Table Of ContentDEVELOPMENT ECONOMICS
INFRAMARGINAL VERSUS MARGINAL ANALYSES
Jeffrey Sachs
and
Xiaokai Yang
The final version: July, 2000
will be published by Blackwell in 2000
To Our Parents
ii
Preface
The core of classical mainstream economics represented by William Petty and Adam
Smith was development economics. The classical development economics differed from
neoclassical development economics in two aspects. It focused on development
implications of division of labor and it emphasized the role of the market (the invisible
hand) in exploiting productivity gains from the division of labor. As shown in this
textbook, inframarginal analysis of individuals' networking decisions is essential for
formalizing the classical development economics. Here inframarginal analysis is the total
cost-benefit analysis across corner solutions in addition to the marginal analysis of each
corner solution. If the optimum value of a decision variable takes on its upper or lower
bound, the optimal decision is a corner solution. Formally, it relates to nonlinear
programming, mixed integer programming, dynamic programming, the control theory,
and other nonclassical mathematical programming.
The first decision that you have to make when you get in the university is to choose a
major. If you choose economics as your major, then you do not go to classes of chemistry
and physics, but you take classes of microeconomics, macroeconomics, and econometrics.
We call such a decision an inframarginal decision, since values of decision variables
discontinuously jump between zero and interior values as you shift between majors. After
you have chosen a major, you allocate your limited time between the fields in this major.
This decision of resource allocation for a given major (or occupation) is called marginal
decision since standard marginal analysis is applicable to this type of decision. The
aggregate outcome of all students' choices of their majors in a university generates
division of students among majors and fields, which is analogous to a structure of
division of labor in society.
But when Alfred Marshall formalized classical economics within a mathematical
framework in the end of the 19th century, he did not know inframarginal analysis. He
made an assumption of dichotomy between pure consumers' decisions and firms'
decisions to avoid inframarginal analysis of corner solutions. Within the neoclassical
framework, each pure consumer must buy all goods from the market and cannot choose
her level of self-sufficiency or its reciprocal: level of specialization. Hence, the focus of
economics shifted from inframarginal analysis of problems of economic development
concerning how the degree of scarcity can be reduced by division of labor in society to
marginal analysis of problems of resource allocation for given degree of scarcity.
Neoclassical development economics departures, by following the neoclassical
framework, from classical development economics. Hence, neoclassical development
economics loses the central position that classical development economics occupied in
the mainstream economics. Some neoclassical development economists departure from
classical development economics also by their advocacy for state-planned
industrialization and development.
Since the 1950s, economists have applied inframarginal analysis to various decision
problems. However, many economists still follow Marshall’s assumption of dichotomy
between pure consumers and firms, under which the corner solution is exceptional and
the interior solution is the rule. Hence, implications of formal inframarginal analysis for
investigating effects of network size of division of labor on economic development could
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not be fully explored until the late 1970s. This text shall show that if a Smithian
framework is adopted, the interior solution is never optimal and corner solution is a rule
rather than an exception. Hence, marginal analysis is not enough and inframarginal
analysis is essential for exploring implications of the division of labor for economic
development.
Recent renaissance of classical development economics not only revives the spirit of
the classical development economics, but also provides new frameworks for
inframarginal analysis of network of division of labor. Hence it creates an opportunity for
bring development economics back to the core of modern mainstream economics. The
new thinking of development economics is associated with the literature of the economics
of property rights, transaction costs, and institutions, the literature of new economic
history school, the formal models of endogenous transaction costs, the formal models of
high development economics (general equilibrium models with economies of scale), the
endogenous growth models, and the literature of endogenous specialization. The formal
general equilibrium models of division of labor and transaction costs also echo recent
rethinking of development policies, represented by Bhagwati, Krueger, Srinivasan, and
the World Bank. The current text organizes the literatures under an overarching
framework with emphasis of inframarginal analysis of network of division of labor and
related transaction costs. As one of the referees points out, “this book does bring recent
literature on development to bear in a cohesive way. It manages to simplify complex
ideas and tie them together.” Not only structuralist views of Lewis (1955) and Chenery
(1986) and many neoclassical views of economic development, but also many
nonmainstream views, such as ones of Alizadeh (1984), Bacha (1978), Emmanuel (1972),
Frank (1995), Myrdal 1957, Nelson 1956, Palma 1978, Prebisch (1988), and Smith and
Toye (1979) are reassessed using the inframarginal analysis and formal models in this
text.
