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Development Economics$

Yujiro Hayami and Yoshihisa Godo

Print publication date: 2005

Print ISBN-13: 9780199272709

Published to Oxford Scholarship Online: October 2005

DOI: 10.1093/0199272700.001.0001

A Theoretical Framework for Economic Development

(p.9) 1. A Theoretical Framework for Economic Development
Development Economics

Yujiro Hayami

Yoshihisa Godo

Oxford University Press

Abstract and Keywords

As a basic framework of this book, development of the social system is considered a process of interactions between the economic subsystem and the cultural-institutional subsystem. The former consists of activities combining economic resources (labour, capital, and natural resources) through technology to produce goods and services useful for human living. These economic activities are coordinated and controlled by the latter, which consists of institutions (the rules of society) and culture (people's value system). A model is developed to conceptualize how technological and institutional changes interact with each other, how they respond to changes in resource endowments, and how such responses are governed by cultural traditions.

Keywords:   dialectic social development, institutional innovation, path dependency, political market, technological innovation, property right

In this book we will examine the economic development necessary to bridge the extremely wide gap in per capita income between the low-income developing economies and the high-income developed economies in the world today. Such extensive economic growth cannot be realized without examining the requisite major changes in social organizations and people's value systems. Understanding the process by which quantitative expansions in economic variables (such as capital and labour force) interact with culture and institutions to evolve a social system that supports major growth in per capita income should be the ultimate goal of development economics. As a step towards this goal, development of a theoretical framework for the analysis of complex relationships among economic, cultural, and institutional changes is presented in this chapter.

1.1 Development of the Social System

1.1.1 A model of dialectic social development

A broad conceptual framework for development of social systems is outlined in Figure 1.1. This figure illustrates a model of the evolution in social systems through dialectic interactions between economic and cultural–institutional variables. The lower section of this figure represents the economic sector as a subsystem of society. This subsystem consists of interactions between technology and ‘resources’—broadly defined as ‘factors of production’, including natural resources, labour, and capital. Technology is the determinant on the value of product to be produced from a given combination of production factors, commonly called ‘production function’ in economics.

If we measure economic growth by the increase in average per capita product (or income), it is realized through increases in per capita endowments of resources and/or ‘progress in technology’ defined as an increase in product for given inputs of resources. ‘Product’ is defined here as economic value newly added to society by the inputs of labour, capital, and natural resources within a period; this ‘value added’ is distributed to owners of the resources to become their incomes, which are aggregated into the income of the society.

Increases in economic resources and progress in technology are not independent. For example, as the technology of controlling water-flows is (p.10)

                   A Theoretical Framework for Economic Development

Fig 1.1 Interrelated developments in the social system

developed and necessary investments are made for use of the technology—such as construction of irrigation canals and diversion dams—hitherto useless barren lands could be converted into economically useful arable lands. If more food could be produced on the increased land resources, the food surplus might be stored, allowing a greater portion of labour input to be diverted from food production to capital formation activities in the next period.

Thus, while the progress of technology provides a basis of resource augmentation, it is promoted by purposive resource-using activities. For example, advances in irrigation technology are achieved through research on the identification of water-flow patterns as well as the development of irrigation facilities for adequate control of the water-flows through experiments of various designs, be it done by scientists and engineers in modern research laboratories or by primitive trial and error by peasants on their farms. Those activities use both human effort and capital for the addition of the stock of engineering knowledge. Since this increase in knowledge has the same output-increasing effect as investment in tangible capital—such as the construction of irrigation canals and dams—research and development activities can be called ‘investment in intangible capital’.

(p.11) Similar to the production of tangible capital, it is possible to formulate a process of producing technical knowledge from the inputs of labour and capital. A critical element in augmenting this knowledge production function is ‘investment in human capital’, defined as enlargement of human capacity by such means as education, training, and health care. Investment in human capital will increase the efficiency of knowledge production, which in turn will improve the efficiency of production of economic value added from given resources in the society. Thus, cumulative increases in average product per capita will result from investments in both tangible and intangible capital.1

The productivity of an economic subsystem, consisting of its resource endowments and technology, is conditioned by culture and institutions in society. Broadly defined, institutions as well as technology are a part of culture. However, culture is here narrowly defined to imply the value system of people in the society, while institutions are defined as ‘rules sanctioned by the members of the society’ including both formally stipulated laws and informal conventions. Cultures and institutions thus defined are inseparably related. The rules that contradict the morals of people would not be sanctioned socially and, if stipulated formally, would not function effectively. For example, the institution of slavery to stipulate a person's property rights on other human beings could hardly be expected to function as a social institution today as it is inconsistent with the culture of the modern world. Yet, it was a perfectly legitimate and effective institution under different cultures such as in ancient Greece and Rome.

Culture and institutions indicated in the upper section of Figure 1.1 as components of the social system exert significant influences on the economic subsystem located in the lower section. For instance, an important parameter to determine the rate of investment is the ratio of saving to income; this parameter is determined largely by people's future preference over present consumption, which is a part of their value system. It has been the tradition of modern neoclassical economics to analyse the workings of the economic subsystem under the assumption of fixed preferences. Such an approach would be effective for the analysis of a situation in which the upper subsystem was relatively constant. Yet, the approach would be grossly inadequate for dealing with the wide range of economic development within which major cultural and institutional changes inevitably occur. In this respect, the theory of Max Weber (1920) identifying the Protestant ethic as a source of modern capitalist development represents an important methodological suggestion, irrespective of its empirical validity.

