© Natalya Brown 2008

ECON 3066Economic

Development

Classic Theories of Economic Development

Reading: Todaro Chapter 3

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QUOTES OF THE DAY

It matters little how much information we

possess about development if we have not

grasped its inner meaning.

(Denis Goulet. The Cruel Choice)

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QUOTES OF THE DAY

Development must be redefined as an attack on the chief evils of the world today: malnutrition, disease, illiteracy, slums, unemployment and inequality. Measured in terms of aggregate growth rates, development has been a great success. But measured in terms of jobs, justice and the elimination of poverty, it has been a failure or only a partial success. (Paul P. Streeten, Former Director, World Development Institute)

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Part I

• Four Major Strands of Thoughts:

Often competing development theories, all trying to explain how and why development does or does not occur.

• Newer models, an eclectic approach, often draw on various aspects of these four classic theories.

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Four Approaches

1) Linear-Stages-of-Growth Models

2) Structural-Change Models

3) International-Dependence Revolution

4) Market Fundamentalism

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1). Linear-Stages-of-Growth Models

• Popular in the 1950’s and 1960’s• The process of development as a series of successive

stages.• Economic theory, right quantity and mixture of saving,

saving and foreign aid, along an economic growth path that had been followed by MDCs.

• Synonymous with rapid, aggregate economic growth• Replaced in the 1970’s by Structural Change and

International Dependence models.

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2). Structural change models

• Used modern economic theory and statistical analysis

• Emphasizing the internal process of structural change that a “typical” DC must go through

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3). International dependence models

• viewed underdevelopment in terms of international and domestic power relationships, institutional and structural rigidities and

• the resulting proliferation of dual economies and dual societies both within and among nations of the world.

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4). Market Fundamentalism

• In the 1980’s and 1990’s the neoclassical counterrevolution focused on the beneficial role of free markets, open economies and the privatization of public enterprises

• suggested that the failure of some economies to develop is a result of too much government intervention and regulation.

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1. Linear-Stages-of-Growth Models

• The LDCs could learn a lot from the historical growth experience of the now MDCs in transforming their economies from poor agrarian societies to modern industrial giants.

• Emphasized the role of accelerated capital accumulation.

• Rostow’s Stages of Growth and Harrod-Domar’s Growth Model

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1.1 Rostow’s Stages of Growth

• Economic development can be described in terms of a series of steps through which all countries must proceed:

1. The Traditional Society

2. The Pre-conditions for take-off into self-sustaining growth

3. The Take-off

4. The Drive to Maturity

5. The Age of High Mass Consumption11

Rostow’s Stages of Growth

• Advanced nations were considered well beyond the take-off stage while underdeveloped nations were seen as still in the traditional or pre-conditions stages.

• Emphasized the need for the mobilization of domestic and foreign investment in order to accelerate growth.

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It also denies Friedrich List’s argument that countries reliant on exporting raw materials may get “locked in”, and be unable to diversify, in that Rostow’s model states that countries may need to depend on a few raw material exports to finance the development of manufacturing sectors which are not yet of superior competitiveness in the early stages of take-off. In that way, Rostow’s model does not deny John Maynard Keynes in that it allows for a degree of government control over domestic development not generally accepted by some ardent free trade advocates.

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As a basic assumption, Rostow believes that

countries want to modernize as he describes

modernization, and that the society will ascent to

the materialistic norms of economic growth.

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1. Traditional Societies

Traditional societies are marked by their pre-Newtonian understanding and use of technology. These are societies which have pre-scientific understandings of gadgets, and believe that gods or spirits facilitate the procurement of goods, rather than man and his own ingenuity. The norms of economic growth are completely absent from these societies.

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2. Preconditions for Take-off

• The preconditions to take-off are, to Rostow, that the society begins committing itself to secular education, that it enables a degree of capital mobilization, especially through the establishment of banks and currency, that an entrepreneurial class form, and that the secular concept of manufacturing develops, with only a few sectors developing at this point. This leads to a take off in ten to fifty years.

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3. The Take-off

• Take-off then occurs when sector led growth becomes common and society is driven more by economic processes than traditions. At this point, the norms of economic growth are well established.

