Beyond Rosenstein-Rodan:Beyond Rosenstein-Rodan:

The Modern Theory of The Modern Theory of Coordination Problems in Coordination Problems in

DevelopmentDevelopment

Karla Hoff

ABCDE Conference, 4-18-00, Revised 9-16-00

A coordination failure can occur if: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

Early 1970s: Early 1970s: Externalities are a “fable,” Externalities are a “fable,”

say Coase’s followerssay Coase’s followers

Coase (1974)British history suggests that market arrangements (once property rights are defined) can efficiently provide for lighthouses.

Cheung (1973)Contracts between beekeepers and orchard owners resolve the market failure of "unpaid" services

Old and modern views of externalities Old and modern views of externalities and public goodsand public goods

Old view:

“Atomistic”

New view:

“Ecological"

Externalities Beekeeper

Systematic, diffuse externalities• Search costs• Corruption• Spillovers in technology• Social and political interactions• Role model effects

Public goods Lighthouse

Price vector (if there are multiple equilibrium price vectors)Group reputationKnowledge

Are coordination failures important?Are coordination failures important?

• In theory?

• In empirical investigations?

• For policy?

Example 1. Training and innovationExample 1. Training and innovation

A central difference between advanced and less developed economies is the extent oftraining and innovation.

Can we explain a low level of training and innovationas a coordination failure?

Training and innovationTraining and innovation

Train Do not train

Worker’s decision treeWorker’s decision tree

InnovateDo not

innovate

Firm’s decision treeFirm’s decision tree

Suppose that there is perfect contracting between a firm and its employee.How can a “coordination failure” then occur?

Joint decisions are made by a single Joint decisions are made by a single worker and his employerworker and his employer

Period 1 Period 2Decisions over investment in innovation and training

output is produced

Separation with probability s

Source: Acemoglu 1997. Note: The pink node is a chance node, reflecting exogenous risk of separation.

Train and

innovateDo

neither

0Stay together

Separate

- C + B-C + [B • probability of a good

match]

Example 2. Rent-seekingExample 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?

Agent’s decision treeAgent’s decision tree

Cash crop producer

Subsistence producer

Rent seeker

510 if there are no rent-seekers

8if producers do notretreat to subsistence

Multiple equilibria may existMultiple equilibria may exist

$

0

payoff to cash-crop producer

High-income equilibrium

ratio of rent-seekers to cash crop producers

payoff to rent-seeker

Source: Murphy-Shleifer-Vishny 1993 Acemoglu 1994

10

8

5

Low-income equilibrium

Example 3. Social organizationExample 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?

Household’s decision tree in residential Household’s decision tree in residential

communitycommunity

Buy home equity and expend effort in home and community improvement

Do not buy home equity and do not expend effort

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.

Payoff to homeownership - cost of borrowing - cost of effort

Payoff to renting

Multiple equilibria may existMultiple equilibria may exist

Income, y

0 1

critical value of y at which homeownership becomes the preferred strategy

income of the richest xth percentile of households

x, fraction of homeowners

Blighted neighborhood

Neighborhood with high civic activism

Source: Hoff and Sen 1999

Unresolved QuestionUnresolved Question

How important are local interaction effects in explaining

divergent fortunes of countries and communities?

Ex. 4. Transition Economies and Ex. 4. Transition Economies and the Emergence of the Rule of Lawthe 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

Two ViewsTwo 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

Decision tree of agent with controlling interest in a Decision tree of agent with controlling interest in a firm,firm,

after privatizationafter privatization

State capture

Rule of law

VS VL

If VL > t > VS , the “efficient owner” is acreature of his environment

Note: The pink node is a chance node.

Tunnel value out

Maximize firm value

t

A “partial reform” trap is possibleA “partial reform” trap is possible

t

0 1

Critical value of t at which tunneling becomes the preferred strategyt*

Tunneling value for the richest xth percentile of owners

fraction of owners who tunnel

Rule of law

State capture

Source: Hoff 2000

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

Summary of the ecological/social Summary of the ecological/social interactions perspectiveinteractions perspective

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

•depend on,•shape & ultimately•may make traps of

Role for Policy ExperimentsRole 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.