Kremer's O-Ring Theory of Economic Development
The O-ring theory of economic development is a model of economic development put forward by Michael Kremer in 1993, which proposes that tasks of production must be executed proficiently together in order for any of them to be of high value. The key feature of this model is positive assortative matching, whereby people with similar skill levels work together.
The name comes from the 1986 Challenger shuttle disaster, a catastrophe caused by the failure of a single O-ring.
Kremer thinks that the O-ring development theory explains why rich countries produce more complicated products, have larger firms and much higher worker productivity than poor countries.
There are five major assumptions of this model: firms are risk-neutral, labor markets are competitive, workers supply labor inelastically, workers are imperfect substitutes for one another, and there is a sufficient complementarity of tasks.
Production is broken down into 'n' tasks. Laborers can use a multitude of techniques of varying efficiency to carry out these tasks depending on their skill. Skill is denoted by q, where 0≤q≤1. The concept of q differs depending on interpretation. It could mean: the probability of a laborer successfully completing a task, the quality of task completion expressed as a percentage, or the quality of task completion with the condition of a margin of error that could reduce quality. Output is determined by multiplying the q values of each of the n tasks together and then multiplying this result by another term (lets say, B) denoting the individual characteristics of the firm. B is positively correlated with the number of tasks. The production function here is simple:
The important implication of this production function is positive assortative matching. We can observe this through a hypothetical four-person economy with two low skill workers (qL) and two high skill workers (qH). This equation dictates the productive efficiency of skill matching:
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