History, Expectations, and Development, part 2

1. History, Expectations, and Development, part 2 Econ 6060

2. Outline • A model of supply diversion: pitfall of partial reforms • Linkages: Hirschmann’s criticism of big push • Other constraining roles of history • Rise and fall of high development theory

3. Pitfalls of Partial Reforms • Murphy, Shleifer, and Vishny (QJE, 1992) • in response to reform experiences in Soviet Union in late 80s • Partial reform started in 1988 • The GNP fell 2% in 1990; fell 8% in the 1st quarter of 1991 • Did partial reforms cause output fall?

4. An analogy • Suppose the state of Washington produces apples which are sold throughout the US. • Let the market clearing price be 15. • Suppose all states impose a price ceiling at 10. • Then supply falls and apples are rationed. There may be lines and speculation as well.

5. An analogy • Suppose, now, only 30 states have the price ceiling and other states don’t have it. What happens? • Consumers in the unconstrained 20 states get all the apples they want at the price of 10 (because they can bid epsilon above 10, defeating the other 30 states). • Consumers in the constrained 30 states get the remainder. • Downstream firms (e.g., apple juice makers) in these 30 states have to cut down their production. • Hence, liberalizing some states actually makes things worse!

6. A model of supply diversion • Three goods: a) timber, and b) boxcars and c) houses • The official price of timber, P, is below the market clearing price • The price P is what the buyers actually pay • Producers of timber are on their supply curves • Initially, timber is rationed efficiently • After reform, the timber industry can choose to whom to sell its output • After reform, the boxcar industry cannot bid more than P for timber, but the industry sector can.

7. A model of supply diversion • All sectors are state owned • Db, Dh are marginal value product curves • p*: market clearing price • Timber rationed efficiently, hence Qb and Qh Before reform

8. A model of supply diversion

9. A model of supply diversion • Welfare loss in the boxcars sector: A + B • Welfare gain in the house sector: C • Total welfare change: C - A – B < 0

10. A model of supply diversion • The welfare loss is higher when the demand for timber by the housing sector is more elastic and the demand for timber by the boxcar sector is less elastic • For several reasons, the case of elastic demand for timber the free sector and inelastic demand in the state sector is realistic.

11. Sell to housing only when meeting boxcars’ demand • We now assume that the state uses quantity controls to force the delivery of timber to the boxcar industry a the price P. • Take the case where the boxcar sector got all the timber in wanted under rationing, and assume even after the liberalization of the housing sector the state can still enforce the delivery of that same amount of timber to the boxcar sector. • In timber sector delivers its lowest production cost units to the boxcar sector, and then sells what it produces afterwards to the housing at an equilibrium price.

12. Sell to housing only when meeting boxcars’ demand Suppose the timber industry is required to supply Qb at p to boxcar industry. Then partial reform is welfare improving!

13. China versus Russia reforms • This sheds light on an important difference between partial reforms in the former Soviet Union and in China. • China has pursued partial reforms but the central government maintained extremely strict enforcement of state quotas and allowed firms to sell only the units above the state quotas to private buyers. Hence containing the supply diversion problem.

14. Linkages • Inter-industry links (Hirschman 1958) • Steel sector has a forward linkage with railways, say • Steel also has a backward linkage to the coal sector

15. Linkages • Suppose an economy is in a depressed equilibrium: how would a policy be framed so as to take the economy to a better equilibrium? • According to Rosenstein-Rodan: big push • Requiring: massive investments, knowing the optimal allocation mix

16. Hirschman’s (1958) criticism • “My principal point is that the theory fails as a theory of development. Development presumably means the process of change of one type of economy into some other more advanced type. … • “The argument is reminiscent of the paradox about the string that is equally strong everywhere and that therefore when pulled cannot break anywhere first…However, as Montaigne pointed out in considering this paradox, its premise “is contrary to nature” for “nothing is ever encountered by us that does not hold some difference however small it may be.”

