Fixed Cost Assumptions in Industrialisation Theories

by

JOSHUA S. GANS
Melbourne Business School, University of Melbourne
200 Leicester Street, Carlton, Victoria, 3053, Australia
E-mail: J.Gans@mbs.unimelb.edu.au

First Draft: 7 August, 1995

This Version: 19 November, 1996

A recent literature has demonstrated that fixed costs at the firm level can
lead to strategic complementarities and hence, coordination failure in
industrialisation across sectors. The existence of such complementarities
appears to hinge critically on the nature of these fixed costs -- that is, whether
they are composed of labour overhead or final goods. This paper
endogenises the firm’s choice of fixed cost composition by assuming that
labour and final goods are imperfect substitutes in plant production. It is
shown that allowing for such choice eliminates the criticality of fixed cost
assumptions, focusing attention instead on other parameters as driving forces
of intersectoral complementarities. Journal of Economic Literature
Classification Number: O14.

Keywords: industrialisation, specialisation, complementarities, fixed costs,

multiple equilibria.
 Recent theories of industrialisation have shown how increasing returns at the firm

level can generate market size effects and coordination failure (i.e., multiple equilibria) at

the aggregate level. In these models, increasing returns arise either because of fixed costs

associated with modernisation (the adoption of more efficient process technologies)1 or

entry (the production of a greater variety of commodities).2 However, the conclusions

regarding the likelihood of coordination failure have been shown to depend critically on the

nature of these fixed costs.3 When fixed costs took the form of pure labour overhead, the

industrialisation decisions of individual firms were strategic substitutes and hence,

multiplicity could not be generated without making additional assumptions.4 On the other

hand, Ciccone (1993) and Matsuyama (1995) demonstrated that, when fixed costs were in

final good units (i.e., have the same factor intensity as final good production), entry and

modernisation decisions became strategic complements, a necessary condition for multiple

equilibria in such games (Cooper and John, 1988).

In reality, the intensity of labour as part of the fixed outlays of production is a

choice variable. Firms could choose to build plant using more or less labour depending on

prevailing wage conditions -- they are imperfect substitutes. As such, the purpose of this

paper is to endogenise the choice of factors in plant production. In so doing, the

robustness of the differing conclusions of industrialisation theories can be explored.

I. The Basic Framework

The economy consists of two production sectors.5 The first is a downstream sector

with a measure one continuum of firms who are competitive price-takers producing a
homogenous final good, Y. They combine labour, LY , and a composite of intermediate

inputs, X, according to, Y = X α L1Y−α , α > 0. This final good, Y, is taken as numeraire.

1For example, Murphy, Shleifer and Vishny (1989) and Baland and Francois (1995).
2Matsuyama (1995) and Ciccone and Matsuyama (1996).
3The considerations in this paper also apply for assumptions in endogenous growth theory. For instance,
Rivera-Batiz and Romer (1991) distinguish between R&D generated by human capital and by “lab
equipment.” These correspond to the labour overhead and final good cases discussed below. Romer (1987),
on the other hand, considers fixed costs in terms of an intermediate input composite.
4 For instance, in their seminal paper, Murphy, Shleifer and Vishny (1989) demonstrate that multiplicity
can only arise if a wage premium is paid to workers in the industrialised sector.
5 The model is a simplified version of the model in Gans (1995).
 2

The intermediate input composite is assembled by final good producers according to

the following technology,

σ

 ∞ σ −1  σ −1
X =  ∫ xn σ dn , σ > 1,
0 

where xn denotes the amount of intermediate input of type n that the final good producer

employs. Each variety of intermediate input, n, is produced by a single monopolist in the

upstream sector. There is a continuum of such firms lying on the (extended) real line.

Households consume final goods not used in production and supply one unit of

labour inelastically for which they receive a wage, w. L is the constant total labour

endowment.

Apart from the usual pricing decisions, potential upstream producers face the

decision of whether to enter into production. Following Matsuyama (1995), it is supposed

here that the fixed costs are associated with entry rather than modernisation. Entry is costly

in that upstream firms must build a plant of size F in order to begin production. In

principle, the plant requires a combination of labour, intermediate inputs and final goods to
be produced, i.e., F = Ω( LF , X , Y ). For simplicity, I will assume that Ω takes the

following CES form:

ε

Fn =  γ (lnF ) ε + (1 − γ )(YnF ) ε  , ε > 1. 6

ε −1 ε −1 ε −1

This functional form allows us to consider the affects of alternative assumptions on the

substitutability (ε) between labour and final goods, and the intensity of each ( γ ) on the

equilibria in the model below.

