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Industrialisation*
by
JOSHUA S. GANS
Melbourne Business School, University of Melbourne
Carlton, Victoria, 3053, Australia
E-Mail: J.Gans@mbs.unimelb.edu.au
* This paper draws on results from Chapter 4 of my Ph.D. dissertation from Stanford University (see Gans,
1994). I wish to thank Kenneth Arrow, Paul Milgrom, Scott Stern and two anonymous referees for helpful
discussions and comments. I also thank the Fulbright Commission for financial support. All errors remain
my responsibility.
2
I Introduction
industrialisation as involving the use of production techniques that are more efficient at the
margin. Hence, in recent times, it has been argued that increasing returns are at the heart of
industrialisation processes. Moreover, it has been demonstrated that this implies that
giving rise to the notion that industrialisation or the lack of industrialisation can be
The idea that a lack of industrialisation can be the result of pessimistic self-fulling
expectations suggests that indicative planning could be used fruitfully to push an economy
from a low industrialisation equilibrium. However, while a static model with multiple
equilibria can give rise to this possibility, it is only in an explicitly dynamic model where
transition processes and expectations formation are endogenised can such conclusions
readily be explored.
This point has been recognised by researchers. Krugman (1991) and Matsuyama
(1992) consider an explicit transition process associated with a static model of coordination
failure. By positing the existence of exogenous switching costs, they are able to
demonstrate under what parameters history rather than expectations determines whether the
economy reaches a good versus bad equilibrium. Specifically, when these exogenous
switching costs are high, the possibility of expectations driven transitions are limited and
industrialisation.
The purpose of this paper is to develop an explicit dynamic model where there are
no exogenous switching costs. Instead, I assume that production simply takes time. These
time lags have the effect of limiting the period by period growth of the state variable (i.e.,
the level of industrialisation). More significantly, this also means that the model exhibits
3
multiple steady states as opposed to multiple equilibria, with both states of persistent
industrialisation exhibiting increasing growth over time and a development trap. In the
development trap, even if firms are optimistic about the general level of demand in the
economy, each finds it optimal to wait rather than modernise or enter immediately. As
such, no rational expectations path exists from the development trap to a state of persistent
industrialisation suggesting that transition policies based on indicative planning are unlikely
to be successful.
the paper, the model developed is interesting in its own right. This is because it unifies two
recent strands in the literature on industrialisation. Each strand takes a different perspective
on what the adoption of “progressively modern” technologies means. One strand posits a
direct linkage between technology adoption and greater marginal efficiency. Production
processes are potentially carried out by two processes: one with no fixed costs and constant
marginal costs and the other with some fixed cost but lower marginal costs than the first
Another strand of the recent literature has considered industrialisation as the use of
inputs are imperfect substitutes for one another. Therefore, the employment of an
additional variety raises the efficiency of final good production at the margin.2 Sometimes
specialisation. The metaphor here is that additional varieties of intermediate inputs allow
This strand of the literature shares with the direct approach outlined above a
requirement that a fixed cost must be incurred before efficiency gains can be realised.
Here, the fixed costs are associated with the entry of new varieties into production. On the
1 This strand is best exemplified by the model of Murphy, Shleifer and Vishny (1989). An alternative
approach is developed by Baland and Francois (1995).
2 The industrialisation as greater product variety view has been analysed by Romer (1987), Rodriguez-
Claire (1996), and Ciccone and Matsuyama (1996) among others.
4
other hand, in the direct strand, the fixed costs are associated with the modernisation of
production processes. Without the existence of such fixed costs, final goods producers
would demand a potentially infinite variety of intermediate inputs and would always adopt
becomes a problem because firms face a trade-off between the action generating greater
doing, the common element of both strands is maintained, that is, that the size of the
the technological side, however, producers in the intermediate input sector will face a multi-
dimensional choice. They will face an entry decision of whether to enter into production or
not and a modernisation decision. The modernisation decision will involve a choice from a
menu of technologies rather than a simple binary choice between some constant returns and
increasing returns technology. Therefore, the level of fixed costs becomes a choice variable
of firms. By incurring greater levels of fixed costs, firms obtain progressively higher
the greater the level of fixed costs incurred by intermediate input producers and the more
approach of Ciccone (1993) and consider the fixed costs associated with entry and
assumption that the intensity of factor use in plant production are the same as for final good
intermediate inputs at all and was solely composed of labour (as in Murphy, Shleifer and
Vishny, 1989). While this latter interpretation might be appropriate for models of growth
3 In the model to presented here, therefore, the fixed and marginal cost components of the increasing returns
technology are no longer parameters that determine the range of equilibrium. They are replaced by a meta-
parameter describing the rate at which fixed costs are translated into lower marginal costs.
