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Beyond Rosenstein Rodan: The Modern Theory of Coordination Problems in Development

Karla Hoff
Coordination problems-and solutions-help determine whether development
occurs. More than 50 years ago Paul Rosenstein-Rodan pointed out that spillovers
may cause the return to an activity to increase with the number of other actors under-
taking the same or complementary activities. If such spillovers are strong enough,
multiple equilibria may exist-some of them better for everyone than the alternatives,
but with no tendency for market forces to lead to the better state of affairs. Modern
economic theory has broadened our view of the sources of spillovers that could lead
to underdevelopment as an equilibrium. This article argues for an "ecological" per-
spective on development, where the influences from others in one's environment are
a critical determinant of outcomes, and many interaction effects are not mediated by
markets. This perspective distinguishes between deep interventions, which change
underlying forces, and shallow interventions, which do not and may actually make
things worse.
P aul Rosenstein-Rodan (1943) famously argued that at an early stage of devel-
opment, the investments of industrializing firms in one sector may increase the
profitability of other sectors throughout the economy. Simultaneous industri-
alization of many sectors could be profitable for all of them, but no sector would be
profitable industrializing alone. As a result, an underdevelopment equilibrium was
possible: even the market may not succeed in coordinating the activities needed to
ensure development.
In modern terms there could be a coordination failure, where individuals' failure
to coordinate complementary changes in their actions leads to a state of affairs that
is worse for everyone than some alternative state of affairs that is also an equilibrium.
Karla Hoff is a research economist in the Development Research Group at the World Bank. This article
draws on Hoff and Stiglitz (2001a). The author thanks Irma Adelman for helpful comments and to
Abhijit Banerjee, Arnold Harberger, Gustav Ranis, Debraj Ray, and Joseph E. Stiglitz for useful discus-
sions of the issues raised in this article. Financial support from the MacArthur Foundation for the
research that underlies this article is gratefuilly acknowledged.
Annual World Bank Conference on Development Economics 2000
@2001 The International Bank for Reconstruction and Development / THE WORLD BANK
46 Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
The obstacle to achieving the better state of affairs is not a matter of technological
opportunities (or even knowledge of those opportunities), or of resources or pref-
erences, but only of coordination.
In the 1950s the possibility of "underdevelopment equilibria" and "vicious circles
of poverty" was elaborated on by many other authors (including Nurkse 1953;
leibenstein 1957; Myrda11957; and Hirschman 1958). But individuals are rarely
convinced by those who do not address their concerns. Without a well-developed
theory of the sources of spillover effects (externalities), the idea of an underdevel-
opment equilibrium had little influence on neoclassical economists of that period.
They continued to argue that the market could coordinate the changes needed for
development (Krugman 1993, 1995; Stiglitz 1993).
Advances in the past 30 years in the modeling of externalities, technological
progress, and scale economies have made it possible to provide formal models that
capture Rosenstein-Rodan's insights. At the same time, information economics has
shown that neoclassical theory is based on a special case-perfect, costless informa-
tion-and that its implications for efficiency are no longer valid as soon as one departs
in almost any respect from that special case.! Before these theoretical developments,
most economists thought that the implication of externalities was that the economy
would be slightly distorted. But we now understand that the interaction of slightly dis-
torted behaviors of many different agents may produce very large distortions.2
Although it formalizes Rosenstein-Rodan's basic insight, modern work on coor-
dination problems is far from his original story in several respects:
.Remedies through international trade. Rosenstein-Rodan was particularly
concerned with the demand effects associated with industries experiencing
increasing returns. In some cases this argument loses its force when an econ-
omy is opened to international trade, as Tinbergen (1967) pointed out.
.Other channels of spillovers. Whereas Rosenstein-Rodan focused on
demand effects, modern theory has identified many other channels of
spillovers that can lead to coordination failures: spill overs in the technol-
ogy of an individual agent, spillovers mediated by social or political inter-
actions, information externalities, and spill overs when agents come
together through a search process.3 The result can be coordination prob-
lems for a wide range of behaviors that marter for development. This arti-
cle considers examples involving corruption, innovation, contract
enforcement, and property rights.
.Role of government. Rosenstein-Rodan argued that there could be coordina-
tion "from above" when government planned the process of industrializa-
tion. In contrast, most recent scholars recognize that there is no such thing
because government is pan of the endogenous set of institutions to be
explained (see Dixit 1996 and Basu 1997, 2000). Moreover, governments
fail even in democracies, just as markets do.4 But a positive development of
recent years, discussed below, is to try more limited interventions to harness
the spillovers among agents, and to try to sequence policy reforms in a way
that makes it more likely for good equilibria to emerge.
Karla Hoff
This article shows how developments in economic theory in the past 30 years
have broadened our understanding of the chann.els of spillovers and made possible
a new understanding-which I refer to as the "ecological perspective"--of pitfalls
and opportunities in development.
The Place of Coordination Failures in Modern Economic Theory
Neoclassical Theory and the Coase Theorem
Neoclassical theory, as I use the term here, was the central economic paradigm until the
mid-1970s. It studies price-mediated allocations in a setting of "complete" markets.
There is a market for all commodities that are, or could be, produced. "Virtual" prices
ensure that actions are taken if their social benefits exceed their opportunity costs.
Such models served as a benchmark. Neoclassical economists recognized that
their models did not take into account direct interdependencies among individu-
als that were not mediated through markets (such as Pigou's polluting factories).
But by and large, neoclassical economists believed that these were relatively
unimportant and that interdependencies that were mediated through markets
(pecuniary externalities) did not have efficiency effects (Mishan 1971; Cheung
In an extension of neoclassical economics, Coase (1960) argued that when an
economy departed from the complete markets assumption of neoclassical theory,
private agents would negotiate efficient outcomes (if there were no transaction
costs). In that tradition, North and Thomas (1973) argued that the institutional
changes in the West between 900 and 1700 were driven by changes in the scarcity
values of products and factors. As with competition among firms in neoclassical
economics, superior institutions ultimately eliminated inferior institutions.
Institutional Economics outside the "Straitjacket" of Neoclassical
But another strand of the literature recognized that markets were inherently limited
by problems of information and enforcement.6 There could never be the complete
set of markets in goods, risks, and futures on which the efficiency results of neo-
classical theory rest. And transaction costs are important, particularly in economic
development. Nonmarket institutions arise in response to limits on markets, but
there need not be forces that bring about efficiency.
This can be put another way. Individual actions that are privately rational need not
be socially rational when the individual takes his environment as fixed. There might
be another set of individual actions that would create a different environment in
which a different set of actions would be an equilibrium, and that environment might
be a better state of affairs. And there could be multiple equilibria in institutions, with
no tendency for market forces to select the one that was best.
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
This can be illustrated in a simple way, following de Meza and Gould (1992).
Suppose that property rights are well defineq but that owners of forested land must
incur a fixed cost--say, building a fence or hiring a patrol-to enforce their property
rights over the forest. Without this private expenditure, workers will be free to use
the private forests and extract income from them. By enforcing their property rights,
owners can hire workers to exploit their forests and collect the resource rents.
In deciding whether to enforce their property rights, owners compare the poten-
tial rents and the enforcement cost. Rents will be larger if workers' reservation wage
is lower. The reservation wage, in turn, depends on how many other owners are
enforcing their property rights. As the number of owners who enforce their rights
increases, the outside opportunities of workers fall, and so does the reservation
wage. With lower wages, potential resource rents rise. Thus two stable equilibria
may exist, indicated in figure 1. In the first, all owners enforce their property rights,
wages are low, and rents are high. In the second, no one enforces, wages are high,
foregone rents are low, and aggregate surplus is maximized.
As Coase (1937) emphasized, when the enforcement of property rights is costly,
a market mayor may not be the best allocation system. But as those working in the
Coase tradition did not generally recognize, whatever the best allocation system is,
a decentralized economy may not achieve it.
A general insight of recent theoretical work is that while institutions may be
established to improve economic outcomes, there is no assurance that will hap-
pen. Institutions may be part of an equilibrium yet be dysfunctional. For exam-
ple, Arnott and Stiglitz (1991) consider the consequences of the social
institutions that arise as a result of the incomplete insurance provided by markets
Figure 1. Multiple Equilibria in the Level of Enforcement
Source: Author's illustration.
Karla Hoff
because of moral hazard. They show that informal social insurance may crowd
out market insurance and lower welfare. More generally, developing countries
may be caught in a vicious circle where limited market development results in
large information imperfections, and these information imperfections give rise to
institutions-such as informal, personalized networks of exchange (Kranton
1996)-that impede the development of markets. Banerjee and Newman (1998)
show that an inefficient dualistic economic structure, where market forces gov-
ern economic exchange in one sector but not in another, can be explained as the
consequence of a self-sustaining network in the informal sector. Dualism may be
one equilibrium among several.
