Economic   Planning

Planning is defined as conceiving, initiating, regulating and controlling economic activity by the state according to set priorities with a view to achieving well-defined objectives within a given time.

According to Professor Dickinson, economic planning is the making of major economic decisions by a determinate authority on the basis of a comprehensive survey of the economy as a whole. Such decisions include what and how much to produce; how, when and where it is to be produced; and to whom it is to be allocated.

With reference to underdeveloped countries, Subrata Ghatak defines economic planning as a conscious effort on the part of any government to follow a definite pattern of economic development in order to promote rapid and fundamental change in the economy and society.

Essentials of Economic Planning

According to Arthur Lewis, a development plan may consist of the following parts:

1. Survey of current economic conditions2. List of proposed public expenditures3. Discussion of likely development in private sector

4. Macro economic projections of the economy5. Review of government policies

1. Survey of current economic conditions: The economic survey shows the changes in respect of population, NI, taxation, government expenditures and BOP, etc. It also tells us the changes needed or

expected to occur in these economic variables. The economic survey is usually for one year.

2. List of proposed public expenditures: The proposals and suggestions for incurring public expenditures on development projects are invited from various government departments and agencies. After a thorough scrutiny of these recommendations, an order of priority is determined deciding what is to be included, what is to be postponed or rejected as the financial resources are less than required

3. Discussion of likely development in private sector: It is said that both public and private sectors are inter-related and rate of economic development depends more on the working of the private sector than expenditures in public sector. The government reviews the performance of major industries in economic planning, and sets quantitative targets for the plan period. All this involves a brief in-depth analysis of the working and implications of market structure.

4. Macro economic projections of the economy: It refers to the preparation of aggregate models which are applied to the economy as a whole. These models deal with production and consumption as single aggregates. Aggregate models are used to determine the possible growth rates in NI, the division of national product among consumption, investment and exports, the required volume of domestic

savings, imports and foreign assistance needed to carry out a given development programme. This

involves massive calculations and paper works.

5. Review of government policies: The government through development policy can influence the decisions indirectly in the private sector.

Importance / Objectives of Economic Planning w.r.t. Mixed Economy & Under-Developed CountriesIn the following section we will discuss the economic planning with reference to mixed economies and under-developed countries:

1. Efficient utilization of resources: The most essential function of economic planning is to ensure the

best use of given resources within the country. Maximum social benefits can only be ensured when the available resources are allocated and utilized in the most efficient manner. Unused or slack

utilization of resources will adversely affect the employment and productivity level of the economy. The government has to do some arrangements in order to bring equality between demand and supply.

In the market economy, there are wasteful expenditures in the form of selling costs. Sometimes, few producers established their cartels in order to control the market. All this can be undone by the government through effective planning.

2. Market imperfections and price distortions: In market economies, there are certain market imperfections and price distortions both in commodity market and factor market. These distortions rise because of institutional arrangements. As the wage rate in some sectors of the economy exceeds the opportunity cost of the labour. This may be due to trade unions’ influence. Moreover, the goods whose demand is less elastic their producers may pursue monopolistic behaviour. There may be dualistic

approach in the money market. In the organized money market the rate of interest is kept artificially low or inexpensive credit facilities are provided. While on the other hand, in less organized money market or in agriculture market, the ROI is extraordinary high. This situation also creates price distortion. These market imperfections can only be corrected by efficient economic planning.

3. Greater opportunities: The most common benefit that any democratic country enjoys is that the greater market opportunities are and should be provided to the producer and consumers. But this can be handicapped because of two reasons:

(a) Limited life span of an individual(b) Limited resources at the disposal of an individual

4. Because of these common problems, the individuals undertake those projects which require small amount of resources and the profit can be earned within a short period of time. In this way, the individuals would hardly be prepared to launch big projects like construction of highways, power-stations, land-reclamation, anti water logging and salinity schemes, rail-roads, sea ports, telecommunication, etc. It is the duty of the modern government to provide greater resources at the disposal of individuals. At the same time the government has to reduce excessive-consumption or the disposal of resources in few hands. This can only be ensured under efficient economic planning.

5. Maximisation of National Income and Raising Living Standard: It is the responsibility of modern state to maximise the national income and raise the standard of living. It can only be ensured when the government correctly addresses the economic needs of the country and takes desired actions in economic planning.

6. Full Employment: In economically advanced countries, the government’s aim is to provide full employment. All modern governments have, in fact, underwritten employment. If they cannot provide work, they have to give doles. Unemployment is the biggest by product of any capitalist society. The government can redistribute labour and create more work opportunities for both private and public sector.

7. Equitable distribution of income: Economic planning is the most powerful tool of equitable distribution of income. The price-mechanism rewards people according to the resources they possess but contains in itself no mechanism for equalization of the distribution of those resources. Therefore, there is a wide gap between haves and have-nots. Shocking economic inequalities are a marked feature of an unplanned economy. Reduction of economic inequalities is now the avowed aim of a modern welfare state and is impossible without the instrument of economic planning.

8. Public oriented goals: In market economy, only those goods are produced whose demands are backed by money offers. As a result the production of public goods / services, including health, research and education, old-age benefits, poor houses, orphan houses, clean water, sewerage and drainage, free entertainment, art and culture, historical assets, wildlife, forests, security, and defence, are altogether ignored or very less attention is paid. It is planning which distributes the resources between present consumption and future consumption, social development and economic development, etc. As a result the goals of planned economies are more welfare and public oriented.

9. Price Stability: The purpose of economic planning is to reduce the price instability created by business fluctuations. During the period of increasing demand, the price hikes are inevitable due to supply shortages. In under-developed countries, because of low productive capacity, low savings and investment, and traditional set up, the price starts rising very sharply, and its impact on the developing society is very deep. In order to eliminate the adverse effects of price instability and

business fluctuations, the government comes forward and play a vital role in creating a favourable economic condition. This can only be done through wise economic planning.

10. Larger savings and investment: The ultimate task of any finance ministry is to boost up the savings and investment, esp. foreign investment. In UDCs on one hand there is a vicious circle of poverty, while on the other, there is an operation of international demonstration effect. In UDCs, there is a general tendency of demonstration effect within the people, and the whole economy’s growth is hampered by dualism. Savings remain at the lowest level. The boost in investment, domestic or foreign, depends on the level and duration of economic stability. More stable and viable economic growth planning may motivate the investors in investing and thus increasing the level of employment in the economy.

11. Provision of Social Services: In UDCs, the provision of social services forms an important objective of planning. In the fifth five year plan, two important objectives were:

(a) Development of rural areas through various programmes and policies alongwith widespread extension of social services such as schooling, health and clean water facilities.

(b) Easing of urban problems like water supply, sewerage and drainage, electricity, gas supply, housing and transportation facilities, etc.

12. Aid to victims of catastrophe: The granting of assistance and the organisation of relief to victims of natural catastrophes, such as flood, earthquakes, tsunamis, tropical storms, drought, etc. are the main the responsibilities of any government.

Limitations of Economic Planning

The following obstacles come in the way of economic planning:

1. Measurement of labour force: In economic planning, the identification and enumeration of gainfully employed population is a difficult task, esp. in agriculture, where the employment is of part-time or seasonal nature. The important contributions to economic activities by women and children raise further complications. In backward economies, it is very difficult to distinguish between voluntary and involuntary unemployment.

2. Statistical data: The biggest problem with economic planning is that the planner has to work with a limited statistical data provided. Moreover, the planner has to work with these data, collected through different surveys, consensus, polls, etc., without much questioning about their reliability and accuracy.

3. Unused natural resources: The UDCs are identified of their unused natural resources like land, mines, rivers, forests, livestock, sea, etc. A resource such as land, a mineral deposit, a forest or a rive may not be used in production because it is economically inaccessible. A natural resource is valueless when its cost of extraction is greater than the price the product can command in the market. Therefore, the fullest possible use of natural resources is not a sensible aim of an economic planning, and the extent of the use of land or other natural resources is not a measure of economic efficiency. There are four types of resource idleness:

(a) Idleness reflecting the inability of the resource to contribute to profitable production,(b) Withholding of the resources in the interests of monopolistic exploitation of the market,(c) Employment of resources for commercial or private use, and(d) Withholding of a natural resource from current production because the owner believes that it will make a more valuable contribution to production at a later date.

4. Population and real income: The biggest problem regarding human resources is that in UDCs, the population is growing at a very high rate. Moreover, most of the UDCs population heavily rely on agricultural income. The present rate of population growth in India and Pakistan is not significantly greater than in the United States. But the significant point of contrast is that in the South Asia and Central Asia, there is a heavy reliance on comparatively backward agriculture. Real income is vitally affected by the quality of the population.

5. Economic repercussions of social institutions: Certain social institutions, such as extended family

system or joint family system, which are appropriate to a subsistence economy may impede economic growth directly by reducing the rewards of individuals who take advantage of the opportunities presented by wider markets. Subsistence economy is the economy in which people strive for the minimum necessities to support life. The extended family system acts as a serious obstacle to economic progress. A man is much less likely to be willing and able to save and invest, when he knows that he would have to maintain a large number of distance relatives. It minimises the inducement for people to improve their own position. It obstructs the spreading of banking habit since people are unwilling to have banking accounts as there is no willingness to save. However, the economic planner can overcome this situation by introducing private or public insurance or other arrangements to replace the traditional methods for the relief of personal distress or disability.

6. Implications of restrictive tendencies: Social, political and administrative restrictive measures are directed against foreigners on the basis of racial, national or tribal differences. Such restrictive measures are often directed also against the members of local population. It may put restrictions on the movement of people or on the acquisition and exercise of goods or services. It may also be connected with ‘xenophobia’, esp. in the tribal areas and villages. This problem is common in Pakistan and hampers the economic development in rural and tribal areas.

7. Wage rates and unemployment: In UDCs, the wage rate is relatively low and there is a high unemployment rate in the economy. Limited employment opportunities may create a pool of urban unemployed. These urban members do not enjoy the security of the extended family system, nor are they related to agricultural sector. They therefore are apt to constitute a more serious social and political problem then the rural unemployed.

8. Monopsony in the labour market: It is a common situation in UDCs in which there are very few employers and they exercise their monopsony powers in the labour market. Labour is more exploited when the wage rate is below the equilibrium point indicating the unsatisfied demands of labour. Whereas in advanced countries, the supply of labour is elastic and there is little scope for monopsonistic exploitation. The planner must address the labour issues like wage rates, overtime, bonus, allowances, perquisites, working hours, safety measures, health and medical facilities, life insurance, transportation, children education, pension and benevolent funds, old age benefits, income tax on salaries, etc.

9. Uneven distribution of entrepreneurial faculties: The material progress of a society is likely to be assisted greatly when there are dynamic entrepreneurial abilities. In economically backward countries, there are difficulties in the way of developing and utilising the entrepreneurial qualities. The government can support small and medium enterprises to come forward and develop new economic opportunities. The government must encourage, both on private and public level, new agricultural or industrial techniques, adoption or adaptation of new improved methods, innovative activities, internship, on-the-job training, etc. in order to raise the level of economy.

10. Low level of capital in UDCs: The biggest problem of less developed countries is that there is a dearth of capital, whether it is physical or financial. The low level of capital is also indicated by statistics of consumption of energy for purposes of production. In developed countries, there is a high consumption of energy, whereas in UDCs, the energy consumption is considerably low. The general implication of low level of capital is a low level of output and a low level of consumption per head. In such economies, there is no assurance of a continuity in supply of goods. Transport costs are very high and limited availability of perishable or bulky goods. Because of low level of working capital and storage facilities, there is a danger of acute shortage of food crops.

11. Methods of production: The methods of production, farming, marketing and domestic operation are not usually the same in all the countries. What is an economic use of resources in one country may be uneconomic in another in which relative factor prices are comparatively different. It follows that the economic efficiency of methods of production and economic organisation in UDCs cannot be judged simply by comparing them with those familiar in advanced countries. The planner has to jot out all the possible opportunities and focus on major weaknesses, and must plan within the available resources.

12. International demonstration effect: In UDCs, there is a strong desire to enjoy as much of attractive way of living in the advanced countries as incomes permit. There is an international demonstration effect. Moreover, the under developed economy is divided into two extreme sections – traditional section and modern section. There are old and new production methods, educated and illiterate

population, rich and poor, modern and backward, capitalistic and socialistic, donkey carts and motor cars existing side by side. This situation creates great atmosphere of conflict and contradiction, as a result the economic development is hampered.

13. Political instability: Most of UDCs, especially Asian and African countries, are known of their political instability, bureaucratic malfunctioning, corruption on administrative level, and nepotism, like India, Pakistan, Sri Lanka, Bangladesh, Afghanistan, Vietnam, Cambodia, Myanmar, Nigeria, Zimbabwe, Uganda, Somalia, Kenya, etc. Perhaps the biggest challenge for any economic planner is the political and administrative malfunctioning in his way of economic planning.

Elements of Economic Development

The economic development in advanced or under-developed countries depends on four elements:

1. Human resources: In poor countries GDP rises but at the same time the population also grows. Several developing countries are facing high birth rates with stagnant national income per head. It is hard for poor countries to overcome poverty with birth rates so high. In under-developed countries, the economic planners emphasise the following specific programmes:

(a) Control disease and improve health and nutrition,(b) Improve education, reduce illiteracy and train workers, and(c) Ensure that the labour force is well-equipped with necessary and competing skills.

2. Natural resources: Many poor countries have enormous amount of natural resources, but they are failed to explore them. The reason is that the government has not provided necessary incentives to the farmers and landowners to invest in capital and technologies that will increase their land’s yield.

3. Capital formation: Capital formation or inducement to invest depends on the propensity to save. In less-developed countries, there is a very low saving tendency because of low income. Developed countries managed to save 20% of their output in capital formation. Whereas only 5% of the national income is saved in UDCs. Much of the savings goes to housing and basic needs and, therefore, a very small amount is left over for development.

Capital formation is the basic tool for economic development. It may take decades to invest in building up a country’s infrastructure, information technologies, power-generating plants, and other capital goods industries. Developing countries must have to build up their infrastructure, or social overhead capital in order to set path for economic glory.If there are so many obstacles in finding domestic savings for capital formation, then the country depends on foreign sources of funds. Less-developed countries have to welcomed the flow of foreign capital or foreign borrowings. As long as the exports of these countries grew at the same rate as borrowings, it is a favourable condition. But several poor countries needed all their earnings simply to pay interest on their foreign debts. This is an adverse situation. Such countries need to boost up their production in order to cope with their current indebtedness.

4. Technological change and innovations: The developing countries have a potential advantage in the economic development – i.e., they can be benefited from up-to-date technologies developed by advanced countries. They can climbed up to industrialisation more rapidly than those advanced countries who struggled for more than 500 years.

Vicious Cycle of Poverty

Many developing countries are caught up in vicious cycle of poverty. Low level of income prevents savings, retards capital growth, hinders productivity growth, and keeps income low. Successful development may require taking steps to break up the chain at many points. Other points in poverty are also self-reinforcing. Poverty is accompanied by low levels of education, literacy and skill; these in turn prevent the adaptation to new and improved technologies and lead to rapid population growth. The vicious cycle of poverty is depicted as below:

Overcoming the barriers of poverty often requires a concentrated effort on many fronts and a ‘big-push’ is required to break the ‘vicious cycle’ into ‘virtuous circle’. If the country has stepped to invest more, improve health and education, develop labour skills, and curb population growth, she can break vicious cycle of poverty and stimulate a virtuous circle of rapid economic growth.

Stages of Economic Development

W.W. Rustow has defined and analysed in his book ‘The Stages of Economic Growth’ the five stages of economic development:

1. Traditional society,2. Pre-conditions for take-off,3. Take-off stage,4. Drive to maturity, and5. Stage of mass production and mass consumption.

1. Traditional society: In the traditional long-lived social and economic system, the output per head is low and tends not to rise. Economic activities are static and national income is very low. The examples are Somalia, Bangladesh, Afghanistan, etc.

2. Pre-conditions for take-off: The second stage is ‘Pre-take-off’. It is a period of transition in which the traditional systems are overcome, and the economy is capable of exploiting the fruits of modern science and technology. Pakistan, India, Sri Lanka, etc. are operating at this stage.

3. Take-off: Take-off represents the point at which the resistances to steady growth are finally overcome and the growth is normally inevitable. The economy generates its own investment and technological improvement at sufficiently high rates so as to make growth virtually self-sustaining. South Africa, UAE, etc. are the examples.

4. Drive to maturity: The fourth stage is the drive to maturity. It is the stage of increasing sophistication of the economy. Against the background of steady growth new industries are developed, there is less reliance on imports and more exporting activity. The economy demonstrate its capacity to move beyond the original industries which powered its take off, and to absorb and to apply efficiently the most advanced fruits of modern technology. China, South Korea, Malaysia, etc. are the examples.

5. Stage of mass production and mass consumption: The fourth stage ends in the attainment of fifth stage, which is the age of mass production. It is the stage in which there is an affluent population, and durable and sophisticated consumer goods. There are huge capital and technological intensive industries in such an economy. People are more quality conscious and comfort lovers. Wage rates are high. Health and safety issues are addressed by the government. The whole economy is dynamic. USA, UK, France, Germany, Japan, Canada, Italy, Netherlands, Denmark, etc. are the examples.

Approaches to Economic Development

The following approaches are developed in recent years to explain the economic development and answer the question how countries break out of the vicious cycle of poverty to virtuous circle of economic development:

1. The Take-off Approach: Take-off is one of the stages of economic growth. Different economies have been benefited from ‘take-off’ approach in different periods, including England at the beginning of eighteenth century, the United States at the mid of nineteenth century, and Japan in early twentieth century. The take-off is impelled by leading sectors such as a rapid growing export market or an industry displaying large economies of scale. Once these leading sectors begin to flourish, a process of self-sustained growth (i.e. take-off) occurs. Growth leads to profits, profit are reinvested, capital, productivity and per capita income spur ahead. The virtuous cycle of economic development is under way.