4 The use of labour versus final goods units as fixed costs can radically alter conclusions regarding the
multiplicity of equilibria (see Matsuyama, 1995). In Gans (1997a), we consider the choice of which factors
5
When fixed costs are in final good units rather than labour units, this model
generates the multiplicity of equilibria that is common to static models basing themselves on
one aspect of industrialisation (as noted by Ciccone, 1993). More importantly, the model
demonstrates that the same assumptions on parameters that allow the possibility of
multiplicity for one aspect also generate the possibility of multiplicity for the other. That is,
the same conditions that generate strategic complementarities between sectors in their entry
because each action affects others though the same aggregate variables.
Section III then presents a dynamic version of the model in a discrete time setting.
This section contains the main results of the paper concerning indicative planning. It is
shown that conclusions regarding complementarities do not carry over into the dynamic
context. This creates the possibility of a development trap where expectations alone cannot
II Static Model
The model to be presented here is similar to the model of Gans (1995a) which itself
builds upon that of Ciccone (1993). The latter develops models of industrialisation in
which the fixed costs of entry and modernisation are in final good units while the former
production sectors -- an upstream and a downstream sector. The downstream (or final
to use in plant production to be endogenous. It is shown there that the conclusions of models where fixed
costs are in final goods units are more robust to this change.
5 The model also shares with Ciccone (1993) that intermediate goods are the driving force of
industrialisation. This assumption need not have been made. For instance, Hansen (1995), considers a
model where industrialisation takes place at the level of final goods and entrepreneurial effort is the critical
fixed cost allowing for technology adoption.
6
denoted Y. Firms in this sector use a Cobb-Douglas technology, employing both labour,
LY , and a composite of intermediate inputs, X,
Y = X α L1Y−α , 1 > α ≥ 0.
This production function exhibits constant returns to scale.6 In addition, it is assumed that
the downstream sector is competitive with all firms being price takers. I assume the good
Households consume final goods not used in production and supply one unit of
labour inelastically for which they receive a competitive wage, w. The total labour
endowment is L .
k σ −1 σ −1
X = ∫ xn σ dn , σ > 1
0
where xn denotes the amount of intermediate input of variety n that final good producers
greater than one implying that no single variety is necessary for production. It is assumed
technology.7 Thus, there is potentially a continuum of such firms lying on the [0,k]
interval of the real line.8 Apart from the usual pricing decisions, potential producers in this
sector face two additional classes of decisions: (i) whether to enter production; and (ii) if
so, at what level of technology. The first class of decisions I term entry, while the second
is termed modernisation. Together these constitute industrialisation. I will deal with the
6 The Cobb-Douglas assumption is not critical here. The results below could also be presented using a
general constant returns to scale production function with the restrictions discussed by Ciccone and
Matsuyama (1996).
7 The fixed costs associated with entry make this a reasonable assumption as potential entrants find it
optimal to produce a new variety rather than compete with incumbent firms. Strictly speaking, however,
these firms are in monopolistic competition with each other as in Dixit and Stiglitz (1977).
8 The model is similar to the set-up of Romer (1987), although it contains some additional generality for he
−1
assumes that σ = (1 − α ) .
7
Entry Decisions
Entry into intermediate good production is costly. It is assumed here that a variety
cannot be produced without the firm incurring a unit charge in terms of the final good.9
The level of this charge is independent of both the technological choice and the actual level
of production. Thus, it is a pure sunk cost of entry. As will be apparent below, firms will
find it optimal to enter production if and only if they face non-negative profits upon entry
ln .
xn =
Ψ( Fn )
The choice of Fn , itself, is assumed to be endogenous -- it represents a fixed cost (in final
good units) to the firm as well as a technological choice. Higher choices of Fn mean a
lower labour requirement, that is, Ψ ′( Fn ) < 0 with a choice of zero fixed costs resulting in a
constant returns to scale technology with Ψ(0) = 1 . 10 Upstream firms are able to choose
their technology from a menu -- assumed here to be any positive real number.11
The actual technology adopted will depend upon demand conditions. As final
goods producers earn zero profits, the inverse demand for a given intermediate input
depends on the marginal cost of producing a unit of the composite, X. This is also the price
9 Many models of industrialisation assume that the fixed costs of industrialisation are in labour units (e.g.,
Murphy, Shleifer and Vishny, 1989; Rodriguez-Clare, 1996; and Ciccone and Matsuyama, 1996). This
assumption makes it more difficult to generate strategic complementarities. The substantive results of the
model to be presented below could be generated under the labour units assumptions but only at the expense
of additional restrictions of the kind explored by Ciccone and Matsuyama (1996).
10 Every result to come only requires that the marginal labour requirement when F = 0 be some positive
n
constant.
11 Dasgupta and Stiglitz (1980) and Vassilikas (1989) analyse continuous mechanisms for technological
choice but in very different contexts to that here.
8
1
k k
k 1−σ 1−σ
P = min{x }k ∫ pn xn dn ∫ xn dn = 1 = ∫ pn dn . 12
σ −1
σ
n n=0
0 0 0
Profit maximisation by final goods producers yields their demand for an individual variety,
xn ,
σ
P
xn = X ,
pn
where use is made of the assumption of constant returns to scale in final good production.13
Since intermediate input producers face demand curves with a constant elasticity, -
σ, their optimal pricing scheme if they undertake positive production in period t is,
1
k σ 1− σ
P = ∫ ( σ −1 wΨ( Fn )) dn
1− σ 1
= σ
σ −1 wℑ1−σ ,
0
[( )]
k
ℑ = ∫ Ψ( Fn )1−σ dn = ℑ k, {Fn }n ≤ k .
