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ECON

3066
Economic
Developm
ent

Reading: Todaro Chapter 3


Classic Theories of
Economic Development
© Natalya Brown 2008
Part I
• Four Approaches
• Linear-Stages-of-Growth Models
• Structural-Change Models
• International Dependence Revolution
• Market Fundamentalism
Four Approaches
• Four major and often competing development
theories, all trying to explain how and why
development does or does not occur.
• Newer models often draw on various aspects of
these classical theories.
• In the 1950’s and 1960’s, linear-stages-of-
growth models were popular. They described the
process of development as a series of
successive stages.
• These models were replaced in the 1970’s by
Structural Change and International
Dependence models.
• Structural change models emphasized the
internal process of structural changes that a
developing country must go through, while
international dependence models viewed
underdevelopment in terms of international and
domestic power relationships, institutional and
structural rigidities and the resulting proliferation
of dual economies and dual societies both within
and among nations of the world.
• In the 1980’s and 1990’s the neoclassical
counterrevolution focused on the
beneficial role of free markets, open
economies and the privatization of public
enterprises and suggested that the failure
of some economies to develop is a result
of too much government intervention and
regulation.
Linear-Stages-of-Growth Models
– Rostow’s Stages of Growth
– Harrod-Domar’s Growth Model
• The thinking here was that the developing
countries could learn a lot from the historical
growth experience of the now developed
countries in transforming their economies from
poor agrarian societies to modern industrial
giants.
• Emphasized the role of accelerated capital
accumulation.
Rostow’s Stages of Growth
• Rostow argued that economic development can be
described in terms of a series of steps through which
all countries must proceed:
1. The Traditional Society
2. The Pre-conditions for take-off into self-sustaining growth
3. The Take-off
4. The Drive to Maturity
5. The Age of High Mass Consumption
• Advanced nations were considered well beyond the
take-off stage while underdeveloped nations were
seen as still in the traditional or pre-conditions stages.
• Emphasized the need for the mobilization of domestic
and foreign investment in order to accelerate growth.
• It also denies Friedrich List’s argument that countries
reliant on exporting raw materials may get “locked in”,
and be unable to diversify, in that Rostow’s model states
that countries may need to depend on a few raw material
exports to finance the development of manufacturing
sectors which are not yet of superior competitiveness in
the early stages of take-off. In that way, Rostow’s model
does not deny John Maynard Keynes in that it allows for
a degree of government control over domestic
development not generally accepted by some ardent free
trade advocates.
• As a basic assumption, Rostow believes that countries
want to modernize as he describes modernization, and
that the society will ascent to the materialistic norms of
economic growth.
Traditional Societies
• Traditional societies are marked by their
pre-Newtonian understanding and use of
technology. These are societies which
have pre-scientific understandings of
gadgets, and believe that gods or spirits
facilitate the procurement of goods, rather
than man and his own ingenuity. The
norms of economic growth are completely
absent from these societies.
Preconditions for Take-off
• The preconditions to take-off are, to Rostow,
that the society begins committing itself to
secular education, that it enables a degree of
capital mobilization, especially through the
establishment of banks and currency, that an
entrepreneurial class form, and that the
secular concept of manufacturing develops,
with only a few sectors developing at this point.
This leads to a take off in ten to fifty years.
The Take-off
• Take-off then occurs when sector led
growth becomes common and society is
driven more by economic processes than
traditions. At this point, the norms of
economic growth are well established.
• Transition from traditional to modern
economy
The Drive to Maturity
• The drive to maturity refers to the need for
the economy itself to diversify. The sectors
of the economy which lead initially begin
to level off, while other sectors begin to
take off. This diversity leads to greatly
reduced rates of poverty and rising
standards of living, as the society no
longer needs to sacrifice its comfort in
order to strengthen certain sectors.
Age of High Mass Consumption
• The age of high mass consumption refers to the
period of contemporary comfort afforded many
western nations, wherein consumers
concentrate on durable goods, and hardly
remember the subsistence concerns of previous
stages.
• in the age of high mass consumption, a society
is able to choose between concentrating on
military and security issues, on equality and
welfare issues, or on developing great luxuries
for its upper class.
Criticism
• Strong bias towards western model of
modernization (free vs. controlled markets,
China).
• Tries to fit economic progress into a linear
system (many countries make false starts,
Russia).
• It considers mostly large countries: countries
with a large population (Japan), with natural
resources available at just the right time in its
history (Coal in Northern European countries), or
with a large land mass (Argentina).
Harrod-Domar Growth Model
(AK Model)
• Following on Rostow’s theory the AK model
describes the mechanism by which more
investment leads to more growth.
• Pointed to the necessity of net additions to the
capital stock
• Used to explain an economy's growth rate in
terms of the level of saving and productivity of
capital.
• It suggests there is no natural reason for an
economy to have balanced growth.
Concepts of Growth
• Warranted growth – the rate of output growth at which
firms believe they have the correct amount of capital and
therefore do not increase or decrease investment, given
expectations of future demand.
• Natural rate of growth – The rate at which the labour
force expands, a larger labour force generally means a
larger aggregate output.
