The fundamental problem of most developing countries is the unemployment and underemployment of an important segment of the labor force. The cause of this problem is the shortage of capital equipment and productive capacity, the latter understood as potential production (Box 2.1). This view is very much consistent with the analyses of the classical authors and with the modern treatment in terms of growth diagnostics of Hausmann, Rodrik, and Velasco (2005). See Box 2.2.

Suppose the quantities produced of two goods x and y might be represented by point p in Figure 2.1, inside the curve. In this case, some of the available resources are clearly not fully utilized (e.g., people are unemployed). Under these circumstances, growth requires higher utilization of the country's production capacity. The country has to try to get closer to the transformation curve. This is the typical problem that most developing countries suffer from.

This does not mean that developing countries do not suffer from inadequacy of effective demand or from allocative efficiency problems. Indeed they do. The problem of markets—that, because of their small internal demand, there will be no outlet for the products of the newly built factories—may limit developing countries’ growth rate. Hence, industrialization will prove impossible unless it is oriented toward external markets (even though this problem could potentially be solved if investment were sufficiently high, as this would generate demand for consumption goods). Likewise, effective demand problems can become the binding constraint on production in developing countries at a fairly advanced stage of industrialization (e.g., Malaysia, Thailand, the People's Republic of China) as they can be “balanceof- payments constrained” ( McCombie and Thirlwall [1994]; also see section on Export-Led Growth and the Balance-of-Payments Constraint in chapter 16 of this book).

Allocative efficiency problems are also present in developing countries. The combination of goods and services being produced in developing countries is often not the one that maximizes the value of output at the prevailing prices. In Figure 2.2, p’ is on the transformation curve.