2. The Backwardness Hypothesis and Convergence: The second approach emphasises the global context of economic development. Poor countries have important advantages that the pioneers of

industrialisation had not. Developing nations can draw upon the capital, skills and technologies of advanced countries. Developing countries can buy modern textile machinery, efficient pumps, miracle seeds, chemical fertilisers and medical supplies. Because they can lean on the technologies of advanced countries. Today’s developing nations can grow more rapidly than Great Britain, Western European Countries and United States in past. By drawing upon more productive technologies of the leaders, the developing countries would expect to see convergence towards the technological frontier.

3. Balanced Growth: Some writers suggest that growth is a balanced process with countries progressing steadily ahead. In their view, economic development resembles the tortoise making continual progress, rather than the hare, who runs in spurts and then rats when exhausted. Simon Kuznets examined the history of thirteen advanced countries and conceived that the balanced growth model is most consistent with the countries he studied. He noticed no significant rise or fall in economic growth as development progressed.

Note one further important difference between these approaches. The ‘take-off’ theory suggests that there will be increasing divergence among countries (some flying rapidly, while others are unable to leave the ground). The ‘backward’ hypothesis suggests ‘convergence’, while the ‘balanced-growth’ model suggests roughly ‘constant’ differentials. In the following diagrams, advanced countries are represented by curve A, middle income countries by curve B and low-income countries by curve C. The curves show per capita income:

Issues in Economic Development

Following are the important issues in under developed countries:

1. Industrialisation vs. Agriculture: In most countries, incomes in urban areas are almost more than double in rural areas. Many nations jump to the conclusion that industrialisation is the cause rather than effect of affluence. To accelerate industrialisation at the expense of agriculture has led many analysis to rethink the role of farming. Industrialisation tends to be capital intensive, attract workers into crowded cities, and often produces high level of unemployment. Rising productivity on farms may require less capital, while providing productive for surplus labour.

2. Inward vs. Outward Orientation: This is a fundamental issue of economic development towards international trade. Should the developing countries be self-sufficient? If yes, the country has to replace imported goods and services with domestic production. This strategy is known as ‘import substitution’ or ‘inward orientation’.If the country decides to pay for imports it needs by improving efficiency and competitiveness, developing foreign markets, and giving incentives for exporters. This is called ‘outward orientation’ strategy. It is generally observed that by subsidising import substitution, competition is limited, innovation is dampened, productivity growth is slow down and country’s real income falls to a lower level. Whereas, the outward orientation sets up a system of incentives that stimulates exports. This approach maintains a competitive FOREX rate, encourages exports, and minimises unnecessary government regulation of businesses esp. small and medium sized firms.

3. State vs. Market: The cultures of many developing countries are hostile to the operation of markets. Often competition among firms or profit seeking behaviour is contrary to traditional practices, religious beliefs, or vested interest. Yet decades of experience suggest that extensive reliance on markets provides the most effective way of managing an economy and promoting rapid economic growth.

The government has a vital role in establishing and maintaining a healthy economic environment. It must ensure law and order, enforce contracts, and orient its regulations towards competition and innovation. The government plays a leading role in investment in human capital through education, health and transportation, but the government should minimise its intervention or control in sectors where it has no comparative advantage. Government, should focus its efforts on areas where there are clear signs of market failure

Types of Economic Planning

Planning by Inducements

Planning by inducement is often referred to as ‘indicative planning’ or ‘market incentives’. In such type of planning, the market is manipulated through incentives and inducements. Accordingly, in this system there is persuasion rather than compulsion or deliberate enforcement of orders. Here the consumers are free to consume whatsoever they like, producers are free to produce whatsoever they wish. But such freedom of consumption and production are subject to certain controls and regulations. The consumers, producers and other factors of production are induced with the help of various fiscal and monetary devices. For example, if the planning authority wishes to boost the production of corn oil in Pakistan it will provide subsidies, tax holidays and loans to the firms involved in production of corn oil. To encourage savings and investment and discourage consumption a suitable package of fiscal and monetary policies can be introduced in the market. Therefore, the desirable results can be attained with the help of incentives and without the imposition of orders and instructions. Moreover, in such planning there is less sacrifice and less loss of liberty – economic as well as non-economic.

Merits of Planning by Inducements:

(a) Consumers’ sovereignty remain intact. Planning by inducements is more democratic as compare to planning by directions.

(b) There is a freedom of choice of profession.

(c) In planning by inducements, there is freedom of enterprise. Produces are free to produce whatever they like but within in the capacity of given rights.

(d) Planning by inducements is smooth and flexible. It is more popular because it enables to incorporate the changes in resources, technology and taste etc. even after the finalisation and implementation of plan.

(e) Under this sort of planning, the inertia attached with standardisation can be put to an end and producers are free to produce in accordance with the desire of consumers. Therefore, there is a variety of goods and services in the market.

(f) There are less administrative costs involved in planning by inducements.

(g) The problem of shortages and surpluses is solved as there is an existence of automated market system. The demand and supply is automatically adjusted and remain in balance under market economy.

Demerits of Planning by Inducements:

(a) It also fails to achieve 100% targets of economic planning.

(b) Under planning by inducements, there are profit motives more than welfare of public. Private entrepreneurs care for those products which yield high profits. Products or services with less profit or no profit do not attract private entrepreneurs. Such products or services include education, health, defence, security, etc.

(c) The producers may find the government policies regarding economic affairs not attractive enough to follow. There may be disputes among entrepreneurs and the government regarding tax rates, investment policies, interest rates, etc.

(d) The mechanism of market economy may cause the prices to inflate esp. with reference to under-developed countries or in case of oligopoly where there is a shortage of certain products like petroleum and gas.

(e) There may be disharmony between labour and producer, and there may be serious industrial disputes.

Planning by Directions

This type of planning is practised in socialist countries like China, Former USSR, Cuba, North Korea, etc. Under planning by direction, there is one central authority which plans, directs and orders the execution of the plan in accordance with the pre-determined targets and priorities. It determines the production figures, delivery schedules, quotas regarding the production of the goods, price controls, use of foreign exchange and allocation of resources like labour, etc. amongst different competing uses. Thus, such planning is comprehensive and encompasses the whole economy. Planning by directions is similar to military or defence plans which are carried through orders and instructions. Thus the strategy of planning through directions coincides with the military strategy. Alongwith the disintegration of former Soviet Union, the methodology of planning by directions has received certain serious setbacks. Now most of the UDCs are tend to adopt market economic system.

Demerits of Planning by Directions:

(a) Planning by direction is undemocratic since the people are ignored all along.

(b) It is bureaucratic and totalitarian. Under bureaucratic system, the individual’s sovereignty is completely abolished. Corruption, red tapism, VIP system, tyranny and austerity are the by products of bureaucracy.

(c) Rationing and control result in black marketing.

(d) There are shortages of some goods and as well as surpluses of other goods. That is, there is an imbalance in production output.

(e) This sort of planning is inflexible. Once the plan is prepared, there is no room for alterations in later phases of planning. A part of the plan cannot be changed without simultaneous changes in many interconnected activities. Planning by direction is so complex that it is impossible to change even a part of it as it will involve in altering the whole plan.

(f) The fulfilment of plan cannot be guaranteed, as the planning by direction is hampered by black marketing and corruption.

(g) Planning by direction also leads to excessive standardisation which impinges on consumer sovereignty. In other words, under planning by direction the goods produced are standardised lacking the variety. As in case of USSR, the produced TV, Fridges and Automobiles were identical having no differentiation.

(h) It also involves huge administrative costs, as the planning by direction involves in elaborate census, numerous forms and army of clerks.

Physical and Financial Planning

Physical planning is concerned with physical allocation of resources on the one side, while with the product yields on the other side. Its aim is to bring physical balance in between investment and output. Accordingly, investment coefficients are computed. These coefficients show how much amount of investment will be required for a given amount of output. Moreover, in such planning it is also analysed that what will be the composition of investment to obtain an increase in output. As, how much iron, how much coal, oil and electricity will be required to produce some specific amount of steel. While making physical planning, an overall assessment is made regarding the real resources of the economy like raw material and manpower.

In financial planning, equilibrium is established between demand and supply to avoid inflation and bring economic stability. The difference between physical planning and financial planning is that the physical planning tells us the size of investment in terms of real resources, whereas the financial planning tells us the size of investment in terms of money. In financial planning, the planner determines how much money will have to be invested in order to achieve the pre-determined

objectives. Total outlay is fixed in terms of money on the basis of growth rate to be achieved, the various targets of production, estimates of the required quantity of consumer goods and the various social services, expenditure on the necessary infra structure, etc. as well as revenue from taxations, borrowings and savings.

Centralised Planning and Decentralised Planning

Under centralised planning, all the economic decisions are taken by the central authority or the government. It is the government which formulates economic plans, determines objectives, sets targets and priorities. Every member has simply to carry out the instructions without questioning about its viability. There are more chances of failure as the individuals are not allowed to carryout the plans in accordance to their needs and preferences. It is the government who takes responsibility of the success or failure of the plan. It is the government who takes all the decisions of consumption, production, wages and prices. What amount of investment is to be made?, What should be the price?, What should be the output?, How the products are to be distributed?, How much amount of loans is to be granted?, What should be the rate of interest?, etc. Centralised planning is mostly executed in socialist or communist countries.

Decentralised planning is connected with the capitalistic economies. The decentralised planning is implemented through market mechanism. Decentralised planning empowers the individuals or small groups to carryout their plans for achievement of a common goal. Under decentralised planning, the operation is from bottom to top. The planning authority formulates the plan by having made consultation with different administrative units of the economy. The plans regarding different industries are designed by the representatives of these industries. In such type of planning, the planning authority issues the instructions to central and local bodies regarding incentives given over to private sectors.

Structural and Functional Planning

The planning which is aimed at bringing changes in socioeconomic set-up of a country is termed as structural planning. This type of planning is attributed to the planning which was made in USSR in 1929 when the existing land-lord-system was abolished, collective farming was introduced, trade, industries and transport system was nationalised.While functional planning is a type of planning where hardly any big change is brought about in the existing socio-economic set-up of the country. It means when planning is made in the presence of existing institutions is termed as functional planning. In France, Germany, UK, etc planning is being made in the existing framework of capitalism.

Indicative and Imperative Planning

Indicative or planning by inducements has already been discussed in a previous section. In the following section we will discuss the three components or approaches regarding indicative planning:

(a) Forecasting Approach: Under forecasting approach, the individuals are provided with the information, through making certain forecasts. Such forecasting serve as a guide to their decision making. The forecasting not only indicate about the feasible future, but they also specify a desirable future in terms of growth rate of the economy.

(b) Policy Approach: The second component of the indicative planning is concerned with policy approach. Through policy approach, the inconsistent policies of government departments are co-ordinated within a coherent model framework keeping in view the set objectives. Moreover, when once the policies are co-ordinated, they will provide guidelines to the people, consumers and producers.

(c) Corporate Approach: The third way to demonstrate indicative planning is through corporative approach. This approach is practised in France. Here the co-ordination function of indicative planning envisages at two level. In the first place, it requires co-ordination of the behaviour of economic groups like business enterprises and trade unions, etc. which hold power in the market. In the second place, it co-ordinates the relation between private and public activities.

Imperative planning is the planning where the formulation and implementation of the plan is made by the central planning authority. It is also known as ‘directive planning’. Under imperative planning, it is the duty of the state to provide necessary supplies like raw material, machines, manpower and entrepreneurs as all such resources are owned by the state. Under socialist economies, where the imperative planning is in practice the planners always prefer future consumption over present consumption. Thus under imperative planning the priorities laid down by the planners always supersede those of masses. There is no consumer sovereignty under imperative planning.

Democratic and Totalitarian Planning

Under democratic planning, the philosophy of democracy is followed. Since formulation to the execution of the plan, the people are taken into confidence. Whenever the plan is prepared, the ruling party makes a dialogue with the public firms and even with opposition party. The purpose of such arrangements is to satisfy different segments of the economy regarding growth and welfare programmes. After the formulation of the plan, an open discussion is make in the parliament. Under democratic planning, whole of the economic activities are performed through price mechanism. The government influences the private sector through fiscal and monetary policies. Moreover, the government passes anti-monopoly laws to protect the consumer’s sovereignty.

In totalitarian planning, there is a central control, and all economic activities are governed by the central authority. In totalitarian planning, all of consumption, production, distribution and exchange like activities are controlled by the central planning authority. Totalitarian allows no consumer sovereignty and democratic freedom.

Fixed Plan and Rolling Plan

Fixed Plan

In a fixed plan, the contents of the plan are fixed in relation to a fixed time period. These contents consisting of targets, priorities, strategies and resources, etc. will not be changed during the particular time period for which the plan has been prepared except for severe unforeseen events.

Merits of Fixed Planning:

(a) There is a boldness in planning. This is the essence of planning that the planners and implementing machinery will not bow down before the obstacles.

(b) There is effective implementation of plan.

(c) The targets of fixed plan are certain and this certainty in objectives brings stability to the economy.

(d) Fixed plans ensure discipline for the planning process.

Demerits of Fixed Planning:

(a) Fixed plans are inflexible plan. They cannot be altered in later phases.

(b) There is no revision of economic objectives and targets as there is no alteration allowed under fixed planning.

(c) If the state is an under-developed country, the fixed plan would give the economy a hard time to achieve the basic objectives like employment, industrialisation, education, health, etc.

(d) Fixed plans, if not properly formulated and implemented, lead to wastage of resources.

Rolling Plan

Rolling planning refers to the rolling of a plan at intervals usually one year, so that it continues to be a plan of certain number of years. It is usually the medium term plan.

Merits of Rolling Plan:

(a) Rolling plans are flexible and can be altered in later phases.

(b) The rolling plan allows for revisions and adjustments. In rolling plan, review of the plan is a continuous exercise.

(c) Rolling plans enable the planners to keep the time horizon moving, alongwith making revisions and adjustments so as to prepare a new plan every year in accordance with the changing circumstances.

Demerits of Rolling Plan:

(a) Rolling plan is furnished with uncertainty, as there is no fixation of economic objectives.

(b) In rolling plans, the planners are always reluctant in taking difficult decisions or taking courageous decisions.

(c) Under rolling plan, there is a lack of commitment. As there is no fixity attached with the plans, the enthusiasm on the part of planning and administrative machinery will hardly be found.

Short-term, Medium and Long-term Planning

Short-term plans are also known as ‘controlling plans’. They encompasses the period of one year, therefore, they are also known as ‘annual plans’. In annual plans or budgets the financial aspects of the plan, i.e., financial sources and applications are shown. In the annual developmental plans the items pertaining to capital budgets, i.e., the capital revenue and expenditure are listed. The main objectives of short-term planning is to raise the revenue, attain the short-term economic targets, bring price stability, and remove deficit in BOP.

The medium-term plans last for the period of 3 to 7 years. But normally, the medium term plan is made for the period of five years. The medium-term planning is not only related to allocation of financial resources but also physical resources. The main objectives of medium-term economic planning are to raise per capita income, raise the level of employment, create self-sufficiency in the economy, reduce dependence over foreign aid and raise revenues through domestic sources, and to remove regional and intra-regional disparities.

Long-term plans last for the period of 10 to 30 years. They are also known as ‘perspective plans’. The origin of long-term planning goes back to USSR where Goelro Plan 1920-35 was first formulated and implemented in 1920. The basic purpose of that plan was to electrify the rural areas. The basic philosophy behind long-term planning is to bring structural changes in the economy. Under long-term planning, there is greater freedom of choice and there is a wide scope of planning.

Corrective and Developmental Planning

The planning consisting of fiscal and monetary measures with the aim of removing the imbalances of the economy is known as ‘corrective planning’. As to control inflation, if the government follows a very strict fiscal and monetary package; controls aggregate demand by checking consumption, investment and government expenditure – this will be the case of corrective planning.

On the other hand, the planning which is aimed at developing the whole economy is known as developmental planning. Development planning involves the application of a rational system of choices among feasible courses of investment and other development actions.

Capitalist and Socialist Planning

Capitalistic economy is also known as ‘free-enterprise economy’. Under capitalism, there was no authority governing the planning activity. All the economic activities were controlled by the private sector. The state function was limited to tax collection and defence. There was no public welfare measures, no developmental planning and no labour rights. But with the capacity of time esp. after the great depression of 1930s and development of economic, social and political economic thoughts, the capitalist economies adopt the modern functions like:

(a) formulating and implementing monetary, fiscal and trade policies,

(b) promulgating anti-monopoly and anti-cartel laws,

(c) working for the sake of community’s benefits,

(d) formulating and implementing development plans

(e) providing basic facilities of health, education, transportation, communication, and recreation, etc.

In socialism, the central planning board formulates the plan which covers the whole economy. The central planning board has unlimited powers regarding allocation of resources and production of goods and services. The central planning authority determines the goals and priorities regarding distribution of national income, employment, economic needs, capital accumulation and economic growth. Under socialism all factories, resources, financial institutions, shops, stores, ware houses, foreign and domestic trades, means of communication and transportation are under government control.

