In 1970’s the world of economic thought experienced a re-emergence of neoclassical economics that has traditionally been pre-occupied with laissez-faire. Given such obsession, neoclassicals posited that the application of standard microeconomic principles in the third world context would tackle the issue of underdevelopment as it (i.e. underdevelopment) is born out of lack of markets due to weak or non-existent property rights. In this essay, with the help of QWERTY example, I want to argue that even if one comes from a neoclassical perspective, still there will exist market failure that may require some form of state intervention; and in the LDCs underdevelopment will be the result of such massive coordination failures. In particular, under neoclassical assumptions, issues of complementarities and increasing returns to scale will lead to existence of multiple equilibria where only one is pareto-efficient; in the presence of multiple equilibria, issues such as path dependency and history will force the economy to get stuck with pareto-suboptimal equilibrium.
The types of externalities can broadly be categorized into technological and pecuniary ones. While market can capture technological externalities (i.e. due to such externalities market might be in disequilibrium), pecuniary externalities are not captured in the General Equilibrium framework. Pecuniary externality occur when the profit of one producer is affected by the actions of other producers through market prices; in other words, pecuniary externality arises when the price of one good in an economy depends on the prices of other goods in the economy:
, where P is the price at which the first firm sales its products.
Pecuniary externality leads to market imperfection and complementarities that will in turn, along with the assumption of increasing returns to scale (IRS), will lead to the existence of multiple equilibrium. Let’s consider To-Become-Tea-Lovers country. Suppose that two firms, T and S exist in this economy: while T produces tea, S produces sugar; suppose that due to some changes in the taste of people living in this economy, the demand for tea increases and as a result T expands. This will result in increase in the demand for S’ product; so, S will expand. This in turn will have a positive impact on the demand for T’s products because now with more income available from the expansion of S, demand for tea further increase. These two firms will keep reinforcing each other’s profit. Thus, a monopolistic economy will be shaped: imperfect market. This way, pecuniary externality leads to imperfection in the market. Let’s note that in such a scenario, the First Fundamental Theorem of Welfare Economics stands in the way because it rules out Pareto-ranked equilibria in the absence of technological externalities.
Now, to show that
complementarities and IRS lead to the existence of multiple equilibria, let’s
consider QWERTY example. Dvorak Simplified Keyboard (DSK), according to
experiments, is more efficient arrangement compared to QWERTY, and it is said
that typing with DSK is 20 to 40% faster compared to QWERTY. However, we are
still stuck with the later due to 3 issues, namely (1) technical
interrelatedness, (2) economies of scale, and (3) quasi-irreversibility of
investment.
Technical inter-relatedness
refers to the interdependence that exists between typewriters and typing skill.
In the past, when typewriters were invented, it was purchased by businesses for
business use. The purchaser wouldn’t himself/herself use the machine, rather it
was used by typists who were trained in typing schools. This gives rise to some
form of inter-relatedness; the business will buy those types of machines for
which typist (soft skill) can be found; on the other hand, the typist would try
to learn typing with those types of machine that are available with businesses.
Thus, a form of complementarity is formed.
In this situation, when a firm
buys a QWERTY-keyboard typewriter, this signals a positive pecuniary
externality to those typists who are skilled in typing with QWERTY-keyboard.
Also, the demand for QWERTY-keyboard learning will go up which will result in
the reduction of average cost of learning QWERTY-keyboard due to economies of
scale (IRS). Thus, complementarity and economies of scale create QWERTY
path-dependency, meaning the purchase of a QWERTY-keyboard by a firm and
subsequence choice of learning this QWERTY-keyboard skill by potential learners
will finally lead to dominance of QWERTY-keyboard. However, if the issue of
quasi-irreversibility of investment did not exist, it would have been possible,
even now, to go to DSK.
Quasi-irreversibility of
investment refers to rise of asymmetry that rose between the cost of hardware
and software conversion in mid-1890s. In mid-1890’s, the possibility to move
back and forth between QWERTY-keyboards and DSKs without any extra cost was
made possible but the cost of learning DSK was going up because the demand for
QWERTY-keyboard learning was rising. This is called Quasi-irreversibility of
investment.
In this example, we see that
pecuniary externalities, complementarities, increasing returns to scale,
history and path dependency and quasi-irreversibility of investment have led to
multiple equilibria, being caught up in low level equilibrium and market
failure. In other words, if someone, say government coordinated the actions of
business owners and labor force at the initial stage, pareto-optimal equilibrium
would have been achieved. Based on this example, we can argue that even coming
from a pure neoclassical perspective, market failure can happen and there is a
need for coordinated action to help the economy achieve a pareto-efficient
equilibrium. In the LDCs, underdevelopment can be a result of massive coordination
failures do to the issues of complementarities and increasing returns to
scale. We can also show the existence of
multiple equilibria, coordination failure and the need for some form of
intervention to coordinate actions by considering an economy where left to
themselves, firms may not invest because they might expect that other firms
will not invest.
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