history expectation and growth 1.ppt

History, Expectations,
and Development

Questions
 Why have living standards failed to
converge
 Why do investment rates differ
between developing countries?
 How can equal savings rates lead to
different economic growth rates?
 How do historical forces and
expectations influence current rates of
growth?

The Questions:
 what determines the saving
(investment) rate?
 What if it depends on the past
history of a country?
 What is the role of expectations
about the future?

History and expectation
 A-Positive and negative externalities (Viner, 1923):
 -”positive externalities” – when benefits cannot be fully
“internalized” by the producer as extra profits
 -”negative externalities” – when pain suffered from
surroundings cannot be fully “compensated” by the
producer.
 Externalities are a pervasive feature of economic life.
We will explore how externalities severely distort
decision-making away from desirable outcomes

Cont….
 History and expectations: work through
complementary channel:
complementarities: - the more others do
something the greater your incentive to do it
and

II. Complementarities
idea: (network) externalities cause the cost of
implementing certain action to decrease as
more and more people implement it
 lock-in effect: if already many people use
the previous technology
 this may prevent new better technologies,
productsto be used; history would matter
(what was adopted first)

Cont….
 Effects of complementarities:
 There can be multiple equilibria

Cont…
 Complementarities between actions allows
network effects
 E.g of a complementarity
 The availability of specifically skilled labor and the
presence of firms that needs the labor with specific
skills
 Complementary investments must come at the
same time

Cont…
 In many cases, the presence of
complementarities creates a classic "chicken
and egg" problem: Which comes ﬁrst, the
skills or the demand for skills?

coordination failure
 because of the presence of
complementarities it can happen
that the economy get stuck in a
low-level equilibrium trap while
there exist a better equilibrium

Cont…
 coordination failure is situation in which
agents inability to coordinate their choices
leads to an outcome (equilibrium) in which
all agents worse, compared to an
alternative situation that is also an
equilibrium (prisoner.s dilemma).

• Illustrates how the structure of the
situation can lead to insecurity on
both sides/lead to both sides going
to the brink
• Illuminates why we continue to
wonder about how we can issue
credible threats
• Demonstrates we are caught in a
dilemma due to structural
imperatives and worst-case thinking
Prisoner’s Dilemma

PRISONER’S DILEMMA EXPLAINED
• The Prisoner’s Dilemma constitutes a problem
in game theory. In its classical model
Prisoner’s Dilemma is presented as follows:
• Ivan and Sam are interviewed separately.
• They have the option to either cooperate or
defect.

A or Sam’s Choices (Sitting Alone in Prison!)
• if I choose to be silent (-10) and Ivan chooses to be
silent, we’ll both get 1 year in jail
• if I’m silent and Ivan confesses, then I get 10 years
and he gets 3 months
• if I confess and Ivan doesn’t, then I get
only 3 months and he gets 10 years
• if we both confess, then we both get 5
years

The worst-case
outcome is 10 years
in jail. If both make
the same calculations
based on their desire
to avoid serving 10
years (worst-case
outcome), then both
will tattle and both
are jailed for 5 years.

Lesson of Prisoner’s
Dilemma:
Despite the existence of a
mutually preferable outcome
(CC box = 3 months), the
rational calculations of both
prisoners in favour of their
own self-interest dictate that in
avoiding the worst-case
outcome (DD box = -10
years), they are both worse-off
(-5 years).

Lessons for Peace Research:
Prisoner’s Dilemma shows how we can become caught
in dilemmas due to our desire to avoid the worst-case
scenario at all costs.
It is based on our unwillingness to risk the costs of
cooperating if the other guy doesn’t cooperate.

Back to coordination failure…
 Illustrated by the “where-to-meet” problem
 Lack of coordination can lead a country to be
trapped in underdevelopment.
 government deep intervention can help solve
at times

Cont….
According to Rosenstein-Rodan – forwarded
the idea that economic underdevelopment can
be a result of coordination failure – some
investments don’t occur simply
 because other complementary investments
are not made – two equilibria possible

Externalities, technical progress and growth
Illustration
Productivity depends on the future path of average capital accumulation by all firms in
the economy
Actions of others increase your relative preference for choosing similar
actions.
Illustration:
Where does the shape come from?
Examples of complementarity
Equilibria in this type of problem
1
i i i
Y AK L K
  


Private Rational
Decision
Expected Decision by other
agents

Equilibrium –situation in which everyone is doing what is best for them, given
what they expect others to do, which in turn matches what others are actually
doing.
Implications
- An economy can get stuck in a low growth rate largely because the
economy is expected to have a low investment rate.
-Market forces bring to one of the equilibria, but they are not sufficient to
ensure that the best equilibrium will be achieved
Thus, the need for coordination
Changing expectations may not be enough since there is an incentive not to be
the first mover.
This implies that there room for government policy.

