The pace of development can be slowed down, or even reversed, by various factors affecting the economy. Some of these constraints can be dealt with through economic and social policy, while others may be difficult to resolve.
The constraints on development include:
Inefficiencies within the micro-economy.
Imbalances in the structure of the economy.
A rapidly growing or declining population.
Lack of financial capital.
Lack of human capital.
Poor governance and corruption.
Over-exploitation of environmental capital.
Producers in less developed countries may not be able to produce at the lowest possible average cost. This may be because of the failure to apply technology to production, or because of the inability to achieve economies of scale. Opening up the economy to free trade may help reduce this type of inefficiency, and encourage technology transfer.
When developing economies remain closed to competition, when they are dominated by local monopolies, or when production is in the hands of the state, prices might not reflect the marginal cost of production. Opening up the economy to free trade, and privatisation of industry may help promote a more competitive environment, and reduce allocatively inefficiency.
X inefficiency can arise when there is a lack of competition in a market. It is primarily associated with inefficient management, where average cost is above its minimum. Competition is limited in many developing economies, and resources are often allocated by government. This means that inefficient management is common.
Social inefficiency exists when social costs do not equate with social benefits. This can arise when externalities are not taken into account. For example, under-spending on education creates social inefficiency. Some of these inefficiencies are the result of the economy not allowing market forces to operate, while others are the result of market failures. Negative externalities like pollution are often largely uncontrolled in less developed parts of the world, and this imposes a constraint on the sustainability of development.
Not all sectors of an economy are capable of growth. For some developing economies, too many scarce resources may be allocated to sectors with little growth potential. This is especially the case with the production of agriculture and commodities.
In these sectors, there is little opportunity for economic growth because the impact of real and human capital development is small, and marginal factor productivity is very low. Failure to allocate scarce resources to where they are most productive can impose a limit on development.
Population is a considerable constraint on economic growth, either, and most commonly, because there is too a high rate of population growth for the country’s current resources, or because the population is growing too slowly or declining as a result of war, famine, or disease. Many economists see population growth as the single biggest issue facing developing countries. The line of argument runs as follows:
At first, the take-off phase of development and economic growth creates positive externalities from the application of science and technology to healthcare and education and this leads to a decline in the death rate, but no decline, or even an increase, in the birth rate. Over time life expectancy rises, but the age distribution remains skewed, with an increasing number of dependents in the lower age range. As a result, the number of consumers relative to producers increases.
The short-term gains from growth are quickly eroded as GDP per capita actually falls, hence, only when the birth rate falls will GDP per capita rise. In this case, there is a positive role for government in terms of encouraging a lower birth rate.
Many developing economies do not have sufficient financial capital to engage in public or private investment. There are several reasons for this, including the following:
Growth is not sufficient to allow scarce financial resources to be freed up for non-current expenditure.
A general lack of savings is often seen as the key reason why financial capital is in short supply. High interest rates to encourage saving will, of course, deter investment.
In the case of public sector funding, spare public funds are often used to repay previous debts, so there are less available funds for capital investment by government. This is often called the problem of debt overhang. The recent sovereign debt crisis has highlighted the problems faced by countries with large public debts, and how such debts limit the ability of government to inject spending into a developing economy.
In addition, because many developing economies have large public sectors, private investment may be crowded out by public sector borrowing. This means that a government may borrow from local capital markets, if indeed they exist, which causes a relative shortage of capital and raises interest rates.
Finally, there is an absence of credit markets in many developing economies, and this discourages both lenders and borrowers. Credit markets often fail to form because of the extremely high risks associated with lending in developing countries. This is one reason for the importance of micro-finance initiatives commonly found across India, Pakistan and some parts of Africa.
Some developing economies suffer from corruption in many different sectors of their economies. Corruption comes in many forms, including the theft of public funds by politicians and government employees, and the theft and misuse of overseas aid. Bribery is also alleged to be a persistent threat, and tends to involve the issuing of government contracts. In some developing economies, bribery is the norm, and this seriously weakens the operation of the price mechanism.
Missing markets usually arise because of information failure. Because of asymmetric information lenders in credit markets may not be aware of the full creditworthiness of borrowers. This pushes up interest rates for all borrowers, even those with a good credit prospect.
Low risk individuals and firms are deterred from borrowing, and a lemons problem arises, with only high risk individuals and firms choosing to borrow. Thus, the credit market in developing economies is under-developed or completely missing, with few wishing to borrow, and with those who wish to lend expecting high loan defaults and hence charging very high interest rates.
In a similar way to credit markets, insurance markets may be under-developed, with few insurers willing to accept ‘bad’ risks. Insurance charges (premiums) will be driven up, and potential entrepreneurs may be deterred from taking out insurance, or will be unwilling to take uninsured risks. The result is that new businesses may fail to develop.
In agriculture in particular, the principal-agent problem existing between landlord (principal) and worker (agent) creates asymmetric information and moral hazard. Workers may not bother to work hard. With low pay rates, the risks of being caught ‘shirking’ are small – the loss of pay is not a big enough incentive to work hard and efficiently.
In many developing economies it is not always clear who owns property, especially land. Given this there is no incentive to develop the land because of the free-rider problem.
In many developing economies there is an absence of a developed or appropriate legal system in the following areas:
Property rights are not protected
The right to start a business is limited to a small section or a favoured elite
Consumer rights are not protected
Employment rights do not exist
Competition law is limited or absent
Human capital development requires investment in education. Education is a merit good, and the long term benefit to society is often considerably under-perceived, and therefore, under-consumed.
For many in developing economies, the return on human capital development is uncertain compared to the immediate return from employment on the land. Therefore, there is little incentive to continue in full-time education.
The solution is to reduce information failure by promoting the benefits of education and using the market system to send out effective signals to encourage people to alter their behaviour. For example, loans, grants and aid can be made conditional upon funds being allocated to provide ‘free’ education and books, or to fund teacher training, or to raise the wages of teachers so that more will train in the future.
The long term negative effect of the excessive use of resources may be less clear than the short term benefit. This means that there is a tendency for countries not to conserve resources. However, this can have an adverse effect on growth rates in the future.
Evidence suggests that some countries with the greatest scarce resources do not necessarily exploit them effectively, and may fail to develop fully. This might be because over-abundance creates a kind of Dutch disease - a complacency which can exist when a country has high quantities of valuable resources. This means that there is a tendency to squander any comparative advantage, and the potential benefits of the resources are lost.
Over-abundance creates a disincentive to be efficient - the reverse of what has happened to Japan, which has very limited oil reserves, and needs to be efficient in the production of manufactures to enable it to import the oil it needs.
One issue is that the allocation of property rights may be difficult when resources are so vast. Furthermore, there are likely to be inefficiencies associated with government failure as government attempts to dominate the economy and the exploitation of resources.
One significant constraint on the economic prosperity of less developed countries is the protectionism adopted by some developed one. Developed counties can impose tariffs, quotas, and other protectionist measures individually, or more commonly as a member of a trading bloc.
See: The WTO Doha Development Round