Classical Theories of Economic Development (Uganda Christian University) PDF

1 Uganda Christian University School of Education BA. Education ECON 2102: Classical theories of Economic Development Classical theories of economic development, which emerged in the 18th a...

1 Uganda Christian University School of Education BA. Education ECON 2102: Classical theories of Economic Development Classical theories of economic development, which emerged in the 18th and 19th centuries, form the foundation of modern economic thought and have significantly influenced our understanding of the processes that drive economic growth and development. These theories sought to explain the determinants of economic progress and the accumulation of wealth in societies. Key figures such as Adam Smith, David Ricardo, and Thomas Malthus laid the groundwork for classical economic thought, focusing on the roles of capital accumulation, technological progress, and the division of labor in driving economic development. Their ideas continue to shape contemporary discussions on economic growth and provide valuable insights into the enduring principles that underpin development theory. In this class we will focus on Adam Smith and Thomas Malthus Adam Smith's Theory of Development in Economics Adam Smith is considered to be the father of economics. Adam Smith contained all his ideas in his “Wealth of Nations”. The most important aspect of this book was a Theory of Economic Development. The main points of the theory are as under: Natural Law: Adam Smith proposes natural law in economic affairs. He advocated the philosophy of free and independent action. If every individual member of society is left to peruse his economic activity, he will maximize the output to the best of his ability. Freedom of action brings out the best of an individual which increases society wealth and progress. Adam Smith opposed any government intervention in industry and commerce. He was a staunch free trader and advocated the policy of Laissez-Faire in economic affairs. He opines that natural laws are superior to law of states. Statutory law or manmade law can never be perfect and beneficial for the society, that is why Smith respects nature’s law because nature is just and moral. Nature teaches man the lesson of morality and honesty. These exercise favourable effects on the economic progress of society. Laissez Faire: Adam Smith’s theory is based on the principle of ‘Laissez-Faire’ which requires that state should not impose any restriction on freedom of an individual. The theory of economic development rests on the pillars of saving, division of labour and wide extent of market. Saving or capital accumulation is the starting point of this theory. He believed that “there is a set of rules or rights of justice and perhaps even of morality in general which are, or may be known by all men by hello either or reason or of a moral sense, and which possesses an authority superior to that of such commands of human sovereigns and such customary legal and moral regulations as may contravene them”.  2 The policy of laissez-faire allows the producers to produce as much they like, earn as much income as they can and save as much they like. Adam Smith believed that it is safe to leave the economy to be propelled, regulated and controlled by invisible hand i.e. the forces of competition motivated by self interest be allowed to play their part in minimizing the volume of savings for development. Production Function: Adam Smith recognized three factors of production namely labour, capital and land i.e. Y = f (K, L, N) K = Stock of Capital L = Labour force N = Land He emphasized labour as an important factor of production along with other factors and observed, “The annual labour of nation is the fund which originally supplies it with all necessaries and conveniences of life which it annually consumes and which consists always either in immediate produce from other nations”. Since the growth is a function of capital, labour, land and technology and land being passive element is least important. Prof. Adam Smith regarded labour as father and land as mother. He wrote, “To him (farmer) land is the only instrument which enables him to earn the wages of his labour and to make profits of this stock”. The production function does not conceive the possibility of diminishing marginal productivity. It is subject to law of increasing returns to scale. Smith argued that real cost of production shall tend to diminish with the passage of time, as a result the existence of internal and external economies occurring out of the increases in market size. Adam Smith asserted that division of labour does not depend merely on technological feasibility, it greatly depends on the extent of the market as well and the size of market depends on the available stock and the institutional restrictions placed upon both domestic and international trade. Smith observes that, “when the market is small, no person can have encouragement to dedicate himself entirely to one employment, for want of power to exchange all the surplus part of production of his own labour, which is over and above his own consumption, for such parts of the produce of other man’s labour as he has occasion for”. Smith also recognizes the importance of technological development for improvement in productivity and which is possible only if sufficient capital is available. He wrote, “The person who employs his stock in maintaining labour, endeavors, therefore, both to make among his workmen the most proper distribution of employment and furnish them with the best machines which he can either invent or afford to purchase. His ambition in both these respects is generally in proportion to the extent of his stock or to the number of people which it can employ”. Division