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JOSHUA S. GANS
Melbourne Business School, University of Melbourne
200 Leicester Street, Carlton, Victoria, 3053, Australia
E-mail: J.Gans@mbs.unimelb.edu.au
A recent literature has demonstrated that fixed costs at the firm level can
lead to strategic complementarities and hence, coordination failure in
industrialisation across sectors. The existence of such complementarities
appears to hinge critically on the nature of these fixed costs -- that is, whether
they are composed of labour overhead or final goods. This paper
endogenises the firm’s choice of fixed cost composition by assuming that
labour and final goods are imperfect substitutes in plant production. It is
shown that allowing for such choice eliminates the criticality of fixed cost
assumptions, focusing attention instead on other parameters as driving forces
of intersectoral complementarities. Journal of Economic Literature
Classification Number: O14.
level can generate market size effects and coordination failure (i.e., multiple equilibria) at
the aggregate level. In these models, increasing returns arise either because of fixed costs
regarding the likelihood of coordination failure have been shown to depend critically on the
nature of these fixed costs.3 When fixed costs took the form of pure labour overhead, the
multiplicity could not be generated without making additional assumptions.4 On the other
hand, Ciccone (1993) and Matsuyama (1995) demonstrated that, when fixed costs were in
final good units (i.e., have the same factor intensity as final good production), entry and
choice variable. Firms could choose to build plant using more or less labour depending on
prevailing wage conditions -- they are imperfect substitutes. As such, the purpose of this
The economy consists of two production sectors.5 The first is a downstream sector
with a measure one continuum of firms who are competitive price-takers producing a
homogenous final good, Y. They combine labour, LY , and a composite of intermediate
inputs, X, according to, Y = X α L1Y−α , α > 0. This final good, Y, is taken as numeraire.
1For example, Murphy, Shleifer and Vishny (1989) and Baland and Francois (1995).
2Matsuyama (1995) and Ciccone and Matsuyama (1996).
3The considerations in this paper also apply for assumptions in endogenous growth theory. For instance,
Rivera-Batiz and Romer (1991) distinguish between R&D generated by human capital and by “lab
equipment.” These correspond to the labour overhead and final good cases discussed below. Romer (1987),
on the other hand, considers fixed costs in terms of an intermediate input composite.
4 For instance, in their seminal paper, Murphy, Shleifer and Vishny (1989) demonstrate that multiplicity
can only arise if a wage premium is paid to workers in the industrialised sector.
5 The model is a simplified version of the model in Gans (1995).
2
∞ σ −1 σ −1
X = ∫ xn σ dn , σ > 1,
0
where xn denotes the amount of intermediate input of type n that the final good producer
upstream sector. There is a continuum of such firms lying on the (extended) real line.
Households consume final goods not used in production and supply one unit of
labour inelastically for which they receive a wage, w. L is the constant total labour
endowment.
Apart from the usual pricing decisions, potential upstream producers face the
here that the fixed costs are associated with entry rather than modernisation. Entry is costly
in that upstream firms must build a plant of size F in order to begin production. In
principle, the plant requires a combination of labour, intermediate inputs and final goods to
be produced, i.e., F = Ω( LF , X , Y ). For simplicity, I will assume that Ω takes the
This functional form allows us to consider the affects of alternative assumptions on the
substitutability (ε) between labour and final goods, and the intensity of each ( γ ) on the
If they choose to enter into production, firms seek to minimise costs when building
The cost minimising labour, final good and cost functions for a plant of size F are:
6 This involves a simplification in that there is not direct demand for intermediate inputs in plant
production. Here they are only demanded indirectly through the use of final goods.
3
( )
1
Turning to the returns to entry, the technologies of production are the same across
intermediate input sectors. Upstream producers, once they have constructed a plant of size
F , can generate output according to xn = ln . 7 There are no productivity gains to building
larger plants and hence, firms never wish to build a plant greater than size F .
appendix, the general equilibrium of the model is solved for a given k. It is shown that
( )
1
1− ε
c( k ) = F Λ σ α−α k σ −1 + (1 − γ ) 1−ε . Entry raises wages and hence, c(k).
