1. H ISTORY, E XPECTATIONS AND D EVELOPMENT

2. T HE Q UESTION : Theory and evidence reviewed so far indicate that the level and growth of GDP depends on savings (investment) rates and that, conditional on (s, n) countries converge to the same growth rate But then 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?

3. H ISTORY AND E XPECTATIONS WORK THROUGH TWO C HANNELS : Complementarities Increasing Returns

4. C OMPLEMENTARITIES Complementarities are a special kind of externalities. They happen when the cost of an action is lower (or the benefit is higher) if many agents are undertaking the same action. Examples: Qwerty vs. Dvorak; XBox vs. PSII

5. C OMPLEMENTARITIES HAVE 3 IMPORTANT C ONSEQUENCES : There can be multiple equilibria History matters Short-lived policy interventions can have long lasting effects

6. M ULTIPLE E QUILIBRIA -1- Assume Nintendo come up with a new console, clearly better than the PSII, With complementarities, the cost of using either console depends on how many other people are using it. We can have 2 equilibria: everybody buys N, everybody buys PSII. Note that “everybody buys PSII” is a “worse” equilibrium. However, due to complementarities it is rational for each consumer to buy PSII when everybody else is doing so.

7. M ULTIPLE E QUILIBRIA -2-

8. H ISOTY M ATTERS The equilibrium reached by the economy depends on its initial conditions, in the example above, the fact that many consumers are purchasing PSII before the introduction of N, makes it more likely that the economy ends up in the equilibrium where everybody sticks with PSII even if N is better

9. S HORT - LIVED P OLICIES CAN H AVE A L ONG L ASTING E FFECT Assume Nintendo sells games cheap enough to overcome the complementarity effect (in the graph AC curve for N shifts down “enough”). This will make each consumer want to shift regardless of what everybody else is doing. Once enough people have shifted to N, the equilibrium is self- sustaining – i.e. Nintendo can stop the sale The fact that externalities take the form of complementarities plays a key role

10. C OMPLEMENTARITIES & E CONOMIC D EVELOPMENT : M ICRO I SSUES Complementarities arise in many circumstances – they are particularly important for the adoption of new technologies, Rethink of the example above in terms of crops varieties instead of game consoless, Namely farmers can choose between traditional staple crop and a new cash crop, Complementarities arise for several reasons: information sharing, marketing costs.. The example illustrates that the new cash crop will not necessarily be adopted, even if it is more profitable than the traditional staple crops

11. C OMPLEMENTARITIES & E CONOMIC D EVELOPMENT : M ACRO I SSUES -1- Idea: Coordination Failure (Rosenstein – Rodan) Assume all production must be sold within a country. Compare two industrialisation paths: Huge shoe factory, employing all workers => not sustainable: all income needed to be spent on shoes. Divide resources into shoe, cloth and food factories => is sustainable Profitablity of each industry depends on the other existing (and paying wages) => jointly viable

12. C OMPLEMENTARITIES & E CONOMIC D EVELOPMENT : M ACRO I SSUES -2- Need for Coordination: Every entrepreneur invests if he thinks others will Multiple equilibria History matters Complementarities in investment can lead similar economies to very different equilibria. Endogenous growth model with externalities in capital accumulation

13. A R ELATED C ONCEPT : L INKAGES Industries are connected not only through the demand for final products, but also through input markets Example

14. A P OLICY A LTERNATIVE Activate Links – Less costly and lower information requirement Which Sectors? Sectors with many strong links, preferable backward Sectors that are least profitable for private investors (eg. Railways)