What is Development Economics All About?

Suppose you were blindfolded and airlifted abroad. After you arrive in a small town and remove the blindfold, your job is to determine the income level of the place based only on sixty seconds of observation. What would you look for? If you have travelled or lived in a developing country, you might have a head start on this assignment: Is it hot and humid? What are people wearing? Eating? How are people getting around? What do the streets and buildings look like? Do the animals look pampered? Do you see trash or trash cans? And the smells!  Most people, when exposed to living standards far below their own, want to help in some way. Economists (yes, even economists!) feel this impulse and wonder: Why are some places rich and others poor? What can be done to reduce poverty and encourage economic growth? In this chapter, we introduce development economics and describe the emergence and evolution of this field.


  • Description of development economics
  • Evolution of development economics
  • Import substitution and export promotion
  • Market failures
  • Inseparability of efficiency and equity
  • Millennium Development Goals

Malawi is one of the poorest countries in the world.  The  average  person living  there  had  an  annual  income  of  $330  in  2010.  That is not even a dollar a day.  Even  when  we  adjust  for  a  low  cost  of  living,  the  average Malawian  lived  off  what  in  the  United  States  would  be  the  equivalent  of around $850 per year. What is the solution to Malawi’s pervasive poverty?

Like  other  least-developed  countries  (LDCs), Malawi  has  tried  a number  of  different  strategies  to  stimulate  development  and  raise  the welfare  of  its  people.  It  made  the  growth  of  smallholder  production  a cornerstone  of  its  development  and  poverty-alleviation  strategy  by focusing  on  improving  smallholders’  access  to  agricultural  input  and output  markets.  Eighty-one  percent  of  Malawi’s  population  is  rural, and  smallholders  make  up  about  90%  of  the  poor.  Food  production  is a  major  source  of  livelihood  for  most  rural  households.  Productivity and, in particular, fertilizer use are low.  Only 67% of agricultural households used fertilizer in 2004.

Before  1998,  Malawi  relied  on  market  price  supports  to  transfer income  to  farm  households.  (Next  door  in  Zambia,  where  per  capita income  was  $1,400  in  2010,  the  government  continues  to  pay  farmers prices  well  above  market  levels  for  their  maize.)4  In  recent  years,  fertilizer  subsidies  were  the  primary  method  of  transferring  income  to  rural Malawi  households.  Paying for farmers’ inputs is expensive and controversial.  More than 50% of the Ministry of Agriculture’s budget has gone toward paying for input subsidies.

Most  recently,  the  country  has  taken  a  new  line  of  attack  by  introducing  a  social  cash  transfer  (SCT)  scheme  that  targets  ultra-poor households  (those  living  on  less  than  $0.10  per  day)  whose  members  are unable  to  work  due  to  disability,  age,  illness,  or  a  high  dependency  ratio (too  many  people  to  take  care  of  at  home).  Rather  than  specifically  targeting  agricultural  production,  like  the  price  supports  or  fertilizer  subsidies,  cash  transfers  raise  incomes  directly,  allowing  households  to increase  consumption  or  to  invest  in  production  activities.  The  government  and  researchers  hope  these  transfers  will  stimulate  production  in other  ways  while  creating  positive  spill overs  that  benefit  other


Field  research  to  test  the  effectiveness  of  SCT  programs  is  ongoing. SCT  programs  are  being  implemented  throughout  the  continent,  in Ethiopia,  Ghana,  Kenya,  Zambia,  Zimbabwe,  Lesotho,  and  other  poor countries.  The

United  Nations  Children’s  Fund  (UNICEF)  and  the  UN’s Food  and  Agricultural  Organization  (FAO),  in  conjunction  with  several universities  and  agencies,  have  launched  an  ambitious  project  to  document  the  impacts  of  these  transfer  programs  on  a  range  of  outcomes, from crop production to HIV/AIDS prevention.6 Development  economists  are  on  the  front  line  of  this  effort,  helping to  design  and  evaluate  SCT  programs.  On  a  micro  level,  this  is  a  good example  of  the  sorts  of  things  development  economists  do.



Usually,  a  development  economics  class  is  a  potpourri  of  special  topics. It’s  hard  for  it  not  to  be,  because  economic  development  involves  so many different things:

  • It’s income growth (how can we have development without growth in countries whose per capita incomes now hover around $1–$2 per day?).


  • It’s welfare economics, including the study of poverty and inequality.


  • It’s agricultural economics. How to make agriculture more productive is a big question in countries where most of the population—particularly the poor population—is rural and agricultural.