Planning under Mixed Economy

Most economists suggest the operation of mixed economy because both extreme capitalistic and socialistic system are not suitable. Capitalistic or free enterprise economy are characterised by lot of problems including misallocation of resources, market imperfections, monopolies, oligopolies, labour exploitation, widening gap between haves and have-nots, and consumer’s exploitation. On the other hand, socialistic form of economy may create the problems like State’s monopoly and supremacy, bureaucratic hold, corruption, red tapism, VIP-system, loss of consumer’s sovereignty, standardisation of products, poor quality of products, less foreign trade, etc.

While in case of mixed economy, consumer’s sovereignty, private property ownership and operation of price mechanism are ensured. The public sector also works parallel to private sector. The public sector in a mixed economy consists of those projects which require heavy funds like railways, air transportation, roads, bridges, fly-overs, underpasses, power generation, irrigation, telecommunication, research, etc. The government also addresses people’s basic needs like employment, health, and education. In under-developed countries, the government also provides housing facilities to poor families. To avoid labour exploitation and consumer’s exploitation, the government promulgates anti-monopoly and anti-cartel laws. In mixed economies, the government even adopts safety measures against pollution and unhealthy working conditions in factories, offices, etc. In case of agricultural sector, the government provides short term loans to farmers, and imports farm machines.

Economic Development

Economic development is fundamentally about enhancing a nation’s factors of productive capacity, i.e., land, labour, capital, and technology, etc. By using its resources and powers to reduce the risks and costs, which could prohibit investment, the public sector often has been responsible for setting the stage for employment-generating investment by the private sector. The public sector generally seeks to increase incomes, the number of jobs, and the productivity of resources in regions, states, counties, cities, towns, and neighbourhoods. Its tools and strategies have often been effective in enhancing a

community's:

*labour force (workforce preparation, accessibility, cost)*

infrastructure (accessibility, capacity, and service of basic utilities, as well as transportation and telecommunications)*

business and community facilities (access, capacity, and service to business incubators, industrial/technology/science parks, schools/community colleges/universities, sports/tourist facilities)*

environment (physical, psychological, cultural, and entrepreneurial)*

economic structure (composition)*Institutional capacity (leadership, knowledge, skills) to support economic development and growth. 

However, there can be trade-offs between economic development's goals of job creation and wealth generation. Increasing productivity, for instance, may eliminate some types of jobs in the short-run. Economic development encompasses a broad and expansive set of activities and tools that assist communities in growth and prosperity. The best economic development practitioners strive to bring quality jobs, new businesses and increased services (along with numerous other benefits) to communities through innovative approaches and outcome driven strategies.

Technology development has added a new dimension to the role of economic development professionals. The quest for increased technology can be confusing and challenging from many perspectives. Communities must judge to what extent they should strive to recruit and support the technology industry, how to determine the proper role of advanced technology on the organization’s everyday activities and design ways to help local businesses tap into technology opportunities. Many communities have been able to incorporate technology into both their practices and programs while others have struggled to understand the capabilities of this industry. As the information age and technology sector maintain steady growth, the need for more advanced economic development activity is expanding as well. Technology development encompasses increased infrastructure capabilities, advanced financing options, innovative marketing processes and start-up business assistance.

Economic Development vs. Economic Growth

*

Development is a qualitative change, which entails changes in the structure of the economy, including innovations in institutions, behaviour, and technology*

Growth is a quantitative change in the scale of the economy - in terms of investment, output, consumption, and income. 

According to this view, economic development and economic growth are not necessarily the same thing. First, development is both a prerequisite to and a result of growth. Development, moreover, is prior to growth in the sense that growth cannot continue long without the sort of innovations and structural changes noted above. But growth, in turn, will drive new changes in the economy, causing new products and firms to be created as well as countless small incremental innovations. Together, these advances allow an economy to increase its productivity, thereby enabling the production of more outputs with fewer inputs over the long haul. Environmental critics and sustainable development advocates, furthermore, often point out that development does not have to imply some types of growth. An economy, for instance, can be developing, but not growing by certain indicators. Indeed, the measure of productivity should not be solely monetary; it should also address the issues like how

effectively scarce natural resources are being used? How well pollution is being reduced or prevented? Etc.

Stages of Economic Development

Professor W.W. Rustow has defined and analysed in his book ‘The stages of economic growth’, the five stages of economic development:

1. The traditional society: In the traditional long-lived social and economic system, the output per head is very low and tends not to rise. There are still few examples of traditional societies in this 21st century, that is, Afghanistan, Somalia, Ethiopia, etc.

2. The pre-conditions for take-off: sometimes also referred to ‘preparatory period’. It covers a long period of a century or more during which the preconditions for take-off are established. These conditions mainly comprise fundamental changes in the social, political and economic fields; for example, (i) a change in society’s attitudes towards science, risk-taking and profit-earning, (ii) the adaptability of the labour force; (iii) political sovereignty; (iv) development of a centralised tax system and financial institutions; and (v) the construction of certain economic and social overheads like rail roads and educational institutions.

3. The take-off stage: This is the crucial stage which covers a relatively brief period of two or three decades in which the economy transforms itself in such a way that economic growth subsequently takes place more or less automatically. The take-off is defined as the interval during which the rate of investment increases in such a way that real output per capita rises and this initial increase carries with it radical changes in the techniques of production and the disposition of income flows which perpetuate the new scale of investment and perpetuate thereby the rising trend in per capita output.

4. The drive to maturity: It is the stage of increasing sophistication of the economy. Against the background of steady growth, new industries are developed, there is less reliance on imports and more exporting activity. The economy demonstrate its capacity to move beyond the original industries which powered its takeoff, and to absorb and to apply efficiently the most advanced fruits of modern technology.

5. The stage of mass production and mass consumption: The fourth stage ends in the attainment of fifth stage, which is the period of mass production and consumption. The economy is characterised by affluent population, availability of durable and sophisticated consumer goods, hi-tech industries, and production of diversified goods and services. USA, UK, Canada, France, Germany, Japan, Spain, Italy, etc are the examples.

Characteristics of Developing Economies

A developing country is one with real per capita income that is low relative to that in industrialised countries like US, Japan and those in Western Europe. Developing countries typically have population with poor health, low levels of literacy, inadequate dwellings, and meagre diets. Life expectancy is low and there is a low level of investment in human capital.

1. Deficiency of capital: One indication of the capital deficiency is the low amount of capital per head of population. Shortage of capital is reflected in the very low capital-labour ratio. Not only is the capital stock extremely small, but the current rate of capital formation is also very low, which is due to low inducement to invest and to the low propensity to save. Thus low level of per capita income limits the market size.

2. Excessive dependence on agriculture: Most of the less-developed countries are agrarians. In Pakistan, most of the people are engaged in agriculture. Whereas in developed countries 15% of the population is engaged in agriculture. The excessive dependence on agriculture in less developed countries is due to the fact that non-agricultural occupations have not grown in proportion with the growth in population. Hence, the surplus labour is to be absorbed in agriculture.

3. Inequalities in the distribution of income and wealth: In under-developed countries, there is a concentration of income in a few hands. In other terms, the income is insufficient to meet the requirements of the whole economy. Such income is diverted to non-productive investments such as jewellery and real-estates, and unproductive social expenditure.

4. Dualistic economy: Dualistic economy refers to the existence of two extreme classes in an economy, particularly less-developed economy. There are old and new production methods, educated and illiterate population, rich and poor, modern and backward, capitalists and socialists, donkey carts and motor cars existing side by side. This situation creates an atmosphere of great conflict and contradiction, and hampers the economic development in the long-run.

5. Lack of dynamic entrepreneurial abilities and highly skilled labour

6. Inadequate infrastructure: like airports, rail roads, highways, overheads, bridges, telecommunication facilities, sewerage and drainage, power generation, hospitals, etc.

7. Rapid population growth and disguised unemployment

8. Under-utilisation of natural resources

9. Poor consumption pattern: In less-developed countries, most of the people’s income is spent on basic necessities of life. They are too poor to spend on other industrial goods and services.

Determinants of Economic Growth

(Factors of Economic Development in UDCs / Reasons of Failure of Under-Developed Countries)

The process of economic development is a highly complex phenomenon and is influenced by numerous and varied factors, such as political, social and cultural factors. The supply of natural resources and the growth of scientific and technological knowledge also have a strong bearing on the process of economic development. From the standpoint of economic analysis, the most important factors determining the rate of economic development are:

1. Availability of natural resources: The availability and use of natural resources within a country play a vital role in the economic development. Many poor countries have enormous amount of natural resources, but they are failed to explore them. The reason is that the government has not provided necessary incentives to the farmers and landowners to invest in capital and technologies that will increase their land’s yield. In natural resources, minerals, oil and gas, forests, oceans and seas, livestock, land’s fertility, and mountains are generally included. It must be noted here that the existence of natural resources is not a sufficient condition of economic growth. Many poor and under-developed countries are rich with natural resources but there is a problem of availability of capital required for their extraction. Such countries include Pakistan, India, Afghanistan, and several African and Latin American countries.

2. Rate of capital formation: The second important factor of economic development is the rate of capital formation. Keynes also ascribed the economic development of Europe to the accumulation of capital. According to him, Europe was so organised socially and economically as to secure the maximum accumulation of capital. The crux of the problem of economic development in any under-developed country lies in a rapid expansion of the rate of its capital investment so that it attains a rate of growth of output which exceeds the rate of growth of population by a significant margin. Only with such a rate of capital investment will the living standards begin to improve in a developing country.

Capital formation or inducement to invest depends on the propensity to save. In less-developed countries, there is a very low saving tendency because of low income. Developed countries managed to save 20% of their output in capital formation. Whereas only 5% of the national income is saved in UDCs. Much of the savings goes to housing and basic needs and, therefore, a very small amount is left over for development.

Capital formation is the basic tool for economic development. It may take decades to invest in building up a country’s infrastructure, information technologies, power-generating plants, and other capital goods industries. Developing countries must have to build up their infrastructure, or social overhead capital in order to set path for economic glory.

If there are so many obstacles in finding domestic savings for capital formation, then the country depends on foreign sources of funds. Less-developed countries have to welcomed the flow of foreign capital or foreign borrowings. As long as the exports of these countries grew at the same rate as borrowings, it is a favourable condition. But several poor countries needed all their earnings simply to pay interest on their foreign debts. This is an adverse situation. Such countries need to boost up their production in order to cope with their current indebtedness.

3. Capital-output ratio: Apart from the ratio of capital formation to the aggregate national income, the growth of output depends upon the capital-output ratio. The capital-output ratio may be defined as the relationship of investment in a given economy or industry for a given time period to the output of that economy or industry for a similar time period. The productivity of capital depends on many factors such as the degree of technological development associated with capital investment, the efficiency of handling new types of equipment, the quality of managerial and organisation skill, the existence and the extent of the utilisation of economic overheads and the pattern and rate of investment. For instance, the higher the proportion of investment devoted to the production of direct commodities, the lower the capital-output ratio, and higher the proportion of investment devoted to public utilities, i.e., economic and social overheads, the higher shall be the capital-output ratio, and vice versa. Higher the investment devoted to heavy industry, the higher will be the capital-output ratio, and vice versa. Higher the rate of investment and greater the technological progress, the lower will be the capital-output ratio. The capital-output ratio also varies with the prices of inputs.

4. Technological progress: The key to economic development for any country is the technological progress. Greater the technological progress, the higher will be the economic progress. The great importance of technological progress in the economic progress of Western European countries was recognised by Karl Marx himself. The technological progress of a country includes development in research and development, means of transportation, telecommunication, energy-generation, oil and gas exploration, information technologies, integrated circuits manufacturing, etc. Again, without capital formation, the technological progress is impossible, because building huge hi-tech industries requires a huge investment and a favourable economic condition.

5. Dynamic entrepreneurship: The modern economists recognise the dynamic role of entrepreneurs in promoting the economic growth of the country. The efficient utilisation of entrepreneurial skills can only be ensured when there is presence of considerable profit motive. The entrepreneur maximises his profit by making innovations, i.e., by bringing out a new product, new technologies, new product lines, new market, new sources of raw materials and by adopting an optimum combination of factors of production. Thus he is making the most significant contribution in the national income and in the technological progress.

The private enterprises in UDCs like India and Pakistan, has not taken them any far on the road of economic development. There is a lacking of entrepreneurial skills in under-developed countries. There is a lack of innovation. Entrepreneurs are more attracted by commerce than by industries. So it becomes the government’s duty to ensure the supply of required type of entrepreneurship.

6. Human Resources: Besides efficient entrepreneurs, the economic development of a country depends on the supply of skilled and semi-skilled labour, and requires government’s greatest contribution to the development of human resources. The development of human resources depends on the availability of hygienic food; quantity and quality of education centres and health centres; clean water; means of transportation and communication; entertainment; counselling services; loan facilities; scholarship; job security and old age benefits; etc.

In poor countries GDP rises but at the same time the population also grows. Several developing countries are facing high birth rates with stagnant national income per head. It is hard for poor countries to overcome poverty with birth rates so high. In under-developed countries, the economic planners emphasise the following specific programmes:

(a) Control disease and improve health and nutrition,

(b) Improve education, reduce illiteracy and train workers, and

(c) Ensure that the labour force is well-equipped with necessary and competing skills.

7. Rate of growth of population: The size and rate of population growth has an important bearing on the economic development of a country. A rapidly growing population aggravates the food problem, worsens the unemployment situation, adds to the number of unproductive consumers, keeps down per capita income and labour efficiency, and militates against capital formation. A rapid rate of population growth acts like a drag on economic development and slows down the pace of economic growth.

8. Price Mechanism: In under-developed economies, a very little emphasis is placed on price mechanism. The disequilibrium of prices has severe consequences on the efficiency of the economy. The resource utilisation becomes lack of optimality. The productive machinery of the community is hampered. There is no guarantee as regard to the quantity and quality of the production.

In order to speed up the economic development, price mechanism must go or confined to unimportant sectors of the economy like the purchase and sale of consumer goods.

9. Non-economic factors: Non-economic factors include social factors, demographical factors, institutional factors and political factors. The economic development depends on the political sovereignty, the complexion and competence of government, quality of administration, and political ideology of government.

Vicious Cycle of Poverty

Many developing countries are caught up in vicious cycle of poverty. Low level of income prevents savings, retards capital growth, hinders productivity growth, and keeps income low. Successful development may require taking steps to break up the chain at many points. Other points in poverty are also self-reinforcing. Poverty is accompanied by low levels of education, literacy and skill; these in turn prevent the adaptation to new and improved technologies and lead to rapid population growth. The vicious cycle of poverty is depicted as below:

Overcoming the barriers of poverty often requires a concentrated effort on many fronts and a ‘big-push’ is required to break the ‘vicious cycle’ into ‘virtuous circle’. If the country has stepped to invest more, improve health and education, develop labour skills, and curb population growth, she can break vicious cycle of poverty and stimulate a virtuous circle of rapid economic growth.

Approaches to Economic Development

The following approaches are developed in recent years to explain the economic development and answer the question how countries break out of the vicious cycle of poverty to virtuous circle of economic development:

1. The Take-off Approach: Take-off is one of the stages of economic growth. Different economies have been benefited from ‘take-off’ approach in different periods, including England at the beginning of eighteenth century, the United States at the mid of nineteenth century, and Japan in early twentieth century. The take-off is impelled by leading sectors such as a rapid growing export market or an industry displaying large economies of scale. Once these leading sectors begin to flourish, a process of self-sustained growth (i.e. take-off) occurs. Growth leads to profits, profit are reinvested, capital, productivity and per capita income spur ahead. The virtuous cycle of economic development is under way.

2. The Backwardness Hypothesis and Convergence: The second approach emphasises the global context of economic development. Poor countries have important advantages that the pioneers of industrialisation had not. Developing nations can draw upon the capital, skills and technologies of advanced countries. Developing countries can buy modern textile machinery, efficient pumps, miracle seeds, chemical fertilisers and medical supplies. Because they can lean on the technologies of advanced countries. Today’s developing nations can grow more rapidly than Great Britain, Western European Countries and United States in past. By drawing upon more productive technologies of the leaders, the developing countries would expect to see convergence towards the technological frontier.

3. Balanced Growth: Some writers suggest that growth is a balanced process with countries progressing steadily ahead. In their view, economic development resembles the tortoise making continual progress, rather than the hare, who runs in spurts and then rats when exhausted. Simon Kuznets examined the history of thirteen advanced countries and conceived that the balanced growth model is most consistent with the countries he studied. He noticed no significant rise or fall in economic growth as development progressed.

Note one further important difference between these approaches. The ‘take-off’ theory suggests that there will be increasing divergence among countries (some flying rapidly, while others are unable to leave the ground). The ‘backward’ hypothesis suggests ‘convergence’, while the ‘balanced-growth’ model suggests roughly ‘constant’ differentials. In the following diagrams, advanced countries are represented by curve A, middle income countries by curve B and low-income countries by curve C. The curves show per capita income:

Strategies of Economic Development

Following are the strategies commonly applied in economic planning:

1. Balanced vs. Unbalanced Growth: Currently there are two major schools of thoughts regarding the process of growth, i.e., balanced growth strategy and unbalanced growth strategy:

(a) Balanced Growth Strategy: Economists like Ragnar Nurkse and Rosenstsein-Rodan strongly advocate balanced growth strategy. According to them, the pattern of investment should be so designed as to ensure a balanced development of the various sectors of the economy. They advocate simultaneous investment in a number of industries so that there is a balanced growth of different industries.

(b) Unbalanced Growth Strategy: Economists like H.W. Singer and A.O. Hirschman, on the other side, believe that rapid economic growth follows ‘concentration’ of investment in certain strategic industries rather than an even distribution of investment among the various industries. In the view of these economists, unbalanced growth is more conducive in economic development than a balanced one.

