Question

If you have to draw any graphs, label them and use them to illustrate a concept

Discuss (in detail) the O-ring theory and explain how it is useful in 2 applications in economic development

Answer 1

The O-ring theory was proposed by Michael Kremer in the year 1993. The model is essentially based on assortative matching where people who have similar skill sets work together. Kremer believes that this theory explains why countries that are rich produce complicated products, they tend to have large firms and more productivity than those who are in poor countries. The five assumptions of the model are:

1. Firms are risk neutral.

2. Workers are not perfect substitutes for each other.

3. Ther labour markets are competitive.

4. The labour supply is inelastic.

5. There is sufficient complementarity in tasks.

The theory was formulated with the help of a production function consists of all the tasks which need to be performed. As per the theory even the smallest task in the production process has to be performed efficiently. The workers with highest qualifications are allocated jobs at the end of the production stage which require more skills. Better workers move to work for better firms which more often than not are located in developed countries. The model was criticised for not being able to suggest policy implications. This theory has many applications as it was tested in various situations:

1. Alberto Dalmazzo used the O-Ring production function along with efficiency wages that showed that those workers who perform identical tasks should be paid lesser than those who perform complex tasks.

2. This theory also explains why a government which wants to attain economic development has to focus on even the smaller industries as is explained by the various policies implemented by the Indian government to foster growth of MSMEs.