Chapter 5

Are “initial conditions” important in determining final outcomes for countries? Does it matter where a country starts its

development process from?

Is it possible that two countries with similar potential for development end up at two different equilibria?

These questions lead to a study of the relationship between history and expectations in determining the process of economic development.

ComplementaritiesComplementarities: coordination failures linkages

Increasing returns and development

The role of social norms social norms and status status quoquo

ComplementaritiesComplementarities : type of externalities that create incentives (or disincentives) for economic agents to adopt a commoncommon course of action.

Example: QWERTY vs. Dvorak keyboards for typewriters and computers

It makes sense to adopt a technology because everyone else is using or adopting it. This lowers the cost of adoption and learning for a new user (returns to an individual depends on what everybody else is doing)

Even if a new alternative technology appears on the market that is more cost-effective, it may never get adopted because no one is expected to deviate from the older (and possibly more inefficient) technology.

Both history (the existing technology being a leader in the market) and expectations (no one is expected to adopt the new technology) interact to prevent a new equilibrium from being attained (even though it is perfectly feasible).

Therefore, the economy can be stuck in a “bad” or inefficient equilibrium, even though a “good” or more efficient equilibrium exists.

This phenomenon is called a coordination failurecoordination failure: Individuals fail to coordinate to reach the good

equilibrium, either due to history or expectations about the future, or both.

What happens when the cost of an action increases with the number of users? No complementarities, but negativenegative externalities Does history or expectations matter?

Suppose there are two ways to travel between two cities. Call these Routes A and B.

Cost to a commuter depends on congestion on the route she is using: the more the traffic, higher is her adoption cost for a route

B A

Complementarities can cause an economy to be stuck in a “low-level equilibrium trap.” A “better” equilibrium cannot be reached because individuals cannot

coordinate their actions

Rosenstein-Rodan (1943): economic underdevelopment is due to a massive coordination failure Critical investments do not occur because complementary investments are

not made One feeds on the other perpetually But if individuals expect others to make complementary investments, then

coordination can be achieved; otherwise, no one will want to make investments

Multiple equilibria (“good” and “bad”), depending on underlying expectations about the actions of others

This can explain why regions that have been historically poor remain poor, while others that have been historically rich become richer, even though there are no intrinsic differences between them!

LinkagesLinkages can be crucial in overcoming the coordination problem: one action or activity might create appropriate conditions for another activity.

A forward linkageforward linkage lowers the cost of production for another activity

A backward linkagebackward linkage raises the demand for another activity or good.

A historically “depressed” economy can be given a big push big push by the government: A simultaneous creation of coordinated

investments in many different sectors Problems with the “big push” theory:

The government needs to know the correct mix of investments (why?)

Informational requirements are huge and impractical

Instead of all-round investments, government can create incentives selectivelyselectively for certain “leading” sectors, and let the market correct the coordination failure

Sectors that are “favored” or “promoted” will generate linkages and create incentives for further investments

Growth will be “unbalanced” in the short run, but the leading sectors will eventually pull the economy out of its low-level equilibrium

Examples of leading sectors: heavy industry, exports, tourism, and agriculture

What we have learnt so far: HistoryHistory often determines equilibrium, and

makes it difficult for economic agents to coordinate to “escape” a low level “trap”

If somehow expectationsexpectations of economic agents could be changed, economy could escape the trap to a better equilibrium

Critical questionCritical question: what prevents expectations from changing?

In the presence of fixed costsfixed costs, a firm’s average cost of production decreases as its production volume increases.

This typically happens in markets that are imperfectly competitive.

The ability to exploit increasing returns depends on: Size of the market Size of the market in turn may depend on the firm’s

ability to exploit increasing returns

The inability to exploit increasing returns can lead to “development traps”

Social NormsSocial Norms:: Individual actions are often tempered by

what society thinks is “acceptable” Social norms are sustained over time by

the immense desire for human beings to “conform”

As development proceeds, certain social norms can be “sluggish” to change

Need for conformity can create disincentives for innovation

Status Quo:Status Quo:

The implementation of certain policies can create winners and losers, even though it raises total welfare of a society.

Problems can arise due to an inability to value the gains or losses and identification of winners and losers

If losers cannot be compensated by winners, then implementing such policies can be difficult (they may face political opposition) which, in turn, can slow down the pace of development.