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Development all chapter

Development Economics II (Jimma University)

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CHAPTER ONE: INTRODUCTION

1.1. Definition and History of Development Economics

The study of development economics as a separate subject is a relatively recent phenomenon
(sine 1950s). Today, it is very common everywhere in the world. Development economics deals
with the problems of developing nations. Development economics focus on various development
issues like; structural transformation, Sustainable development, Human capital development,
Infrastructural development, Economic growth and Macroeconomic stability.

Reasons behind the existence of development economics.

 Interest on growth &development post 1930’s great depression and end of WWI and II

 Poor countries recognition of their backwardness and need for development.

 Recognition of mutual interdependence of the world economy.

 Economic development is the major priority of the world’s nations.

 All nations are being challenged by the crucial task of improving income, well-being and
economic capabilities of people.

1.2. Nature and Scope of Development Economics

Traditional economics Concerned primarily with the efficient, least cost allocation of scarce
productive resources and producing an ever-expanding goods and services within these resource.
While political economy goes beyond traditional economics to study the social and institutional
processes through which certain groups of political and economic elites influence the allocation
of scarce productive resources now and in the future. Political economics is concerned with the
relationship between politics and economics, with a special emphasis on the role of power in
economic decision-making.

Development economics has an even greater scope. It studies how economies are transformed
from stagnation to growth and from low income to high-income status, and overcome problems

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of absolute poverty (Todaro). It is the economics of contemporary poor and underdeveloped

nations or /non-occidental/ countries. It has an even greater scope than traditional economics and
political economy. Development economics concerned with the economic, cultural, and political
requirements to affect rapid structural and institutional transformations of entire societies of
developing nation, which are Poverty stricken Malnourished and illiterate. It focuses on broader
multidisciplinary approaches that attempt to combine relevant concepts and theories from
traditional economic analysis along with new models.

1.3. Concepts of Economic Growth and Development

Economic growth is a sustained increase in a country’s output of goods and services, or product
per capital. Economic growth may be defined as an increase in a country's ability to produce
goods and services. Economic growth merely refers to an increase in the real Gross Domestic
Product, or GDP per capita over a period. Economic growth means more output or national
income. If the production of goods and services in a nation rises, by whatever means, one can
speak of that rise as economic growth. However, Economic growth is not the end of human
development. According to Friedman, economic growth is an expansion of the system in one or
more dimensions without the change in structure economic growth can be shown by an outward
shift in the PPF of the economy.

CONSUMER GOOD

NEW PPF

CAPITAL GOOD

FIGURE 1.1: PPF and Economic Growth

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Economic growth was not followed by similar progress in human development. Instead, growth
was achieved at the cost of:

 greater inequality,

 higher unemployment,

 weakened democracy,

 Negative externalities and lack of sustainability

 loss of cultural identity, or

 over consumption of natural resources

Development is an innovative process leading to the structural transformation of social system.

Economic development is taken to mean growth plus change. Development is a
multidimensional process (includes change in social structure, economic growth, reduction of
inequality, and eradication of poverty). The following are the three-core value of Economic
development.

– Sustenance: Provision of basic need

– Self esteem: Self respect

– Freedom from servitude: The right to choose

Sustenance: All people have certain basic needs without which life would be impossible. These
life-sustaining basic human needs include food, shelter, health, and protection. When any of
these is absent or in critically short supply, a condition of "absolute underdevelopment" exists. A
basic function of all economic activity, therefore, is to provide as many people as possible with
the means of overcoming the helplessness and misery arising from a lack of food, shelter, health,
and protection. Rising per capita incomes, the elimination of absolute poverty, greater
employment opportunities, and falling income inequalities constitute the necessary condition but
not the sufficient condition for development.

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Self-esteem: A second universal component of the good life is self-esteem—a sense of worth
and self-respect, of not being used as a tool by others for their own ends. All peoples and
societies seek some basic form of self-esteem, although they may call it authenticity, identity,
dignity, respect, honor, or recognition.

Freedom from servitude: A third and final universal value that he suggests should constitute the
meaning of development is the concept of human freedom. Freedom here is to be understood in
the sense of emancipation from alienating material conditions of life and from social servitude to
nature, ignorance, other people, misery, institutions, and dogmatic beliefs. Freedom involves an
expanded range of choices for societies and their members together with a minimization of
external constraints in the pursuit of some social goal we call development.

Generally, Growth without development is possible but it is difficult to conceive development

without growth. Economic Development requires Economic Growth.

1.4. OBJECTIVE of Economic Development

Development in all societies must have at least the following three objectives.

 To increase the availability and widen the distribution of basic life-sustaining

goods such AS food, shelter, health and protection.

 To raise levels of living and incomes: the provision of more jobs, better education,
and greater attention to cultural &human values.

 To expand the range of economic and social choices available to individuals and
nations BY freeing them from servitude and dependence on other people, nations,
state and forces of ignorance and human misery.

To say a country has achieved economic development, at least the following condition should be
satisfied.

o Long period of economic growth (at least) for two or three decades

o Reduce income inequality

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o The economic growth should come with participation of many people

(mass participation)

O Reduce absolute poverty over a PERIOD.

1.5. Measurements OF Economic Growth and Development

In order to know the performance of the economy we need measurement of economic

development. During the last five decades, a number of MEASUREMENTS used to show the
economic development in the given country. The following are the major types of economic
development measurements;

– Gross national product/per capita income

– Human development index

– Human poverty index

– Multidimensional poverty index

GDP/Per capita income

The first measurement of economic development was Gross Domestic Product (GDP)/Gross
National product and Per capita Income. GDP refers the market value of all final goods and
services produced within an economy/ the borders of a country, regardless of whether the
ultimate recipient of that income resides within or outside the country/ in a given period of time.
Thus, GNI comprises GDP plus the difference between the income residents receive from abroad
for factor services (labor and capital) less payments made to nonresidents who contribute to the
domestic economy.
Thus, using the growth of GDP or per Capita Real Income (GNI) to measure developments is
misleading because of the following reasons.
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 GNP/GDP measures “productive” activity in a very narrow way, excluding, for

example, the non-marketed productive activities of the household, including those
produced by women and children.

 GNP measure of development do not include non-monetary change variable in the

economy such as Life expectancy, family love and affection, peace, and other
variables capturing the change in welfare. Therefore, GNP is a very blurred
instrument for measuring economic development without considerable attention
being given to other variables.

 GNI/GNP does tell us nothing about the distribution of the change income that
has appeared in GDP growth.

 The necessary data are often incomplete, unreliable or not available. For e.g. a
population figure or estimates of output, or incomes or expenditure may be
inaccurate.

Realizing the problem of GNP or GNI as a measure of economic development, most researchers
want to include the human element than only including the monetary value in economic
development measurement. In this regard, they want to include the following indicators.

 Education and literacy rates

 Life expectancy

 The level of nutrition as measured by calorie supply per head

 Consumption of energy per head

 Consumption of consumer durable per Capita

 The proportion of infant mortality per thousand of live population

Human Development Index (HDI)

In 1990, the United Nation Development Program (UNDP) published a Human Development
Index (HDI), a new measurement that provides a broad method by which inter-country and inter-

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temporal comparisons of living standards can be undertaken. It measures both social and
economic development. The Human Development Index (HDI) is a composite index that
measures the average achievements in a country in three basic dimensions of human
development:

• A long and healthy life, as measured by life expectancy at birth;

• Knowledge, as measured by the adult literacy rate (2/3 weight) and the combined gross
enrolment ratio for primary, secondary and tertiary schools(1/3weight) ; and

• A decent standard of living, as measured by GDP per capita in Purchasing Power Parity
(PPP) US dollars”.

Individually each index can be calculated as

The HDI used to be simple average of the three.HDI value ranges between 0 and 1where 0 shows
the worst result and 1 the best. HDI uses logarithms of GDP per capital.

Importances of HDI are;

 The HDI offers an alternative to GNP for measuring relative socio-economic progress of
nations.

 It enables people and their government to evaluate progress overtime and to determine
priorities for policy intervention

 It also permits comparisons of the experience in different countries.

