History, Expectations, and
Development, part 2
Econ 6060
1
Outline
A model of supply diversion: pitfall of
partial reforms
 Linkages: Hirschmann’s criticism of big
push
 Other constraining roles of history
 Rise and fall of high development theory
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2
Pitfalls of Partial Reforms
Murphy, Shleifer, and Vishny (QJE, 1992)
 in response to reform experiences in
Soviet Union in late 80s
 Partial reform started in 1988
 The GNP fell 2% in 1990; fell 8% in the 1st
quarter of 1991
 Did partial reforms cause output fall?

3
An analogy
Suppose the state of Washington
produces apples which are sold
throughout the US.
 Let the market clearing price be 15.
 Suppose all states impose a price ceiling
at 10.
 Then supply falls and apples are rationed.
There may be lines and speculation as
well.
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An analogy
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Suppose, now, only 30 states have the price ceiling
and other states don’t have it. What happens?
Consumers in the unconstrained 20 states get all
the apples they want at the price of 10 (because
they can bid epsilon above 10, defeating the other
30 states).
Consumers in the constrained 30 states get the
remainder.
Downstream firms (e.g., apple juice makers) in
these 30 states have to cut down their
production.
Hence, liberalizing some states actually makes
things worse!
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A model of supply diversion
Three goods: a) timber, and b) boxcars and c)
houses
1. The official price of timber, P, is below the
market clearing price
2. The price P is what the buyers actually pay
3. Producers of timber are on their supply curves
4. Initially, timber is rationed efficiently
5. After reform, the timber industry can choose to
whom to sell its output
6. After reform, the boxcar industry cannot bid
more than P for timber, but the industry sector
can.
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A model of supply diversion
Before reform
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All sectors are state owned
Db, Dh are marginal value product curves
p*: market clearing price
Timber rationed efficiently, hence Qb and Qh
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A model of supply diversion
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A model of supply diversion
Welfare loss in the
boxcars sector: A +
B
 Welfare gain in the
house sector: C
 Total welfare change:
C -A – B < 0
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A model of supply diversion
The welfare loss is higher when the
demand for timber by the housing sector
is more elastic and the demand for timber
by the boxcar sector is less elastic
 For several reasons, the case of elastic
demand for timber the free sector and
inelastic demand in the state sector is
realistic.

10
Sell to housing only when meeting
boxcars’ demand
We now assume that the state uses quantity
controls to force the delivery of timber to the
boxcar industry a the price P.
 Take the case where the boxcar sector got all the
timber in wanted under rationing, and assume
even after the liberalization of the housing sector
the state can still enforce the delivery of that
same amount of timber to the boxcar sector.
 In timber sector delivers its lowest production
cost units to the boxcar sector, and then sells
what it produces afterwards to the housing at an
equilibrium price.
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Sell to housing only when meeting
boxcars’ demand
Suppose
the timber
industry is
required to
supply Qb
at p to
boxcar
industry.
Then
partial
reform is
welfare
improving!
12
China versus Russia reforms
This sheds light on an important
difference between partial reforms in the
former Soviet Union and in China.
 China has pursued partial reforms but the
central government maintained extremely
strict enforcement of state quotas and
allowed firms to sell only the units above
the state quotas to private buyers. Hence
containing the supply diversion problem.
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Linkages
Inter-industry links
(Hirschman 1958)
 Steel sector has a
forward linkage with
railways, say
 Steel also has a
backward linkage to
the coal sector
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Linkages
Suppose an economy is in a depressed
equilibrium: how would a policy be
framed so as to take the economy to a
better equilibrium?
 According to Rosenstein-Rodan: big push
 Requiring: massive investments, knowing
the optimal allocation mix
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Hirschman’s (1958) criticism
“My principal point is that the theory fails as a
theory of development. Development presumably
means the process of change of one type of
economy into some other more advanced type.
…
 “The argument is reminiscent of the paradox
about the string that is equally strong everywhere
and that therefore when pulled cannot break
anywhere first…However, as Montaigne pointed
out in considering this paradox, its premise “is
contrary to nature” for “nothing is ever
encountered by us that does not hold some
difference however small it may be.”
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Hischman’s criticism, contd
“Among all vicious cycles, there is a
weakest one
 “It (the balanced growth theory)
combines a defeatist attitude toward the
capabilities of underdeveloped economies
with completely unrealistic expectations
about their creative abilities.”
 Gave notions as forward linkage,
backward linkage
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Hischman’s criticism, contd