0
both the variety of intermediate inputs produced and the level of technology chosen by
upstream firms.
Now consider the labour market. To satisfy demand, the labour requirement for an
σ
intermediate input producer is simply, ln = Ψ( Fn )1−σ Xℑ1−σ . As such, total labour demand
LX = ∫ ln dn = Xℑ1−σ .
1
12 There is a formal difficulty here when k = 0. One could with additional notation assume that there is
always an arbitrarily small subset of upstream that always chooses to produce. However, here it is more
convenient to adopt the convention that when k = 0, P = ∞.
13 In deriving this demand function, the infinite product space is approximated as the limit of a sequence of
finite economies. See Romer (1987, 1990) and Pascoa (1993) for a more complete discussion of this issue.
9
For the final goods sector, note that the Cobb-Douglas production implies that,
( α ) = X ( α )( σ −1 )ℑ .
PX 1−α 1
LY = 1− α σ 1−σ
It is assumed that the labour market clears in every period. As such, L = LY + LX and,
therefore, X = L ( ασ(σ−−α1) )ℑσ −1 . Finally, it remains to find the wage level each period. This
1
can be found by looking at the marginal product of labour in the production of final goods
and using the solution for X: w = σ1 (α (σ − 1)) ((1 − α )σ )
α
α 1− α
ℑσ −1 .
Substituting the relevant aggregate variables into this equation gives a convenient
reduced form for the payoffs of an intermediate input producer entering into production.
To examine the structure of these payoffs, consider upstream profits (of an entrant) when
The effect of rising industrialisation in this case is to depress profits and the marginal return
more competition for any given upstream firm, reducing their total revenue. However,
equation are depicted in Figure One. The wage effect14 exerts a positive feedback on both
entry and industrialisation decisions -- they reflect higher demand for final goods and
greater efficiency in its production, raising demand for intermediate inputs. As explored by
Ciccone (1993), if the so-called increasing returns due to specialisation ( (σ − 1)−1 )
outweigh the decreasing returns to additional use of the intermediate input composite (α ),
the game between intermediate input producers exhibits strategic complementarities (with
the wage effect outweighing the competition effect). The greater the level of
14 Ciccone (1993) refers to this as a “(fixed) cost effect.” This interpretation simply reflects the choice of
numeraire. Basically, the wage effect is how industrialisation generates a rise in wages relative to the price
of final goods, further raising individual returns to entry and modernisation.
10
industrialisation, the greater the marginal return to both entry and modernisation.
affect industrialisation and, in turn, how industrialisation effects those decisions are
essentially the same. Both entry and modernisation decisions reduce the revenues of others
through the competition effect and raise them through the wage effect. Moreover,
industrialisation impacts upon these decisions through a single variable in the profit
function -- raising the gross profits (and marginal profits) net of modernisation and entry
costs. Thus, it impacts upon these decisions in a very similar manner.15 Both aspects of
Equilibria
In order to simplify the exposition of what follows, I will adopt the following
functional form for Ψ( Fn ) ,
Ψ( Fn ) = ( Fn + 1)−θ , θ > 0 .
This functional form captures the notion that greater sunk costs reduce the marginal labour
requirement and also imposes diminishing returns to this process. To ensure π is concave
in Fn , it is assumed that θ < 1
σ −1 .
Since the reduced form profit function already takes into account labour and good market
clearing, only equilibria in the game between intermediate input producers need be
15 Slight differences do occur because the entry decision depends on gross profits, while the modernisation
decision depends on marginal profits. Their qualitative aspects are, however, the same.
16 This involves an implicit assumption that firms producing low ordered varieties will enter first in any
equilibrium. This is a reasonable assumption given the symmetry among upstream producers producing
modern varieties and the fact that basic input producers do not face an entry charge.
11
ˆ ) < 0, ∀n > m .
(iii) max Fn π n ( Fn , ℑ
Thus, in equilibrium, all firms choose the technology that maximises profits and these
The following proposition summarises the possible equilibria arising in this model.
Several remarks on this proposition are in order. First, the presence of the entry cost
means that a development trap is somewhat generic to the model (i.e., we can always find
an initial level of industrialisation that makes this an equilibrium). If the labour endowment
is large enough or if k is large enough, there exist multiple equilibria in this model. Both
the entry and industrialisation equilibria Pareto dominate the development trap since positive
output (and hence, consumption) occurs in these cases. The additional condition for the
appear to be excessively restrictive here. Note too that (along with the condition for
strategic complementarity) this condition implies that firm profit functions are concave in
technology choice.