A further implication of the modern theory of coordination failures is that
improvements in existing institutions-"good mutations"-may not survive if they
require accompanying changes in other social institutions. For example, "if the insti-
tutional matrix rewards piracy, then [only] piratical organizations will come into
existence" (North 1994, p. 361).
History Dependence and Poverty Traps
Recent historical accounts go beyond the observation that there are multiple equi-
libria and show that economic outcomes exhibit history dependence. History (or
path) dependence means not just the obvious fact that past events may circumscribe
current choices, but that past events determine and predict the decisions at all cross-
roads since some initial starting point. For example, after a wartime disruption of
trade, an economy may undergo a structural change, develop a new system, and
never return to the original one.
The distribution of wealth is one of the most important channels through which his-
tory can have potentially large, permanent effects. Here I summarize a few central ideas
from a rapidly growing literature. One line of thought emphasizes political influences
of wealth. Engerman and Sokoloff (1997) and Sokoloff and Engerman (2000), for
example, find that the highly unequal distribution of wealth in the colonies of North
and South America that practiced plantation agriculture had long-lasting effects on
legal, educational, and political institutions. Another line of thought, discussed in Hoff
(1994, 1996), Hoff and Lyon (1995), and Bardhan, Bowles, and Gintis (2000), empha-
sizes that with imperfect capital markets, poor people have limited access to credit and
may be unable to enter into labor and land rental contracts that provide strong incen-
tives for effort. For example, they may be sharecroppers instead of renters, and entre-
preneurial activities may be foreclosed. Some initial distributions of wealth are
associated with subsequent economic groWth, but for others groWth paths do not exist. 7
History also affects outcomes by affecting beliefs. An obvious case is one where
expectations are at least partly adaptive: people expect others to behave in the
future as they have in the past. But even with fully rational expectations, history can
cast a long shadow.
For example, an outbreak of corruption, or the revelation that some firms in an
industry passed off shoddy goods as high-quality goods, can tarnish the reputation
150 Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
of the whole industry and reduce the incentive of every member of the group to
behave honestly in the future. Suppose that the reputation of a group member
(such as an employee in an organization or a firm in an industry) depends on the
member's past behavior and, because the member's track record is observed with
noise, on the group's past behavior. As Tirole (1996) shows, the revelation that
some group members were dishonest in the past will increase the time it takes for
any agent to establish a reputation for honesty. This will reduce his incentives for
honesty and may create a vicious circle of corruption: "the new members of an
organization may suffer from the original sin of their elders long after the latter are
gone" (p. 1).
A Radically Broadened View of Externalities and Public Goods
Coase recognized the limits imposed by transaction costs, but many of his followers
did not. They tended to argue (counter to the view in Rosenstein-Rodan) that real-
world externalities were hard to find. In the 1970s, the iconic example of external-
ities was still Meade's apple farmer and beekeeper, who each provide "unpaid
factors" to the other. But Cheung (1973) found in the cases he investigated that con-
tracts internalized these externalities. The iconic example of a public good was the
lighthouse. But Coase (1974) argued that throughout much of British history, pri-
vate arrangements had addressed this problem, too.8
Modern theory, in contrast, suggests that those working in the Coase tradition
were looking for inefficiencies in the wrong place. The iconic examples of techno-
logical externalities-the pastoral examples and the lighthouse-are ones that con-
tracts among the affected parties, or mergers among firms, may be able to
internalize. But many other externalities are too diffuse to be amenable to private
solution. They include information externalities, group reputation effects, agglom-
eration effects, and knowledge spillovers. They also include pecuniary externalities
(Newbery and Stiglitz 1982, Greenwald and Stiglitz 1986). Pecuniary externalities
often look analytically like externalities of the familiar technological sort. Recall the
example above on property rights, where as more owners fenced in their forests, the
return to fencing went up. In that example the spillover effects were transmitted
only through the change in the wage rate.
Modern theory radically broadens our notion of spillover effects. It shows that
in many cases even the set of equilibrium prices has public good properties. When
spillover effects are sufficiently strong, there can exist multiple, Pareto-ranked
equilibrium outcomes-each supported by some set of prices. Each individual's
choices contribute to the selection of one of those equilibria, but he ignores his
effect on the outcome.
"Ecological Economics"
Whereas neoclassical economics emphasizes the forces pulling toward equilibrium-
and with similar forces working in all economies, all should be pulled toward the
Karla Hoff
same equilibrium-modern development economics focuses more on evolutionary
processes, complex systems, and chance events ~hat may cause systems to diverge.
Thus modern theory tends to be influenced more by biological than physical mod-
els. Near the end of The Origin of Species, Darwin (1993 [1859]) wrote, in think-
ing about the Galapagos Islands:
[The plants and animals of the Galapagos differ radically among islands
that have] the same geological nature, the same height, climate,
etc. ...This long appeared to me a great difficulty, but it arises in chief
part from the deeply seated error of considering the physical conditions of
a country as the most important for its inhabitants; whereas it cannot, I
think, be disputed that the nature of the other inhabitants, with which each
has to compete, is at least as important, and generally a far more impor-
tant element of success. (p. 540)9
The economy is like an ecosystem, and Darwin was implicitly recognizing that
ecosystems have multiple equilibria. Far more important in determining the evolu-
tion of the system than the fundamentals (weather, geography) are the endogenous
variables, the ecological environment. Luck-accidents of history-may playa role
in determining that and, thus, in the selection of the equilibrium.
The main differences between the old and new views of spillover effects are sum-
marized in table 1. From these effects it is easy to formulate models with underde-
velopment equilibria, as the next section illustrates.
Coordination Problems in Development
This section presents an overview of theories of development in which spillover
effects exist and are so large that some societies may be characterized by a high
Table 1. Old and New Views of Externalities and Public Goods
Old view:
Iconic examples
Beekeepers and apple farmers
Polluting factories
Pecuniary externalities arising from:
.Enforcement of property rights
.Information spillovers
.Ownership strudures
.Demand effects on nontradables pro-
duced with increasing returns
Knowledge spillovers
Externalities in contrad enforcement
Search externalities
Social and political economy interadions
The equilibrium set of prices
Public goods
Group reputation
Knowledge (say, that a certain technologi-
cal result is feasible)
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
level of innovativeness, whereas others-which are intrinsically similar-are char-
acterized by a low level. In these theories, a~ individual's behavior depends on the
environment, and among the most important elements of the environment are the
behaviors of others. If the incentive for agents to choose an action is sufficiently
positively related to the number of agents who choose similar actions, then an
economy can have multiple equilibria, some better for every agent than an alterna-
tive equilibrium.
Know/edge Spit/overs
One way to conceptualize the tesearch and development (R&D) that producers
undertake is that it transforms known facts and accepted principles into potentially
profitable new applications. In this view, the expected return to an investment in
R&D increases with the stock of ideas in the public domain. If part of the outcome
of private research seeps into the local public pool of knowledge, then the more
research that is conducted, the larger the pool of ideas on which each producer in
the community draws. (There is persuasive evidence that knowledge spillovers are
strongest over short distances; see Jaffe, Trajtenberg, and Henderson 1993.) Thus
one possible impact of expanded R&D is a greater incentive to invest in R&D
(Romer 1986).
To analyze this situation, consider a simple model with a large number of identi-
cal producers. The profit (utility) of any producer depends on prices, the producer's
level of R&D (denoted by ai, which can be any value between 0 and 1), and the level
of R&D of all others. Because I will focus on symmetric equilibria, I consider the
case where all other producers choose the same level of R&D (denoted by a). Thus
the profit function is written as
Ui = ui[ai; a, p(a)]
where p is the price vector (which depends on the agents' actions). Assume for each
agent diminishing marginal returns to his action. Each agent chooses a level of
action to maximize his utility given the actions of others. (Each agent is small
enough that he ignores the direct effect of his actions on others and on p.)
Let ui I represent the partial derivative of Ui with respect to the first argument (ai).
The reaction function,
U;1 [a; ; a, p(a)] = 0
characterizes the action that the representative agent i will take for all possible values
of a selected by the remaining actors. The reaction function states that, given a, the
agent cannot obtain a higher payoff by a marginal change in the level of his action.
Figure 2 depicts the case where a higher action a by all other agents will lead the remain-
ing agent i to follow suit. A higher action by other agents increases the marginal return
to higher action by each. The actions of different agents are strategic complements.
Karla Hoff
Figure 2. Multiple Equilibria in a Model with Symmetric Agents
Source: Author's illustration.
