Theories of Development PDF

Theories of Development D EV ELOPMENT ECO N OMICS EB 2201 LEC T U R E 3 D I LI NI H EMA CHANDRA ( PH D ) 1 Development Rostow: Stages of Development 1. What sectors of the economy do you see? 2. What are the economic and social charac...

Theories of Development D EV ELOPMENT ECO N OMICS EB 2201 LEC T U R E 3 D I LI NI H EMA CHANDRA ( PH D ) 1 Development Rostow: Stages of Development 1. What sectors of the economy do you see? 2. What are the economic and social characteristics of LDCs? 2 Development 3. Where do we find MDCs and LDCs on the globe? 3  Theories of Economic Development Theory – systematic explanation of interrelationships among economic variables Purpose – to explain causal relationships among these variables, to understand world better and provide basis for policy 4  Theories of Economic Development Economists tried to look at the characteristics of developed, least developed and/or developing countries in trying to explain how development can/cannot be achieved Came up with theories Theories about how and why development does or does not take place Examining four major and often competing development theories 1. The linear-stages-of-growth 2. Theories and patterns of structural change 3. The international-dependence revolution 4. The neoclassical, free-market counterrevolution What is happening now (in more recent times) 5  Theories of Economic Development 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. What is happening now (in more recent times) 6 (1) the linear-stages-of-growth model We shall cover two models Rostow’s stages of growth model Harrod-Domar growth model 7 (1) the linear-stages-of-growth model (1950s-1960s) Rostow’s Model by Walt Whitman Rostow 5-stage model ◦ Traditional society ◦ Preconditions for take-off ◦ Take-off ◦ Drive to maturity ◦ High Mass Consumption Countries climb (the ladder) from one stage to another 8 Traditional Society Little technology No social changes Moves to next stage when other countries invest in resources or new markets appear. (Role of IMF, World Bank, WTO???) Ex: OIL! GOLD! Minerals! 9  Rostow’s stages of growth 1. Traditional society This is an agricultural economy of mainly subsistence farming, little of which is traded The size of the capital stock is limited and of low quality resulting in very low labour productivity Little surplus output left to sell in domestic and overseas markets 10 Preconditions for Take-Off Commercial companies invest ◦ Plantation agriculture ◦ Garment industry ◦ Mining Moves to next stage when roads/railroads (infrastructure improves) and social and political leaders emerge. 11  Rostow’s stages of growth 2. Preconditions for takeoff Agriculture becomes more mechanised and more output is traded Savings and investment grow although they are still a small percentage of national income (GDP) Some external funding is required - for example in the form of overseas aid or perhaps remittance incomes from migrant workers living overseas A more national/international, as opposed to regional, outlook 12 Take-off Development of manufacturing (a country’s own companies for export) Moves to next stage with even more investment in this sector and the creation of modern social, economic, and political institutions… 13  Rostow’s stages of growth 3. Takeoff A short period of intensive growth, in which industrialization begins to occur Manufacturing industry assumes greater importance Political and social institutions start to develop - external finance may still be required Savings and investment grow, perhaps to 15% of GDP Agriculture assumes lesser importance in relative terms although the majority of people may remain employed in the farming sector 14 Drive to Maturity Development of economy beyond manufacturing (widening base of industry and business) Moves to last stage when it can take advantage of its abilities to produce for both the export and domestic markets. Assumes a middle (consumer) class 15  Rostow’s stages of growth 4. Drive to maturity This stage takes place over a long period of time, as standards of living rise, the use of technology increases, and the national economy grows and diversifies Industry becomes more diverse Growth should spread to different parts of the country as the state of technology improves 16 High Mass Consumption Top of the ladder People buy a lot of stuff…. WE HAVE ARRIVED!! Key Question: How would Rostow view the IMF, World Bank and WTO? 17  Rostow’s stages of growth 5. Age of high-mass consumption A country's economy flourishes in a capitalist system, characterized by mass production and consumption. Output levels grow, enabling increased consumer expenditure. There is a shift towards services sector activity The growth is sustained by the expansion of a middle class of consumers. 