Contemporary models have been enriched by discussions among development economists about the suitability of market fundamentalism as expressed by the Washington Consensus. These discussions have led to the development of new tools to better understand problems related to market failures. They have provided significant insights into why markets fail to coordinate various actors. The new models are better to handle problems related to the notion of economies of scale and its connection with learning by doing and the neglect by the Washington Consensus of poverty has led to strong focus on why communities get stuck in poverty traps. The latter has intensified studies of economic processes with multiple equilibriums.
T/S ask why it is so difficult to start modern growth, where traditional methods of production are replaced by new methods. According to market fundamentalists it is a matter of transferring new technology from the developed countries and establish efficient institutions for securing free markets in the developing countries.
An example from the traditional rural economy may illustrate. In the Gambia, bee keepers remove bees from trees by smoke and, therefore, have sometimes been made scapegoats for bushfires. When this mode of producing honey actually leads to bushfires, beekeeping becomes extremely harmful to women, who by tradition use the forest for collecting firewood, which afterwards is sold at the market. This is an example of negative externalities in the traditional rural economy. Pecuniary externalities are positive or negative spillover effects on an agent’s costs or revenues.
Instead of using wild beehives in trees in the forests, beekeepers can buy separate beehives , which they place close to their villages. This is a new technology without negative pecuniary externalities. Contrary, bees are pollinators, and if the women have gardens with fruit trees, activities by the beekeepers may increase the incomes of the women. Opposite, the orchards the women keep constitute a positive pecuniary externality for the beekeepers as they help the bees to produce more honey.
However, the yields from the beehives depend on how many orchards the women will establish. This brings us back to the original question about why it is difficult to start modern growth. In order to answer this question we notice, firstly, that in this illustration there are complementarities involved, which indicate that there may be an equilibrium that is better than the traditional. Complementarities, then, are present when an action taken by one economic agent increases the incentives for other economic agents to take similar actions. Secondly, even if both the women and the beekeepers would prefer the equilibrium with modern growth, there may be a coordination failure that leads the agents to an equilibrium, where all are worse off than in an alternative equilibrium. They cannot get to the alternative “better” equilibrium because of difficulties to coordinate their actions even if they have full information and therefore know that the modern-growth equilibrium is better for all than the traditional one.
Coordination failures appear; either because they have different expectations about one another’s behavior or because of free riding where everyone is better off waiting for another to be the first mover. Figure 4.1 illustrates the situation with coordination failure in case of multiple-equilibria. The S-shape of the individual decision curve is explained by the fact that investments in new technology is associated with a critical mass of investments, i.e. the benefits of an individual’s action depends on how many other agents take the same action or on the extent of their actions.
We associate the traditional equilibrium with origo. Some agents invest individually in the new technology (Y1 in figure 4.1) expecting that no one else will make any investments. Since the average is higher than expected, the agents adjust their expectations to the average and increase their investments. Since the individual investments are based on expectations about the average investment level, it is only when the individual investment levels are equal to the average investments that the process is in equilibrium. There are three equilibriums out of which D1 and D3 are stable equilibriums. These are stable as a small increase in the expectations would lead to individual investment levels below the expected average, which would lead to a return to the original equilibrium /similar reasoning for reduction in expectations and for showing that D2 is unstable/
The utility of D1 and D2 is not the same. For instance, D2 with the high average level of investments may be associated with farms, where the women have set up life fences of cashew-nut trees (a practice found in the Gambia) to protect the orchards from wind and animals. This increase the soil quality and the amount of fruit produced and due to the complementarities it will also increase incentives in investing in bee hives. All in all moving from D1 to D2 represents a Pareto improvement. However, since D1 is stable, and a small change in expectations and investments will bring the village economy back to D1, the move from D1 to D2 cannot usually be brought about by individual decisions and market mechanisms.
To solve the problem of coordination failure, there is usually a need of an external agent – a governmental body or an NGO – to bring about Pareto improvements . A more detailed analysis of this agent is provided in my next lecture.
In the literature, Issues on how to start modern development have often been discussed under the heading of the “big push”. Here I will discuss a model used for analyzing these issues which have been proposed by P Krugman, and is discussed on p 165 in T/S. In this model, like in most of the recent discussions about the problem how to start development, the barrier preventing free markets to bring about Pareto improvements by moving the economies from the traditional equilibrium to a modern one has been associated with high wages in the modern sector.
This model is based on a few crucial assumptions:
1) Technology: Contemporary models usually associate the modern sector with Increasing Returns to Scale (IRTS). For developing countries, one interesting interpretation is that the technology is new, and therefore, has to be “learned by doing”, there is a learning effect involved in the sense that every time the production process is repeated the efficiency will be increased. There are N products in the economy.
2)Labor is the only production factor. In the traditional sector, and for each product, one worker is used for the production of one unit of output. In the modern sector, IRTS is taken into account in terms of a fixed cost expressing that the product cannot be produced without a minimum of F workers. We may think about the F workers as instructors needed for training the workers to increase the learning effect. Producing a product within the modern sector requires the following number of workers: L = F + cQ, where c < 1.
3) Factor payments: In the traditional sector workers receive a wage equal to 1 and in the modern sector w > 1. Remember; high wages in the modern sector have often been used as an explanation of underdevelopment traps.
4) Competition. Models by Krugman I am acquainted with are usually based on the assumptions of perfect competition in the traditional sector and monopolistic competition in the modern sector. The latter is logical, with regard to the assumption about IRTS in the sector. However, when a firm producing in the modern sector enter a product market, the assumption about perfect competition in traditional production implies, if it sets a price higher than 1 (MC = 1 = p) it will lose all its customers to traditional producers.
5) Demand. To make things simple, it is assumed that the economy is closed and each domestic product market receives the same share of the total national income Y: Y/N
/present the model analysis on the board pp 168 -169/