12
The above model shares with other static models of the “big push” the idea that
temporary government intervention can potentially facilitate a change from the development
trap to persistent industrialisation. It also shares with those models the possibility that
generating optimistic expectations or some form of indicative planning could achieve this
As has been noted elsewhere (e.g., Krugman, 1991), in order to properly analyse
this latter possibility one needs to move from a static model to consider dynamics
explicitly.17
Taken literally, the economy could easily move back and forth between the two
[equilibria]. The problem is that, in a completely static framework, one cannot capture
the difficulty of the transition in the process of industrialization, which may be
responsible for stagnation. In order to understand the self-perpetuating nature of
underdevelopment and the inability of the private enterprise system to break away from
the circularity, it is necessary to model explicitly the difficulty of coordination.
(Matsuyama, 1992a, p.348)
Matsuyama extends the Murphy, Shleifer and Vishny (1989) model to a dynamic setting.
In his model, firms face adjustment costs in adopting the modern technology or switching
back to the traditional one. As such, they need to anticipate not only the current movements
of others but their future movements as well. In this set-up, Matsuyama finds that
indicative planning will not be sufficient to generate an escape from a development trap if
Ciccone and Matsuyama (1996) also offer an explicitly dynamic model of the big
push.18 Their model has the same structure as the static model above although they do not
consider a modernisation choice and entry costs are in labour (rather than final good) units -
- this being the substantive difference between their model and that described above. The
only other significant difference between their model and the one in the previous section is
that:
σ
∞ σ −1 σ −1
X (t ) = ∫ xn (t ) dn , σ > 1.
σ
0
There is potentially an infinite number of entrants in any period t. Using this framework
they analyse several models in a continuous time setting. They provide several examples of
models that exhibit multiple dynamic equilibria and thus, allow the possibility of indicative
constant per capita consumption. They do present one model with rising per capita
consumption and multiple steady states without the possibility of indicative planning.
However, that involves constant growth in the industrialisation steady state. Allowing the
possibility of increasing growth may be more consistent with the empirical reality of
model of section II. In so doing, I will use the form of X(t) above but, for reasons that will
soon become apparent, use a discrete rather than continuous time setting.19 Households
and firms in this model solve intertemporal maximisation problems. For upstream firms,
incurring entry costs in period t allows them to start production in period t and successive
periods. Their technological choices involve sunk costs as well, although these can be
spread over time. By accumulating quantities of the final good over time, upstream
producers can increase their labour productivity. Thus, suppose that, at time t, the
where fn (s) is the amount of the final good purchased in period s. Then in t, and in
subsequent periods. To make the choice space of upstream firms continuous, I suppose
that their choice of fn (t ) is endogenous in each period and can take any positive real value.
19 All dynamic recent models of industrialisation and endogenous growth that I am aware of use a
continuous time setting.
14
Ψ ′( Fn (t )) < 0. 20
∞ ∞
∑( ) C (t ) ≤ L ∑ ( ) w (t ) + v( 0 )
t t
1 1
subject to 1+ r ( t ) 1+ r ( t )
t =1 t =1
where v(0) is the value of share holdings in upstream firms, U(.) is a continuously
rate and r(t) is the interest rate. The solution to this optimisation problem is characterised
That is, to justify any rising growth in consumption, the interest rate must rise over time.
unbounded. Indeed, in this framework, from any positive level of industrialisation, all
intermediate input producers choose to enter and modernise in a single period, leading to
nonsensical infinite production. To avoid this difficulty, here I exploit the structure of the
positive and negative feedbacks in the model in section II by introducing time lags into
production.
Y (t + 1) = X (t )α LY (t )1−α .
20 Some depreciation could be included in this specification, although it would not alter the results to come
in any substantive manner.
15
That is, production of final goods takes one period. This is the reason why I have used a
discrete time setting. Allowing for this possibility means that the positive feedback (i.e.,
wage effect) from industrialisation will be delayed one period. As will be shown, this leads
equilibrium of the model. Substituting these into the cash flow equation gives a convenient
reduced form for the cash flow of an intermediate input producer producing a positive
output in period t,
α
π n (t ) = ΛL Ψ( Fn (t ))1−σ ℑ(t − 1) σ −1 ℑ(t )−1 − fn (t ) .
there exists a positive feedback between the past technological choices of intermediate
input producers and the firm’s current choice. To see this more clearly, suppose that there
to,
α
ℑ(t − 1) σ −1
∂
∂ℑ( t −1) ≥ 0,
ℑ(t − 1) + ∆ℑ(t )
which is true if and only if σ − 1 ≤ α . Then, ceteris paribus, the greater the past level of
industrialisation, the greater is the marginal return to both entry and modernisation.
strategic substitute with the current choices of other intermediate input producers. So while
a greater level of past industrialisation raises the marginal returns to entry and technological
decisions today, greater current industrialisation dampens those incentives. The former
wages which in turn raises demand for intermediate inputs through higher aggregate
16
demand. On the other hand, the latter (substitution) effect occurs because of the reduction
in current intermediate input prices caused by lower marginal costs of production and the
competition of entrants.