If they choose to enter into production, firms seek to minimise costs when building

their plant. As such, they solve the following problem:

Minimise( l F , Y F ) Fn = Ω(lnF , YnF ) subject to Fn ≥ F .

n n

The cost minimising labour, final good and cost functions for a plant of size F are:

6 This involves a simplification in that there is not direct demand for intermediate inputs in plant
production. Here they are only demanded indirectly through the use of final goods.
 3

( )
1

lnF = F Φ( w )((1 − γ )w ) , YnF = F Φ( w )γ − ε and c( w ) = F w1− ε γ ε −1 + (1 − γ )

−ε 1− ε 1− ε

where Φ( w ) = (γ − ε w1− ε + (1 − γ )− ε ) . As such, entry costs will be dependent on wages.

−1

Turning to the returns to entry, the technologies of production are the same across

intermediate input sectors. Upstream producers, once they have constructed a plant of size
F , can generate output according to xn = ln . 7 There are no productivity gains to building

larger plants and hence, firms never wish to build a plant greater than size F .

The entry decision of producers depends upon demand conditions. In the

appendix, the general equilibrium of the model is solved for a given k. It is shown that

( )
1
1− ε
c( k ) = F  Λ σ α−α k σ −1 + (1 − γ )  1−ε . Entry raises wages and hence, c(k).
α
ε −1 1− ε
γ This
 

dose not necessarily reduce total labour demand because while greater industrialisation

involves the use of more labour it also induces firms to build plants using labour less

intensively. The larger is the marginal product of labour in plant production ( γ ) and the

smaller is the elasticity of substitution between labour and final goods ( ε ) the lower is the

latter negative effect on total labour input.

As shown in the appendix, when a firm enters into production its total profits are,
α − ( σ −1 )
π = Λ( L − LF ( k ))k σ −1
− c( k ) .

From this it can be seen that greater industrialisation (k) influences firm profits through

three broad pathways. First, greater entry means greater competition and thus, ceteris

paribus, a reduction in revenues for the firm. Second, more of the scarce labour input is

used when greater entry occurs. This resource effect manifests itself in a reduction in

production of final goods and hence, overall demand for intermediate inputs.

Finally, there are wage effects. Greater industrialisation raises wages. On the one

hand, this raises the set-up costs of entry, but on the other, it reduces the potential impact of

the resource effect by causing firms to substitute away from labour in plant production.

7 This production function could be generalised to any constant returns technology without any change in
the results to follow. The use of labour units exclusively for the variable input does not alter the results to
follow, as these costs have a linear effect on the optimal price of firms.
 4

Most importantly, however, higher wages raise final good demand and hence, raise the

overall demand for intermediate inputs. It is quite easy to show, however, that overall the

impact of wages on the returns to entry is positive. Note first that c(w) is homogeneous of

degree less than or equal to 1 (the equality holding as γ = 1), while profits net of plant costs

are homogeneous of degree greater than or equal to 1 in the wage level (once again, the

equality holding as γ = 1). This latter feature occurs because higher wages raise the price

and marginal costs of the firm upwards in equal proportion but also cause the total level of

labour in plant production to fall, raising aggregate demand. This means that higher wages

strictly raise the returns to entry when γ < 1 and have no impact when γ = 1.

Both the competitive and resource effects cause the returns from entry to fall as

industrialisation proceeds. However, it is possible that this is mitigated by the wage effect.

Therefore, the entry choices of individual firms could be strategic substitutes or strategic

complements depending on the relative strength of each of these effects. Apart from the

competitive effect, all of the other forces are sensitive to alternative assumptions regarding

the plant production technology. Hence, in what follows, I will explore the equilibria that

arise for alternative assumptions on this technology.

II. Equilibria

In the most general case of the model introduced above, characterising equilibria can

become quite complicated. Therefore, to build up intuition I will first consider three special

cases. The first two involve pure labour overhead and final good units in plant production.

In effect, they correspond to previous models that allowed no choice of input intensities in

plant production. The third case considers the situation in which labour and final goods are

perfect substitutes in plant production. Finally, the general case is considered.

Case I: Pure Labour Overhead (γ = 1)

In this case, no final goods are used in plant production. This means that when

wages rise no substitution toward final good use occurs and no increase in final good
 5

demand is forthcoming. Greater industrialisation results in higher wages but, as noted

above, the impact of this on entry returns is zero. This leaves only the competition and

resource effects both of which have negative impacts on entry returns. Therefore, profits,
π = Λk σ −1 ( Lk −1 − F σα ) , are shown to be falling in the level of industrialisation (k) -- entry
α

decisions are strategic substitutes across sectors.