of Labour: The rate of economic growth is determined by the size of productive labour and productivity of labour. The productivity of labour depends upon technological progress of a country and which, in turn, depends upon the division of labour. This division of labour becomes the true dynamic force in Adam Smith’s theory of growth. The only remarkable feature of Smith’s account of division of labour is pointed by Prof.  3 Schumpeter as “nobody, either before or after Adam Smith ever thought of putting such a burden upon division of labour. With Adam Smith it is practically the only factor in economic progress”. Division of labour increases the productivity of labour through specialization of tasks. When a work is sub- divided into various parts and the worker is asked to perform small parts of whole job, his efficiency increases as now he can focus his attention more carefully. Thus, the concept of division of labour means the transference of a complex production process into number of simpler process in order to facilitate the introduction of various methods of production. Adam Smith concentrated upon the social division of labour which emphasized the co-operation of all for satisfaction of the desires of each. It is the process by which different types of labour which produce goods to satisfy the individual needs of their producers are transformed into social labour which produces goods for exchanging them for other goods. Adam Smith in his book ‘Wealth of Nations’ pointed out three benefits of division of labour: 1. Increase of dexterity of workers. 2. Saving time required to produce commodity. 3. Invention of better machines and equipment. The third advantage implies that invention is the result of worker’s intelligence. But Smith wrote that workers become ‘as stupid and ignorant as it is possible for human creature to become as a result of division of labour’. Division of labour necessarily leads to exchange of goods, which highlights the importance of trade. In short, division of labour leads to exchange of goods which, in turn, promotes trade and widens the extent of market. Wide extent of market is an essential pre- requisite for economic development. Capital Accumulation: It is the pivot around which the theory of economic development revolves. The growth is functionally related to rate of investment. According to Smith, “any increase in capital stock in a country generally leads to more than proportionate increase in output on account of continually growing division of labour”. Capital stock consists of: (а) Goods for the maintenance of productive workers. (b) Goods for helping the workers in their productive activities. Adam Smith distinguished between non capital, circulating capital and fixed capital goods. Non capital goods refer to those which are useful directly and immediately to their owner. Fixed capital refers to those goods which are directly used in production processes, without changing hands. Fixed capital consists of all the means of production. Capital is increased by parsimony and diminished by prodigality and misconduct. The rate of investment was determined by the rate of saving and savings were invested in full. The classical economists also believed in the existence of wage fund. The idea is that wages tend to equal to the amount necessary for the subsistence of labourers.  4 If the total wages at any time become higher than subsistence level, the labour force will increase, competition for employment will become keener and the wages come down to the subsistence level. Thus, Smith believed that, “under stationary conditions, wage rate falls to the subsistence level, whereas in periods of rapid capital accumulation, they rise above this level. The extent to which they rise depends upon the rate of population growth”. Thus, it can be concluded that wage fund could be raised by increasing the rate of net investment. According to Smith, “investments are made because the capitalist want to earn profits on them. When a country develops and its capital stock expands, the rate of profit declines. The increasing competition among capitalists raises wages and tends to lower profits”. So it is a great difficulty of finding new profitable investment outlets that leads to falling profits. Regarding the role of interest, Smith postulated a negatively sloped supply curve of capital implying that supply of capital increased in response to decline in interest rate. Smith wrote that with the increase in prosperity, progress and population, the rate of interest falls and as a result, capital is augmented. With the fall in interest rate, the money lenders will lend more to earn more interest for the purpose of maintaining their standard of living at the previous level. Thus, the quantity of capital for lending will increase with the fall in rate of interest. But when the rate of interest falls considerably, the money lenders are unable to lend more in order to earn more to maintain their standard of living. Under these circumstances, they will themselves start investing and become entrepreneurs. Smith believed that economic progress- involves rise in money as well as real rentals, and a rise in rental share of national income. This is because the interest of land owners is closely related to general interest of the society. Agents of Growth: Smith has observed that farmers, producers and businessmen are the important agents of economic growth. It was the free trade, enterprise and competition that led farmers, producers and businessmen to expand the market and which, in turn, made the economic development inter-related. The development of agriculture leads to increase in construction works and commerce. When agricultural surplus arises as a result of economic development, the demand for commercial