Development Economics PDF

DEVELOPMENT #gamechangers ECONOMICS SOCSC13 R.LANCE CHUA, MA PPT2 Classic Theories of Economic Development CLASSIC THEORIES OF ECONOMIC DEVELOPMENT FR The classic post–World War II literature on economic devel...

DEVELOPMENT #gamechangers ECONOMICS SOCSC13 R.LANCE CHUA, MA PPT2 Classic Theories of Economic Development CLASSIC THEORIES OF ECONOMIC DEVELOPMENT FR The classic post–World War II literature on economic development has been dominated by four major and sometimes competing strands of thought 1. the linear-stages-of-growth model 2. theories and patterns of structural change 3. the international-dependence revolution 4. the neoclassical, free market counterrevolution CLASSIC THEORIES OF ECONOMIC DEVELOPMENT FR 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 had historically been followed by the more developed countries Development thus became synonymous with rapid, aggregate economic growth This linear-stages approach (#1) was largely replaced in the 1970s by two competing schools of thought CLASSIC THEORIES OF ECONOMIC DEVELOPMENT FR The first, which focused on theories and patterns of structural change (#2), used 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 rapid economic growth The second, the international-dependence revolution (#3), was more radical and more political 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 CLASSIC THEORIES OF ECONOMIC DEVELOPMENT FR 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 These and other egalitarian objectives were to be achieved within the context of a growing economy, but economic growth per se was not given the exalted status accorded to it by the linear-stages and structural-change models Throughout much of the 1980s and 1990s, a fourth approach prevailed This neoclassical counterrevolution (#4) in economic thought emphasized the beneficial role of free markets, open economies, and the privatization of inefficient public enterprises  Failure to develop, was not due to exploitive external and internal forces as expounded by dependence theorists Rather, it was primarily the result of too much government intervention and regulation of the economy Today’s eclectic approach draws on all of these perspectives, and we will highlight the strengths and weaknesses of each Add a footer 7 #1 Rostow’s Stages of Growth #1 ROSTOW’S STAGES OF GROWTH FR The most influential and outspoken advocate of the stages-of-growth model of development was the American economic historian Walt W. Rostow The transition from underdevelopment to development can be described in terms of a series of steps or stages through which all countries must proceed The advanced countries, it was argued, had all passed the stage of “takeoff into self-sustaining growth,” and the underdeveloped countries that were still in either the traditional society or the “preconditions” stage had only to follow a certain set of rules of development to take off in their turn into self-sustaining economic growth  #1 ROSTOW’S STAGES OF GROWTH One of the principal strategies of development necessary for any takeoff was the mobilization of domestic and foreign savings in order to generate sufficient investment to accelerate economic growth Add a footer 10 #2 Harrod-Domar Growth Model #2 HARROD-DOMAR GROWTH MODEL FR Every economy must save a certain proportion of its national income, if only to replace worn-out or impaired capital goods (buildings, equipment, and materials) 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 GDP #2 HARROD-DOMAR GROWTH MODEL FR Example: Suppose that the capital-output ratio is roughly 3 to 1 capital-output ratio = c & national net savings ratio = s, is a fixed proportion of national output (e.g., 6%) total new investment is determined by the level of total savings National income = Y we can construct the following simple model of economic growth: #2 HARROD-DOMAR GROWTH MODEL FR It says that in the absence of government, the growth rate of national income will be directly or positively related to the savings ratio Example: the more an economy is able to save and invest—the greater the growth of that GDP will be And inversely or negatively related to the economy’s capital-output ratio Example: the higher c is, the lower the rate of GDP growth will be To grow, economies must save and invest a certain proportion of their GDP The more they can save and invest, the faster they can grow The actual rate at which they can grow for any level of saving and investment can be measured by the output-investment ratio It follows that multiplying the rate of new investment by its productivity, will give the rate by which GDP will increase #2 HARROD-DOMAR GROWTH MODEL FR In addition to investment, two other components of economic growth are labor force growth and technological progress Labor force growth is not described explicitly This is because labor is assumed to be abundant in a developing country context and can be hired as needed in a given proportion to capital investments This assumption is not always valid Technological progress can be expressed in the Harrod-Domar context as a decrease in the required capital-output ratio, giving more growth for a given level of investment In the longer run, this ratio is not fixed but can change over time in response to the functioning of financial markets and the policy environment #2 HARROD-DOMAR GROWTH MODEL FR Tejvan Pettinger points out that based on the Harrod Domar Model, the rate of economic growth depends on two things: 1.) Level of Savings Higher savings enable higher investment 2.) Capital-Output Ratio. A lower capital-output ratio means investment is more efficient and the growth rate will be higher #2 HARROD-DOMAR GROWTH MODEL FR The capital-output ratio is the amount of capital needed to increase output A