The interior, symmetric equilibria are values of a" that solve the equation
Ui! [a* ; a*, p(a*)] = O.
Figure 2 illustrates a stable low-level equilibrium at a.' and a stable high-level equi-
librium at u. "'.10 By themselves, equilibrium prices do not provide the incentive
needed to implement the efficient equilibrium (a. "').
Externalities from Innovative Behavior
In some countries, individuals appear to be constantly looking around for new ideas.
In other countries, they appear to resist them. These behaviors create externalities;
each individual's choices may thus depend on the choices made by other people. Sah
and Stiglitz (1989) formalize this idea. They construct a model of social equilibrium
in which individuals can choose to behave bureaucratically or innovatively.
Bureaucrats make life more difficult for innovators, and vice versa. Let x be the share
of the population that chooses to be innovative. Let U(I; x, p) be the utility associated
with the innovative strategy, and let U(B; x, p) be the utility associated with the
bureaucratic strategy. Each individual chooses the activity that yields the greater util-
ity, taking x and p as given, where p is a function of x: p = p(x). Then it is easy to see
that there may be multiple equilibria. If most people choose to behave bureaucrati-
cally, it may pay only a few people to behave innovatively, and vice versa. An interior
equilibrium (where x is between 0 and 1) is a fraction x" that solves the equation
U[I; x*, p(x*)] = U[B; x*, p(x*)].
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
Equilibria also may exist where all agents make the same choice, one entailing
bureaucratic behavior if
U[I; 0, p(O)] < U[B; 0, p(O)]
and another entailing innovative behavior if
U[I; 1, p(l)] > U[B; 1, p(l)].
A slight variant of this model can be used to explore evolutionary dynamics.
Assume that rather than the individual choosing to be innovative or bureaucratic,
each individual has a certain fixed type that may reflect his upbringing, and agents
live just one period. Different reproductive rates are a function of utility levels so that
dIn x/dt = k [U(I; x, p) -U(B; x, p)]
for some positive constant k and time variable t. Then the set of equilibria will be
the same as before, and the equilibrium on which the economy converges will
depend on its history. Historical events-such as a country's opening to interna-
tional competition that hurts bureaucratic firms-may move the economy from one
equilibrium to the other, thereby affecting the long-run rate of technological
progress. II
Externalities from Rent-Seekers
A variant of the preceding model focuses on externalities from rent-seeking. Rent-
seeking is broadly defined as unproductive activities that use resources and extract
income from others-such as taking bribes, lobbying for preferences, and predation.
For example, Murphy, Shleifer, and Vishny (1993) consider a farm economy where
each individual chooses to engage in one of three activities:
.Producing a cash crop for the market, but with output from the activity vul-
nerable to rent-seeking.
.Producing a subsistence crop, with output not vulnerable to rent-seeking.
.Being a rent-seeker, and expropriating part of the output of cash crop pro-
An equilibrium is an allocation of the population among the three activities.
Suppose that over some range, as more resources move into rent-seeking, returns to
cash crop production fall faster than returns to rent-seeking. As a result, the returns
to rent-seeking increase relative to production for the market. This can give rise to
multiple equilibria. An economy can be in an equilibrium where the number of cash
crop producers is low and returns to such production are low because the number
of rent-seekers is high. But there is another equilibrium where the opposite is true.
As Acemoglu (1995) emphasizes, this means that economies with the same initial
opportunities may diverge over time-some towards a high growth path where
Karla Hoff
activities that increase aggregate output have high economic and social rewards, and
others towards a low-groWth path where they do not.
Externalities from Enforcement Mechanisms
Most development economists agree that among the most important institutions in an
economy are those that enforce contracts. Greif (1994) examines cultural factors that
might explain why cwo premodern societies-the Magribi in North Mrica and the
Genoese in Italy--evolved along different trajectories of social organization. To illus-
trate the main ideas, he presents a model with cwo kinds of actors: merchants and
agents. Agents carry out overseas trade on behalf of the merchants and choose becween
cwo strategies: to be honest or to cheat. A merchant also chooses becween cwo strate-
gies: to rely on collectivist or individualist means to punish cheaters. Under collectivist
enforcement, a merchant refuses to hire an agent known to have cheated any merchant
in the collective group. Under individualist enforcement, a merchant punishes only
agents who have cheated him. Greif shows that if a merchant believes that collectivist
enforcement is likely, then it may not be in his interest to hire an agent known to have
cheated other merchants. That makes such expectations self-fulfilling.
The intuition for this result is straightforward: an agent who has already damaged
his reputation has little to lose by cheating again, and so will be more easily tempted
to cheat his current employer than would an agent with an unblemished reputation.
That makes the agent who has damaged his reputation an undesirable hiring
prospect. But if the merchant believes that individualist enforcement will occur, the
motive for collectivist enforcement is absent. Thus cwo equilibria may exist, one
entailing collectivist enforcement and the other individualist enforcement. The equi-
librium that is "selected" will depend on beliefs (culture).
In the short run, individualist enforcement will be more costly because it forgoes
the stronger, group-level punishment mechanism. But in the long run, individualist
enforcement will increase the likelihood that government takes on a role in enforc-
ing contracts. By widening the scope of markets through which anonymous trading
can occur, such institutions promote long-run growth. Greif (1994) interprets the
history of the West in just such terms.
Local Externalities from Community Stakeholders
Civil society is an important vehicle for change in instimtions and policies. Community
participation is also a factor in the success of development projects (Isham, Narayan,
and Pritchett 1995). There is persuasive evidence from developed countries that the
individuals who are most likely to participate in community associations, respond to
neighborhood problems, vote, and maintain their property are those with a secure
property stake in their residence.12 Since stakeholders create local spillovers, house-
holds' decisions over stakeholding are interdependent. Hoff and Sen (2000) present a
framework in which to examine the possible consequences of local spillovers from
homeownership.13 They show that even if all households have identical preferences and
156 Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
identical abilities to contribute to their communities, polarized cities can emerge-the
rich in homeowning communities with high .levels of civic engagement and home
improvement effort, the poor in rental communities with low levels of both.
The basic story goes as follows. Every household desires to own its home because
it realizes that then it will obtain a greater return on any effort it makes to improve
its home and community (since it can "capitalize" the gains from these investments).
However, because of capital market imperfections, a household can afford to buy its
home only if its income is above a threshold. So the richer households buy their
homes and expend more effort in improving their homes and communities than do
the poorer households, who rent. It is in these effort choices that there exist com-
munity-wide interaction effects. The quality of a home and its future market value
are higher when it is in a community where neighbors expend high effort (a spillover
effect); and for an individual household, the marginal returns to effort are higher
when neighbors expend high effort (a complementarity effect).
The interplay of these effects influences community formation. Compared to
renters, homeowners take more out of the community and so may be willing to pay
more for land in a community with a larger number of stakeholders. This case is
depicted in figure 3A. A typical indifference curve of a homeowner (denoted by ue
because he expends effort in home and community improvement) is steeper than the
indifference curve of a renter (denoted by un, because a renter expends negligible
effort). Homeowners segregate in response to this complementarity relation, no
matter how weak. (There cannot be a stable equilibrium where renters and home-
owners live together in more than one community, for the homeowners would
always be willing to bid more for a home in the high-horne-owning community than
the renter would. Homeowners and renters would continue to switch places until at
least one community was completely segregated by tenure.) The outcome can be
socially very inefficient. Figure 3B depicts the case where segregation of a commu-
nity that was initially 50 percent homeowner results in a large loss in housing qual-
ity to renters that more than offsets homeowners' small gains in housing quality. But
land price differentials support the segregated equilibrium.
To summarize, interaction effects across community residents may cause house-
holds to self-organize into "good" and "bad" communities. The capital market fric-
tions faced particularly by the poorer households induce in them choices over
contracts and behaviors that make them less desirable as neighbors. This, in turn,
induces a pattern of community formation where "bad behavior" is concentrated.
The implication is that market forces together with social interaction effects can
produce a class of communities that, for lack of local stakeholders, cannot respond
to development opportunities.
"Big Push" Theories of Industrialization
Let us now return to the central concern of Rosenstein-Rodan: that an economy
with all the preconditions for industrialization would fail to industrialize because of
a failure to coordinate complementary investments. The relevance of models of
Karla Hoff
Figure 3. Stakeholding. local Interactions. and Segregation
(A) Compared to renters, homeowners take more out of the community and so, as depicted
in Panel A, they may be willing to pay more for land in a community with a larger fraction of
residents who expend high effort. (8) This will lead to tenure-segregated communities,
which may be socially very inefficient, as Panel 8 illustrates.