Cont…
 What will happen if there is coordination
failure?

Multiple Equilibria
 Multiple equilibria can arise when there is
coordination failure
 Multiple equilibria is a condition in which more
than one equilibrium exists.

 Suppose that firms expected no other firms to
make investments, but some firms did
anyway.
 But then, seeing that some firms did make
investments, it would not be reasonable to
continue to expect no investment!
 Firms would have to revise their expectations
upward, matching their expectations to the
level of investment they actually see.

Cont…
 But if ﬁrms now expect this higher level of
investment, ﬁrms would want to invest even
more.
 This process of adjustment of expectations
would continue until the level of actual
investment would just equal the level of
expected investment.

Cont…
 process of adjusting expectations continues until
‘number observed equal number expected.’

Cont…
 Why should it be so difﬁcult to start modern
growth?
 As we said, coordination failure is an
important factor

Models for coordination
failures
 Big push
 O-ring theory
 The Growth Diagnostics Framework

II-Moving from Bad to Good Equilibria: The Big Bush
A – A graphical model of the Big Push
Challenge to initiate industrialization in a subsistence economy:
coordination failure (Rosenstein-Rodan, 1943)
Potential externalities from first manufacturing firm for followers
-increase sales
-provide trained employees
-provide ideas to copy
Implications
-No incentive to be the First Mover
-But if no one moves, no industrialization: “Circular
Cusation.”
-Typical coordination failure

CONT…
 Assumptions
 Progress in our understanding without sacrificing generality
- Economy is closed - most conclusions will remain when trade is
allowed.

4-34
The Big Push to Industrialization
Assumptions:

cont
Assumptions
1) Factors
 Only one factor of production – Labour
 Fixed total supply: L
2)Factor Payments
 Labour market has 2 sectors
 Traditional sector wage: 1
 Modern sector wage: w > 1

Cont....
3)Technology
 N types of products (N is a large number)
 Traditional Market: one worker = one unit
of output ( constant-returns-to-scale)
 Modern Market: one worker  increasing
returns to scale

Cont....
4) Domestic Demand
 Each good receives CONSTANT and
EQUAL share of consumption out of
national income
 No assets; no savings
5) International Supply and Demand
 Economy is closed

cont
Conditions for Multiple Equilibria: When does a
Case need a Big Push
 Depends on
a) how much more efficient the modern
sector is
b) how much higher wages are in the
modern sector

-Domestic demand – There are N (large) types of products on which consumers
spend an equal amount national income Y : Y/N is spent on each product
(whatever is produced with modern or traditional technology). So each product
will be produced with L/N workers before industrialization starts.
-Technology – In the Traditional Sector- constant returns to scale (each worker
produces 1 unit). In the Modern Sector – increasing returns to scale; at least F
workers are required to start production but after that, workers are more
productive: marginal labor requirement is c (c<1) for 1 unit of output. Labor
requirement to produce Q is L = F+cQ; c<1.
Traditional Production Function for each product
Output =
Q
Labor
=L
Traditional Sector Production : 45 degree
line means that 1 worker produces 1 unit.
Also, Price = Wage=1
Q1
L/N

Modern Sector Production Function: Starts at
F and is steeper than the 45˚line. 1 worker
produces more than 1 unit of output
Output = Q
Labor = L
F L/N
Q1
Modern Sector Production Function for each product

II-Moving from Bad to Good Equilibria: The Big Push
What does it take for the modern firm to enter, (i.e. adopt modern technology to
produce a product)?
-needs to be profitable: What do profits depend on?
-Output value (price =1)
-Costs: F and c (Fixed cost and marginal labor requirement for extra unit of output
respectively) corresponds to the technology
What is the output that the first modern firm will produce if it enters?
-the maximum that it can sell: Y is unchanged so output is still Y/N

II-Moving from Bad to Good Equilibria: The Big Push (continued)
The outcome depends on the wage level in the
Modern Sector: Examine 3 scenarios
-Wage is W1
-Wage is W2
-Wage is W3
What outcome is Pareto-enhancing under these
different scenarios?
Gist: The problematic cases occur when the wage bill
line passes between A and B: it is efficient to
industrialize, but the market will not achieve this on its
own.
Why? Because of coordination failure.