(p.12) 1.1.2 A historical example

While accumulation of resources and progress in technology are conditioned by culture institution changes in the latter are also induced by the former. Such a process of social development through dialectic interactions between the economic and the cultural–institutional subsystems may be understood more concretely by tracing the transition from the hunting and gathering economy to the agricultural (and pastoral) economy.

A basic force inducing this epochal change in human history was the increased scarcity of natural resources under the pressure of population growth.2 As long as population was sparse and land was felt to infinitely exist like air, the killing of wild animals and the harvesting of wild crops in unlimited amounts would have shown no sign of exhaustion. However, as population grew (though very gradually), it was inevitable that the day would come when exploitation of the wild resources began to exceed their reproductive capacity and, thereby, the hunting–gathering economy could not be sustained.

To avoid the subsistence crisis that arose from this resource exhaustion, it became imperative for hunters to augment/increase the reproduction process by raising animals instead of killing and eating them immediately, and for gatherers to plant nuts and cereals for future harvests. An economic basis of the increased reproduction was the accumulation of capital. A limited list of capital items was required for hunting and gathering, such as stones, knives, clubs, and bows and arrows. A larger capital stock was required for shifting to the agriculture-based system, especially in the forms of reared animals, standing crops and trees, and opened and cultivable farmlands. Capital requirement increased further as the agricultural production system advanced to the stage at which it began to rely heavily on man-made land infrastructure, such as irrigation and drainage facilities.

To convert animals and plants to productive capital, it was necessary to accumulate knowledge to identify useful animals and plants for domestication as well as the appropriate methods to feed and grow them. Countless efforts of primitive producers to advance agricultural technology through trial and error were the major source of investment in intangible capital. These efforts to enlarge the reproduction process under the growing scarcity of natural resources are likely to have been induced by the producers' need for survival.

While such advancement in technical knowledge was necessary, it was not sufficient for the development of the agriculture-based economic system. This development required a major institutional change: establishment of property (p.13) rights on productive resources. A basic rule in ideal primitive hunting and gathering economies was free access to natural resources, under which all the resources were the property of everyone but no one person's property in particular. Under this rule anyone could capture and consume any useful animals and plants as they found them. As long as this rule prevailed, a person who attempted to engage in agricultural production had to face the difficulty of preventing others from taking away the animals and crops he raised. In such circumstances there would have been little incentive for anyone to start agricultural production by investing in livestock and standing crops. Therefore, the requisite for the formation of an agricultural economy was the establishment of a new social order of clearly defined property rights by which the person who made efforts to invest in productive capital could exclude others from its use (Demsetz, 1967; Alchian and Demsetz, 1973). In the course of this development of agrarian civilization, property rights were first assigned to livestock and standing crops, and later extended to cover agricultural lands.

Those who were assigned property rights on land would have been equipped with strong incentives to invest in improving the quality of the land, from removing stones and tree roots, fencing and terracing, to irrigation and drainage. The form of property rights also evolved from communal ownership by tribe or village to private ownership by household or individual, with a stronger power of exclusion and, hence, a stronger incentive for private investment.

Common to all institutions, stipulation and enforcement of property rights entail costs. The most profitable situation for an individual is for him to break the rules (e.g. steal others' properties) while others are observing the rules (e.g. do not steal others' properties). Thus, the temptation is always high for anyone to become a ‘free-rider’ who tries to gain from breaking the rules. To the extent that people's propensity to become free-riders is high, it is costly to enforce the property rights by such means as police and courts. It is the ethics as a part of culture that reduces the cost of enforcing the rules of society. Indeed, ‘thou shall not steal’ is a unanimous moral code in the commandments of the great religions that coincided with the development of agrarian civilizations. It seems reasonable to hypothesize that such a religious doctrine was both the cause and the consequence of establishment of the agriculturally based economic system.

Economic and social development through such interactions between economic forces and cultural–institutional elements have been repeated over history. For instance, the patent system that was established with the development of modern industrial society was aimed at assigning property rights on engineering knowledge and information, thereby promoting private (p.14) investment in this critical component of intangible capital (Evenson and Westphal, 1995). Negotiations in the GATT (General Agreement on Tariffs and Trade) Uruguay Round followed up by WTO (World Trade Organization) on intellectual property rights represented an attempt to establish internationally uniform rules on the protection and the transactions of property rights over a wide range of knowledge and information including computer software. This attempt was a response to the growing need of the world today in which the role of knowledge and information, as a factor of economic production, has been rising faster than that of tangible capital. Likewise, the establishment of the International Law of the Sea creating exclusive economic zones over 200 nautical miles from each country's coast was an attempt to mobilize conservation efforts for marine resources at the national level in response to growing scarcity and high prices of fish and other marine products (Hannesson, 1991). These are among the efforts to achieve the institutional innovation of the same nature as developing property rights on livestock, crops, and lands in the prehistoric initiation of agriculture.