α
ε −1 1− ε
γ This
dose not necessarily reduce total labour demand because while greater industrialisation
involves the use of more labour it also induces firms to build plants using labour less
intensively. The larger is the marginal product of labour in plant production ( γ ) and the
smaller is the elasticity of substitution between labour and final goods ( ε ) the lower is the
As shown in the appendix, when a firm enters into production its total profits are,
α − ( σ −1 )
π = Λ( L − LF ( k ))k σ −1
− c( k ) .
From this it can be seen that greater industrialisation (k) influences firm profits through
three broad pathways. First, greater entry means greater competition and thus, ceteris
paribus, a reduction in revenues for the firm. Second, more of the scarce labour input is
used when greater entry occurs. This resource effect manifests itself in a reduction in
production of final goods and hence, overall demand for intermediate inputs.
Finally, there are wage effects. Greater industrialisation raises wages. On the one
hand, this raises the set-up costs of entry, but on the other, it reduces the potential impact of
the resource effect by causing firms to substitute away from labour in plant production.
7 This production function could be generalised to any constant returns technology without any change in
the results to follow. The use of labour units exclusively for the variable input does not alter the results to
follow, as these costs have a linear effect on the optimal price of firms.
4
Most importantly, however, higher wages raise final good demand and hence, raise the
overall demand for intermediate inputs. It is quite easy to show, however, that overall the
impact of wages on the returns to entry is positive. Note first that c(w) is homogeneous of
degree less than or equal to 1 (the equality holding as γ = 1), while profits net of plant costs
are homogeneous of degree greater than or equal to 1 in the wage level (once again, the
equality holding as γ = 1). This latter feature occurs because higher wages raise the price
and marginal costs of the firm upwards in equal proportion but also cause the total level of
labour in plant production to fall, raising aggregate demand. This means that higher wages
strictly raise the returns to entry when γ < 1 and have no impact when γ = 1.
Both the competitive and resource effects cause the returns from entry to fall as
industrialisation proceeds. However, it is possible that this is mitigated by the wage effect.
Therefore, the entry choices of individual firms could be strategic substitutes or strategic
complements depending on the relative strength of each of these effects. Apart from the
competitive effect, all of the other forces are sensitive to alternative assumptions regarding
the plant production technology. Hence, in what follows, I will explore the equilibria that
II. Equilibria
In the most general case of the model introduced above, characterising equilibria can
become quite complicated. Therefore, to build up intuition I will first consider three special
cases. The first two involve pure labour overhead and final good units in plant production.
In effect, they correspond to previous models that allowed no choice of input intensities in
plant production. The third case considers the situation in which labour and final goods are
In this case, no final goods are used in plant production. This means that when
wages rise no substitution toward final good use occurs and no increase in final good
5
above, the impact of this on entry returns is zero. This leaves only the competition and
resource effects both of which have negative impacts on entry returns. Therefore, profits,
π = Λk σ −1 ( Lk −1 − F σα ) , are shown to be falling in the level of industrialisation (k) -- entry
α
Under free entry, firms will enter into production until the point at which the profits
from doing so become negative. Therefore, setting profits equal to zero, the equilibrium
level of entry is: k̂ = αL σF . This equilibrium is unique and is stable. Since profits are
decreasing at this level of industrialisation, if k < kˆ , entry will rise and it will fall if k > kˆ .