Cont…
 Divergence between advocates of balanced growth
(Nurkse) and unbalanced growth (Hirschman).
 -Big Push refers to coordinated, broadly based
investment program: balanced growth as problems of
bottlenecks
 -Unbalanced growth stresses upstream-downstream
industry linkages
 Backward linkages exist when the growth of an industry
leads to the growth of the industries that supply it
(demand linkages)
 Forward linkages (cost linkages): exist when increases
in output in the upstream creates pecuniary opportunities
for the downstream.

4-46
The Big Push:
Graphical Illustration

4-47
The Big Push:
Coordination Failure
 At a low wage rate like W1, a new firm will
enter the modern sector after paying the
fixed labor cost (F). With high demand
(Q2), the firm makes profit and invests in
modern technology
 As W2 > W1, other firms enter the modern
sector to share the profit. Coordination
between these firms is now needed for the
economy to adopt modern technology

4-48
The Big Push:
Coordination Failure
 At W2, investment becomes profitable if all
firms invest in modern technology to
industrialize the economy. High demand
for manufactured products makes workers
and firms benefit from capital investment
 At a high wage like W3, investment in
modern technology is not profitable

CONT….
 Other cases in which a Big Push may be
necessary
 -Inter-temporal effects
 -Urbanization effects
 -Infrastructure
 -Training effects

4-50
Conditions Making
The Big Push Necessary
 Intertemporal effects: investment in the
modern sector becomes profitable over-
time as the market size increases
 Urbanization effects: demand for
manufactured goods increases with
urban population growth

4-51
Conditions Making
The Big Push Necessary
 Infrastructural effects: improvement in
transportation, communication, and
distribution systems reduces the cost of
investment
 Training effects: the labor force
becomes more productive and skilled
with education

4-52
Why Coordination Problem Cannot
Be Solved by a Super-Entrepreneur
 Capital market failure: bankers are unwilling to
provide loans to a single firm
 Cost of monitoring managers: expensive
agency costs to ensure compliance of
employees
 Communication failure: agents wanting to
share profit cannot convince the super-
entrepreneur to do so

4-53
Cont….
 Limited knowledge: agents do not have
sufficient information about the importance of
industrialization
 Lack of empirical evidence: agents do not know
that other firms are investing in modern
technology

4-54
2) The O-Ring Theory of
Economic Development
 O-ring production based on completing series of tasks.
 Failure of any one task reduces the value of the entire
product, perhaps to zero(weakest link problem)
 Means one weak link in the chain destroys the entire value
of the chain
 Cant substitute quantity for quality
- Damage in quality of a single quantity destroys the entire
- - we cant substitute one greate music composure with
three or four others who have low performance

Cont….
Hypotheses
 -firms are risk-neutral
 -labor markets are competitive
 -workers supply labor inelastically
 -workers are imperfect substitutes for one
another
 -a sufficient complementarity of tasks

 Assume N tasks, one worker per task
 Production is modeled with strong
complementarities of inputs (labor &
capital) and interdependencies among
firms (output of one firm is input of
another)
 Positive assortative matching in
production: skilled labor works with its
peers; profitable and modernizing firms
coordinate with their counterparts

4-68
The O-Ring Theory of
Economic Development
 Implications of strong complementarities for
economic development and the distribution of
income across countries will induce countries
at the same level of development to coordinate
their actions
 MDCs cooperate and coordinate with each
other in the development and transfer of
modern technology

4-69
3) The Growth Diagnostics
Framework
 Focus on a country’s most binding constraints of
economic development: low rate of return on
investment and high cost of financing
 No “one size fits all” in development policy of
market coordination

Linkages
 Linkages can be crucial in overcoming the
coordination problem: one action or activity might
create appropriate conditions for another activity.
 A forward linkage lowers the cost of production for
another activity
-one industry provides inputs for another (steel for
railways)
 A backward linkage raises the demand for another
activity or good.
- one industry provides demand for another (steel
for coal)

Linkages
 Industries are connected not only through the demand
for final products, but also through input markets
 Example

history expectation and growth 1.ppt

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