A Dual-Economy Model Of Modernization And Development

The purpose of this paper is to formally model the interaction between economic growth and the process of institutional modernization which frequently goes with it. We model an economy with a modern sector, where productivity is high but agents have little information about each other, and a traditional sector where productivity is low but agents know a lot about each other. Consequently, agency costs in the modern sector make insurance against idiosyncratic shocks difficult, while such insurance is readily obtainable in the traditional sector. Because of the resulting tradeoff between insurance and productivity, not everyone will move to the modern sector: the richest and most productive, as well perhaps as the poorest and least productive agents are more likely to move to the modern sector than are the intermediate ones. We also show that the laissez-faire level of modernization may be too low in the sense of not maximizing net social surplus; whether this occurs depends in part on the distribution of wealth.. In a dynamic version of the model, the rate of modernization of the economy may be too slow, and it is possible that the economy gets stuck in a trap and never fully modernizes. The dynamics of movement between the sectors also leads to well-defined dynamic relations between average income and inequality. We find that although the Kuznets inverted-U curve may arise, it is equally likely that the relationship between inequality and income follows other patterns, including an upright U.