• Actual growth – The actual aggregate output change.
• There is no guarantee that an economy will achieve
sufficient output growth to sustain full employment in a
context of population growth.
• The problem arises when actual growth either exceeds
or fails to meet warranted growth expectations. A vicious
cycle can be created where the difference is
exaggerated by attempts to meet the actual demand,
causing economic instability.
Components
– Capital stock (K)
– Output (Y) - GDP
– Capital-Output ratio (k): the dollar amount of
capital needed to produce a $1 stream of
GDP. K/Y or ΔK/ΔY
– Savings (S) and the savings ratio (s): the fixed
proportion of national output that is used for
new investment.
∆K = I − δK
So S = sY (1)
• Net investment is the change in the capital stock
I = ΔK (2)
• Remember that k = K/Y or ΔK/ΔY, so that
ΔK = kΔY (3)
• Net savings must equal to net investment so that
S = I. Combining (1), (2) and (3):
sY = kΔY
s/k = ΔY/Y
ΔY/Y is the growth rate of GDP.
• Increasing the savings rate, increasing the
marginal product of capital, or decreasing
the depreciation rate will increase the
growth rate of output;
• So the growth rate of GDP is determined
jointly by the savings ratio, s, and the
national capital-output ratio
• So the rate of growth of GDP is positively
related to the economies savings ratio and
negatively related to the economies
capital-output ratio.
• The more economies save and invest, the
faster they can grow but the actual rate of
growth is measured by the inverse of the
capital-output ratio – the output-capital
ratio.
• The fact that LDCs savings levels are often not enough
to meet the levels suggested by the linear-stages
models, the need to fill the “savings gap” was used to
justify massive transfers of capital and technical
assistance from developed countries to LDCs.
• More savings and investment is not a sufficient condition
for accelerated rates of economic growth. Many LDCs
lack the necessary structural, institutional and attitudinal
conditions to convert new capital effectively into higher
levels of output. They also lacked the complementary
factors of production (e.g. skilled labour and managerial
competence).
• Also the development strategies proposed by the stages
models failed to take into account the global environment
in which developing countries exist – one in which
development strategies can be thwarted by external
forces beyond the countries control.
• The main criticism of the model is the level of
assumption, one being that there is no reason
for growth to be enough to maintain full
employment, this is based on the belief that the
relative price of labour and capital is fixed, and
that they are used in equal proportions. The
model explains economic boom and bust by the
assumption that investors are only influenced by
output (known as the accelerator principle), this
is now widely believed to be false.
• Sees economic growth and development as the
same, in reality, economic growth is only a part
of development.
Structural Change Models
– Lewis Two-Sector Model
– Patterns-of-Development Approach
• These models tend to emphasize the
transformation of domestic economic
structures from traditional subsistence
agriculture economies to more modern,
urbanized and industrially diverse
manufacturing and service economies.
Lewis Two-Sector Model
• The economy consists of two sectors
– The traditional agricultural sector is typically characterized by
low wages, an abundance of labour, and low productivity
through a labour intensive production process.
– the modern manufacturing sector is defined by higher wage
rates than the agricultural sector, higher marginal productivity,
and a demand for more workers initially
• Labour can be withdrawn from the traditional sector
without any loss of output
• Focus is on labour transfer and output and employment
growth in the modern sector. The rate at which this
occurs is determined by the rate of industrial investment
and capital accumulation in the modern sector.
• Wages in the industrial sector are fixed at a premium
above wages in the traditional sector. It is assumed that
rural labour supply is perfectly elastic.
• Lewis assumed that with the urban wage above the
average rural wage, that the modern-sector employers could
hire as many surplus rural workers as the wanted without
fear of rising wages
•The successive reinvestment of profits from the modern
sector would increase the production possibilities of that
sector leading to successive increases in the demand for
labour. The employment expansion in the industrial sector
would continue until all the excess labour from the traditional
sector is absorbed. From that point onwards, modern sector
wages would rise in order for industrial employers to attract
additional workers from the traditional sector.
•Improvement in the marginal productivity of labour in the
agricultural sector is assumed to be a low priority as the
hypothetical developing nation's investment is going towards
the physical capital stock in the manufacturing sector.
• Over time as this transition continues to take place and
investment results in increases in the capital stock, the
marginal productivity of workers in the manufacturing will
be driven up by capital formation and driven down by
additional workers entering the manufacturing sector.
Eventually, the wage rates of the agricultural and
manufacturing sectors will equalize as workers leave the
agriculture for the manufacturing, increasing marginal
productivity and wages in the agriculture while driving
down productivity and wages in manufacturing.
• The end result of this transition process is that the
agricultural wage equals the manufacturing wage, the
agricultural marginal product of labour equals the
manufacturing marginal product of labour, and no further
manufacturing sector enlargement takes place as
workers no longer have a monetary incentive to
transition.
• One of the problems with Lewis’ model is that it assumes that the
rate of labour transfer and employment creation is proportional to the
rate of modern sector capital accumulation. It does not leave room
for the possibility that capitalist profits could be reinvested in labour-
saving capital equipment nor does it leave room for the possibility of
capital flight.

