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.

 Complementarities  Complementarities:  coordination failures  linkages  Increasing returns and development social norms status quo  The role of social norms and status quo

 Complementarities common  Complementarities : type of externalities that create incentives (or disincentives) for economic agents to adopt a common 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. coordination failure  This phenomenon is called a coordination 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? negative  No complementarities, but negative 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

BA

 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!

 Linkages  Linkages can be crucial in overcoming the coordination problem: one action or activity might create appropriate conditions for another activity. forward linkage  A forward linkage lowers the cost of production for another activity backward linkage  A backward linkage raises the demand for another activity or good.

big push  A historically “depressed” economy can be given a 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

selectively  Instead of all-round investments, government can create incentives selectively 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:  History  History often determines equilibrium, and makes it difficult for economic agents to coordinate to “escape” a low level “trap” expectations  If somehow expectations of economic agents could be changed, economy could escape the trap to a better equilibrium  Critical question  Critical question: what prevents expectations from changing?

fixed costs  In the presence of fixed 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 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:  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.