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:
 coordination failures
 linkages

Increasing returns and development

The role of social norms and status quo

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.

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?
 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
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!

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

A backward linkage raises the demand for
another activity or good.

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

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 often determines equilibrium, and makes
it difficult for economic agents to coordinate to
“escape” a low level “trap”
 If somehow expectations of economic agents
could be changed, economy could escape the trap
to a better equilibrium

Critical question: what prevents
expectations from changing?

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.