MMPA 621

Coordination Failures

• A state of affairs in which agents’ inability to

coordinate their behavior (choices) leads to an
outcome (equilibrium) that leaves all agents worse
off than in an alternative situation that is also an
equilibrium

This may occur even when all agents are fully

informed about the preferred alternative
equilibrium.

 Because people hold different expectations

 Because everyone is better off waiting for

someone else to make the first move
1. When complementarities are present, an action taken by
one firm increases the incentives for other agents to take
similar actions.

2. These complementarities often involve investments whose

returns depend on other investments being made by
others.

Examples:

a) Big Push, in which production decisions by modern-sector

firms are mutually reinforcing.
b) O-Ring model, in which the value of upgrading skills or
quality depends on similar upgrading by other agents.
c) Analyses of frontier technologies in developed
countries (information technologies).
d) Analyses of the middle-income trap in which countries
develop to a degree but chronically fail to reach high-
income status, often due to a lack of innovation capacity.
Example

Skilled Workers

1. Firm will not enter a market or locate in an area if workers

do not possess the skills the firms need;

2. But workers will not acquire the skills if there are no firms
to employ them; and

3. This coordination problem can leave an economy stuck in a

bad equilibrium (low average income with a class of
citizens trapped in extreme poverty)
Example

Commercialization of agriculture

• Specialization is one of the sources of high productivity

but we can specialize only if we can trade for the other
goods and services we need.
• In the development of agricultural markets, middlemen
play a key role by effectively vouching for the quality of the
products they sell.
 There needs to be a sufficient number of concentrated
producers with whom a middleman can work effectively.
 But without available middlemen to whom the farmers
can sell, they will have little incentive to specialize in the
first place and will prefer to continue producing a range
of goods primarily for personal consumption or sales
within the village.
• Underdevelopment trap in which a region remains stuck in
subsistence agriculture.
Example

• It expands the scope for potentially valuable government

policy interventions.

• Pushing the economy toward a self-sustaining, better

equilibrium, in which there is no incentive to go back to the
behavior associated with the bad equilibrium.

• Organizing complementarities/investments and fostering

new markets.

• Deep intervention in the first steps of development (in

order to reach the high equilibrium), then the government
can focus on other goals (education/health, etc.)

• Complementarities imply a certain level of agglomeration It

can turn to congestion I ... Which is also an externality (but
negative).
Multiple equilibria
– the existence of
more than one
solution to the
equations describing
the equilibrium of an
economic model.

Application of
Multiple equilibria:

• Impact of media
on economics
There are six Other cases in which A big push
assumptions in a may be necessary:
Graphical Model of the
Big Push namely: 1.Intertemporal effects

1.Factors 2.Urbanization effects

2.Factor payments 3.Infrastructure effects

3.Technology 4.Training effects

4.Domestic demand Conditions for Multiple Equilibria

5.International Supply and Sometimes, market failures lead to

Demand a need for public policy intervention

6.Market Structure
Why the Problem Cannot Be Solved by a Super-
Entrepreneur?

1. There may be capital market failures

2. Agency Costs

3. There may be communication failures

4. There are limits to knowledge

5. There is the empirical reason that no private agent has been

observed playing the role of super-entrepreneur
Increasing Returns

• The ability to realize the gains from IR depends on the size of the available market
• The market size however may itself depend on the ability to exploit IR to expand
production and income.
• Thus an economy can be caught in a vicious or virtuous cycle in the presence of
increasing returns – multiple equilibria.

Example – IR & Market Entry

Auto manufacturing – local guy – can produce a car at a lower average cost at any output
level, the market is however saturated (an incumbent is already present) – not profitable
to start given that other producers are already there.

• Under IR: If introduce a new product – suffer a loss until enough people switch
• If capital markets are perfect – these temporary losses are not a problem – every bank
would find it profitable to lend. However, they are usually not in developing countries –
a problem
• IRS is crucial – if DRS – can start at an arbitrarily small scale.
Complementarities

Idea: (network) externalities cause the cost of implementing certain actions to decrease
as more and more people implement it.