services and manufactured articles arises. This leads to commercial progress and establishment of manufacturing industries. On the other hand, their development leads to increase in agricultural production when farmers use advanced techniques. Thus, capital accumulation and economic development take place due to the emergence of the farmer, the producer and the businessmen. Process of Growth: “Taking institutional, political and natural factors for granted, Smith starts from the assumption that a social group may call it a ‘nation’ will experience a certain rate of economic growth that is accounted for by increase in numbers and by savings. This induces a widening of market which, in turn, increases division of labour and thus, increases productivity. In this theory, the economy grows like a tree. This process is no doubt exposed to disturbances by external factors that are not economic… but in itself, it proceeds continuously and steadily. Each situation grows out of preceding one in a uniquely determined way and the individuals whose act combine to produce each situation count individually for no more than the individual cells of a tree”. The process of growth is cumulative. Division of labour made possible by accumulation of capital and expansion of market, increases national income and output, which in turn, facilitates saving and further investment and in this way, economic development rises higher and higher. Smith’s progressive state is in reality the cheerful and hearty  5 state to all the different orders to the society. But this progressive state is not endless. It ultimately leads to stationary state. It is the scarcity of natural resources that stops growth. An economy in stationary state is characterized by unchanged population, constant total income, subsistence wage, elimination of profit in excess of the minimum consistent with risk and absence of net investment. In his opinion, an economy is stationary state finds itself at the highest level of prosperity consistent with its natural resources and environment. The competition for employment reduces wages to subsistence level and competition among the businessmen brings profits as low as possible. Once profit falls, it continues to fall. Investment also starts declining and in this way, the end results of capitalist is stationary state. When this happens, capital accumulation stops, population becomes stationary, profits are minimum, wages are at subsistence level, there is no change in per capita income and production and the economy reaches the state of stagnation. The stationary state is dull, declining, melancholy life is hard in stationary state for different sections of the society and miserable in declining state. Smith’s theory is explained with the help of a diagram 1. Time is taken along the X-axis and the rate of accumulation along the Y-axis. The economy grows from K to L during the time path T. After T, the economy reaches stationary state. Linked to L where further growth does not take place because wages rise so high that profits become zero and capital accumulation stops. Conclusion: It can be concluded that Prof. Adam Smith did not propound any specific growth theory. His views relating to economic development are part of general economic principle propounded by him. R. Lekachaman says, “A good deal of Smith’s analysis reads as though written with todays UDC’s in mind”. In a very important aspect then this book (Wealth of Nations) was the theory of economic development.  6 The Malthusian theory of economic development: Thomas Robert Malthus, with whose name the famous Malthusian theory of population is associated showed more appreciation than most of his contemporaries of the importance of distinct and systematic theory of growth. One of the leading economists of the classical school, Malthus made some significant contributions to the understanding of the subject of growth. These focused on the demand aspect of capital accumulation, population, growth nexus, and the underdeveloped state of some countries. His ideas about economic development are found in Book II entitled “The progress of wealth” of his “Principles of political economy” published in 1820. Concept of development: Malthus did not regard the process of economic development as automatic. Rather, it requires consistent efforts on the part of the people. He did not conceive of any movement towards the stationary state but emphasized that the economy reached the slump many times before attaining the optimum level of development. Thus for him the process of development was one of ups and downs of economic activities rather than smooth. Malthus was concerned with the progress of wealth of a country. By progress of wealth, he meant economic development which could be achieved by increasing the wealth of the country. The wealth of the country depends partly upon the quantity of produce obtained by its labour, and partly upon the valuation of this product. But, “wealth of the country does not always increase in proportion to the increase in value, because an increase in value may sometimes take place under an actual diminution of commodities”. Population growth and economic development: In his principles of political economy Malthus was more realistic in his analysis of population growth in the context of economic development than in his essay of population. According to him, population growth by itself is not sufficient to bring about economic development. Rather, it is the result of the development. Rather, it is the result of the development process. As Malthus wrote: “An increase of population cannot take place without proportionate increase of wealth”. As the rate of capital accumulation increases, the demand for labour also increases. This encourages population growth. But