1.1.3 Marx and new institutionalism

The theoretical framework outlined above has a basic similarity with the perspective on evolution of the social system described by Karl Marx and Friedrich Engels.3 The economic subsystem and the cultural–institutional subsystem in Figure 1.1 correspond broadly with what they term ‘infrastructure’ and ‘superstructure’, respectively. In their system, the core of the superstructure is the property-rights relations of production factors (so-called ‘production relations’), while infrastructure is the technology needed to determine the capacity of material production from available resources. While the institution is believed to determine realization of the technology's production potential, technology is identified as the basic force in structuring the institution; at the origin the institution is so structured as to best exploit the potential of material production. This view on the formation of institutions in response to economic demand is analogous to the theory of induced institutional innovation.

Marx and Engels assumed a major time-lag between increases in material production capacity and changes in institutions; this made changes in the social system discontinuous and abrupt. In their perspective technical knowledge and tangible capital are accumulated gradually to bring about continuous growth in productive capacity. In contrast, institutions cannot adjust immediately—they must be stable over time so that the rules of society (p.15) for structuring people's stable expectations in dealing with others could effectively function.

Moreover, the core institution in the Marx–Engels theory is the property-right assignment of a key production factor at each stage of economic development—such as slaves in the ancient classical world, land in medieval feudalism, and capital in modern industrial capitalism. Changes are bound to take time as it will be strongly resisted by the prestige class to whom property ownership is exclusively bestowed. As a result, even though the institution was originally designed to best exploit the productive potential of society, as it becomes inconsistent with the changed conditions of material production resulting from technological progress and capital accumulation, it tends to survive. In other words, the institution that was once a carrier of economic development over time turns out to be the ‘fetter’ against further development under a new technology regime. Marx and Engels theorized that this gap between the institution and the production potential would be ultimately closed through a violent political revolution. This perspective was forcibly marshalled in a classic statement by Marx:

The mode of production of material life determines the general character of social, political and spiritual processes of life. At a certain stage of their development, the material forces of production in society come into conflict with the existing relations of production, or—what is but a legal expression for the same thing—with the property relations within which they had been at work before. From forms of development of the forces of production these relations turn into their fetters. Then comes the period of social revolution. With the change of the economic foundation the entire immense superstructure is more or less rapidly transformed. (Marx [1859], 1904: 11–12)

Marx considered technological progress and capital accumulation decisive in determining the productive capacity of society and denied the importance of natural resources relative to population. In this respect, our perspective differs from Marx's and is closer to that of new institutional historians in emphasizing the influence of changes in relative resource endowments and prices due to population growth and other factors (North and Thomas, 1973; North, 1981). We also consider that institutions are not quite as inflexible as to make violent revolution inevitable for major institutional changes. There is considerable historical evidence to support the hypothesis that the basic institutional framework, including property relations, changed through cumulative adjustments by such means as informal agreements and reinterpretations of laws and codes (Davis and North, 1970).

However, there is no guarantee that such cumulative adjustments are sufficiently rapid and responsive to emerging social needs. The cost of (p.16) incremental change in one institution can be prohibitively high as this particular institution is inseparably intertwined with others. Its change thereby demands a change in the total institutional framework that has been historically determined (see Section 1.2.4 on this historical path dependency). Due to fear of social sanctions, such as ostracism, against the deviation by individuals from established norms and conventions, even obviously inefficient institutions like castes are often difficult to change (Akerlof, 1984). Because a future gain from an institutional reform is uncertain, and its distribution among various social groups is difficult to predict relative to the obvious loss to a specific group, opposition to reform tends to be strongly organized, while support is only weakly so (Fernandez and Rodrik, 1991), in terms of the logic of the political market (Section 1.2.3). It is therefore not uncommon to observe that a society continues to be trapped in economic stagnation and poverty under a dysfunctional system bound by strong social inertia for the preservation of established institutions (Basu et al., 1987).

Thus, it is likely that changes in institutions and, more so, in culture lag significantly behind changes in the material production base, and that the resulting contradictions could often create strong social and political tension, culminating in major disruptions, as Marx and Engels envisioned.

1.2 The Theory of Induced Innovation*

The theoretical framework developed in the previous section is general but not very operational for economic analysis in the sense that the implied hypotheses are too broad for empirical testing. In the following section we will construct an operational economic model by extracting some elements from the general model, on which development economics must focus. For this purpose it is necessary to use technical terms specific to economics.

1.2.1 Induced technological innovation

First, our focus will be placed on a causal relationship within the economic subsystem in Figure 1.1, in which changes in resource endowments induce changes in technology. A standard economic theory on this relationship is called the theory of ‘induced technological innovation’ in the tradition of John R. Hicks (1932).

The Hicksian theory presupposes a mechanism in which, as the endowment of one factor (e.g. capital) becomes more abundant relative to another factor (p.17) (e.g. labour), a change in technology is induced towards using more capital and saving labour for given relative factor prices (for a more exact definition, see Appendix A.2). Such a biased change in technology stems from the efforts of profit-seeking entrepreneurs to reduce production costs by substituting relatively more abundant (hence cheaper) resources for scarcer (hence dearer) resources. The induced innovation theory within the framework of neoclassical economics has assumed a competitive market by which relative abundance and scarcity of factors are reflected in factor prices used as data for entrepreneurs' production plans. However, this theory can be applicable to subsistence-orientated non-market economies also, if it is assumed that relative resource scarcities are recognized by producers, even very roughly, in terms of shadow prices reflecting the social opportunity costs of the resources.