  • It’s economic demography, the study of population growth in a world with more than 7 billion people, and population distribution in a world with more than a quarter of a billion international migrants and many more internal ones. (China will have about that many internal migrants in the near future, if it doesn’t already.)


  • Its labour economics: education, health, conditions in the workplace.


  • It’s the study of markets for goods, services, inputs, outputs, credit, and insurance, without which whole economies can grind to a standstill.


  • Its public economics, including the provision of public goods from roads and communications to utilities and waste treatment, and it’s about managing the macro economy, too.


  • It’s about natural resources and the environment: energy, water, deforestation, pollution, climate change, sustainability.


What is economic development not about, you might ask? Lurking  behind  this  question  is  another  one,  which  lies  at  the  heart of  why  we  wrote  this  book:  Why  is  there  even  a  field  of  development economics?  After all, most economics departments have courses in each one of the above areas—and more. Development  economics  seeks  to  understand  the  economic  aspects  of the  development  process  in  low-income  countries.  This  implies  that there  must  be  something  different  about  studying  economics  in  low-income countries. Clearly there is.  Economic  development  entails  far-reaching  changes in  the  structure  of  economies,  technologies,  societies,  and  political  systems.  Development  economics  is  the  study  of  economies  that  do  not  fit many  of  the  basic  assumptions  underpinning  economic  analysis  in  high-income  countries,  including  well-functioning  markets,  perfect  information,  and  low  transaction  costs.  When these assumptions break down, so do the most basic welfare and policy conclusions of economics. This  book,  like  other  development  economics  texts,  touches  on  many different  topics.  However,  its  focus  is  on  the  fundamental  things  that distinguish  rich  and  poor  countries  and  the  methods  we  use  to  analyse critical  development  economic  issues.  After  reading  and  studying  it, you’ll  be  familiar  with  the  basic  tool  kit  development  economists  use  to do  research,  begin  to  understand  what  makes  rich  and  poor  countries different,  and  have  an  appreciation  for  the  theory  and  practice  of  development economics.



Economics classes rarely spend much time on history.  But the brief history of development economics is instructive.  Appreciating  how  economists  have  come  to  understand  economic  development  helps  us  understand  the  various  development  approaches  people  have  taken  over  time and  how  we  got  to  the  ideas  that  are  popular  now.  What  economists thought  development  meant  at  the  beginnings  of  our  field’s  history  is quite different from the way we see it today. The  origins  of  modern  development  economics  are  not  found  in  low-income  countries,  but  rather  in  relatively  developed  countries  devastated  by  war.7  In  the  aftermath  of  World  War  II,  there  was  a  need  for economic  theories  and  policies  to  support  the  rebuilding  of  war-torn Europe  and  Japan.  The  United  States  adopted  the  Marshall  Plan  to  help rebuild  European  economies.  This was a massive program:  $13 billion over four years was a lot of money back then! In  the  wake  of  the  success  of  the  Marshall  Plan,  economists  shifted their  attention  in  the  1950s  and  1960s  from  Europe  to  the  economic

Problems of Africa, Asia, and Latin America.  Lessons  learned  in  Europe did  not  transfer  easily  to  those  settings;  it  quickly  became  clear  that poor countries faced fundamentally different challenges.

Early  development  economists  focused  on  income  growth,  often blurring  the  lines  between  growth  and  development.  In poor countries, major structural transformations were needed to achieve growth.  By comparing  different  countries’  growth  experiences  (including  the  past experiences  of  the  more  developed  countries),  economists  tried  to uncover  the  conditions  that  determine  successful  development  and  economic growth.

1.2.1 Taking Off

Seminal  work  during  this  early  period  of  development  economics  includes  Walter  Rostow’s  treatise  on  the  stages  of  economic  growth:  the traditional  society,  the  preconditions  for  take-off,  the  take-off,  the  drive  to maturity,  and  the  age  of  high  mass  consumption.  Nobel  laureate  Simon Kuznets  (whom  we  shall  revisit  later  in  this  chapter)  countered  this  simplistic  view  that  all  countries  go  through  a  similar  linear  set  of  stages  in their  economic  history.  He  argued  instead  that  key  characteristics  of today’s  poor  countries  are  fundamentally  different  from  those  of  high-income  countries  before  they  developed. The Anatomy of Growth Economists recognized the need to understand how the growth process works.  Growth  is  important  enough  to  get  its  own  chapter  in  this  book.  There,  we’ll  focus  on  modern  theory,  but  growth models  have  played  an  important  role  since  the  start  of  development economics.