• Transition from traditional to modern economy

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4. The Drive to Maturity

• The drive to maturity refers to the need for the economy itself to diversify. The sectors of the economy which lead initially begin to level off, while other sectors begin to take off. This diversity leads to greatly reduced rates of poverty and rising standards of living, as the society no longer needs to sacrifice its comfort in order to strengthen certain sectors.

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5. Age of High Mass Consumption

• The age of high mass consumption refers to the period of contemporary comfort afforded many western nations, wherein consumers concentrate on durable goods, and hardly remember the subsistence concerns of previous stages.

• in the age of high mass consumption, a society is able to choose between concentrating on military and security issues, on equality and welfare issues, or on developing great luxuries for its upper class.

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Criticism

• Strong bias towards western model of modernization (free vs. controlled markets, China).

• Tries to fit economic progress into a linear system (many countries make false starts, Russia).

• It considers mostly large countries: countries with a large population (Japan), with natural resources available at just the right time in its history (Coal in Northern European countries), or with a large land mass (Argentina).

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1.2 Harrod-Domar Growth Model(AK Model)

• Following on Rostow’s theory the AK model describes the mechanism by which more investment leads to more growth.

• Pointed to the necessity of net additions to the capital stock

• Used to explain an economy's growth rate in terms of the level of saving and productivity of capital.

• It suggests there is no natural reason for an economy to have balanced growth.

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Concepts of Growth

• Warranted growth – the rate of output growth at which firms believe they have the correct amount of capital and therefore do not increase or decrease investment, given expectations of future demand.

• Natural rate of growth – The rate at which the labour force expands, a larger labour force generally means a larger aggregate output.

• Actual growth – The actual aggregate output change.

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Concepts of Growth

• There is no guarantee that an economy will achieve sufficient output growth to sustain full employment in a context of population growth.

• The problem arises when actual growth either exceeds or fails to meet warranted growth expectations. A vicious cycle can be created where the difference is exaggerated by attempts to meet the actual demand, causing economic instability.

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Components

– Capital stock (K)– Output (Y) = GDP– Capital-Output ratio (k): the dollar amount of

capital needed to produce a $1 stream of GDP.

K/Y or ΔK/ΔY– Savings (S) and the savings ratio (s): the fixed

proportion of national output that is used for new investment.

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KIK

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So S = sY (1)• Net investment is the change in the capital stock

I = ΔK (2)• Remember that k = K/Y or ΔK/ΔY, so that

ΔK = kΔY (3)• Net savings must equal to net investment so that

S = I. Combining (1), (2) and (3):

sY = kΔYs/k = ΔY/Y

ΔY/Y is the growth rate of GDP.

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• Increasing the savings rate, increasing the marginal product of capital, or decreasing the depreciation rate will increase the growth rate of output;

• So the growth rate of GDP is determined jointly by the savings ratio, s, and the national capital-output ratio

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• So the rate of growth of GDP is positively related

to the economies savings ratio and negatively

related to the economies capital-output ratio.

• The more economies save and invest, the faster

they can grow but the actual rate of growth is

measured by the inverse of the capital-output

ratio – the output-capital ratio.

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• The fact that LDCs savings levels are often not

enough to meet the levels suggested by the

linear-stages models, the need to fill the

“savings gap” was used to justify massive

transfers of capital and technical assistance

from developed countries to LDCs.

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• More savings and investment is not a sufficient condition for accelerated rates of economic growth. Many LDCs lack the necessary structural, institutional and attitudinal conditions to convert new capital effectively into higher levels of output. They also lacked the complementary factors of production (e.g. skilled labour and managerial competence).

• Also the development strategies proposed by the stages models failed to take into account the global environment in which developing countries exist – one in which development strategies can be thwarted by external forces beyond the countries control.

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• The main criticism of the model is the level of assumption, one being that there is no reason for growth to be enough to maintain full employment, this is based on the belief that the relative price of labour and capital is fixed, and that they are used in equal proportions. The model explains economic boom and bust by the assumption that investors are only influenced by output (known as the accelerator principle), this is now widely believed to be false.

• Sees economic growth and development as the same, in reality, economic growth is only a part of development.

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• Sees economic growth and development as the same, in reality, economic growth is only a part of development.

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2. Structural Change Models

2.1 Lewis Two-Sector Model

2.2 Patterns-of-Development Approach

• These models tend to emphasize the transformation of domestic economic structures from traditional subsistence agriculture economies to more modern, urbanized and industrially diverse manufacturing and service economies.

