Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development

1. Beyond Rosenstein-Rodan:The Modern Theory of Coordination Problems in Development Karla Hoff ABCDE Conference, 4-18-00, Revised 9-16-00

2. A coordination failure can occur if: • Agents' behavior creates externalities that • raise the relative return to each agent of those behaviors by an amount large enough that • there are multiple equilibria, and some are better for everyone

3. Coase (1974)British history suggests that market arrangements (once property rights are defined) can efficiently provide for lighthouses. Early 1970s: Externalities are a “fable,” say Coase’s followers Cheung (1973)Contracts between beekeepers and orchard owners resolve the market failure of "unpaid" services

4. Old and modern views of externalities and public goods New view: “Ecological" Old view: “Atomistic” • Systematic, diffuse externalities • Search costs • Corruption • Spillovers in technology • Social and political interactions • Role model effects Externalities Beekeeper Price vector (if there are multiple equilibrium price vectors) Group reputation Knowledge Lighthouse Public goods

5. Are coordination failures important? • In theory? • In empirical investigations? • For policy?

6. Example 1. Training and innovation A central difference between advanced and less developed economies is the extent of training and innovation. Can we explain a low level of training and innovation as a coordination failure?

7. Firm’s decision tree Do not innovate Innovate Training and innovation Worker’s decision tree Do not train Train Suppose that there is perfect contracting between a firm and its employee. How can a “coordination failure” then occur?

8. 0 Stay together Separate -C + [B • probability of a good match] - C + B Period 1 Period 2 Decisions over investment in innovation and training Separation with probability s output is produced Source: Acemoglu 1997. Note: The pink node is a chance node, reflecting exogenous risk of separation. Joint decisions are made by a single worker and his employer Train and innovate Do neither

9. Example 2. Rent-seeking DC’s and LDCs differ in the extent to which economic activity is directed at rent-seeking, rather than output enhancement. Can we explain a high proportion of rent-seekers in the population as a coordination failure?

10. Agent’s decision tree Cash crop producer Subsistence producer Rent seeker 8 if producers do not retreat to subsistence 10 if there are no rent-seekers 5

11. High-income equilibrium payoff to rent-seeker Multiple equilibria may exist $ 10 8 Low-income equilibrium payoff to cash-crop producer 5 0 ratio of rent-seekers to cash crop producers Source: Murphy-Shleifer-Vishny 1993 Acemoglu 1994

12. Example 3. Social organization Some neighborhoods are characterized by low civic participation and crime, and also low maintenance of property. Can we explain that as a coordination failure?

13. Household’s decision tree in residential community Buy home equity and expend effort in home and community improvement Do not buy home equity and do not expend effort Payoff to homeownership - cost of borrowing - cost of effort Payoff to renting 3 assumptions: (1) Price appreciation depends on fraction (x) of households who are homeowners; (2) There are capital market imperfections; and (3) “Home improvement effort” can’t be contracted for. These assumptions imply that a homeowner’s payoff increases with income and with x.

14. income of the richest xth percentile of households Blighted neighborhood Neighborhood with high civic activism Multiple equilibria may exist Income, y critical value of y at which homeownership becomes the preferred strategy 0 1 x, fraction of homeowners Source: Hoff and Sen 1999

15. Unresolved Question How important are local interaction effects in explaining divergent fortunes of countries and communities?

16. Ex. 4. Transition Economies and the Emergence of the Rule of Law There is a debate about two alternative strategies in the transition process: regulation followed by privatization versus privatization without prior regulation

17. Two Views • “Privatization offers an enormous political benefit for the creation of institutions supporting private property because it creates the very private owners who then begin lobbying the government...for institutions that support property rights.” Murphy-Shleifer-Vishny 1998 • “[The owner typically] doesn’t pay wages to the employees, doesn’t pay taxes, is not interested in the enterprise’s development, establishes subsidiaries in order to ‘pump out’ the assets while leaving only the legal shell of the company, etc.” Radygin 1999

18. Maximize firm value Tunnel value out t Rule of law State capture VL VS If VL > t > VS , the “efficient owner” is a creature of his environment Note: The pink node is a chance node. Decision tree of agent with controlling interest in a firm,after privatization

19. Tunneling value for the richest xth percentile of owners Rule of law State capture A “partial reform” trap is possible t Critical value of t at which tunneling becomes the preferred strategy t* 0 1 fraction of owners who tunnel Shift up to pink curve depicts the effect of an increase in the entrepreneurial ability of those with control rights, or greater confidence in the emergence of the rule of law Source: Hoff 2000

20. Summary of the ecological/social interactions perspective • depend on, • shape & ultimately • may make traps of Agents’ decisions Train/innovate or not Rent-seek or produce Own or rent Tunnel or invest productively the environment search costs returns to production local civic participation state capture or rule of law

21. Role for Policy Experiments "The task of ... finding out which combination of activities should be coordinated is not unlike the problem of hundreds of people, scattered in a dense, foggy forest, trying to locate one another. ..even the market mechanism cannot solve it ...” Matsuyama 1995 There may be great scope for improvement through experimentation.