Exercise judicious judgement on choosing a
leading sector to focus on:
◦ Number of linkages
◦ linkage strength (importance of the link)
◦ Profitability of the activity (other things being equal,
help the least profitable one)
…read his book…
 See discussion by D. Rodrik, the 2007 receipent of
the Hirschman prize of Social Sciences, on insight
from Hirschmann on reform outcomes
http://www.ssrc.org/hirschman/content/2007/rodr
ik_transcript.pdf
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Other constraining roles of history
Social norm: what individuals can do is
tempered by what society thinks it
acceptable (but some norms are bad
norms)
 Is it acceptable to make profits in a
business?
 Is it acceptable for women to work?
 Is it acceptable to forsake long-standing
ties with an extended family and migrate?
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Other constraining roles of history
Status quo bias
 Most new policies have winners and
losers, even though they may be desirable
in some overall sense
 The promise to pay compensation to the
losers may not be credible
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Status quo bias
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Suppose a policy will benefit 60% of
population by $100 and hurt the remaining
40% by $100.
Suppose it is commonly known that a
certain group (accounting for 40% of
population) will benefit. Then the expected
gain for any body else is 20/60*100 –
40/60*100 = - 33.3
Hence, 60% of population will be against the
new policy
A reform policy that is beneficial ex post
may be vetoed ex ante.
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“Rise and fall of development
economics,” by Paul Krugman
One is the strange history of development
economics, or more specifically the linked set of ideas
that I have elsewhere called "high development
theory". This set of ideas was and is highly persuasive
as at least a partial explanation of what development
is about, and for a stretch of about 15 years in the
1940s and 1950s it was deeply influential among both
economists and policymakers.
 Yet in the late 1950s high development theory rapidly
unraveled, to the point where by the time I studied
economics in the 1970s it seemed not so much
wrong as incomprehensible. Only in the 1980s and
1990s were economists able to look at high
development theory with a fresh eye and see that it
really does make a lot of sense, after all.

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Kurgman on high development theory,
contd

the crisis of high development theory in the late
1950s was neither empirical nor ideological: it
was methodological. High development theorists
were having a hard time expressing their ideas in
the kind of tightly specified models that were
increasingly becoming the unique language of
discourse of economic analysis. They were faced
with the choice of either adopting that
increasingly dominant intellectual style, or finding
themselves pushed into the intellectual periphery.
They didn't make the transition, and as a result
high development theory was largely purged from
economics, even development economics.
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Krugman on high development
theory, contd
Hirschman's Strategy appeared at a critical point
in this methodological crisis. It is a rich book, full
of stimulating ideas. Its most important message
at that time, however, was a rejection of the drive
toward rigor. …
 The irony is that we can now see that high
development theory made perfectly good sense
after all. But in order to see that, we need to
adopt exactly the intellectual attitude Hirschman
rejected: a willingness to do violence to the
richness and complexity of the real world in
order to produce controlled, silly models that
illustrate key concepts.

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Krugman on high development
theory, contd
This paper, then, is a meditation on
economic methodology, inspired by the
history of development economics, in which
Albert Hirschman appears as a major
character. I hope that it is clear how much I
admire his work; he is not a villain in this
story so much as a tragic hero.
 Krugman: “The rise & fall of development
economics”, found in

http://web.mit.edu/krugman/www/dishpan.html
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Who is Hirschman?
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What Wikipedia tells us:
Albert Otto Hirschman (Otto Albert Hirschmann) (April 7, 1915
– December 10, 2012) was an influential economist and the author
of several books on political economy and political ideology. His
first major contribution was in the area of development
economics.[1] Here he emphasized the need for unbalanced growth.
Because developing countries are short of decision making skills,
disequilibria to stimulate these and help mobilize resources should
be encouraged. Key to this was encouraging industries with a large
number of linkages to other firms.
His later work was in political economy and there he advanced two
simple but intellectually powerful schemata. The first describes the
three basic possible responses to decline in firms or polities: Exit,
Voice, and Loyalty. The second describes the basic arguments made
by conservatives: perversity, futility and jeopardy, in The Rhetoric of
Reaction.
In World War II, he played a key role in in rescuing refugees in
occupied France.
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Titbits
Invented the
Herfinal-Hirschman
index
 Author of influential
books, such as the
Passions and the
Interests
 Not to mention Exit,
Voice, and Loyalty.
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Conclusions
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We have reviewed two approaches: big bang
versus gradualism
The debates appeared two times: in 50s and
80/90s
Complementarities: demand, or intersectorial linkage
There are both pros and cons regarding the
two approaches
Pro: pitfall of partial reforms
Con: truly big bang is unrealistic, should
exert jud
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