A Journey in Explaining Differences in Development (part-1)

oleh Rizal K.

Indonesian regions exhibit a persistent diverse economic performance. Many studies on inequality in Indonesia had been carried out between the 1980s and 2013 (Akita, 2002; Akita and Lukman, 1999; Garcia and Soelistianingsih, 1998; Hill et al., 2008; Resosudarmo and Vidyattama, 2006; Vidyattama, 2013).  Most of these studies are conducted within the framework of mainstream economics.  The results, however, seem inconclusive.  Beta convergence[1] suggests a converging pattern[2], whereas Sigma convergence reveals widening gap.

The inconsistent empirics on regional convergence in Indonesia and the lack of attention to region specific context motivate us to survey some prevalent theories and concepts explaining the difference in regional development.

Here we critically review some mainstream theories trying to seek explanations of different outcomes of regional development, namely neoclassical economics, Marxist economics, evolutionary economics, institutional economics, geographical economics and economic sociology. Discussion will be devided into several articles that forms a thred of theoretical discussions. We have reviewed some of those theories before, hence we just re-post them in the thred.

Neoclassical economics: the evolution of Growth Theories

One of the mainstream theories that try to seek the regularity in the economy and its geographical implications is neoclassical economics. At the most abstract level, neoclassical economics is based on two assumptions: perfectly rational agents and equilibrium. In the simplest version, this means that every decision and action taken by individuals is based on self-interest, profit maximizing motives after taking into account all information which is assumed to be completely available and accessible (Sokol, 2011). With these assumptions in mind, neoclassical economists believe that unevenness in development is only a transitory state of the economy. In the long run, equilibrium will kick-in through the mobility of factors of production[3], resulting in more even development (Barro and Sala-i-Martin, 2004). For the purpose of this research, the focus will be on neoclassical growth theory.

In its advanced stage of development, growth theory has emphasized the crucial role of knowledge underlying technological progress. How technology is treated in the growth theory itself has evolved from exogenous to endogenous drivers. The implication of endogenous growth theory for the paths of regional growth seems to be dissimilar. Increasing returns-based models imply that regional paths tend to diverge, whereas diffusion models predict convergence paths of regional growth. 

One of the key features of standard neoclassical growth theory (Solow, 1956; Swan, 1956) is the production function with diminishing returns of production factors that result convergence of countries’ growth rates in the long run. A country cannot grow forever by simply saving and investing in physical capital because returns on capital will be continuously decreasing. Once capital per labour reaches its steady state level, the output will still grow but at a decreasing rate. This explains why capital-rich countries grow at a much slower pace. Consequently, capital tends to flow from richer to poorer countries for higher returns. In the absence of barriers to capital flows such in the case of regions within a country, convergence tends to be reached in the long run as richer regions grow slower while poor regions grow faster until they grow at equal rates. The prediction of this model fits with the empirical evidence of inequality in Indonesia discussed in the beginning of this report.

It is important to note that the standard neoclassical theory still treats technology exogenously, meaning that technology comes from outside of the model. The effort to endogenise knowledge and technology into growth theory was introduced by Arrow (1962) in the form of learning by doing. Arrow however still treated knowledge as public goods and, therefore, failed to provide satisfied explanations about incentives for firms and other economic agents to generate new knowledge. In this matter, Romer (1986, 1990) made a key improvement to the long run growth model. He proposed increasing returns and endogenous growth theory to explain the persistent long run growth we are witnessing in the real world. Just like Arrow (1962), Romer (1986) escaped from the diminishing return trap of the neoclassical production function by introducing the role of knowledge. With endogenous technological change, the rate of return on capital may increase instead of decrease as capital accumulates. Consequently, growth rates can be increasing over time, and the level of per capita output may be diverging among countries. The central question is, however, how his model deals with the public goods features of knowledge underlying technological progress so that economic agents have incentives to carry out intentional research and development (R&D). Romer (1990) put forward two explanations on this matter. First, technological advance as the result of purposive R&D activities is rewarded by temporary monopoly power[4]. Second, R&D activities can be considered as fix costs which are always incurred at the beginning of the production process. Once the new knowledge or technology acquired, it can be applied over and over again with small or no marginal cost. Thus, the scale of production becomes important here as gains will be higher in larger markets given a fixed cost of acquiring technology. This explanation is made possible in the context of imperfect competition within international trade theory of which trade can take place between two countries producing similar products[5].