Example; calculate Human Development Index (HDI)

Dimension/indicator Maximum Value Minimum Value

Life expectancy at Birth 85 25

Adult literacy rate (100%) 100 0

Combined gross enrollment 100 0
ratio (100%)

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GDP Per capita (PPP US$) 40000 100

o Assuming a country with PPP GDP per capita of $1,500, the income index is calculated
as follows:

o Income index = [log (1,500) - log (100)] = 3.176 – 2 = 0.452

[Log (40,000) - log (100)] 2.602 – 2

o Assuming a country with 56 years of life expectancy, the life expectancy index is
calculated as follows

o Life expectancy index = 56 – 25 = 31 = 0.517

85 – 25 60
o For an economy with adult literacy rate of 40% and gross enrollment ratio (P, S and T) of
52%,

o The adult literacy index = 40-0 = 0.4

100-0
o The gross enrollment index = 52-0 = 0.52

100-0
o Finally, the education index= 2 ( 0.4) + 1 (0.52) =0.267+ 0.173 = 0.44

3 3
o HDI= 1 (0. 452) + 1 (0.517) + 1 ( 0.44) = 0.469

3 3 3

Human Poverty Index (HPI)

In 1998, UNDP introduced the new measurement of economic development, which is known as
human poverty index. The HPI measures deprivation in the three basic dimensions of human
development:

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– A long and healthy life-vulnerability to death at a relatively early age as measured

by the probability at birth of not surviving to age 40;

– Knowledge-exclusion from the world of reading and communication, as measured

by the adult illiteracy rate;

– A decent standard of living-a lack of access to overall economic provisioning as

measured by the unweighted average of two indicators, the percentage of the
population not using an improved water source and the percentage of children
under weight for age.

Multidimensional Poverty Index

Recognizing the limitation of HDI and HPI, in their latest effort, UNDP and OPHI have
presented the new composite measurement of economic development. This new measurement is
called Multidimensional Poverty Index (MPI). MPI is an index of acute multidimensional
poverty. It reveals the combination of deprivation that batters a household at the same time. It
reflects deprivation in education, health and living standard for people across 104 counties. The
health dimension is measured by using child mortality and nutrition. The education dimension is
measured by years of schooling and child enrollment. The last dimension is living standard
which is measured by the availability of electricity, drinking water, sanitation, flooring, cooking
fuel and assets.

1.6. Common and Diverse Characteristics of Developing Nations

The following are the major common characteristics of developing countries.

– Low Levels of Living:

– Low Levels of Productivity

– High Rates of Population Growth and Dependency Burdens

– High and Rising Levels of Unemployment and Underemployment

– Substantial Dependence on Agricultural Production and Primary Product Exports

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– Prevalence of Imperfect Markets and Incomplete Information

– Dominance, Dependence and Vulnerability in International Relations

The Diverse Structures of LDCs

The following are the major components of diverse structure of developing countries.

– The Size of the country (population, area, and Income)

– Historical Background

– Physical and Human Resources

– Ethnic and Religious Composition

– Relative Importance of the Public and Private Sectors

– Industrial Structure

– External Dependence: Economic, Political and Cultural

– Political Structure, Power and Interest Groups

Size of the country: A country can be large in terms of its physical size, its population or by the
level of its national income. When you study this subsection, try to identify the advantages and
disadvantages of being large in size.

Historical Background: Try to understand why the colonial background of a country is

important. Colonial rule usually has a large influence on the pre-existing institutions and culture
of a colonized country. Some of these influences were good but some were very harmful. Once
the colonial rule ended, it took a long time for the newly independent countries to find its own
foothold. Therefore, it is very important to know when a country has become independent or
whether at any point of time it was under colonial rule or not.

Physical and Human Resources: The amount of physical resources, which includes land,
minerals and other raw materials, available to a country can make a huge difference in the life
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style of its population. The countries in the developing world differ very much in terms of
owning these physical resources.

Not only this, they also differ a lot in terms of their human resources. Some countries may have a
small but highly skilled, educated and innovative population. While some countries may have a
very large but very low skill population with very little or no education. Yet there can be
countries which may have large population with average to high levels of skill and education.

Ethnic and Religious Composition: The more diverse a country is, in terms of ethnic and
religious composition, the more will be internal strife and political instability. These internal
strife and political instability can lead to violent conflicts and even self-destructive wars, which
would cause waste of valuable resources, which could definitely be used to promote other
valuable development goals. E.g., Afghanistan, Sri Lanka, Bosnia, Zaire, etc. In general, the
more homogeneous a country is the easier it is for that country to become successful in their
development effort. E.g., Korea, Taiwan, Singapore, Hong Kong.

Relative Importance of Public and Private Sectors: The relative importance and size of public
and private sector varies a lot in the developing countries. Countries where there are severe
shortage of skilled human resources usually used to have large public sectors and state owned
enterprises, on the assumption that limited skilled manpower can be best used by coordinating
rather than fragmenting administrative entrepreneurial activities.

The widespread failure of a number of countries with large public sectors to show any
improvement at all raised questions regarding the validity of these claims. Economic policies to
promote same development objectives would be different in countries with different
compositions of public and private sectors.

Industrial Structure: Developing countries also differ a lot in terms of the size and quality of
their industrial structure. The size and type of the industrial sector depends on the policies
adopted in the past, which again may have to do a lot with the history of the country.

External Dependence: External dependence can be of economic, political or cultural in nature.

Developing countries being mostly small and underdeveloped, have to depend a lot on the

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developed countries for trade, technology and training. The extent of dependence varies among
countries and is influenced by the size, history and the location of the country.

Political Structure, Power and Interest Groups: The developing countries also vary in terms
of the size of the vested interest group and its influence on the political power structure.
Although interest groups are seen to be present in every society, most developing countries are
ruled directly or indirectly by small and powerful elite to a greater extent than the developed
nations are. Effective social and economic change thus requires either that the support of elite
groups be enlisted or that the power of the elite be offset by more powerful democratic forces.

World development disparities

However, there have been growing economic situation, the extent of development patter between
north and south nation are not the same. The United States, along with Canada, most of Europe,
Australia, New Zealand, Japan, and a few other countries, enjoys a per capita GDP of more than
$25,000. The poorest countries tend to be in Africa and Asia, where income per capita can be
below—sometimes much below—$2,500.The uneven pattern of past economic growth means
that a small proportion of the world's population now benefits disproportionately from global
production.

The world disparity also can be seen in terms of declined number of poor. World poverty fell
dramatically from 42 percent in 1981 to 21percent in 2005. In terms of countries, the poverty
incidence declined more in Asia, Latin America. For instance, in china the number of poverty
incidence declined from 84 percent in 1981 to15.9percentin 2005. Sub-Saharan Africa, on the
other hand, saw a huge increase in the number of people living in absolute poverty and only a
small decrease in the poverty ratio.

There are three main factors driving Africa’s decline; High initial income inequality, relatively
higher population growth among developing countries and Lower per capita income growth
among developing countries regions.

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CHAPTER TWO
Classical and Neo-classical Theories of Economic Growth and
Development
Introduction
Economic growth merely refers to an increase in the real gross domestic product, or GDP per
capital over a period. The analysis of economic growth has three purposes. The measurement of
the growth of various aggregate of the economy, the identification and measurement of its
determinants or source and the predication of future growth by help of growth models. In the
growth theory, we are interested in answering question such as;

– What determine economic growth?

– What factors make the most important contribution to growth, the factors of
production or technical change?

– How we can predict economic growth?

This chapter discuss the basic growth model, Harrod-Domar model, neo-classical growth model
and empirical observations.

2.1. The basic concepts of growth model

Economic Growth theory is concerned with the rise and decline of economic system. Its central
task is to explain economic growth and interdependence between growth and other variables.
The most fundamental models of economic output and economic growth are based on a small
number of equations that relate to saving, investment, population growth to the size of the
workforce, capital stock and aggregate production. Our ultimate focus is to explore the key
determinants of the change in output, which is the rate of economic growth.

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The version of the basic model that we examine here has five equation: an aggregate production
function; an equation determining the level of saving; the saving-investment identity; a statement
relating new investment to change in the capital stock ; and an expression for the growth rate of
the labour force.

An aggregate production function has three variables. If Y represent the total output (Total
income), K is the capital stock, and L is the labour supply; at the most general level, the
aggregate production function can be expressed as follows;

Y=F (K, L)

The above function indicate that the increase in the capital stock and number of labour increase
the total production (National Income).

The other four models describe how these increase in K and L come about. Regarding the second
saving equation, it is assumed that saving is the fixed proportion.

S=sY

Where S is the total value of saving and s (lower case), represent the average saving rate. If the
average saving rate is 20 % and total income is 20million birr, then the value of saving in any
year is 4,000,000Birr.

The next equation relates total saving (S) to investment (I). Accordingly, saving and investment
are equal. The model assumes that there is no international trade.

S=I

The fifth equation is the change in capital stock. There are two main forces that determine the
change in capital stock. New investment (which adds to the capital stock over time) and
depreciation (which erode the value of the existing capital stock over time). Using the Greek
letter delta (∆) to represent the change in the value of variable, we express the change in the
capital stock as ∆K, which is determined as follows:

∆k=I-(dxK)

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In this expression, d is the rate of depreciation. The first term (I) indicates that the capital stock
increases each year by the amount of new investment. The second term -(dxK) show that the
capital stock decrease every year because of depreciation of existing capital.