When plant production involves final goods only (i.e., uses a production
technology with the same input intensities as final good production), profits become:
α − ( σ −1 )
π = ΛLk σ −1
− F . In this case, profits are increasing in k if and only if σ − 1 < α -- entry
decisions are strategic complements. This assumption says that the so-called increasing
returns to specialisation ( (σ − 1)−1 )8 outweigh the diminishing returns to the use of the
labour input in final good production (α). Under this assumption, the rise in the efficiency
dominates the competitive effect. These effects are the only relevant ones since the resource
effect is zero. Without this assumption, entry decisions are strategic substitutes across
industrialisation, entry is not profitable and hence, firms do not enter, reinforcing low level
of k. However, when k is above a critical level, k * , defined by k * = ( ΛL F )
− α (−σ( σ−1−)1 )
, entry
becomes profitable, raising k and making further entry profitable. In this equilibrium,
Suppose that labour and final goods were perfectly substitutable for one another in
plant production, that is, Fn = γlnF + (1 − γ )YnF . It is then easy to see that, under cost
Therefore, if wages are below a critical level, plant production consists purely of labour
overhead, otherwise it is purely composed of final goods. Since wages are uniquely
determined by the level of industrialisation, plant production will be pure labour (final
goods) depending upon whether the level of industrialisation, k, is less (greater) than
( )
σ −1
γ
k̃ = α
Λ−1
α
1− γ σ − α .
Suppose σ − 1 < α so that the wage effect dominates the competitive effect and
hence, if plants are composed of final goods, entry decision will be local strategic
complements. So long as 0 < γ < 1, optimal profits, π (k), will fall until k̃ , jump
discontinuously upwards and rise thereafter.10 If this minimal level of profits is less than
zero, two equilibria will exist -- one with pure labour plants and the other pure final goods
plants. This situation is depicted in Figure 1. Here π ( k˜ ) < 0, i.e.,
( )
σ −1
γ −1
L F< σ α
Λ
α
αγ 1− γ σ − α . If the market size to plant size ratio is low, multiplicity arises
exist. At this level of industrialisation, profits when using labour overhead are zero but
wages are low enough to justify that plant production process. In contrast, the final good
of Case II exists. At low values of k, it is always optimal for individual firms to enter into
production with a plant of pure labour overhead. Nonetheless, the multiplicity here still
10 This discontinuity occurs because plants are built without the labour resource, instead raising demand for
final goods and ultimately the returns to entry.
7
Having built up intuition from these special cases, it is now possible to consider the
nature of equilibria in the general case where labour and final goods are imperfect
substitutes in plant production. Internal equilibria will arise for levels of industrialisation
( )
1− ε −1
− F γ − ε Λ σ α−α k σ −1 + (1 − γ )− ε ((1 − γ )Λ σ α−α )− ε k
α − ( σ −1 ) α α ( 1− ε )
π ( k ) = Λ( Lk σ −1 σ −1
)
.
( )
1
1− ε
− F Λ σ α−α k 1− ε
γ ε −1 + (1 − γ )
α 1− ε
σ −1
=0
As in the previous cases if σ − 1 > α , 0 < γ < 1 and ε > 1, the competitive effect dominates
the wage effect and hence, profits falls as k rise. In this case, there is a unique equilibrium.
Note, however, that as k rises the resource effect tends to zero as firms switch to plants
produced using final goods. In this sense, the profit function behaves in a similar manner
When σ − 1 < α , profits fall for low levels of k, reach a critical point, k̃ , and then
rise thereafter. In such a situation, multiple equilibria are possible (see Figure 2).
However, these are special cases. Numerical results indicate that this case occurs the less
the substitutability between labour and final goods in plant production and the higher is the
ratio of market size to plant size. In general, the equilibria correspond to Case II, with a
without bound. Profits are bounded away from zero are k tends to infinity.