Based on such assumptions, Figure 1.1 is a model explaining the process of transition from the hunting–gathering economy to the agricultural economy, as well as subsequent advances in the technology of agricultural production. With some modification, this model can be used to explain a transition to the industrial economy also.

Figure 1.2 represents the production relation (production function) of producing a single commodity (e.g. food) from inputs of three factors: labour L, capital K, and land A representing natural resources. Capital is here assumed to be produced mainly by past labour input.

The upper AL quadrant in Figure 1.2 represents the substitution between land and labour in terms of isoquant for producing one unit of product (unit isoquant). On the other hand, the OZ line in the lower LK quadrant represents the complementary relationship of capital with labour in the event of substituting labour for land. For example, as long as a farmer engages in slash-and-burn shifting cultivation, he can cultivate a large area using his own labour with very little capital consisting of such small items as a hatchet, a digging stick, and a stock of seeds. However, if he attempts to shift to a more labour-intensive, land-saving system under settled agriculture, he must build up large capital by improving farmlands (removing roots and stones, terracing and fencing) and acquiring a greater variety of farming tools and implements than those needed for shifting agriculture. Thus, the substitution of labour for land through such intensification of land-use should be accompanied by exponential growth in the capital–labour (K/L) ratio. To illustrate this relationship, the OZ line is drawn in a concave form.

The I-curve in the AL quadrant represents the ‘innovation possibility curve’, defined as an envelope of unit isoquants corresponding to all the possible technologies that could have been developed with the knowledge and human capacity available at a particular period. This curve shifts over time (p.18)

                   A Theoretical Framework for Economic Development

Fig 1.2 A model of induced innovation

(from I 0 in period 0 to I 1 in period 1 as indicated in Figure 1.2) corresponding to the accumulation of knowledge and the improvement in human capacity. According to the theory of induced technological innovation, a particular technology as represented by i 0 is developed and adopted for period 0, because it is this technology that minimizes the cost of production for the price ratio between land and labour P 0, reflecting relative scarcities of these factors in this period. In other words, i 0 is developed through the effort of producers to reach the cost-minimizing point a within an available set of possibilities I 0.

Assuming complementarity between labour and capital in their substitution for land, as explained earlier, the land–labour ratio at point a(OA 0/OL 0) (p.19) corresponds with the capital–labour ratio at point d(OK 0/OL 0). Since in this particular case it is assumed that capital is the product of past labour alone, the price of capital relative to the price of land can be considered to move largely parallel with the labour–land price ratio P 0. This assumption of complementarity between labour and capital is adopted for the sake of simplicity to represent the three-dimensional relation in a two-dimensional diagram. This simplification might be permissible as an approximation to facilitate understanding the characteristics of technological progress in pre-industrial economies. For the analysis of industrial economies in Chapter 6, the substitution between labour and capital as well as the substitution between tangible and intangible capital will be treated as a central problem.

Assume that, as time passed from period 0 to period 1, relative scarcity of land increased with the result of lowering the relative price of labour to land from P 0 to P 1. Meanwhile, the innovation possibility curve would have shifted towards the origin from I 0 to I 1, reflecting the increased capacity of society to produce a unit of food with a smaller input of factors. Corresponding to these changes, it now becomes optimum for producers to reach point c by choosing a technology represented by i 1, over other possibilities embraced by I 1.

However, until the new i 1 technology is actually developed, producers will have to continue using the old i 0 technology and, hence, can move only from point a to b. It is through producers' efforts in repeated trial and error, as well as organized scientific research and development (in the case of modern society), that the new i 1 technology will become available. The basic premiss in the theory of induced technological innovation is that the expected gain (or reduction in cost) for producers, as measured by the distance between P 1 and P1, in the move from point b to c, will induce them to make efforts for technological development with the result of changing technology from i 0 towards i 1.

The move from hunting and gathering to agriculture may be explained in terms of this theory as follows: When the availability of usable land appeared to be limitless relative to sparse population and, therefore, the relative scarcity of land to labour P 0 was very low, collection of foods from wild animals and plants i 0 could well have been an optimum technology in the sense that it produced food at a minimum cost. Even if population grew, and the relative scarcity of land rose (P 0 to P 1), there would have been little scope to increase food supply by applying more labour to limited land (a to b) as long as hunting and gathering were the sole option for food production. However, if farming technology i 1 became available, people would be able to produce much more food from given land resources (b to c) at a lower cost. This possibility would have worked as a driving force for primitive hunters and (p.20) gatherers to search for ways to increase reproduction of useful animals and plants.

1.2.2 Induced institutional innovation

The theory of induced technological innovation is explained above in terms of producers' cost-minimizing behaviour in the tradition of neoclassical economics. Such a theoretical structure appears to be relevant to modern market economies in which technological innovations are carried out mainly by large firms with research and development capacities, though theory has been a subject of heated theoretical discussion.4 Major modifications are needed to apply the theory to the analysis of transformation within subsistence-oriented economies and transition from subsistence-oriented to market-oriented economies.

