The O-Ring Sector and the Foolproof Sector: An Explanation for Cross-Country Income Differences

But this O-ring sector, with its increasing returns and strategic complementarities, inherently creates opportunities for slightly-less-skilled workers in any other sector that exhibits diminishing returns--if the O-ring sectors are like "rungs on a ladder," then diminishing returns sectors can fill the space between those "rungs." I consider the implications of this fact for development and inequality, both within and between countries. Other less-skilled workers in that same country aren’t good enough to work in this “O-ring” sector, but they can work in a conventional, diminishing-returns-to-labor “Foolproof” sector. Importantly, high-skilled workers can move between the O-ring and Foolproof sectors. The key assumption of this model is that the wage of high-skilled workers must be equal across the two sectors, a simple invocation of the law of one price. Adding only this "Foolproof" sector to Kremer's "O-ring" sector, I show that in general equilibrium, an econometrician will observe that differences in worker skill will have only a small impact on wages and productivity within a given country; but as the econometrician looks across countries with workers of different average skill, she will find massive observed returns to aggregate skill across countries. This is because across countries, workers of the highest skill level will always work in the "O-ring" sector, which itself generates massive differences in returns to skill. I demonstrate these differences quantitatively, and also discuss interesting exceptions to the benchmark model. I also discuss the implications of the model for public policy and future economic research, and I show that both Hanushek and Kimko (AER, 2000) and Jones and Schneider (EI, forthcoming, and J. Econ. Growth, 2006) provide evidence that differences in worker skill have only a small impact on an individual's wage, but a large impact on a nation's productivity.