The fifth and final equation of the model focuses on the supply of labour. If n is equal to the
growth rate of both population and the labour force, then the change in the labour force is
represented by;

∆L=n x L

If the labour force consists of 3 million people and the population is growing by 4 percent, the
labour force increase annually by 120,000

Just to summarize, the above five equations enable us to examine how changes in population,
saving and investment initially affect the capital sock and labour supply and ultimately determine
economic output.

2.2. Harrod-Domar Model

The growth model was particularly popular with economic planners just after World War II. In
the 1940’s Roy Harrod (1948) and Evsey Domar (1946) separately developed a macro-dynamics
model through an extension of Keyns’s theory.
The Harrod-Domar model makes similar assumptions to the Keynesian macroeconomic model.
These include:
 Since there is unlimited amount of unemployed labour, output can be increased without
triggering price increases.
 As there is abundant labour to keep the capital-labour ratio constant, this leads also to the
assumption of constant marginal product of capital (capital output ratio). This implies
capital’s marginal and average product are equal.
 With constant capital-output ratio, therefore, output growth is directly proportional to
new investment in new capital. Y=f(k)
 Moreover, this model assumes that productive investment is always equal to saving.
 There is no international trade because all country produces the same product.
 Assumes a Leontieff or Fixed‐coefficient production function.

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In the (H-D) model, every economy must save a certain proportion of its national income, if only
to replace worn-out or impaired capital goods (buildings, equipment, and materials). However, in
order to grow, new investments representing net additions to the capital stock are necessary.
I. The economy generate saving (s) at a constant proportion (s) of national income (y).

S = sY……………………………………………………. (2.1)

II. Net investment (I ) is defined as the change in the capital stock, k, and can Be represented
by k such that

III. But because the total capital stock, K bears a direct relationship to total National income
or output, Y as expressed by the capital-output ratio, c, It follows that;

Or
At the end
IV. At equilibrium S=I

It therefore follows that we can write the “identity” of saving equaling investment Shown by
equation 2.4 as

Can be written as;

Divide both sides by

This is a simplified version of the famous equation in the Harrod-domar theory of economic
growth, states simply that the net national savings ratio, s, and the national capital-output ratio, c
Determine rate of Growth of GDP jointly.
More specifically, it says that in the Absence of government, the growth rate of national income
will be directly or Positively related to the savings ratio (i.e., the more an economy is able to
Save—and invest—out of a given GDP, the greater the growth of that GDP will Be). On the
other hand inversely or negatively related to the economy’s capital-output ratio (i.e., the higher c
is, the lower the rate of GDP growth will be).

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Implication of HD model
There are two implication of Hd model.
– Firstly, the fixed c implies that there is a fixed relationship between the amount of
capital stock in the economy and the output is generates. In other words, the
underlying production function is of the fixed-proportion or Leontief type.
– Secondly, since labour does not appear anywhere in the model, it is assumed that
labour is not a constant factor, or that labour is always sufficiently available.
Example
In order to see how this model works, let us use a numerical example of closed economy with
national income and production in the base years of y=1000, a saving rate of s=0.2 and an c=4.
Then what is the HD growth rate. DY/Y=s/c
=0.2/4=0.05
If 10 percent of income was saved and the capital coefficient per annum (c) was equal to 4, the
warranted rate of growth would be 2.5 per cent per annum.
Harrod introduce three different growth concept; the actual growth rate, the warranted growth
rate and the natural growth rate. HD model assume that actual and warranted growth rate are the
same.
The actual growth: the expression for the actual growth is definitionally true since it expresses
the Accounting identity that saving equals investment. This can be shown as
G= s/c = (S/Y)/ (I)
= (s/y) ( /I)
= /Y, given S=I the change over the level ( /Y) represents the rate of Growth of output
Warranted rate of growth: warranted rate is that rate of growth, which, if it occurs, will leave
all parties Satisfied. At this rate, producers have produced neither more nor less than the right
Amount. In other words, it is the rate that induces just enough Investment to match planned
saving and therefore keeps capital fully employed.
The demand for investment is given by the acceleration principle. This is Where c r is the
accelerator coefficient measured as the required amount of extra Capital or investment to
produce a unit flow of output at a given rate of interest, Determined by technological condition.
Thus the equation 2.6 indicates the warranted growth.
Planned savings to equal planned investment therefore, we have

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sY = cr
= gw ……………………………………………………………………. (2.6)
For dynamic equilibrium, output must grow at this rate. The condition for equilibrium is that
g=gw
gc = gwcr
(g/gw = cr/c)
The natural growth rate: the natural growth rate is derived from the identity:
Y = L(Y/L) where L= labour &
Y/L= productivity of labour or taking the rate of growth
y=1+q
The natural rate of growth is therefore made up of two components: the growth of labor
force (L) and the growth of labour productivity (q) both exogenously determined. The
natural rate of growth plays two roles in Harrods model.
1. It defines the rate of growth of productive capacity or the long run full
Employment equilibrium growth rate.
2. It sets the upper limit to the actual growth rate. If g>g w, g can only Continue to
diverge from gw until it hits gn. When all available labour has been fully absorbed,
g cannot be greater than gn in the long-run. The long run question for an economy
then is the relationship between g w and gn. With fixed coefficient of production,
the full employment of labour requires g= gn
 The full emp1oyment of labour and capital requires;
g= gw = gn

Criticisms of Harrod-Domar (H-D) model

 Fixed coefficient production function: the H-D model assumes that Labour and capital
are used in fixed proportions. However, this is Untenable. The capital labour ratio
changes with the changes in factor Prices, i.e. one factor is substituted for another factor.
Hence, we cannot ignore substitution of inputs. But H-D model does not allow such
Substitutability

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 Constant assumptions: the h-d model is also criticized for its Unrealistic assumptions. It
assumes that interest rate and prices are Constant. It also assumes that the marginal
propensity to save (APS=MPS and capital output ratio are constants. However, in reality,
they are Likely to change in the long run. As economies develop, mps will be higher.
 The effect of technological progress has not been incorporated in both The models:
 Both models ignore human capital formation
 The two models also fail to consider changes in the general price level. Price changes
always occur overtime and may stabilize otherwise Unstable situations.

2.3. Neo-Classical Growth Models

In 1956, Robert Solow introduced a new model of economics growth that was a big step forward
from the Harrod-Domar framework. It differed from the Harrod-Domar formulation by adding a
second factor, labor, and introducing a third independent variable, technology, to the growth
equation. Solow dropped the fixed-coefficients production function and replaces it with a
neoclassical production function that allows for more flexibility and substitution between the
factors of production. In the Solow model, the capital-output and capital-labour ratios no longer
are fixed. But vary, depending on the relative endowments of capital and labour in the economy
and the production process. It is a starting point for more complex models.

Basic assumptions of the solow growth models

 There is one good, which is produced with two factors of production, capital and labor,
and which can be either consumed in the same period, or invested as capital for the next
period.
 Closed economy: households cannot buy foreign goods or assets and cannot sell home
goods or assets abroad. Hence output =income, investment=saving.
 The production function is well behaved, i.e. Firms’ objective is profit maximization.
 A representative household saves a constant fraction of income (output).
 The presence of perfect substitution between factors of production.
 As a macro model, there is a constant return to scale in that production function. (i.e.
Returns to scale is the rate at which output changes as the quantities of all inputs are

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varied. If, for example, inputs are multiplied by a factor of 2 and output goes up by the
same multiple, constant returns to scale exist. i.e. A +B = 1
 No technical change is also assumed.
By combining variable proportions of the factors and using flexible factor prices, Solow showed
that the growth path of output was not inherently unstable. If the labour force grows faster than
the stock of capital, the price of labour would fall relative to the price of capital. If capital grew
faster than labor, the wage rate would rise. Solow’s model is convergent to equilibrium path
(steady state) to start with any capital labour ratio with factor substitutability.

If gw=gn and equilibrium path is stable.

The neo-classical growth model is best defined or described by the following production
function.

 Q (t) = F(K(t)L(t);At)); or Q =F (AKA Lβ) …….. …………………………………….(1)

 Where: q is the total production of final good at time t,
 K(t) is the capital stock at time t,
 A (t) is technology at time t.
 L (t) is the number of labor used at time t.
 A (t) is a shifter of the production function; the effect of organization of production.
This function is also called as the Cobb-Douglas production function. It is a function of capital
and labor. In the above function i.e. Q = AkA LB where Q = quantity of output, K = capital, L=
labor, A and B are elasticity of output with respect to capital and elasticity of output with respect
to labor. With constant returns to scale, we can transform this into a function relating output per
worker to capital per worker.