The reason is not, as once commonly thought, because small subsistence-oriented producers in premodern economies are ignorant and bound by tradition, and therefore, unable to search for and adopt profitable crops and cultural practices. On the contrary, accumulated evidence shows that subsistence-oriented small farmers in developing economies allocate resources rationally and respond effectively to profitable economic opportunities (T. W. Schultz, 1964; Hopper, 1965; Yotopoulos, 1968; Barnum and Squire, 1979; Rosenzweig, 1984; Tiffen and Mortimore, 1994). This trait would be shared not only by farmers but by hunters and gatherers as well.

It is not reasonable, however, to assume that they anticipate a wide range of innovation possibilities along the I-curve and move linearly towards point c in response to changes in relative factor scarcities and/or innovation possibilities. It is more reasonable to assume an evolutionary process of the Nelson–Winter (1982) type, namely as food production per capita decreased for hunters and gatherers, corresponding to growing population pressure on natural resources, they were forced to search for ways to increase food supply through trial and error. Only those who happened to reach the i 1 curve (agriculture) were able to survive. With this modification, induced technological innovations are thought to produce technological change in the direction that the traditional theory predicts. However, some economies may not be able to survive because they continue to be trapped in the old technology i 0. Some may be able to survive as they adopt better technology than i 0. However, there is no guarantee that they can reach the best technology as represented by i 1.

A major modification required for the theory to cover both primitive and high stages of development would be to combine the theory of technological (p.21) innovation with the theory of institutional innovation. For whatever high profit a technological innovation may be expected to produce, and however rational a producer may be, it may not be possible for him alone to carry out the innovation. As explained earlier, the development from hunting and gathering to agriculture involves the process of capital accumulation in the form of livestock, standing crops, and prepared farm fields, for which property rights need to be established. However, assignment and protection of property rights can hardly be achieved by individual efforts but need collective action by people in the society. Collective action is required not only to create institutions for promoting private investment incentives, but also to undertake large-scale investment in social overhead capital, such as flood control of rivers and building of gravity irrigation systems. Appropriate institutions must be prepared to organize people effectively for such collective action.

Then what mechanism should we assume to organize collective action to facilitate technological progress and capital accumulation in a socially optimum direction? The most naïve model would be to assume that collective action is organized when aggregate social profit from the move from point b to c (Figure 1.2) exceeds the cost of organizing the collective action to enable such a move. This naïve model could well be valid in broad terms of progress in human history in which property rights have been strengthened and institutions have developed to mobilize collective action for building infrastructure (such as irrigation) corresponding to growing population pressure on natural resources.

However, if such a naïve mechanism of induced institutional innovation always operated, all the economies would have grown smoothly and no great income gap would ever have emerged between developed and developing economies. Thus, to understand the causes of the poverty and underdevelopment versus the wealth and development of nations in today's world it is necessary to understand the conditions under which the mechanism of induced institutional innovation fails to operate effectively.

1.2.3 Logic of political market

The supply of public goods in response to social needs is determined through political process at equilibria between demands for and supplies of those public goods from various interest groups, which might be called ‘political markets’ in analogy with economic markets for ordinary goods and services. The problem is that the mechanism of the political market does not guarantee the optimum supply of public goods in terms of economic well-being in (p.22) society. As Mancur Olson (1965) predicted, collective action is usually much less organized than a socially optimum level, because only part of its profit accrues to those who shoulder the cost of organizing the action. This is the basic cause of a general undersupply of public goods.

Social rules (such as property rights) and social overhead capital (such as roads) bear the properties of ‘non-rivalness’ and ‘non-excludability’ common to public goods. Non-rivalness is the property of a good to be utilized jointly by many, and non-excludability is the property of a good where utilization by those who do not pay for the cost of its supply is possible (Musgrave, 1959; Stiglitz, 2000). For example, once an irrigation canal is dug by the collective work effort of villagers, all those who engage in farming along this canal can utilize its water jointly. The problem is that it is difficult and costly to prevent someone from using (or stealing) water who did not contribute labour for the construction of the canal. For this latter property (non-excludability), temptation is high for anyone to become a free-rider in the use of public goods; this applies equally to the enforcement of social rules, such as property rights, as explained in the previous section.

For the supply of public goods someone must take charge of organizing collective action. Collective action is organized at various levels, including voluntary cooperation in the local community and the religious group. For the supply of ‘global public goods’ widely applicable to a large number of people in society, however, it often becomes necessary to set up a mechanism of coercion in the form of ‘state’. The collective action aimed to form and manipulate the coercive power of state is called ‘politics’ or ‘political movements’. The organizer of political movements is called a ‘political leader’ or ‘politician’, whether from small local communities, nation states, or international arenas. The leader must apply major efforts to bring people together in an agreement on collective action and enforce it with persuasion, intimidation, bribery, or violence. Economic benefits expected from the public good produced by organized collective action for society may far exceed the cost paid. This benefit is not usually appropriated by the political leader. For example, the stipulation and protection of property rights on livestock may enable primitive hunters to engage in agriculture (as represented by a move from point b to c in Figure 1.2). However, the economic benefit from this provision of public good, as measured by P 1 P1, is appropriated by individual producers who shifted from hunting to agriculture.