2. Big-Push Strategy: The big-push strategy is associated with the name of Rosenstein-Roden and Harvey Leibenstein. It is contended that a big-push is needed to overcome the initial inertia of a stranger economy. Rosenstein-Roden observes that there is a minimum level of resources that must be devoted to a development programme if it is to have any chance of success. Launching a country into self-sustaining growth is like getting an airplane off the ground. There is critical ground speed which must be passed before the craft can become airborne.

3. Balanced, Unbalanced and Big-Push (BUB) Strategy: The advocates of this strategy suggest that no single strategy will take us to the goal of economic development. Not only has the strategy to be changed from time to time as the situation may require, but it may be necessary sometimes to strike a balance between the alternative strategies. In the initial stage, which is characterised by unbalances, counter-unbalance strategy is to be adopted. But once an appropriate balance is attained by a fair dose of big-push, the strategy of balanced growth may be applied to further planning.

Issues in Economic Development

Following are the important issues in under developed countries:

1. Industrialisation vs. Agriculture: In most countries, incomes in urban areas are almost more than double in rural areas. Many nations jump to the conclusion that industrialisation is the cause rather than effect of affluence. To accelerate industrialisation at the expense of agriculture has led many analysis to rethink the role of farming. Industrialisation tends to be capital intensive, attract workers into crowded cities, and often produces high level of unemployment. Rising productivity on farms may require less capital, while providing productive for surplus labour.

2. Inward vs. Outward Orientation: This is a fundamental issue of economic development towards

international trade. Should the developing countries be self-sufficient? If yes, the country has to replace imported goods and services with domestic production. This strategy is known as ‘import substitution’ or ‘inward orientation’.

If the country decides to pay for imports it needs by improving efficiency and competitiveness, developing foreign markets, and giving incentives for exporters. This is called ‘outward orientation’ strategy. It is generally observed that by subsidising import substitution, competition is limited, innovation is dampened, productivity growth is slow down and country’s real income falls to a lower level. Whereas, the outward orientation sets up a system of incentives that stimulates exports. This approach maintains a competitive FOREX rate, encourages exports, and minimises unnecessary government regulation of businesses esp. small and medium sized firms.

3. State vs. Market: The cultures of many developing countries are hostile to the operation of markets. Often competition among firms or profit seeking behaviour is contrary to traditional practices, religious beliefs, or vested interest. Yet decades of experience suggest that extensive reliance on markets provides the most effective way of managing an economy and promoting rapid economic growth.

The government has a vital role in establishing and maintaining a healthy economic environment. It must ensure law and order, enforce contracts, and orient its regulations towards competition and innovation. The government plays a leading role in investment in human capital through education, health and transportation, but the government should minimise its intervention or control in sectors where it has no comparative advantage. Government, should focus its efforts on areas where there are clear signs of market failure.

Models of Economic Growth

Classical Model of Economic Growth

Every nation strives after development. Economic progress is an essential component, but it is not the only component. Economic development is not purely an economic phenomenon. In an ultimate sense, it must encompass more than the material and financial side of people’s lives. Economic development should therefore be perceived as a multidimensional process involving the reorganization and reorientation of entire economic and social systems. In addition to improvements in incomes and output, it typically involves radical changes in institutional, social, and administrative structures. Finally, although development is usually defined in a national context, its widespread realization may necessitate fundamental modification of the international economic and social system as well.

The classical theories of economic development consist of following four schools of thought:

1. Linear-stages-of-growth model: Theorists of the 1950s and 1960s viewed the process of development as a series of successive stages of economic growth through which all countries must pass. It was primarily an economic theory of development in which the right quantity and mixture of saving, investment, and foreign aid were all that was necessary to enable developing nations to proceed along an economic growth path that historically had been followed by the more developed countries. Development thus became synonymous with rapid, aggregate economic growth.

This linear-stages approach was largely replaced in the 1970s by two competing economic schools of thought – theories of structural change and international-dependence theories.

2. Theories and patterns of structural change: Theories and patterns of structural change uses modern economic theory and statistical analysis in an attempt to portray the internal process of structural change that a “typical ”developing country must undergo if it is to succeed in generating and sustaining a process of rapid economic growth.

Structural-change theory focuses on the mechanism by which under-developed economies transform their domestic economic structures from a heavy emphasis on traditional subsistence agriculture to a more modern, more urbanised, and more industrially diverse manufacturing and service economy. It employs the tools of neo-classical price and resource allocation theory and modern econometrics to describe how this transformation process takes place. Two well-known representative examples of the structural-change approach are the ‘two-sector surplus labour’ theoretical model of Sir W. Arthur Lewis, and the ‘patterns of development’ empirical analysis of Hollis B. Chenery and his co-authors.

3. International-dependence revolution: The international-dependence revolution was more radical and political in orientation. It viewed underdevelopment in terms of international and domestic power relationships, institutional and structural economic rigidities, and the resulting proliferation of dual economies and dual societies both within and among the nations of the world. Dependence theories tended to emphasize external and internal institutional and political constraints on economic development. Emphasis was placed on the need for major new policies to eradicate poverty, to provide more diversified employment opportunities, and to reduce income inequalities.

International-dependence models view developing countries as troubled by institutional, political, and economic rigidities, both domestic and international, and caught up in a dependence and dominance relationship with rich countries. Within this general approach there are three major streams of thought – the neo-colonial dependence model, the false-paradigm model, and the dualistic-development thesis.

4. Neoclassical or free-market counterrevolution: This theory is also known as neo-liberal theory. Throughout of the 1980s and 1990s, the neoclassical or free-market counterrevolution approach prevailed. It emphasizes the beneficial role of free markets, open economies, and the privatisation of inefficient public enterprises. Failure to develop, according to this theory, is not due to exploitive internal and external forces as expounded by dependence theorists. Rather, it is primarily the result of too much government intervention and regulation of the economy.

In the 1980s, the political ascendancy of conservative governments in the United States, Canada, Britain, and West Germany brought a neoclassical counterrevolution in economic theory and policy. In developed nations, this counterrevolution favoured supply-side macroeconomic policies, rational expectations theories, and the privatisation of public corporations. In developing countries it called for freer markets and the dismantling of public ownership, central planning, and government regulation of economic activities. Neo-classicists obtained controlling votes on the boards of the world’s two most powerful international financial agencies — the World Bank and the International Monetary Fund. In conjunction and with the simultaneous erosion of influence of organizations such as the International Labour Organization (ILO), the United Nations Development Program (UNDP), and the United Nations Conference on Trade and Development (UNCTAD), which more fully represent the views of LDC delegates.

The neo-classical approach states that underdevelopment arises from:

*

Poor resource allocation due to incorrect price policies, and*

Government’s intervention in the economic activities. 

Neo-classical or neo-liberal approach states that economic growth can be put to spur by:

* Permitting competitive free markets to flourish,* Privatising state-owned enterprises,* Promoting free trade and export expansions,* Welcoming investors from developed economies, and* Eliminating the plethora of government regulations and price distortions in factor, product and market.

1. Linear-stages-of-growth model:

Following are the growth models studied under linear-stages:

(a) Rostow’s Stages of Growth: The stages-of-growth model of development is taken by most of the newly independent countries. According to Walt W. Rostow doctrine, the transition from underdevelopment to development can be described in terms of a series of steps or stages through which all countries must proceed. According to Rostow, it is possible to identify all societies, in their economic dimensions, as lying within one of five categories:

*

The traditional society,*

The pre-conditions to take-off into self-sustaining growth,*

The take-off,*

The drive to maturity, and*

The age of high mass-consumption. 

Rostow also clarified that these stages are not merely a way of generalising certain factual observations about the sequence of development of modern societies. He argued that the advanced countries had all passed the stage of take-off into self-sustaining growth and the under-developed countries that were still in either the traditional society or the pre-conditions stage. One of the principal strategies of development necessary for any take-off was the mobilisation of domestic and foreign saving in order to generate sufficient investment to accelerate economic growth.

(b) Harrod-Domar Model: This model, developed independently by RF Harrod and ED Domar in the l930s, suggests savings provide the funds which are borrowed for investment purposes.

The model suggests that the economy's rate of growth depends on:

*

the level of saving*

the productivity of investment i.e. the capital output ratio 

For example, if $10 worth of capital equipment produces each $1 of annual output, a capital-output ratio of 10 to 1 exists. A 3 to 1 capital-output ratio indicates that only $3 of capital is required to produce each $1 of output annually.

The Harrod-Domar model was developed to help analyse the business cycle. However, it was later adapted to 'explain' economic growth.

2. Structural-change theory:

Following economic growth model represents the structural-change theory:

(a) Lewis Theory of Development: It is one of the best-known early theoretical models of economic development that focused on the structural transformation of a primarily subsistence economy was that formulated by Noble-prize winner Sir W. Arthur Lewis in the mid 1950s. His theory was later modified by his followers. The Lewis two-sector economy model became the general theory of the development process in surplus-labour Third-World nations during most of the 1960s and 1970s. In the Lewis model, the underdeveloped economy consists of two sectors:

*

A traditional, overpopulated rural subsistence sector characterised by zero-marginal labour productivity. Lewis classify this as ‘surplus-labour’ in the sense that it can be withdrawn from the agricultural sector without any loss of output, and*

A high, productivity modern urban industrial sector into which labour from the subsistence sector is

gradually transferred. 

The primary focus of the model is on both the process of labour transfer and the growth of output and employment in the modern sector. Both labour transfer and modern-sector employment growth are brought about by output expansion in that sector.

(b) Patterns of Development: The patterns of development analysis of structural change focuses 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 addition to the accumulation of capital both physical and human, a set of interrelated changes in the economic structure of a country are required for the transition from a traditional economic system to a modern one.

These structural changes involve virtually all economic functions, including the transformation of production and changes in the composition of consumer demand, international trade and resource use as well as changes in socio-economic factors such as urbanisation, and the growth and distribution of a country’s population.

3. International-dependence revolution:

Within this general approach, there are three major streams of thought:

(a) Neo-Colonial Dependence Model: It is an indirect outgrowth of Marxist thinking. It refers to the existence and continuance of underdevelopment in a highly unequal international capitalist system. The international system is dominated by unequal power relationships between the centre (the developed nations) and the periphery (the less developed countries). The poor nations attempt to become self-reliant and independent but this system makes it difficult and sometimes even impossible.

According to this theory, certain groups in the developing countries (including landlords, entrepreneurs, military rulers, merchants, salaried public officials, and trade union leaders) who enjoy high incomes, social status, and political power constitute a small elite ruling class whose principal interests are in perpetuation of the international capitalist system of inequality. Directly and indirectly, they serve (are dominated by)and are rewarded by (are dependent on) international special-interest power groups including multinational corporations, national bilateral-aid agencies, and multilateral assistance organizations like the World Bank or the International Monetary Fund (IMF). Therefore, a major restructuring of the world capitalist system is required to free dependent developing nations from the direct and indirect economic control of their developed-world and domestic oppressors.

Curiously, a very similar but obviously non-Marxist perspective statement was expounded by Pope John Paul II in his widely quoted 1988 encyclical letter:

“One must denounce the existence of economic, financial, and social mechanisms which, although they are manipulated by people, often function almost automatically, thus accentuating the situation of wealth for some and poverty for the rest. These mechanisms, which are manoeuvred directly or indirectly by the more developed countries, by their very functioning, favour the interests of the people manipulating them. But in the end they suffocate or condition the economies of the less developed countries.”

(b) False-Paradigm Model: The second and less radical international-dependence approach to development, the false-paradigm model, attributes underdevelopment to faulty and inappropriate advice provided by well-meaning but often uninformed, biased, and ethnocentric international ‘expert’ advisers from developed-country assistance agencies and multinational donor organizations. These experts offer sophisticated concepts, elegant theoretical structures, and complex econometric models of development that often lead to inappropriate or incorrect policies. Because of institutional factors such as the central and remarkably resilient role of traditional social structures (i.e., tribe, caste, class, etc.), the highly unequal ownership of land and other property rights, the disproportionate control by local elites over domestic and international financial assets, and the very unequal access to credit, these policies, based as they often are on mainstream, Lewis-type surplus labour or Chenery-type structural-change models, in many cases merely serve the vested interests of existing power groups,

both domestic and international.

(c) Dualistic Development Thesis: Dualism is a concept widely discussed in development economics. It represents the existence and persistence of increasing divergences between rich and poor nations and rich and poor peoples on various levels. One of the elements of dualism is that there is a coexistence of wealthy, highly educated elites with masses of illiterate poor people within the same country or city. According to this theory, there is a coexistence of powerful and wealthy industrialized nations with weak, impoverished peasant societies in the international economy.

This coexistence is chronic and not merely transitional. It is not due to a temporary phenomenon, in which with the capacity of time, the discrepancy between superior and inferior elements would be eliminated.

4. Neo-classical counterrevolution:

This approach can be implemented through the following three models:

(a) Free-Market Analysis: Free-market analysis argues that markets alone are efficient if:

*

Product markets provide the best signals for investments in new activities,*

Labour markets respond to these new industries in appropriate ways,*

Producers know best what to produce and how to produce it efficiently, and*

Product and factor prices reflect accurate scarcity values of goods and resources. 

Under free-market, competition is effective not necessarily perfect. Technology is freely available and nearly costless to absorb. Information is correct and nearly costless to obtain.

(b) Public-Choice Theory: Public-choice theory, also known as ‘new political economy approach’, goes even further to argue that government can do nothing right. This is because that politicians, bureaucrats, citizens and states act solely from a self-interested perspective, using their powers and the authority of government for their own selfish needs. Citizens use political influence to obtain special benefits (sometimes also referred to as ‘rent’) from government policies, for example, import licenses, or rationed forex. Politicians use government resources to consolidate and maintain positions of power and authority. Bureaucrats use their positions to extract bribes from rent-seeking citizens and to operate protected business on the side. And finally state uses its power to confiscate private property from individuals. The net result is not only a misallocation of resources but also a general reduction in individual freedoms. The conclusion, therefore, is that minimal government is the best government.

(c) Market-Friendly Approach: The third approach is market-friendly approach, which is the most recent variant on the neoclassical counterrevolution. It is associated principally with the writings of the World Bank and its economists, many of whom were more in the free-market and public-choice camps during the 1980s. This approach recognizes that there are many imperfections in LDC product and factor markets and that governments do have a key role to play in facilitating the operation of markets through ‘non-selective’ (market-friendly) interventions — for example, by investing in physical and social infrastructure, health care facilities, and educational institutions and by providing a suitable climate for private enterprise.

Karl Marx’s Model

Czarist Russia grew rapidly from 1880 to 1914; it was considerably less developed than industrialised countries like US and Great Britain. World War I brought great hardship to Russia and allowed the communists to seize power. From 1917 to 1933, the Soviet Union experimented with different socialist

models before settling on central planning. Most economists believed until recently that the Soviet Union grew rapidly from 1928 until the mid 1960s. After the mid 1960s, growth in Soviet Union stagnated and output actually began to decline. In the late 1980s and early 1990s, open inflation erupted. Prices were well below market-clearing levels and acute shortages arose in what is called ‘repressed inflation’. The repressive political system was unacceptable to the people in Soviet Union and some countries in Eastern Europe and was universally rejected in 1989.

The father of this repressive political system – Communism is Karl Marx (1818 – 1883). The centrepiece of Marx’s work is an incisive analysis of the strengths and weaknesses of capitalism. He argued that it is the only labour power that gives value to a commodity. By imputing all the value of output to labour, Marx hoped to show that profits, which is the part of output that is produced by workers but received by capitalists, amount to ‘unearned income’. According to Marx, this unearned income is unjustly received by capitalists. This injustice can be eliminated by transferring the ownership of factories and other means of production from capitalists to workers.

Marx saw capitalism as inevitably leading to Socialism. In Marx’s world, technology enables capitalists to replace workers with machinery as a means of earning greater profits. As a result unemployment increases with the increased use of technological advances. This increasing accumulation of capital will reduce the rate of profit and investment opportunities, and therefore, the ruling capitalists will become imperialists. Karl Marx believed that the capitalist system could not continue this unbalanced growth. Marx predicted increasing inequality under capitalism. Business cycles would become ever more violent as mass poverty resulted in macro-economic under-consumption. Finally, a cataclysmic depression would sound the death knell of capitalism. The economic interpretation of history is one of Marx’s lasting contributions to Western thought. Marx argued that economic interests lie behind and determine our values. His arguments against capitalism suggested communism would arise in the most highly developed industrial countries. Instead, it was backward, feudal Russia that adopted the Marxist vision.

Features of Karl Marx’s Socialist Model:

1. Government ownership of productive resources,2. Planning is centralised,3. Equal distribution of income,4. Peaceful and democratic evolution,5. Labour theory of value – value of a product represents the human labour used in production, and6. Theory of surplus value.

Theory of Surplus Value:

Marx propounded his theory of surplus value on the basis of his theory of value. He said that in order to enable labour to carry on the work of production, he should have some instruments of production and other facilities but he lacks these facilities. Hence, he has to sell his labour to the capitalist. It is, however, not necessary for the capitalist to pay labour the full value of the product produced by him. Here Karl Marx supported his theory on the basis of a classical theory, viz., the subsistence theory of value, according to which the level of wages is determined by the subsistence of the worker. The work of labour force is not merely to produce value equal to its price but much more. This surplus value is the difference between the market value of the commodity and the cost of the factors used in the production of commodity. Karl Marx says that the manufacturer gets for his commodity more than what he has spent on labour and other costs. The excess of market value over the costs is the surplus value. This surplus is created because labour is paid much less than is due to it. He characterises the appropriation of the surplus value by the capitalist as robbery and exploitation. The capitalist class goes on becoming richer and richer through exploitation of the working class.