Q/L = F(AK/LA Lβ/L) q= F (Ak/LA 1) …………………………………… ..(2)

Rewritten as;

q = F(A(k))………………………………………………………………………. (3)
Where; q = Q/L, and k = K/L

The equation (3) shows that output per worker is a function of capital per worker and technology.
This equation tells us that capital per worker is fundamental to the growth process. Thus, both

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output per worker and investment per worker are an increasing function (at a decreasing rate,
because of diminishing MPK) of capital per worker. According to traditional neoclassical growth
theory, output growth results from one or more of three factors: increases in labor quantity and
quality (through population growth and education), increases in capital (through saving and
investment), and improvements in technology. There are two sources of variation in output per
worker /q/according to the Solow model:
– Differences in capital per worker, K/L /k/ (these, in turn, depend on differences in
the savings rate and population growth);

– Differences in knowledge, A.

The capital stock per worker increases due to savings and decreases due to depreciation and an
increase in the labor supply.

q=f(k)

Diminishing MPK

Figure 2.1: per worker production function

The change in the capital stock per worker is equal to per worker gross investment minus
depreciation:

∆k = i – dk

Ignore government for present purposes, so that investment is equal to private sector saving:

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i = S/L = s Q/L = sq

Where s is the saving ratio, (the MPS is for simplicity the same as the APS). This we can write in
terms of the production function:

i = s f(k)

The proportional saving-income relationship implies that this investment function is like a
scaled-down production function. The savings curve (sf(k) in the diagram) is the same shape as
the production function, but is scaled downward (because savings is equal to output multiplied
by the savings rate, a constant between 0 and 1). A ray from the origin is drawn in for the factors
of production retarding the growth of capital per worker (the term (dk)) or depreciation

q,i q=f(k)

K*

Figure 2.2 Investment ,depreciation and production functions

To the left of k*: if the capital stock is less than k* then the sy curve lies above the dk curve so
the amount of savings per worker more than offsets depreciation. To the right of k*: if the
capital stock is more than k*, then the addition to the capital stock by savings will not be
enough to compensate for depreciation growth so the capital stock per worker will decline.
Thus, the amount of capital per worker will be driven to point A, which is a steady-state
equilibrium. In the steady state, all variables growth at constant rates. Once the new steady state
is attained, all variables grow again at the same rates as before; output per worker again grows at
the rate of growth of technological progress, g, which is independent of s.

An increase in the savings rate only leads to a temporary increase in the growth rate of output per
worker (but a permanent rise in the level of capital per worker and output per worker). In the
Solow model, only changes in technological progress have permanent growth effects, all other
changes have level effects only.

Some Limitations of the Solow model

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1. Solow’s model takes only the problem of balance between Harrod’s Gw & Gn and leaves out
the problem of balance between G & Gw.
2. In Solow’s model investment function is absent once it is introduced. The Harrodian problem
of instability quickly appears in the Solow’s model.
3. Solow’s model is based on the assumption of labour augmenting technical progress. However,
low or falling wages do not induce the capitalist to substitute the already in use capital-intensive
technique.
4. Solow’s model is based on the unrealistic assumption of homogeneous capital, homogeneous
labour etc but capital goods are highly heterogeneous and pose problem of aggregation.
5. Solow leaves out the causative of technical progress and treats the latter as an exogenous
factor in the growth process. He thus ignores the problems of inducing technical progress
through the process of learning, investment in research & capital accumulation.
6. Solow assumed flexibility of factor prices, which may bring difficulties in the path towards
steady growth. For instance the rate of interest may be prevented from falling below a certain
minimum level due to the problem of liquidity trap.

Empirical evidence(observation)
A key prediction of neoclassical growth models is that the income levels of poor countries will
tend to catch up with or converge towards the income levels of rich countries. Since the 1950s,
the opposite empirical result has been observed on average. Whether convergence occurs or not
depends on the characteristics of the country or region in question, Such as institutional
arrangements, free markets internally, trade policy with other countries and Education policy.

2.4. New (Endogenous) Growth Theory

Economists have developed new theories that address the limitations of the neoclassical theory.
The models are referred to as endogenous growth models because growth occurs as a result of
forces the model explicitly considers. In economics, endogenous growth theory or new growth
theory was developed in the 1980s as a response to criticism of the neo-classical growth model.
The primary contribution of these new growth theories is that they display steady-state growth
in per capita output without relying on exogenous technological change. The models are

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referred to as endogenous growth models because growth occurs as a result of forces the model
explicitly considers.

Unlike the neoclassical model, many of the models in the literature on endogenous growth
provide a framework for analyzing the effects of government policies on economic growth. The
endogenous growth theory holds that policy measures can have an impact on the long-run
growth rate of an economy.

 For example, subsidies on research and development or education increase the growth
rate in some endogenous growth models by increasing the incentive to innovate.

Concept of endogenous growth theory

New Growth Theory is a view of the economy that incorporates two important points. First, it
views technological progress as a product of economic activity. Previous theories treated
technology as a given, or a product of non-market forces. New Growth Theory is often called
“endogenous” growth theory, because it internalizes technology into a model of how markets
function. Second, New Growth Theory holds that unlike/different/physical objects, knowledge
and technology are characterized by increasing returns, and these increasing returns drive the
process of growth. The New Growth Theory emphasizes the importance of increasing returns to
the overall opportunities for economic growth.

The new endogenous growth model argues that the law of diminishing returns to-scale
phenomenon may not be true as is the case for East Asian economies. The continuous
economic growth in East Asian countries could not experience the diminishing marginal
return, which is the central argument of Neo-classical growth theory. In simple terms, it
means that if the economy that invests in capital also employs educated and skilled workers
who are also healthy, then not only will the labor be productive but it will also be able to use
the capital and technology more efficiently.

For state and local governments, New Growth Theory suggests four broad strategies:

– Economic strategies should focus on creating new knowledge, not just in

universities and laboratories, but by businesses as well.

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– States and communities are not powerless to influence their economic destiny.

– Positive feedbacks and chaotic development patterns of knowledge-based

growth mean that some actions will have big paybacks. Even so, it will be
difficult or even impossible to know what will work.

– The path dependent quality of growth means that even in an Internet economy,
the opportunities for future growth will depend, in large part, on the current local
base of knowledge and expertise, and communities should seek to build on this in
their strategies.

In this chapter we will see the two group of endogenous growth theory: Lucas and Romer

Although the models share the same basic idea, they rely on different mechanisms to drive long-
run growth. Some models explain the forces that lead to technological change, and others modify
the structure of the model so that investment in physical or human capital sustains growth.
Therefore, we focus on the two main branches of the new growth theories that are used today,
namely the Robert Lucas (1988) and the Paul Romer (1990) model.

The model of Romer (1990) is based on technological growth (that depends on the level of
human capital), whereas the model of Lucas is based on human capital accumulation (the growth
of human capital determines the growth of the economy).

2.5. Human capital and economic growth

The notion of human capital arose out of the awareness that physical capital alone was not
enough to explain long run growth. Studies suggest that investment in human capital leads to
increased investment in physical capital. With more education and training, people adapt more
effectively to new technologies, thereby raising productivity and economic growth. Many social
indicators such as educational enrolments and life expectancy became combined in a common
term: human capital. Often, human capital is implicitly/perfectly/ referred to as formal and
informal education. Yet, it can also contain factors such as the costs of raising children, health
costs, and ability.

What is human capital?

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Human capital refers to the stock of skills embodied in the ability to perform labor so as to
produce economic values. It is the skills and knowledge gained by a worker through education
and experience. Human Capital is the term used for education, health add other human capacities
that can raise productivity when increased. Every agent has an endowment of three types of
skills:

– physical skills like eye—hand coordination and strength;

– educational skills acquired in primary and secondary school; and

– scientific talent acquired in post—secondary education

The literature starts with the seminal paper of Lucas (1988) which shows that the growth rate of
per capita income depends on the growth rate of human capital which again depends on the time
allocation of the individuals for acquiring skill. Since then many eminent economists have dealt
with the issue of human capital accumulation and endogenous growth. Since human capital
embodied knowledge and skills, and economic development depends on advances in
technological and scientific knowledge, development presumably depends on the accumulation
of human capital. Investment in human capital has been a major source of economic growth in
advanced countries.

The accumulation of human capital differs from the creation of knowledge in the form of
technological progress. If we think of human capital as the skills embodied in a worker, then the
use of these skills in one activity precludes their use in another activity. Hence, human capital is
a rival good. Since people have property rights in their own skills, as well as in their raw labor,
human capital is also an excludable good. In contrast, ideas or knowledge may be non rival – in
that they can be spread freely over activities of arbitrary scale – and may in some circumstances
be non excludable.

Then human capital embodied in people, rival and excludable. Therefore it markedly different
from ideas, knowledge, or a general “technology level”.

