacrifice comprehensiveness. Nevertheless, I do believe that the book goes quite far in attaining the original objective, within the limitations created by an enormous and unwieldy literature and the constraints imposed by my own knowledge and understanding.

The primary target for this book is the senior undergraduate or masters level student with training in introductory or intermediate economic theory. I also recommend this book as background or supplementary reading for a doctoral course in development economics, along with the original articles on the subject.

Mathematical requirements are kept to a minimum, although some degree of mathematical maturity will assist understanding of the material. In particular, I have eschewed the use of calculus altogether and have attempted to present theoretical material through verbal argument, diagrams, and occasionally elementary algebra. Because the book makes some use of game-theoretic and statistical concepts, I have included two introductory appendixes on these subjects. With these appendixes in place, the book is self-contained except for occasional demands on the reader’s knowledge of introductory economic theory.

I begin with an overview of developing countries (Chapter 2). I discuss major trends in per capita income, inequality, poverty, and population, and take a first look at the important structural characteristics of development. Chapters 3–5 take up the study of economic growth from several aspects.

Chapters 6–8 shift the focus to an analysis of unevenness in develepment: the possibility that the benefits of growth may not accrue equally to all. In turn, these inequalities may influence aggregate trends. This interaction is studied from many angles. Chapter 9 extends this discussion to population growth, where the relationship between demography and economics is explored in some detail.

Chapter 10 studies unevenness from the viewpoint of structural transformation: the fact that development typically involves the ongoing transfer of resources from one sector (typically agriculture) to another (typically industry and services). This chapter motivates a careful study of the agricultural sector, where a significant fraction of the citizens of developing countries, particularly the poor, live and work.

Chapters 11–15 study informal markets in detail, with particular emphasis on the rural sector. We analyze the land, labor, credit and insurance markets.

Chapter 16 introduces the study of trade and development. Chapter 17 motivates and studies the instruments of trade policy from the point of view of a single country. Finally, Chapter 18 studies multilateral and regional policies in trade.

For programs that offer a single semester course in economic development, two options are available: (1) if international economic issues can be relegated to a separate course, cover all the material up to the end of Chapter 15 (this will require some skimming of chapters, such as Chapters 4–6 and 11–15); (2) if it is desirable to cover international issues in the same course, omit much or most of the material in Chapters 11–15. A year-long course should be able to adequately cover the book, but some supplementary material may be required for international economics, as well as financial issues in development, such as inflation and monetary policy.

This book could not have been written without my students and the many classes I have taught in development economics over the years: I thank students at Boston University, at the Indian Statistical Institute, at the People’s University of China in Beijing, at Stanford, and at Harvard. I would also like to thank the many people who have read and commented on earlier drafts of this book and have used them in courses they have taught, among them Jean-Marie Baland, Abhijit Banerjee, V. Bhaskar, Gautam Bose, Ira Gang, James Foster, Patrick Francois, Gabriel Fuentes, Bishnupriya Gupta, Ashok Kotwal, Dilip Mookherjee, Jonathan Morduch, James Robinson, Ann Velenchik, Bruce Wydick, and Frederic Zimmerman.

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Several people have made contributions to this text. Chief among them is Parikshit Ghosh, my intrepid and thoroughly uncontrollable research assistant, whose contributions to this book are too numerous to mention. I would also like to thank Eli Berman, Gary Fields, Hsueh-Ling Huynh, Chiente Hsu, Luis-Felipe López-Calva, Anandi Mani, Ghazala Mansuri, Jonathan Morduch, and Hiranya Mukhopadhyay for input at various stages.

Much of this book was written while I was Director of the Institute for Economic Development at Boston University. I thank Margaret Chapman, Administrative Assistant to the Institute, for covering for my many administrative lapses during this period. I thank the Instituto de Análisis Económico (CSIC) in Barcelona, where this book was completed, and the Ministerio de Educación, Government of Spain for financial support during my stay. I am very grateful to Peter Dougherty, my publisher at Princeton University Press, for his help and encouragement.

I would like to record my deep appreciation to a (smaller) set of people who have shaped the way I think about economics: Kenneth Arrow, Doug Bernheim, Bhaskar Dutta, Joan Esteban, Mukul Majumdar, Tapan Mitra, Dilip Mookherjee, Kunal Sengupta, Amartya Sen, and Rajiv Vohra.

I thank Monica Das Gupta for innumerable discussions, and words of advice and encouragement. Finally, I owe gratitude to Angela Bhaya Soares who always wanted me to write a magnum opus but will have

to be content with what she gets, to Bissera Antikarova and Farahanaaz Dastur for seeing me safely through bad times, to Nilita Vachani for creating unforeseen but happy delays, and to Jackie Bhaya for getting me started on it all.