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2.1 Lewis Two-Sector Model

• The economy consists of two sectors:

– The traditional agricultural sector is typically characterized by low wages, an abundance of labour, and low productivity through a labour intensive production process.

– the modern manufacturing sector is defined by higher wage rates than the agricultural sector, higher marginal productivity, and a demand for more workers initially

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2.1 Lewis Two-Sector Model• Labour can be withdrawn from the traditional

sector without any loss of output

• Focus is on labour transfer and output and employment growth in the modern sector. The rate at which this occurs is determined by the rate of industrial investment and capital accumulation in the modern sector.

• Wages in the industrial sector are fixed at a premium above wages in the traditional sector. It is assumed that rural labour supply is perfectly elastic.

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• Lewis assumed that with the urban wage above the average rural wage, that the modern-sector employers could hire as many surplus rural workers as the wanted without fear of rising wages

•The successive reinvestment of profits from the modern sector would increase the production possibilities of that sector leading to successive increases in the demand for labour. The employment expansion in the industrial sector would continue until all the excess labour from the traditional sector is absorbed. From that point onwards, modern sector wages would rise in order for industrial employers to attract additional workers from the traditional sector.

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•Improvement in the marginal productivity of labour in the agricultural sector is assumed to be a low priority as the hypothetical developing nation's investment is going towards the physical capital stock in the manufacturing sector.

• Over time as this transition continues to take place and investment results in increases in the capital stock, the marginal productivity of workers in the manufacturing will be driven up by capital formation and driven down by additional workers entering the manufacturing sector. Eventually, the wage rates of the agricultural and manufacturing sectors will equalize as workers leave the agriculture for the manufacturing, increasing marginal productivity and wages in the agriculture while driving down productivity and wages in manufacturing.

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• The end result of this transition process is that the agricultural wage equals the manufacturing wage, the agricultural marginal product of labour equals the manufacturing marginal product of labour, and no further manufacturing sector enlargement takes place as workers no longer have a monetary incentive to transition.

• One of the problems with Lewis’ model is that it assumes that the rate of labour transfer and employment creation is proportional to the rate of modern sector capital accumulation. It does not leave room for the possibility that capitalist profits could be reinvested in labour-saving capital equipment nor does it leave room for the possibility of capital flight.

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• The model also assumes surplus labour in rural areas and full employment in urban areas. By and large this is not the case in most developing nations.

•The assumption of a competitive modern-sector labour market that allows modern sector wages to remain fixed until the rural sector labour surplus is exhausted is unrealistic. In reality there is a tendency for urban wages to rise over time, even when there is considerable urban unemployment.

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2.2. Patterns-of-Development Approach

• Focus on the sequential process through which the economic, industrial, and institutional structure of an underdeveloped economy is transformed over time to permit new industries to replace traditional agriculture as the engine of economic growth.

• In contrast to the Lewis model and the original stages view of development, increased savings and investment are perceived as necessary but not sufficient conditions for economic growth.

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2.2. Patterns-of-Development Approach

• Along with accumulation of human and physical capital, a set of interrelated structural changes are needed to make the transition from traditional economy to a modern one.

• Structural changes:– Transformation of production and changes in the

composition of consumer demand– International trade– Resource use– Changes in socioeconomic factors such as

urbanization and the growth and distribution of the population

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• Both domestic and international constraints on development are emphasized.

Domestic constraints: economic constraints (country’s resource endowment and

physical and population size), and institutional constraints (government policies and objectives).

International constraints: Access to external capital, technology and international

trade.• The extent to which countries face these constraints

determines their development level.• The importance of the integrated international system

in which developing countries belong – a system that can promote or hinder their development.

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• Based on extensive empirical work conducted by Hollis B. Chenery and his colleagues identified several characteristic features of the development process:– The shift from agricultural to industrial production– The steady accumulation of physical and human

capital– The shift in consumer demands from basic

necessities to desires for diverse manufactured goods and services.

– The growth of cities and urban industries as people migrate from farms and small towns

– The decline in family size and overall population growth

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CONCLUSIONS

The main hypothesis of structural change models is that development is an identifiable process of growth and change whose main features are similar in all countries.

However recognition is given to the differences in the circumstances of developing countries such as differences in physical endowments.

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CONCLUSIONS

Practitioners of this approach may be lead to draw incorrect conclusions about causality since the approach is based on empirical observation and less on theory.

