Chapter 3 Lecture – Classic Theories of

Economic Growth and Development

EC348 Development Economics

Opera House, Hanoi*Dennis C. McCornac

Costs

Models of DevelopmentIf we can understand how development occurs, strategies

can be adopted to help countries to develop

(adopted from Biz/ed http://www.bized.co.uk

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Rostow - Stages of Growth

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Rostow - Stages of Growth

• The work of American Walt W. Rostow

• Rostow is an economic historian

• Countries can be placed in one of five categories in terms of its stage of growth:A child in Sierra Leone making breakfast.

Which stage would a country like Sierra Leone fit in?

Copyright: Dave Dyett, http://www.sxc.hu/

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Rostow - Stages of Growth

1. Traditional Society

Characterised by

– subsistence economy – output not traded or recorded

– existence of barter

– high levels of agriculture and labour intensive agriculture

2. Pre-conditions:

Development of mining industries

Increase in capital use in agriculture

Necessity of external funding

Some growth in savings and investment

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Rostow - Stages of Growth

4. Drive to Maturity:– Growth becomes

self-sustaining – wealth generation enables further investment in value adding industry and development

– Industry more diversified

– Increase in levels of technology utilised

As the economy matures, technology plays an increasing role in developing high value added

3. Take off:

Increasing industrialisation

Further growth in savings and investment

Some regional growth

Number employed in agriculture declines

At this stage, industrial growth may be linked to primary industries. The level of technology required will be low

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Rostow - Stages of Growth5. High mass

consumption

– High output levels

– Mass consumption of consumer durables

– High proportion of employment in service sector

Service industry dominates the economy – banking, insurance, finance, marketing, entertainment, leisure and so on.

Copyright: Elliott Tompkins, http://www.sxc.hu

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Criticisms

• Too simplistic

• Necessity of a financial infrastructure to channel any savings that are made into investment

• Will such investment yield growth? Not necessarily

• Need for other infrastructure – human resources (education), roads, rail, communications networks

• Efficiency of use of investment – in palaces or productive activities?

• Rostow argued economies would learn from one another and reduce the time taken to develop – has this happened?

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Market Based

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Market Based• Development is determined by the extent to which the

market is able to allocate resources

• The price signal acts to allocate scarce resources

• Governments limit interference in the working of the economy

• Government role is to encourage enterprise and to reduce regulation and inefficiencies in free markets and establish ownership of property rightsProblems

• Existence of market failure – externalities, monopoly power, public goods

• Problems of lack of infrastructure – education and health, public transport, legal structure

• Problems of equity in allocation – wealth and income distribution

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International Dependence or Dependency Theory

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International Dependence• International division of labour – rich in high value activity,

poor in low value, can be traced back to colonial and imperial dominance

• Dominance of political decision making in the hands of a few wealthy and powerful groups who aim to maintain the status quo

• Such interest groups also exercise power over international institutions and initiatives such as World Trade Organisation, International Monetary Fund, Kyoto talks, etc.

• Advice given to poorer nations has been poor – e.g. lending to less developed countries, investment advice, etc.

• Inability to solve the debt crisis and protectionism continues to prevent development of poorest countries

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Criticism

• Offers causes but no solutions

Talks to free up trade have been going on for many years, progress is slow.

We know that protectionism is disadvantageous to developing countries but how do we go about putting in place solutions to help solve the problem?

Copyright: Doug Wray, http://www.sxc.hu

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Structural Change

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The Solow Model

• Due to Robert Solow, who won Nobel Prize for contributions to the study of economic growth

• A major paradigm:

– widely used in policy making

– benchmark against which most recent growth theories are compared

• Looks at the determinants of economic growth and the standard of living in the long run

https://unlearningeconomics.wordpress.com/tag/the-solow-growth-model

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Explaining the Sources of Growth

• Try to decompose the growth in income into growth in labor, growth in the capital stock, and growth in productivity

• It is a somewhat mechanical exercise, but an interesting descriptive tool

• Assume the following production function: Y = AF(K,L)

• “A” represents the technological level, usually called Total Factor Productivity

• We want to decompose the changes in Y into changes in A, K, and L Next 3 slides for economics majors

Decomposition of the Growth in Income

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ln ln ln ln

ln ln ln ln

aY AK L Y A K L

Taking derivative

d Y d A d K d L

Y A K L

Y A K LY A Y K K Y L L

Y A K Y K L Y L

Decomposition of the Growth in Income - Result

K L

K N

g g a g g

We assume perfect competition so MP = i and MP = w

and we know MP = and MP =

Define as share of pa

Y A K L

K

Y A Y K K Y L L

Y A K Y K L Y LY A K L

Let orY A K L

Y Y

K L

yment to capital as total of national income =

Define as share of payment to labor as total of national income =

Thus, our equation becomes

L

iK

YwL

YY A Y K K Y L L

Y A K Y K L Y L

g g gY K K L La

K

L

We know MP i

We know MP w

ReviewingDefine:

, , ,Y K L

Y K Lg g g

Y K L

Result . .y K K L Lg a g g

.share of in national income,

.share of in national income

growth rate in A

K

L

i KK

Yw L

LY

Aa

A

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• Expression allows one to decompose the changes in Y, and, besides, to estimate the changes in “Total Factor Productivity”

• We can estimate shifts in the production function due to greater efficiency in the use of inputs

• We only need data readily available to do that: income, capital, and labor growth rates, and wages and interest rates

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Imagine an economy that grew at 5% in a given year, when capital stock grew by 7%, and the labor force grew by 2%.

In that same year, the share of labor income in total output was 60%, and the share of capital income was 40%.