18 19 20 21  Critique of Rostow’s stages of growth Lack of empirical evidence Difficult to test Stages defined not explained Stages not unique How does an economy move to next stage? Does self-sustained growth imply effortlessness? Are obstacles to growth removed? Savings and investment is necessary but are they sufficient? Strategy of growth : Role of c (1) the linear-stages-of-growth model (1950s-1960s) Harrod-Domar growth model Explain an economy's growth rate in terms of the level of saving and productivity of capital Developed by Roy Harrod and Evsey Domar An exogenous growth model 23  Harrod-Domar growth model Y(t) – Output/income at time t 𝑌(𝑡+1) – 𝑌(𝑡) Growth rate (𝑔) = 𝑌(𝑡) C(t) - Consumption at time t S(t) - Savings at time t I(t) - Investment at time t 24  Harrod-Domar growth model 𝑌(𝑡) = 𝐶(𝑡) + 𝑆(𝑡) Output/Income = Consumption + Savings 𝐼(𝑡) = 𝑆(𝑡) Savings equals Investment 25  Harrod-Domar growth model K(t) - Stock of capital at time t (Depends on depreciation and investment) Depreciation measured as a rate (Depreciation rate = 𝛿) Rate at which K(t) is depreciating Investment increases K while depreciation decreases K 𝐾 𝑡 + 1 = 1 − 𝛿 𝐾(𝑡) + 𝐼(𝑡) 26  Harrod-Domar growth model Define savings rate (s) 𝑆(𝑡) 𝑠= 𝑌(𝑡) Fraction of the income you save Define capital output ratio (𝑐) 𝐾(𝑡) 𝑐= 𝑌(𝑡) How much capital is produced per unit output (measure of productivity) Depends on technology, labour, what you produce 27  Harrod-Domar growth model 𝐾 𝑡+1 = 1−𝛿 𝐾 𝑡 +𝐼 𝑡 (1) Since 𝐼(𝑡) = 𝑆(𝑡) 𝐾 𝑡 + 1 = 1 − 𝛿 𝐾(𝑡) + 𝑆(𝑡) (2) 𝑆(𝑡) From 𝑠 = 𝑌(𝑡) , we can write 𝑆 𝑡 = 𝑠𝑌 𝑡 (3) 𝐾(𝑡) From 𝑐 = 𝑌(𝑡) , we can write 𝐾 𝑡 = 𝑐𝑌 𝑡 4 Plug (3) and (4) into (2) 28  Harrod-Domar growth model 𝑐𝑌 𝑡 + 1 = 1 − 𝛿 𝑐𝑌 𝑡 + 𝑠𝑌 𝑡 (5) Remember that if 𝐾 𝑡 = 𝑐𝑌 𝑡 then, 𝐾 𝑡 + 1 = 𝑐𝑌 𝑡 + 1 Rewrite (5) as below 𝑌(𝑡+1) – 𝑌(𝑡) 𝑠 = −𝛿 𝑌(𝑡) 𝑐 Finally we have 𝒔 𝒈= −𝜹 𝒄 Known as the H-D equation 29  Harrod-Domar growth model 𝒔 𝒈= −𝜹 𝒄 What does this equation say Increase savings rate increases growth Decreasing the capital-output ratio (or being more productive) will increase growth Less depreciation rate will increase growth Strengths of this model Performs well in the short-run Simple 30  Harrod-Domar growth model 𝒔 𝒈= −𝜹 𝒄 s=6% and c=3 and δ=1. Then what is g? s=15% and c=3 and δ=1. Then what is g? To get from 1% to 4% growth, an increase in savings should be from 6% to 15% More savings, more investment, more capital formation If you can’t save, then use foreign aid or private foreign investment 31 Critique for Harrod-Domar growth model Assumes a constant relationship Parameters (𝑠, 𝛿, 𝑐) are exogenous Here, 𝑠, 𝛿, 𝑐 are given (determined outside the system) But in reality, as a country’s economy grows, the parameters may change For an example, the savings rate in a low income country is low but as the country grows, the savings rate increases Savings and investment is not the only thing 32 Lecture 2 33  Structural Change Models Focuses on the processes by which underdeveloped economies transform their domestic economic structures from a heavy emphasis on traditional subsistence agriculture to a more modern, more urbanized, and more industrially diverse manufacturing and service economy (Structural Transformation). We study two structural change models 1. “two-sector surplus labor” model by Arthur Lewis in the 1950s. Also known as “Lewis model” 2. The Patterns-of-Development Analysis Sir Arthur Lewis  Lewis model Assumes the Economy consists of two sectors A traditional, overpopulated, rural subsistence agricultural sector A high-productivity modern, urban industrial sector The traditional sector (mostly agricultural) consist of surplus labor This surplus labor is absorbed into the modern sector 36  Lewis Model Assume two factors of production (LA and ) Assumes MPLA = 0 for agriculture (surplus labor) i.e. Increase or decrease of labor by 1 unit will not change output (TPA) Wages in agriculture sector low but positive (paid APLA) Wage in the modern sector is larger than the subsistent agriculture sector (i.e. wM > wA ) Because wages are higher, and there is surplus labor, workers migrate from traditional sector to the modern sector to work 37 Traditional Agricultural Sector 38  Lewis Model Assume MPLM positive. More labor increase give more output. Because of this, the modern sector capitalist earn more profits All Profits earned by the modern sector reinvested (zero profits) This reinvestment increases productivity and increases production (i.e. higher TPA curve in next figure) More workers hired 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. 