mere population growth does not increase wealth. Population growth increases wealth only if it increases effective demand, and, it is increase in effective demand which leads to increase in wealth. Role of production and distribution: Malthus regarded production and distribution as,” the two grand elements of wealth”. If they are combined in right proportions, they can increase the wealth of a country in a short time. But, if they are taken separately or combined in undue proportions, they may take many thousands years to increase wealth. So, Malthus emphasizes maximum production and optimum allocation of resources for increasing the wealth of a country during the short run. Factors in economic development: Malthus defined the problem of economic development on to explaining the difference between potential gross national product( power of producing riches) and actual gross national product( actual riches). But the principal problem is one of achieving a high level of potential gross national product. According to Malthus, the size of potential gross national product depends upon land, labour, capital and organisation. When these four factors are employed in right proportions they maximize production in the two major sectors of the economy- the agricultural and industrial sector. It is the accumulation of capital, the fertility of the soil, and technological progress that lead to increase in both agricultural and industrial production. Besides this, Malthus also emphasized the importance of non-economic factors in economic development,” which come under the head of politics and morals”. They are security of property, good constitution and excellent laws properly administered and hard working and regular habits general rectitude of character. Process of capital accumulation: Of all the factors it is the accumulation of capital which is the most important determinant of economic development. The source of capital accumulation is higher profits. Profits come from savings of capitalists, not from workers, because workers are too poor to save. If capitalists save more and spend less on consumer goods in order to have larger profits, economic growth will be retarded. In fact, Malthus suggested a concept of the  7 ‘optimum propensity to save’. To Malthus this means, “Savings from the stock which might have been destined for immediate consumption and adding to that which is to yield a profit”. Thus he concludes that, “Saving pushed to excess would destroy the motive to production”. Deficiency of effective demand: This view of Malthus is based on his denial of Say’s law of market and deficiency of effective demand. Malthus does not agree with Say that there cannot be general over-production or glut in the market. According to him, it is not at all true that commodities are always exchanged for commodities. In fact the great mass of commodities is exchanged directly for labour rather than for commodities. Since workers, who are consumers, receive less than the value of the product they produce, they cannot buy all commodities. Thus there is an excess supply of commodities in the market in relation to the demand. This gap between supply and demand cannot be filled even by the demand of capitalists. Capitalists believe in parsimony (extreme care in spending) and “deprive themselves of their usual conveniences and luxuries to save from their revenue and add to their capital”. By being, parsimonious, they employ more productive workers who are consumers, and, in turn, are not able to buy all commodities they produce. Thus there is general over-production and glut of commodities in the market due to the deficiency of effective demand or under-consumption. This leads to fall in prices, profits, saving, investment and capital accumulation. Economic stagnation: Malthus believed that the supply of labour is inelastic in the short-run. He wrote,” from the nature of population, an increase of labourers cannot be brought into the market in consequence of a particular demand. But the supply of capital can be increased faster than the increase of labour. The increasing competition in the labour market leads to rise in wages which do not increase effective demand because workers prefer leisure to increased consumption. So there may be general glut or over supply of goods in the market. It consequently leads to fall in prices, saving, investment and profits. It restricts both the power and motive of capital accumulation. It is, thus, the under consumption or glut that leads to economic stagnation. Measures to promote economic development: Malthus made several policy recommendations to promote economic development. The main recommendations are as follows: 1. Balanced growth: According to Malthus, the economy of a country is divided into two main sectors, that is, industrial sector and agricultural sector. It is the technological progress which can lead to rapid economic development in both economic development starts with capital investment in agricultural sector. The investment in agriculture continues till all the cultivable land is brought under agriculture and the agricultural sector starts yielding profits. However, soon the law of diminishing returns begins to apply and there is sharp decline in profits and there is an increase in unemployment. In order to avert this situation, Malthus suggested introduction of land reforms in agriculture. Lands reforms confer ownership rights on the actual tillers of the soil, which is an incentive to raise output. But this is a temporary measure. In order to put a break on the operation of the law of diminishing returns, Malthus suggested heavy capital expenditure and rapid technological progress in industrial sector. In this way, most of the population will be absorbed in industrial sector. The cost of living of workers on the land will be reduced permitting reduction in their wage rates. It will also lead to increased profits. In this way, Malthus favored balanced growth of both the sectors. If any of the two sectors fail to grow for whatever reasons the other sector also finds it difficult to expand. In the words of Malthus, economic development means the balanced growth of both the sectors. 