The latest development of growth theory still focuses on the knowledge and technology changes, for example, analysing whether technological progress will be labour or capital augmenting (Acemoglu, 2002) and developing models of the diffusion of technology (Barro and Sala-i-Martin, 2004). Focusing on the diffusion of technology, Barro and Sala-i-Martin (2004) developed two formal models of technical progress in the form of new products and quality improvement. Since imitation tends to be cheaper than innovation, the diffusion models predict a form of conditional convergence that resembles the predictions of the neoclassical growth models (p. 20).

The brief review on the neoclassical growth theory above suggests that even though endogenous growth theory has incorporated the role of knowledge in its models, the actual process of knowledge creation through learning is ignored. Generation and imitation of knowledge are assumed to occur automatically regardless of the capability of regions. In this sense growth theory ignores regional differences in industrial structure, human capabilities and institutional differences that are understood as vital for explaining regional growth and development in other approaches.

References

Acemoglu, D 2002, Labor- and capital-augmenting technical change, Unpublished Publication, MIT, December. Accessed at http://web.cenet.org.cn/upfile/80212.pdf, on July 2014.

Akita, T & Lukman RA 1999, Spatial patterns of expenditure inequalities in Indonesia: 1987, 1990 and 1993, Bulletin of Indonesian Economic Studies, vol. 35(2), p. 67-90.

Akita, T & Alisjahbana, AS 2002, Regional income inequality in Indonesia and the initial impact of the economic crisis, Bulletin of Indonesian Economic Studies, vol. 38(2), p. 201-22.

Arrow, KJ 1962, The economic implications of learning by doing, The Review of Economic Studies, vol. 29 (3), p. 155-173.

Barro, RJ & Sala-i-Martin, X 2004, Economic Growth, Second Edition, MIT Press, Massachusetts.

Garcia, JG and Soelistianingsih, L 1998, Why do differences in provincial incomes persist in Indonesia?, Bulletin of Indonesian Economic Studies, vol. 34(1), p. 95-120.

Hill, H, Resosudarmo BP & Vidyattama, Y 2008, Indonesia’s changing economic geography, Bulletin of Indonesian Economic Studies, vol. 44 (3), p. 407-35.

Resosudarmo, BP & Vidyattama, Y 2006, Regional income disparity in Indonesia: a panel data analysis, ASEAN Economic Bulletin, vol. 23(1), p. 31-44.

Romer, PM 1986, Increasing return and long-run growth, Journal of Political Economy, vol. 94(5), p. 1002-37.

Romer, PM 1990, Endogenous technological change, Journal of Political Economy, vol. 98(5), p. 71-102.

Sokol, M 2011, Economic Geographies of Globalization: A Short Introduction, Edward Elgar Publishing Limited, Cheltenham, UK.

Solow, R., 1956. A Contribution to the Theory of Economic Growth. Q. J. Econ. 70, 65–94.

Swan, T.W., 1956. Economic Growth and Capital Accumulation. Econ. Rec. 32, 334–361. doi:10.1111/j.1475-4932.1956.tb00434.x

Vidyattama, Y 2013, Regional convergence and the role of the neighborhood effect in decentralized Indonesia, Bulletin of Indonesian Economic Studies, vol. 49(2), p. 193-211.


Footnote

[1] Beta convergence measures whether poor regions tend to grow faster than richer regions, while sigma convergence concerns the overall dispersion of regional growth rates.

[2] (Vidyattama, 2013) finds converging patterns among regions in Indonesia between 1999 and 2008. Hill et al. (2008) confirm regional convergence in Indonesia for the period 1975 to 2002. Using panel data of GDP per capita between 1993 and 2002, Resosudarmo and Vidyattama (2006) found a narrowing gap between regions after controlling for some variables that influence growth, i.e. physical and human capital, population growth, and trade openness. Earlier study by Garcia and Soelistianingsih (1998) reveals similar results between 1975 and 1993.

[3] As assumed that economic agents are economically rational, labors will move from less-developed low-wage to more-developed high-wage territories. In contrast, capital will move in opposite direction for more profits by reducing the cost of labors which counts a large portion of the production cost (see Wood and Roberts, 2010, Economic Geography: Place, Networks and Flows).

[4] This is the main difference between Romer and Porter who argues competition is necessary to promote innovations.

[5] Imperfect competition theory explains that in reality no products perfectly compete one to other as each product is unique. Therefore, Japan can export cars to the US at the same time import cars from the US as both countries produce two different cars.

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