Despite innovative structure of the text, standard topics on population (chapters 2, 5,
7, 11, 13), income distribution (chapters 3, 5, 6), human capital (chapters 14, 16),
entrepreneurship (chapter 8), dual structure, structural changes (chapters 3, 5, 6, 12),
industrialization (chapter 12), and urbanization (chapter 13) in development economics
are covered by comparing new and old models. In addition, empirical evidences for or
against the new and old models are reviewed (for instance in chapters 1, 2, 5, 7, 11, 12,
13, 14, 16). Since, as suggested by two of the referees of the text, the main purpose of the
text is to teach theories of development economics in a systematical and coherent way
and to bring considerable analytic machinery to bear on important problems of economic
development, it reviews empirical research rather than covering details of regressions.
The coverage of empirical research is thus selective. For instance, a large part of recent
empirical research of some microeconomic development problems (for instance, Case
and Deaton, 1998, 1999a, b, and Deaton and Paxson, 1998a, b) is not covered in the text.
This text can be used at two different levels. Since each chapter includes a part of
descriptive intuition behind the formal models and mechanism at work, with aids of
graphical illustrations in each chapter, the text can be used for third or fourth year courses
of development economics. The focus for the undergraduate courses is on training of
economic thinking. If the text is used for the purpose, questions for assignments and
examinations can be chosen from the questions in the end of each chapter and difficult
algebra in the text and exercises in the end of each chapter can then be skipped. The
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questions not only expose students to different ideas and controversies, they also include
important readings from the documentation of economic history, classic pieces, empirical
findings, and interesting debates. Teachers will find that the graphs used in the text to
describe topological properties (the number of trade connections between individuals and
the number of goods involved in the division of labor) of evolution of division of labor in
the Smithian models are much more intuitive than conventional demand and supply
curves. Hence, if a teacher can use demand and supply curves to teach neoclassical
development economics without mathematics, she will certainly feel much comfortable
to teach materials in this text, using the graphs of evolution of division of labor without
mathematics.
The text can be used for a course of development economics at graduate level. The
focus for the graduate course is on formal basic training as well as on innovative, creative,
and critical economic thinking. For the part of basic training, students are asked to pay
more attention to duplication of major models in the text and to work out main exercises
in the end of each chapter. One hour spent on duplicating the models is as effective as 8
hours spent on listening and reading. The formal training is characterized by strong
accumulation effects. If each model covered in the lectures is duplicated and well
understood, the studies will become increasingly easier. But if one of the major models
cannot be duplicated or a lecture is missed out, the studies may become increasingly
more difficult later on.
For the part of creative and critical thinking, students are asked to pay more attention
to the trial-error process in designing models and in choosing one from many possible
frameworks. Not only all original ideas must stand the test of rigorous deduction, of
logical consistence, and of empirical evidences, but also insights that might be too
sophisticated to be formalized by any available mathematical instruments are encouraged.
Questions and exercises in the end of each chapter include many good thesis topics for
master and Ph.D. programs. Free assistance can be obtained for such programs from the
authors upon request. You may contact the authors via [email protected],
[email protected] or [email protected]. The website
www.inframarginal.com provides updated information on research, teaching,
dissertations, contact information of economists in the field, and conferences related to
this text. We are developing a teaching and research franchise of this text. If you are
interested in developing an independent unit of the franchise, such as an undergraduate
version of this text without advanced mathematics or a version of this text focusing on
country specific economic development rather than general theories of development
economics, please contact us. We will provide basic training, assistance for applying
technical substance covered in this text, answers to questions in the text, and other
materials that are essential for the independent franchise units.
