Beyond Rosenstein-Rodan The Modern Theory of Coordination Problems

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

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

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

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

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?

Training and innovation Worker’s decision tree Train Do not train Firm’s decision tree Innovate Do not innovate 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 worker and his employer Train and innovate Stay together -C+B Do neither 0 Separate -C + [B • probability of a good match] Period 1 Decisions over investment in innovation and training Period 2 Separation with probability s output is produced Source: Acemoglu 1997. Note: The pink node is a chance node, reflecting exogenous risk of separation.

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

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

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

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?

Household’s decision tree in residential community Buy home equity and expend effort in home and community improvement Payoff to homeownership - cost of borrowing - cost of effort Do not buy home equity and do not expend 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.

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

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

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

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

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

A “partial reform” trap is possible t Tunneling value for the richest xth percentile of owners Rule of law State capture 0 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 Critical value of t at which tunneling becomes the preferred strategy t* 1 fraction of owners who tunnel

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

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.