Measurement of human capital

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The most popular method to proxy the human capital stock is the educational stock approach.
In essence, it is an umbrella term for proxies of human capital, variables supposed to reflect the
fluctuations of human capital. The easily accessible variables that used to measure human capital
is adult literacy ratios and school enrolment ratios. These proxies, however, have some
disadvantages.

– First, the enrolment ratios are flow, and not stock variables.

– Second, school enrolment is a measure of the number of students (who do not

take part in the labor force yet) only, while adult literacy, by definition, only
focuses on one effect of primary education and ignores other components of
knowledge and human capital.

The other measured of human capital is ‘average years of education’ in the adult population.

Lucas’ endogenous growth model

Human capital is the main source of growth in several endogenous growth models as well as one
of the key extensions of the neoclassical growth model. According to Locus (1988) each person
can the master of his or her own skills and the use in one occupation precludes the use in another
occupation: these skills are rival and excludable. The basic difference from the neo-classical
growth theory is that the Lucas (1988) model has two sectors.

In the first sector, human- and physical capital is used to produce output, leading to the
following production function:

Where;

A is the level of technology,

K is physical capital,

u is the time devoted to productive activities,

h is per capita human capital,

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L is the size of the labor force, and

γ ha is the average positive external effect of human capital.

The difference between this branch of the new growth theories and the neo-classical thus arises
out of the main source for endogenous growth.

In the second sector, a share of human capital that is not utilized in the productive sector
which is used to produce extra human capital. Only if this exhibits non-diminishing returns
there is endogenous growth. This can be written as:

Where δ is the depreciation of human capital, (h) , B(1− u) indicates the increase in the amount
of human capital.

In other words, B is a technical parameter determining at what rate investments in the second
sector are converted to a growth of human capital, and (1− u) is the share of human capital that is
devoted to human capital formation. Equation (2) has constant marginal returns because the
growth of human capital is independent of its level, i.e. an increase in human capital for a higher
educated person requires the same effort as for someone at primary school.

Consequently, the growth of human capital can be written independent of its level:

• Then we can rewrite equation 3.1 above as follow.

Finally we will get the following growth equation in terms of out put per labour.

2.6. Technical progress and Economic growth

Technical progress consists in the increase of technological knowledge and depends, to a large
extent, on scientific progress. According to the cognitive view, technology is a form of science-

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based practical knowledge that allows us to design efficient artifacts to solve practical problems.
Technological change is mainly produced through applied scientific research and the
improvement of technological knowledge. Technological advance involves the creation of new
ideas, which are partially non-rival and therefore have aspects of public goods.

We can characterize technological systems as action systems intentionally oriented toward

transforming concrete objects in order to obtain, in an efficient way, a valuable result.
Technological change consists in the design and production of new technical systems and in the
improvement of their efficiency. Technological progress may be interpreted as an increment of
human power to control reality: new and more efficient technical systems applied to new and
larger parts of reality mean higher capacity to adapt reality to human desires

Unlike physical labor (and the other factors of production), knowledge is:

 Expandable and self generating with use: as doctors get more experience, their
knowledge base will increase, as will their endowment of human capital. The economics
of scarcity is replaced by the economics of self-generation.
 Transportable and shareable: knowledge can be moved and shared. This transfer does
not prevent its use by the original holder. However, the transfer of knowledge may
reduce its scarcity-value to its original possessor.
• Knowledge is non-rival: it can be used by others without diminishing the amount of
knowledge available to the original user or inventor.

2.7. Romer’s Endogenous Growth Model

Romer's contribution is his finding that any technical knowledge discovered by a firm (and
embodied in its products) will eventually benefit other firms, even those that do not engage in
research and development (R&D). Innovation and R&D activities can play a major role in
economic progress increasing productivity and growth. This is due to increasing use of
technology that enables introduction of new and superior products and processes. Various
endogenous growth models have stressed the role of R&D, and the strong relation between
innovation/R&D and economic growth has been empirically affirmed by many studies.

Romer’s three premises

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The following are the major premises in the Romer’s growth theory

– Economic growth is driven by technological progress as well as capital

accumulation;

– Technological progress results from deliberate actions taken by private agents

who respond to market incentives;

– Technological knowledge is a non-rivalrous input (modeled as positive

knowledge spillovers).

An increase in the size of the population, other things equal, raises the number of researchers and
therefore leads to an increase in the growth rate of per capita income.

Romer (1990) model has three sectors:

– a technology producing sector;

– an intermediate goods producing sector where capital goods are produced; and

– a final output producing sector

In the first sector, technology is used as targeted knowledge, e.g. a set of institutions that makes
it possible to manufacture capital goods for the second sector. The part of human capital that is
not used directly in the sector producing final output is used to create new technologies.

The level of human capital, H, thus has a positive effect on the growth of technology, A. The
growth of technology in the first sector can thus be given as:

Here A and A are the growth and level of a technology index respectively. A H is the amount of
human capital devoted to the accumulation of technology (A) and σ is a productivity parameter.

In the second sector, each new A creates a new intermediate product, x., which in turn determine
capital, K. Hence, K depends on the number of intermediate products, t=1…A, and the price of
a unit of x expressed in consumption, η :

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• The function for the third, final output, sector thus becomes:

Here, Y H is an exogenous variable indicating the amount of human capital not used in the
technology producing first sector. In other words, it is the amount of knowledge used to apply
technologies to the production process. In this model, endogenous growth thus stems from the
positive effect of research on innovations whereas more innovations increase productivity of
researchers in the future.

In other words, if we see equation (6) in terms of the Lucasian second sector (without
depreciation) we can argue that the source of endogenous growth is the existence of constant
marginal returns to technology accumulation that is indeed implicitly assumed in equation (6).
This has the consequence that, on a balanced growth path, the level of human capital increases
output growth, i.e.:

Limitations

 Romer model predict that the growth rate is proportional to the number of researchers and
thus to the size of the population of the economy, given the assumed constant share of
researchers in total population. Such prediction makes the models unable to explain why
the United States and OECD countries have failed to grow faster despite substantially
increased numbers of researchers in these economies.
• Lucas model unable to include the quality of education

• Perfect competition

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 The scale-effects prediction is eliminated in the new model because technological growth
does not depend on the number of researchers, but instead on the rate of growth of
human capital

CHAPTER THREE

Structural Change and Dualistic Economy

Structural-change theory focuses on the mechanism 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. It employs the tools of neoclassical price and resource allocation theory and
modern econometrics to describe how this transformation process takes place.

3.1. Rostow’s Stages of economic growth

The most influential and outspoken advocate of the stages-of-growth model of development
was the American economic historian Walt W. Rostow. According to Rostow, the transition from
underdevelopment to development can be described in terms of a series of steps or stages
through which all countries must proceed.
In Modernization theory, problems that held back the industrialization of poor countries were
related to the “irrational” way in which resources were allocated in a traditional society.
Traditional societies became modern by rationalizating resource allocation, and by the

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elimination of cultural, institutional and organizational roadblocks that did not allow countries to
develop.

Positivist evolution implied that all societies would pass through the same set of stages that the
western society had passed: from a traditional to a modern society. W. Rostow identified five
stages of modernization:

1) The traditional society,

2) Preconditions for take-off,

3) Take-off,

4) The drive to maturity, and

5) The age of high mass consumption.

1. Traditional Society:

• The economy is dominated by subsistence activity where output is consumed by

producers rather than traded

• Economic change and improvement are not sufficient to increase output per
capita.

• Resource allocation is determined very much by traditional methods of

production.

• Most of the economy is oriented toward producing primary products. i.e.

Agriculture, Fuel, Forestry, Raw materials

• Majority of people live and work in rural sectors

• Literacy is low.

• Any trade is carried out by barter where goods are exchanged directly for other
goods.

2. Transitional Society: The pre-condition to take off

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• Transition society has some sort of association with cultures. Such cultures
include various transfers of more developed nations’ values, attitudes, institutions,
best practices, technology, foreign aid, foreign direct investment etc.

• The economic transitions are accompanied by the evolution of new political and
social institutions that support the industrialization

• Development of Physical and social infrastructure has begun in a small but

important way.

• Increased specialization generates surpluses for trading.

• As incomes, savings and investment grow entrepreneurs emerge. External trade

also occurs concentrating on primary products.

3. Takeoff Society:
• At this stage, nations experience an accelerated growth rate.

• Improvement in production leads to expansion of supporting and related

industries

• Capital stock is very active and dynamic

• Some key sectors generate sufficient capital to finance further growth

• Nations need to obtain foreign exchange to finance many developmental projects

• Export typically accounts for a very high percentage of the annual flow of total
foreign currency earnings

• Physical and social infrastructure have been developed to sustain steady

development

• Industrialization increases, with workers switching from the agricultural sector to

the manufacturing sector.