● Examples: Windows, QWERTY keyboards (were efficient for typewriters, not necessarily
computers)

Lock-in effect: if already many people use Windows may be less worth writing software
for Mac, and Linux; this may prevent new better technologies, and products to be used;
history would matter (what was adopted first)

● What is crucial is the complementarity – if the cost of action increases in the number
of people doing it – no lock-in but instead congestion – no role for history

● Effects of complementarities:
 There can be multiple equilibria (e.g. all use Mac vs. all use Windows)
 The particular equilibrium that ends up occurring depends on history (e.g. IBM
deciding to go with Microsoft in early 80s) – nothing is predicted by the theory.
Coordination Failure

• because of the presence of complementarities it can happen that the economy gets
stuck in a low-level equilibrium trap while there exists a better equilibrium

• Rosenstein-Rodan – forwarded the idea that economic underdevelopment can be a

result of coordination failure – some investments don’t occur simply because other
complementary investments are not made – two equilibria possible – one with all
industries inactive and one with all active.

• Both pessimistic or optimistic expectations can be self-fulfilling; for example –

through demand – an enhanced level of economic activity generates greater income
which creates in turn additional demand to justify the activity.

 Example: setting up factories in a region; suppose no entrepreneur is large enough

to invest in more than one. Then there can be 2 equilibria: if all entrepreneurs
believe that others will invest – pays off to invest – all invest is equilibrium, if
believe – nobody investing is also an equilibrium.
Corruption,
Rent-Seeking,
and Multiple
Equilibria
I Modern production: it requires many Production with strong complementarities
activities to be done well together in among inputs
order for any of them to amount to high
values → Strong complementarity a) n tasks, ordered by level of skill q (0 ≤ q ≤
1)
• Specialization and division of labor, b) The higher the skill, the higher the
along with economies of scale probability that the task will be successfully
completed (the part created in this task will
• O-Ring: taken from the 1986 not fail)
Challenger disaster, in which the c) Other interpretation: quality index for
failure of one small, inexpensive characteristics of the good I The probability
part caused the space shuttle to of mistakes by different workers is
explode. independent
d) O-ring production function (with 2 workers):
O-Ring theory: explains the existence
of poverty traps and the reasons that BF(qiQj) = qiqj (4) I
countries caught in such traps With B: productivity (that can be normalized to 1)
 • There is uncertainty about what
The assumption is that products in products a country can produce
question have already been efficiently
discovered by someone else and
what remains to be discovered is
which of these products a Local • There is a need for local adaptation of
Economy is relatively good at imported technology so that it cannot
making. be used productively “off the shelf”

• Imitation is often rapid

Purposes of Measuring Poverty

■ helps maintain poor people on the agenda;

■ identifies poor people, thereby enabling to target of

appropriate interventions;

■ aids in the monitoring and evaluation of projects and

policy interventions that target poor people; and

■ identifies institutions and their effectiveness in helping

the people.
Poverty lines around the globe
Foster-Greer-Thorbecke (FGT)

“The Foster-Greer-Thorbecke
(FGT) class of poverty
measures is one of the best
known. It includes the
headcount index (P0) which
measures the proportion of the
population that is poor. This is
the most popular because it is
easy to understand and
measure. But it does not
indicate how poor the poor
are.”
Poverty Gap Index (P1)

“The poverty gap index (P1)

measures the extent to which
individuals fall below the
poverty line (the poverty gaps)
as a proportion of the poverty
line. The sum of these poverty
gaps gives the minimum cost
of eliminating poverty. The
measure does not give any
special weight to the poorest
among the poor.”
Squared Poverty Gap Index