Fraction of community residents who expend high effort
Fraction of community residents who expend high effort
Source: Author's illustration.
coordination failures rests on diffuse externalities. If externalities were not diffuse,
negotiation among the affected parties--or mergers among firms-should internal-
ize them. Rosenstein-Rodan was particularly concerned with diffuse externalities
through demand effects associated with industries experiencing increasing returns.
But if all goods are tradable, this argument loses its force.
Thus the modern theory of underdevelopment equilibria based on demand effects
focuses on nontradable inputs into production. Complicated technologies often
require a variety 6f local inputs and producer services. Increasing returns in their pro-
duction can generate external economies at the level of final (tradable) goods. An
expansion of industry in an economy increases the demand for these nontradable
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
inputs, which lowers their costs and increases the available variety. With greater vari-
ety of intermediate inputs, production of final goods may be more efficient (for
example, computer technicians who specialize in certain programs can troubleshoot
those problems faster than can generalists). Thus it can be the case that when all other
sectors industrialize, it pays the remaining sector to do so. But when all other sectors
use a traditional technology that does not require intermediate inputs, it pays the
remaining sector to do so too. An underdevelopment equilibrium can thus be sus-
tained even when the economy is fully open to international trade (Helpman and
Krugman 1985, ch. 11; Rodriguez-Clare 1996; Rodrik 1996).
There are a variety of ways to think of the nontradable inputs. One is that they
represent different categories of specialized skilled labor, such as computer techni-
cians and software designers. As Rodrik (1996, p. 2) argues, "A worker's decision to
invest in a specialized skill depends both on the demand for the particular skill and
the existence of complementary skills in the economy." But why can't a single firm
train the labor force it needs arid so internalize the externalities among the decisions
of employees and between their decisions and those of the firm? Acemoglu (1997)
suggests one reason. He shows that even perfect contracting within a firm and a per-
fect capital market may fail to internalize the social consequences of the decisions
made by workers and firms. His explanation relies on search costs.
Suppose that there are two kinds of actors: firms that choose whether to adopt a
new technology, and workers who choose whether to become trained to use the new
technology. Training pays off only if the worker is employed by a firm that has inno-
vated, and innovation pays off only if the firm employs a worker who has trained.
There is a large and equal number of firms and workers. Each firm employs one
worker and there are two time periods. In the first period, a firm is matched with one
worker, they jointly make decisions on training and innovation, and there is complete
contracting between them (that is, no information problems or transaction costs). At
the end of the first period there is some risk of separation. If separation occurs, a firm
has to find a new worker, and a worker has to find a new firm. In the second period,
output is produced.
If there were no search costs in the labor market, separation between a firm and
a worker would not create a loss. If separation occurred, the worker would simply
move to another firm that had adopted the new technology, and all the surplus from
training and investment would be captured by the firms and workers who made the
investments. But suppose that search is costly. With costly search, matching will be
imperfect. There is no guarantee that the firm with the investment in the new tech-
nology will be matched with the worker who has the training.
Multiple equilibria can occur because a firm's likelihood of finding the right
worker depends on the thickness of the market (the number of trained workers).
The worker's likelihood of finding the right employer also depends on the thickness
of the market (the number of firms that have adopted the new technology). Without
a risk of separation, there would be no inefficiencies because there would be no
interactions with future employees or employers. The inefficiency arises because of
an externality between workers and their future employers, and between firms and
Karla Hoff
their future employees, that cannot be internalized because the identity of the actor
with whom one may be matched is unknown.
In contrast, Rosenstein-Rodan identified the obstacles to training with incomplete
contracting between a given firm and its employee: "There are no mortgages on work-
ers-an entrepreneur who invests in training workers may lose capital if these work-
ers contract with another firm" (1943, p. 205). This imperfection is not necessary to
generate inefficiency. Search costs create the possibility of multiple, Pareto-ranked
equilibria, where some countries are characterized by a high level of innovativeness,
and other countries by a low level. Training and innovation within any single firm may
payoff only if a sufficiently large fraction of the population trains and innovates.
An Econometric Test of Spillovers and Local Poverty Traps in Rural China
Testing has become possible with the formalization of coordination problems and
underdevelopment traps. It is beyond the scope of this article to review the empiri-
calliterature, which is still at an early stage. 14 This section presents a promising line
of investigation based on work using Chinese census data by Jalan and Ravallion
(1998) and Ravallion and Jalan (1996, 1999).
China is a good place to examine the theory for several reasons. Because the gov-
ernment severely limits geographic mobility in China, and because capital mobility
is also limited, factors move little in response to different opportunities across
regions. Thus it may not be too unrealistic to treat the assignment of households to
particular counties as random (and not the result of self-selection) and to view each
household's investment opportunities as a function of its local opportunities.
Further, China exhibits remarkable regional differences in living standards and
growth rates. For example, in 1990 rural poverty in the inland mountainous
province of Guizhou was 7-10 times (depending on the poverty line) that in the
neighboring coastal province of Guangdong-just a few hundred kilometers away.
The census data come from a 1985-90 panel of 5,600 farm households in south-
ern China. Jalan and Ravallion estimate two models derived from optimizing behav- The first is a simple expository model with just two explanatory variables for
growth in household consumption (apart from household time-varying fixed effects):
initial household wealth per capita (HW) and mean wealth per capita in the county
of residence (CW). The equation for the growth rate, g, is (t-ratiosin parentheses):
g = -0.143 -0.0166 In HW + 0.0378 In CW
(5.61) (5.91) (8.13)
Counties with higher average wealth showed higher average growth in household
consumption. Note also that the sum of the coefficients on in HW and in CW is pos-
itive, which implies that the effects are large enough to lead to divergence across
counties, which is the aggregate pattern over the six-year period of the survey. Jalan
and Ravallion interpret their results to mean that an increase in a county's average
wealth increases the marginal return to household wealth. This is due entirely to
160 Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
geographic externalities rather than to increasing returns to wealth at the household
level, since the negative coefficient on initial. household wealth (In HW) implies that
there are decreasing returns to capital within households.
I illustrate these results in figure 4. Let K denote the household's capital stock and
K denote the average household capital stock in the county. The econometric results
suggest that the marginal productivity function is downward sloping with respect to
household capital, and shifts up with an increase in the county's average level of cap-
ital. (Ignore points 1 and 2 in the figure for now.)
Figure 5 depicts the equation g = 0; that is:
g = -0.143 -O.O166/n HW + O.O378/n CW = 0
and plots the values of household wealth and county wealth from the survey. Note
that every household is near the critical line. (Readers can check their understand-
ing of the figure by noting that a typical household whose per capita wealth is In 6
yuan will enjoy rising or falling consumption over time as the household lives in a
county with per capita wealth higher or lower than In 6.5 yuan.) For a large subset
of the data county wealth is too low, given household wealth, to permit rising con-
sumption. Spillover effects appear to be large enough to generate poverty traps.
Looking back at figure 4 makes it clear why a household in a poor county might
have less incentive to accumulate capital than a household in a richer county. Suppose
that all households in a county are identical, so K = K. At point 1, household capital
is low and the retUrns to new investment are low because other households' capital
is low. But there is another equilibrium at point 2 where the reverse is true.
The second model that Jalan and Ravallion estimate does not use county wealth but
instead the detailed county variables listed in table 2. The table shows the main results.
(Dummies for county, period, mountains or plains, coast or inland, and the like have
been deleted. All the regressions were run with household time-varying fixed effects.)
County-level variables related to agricultUral modernization (farm machinery use
per capita and fertilizer use per cultivated area) and to the share of the population
employed in nonfarm commerce had highly significant positive effects on individual
consumption growth rates. Holding all else constant, a one standard deviation
increase in farm machinery use in an area adds 0.6 percentage points to annual con-
sumption growth, and a one standard deviation increase in fertilizer use adds 1.5
points. By comparison, a one standard deviation increase in rural road density adds
0.7 points to annual consumption growth. Following the same basic procedure as
above (setting g = 0 and evaluating all but one of the variables at its mean value),
Jalan and Ravallion show that these spillovers are big enough to generate underde-
velopment traps, consistent with the implication of their simple expository model.
Perspectives on Policy
The literature on coordination problems and poverty traps suggests that develop-
ment may be both easier and harder than was previously thought. Under the older
Karla Hoff
Figure 4. Marginal Productivity of Household Capital as a Decreasing Function
of Household Capital and an Increasing Function of Average County Capital
household capital
Source: Author's illustratIon.
Figure 5. Minimum Levels of County Wealth Needed to Ensure Rising Household
Consumption Given Household Wealth
Note: Wealth is measured in yuan per capita at 1985 prices.