A  simple  aggregate  growth  model  developed  by  Sir  Roy  F.  Harrod and  Evsey  Domar  became  part  of  the  basic  creed  of  development  economists  in  the  1950s  and  1960s.  The  Harrod-Domar  model’s  main  implication  was  that  investment  is  the  key  driver  of  economic  growth.  It focused  economists’  and  policy  makers’  attention  on  generating  the  savings  required  to  support  higher  growth  rates  in  poor  countries.  Although simplistic,  this  was  a  precursor  to  models  used  to  analyse  economic growth in developing countries today. Nobel laureate W.  Arthur Lewis viewed growth through a higher resolution lens.  His famed work, “Economic Development with Unlimited

Supplies  of  Labour,”  shifted  attention  from  aggregate  growth  to  structural transformation.  Lewis  introduced  the  dual-sector  model,  demonstrating that  the  expansion  of  the  modern  (industrial  or  capitalist)  sector  depends on  drawing  labour  from  the  traditional  (agricultural  or  subsistence)  sector. He  focused  on  poor,  labour-rich  countries,  in  which  a  labour  surplus  in  the subsistence  sector  could  be  a  valuable  resource  for  industrial  growth: industry  could  expand  without  putting  upward  pressure  on  wages. Implicit  in  the  Lewis  model  is  a  simple,  demand-driven  model  of  migration:  as  urban  industry  expands,  people  move  off  the  farm  to  fill  the  new jobs.  Whether  or  not  workers  really  can  be  moved  out  of  agriculture without  losing  crop  production  is  an  empirical  question  that  some  economists  still  try  to  answer  today.

Lewis was criticized for largely ignoring agriculture.  His  work  was extended  and  formalized  by  Gustav  Ranis  and  John  Fei,  who  demonstrated  that  industrial  growth  depends  on  agricultural  growth  as  well  as industrial  profits.  If  agricultural  production  does  not  keep  up,  food prices  rise,  and  this  forces  urban  wages  up,  squeezing  profits  and  investment  in  industry.  The  growth  of  industry,  then,  depends  on  agriculture in  a  way  that  is  easy  to  miss.  Recognition  that  different  sectors  of  the economy  are  linked  in  critical  ways  was  an  important  contribution  of dual-economy  models  and  is  a  basis  for  more  sophisticated  economy wide  models  today.

The  assumption  that  there  is  surplus  labour  in  the  traditional  sector (i.e.,  that  the  marginal  product  of  labour  there  is  zero)  was  questioned  by another  Nobel  laureate,  Theodore  Schultz. He  pointed  out  evidence  of labour  shortages  during  peak  harvest  periods  even  in  economies  like India  and  China,  where  a  labour  surplus  existed  at  other  times  of  the year.  Thus,  he  argued,  one  cannot  assume  that  countries  can  move  labours out  of  agriculture  without  suffering  a  drop  in  crop  production—unless they  adopt  new  agricultural  technologies.  Schultz  emphasized  the importance  of  technological  innovation  and  revolutionized  economists’ thinking  by  putting  forth  the  thesis  that  farmers  in  LDCs  are  “efficient but  poor.”  That  is,  while  they  might  appear  to  be  inefficient  (compared, say,  to  commercial  farmers  in  rich  countries),  poor  farmers  actually optimize  given  the  severe  resource  constraints  they  face,  including  traditional  technologies  and  limited  human  capital.  The  efficient-but-poor hypothesis  continues  to  shape  the  way  development  economists  think about  and  model  poor  rural  economies,   Nevertheless,  recent  work  questions  whether  production, land  tenancy  (e.g.,  sharecropping),  and  other  institutions  in  poor  countries really are efficient in an economic sense. The  burgeoning  early  development  economics  literature  produced far  too  many  works  to  catalogue  here,  but  two  others  deserve  special mention  because  of  the  far-reaching  impact  they  had  on  economic thinking and, more importantly, policies.

1.2.2 Import-Substitution Industrialization

In  1950,  Raúl  Prebisch  and  Hans  Singer  independently  observed  that  the terms of trade, or the ratio of prices, between primary (agricultural, resource extraction)  and  manufactured  products  erodes  over  time.  As people’s income increases, the share of income they spend on manufactures increases, while the share spent on primary goods falls.  This happens globally as well as locally.  Prebisch  and  Singer  argued  that  this  drives  up  the  prices  of  manufactured  goods  relative  to  primary  goods.  Poor  countries  that  continue  to specialize  in  primary-goods  production  lose  out  compared  to  countries  that protect  and  promote  their  industries.  The  way  Prebisch  and  Singer  saw  it, sticking  with  primary-goods  production  is  like  investing  in  a  waning  industry—the  opposite  of  what  good  investors  do.

