Chapter 3: Diverse Paths to Growth

• Is wealthier healthier?

• Determinants of growth in health and education

• Inequality and HDI

• Market, State, and Institutions

• Microfinance

Economic Growth and Changes in Health and

Education

Income, Life Expectancy and Education: Level

Relationship

Income, Health, and Education

• There is strong positive association between level of income

and level of education and health.

• There is a weak association between change in income and

change in level of education and health.

• The apparent contradiction is resolved by the fact that there is

strong association between level of income and level of

education and health for high income (HDI) countries, but no

association between level of income and level of education and

health for low income (HDI) countries .

Reasons for Rapid Improvement in Health

Outcomes for Low Income Countries

1. Rapid innovations in medicine and medical

practices and their faster diffusion

2. International co-operation, education, and

public awareness

3. Political reforms particularly expansion of

democracy and participatory government

Reasons for Rapid Improvement in Educational

Outcomes for Low Income Countries

1. Shift from agriculture to industry and services

2. Expansion of democracy

3. Increasing focus on equality

4. International co-operation

Factors of Underperformance

Factors Conducive for Faster Growth in HDI

1. Urbanization

2. Strong institutions: rule of law, quality of

bureaucracy, ease of opening businesses,

internal conflicts

3. Gender equity

Urbanization

• Natural Population Growth

• Migration from rural areas to urban areas:

1. Internal (within country)

2. External (from outside country)

Migration

• Pull Factors: Factors which make urban area attractive (more economic opportunities, better amenities, better infrastructure (physical and social))

• Push Factors: Factors which make living in rural areas difficult (technological changes, natural calamities, environmental degradation, law and order etc.)

Agglomeration Effect of

Urbanization1. Agglomeration effect: Cost advantages to producers and

consumers from location in cities, which take the forms of urbanization economies and localization economies.

a. Urbanization economies: Agglomeration effects associated with the general growth of a concentrated geographical region.

b. Localization economies: Agglomeration effects captured by particular sectors of the economy, such as finance or autos, as they grow within area.

c. Emergence of industrial/financial clusters.

d. Economies of scale (fall in cost as volume increases). It also affords division of labor i.e. people/work-force, firms can specialize according to their comparative advantage.

Pitfalls of Urbanization

1. Congestion effect: Limited land supply, higher

cost of real estate, increased cost of providing

facilities (transport, water, sanitation etc.).

2. Emergence of mega cities: Large cities by

concentrating resources may adversely affect

development of smaller cities (Urban Giantism

Problem).

3. Emergence of Slums: A significant section of

urban population living in bad conditions.

Policies to Reduce Inequality

1. Fiscal Policy: It refers to tax and government expenditure policies.

• There are two types of taxes: (i) Direct Tax: It is a tax whose incidence (or tax burden) cannot be shifted (e.g. income tax, corporate tax). (ii) Indirect Tax: It is a tax whose incidence (or tax burden) can be shifted (e.g. HST).

• Using progressive income taxes in which individuals with higher income pay larger proportion of their income as tax and poor individuals receive income subsidy can improve income distribution.

• Using taxes to finance goods and services used by poor (e.g. health, education, unemployment insurance etc.) can reduce inequality.

• Targeted transfers to poor households (food-stamp, social housing etc.) also reduces inequality.

Monetary and Financial Market Policies

2. Monetary and Financial Market Policies – These policies refer to policies governing interest rate, banking, insurance, and other financial institutions.

• Poorer households have least access to financial institutions. Thus, they have to rely on informal sector (e.g. money-lenders, borrowing from relatives and friends) in order to meet their financial needs.

• The informal sector borrowing is usually inadequate and/or very costly.

• Poorer households are unable to receive loans from formal banking sector for variety of reasons: (i) lack of collateral (ii) lack of information about borrowers (credit history) (iii) weak enforcement of contracts (iv) high monitoring cost and (v) asymmetric information

• Asymmetric information is of two types: (i) adverse selection: lenders do not know the true ability of borrowers or true quality of projects (hidden quality) (ii) moral hazard (hidden action): lenders are not able to observe the efforts or actions of borrowers.

• Improving access of poorer households to financial sector increases their productive capacity and goes a long way in reducing inequality.

Informal Credit Market

• Sources of Demand for Credit:

(1) Fixed Capital: Investment made in capital stock (machines, buildings etc.). They increase the production capacity.

(2) Working Capital: Credit required to meet ongoing cost of production (wages, purchase of inputs etc.).

(3) Consumption Credit: Credit required to meet increase in expenditure (e.g. health cost, wedding expenses, death etc.) or shortfall in income (e.g. crop failure, unemployment).

