ECO 102 Development Economics Aisha Khan Summer 2009 Section G & I Lecture Thirteen

Contemporary Models of Development Chapter Five

Kremer’s O-ring Theory Attempts to explain the existence of poverty traps and why countries caught in poverty traps can have such extremely low incomes compared to richer countries. Features Strong Complementarities in production which results in the positive assortative matching of the factors of production by productivity.

O-Ring Model Production of a single product is broken down into n tasks. 0 < qi < 1, is the skill level with which each component is produced. qi can be interpreted as a measure of quality of the component or the probability that the component will function properly.

The total quality of the final product is given by multiplying the quality of the n components. Y = q1 x q2 x q3 x…x qn

Assumptions Firms are risk-neutral Labour markets are competitive and labour supply is inelastic So, workers are paid according to their productivity. Strong complementarities in production Workers are imperfect substitutes for each other. Closed economy (inputs cannot be imported)

Positive Assortative Matching High productivity firms have the means to attract high productivity workers. High productivity workers prefer to work with high productivity firms because their pay is based on how productive they are and their productivity is affected by the skill level of the workers around them So all the high productivity workers will be grouped together, leaving the low productivity workers to work with other low productivity workers.

It is also socially efficient to group workers together by productivity Suppose that there are 4 workers producing two components to the production of a product and also two types of workers – low productivity workers with skill level qL and high productivity workers with skill level qH. So Y = q1q2 Output is higher if we group the workers by skill qH2 + qL2 > 2qHqL

Implications Firms tend to employ workers with matching skill levels Income is higher for workers in higher-skilled firms so all workers prefer to work in higher-skilled firms Wages increase at an increasing rate in quality, explaining the large disparity between wages in developed and developing countries.

Implications (cont’d) Individual decisions to invest in training and education are based on the average skill level of others around you. Multiple equilibria can exist in which everyone invests at a high level or in which every invests at a minimal level leading to lower product quality. Strategic complementarities can result in low-skill equilibria.

Implications (cont’d) An industrial policy to promote economy-wide quality improvement could result in tremendous growth. O-ring effects magnify the impact of local production bottlenecks which reduce the incentive of workers to invest in skills. International trade and investment could improve product quality with the importation of higher-quality inputs and high-productivity technology.

Implications (cont’d) When the availability of high-skilled workers is limited, firms will choose less complicated technology and specialize in the production of simple goods. Large firms that specialize in complex products place a premium on high-quality, skilled workers. So the model has predictions on choice of technology given the available skill level. The model can also explain international brain drain as highly-skilled workers in developing countries emigrate to developed countries where they can receive higher wages for their skills.

Conclusion The coordination failure and multiple equilibria result with agents behaving rationally The potential benefit of the active role of government is emphasized After the big push, the need for an active government in the economy is reduced. Bad policies can reinforce the bad equilibrium and even drive the economy to a worse equilibrium. The benefits to outside development assistance goes beyond capital provision.

Case-Study: Economist Article

Case-Study: South Korea and Argentina