The O-Ring Theory: The One Theory to Rule Them All
Okay, the subtitle is only a small exaggeration
I studied Michael Kremer’s O-Ring Theory of Economic Development in my Development class in my final year of my bachelor’s. It remains one of the most important ideas I have found in economic development.
I was invited to think about it again by Nicholas Decker’s excellent post on it earlier today.
One of the most important stylized facts that the paper explains is: “Wage and productivity differentials between rich and poor countries are enormous.” According to Lucas (1990), if the income difference between the United States and India were due to differences in physical capital alone, the marginal product of capital in India would be 58 times that of the United States.
And with his theory, Kremer proposes:
“An O-ring production function provides a mechanism through which small differences in worker skill create large differences in productivity and wages.”
Garrett Jones provides a simplified version of the theory:
In firm’s output equals the following, where n is the number of workers, and q (on a scale of 0 to 1) denotes the quality (or skill level of the worker); n*q^n.
The immediate implication of this O-ring technology is that small declines in average skill lead to big declines in productivity. For example, if every production process has two activities, and the workers perform them perfectly, then n=2, q=1, and total output = q*q*2=2. But if the same two-link process is used with two less-skilled workers of q=0.9, then total output = 0.92 *2 =1.62; in this case a 10% drop in labor quality causes a 21% drop in output. And of course, if production in the O-ring sector involves many links, then even if worker quality only declines slightly, the productivity decline can be massive.
I would invite you to read all three, Kremer’s paper, Jones’ paper extending the model, and Nicholas Decker’s Substack, to understand the extensions of the model.
The following video from Marginal Revolution University is also very good, to understand the theory. It’s a classic MRU lesson!
How I found the model useful for myself
Stylized facts from my life that are, to some extent, explained by this model.
(i) I was more productive and a better consumer of knowledge outside the classroom than inside, during my master’s.
When someone asks me for advice regarding the master’s at GIPE, the one nugget I give them is that they should optimize for spending as little time in the classroom as possible (especially with the loosely imposed 75% attendance criterion). While education in a classroom does not necessarily involve sequential tasks as in Kremer’s model, in a classroom format it is a collective production function with interdependencies in the production process. This also connects to Kremer’s discussion of investment in human capital (education) and productivity in the game theoretic model he develops.
Finding people who would be as productive as I wanted to be, or be engaged in the same kind of production process that I wanted to be in, was difficult, if not impossible. I found more value and output in my activities outside the classroom and the institution.
In economic terms, I try to positively assortatively match, given positive cross production in the association production functions.
You should also look at Becker’s theory of marriage markets on this!
(ii) The internet is a great enabler in reducing the effect of national boundaries, and thus across country income disparity.
I work (intern) remotely from India with a team that is largely based in the US. In my previous work and internships, I worked largely with organization within India. Technology, especially the internet, allowed me to “cross” the national boundaries. I noticed a significantly increased level of productivity and enjoyed a much higher wage.
This actually also related to my first point, since ‘outside the classroom’ was largely a function of the internet.
On a related but separate note, I am excited to be heading to a place with people of “my tribe” — in an environment where I have already been highly incentivized to increase my investments in my human capital :)
If you are interested in Development, Robert Lucas wrote some cool papers. I want to say one was the Mechanics of Economic Development. I loved that subject as an undergrad.
When I graduated from university in 2000, labor economics was even less useful than studies in development. We know that countries that are open to trade and capital AND that have stable social structures along with really high rates of savings can develop quickly (Singapore, Hong Kong, Taiwan , South Korea). Even if the economy is pretty closed with a repressive government, development can still occur (the People's Republic of China).
What bothers me so much is all the fake posturing and nonsense criticizing the Washington Consensus. Those who do so always use fake references (claiming that Argentina had a real currency board like Hong Kong, the claim that South Korea was somehow harmed by getting bailed out by the World Bank, with the horror of billionaires losing money (the humanity!), all of it struck me as deranged.
Now those critics are in positions of power, and we have a president putting in place stupid tariffs, development agencies wasting money on social programs that have no measurable benefit on anyone save for rich white NGO workers who want extended paid vacations in the developing world, and worst of all, the failure to promote policies that work has meant that few countries have followed the East Asian tigers outside of Europe (Ireland, Estonia, and to a lesser extent other Eastern EU members). Mexico seems to perpetually be on the verge of a economic growth boom, but Trump will kill that if he gets his misguided tariffs.
So the O-ring theory, what does it really have to do with development? Why does an Indian suddenly become more productive when he sets foot on American soil? With a country such as India, how much are they limiting their own growth by imposing protections on industries? India should be growing far faster than it is. Much of this may be a drag from overbearing government and excessive regulation, but why are pro-growth policies unpopular? I never understood this. Does India have the same kind of economic misconceptions that plague the American voter (see Trump)? I may simply be blinded by the sample of brilliant Indians I have worked and socialized with here in the US, but Indian domestic economic decisions perplex me. How should one learn more about that? Can you recommend any books, articles?