Informal Credit Market

• Supply of Credit

(1)Institutional Lenders

(2) Informal Lenders (e.g. Money Lender,

Landlord)

Characteristics of Informal Credit

Market(1) Informational Constraints: a) Adeverse Selection

b) Moral Hazard c) Enforcement Problems

(2) Segmentation: Many credit relationships are personalized and take time to build up. Typically, a moneylender serves a fixed clientele, whose members he lends to on a repeated basis. Usually, they do not lend individuals outside this circle.

(3) Interlinked Credit Transactions: Typically, lender and borrower interact with each other in many markets (product market, labor market).

Characteristics of Informal Credit

Market

(4) Interest Rate Variation: Due to segmentation informal interest rates on loans vary a great deal (geographical location, sources of funds, characteristics of the borrowers).

(5) Rationing: These markets are characterized by widespread rationing: upper limits on how much a borrower can receive.

(6) Exclusivity: Moneylenders typically dislike situations in which their borrowers are borrowing from more than a single source.

Informal Credit Market

• Why money lenders succeed where formal

banking sector does not?

(1) Superior Information

(2) Better Enforcement

(3) Wide Variety of Collateral

Micro-Finance

• Microfinance refers to financial services,

particularly but not only credit, supplied in

small allotments to people who might

otherwise have no access to them or have

access only on very unfavorable terms.

• Microfinance institution: A bank or NGO that

provides microfinance, particularly to the poor.

The Grameen Bank of Bangladesh

• The Grameen Bank was started by Dr. Muhamad Yunus, an economist, in mid-70’s in order to provide loans and other financial services to the poor. His research showed that the lack of access to credit on the part of poor was one of key constraints in improving their condition.

• He wanted to demonstrate that it was possible to lend to the poor without collateral and poor are good risks.

• Today the bank has over 6 million borrowers and its success has led to rapid expansion of microfinance institutions all around the world.

• The bank mainly lends to women. Nearly, 97% of its borrowers are women.

• Borrowers are generally limited to those who own less than half an acre of land.

• On average the bank charges interest rate of 12% per-annum on loans.

• Despite lending to poor without collateral, the repayment rate of loan is 97%.

• Dr. Yunus was awarded the Nobel Peace Prize in 2006 for his pioneering work.

Group Lending and the Use of Information

• In order to borrow from the bank, borrowers have form a group (usually of four).

• Money is lent sequentially to the group. One borrower is first lent the money and only if she repays the loan, the loan is given to the next member and so on.

• In the case, a member of the group defaults, the entire group is excluded from future borrowing.

Group Lending and the Use of

Information• The formation of group and the sequential lending solves many of the

informational problems faced by the formal banks and reduces the cost of

monitoring and default due to:

1. Positive assortative matching: Borrowers have incentive to form a good

group. It reduces adverse selection problem.

2. Peer monitoring: If a member borrows, other members have incentive to

monitor the borrower. It reduces moral hazard problem.

3. Collateral: Since other members of the group require credit, their

requirement of credit serves as collateral. In other words, other members

serve as guarantors of the loan.

Performance of Micro-Finance

(1) Does it pull out poor households out of poverty permanently?

• Answer Varies. In Bangladesh, micro-finance seems to have lasting impact on poor households. But evidence from Thailand and India suggests only temporary and small effects on poor households.

(2) To what extent it serves only better-off sections of the poor and leaves out the ``core poor".

• Most of the empirical evidence suggests that micro-finance institutions mainly benefit relatively ``better-off" poor. These institutions either do not lend to very poor due relatively high risk of default and also very poor do not approach these institutions due relatively high interest rate and high cost of default.

Performance of Micro-Finance

(3) Is it a cost-effective means of transferring income to

the poor?

• Results vary. Most micro-finance institutions require

subsidy either from the government, development, or aid

agencies. In some cases (e.g. Grameen Bank) these

subsidies have been found to be cost-effective, but not in

all cases.

(4) Mission Drift: See the article by Dr. Yunus in New York

Times.

Labor Market Policies

• Introduction of minimum wage

• Unemployment Insurance

• Policies to reduce discrimination in labor

market particularly against women and

indigenous people

Role of Market and State in Human Development

1. There is enormous heterogeneity in the experiences of high growth

countries. In some successful countries, states have played a

leading role in the provision of education and health. In other

successful countries, markets provide these services.

2. Both markets and state are complementary. Markets do not operate

in vacuum. Poorly regulated markets can cause enormous damages

(e.g. recent Gulf oil spill-over, financial crisis)

3. Every society needs institutions to ensure and enforce basic

property rights and uphold rule of law. These are typically

provided by states.