Debraj Ray Boston University September 1997

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Development Economics

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Chapter 1 Introduction

I invite you to study what is surely the most important and perhaps the most complex of all economic issues: the economic transformation of those countries known as the developing world. A definition of “developing countries” is problematic and, after a point, irrelevant.1 The World Development Report (World Bank [1996]) employs a threshold of $9,000 per capita to distinguish between what it calls high-income countries and low- and middle- income countries: according to this classification, well over 4.5 billion of the 5.6 billion people in the world today live in the developing world of “low- and middle-income countries.” They earn, on average, around $1,000 per capita, a figure that is worth contrasting with the yearly earnings of the average North American or Japanese resident, which are well above $25,000. Despite the many caveats and qualifications that we later add to these numbers, the ubiquitous fact of these astonishing disparities remains.

There is economic inequality throughout the world, but much of that is, we hope, changing. This book puts together a way of thinking about both the disparities and the changes.

There are two strands of thought that run through this text. First, I move away from (although do not entirely abandon) a long-held view that the problems of all developing countries can be understood best with reference to the international environment of which they are a part.2 According to this view, the problems of underdevelopment must first and foremost be seen in a global context. There is much that is valid in this viewpoint, but I wish to emphasize equally fundamental issues that are internal to the structure of developing countries. Although a sizeable section of this book addresses international aspects of development, the teacher or reader who wishes to concentrate exclusively on these aspects will not find a comprehensive treatment here.

The second strand is methodological: as far as possible, I take a unified approach to the problems of development and emphasize a recent and growing literature that takes a level-headed approach to market failure and the potential for government intervention. It is not that markets are intrinsically bad or intrinsically good: the point is to understand the conditions under which they fail or function at an inefficient level and to determine if appropriate policies grounded in an understanding of these conditions can fix such inefficiencies. These conditions, I argue, can be understood best by a serious appreciation of subjects that are at the forefront of economic theory but need to permeate more thoroughly into introductory textbooks: theories of incomplete information, of incentives, and of strategic behavior. Few people would disagree that these considerations lie at the heart of many observed phenomena. However, my goal is to promote a student’s understanding of such issues as a commonplace model, not as a set of exceptions to the usual textbook paradigm of perfect competition and full information.

Because I take these two strands to heart, my book differs from other textbooks on development in a number of respects. Most of these differences stem from my approach to exposition and choice of subject matter. Although I do not neglect the historical development of a line of research or inquiry, I bring to bear a completely modern analytical perspective on the subject. Here are some instances of what I mean.

(1) The story of economic underdevelopment is, in many ways, a story of how informal, imaginative institutions replace the formal constructs we are accustomed to in industrialized economies. The landlord lends to his tenant farmer, accepting labor as collateral, but a formal credit market is missing. Villagers insure each other against idiosyncratic shocks using their greater information and their ability to impose social sanctions, but a formal insurance market is missing. Institutions as diverse as tied labor, credit cooperatives, and extended families can be seen as responses to market failure of some sort, precipitated in most cases by missing information or by the inability of the legal system to swiftly and efficiently enforce contracts. This common thread in our understanding is emphasized and reemphasized throughout the book.

(2) The absence or underfunctioning of markets gives rise to two other features. One is the creation of widespread externalities. Proper classification of these externalities provides much insight into a variety of economic phenomena, which appear unconnected at first, but which (in this sense) are just the common expression of a small variety of external effects. So it is that simple concepts from game theory, such as the Prisoners’ Dilemma or the coordination game, yield insights into a diverse class of development-related problems. Again, the common features of the various problems yield a mental classification system—a way of seeing that different

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phenomena stem from a unified source. (3) A fundamental implication of missing markets is that inequality in the distribution of income or wealth plays

a central role in many development problems. It isn’t that inequality has not received attention in treatises on development; it certainly has. However, what has recently begun to receive systematic analytical treatment is the functional role of inequality: the possibility that inequality, quite apart from being of interest in its own right, has implications for other yardsticks of economic performance such as the level of per capita income and its rate of growth. The emphasis on the functional role of inequality runs through the book.

(4) It is necessary to try to integrate, in an intuitive and not very abstract way, recent theoretical and empirical literature with the more standard material. This isn’t done to be fashionable. I do this because I believe that much of this new work has new things to teach us. Some important models of economic growth, of income distribution and development, of coordination failures, or of incomplete information are theories that have been developed over the last decade. Work on these models continues apace. Although some of the techniques are inaccessible to a student with little formal training, I do believe that all the ideas in this literature that are worth teaching (and there are many) can be taught in an elementary way. In this sense this book coincides with existing texts on the subject: the use of mathematics is kept to a minimum (there is no calculus except in an occasional footnote).

Partly because other development texts have been around for a good while, and perhaps in part because of a different approach, this text departs significantly from existing development texts in the points cited in the preceding text and indeed in its overall methodological approach.