Equilibrium Defined
Given the dynamic context, the definition of what constitutes an equilibrium in the
be the best response set for an active firm n ≤ k (t ). A strategy pair, ( k (t ),{ fˆn (τ )}n ≤ k ( t ) ) { }
τ ≥t
∫
t
ˆ (t ) =
(ii) ℑ fˆ (τ ) + 1 dn ;
0 s=0 n
∑ ( )
t −τ
(iii) max{ fn (τ )} 1
τ ≥ t 1+ r (τ )
π n (τ ) < 1, ∀n > k (t ) ;
τ ≥t
Thus, in equilibrium, all firms choose the technology that maximises discounted cash flows
equilibrium, if they chose to enter, non-active firms would earn negative profits. Finally,
the rate of interest satisfies the intertemporal optimisation condition for households.
Linear Utility
As will be discussed further below, the time structure of production makes the
specification of industrialising equilibria very difficult. However, one can show that
persistent industrialisation is possible.21 In order to make clear the forces driving this
result, I will start with the case of linear utility (i.e., U(C(t)) = C(t) for all t) and generalise
this in Proposition 2’ below. In this simple case, the interest rate, r, is constant and equal
21 This result is related to the Momentum Theorem, initially stated in Milgrom, Qian and Roberts (1991)
for contracting problems, and extended in Gans (1994, Chapter 3) to game theoretic contexts.
17
Once again the proof is in Appendix A. This proposition says that once industrialisation
reaches a critical level, the process will persist and continue of its own accord. Note too
according to,
α
ℑ(t ) = ΛL (1+δ δ ) ℑ(t − 1) σ −1 ,
a unique path. Thus, in the spirit of “big push” theories of industrialisation, the economy
can be stuck in a development trap from which an escape could be made provided sufficient
With more general utility functions, the result here becomes more complicated as the
interest rate, r(t), changes over time. Suppose that in period t, ℑ(t ) > ℑ* , and ∆k (t + 1)
firms choose to enter in t+1 with firms modernising to a level, f. In this case, the relevant
Euler condition for intermediate input producers becomes (with ∆ℑ(t + 1) ≡ ℑ(t + 1) − ℑ(t ) ),
α
g( ∆ℑ(t + 1), ℑ(t )) ≡ ΛL 1+r (rt(+t +1)1) ( f + 1)θ (σ −1) −1 ℑ(t ) σ −1 − ℑ(t ) − ∆ℑ(t + 1) = 0 .
When utility is linear, the g(.) (i) is positive at ∆ℑ(t + 1) = 0 since ℑ(t ) > ℑ* ; (ii) becomes
negative as ∆ℑ(t + 1) grows large; (iii) is strictly decreasing in ∆ℑ(t + 1) ; and (iv) is strictly
increasing in ℑ(t ) , once again, since ℑ(t ) > ℑ* . The first three properties guarantee that
∆ℑ(t + 1) is positive and finite (as depicted in Figure 2(a)), while the last guarantees that
These four properties are potentially violated when utility takes a more general form
and the interest rate varies over time. Observe that the interest rate depends both on
∆ℑ(t + 1) and ℑ(t ) . From the household Euler condition,
1 + r (t + 1) = (1 + δ )
( α
U ′ Λ σα L ℑ(t − 1) σ −1 − ∆k (t ) )
( )
α .
U ′ Λ L ℑ(t )
α
σ
σ −1
− ∆k (t + 1) − F
18
With strictly concave utility, one can see that r(t+1) is decreasing in ∆ℑ(t + 1) and
increasing in ℑ(t ) . This means that any of the above properties could be violated.
Therefore, we need additional conditions to assure that any solution, ∆ℑ(t + 1) , to the
general firm Euler condition is positive, finite and increasing in ℑ(t ) . Let
ℑ* ≡ {ℑ(t ) g(0, ℑ(t )) = 0} . The sufficient conditions are:
(i) Marginal utility is bounded from below, lim U ′(C(t )) = µ < ∞ ;
C ( t )→ 0
(ii) There exists no ∆ℑ(t + 1) > 0 with the property that g( ∆ℑ(t + 1), ℑ(t )) > 0, ∀ℑ(t ) < ℑ* ;
(iii) g( ∆ℑ(t + 1), ℑ(t )) ( g(0, ℑ(t )) ) is non-decreasing (increasing) in ℑ(t ) , for all ∆ℑ(t + 1)
Of these conditions, only (ii) appears to differ significantly from the properties listed for the
linear case. It does not require that g be nonincreasing in ∆ℑ(t + 1) , although this is
sufficient for (ii) to hold. All that is required is that the highest value of g occurs at
∆ℑ(t + 1) = 0 when ℑ(t ) < ℑ* . 22 This guarantees that entry and modernisation can only
possibly occur if past industrialisation reaches a critical value. Figures 2(b) and 2(c), give
two examples of g satisfying these conditions. Note that in each ∆ℑ(t + 1) > 0 and
It is worth emphasising here that these propositions guarantee that only ℑ(t + 1) − ℑ(t ) and
hence, C(t + 1) − C(t ) is increasing over time. They do not guarantee that the growth rate
although that is possible. In Appendix C it is shown that, by dropping condition (iii) and
replacing it with an alternative bound on g(0, ℑ(t )) , the growth rate in consumption is
bounded away from zero, for all time after ℑ(t ) > ℑ* . Thus, in contrast to neoclassical
growth theory, positive per capita growth persists over time. Proposition 2’ also ensures
property has an interesting implication (as will be shown below). It also holds for all utility
is shown in the appendix that without (ii), if it is ever the case that growth become positive
(not just at a critical level of industrialisation), then positive growth would persist
thereafter.
