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Judul Asli: Time Lags and Indicative Planning in a Dynamic Model Of

Diunggah oleh Joshua Gans

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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 Version: June 11, 1997

and adoption of modern technologies views of industrialisation. Both of these

views have been used in the recent literature to demonstrate the possibility of

coordination failure. With simultaneous production across sectors, the model

generates the indeterminancy of equilibria common to the recent literature.

However, by positing quite natural time lags in production this

indeterminancy is eliminated. It is shown that, in such a framework, even with

optimistic expectations, firms prefer to delay industrialisation in the

development trap. This suggests that policies aimed at transition by using

indicative planning are unlikely to be successful. Journal of Economic

Literature Classification Numbers: O14 & O20.

adoption, complementarities, irreversible investment, indicative planning.

* 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 .

σ

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

production. After entry, a typical technology has them using labour, ln , and producing

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

1

Using the optimal pricing rule, some simple substitutions show that, P = σ

σ −1 wℑ1−σ

σ

and xn = Ψ( Fn )−σ Xℑ1−σ , where,

[( )]

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

k

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,

α − ( σ −1 )

π n = ΛL Ψ( Fn )1−σ ℑ σ −1

− Fn − 1.

α 1− α α

σ (σ − α ) . The flows of income and goods leading to this

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

Bn ( ℑ) ≡ arg max Fn π n ( Fn ; ℑ) be the best response set for their modernisation decisions.16

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 ) for all n ≤ m ;

(i) Fˆn ∈ Bn ( ℑ

ˆ = m ( Fˆ + 1)θ (σ −1) dn ; and

(ii) ℑ ∫

0

n

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.

industrialisation is ℑ0 . The following characterise, completely, the set of pure

strategy Nash equilibria:

α − ( σ −1 )

(i) If L < Λ1 ℑ0− σ −1 , then for all parameters, there exists a “development trap”

with no further entry (or modernisation) by intermediate input producers;

− α −( σ −1 ) − α −( σ −1 ) − α −( σ −1 )

(ii) If θ (σ 1−1) Λ k σ −1 ≥ L > Λ1 k σ −1 and L < Λθ (1σ −1) ℑ0 σ −1 , there exists an “entry

equilibrium” with no modernisation (i.e., k firms enter into production but

Fn = 0 for all n);

− α −( σ −1 )

(iii) If L > θ (σ 1−1) Λ k σ −1 and α1 > θ , there exists an “industrialisation equilibrium”

(i.e., k firms enter into production and Fn > 0 for all n).

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

18Murphy, Shleifer and Vishny (1989) also offer a simple dynamic model of industrialisation. It is,

however, only a two period model whereas the alternatives here and elsewhere have a long time horizon.

13

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

t

Fn (t ) = ∑ fn (s),

s=0

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

∞

max{C ( t )} ∞

t =0

∑ ( ) U (C(t ))

t =1

1 t

1+ δ

∞ ∞

∑( ) 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

U ′(C(t )) 1 + r (t + 1)

= for all t,

U ′(C(t + 1)) 1+δ

t

1

1+ r ( t )

t =1

That is, to justify any rising growth in consumption, the interest rate must rise over time.

with net profits increasing in the level of industrialisation, ℑ(t ) , utility could become

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

derivative of the profit function with respect to fn (t ) and ℑ(t − 1) is nonnegative if and only

α

if ℑ(t − 1) σ −1 ℑ(t )−1 is nondecreasing in ℑ(t − 1) for all fn (t ) . Observe that holding the

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

t −τ

Bn, t {ℑ(τ ), ℑ(τ − 1)}τ ≥ t ≡ arg max{ fn (τ )} 1

τ ≥ t 1+ r (τ )

τ ≥t

be the best response set for an active firm n ≤ k (t ). A strategy pair, ( k (t ),{ fˆn (τ )}n ≤ k ( t ) ) { }

τ ≥t

(i) { fˆn (τ )}τ ≥ t ∈ Bn, t {ℑ (

ˆ (τ ), ℑ

ˆ (τ − 1)}

τ ≥ t for all active n; )

(∑ )

k (t ) θ (σ −1)

∫

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

ℑ* = ( 1+δ δ ΛL ) σ −1−α .

σ −1

ℑ(τ ) − ℑ(t ) ≤ ℑ(τ + 1) − ℑ(τ ) ≤ ... for τ > t.

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

hold and suppose that at some time t, ℑ(t ) > ℑ* , where ℑ* ≡ {ℑ(t ) g(0, ℑ(t )) = 0} . Then

ℑ(τ ) − ℑ(t ) ≤ ℑ(τ + 1) − ℑ(τ ) ≤ ... for τ > t.

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

22 *

19

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

α −1

.

+( )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,

α +1−σ

σ −1

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,

α −1

σ −1

.

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

22

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.

28 As in Rodriguez-Claire (1996).

23

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.,

24

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

inequalities hold requires that: 1

θ ( σ − 1) Λ k ≥ L > Λ1 k ⇔ 1

σ −1 >θ .

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

25

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

σ

P(t )

xn (t ) = X (t )

pn (t )

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.

k (t )

σ

∫ 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 )

1

Finally, it remains to find the wage level each period. Observe, first, that in each

27

where

k (t ) k (t )

( α

σ −α ) ∫ Ψ( Fn )

1− σ

dn − ∫ f (t )dn

n

0 0

α

1− α σ −1

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

(iv)’ If there exists some ℑ* such that g(0, ℑ* ) > 0 , then g(0, ℑ(t )) > 0 , for all ℑ(t ) > ℑ* .

Assume that only (ii) and (iv)’ hold and suppose that at some time t, ℑ(t ) is such that

g(0, ℑ(t )) > 0 .. Then, ℑ(τ ) < ℑ(τ + 1) < ... for τ > t.

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.

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