Combining the complementary notions of incomplete information, a weak legal structure (so far as implementation goes), and the resulting strategic and economic considerations that emerge, we begin to have some idea of what it is that makes developing countries somehow “different.” Economic theorists never tire of needling their friends with questions in this regard. Why is the study of developing countries a separate subject? Why can’t we just break it up into separate special cases of labor economics, international trade, money, and finance, and so on? Certainly, they have a point, but that’s only one way to cut the cake. Another way to do so is to recognize that developing countries, in their different spheres of activity, display again and again these common failures of information and legal structures, and therefore generate common incentive and strategic issues that might benefit from separate, concentrated scrutiny.

This approach also serves, I feel, as an answer to a different kind of objection: that developing countries are all unique and very different, and generalizations of any kind are misleading or, at best, dangerous. Although this sort of viewpoint can be applied recursively as well within countries, regions, districts and villages until it becomes absurd, there is some truth to it. At the same time, while differences may be of great interest to the specialized researcher, emphasizing what’s common may be the best way to get the material across to a student. Therefore I choose to highlight what’s common, while trying not to lose sight of idiosyncrasies, of which there are many.

A final bias is that, in some basic sense, the book is on the theory of economic development. However, there is no theory without data, and the book is full of empirical studies. At the same time, I am uninterested in filling up page after page with tables of numbers unless these tables speak to the student in some informative way. So it is with case studies, of which there will be a number in the text.3 I try to choose empirical illustrations and case studies throughout to illustrate a viewpoint on the development process, and not necessarily for their own sake.

I started off writing a textbook for undergraduates, for the course that I have loved the most in my fourteen years of teaching. I see that what emerged is a textbook, no doubt, but in the process something of myself seems to have entered into it. I see now that the true originality of this book is not so much the construction of new theory or a contribution to our empirical knowledge, but a way of thinking about development and a way of communicating those thoughts to those who are young, intelligent, caring, and impressionable. If a more hard-bitten scholar learns something as a by-product, that would be very welcome indeed.

My commitment as the author is the following: armed with some minimal background in economic theory and statistics, and a healthy dose of curiosity, sympathy, and interest, if you study this book carefully, you will come away with a provocative and interesting introduction to development economics as it is practiced today Put another way, although this book offers (as all honest books in the social sciences do) few unambiguous answers, it will teach you how to ask the right questions.

1 The Third World, a group of low-income countries united by common economic characteristics and often a common history of colonialism, is just as much a political as an economic concept. Narrower economic classifications are employed by several international organizations such as the World Bank. A composite index that goes beyond per capita income is described in Human Development Report (United Nations Development Programme [1995]). There is substantial agreement across all these classifications.

2 This view includes not only the notion that developing countries are somehow hindered by their exposure to the developed world,

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epitomized in the teachings of dependencia theorists, but also more mainstream concerns regarding the central role of international organizations and foreign assistance.

3 Case studies, which are referred to as boxes, will be set off from the text by horizontal rules.

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Chapter 2 Economic Development: Overview

By the problem of economic development I mean simply the problem of accounting for the observed pattern, across countries and across time, in levels and rates of growth of per capita income. This may seem too narrow a definition, and perhaps it is, but thinking about income patterns will necessarily involve us in thinking about many other aspects of societies too, so I would suggest that we withhold judgement on the scope of this definition until we have a clearer idea of where it leads us.

—R. E. Lucas [1988]

[W]e should never lose sight of the ultimate purpose of the exercise, to treat men and women as ends, to improve the human condition, to enlarge people’s choices. . . . [A] unity of interests would exist if there were rigid links between economic production (as measured by income per head) and human development (reflected by human indicators such as life expectancy or literacy, or achievements such as self-respect, not easily measured). But these two sets of indicators are not very closely related.

—P. P. Streeten [1994]

2.1. Introduction Economic development is the primary objective of the majority of the world’s nations. This truth is accepted almost without controversy To raise the income, well-being, and economic capabilities of peoples everywhere is easily the most crucial social task facing us today. Every year, aid is disbursed, investments are undertaken, policies are framed, and elaborate plans are hatched so as to achieve this goal, or at least to step closer to it. How do we identify and keep track of the results of these efforts? What characteristics do we use to evaluate the degree of “development” a country has undergone or how “developed” or “underdeveloped” a country is at any point in time? In short, how do we measure development?

The issue is not easy to resolve. We all have intuitive notions of “development.” When we speak of a developed society, we picture in our minds a society in which people are well fed and well clothed, possess access to a variety of commodities, have the luxury of some leisure and entertainment, and live in a healthy environment. We think of a society free of violent discrimination, with tolerable levels of equality, where the sick receive proper medical care and people do not have to sleep on the sidewalks. In short, most of us would insist that a minimal requirement for a “developed” nation is that the physical quality of life be high, and be so uniformly, rather than being restricted to an incongruously affluent minority.