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• Growth is concentrated in a few regions of the country and in one or two

manufacturing industries.

• The level of investment reaches over 10% of GNP.

4. Technological Maturity:
a. The economy is effectively applying modern technology to the full range of its
economic activities

b. Unskilled labor and capital-intensive industries are replaced by more skilled labor
as well as more advanced technology-intensive industries

c. Productivity and wages increase very rapidly. Technological innovation is

providing a diverse range of investment opportunities.

d. The economy is producing a wide range of goods and services and there is less
reliance on imports.

5. High Mass Consumption:

a. Per capita income has increased to levels that provide purchasing power beyond
that of basic necessities

b. The economy is geared towards mass consumption. The consumer durable

industries flourish.

c. The service sector becomes increasingly dominant.

d. Consumers start shifting their attention from the quantity of products to the
quality of products in order to augment quality of life

According to Rostow development requires substantial investment in capital. For the economies
of LDCs to grow, the right conditions for such investment would have to be created. If aid is
given or foreign, direct investment occurs at stage 3 the economy needs to have reached stage 2.
If the stage 2 has been reached then injections of investment may lead to rapid growth.

Then what was Rostow’s argument?

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• The following was the major argument of Rostow’s stage of economic growth.

– All advanced countries already through the take-off stage.

– LDCs still in the traditional or "pre-conditions" stage.

– LDCs only need to follow certain set of rules to move into take-off stage.

– Principal strategy for development: Generate high levels of domestic and foreign
saving to generate sufficient investment to accelerate economic growth. (But
how?)

Limitations of Rostow’s

• Many development economists argue that Rostows’s model was developed with Western
cultures in mind and not applicable to LDCs.

• In reality, policy makers are unable to clearly identify stages as they merge together. Thus
as a predictive model it is not very helpful.

• Saving and investment are NECESSARY but not SUFFICIENT conditions for growth.

• The importance of external, international influences.

3.2. Labour Surplus and Migration models

Theoretically, migration is defined simply as a process of personal movement from one area to
another. Rural-to-urban migration in particular is the process of rebalancing economic resources
(human and physical ones) in order to set up a new stage of economic development. Economists
consider rural-to-urban migration as a process of labor movement from less-developed to more
advanced areas. Industrialization always takes place in urban areas, and as soon as it starts, the
labor force in urban areas becomes scarce, and it needs to be supplemented by labor from rural
areas.

For the purpose of our discussion, we classify the different theoretical frameworks in which
internal migration has been modeled into two types:

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– The first type covers the dual economy models which emerged in the 1950s ; and

– The second type covers the Harris-Todaro models developed in the 1970s .

Lewis model, internal migration removed ‘disguised unemployment’ from rural areas and
enabled the transition to a modern economy. In Todarian models, the focus is on explaining the
existence of unemployment in urban areas and its link with internal migration.

3.3. Lewis rural -urban migration model

The two-sector model of structural transformation was developed in1954 by Arthur Lewis. In the
Lewis model, the underdeveloped economy consists of two sectors: a traditional, overpopulated
rural subsistence sector and modern industrial sector. Lewis viewed development process as a
structural change involving transformation of primarily agricultural economy to an industrial
one.The marginal labor productivity is zero in agricultural sector or labor surplus and higher
productivity in modern urban sector. Both labor transfer and modern-sector employment growth
are brought output expansion in that sector. The speed with which this expansion occurs is
determined by the rate of industrial investment and capital accumulation in the modern sector.

Lewis Model: Main Assumptions

• Two-Sectors (two goods): Agriculture and Industry.

• Diminishing marginal productivity of labor in both sectors.

• Dual Economy: Underdeveloped economies are characterized by dualism, which is

coexistence of traditional and modern sectors.

• Interaction between agriculture (traditional sector/rural) and industry (modern

sector/urban) in the development process.

• Role of capital investment in industry, rural-urban migration, and agricultural surplus in

the development process.

Traditional sector is characterized by:

• backward or traditional technology and low capital intensity.

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• The production is normally organized on the basis of family labor with overall
output distributed not in the form of wages and profits, but in the form of shares
that accrue to each family member.

• Producers in this sector maximize family income and not profit.

Modern sector on the other hand is characterized by:

• Advanced technology and relatively high-capital intensity.

• Producers in this sectors are profit maximizes.

Given these assumptions, the agricultural sector is able to supply a perfectly elastic labor force to
the modern industrial sector.

The figure 4.1 below show that labor supply is infinitely elastic, which ensures a constant low
wage OW fixed below the labor productivity trend OP but significantly above the average
product (or income) OWa in peasant agriculture. So that OW/OWa>1 is the ratio of the
industrial wage to income level in peasant agriculture. Given OP=MPL in capitalist industry and
employment level in industry equal to OL, total industrial product amounts to OPEL and wage
bill to OWEL, so that the capitalist surplus amounts to OPEL – OWEL=WPE.

Figure 3.1: Lewis urban wage determination

Wage

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WA

Finally, Lewis assumed that the level of wages in the urban industrial sector was constant,
determined as a given premium over a fixed average subsistence level of wages in the traditional
agricultural sector. At the constant urban wage, the supply curve of rural labor to the modern
sector is considered perfectly elastic.
Lewis makes two assumptions about the traditional sector. First, there is surplus labor in the
sense that MPLA is zero, and second, all rural workers share equally in the output so that the
rural real wage is determined by the average and not the marginal product of labor (as will be the
case in the modern sector). The 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.
The structural transformation of the economy will have taken place, with the balance of
economic activity shifting from traditional rural agriculture to modern urban industry.

Criticisms of the Lewis Model

 Lewis’s assumption of rural surplus labor is generally not valid. Most contemporary
research indicates that there is little surplus labor in rural locations.
 The assumption of competitive modern sector labor market guarantees continued
existence of constant real urban wages up to the point where the supply of rural surplus
labor is exhausted. Institutional factors such as union bargaining power, civil service
wage scales, and multinational corporations’ hiring practices tend to negate competitive
forces in modern-sector labor markets in developing countries.
 A final concern with the Lewis model is its assumption of diminishing returns in the modern
industrial sector. Yet there is much evidence that increasing returns prevail in that sector,
posing special problems for development policymaking.

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3.4. Harris-Todaro Model

Harris and Todaro (1970) presented a static framework version of the Todaro model in which the
interaction between the rural and urban sectors is more detailed. This model tried to observe the
relationship between urban employment and unemployment with rural-urban migration.

Critical Assumptions

• Two-Sectors (two goods): Rural and Urban. Rural sector produces agricultural goods and
the urban sector produces manufactured goods.

• Marginal product of labor in both agriculture and manufacturing is positive and depends
on the amount of labor employed in both the sectors. Diminishing marginal productivity.

• Producers in both sectors are profit maximizes.

• Full employment in the rural sector.

• In the urban sector, employers must pay at least the mandated minimum wage. Introduces
the possibility of unemployment in the urban sector (source of inefficiency).

• Migration is positively related to the urban-rural real income differential.

Todaro rural-urban migration is shown in the figure 4.3 below. The model assume that there is
only two sector, rural agricultural and urban manufacturing sector. The demand for labour ( the
marginal product of labour curve) in Agricultural is given by the negatively slope line AA’.
Labour demand in manufacturing is given by MM’. The total labour force is given by line
OAOM. In a neo-classical, flexible, wage, full employment market economy, the equilibrium
wage would be established at, and with workers in agriculture and workers employed in urban
manufacturing. All available workers are therefore employed.

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Manufacturing wage rate

Figure 3.2 The Harries –Todaro Migration Model

But what of urban wages are institutionally, determined as assumed by Todaro at a level of ,
which is above. If for the moment we continues to assume that there is no unemployment,
workers would get urban jobs and the rest, ,would have to settle for rural employment of Wage
(below the free-market level of ). So now we have an urban-rural real wage gap of ,with
institutionally fixed. If rural workers were free to migrate then despite the availability of only
jobs, they are willing to take their chance in the urban job lottery.

If their chance (probability) of securing one of these favoured jobs is expressed by the ratio of
employment in manufacturing , to the total urban labour pool, ,then the expression:

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The equation 4.1 shows the probability of urban job success necessary to equate agricultural
income , thus causing a potential migrant to be indifferent between job locations. The locus of
such points of indifference is given by the curve in above figure.

• The new unemployment equilibrium now occur as point ,where the urban-rural actual
wage gap is - - , workers are still in the agricultural sector and of these workers
have modern(formal) sector jobs paying wages. The rest - ,are either unemployed
or engaged in low income informal-sector activities.

This explain the existence of urban unemployment and the private economic rationality of
continued rural to urban migration despite this high unemployment.