39 Modern Industrial Sector 40  Lewis model The structural transformation of the economy will have taken place, with economic activity shifting from traditional rural agriculture to modern urban industry 41  Critique of Lewis model Assume unlimited supply of labor in agriculture Not consider that food prices increase from more demand from urban sector and its implications on the agricultural sector Not realistic to assume only urban sector saves Rate of labor transfer and employment creation may not be proportional to rate of modern-sector capital accumulation (how about labor saving technology?) No Capital flight to foreign countries Perfectly elastic labor supply curve in the industrial sector 42  Patterns-of-Development Analysis Shows that there are certain patterns occurring in almost all countries during the development process Increased savings and investment are perceived by patterns-of-development analysts as necessary but not sufficient conditions for economic growth. In addition, 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. Structural changes involve all economic functions : transformation of production and changes in the composition of consumer demand, international trade, resource use, changes in socioeconomic factors such as urbanization and the growth and distribution of a country’s population 43  Patterns-of-Development Analysis Identify several characteristic features of the development process. shift from agricultural to industrial production the steady accumulation of physical and human capital the change in consumer demands from emphasis on food and basic necessities to desires for diverse manufactured goods and services the growth of cities and urban industries as people migrate from farms and small towns the decline in family size and overall population growth as children lose their economic value parents substitute what is traditionally labeled child quality (education) for quantity , with population growth first increasing and then decreasing in the process of development. 44  Patterns-of-Development Analysis Limitations Emphasize on patterns rather than theory Therefore, runs the risk of making the wrong conclusions about causality e.g. Wrong conclusions about importance agriculture and education sector in developing countries 45  3. The International Dependence Revolution (1970s) These models view developing countries as affected by institutional, political, and economic rigidities, both domestic and international, and caught up in a dependence and dominance relationship with rich countries. Went out of fashion in late80s and 90s and again recognized in 2000s (Anti-globalization view) We discuss three models under this. I. Neo-colonial dependence II. False paradigm III.Dualistic development thesis 46  I. Neo-colonial dependence View the existence and continuance of underdevelopment primarily as a result of the historical evolution of a highly un equal international capitalist system of rich country–poor country relationships. The coexistence of rich and poor nations in an international system dominated by such unequal power relationships between the center (the developed countries) and the periphery (the developing countries) makes attempts by poor nations to be self-reliant and independent difficult and sometimes even impossible. Certain groups in the developing countries (including land lords, entrepreneurs, military rulers, merchants, salaried public officials, and trade union leaders) who enjoy high incomes, social status, and political power. 47  II. False paradigm 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. These policies, based as they often are on mainstream, neoclassical models, in many cases merely serve the vested interests of existing power groups, both domestic and international. Desirable institutional and structural reforms, many of which we have discussed, are neglected or given only cursory attention. 