Under free entry, firms will enter into production until the point at which the profits

from doing so become negative. Therefore, setting profits equal to zero, the equilibrium
level of entry is: k̂ = αL σF . This equilibrium is unique and is stable. Since profits are

decreasing at this level of industrialisation, if k < kˆ , entry will rise and it will fall if k > kˆ .

Case II: Pure Final Good Fixed Costs (γ = 0)

When plant production involves final goods only (i.e., uses a production

technology with the same input intensities as final good production), profits become:
α − ( σ −1 )
π = ΛLk σ −1
− F . In this case, profits are increasing in k if and only if σ − 1 < α -- entry

decisions are strategic complements. This assumption says that the so-called increasing
returns to specialisation ( (σ − 1)−1 )8 outweigh the diminishing returns to the use of the

labour input in final good production (α). Under this assumption, the rise in the efficiency

of final good production of greater industrialisation as reflected by the wage effect

dominates the competitive effect. These effects are the only relevant ones since the resource

effect is zero. Without this assumption, entry decisions are strategic substitutes across

sectors and hence, the resulting equilibria is unique.9

When σ − 1 < α , there exist multiple static equilibria. At low levels of

industrialisation, entry is not profitable and hence, firms do not enter, reinforcing low level
of k. However, when k is above a critical level, k * , defined by k * = ( ΛL F )
− α (−σ( σ−1−)1 )
, entry

becomes profitable, raising k and making further entry profitable. In this equilibrium,

industrialisation can potentially increase without bound.

8 See Romer (1987) and Ciccone (1993).

9 This equilibrium corresponds to k* below.
 6

Case III: Perfect Substitutability (ε = ∞)

Suppose that labour and final goods were perfectly substitutable for one another in
plant production, that is, Fn = γlnF + (1 − γ )YnF . It is then easy to see that, under cost

minimisation, the firm’s choice of plant inputs will be:

 γlnF w < 1−γ γ

F = γlnF + (1 − γ )YnF if w = 1−γ γ .
 (1 − γ )Y F w > 1−γ γ
 n

Therefore, if wages are below a critical level, plant production consists purely of labour

overhead, otherwise it is purely composed of final goods. Since wages are uniquely

determined by the level of industrialisation, plant production will be pure labour (final

goods) depending upon whether the level of industrialisation, k, is less (greater) than
( )
σ −1
γ
k̃ = α
Λ−1
α
1− γ σ − α .

Suppose σ − 1 < α so that the wage effect dominates the competitive effect and

hence, if plants are composed of final goods, entry decision will be local strategic

complements. So long as 0 < γ < 1, optimal profits, π (k), will fall until k̃ , jump

discontinuously upwards and rise thereafter.10 If this minimal level of profits is less than

zero, two equilibria will exist -- one with pure labour plants and the other pure final goods
plants. This situation is depicted in Figure 1. Here π ( k˜ ) < 0, i.e.,
( )
σ −1
γ −1
L F< σ α
Λ
α
αγ 1− γ σ − α . If the market size to plant size ratio is low, multiplicity arises

allowing a labour overhead plant equilibrium with industrialisation level, k̂ = γ αL σF , to

exist. At this level of industrialisation, profits when using labour overhead are zero but

wages are low enough to justify that plant production process. In contrast, the final good

plant equilibrium involves continuing industrialisation similar to the industrialisation

equilibrium in Case II. Significantly, no equivalent to the non-industrialisation equilibrium

of Case II exists. At low values of k, it is always optimal for individual firms to enter into

production with a plant of pure labour overhead. Nonetheless, the multiplicity here still

10 This discontinuity occurs because plants are built without the labour resource, instead raising demand for
final goods and ultimately the returns to entry.
 7

represents coordination failure because aggregate consumption is lower in the labour

overhead plant equilibrium.

The General Case

Having built up intuition from these special cases, it is now possible to consider the

nature of equilibria in the general case where labour and final goods are imperfect

substitutes in plant production. Internal equilibria will arise for levels of industrialisation

such that optimal profits equal zero:

( )
1− ε −1
− F  γ − ε Λ σ α−α k σ −1 + (1 − γ )− ε  ((1 − γ )Λ σ α−α )− ε k
α − ( σ −1 ) α α ( 1− ε )
π ( k ) = Λ( Lk σ −1 σ −1
)
 
.
( )
1
1− ε
− F  Λ σ α−α k  1− ε

γ ε −1 + (1 − γ )
α 1− ε
σ −1
=0
 

As in the previous cases if σ − 1 > α , 0 < γ < 1 and ε > 1, the competitive effect dominates

the wage effect and hence, profits falls as k rise. In this case, there is a unique equilibrium.

