Sources of Economic Growth

Sources of Growth

• Economic growth is measured through increases in GDP per capita
• Economies and societies become more prosperous as a result of:
  • Discovery of riches and natural resources
  • Effort
  • Savings and capital accumulation
  • Education
  • Theft
  • Efficiency
  • Technological change
• The Growth Function: Output (O) = F(K, L, R)e + A + P
  • "F" means "function of"
  • K is capital
  • L is labor
  • R is natural resources
  • E is an exponent that measures how efficiently K, L & R are used to transform intermediate inputs into final goods and services
  • "A" refers to net income from capital investments and labor abroad
  • "P" refers to colonial plunder and expropriation (-) or transfers and development aid (+)

Intermediate and Ultimate Sources of Growth

• Intermediate Sources include:
  • Trends in domestic and international demand
  • Economic and social policies
  • The distance to the world technological frontier
• The Ultimate Sources of Growth include:
  • Long-run trends in scientific and technological knowledge
  • Demographic trends
  • Institutions and institutional change
  • Historical developments
  • Basic social attitudes and capabilities
  • Changes in class structures, etc

Classical Thinking About Growth, Development & Stagnation

• Since the 1700s, classical economists and sociologists have tried to determine the reasons for the success of the capitalistic West in terms of economic growth and advancement
• Their main focus has been on the ultimate sources of growth and development in these countries

Adam Smith

• Adam Smith was interested in how differences between countries came about in terms of their relative income and wealth
• He sought to understand the causes of prosperity for some countries
• Smith was a firm believer in the free market/invisible hand/price mechanism
• Smith believed that the free market would promote and improve collective welfare
• Limited government intervention
• He believed that free trade and free competition would improve net gains from world trade
• Adam Smith emphasized the importance of specialization & division of labor, which results in dramatic increases in productivity

Ricardo, Malthus & Mill

• Ricardo (1792 – 1823), Malthus & Mill (1806-73) shared Adam Smith's preference for free markets
• Ricardo's law of Comparative advantage states that all countries entering into international trade will benefit if they specialize in the production of products they are relatively most efficient at producing
• Ricardo feared that economic development would stagnate in the long run due to population growth
• Increased population growth will call into production less and less fertile soils which will then result in diminishing marginal returns and a lowering of productivity
• Food will then become scarce causing prices to rise and wage rates to increase
• Rising wages cut into profits, which then reduces future investment
• Falling investment lowers economic growth
• To postpone the slowdown of growth, Ricardo advocated for abolishing tariffs on imported food
• Thomas Malthus (1766 – 1834) believed that food production grew arithmetically while population grew geometrically
• Thomas Malthus asserted that food production would not keep up with population growth
• Malthus theorized that this would result in starvation and famine in the long run

Friedrich List

• Friedrich List (1789 – 1846) was a firm believer in protection and government intervention, unlike Ricardo, Malthus & Mill
• List believed that dominant nations mainly benefited from free trade
• List argued for tariff protection for German infant industries
• He believed that active government intervention was necessary to build up an industrial sector in later-developing economies
• Active government intervention was vital to furthering the structural transformation of agrarian societies into industrial societies

Herbert Spencer

• Herbert Spencer (1820-1903) and other classical sociologists focused on the major development trends associated with the rise of modern capitalist societies
• Spencer favored free markets
• He argued that societies evolve, adapting to changing environmental conditions
• Social evolution involves growth in size, differentiation and complexity
• Militant hierarchical societies represent earlier stages of social evolution
• Industrial societies represent later stages of social evolution
• Market competition promoting the survival of the most efficient firms, contributes to social change and increasing welfare

Ferdinand Tonnies

• Ferdinand Tonnies (1855-1936) and other sociologists examined the changes accompanying economic growth
• Tonnies highlighted the shift from communal social patterns (Gemeinschaft) to more individualistic, specialized, and impersonal relationships (Gesellschaft)

Rostow's Stages of Development

• In 1960, American Economic Historian W. W. Rostow suggested that countries pass through five stages of economic development
• Stage 1 - Traditional Society
  • The economy is dominated by subsistence activity where output is consumed by producers rather than traded
  • Trade is conducted through barter (goods for goods)
  • Agriculture is the most important industry
  • Production is labor-intensive with limited capital
  • Resource allocation is determined by traditional methods
• Stage 2 - Transitional Stage (preconditions for takeoff)
  • Increased specialization generates surpluses for trading
  • Emergence of transport infrastructure to support trade
  • Incomes, savings and investment grow
  • Entrepreneurs emerge
  • External trade occurs, focusing on primary products
• Stage 3 - Take-Off
  • Industrialization increases and workers move from agriculture to manufacturing
  • Growth is concentrated in a few regions of the country, and in one or two manufacturing industries
  • Investment levels reach over 10% of GNP
  • Economic transitions are accompanied by the evolution of new political and social institutions that support industrialization
  • Self-sustaining growth as investment leads to increasing incomes, which generates savings to finance further investment
• Stage 4 - Drive to Maturity
  • The domestic economy diversifies into new areas
  • Technological innovation drives investment opportunities
  • The economy produces a wide range of goods and services
  • The level of imports drops
• Stage 5 - High Mass Consumption
  • The economy gears itself towards mass consumption
  • The consumer durable industries flourish
  • The service sector becomes increasingly dominant
  • Development requires substantial investment in capital
  • For LDCs, the right conditions for investment must be created
  • Aid or foreign direct investment needs to occur at stage 3 but only after stage 2 has been reached: then investment leads to rapid growth
• Limitations of Rostow’s Model
  • Many development economists argue Rostows's model was developed with Western cultures in mind, and is not applicable to LDCs
  • General and limited nature
  • It does not set down the detailed nature of the pre-conditions for growth
  • The main use is highlighting the need for investment.
  • As an economic development model it only addresses growth, not development in a wider context

Advantages of Backwardness

• Industrialization in late developing economies happens in leaps or rapid spurts, such as in Taiwan, Korea, & China
• Financial institutions, e.g. banks, play a prominent role
• There also exists international technology transfer

Neoclassical Theories of Growth

• Neo-classical economic theory maintains that economic growth is caused by:
  • Increase in labour quantity (population growth)
  • Improvements in labour through training and education
  • Increase in capital (through higher savings and investment)
  • Improvements in technology
• Underdevelopment comes from a government that does not utilize resources efficiently with state intervention and price regulations
• Neoclassical economists believe government control inhibits growth by encouraging corruption, inefficiency, and removing profit motive for entrepreneurship
• Root cause of underdevelopment is the governments of LDCs themselves
• Economies will grow through proper government policies that free up markets and improve the supply side
• As a result, the long-run aggregate supply shifts and potential output increases
• Advocation of strategies that should be encouraged:
  • Competitive free markets
  • Privatization of state owned industries
  • A move from closed (no trade) to open (trading) economies
  • Opening up the domestic economy by cutting tariffs and quotas to promote free trade and foreign direct investment
  • Policies should stimulate investment, output and income to raise savings
• Problems with the Model:
  • Makes unrealistic assumptions and ignores issues
  • Assumes creating a free market and private enterprise culture is possible and desirable
  • Market failure in externalities gets ignored during economic growth
  • Uneven distribution of income is ignored

Explanations of Underdevelopment: Theories of Unequal Exchange

• Unequal exchange states that participation of developing countries in the international division of labor is detrimental to economic development