Modern Economic Theory and Development

The past 50 years have seen marked changes in our understanding of development. We know that development is possible, but not inevitable. We have had a wealth of experiments. There are clearly no surefire formulas for success; if there were, there would be more successes. Some strategies seem to work for a while and then stall; some strategies seem to work in some countries and not in others.1 Economic theory has evolved to account for the successes and failures. This chapter attempts to describe these changes in economic theory—both in the kinds of models used and in the factors that are identified as playing key roles. It focuses on two pivotal questions: What forces can explain the divergence in incomes across countries? What implications can we draw for the nature of the interventions most likely to promote development? A basic theme of this chapter is that industrial countries differ from developing countries by much more than their level of capital—or even their human capital. More capital may be helpful, but, remarkably, even a transfer of funds may not have a large effect on economic growth (see World Bank 1999a). Eliminating government-imposed distortions is also obviously desirable but seems neither necessary nor sufficient for sustained growth.2 A view shared by all the perspectives on development that we explore in this chapter is that industrial and developing countries are on different production functions and are organized in different ways. Development is no longer seen primarily as a process of capital accumulation but rather as a process of organizational change. We discuss work done in three broad, interrelated research programs—the economics of information, the theory of coordination problems, and institutional economics. These research programs depart from the strong assumptions of neoclassical theory. In that theory, every equi-