Harrod Domar Growth Model

As we know that one of the principal strategies of development is mobilisation of domestic and foreign saving in order to generate sufficient investment to accelerate economic growth. The economic mechanism by which more investment leads to more growth can be described in terms of Harrod-Domar growth model, often referred to as the AK model.

Every economy must save a certain proportion of the national income, if only to replace worn-out or

impaired capital goods (buildings, equipment, and materials). However, in order to grow, new investments representing net additions to the capital stock are necessary. If we assume that there is some direct economic relationship between the size of the total capital stock, K, and total GNP, Y – for example, if $3 of capital is always necessary to produce a $1 stream of GNP – it follows that any net additions to the capital stock in the forms of new investment will bring about corresponding increases in the follow of national output, GNP. This relationship is known as ‘capital-output ratio’ and is represented as ‘k’. in the above case ‘k’ is roughly 3:1.

If we further assume that the national savings ratio ‘S’ is a fixed proportion of national output (e.g. 6%) and that total new investment is determined by the level of total savings. We can construct the following simple model of economic growth:

· Saving (S) is some proportion, s, of national income (Y) such that we have the simple equation:

S = s .Y ---------------------------- (i)

· Net investment (I) is defined as the change in the capital stock, K, and can be represented by ΔK such that:

I = ΔK ----------------------------- (ii)

But because the total capital stock, K, bears a direct relationship to total national income or output, Y, as expressed by the capital-output ratio, k, it follows that:

K = k

Y

Or

ΔK = k

ΔY

Or

ΔK = k.ΔY ------------------------------- (iii)

· Finally, because net national savings, S, must equal net investment, I, we can write this equality as:

S = I ------------------------------- (iv)

But from equations (i), (ii) and (iii), we finally get the following equation:

I = ΔK = k. ΔY

Therefore, we can rewrite the equation (iv) as follows:

S = s.Y = k.ΔY = ΔK = I --------------- (v)

Or simply

s.Y = k.ΔY -----------------------------------(vi)

Dividing both the sides of equation (vi) first Y and then by k, we obtain the following expression:

ΔY = s -------------------------------------- (vii)

Y k

Note that the left-hand side of the equation i.e., ΔY / Y represents the rate of change or rate of growth

in GNP (i.e., the percentage change in GNP).

The Harrod Domar Model, more specifically says that in the absence of government, the growth rate of national income will directly or positively related to the savings ratio (i.e., the more an economy is able to save and invest out of a given GNP, the greater the growth of that GNP will be. Harrod Domar Model further states that the growth rate of national income will be inversely or negatively related to the economic capital-output ratio (i.e., the higher k is, the lower the rate of GNP growth will be).

The additional output can be obtained from an additional unit of investment and it can be measured by the inverse of the capital-output ratio, k, because this inverse, 1 / k, is simply the output-capital or output-investment ratio. It follows that multiplying the rate of new investment, s = I / Y, by its productivity, 1 / k, will give the rate by which national income or GNP will increase.

For example, the national capital-output ratio in an under-developed country is, let say, 3 and the aggregate saving ratio (s) is 6% of GNP, it follows that this country can grow at a rate of 2% (i.e., 6% / 3 or s / k or ΔY / Y). Now suppose that the national saving rate increased from 6% to 15% through increased taxes, foreign aids, and / or general consumption sacrifices – GNP growth can be transferred from 2% to 5% (15% / 3).

According to Rostow and other theorists, the countries that were able to save 15% to 20% of GNP could grow at a much faster rate than those that saved less. Moreover, this growth would then be self-sustained. The mechanisms of economic growth and development, therefore, are simply a matter of increasing national savings and investment.

The main obstacle or constraint on development, according to this theory, was the relatively low level of new capital formation in most poor countries. But if a country wanted to grow at, let say, a rate of 7% per annum and if it could not generate savings and investment at a rate of 21% (i.e., 7% × 3) of national income but could not only manage to save 15%, it could seek to fill this saving gap of 6% through either foreign aid or private foreign investment.

Limitations of the model:

1. Economic growth and economic development are not the same. Economic growth is a necessary but not sufficient condition for development

2. Harrod Domar model was formulated primarily to protect the developed countries from chronic unemployment, and was not meant for developing countries.

3. Practically it is difficult to stimulate the level of domestic savings particularly in the case of LDCs where incomes are low.

4. It fails to address the nature of unemployment exists in different countries. In developed countries, the unemployment is ‘cyclical unemployment’, which is due to insufficient effective demand; whereas in developing countries, there is ‘disguised unemployment’.

5. Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment problems later.

6. The law of diminishing returns would suggest that as investment increases the productivity of the capital will diminish and the capital to output ratio rise.

The Harrod-Domar model of economic growth cannot be rejected on the ground of above limitations. With slight modifications and reinterpretations, it can be made to furnish suitable guidelines even for the developing economies.

Schumpeter’s Model of Economic Growth

Joseph Schumpeter was a famous Austro-Hungarian economist, but never followed Austrian school of thought. His famous book was the Theory of Economic Development (1912), in which he first outlined his famous ‘theory of entrepreneurship’. He argued that only daring entrepreneurs can create technical and financial innovations in the face of competition and falling profits, and that it was these

spurts of activity which generated economic growth. After the World War I, Schumpeter joined the German Socialization Committee in Berlin - which then was composed of several Marxian scholars, and the Kiel School economists.

In 1919, Schumpeter became the Austrian Minister of Finance - unfortunately, presiding over the hyperinflation of the period, and thus was dismissed later that year. Schumpeter migrated in 1921 to the private sector and became the president of a small Viennese banking house. Ill luck dogged him: his bank collapsed in 1924. He drifted once again back into academia - taking up a teaching position at Bonn in 1925. In 1932, Schumpeter took up a position at Harvard, succeeding the Marshallian F.W. Taussig. Schumpeter ruled Harvard during the period of the ‘depression generation’ of the 1930s and 1940s - when Samuelson, Tobin, Heilbroner, and Bergson were his students. His famous publications include Theory of Economic Development (1912), Business Cycles (1939), Capitalism, Socialism and Democracy (1942) and History of Economic Analysis (1954). He presented the theory of entrepreneurship, theory of business cycles, and theory of evolutionary economics.

In order to understand the Schumpeter’s theory of economic development, it is necessary to understand the theory of evolutionary economics. The concept of evolution is an offspring of late 18th and early 19th century debates within philosophy and the social sciences. The theory of evolutionary economics is much more inspired by the Darwinian theory of natural selection. The general definition of evolution is the self-transformation process over time of a system. Such a system may be a population of living organisms, a collection of interacting individuals as in an economy or some of its parts, or even the set of ideas produced by the human mind. Therefore, an evolutionary theory is:

* Dynamic — such that the dynamics of the processes, or some of their parts, can be represented;* Historical — in that it deals with historical processes which are irrevocable and path-dependent;* Self-transformation — in that it includes hypotheses relating to the source and driving force of the self-transformation of the system.

Schumpeter’s theory of economic development is considered as a radical theory. It is considered radical in the context that it described the capitalist system as an evolutionary system. According to Schumpeter, capitalism is the system that internally generates changes and technological progresses. According to him, the process of economic development is inherently dynamic, as opposite to static nature of the theory of equilibrium. This does not mean that Schumpeter is against the theory of equilibrium. On the contrary it is the underlying base for his own capitalist dynamic model.

Schumpeter’s model of economic development is not a substitute for the theory of equilibrium but rather a necessary complement. Without it, it is impossible to understand the functioning of an economic system. Schumpeter started through the ‘circular flow’ as an essential block for building dynamic model. Schumpeter describes the circular flow with the following assumptions:

* somewhere in the economic system a demand is ready awaiting every supply, and* nowhere in the system are there commodities without complements.

Under these conditions, all goods find a market, and the circular flow of economic life is closed. In a steady state, costs in this closed system are the price totals of the services of the production factors. Prices obtained for the products must equal these price totals. The ultimate logical consequence of this ideal model of the clearing market is that production must flow on essentially profitless – profit is a symptom of imperfection.

Schumpeter defines production as the combinations of materials and forces that are within our reach. The producer is not an inventor. All components that he needs for his product or service, whether physical or immaterial, already exist and are in most cases also readily available. The basic driving force behind structural economic growth is the introduction of new combinations of materials and forces, not the creation of new possibilities.

Development in the Schumpeterian sense is defined by the carrying out of new combinations. This concept covers the following five cases:

(i) The introduction of a new good – that is one with which consumers are not yet familiar – or a new quality of a good.

(ii) The introduction of a new method of production – that is one not yet tested.

(iii) The opening of a new market – that is a market into which the country in question has not previously entered.

(iv) The conquest of a new source of supply of raw materials or half-manufactured goods.

(v) The carrying out of the new organisation of any industry, like the breaking up of a monopoly position.

The basic structure from Schumpeter’s model of economic development has two distinctive spheres. On the one hand is the semi-closed system of the circular flow that is either in equilibrium or striving for it. And, on the other hand, is the symbiotic pair of the entrepreneur and the sponsor that is always looking for ways to induce change in the peaceful yet boring routine-life of the circular flow. Both spheres function within an endless reservoir of new combinations, for example, scientific knowledge and technological inventions, but it is only the entrepreneur – backed by the capitalist – who is able to introduce new combinations and new routines in the circular flow.

According to Schumpeter, entrepreneur who initiates the process of innovation is the central of the process of economic development. Entrepreneurs are neither capitalists nor inventors; they see the potential of inventions and assume risk in innovating. Schumpeter regarded the entrepreneur as something of a social deviant and noted that migrants or aliens in any society have great potential to behave entrepreneurially. Schumpeter noted that increases of taxes, public policies favouring labour organisations, price controls, and licensing requirements that increase the costs of doing business are the greatest impediments to entrepreneurship. Under oppressive conditions, for example, the former Soviet Union, China, and present day Islamic societies, very few people innovate.

The creation of something new usually requires that something old be eliminated, for example, changes in the structure of demand or production result in structural unemployment. Economic growth cannot proceed without structural changes, i.e., economic development. Most technological progress is a result of activity specifically undertaken to develop new products, reduce costs, improve quality, or develop new markets.

Economic evolution is based on cyclical disruptions and breaks of economic structures, an endogenous transformation that results from the ‘process of creative destruction’ as an essential feature of modern capitalism. This points at the internal logic of the cyclical restructuring of modern capitalism for evolutionary change.

Business cycle refers to regular fluctuations in economic activity. In the 19th century, business cycles were not thought of as cycles at all but rather as spells of "crises" interrupting the smooth development of the economy. In later years, economists and non- economists alike began believing in the regularity of such crises, analysing how they were spaced apart and associated with changing economic structures. Schumpeter divided a business cycle into four process – boom, recession, depression and recovery. He also classified the business cycles in the following classes:

(a) Seasonal cycles – for a year

(b) Kitchin cycles – covering a period of 3 years

(c) Juglar cycles – covering a period of 10 years

(d) Kuznets cycles – covering a period of 15 to 20 years

(e) Kondratiev cycles – covering a period of 48 to 60 years, for example, Industrial Revolution (1787 – 1842), Bourgeois Kondratiev (1843 – 1897), and Neo-Mercantilist Kondratiev (1898 – 1950) with the expansion of electric power and the automobile industry.

Planning Techniques

Methodology of Planning:

The planner is gone through the following steps in economic planning:

(a) Collecting information: The most important aspect of economic planning is the collection of economic data. The data are not only comprised of economical data, but they also cover the demographical, geographical, and political data. The planner also considers non-quantitative data for economic planning. The planner or the team of planners must have an enough knowledge regarding the fields like sociology, religion, politics and ethics in addition to economics.

(b) Deciding nature and duration of the plan: Once the planning authority gets the knowledge in respect of the economy on the basis of necessary statistics, the next step is to determine the nature and size of the plan. In this connection, the planner has to decide between the planning on micro-basis and planning on macro-basis, functional or structural, centralised or decentralised, etc. Again it is to be decided that whether the planning will be on short-term basis, medium term, or long term. In most of the countries, the medium term plans are advocated. The medium term plan which mostly lasts for the period of 5 years is neither too short nor too long. In the period of five years the ruling party is in a position to implement upon its programmes, policies and manifesto.

(c) Setting the objectives: After the nature and the duration of plan, the next issue is of setting the objectives. In other worlds, it is an important task before the planner to decide regarding the social and economic objectives which will have to be attained in the specified period of the plan. Most of the objectives or goals of the plan are concerned with the attainment of higher growth rate of GNP, reduction of unemployment, removal of regional disparities, removal of illiteracy, development of agriculture and industrial sectors, etc. After identifying such objectives, planner arranges these objectives in order of their importance to the society and the economy as a whole.

(d) Determination of growth rate: This is the most important decision which the planner has to make while formulating the plan. It is about to determine the growth rate during the plan period, i.e., at what rate the economy will grow during this period. The economists agree that the growth rate of the economy should be one which could at least maintain the per capita income of the country. This would be possible if the growth rate of the economy or growth rate of GNP and growth rate of the population are equal. But this growth rate is least recommended. Rather, the planner will opt for that growth rate which is greater than the population rate. For example, if Pakistan wants to maintain its existing per capita income while population is growing at the rate of 3% p.a., then the required GNP growth rate should not be less than 3%. If we want to grow GNP by 3%, NI should grow @ 6%. If the capital output ratio (COR) is 1:3, then we will have to invest 18% of GNP. While determining the growth rate, the planner must keep in view the growth rate of other neighbouring or developing countries like India, China, Sri Lanka, Indonesia, Bangladesh, etc.

(e) Financial resources of the plan: The economic planner is aimed at utilising the resources of the country in such a way that the pre-determined objectives are attained. The real resources of a country consist of manpower, natural resources, technological advancement, infra-structure, good governance, entrepreneurial skills, etc. The planner also has to consider the various optional external resources in case the internal resources are short to fulfil the planning requirements. Such external resources consist of foreign aid and assistance, foreign grants, foreign direct investment, and foreign borrowings from various IFIs and rich countries.

(f) Sectoral allocation or determination of priorities: The resources at the disposal of a country are always short of the requirements. Therefore, a plan is aimed at utilising the resources in such a way that the maximum social benefit could be attained. Accordingly, the planner has to decide which project be taken-up and which project be postponed. In this way, the planner has to prepare a schedule on the basis of relative importance of projects. Then a choice has to be made regarding allocation of resources amongst different uses. Normally the planner has to decide between industrial sector development or agricultural sector development, private sector or public sector, labour-intensive technology or capital-intensive technology, etc. To settle the issue of ‘choice of priorities’ amongst different alternatives, the planners have given the concept of ‘investment criteria’.

(g) Role of the government: In most of the countries, the purpose of planning authority is to prepare the draft of the plan consisting of lot of proposals, schemes and projects. When once the plan is chalked out the proposals are sent to operating agencies, ministries and other government departments which are to implement the plan. The government agencies are inquired of their recommendations regarding the economic feasibility of different schemes and projects of the plan

keeping in view the sectoral allocation and size of the plan. The operating agency, i.e. the government has to consider the role to be played by private sector and public sector. The government has to inform the planning agency regarding the prospective bottlenecks in the way of effective planning. These recommendations will be helpful in finalising the draft of the plan.

(h) Formulation of economic policies: The role of planners in planning methodology is not just confined to preparation of schemes and projects, they also have to devise economic policies which could provide a favourable atmosphere for the operation of the plan. Accordingly, economic policies play an important role in economic planning, they provide fuel to the engine of economic development.

(i) Plan execution: The last step is plan execution. For effective implementation of plan, following conditions are the pre-requisites:

(i) the government should be stable, honest, sincere and constructive,

(ii) the administrative system must be efficient, i.e. free of favouritism, corruption, bribery, red tapism, etc.

(iii) maintenance of law and order situation,

(iv) equal participation of private and public sectors in economic development,

(v) readily availability and computerised maintenance of government records, financial statements and cost statements,

(vi) vigilant and constructive opposition, etc.

Types of Economic Policies:

Following are types of economic policies considered in the economic policy formulation:

(a) Budgetary Policy: The planner would suggest to devise such a budgetary policy which could transfer the revenue surplus from revenue budget to capital budget. Moreover, the balanced budget would provide a guarantee for price stability.

(b) Tax Policy: The tax policy be stipulated in such a way that more revenues could be raised from taxes for the sake of public expenditures. Moreover, the tax policy should aim at removing income disparities and wasteful expenditures on luxurious consumption. Thus the taxes be imposed in accordance with the ability to pay.

(c) Credit Policy: The credit policy be formulated in such a way that short-term, medium-term and long-term credit could be made available to the different sectors of the economy. When the funds are obtained by the needy sectors of the economy, the pace of development will be accelerated and the plan targets will be realised.

(d) Foreign Trade and Foreign Exchange Policy: According to this policy a plan should seek to earn the sufficient amount of foreign exchange by boosting the exports and reducing the imports. When the foreign exchange resources of a country increase, the problem of debt repayment will also be alleviated.

(e) Tariff Policy: An economic plan should devise such a tariff policy that the unnecessary and luxurious imports could be checked. However, it should encourage the imports of essential consumer goods, capital goods, raw stuff and machinery which would be helpful in accelerating the pace of development. Moreover, tariff policy should aim at protecting the infant industries.

(f) Price Policy: The price stability provides guarantee to the success of a plan. Therefore, such a policy should be devised by the planners that monopolies could not grow, the limits be imposed on profit margins, government expenditures be controlled and competitive forces be restored in the economy.

(g) Wage Policy: An economic plan should aim at protecting the rights of the labour. They must be having job security, minimum wage laws and constitute labour unions. Civil and government servants

should be given reasonable emoluments to attract personnel to public services. Exploitation of labour by producers should be discouraged.