For example, practitioners may observed the important role of higher education in developed countries and recommend policies to develop an advanced university system even before the majority of the population has gained basic literacy. This policy could backfire by leading to an increase in inequality.

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CONCLUSIONS

Often the patterns identified through empirical observation point to international factors that are largely out of the control of individual countries.

Structural change analysts are optimistic because they believe that the right mix of economic policies will generate beneficial patterns of self-sustaining growth

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3. International-Dependence Revolution

3.1 Neocolonial Dependence Model

3.2 False-Paradigm Model

3.3 Dualistic-Development Thesis

Grew out of the increasing disenchantment with both the stages-of-growth and structural-change models.

Went out of favor in the 80’s and 90’s, its versions enjoyed resurgence in the early years of 21th century.

These models view developing countries as beset by institutional, political, and economic rigidities both domestic and international, and caught up in a dependence and dominance relationship with rich countries.

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3.1 Neocolonial Dependence Model

• Indirect outgrowth of Marxist thinking, laying the blame for the existence of underdevelopment on the shoulders of the historical evolution of a highly unequal capitalist system of rich country-poor country relationships.

• The dominance of the unequal power relationships between the center (the rich countries) and the periphery (the developing countries) renders the attempts by the LDCs to be self-sufficient and independent difficult.

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3.1 Neocolonial Dependence Model

• Also the members of the small elite ruling class in the DCs has principal interests, knowingly or not, that help to perpetuate the international capitalist system of inequality and conformity.

• Directly and indirectly the elite class serve and are

rewarded by international special-interest power groups (e.g. multi-national corporations, multilateral assistance organizations like the IMF), which are tied by the allegiance or funding to the wealthy capitalist countries.

• Often, elite activities tend to hinder any reform efforts that might benefit the population at large leading to perpetual underdevelopment.

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• The continuing poverty in the developing world is largely attributed to the existence and policies of the industrial capitalist countries and their extensions in the form of small but powerful elite groups in LDCs.

• Underdevelopment is seen as an externally-induced phenomenon. Dependent countries can only expand as a reflection of the expansion of the dominant countries. Dependence causes the dependent nations to be both backward and exploited.

• Revolutionary struggles or at least the restructuring of the world capitalist system are therefore required.

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3.2 The False-Paradigm Model

• Less radical than international dependence models, these models attribute underdevelopment to faulty and inappropriate advice provided by well-meaning but often uninformed, biased and ethnocentric international advisers from developed-country assistance agencies and multinational donor organizations.

• The advice given fails to recognize resilient traditional social structures, the highly unequal ownership of land and other property rights, the disproportionate control of elites over domestic and international financial assets and the very unequal access to credit.

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3.2 The False-Paradigm Model.

• The policy advice generated from classical and neo-classical models in many cases merely serve to protect the interests of the existing power groups, both domestic and international.

• Also local university intellectuals, high-government officials and other civil servants receive training in developed-country institutions where they learn ‘irrelevant’ theoretical models.

• Too much ‘technoratic’ measures, e.g. ICOR, investment ratios, privatization and deregulation, neglecting desirable institutional and structural reforms

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3.3 Dualistic Development Thesis

• A world of dual societies, the existence and persistence of increasing divergences between rich and poor nations, and in the DCs, pockets of wealth within broad areas of poverty.

• Four elements of dualism:1. Different sets of conditions, of which some are superior

and others inferior, can coexist in a given space. 2. The coexistence is chronic and not transitional.3. The degrees of superiority or inferiority have a tendency

to increase over time.4. The superior element does little or nothing to pull up the

inferior element and may in fact serve to push it down.

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TWO MAJOR WEAKNESSES OF DEPENDENCE THEORIES

• Offer little formal or informal explanation of how countries initiate and sustain development

• Actual economic experience of LDCs having pursued revolutionary campaigns on industrial nationalization and state-run production has been mostly negative.

Dependency theory suggests that countries should become more inward-looking and less entangled with developed countries, trading only with other developing countries. India and Chine pursuing inwardly directed development experienced stagnant growth and eventually opened up their economies. The Four Asian Tigers emphasized exporting to developed countries and have prospered.