17. Hischman’s criticism, contd • “Among all vicious cycles, there is a weakest one • “It (the balanced growth theory) combines a defeatist attitude toward the capabilities of underdeveloped economies with completely unrealistic expectations about their creative abilities.” • Gave notions as forward linkage, backward linkage

18. Hischman’s criticism, contd • Exercise judicious judgement on choosing a leading sector to focus on: • Number of linkages • linkage strength (importance of the link) • Profitability of the activity (other things being equal, help the least profitable one) • …read his book… • See discussion by D. Rodrik, the 2007 receipent of the Hirschman prize of Social Sciences, on insight from Hirschmann on reform outcomes http://www.ssrc.org/hirschman/content/2007/rodrik_transcript.pdf

19. Other constraining roles of history • Social norm: what individuals can do is tempered by what society thinks it acceptable (but some norms are bad norms) • Is it acceptable to make profits in a business? • Is it acceptable for women to work? • Is it acceptable to forsake long-standing ties with an extended family and migrate?

20. Other constraining roles of history • Status quo bias • Most new policies have winners and losers, even though they may be desirable in some overall sense • The promise to pay compensation to the losers may not be credible

21. Status quo bias • Suppose a policy will benefit 60% of population by $100 and hurt the remaining 40% by $100. • Suppose it is commonly known that a certain group (accounting for 40% of population) will benefit. Then the expected gain for any body else is 20/60*100 – 40/60*100 = - 33.3 • Hence, 60% of population will be against the new policy • A reform policy that is beneficial ex post may be vetoed ex ante.

22. “Rise and fall of development economics,” by Paul Krugman • One is the strange history of development economics, or more specifically the linked set of ideas that I have elsewhere called "high development theory". This set of ideas was and is highly persuasive as at least a partial explanation of what development is about, and for a stretch of about 15 years in the 1940s and 1950s it was deeply influential among both economists and policymakers. • Yet in the late 1950s high development theory rapidly unraveled, to the point where by the time I studied economics in the 1970s it seemed not so much wrong as incomprehensible. Only in the 1980s and 1990s were economists able to look at high development theory with a fresh eye and see that it really does make a lot of sense, after all.

23. Kurgman on high development theory, contd • the crisis of high development theory in the late 1950s was neither empirical nor ideological: it was methodological. High development theorists were having a hard time expressing their ideas in the kind of tightly specified models that were increasingly becoming the unique language of discourse of economic analysis. They were faced with the choice of either adopting that increasingly dominant intellectual style, or finding themselves pushed into the intellectual periphery. They didn't make the transition, and as a result high development theory was largely purged from economics, even development economics.

24. Krugman on high development theory, contd • Hirschman's Strategy appeared at a critical point in this methodological crisis. It is a rich book, full of stimulating ideas. Its most important message at that time, however, was a rejection of the drive toward rigor. … • The irony is that we can now see that high development theory made perfectly good sense after all. But in order to see that, we need to adopt exactly the intellectual attitude Hirschman rejected: a willingness to do violence to the richness and complexity of the real world in order to produce controlled, silly models that illustrate key concepts.

25. Krugman on high development theory, contd • This paper, then, is a meditation on economic methodology, inspired by the history of development economics, in which Albert Hirschman appears as a major character. I hope that it is clear how much I admire his work; he is not a villain in this story so much as a tragic hero. • Krugman: “The rise & fall of development economics”, found in http://web.mit.edu/krugman/www/dishpan.html

26. Who is Hirschman? • What Wikipedia tells us: • Albert Otto Hirschman (Otto Albert Hirschmann) (April 7, 1915 – December 10, 2012) was an influential economist and the author of several books on political economy and political ideology. His first major contribution was in the area of development economics.[1] Here he emphasized the need for unbalanced growth. Because developing countries are short of decision making skills, disequilibria to stimulate these and help mobilize resources should be encouraged. Key to this was encouraging industries with a large number of linkages to other firms. • His later work was in political economy and there he advanced two simple but intellectually powerful schemata. The first describes the three basic possible responses to decline in firms or polities: Exit, Voice, and Loyalty. The second describes the basic arguments made by conservatives: perversity, futility and jeopardy, in The Rhetoric of Reaction. • In World War II, he played a key role in in rescuing refugees in occupied France.

27. Titbits • Invented the Herfinal-Hirschman index • Author of influential books, such as the Passions and the Interests • Not to mention Exit, Voice, and Loyalty.

28. Conclusions • We have reviewed two approaches: big bang versus gradualism • The debates appeared two times: in 50s and 80/90s • Complementarities: demand, or inter-sectorial linkage • There are both pros and cons regarding the two approaches • Pro: pitfall of partial reforms • Con: truly big bang is unrealistic, should exert jud