Characteristics of Todaro model

To sum up, the Todaro Migration model has four basic characteristics.

 Migration is stimulated primarily by rational economic consideration of relative

benefits and costs, mostly financial but also psychological.

 The decision to migrates depends on expected rather than actual urban-rural wage
differential where the expected differentials is determined by the interaction of
two variables, the actual urban-rural wage differential and the probability of
successfully obtaining employment in the urban sector.

 The probability of obtaining an urban job is directly related to the urban

employment rate and thus inversely related to the urban unemployment rate.

 Migration rate in access of urban job opportunity growth rates are not only
possible, but also rational and even likely in the face of wide urban-rural excepted
income differentials. High rate of urban unemployment are therefore inevitable
outcome of the serious imbalance of economic opportunities between urban and
rural area in most underdeveloped countries.

Policy Implications of Todaro model

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• Urban bias in the development policy aggravates the urban unemployment problem.

• Faster job-creation in the urban formal sector is insufficient solution to the urban
unemployment problem.

• Providing wage subsidy to the urban formal may increase urban unemployment.

• Optimal policy requires either a mix of wage subsidy to the urban formal sector and
restriction on migration or wage subsidy to both the urban formal sector and agriculture

3.5. Kalder’s Growth Law

Kaldor’s analysis of development hinges on four fundamental concepts:

– increasing returns in the manufacturing sector;

– effective demand-constrained growth;

– the agriculture-industry relationship; and

– internal-external market relations.

In terms of development policies, Kaldor believed that economic development requires

industrialization. This in turn presupposes an ‘agriculture revolution and strength the agriculture
industry linkage. In addition, Kaldor implies entering into the global market with a temporary
stage of protection for newly established industries. This must be accompanied by export-led
growth policies.

Kaldor developed four ‘empirical laws’:

 The first law is Manufacturing Sector as the Engine of Growth. He found evidence that
manufacturing industry is the engine of growth for every country at every stage of
growth.
 The second law is the more the output of the manufacturing sector grows the greater is
the increase of productivity in the system as a whole. There are three external reasons:
first, because the growth of manufacturing provides capital goods and hence technical
advances embodied in them as input for other sectors. second, because an increase in

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output and employment in the manufacturing sector reduces the employment in

agriculture but not its output. Third, because greater activity in the manufacturing sector
produces greater turnover per worker in the distribution sector.
 The third law, the industry-agriculture relation.
 The last law is export growth increase economic growth.

3.6. Dualism, center-periphery models and the process of cumulative

causation

Implicit in structural-change theories and explicit in international-dependence theories is the

notion of a world of dual societies, of rich nations and poor nations and, in the developing
countries, pockets of wealth within broad areas of poverty. Dualism is a concept widely
discussed in development economics. It represents the existence and persistence of substantial
and even increasing divergences between rich and poor nations and rich and poor people’s on
various levels. Specifically, although research continues, the traditional concept of dualism
embraces four key arguments:
1. Different sets of conditions, of which some are “superior” and others “inferior,” can coexist in
a given space. Examples of this element of dualism. include Lewis’s notion of the coexistence of
modern and traditional methods of production in urban and rural sectors; the coexistence of
wealthy,
highly educated elites with masses of illiterate poor people; and the dependence notion of the
coexistence of powerful and wealthy industrialized nations with weak, impoverished peasant
societies in the international economy.
2. This coexistence is chronic and not merely transitional. It is not due to a temporary
phenomenon, in which case time could eliminate the discrepancy between superior and inferior
elements. In other words, the international coexistence of wealth and poverty is not simply a
historical phenomenon that will be rectified in time. Although both the stages-of-growth theory
and the structural-change models implicitly make such an assumption, to proponents of the
dualistic development thesis, the facts of growing international inequalities seem to refute it.
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. For example, the productivity gap between

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workers in developed countries and their counterparts in most developing countries seems to
widen with each passing year.
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, let alone “trickle down” to
it. In fact, it may actually serve to push it down—to “develop its underdevelopment.”
Dualism may be characterized by the coexistence of a modern sector and a traditional sector
within the framework of the same economic system. In other ward, dualism refers to economic
and social division in the economy. such as;
– Difference in technology between sector or regions
– Difference in the degree of geographic development
– Difference in social custom and attitudes between an indigenous and an imported
social system.
Dualism in all its aspects is a concomitant of the growth of a money economy. Basically,
therefore a dual economy is characterised by
– A difference in social custom between the subsistence and exchange sectors in the
economy.
– A gap between the level of technology in the rural subsistence sector and the
industrial modernized sector.
– A gap in the level of per capita income between regions of the country.
• There are three types of dualism
– Geographic dualism
– Social dualism
– Technological dualism

Technological Dualism
The major cause of labour employment problem is the existence of technological dualism.
Technological dualism refers to the use of different production function in the advanced and
traditional sectors. In this interpretation; dualism is associated with structural unemployment or
technological unemployment. This is a situation in which productive employment opportunity

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are limited, not because of lack of effective demand, but also because of resource and
technological restraint in the two sector(traditional and modern sectors).
The figure 3.3 shows the fixed combination of capital and labour. The line OE joining the points
a,b,c, etc., representing the expansion path of the sector and its slop is equal to a constant,
relatively capital intensive factor ratio. If the actual factor endowment is the right of line OE-
say, at point F-there must then be some unemployment of labour in this sector. To produce an
output of q1, the sector will use OK1 units of capital and OL1 units of labour ; even though OL2
units of labour are available, the excess supply of labour will have no effect on production
techniques and L1L2 units of labour will remain in excess supply, regardless of the relative
factor prices of capital and labour.

Figure 3.3: fixed combination of capital and labour.

Centre-Periphery Model
According to the centre-periphery model, the world is comprised of the two sectors-the centre
and the periphery-in which production structure are very different from each other. In the
periphery, backward sector (with low productivity and backward production) coexist with the
modern sectors and high productivity levels. The periphery also tend to export a small range of
products and to benefit from very few linkage(horizontal or vertical). At the centre, on the other
hand, production structure are modern throughout and cover a wide range of capital, intermediate
and consumer goods.

The difference in the productivity result in an international division of labour, with the periphery
producing and exporting primary product and a core specialization in manufactures. The lower
export price for periphery state. This would lead to a transfer of income from the periphery to the
centre. Finally, the income elasticity of demand was higher for manufactures than for primary
products. Therefore, whenever the periphery grew faster than the centre, it would import more
and incurs recurrent trade deficit. Protection is needed to counter this.

The process of cumulative causation

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A major component of the foundation of the neo-classical system of economics thought is the
notion that free market economics tends to move towards “equilibrium” to stay in equilibrium
once established and return to “equilibrium” if temporarily dislodged by some “shock”
emanating from outside the system. Far from a market system generating forces that will return it
to equilibrium when disturbed, the new argument maintains, it is more likely to generate a
process of cumulative causation that will carry it further and further away from equilibrium.

Cumulative causation refers to the unfolding events connected with a change in the economy.
These change apply to a whole set of variable as a consequence of the multiplier effect. Thus, the
location of a new factory may be the basic of more investment, more jobs both in that factory
and in ancillary and service industries in the area, and have a better infrastructure, which would,
in turn attract more industry. The figure below illustrate cumulative causation as envisaged by
G.Myrdal(1957).

Improved infrastructure

External economies

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Expansion of one region may have either favourable or unfavourable effect on other regions.
Myrdal calls these “spread effect” and “backwash effects” respectively. Given the coexistence of
the spread effects and backwash effect, tree possibility may emerge;

– If the two kinds of effects balance each other, the current special pattern of
income distribution will persist.

– If the spread are stronger than the backwash effect, the process of cumulative
causation will lead to the development of new economic centre, and hence
convergence.

– In the case in which backwash effect outweigh spread effect market forces will
lead to polarization or divergence

Inverted U shape of the growth of the economy and regional inequality. Initially when the
economy grow, the inequality became higher, if the economy continue to grow, the regional
inequality begin to decline.

3.7. Theories of dependency and unequal exchange

Dependency theory is based on the notion that resources are flowing from a "periphery" of poor
and underdeveloped states to a "core" of wealthy states, enriching the latter at the expense of the
former. It is a central contention of dependency theory that poor states are impoverished and rich
ones enriched by the way poor states are integrated into the "world system". These theories
attempts to explain the perpetuation and widening of the difference between centre and
periphery. Dependency refers to a situation in which the economy of certain countries in
conditioned by the development and expansion of another economy in which the former is
subjected. The dependency and unequal exchange relation is related to the characteristics of
trade; but there are many other important dimensions to the argument.

– The dependency on foreign exchange

– The dependency on foreign technology

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– The decline in terms of trade

– The impact of neo-colonialism influence in developing countries.