Prebisch  and  Singer’s  work  was  enormously  influential  in  promoting protectionist  trade  policies,  shielding  infant  industries  in  poor  countries from  international  competition.  Its  policy  prescriptions  ran  soundly against  the  doctrine  that  countries  should  follow  their  comparative advantage  in  trade.  In  retrospect,  countries  that  followed  this  advice  did not  fare  as  well  as  countries  like  the  “Asian  Tigers”  (Hong  Kong,  Singapore,  South  Korea,  and  Taiwan),  which  followed  more  outward (trade)-oriented  development  models, (“International Trade and Globalization”).

1.2.3 Linkages

Albert  Hirschman,  another  early  pioneer  in  development  economics,  put forth  the  interesting  and  influential  argument  that  imbalances  between demand  and  supply  in  LDC  economies  can  be  good:  they  create  pressures  that  stimulate  economic  growth.  Hirschman  was  instrumental  in creating  a  focus  on  economic  linkages,  which  pervade  economy-wide modelling,  a  staple  of  development  policy  analysis  today as  well  as  of  some  recent  project  impact evaluation  models promoting  investments  in  industries  with  many  linkages  to  other  firms, governments  can  have  a  multiplier  effect  on  economic  growth;  the  effects of  a  policy  spread  to  industries  linked  to  the  targeted  industry.  Backward linkages  transmit  growth  effects  from  an  input-demanding  activity  (e.g., textiles)  to  input  suppliers  (cotton  mills  or  wool  producers).  Forward linkages  stimulate  the  growth  of  activities  ahead  of  firms,  as  when  investment  in  an  electricity  generator  facilitates  the  growth  of  electricity-using industries.

Hirschman  argued  that  agriculture  generated  few  linkages  with  the rest  of  the  economy.  This,  particularly  when  combined  with  the  Prebisch-Singer  hypothesis,  contributed  to  the  sense  among  policy  makers  that agriculture  is  unimportant  and  countries  ought  to  use  their  scarce resources  to  promote  industrial,  not  agricultural,  growth.  John  Mellor countered  this  argument  in  his  seminal  work,  The  New  Economics  of Growth,  which  documented  the  importance  of  consumption  linkages between  rural  households  and  urban  industries.  If  most  of  a  country’s population  is  rural,  where  will  the  demand  for  new  industrial  production be  if  not  in  rural  households?  Rising  agricultural  incomes,  then,  provide a  critical  market  for  manufactures,  thereby  stimulating  industrial  growth. Development  economists  had  begun  to  take  more  of  a  systems  view  of poor  economies,  recognizing  the  linkages  among  production  sectors  and between  firms  and  households  that  are  important  in  shaping  economic growth.  They would soon rethink their emphasis on growth, though.

1.2.4 Rethinking Growth: Inequality and Poverty

The  United  Nations  declared  the  1960s  to  be  the  decade  of  development. In  1961,  it  “called  on  all  member  states  to  intensify  their  efforts  to  mobilize  support  for  measures  required  to  accelerate  progress  toward  self-sustaining  economic  growth  and  social  advancement  in  the  developing countries.”  Each  developing  country  set  its  own  target,  but  the  overall goal  was  to  achieve  a  minimum  annual  growth  rate  of  5%  in  aggregate national  income  by  the  end  of  the  decade.  The world came close to realizing the UN’s goal.  LDCs  achieved  an  average  annual  growth  rate of  4.6%  from  1960  to  1967.  However, their population also increased. As  a  result,  their  per  capita  gross  product  (income  divided  by  population)  rose  only  about  2%. When  the  UN  Development  Decade  ended  in  1970,  the  gap  between rich  and  poor  countries  had  widened:  two-thirds  of  the  world’s  population  had  less  than  one-sixth  of  the  world’s  income.  This raised new questions about the meaning of development.  Evidently,  a  tide  of  rising world  income  did  not  lift  all—or  even  most—boats.  The  UN  General Assembly  concluded  that  one  of  the  reasons  for  the  slow  progress  was the absence of a clear international development strategy.

The  problem  of  rising  inequality  made  development  economists rethink  their  focus  on  growth.  Before  then,  the  key  work  linking  growth and  inequality  was  Simon  Kuznets’s  “inverted  U”  hypothesis.  It  stated that  economic  growth  decreases  inequality  in  rich  countries  but  increases it  in  poor  countries.  It  tended  to  create  a  sense  of  complacency  about inequality:  sure,  inequality  increases  for  a  while  as  poor  countries  grow, but  eventually  countries  “outgrow”  it  and  become  more  equal.  At  least, that’s  what  Kuznets  saw  when  he  used  cross-section  data  to  compare rich  and  poor  countries.  (Cross-section  data  are  data  on  different  countries  at  the  same  point  in  time.  It  would  have  been  nice  to  track  the  same countries  over  time  to  see  if  inequality  first  increases  then  decreases  as economies  grow,  but  we  didn’t  have  the  data  to  do  that  back  when Kuznets put forth his novel theory.)

