Photo: Mint
Photo: Mint

Opinion | Lessons we could learn from Kremer’s O-Ring theory

The weakest link in the Indian economy are the MSMEs, whose incentive structure needs policy addressal

Even as India debates the achievement of a $5 trillion economy, the work of the third Nobel prize winner for economics this year, Michael Kremer, especially his O-Ring Theory of Economic Development, becomes significant. The O-Ring Theory owes its name to the National Aeronautics and Space Administration disaster in 1986, involving the space shuttle Challenger. The shuttle was made up of thousands of components. However, it was the malfunctioning of the tiniest of components, the O-ring, brought on by the high temperature at which the shuttle was launched, which caused it to explode.

Kremer, in his 1993 paper, posited that in production processes involving several tasks of different complexities, the skill levels of workers involved in those tasks become important. This is because workers with differential skill levels have different likelihoods of making mistakes. Such errors, made especially by workers with lower skill levels, can turn an entire product worthless. The tiniest and most innocuous components or processes at the company or the economy level can lead to failure.

As India struggles to maintain its economic growth, what are the pointers one can derive from this piece of work?

At an economy level, the micro, small and medium enterprises (MSME) sector is an important O-ring equivalent. The sector at present contributes around 29% to India’s overall gross domestic product (GDP). As the economy moves onto a trajectory of high growth, it is the malfunctioning of this critical component that could cause the failure of the Indian economy.

What makes the MSME malfunction? According to conventional wisdom, the reasons for the non-performance of MSMEs are all too familiar—the lack of access to timely credit, modern technology and requisite skills being the most important. However, the O-ring theory would look at the problems faced by Indian and indeed all developing-country MSMEs differently.

If the O-ring theory is true, the more complex the production process, the costlier each mistake. As such, MSMEs in a country like India, which has a deficit of skilled labour, would concentrate on simple production activities using lower amounts of capital. This is because were they to use large amounts of capital and complex production processes, the less skilled workers, with their greater propensity to make mistakes, would lead to such capital getting wasted. Such firms will then employ less physical capital. A combination of low physical capital and low skilled workers would mean lower output and lower wages within Indian MSMEs, as compared to that within large corporates or those of developed countries that use higher value inputs.

Further, workers themselves would have very little incentive to upgrade their skills. Workers with higher skills may find themselves unemployed, as firms tend to employ workers with matching skills. An MSME manufacturing firm that is producing pins with a large number of unskilled labourers is unlikely to hire a better skilled labourer, paying him double the wages to replace two or three workers. So employees face disincentives to invest in skills, with consequences for joblessness.

Kremer further posits that bottlenecks of all kinds increase the disincentives to invest in skills. If this were true, the O-ring production theory would have deeper implications for smaller firms in countries such as India. Such bottlenecks may take the form of ‘institutional voids’ in the product, capital or labour markets of such countries. They may also take the form of an absence of public goods such as law and order, water and electricity, education, roads, railways and other infrastructure. The lack of complementary public sector inputs and other institutional inputs pose MSMEs challenges that are unlike those faced by their larger counterparts. While the latter may fill in the gaps through vertical integration and build on economies of scale, MSMEs would find it difficult to do so, given their size. They would then find it worthless to build on their inputs, especially skills, in the face of unreliable or missing inputs from the rest of the economy.

Thus, the best skilled labourer will work with other similarly skilled labourers in jobs that involve complex production processes. The productivity of workers in MSMEs then would be far less than that in large corporation and multinationals, exacerbating wage inequities.

What are the policy implications of such an application of the O-ring theory to MSMEs in India?

MSMEs can prove to be India’s vulnerable O-rings, holding the country back from the kind of take-off that is required for a $5 trillion economy. The vulnerability of MSMEs arises because of their low incentive to invest in skilled labour, which can create large differences in productivity and output, and hence wages. Such differences in productivity get exacerbated because of bottlenecks in the form of lack of institutions and public sector goods, which reduce further the incentives to invest in skills. Such gaps can be bridged through education subsidies to improve skills. MSMEs will also need to be educated on this vicious cycle of low skills-low productivity-low skills, and given active support through appropriately designed subsidies to break out of such traps. A path to higher economic growth will require recognising the O-rings in the Indian economy and preventing their malfunctioning.

Tulsi Jayakumar is a professor of economics at S.P Jain Institute of Management and Research, Mumbai

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