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Structural-Change vs. International Dependence

Structural Change• Emphasis is on traditional

neoclassical theories designed to generate GDP growth

• Optimistic that the right mix of economic policies will generate beneficial patterns of self-sustaining growth

• Underdevelopment is a result of internal constraints such as insufficient savings and investment or lack of education and skills.

International Dependence• Emphasis is on international

power imbalances and the need for fundamental economic, political and institutional reforms both domestic and worldwide.

• Pessimistic in that they offer an appealing explanation of underdevelopment but they offer little formal or informal explanation of how countries can initiate and sustain development.

• Underdevelopment is an externally induced phenomenon

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4. The Neoclassical Counterrevolution

4.1. Challenging the Statist Model: Free Markets, Public Choice and Market-Friendly Approaches

• In developed countries: favored supply-side policies, rational expectation, and privatization

• In developing countries: freer markets and the dismantling of public ownership, statist planning, and government regulation of economic activities.

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• Neoclassicists also obtained controlling power of the world’s two most influential international financial agencies - the World Bank and the International Monetary Fund (IMF).

• Neoclassical counterrevolution argues that underdevelopment is the result of poor resource allocation due to incorrect pricing policies and too much state intervention by overly-active developing-nation governments.

• State intervention often slows the pace of economic growth.

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• Allowing competitive free markets to flourish, privatizing state-owned enterprises, promoting free trade and export expansion, welcoming investment from developed countries and removing the plethora of government regulations and price distortions in factor, product and financial markets, will stimulate both economic efficiency and economic growth.

• Third World is underdeveloped dues to:

heavy hand of the state and corruption, inefficiency, and lack of economic incentives.

• Need to promote free markets and laissez-faire economies

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THREE COMPONENT APPROACHES

(i) The Free Market Approach:

markets alone are efficient competition is effective, if not perfect;

technology is freely available and nearly costless to absorb; information is also perfect and nearly costless to obtain.

So government intervention in this context is distortionary and counterproductive.

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THREE COMPONENT APPROACHES

(ii) Public-choice theory or new political economy approach:

Government can do nothing right. Politicians, bureaucrats, citizens and states are all self-interested and take action to achieve their own ends. Minimal government is the best government.

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THREE COMPONENT APPROACHES

(iii) Market-friendly Approach:

Recognizes the imperfections in LDC product and factor markets and recognizes the need for government to facilitate the operation of markets through market-friendly interventions. Also recognizes that marker-failures are more prominent in developing countries.

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4.1. Traditional Neoclassical Growth Theory

• Traditional neoclassical models of growth are a direct outgrowth of the Harrod-Domar and Solow models, which both stress the importance of savings.

• The Solow Model expanded on the Harrod-Domar formulation by adding a second factor of production – labour – and by introducing a third independent variable – technology – to the growth equation.

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Solow Model• Exhibits diminishing returns to labor and

capital separately and constant returns to both factors jointly.

• Technological progress became the residual factor explaining long-term growth. The level of technological progress was assumed to be exogenous.

1)(ALKYY is GDP, K is the capital stock, L is labour and A represents the productivity of labour which grows at an exogenous rate.

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• According to traditional neoclassical growth theory, output growth results from

– Increases in labour quantity and quality

– Increases in capital

– Improvements in technology

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• Closed economies with lower savings rates grow more slowly in the short run than those with high savings rates and tend to converge to lower per capita GDP levels.

• Open economies experience income convergence at higher levels.

• By impeding the inflow of foreign investment, heavy-handed LDC governments retard growth.

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• The problem with the arguments of the neoclassical counterrevolution is that most LDC economies are so different in structure and organization from the developed countries that the behavioural assumptions and policy prescriptions are often incorrect. – Markets are hardly competitive– The invisible hand often acts to promote the

welfare of those who are already well-off while pushing down the vast majority.

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Conclusions

• In an environment of widespread institutional rigidities and severe socioeconomic inequality, both markets and governments will typically fail.

• The linear-stages model emphasizes the crucial role of savings and investment.

• The Lewis two-sector model emphasizes the importance of attempting to analyze the many linkages between the traditional sector and the modern industry

.

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Conclusions

• International dependence theories highlight the role of the structure and workings of the world economy and the impact of decisions made in the developed world on the growth prospects for LDCs.

• The neoclassical economic models point to the promotion of efficient production and distribution through a proper functioning price system and the damaging effect of government-induced domestic and international price distortions.

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