As  panel  data  have  became  available  to  track  individual  countries’ growth  and inequality,  the  inverted-U  theory  has  been  challenged  repeatedly  in  the  development  economics  literature,  though  it  seems  to  fit  some countries  well.  (Panel  data  provide  information  on  the  same  units  [here, countries]  over  time.)  Today, China is growing fast, and inequality there is increasing.  Brazil  and  Mexico  have  much  higher  per  capita  incomes than  China,  and  inequality  there  is  going  down.  Then  there’s  the  United States,  where  inequality  fell  through  the  1970s  but  is  rising  again  now.

Development economics shifted its attention from income growth to income inequality).  In  1974,  Hollis  Cheery,  head of  the  World  Bank’s  economic  research  department,  and  colleagues  published  an  influential  book  called  Redistribution  with  Growth.  It  demonstrated  that  when  assets  (such  as  land)  are  distributed  unequally,  economic growth  creates  an  unequal  distribution  of  benefits.  Around  the  same  time (1973),  Irma  Adelman  and  Cynthia  Taft  Morris  published  a  book  called Economic  Growth  and  Social  Equity  in  Developing  Countries.  They found  that  as  incomes  grew,  not  only  did  inequality  increase,  but  the  absolute  position  of  the  poor  worsened.  At  the  early  stages  of  a  country’s  economic  growth,  the  poorest  segment  of  society  may  be  harmed,  as  traditional  economic  relationships  in  subsistence  economies  are  displaced  by emerging  commercial  ones.  Growth  was  more  equitable  in  countries  that redistributed  assets,  like  land  and  human  capital  (education),  before  the growth  happened.

Robert  McNamara,  the  World  Bank’s  president,  presented  Cheney’s  findings  at  a  1972  UN  conference  in  Santiago,  Chile.  This  staked out  a  new  position  for  the  World  Bank  and  development  economics profession  more  broadly  that  growth  alone  is  not  enough. McNamara and  many  development  economists  recommended  redistribution  before growth;  for  example,  land  reforms  and  other  measures  to  raise  the  productivity  of  small  farmers  and  widespread  rural  education  programs. The  development  economics  mantra  had  shifted  from  income  growth  to  poverty  and  inequality.  The work  of  Amartya  Sen  expanded  the  scope  of  economic  development  yet further  to  include  dimensions  of  human  development  such  as  health, nutrition, education, and even freedom.

National  planning  offices  cropped  around  the  world,  often  with “five-year  plans”  inspired  by  the  Soviet  Union’s  planning  models  but  not necessarily  socialistic  in  nature.  (While  Ed  was  an  undergraduate  student he  worked  for  a  year  with  the  National  Planning  Office  in  Costa  Rica, which  had five-year  plans  but  was  hardly  a  communist  state!) This  period saw  the  advent  of  economy-wide  models  as  a  tool  for  development  planning  and  policy.  These  models  were  designed  to  simulate  the  complex impacts  that  policies  have  on  whole  economies  as  well  as  on  particular social  groups.  They  continue  to  be  a  staple  of  development  economics research  and  policy  design  and  are  often  at  the  crossfire  of  a  lively  debate about  the  role  of  planning  and  markets  in  economic  development.

The 1970s marked the beginning  of  what  has become an ongoing friction  between  direct  government  involvement  in  the  development  process and  market-led  development—a  tension  we  will  address  throughout  this book  because  it  stems  from  essential  ideas  in  development  economics. The  traditional  neoclassical  economic  view,  inspired  by  Adam  Smith’s “invisible  hand,”  is  that  individuals  and  firms,  in  the  pursuit  of  their  self-interest,  are  led  as  if  by  an  invisible  hand  to  economic  efficiency.  For example, competition among profit-maximizing firms drives down prices for selfish, utility-maximizing consumers.  However,  the  invisible  hand does  not  typically  lead  to  fair  outcomes,  so  government  intervention  can often  play  a  role  in  promoting  social  objectives  other  than  efficiency, such  as  equality  or  protection  of  domestic  industries.

