Should-Read: Michael Kremer (1993): The O-Ring Theory of Economic Development: “This paper proposes a production function describing processes subject to mistakes in any of several tasks…

…It shows that high-skill workers-those who make few mistakes-will be matched together in equilibrium, and that wages and output will rise steeply in skill. The model is consistent with large income differences between countries, the predominance of small firms in poor countries, and the positive correlation between the wages of workers in different occupations within enterprises. Imperfect observability of skill leads to imperfect matching and thus to spillovers, strategic complementarity, and multiple equilibria in education….

Quantity cannot be substituted for quality… workers of similar skill will be matched together… schedule of wages as a function of worker skill. Under this production function, small differences in worker skill lead to large differences in wages and output, so wage and productivity differentials between countries with different skill levels are enormous…. Firms will offer jobs to only some workers rather than paying all workers their estimated marginal product. If tasks are performed sequentially, high-skill workers will be allocated to later stages of production…. If firms can choose among technologies with different numbers of tasks, the highest skill workers will use the highest n technology…. These predictions of the model match stylized facts about the world, and although each of these facts may be due to a variety of causes, together they suggest that O-ring production functions are empirically relevant.

Imperfect matching of workers due to imperfect information about worker skill leads to positive spillovers and strategic complementarity in investment in human capital. Thus, subsidies to investment in human capital may be Pareto optimal. Small differences between countries in such subsidies or in exogenous factors such as geography or the quality of the educational system lead to multiplier effects that create large differences in worker skill. If strategic complementarity is sufficiently strong, microeconomically identical nations or groups within nations could settle into equilibria with different levels of human capital.

Michael Kremer (1993): The O-Ring Theory of Economic Development: Quarterly Journal of Economics 100:3 (August), pp. 551-575