Source: Jalan and Ravallion 1998, figure1.
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
Table 2. Determinants of local Opportunities in Rural China
Geographic variable
Coefficient estimate
-~ Farm machinery use per capita (x 1,000) 0.0420 *
Cultivated area per 10,000 people 0.0013
FertilIzer used per cultivated area 0.0023 .
Population density (log) 0.0160
Illiteracy rate among people 15 and older (x 100) 00159
Infant mortality rate (x 100) -0.0313'
MedIcal personnel per capita 0.0011 *
Share of population employed in
nonfarm commerce (x 100)
KIlometers of roads per capita (x 100)
Share of county population living in urban areas
.SIgnIfIcant at as level
Source Jalan and Ravalilon 1998, table 2
0.0067 *
0.0741 *
-1 0254
theory "all" one had to do to ensure development was transfer enough capital and
remove government-imposed distortions. Under the new theories "all" one has to
do is induce a movement out of the old equilibrium, sufficiently far and in the right
direction that the economy will be drawn to a good equilibrium. While this may
require fewer resources, it may require more skill. Some policies could 1ead the
economy to a worse equilibrium. That is, even after the policies were removed, their
ill effects would persist. And just as the equilibrium set of behaviors in a decentral-
ized economy may not be Pareto efficient, one cannot assume that Pareto improve-
ments are likely to emerge from the political process (see below).
One response to the modern literature on coordination problems has been to
emphasize our limited knowledge of the activities that should be coordinated-and
hence, the dangers of relying on the state to establish a coordination mechanism
(Matsuyama 1995). The problem with highly centralized coordination of activities
by government, as occurred in centrally planned economies, is not so much that they
never experienced rapid growth but that they suffered from a lack of inventiveness
and became "prematurely gray" (attributed to Jeffrey Sachs by Matsuyama 1995).
For Matsuyama the problem of coordination is like "the problem of hundreds of peo-
ple, scattered in a dense, foggy forest, trying to locate one another" (p. 134, empha-
sis added). Neither governments alone nor markets alone can solve it. Early writers
who pointed out the right sources of coordination failures drew the wrong policy
conclusions when they interpreted coordination failures as a call for a "big push"
industrialization centrally planned by the state.
Another strand of the literature emphasizes the incompleteness of models of coor-
dination failures. The selection of the equilibrium is determined outside the model by
initial conditions. Making the analysis of intervention precise requires a dynamic
framework. Only in a dynamic framework can one ask whether an initial coordina-
tion failure will transmit itself over time. Why wouldn't forward-looking agents with
sufficiently low discount rates adopt a path (which might include the option of
changing their behavior several times) that would permit as an equilibrium a self-ful-
filling move from a bad to a good equilibrium? Is there really any scope for policy?
Karla Hoff
Adsera and Ray (1998) address these questions in a setting where each agent
chooses betWeen tWo activities (which could be. interpreted as entry into a high-
technology sector that offers a high return in the long run if it obtains a critical mass,
relative to the returns in a low-tech sector). They obtain a striking result: if the pos-
itive externalities from moving to the more favorable activities appea~ with a lag
(which can be made arbitrarily short), then the final outcome depends entirely on
initial conditions unless there is some gain to being the first to switch. Put another
way, without some gain to being among the first to switch, each individual will
rationally wait for others to switch first-so no one will switch at all! Thus initial
conditions will determine the entire equilibrium outcome.
Interventions to Solve a Coordination Problem
Adsera and Ray show that there is a potential role for policy to enable an economy to
break free of history. A temporary intervention can force an equilibrium-but once the
equilibrium is attained, the intervention is no longer needed to support it. (This has
the advantage that by the time agents have learned how to corrupt the rule-adminis-
tering process, the rule may no longer be needed.) I consider four examples below.
ANTICORRUPTION PROGRAMS. As Tirole's (1996) model of group reputation, discussed
above, suggests, it may be possible for a temporary anticorruption program to
switch an economy from a high-corruption equilibrium (sustained by expectations
of high corruption) to a low-corruption equilibrium (sustained by expectations of
low corruption). An interesting historical case is the Republic of Korea in 1961. Park
Chung Hee, president of South Korea from 1961 to 1979, inherited from Synghman
Rhee a corrupt bureaucracy that chose policies based on self-enrichment. Within a
month of seizing office, Park dismissed the top 10 percent of bureaucrats, jailed a
number of the country's leading businessmen for corruption, and sent the rest of the
bureaucracy to tWo-week training courses in management, efficiency, and public
spiritedness. He then monitored the performance of economic bureaucrats and
quickly shifted them from one bureau to another so that they could not develop cor-
ruption netWorks. These efforts transformed the government's functioning and
shifted from soft to hard its interaction with the chaebols (conglomerates). Park then
designed the development plan (Mason 1980).
AFFIRMAnVE AcnON. A change in a legal statute may be able to force a new equi-
librium if the path to it involves revising beliefs and the revised beliefs sustain the
new equilibrium. Stiglitz (1974) shows that affirmative action programs can elimi-
nate equilibria in which productivity is unequal between groups (such as races or
ethnic groups) with the same innate abilities but different histories. Productivity
between groups may be unequal if, for example, individuals' preferences for educa-
tion depend on their parents' education and if the resulting differences in education
lead to different expectations by employers about the payoffs to training workers.
Decisions by employers may then lock groups into different positions in the income
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
distribution. An affirmative action program changes the behavior of employers, the
new behavior creates a new "history" and reyeals information about the group that
suffered from discrimination, and the revised information can lead to an equilibrium
in which prospective employers no longer want to discriminate.
LAw BASED ON SOCIAL NORMS. The law can also serve as a coordination device by
changing the extent to which individuals impose social sanctions on violators of a
norm. Following Cooter (2000), suppose that a person who punishes someone for
violating a social norm risks confrontation or revenge, but that this risk falls as the
number of people willing to punish increases. Suppose too that enactment into statu-
tory law of the social norm-say, t<? use generally accepted accounting standards-
lowers the private cost of enforcement because it leads an individual to believe that
other individuals will be more likely to impose social sanctions on those who violate
the norm. That expectation can be self-fulfilling. There can be multiple equilibrium
levels of private enforcement of social norms. Making the social norm into law can
"pull in" private activity rather than crowding it out (as occurs in traditional analysis
of government provision of public goods), and thus shift society from an equilibrium
with little private enforcement of the norm to one with high private enforcement.
By extension, Cooter (1997) argues that a state governed by laws that mirror
social norms (a rule of law state) tends to be hard to corrupt-whereas a state where
laws are imposed and enforced from above (the rule-of-state law) tends to be costly,
ineffective, and easily corrupted. A related view of statutory law comes from Basu
(2000), who argues that the only way government-enacted law can influence an
economy is to switch it from one equilibrium to another: if an outcome is not an.
equilibrium candidate absent the law, it is still not an equilibrium under any con-
ceivable legal regime.
RESOURCE STOCKPILING TO DETER POACHING. It is sometimes suggested that the litera-
ture on coordination problems implies that progress is possible only if one changes a
broad array of policies at the same time. But that is not the general message of the lit-
erature. The following example shows how a modest policy intervention-one well
within the reach of most developing countries-can resolve a coordination problem
in the exploitation of a storable open access resource, such as ivory from elephants.
Kremer and Morcom (2000) consider a setting where more intensive harvesting of
open access resources leads to anticipated future scarcity of such resources, which leads
to higher current prices, and so to more intensive current exploitation. In particular,
elephant poaching can lead to expectations of ivory shortages and thus raise future
ivory prices. Because ivory can be stored, the rise in future prices raises current prices,
which increases incentives for poaching today. There may be multiple rational expecta-
tions of paths of ivory prices and of the elephant population. The paths along which
extinction occurs are worse for everyone (not to mention the elephants). Government
can eliminate the extinction equilibria by accumulating a sufficient stock of ivory-per-
haps from sick elephants-and threatening to flood the market if the elephant popula-
tion becomes dangerously low. That would drive down the price for ivory and
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
become a private producer. Many analysts expected these farmers to exit the inefficient
collective system in droves and produce for themselves. Yet the share of agricultural
land used by cooperatives fell little: from 91 percent in 1991 to 80 percent in 1997.
When the Soviet system collapsed and cooperatives were left without federal
support, district politicians had the incentive and the power to ensure a supply of
inputs and subsidies to the cooperatives, just as the Soviet center had done.I7 This
support inhibited the potential demand for new market institutions and for suppli-
ers capable of serving small producers. By 1997, there were still no market institu-
tions providing farmers with storage, processing, transport, and insurance (and
given the fixed costs of setting up those services, they could succeed only if the
number of private farmers was high enough). But there had emerged district-level
programs to sustain cooperative farms. Amelina (forthcoming) interviewed farmers
to learn why they stayed within the cooperative system. Among the top two rea-
sons in both districts she studied was that "there is no other place to work."
