economics 448: history, expectations, and dependence

OutlineIntroduction

ComplementaritiesIncreasing Returns

Other roles for historySummary

Economics 448:History, Expectations, and Dependence

18 & 20 February 2014

Lectures 9-10

OutlineIntroduction



Introduction

ComplementaritiesIntroduction: QWERTYCoordination FailureLinkages and PolicyHistory versus Expectations

Increasing ReturnsIntroductionIncreasing Returns and entry into Markets

Other roles for history

Summary

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Transitional Chapter

I This chapter is uniquely Ray’s perspective. Connecthistorical perspective and economic analysis.

I Modern neoclassical economics (mainstream) assume:Economic agents are forward looking, ⇒ behavior is drivenby their (subjective) expectations and beliefs.

I Expectations are informed by what has happened in thepast, i.e., history.

I Path Dependence. History defines current institutions andhence opportunity set.

I These issues are particularly important for economicdevelopment.

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Consider China and England 1800

I China had labor intense agricultural system, involved (ess)only human power. Extremely labor intensive. Populationpressure could not spare land for pasture.

I Agricultural revolution in England sending excess labor toputting–out system and cities.

I 1850 height of British Empire (Crystal Palace Exposition).I Qing dynasty corruption, losing control of society. Not able

to defend itself from West, Opium War 1830, TaipingRebellion mid–century, 30–40 million killed in civil war.

I Not pre–determined or deterministic but takes decades(and longer) consequences of history to unwind.

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Introduction: QWERTYCoordination FailureLinkages and PolicyHistory versus Expectations

Path Dependence and Strategic Complementarities

I Path dependence obvious, yet subtle.I Importance aspect of timing involves concept of

complementarities.

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Complementarity

I A particular type of externality that may be positive ornegative.

I Two projects may complement one another, but done bydifferent groups. Highest payoffs if both done. Lossesinvolved if only one (either) project.

I Big box store (e.g., Walmart) and city roads. City centerand transportation system (rail, metro). An investment hashigher payoff if other is done.

I Timing and coordination important.

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QWERTY

I Ray uses QWERTY as an example of Complementarities.I QWERTY invented to slow speed in mechanical

typewriters.I Has the value of being first history. And has a large

(virtually all) base of users.I Other keyboards may exist (Dvorak) that may be

ergonomically better.I But the adoption cost declines with the number of users.

Thus there is an externality and specifically acomplementarity.

I Lock–in because the number of users is so large it isdifficult to switch to a new system.

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Green Revolution

I Hybrid seeds more productive and produce higher cropyield per unit of land.

I Yet use of new technology represents a change fromtraditional ways.

I Social Norms or “culture” may inhibit adoption of newtechnology.

I Psychic costs decline with proportion of local adoptees.

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Green Revolution

Expect the social cost of adopting the new technology todecline with the proportion of local adoptees.

Each adopter thus has the direct effect of increased individualproduction, and the indirect positive effect of propensity toadopt by others.

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Defined and Example

I A strategic complementarity affects the ranking ofalternatives, and not the level of utility or financial reward.

I Importantly, complementarity reduces the cost as thenumber of users increases. The number of users thenaffects the ranking, how likely this alternative is the bestmore so than the actual payoff.

I Example: Vaccination. Externality: but key is relative effecton others. Your getting vaccinated makes others morelikely to be vaccinated as the greater fraction of thepopulation vaccinated makes the vaccine more effective.

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Multiple Equilibrium

I The existence of Complementarities may generate multipleequilibriums.

I Vaccination: one equilibrium is that no one (few) getsvaccinated; each individual has subjective belief othersunlikely to get vaccinated.

I Vaccination: another equilibrium is that all (most) getvaccinated.

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Multiple Equilibriums

One equilibrium could be if no one adopts the technology(QWERTY)

Or everyone may adopt.

Or somewhere in between. Critical point equilibrium may not be

stable.

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Unstable Equilibrium

Small changes in condition may induce large changes inoutcomes (i.e., switch from one equilibrium to another)

Opportunity for Policy.

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Family Planning Policy

Birth control, contraceptive practice in developing countries inwhich there are cultural and social norms againstcontraception. (e.g., concern over a woman’s health)

Government intervention program — family planning distributecontraceptives and knowledge about contraceptives.

