Economic Development PDF

Chapter 1 Classic Theories of Economic Growth and Development  1.1 Classic Theories of Economic Development: Four Approaches 1. Linear stages of growth model 2. Theories and Patterns of Structural Change 3. International-Dependence Revolution 4. Neoclassical...

Chapter 1 Classic Theories of Economic Growth and Development  1.1 Classic Theories of Economic Development: Four Approaches 1. Linear stages of growth model 2. Theories and Patterns of Structural Change 3. International-Dependence Revolution 4. Neoclassical, Free Market Counterrevolution Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-2  1.2 Development as Growth and Linear-Stages Theories A Classic Statement: Rostow’s Stages of Growth Harrod-Domar Growth Model (sometimes referred to as the AK model) Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-3  A classic statement: Rostow – Stages of Growth 1. A model where economic development is based on the idea of successive stages of development. 2. Rostow identified 5 stages of growth: ▪ The traditional society ▪ The pre-conditions for take-off ▪ The take-off ▪ The drive to maturity ▪ The age of high mass consumption 3. All advanced economies have passed the stage of take-off into self sustaining growth 4. Developing countries are still in the traditional society or the pre-conditions stage. Why? Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-4  Rostow – 5 Stages of Growth Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-5  Rostow – Stages of Growth 1. Traditional Society ▪ Characterised by ▪ subsistence economy – output not traded or recorded ▪ existence of barter ▪ high levels of agriculture and labour Village in Lesotho. 86% of the resident workforce in intensive agriculture Lesotho is engaged in subsistence agriculture. Copyright: Tracy Wade, http://www.sxc.hu/ ▪ Limited ability to growth due to lack of modern technology Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-6  Rostow – Stages of Growth 2. Pre-conditions: ▪ Development of mining industries ▪ Increase in capital use in agriculture – commercialized & mechanized ▪ Necessity of external funding ▪ Some growth in savings and The use of some capital equipment can help increase productivity and generate small surpluses which can be investment traded. Copyright: Tim & Annette, http://www.sxc.hu Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-7  Rostow – Stages of Growth 3. Take off: ▪ Increasing industrialisation ▪ Further growth in savings and investment – Productive investment rises from 5%-10% of national income At this stage, industrial growth may be linked to ▪ Some regional growth primary industries. The level of technology required will be low. ▪ Number employed in Copyright: Ramon Venne, http://www.sxc.hu agriculture declines Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-8  Rostow – Stages of Growth 4.Drive to Maturity: ▪ Growth becomes self- sustaining –wealth generation enables further investment in value adding industry and development ▪ Industry more As the economy matures, technology plays an increasing role in developing high value added diversified products. Copyright: Joao de Freitas, http://www.sxc.hu ▪ Increase in levels of technology utilised Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-9  Rostow – Stages of Growth 5. High mass consumption ▪ High output levels ▪ Expansion of consumption level beyond basic food, shelter, clothing - consumption of durables consumers' goods & services ▪ High proportion of employment in service sector ▪ National pursuit of external power & influence - increased allocation to military & foreign policy ▪ Mature economy becomes "Welfare state" Service industry dominates the economy – banking, - government use power to redistribute insurance, finance, marketing, entertainment, leisure income through progressive taxation - and so on. increase social security, shorten working Copyright: Elliott Tompkins, http://www.sxc.hu days (more leisure). Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-10  Implications of Rostow’s Theory Development requires substantial investment in capital equipment (K); to foster growth in developing nations, the right conditions for such investment would have to be created i.e. the economy needs to have reached Stage 2. For Rostow: 1. Savings and capital formation (accumulation) are central to the process of growth, hence development. 2. The key to development is to mobilize savings to generate the investment to set in train self generating economic growth. 3. Development can stall at Stage 3 for lack of savings. Suppose the deficiency in savings is on the order of 15-20% of GDP. If S = 5% then foreign aid/loans of about 10-15% plugs this ‘savings gap’. Resultant investment means a move to Stage 4- Drive to Maturity and self generating economic growth: i.e. virtuous cycles (e.g. Botswana) and not vicious cycles (e.g. Argentina). Once Stage 5(High Mass Consumption ) is achieved, this society continues to have high consumption and maintains such by incentives to savings plus additional key ingredients (good governance, property rights, human capital and functioning institutions) Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-11  Limitations of Rostow’s Theory 1.Rostow's model is limited. The determinants of a country's stage of economic development are usually seen in broader terms i.e.depend on: (a) the quality and quantity of resources (b) a country's technologies (c) a countries institutional structures e.g. law of contract 2. Rostow explains the development experience of Western countries, well. However, Rostow does not explain the experience of countries with Different cultures and traditions e.g. Sub Sahara countries which have experienced little economic development. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-12  Criticisms: 1. Too simplistic 2. Necessity of a financial infrastructure to channel any savings that are made into investment 3. Will such investment yield growth? Not necessarily 4. Need for other infrastructure –human resources (education), roads, rail, communications networks 5. Efficiency of use of investment –in productive activities? 6. Rostow argued economies would learn from one anotherand reduce the time taken to develop – has this happened? NASEEM Copyright ©2015 Pearson Education, Inc. All rightsSHAHZAD reserved. 3-13  The Harrod-Domar Model Every economy must save a certain proportion of its national income, in order 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 GDP, Y—for example, if $3 of capital is always necessary to produce an annual $1 stream of GDP—it follows that any net additions to the capital stock in the form of new investment will bring about corresponding increases in the flow of national output, GDP. Suppose that this relationship, known in economics as the capital-output ratio, is roughly 3 to 1. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-14  The Harrod-Domar Model Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-15  The Harrod-Domar Model - Simplified Version Net saving (S) is some proportion, s, of national income (Y) such that we have the simple equation → s also called net savings ratio Net investment (I) is defined as the change in the capital stock, K, and can be represented by ΔK such that 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, c it follows that Rearrange, Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-16  The Harrod-Domar Model - Simplified Version Finally, because net national savings, S, must equal net investment, I, we can write this equality as We know that and It therefore follows that we can write the “identity” of saving equaling investment Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-17  The Harrod-Domar Model - Simplified Version For example, let's say that the savings rate is 20% of GDP, the capital-output ratio is 4, it means the GDP growth rate is 20/4 – 5% Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-18 Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-19  Criticisms of the Stages Model Low level of new capital formation in most poor countries. – Create “savings gap” – if insufficient saving & investment, poor countries would seek for foreign aid & private foreign investment. Necessary versus sufficient conditions – Saving and investment is not necessary condition to accelerate growth rate, but rather it is not sufficient condition. (Other factors need to consider) – For example: Marshall Plan – US Aid to the Western Europe after WW2 - Why? (let watch this: https://goo.gl/d1Srhq) Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-20  Criticisms of the Stages Model Under the Marshall Plan, between 1948 and 1951, the United States provided $13.3 billion ($150 billion in 2017 dollars) in assistance to 16 European countries Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-21  Criticisms of the Stages Model For example in the United Kingdom in 1950s, population 50 million Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-22  Criticisms of the Stages Model Whilst in the Lesotho in 1950s, population - 734,000 Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-23  1.3 Structural-Change Models Focuses on the mechanism of transformation of domestic economic structures from traditional subsistence level agriculture to modern, urbanized & diverse manufacturing and services industry. The Lewis two-sector model – 1st sector – traditional, overpopulated, rural subsistence with zero MPL (Labor surplus) – 2nd sector – high productivity modern, urban industrial sector – The model focuses on the process of labor transfer and growth of output & employment in the modern sector. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-24  Fixed capital + unchanging technology Figure 1.1 The Lewis Model of Increase in capital stock due to Modern-Sector reinvestment by the industrial capitalist Growth in a Two- Sector Surplus- Demand curve for Labor Economy labour is determined by labour’s declining Modern sectors marginal product employers can hire as much as labourer from the rural areas, Underdeveloped without fear of rising economy + much of wages. population lives and works in rural areas Profits to industrial capitalist, which is reinvested to increase capital stocks Amount of wage paid to workers Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-25  Criticisms of the Lewis Model 4 Assumptions 1st – The rate of labor transfer and employment creation in the modern sector is proportional to the rate of modern sector capital accumulation. The faster the rate of capital accumulation, the higher the growth rate of the modern sector and the faster the rate of new job creation. Counter argument – If the capitalist reinvested profits into more sophisticated labor-saving equipment rather than taking more workers, no new job creation happens. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-26  Criticisms of the Lewis Model 2nd - Surplus labor in rural areas and full employment in the urban areas. Counter argument – Development economists today agree that Lewis’s assumption of rural labor surplus is not valid. Contemporary research shows that there is little labor surplus in rural location due to seasonal & geographic exceptions. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-27  Criticisms of the Lewis Model 3rd – A competitive modern-sector labor market that guarantees the continued existence of constant real urban wages up to the point where the supply of rural surplus labor is exhausted. Counter arguments – Institutional factors such as union bargaining power, civil service wage scales and MNC hiring practices tend to negate competitive forces in modern-sector labor market in developing countries. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-28  Criticisms of the Lewis Model 4th - Assumption of diminishing returns in modern industrial sector due to increase in number of labour. Counter argument – Yet there is much evidence that increasing returns prevail in that sector. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-29  1.4 The International- Dependence Revolution It attributes the existence and continuance of underdevelopment – (persistent low of living in conjunction of absolute poverty, low economic growth rates, low consumption level, poor health services, dependence on foreign economies) Due to the historical evolution of a highly unequal international capitalist system of rich-poor country relationship. International-dependence models view developing countries as beset (hampered) by institutional, political, and economic rigidities, both domestic and international, and caught up in a dependence and dominance relationship with rich countries. Three main theories – The neocolonial dependence model – The False-Paradigm Model – The Dualistic-Development Thesis Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-30  The Neoclassical Dependence Model Center (developed countries) vs Periphery (developing countries) relationship. Existence of small elite group with power, who serve for international special interest power groups – MNCs, national bilateral aid agencies & multilateral assistance organization (IMF / World Bank) – who also enjoys high income, social status & political power Underdevelopment is seen as an externally induced phenomenon – in contrast to linear stage of growth & structural change theories stress on internal constraints. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-31  1.4 The International- Dependence Revolution It attributes the existence and continuance of underdevelopment – (persistent low of living in conjunction of absolute poverty, low economic growth rates, low consumption level, poor health services, dependence on foreign economies) Due to the historical evolution of a highly unequal international capitalist system of rich-poor country relationship Center vs Periphery relationship. Existence of small elite group with power, who serve for international special interest power groups – MNCs, national bilateral aid agencies & multilateral assistance organization (IMF / World Bank) Underdevelopment is seen as an externally induced phenomenon – in contrast to linear stage of growth & structural change theories stress on internal constraints. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-32  The False Paradigm Model Pitfalls of using “expert” foreign advisors who misapply developed-country models 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 are said to offer complex but ultimately misleading 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 (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 Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-33  The False Paradigm Model In university economics courses, for example, this typically entails the perpetuation of the teaching of many “irrelevant” Western concepts and models, while in government policy discussions, too much emphasis is placed on attempts to measure capital-output ratios, increase savings and investment ratios, privatize and deregulate the economy, or maximize GDP growth rates. As a result, proponents argue that desirable institutional and structural reforms, are neglected or given only cursory attention. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-34  The Dualistic-Development Thesis Dualism is the existence and persistence of substantial and even increasing divergences between rich and poor nations and rich and poor peoples on various levels. Superior and inferior elements can coexist – the coexistence of modern and traditional methods of production in urban and rural sectors – the coexistence of wealthy, highly educated elites with masses of illiterate poor people; – the dependence notion of the coexistence of powerful and wealthy industrialized nations with weak, impoverished peasant societies in the international economy. Does little to show how to achieve development in a positive sense; accumulating counterexamples Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-35  1.5 The Neoclassical Counterrevolution: Market Fundamentalism Free market approach – Argues that markets alone are efficient—product markets provide the best signals for investments in new activities; labor 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 now and in the future. – Competition is effective, if not perfect; technology is freely available and nearly costless to absorb; information is also perfect and nearly costless to obtain. – Under these circumstances, any government intervention in the economy is by definition distortionary and counterproductive. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-36  1.5 The Neoclassical Counterrevolution: Market Fundamentalism Public choice approach – This is because public-choice theory assumes that politicians, bureaucrats, citizens, and states act solely from a self- interested perspective, using their power and the authority of government for their own selfish ends. – Citizens use political influence to obtain special benefits (called “rents”) from government policies (e.g., import licenses or rationed foreign exchange) that restrict access to important resources. – Politicians use government resources to consolidate and maintain positions of power and authority. – Bureaucrats and public officials use their positions to extract bribes from rent-seeking citizens and to operate protected businesses on the side. – Finally, states use their 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. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-37  1.5 The Neoclassical Counterrevolution: Market Fundamentalism Market-friendly approach – This approach recognizes that therevare many imperfections in developing-country product and factor markets and that governments do have a key role to play in facilitating the operation of markets through “nonselective” (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. – Market failures are more widespread in developing countries in areas such as investment coordination and environmental outcomes. – Missing and incomplete information, externalities in skill creation and learning, and economies of scale in production are also endemic to markets in developing countries. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-38  1.5 The Neoclassical Counterrevolution: Market Fundamentalism Main Arguments – Denies efficiency of intervention – Points up state owned enterprise failures – Stresses government failures – Traditional neoclassical growth theory - with diminishing returns, cannot sustain growth by capital accumulation alone Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-39  1.5 The Neoclassical Counterrevolution: Market Fundamentalism Solow Neo-classical Growth Model – The Solow neoclassical growth model in particular represented the seminal contribution to the neoclassical theory of growth and later earned Robert Solow the Nobel Prize in economics. – It differed from the Harrod-Domar formulation by adding a second factor, labor, and introducing a third independent variable, technology, to the growth equation. Unlike the fixed- coefficient, constant returns-to-scale assumption of the Harrod- Domar model, Solow’s neoclassical growth model exhibited diminishing returns to labor and capital separately and constant returns to both factors jointly. – Technological progress became the residual factor explaining long-term growth, and its level was assumed by Solow and other neoclassical growth theorists to be determined exogenously, that is, independently of all other factors in the model. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-40  1.5 The Neoclassical Counterrevolution: Market Fundamentalism Solow Neo-classical Growth Model – where Y is gross domestic product, K is the stock of capital (which may include human capital as well as physical capital), L is labor, and A represents the productivity of labor, which grows at an exogenous rate. – 𝛼 represents the elasticity of output with respect to capital (the percentage increase in GDP resulting from a 1% increase in human and physical capital). Since 𝛼 is assumed to be less than 1 and private capital is assumed to be paid its marginal product so that there are no external economies, this formulation of neoclassical growth theory yields diminishing returns both to capital and to labor. – the Solow neoclassical model is sometimes called an “exogenous” growth model. Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-41  1.6 Classic Theories of Development: Reconciling the Differences Governments do fail, but so do markets; a balance is needed Must attend to institutional and political realities in developing world Development economics has no universally accepted paradigm Insights and understandings are continually evolving Each theory has some strengths and some weaknesses Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-42  End to Topic 1 Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-43  Concepts for Review Autarky Dualism Average product False-paradigm model Capital-labor ratio Free market Capital-output ratio Free-market analysis Center Harrod-Domar growth Closed economy model Comprador groups Lewis two-sector model Dependence Marginal product Dominance Market failure Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-44  Concepts for Review (cont’d) Market-friendly approach Production function Necessary condition Public-choice theory Neoclassical Self-sustaining growth counterrevolution Solow neoclassical growth Neocolonial dependence model model Stages-of-growth model of Net savings ratio development New political economy Structural-change theory approach Structural transformation Open economy Sufficient condition Patterns-of-development Surplus labor analysis Underdevelopment Periphery Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-45  Appendix 3.1: Components of Economic Growth Capital Accumulation, investments in physical and human capital – Increase capital stock Growth in population and labor force Technological progress – Neutral, labor/capital-saving, labor/capital augmenting Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-46  Figure A3.1.1 Effect of Increases in Physical and Human Resources on the Production Possibility Frontier Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-47  Figure A3.1.2 Effect of Growth of Capital Stock and Land on the Production Possibility Frontier Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-48  Figure A3.1.3 Effect of Technological Change in the Agricultural Sector on the Production Possibility Frontier Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-49  Figure A3.1.4 Effect of Technological Change in the Industrial Sector on the Production Possibility Frontier Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-50  Appendix 3.2 The Solow Neoclassical Growth Model Y L = f (K L ,1) or y = f (k ) Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-51  Appendix 3.2 The Solow Neoclassical Growth Model Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-52  Appendix 3.2 The Solow Neoclassical Growth Model Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-53  Figure A3.2.1 Equilibrium in the Solow Growth Model Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-54  Figure A3.2.2 The Long-Run Effect of Changing the Saving Rate in the Solow Model Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-55  Appendix 3.3 Endogenous Growth Theory Motivation for the new growth theory The Romer model Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-56