Beyond Rosenstein-Rodan: The Modern Theory of Underdevelopment Traps

The theme of this article is the importance – and the many causes – of lowlevel equilibrium “traps.” Rosenstein-Rodan pointed out that spillovers may cause the return to an activity to increase with the number of others who undertake that activity. If spillovers are strong enough, both lowand high-level equilibria are possible, with no tendency of market forces to lead from the worse to the better state of affairs. This article shows how modern economic theory broadened our view of the sources of spillovers that could lead to "traps" with low innovation and inefficient institutions. Evidence from China is consistent with local underdevelopment traps. The article argues for an “ecological” perspective on development, where the influences from others in one’s environment are a critical determinant of outcomes. This perspective provides the basis for the distinction between "deep" interventions, which change underlying forces, and "shallow" interventions, which do not. Karla Hoff is a research economist at the World Bank. This article draws on Hoff and Stiglitz (forthcoming). The author would like to thank Irma Adelman for helpful comments, and Abhijit Banerjee, Arnold Harberger, Gustav Ranis, Debraj Ray, and Joseph Stiglitz for discussions of the issues raised in this article. OUTLINE 1. The place of coordination failures in modern economic theory Neoclassical theory and the Coase theorem Institutional economics outside the 'straitjacket' of neoclassical economics Path dependence A radically broadened view of externalities and public goods "Ecological economics" 2. Examples of underdevelopment traps A low R&D trap Self-sustaining institutions Big Push theories of industrialization 3. An econometric test: Local poverty traps in rural China 4. Perspectives on policy Coordinating good equilibria Sequencing of policy reforms A word of caution: Deep versus shallow interventions 5. Conclusion Mathematical appendix Table and Figures Table 1. Old and new views of externalities and public goods Table 2 Taxonomy of models with complementarities. Figure 1. Multiple equilibria (with corner solutions) in the level of enforcement Figure 2. Multiple equilibria in a model with symmetric agents Figure 3. Multiple equilibria in the fraction of homeowners Figure 4. Different individual capital stocks may have the same marginal productivity Figure 5. Minimum levels of county wealth in China to assure rising household consumption given household wealth Paul Rosenstein-Rodan (1943) famously argued that at an early stage of development, the investments of industrializing firms in one sector may increase the profitability of other sectors throughout the economy. Simultaneous industrialization of many sectors of the economy could be profitable for them all, even though no sector would be profitable industrializing alone. As a result, an underdevelopment trap was possible. Even the market mechanism need not succeed in coordinating the activities needed to ensure development. In modern terms, there could be a coordination failure, where individuals' inability to coordinate their choices leads to a state of affairs that is worse for everyone than some alternative state of affairs that is also an equilibrium. The obstacle to achieving the better state of affairs is not a matter of technological opportunities (or even knowledge of those opportunities), nor resources or preferences, but only of coordination. In the 1950s, the possibility of underdevelopment traps or “vicious circles of poverty” was elaborated on by many others (including Nurkse 1953 and Leibenstein 1957). But individuals are rarely convinced by those who do not address their concerns. Without a well-developed theory of the sources of externalities (spillover effects), the idea of an equilibrium trap had little influence on neoclassical economists of that period. They continued to use their models to argue that the market mechanism could coordinate