The Rule of Law in the Transition Economies
Consider again privatization in the transition economies. Only under the rule of law can
capitalism fully take root. But how does one establish the rule of law? Recent work sug-
gests that coordination failures can block establishment of the rule of law. One coordi-
nation problem relates to financing the legal system Gohnson, Kaufmann, and Shleifer
1998; Roland and Verdier 1999). Another, perhaps more fundamental, coordination
problem relates to political support for the rule of law. I discuss this problem here.
Many economists believed that transferring state property to private agents
would automatically create strong incentives for investment and support for the rule
of law. But this claim overlooked an alternative activity that might also be profitable
in an environment where property rights were ill-de fined-stripping assets.
Consider two contrasting images of the agents who received control of state
assets after privatization:
Privatization offers an enormous political benefit for the creation of insti-
tutions supporting private property because it creates the very private
owners who then begin lobbying the government. ..for institutions
that support property rights. (Shleifer and Vishny 1998, p. 10)
[T]he efficient (responsible) owner. ..became one of the mythological
figures of many official programs. ...[The owner of a privatized firm]
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, pp. 32-33).
Here I will sketch a model, based on Hoff and Stiglitz (lOOlb), that argues that
the entrepreneur who builds up the value of his firm is not a mythological figure,
Karla Hoff
but rather a creature of a particular environment. He reflects the opportunities of
his environment. As emphasized throughout this paper, an important part of that
environment is the behavior of others. As in the case of enclosures of forests, there
may be many property rights systems that are equilbria.
The easiest way to think about this problem is through a model that has a very
limited set of issues associated with the definition of property rights. Consider a
model where the agents are individuals with control rights over privatized property.
And the conceivable set of actions is building value (entrepreneurship) or stripping
assets, tunneling value out of the firm, and letting the capital stock wear out (strip-
ping, for short). Entrepreneurs support reforms that lead to the rule of law, while
asset strippers do not.19 The rule of law in this case is the enforcement of ownership
rights (the most elemental property right). The probability x that the rule of law is
enacted depends on the number of entrepreneurs. We assume that this probability is
higher the larger the fraction of agents who support the rule of law. Then x = x(x),
where x denotes the share of agents who choose to strip assets, and x is a decreas-
ing function of x.
Time is divided into two periods. Asset strippers receive a payoff, denoted by s,
in period 1 and nothing in period 2. Let F denote the distribution of the payoffs s
across all agents.20
The payoff to entrepreneurs comes in period 2. In present value terms it is V L if
the rule of law is in place and zero if it is not (figure 6). For simplicity, assume that
V L is constant and the same for all agents.
The expected payoff to building value is xV L .Agents compare that value to their
payoff from asset stripping. Thus, there is a threshold, denoted by sot,
s* = 1t (X)VL
Source: Author's illustration.
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
such that agents for whom s > s" choose to strip assets, and agents for whom s < s"
choose to build value.
Any given value of the probability 7t maps into a unique value of the threshold
s", and a unique fraction of agents, denoted x", for whom s > s";
x" = I-F(s").
This model has elements of the enttepreneurship models discussed above. But now
the spillovers are mediated through the political process. The higher the fraction of
sttippers, the smaller the support for the rule of law and therefore the higher the rela-
tive return to stripping. Thus, there can be multiple equilibria, as depicted in Figure 7.
Figure 7 is divided into tWo areas by the boldface curve, s*. Below the curve, s <
s* and so an agent with such a value of s is better off building value than sttipping
assets. Above the curve, the opposite is ttue. The curve 1 -x = F(s*) is superim-
posed on the graph. These points are the payoffs to asset sttipping of the 1 -x th per-
centile of the population. The figure illusttates the special case where every individual
would be better off as an enttepreneur under the rule of law than as an asset sttip-
per. At x = 0, even the agent with the highest value of sttipping assets, denoted S, is
better off building value than stripping assets: 7t(O)V L > s. Thus, if all controllers
build value, the legal regime needed for investment is perceived as likely to emerge,
7t (0) V L is high, which makes x = 0 an equilibrium. However, at x = 1, even the agent
with the lowest value of stripping assets, denoted §., is better off stripping assets than
building value. Thus, all conttollers strip assets, the support for the rule of law is
weak, 7t(l)VL is low, which makes x = 1 an equilibrium. In short, when few agents
support the rule of law, the relative returns to building value are low and it does pay
to strip assets.
Some analysts have asked, "Why steal Gazprom (the giant Russian energy com-
pany) if you can make billions from it?" The model brings out the simple idea that
if an agent's current property rights to Gazprom are not respected in the future,
then he cannot make billions from it (by normal business investments).
Developments in economics over the past 30 years have validated Rosenstein-
Rodan's basic intuition. A critical determinant of actions is one's environment, one's
environment is endogenous, and an important aspect of the environment are the
actions of other people. We used to believe that externalities would slightly distort
the economy, but now we understand that the interaction of these slight distortions
can produce large distortions. An economy may be in equilibrium in an environment
with weak incentives for productivity, even though there is a better set of incentives
for all individuals that would also be an equilibrium.
Modern theory has considerably extended Rosenstein-Rodan's insight. We now see
that some of the basic distinctions developed in neoclassical theory do not hold. There
is no simple technology-based distinction between activities that produce externalities
Karla Hoff
Figure 7. Multiple Equilibria in Asset Stripping
Rule of law equilibrium
Strip assets
Stripping payoff for the
Equilibrium with 1 -xxrh percentile of the population
Payoff to building value, s*
fraction of asset
strippers. x
Decreasing security of property rights -'+
Source: Author's illustration.
and those that do not, or between activities with public good properties and those with
private good properties. The externalities that matter for welfare are not just direct
interdependencies (Meade's beekeeper and apple farmer). There are many other classes
of externalities with welfare consequences, an important example of which are those
that arise in purely price-mediated interactions. Reflecting history, beliefs, and chance,
certain behaviors are rewarded, others are not. Rewarded behaviors tend to increase
relative to others, and that may further increase the rewards to those behaviors. Initial
differences in circumstances or beliefs may not just persist, but be magnified over time.
In this view development policy is both easier and harder than before. It is easier
because there is generally slack. A lack of resources need not be the fundamental con-
straint on development. A temporary policy intervention or seemingly minor shock
may produce discontinuous change. But policy is harder because there is no single, eas-
ily identifiable source of failure waiting to be resolved}! Development is not ensured
by free markets and international trade, the transfer of capital, or the emergence of an
entrepreneurial class. In some environments the entrepreneurial class becomes entre-
preneurs to achieve predatory goals! Development requires complementary changes in
the behavior of agents that not even the market can coordinate. Certain policies-
policies that change beliefs, legal reforms, and the sequencing of policies-may con-
tribl,1te to coordinated changes to shift an economy to a better equilibrium.
Finally, there is an important difference between shallow interventions-which
do not change the incentives of key players and so may fail to improve matters-
and deep interventions-which entail irreversibilities. The sequencing of reforms
Payoff to
stripping assets, s
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
may make the difference between a deep intervention and a shallow one, as with pri-
vatization and anticorruption efforts.
Thus multiple equilibria, some with high incomes and others with low incomes,
can result from strategic complementarities-an intellectually exciting idea with
potentially enormous applications. Consider the simple adage, "If a man can. ..
make a better mousetrap than his neighbor, though he builds his house in the woods,
the world will make a beaten path to his door."22 Can strategic complementarities
matter even here? From the perspective of the literature reviewed in this article, the
outcome predicted by the adage might stilI. require that individuals expect that there
will be enough users to make services in mousetrap repair affordable and search costs
for those services low, that there be political support for property rights in mouse-
traps, that infrastructure sufficiently restrict the free movement of mice so that indi-
viduals have an incentive to buy their own mousetraps, and that there be a means for
the disposal of dead mice.
The basic lesson from this literature is that externalities arise in many economic and
social interactions and can give rise to coordination failures. Neither the market alone
nor government alone can solve them. There are many misguided incentives in the pri-
vate sector. There are different misguided incentives in the public sector. But it need
not be that the misguided government cannot correct the misguided private sector.
There may be a social equilibrium in which forces ~re balanced in a way that is Pareto
improving relative to one in which the government's hands are completely tied-and
certainly better than one in which the private sector's hands are completely tied.
