DP1426 | Was Prometheus Unbound by Chance? Risk, Diversification and Growth

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This paper offers a theory of development which links the degree of market incompleteness to capital accumulation and growth. At early stages of development, the presence of indivisible projects limits the degree of risk-spreading (diversification) that the economy can achieve. The desire to avoid highly risky investments slows down capital accumulation and the inability to diversify idiosyncratic risks introduces high uncertainty in the growth process. The typical development pattern will consist of a lengthy period of ?primitive accumulation? with highly variable output, followed by take-off and financial deepening and lastly, steady growth. ?Lucky? countries will spend relatively less time in the primitive accumulation stage and develop faster. Although all agents are price-takers and there are no technological spillovers, the decentralized equilibrium is inefficient because individuals do not take into account their impact on the diversification opportunities of others. We also show that our results generalize to economies with international capital flows.