This text is a response to increasing demand for a text and a survey from which
technical substance of inframarginal analysis of economic development can be
systematically learnt. It covers many new research results of the inframarginal analysis
and compares it with conventional marginal analysis of economic development. Some of
the new research results are published for the first time. We hope that the reader will
experience exciting intellectual adventure and find inframarginal analysis of development
of the network of division of labor as a bridge between the mainstream economics and
this era of networking and globalization.
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Many individuals and institutions contribute to this project. We are first greatly
grateful to Ken Arrow, Fischer Black, James Buchanan, John Gallup, Edwin Mills, Yew-
Kwang Ng, Hugo Sonneschein, and Lloyd Renolds for their supports for research
projects that relate to this book.
We are also greatly indebted to our coauthors of various research papers which are
covered in this text: Jeff Borland, Been-Lon Chen, Wen-Li Cheng, John Gallup, Ben
Heijdra, Geoff Hogbin, Chien-fu Lin, Monchi Lio, Mong-Chun Liu, Pak-Wai Liu, Siang Ng,
Yew-Kwang Ng, Katharina Pistor, Steven Radelet, Bob Rice, He-Ling Shi, Guangzhen Sun,
Jianguo Wang, Ian Wills, Kar-yiu Wong, Wing Thye Woo, Shuntian Yao, Dingsheng
Zhang, Yiming Zhao, and Lin Zhou.
We have benefited immensely from comments and criticisms on research papers and
books that relate to this text from Olivier Blanchard, Gary Becker, Avner Ben-Ner, Steven
Cheung, Cyrus Chu, Eric van Damme, Herbert Dawid, Jurgen Eichberger, Karl Farmer,
Robyn Frandson, John Gallup, Robert Gilles, Gene Grossman, Oliver Hart, Michael
Kremer, Heinz Kurz, Lachie McGregor, Douglas North, Eric Maskin, Yingyi Qian, Lloyd
Reynolds, Peter Ruys, Andre Shleifer, Hugo Sonnenschein, Sherwin Rosen, Donald
Smythe, Willy Spanjers, Guoqiang Tian, Yingjiang Wang, Andrew Warner, Chenggang Xu,
Gang Yi, Weiying Zhang, and participants of numerous seminars and conference sessions.
Many students at Harvard University, Monash University, Peking University, Chinese
University of Hong Kong, University of Hong Kong, National University of Taiwan, and
University of Louisville provide useful feedback to the teaching of the materials covered in
this text. Special thanks go to Jeff Borland, Monchi Lio, Yingyi Qian, Sherwin Rosen, Mei
Wen, and Julan Du for drawing several references cited in the text to our attention. Lijun
Chen, Mei Wen, and Yiming Zhao have done an excellent job for research assistance related
to this text. Our gratitude also goes to Andrew Warner, eleven anonymous reviewers of the
draft of this text for their helpful comments, and Blackwell editors who commission the
unusually large scale review process.
The financial support for this project and related research from the Center for
International Development at Harvard University, Australian Research Council, National
Taiwan University, Institute of Economics of Academia Sinica, the National Sciences
Council of the Republic of China, Guanghua School of Management of Peking University,
and Centre for Economic Research at Tilburg University is gratefully acknowledged.
Last, but not least, without love, patience, and strong support of our families, it is hard
to image the completion of this book. We hereby express our deepest love and thanks to
Sonia Ehrlich, Xiaojuan Wu, Adam, Lisa, Hannah, Xiaoxi, James, and Edward.
Of course, any remaining errors are solely our own responsibility.
Jeffrey Sachs and Xiaokai Yang
November, 1999, at Cambridge, MA.