1. This article uses the term neoclassical theory as short-hand for models that postulate
rational agents who interact through a complete set of perfectly competitive markets. This
narrow definition is for convenience only. There is no consensus on the scope of this term,
which is sometimes used broadly to include any "systematic exploration of the implications
of rational behavior in economics" (Laffont 1989, p. 6). In that broad sense all the models
discussed in this article, except for one evolutionary model, are neoclassical, and information
economics represents an intellectual revolution within neoclassical theory (Stiglitz 2001).
2. This can occur if there are agents for whom the incentive to choose an action is positively
related to the total number of agents who choose that action-formally, there are strategic
complementarities. Hoff and Stiglitz (2001a, appendix B) provide a simple mathematical tax-
onomy of models with strategic complementarities. Haltiwanger and Waldman (1991) show
that a variety of phenomena in industrial organization and macroeconomics can be under-
stood in terms of a framework where some agents are responsive to others' actions, and some
are not. Cooper (1999) surveys macroeconomic models with strategic complementarities.
3. Another channel of spillovers, outside the scope of this article, arises when one person's
preferences depend on another person's preferences, as in role model effects. These effects
can also give rise to coordination failures: the value placed on conformity can lead each indi-
vidual to choose an action because others do. Yet because of intragroup interactions, another
group with identical intrinsic characteristics can exhibit different behaviors that make all indi-
viduals better off. Durlauf (1999) illustrates this idea formally.
4. Besley and Coate (1998, pp. 151-52) provide a definition of political failure that is par-
allel to that of market failure. One begins in each case by defining technologically feasible util-
ity allocations. For political failure, this reflects available policy instruments such as taxes,
Karla Hoff
transfers, and invesmtents. Political institutions are then modeled. By analogy with market
failure, a political failure occurs when equilibrium policy choices result in an outcome where
it is technologically feasible (given available tax and transfer instruments, information, and so
on) to implement a Pareto-improving policy, but that policy will not be an equilibrium choice.
5. In an economy with complete markets, pecuniary externalities correspond only to a move-
ment from one Pareto efficient outcome to another. Such externalities give rise to changes in dis-
tribution that net out: gains by agents whose prices increase are exactly offset by losses to agents
who must pay higher prices. There are no efficiency consequences from the allocation effects of
price changes because equilibrium prices are always equated to marginal costs and benefits. But in
an economy with incomplete markets, pecuniary externalities generally do not net out. A general
framework is provided in Greenwald and Stiglitz (1986). One application of that idea (Hoff 1998)
shows that in an economy where lendets cannot distinguish among borrowets who differ in their
probabilit}, of default, pecuniary externalities from an improvement in technology can dissipate
some, all, or more than all of the gains from the technological change. This occurs if the marginal
borrower produces negative expected value (getting an implicit subsidy from the lower-risk,
higher-qualitY horrowets). As the technological change induces the entry of marginal borrowers,
the interest rate rises to reflect the lower average borrower quality, which hurts all borrowers.
6. Whereas most authors are associated with one strand or the other, Douglass North's work
helped advance both. North's early work ',\'as in the Coasean tradition and pioneered its
application to economic history. North's later work disparages prospects for understanding
economic history as a more or less inevitable movement toward more efficient institutions:
~Throughout most of history, the experience of the agents and the ideologies of the actors do
not combine to lead to efficient outcomes" (North 1990, p. 96; see also North 1994). I owe
to North the metaphor of the straitjacket (from his unwritten comments at a May 1999 World
Bank conference, ~Frontiers of Development Economics").
7. The literature on the relationship between wealth distribution and growth in economies
with imperfect credit markets includes Galor and Zeira (1993), Banerjee and Newman
(1993), Aghion and Bolton (1997), Piketry (1997), and Mookherjee and Ray (1998,1999).
8. In a rejoinder to Coase (1974), van Zandt (1993) notes that even the early lighthouses in
Britain did not operate in the ~pristine 'private' world," but relied on government interven-
tion to fix rates, grant monopolies, and collect user fees (p. 56).
9. Darwin (1993 [1859J) devotes two chapters to this idea (chs. 12 and 13).
10. An unstable equilibrium is one where the reaction curve is steeper than the 45 degree line.
11. For recent examples of evolutionary approaches to individual characteristics, see Bowles
(1998), Fershtman and Weiss (1998), and Francois and Zabojnik (2000).
12. Hoff and Sen (2000) survey the evidence.
13. We focus on the example of owning vs. renting, but other applications offer a choice
between obtaining a formal ownership title vs. an informal one, or holding secure vs. inse-
cure rights to property.
14. See, for example, Manski (2000), Azariadis and Drazen (1990), and Easterly and Levine
15. The key equilibrium condition equates the intertemporal marginal rate of substitution with
the marginal product of household capital, which is a function of the initial endowment of
household capital and the stock of capital in the county. The econometric analysis then tests the
hypothesis that this function is decreasing in household capital and increasing in county capital.
16. Palfrey and Rosenthal (1984) present a model in which the larger is the number of poten-
tial beneficiaries of a discrete public good, the less likely the public good is to be supplied.
17. Amelina's comparison of two districts finds that this was more likely in the districr where
agriculture played a bigger role in the economy. In that district most politicians had risen
through the ranks of the cooperative system. They had mastered the ability to transfer funds
to and from the cooperatives and had a large political stake in meeting cooperatives' needs.
Beyond Rosenstein-Rodan: The Modern Theory of Coordination Problems in Development
18. In practice a productive entrepreneur can always find ways of self-dealing. Even in
developed economies there are well-known opportunities for tunneling Oohnson, La Porta,
Lopez-de-Silanes, and Shleifer 2000). But there are tradeoffs between the two strategies: sup-
pliers, minority shareholders, and employees will ultimately refuse to do business with a firm
that defrauds them. Black, Kraakman, and Tarassova (2000) provide many examples of these
tradeoffs faced by privatized Russian firms.
19. Black, Kraakman, and Tarassova (2000) provide extensive evidence for Russia of the
asset strippers' flagrant use of the political process to undermine the rule of law.
20. There are many possible reasons for differences in 5 across agents who do not differ in
terms of V L' Asset stripping possibilities are greater in extractive sectors than in manufac-
turing. Among extractive industries, stripping possibilities are greater in firms where the cap-
ital investments needed for extraction are already in place. They are also greater where
agents are able to collude with bureaucrats or to loot state banks, where the firms whose
assets the agents control are highly leveraged, and where there is a ready market for the
assets of the firm. So, agenrs who face the same rewards from entrepreneurship may face dif-
ferent rewards from asset stripping.
21. This despite a long history in development economics of arguing that there was such a
source; see Adelman (2000).
22. Attributed to Ralph Waldo Emerson by Bartlett (1980). I consider the favorable case
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... There is inequity because the procedure of economic growth is spatially uneven. There is also inefficiency because spatial development procedures result in market failures due to coordination failures, and government and political failures which need more considered government intervention, deep vs. shallow (Hoff 2001;Duranton and Venables 2019). Some places are relatively well-served with roads, power, telecommunications, and other public facilities, while others fall short of such provision. ...
... The CII also contributes to the debate on 'people-centred' (e.g., Workers, Leadership, etc.) versus 'place-based' (e.g., Infrastructure, Housing, etc.) development (Wismadi et al. 2015). Whereas more traditional place-based policies (PBP) comprise infrastructure investments dealing with special zones, lagging regions, and local growth policies, (Duranton and Venables 2019), the approach should place people at the centre, including deep interventions in skills and training in the sector (Hoff 2001). Policies and strategies are known as progressive if they favour deprived/disadvantaged groups and regressive if they hurt such groups (Litman 2020). ...
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Sustainable development aims to enhance the quality of life in an inclusive manner, including economic prosperity, social equity, and environmental protection. Megaprojects are ‘large unique projects’ where public actors play a significant role and are often the conduit of corruption, and eradication of corruption is one of the critical challenges in most parts of the world, particularly the developing countries. Besides, corruption in construction can decrease the efficiency, effectiveness, and equity of infrastructure and services, resulting in the execution of ‘white elephant’ projects that are neither growth-inducing nor relevant to needs. Therefore, lack of access to roads, electricity, mobile phones, and the Internet limits the potential earnings of modern accessibilities and facilities in developing countries, and it also has a negative impact on poverty reduction. Although there are high perceptions about infrastructure inequity in Ethiopia, the difference between relatively developed and underdeveloped regions or states is not clear, especially in the equitable allocation of infrastructure resources. By analysing regional infrastructure, the states are categorised based on the results of the Composite Infrastructure Index, thereby exposing the unequal distribution of infrastructure and services. This paper shows gross inequity of public investments in Ethiopia, hindering the country's nation-building process. In substantially unequal societies, elite groups are more able to manipulate and influence policymakers to their advantage. Understanding the nature and extent of regional inequities in Ethiopia, as exemplified by regional infrastructure differentials, and finding sustainable solutions is imperative to socioeconomic development and shared prosperity.