III. Conclusion
This paper has explored how the nature of fixed cost assumptions affect the
conclusion of recent theories of industrialisation. It has confirmed the results that having
8
final goods as opposed to labour overhead as fixed costs can generate multiplicity of
equilibria. Indeed, in many ways the case for strategic complementarities across sectors
and hence, for multiplicity has been strengthened by this analysis. Using some final good
input in plant production and giving firms discretion over the composition of plant
production will generate strategic complementarities. In this general case, the critical
π (k)
0
k̂ k̃ k* k
9
π(k)
k
k̂ k*
π(k)
* k
k̂ k
π(k)
k
*
k
Appendix
As final goods producers earn zero profits, the inverse demand for a given
intermediate input depends on the marginal cost of producing a unit of the composite, X.
This is also the price of X and it is denoted by P. Thus,
1
k k
k 1−σ 1−σ
P = min{x }k ∫ pn xn dn ∫ xn dn = 1 = ∫ pn dn . 11
σ −1
σ
n n=0
0 0 0
Profit maximisation by final goods producers yields their demand for an individual variety,
xn = X ( P pn ) , where use is made of the assumption of a Cobb-Douglas production
σ
technology.12 Since intermediate input producers face demand curves with a constant
elasticity, -σ, their optimal pricing scheme after entry is, pn = σσ−1 w , the standard constant
mark-up over marginal costs. With this, some simple substitutions show that,
1 σ
P = σ −1 wk and xn = Xk . In this sense, k can be interpreted as a measure of the level
σ 1−σ 1−σ
of industrialisation.
Now consider the labour market. To satisfy demand, the labour requirement for an
σ
intermediate input producers is simply, ln = Xk 1−σ . Using the Cobb-Douglas assumption,
total labour demands in each sector are:
k k
( α ) = X ( α )( σ −1 )k
PX 1−α
LX = ∫ ln dn + ∫ lnF dn = Xk 1−σ + LF and LY =
1 1
1− α σ 1−σ
.
0 0
w
It is assumed that the labour market clears in every period. Therefore, L = LY + LX + LF .
This gives a solution for X = ( L − LF )( ασ(σ−−α1) )k σ −1 .
1
Finally, it remains to find the wage level. This is determined by the condition that
total household income (the wage bill plus aggregate profits, Π) must equal consumption.
α
That is, Y − YF = wL + Π. 13 From this the wage can be solved as, w = Λ σ α−α k σ −1 where
Λ = ((1 − α )σ ) (α (σ − 1))α σ (σα−α ) . Wages rise with greater industrialisation because this
1− α
raises final good demand and hence, the marginal product of labour and labour demand.
Some simple substitutions give the c(k) and π(k) in the main text.
11 There is a formal difficulty here when k = 0. One could with additional notation assume that there is
always an arbitrarily small subset of upstream that always chooses to produce. However, here it is more
convenient to adopt the convention that when k = 0, P = ∞.
12 In deriving this demand function, the infinite product space is approximated as the limit of a sequence of
finite economies. See Romer (1987, 1990) and Pascoa (1993) for a more complete discussion of this issue.
(
Π = kπ = w( L − kF Φ( w )((1 − γ )w ) )( σ α− α ) − kF w γ + (1 − γ ) )
1
13 −ε 1− ε ε −1 1− ε 1− ε 1
Where and
Y = ( L − kF Φ( w )((1 − γ )w ) ) Λ ασ k .
α
−ε σ −1
11
References
Ciccone, A., and K. Matsuyama (1996), “Start-Up Costs and Pecuniary Externalities as
Barriers to Economic Development,” Journal of Development Economics, 49,
pp.33-59.
Gans, J.S. (1995), “Industrialisation with Specialisation and Modernisation: Static and
Dynamic Considerations,” Discussion Paper, No.95/46, School of Economics,
University of New South Wales.
Murphy, K.M., A. Shleifer, and R.W. Vishny (1989), “Industrialization and the Big
Push,” Journal of Political Economy, 97 (5), pp.1003-1026.
Rivera-Batiz, L.A., and P.M. Romer (1991), “Economic Integration and Endogenous
Growth,” Quarterly Journal of Economics, 106 (2), pp.531-556.