Tuesday, November 01, 2005

On increasing returns

Standard economic theory is based on the assumption of diminishing marginal returns. This means that, for example, if you keep drinking coke, the fifth can probably won’t give you as much satisfaction as the fourth one, which wouldn’t have given you as much as the third one, and so forth. This also means that if you kept pouring in more machines without increasing your workers, your marginal machine wouldn’t give as much output.

One implication of this is that in countries with lots of machines, adding one more machine wouldn’t be as useful, and the machine owners in these countries would pay less for the additional machine, when compared with countries with few machines. This in turn implies that if you had machines to sell, you should sell them in poor countries, because that’s where the machines would fetch higher return. Same intuition should work for your skills. A skilled person should migrate to a country where there aren’t many such skilled persons.

Of course this theoretical prediction is belied by what we observe. Capital doesn’t flow to poor countries — quite the contrary, the Unites States receives more foreign investment every year than the entire non-OECD world put together (and that includes China and India). And skilled people, when they can, tend to move to the rich world.

So how do the economists reconcile this? One major explanation involves abandoning the assumption of diminishing returns. Think of a laboratory where some of the world’s greatest physicists are working to build a time machine, it’s probably no surprise that another top scientist’s mind would be best used in this lab than anywhere else. Instead of diminishing returns, here we have a situation of increasing returns.

Turns out that there is increasing returns within the IMF and the World Bank. Your best and the brightest tend to work together. And where do they work? They tend to flock to the Europe and North America desks. Africa desks on the other hand are where you go if you think your career is going nowhere. This in turn means that the Bank and the Fund typically don't change their policy prescriptions to the poor countries even when there are enough evidence that the prescribed policies simply don't work. Typically, people working in those desks are your bureaucratic timeservers with no motivation or desire to try new things.

In the presence of increasing returns, market forces by themselves won’t generate a resource flow to the poor countries. The same intuition means that within the Fund and the Bank, unless the management does something, Africa desks won’t attract motivated and bright people, and same stale policies will be prescribed again and again.