(h) Manpower Policy: Manpower policy is an economic policy pursuing the regularisation of skilled, semi-skilled and unskilled persons to bring a balance between the demand and supply of labour. This will lead to maximum utilisation of manpower.

(i) Immigration Policy: Restrictions should be imposed on internal mobility of labour in horizontal, vertical and geographical forms. Brain drain should be checked in the early stages of development.

(j) Nationalisation Policy: As a result of severe market imperfections, the planner may pursue nationalisation policy in economic planning. The sector or the sectors that are causing market imperfections may be nationalised or taken into government control.

(k) Privatisation and Deregulation Policy: The purpose of this policy is to reduce the burden of governmental expenditures and the operational inefficiencies caused by state-owned enterprises. To improve investment conditions and to promote healthy competition, such state-owned enterprises are given under the control of private hands.

Planning Techniques:

There are several planning techniques used in different stages of planning. Some of them are discussed below:

(a) Capital-Output Ratio (COR): The Capital-Output Ratio (COR) is used during the planning stage of determination of growth rate. COR defines the relationship between capital and output. This concept shows that how much of capital is required for how much of output. Broadly speaking, it tells us that how much of investment is required to produce a certain level of consumption goods. We also found its traces in Harrod-Domar Model of economic growth. According to COR, the sustained growth rate can be represented by the following equation:

Where Gw = sustained growth rate;

s = saving ratio;

v = capital-output ratio (COR). 

The above equation shows that if a developed country wishes to attain a sustained equilibrium growth rate the national income must grow at the proportion of saving ratio (s) to capital-output ratio (v).

In planning, the planner is concerned with additional amount of capital required for additional output, then the concept of marginal capital-output ratio (MCOR) or incremental capital-output ratio (ICOR) is used. Its equation is shown as below:

Where w = marginal capital-output ratio (MCOR) or incremental capital-output ratio (ICOR);

∆K = change in capital stock;

∆Y = change in output;

∆I = change in investment.

For example, if the ratio is 3:1, then it shows that to produce the goods worth Re. 1 will require to make the net investment worth Rs. 3. In other words, if the economy wants to increase the output by Rs. 1 billion with the COR 3, then the required addition to the capital stock to be provided by new investment will be Rs. 3 billion.

The economists and planners also use the concept of average capital-output ratio (ACOR). This concept shows the ratio of existing stock of capital and the level of output which results from such capital. In other words, if we divide the value of total capital stock by the total annual income, we will get ACOR. It is represented as follows:

Where K = existing capital stock;

Y = existing level of output.

For example, the existing capital stock of the economy is Rs. 6 billion, while the output of the economy is Rs. 1.5 billion, then the value of ACOR will be equal to 4.

More is the value of ICOR, less will be the growth rate and vice versa. For example, if the COR is 3, saving ratio is 18%, then the growth rate of the economy will be:

For COR 4 and 2, the growth rates at the same saving ratio will be 4.5% and 9% respectively.

COR

Saving Ratio

Growth Rate

4

18%

4.5%

3

18

6

2

18

9

(b) Plan Consistency and Tabulation: A good plan must be having the elements of realism and consistency in numbers. It means that it should not only represent true picture of the economy, but it should have a balance in context with different sectors of the economy regarding numbers. Therefore, to attain such arithmetic target it becomes necessary the resources be analysed arithmetically. For this purpose ‘ex-ante’ (expected) tabulation of balances between demands and supplies is made. All the estimations and projections are entered in interlocking tables in such a way that they are linked with one another. The interlocking tables show different items along with their statistics and importance. Following are the specimen of interlocking tables:

1. Projected Sector Growth

Sectors

Growth in Zero Period

Growth during 5 years

Agriculture

Industry

Services

GDP

2. Resources and their Uses

Resources

In

zero period

In 5 years

Uses

In

zero period

In 5 years

GDP

Capital

Surplus of FT sector

Govt. expenditure

Private consumption

Total

3. Capital Account

In

zero period

In 5 years

In

zero period

In 5 years

Fixed investment

Capital

Stocks

Corporate saving

Private saving

Govt. saving

Foreign saving

Total

4. Government Current Account

Revenues

In

zero period

In 5 years

Expenditures

In

zero period

In 5 years

Taxes

Govt. expenditures

Other revenues

Transfer payments

Saving

Total

(c) Input-Output Analysis: The purpose of Input Output (IO) Analysis is to provide a balance between input, output and final demand. It is also connected with plan consistency. Efficient planning requires that how much an industry produces must be equal to the demand for that particular commodity. On the same lines, each industry wishes to have an assurance of the inputs necessary for its output. It may happen that output of one industry may be an input of another industry. Thus, the purpose of IO Analysis is to observe such input output relationships. In other words, IO Analysis encompasses the inter-industry transactions. This technique was invented by Professor Leontief in 1951. It is also known

as ‘inter-industry analysis’.

The planner constructs input-output tables where the relevant transactions are recorded. Then with the help of transaction data, the input-output co-efficients are derived. Finally, the ‘Leontief Matrix’ is inverted to obtain a general solution. IO Table shows the values of the flows of goods and services between different productive sectors especially inter-industry flows. In the following IO Table, we have a 3-sector economy where there are two inter-industry sectors, i.e. agriculture and industry, and one final demand sector:

Purchasing Sectors

(All figures in million rupees)

Sectors

(1)

Inputs to

Agriculture

(2)

Inputs to

Industry

(3)

Final demand

(Household)

(4)

Total Output

or Total Revenue

Selling Sectors

Agriculture

500150010003000

Industry

1000250015005000

Value added

(Payment to factors)

1500100002500

Total Inputs

or Total Cost30005000250010500

(d) Linear Programming: In economic planning, the planners wish to include in plans those methods, techniques and programmes which would ensure the optimal use of resources. Thus the programming that is used for the best or optimum use of resources is known as ‘linear programming’. It is programming because it has been formulated in mathematical mould and its results are shown in terms of linear relationship. It is also known as ‘activity analysis’. It helps the planner to allocate resources optimally among alternative uses within the specific constraints. It also helps to tackle the problems of investment planning. Linear programming can be applied in case of number of economic problems concerning with maximisation or minimisation subject to constraints. Through linear programming the profit function can be formulated. For e.g., for a firm producing bicycles and motor cycles, the profit maximisation function is construction as below:

Where = maximum profit

x1 = bicycles (profit of $45 per bicycle)

x2 = motor cycles (profit of $55 per motor cycle)

Following are the given constraints:

While x1,x2≥0 (non-negativity condition)

If x1=0, then x2=30; and if x2=0then x1=20

This linear relationship can be built into a graph:

(e) Project Appraisal: Project appraisal is widely used both in the developed as well as in under-developed countries both independently as well as an integrated scheme of national planning. The government formulate and evaluate investment projects in such a way as to be able to compare and evaluate alternative projects in terms of their contribution to the objectives of the nation. The team preparing project report consists of engineers and economists specialised in investment analysis and the relevant fields. The sociologists and natural environmentalists must also be included. There are different techniques of project evaluation, such as cost-benefit analysis, LM method, and UNIDO guideline:

(i) Cost-Benefit Analysis: This technique is also known as ‘social cost benefit analysis’. In this technique, the costs of projects are evaluated. For the purpose of analysis the cost is disintegrated into various categories, viz., project costs, associated costs, real and nominal costs, primary or direct costs, secondary or indirect costs, etc. The benefits are also classified as real benefits, direct and indirect benefits, etc. The next step is to find the present value of costs and benefits applying a certain rate of interest. Then a comparison is made between the discounted benefits with the costs of projects to get the ratio of costs and benefits. If this ratio is one or more than one, the project is acceptable, otherwise rejected. This technique is known as ‘net present value (NPV) method’. For this we need to calculate the present value (PV), which can be calculated as below:

Where C = annuity amount

i = interest rate or discount rate

The decision rule for a project under NPV method is to accept the project if the NPV is positive and reject if it is negative. Zero NPV implies that the government is indifferent between accepting or rejecting the project. This method can also be used to make a choice between two or more than two mutually exclusive projects. On the basis of NPV method, the various proposals would be ranked in order of NPV. The project with highest NPV would be preferable to the project with lowest NPV.

Suppose the government has two proposed projects, i.e. project A and project B.

Project A

Project B

Initial investment

60,000

59,000

Cash inflow / profit:

200514,00011,000200615,00014,000200716,00017,000200818,000

18,000200919,00020,500

PV Factor10%

10%

The NPV of both projects is calculated as below:

Net Present Value

Years

Project A

Project B

Cash

Inflow

PV factor

@ 10%

PV

Cash

Inflow

PV factor

@ 10%

PV

200514,0000.90912,72611,0000.9099,999

200615,0000.82612,39014,0000.82611,564

200716,0000.75112,01617,0000.75112,767

200818,0000.68312,29418,0000.68312,294

200919,0000.62111,79920,5000.62112,731

PV of Cash inflows61,22559,355

Less: Initial investment60,00059,000

Net Present Value

1225355

In the above case, the planners will opt for project A, because the NPV of the project is positive and is greater than the NPV of project B. The economy will benefit more from project A than from project B.

(ii) The Little and Mirrless (LM) Method of Project Evaluation: There are two main features of LM method:

*

Foreign exchange used as a ‘measuring rod’. Rather domestic prices, foreign exchange measures the true costs and benefits of commodities produced. Therefore, the net value of all the goods produced should be converted into its foreign exchange equivalents.*

The amount of savings in LDCs is less than the socially optimal level. Hence, one additional unit of investment is more valuable than an extra unit of consumption at the margin. 

(iii) UNIDO Guideline: LM method tries to convert all the benefits and costs to an index of government income, UNIDO translates such all benefits and costs to an index of present consumption. Thus the UNIDO method tries to find out the NPV of all consumption flows because of an additional unit of investment.

(f) Investment Criteria for Allocation of Resources: The 'investment criteria' is a useful planning technique used in sectoral allocation. Investment criteria refers to pattern of investment, choice of investment, choice of projects in various sectors, and choice of technique for a particular project.

(i) Capital Turn-Over Criterion: The H-D model hints out the values of different variables which would guarantee the UDCs to maximise their growth. According to it, the growth rate is represented as follows:

Where g = growth rate of outputS = saving income ratioC = capital-output ratio (COR)

This equation states that to raise the growth, we are required to raise S or to lower the value of C. Professor Polak and Buchnan argued that given the scarcity of capital in LDCs the C should be minimised. This is called ‘capital turn-over criterion’. According to Polak and Buchnan those investment projects should be chosen which have low C, i.e. high rate of capital turn over.

(ii) Social Marginal Productivity (SMP) Criterion: This criterion has been presented by Kahn and Chenery. They are of the view that it is necessary to consider the total net contribution of marginal unit of investment to national output, and not merely that portion of contribution which is gotten by private investors.

Efficient allocation consists of maximisation of national product and the principle to obtain this objective is to equate SMP of capital in different uses. SMP criterion is represented as:

Where V = annual value of total outputC = total annual cost of amortisationK = total investment

VB = variations in income because of changes in 1 unit of BOP.

(iii) Maximisation of the Rate of Creation of Investible Surplus (MRIS) Principle: The objective of MRIS criterion is to maximise per capita real income at a future point of time. Thus to achieve a higher rate of growth, it is stressed upon role of capital accumulation. According to MRIS criterion, those projects

should be selected which involve higher capital intensity. In other words, those projects should be select which have higher COR.

(iv) Reinvestible Surplus (RS) Criterion: This criterion was suggested by Dobb and Sen. In Sen’s model the economy is divided into two sectors, i.e. backward and modern. The modern sector is again sub-divided into two, i.e. (A) producing machinery with labour only, and (B) producing corn with labour and machines. In the backward economy the corn is produced by labour alone. Sen assumes that wages in the modern sector are determined by corn output by sector B. But since it takes sometime to set-up the modern sector, wages in the modern sector would have to be paid of with the surplus in backward sector. Sen describes how a conflict can arise between current output maximisation principle and criterion to maximise the rate of growth of output.

World Trade Organisation

History

At the United Nations conference held at Geneva in 1947, twenty three countries including United States of America signed General Agreement on Tariffs and Trade (GATT). During the same year, a charter was put on the table for setting up, within the United Nations Organisation, of a new agency to be called International Trade Organisation (ITO). Fifty nations signed the charter in Havana the following year, but it was never subsequently ratified by the required number of countries. The purpose of the agreement was to promote international trade free of barriers in the aftermath of World War II, and to draw up proposals for the implementation of policies based on those principles set in the agreement. It covered all the issues like tariffs, quotas, taxes, international commodity agreements and whatever was considered to have a bearing on the development of international trade, and was based on policies of non-discrimination and tariff reductions. 

GATT has been expanded and updated through a series of multi-year conferences. The most famous have been the Kennedy Round (1963-1967), the Tokyo Round (1973-1979), and the Uruguay Round (1986-1994). The Uruguay Round ended with the decision to dissolve GATT and establish the more powerful and more institutionalised World Trade Organization (WTO) in 1995. The WTO replaced GATT as an international organization, but the General Agreement still exists as the WTO’s umbrella treaty for trade in goods. Trade lawyers distinguish between the GATT 1994, the updated agreement, and the GATT 1947, the original agreement which is still the heart of GATT 1994.

Introduction

The WTO has nearly 150 members, accounting for over 97% of world trade. Around 30 others are negotiating membership. By definition, the World Trade Organization (WTO) deals with the rules of trade between nations at a global or near-global level. But there is more to it than that. There are a number of ways of looking at the WTO. It’s an organization for liberalizing trade. It’s a forum for governments to negotiate trade agreements. It’s a place for them to settle trade disputes. It operates a system of trade rules. (But it is not a Superman, just in case anyone thought it could solve — or cause — all the world’s problems!). The WTO is like a table. People sit round the table and negotiate, and resolve trade disputes.

Essentially, the WTO is a place where member governments try to sort out the trade problems they face with each other. Therefore, the first step is to talk. The WTO was born out of negotiations, and everything the WTO does is the result of negotiations. Where countries have faced trade barriers and wanted them lowered, the negotiations have helped to liberalize trade. But the WTO is not just about liberalizing trade, and in some circumstances its rules support maintaining trade barriers — for example to protect consumers or prevent the spread of disease.

WTO also ensures that individuals, companies and governments know what the trade rules are around the world, and gives them the confidence that there will be no sudden changes of policy. In other words, the rules have to be “transparent” and predictable.

Principles / Characteristics of WTO Trading System

The World Trade Organisation is based on the following core-principles or characteristics:

1. Trade without discrimination:

The main principle in the charter of the World Trade Organisation is to promote international trade without any discrimination. This principle is further elaborated into two – MFN and national treatment:

(a) Most-favoured-nation (MFN) – treating other people equally: Under the WTO agreements, countries cannot normally discriminate between their trading partners. If a member country grants a special favour (such as a lower customs duty) to another member country, she has to do the same for all other WTO members.

This principle is also known as most-favoured-nation (MFN) treatment. It is so important that it is the first article of the GATT, which governs trade in goods. MFN is also a priority in the General Agreement on Trade in Services (GATS) and the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS).

However, some exceptions are allowed. For example, countries can set up a free trade agreement that applies only to goods traded within the group —discriminating against goods from outside. Or they can give developing countries special access to their markets. Or a country can raise barriers against products that are considered to be traded unfairly from specific countries. In general, MFN means that every time a country lowers a trade barrier or opens up a market, it has to do so for the same goods or services from all its trading partners — whether rich or poor, weak or strong.

(b) National treatment – Treating foreigners and locals equally: Imported and locally-produced goods should be treated equally — at least after the foreign goods have entered the market. The same should apply to foreign and domestic services, and to foreign and local trademarks, copyrights and patents.

National treatment only applies once a product, service or item of intellectual property has entered the market. Therefore, charging customs duty on an import is not a violation of national treatment even if locally-produced products are not charged an equivalent tax.

2. Freer trade:

First of all it should be noted here that the WTO is not for free trade at any cost. It is all about lowering trade barriers between trading countries. The barriers concerned include customs duties (or tariffs) and measures such as import bans or quotas that restrict quantities selectively. From time to time other issues such as red tape and exchange rate policies have also been discussed.

Opening markets can be beneficial, but it also requires adjustment. The WTO agreements allow countries to introduce changes gradually, through ‘progressive liberalization’. Developing countries are usually given longer to fulfil their obligations.

3. Predictability:

Sometimes, promising not to raise a trade barrier can be as important as lowering one, because the promise gives businesses a clearer view of their future opportunities. With stability and predictability, investment is encouraged, jobs are created and consumers can fully enjoy the benefits of competition — choice and lower prices. The multilateral trading system is an attempt by governments to make the business environment stable and predictable.

One way of making investment stable and predictable is to ‘bind’ the member countries to their commitments. For example, ceilings on customs tariff rates, etc. However, a country can change its bindings, but only after negotiating and compensating its trading partners.

There are other ways as well to improve predictability and stability. One way is to discourage the use of quotas and other measures used to set limits on quantities of imports. Another way is to make countries’ trade rules as clear and transparent as possible. Many WTO agreements require governments to disclose their policies and practices publicly within the country or by notifying the WTO. The regular surveillance of national trade policies through the Trade Policy Review Mechanism provides a further means of encouraging transparency both domestically and at the multilateral level.

4. Promoting fair competition:

WTO is a system of rules dedicated to open, fair and undistorted competition. The rules on non-discrimination — MFN and national treatment — are designed to secure fair conditions of trade. So these rules also apply on dumping and subsidies. Many of the other WTO agreements aim to support fair competition, for example, in agriculture, intellectual property, services, etc. 