2. Raising effective demand: According to Malthus, technological progress alone cannot lead to economic development of a country unless effective demand increases. Thus, an increase in effective demand is essential. The limited effective demand is less developed countries prevent their economic development. Malthus suggested the following measures for increasing effective demand: a. Equitable distribution of wealth and landed property: According to Malthus,” Thirty or forty proprietors with income averaging between one thousand and five thousand a year would create a much more effective demand for wheat, bread, good meat and manufactured  8 products than a single proprietor possessing hindered thousand a year”. Thus, Malthus believed that moderately rich people can raise effective demand more than one millionaire among the poor masses. In this way, Malthus favored equitable distribution of wealth and landed property for increasing effective demand. It will also increase production. b. Expansion of the internal and external trade: Another important measure of increasing effective demand is the expansion of internal and external trade. According to Malthus,” it is the internal and external trade that increases wants and desire to consume which are absolutely necessary to keep up market prices of commodities and prevent the fall of profits”. Expansion of the internal and external value of products and widens the scope of the market. c. Maintenance of unproductive consumers: Another measure of increasing effective demand is the maintenance of unproductive consumers. Unproductive consumers are those persons who do not produce material objects. It is the under-consumption which leads to gluts and economic stagnation. Production depends on consumption, if consumption increases, production would also increase, which leads to increase in effective demand. d. Public works schemes: Malthus emphasized the need for public works schemes for removing unemployment and increasing the effective demand. Malthus pointed out, “the employment of the poor people on roads and public works and a tendency among landlords and persons of property to build, to improve and beautify their grounds and to employ workmen and menial servants are the means to remedy the evils arising from that disturbance in the balance of produce and consumption”. However, Malthus himself noted two weaknesses of this measure. Firstly, it might prevent workers from gradually accommodating themselves to a reduced demand. In this connection he suggested that this weakness can be removed by giving low wages to workers. Secondly, it would lead to increase in taxes so as to finance public works. It would affect the private investment adversely, that is, it would reduce private investment. But this weakness was in fact the advantage of public works because it would not have the tendency to diminish capital employed to productive labour. 3. Keep the population under control: According to Malthus population tends to grow faster than food production. Food production increases in arithmetical progress(1,2,3,4,5,6,7,………so on) while the population has a universal tendency to grow in geometrical progression (1,2,4,8,16,32,64……….so on). Population has a tendency to double itself every 25 years. Food production and population growth are affected by independent factors. Food production is influenced by the law of diminishing returns. In the race between food production and population growth, the food production is thus is left far behind. There arises, therefore, disequilibrium between food production and population growth. This disequilibrium adversely affects the economic development of a country. Due to the disequilibrium or the imbalance between food production and population growth, the increasing population cannot be maintained at the existing level. There arises starvation and undernourishment on a large scale. Famines, epidemics, floods, earthquakes, wars, and other natural calamities take a heavy toll of human life. Malthus referred to these calamities as” positive checks”. These positive checks take away the excessive population and restore the equilibrium between food production and restore the equilibrium between food production and population growth. The positive checks are also called the “natural checks”. Since they are applied by nature only when man fails to check the excessive growth of population through his own efforts. Man could avert the positive checks by resorting to what Malthus called “preventive checks”. The preventive checks are man-made checks and consist of artificial devices, such as, celibacy, late marriages, moral restraints etc. to keep the population down to reasonable levels. If man applies the preventive checks, the equilibrium between food supply and population will be maintained and there will be no need for nature to apply its own checks. Preventive checks are thus, better than positive checks which take such a heavy toll of human life. Thus, for economic development it is essential that the growth of population is kept under control. Critical appraisal:  9 Malthus is regarded as a predecessor of Keynes. Keynes has rightly “claimed Robert Malthus as the first of the Cambridge economists. It was Malthus who condemned Say’s law of markets and laid emphasis upon the role of effective demand in the process of economic development. He brought out the