The 1960s and 1970s witnessed increasing  government  involvement  in markets:  setting  prices,  controlling  trade,  and  creating  “parastatal”  enterprises  that  did  everything  from  buying  and  selling  crops  to  drilling  for  oil. Much  of  the  focus  of  these  efforts  was  on  stimulating  industrial  growth; however,  most  of  the  population  in  poor  countries—especially  the  very poor—depended  heavily  on  agriculture.  In  many  countries,  import-substitution  industrialization  policies  created  severe  biases  against  agriculture,  in  three  ways:

  1. “Cheap food policies” directly harmed agriculture while helping to keep urban wages low.
  2. Steep tariffs and quotas on imported industrial goods and direct subsidies were used to promote industrialization. This increased the profitability of industrial compared to agricultural production
  3. Macroeconomic policies like overvalued exchange rates made imported industrial inputs and technologies (as well as food) cheaper. This created yet another bias against agriculture by making traded goods (food) less profitable than nontraded goods (manufactures, which were protected from trade competition).

1.2.5 Trusting Markets

The  1980s  saw  the  beginning  of  a  backlash  against  too  much  state involvement in  the  economy.  This  was  the  era  of  Ronald  Reagan  and Margaret  Thatcher,  in  which  we  recognized  the  inefficiencies  of  state planned  economic  systems  such  as  those  in  the  Soviet  Union  and  China compared  with  the  more  laissez-faire  political  systems  in  the  west. Meanwhile,  it  became  clear  that  the  countries  that  were  experiencing the  most  rapid  and  broad-based  growth  were  not  the  inward-oriented countries  following  import-substitution  industrialization,  like  Kenya, Mexico,  and  Brazil.  Instead, they were the outward export-oriented economies, particularly the Asian Tigers.  In  those  countries,  governments  were  involved,  sometimes  heavily,  in  the  economy,  but  opening up  to  market  competition  made  it  possible  to  become  competitive  on  a world scale.

Another  part  of  the  impetus  for  shifting  away  from  state  involvement and  toward  markets  came  in  the  1970s  and  1980s  as  the  world  economy  went  into  recession  with  soaring  oil  prices.  This  sparked  debt  crises in  many  LDCs  (particularly  in  Latin  America),  forcing  them  to  rethink their  development  policies—often  as  part  of  “structural  adjustment” programs  required  by  the  International  Monetary  Fund  (IMF)  as  a  condition  for  restructuring  their  debt.  These adjustments invariably reduced the direct involvement of the state in the troubled economies

The  World  Bank’s  1984  World  Development  Report  endorsed  many of  these  dominant  promarket  positions.  It  called  for  removing  distortions  created  by  governments’  over involvement  in  agricultural  markets. Almost  overnight,  governments  began  to  withdraw  from  markets,  dismantling  import-substitution  industrialization  policies  and  opening  up to  trade.  Less-developed countries around the world entered into free trade agreements.

1.2.6 Not (Quite) Trusting Markets

The  market  liberalization  movement  continued  into  the  1990s;  however,  the  enthusiasm  for  free  trade  became  tempered  by  a  realization that  market  liberalization  does  not  necessarily  improve  people’s  economic  welfare  if  markets  do  not  work  properly. This  produced  a  surge of  research  documenting  market  failures  in  LDCs  as  well  as  their  underlying causes.

Broadly  speaking,  a  free  market  fails  if  it  does  not  work  efficiently— that  is,  if  there  is  another  scenario  in  which  a  market  participant  could  be made  better  off  without  making  others  worse  off.  Often,  markets  fail  so miserably  that  they  do  not  exist  at  all  for  many  people.  Most  poor  people do not have access to credit,  most  farmers  in  Africa  do  not  sell  their  crops, and  almost  nobody  in  poor  countries  has  access  to  formal  insurance.

Joseph  Stiglitz,  who  received  the  2001  Nobel  Prize  in  economics, along  with  other  economists,  demonstrated  that  markets  are  rarely  efficient.  He  attributed  this  largely  to  imperfect  information,  which  creates high  transaction  costs  that  lead  to  widespread  market  failures,  particularly  in  poor  countries.  Since  understanding  market  failures  is  fundamental  to  development  economics,  we  will  learn  about  several  sources of market failures in this book.

When markets do not work well, government involvement in the economy can often improve welfare.  Development  economists  have  been  careful  to  warn  that  market  failures  do  not  necessarily  warrant  broad  state intervention  in  the  economy:  government  failures  can  be  worse  than  market  failures.  However,  the  scope  for  the  state  to  improve  welfare  by  intervening  in  markets,  it  seems,  is  much  larger  than  previously  thought.

1.2.7 The Experimental Revolution

Today,  much  of  the  focus  of  development  economics  has  shifted  to  the micro-level  and  to project  evaluation.  Increasingly,  development  economics  research  involves  using  experiments  to  learn  about  people’s  economic  behaviour  and  evaluate  the  impacts  of  policy  interventions  on  welfare  outcomes.  When  experiments  are  not  possible,  economists  use other  methods,  including  econometrics  and  simulation  modelling,  to  try to  identify  the  impacts  of  policies  and  programs.  The  social  cash  transfer  programs  mentioned  at  the  start  of  this  chapter  are  an  example. Today,  if  you  work  for  a  nongovernmental  organization  (NGO),  an international  development  agency,  or  even  an  LDC  government,  there  is a  good  chance  you’ll  be  dealing  with  experimental  economics.  Experiments have become such an important part of development economics that we devote an entire chapter to them in this book.



Economic development has different meanings in different contexts.  In rich countries, it is pretty much equated with growth.  Picture  the  urban developer  who  makes  skyscrapers  sprout  from  vacant  lots  in  a  blighted city  core.  Politically,  development  projects  in  high-income  countries often  are  motivated  by  some  of  the  same  goals  that  inspire  development projects  in  poor  countries,  particularly  the  creation  of  new  jobs, incomes,  and  tax  revenues.  Their ultimate aim, however, is likely to be growth.

Most  development  economists  today  would  say  that  economic  development  is  not  equivalent  to  growth,  although  it  is  difficult  to  achieve development  goals  without  growth.  Development  projects  around  the world  focus  on  concrete  outcomes  related  to  poverty,  malnutrition, inequality,  and  health.  Development  is  about  satisfying  basic  physical needs  like  nutrition,  shelter,  and  clothing,  and  about  the  development of  the  mind  (and  of  course  people’s  earnings  potential)  through  education.  Projects  also  focus  on  the  environment,  conservation,  and  sustainable  resource  use;  on  human  rights,  gender  and  ethnic  equity,  and  even government  corruption.

All  of  these  questions  can  be  vital  not  only  to  determining  who  reaps the  benefits  of  economic  growth,  but  also  to  understanding  growth itself.  Herein  lies  a  fundamental  difference  in  the  way  we  tend  to  look at  economics  and  politics  in  rich  and  poor  countries.  In  high-income countries  (not  to  mention  our  microeconomics  courses),  economic  efficiency  and  equity  tend  to  be  viewed  as  separate  questions.  The  efficient allocation  of  resources  is  critical  to  ensure  that  economies  produce  the  biggest  possible  economic  pie,  given  the  constraints  they  face  (i.e., limited  resources  and  technologies).  Efficiency is the primary focus of the vast majority of our economics classes.

What about equity?  How  the  pie  gets  distributed  is  usually  an  afterthought  in  economics—something  more  in  the  domain  of  politics  than economics.  Think about the economics courses you’ve taken.  The  textbook  view  is  that  efficiency  and  equity  are  sequential,  or  recursive, problems:  first  grow  the  pie,  then,  once  that’s  done,  think  about  how  it gets distributed (or step back and let the market decide).

Clearly,  there’s  an  important  separability  assumption  here:  that  efficiency  can  be  achieved  regardless  of  how  income  is  distributed.  Is this a reasonable assumption?  In  a  competitive  market  equilibrium,  there  will be  different  outcomes  depending  upon  what  the  initial  distribution  of wealth  looks  like.  But  provided  the  basic  assumptions  of  the  competitive  model  (which  you  learned  in  your  introductory  economics  courses) hold,  all  will  be  efficient  in  the  Pareto  sense:  you  cannot  make  anyone better  off  without  making  someone  else  worse  off.  If you ever studied an Edge worth box, you’ve seen how economists show this.

The  separability  of  equity  and  efficiency  was  reinforced  by  the  Nobel laureate  Ronald  Coase,  who  argued  that  bargaining  will  lead  to  an  efficient  outcome  regardless  of  the  initial  allocation  of  property  rights,  even in  the  case  of  externalities  (a  cost  or  benefit  not  reflected  in  prices,  like pollution).  According  to  Coase,  as  long  as  we  can  costlessly  negotiate  it doesn’t  matter  whether  you  have  the  right  to  smoke  or  I  have  the  right to  breathe  clean  air.  Once  we  have  finished  bargaining  with  each  other, the  amount  of  smoke  in  the  air  will  be  the  same.  This view has achieved the status of a theorem: Coase’s Theorem.

If  efficiency  and  equity  are  truly  separate  issues,  then  there  is  not much  room  for  economic  policy,  nor  much  reason  for  efficiency-minded economists  to  worry  about  equity.  (Of course, even economists might worry about equity for other [i.e., humanitarian] reasons.)