5. Encouraging development and economic reform:

The WTO system contributes to development. On the other hand, developing countries need flexibility in the time they take to implement the system’s agreements. Over 3/4th of WTO members are developing countries and countries in transition to market economies. During the seven and a half years of the Uruguay Round, over 60 of these countries implemented trade liberalization programmes autonomously. At the end of the Uruguay Round, developing countries were prepared to take on most of the obligations that are required of developed countries. But the agreements did give them transition periods to adjust to the more unfamiliar and, perhaps, difficult WTO provisions — particularly for the poorest or ‘least-developed’ countries such as Bangladesh, Cambodia, Djibouti, Central African Republic, Guinea, Madagascar, Myanmar, Nepal, Uganda, etc. A ministerial decision adopted at the end of the round says better-off countries should accelerate implementing market access commitments on goods exported by the least-developed countries, and it seeks increased technical assistance for them. More recently, developed countries have started to allow duty-free and quota-free imports for almost all products from least-developed countries.

Benefits of World Trade Organisation

The following common benefits of the WTO’s trading system doesn’t claim that everything is perfect, otherwise there would be no need for further negotiations and for the system to evolve and reform continually:

1. The system helps promote peace. Peace is partly an outcome of two of the most fundamental principles of the trading system:

*

helping trade to flow smoothly, and*

providing countries with a constructive and fair outlet for dealing with disputes over trade issues. 

It is also an outcome of the international confidence and cooperation that the system creates and reinforces.

2. Disputes are handled constructively. As trade expands in volume, in the number of products traded, and in the numbers of countries and companies trading, there is a greater chance that disputes will arise. The WTO system helps resolve these disputes peacefully and constructively.

Around 300 disputes have been brought to the WTO since it was set up in 1995. Without a means of tackling these constructively and harmoniously, some could have led to more serious political conflict.

3. A system makes life easier for all. Decisions in the WTO are made by consensus. The WTO agreements were negotiated by all members, were approved by consensus and were ratified in all members’ parliaments. The agreements apply to everyone. This makes life easier for all, in several different ways. Smaller countries can enjoy some increased bargaining power. Without a multilateral regime such as the WTO’s system, the more powerful countries would be freer to impose their will unilaterally on their smaller trading partners. Smaller countries would have to deal with each of the major economic powers individually, and would be much less able to resist unwanted pressure.

In addition, smaller countries can perform more effectively if they make use of the opportunities to form alliances and to pool resources. Several are already doing this.

4. Freer trade cuts the costs of living. Protectionism is expensive as it raises prices through imposition

of import duties and quotas. The WTO’s global system lowers trade barriers through negotiation and applies the principle of non-discrimination. The result is reduced costs of production (because imports used in production are cheaper) and reduced prices of finished goods and services, and ultimately a lower cost of living.

5. It provides more choice of products and qualities. This expands the range of final products and services that are made by domestic producers, and it increases the range of technologies they can use. When mobile telephone equipment became available, services sprang up even in the countries that did not make the equipment. Sometimes, the success of an imported product or service on the domestic market can also encourage new local producers to compete, increasing the choice of brands available to consumers as well as increasing the range of goods and services produced locally.

6. Trade raises incomes. Lowering trade barriers allows trade to increase, which adds to incomes — national incomes and personal incomes. But some adjustment is necessary. Trade also poses challenges as domestic producers face competition from imports. But the fact that there is additional income means that resources are available for governments to redistribute the benefits from those who gain the most — for example to help companies and workers adapt by becoming more productive and competitive in what they were already doing, or by switching to new activities.

7. Trade stimulates economic growth. This is a difficult subject to tackle in simple terms. There is strong evidence that trade boosts economic growth, and that economic growth means more jobs. It is also true that some jobs are lost even when trade is expanding. But the picture is complicated by a number of factors. Nevertheless, the alternative – protectionism – is not the way to tackle employment problems. In fact, the protectionism hurts the employment in the long run. For example, the US car industry, when the US Government designed trade barriers to protect the jobs by restricting imports of Japanese Cars, the American cars became more expensive, fewer cars were sold and there were major job cuts.

8. The basic principles make life more efficient. One of the most important features of WTO is that it provides efficiency in the international trade mechanism. It helps to cut costs because of important principles enshrined in the system. Such principles include non-discriminatory trade, transparency, increased certainty in trade conditions, simplification and standardisation of customs procedures, removal of red tapism, removal of bureaucracy, centralised databases of information, and such other measures that come under the head ‘trade facilitation’.

9. Governments are shielded from lobbying. One of the lessons of the protectionism that dominated the early decades of the 20th Century was the damage that can be caused if narrow sectoral interests gain an unbalanced share of political influence. The result was increasingly restrictive policy which turned into a trade war.

Superficially, restricting imports looks like an effective way of supporting an economic sector. But it biases the economy against other sectors which shouldn’t be penalized — if you protect your clothing industry, everyone else has to pay for more expensive clothes, which puts pressure on wages in all sectors.

Governments need to be armed against pressure from narrow interest groups, and the WTO system can help. The GATT-WTO system covers a wide range of sectors. So, if during a GATT-WTO trade negotiation one pressure group lobbies its government to be considered as a special case in need of protection, the government can reject the protectionist pressure by arguing that it needs a broad-ranging agreement that will benefit all sectors of the economy.

10. The system encourages good government. Under WTO rules, once a commitment has been made to liberalize a sector of trade, it is difficult to reverse. The rules also discourage a range of unwise policies. For businesses, that means greater certainty and clarity about trading conditions. For governments it can often mean good discipline.

The WTO agreements help in reducing corruption and bad government. But, quite often, governments use the WTO as a welcome external constraint on their policies. This cannot be done because it would violate the WTO agreements.

Criticism on World Trade Organisation

Criticisms of the WTO are often based on fundamental misunderstandings of the way the WTO works. Following are most common misunderstandings or criticisms on WTO:

1. The WTO dictates policy. According to critics, the WTO dictates the trade policy on its member countries. But that is not the case; in fact, it’s the governments who dictate to the WTO. WTO is a member-driven organisation. The rules of WTO are based on agreements resulting from negotiations among member governments. These rules are ratified by members’ parliaments. And all the decisions taken in the WTO are virtually made by consensus among all members.

2. The WTO is for free trade. There is another criticism on the World Trade Organisation is that it promotes free trade. According to critics, free trade could hamper the domestic production and serves the interests of giant global companies. Small domestic companies are unable to compete with such multinational companies and would not be able to survive. As a result, unemployment increases and national income decreases. It is true that it is one of the principles of WTO system that the member countries should lower their trade barriers and allow trade to flow more freely. But how low those barriers should go depends on the bargaining of member countries.

Moreover, the rules written into the agreements allow barriers to be lowered gradually so that domestic producers can adjust.

3. According to critics, the commercial interests take priority over development. Whereas, the WTO agreements are full of provisions taking the interests of development into account. Freer trade boosts economic growth and supports development. In that sense, commerce and development are good for each other.

4. Environmental issues. In WTO system, commercial interests do not take priority over environmental protection. Whereas, many provisions of WTO take environmental concerns specifically into account. For example, the preamble of the Marrakesh (Morocco) Agreement establishing the World Trade Organization includes among its objectives, optimal use of the world’s resources, sustainable development and environmental protection.

5. Health and safety issues. Key clauses in the agreements (such as GATT Art. 20) specifically allow governments to take actions to protect human, animal or plant life or health. But these actions are disciplined, for example to prevent them being used as an excuse for protecting domestic producers — protectionism in disguise.

6. The WTO destroys jobs and worsens poverty. Another accusation on WTO is that WTO system destroys jobs and widens the gap between rich and poor. In other words, it promotes economic inequalities internationally. The accusation is inaccurate and simplistic. Trade can be a powerful force for creating jobs and reducing poverty. Sometimes adjustments are necessary to deal with job losses, and here the picture is complicated. In any case, the alternative of protectionism is not the solution. It should be borne in mind that the biggest beneficiary is the country that lowers its own trade barriers.

7. Small countries are powerless in the WTO. But small countries are not powerless in WTO. In fact, they would be weaker without WTO. The WTO increases their bargaining power. In recent years, developing countries have become considerably more active in WTO negotiations, submitting an unprecedented number of trade proposals. They expressed satisfaction with the process leading to the Doha declarations. All of this bears testimony to their confidence in the system.

8. The WTO is the tool of powerful lobbies. This is a common misunderstanding that the system of the World Trade Organisation supports the powerful countries such as US, EU, Japan, etc. Giant corporations get undue protection from the WTO. The answer is that the WTO is a common platform for all the governments. The WTO treats all the countries equally. Therefore, WTO is not the tool of powerful lobbies; in fact, it offers governments a means to reduce the influence of narrow vested interests. The most common feature of the WTO is the negotiations that took place between the governments. These negotiations create a balance of interests. Governments can find it easier to reject pressure from particular lobbying groups by arguing that it had to accept the overall package in the interests of the country as a whole.

The WTO does not support the giant multinational companies. The WTO is an organisation of

governments. The private sector, non-governmental organizations and other lobbying groups do not participate in WTO activities except in special events such as seminars and symposiums.

9. Weaker countries are forced to join the WTO. Another criticism about the WTO is that the weaker or developing countries or poor countries are influenced by developed countries or by the WTO itself to join the WTO. In fact, weaker countries do have a choice to join the WTO or not. However, they are convinced to join the WTO, because they can enjoy the benefits that all WTO members grant to each other. They have the opportunity to trade, negotiate, and settle their disputes with advanced countries within the WTO. Whereas, outside the WTO, i.e., under bilateral agreements, smaller countries are weaker and cannot increase their bargaining power esp. with advanced countries.

10. The WTO is undemocratic. Some theorists claim that the system of the WTO is undemocratic. Whereas, decisions in the WTO are generally by consensus. In principle, that’s even more democratic than majority rule because no decision is taken until everyone agrees.Wages

The term 'wage' has been defined as a sum of money paid under contract by an employer to a

worker for services rendered. A wage payment is essentially a price paid for a

particular commodity, viz., labour services. According to the classical wage theory, labour supply was considered a function of real wages. But according to Keynes, the workers acted irrationally

and generally bargained for money wages and they sharply reacted against any cut in money wages. The money wage has also been called nominal wage. But money wages alone may not give us a correct idea of what a worker really earns, it is the real wage that determines the standard of living of a worker

Factors determining Real Wages:

Following are the factors that determine the real wages or the standard of living of a worker:

(a) Purchasing Power of Money: The purchasing power of money is used to compare wages at different places and at different times. It varies inversely with the price level, i.e., higher the prices, lower the

purchasing power, and vice versa. A part of high wages in England and North America may be due to higher prices prevailing in those countries/regions.

(b) Subsidiary Earnings: Subsidiary earning is the income in addition to the regular money wage,

an employee has in the form of money or goods. For example, free board and lodging are provided

to the domestic servants or peons; professors earning additional income by marking examination papers, etc.

(c) Extra Work without Extra Payment: If an employee is required to do extra work without any compensation, his real wage is reduced by that extent.

(d) Regularity or Irregularity of Employment: Regular or more secure employment may be given money wages, but their real earning may be higher than irregular and unsecured employees receiving higher money wages.

(e) Conditions of Work: Some occupations are healthier than others, and in some the hours of work are shorter than in others. All these things are taken into account in evaluating real wages.

(f) Future Prospects: A low money income will be considered a high real wage if there are good prospects of a rise in the future.

Theories of Wages:

(a) Subsistence Theory: This theory was originated with the Physiocratic School of the French economists and was developed by Adam Smith and the later economists of the classical school. The German economist Lassalle called it the Iron Law of Wages or the Brazen Law of Wages. Karl Marx made it the basis of his theory of exploitation.

According to this theory, wages tend to settle at the level just sufficient to maintain the worker and his family at the minimum subsistence level. If wages rise above the subsistence level, the workers are encouraged to marry and to have large families. The large supply of labour brings wages down to the subsistence level. If wages fall below this level, marriages and births are discouraged and under-nourishment increases death rate. Ultimately, labour supply is decreased, until wages rise again to the subsistence level. It is supposed that the labour supply is infinitely elastic, that is, its supply would increase if the price (i.e. wage) offered rises.

Criticism: This theory is almost completely outdated and has no such practical application, especially in advanced countries. The theory was based on the Malthusian Theory of Population. It is inappropriate to say that every increase in wages must inevitably be followed by an increase in birth rate. An increase in wages may be followed by a higher standard of living.

(i) Ricardo was one of the exponents of the subsistence theory. He stressed the influence of custom and habit in determining what was necessary for the workers. But habits and customs change over time. Hence, the theory cannot hold good for a longer period of time, especially of a world characterised by fast changing habits. Ricardo, therefore, admitted that wages might rise above the subsistence level for an indefinite period in an improving society.

(ii) The second criticism against this theory is that the subsistence level is more or less uniform for all working classes with certain exceptions. The thoery, thus, does not explain differences of wages in different employment.

(iii) The third criticism is that the theory explains wages only with reference to supply; the demand side has been entirely ignored. On the demand side, the employer has to consider the amount of work which the employee gives him and not the subsistence of the worker.

(iv) The fourth criticism is that the theory explains the adjustment of wages over the lifetime of a generation and does not explain wage fluctuations from year to year.

(v) The fifth and the final criticism is that the term 'subsistence' has a very vague impression. Does it refer to the minimum requirements of a modern man or of a tribal savage?

(b) Wages Fund Theory: This theory is associated with the name of J.S. Mill. According to Wages Fund Theory wages depend upon two quantities, viz.:

(i) The wage fund or the circulating capital set aside for the purchase of labour, and

(ii) The number of labourers seeking employment.

Since, the theory takes the wage fund as fixed, wages could rise only by a reduction in the number of workers. According to this thoery, the efforts of trade unions to raise wages are futile. If they succeeded in raising wages in one trade, it can only be at the expense of another, since the wage fund is fixed and the trade unions have no control over population. According to this theory, therefore, trade unions cannot raise wages for the labour class as a whole.

Criticism: This theory has been widely criticised and stands rejected now. Even J.S. Mill himself recanted it in the second edition of his book 'Principles of Political Economy'. Mill thought that wages were paid out of circulating capital alone. Whether the source of wages is capital or the present products, has been the subject of a keen controversy in the past. The fact is that in some cases, where the process of production is short (e.g., final stages of the productive process), wages are paid out of the present production. On the other hand, when a process of production is long, the labourer obviously does not obtain wages from the product of his labour either directly or through exchange. In such cases, wages mainly come out of capital. This theory is inapplicable in highly industrialised countries, but, it is applicable in an under-developed country suffering from capital deficiency, where the wages cannot be increased unless national income is increased and capital accumulated through industrialisation.

(c) Residual Claimant Theory: The Residual Claimant Theory has been advanced by an American economist Walker. According to Walker, wages are the residue left over, after the other facts of production have been paid. Walker says that rent and interest are governed by contracts but profit is determined by definite principles. There are no similar principles as regards wages. According to this theory, after rent, interest and profit have been paid, the remainder of the total output goes to the workers as wages.

This theory admits the possibility of increase in wages through greater efficiency of employees. In this sense, it is an optimistic theory, the subsistence theory and wages fund theory were pessimistic theories. Though this theory has been rejected by most economists on several bases.

(d) Marginal Productivity Theory of Wages: This theory state that, under the condition of perfect competition, every worker of same skill and efficiency in a given category will receive a wage equal to the value of the marginal product of that type of labour. The marginal product of a labour in any industry is the amount by which the output would be increased if a unit of labour was increased, while the quantities of other factors of production remaining constant. Under perfect competition, the employer will go on employing workers until the value of the product of the last worker he employs is equal to the marginal or additional cost of employing the last worker. Further, under perfect

competition, the marginal cost of labour is always equal to the wage rate, irrespective of the number of workers the employer may engage. Since every industry is subject to diminishing returns, the marginal product of labour must start declining sooner or later. Wages remaining constant, the employer stops employing more workers at that point where the value of marginal product is just equal to the wage rate:

Text Box: Wage / Revenue Productivity

It is not true, as it is assumed above, that the quantities of other factors remain constant while that of labour alone increases. To allow for this, a term 'marginal net product of labour' has been used instead of 'marginal product of labour'. The value of marginal net product of labour may be defined as being the value of the amount by which output would be increased by employing one more worker with the appropriate addition of other factors of production, less the addition to the cost of the other factors caused by increasing the quantities of other factors.

Limitations/Criticism of Marginal Productivity Theory: This theory is true only under certain assumptions such as perfect competition, perfect mobility of labour, homogenous character of all labour, constant rates of interest and rent and given prices of the product. It is a static theory. The actual world is dynamic. All assumptions are unrealistic. The following are the criticism against this theory:

(i) According to this theory, the labour is perfectly mobile so that they can be moved from one employment to another employment, which is not true in the real world.

(ii) According to this theory, there is unified wage rate across the market, which is impossible. Workers of the same skill and efficiency may not receive the same wages at two different places.

(iii) In case of monopsony, i.e., one buyer and many sellers, the employer has a grip on wages and can pull down the wages below the value of the marginal net product of labour. If the employees are collectively organised, the wage rates can be bargained. Therefore, the wages are not only determined by the number of workers employed but also by the relative bargaining strength of the labour union and the employer.

(iv) Another assumption of this theory is that there is an existence of perfect competitive market for products, which is also an unrealistic assumption. In the real world, the market for goods is characterised by imperfect competition. This also unsettles the theory.

(v) The productivity of workers is also dependent on factors such as the quality of capital and efficient management, which is outside the scope of this theory.