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DEVELOPMENT ECONOMICS
Inframarginal Versus Marginal Analyses
Table of content
Preface............................................................................................................................................v
Chapter 1: Introduction.................................................................................................................1
1.1. Classical Development Economics and Capitalist Economic Development..................................1
1.2. Breakdown of the First Global Capitalist System and Neoclassical Development Economics.....7
1.3. A Return to Classical Development Economics..........................................................................13
1.4. The Scientific Approach to Development Economics.................................................................19
Key Terms and Review.......................................................................................................................23
Further Reading..................................................................................................................................24
Questions............................................................................................................................................24
Part I: Geography and Microeconomic Mechanisms for Economic Development..35
Chapter 2: Geography and Economic Development...................................................................35
2.1. Uneven Economic Development in Different Parts of the World...............................................35
2.2. Geography and Division of Labor...............................................................................................40
2.3. Empirical Linkages of Geography and Economic Development................................................44
2.3.1. Geographical Correlates of Economic Development...........................................................44
2.3.2. Geography and Levels of per capita Income........................................................................47
2.3.3. Geography and Growth of per capita Income......................................................................49
2.3.4. Geographical Effects on Economic Policy Choices.............................................................53
Key Terms and Review.......................................................................................................................55
Further Readings.................................................................................................................................55
Questions………………………...……………………………………………………………………55
Chapter 3: Driving Force I - Exogenous Comparative Advantage and Trading Efficiency.....57
3.1. Use the Concept of General Equilibrium to Figure Out Mechanisms for Economic Development
............................................................................................................................................................57
3.2. A Ricardian Model with Exogenous Comparative Technological Advantage and Transaction
Costs...................................................................................................................................................61
3.3. Analysis of Decisions vs. Equilibrium Analysis of Development...............................................69
3.4. Per capita Real Income, GDP, GNP, and PPP.............................................................................77
3.5. Economic Development and Trade Policy...................................................................................79
3.6.Comparative Endowment Advantage and Transaction Efficiency...............................................87
Key Terms and Review.......................................................................................................................95
Further Reading..................................................................................................................................95
Questions............................................................................................................................................96
Exercises.............................................................................................................................................99
Chapter 4: Driving Force II - Endogenous Comparative Advantage and Trading Efficiency102
4.1. Endogenous vs. Exogenous Comparative Advantages..............................................................102
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4.2. Configurations and Corner Solutions in a Smithian Model.......................................................104
4.3. How the Markent Coordinates Division of Labor to Utilize Network Effects and Promote
Economics Development..................................................................................................................114
4.4. More Examples..........................................................................................................................123
4.5. Pattern of Trade..........................................................................................................................129
Key Terms and Review.....................................................................................................................131
Further Reading................................................................................................................................132
Questions..........................................................................................................................................132
Exerxcises.........................................................................................................................................136
Chapter 5: Driving Force III - Economies of Scale and Trading Efficiency..........................140
5.1. Economies of Scale and Economic Development......................................................................140
5.2. General Equilibrium Models of Economic Development with Trade offs Between Economies of
Scale, Consumption Variety, and Transaction Costs........................................................................141
5.3. The Ethier Model with Transaction Costs..................................................................................148
5.4. The Murphy-Shleifer-Vishny (MSV) Model of Big Push Industrialization..............................154
5.5. The Sachs and Yang Model with Economies of Scale, Endogenous Degree of Industrialization,
and Transaction Costs.......................................................................................................................158
Key Terms and Review.....................................................................................................................163
Further Reading................................................................................................................................163
Questions..........................................................................................................................................163
Exercises...........................................................................................................................................165
Chapter 6: Coexistence of Endogenous and Exogenous Comparative Advantages and Patterns
of Development and Trade.........................................................................................................168
6.1. Underdevelopment and Dual Structure with Underemployment...............................................168
6.2. A Smithian Model with Dual Structure in the Transitional Stage of Economic Development..170
6.3. General Equilibrium and Its Inframarginal Comparative Statics...............................................173
6.4. Trade Pattern in the Presence of Both Endogenous and Exogenous Comparative Advantages and