high capital-output ratio means investment is inefficient The capital-output ratio also needs to take into account the depreciation of existing capital In developing countries low rates of economic growth and development are linked to low saving rates This creates a vicious cycle of low investment, low output and low savings #2 HARROD-DOMAR GROWTH MODEL FR To boost economic growth rates, it is necessary to increase savings either domestically or from abroad Higher savings create a virtuous circle of self-sustaining economic growth The transfer of capital to developing economies should enable higher growth, which in turn will lead to higher savings and growth will become more self-sustaining #2 HARROD-DOMAR GROWTH MODEL FR #2 CRITICISMS OF ROSTOW’S & HARROD-DOMAR FR The mechanisms of development embodied in the theory of stages of growth did not always work The basic reason they didn’t work was not because more saving and investment isn’t a necessary condition for accelerated rates of economic growth but rather because it is not a sufficient condition The Marshall Plan worked for Europe because the European countries receiving aid possessed the necessary structural, institutional, attitudinal conditions to convert new capital effectively into higher levels of output: 1. well-integrated commodity and money markets 2. highly developed transport facilities 3. a well-trained and educated workforce 4. the motivation to succeed 5. an efficient government bureaucracy #2 CRITICISMS OF ROSTOW’S & HARROD-DOMAR FR The Rostow and Harrod-Domar models implicitly assume the existence of these same attitudes and arrangements in underdeveloped nations In many cases, they are lacking, as are complementary factors such as: 1. managerial competence 2. skilled labor 3. the ability to plan and administer a wide assortment of development projects There was also insufficient focus on another strategy for raising growth which entails increasing the efficiency with which investments generate extra output #3 Lewis Two- Sector Model #3 LEWIS TWO-SECTOR MODEL FR One of the best-known early theoretical models of development that focused on the structural transformation of a primarily subsistence economy was that formulated by W. Arthur Lewis The Lewis two-sector model became the general theory of the development process in surplus-labor developing nations during most of the 1960s and early 1970s It is sometimes still applied, particularly to study the recent growth experience in China and labor markets in other developing countries #3 LEWIS TWO-SECTOR MODEL FR In the Lewis model, the underdeveloped economy consists of two sectors 1.) Traditional, overpopulated, rural subsistence sector: Characterized by zero marginal labor productivity A situation that permits Lewis to classify this as surplus labor in the sense that it can be withdrawn from the traditional agricultural sector without any loss of output 2.) High-productivity modern, urban industrial sector: Into which labor from the subsistence sector is gradually transferred #3 LEWIS TWO-SECTOR MODEL FR The primary focus of the model is on both the 1.) process of labor transfer and the 2.) growth of output and employment in the modern sector Both labor transfer and modern sector employment growth are brought about by output expansion in that sector The speed with which this expansion occurs is determined by the 1.) rate of industrial investment and 2.) capital accumulation in the modern sector Such investment is made possible by the excess of modern-sector profits over wages on the assumption that capitalists reinvest all their profits Lewis assumed that the level of wages in the urban industrial sector was constant, determined as a given premium over a fixed average subsistence level of wages in the traditional agricultural sector At the constant urban wage, the supply curve of rural labor to the modern sector is considered to be perfectly elastic  Consider first the traditional agricultural sector portrayed in the two right-hand diagrams of Figure 3.1b The upper diagram shows how subsistence food production varies with increases in labor inputs  It is a typical agricultural production function in which the total output or product (TPA) of food is determined by changes in the amount of the only variable input = labor (LA) Fixed quantity of capital = KA Unchanging traditional technology = tA In the lower-right diagram, we have the average and marginal product of labor curves, APLA and MPLA, which are derived from the total product curve shown immediately above  The quantity of agricultural labor (QLA) available is the same on both horizontal axes of the right-hand side of the figure and is expressed in millions of workers, as Lewis is describing an underdeveloped economy where much of the population lives and works in rural areas #3 LEWIS TWO-SECTOR MODEL FR Lewis makes two assumptions about the traditional sector: 1. There is surplus labor in the sense that MPLA is zero 2. All rural workers share equally in the output so that the rural real wage is determined by the average and not the marginal product of labor Metaphorically, this may be thought of as passing around the family rice bowl at dinnertime, from which each person takes an equal share  Assume that there are LA agricultural workers producing TPA food, which is shared equally as WA food per person The marginal product of these LA workers is zero  The upper-left diagram of Figure 3.1a portrays the total product (production function) curves for the modern industrial sector Manufactured goods = (TPM) is a function of a variable labor input = LM, for a given capital stock = KM and technology = tM On the horizontal axes, the quantity of labor employed to produce an output of = TPM1, with capital stock = KM1, is expressed in thousands of urban workers = L1  In the Lewis model, the modern sector capital stock is allowed to increase from KM1 to KM2 to KM3 as a result of the reinvestment of profits by industrial capitalists This will cause the total product curves in Figure 3.1a to shift upward from TPM(KM1) to TPM(KM2) to TPM(KM3) The process that will generate these capitalist profits for reinvestment and growth is illustrated in the lower-left diagram of Figure 3.1a  Here we have modern-sector marginal labor product curves derived from the TPM curves of the upper diagram Under the assumption of perfectly competitive labor markets in the modern sector, these marginal product of labor curves are in fact the actual demand curves for labor Here is how the system works  At this wage, the supply of rural labor is assumed to be unlimited or perfectly elastic Lewis assumes that at urban wage = WM above rural average income = WA, modern-sector employers can hire as many surplus rural workers as they want without fear of rising wages  Given a fixed supply of capital KM1 in the initial stage of modern-sector growth, the demand curve for labor is determined by labor’s declining marginal product and is shown by the negatively sloped curve D1(KM1) in the lower-left diagram Because profit-maximizing modern-sector employers are assumed to hire laborers to the point where their marginal physical product is equal to the real wage, total modern-sector employment will be equal to L1  Because Lewis assumes that all of these profits are reinvested, the total capital stock in the modern sector will rise from KM1 to KM2 This larger capital stock causes the total product curve of the modern sector to shift to TPM(KM2), which in turn induces a rise in the marginal product demand curve for labor This outward shift in the labor demand curve is shown by line D2(KM2) in the bottom half of Figure 3.1a A new equilibrium modern-sector employment level will be established at point G with L2 workers now employed #3 SUMMARY: LEWIS TWO-SECTOR MODELFR This process of modern-sector self-sustaining growth and employment expansion is assumed to continue until all surplus rural labor is absorbed in the new industrial sector Thereafter, additional workers can be withdrawn from the agricultural sector only at a higher cost of lost food production because the declining labor-to- land ratio means that the marginal product of rural labor is no longer zero This is known as the Lewis turning point The labor supply curve becomes positively sloped as modern-sector wages and employment continue to grow The structural transformation of the economy will have taken place, with the balance of economic activity shifting from traditional rural agriculture to modern urban industry #3 CRITICISMS: LEWIS TWO-SECTOR MODELFR Four of its key assumptions do not fit the institutional and economic realities of most contemporary developing countries 1.) FIRST ASSUMPTION The model implicitly assumes that 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 But what if capitalist profits are reinvested in more sophisticated labor saving capital equipment rather than just duplicating the existing capital, as is implicitly assumed in the Lewis model? “Anti-developmental” economic growth—all the extra income and output growth are distributed to the few owners of capital, while income and employment levels for the masses of workers remain largely unchanged #3 CRITICISMS: LEWIS TWO-SECTOR MODELFR Although total GDP would rise, there would be little or no improvement in aggregate social welfare measured in terms of more widely distributed gains in income and employment 2.) SECOND ASSUMPTION The notion that surplus labor exists in rural areas while there is full employment in the urban areas Most contemporary research indicates that there is little surplus labor in rural locations True, there are both seasonal and geographic exceptions to this rule but development economists today agree that Lewis’s assumption of rural surplus labor is generally not valid #3 CRITICISMS: LEWIS TWO-SECTOR MODELFR 3.) THIRD ASSUMPTION The notion of 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 Prior to the 1980s, a striking feature of urban labor markets and wage determination in almost all developing countries was the tendency for these wages to rise substantially over time even in the presence of rising levels of open modern-sector unemployment and low or zero marginal productivity in agriculture Institutional factors such as union bargaining power, civil service wage scales, and multinational corporations’ hiring practices tend to negate competitive forces in modern-sector labor markets in developing countries #3 CRITICISMS: LEWIS TWO-SECTOR MODELFR 4.) FOURTH ASSUMPTION The assumption of diminishing returns in the modern industrial sector Yet there is much evidence that increasing returns prevail in that sector, posing special problems for development policymaking #3 WHAT NEXT: LEWIS TWO-SECTOR MODEL FR We study the Lewis model because the model is widely considered relevant to recent experiences in China, where labor has been steadily absorbed from farming into manufacturing, and to a few other countries with similar growth patterns The Lewis turning point at which wages in manufacturing start to rise was widely identified with China’s wage increases #3 WHAT NEXT: LEWIS TWO-SECTOR MODEL FR We take into account the labor saving bias of most modern technological transfer: 1. the existence of substantial capital flight 2. the widespread nonexistence of rural surplus labor 3. the growing prevalence of urban surplus labor 4. the tendency for modern-sector wages to rise rapidly even where substantial open unemployment exists The model requires considerable modification in assumptions and analysis to fit the reality of most contemporary developing nations