• The model also assumes surplus labour in rural areas and full
employment in urban areas. By and large this is not the case in most
developing nations.

•The assumption of a competitive modern-sector labour market that


allows modern sector wages to remain fixed until the rural sector
labour surplus is exhausted is unrealistic. In reality there is a
tendency for urban wages to rise over time, even when there is
considerable urban unemployment.
Part II
• Structural Change Models
– Patterns-of-Development Analysis
• International-Dependence Revolution
• The Neoclassical Counterrevolution:
Market Fundamentalism
Patterns-of-Development Approach
• Increased savings and investment are perceived as
necessary but not sufficient conditions for economic
growth. Along with accumulation of human and physical
capital, a set of interrelated structural changes are
needed to make the transition from traditional economy
to a modern one. Changes in:
– Composition of consumer demand
– International trade
– Resource usage
– Production
– Urbanization
– The growth and distribution of the population
• Both domestic and international constraints on
development are emphasized.
• Domestic constraints: country’s resource
endowment and physical population,
government policies and objectives.
• International constraints: External capital,
technology and international trade.
• The extent to which countries face these
constraints determines their development level.
• Recognition is given to the importance of the
integrated international system in which
developing countries belong – a system that can
promote or hinder their development.
• Based on extensive empirical work conducted by
Hollis B. Chenery and his colleages using cross-
sectional and time-series data, patterns of
development analysis identified several
characteristic features of the development
process.
– The shift from agricultural to industrial production
– The steady accumulation of physical and human
capital
– The shift in consumer demands from basic
necessities to desires for diverse manufactured goods
and services.
– The decline in family size and overall population
growth
• The main hypothesis of structural change models is that
development is an identifiable process of growth and change whose
main features are similar in all countries.
• However recognition is given to the differences in the circumstances
of developing countries such as differences in physical
endowments.
• Practitioners of this approach may be lead to draw incorrect
conclusions about causality since the approach is based on
empirical observation and less on theory.
– For example, practitioners may observed the important role of higher
education in developed countries and recommend policies to develop an
advanced university system even before the majority of the population
has gained basic literacy. This policy could backfire by leading to an
increase in inequality.
• Often the patterns identified through empirical observation point to
international factors that are largely out of the control of individual
countries.
• Structural change analysts are optimistic because they believe that
the right mix of economic policies will generate beneficial patterns of
self-sustaining growth.
International-Dependence
Revolution
• Neocolonial Dependence Model
• False-Paradigm Model
• Dualistic-Development Thesis