“The squared poverty gap index (or

the poverty severity index, P2)
averages the squares of the poverty
gaps relative to the poverty line.
Extreme poverty is given greater
weight than less poverty. It allows
for variation in the weight placed on
the income (or expenditure) level of
the poorest members in society. It is
possible to disaggregate the FGT
poverty measures for population
subgroups.”
Sen-Shorrocks-Thon Index

“The Sen-Shorrocks-Thon index

combines measures of the
proportion of poor people, the depth
of their poverty, and the distribution
of welfare among the poor. These
measures allow a breakdown of
poverty into three components to
see if: there more poor; the poor
are poorer; there is higher
inequality among the poor. They are
a different way of measuring the
same thing.”
Absolute poverty can be defined
as a condition characterized by
severe deprivation of basic human
needs.

These include food, safe drinking

water, sanitation facilities, health,
shelter, education, and access to
benefits.
● Extremely difficult to arrive at a tight
estimate of the extent of global poverty
at any point in time

● There is difficulty in determining the most

appropriate cutoff income for extreme
poverty.
Research suggests that approximately one-third
(⅓) of all people who are poor at any one time are
always poor.

⅔ are made
up of
families
that are
vulnerable
to poverty
and become
extremely
poor from
time to
time
• It depends on the rate of
economic growth.

• It depends on the level of

resources devoted to poverty
programs and the quality of
those programs
1. Widespread poverty creates conditions in which the poor have no access to
credit;

2. The rich in many contemporary poor countries are generally not noted for
their frugality or for their desire to save and invest;

3. The low incomes and low levels of living for the poor, which are manifested
in poor health, nutrition, and education can lower their economic
productivity and thereby lead directly and indirectly to a slower-growing
economy.

4. Raising the income levels of the poor will stimulate an overall increase in
the demand for locally produced necessity products; and

5. A reduction of mass poverty can stimulate healthy economic expansion by

acting as a powerful material and psychological incentive for widespread
public participation in the development process.
 Rural Poverty

We need only point out

here that in view of the
disproportionate
number of the very poor
who reside in rural
areas, any policy
designed to alleviate
poverty must
necessarily be directed
to a large extent toward
rural development in
general and the
agricultural sector in
particular.
 Women and Poverty

Women make up a
substantial majority of
the world’s poor. If we
compared the lives of the
inhabitants of the poorest
communities throughout
the developing world, we
would discover that
virtually everywhere,
women and children
experience the harshest
deprivation.
 Ethnic Minorities, Indigenous
Populations, and Poverty

A final generalization about

the incidence of poverty in
the developing world is
that it falls especially
heavily on minority ethnic
groups and indigenous
populations. Majority of
the indigenous groups live
in extreme poverty and
that
being indigenous greatly
increases the chances that
an individual will be
malnourished,
illiterate, in poor health,
and unemployed.
Altering the Mitigating Moderating Moderating
functional the size (reducing) the size (increasing) the
distribution distribution distribution at the size distribution at
upper levels through the lower levels
progressive taxation through public
of personal income expenditures of tax
and wealth. revenues to raise
the incomes of the
poor either directly
Altering the Functional Distribution of
Income through Relative Factor Prices

The relative price of labor in the formal,

modern, urban sector is higher than what
would be determined by the free interplay
of the forces of supply and demand.
Modifying the Size Distribution
through Increasing Assets of the Poor
Reducing the concentrated control of
assets, the unequal distribution of power,
and the unequal access to educational
and income-earning opportunities that
characterize many developing countries
Progressive Income and Wealth Taxes

Moderating (reducing) the size distribution

at the upper levels through progressive
taxation of personal income and wealth
Direct Transfer Payments and the
Public Provision of Goods and Services

Moderating (increasing) the size

distribution at the lower levels through
public expenditures of tax revenues to
raise the incomes of the poor either
directly
Smith, S. C., & Todaro, M. P. (2012). Economic Development (11th ed.). Addison-Wesley.

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