Note, however, that as k rises the resource effect tends to zero as firms switch to plants

produced using final goods. In this sense, the profit function behaves in a similar manner

to the case of perfect substitutes.

When σ − 1 < α , profits fall for low levels of k, reach a critical point, k̃ , and then

rise thereafter. In such a situation, multiple equilibria are possible (see Figure 2).

However, these are special cases. Numerical results indicate that this case occurs the less

the substitutability between labour and final goods in plant production and the higher is the

ratio of market size to plant size. In general, the equilibria correspond to Case II, with a

non-industrialisation equilibrium involve k = 0, and an equilibrium where k increases

without bound. Profits are bounded away from zero are k tends to infinity.

III. Conclusion

This paper has explored how the nature of fixed cost assumptions affect the

conclusion of recent theories of industrialisation. It has confirmed the results that having
 8

final goods as opposed to labour overhead as fixed costs can generate multiplicity of

equilibria. Indeed, in many ways the case for strategic complementarities across sectors

and hence, for multiplicity has been strengthened by this analysis. Using some final good

input in plant production and giving firms discretion over the composition of plant

production will generate strategic complementarities. In this general case, the critical

assumptions generating conclusions of intersectoral complementarity or substitutability

become whether wage effects outweigh competitive effects or not.

Figure 1: Multiplicity with Perfect Substitutes

π (k)

0
k̂ k̃ k* k
 9

Figure 2: The General Case

π(k)

k
k̂ k*

( L = 40; α = 0.2; σ = 1.1; ε = 1000; γ = 0.5; F = 4)

π(k)

* k
k̂ k

( L = 40; α = 0.2; σ = 1.1; ε = 10; γ = 0.5; F = 4)

π(k)

k
*
k

( L = 40; α = 0.2; σ = 1.1; ε =2; γ = 0.5; F = 4)

 10

Appendix
As final goods producers earn zero profits, the inverse demand for a given
intermediate input depends on the marginal cost of producing a unit of the composite, X.
This is also the price of X and it is denoted by P. Thus,
1
 k k
  k 1−σ  1−σ
P = min{x }k ∫ pn xn dn ∫ xn dn = 1 =  ∫ pn dn . 11
σ −1
σ
n n=0
 0 0   0 
Profit maximisation by final goods producers yields their demand for an individual variety,
xn = X ( P pn ) , where use is made of the assumption of a Cobb-Douglas production
σ

technology.12 Since intermediate input producers face demand curves with a constant
elasticity, -σ, their optimal pricing scheme after entry is, pn = σσ−1 w , the standard constant
mark-up over marginal costs. With this, some simple substitutions show that,
1 σ
P = σ −1 wk and xn = Xk . In this sense, k can be interpreted as a measure of the level
σ 1−σ 1−σ

of industrialisation.

Now consider the labour market. To satisfy demand, the labour requirement for an
σ
intermediate input producers is simply, ln = Xk 1−σ . Using the Cobb-Douglas assumption,
total labour demands in each sector are:
k k

( α ) = X ( α )( σ −1 )k
PX 1−α
LX = ∫ ln dn + ∫ lnF dn = Xk 1−σ + LF and LY =
1 1
1− α σ 1−σ
.
0 0
w
It is assumed that the labour market clears in every period. Therefore, L = LY + LX + LF .
This gives a solution for X = ( L − LF )( ασ(σ−−α1) )k σ −1 .
1

Finally, it remains to find the wage level. This is determined by the condition that
total household income (the wage bill plus aggregate profits, Π) must equal consumption.
α
That is, Y − YF = wL + Π. 13 From this the wage can be solved as, w = Λ σ α−α k σ −1 where
Λ = ((1 − α )σ ) (α (σ − 1))α σ (σα−α ) . Wages rise with greater industrialisation because this
1− α

raises final good demand and hence, the marginal product of labour and labour demand.
Some simple substitutions give the c(k) and π(k) in the main text.

11 There is a formal difficulty here when k = 0. One could with additional notation assume that there is
always an arbitrarily small subset of upstream that always chooses to produce. However, here it is more
convenient to adopt the convention that when k = 0, P = ∞.
12 In deriving this demand function, the infinite product space is approximated as the limit of a sequence of
finite economies. See Romer (1987, 1990) and Pascoa (1993) for a more complete discussion of this issue.
(
Π = kπ = w( L − kF Φ( w )((1 − γ )w ) )( σ α− α ) − kF w γ + (1 − γ ) )
1

13 −ε 1− ε ε −1 1− ε 1− ε 1
Where and
Y = ( L − kF Φ( w )((1 − γ )w ) ) Λ ασ k .
α
−ε σ −1
 11

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