CID Graduate Student and Postdoctoral Fellow Working Paper No. 17, March 2007

Development Strategy and Economic Institutions in Less Developed Countries

Justin Yifu Lin and Pengfei Zhang

Abstract 

In this paper, we construct a three-sector model to explore the politically determined development objectives and the intrinsic logic of government intervention policies in less developed countries (LDCs). We argue that many interventionist and distorted institutional arrangements in China, socialist countries, and other LDCs after World War II can be largely explained by their governments’ adoption of an inappropriate development strategy. Motivated by nation building, most LDCs, both socialist and non-socialist, adopted a Catch-up type comparative advantage-defying (CAD) strategy to accelerate the growth of capital-intensive, advanced sectors in their countries. Many firms in the priority sectors of this strategy were nonviable in open, competitive markets because the priority sectors were not their economies’ comparative advantages. The model shows that the government’s interventions, including distorted prices for products and essential factors of production, highly centralized planned resource allocation system and a micro-management mechanism in which firms were deprived of autonomy, are endogenous to the needs of maximizing resource mobilization for building up the priority sectors and to support non-viable firms in those sectors. Thus, given the government’s motivation, i.e., pursuing Catch-up type CAD strategy, these distorted economic institutions and interventionist policies existing in the LDCs were desirable. Without addressing the firms’ viability issue and giving up the Catch-up type CAD strategy, the implementation of price liberalization, privatization, and elimination of other distortions would result in poorer economic performance in the LDCs than that before the reform.

Keywords: development strategy, factor endowments, incomplete contract, institution, regulation, trinity system

JEL codes: D23, D45, H21, L25, L33, L5, O2, P3

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