... Ряд экономических дисциплин изучают такие сценарии устойчивой неэффективности, воспроизводимые в различных сферах экономики, в частности это делают институциональная экономическая теория, а также экономика развития. И если первая акцентирует внимание на механизмах неоптимальных трендов развития в связи с доминированием специфических правил (норм) (lock-in) (Arthur, 1989), то экономика развития указывает на устойчивые причинно-следственные связи в экономике и смежных с ней сферах, воспроизводящих так называемые ловушки недоразвития (бедности) (traps of underdevelopment, poverty traps) (Hoff, 2000). Классическим примером здесь может служить известная «мальтузианская ловушка», описывающая ситуацию, когда плоды первоначального экономического роста быстро исчерпываются ускорением демографического роста в рамках традиционного общества. ...
The article is devoted to the analysis of alternative approaches applicable to modern reform of higher education. Last three decades, the set of management technologies of the new public management (NPM) has significantly transformed higher education, introducing application some elements of quasi-markets and metric systems of performance indicators. Their large-scale use was reinforced by the ideology of new manageralism, which builds confidence among managers in effectiveness of their application in higher education. However, the experience of their practical implementation has given rise to negative effects and problems associated with emergence of institutional traps. These traps have become serious obstacles to development of modern higher education. The possible alternative when adjusting development in this sphere can be the concept of “the new public service”, which has been implemented in recent years within civil service reform. This new approach is based on cultivating the set of ethical values and principles that promote openness, transparency, democracy and cooperation between bureaucrats and consumers of public services. Due to some specifics of professional activity in the academic environment, its principles and values can be successfully applied in higher education too. The article offers an interpretation of application of this approach in the context of expanding project education and cultivating key values of the academic community in context of management of higher education.
This paper theoretically examines trade liberalization’s effects on workers’ human capital for a high-wage economy. Using an evolutionary game theory approach (EGT), we examine whether liberalization affects workers’ education, perhaps making them fall into a poverty trap. We find that, on average, workers increase their investment in human capital. We extend the investigation to include that, due to ex-ante historical and institutional circumstances, trade liberalization exerts heterogeneous effects on different types of workers and that the circumstances enabling them (or not) to educate differ. We find that liberalization makes some workers increase their human capital while other workers do not, leaving the latter more likely to fall into a poverty trap. By extending this investigation to the issues of trade liberalization and heterogeneous workers, we contribute to the EGT literature on poverty traps. Furthermore, unlike existing theoretical literature, which has ultimately argued that people’s different natural abilities are the reason behind their heterogeneous education responses, our analysis brings to the forefront the role of ex-ante historical and institutional factors. The paper also offers a novel theoretical foundation for empirical findings related to globalization’s effects on Americans’ education.
This study proposes a systematic approach to detecting and analysing coordination and/or coordination failure in regional environments. Specifically, it proposes leveraging the logic of the coordination game known as the Stag Hunt to infer whether levels of cynicism, distrust, poor communication and a lack of leadership are anchoring a region in poverty and inhibiting the transition to a more solvent and competitive economy. An application to the Mahoning Valley region in the United States highlights the many benefits of this approach as well as opportunities for future research.
This paper examines policy effectiveness as a function of leader identity. We experimentally vary leader religious identity in a coordination game implemented in India and focus on citizen reactions to leader identity, controlling for leader actions. We find that minority leaders improve coordination, and majority leaders do not. Alternative treatment arms reveal that affirmative action for minorities reverses this result, while intergroup contact improves the effectiveness of leaders of both identities. We also find that minority leaders are less effective in towns with a history of intergroup conflict. Our results demonstrate that leader and policy effectiveness depend on citizen reactions, conditioned by social identity and past conflict.
This article, based on previously untapped archival sources, offers an assessment of the life and thought of Paul Rosenstein-Rodan, a pioneer of development economics and one of the first articulators of both the “Big Push” and “balanced growth” theories. In addition to documenting the early life of Rosenstein-Rodan, this article discusses two critical junctures in the history of development economics, namely, the birth of the discipline in the late 1940s and its decline approximately a quarter century later. Rosenstein-Rodan was a fundamental player in both instances. Through the lens of his experience it is possible to understand the eclectic beginnings of development economics and locate some of its most important roots in the intellectual milieu of interwar Europe, from Vienna to London via Eastern and Southern Europe. What is more, Rosenstein-Rodan’s subsequent career epitomizes the arc of development economics, casting new light on the debates and practices that shaped the discipline during its rise and on the unresolved issues that help explain its decline.
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Official development assistance (ODA) and domestic expenditures of developing countries on food and agriculture are often too small, relative to needs or for stimulating private investment. ODA and expenditures are suboptimally allocated mostly to subsidies, with little to public goods, such as agricultural education, research, and extension. Learning and evaluation of impacts need to improve and expand to meet complex challenges facing farmers. The multisectoral nature of agriculture means that agricultural financing must consist of multiple components, with resources that are public, private (household), and private (external to household), coming from six categories: public—domestic and international; private—domestic and international; and household—savings and remittances. Information on “traditional” ODA for agriculture is more available than for “nontraditional” ODA: for example, from emerging countries, including China’s growing involvement in Southern countries, private investments in value chains, land purchases, and private philanthropy. Aside from the Bill and Melinda Gates Foundation (BMGF), few philanthropists report aid to the Organisation for Economic Co-operation and Development–Development Assistance Committee (OECD–DAC). BMGF’s Aid Transparency Index (ATI) rating improved only from “very poor” (18.1 percent) in 2013 to “fair” (47.3 percent) in 2018. The 2020 ATI reported significant improvement in aid donors’ overall transparency, but less in impact of aid projects. New themes, including nutrition and the environment, pose challenges to estimating sources of resource flows in support of adaptation of agriculture. We show that, even though available aid has increased since 2020, resources are very small relative to needs and the extent of advocacy.
This paper presents an evolutionary model of coordination problems in economic development that examines technology adoption jointly with skill acquisition. The model allows for multiple channels of interdependence across firms and for employment creation to be determined by technological and institutional factors. We show that industrial policies are key to ensuring the effectiveness of educational policies, and that robust employment creation is key to ensuring the effectiveness of both industrial and educational policies. These results speak to recent concerns about insufficient employment creation in high‐productivity activities and suggest the need to include employment promotion as an objective of development policy.
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CNMT (Classical Neoclassical Monetary Theory) has defined monetary policy and the role of Central Banks for the last one hundred years. This book argues that it is time to change. It proposes a NMT (New Monetary Theory) which argues that Central Banks should be responsible for the whole relation between money and economic growth. For monetary policy it means that in regular times Central Banks will continue being guided by CNMT and QE (Quantitative Easing) should not be used. But in major crises like 1930, 2008, and 2020, NMT should be the guide and QE should be used extensively. NMT proposes that Central Banks should become even more independent and responsible for the productive economy, while traditional governments remain responsible mainly for the social economy. NMT argues that in major crises fiscal policy should only be limited to support the social economy - that one which does not have survival productive characteristics. And that extended QE, which we call in here the Monetary Credit Bazooka (MCB), should be used to support the productive economy - the one capable to receive and repay long term preferential loans. NMT implies a major revolution both in Monetary Theory and in Monetary Policy, but it is required both to have fast and efficient responses in major economic crises, and to avoid the inefficiencies associated with government spending and the unnecessary long term burdens to the tax payers which always imply unjust economic transfers.
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We show that individuals with identical preferences and abilities can self-organize into communities with starkly different civic environments. Specifically, we consider a multi-community city where community quality depends upon residents’ efforts towards preventing crime, improving local governance, etc. Homeownership raises incentives for such civic efforts, but is beyond the reach of the poor. Within-community externalities lead to segregated cities: the rich reside in healthy homeowner communities, while the poor live in dysfunctional renter communities. Tenure segregation in the U.S. accords well with our prediction. We study alternative tax-subsidy policies to expand homeownership and to promote integration of homeowners and renters
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This paper analyzes the role of wealth distribution in macroeconomics through investment in human capital. It is shown that in the presence of credit markets' imperfections and indivisibilities in investment in human capital, the initial distribution of wealth affects aggregate output and investment both in the short and in the long run, as there are multiple steady states. This paper therefore provides an additional explanation for the persistent differences in per-capita output across countries. Furthermore, the paper shows that cross-country differences in macroeconomic adjustment to aggregate shocks can be attributed, among other factors, to differences in wealth and income distribution across countries.