48  III. Dualistic development thesis Sees the world as composed of dual societies, of rich nations and poor nations and, in the developing countries, pockets of wealth within broad areas of poverty. Dualism represents the existence and persistence of substantial and even increasing divergences between rich and poor nations and rich and poor peoples on various levels. There are four key arguments. 1. A “superior” group and “inferior,” group can coexist in a given space (Dualism) e.g. extreme poverty and affluence, modern and traditional economic sectors, growth and stagnation, and higher education among a few amid large-scale illiteracy 2. This coexistence is chronic (i.e. not temporary) and not merely transitional. 3. Not only do the degrees of superiority or inferiority fail to show any signs of diminishing, but they even have an inherent tendency to increase. 4. The interrelations between the superior and inferior elements are such that the existence of the superior elements does little or nothing to pull up the inferior element, or may be even pushing them down for underdevelopment. 49  4. The neoclassical, free market counterrevolution (1980s) Back to neoclassical free-market orientation toward development problems and policies. Based on neo-classical economics. The idea is opposite to the dependence theory. The neoclassical counter revolutionaries argue that the developing world is underdeveloped not because of the predatory activities of the developed world and the international agencies that it controls (like dependence theorists argued) but rather because of the heavy hand of the state and the corruption, inefficiency, and lack of economic incentives that permeate the economies of developing nations. Basic idea is that underdevelopment results from poor resource allocation due to incorrect pricing policies and too much state intervention by overly active developing- nation governments. Overall this promotes free markets with minimum interventions. e.g. African and Latin American countries 50 The neoclassical, free market counterrevolution (1980s) The neoclassical counterrevolution can be divided into three component approaches: 1. The free-market approach markets are efficient and government intervention in the economy is by definition distortionary and counterproductive) 2. The Public-choice theory (new political economy approach) Governments cannot do anything right, minimal government is the best government 3. The “market-friendly” approach. (1990s) recognizes that there are 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 51  Traditional Neoclassical Growth Theory Solow neoclassical growth model (Robert Solow 1924 - ) 52  Solow neoclassical growth model Solow model implies that economies will conditionally converge to the same level of income if they have the same rates of savings, depreciation, labor force growth, and productivity growth. Thus the Solow model is the basic framework for the study of convergence across countries. The key modification from the Harrod-Domar (or AK) growth model, is that the Solow model allows for substitution between capital and labor. assumes that there are diminishing returns to the use of these inputs. The aggregate production function, Y = F(K, L) is assumed characterized by constant returns to scale. 53  Solow neoclassical growth model For example, in the special case known as the Cobb-Douglas production function, at any time t we have, 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 over time at an exogenous rate. Solow model highlighted the importance of savings, and diminishing marginal returns. According to traditional neoclassical growth theory, output growth results from one or more of three factors: i. increases in labor quantity and quality (through population growth and education), ii. increases in capital (through saving and investment), and iii. improvements in technology 54  Solow Equation Where, k= capital per worker s-savings rate f(k)= output per worker Ᵹ =depreciation rate n=population growth At steady state, Δk is zero, 55 Equilibrium in the Solow Growth Model 56  Solow neoclassical growth model No matter where you start, you will end up at the steady state If the rate of savings increases, output per person (per capita income) will increase If the rate of depreciation decreases, output per person will increase 57 Practical Assignment Compare the Development Experience and Process of Sri Lanka and Singapore using the Neo-Classical Development Theories Discussed in class. 58