Returns to the leader for his cost of organizing collective action for the supply of a public good (e.g. property-rights protection) would be the strengthening of his power base due to increased support from people who capture economic gains from the public good. Unless the increment in his (p.23) utility arising from his strengthened political power was expected to exceed his cost, he would not attempt to organize the collective action.

Such behaviour of the political leader is modelled in Figure 1.3, in the tradition of public choice theory or the economics of politics (Downs, 1957; Buchanan and Tullock, 1962; and Breton, 1974). Line MR represents decreasing marginal revenue of the leader for increasing the supply of a public good. Marginal revenue for the politician is defined as the marginal increase in his utility from the strengthening of his power base (increased votes in the case of parliamentary democracy) expected from a unit increase in the public good provision. Line MR is drawn as a downward slope since it seems reasonable to assume that the marginal social productivity of a public good tends to decrease as its supply increases, with a resulting decrease in the marginal gain in political support from the beneficiaries.

On the other hand, the leader's marginal cost MC is defined as the marginal disutility of his time and effort in organizing the collective action. Line MC is upward-sloping because the cost of preventing ‘free-riders’ rises progressively as a greater number of people will have to be organized for an increased supply of the public good.

Because the vertical distance between MR and MC measures the marginal net utility or marginal profit (revenue minus cost) of the political leader, his profit will be maximized by the level of public good supply at the intersection

                   A Theoretical Framework for Economic Development

Fig 1.3 A model of political market for a public good

(p.24) of these two lines. There is no guarantee at all that this optimum for the politician coincides with the optimum for society. In general, it is probable that the supply of public good is below the social optimum because only a fraction of social benefits will accrue to the politician.

If the political leader's marginal revenue and cost are located in an initial period (0) at MR 0 and MC 0, OO 0 is the optimum supply of the public good for the political leader. If, towards the next period (1), changes occur in relative resource scarcities and in technological possibilities (as represented respectively by P 0 to P 1 and I 0 to I 1 in Figure 1.2), a shift from the old to the new technology (i 0 to i 1) would become profitable for a large number of producers in the society. Then these potential beneficiaries from the new technology would render stronger support for the politician who would act to provide the public good (such as the protection of property rights) that is needed for the adoption of the new technology. The result would be the moving up of the politician's marginal revenue curve from MR 0 to MR 1. The mechanism of induced innovation in technology and institution would thus work through such an inducement mechanism for the supply of public goods in the ‘political market’.

The problem lies in how efficiently this inducement mechanism would work in terms of the economic welfare maximization criteria for the society. How much the supply of a public good would increase in response to an increase in social demand depends, in part, on how efficiently the increased social demand is translated into the upward shift in the politician's MR curve. This efficiency tends to be low, especially for the type of public good whose social benefit is large in aggregate but is distributed thinly over a large number of private producers, and, hence, not visible enough to mobilize political support (or lobbying) activities. This is the basic dilemma that results from major under-investment in the public goods with high social pay-offs (Olson, 1965).

Another factor determining the efficiency of the political inducement mechanism is the slope of the MC curve. The increase in the supply of public good in response to a given shift in the marginal revenue curve from MR 0 to MR 1 is larger for a relatively flat marginal cost curve such as MC 0 than for a sharply rising curve such as MC0. A major determinant of the location and shape of the MC curve is people's value system. For example, the marginal cost of strengthening property rights would be high in a society in which the theft of animals had not been recognized as a major crime.

Conflict of interests among various groups in a society would also sharpen the slope of the MC curve. For example, the establishment of property rights on land should produce major benefits to those undertaking the change to (p.25) settled agriculture. It would be opposed, however, by hunters and nomads who would be excluded from the use of the land to which property rights are assigned. If this opposition is well organized, the marginal cost of strengthening property rights on land would rise sharply so that the supply of this public good would be severely limited relative to increased social need.

How can the efficiency in the translation of social demand to the politician's marginal revenue curve be improved? How can his marginal cost curve be lowered? To a large extent, these tasks were facilitated in premodern societies by the religious developments that changed people's moral perceptions. What ideologies would be an effective substitute for this role of religion in modern societies? How can modern education and information media promote efficiency of the induced innovation mechanism involving political processes? This problem is one of the most difficult and most important agendas in development economics (to be discussed in detail in Chapters 8, 9, and 10).

1.2.4 Historical path dependency

A major constraint on the effective working of the induced innovation mechanism would be scale economies in an institutional set-up corresponding to a particular technological regime. Such scale economies would make incremental changes difficult in an economic system that was historically formed. For example, in the process of transition from nomadism to agriculture, it may have been difficult for a small number of farmers to establish arable farming with their collective action, even if they agreed to respect each others' property rights on lands and crops. They could hardly prevent nomads from grazing animals on their croplands because of the customs of nomadic society. Thus, the transition to settled agriculture induced by population pressure on land resources could have been disrupted by the binding power of traditional nomadic culture and institutions. However, if for some historical reason (such as a large-scale migration of agriculturalists like homesteading in the US West) a majority of land happened to be enclosed, nomads may have found it difficult to continue their traditional way of life and would have been compelled to move to settled agriculture, thereby eliminating the nomadic system.