factors which accelerate and retard economic growth. He pointed out the contribution of technological progress equitable distribution of wealth and landed property, internal and external trade, maintenance of unproductive consumption, balanced growth, public works schemes and good administration etc. these measures have come to be recognized as the main planks of modern economic growth. However, despite these virtues, Malthusian theory of economic development has certain weaknesses and thus, is subject to the following criticisms: 1. Unproductive consumers retard economic progress: Malthus has suggested that unproductive consumers try to overcome under consumption and increase effective demand. As a matter of fact such a measure retards economic progress. This remedy is tantamount to giving doles to workers and deliberately supporting idle, lazy and inefficient persons. Actually, such a measure slows down the rate of capital accumulation. 2. Negative view of capital accumulation: Malthus has taken negative view of capital accumulation. Capital accumulation leads inherently to secular stagnation is not correct. Really speaking, capital accumulation does not lead to a reduction in demand for consumer goods and decrease in profits. The fact is that when capital accumulation increases, the share of wages, profits and aggregate national income increases and all these factors increase demand for consumer goods. 3. Secular stagnation not inherent in capital accumulation: According to Malthus, the process of capital accumulation leads inherently to secular stagnation. However, it is a wrong conception for Malthus, there is a possibility of a permanent under-consumption of all commodities. But the fact is that under-consumption is not a permanent phenomenon but a temporary one. Hence, secular stagnation is not inherent in capital accumulation. 4. Exchange of commodities for commodities: Malthus does not agree with Say’s argument that commodities are not exchanged for commodities but they are exchanged for labour. In fact, labour is not a correct measure of commodities. In fact, commodities are measured by real tangible prices and not by labour. 5. Wrong saving base: According to Malthus, it is only landlords who save. However, it is one-sided. The fact is that main source of savings in society is the wage earners and not profit earners. 6. Increase of population retards economic development: According to Malthus, increase in population is always harmful and retards economic development. But this view has been criticized by modern economists. Actually we can divide the countries of the world into two categories on the basis of population: 1. Over-populated countries 2. under populated countries Increase of population is harmful for an over populated country, which will retard economic development. But increase in population is not harmful in an under populated country. Increase in population in an under populated country actually stimulates the rate of its economic growth, raises the income per capita of the people and stimulates economic development. Conclusion: In conclusion, one can say that, in his ’theory of economic growth’ Malthus has laid emphasis on under consumption or the deficiency of effective demand which leads to gluts in the economy, which is the main cause of underdevelopment. For rapid economic development, Malthus suggested maximizing production both in agricultural and industrial sectors of the economy, and therefore, state should emphasize technical progress, equitable distribution of wealth and land, expansion of internal and foreign trade, increase in consumption of consumer goods and in employment opportunities through public works schemes and also control on the population growth. It has also to take into account the consideration of non-economic factors f economic  10 development for enhancing the growth of the economy. Thus Malthus has made valuable contribution in the field of economic growth and development. Malthusian theory and its applicability to underdeveloped countries: Malthus who has done the pioneer work in the field of economic development has mentioned the factors of economic development and the causes of backwardness of an underdeveloped country in his principles of political economy’. He pointed out the various reasons of economic backwardness of the underdeveloped countries like Spain, Portugal, Hungary, Asia, Africa and Latin American countries. In view of applicability, his theory of economic growth is more relevant to poor countries of today than the theories of other classical economists. According to Malthus, the under-developed countries are dual economies, where the agricultural sector retards the development of the industrial sector, because the former operates subject to the law of increasing returns. His division and analysis of an underdeveloped economy is rather realistic. Similarly, his analytical approach to study the causes of poverty in the poor economies is also highly realistic. Similarly, his analytical approach to study the causes of poverty in the poor economies is also highly realistic even in the modern times. His explanation regarding the relation between population growth and economic development is also applicable to the present-day poor economies. But it is a fact worth nothing that the Malthusian theory of economic development has also certain aspects which are not applicable to underdeveloped countries. Firstly, his concept of ‘under-consumption’ is not applicable to underdeveloped countries. Secondly, Malthus’s view that the deficiency of effective demand was due to parsimony of capitalists, and its remedy was ‘unproductive consumption’ both on the part of capitalists and workers are not applicable to the underdeveloped and poor countries. __________________