If only things were that simple!  Alas, negotiation is never costless (and often prohibitively expensive).  For  this  and  many  other  reasons,  a great  deal  of  development  economists’  effort  goes  into  discovering  how equity  and  efficiency  are  intertwined,  especially  in  poor  countries.  How assets are distributed clearly affects efficiency if the following conditions hold:

  • Banks are unwilling to loan money to small farmers.


  • Poor people cannot get insurance to protect themselves against crop loss or sickness.


  • Poverty and malnutrition prevent kids from growing up to become productive adults.


  • Access to markets for the stuff people produce, the inputs they use, and the goods they demand is different for the poor and rich.


  • The ability to get a job depends on who you are, not on how productive you are.

In  these  and  many  other  cases,  the  separability  of  equity  and  efficiency breaks  down.  A  person’s  capacity  to  produce  (or  even  consume)  efficiently  depends  upon  how  wealth  is  distributed  to  start  out  with  because the  basic  assumptions  of  competitive  markets  often  don’t  hold  for  the poorest  members  of  society.  A  rich  farmer  can  produce  where  the  market  price  equals  the  marginal  cost  of  producing  a  crop,  the  basic requirement  for  profit  maximization  and  efficiency.  But  if  a  poor  farmer lacks  the  cash  to  buy  fertilizer,  and  no  bank  will  lend  to  her,  she  will  not  be  able  to  produce  as  efficiently  as  the  large  farmer.  This  implies that  efficiency  depends  on  how  income  is  distributed  to  begin  with, which  is  an  important  departure  from  standard  assumptions  in  economics.

The  conditions  under  which  equity  affects  efficiency  are  many,  and they  permeate  the  economies  and  societies  of  poor  countries.  Development  economics,  more  than  anything  else  perhaps,  is  the  study  of  economies  in  which  equity  and  efficiency  are  closely  interrelated.  This  opens up  a  whole  realm  of  possibilities  for  policy  and  project  interventions  to increase  economic  efficiency  as  well  as  equity.  More  often  than  not, equity  and  efficiency  are  not  only  complementary;  they  are  inseparable.



Eradicating  extreme  poverty  continues  to  be  one  of  the  main  challenges  of our  time,  and  is  a  major  concern  of  the  international  community.  Ending  this scourge  will  require  the  combined  efforts  of  all,  governments,  civil  society organizations  and  the  private  sector,  in  the  context  of  a  stronger  and  more effective  global  partnership  for  development.  The  Millennium  Development Goals  set  time bound  targets,  by  which  progress  in  reducing  income  poverty, hunger,  disease,  lack  of  adequate  shelter  and  exclusion—while  promoting gender  equality,  health,  education  and  environmental  sustainability—can  be measured.  They  also  embody  basic  human  rights—the  rights  of  each  person on  the  planet  to  health,  education,  shelter  and  security.  The  Goals  are  ambitious  but  feasible  and,  together  with  the  comprehensive  United  Nations development  agenda,  set  the  course  for  the  world’s efforts  to  alleviate extreme  poverty  by  2015.  (United Nations Secretary-General BAN Ki-moon).

In  September  2000,  189  nations  came  together  at  United  Nations  Headquarters  in  New  York  and  adopted  the  United  Nations  Millennium Declaration.  In  it,  they  committed  to  creating  a  new  global  partnership to  reduce  extreme  poverty  and  achieve  a  set  of  specific  development targets  by  2015.  These  targets  (see  appendix  at  the  end  of  this  chapter), which  range  from  health  to  environment  to  gender  equality,  have become  known  as  the  Millennium  Development  Goals  (MDGs).  Setting  goals  like  these  and  monitoring  our  progress  toward  achieving them  requires  tremendous  amounts  of  data,  measurement  methods,  and above all, commitment.

If  you  attend  almost  any  international  development  meeting,  you almost  certainly  will  hear  the  MDGs  come  up.  The  MDGs  are  often used  by  governments  and  international  development  agencies  to  motivate  and  justify  specific  development  projects.  They  have  galvanized efforts  to  meet  the  needs  of  people  in  the  world’s  poorest  countries,  but they  are  not  without  their  detractors.  There  is  ongoing  debate  among economists  about  whether  this  kind  of  formal,  “technocratic”  approach, in  which  scientists  and  experts  are  in  control,  is  beneficial  or  harmful.  It may  help  the  poor  by  funnelling  funds  and  expertise  to  areas  of  urgent need.  However, it could do the opposite by imposing external power and plans that do not reflect local context.

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