Information, the dual economy, and development

We examine the interactions between different institutional arrangements in a general equilibrium model of a modernizing economy. There is a modern sector, where productivity is high but information asymmetries are. large, and a traditional sector where productivity is low but information asymmetries are small. Consequently, agency costs in the modern sector make consumption lending difficult, while such lending is readily done in the traditional sector. The resulting trade-off between credit availability and productivity implies that not everyone will move to the modem sector. In fact, the laissez-faire level of modernization may fail to maximize net social surplus. This situation may also hold in the long run: in a dynamic version of the model, a "trickle-down" effect links the process of modernization with reduction in modern sector agency costs. This effect may be too weak and the economy may get stuck in a trap and never fully modernize. The two-sector structure also yields a natural theoretical testing ground for the Kuznets inverted-U hypothesis: we show that even within the "sectoral shifting" class of models, this phenomenon is not robust to small changes in model specification.