(vi) It should be borne in mind that the marginal net product of labour depends not merely on the supply of labour but also on the supply of all other factors of production. If other factors are plentiful and labour relatively scarce, the marginal product of labour will be high, and vice versa.

(vii) This theory takes the supply of labour for granted. Productivity is also a function of wages. Low productivity may be the cause of low wages, which may tell on the efficiency of the worker, lower his standard of living and ultimately check the supply of labour.

(e) Taussig's Theory of Wages: The American economist Taussig gives a modified version of the Marginal Productivity Theory of Wages. According to him, wages represent the marginal discounted product of labour. According to Taussig, the labourer cannot get the full amount of the marginal output. This is because production takes time and the final product of labour cannot be obtained immediately. But the labourer has to be supported in the meantime. This is done by the capitalist employer. The employer does not pay the full amount of the expected marginal product of labour. He deducts a certain percentage from the final output in order to compensate himself for the risk he takes in making an advance payment. This deduction, according to Taussig, is made at the current rate of interest.

Criticism: Two weaknesses of the theory have been recognised by Taussig himself, i.e., (i) a dim and abstract theory remote from the problem of real life. To this he replies that this weakness is common to all economic generalisations. (ii) The joint product is discounted at the current rate of interest, but according to his own analysis, the rate of interest is a result of the process of advance to the labourers. To meet this difficulty, Taussig suggests that we determine rate of interest independently of marginal productivity by the rate of time preference, and with the interest thus determined discount the marginal product of labour.

This theory is also rejected by most economists.

Modern Theory of Wages:

According to this theory, the wages are determined by the interaction of demand and supply as in the

case of ordinary commodity. Thus, this theory is also referred to demand and supply theory.

Demand for Labour: According to the modern theory of wages, the demand for labour reflects partly labourer's productivity and partly the market value of the product at different levels of production. Following are the factors that determine the demand for labour:

(a) Derived Demand: The demand for labour is a derived demand. It is derived from the demand for the commodities it helps to produce. Greater the consumer demand for the product, greater the producer demand for labour required to produce that commodity. It may be observed that it is expected demand and not existing demand for the product that determines demand for labour. Hence, the expected increase in the demand for a product will increase the demand for labour.

(b) Elasticity of Demand for Labour: The elasticity of demand for labour depends on the elasticity of demand for commodity. According to this theory, the demand for labour will generally be inelastic if their wages form only a small proportion of the total wages. The demand, on the other hand, will be elastic if the demand for product is also elastic or if cheaper substitutes are available.

(c) Prices & Quantities of Co-Operating Factors: The demand for labour also depends on the prices and the quantities of the co-operating factors. If the machines are costly, the demand for labour will be increased. The greater the demand for the co-operating factors the greater will be the demand for labour, and vice versa.

(d) Technical Progress: Another factor that influences the demand for labour is technical progress. In some cases labour and machineries are used in definite proportions.

After considering all relevant factors as discussed above, the employer is governed by one fundamental factor, viz., marginal productivity.

The change in wage rate determines the direction of change in the demand for labour but the degree of this change depends on the elasticity of demand for labour. In case of elastic demand, a small change in the wage rate will lead to a considerable change in demand for labour, and vice versa. Whether the demand for labour is elastic or not will depend on (i) the technical conditions of production, and (ii) elasticity of demand for the commodity which that labour produces. Generally the short term demand for labour is less elastic than the long-term demand. That is why the employers and trade unions adopt a stiff attitude in wage negotiations.

Demand for Labour under Perfect Competition: Under perfect competition, each firm constitutes a very small portion of the entire industry that it cannot influence wages appreciably by employing more or less of labour. The supply curve of labour confronting each employer is perfectly elastic, i.e., horizontal straight line at the level of the market wage rate. The individual demand curve is determined by marginal productivity. The individual employer hires as many labourers as will equate the marginal productivity of labour with the rate of wages in the market.

Text Box: WageText Box: Wage

It is the demand of the entire industry, not an individual firm, determines the wage rate. The individual firm has to accept the market rate of wages and adjust its own demand for labour accordingly.

Supply of Labour: The supply of labour depends on:

(a) The number of workers of a given type of labour which would offer themselves for employment at various wage rates, and

(b) The number of hours per day or the number of days per week they are prepared to work,

The labour may be supplied to three destinations:

(i) Supply of Labour to a Firm: To a given firm, the supply of labour is perfectly elastic because at the current wage rate, it can engage as many workers as it wants. Its own demand constitutes only a very small fraction of the total supply of labour. Hence the supply curve of labour for a firm is a vertical straight line.

(ii) Supply of Labour to an Industry: For the industry as a whole, the supply of labour is not infinitely elastic. If the industry wants more labour it has to attract it from other industries, by offering higher wage rates. The supply of labour for the industry is subject to the law of supply, viz., supply varies

directly with price, which means low wage small supply and high wage large supply. Hence the supply curve of labour for an industry slopes upwards from left to the right.

(iii) Supply of Labour to an Economy: The supply of labour for the entire economy depends on economic, social and political factors or institutional factors, e.g., attitude of women towards work, working age, school and college age and possibilities of part-time employment for students, size and composition of the population and sex distribution, attitude towards marriage, size of the family, birth control, etc.

Over a short period of time, reduction in wages may not cause any reduction in the supply of labour. But if wages are driven too low, competition among employers themselves will push them up. Even over a long period, the supply of labour is not very elastic.

There is a certain minimum wage below which labour will not work at all. Once this minimum is exceeded, supply of labour will increase as the wage rate goes up. But this will happen only up to a point beyond which wage increase will lead to a reduction in the supply of labour. Again, after a point, this tendency will be reversed when the worker thinks that he can move to a higher level of living. Hence a rise in wages may lead to rise or fall in the supply of labour. It will depend on the worker's relative valuation of goods and leisure.

Thus, the supply of labour will depend on the elasticity of demand for income which will vary according to the worker's temperament and social environment. When the workers' standard of living is low, they may be able to satisfy their wants with a small income and when they have made that much, they may prefer leisure to work. That is why it happens that sometimes increase in wages leads to a contraction of the supply of labour. This is represented by a backward bending supply curve of labour as shown in the following figure:

For some time this particular individual is prepared to work longer hours as the wages go up (wage is represented on OY-axis). But beyond OW wage, he will reduce rather than increase his working hours.

Interaction of Demand and Supply:

Text Box: WageText Box: Wage

In the above diagram, figure (a) represents the supply curve faced by an industry, and figure (b) represents the supply curve faced by an individual firm. W-AW is an extended line that cuts the MRP (marginal revenue productivity) curve of the firm at E ' in figure (b). At this level, the ARP (average revenue productivity) is MR which is greater than the wage OW in figure (b). Hence, all the firms (since this firm represents all the firms in the industry) are making supernormal profit at this wage level. This will lead to entry for new firms in the industry; the demand for labour will increase and the wage level will go up. Thus, supernormal profits will be competed away in the long run by the entry of new firms.

The new demand curve D'D' cuts the supply curve SS in figure (a) at point F. The wage level in this situation will be OW' which is higher than the original wage level OW. This is how the interaction of demand and supply determines the wage. When the wage is OW, the firm is in equilibrium at E' and when the wage rises to OW', the equilibrium is at F'. At this point, average revenue productivity (ARP)

and marginal revenue productivity (MRP) are equal, and the average wage OW' is equal to both of them. It means the individual firms are earning normal profits.

It may also happen that the occurrence of supernormal profits attracts some firms from outside, which may further increase the demand for labour to D"D". The wage level will then be OW". Here the ARP is less than the wage OW", i.e., the firms are suffering from losses. The result will be that some firms will leave the industry and the wage will come down to the level of OW'.

Long Run: Under perfect competition, wages are, in the long run, equal to the marginal as well as to the average productivity of labour. If marginal productivity is greater than average, it will be worthwhile to employ more labour till marginal productivity falls to the level of average productivity. On the other hand, if marginal productivity is less than average productivity, less labour will be employed and the marginal productivity will rise to the level of average productivity. Marginal productivity and average productivity thus tend to be equalised. Since wages are equal to marginal productivity, they are also equal to average productivity in the long run. This is shown in the following diagram:

OR is the wage level, AP is the average productivity curve and MP is the marginal productivity curve. They intersect at P which shows that wages are equal both to the MP and AP. When AP is rising, MP > AP, and when AP is falling, MP < AP. But when AP is neither rising nor falling, MP = AP. Hence, at equilibrium point: Wage = MP = AP.

Wages Under Imperfect Competition:

Imperfect competition may result:

(a) Bilateral Monopoly: When strong employers' associations are confronted with strong labour organisations.

(b) Monopsony: When an industrial employer or a group of employers occupy a very strong monopolistic position as compared with labour.

(a) Bilateral Monopoly: The term 'bilateral monopoly' is applicable both to commodities and labour. It is applied to a situation when a monopoly of purchase is matched with the monopoly of sale, i.e., a single monopolist facing a single monopsonist. The monopolist wishes to operate on a scale where the marginal cost is equal to marginal revenue, because that will bring him the maximum monopoly profit. On the other hand, the monopsonist wishes to purchase an amount at which marginal cost is equal to marginal utility. This indicates one optimum price for the buyer and another for the seller. There is no economic principle to determine an equilibrium price.

It is not possible to indicate definitely the output and the price which will rule. The price will depend on the circumstances of each case. In some cases, it will be a compromise price which may be influenced by the bargaining power of each party. Therefore, under bilateral monopoly, the price and output are 'indeterminate'.

Text Box: Wage

In bilateral monopoly, each side wants to get the better of the other through bargaining skill. The

monopolist will like the monopsonist to behave, as if he were one of the many buyers as in perfect competition, so that he (i.e. buyer) may accept the price fixed by firm (the monopolist producer). Similarly, the monopsonist will like the monopolist to behave as if he were a perfect competition producer (i.e. one of so many) unable to influence price, so that he (the monopsonist buyer) can purchase at his own price. Now nothing can be said as to who will succeed and how far. Most probably, there will be a compromise between the two extremes.

According to the above diagram, the monopolist will be maximising his profit (MR=MC) if he sold OM' output and charged OP1 (M'Q) price, since Q1 is a point on the demand curve DD showing what the purchaser will be willing to pay under perfect competition. On the other hand, the monopsonist will like to buy OM at OP price, since Q2, where DD and MC1 intersect, is a point where buyer's marginal valuation equals marginal cost of purchase. There will be a compromise between both the parties, i.e. the employer and the employee. Hence, factor price will be somewhere between OP and OP1, and the output between OM and OM' depending on the relative bargaining skill of the parties.

(b) Monopsony: This is the most general situation of imperfect competition, where the employer embodies in his person concentrated monopoly power of being the sole purchaser of labour, whereas labour occupies a very weak position in comparison. Monopsony also occurs when a big employer employs proportionately a very large number of a given type of labour so that he is in a position to influence the wage rate. In the following diagram, a situation is depicted where a monopsonist exploit the labour:

Text Box: Wage & Employment

In the above diagram, the MRP is the marginal revenue productivity curve representing demand for labour. The supply curve of labour is AW (Average wage curve) which is rising to the right which shows

that higher wages have to be paid to engage more labour. MW is the marginal wage curve corresponding to the AW curve. These two curves, i.e., MW curve and the MRP curve intersect at point E. It is the point where the monopsonist is in equilibrium. Here the marginal wage is equal to marginal revenue productivity of labour at the level of labour employment ON, at wage level NH (=OW).

It can be seen that this wage, i.e., NH is less than marginal revenue productivity which is NE. Thus each worker gets EH less than this marginal revenue product. This is the measure of labour exploitation under monopsony. This is called by Mrs. Robinson as 'monopsonistic exploitation'. Thus, under monopsony, wage is lower and employment is less than under perfect competition in the labour market. Under perfect competition, the equilibrium would have been at C where the supply curve AW cuts the demand curve MRP. At this point, the wage would have been higher at OW’ (=N'C) and the labour employed would have been larger at ON'.

Exploitation of Labour:

There are three types of labour exploitation:

(a) Monopsonistic Exploitation: Where the single employer has the strongest influence on the wage rate.

(b) Monopolistic Exploitation: In this condition, there is perfect competition in the labour market but there is an imperfect competition in the product market. In equilibrium, the firm will equate wage with marginal revenue product. This means that labour is paid less than the value of the marginal product which shows exploitation:

Text Box: Wage

(c) Double Exploitation: It occurs when there is imperfect competition both in the labour market (monopsony) and in the product market (monopoly). Thus there is double exploitation of labour both monopsonistic and monopolistic and labour is exploited the most.

Remedies: Following the remedial steps or the weapons to stop labour exploitation:

(i) Government intervention, and

(ii) Trade union action.

Wage Differentials:

Wages everywhere tend to approximate to the marginal productivity of labour. But, the marginal productivity of labour is different in different employments and grades. It varies with the degree of scarcity of each kind of labour in relation to the demand for it. Following are the causes of differences in wages in different employments, professions and localities:

(a) Differences in efficiency: that is, differences in education, training, and conditions under which the work is performed.

(b) Existence of non-competing groups: These groups arise because of the difficulties in the way of

mobility of labour from low-paid to high-paid empolyments. These difficulties may be due to geographical, social and economic reasons.

(c) Difficulty of learning a trade: The number of those who can master difficult trades is small. Their supply is less than demand for them, and their wages are higher.

(d) Differences in agreeableness or social esteem: Disagreeable employments must pay higher wages in order to attract labourers. If disagreeable work are performed by unskilled workers, who cannot do anything better, wages may be quite low, e.g., sweepers.

(e) Future prospects: If an occupation provides opportunities for future promotion, people will accept a lower star in it, as against another occupation offering higher initial rewards, but no chances of promotions in the future.

(f) Hazardous and dangerous occupations: generally offer higher emoluments.

(g) Regularity or irregularity of employment: also exerts a strong influence on the level of wages.

(h) Collective Bargaining: The differences in the strength and militancy of trade unions also account for differences in wages in different industries.

Price Determination under Monopolistic Competition

Imperfect competition covers all situations where there is neither pure competition nor pure monopoly. Both perfect competition and pure monopoly are very unlikely to be found in the real world. In the real world, it is the imperfect competition lying between perfect competition and pure monopoly. The fundamental distinguishing characteristic of imperfect competition is that average revenue curve slopes downwards throughout its length, but it slopes downwards at different rates in different categories of imperfect competition. The monopolistic competition is one form of imperfect competition.

Features of Monopolistic Competition:

Monopolistic competition refers to the market situation in which many producers produce goods which are close substitutes of one another. Two important distinguishing features of monopolistic competition are:

Product differentiation, and

Existence of many firms supplying the market.

Product Differentiation: In contrary to perfect competition where there is only one homogeneous commodity, in monopolistic competition there is differentiation of products. In monopolistic competition, products are not homogenous nor are they only remote substitutes. These are the products produced by competing monopolists that have separate identity, brand, logos, patents, quality and such other product features. Product differentiation does not mean that goods are completely different. Rather it means that products are different in some ways, but not altogether so. These imaginary differences are created through advertising, marketing, packaging and the use of trademarks and brand names.

Existence of Many Firms: Under monopolistic competition, there is fairly large number of sellers, let say 25 to 70. Each individual firm has relatively small part of the total market so that each has a very limited control over the price of the product. And each firm determines its own price-output policy without considering the reactions of rival firms.

In monopolistic competition, in the long run, there is freedom of entry and exit.

The commodity sold in a monopolistic competitive market is not a standardised product but a differentiated product. Hence competition is no longer exclusive on price basis. Buyers are buying a combination of physical product and the services which go with it.

Because of consumers’ attachment to a particular brand, the seller acquires a monopolistic influence on the market. Thus, the demand curve facing a firm under monopolistic competition is a downward sloping curve, i.e., if he wants to sell more, he has to lower his price. The demand curve or AR curve under monopoly also slopes downwards, but there is a difference between demand curves facing under monopolistic competition and pure monopoly. The demand curve faced by a ‘competing monopolist’ is more elastic than the demand curve faced by the ‘monopolist’, because there are no close substitutes available for the monopolist commodity.

Price Determination under Monopolistic Competition:

Under monopolistic competition, the firm will be in equilibrium position when marginal revenue is equal to marginal cost. So long the marginal revenue is greater than marginal cost, the seller will find it profitable to expand his output, and if the MR is less than MC, it is obvious he will reduce his output where the MR is equal to MC. In short run, therefore, the firm will be in equilibrium when it is maximising profits, i.e., when MR = MC.

(a) Short Run Equilibrium: Short run equilibrium is illustrated in the following diagram:

In the above diagram, the short run average cost is MT and short run average revenue is MP. Since the AR curve is above the AC curve, therefore, the profit is shown as PT. PT is the supernormal profit per unit of output. Total supernormal profit will be measured by multiplying the supernormal profit to the total output, i.e. PT × OM or PTT’P’ as shown in figure (a). The firm may also incur losses in the short run if it is facing AR curve below the AC curve. In figure (b) MP is less than MT and TP is the loss per unit of output. Total loss will be measured by multiplying loss per unit of output to the total output, i.e., TP × OM or TPP’T’.

(b) Long Run Equilibrium: Under monopolistic competition, the supernormal profit in the long run is disappeared as new firms are entered into the industry. As the new firms are entered into the industry, the demand curve or AR curve will shift to the left, and therefore, the supernormal profit will be competed away and the firms will be earning normal profits. If in the short run firms are suffering from losses, then in the long run some firms will leave the industry so that remaining firms are earning normal profits.

The AR curve in the long run will be more elastic, since a large number of substitutes will be available in the long run. Therefore, in the long run, equilibrium is established when firms are earning only normal profits. Now profits are normal only when AR = AC. It is further illustrated in the following diagram: