Chapter III: Economic Growth Theories

I. Resource Constraints on Economic Growth II. Adam Smith & David Ricardo III. Marx IV. Rostow V. Balanced Growth Theory VI. Harrod-Domar VII. Model of low equilibrium trap VIII. Solow IX. Endogenous Growth
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Every school of thought is like a man who has talked to himself for a hundred years and is delighted with his won mind, however stupid it may be.
(J.W.Goethe, 1817, Principles of natural Science)

SCHOOLS OF THOUGHT

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The growth position of the less developed countries today is significantly different in many respects from that of the presently developed countries on the eve of their entry into modern economic growth

Simon Kuznets, Nobel Laureate in Economics

Q = f (K, L, A, Technology)

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I. Resource Constraints on Economic Growth

1. Malthus

Population growth rate

Subsistence wage rate

H

W
G Chapter3

Wage
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Changes in the birth & death-rates in UK, 1750-1970, 9-year moving averages (Hayami and Godo, 2005)

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Long-term changes in real prices of corn and wheat

(Hayami and Godo, 2005)
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y ea r : 1860-2000
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Why Malthus theory failed to predict the demographic change of the world population? Utility of having children: - instinctive pleasure - expected income from children (compulsory education, labor law) - security for parents during old age (social security system: social insurance) Disutility of having children: - physical and psychological hardships of bearing and rearing children - Costs paid for child-bearing and rearing: food, education... - Opportunity costs of parents labor used for child-bearing and rearing
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The household utility maximization model on the determination of the number of children
MU0 MU2 MU1

MD2
c
b

Parents marginal utility / disutility

MD1
MD0

n2
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n0 n1

No. of children

2. Vent-for-surplus theory (Hla Myint, 1971)

The development in empty lands: low population density, large tracts of unused land, abundant natural resources.
Unused natural resources:............ ...........................
Integrated into international trade under colonialism External demand

Export:................. ...........................

Income:................ ...........................

Conditions for sustained economic growth:.....................................................

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Argument between Hla Myint and Arthur Lewis

Hla Myint: - Edu and skill formation: ......................................... - Small peasants:..................................................... - Luxurious goods:...................................................
Arthur Lewis: - Small peasants:..................................................... - Peasants income:................................................. - Industrialization:.................................................... - Financial basis of the colonial government: .................................................................................
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Vent-for-surplus: Northeast Thailand (Keith Fuglie, 1989)

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- Before 1968: Limited cassava production - 1968: EEC implemented common agri. policies: high import tax on cereal grains large impact on animal husbandry - Demand for substitutes of corn in EEC increased. - 1968, a German enterprise invested in production of cassava pellets export Entry of domestic enterprises. - Export of cassava increased 10 times: 0.58 to 5.8 milion tons. - Heavy investment of Thai government on infrastructure in the region: roads, sea ports...
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2. The staple theory

(Harold Innis, 1930, 1936, 1940)

The development of Canada, Australia...: economic development of empty lands from exploitation of natural resource slack for export (Cod & fur timber wheat) Staple:.......................................................................... The mechanism:...........................................................

An important condition:.................................................
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Railways in 1891

Railways in 1911

Railways in 1931

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Victorian economic development (1861-1900): exports accounted for about 20% GDP Early period: gold and wool Later period: wheat, butter and cheese, and refrigerated meat. Railway networks: 100 miles in 1861 to 3200 miles in 1900 Development of communication system, banking system, stock exchange, foreign capital inflow

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GDP is not a good proxy for income. Retained imports = imports re-exports

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Strengths: A historical and political perspective for economic development; Explains how growth (in the early stages) is due to local staples Weaknesses: Hard to apply the theory; Better at explaining past development than providing guidance for local actions Applications: Exploit the local staple as long as it remains competitive; Do not diversify local industries as long as the staple export is high; Improve the competitiveness of the staple.
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2. Dutch disease (Corden and Neary, 1982)

Experience: Rich natural gas deposit in the North Sea in 1950s in the Netherlands
Natural resources (oil, ores)
Export:................Trade surplus:.............. External demand

Real rate of exchange for local currency:.................

Economy:...........................

Industry:... ................

Agriculture:.. ....................

Mining and related services: ..........................

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Dutch disease: worldwide experience

Mexico (during the world oil crises)

- Discovery of a large oil reserve - Export foreign currency - Also, foreign banks increased loans to Mexico - Mexican Dollars appreciated - Government expenditure rocketed (food subsidy) - After the crises, price declined budget deficit - Printing money high inflation tight fiscal policy economic downturn
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Nigeria (during the world oil crises) High revenue from oil export conspicuous development projects (capital intensive) and government consumption excess demands inflation real rate of exchange appreciated (fixed official exchange rate) non-oil sectors (esp. agri) damaged rural villages deserted, urban slums inflated by migrants desolated rural villages, swarms of unemployed workers in cities: lowequilibrium trap (Krugman, 1987; Matsuyama, 1991).
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Indonesia:
High revenue from oil heavy investment in agriculture (research, irrigation, fertilizer subsidy...) + disciplined fiscal policy + repeated devaluations in the exchange rate and liberalization in international trade and FDI to promote labor-intensive industries escape from the Dutch disease.

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GDP/capita (current exchange rate-USD) 2000 Average annual growth rate 1965-2000 GDP/capita (PPP) 2000 HDI, 2000

Nigeria Indonesia

324 738

0.1 4.1

860 2970

0.462 0.684

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1965 Agr Ind

Nigeria Indonesia 55 56 12 13

1980 Ser Agr Ind

33 31 21 30 46 49

2000 Ser Agr Ind

34 21 30 17 46 47

Ser
25 36

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Manufactured goods / export

Industrial competitiveness index (UNIDO)

Nigeria

Indonesia

1965 1 4

2000 0 57

1985 0.006 0.012

1998 0.006 0.054

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Venezuela - 1917: first oil extraction - 1928: a large oil exporter (1930: 98% export turnover from oil) - 1960: 50% of oil export income invested in Agri. and Industry GDP/capita increased by 25% - 1973-79: oil price increased dramatically - Government expenditure rose (esp. on imports) - 1983: oil crisis over serious budget deficit - 1989: Interference of IMF - 1998-2003: GDP declined by 27%
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Arab Saudi - Oil discovery in 1938. - Income from oil export increased from $4.3b in 1973 to $101.8b in 1980. - Disciplined fiscal policy - Investment in non-oil industries - Huge oil reserve in Arab Saudi - However, a successful case that escapes from the Dutch disease

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A question: is investment a source of growth?

Countries Average annual real GDP growth rate (%) Investment/GDP (%)

9 miracle East Asian

112 countries 38 Sub-Sahara 23 OECD countries

4.9
1.8 0.6 2.7

25
16 10 24

Penn World Tables (1960-2000)

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II. Adam Smith and David Ricardo 1. Adam Smith (1723-90) Famous book ...................................................................... ....................................................................... ................................................ (1776) A condition of economic growth: Increase investment by suppressing consumption

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Wealth of Nations Public goods:

Capital stock

Expanded market

Income of entrepreneurs:

Income of spendthrifts (courtiers, landlords, privileged merchants):

Policies:

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2. D. Ricardo (1772-1823) Ricardos Book ............................................... ................................................ ................................................ ........... (1817)

K accumulation: driving force of economic growth. K = payments to labor in advance + purchase of tools and structures
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Ricardian Trap or food problem: ........ ............................................................ ............................................................ Ricardian trap is more serious in the early stage of development:........................... ............................................................ Proposal of Ricardo:............................... ........................................................... Is the proposal appropriate for developing countries now?

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Real prices of corn and wheat in USA (Hayami and Godo, 2005)

y ea r : 1860-2000
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Rice prices of difference countries (Hayami and Godo, 2005)

Rice price

Sri Lanka domestic price Philippine domestic price

Thai export price

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Yield of wheat and corn in the USA: 1860-2000

(Hayami and Godo, 2005)
50

40

30

20

10

0 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

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Paddy yield- modern varieties with characteristics of resistance to brown planthopper (Hayami & Godo, 2005)

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Rice Yield per hectare (Hayami & Godo, 2005)

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III. Marx model of capitalist development 1818-1883

- Similarity to Ricardos:

- Causes of the infinitely elastic labor supply curve:

- 2 assumptions of the model:

Industrial reserve army: Technological progress:
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why?

Wage rate

D1 So D0 S1

R0
R1 D0 (K0) D1 (K1)

L0

L1

Labor employment

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Differences in subsistence wage rate in Ricardos and in Marxs:

Income share of laborer and capitalist: Technology in developing countries: Food problem in the Marx model:

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The Marx model and the efficiency wage theory:

Inconsistencies of the model: - high wage rate: - theory and practice: Originally, Harvey Leibenstein (1957) observes a positive relationship: Efficiency wage model of Carl Shapiro & Joseph Stiglitz (1984)

Assumption:
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z: w: m: p: n:

z < (w m) pn

How to make the inequality satisfied:

The minimum wage that deter laborers from cheating (efficiency wage):

Why w can be low:

1) 2)
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IV. Rostow 5-stage model of development

S & I in industry

5. Age of high mass-consumption 4. Drive to maturity 3. Take-off 2. Preconditions for take-off 1. Traditional society time

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1. Traditional Society

Subsistence economy dominated by agriculture, which is labor intensive and uses limited quantities of capital Trade is by barter Limited technology to process raw materials Investment is almost 0 Productivity is low

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A village in Lesotho. 86% of labor force in Lesotho produce agri., which is selfsufficient. Copyright: Tracy Wade, http://www.sxc.hu/
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2. Preconditions for take off A prerequisite: Industrial revolution

Surpluses for trading emerge supported by a developing transport infrastructure Agriculture becomes more commercialized and mechanized with technological improvements Savings and investment growth Entrepreneurs emerge A single industry begins to dominate often textiles
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The production is equipped with some tools (capital) to increase productivity and goods for trade. Copyright: Tim & Annette, http://www.sxc.hu
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3. Take off

Industrialization increases may cause large scale ruralurban migration

Growth is concentrated in few regions and in few industries New institutions evolve to support industrialization Investment is higher (min 10%) Airports, roads, railways are built intensively

Lasts for 2-3 decades

(England in mid 17th century; Germany in late 17th century)
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High industrial development Copyright: Ramon Venne, http://www.sxc.hu

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4. Drive to maturity
Growth is diverse supported by technological innovation Economic development spread to all parts of country A more complex transport system develops Increase in number and new types of industries; early industries decline Continued rapid urbanization Investment is high: 40-60 % of GDP Lasts for 60 years (Europe in 1900)
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In a matured economy, Manfacturing plays an increasingly important role to produce high value added products. Copyright: Joao de Freitas, http://www.sxc.hu
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5. High mass consumption

Rapid expansion of tertiary industry Industry shifts to produce durable consumer goods (Western nations; 100 years for the U.S.)

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Economy is dominated by the service sector (Banking and Finance, Insurance, Marketing, Entertainment...)
Copyright: Elliott Tompkins, http://www.sxc.hu
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Implications of the Rostows model:

Limitations of the Rostows model:

-

Other infrastructures: 1) financial institutions: SI; 2) others

Efficiency of investment is not considered

All countries follow the same path?
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V. The theory of balanced growth

-

Rosenstein-Rodan (1943) and Ragner Nurkse (1952, 1953) Export pessimism: Hitherto imported industrial commodities: Markets: Solutions: Imported capital ............saving rate:......... Roles of government:
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VI. Harrod Domar model

Perkins (pp. 110-117) g=s/v d Major weaknesses:

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VII. Model of low equilibrium trap

- Model of a vicious circle between low per capita income and low saving in low-income economies - Critical minimum effort or Big push

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Pop growth rate m

(N/N)
(Y/N)

s = S/Y Saving rate i

m s/c = Y/Y

(Y/N)

Pop and income growth rate m

h

e d

b (N/N) f
(Y/N)

n k
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VIII. Solow model

Production function: Y = AKL1- K(t) = I(t) - K(t) = sY K(t) (closed economy) Assuming: L(t) = ent Steady state: k = 0 At steady state: sAk (n+)k = 0

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Capital deepening and capital widening:

In the steady state: k = const y = const; c = 1-s = const.

Growth rate of k, y, c:
Growth rate of K, Y, C:

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d i

d=(n+)k

i1 = s1Ak

k*
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k
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Changes in the saving rate

d i

d=(n+)k i2= s2Ak

i1 = s1Ak

k 1*
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k2*

k
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From k=sAk - (n+ )k we have k/k = sAk-1 (n+ )

n+ s2f(k)/k s1f(k)/k k1* k2*

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Changes in the population growth rate

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Log y1960 Secondary schooling (Logy) x (schooling) Life expectancy Fertility rate Government consumption Rule-of-law index Terms of trade Democracy index Democracy index square Inflation rate

-0.023 0.010 -0.005 0.042 -0.014 -0.115 0.026 0.127 0.094 -0.091 -0.039

0.003 0.003 0.002 0.014 0.005 0.027 0.006 0.030 0.024 0.024 0.008

Sub-saharan dummy Latin America East Asia dummy

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-0.004 -0.005 0.005

0.004 0.003 83 0.004

Paul Krugman & East Asian Miracle

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Real GNI/capita (Atlas method)

410$
South Korea Taiwan 1973 1972

1000$
1977 Not available

10000$
1995 1997

Hong Kong
Singapore Kenya Colombia Vietnam

1960
1962 1988 1972 2001

1971
1971 not yet in 2008 1979 2008

1988
1989

not yet in 2008

Source: WB, NBS

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Singapore (1966-94): working/total pop increased from 27 to 51%; Investment/GDP increased from 11 to 40%

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TFP of Asian Dragon compared to G-7

Canada 1960-89 0.5 Hong Kong 1966-91 2.3

France Germany Italy Japan UK US

1960-89 1960-89 1960-89 1960-89 1960-89 1960-89

1.5 Singapore 1.6 South Korea 2.0 Taiwan 2.0 1.3 0.4

1966-90 1966-90 1966-90

0.2 1.7 2.1

Source: Aylwin Young (1995)

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Technology advancement in Solow model

d i
d=(n+)k i2= sA2k i1 = sA1k
n+ sf2(k)/k sf1(k)/k

k1*

k 2*

k
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k2*

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Strengths of Solow model: - more reasonable assumption: diminishing marginal product of capital - long-run steady-state level and transition path to the steady state
Weaknesses of Solow model: - s, n, skills of workforce, technology are given - What are fundamental determinants of factor accumulation and productivity that affect the steady state ? - Does not take into account other factors: health, education, politics, institutions, trade policies, geography... - Includes only one sector
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IX. Endogenous growth model

1. AK model
Y= AK y=Ak y, k, c increase at constant rate

sA
n+

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2. AK & Cobb-Douglas model

Y= AK + BKL1- y = Ak+Bk

sf(k)/k sA
n+

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3. Romer model Addresses technological spillovers.

Assumptions:
- Each producer: constant returns to scale (perfect competition) - Economywide capital stock, Ke, positively affects output at the industry level increasing returns to scale at the economywide level
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For each industry: Yi=AKiLi1-Ke (A is constant) Assume that each industry use the same level of K and L: Y=AK+L1- Prove that g = n(1-)/(1--)

Assume that > 0 so that g-n>0 and y is growing

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sf(k)/k sA
n+

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