The model under conditions (i) to (iii) has a very interesting implication. As a
model of dynamic coordination failure this one differs from analogous static models (like
that of section II) in that optimistic expectations would not generate an escape from the
development trap. In many models of coordination failure, there exist rational expectations
paths from the development trap to industrialisation. Here, however, there exists no
industrialisation.
To see this, suppose that, the economy is at some low level of economic activity,
k0 < ℑ* . Also, for this demonstration, suppose that utility is linear (this will not be
necessary for Proposition 3 below). Now suppose that, beginning in the development trap,
all potential intermediate input producers expect k − k0 others to enter and adopt some
modern technology in the current period. Let the expected level of technology be some
constant, f > 0, and the new number of intermediate input producers be high enough such
that the resulting expected level of industrialisation would make these decisions profitable
when considered overtime (i.e., k ( f + 1)θ (σ −1) > ℑ* ). The question must be asked: is it
profitable for a given modern input producer to enter and modernise their technology this
period? A producer could, after all, wait one period before taking either of these actions.
To consider the optimal decision, all that is relevant are the cash flows of firms in the
current and next period. The two period cash flow from entering and modernising today is,
1−γ
23 The easiest way to see this is to examine utility of the form, U ( C(t )) = 1
1−γ
C(t ) , 0 ≤ γ < 1 . All of
the conditions (i) to (iv) hold for γ close enough to 0.
20
.
+( )ΛL ( fn + 1) ((k − k )( f + 1) + k0 )
α +1−σ
θ ( σ − 1) θ (σ −1)
1
1+ δ 0
σ −1
− fn − 1
And the two period cash flow from waiting until tomorrow to enter and modernise is,
Thus, there is a trade-off between the earnings from production and higher productivity
today and deferring the sunk costs of entry and modernisation. An intermediate input
producer will choose to wait rather than produce if the following inequality is satisfied,
When fn = 0, this inequality holds, strictly, by the condition for the development trap (i.e.,
that k0 < ℑ* ). Moreover, it is easy to show that, from low levels of industrialisation, the
left hand side increases with fn faster than the right hand side. This means that it is always
optimal to wait.
This argument leads to the following proposition for general utility functions.
Proposition 3. Assume conditions (i) to (iii) hold. Given any initial level of
industrialisation, ℑ(0) , if ℑ(0) < ℑ* then the economy is in a development trap for all
t. Otherwise, it is in a state of persistent industrialisation.
The optimality of waiting means that no rational expectations/perfect foresight path exists
from the development trap to persistent industrialisation. The reason for this is that if it is
always optimal for one intermediate input producer to wait, by symmetry, it is optimal for
expectations to the contrary would not be fulfilled. Observe that this result holds for any
positive discount rate. Thus, the non-industrialisation equilibrium is absorbing in the sense
of Matsuyama (1991, 1992).25 Note, however, this fact is a direct result of the assumed
time lag in production of the final good. This assumption makes modernisation and entry
24 This result is similar in flavour to the example of Rauch (1993) although in a very different context to
the one presented here.
25 Matsuyama (1991) states that one state is accessible from another if there exists a rational
expectations/perfect foresight equilibrium path from one that state that reaches or converges to the other. A
state is absorbing if, within a neighbourhood of it, no other state is accessible.
21
today strategic substitutes with similar decisions on the part of other producers. It is also
important to note that there does not exist a rational expectations path from industrialisation
to the development trap. This latter feature is a direct consequences of the irreversibility of
argued that the role for the government is to coordinate the expectations of individual
agents, making them consistent with those for persistent industrialisation. This is also the
stated goal of indicative planning. If possible, such a policy would be costless (save,
perhaps, the costs of communication), and firms would modernise on the basis of
optimistic expectations.
The above proposition shows that this solution will not work. This is essentially
because the problem, while one of a failure to coordinate investment, is not one of a failure
to a certain degree, even if this were believed perfectly by firms, each individual firm
would still have an incentive to wait one period before modernising. And, in that case, the
optimistic expectations created by the government would not be realised and the policy
would be ineffective.
Irreversibility and the time lag of production mean that history rather than
economy will continue to industrialise in the future. However, it does not specify the
precise path this could take and there could be a multiplicity of steady states involving
why it is difficult to characterise the industrialising paths of the economy. It is also difficult
involves foregone consumption in its initial periods. Therefore, to examine welfare issues
would involve some specification of household preferences. This issue is beyond the
In summary, the above model exhibits, in a certain sense, both the development
traps and persistent industrialisation that are the hallmark of the “big push” theories of
industrialisation. It is important to note, however, that the distinction between this model
and other models of coordination failure lies solely in the assumption of a time lag to
production.27 With linear utility, this makes the steady state completely determinant. It is
worth noting therefore, that for a small open economy with perfect international capital
mobility and non-tradable intermediate inputs,28 that even with general utility functions the
interest rate will not depend on the state of industrialisation. In this case, the uniqueness
VII Conclusion
This paper has done two things. First, a model that combines both the
doing, it was shown that the qualitative characteristics and hence, conclusions of the both
views were essentially the same. Thus, both viewpoints are complementary.
Second, this model was put into an explicit dynamic framework. In order to prove
the existence of a dynamic equilibrium, time lags into final good production were
introduced. This change meant that the wage effect from industrialisation was delayed
relative to competition effect. Firms would then have an incentive to industrialise over time
rather than in a single period. This eliminated the possibility of unbounded utility as
discussed in Romer (1986). This change also implied that policies for industrialisation
Even if firms were optimistic about future industrialisation they would have an incentive to
delay their own decisions. Since this applied to all firms, optimistic expectations would not
be realised.
and its characterisation is distinct from those usually undertaken in the growth literature. In
conclusions are found by assuming a specific functional form for utility functions, and
solving for balanced growth paths of interest rates and other state variables. Then it is
shown how these imply that positive growth will persist over time. In contrast, here I used
the monotone methods of Milgrom and Roberts (1994), to show that momentum, once
begun, will persist over time. This allowed a characterisation of dynamic paths as
involving persistent growth without looking for balanced growth paths or imposing specific
the assumptions that allowed for persistent growth over time. A direction for future
research would be to use this approach directly on endogenous growth models (e.g.,
Appendix A
Proof of Proposition 1
Note first that the strategic complementarities and symmetry in payoff functions
ensure that any equilibrium is symmetric. Second, observe that any upstream firm who
enters into production chooses their technology according to the following best response
function,
( )
1
α − ( σ −1 ) 1−θ ( σ −1 )
Fn* = max 0, Λθ (σ − 1) L ℑ σ −1 − 1 .
Note that this is not positive under the condition for case (i). Moreover, under that
condition, π n (0; ℑ0 ) < 0 for all n. This remains true so long as no upstream firm chooses
Now suppose that all k upstream firms entered but none invests in a more modern
technology than their initial level. In this case, ℑ = k and individual profits are
α − ( σ −1 )
− α −σ( σ−1−1 )
π n (0; k ) = ΛLk σ −1
− 1 . This is positive so long as, L > Λ1 k . Observe, however,
− α −σ( σ−1−1 )
that Fn* = 0 ⇒ L ≤ θ (σ 1−1) Λ k . For there to exist a range of L such that these two
Finally, suppose all producers of modern varieties enter and adopt some positive
( )
1
α − ( σ −1 ) 1−θα
Fˆ = θ (σ − 1)ΛLk σ −1
− 1 . This is positive by the conditions of the proposition.
Proof of Proposition 2
Suppose that in period t, ℑ(t ) > ℑ* . Entry and technological choices are considered
in turn. First, given the shock in period t, new varieties enter in period t+1 until the
difference in discounted cash flows from entering in t+1 as opposed to t+2 fall to zero for
all firms. Without loss of generality, assume that entering firms do not adopt more modern
upstream firm, the difference in discounted sum of cash flows between entering t+1 as
α
opposed to t+2 is ΛL ℑ(t ) σ −1 ( ℑ(t ) + ∆k (t + 1))−1 − ( 1+δ δ ) . Setting this equal to zero gives a
α
unique solution: ∆k (t + 1) = ℑ(t ) σ −1 δ (1σ+−δ 1) ΛL − ℑ(t ) . ∆k (t + 1) is positive since ℑ(t ) > ℑ* .
This, in turn, implies that ℑ(t + 1) > ℑ(t ) , meaning that ∆k (t + 2) > 0 since the right hand
side of the equation is increasing in ℑ(t ) . Note too that the finiteness of ∆k (t + 1) puts a
Proof of Proposition 2’
First, observe that (i) guarantees that as ∆ℑ(t + 1) → ∞ , g( ∆ℑ(t + 1), ℑ(t )) → ∞ .
This along with (iv), the continuity of U(.) and the fact that ℑ(t ) > ℑ* ensures there exists at
least one solution to g( ∆ℑ(t + 1), ℑ(t )) = 0, with ∆ℑ(t + 1) > 0 , by Theorem 1 of Milgrom
and Roberts (1994).29 This, in turn, implies that ℑ(t + 1) > ℑ(t ) , meaning that
∆ℑ(t + 2) ≥ ∆ℑ(t + 1) since the right hand side of the equation is non-decreasing in ℑ(t ) .
Note too that (i) guarantees the finiteness of ∆ℑ(t + 1) and hence, puts a bound on period
29That theorem shows that the result here would also hold for some relaxation of the continuity and
concavity assumptions on U(.), so long as the solution to the household’s problem was an interior one.