The international-dependence models grew out of the increasing


disenchantment with both the stages-of-growth and structural-change
models only for them to fall out of favor in the 80’s and 90’s as the
neoclassical models took over in importance.
These models view developing countries as beset by institutional,
political, and economic rigidities both domestic and international, and
caught up in a dependence and dominance relationship with rich
countries.
Neocolonial Dependence Model
• Direct outgrowth of Marxist thinking. It lays the blame for the
existence of underdevelopment on the shoulders of the historical
evolution of a highly unequal capitalist system of rich country-poor
country relationships.
• The dominance of the unequal power relationships between the
center (the rich countries) and the periphery (the developing
countries) renders the attempts by the LDCs to be self-sufficient and
independent difficult.
• Also the members of the elite class in the developing countries have
interests that help to perpetuate the international capitalist system of
inequality and conformity. Directly and indirectly the elite class serve
and are rewarded by international special-interest power groups
(e.g. multi-national corporations, multilateral assistance
organizations like the IMF), which are tied by the allegiance or
funding to the wealthy capitalist countries. Often, elite activities tend
to hinder any reform efforts that might benefit the population at large
leading to perpetual underdevelopment.
• The continuing poverty in the developing world is
largely attributed to the existence and policies of
the industrial capitalist countries and their
extensions in the form of small but powerful elite
groups in LDCs.
• Underdevelopment is seen as an externally-
induced phenomenon. Dependent countries can
only expand as a reflection of the expansion of
the dominant countries. Dependence causes the
dependent nations to be both backward and
exploited.
• Revolutionary struggles or at least the
restructuring of the world capitalist system are
therefore required.
The False-Paradigm Model
• Less radical than international dependence models, these models attribute
underdevelopment to faulty and inappropriate advice provided by well-
meaning but often uninformed, biased and ethnocentric international
advisers from developed-country assistance agencies and multinational
donor organizations.

• The advice given fails to recognize resilient traditional social structures, the
highly unequal ownership of land and other property rights, the
disproportionate control of elites over domestic and international financial
assets and the very unequal access to credit.

• The policy advice generated from classical and neo-classical models in


many cases merely serve to protect the interests of the existing power
groups, both domestic and international.