At start, perhaps zero usage of contraceptives.

Target village leaders; get them to adopt. Then through normallines of communication (through kin mostly). As use ofcontraception increases the social cost declines. Each adopterlowers the cost on subsequent women.

Equilibrium shifts over time from zero to a high fraction ofwomen using contraceptives (though not everyone).

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Increasing cost in adoption

If an externality increases the cost on others of use, then acomplementarity is not possible.

Example congestion. New road opens up. Commutersarbitrage and use new road until incremental travel times areequal.

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Definition of Coordination Failure

Coordination: when groups get their act together.Failure: When groups can not get their act together.

Investment: requires an expectation of future benefit, butprofitability depends on what others do. If coordinate actionraise payoffs for all.

One view of underdevelopment is that underdevelopment is theresult of coordination failure.

Coordination failure offers an explanation for why two countriesfollow different (development) paths over time.

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Forward and Backward Linkages

Consider a heavy industry such as steel making. It depends oncoal and iron as inputs. And transportation system to get inputsto mill and outputs (steel) from mill to customers.

Forward linkage: affects the ease of supply of another product.

Backward linkage: A → B as coal to steel. Then an increase inB (steel) increases the demand for A (coal).

Forward linkages are like “pushes” while backward linkages arelike “pulls”.

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Policy

Interdependences require coordination for development of theeconomy.

Government policy — Big Push — simultaneous coordinatedinvestment in many critical industries to “jump start” theeconomy.

This is the same Big Push discussed in the last chapter of GEH

Which sectors? Could have balanced growth — more or lesssame growth in sectors.

More likely to have unbalanced growth — selectivity promotethe development of certain key sectors, and the linkagesamong these sectors and the rest of the economy will enablethe market to respond to imbalances (arbitrage/profitopportunities). Lectures 9-10

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Which Sectors? (Think Social Planner)

I Notion of Intrinsic Profitability. Should the governmentinvest in the most profitable industries?

I Answer: No. Arbitrage opportunities in the most profitablesectors are likely to attract market response.

I Government maximizes the chances of overcomingcoordination failure by investing in the least profitableactivity, provided that the activities have linkages.

I Role of government sometimes to take up intrinsicallyunprofitable activities/sectors.

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History Versus Expectations

I In the presence of complementarities, payoffs depend onthe number of others using the technology or engaging inthe activity.

I However, we all prefer others to be first, as there is a lagbetween investment and payoffs.

I This can lead to more coordination failure.

I Everyone wants everyone else to go first.

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IntroductionIncreasing Returns and entry into Markets

Increasing Returns

Increasing returns means that total cost falls with increasingoutput.

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Example of Automobile Producer

I Small country imports automobiles from internationalproducer (e.g., Toyota).

I Local producer develops a car that is idea for local market,but is not competitive for other (larger) markets.

I To make a profit, need a large share of the local market(why?)

I Consumers will not instantaneously adopt the new car.Thus, local firm must suffer losses at start up.

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If Perfect Capital Markets: No Problem

I Perfect capital market (definition) all profitable projects thatproduce a rate of return at least as high as the marketinterest rate are funded.

I The local car manufacturer could obtain a loan to cover theinterim period of losses, while consumers shift to the newcar.

I But if capital markets are imperfect or missing no loan isforthcoming.

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Increasing Returns to Scale Critical

Three components interact:1. Increasing returns to scale;

2. Delay in adoption by consumers;

3. Missing or incomplete capital markets.

But the increasing returns are the critical feature. In absence ofincreasing returns, firm with lower costs (better technology) canenter the market and sell a small quantity and make a profit.

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Policy Implication

I If existing products from developed countries have a largeshare of the market, local firms may not be able to sustainlosses over an interim period even if the local firmsproduce a superior (local) product.

I Gives possible role for government intervention. Offerloans to support local firm at early stages of new product.

I Can see that firms in developing countries must not onlyinnovate, but must do so while competing with firms fromdeveloped country.

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General versus Partial Equilibrium

I Previous analysis adopted a partial equilibrium analysis –assumed that the market was of given size.

I Appropriate for analysis of single firm or small industry(small relative to size of national economy).

I But there may be many activities so limited, demand forthese activities will be affected through a feedbackmechanism.

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Roundaboutness

I Think of many intermediate products – or many stages ofproduction between raw materials and production of finalproduct for the consumer market.