the Relationship Between Income Distribution and Development...................................................179
6.5. Development Strategies and Trade Patterns...............................................................................181
6.5.1. A Consumer's Decision......................................................................................................182
6.5.2. Possible Trade Structures..................................................................................................182
6.5.3. Production of Agricultural Good z.....................................................................................184
6.5.4. Production of Final Manufactured Good y........................................................................184
6.5.5. Production of Intermediate Goods.....................................................................................184
6.5.6. Local Equilibrium in Structure A.......................................................................................185
6.5.7. Local Equilibrium in Structure C.......................................................................................185
6.5.8. Local Equilibrium in Structure D.......................................................................................187
6.5.9. Local Equilibrium in Structure E.......................................................................................188
6.5.10. Local Equilibrium in Structure F.....................................................................................189
6.6. General Equilibrium and Inframarginal Comparative Statics....................................................189
6.7. Comparison with Conventional Wisdom Based on the Models with CRS................................192
Key Terms and Review.....................................................................................................................197
Further Reading................................................................................................................................197
Questions..........................................................................................................................................198
Exercises...........................................................................................................................................201
Chapter 7: Structural Changes, Trade, and Economic Development......................................205
7.1. Endogenous Trade Theory and Endogenous Number of Consumer Goods...............................205
7.2. A Model of Economic Development with Fixed Learning Costs..............................................207
7.3. How Are Demand and Supply Functions Determined by Individuals’ Levels of Specialization?
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..........................................................................................................................................................210
7.4. Inframarginal Comparative Statics of the Optimum Decisions.................................................214
7.5. How is the Level of Division of Labor in Society Determined in the Market?..........................215
7.6. Inframarginal Comparative Statics of General Equilibrium and Many Concurrent Development
Phenomena........................................................................................................................................215
7.7. Emergence of International Trade from Domestic Trade...........................................................224
7.8. Comovement of Division of Labor and Consumption Variety..................................................225
7.9. Emergence of Professional Middlemen and Trade Pattern........................................................230
7.10. Trade off Between Economies of Specialization and Coordination Costs...............................232
Key Terms and Review.....................................................................................................................233
Further Reading................................................................................................................................234
Questions..........................................................................................................................................234
Exercises...........................................................................................................................................238
Part II: The Institution of the Firm, Endogenous Transaction Costs, and Economic
Development..................................................................................................................242
Chapter 8: Economic Development, the Institution of the Firm, and Entrepreneurship........242
8.1. What is the Institution of the Firm?...........................................................................................242
8.2. Why are Claims to Residual Rights of the Firm Essential for Nurturing Entrepreneurship? -The
Story behind the Model.....................................................................................................................244
8.3 The Emergence of the Firm from the Evolution of Division of Labor........................................247
8.3.1. Economies of Roundabout Production...............................................................................247
8.3.2. The Corner Equilibria in Four Structures..........................................................................248
8.3.3. General Equilibrium Structure of Transactions and Residual Rights................................254
8.4. The Distinction Between ex ante and ex post Production Functions and the Role of the Institution
of the Firm in Economic Development.............................................................................................257
8.5. Coase Theorem and Other Theories of the Firm........................................................................259
Key Terms and Review.....................................................................................................................263
Further Reading................................................................................................................................264
Questions..........................................................................................................................................264
Exercuses..........................................................................................................................................268
Chapter 9: Endogenous Transaction Costs, Contract, and Economic Development..............271
9.1 Endogenous Transaction Costs and Economic Development.....................................................271
9.2. Endogenous Transaction Costs Caused by Moral Hazard.........................................................275
9.3. Game Models and Endogenous Transaction Costs....................................................................288
9.3.1. Game Models.....................................................................................................................288
9.3.2. Nash Equilibrium...............................................................................................................289
9.3.3. Subgame Perfect Equilibrium............................................................................................291
9.3.4. Bayes Equilibrium..............................................................................................................293
9.3.5. Sequential Equilibrium ......................................................................................................294
9.4. The Role of Nash Bargaining Game in Reducing Endogenous Transaction Costs caused by Trade
Conflict.............................................................................................................................................299
