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Growth and Development Economics – Quiz 2A

Lahore School of Economics

Spring Semester, 2013

Development and Growth Economics

BSc IV – Section C

Quiz 2A – Total Points: 35 – Suggested Solutions

Instructions: Answer all questions in the spaces provided. For full marks, make sure you write
all relevant points and formulate coherent and concrete answers. Pencils, pens, rulers, etc.
cannot be shared and cell phones cannot be used during the session.

Question 1

Define Solow Residual and the Endogenous growth theory. A useful way of expressing
endogenous growth theory is the famous ‘AK Model’. Explain the model focusing on the
variables used and the model’s implications. (15 points)

Solow residual: the proportion of the long term growth not explained by growth in labor or
capital and therefor primarily to exogenous technological change.

Endogenous growth theory: economic growth generated by factors within the production
process that are studied as part of growth model.

Y = AK, whereby A represents any factor that affects technology and K includes both human and
physical capital. Any increase in human capital can generate external economies and social
gains that exceed the private gains by an amount sufficient to realize increasing or at least
constant returns to scale.

Implications:

There is no external force to equilibrate the growth rates across economies; national growth
rates are determined by national savings rate and technology levels

There is no tendency for low income countries to catch up with the growth rates of high income
countries with similar savings and population growth rates

The potentially high rates of return promised by low capital/labor ratios are offset by low levels
of complementary investment. Such alternative forms of capital expenditures have positive
externalities and thus investors are waiting for others to start. The result is a market failure
whereby there is underinvestment. Hence, government has to intervene for more efficient

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Growth and Development Economics – Quiz 2A

resource allocation. New growth models (endogenous growth theory) suggest a promising and
active role of public and industrial policy in promoting development through higher A and K.

Question 2

The S-shaped curve has typically three STABLE equilibria and economies can simply choose to
settle in a bad or good equilibrium. Is this statement true or false? Explain. (10 points)

The diagram has two stable equilibria and one unstable equilibrium. Economy can settle into
any one of these equilibria depending on economic conditions, like savings rates, technological
progress, productivity and extent of investments, etc. The statement is thus false. It can be
illustrated with the following diagram:

We have an S-Shaped curve which states that as expected investment decision by other agents
increase, private investment decision also increases at an increasing rate firstly and then at a
decreasing rate before becoming constant.

Initially, only few agents will invest in the economy. They may do some autonomous level of
investment (particularly when the interaction is with the foreigners or a contract has to be
honored which would indicate that your decision to invest is independent of your expectations
about other agents’ investments). In such a situation, the complementarities (the idea that the
more others invest the greater your incentive to do it) are weak. Hence, your investment
amount is lower. But after certain level of investment has taken place in the economy, the
knowledge and technology spillovers increase and other investors are attracted to do more
investment. Here, complementarities are strong and a snowball effect takes place whereby
investment increases at an increasing rate. When potential investors have been positively
affected and the most important gains have been realized, the rate of investment increases at a
decreasing rate before becoming constant.

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Growth and Development Economics – Quiz 2A

In the diagram, D0/D2 is a stable equilibrium. This is because if any higher average investment is
expected above D0, you are investing a relatively lower amount. Why? This is because there are
positive knowledge and technological externalities (spillovers) which cause the cost of
implementing your investment idea to fall. Hence, due to strong complementarities and
positive externalities, potential investors will not invest or underinvest and wait for the others
to start the process. This gives us a strong reason to adjust our expectations about any higher
level of investment backwards to D0.

D1 (in the diagram ABOVE) on the other hand, is an unstable equilibrium. Let’s choose a point
behind D1 (but above D0). At this point, there are problems of complementarities and strong
positive externalities that benefit the agents investing later and demotivate the agents who
invest first. Since investors know that there is a first mover disadvantage, the investment
doesn’t take place and investors adjust their expectations backwards to D 0. At any point
between D1 and D2, a small increase in expected investment by others leads to a more than
proportionate increase in your own investment and also for each individual producer. So next
period, overall investment is even bigger. This triggers a still bigger adjustment in own
investment. This expectation adjustment process continues until the economy reaches Pareto-
improvement or high investment “good” equilibrium at D2.

If the economy begins from D0 or any point below D1, it’ll be stuck in a bad equilibrium. It might
be possible to move to a “good” (high investment) equilibrium if everyone were simply to
coordinate behavior. Coordination is a responsibility of the government. Following problems
occur because of which government intervention is inevitable:

 There may be period of losses for movers


 This creates an incentive to hang back, let the others go first and hence coordination
process is delayed
 Poorly functioning credit markets exacerbate the problem

Once agent behavior is coordinated and spillovers are exploited without any losers in the
process, the economy will break the poverty trap and invest at a point higher than D 1 after
which, the expectation adjustment process will bring the economy automatically to D2.

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Growth and Development Economics – Quiz 2A

Question 3

Discuss the complementarities and multiple equilibria problems emerging in the Kremer’s O-
Ring Theory. (10 points)

In Kremer’s O-Ring theory, the production function is the following: F = q1 q2 q3 … qn; whereby n
= number of tasks in the production process and q represents success probability of the given
task. If a firm has to produce a high quality product, then the workforce for every production
task should be of a high quality. Efficient firms who have settled in good equilibrium can hire
and attract the high quality workforce through offering economic incentives and positive
assortative matching would make sure that low quality workforce is left with less efficient firms
which will remain in bad equilibrium forever.

The Kremer’s O-ring theory thus reflects multiple equilibria. There is presence of
complementarities  once you have good quality workforce around, you would have a greater
incentive to acquire higher skills.

The fact of the matter is that the firm has to invest in human capital and raise the skill level but
that would only happen if the firm has the incentive to do so. Firms comprising of low quality
workers (who have low success probabilities) have lesser incentive to upgrade the skills. It is
costly for them and the resultant gains are minimal. Even if they start training, there might be
knowledge spillovers to competitive firms which are not acceptable. Hence, such firms are stuck
in a bad equilibrium.

However, if the cost of upgrading the workers’ skill (at least a significant proportion if not of all
workers) is shared or incurred by the government, then the firm can achieve a “good”
equilibrium. And once this equilibrium is achieved, firms can invest more in human capital
themselves and complementarities would make sure that there is continuous improvement in
the firm overtime.

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