This example illustrates the possibility of multiple equilibria (e.g., domination of nomadism versus domination of settled agriculture) for a society to reach in a manner similar to the world of ‘new growth theory’ with the assumption of increasing returns based on externality (Romer, 1987; Murphy et al., 1989; Krugman, 1991; Grossman and Helpman, 1991), which is (p.26) discussed later (Section 6.3.1). To which equilibrium a society will move depends to a large extent on its ‘historical path’ (David, 1985; Arthur, 1988; North, 1990: ch. 1). Useful insights on the emergence of multiple equilibria are also provided by evolutionary game theory (Mailath, 1992; Kandori, Mailath, and Rob, 1993; Matsui, 1996; Aoki, 2001). According to this theory human beings can perceive future possibilities only within a narrow range based on their own past experience, and also they tend to be concerned about short-term profit more than long-term well-being. Institutions are considered to be the equilibria in human relationships that are reached through trial and error by individuals who try to maximize their own profit within the confines of their narrow experience and myopia. Since people's choice set is bounded by their past experience, institutions in a society are usually different from those in other societies with different histories, even if they are surrounded by the same economic conditions. As such, whether institutions being adopted in a society are efficient in organizing economic activities depends largely on the accidents of history. In the long-run, through the working of adaptation and natural selection analogous to the process of biological evolution, societies under efficient institutions will prosper and expand, whereas those under inefficient ones will shrink and may eventually disappear. However, the natural selection of social institutions often lags considerably behind changes in economic environments. As a result, it is common to observe multiple social systems operating with differential economic growth performances.

A good example of a multiple equilibrium can be found in the histories of England and Spain. In England, private property rights of land were gradually strengthened from the late medieval period until ‘commons’ or grazing land for communal use by villagers were enclosed by landlords into large private farms in the eighteenth century. Enclosure prepared the way for significant increases in land productivity based on the change from the traditional three-field system to modern crop rotation including fodder crops such as clover and turnips—the so-called ‘Agricultural Revolution’ (North and Thomas, 1973: 16 and 150–1). This traditional paradigm on the Agricultural Revolution in eighteenth-century England through landlords' enclosure has recently been challenged by Robert Allen (1992). He demonstrated that the major increase in land productivity was brought about by yeomen (small independent farmers) in the seventeenth century, based on their secured land tenurial rights in the sixteenth century.

Therefore, both the old and the new paradigms have identified secure property rights in land as the necessary condition for major agricultural productivity growth in England. In contrast, Spain failed to protect private rights on croplands because of the opposition of politically powerful (p.27) sheepgrazers. Consequently, arable farmers were not able to prevent grazing animals from encroaching on their standing crops. This was identified as one of the major factors underlying stagnation of Spain's agriculture and economy relative to England's in modern history (Klein, 1920; North and Thomas, 1973: 130; Nugent and Sanchez, 1989). It is likely that the contrast between England and Spain was rooted in the different cultural–institutional subsystems that had been historically formed in each country.

This historical example seems to show that, even if the importation of advanced technology from developed countries were economically profitable for developing countries, the importation of foreign institutions for the use of this technology without due regard to differences in cultural values and social conventions may not serve its intended purpose but only create social disorder. Effective policy effort should be directed to the creation of an economic system that can best exploit new economic opportunities by making good use of deeply rooted traditional norms and conventions (Chapters 9 and 10).

1.3 Developing Economies in the Light of the Theoretical Framework

From this theoretical perspective it can be seen that a major problem for developing countries today is the speed with which resource endowments and technology change. Their population growth since around the 1920s has been extremely rapid, with rates two to three times that of developed economies in their initial phase of modern growth in the nineteenth century, even though its speed has been decelerating since the 1970s (Chapter 3). This explosive growth rate has been very rapidly raising the scarcity of natural resources, especially land, relative to labour. In many low-income economies, the endowment of arable land per agricultural worker decreased significantly, resulting in pauperization of the rural population. As the favourable farming area has become relatively smaller and incapable of sustaining subsistence for the increased population, some farmers have been forced to open fragile lands in hills and mountains for cultivation, with the result of serious environmental degradation such as soil erosion and flooding. Alternatively, many have been forced to migrate to urban slums seeking subsistence from various informal activities (Chapter 7).

Such a crisis situation could be overcome by the effort of substituting labour and capital for natural resources and using appropriate technology, as has been repeated in history since the transition from hunting and gathering to settled agriculture. Development of appropriate agricultural technology, though difficult, is possible with investment in adaptive research (p.28) for exploiting the backlog of scientific and technological knowledge accumulated in developed economies (Chapter 4). Also, with appropriate technology borrowing, developing countries should in theory be able to achieve rapid industrialization with the creation of major non-farm income and employment opportunities (Chapter 6). Yet, in reality, foreign technologies imported to developing economies are often highly capital-intensive since they were developed in high-income, labour-scarce economies. Their importation tends to result in aggravation of labour surplus and unemployment in developing economies (Chapter 7).