9.5. Endogenous Transaction Costs caused by Information Asymmetry and Holding Up...............302
9.5.1. Economic Development and Endogenous Transaction Cost caused by Adverse Selection303
9.5.2. Alternating Bargaining Game in a Model of Endogenous Specialization..........................305
9.5.3. Economic Development and Endogenous Transaction Costs Caused by Holding Up.......307
9.5.4. How Can Endogenous Transaction Costs be Eliminated by Consideration of Reputation?
......................................................................................................................................................309
9.6. The Grossman-Hart-Moore Model of Incomplete Contract.......................................................310
9.7. Non-Credible Commitment and Soft Budget Constraint...........................................................313
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Key Terms and Review.....................................................................................................................315
Further Reading................................................................................................................................316
Questions..........................................................................................................................................317
Exercises...........................................................................................................................................320
Chapter 10: Transaction Risk, Property Rights, Insurance, and Economic Development....323
10.1. Uncertainties in Transactions and the Economics of Property Rights.....................................323
10.2. Economic Development and the Trade off between Economies of Division of Labor and
Coordination Reliability....................................................................................................................328
10.3. Endogenization of Coordination Reliability in Each Transaction and Substitution between
Competition and Better Enforced Property Rights ..........................................................................332
10.4. Why Can Insurance Promote Economic Development?..........................................................343
10.5. Economic Development and Endogenous Transaction Costs caused by Moral Hazard..........348
Key Terms and Review.....................................................................................................................355
Further Reading................................................................................................................................356
Questions..........................................................................................................................................356
Exercises...........................................................................................................................................356
Part III: Urbanization and Industrialization.............................................................363
Chapter 11: Urbanization, Dual Structure between Urban and Rural Areas, and Economic
Development...............................................................................................................................363
11.1. Why and How Cities Emerge from the Division of Labor.......................................................363
11.2. The Fujita-Krugman Model of Urbanization based on the Trade off Between Economies of
Scale and Transaction Costs.............................................................................................................366
11.3. Emergence of the Dual Structure between Urban and Rural Areas from the Division of Labor
..........................................................................................................................................................368
11.4. Why Can the Geographical Concentration of Transactions Improve Transaction Efficiency? 372
11.5. Simultaneous Endogenization of Level of Division of Labor, Location Pattern of Residences,
Geographical Pattern of Transactions, and Land Prices....................................................................380
Key Terms and Review.....................................................................................................................391
Further Reading................................................................................................................................392
Questions..........................................................................................................................................392
Exercises...........................................................................................................................................393
Chapter 12: Industrialization, Structural Changes, Economic Development, and Division of
Labor in Roundabout Production..............................................................................................395
12.1. The Features of Industrialization.............................................................................................395
12.2. Industrialization and Evolution of Division of Labor in Roundabout Production...................402
12.3. Corner Equilibria and the Emergence of New Industry...........................................................403
12.4. General Equilibrium, Industrialization, and Structural Changes..............................................406
12.4.1. Changes in the Employment Shares of the Industrial and Agricultural Sectors..............409
12.4.2. The Number of Possible Structures of Transactions Increases More Than Proportionally
as Division of Labor Evolves in Roundabout Production............................................................411
12.5. Evolution in the Number of Producer Goods and Economic Development.............................414
Key Terms and Review.....................................................................................................................419
Further Reading................................................................................................................................419
Questions..........................................................................................................................................420
Exercises...........................................................................................................................................424
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