Coordinating Development: Can Income-based Incentive Schemes Eliminate Pareto Inferior Equilibria?

Individuals’ inability to coordinate investment may significantly constrain economic development. In this paper we study a simple investment game characterized by multiple equilibria and ask whether an income-based incentive scheme can uniquely implement the high investment outcome. A general property of this game is the presence of a crossover investment point at which an individual’s incomes from investment and noninvestment are equal. We show that arbitrarily small errors in the government’s knowledge of this crossover point can prevent unique implementation of the high investment outcome. We conclude that informational requirements are likely to severely limit a government’s ability to use income-based incentive schemes as a coordination device. The authors are from the University of Pennsylvania and Yale University respectively. We are grateful to Debraj Ray, two anonymous referees and, especially, Dilip Mookherjee for detailed comments. We also thank Dino Gerardi, Stephen Morris and Andrew Newman for helpful comments. Bond thanks the Institute for Advanced Study for hospitality and financial support (in conjunction with Deutsche Bank) over the academic year 2002-03. Any errors remain ours.