26
Appendix B
1
k ( t ) k (t )
k ( t ) 1− σ
P(t ) = min{xn ( t )}nk=( t0) ∫ pn (t ) xn (t )dn ∫ xn (t ) dn = 1 = ∫ pn (t )1−σ dn ,
σ −1
σ
0 0 0
where here it is supposed that only a subset [0,k(t)] of firms choose to produce in period t.
Using the optimal pricing rule, some simple substitutions show that, P(t ) = w(t )ℑ(t ) 1−σ
1
σ
σ −1
σ
−σ
and xn (t ) = Ψ( Fn (t )) X (t )ℑ(t ) , where now,
1−σ
[( )]
k (t )
ℑ(t ) = ∫ Ψ( F (t )) n
1− σ
dn = ℑ k (t ), {Fn (t )}n ≤ k ( t ) .
0
The aggregate, ℑ(t ) , is therefore a measure of the overall level of industrialisation in period
t.
∫ l (t )dn = X (t )ℑ(t )
1− σ
ln (t ) = Ψ( Fn (t )) X (t )ℑ(t ) and LX (t ) =
1
1−σ
n
1−σ
.
0
For the final goods sector, since production is lagged one period, producers choose
( 1
1+ r ( t +1) )Y (t + 1) − w(t ) L (t ) − P(t ) X (t ).
Y
The Cobb-Douglas assumption means that the interest rate drops out with,
P(t ) X (t ) 1−α
LY (t ) = ( α ) = X (t )( 1−αα )( σσ−1 )ℑ(t )1−σ .
1
w(t )
Finally, it remains to find the wage level each period. Observe, first, that in each
where
k (t ) k (t )
Therefore,
w(t ) = ( σ α−α )
Y (t ) 1
= α (α (σ − 1)) ((1 − α )σ ) ℑ(t − 1) σ −1 .
α
α 1− α
Wages reflect the previous technological choices of intermediate input producers only
because of the time lag in final good production. Substituting w(t) into the above yields the
relevant equation.
28
Appendix C
The first result here will show what conditions on g(.) guarantee persistent positive
growth as opposed to rising increments to consumption over time (as proved in Proposition
2’). For this purpose, condition (iii) can be dropped as g need not increase over time, but it
needs to be replaced with (iv) below to ensure that it remains positive as the level of
industrialisation rises.
(iv) For all ℑ(t ) > ℑ* ,
α
U ′ Λ ασ L ℑ( t ) σ −1 α
g(0, ℑ(t )) = ΛL (1+ δ )
1
+ 1 ℑ(t ) σ −1 − ℑ(t ) > 0 ;
α
U ′ Λ ασ LL ℑ( t −1) σ −1 − ∆k ( t )
Figure 3(a) provides an example of what happens under these new conditions
Corollary 1 (Persistent Positive Growth). Assume conditions (i), (ii) and (iv)
hold and suppose that at some time t, ℑ(t ) > ℑ* , where ℑ* = ( ΛL 1+δ δ ) σ −1−α . Then
σ −1
PROOF: (i) and (iv) ensure that ∆ℑ(t + 1) > 0 for all t, by the intermediate value
theorem. Hence ℑ(t + 1) > ℑ(t ) for all t. Note too that the finiteness of ∆ℑ(t + 1)
puts a bound on period by period utility. The proof then follows by induction.
Turning to examine the role of condition (ii), if is removed one can prove the
following corollary.
Corollary 2 (No Guaranteed Development Trap). Assume that only (i) and (iii)
hold and suppose that at some time t, ℑ(t ) is such that g( ∆ℑ(t + 1), ℑ(t )) > 0 for some
∆ℑ(t + 1) > 0 . Then ℑ(τ ) − ℑ(t ) ≤ ℑ(τ + 1) − ℑ(τ ) ≤ ... for τ > t.
PROOF: (i) and the condition of the corollary ensure that ∆ℑ(t + 1) is positive and
finite by the intermediate value theorem. Hence ℑ(t + 1) > ℑ(t ) . By (iii) and
Theorem 1 of Milgrom and Roberts (1994), this implies that ∆ℑ(t + 2) > ∆ℑ(t + 1) .
The proof then follows by induction.
Figure 3(b) demonstrates this possibility. What Corollary 2 says is that if it is ever the case
that industrialisation rose to a high enough level (perhaps due to a temporary shock), then
persistent industrialisation will persist thereafter. It differs from Proposition 2’, in that it
does not rule out the possibility that a path to persistent industrialisation could exist from
29
the development trap equilibrium. In this case, Proposition 3 would not hold and indicative
Finally, a similar version of Corollary 1 holding for persistent positive growth can
PROOF: (ii) and (iv)’ ensure that ∆ℑ(t + 1) > 0 for all t, by the intermediate value
theorem. Hence ℑ(t + 1) > ℑ(t ) for all t. Note too that the finiteness of ∆ℑ(t + 1)
puts a bound on period by period utility. The proof then follows by induction.