I Ray uses the example of home construction.

I Another example: clothing manufacturer.

I One production process done through labor intensiveprocess, many individuals working with basic tools (needle,thread, scissors, ruler).

I Another production process is heavily mechanized —automated cutting machines, sewing machines,sophisticated storage and inventory system.

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Capital Intensive

I Production system requires a large market to amortize thecost of equipment (including set up cost).

I Many times intermediate goods produced under increasingreturns to scale.

I Increasing returns benefit from scale, but also variety ofinput (see problem # 8 in Chapter 4).

I Increasing returns to variety because of division oflabor—introduce a new variety of intermediate input,increase the division of labor to make it more efficient(Smith’s pin factory.)

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Smith’s Pin Factory

To take an example from a trifling manufacture . . . the trade of a pin maker. . . [who] could perhaps . . . make one pin in a day, and certainly could notmake twenty. But in the way in which this business is now carried on . . . Oneman draws out the wire, another straights it, a third cuts it, . . . eighteen dis-tinct operations, which in some manufactories, are all performed by distincthands, though in others the same man will sometimes perform two or three ofthem. . . . a small manufactory of this kind where ten men only were employed. . . they could make about twelve pounds of pins in a day. There are in a poundupwards of 4,000 pins of a middling size. . . . together could make upwards of48,000 pins. Each person might be thought of making . . . 4,800 pins in a day.

Smith (1776) Cannan’s Edition [1904] Wealth of Nations Book 1, Chapter 1 page 8. Univer-sity of Chicago Press. 1976.

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Multiple Equilibrium

I Back to the original discussion. See how the interaction ofthe production of process and market size can productmultiple equilibria.

I Economy may be “poor” low demand for final product.Intermediate goods too expensive for use, so adopt a laborintensive production process. Production low and keepsdemand low.

I Virtuous circle. High demand for final product, intermediategoods can be produced via increasing returns, lower cost,raises demand for final product, increased substitutionfrom labor to capital. Productivity of labor increases sodoes income as does demand for final product.Lectures 9-10

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Increasing Returns of Intermediate Goods

I Central to the virtuous circle is the increasing returns ofintermediate goods. Lowers price of intermediate goods,lower cost of final good (competitive market) lower price offinal good.

I Notice the similarities between increasing returns andcomplementarities.

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Externalities as Missing Markets

I Externalities can be viewed as imperfection in somemarkets or the lack of some markets.

I Example: entrepreneur builds mass transportation systemin city. Raises real estate prices of locations neartransportation system (externality).

I There is no competitive market in which potential realestate beneficiaries can compensate the entrepreneur forbuilding the system.

I If so, the externality would be internalized. The systemwould be built if and only if it were socially beneficial.

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Competitive Markets

I Competitive market: there is a price at which one can buyor sell unlimited quantities of a commodity (take prices asgiven and unaffected by your actions).

I Competitive markets fully internalize the benefits and costsat the fixed price and thus will not support coordinationfailure or inability to internalize backward and forwardlinkages.

I Competitive markets and price–taking behavior the notionthat the size of the market imposes a limit to efficientproduction simply does not hold.

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International Trade

I Does it make sense to presume that the seller can sell“unlimited” quantities of a good at any given price? Yes, ifsmall relative to the overall size of the sector.

I Frictionless international trade competitive marketassumption may be compelling.

I Yet, infrastructure is a non-traded good. Likewise, manyintermediate goods are non–traded goods.

I Hence, issues of coordination failure and limited marketsapply (if at all) for domestically produced and non–tradedgoods.

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Other devices that may hinder development

I Social Norms.I Status Quo.

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Social Norms

I Social Norms evolve to reinforce the status quo, and withincurrent system help to coordinate activities.

I Likely, not to change quickly. Hence may serve as a dragon development.

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Status Quo

I Development as in other forms of economic change haswinners and losers.

I If the winners gain enough to compensate the losers fortheir lost then change should be possible.

I However, sometimes that isn’t enough. It may be thatwinners within each subgroup have to be able tocompensate losers within the subgroup.

I This is a high standard and difficult to obtain.

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Summary

Presented ways of thinking about issues of development. Wewill see these ideas in many different forms for the remainder ofthe course.

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economics 448: history, expectations, and dependence

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