To exploit the great opportunities in technology borrowing, and adjust foreign technologies to the economic and social environments of developing economies, institutional innovations are called for in areas such as market structure, industrial organization, labour management and regulation, research, training, and education systems. However, appropriate adjustments to rapidly changing economic forces are not easy. Institutions are slow to change, as they are strongly constrained by cultural traditions and social customs. In some cases, importation of foreign ideologies aggravates the contradiction between the economic subsystem and the cultural–institutional subsystem. For example, based on international diffusion of humanitarianism and respect for human rights, a tendency has emerged in developing economies to introduce social welfare and labour laws such as minimum wage and labour union regulations. These regulations provide limited benefits to a relatively small number of employees in the formal sector consisting of large modern enterprises and government agencies. As effective wage rates are raised in this sector, the substitution of capital for labour is encouraged with the result of decreased employment, as well as increased unemployment and underemployment outside the sector (Chapter 7).

Foreign influences tend to heighten this contradiction in developing economies partly because culture, institutions, and technology change separately, rather than evolving through dialectic interactions within each society. However, a more basic reason appears to be that changes in resource endowments and technology happen too fast for people's value system and organizational principles to adjust. For example, when the population was sparse, and people made their subsistence living in isolated villages and tribes, many of these small communities were able to manage ‘common-property resources' or ‘common-pool resources’, such as forests, pasture lands, and communal irrigation systems, which are subject to the danger of exhaustion due to overexploitation but for which it is difficult to charge the cost to the resource-users. The strong personal ties binding community members together as well as traditional moral codes and conventions, including (p.29) religious taboos, were largely effective in preventing people from becoming free-riders.

However, as the population grew and interlocational interdependencies increased, coordination of people over a wide area covering many villages would have been required. To the extent that social organization and institutions to cope with this situation lagged behind the emerging need, it is well known that, while forests were relatively well preserved and grazing animals were adequately controlled to allow for reproduction of pasture within each village, the surrounding public forests were destroyed by shifting cultivation and pasture lands were turned into deserts by overgrazing (Chapters 7 and 9).

The same problem has been emerging at the state level. In general, people in developing countries have a stronger sense of belonging to communities such as tribes and villages than to the state. This tendency is especially strong in some countries (particularly those in Africa), which were originally subdivided into colonies by Western powers with little consideration for the social integrity of native people. These countries later achieved independence with few adjustments to the colonial boundaries. In these countries it is only natural for politicians to place a high priority on the policies that benefit the communities to which they belong rather than on policies that promote a nationwide benefit. People there also tend to consider such behaviour by politicians to be natural and legitimate. As a result, an oversupply of negative public goods (or more appropriately called ‘public bads’) tends to prevail that benefit a small group at the expense of the majority (Chapter 8).

Such a contradiction or mismatch between the economic subsystem and the cultural–institutional subsystem is likely to become especially critical for the economies characterized by rapid changes in resource endowments and technology, probably culminating in the Marxian solution of revolution and civil war. Yet, hasty reforms of institutions without due consideration for historical path dependency can only aggravate the crisis.

A wide gap exists in technology and institutions between developing and developed economies. This gap could be a potential source of rapid economic development for developing economies. The key to exploiting this potential is to establish a feedback mechanism whereby changes in resource endowments and technology evolve institutions that incorporate cultural tradition appropriately, thus promoting the speed of induced innovation while also avoiding the tragic mismatch between infrastructure and superstructure.

Where is such a mechanism operating in developing economies? Who are the carriers of this mechanism? What means may promote it? Understanding the total interdependency among all the components in the social system will be necessary for an answer. However, we will only be thwarted if we try to (p.30) understand the entire complex system from the beginning. To move toward this understanding, the only option is to start with the analysis of partial relations between population and natural resources, resources and technology, technology and institutions, etc. Then we should try to develop a global perspective by integrating the results of the partial analyses. The theoretical framework outlined in this chapter is designed to serve as an integrating device for the partial analyses that follow.



(*) Readers not accustomed to the technical analysis of economics may wish to skip this section.

(1.) A somewhat similar model is developed in Hayami and Ruttan (1985: 111).

(2.) For a representative case of this view, see Cohen (1977). However, there have developed many other theories concerning the origin of agriculture that took place around 10,000 BC. Some have determined that the desiccation in West Asia and North Africa corresponding to the retreat of glaciers from the end of the Pleistocene forced human and animal inhabitants to concentrate in river valleys and oases, and was therefore a prime pressure on domestication (Childe, 1928). Others have emphasized as a decisive factor the cultural and religious changes, in addition to accumulation of knowledge on animals and plants (Sauer, 1952). There has also been a theory identifying the exhaustion of wild animals due to the innovation of bow-and-arrow hunting technology as the major factor inducing the development of agriculture (V. L. Smith, 1975). These theories have their own truths. They are not inconsistent with the general hypothesis that a shift to agriculture was induced by a decline in the endowment of natural resources per capita. There is little doubt that population growth for given natural resource endowments was one of the most fundamental factors, if not the only factor, to have induced the change to agriculture.

(3.) Marx's view was typically advanced in the famous preface to A Contribution to the Critique of Political Economy ([1859] 1904) to be quoted later. His interpretation of historical processes were expressed in various works, e.g. Marx ([1939–41] 1953). It was Engels ([1884] 1953) who developed a systematic treatise of Marxian interpretation of human history.

(4.) As for the debates on whether the Hicksian bias in technological changes is induced by changes in relative factor prices, see Fellner (1961), Samuelson (1965), and Ahmad (1966). For more detail, see Hayami and Ruttan (1985: 84–6).