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Document Figure 1.1 Page 11 From this figure it is immediately possible to read off what the economy would produce if all labor were allocated either to the modern or the traditional sector. In either case L/N workers would be employed in the production of each good. If all goods are produced traditionally, each good would have an output Q 1. If they are all produced using modern techniques, the output is Q 2. As drawn, Q 2 › Q 1; this will be the case provided that that is, as long as the marginal cost advantage of modern production is sufficiently large and/or fixed costs are not too large. Since this is the interesting case, we focus on it. file:///D|/Export2/www.netlibrary.com/nlreader/nlreader.dll@bookid=409&filename=page_11.html [4/18/2007 10:29:55 AM]
Document Page 12 But even if the economy could produce more using modern methods, this does not mean that it will. It must be profitable for each individual entrepreneur in the modern sector to produce, taking into account the necessity of paying the premium wage w as well as the decisions of all the other entrepreneurs. Suppose that an individual firm starts modern production while all other goods are produced using traditional techniques. The firm will charge the same price as that on other goods and hence sell the same amount; since there are many goods, we may neglect any income effects and suppose that each good continues to sell Q 1. Thus this firm would have the production and employment illustrated by point A. Is this a profitable move? The firm uses less labor than would be required for traditional production, but must pay that labor more. Draw in a ray from the origin whose slope is the modern relative wage w; OW in the figure is an example. Then modern production is profitable given traditional production elsewhere if and only if OW passes below A. As I've drawn it here, this test is of course failed: it is not profitable for an individual firm to start modern production. On the other hand, suppose that all modern firms start simultaneously. Then each firm will produce Q 2, leading to production and employment at point B. Again, this will be profitable if the wage line OW passes below B. As drawn, this test is satisfied. Obviously, there are three possible outcomes. 3 If the wage premium w - 1 is low, the economy always "industrializes"; if it is high, it never industrializes; and if it takes on an intermediate value, there are both low- and high-level equilibria. One would hardly conclude from this model that the existence of multiple equilibria is highly likely, even given file:///D|/Export2/www.netlibrary.com/nlreader/nlreader.dll@bookid=409&filename=page_12.html [4/18/2007 10:29:55 AM]
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