We could estimate the growth in productivity as:

a = gy – ωK.gK – ωL.gL

a = 0.05 – 0.4x(0.07) – 0.6x(0.02) = 0.01 = 1%

TFP accounts for 1/5 of the growth in Y

Example

• Word of caution: “A” actually includes a span of different factors, and also measurement error in other variables. Things that will end up captured in “A” may be related to government policies, technological improvements, corruption, more intense use of existing inputs, etc. Indeed, “A” summarizes everything that we don’t know about.

http://www.macrometria.pt/2013/03/05/total-factor-productivity/

3-25http://www.unido.org/data1/wpd/Index.cfm

https://www.conference-board.org/data/economydatabase/Total Economy Database

United Nations Industrial Development OrganizationWorld Productivity Database

Total Factor Productivity

http://www.bruegel.org/nc/blog/detail/article/1218-decoded-brics/

http://www.choicesmagazine.org/choices-magazine/submitted-articles/productivity-growth-in-global-agriculture-shifting-to-developing-countries

Growth in Agriculture Productivity

• Engel’s Law: As incomes rise, the proportion of an individual’s budget spent on food declines (Ernst Engel, 19th century).

• Main function of agricultural sector is to produce food demand for agricultural products doesn’t grow as rapidly as demand for other goods (industrial products and services)

• Therefore, the share of agriculture on national product declines

Structural-Change Models Explanation for Increased Industry and Decline in

Agriculture Share (I)

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• Productivity of the agricultural sector has risen as growth progressed

• That is actually the only reason why we’re able to have people employed in other (non-food producing) activities; in the beginning of human civilization, all time and labor was devoted to food production (“hunting and gathering”)

• Because productivity is higher, a smaller number in agriculture can feed most of the population

Structural-Change Models Explanation for Increased Industry and Decline in

Agriculture Share (II)

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Figure 3.1 The Lewis Model of Modern-Sector Growth in a Two-Sector Surplus-Labor Economy

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Criticisms of the Lewis Model

• Rate of labor transfer and employment creation may not be proportional to rate of modern-sector capital accumulation

• Surplus labor in rural areas and full employment in urban?• Institutional factors?• Assumption of diminishing returns in modern industrial sector

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Why Do Industrialization and Cities Grow Together?

• Economies of scale for some industrial sectors output per unit of input rises as size of the firm rises

• Different kinds of industries want to locate together, so that they can use same support facilities and infrastructure (power stations, transportation, wholesalers); “public good” aspect of infrastructure

• There’s a tendency towards agglomeration in industrial activity

• Also there’s a reinforcement: the larger the number of people living in cities, the higher the demand for industrial products (they do not produce their own food, clothing, etc)

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Division of Labor and Cities

• More generally, since the middle ages, cities tend to be associated with the division of labor

• When a single person is not responsible for all production, there’s an advantage associated with being located close to other people You can sell your chickens and by clothes, soap, corn, etc

• Industrialization tends to increase division of labor increases the return to urban life

This increased urbanization can become problematic. Why?

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Criticism of Investment Models

• Many LDCs have not been able to take-off or achieve maturity despite massive foreign investment

• Many nations have neglected the development of institutions, organizations, and infrastructure required for industrialization

False-Paradigm Model• Economic development relies heavily on funds from international donor

agencies such as the World Bank and IMF

• The policy of these agencies is to support urban industrial growth and impose capitalistic austerity measures

They reinforce the pattern of “dependent development”

The so-called experts don’t really know anything but they keep trying to help anyway, making the situation worse. They are “assisted” by the local elites who have been trained at Western educational institutions and who believe all that bunk. The main problem with the policy prescriptions is that they overlook:

• traditional social structures• highly unequal ownership of land• disproportionate control by elites of financial assets and access to credit

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Approaches to Development• Free-market approach: rely of the allocation role of markets

and limited government involvement in economics. But, there are several areas in which markets fail to achieve efficient outcomes:

– income distribution - public goods

– Externalities - market power

• Market-friendly approach: improve market operation through “nonselective” interventions such as– income redistribution system– investment in social and human capital– environmental protection policy– anti-trust laws

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•Public-choice approach: public officials and bureaucrats in the position of authority are “rent-seeking” citizens acting on self-interest rather than public-interest

•Need a system of checks and balances to monitor the behavior of public officials and bureaucrats•Need a democratic system to let people choose public officials and bureaucrats for limited duration of authority

Approaches to Development

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• Capital Formation

– Physical capital formation: investment in tools, equipment, machinery, buildings

– Social capital formation: investment in roads, dams, airports, railroads, bridges

– Human capital formation: investment in education, training, health, nutrition

– Political capital formation: investment is creating a secular and democratic government and free mass media

Appendix 3.1: Components of Economic Growth

Effect of Growth of Capital Stock and Land on the Production Possibility Frontier

Concepts for Review

• Autarky

• Average product

• Capital-labor ratio

• Capital-output ratio

• Center

• Closed economy

• Dependence

• Dominance

• Dualism

• False-paradigm model

• Free market

• Free-market analysis

• Harrod-Domar growth model

• Lewis two-sector model

• Marginal product

• Market failure

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Concepts for Review (cont’d)

• Market-friendly approach

• Necessary condition

• Neoclassical counterrevolution

• Neocolonial dependence model

• Net savings ratio

• New political economy approach

• Open economy

• Periphery

• Production function

• Public-choice theory

• Self-sustaining growth

• Solow neoclassical growth model

• Stages-of-growth model of development

• Structural-change theory

• Structural transformation

• Sufficient condition

• Surplus labor

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