• Also local university intellectuals, high-government officials and other civil


servants receive training in developed-country institutions where they learn
inapplicable theoretical models.
Dualistic Development Thesis
• The concept of dualism represents the existence and
persistence of increasing divergences between rich
and poor nations, and rich a poor peoples on various
levels.
• Four elements of dualism:
1. Different sets of conditions, of which some are superior and
others inferior, can coexist in a given space.
2. The coexistence is chronic and not transitional.
3. The degrees of superiority or inferiority have a tendency to
increase over time.
4. The superior element does little or nothing to pull up the
inferior element and may in fact serve to push it down.
Structural-Change vs. International
Dependence
Structural Change International Dependence
• Emphasis is on traditional • Emphasis is on international
neoclassical theories designed power imbalances and the need
for fundamental economic,
to generate GDP growth
political and institutional reforms
• Optimistic that the right mix of both domestic and worldwide.
economic policies will generate • Pessimistic in that they offer an
beneficial patterns of self- appealing explanation of
sustaining growth underdevelopment but they offer
• Underdevelopment is a result of little formal or informal
internal constraints such as explanation of how countries can
initiate and sustain development.
insufficient savings and
investment or lack of education • Underdevelopment is an
externally induced phenomenon
and skills.
• The actual economic experience of developing
countries that have pursued revolutionary
campaigns of industrial nationalization and state-
run production has been mostly negative.
• Also, dependency theory suggests that countries
should become more inward-looking and less
entangled with developed countries, trading only
with other developing countries. Countries like
India and Chine that pursued inwardly directed
development experienced stagnant growth and
eventually opened up their economies. On the
other side, the Four Asian Tigers emphasized
exporting to developed countries and have
prospered.
The Neoclassical Counterrevolution
• The counterrevolution called for freer markets
and the dismantling of public ownership, statist
planning, and government regulation of
economic activities.
• Neoclassicist also obtained controlling power of
the world’s two most influential international
financial agencies - the World Bank and the
International Monetary Fund (IMF).
• Neoclassical counterrevolution argues that
underdevelopment is the result of poor resource
allocation due to incorrect pricing policies and too much
state intervention by overly-active developing-nation
governments and that state intervention often slows the
pace of economic growth.
• The belief is that by allowing free markets to flourish,
privatizing state-owned enterprises, promoting free trade
and export expansion, welcoming investment from
developed countries and removing the plethora of
government regulations and price distortions in factor,
product and financial markets, both economic efficiency
and economic growth will be stimulated.
• The Free Market Approach: markets alone are efficient, competition
is effective if not perfect, technology is freely available and nearly
costless to absorb, information is also perfect and nearly costless to
obtain. So government intervention in this context is distortionary
and counterproductive. Ignores market imperfections in developing
countries.
• Public-choice theory: Government can do nothing right. Politicians,
bureaucrats, citizens and states are all self-interested and take
action to achieve their own ends. Minimal government is the best
government.
• Market-friendly Approach: Recognizes the imperfections in LDC
product and factor markets and recognizes the need for government
to facilitate the operation of markets through market-friendly
interventions. Also recognizes that marker-failures are more
prominent in developing countries.
• Traditional neoclassical models of growth
are a direct outgrowth of the Harrod-
Domar and Solow models, which both
stress the importance of savings.
• The Solow Model expanded on the
Harrod-Domar formulation by adding a
second factor of production – labour – and
by introducing a third independent variable
– technology – to the growth equation.
Solow Model
• Exhibits diminishing returns to labor and
capital separately and constant returns to
both factors jointly.
• Technological progress became the
residual factor explaining long-term
growth. The level of technological
progress was assumed to be exogenous.
α 1−α
Y = K ( AL)
Y is GDP, K is the capital stock, L is labour and A represents the
productivity of labour which grows at an exogenous rate.
• According to traditional neoclassical growth
theory, output growth results from
– Increases in labour quantity and quality
– Increases in capital
– Improvements in technology
• Closed economies with lower savings rates grow
more slowly in the short run than those with high
savings rates and tend to converge to lower per
capita GDP levels. Open economies experience
income convergence at higher levels.
• By impeding the inflow of foreign investment,
heavy-handed LDC governments retard growth.
• The problem with the arguments of the
neoclassical counterrevolution is that most
LDC economies are so different in
structure and organization from the
developed countries that the behavioural
assumptions and policy prescriptions are
often incorrect.
– Markets are hardly competitive
– The invisible hand often acts to promote the
welfare of those who are already well-off while
pushing down the vast majority.
Conclusions
• In an environment of widespread institutional rigidities and severe
socioeconomic inequality, both markets and governments will
typically fail.
• The linear-stages model emphasizes the crucial role of savings and
investment.
• The Lewis two-sector model emphasizes the importance of
attempting to analyze the many linkages between the traditional
sector and the modern industry
• International dependence theories highlight the role of the structure
and workings of the world economy and the impact of decisions
made in the developed world on the growth prospects for LDCs.
• The neoclassical economic models point to the promotion of
efficient production and distribution through a proper functioning
price system and the damaging effect of government-induced
domestic and international price distortions.