Form of dependency

There are different forms of dependency can be distinguished, as they have evolved historically;

– Colonial dependency

– Financial-industerial dependency

– Technological-industerial dependency

Limitation of dependency theory

Some free-market economists said that dependency theory leads to:

– Corruption. Free-market economists hold that state-owned companies have

higher rates of corruption than privately owned companies.

– Lack of competition. By subsidizing in-country industries and preventing outside

imports, these companies may have less incentive to improve their products, to try
to become more efficient in their processes, to please customers, or to research
new innovations.

– Unsustainability. Reliance of industries on government support may not be

sustainable for very long, particularly in poorer countries and countries which
largely budget out of foreign aid.

– Domestic opportunity costs. Subsidies on domestic industries come out of state

coffers and therefore represent money not spent in other ways, like development
of domestic infrastructure, seed capital or need-based social welfare programs. At
the same time, the higher prices caused by tariffs and restrictions on imports
require the people either to forgo these goods altogether or buy them at higher
prices, forgoing other goods

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Unequal exchange

The unequal exchange was introduced by Emmanuel in 1972. Exchange is unequal between rich
and poor countries because wage are lower in poor countries and lower than if the rate of profit
in poor countries was not as high as in rich countries. In other words, exchange is unequal in

relation to a situation where wages would be equalized. In order to explain the above idea with
suitable diagram, let us take two countries and call them “centre”(c) and “periphery” (p). Assume
that prices in the two countries are based on a percentage mark-up (r) on unit labour cost so that;

and

Where w is the money wage rate and wL/O is wage per unit of output. Now assume for
institutional reasons and that the mark-up or rate of profit equalizes between the two
countries.

• In the centre, the given rate of profit wage rate gives a constant price )

• In the periphery, at a give wage rate ( ) there is a positive relation between the rate of
profit and terms of trade(P) given by upward sloping line

• An increase in the periphery wage shifts the periphery rightward to giving a new
terms of trade, at the same rate of profit.

• Unequal exchange is measured as the difference between the actual terms of trade and
what it would be if wages were higher in the periphery and the rate of profit was lower at

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CHAPTER FOUR

Multiple Equilibrium, Coordination Failure and Strategies of Economic

Development

Introduction

Neoclassical theory contends that the particular set of institutions in an economy does not matter.
This position rests on three points:

1. Outcomes are determined by fundamental forces (reflecting resources, preferences, and

technology),
2. These forces lead to pareto-efficient outcomes, and
3. Institutions do not even influence the choice of the equilibrium.
Neo-classical argues that market failure is due to government intervention in the economy. In the
neo-classical growth theory, every equilibrium is a pareto optimum, and, in general, the
equilibrium is unique.

The modern theory of economic growth depart from the strong assumptions of neoclassical
theory. They said that market might fail to reach the optimum allocation of resources. Market
failure is the utmost reason for defending an active economic role of the state. Ideal “markets”
and prices, therefore, are incapable of generating and diffusing information and the formation of
future expectations required to effectively co-ordinate agents. Given some initial equilibrium,
even though each individual may know that there is another equilibrium at which all would be
better off; individuals are unable to coordinate the complementary changes in their actions
necessary to attain that outcome.

Whereas neoclassical economics emphasizes the forces pulling toward equilibrium— and with
similar forces working in all economies, all should be pulled toward the same equilibrium.
Modern development economics focuses more on evolutionary processes, complex systems, and

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chance events that may cause systems to diverge. Three major differences of modern economic
theory from –neoclassical theory:

– Rejects diminishing marginal returns to K investments

– Permits increasing returns to scale to k investment.

– Focuses on the role of externalities in determining the rate of return on capital

investments

Among other market imperfection-based arguments, the theory of coordination failure is widely
used at the present by development economists to define a new case for industrial policy. A
firm’s productivity depends not only on its own efforts and abilities, and on general economic
conditions (e.g., the macroeconomic environment and the legal system), but also on the actions
of other firms, infrastructure, regulation and other public goods”. The central pillar of the
literature on coordination failure is the idea that economy can fail to achieve coordination among
complementary activities. Coordination failure leads the market to an outcome (equilibrium)
inferior to a potential situation where resources would be correctly allocated and all agents would
be better off.

Put it differently, the coordination problem illustrates the old proverbial chicken and egg
dilemma. Agents cannot introduce a new good X on the market because they cannot rely on
complementary suppliers of Y and Z but, in turn, suppliers of Y and Z have no reason to produce
because there is not enough demand for their output.

More precisely, under the circumstances described above, there are multiple equilibrium: a good
equilibrium, obtained when entrepreneurs have optimistic expectations and thus manage to
coordinate their businesses, and a bad equilibrium, resulting from entrepreneurs’ reluctance to
invest and their failure to coordinate. When the market mechanism does not work, the
government should coordinate (stimulate) entrepreneurs into the good equilibrium. Coordination
failures occur when agents’ inability to coordinate their actions leads to an outcome that makes
all agents worse off.

When Coordination Failure arise?

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– Firms’/investors’ inability to coordinate their behavior (choices) leads to an

outcome (equilibrium) that leaves all firms/investors worse off than could be the
case in some other potential equilibrium.

– Everyone is better off waiting for someone else to take the risk of making the
first investment.

– The returns to some critical investments depend on others making similar

investments.

– Investments by one firm/investor increase the incentives to others to make the

necessary investments.

4.1. Multiple Equilibria and Coordination Failure

Basic idea: Whether or not an investor (firm/person) can benefit from some action (like an
investment or adoption of new technology) depends on how many other investors are expected to
also take the same action or on the extent of those actions. Economy can be stuck in a low level
equilibrium because no one (or not enough) is willing to take the risk of going first. A higher
equilibrium (higher level of development) can be reached only if everyone works together
(coordinates) to get there. No one finds it profitable to go first because the capital costs and
associated risks of going it alone are too high for the benefits that can be captured.

Three Complementarities Problems Leading to Coordination Failure: Specialized labor

skills, Commercialization of agriculture and New technology investment are the three
complementarities problems that lead to coordination failure.

1. Specialized labor skills

Firms will not invest in a country if the labor skills the firms needs are not available in the
country. But workers will not acquire necessary skills if there are no firms to employ them. This
coordination problem can leave an economy stuck in a bad equilibrium—that is, at a low average
income or growth rate or with a class of citizens trapped in extreme poverty. Even though all
agents would be better off if workers acquired skills and firms invested, it may not be possible to
get to this better equilibrium without the aid of government.

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2. Commercialization of agriculture
Specialization in producing only certain goods leads to high productivity. But subsistence
producers must produce a little of everything to survive. Producers will specialize only if there is
someone who will buy their goods. But middlemen will buy goods in an area only if there are
sufficient in the area to buy from. It is difficult to be an expert in the quality of many products, so
in order for a specialized agricultural market to emerge, there needs to be a sufficient number of
concentrated producers with whom a middleman can work effectively. But without available
middlemen to whom the farmers can sell, they will have little incentive to specialize in the first
place and will prefer to continue producing their staple crop or a range of goods primarily for
personal consumption or sale within the village. The result can be an underdevelopment trap in
which a region remains stuck in subsistence agriculture.
3. New technology investment
Benefits to any firm investing in new technology but capturing the benefits may require investing
in training workers and infrastructure (roads, railroads, storage facilities, etc.) that others can
benefit from. One firm cannot capture all the benefits from all the required investments. Firms
have incentive to underinvestment in new technology until others invest. Everyone waits on
everyone else so nothing happens.

4.2. Multiple Equilibria: A Diagrammatic Approach

The standard diagram to illustrated Multiple Equilibria with possible coordination failure
presented in the figure 4.1. The basic idea reflected in the S-shaped function of Figure 4.1 is that
the benefits an agent receives from taking an action depend positively on how many other agents
are expected to take the action or on the extent of those actions. For example, the price a farmer
can hope to receive for his produce depends on the number of middlemen who are active in the
region, which in turn depends on the number of other farmers who specialize in the same
product.
How do we find the equilibria in this type of problem?
In the Marshallian supply-and-demand scissors diagram, equilibrium is found where the supply
and demand curves cross. In the multiple-equilibrium diagram, equilibrium is found where the
“privately rational decision function” (the S-shaped curve in Figure 4.1) crosses the 45-degree
line. This is because agents observe what they expected to observe.

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Suppose that firms expected no other firms to make investments, but some firms did anyway
(implying a positive vertical intercept in the diagram). But then, seeing that some firms did make
investments, it would not be reasonable to continue to expect no investment! Firms would have
to revise their expectations upward, matching their expectations to the level of investment they
actually see. But if firms now expect this higher level of investment, firms would want to invest
even more. This process of adjustment of expectations would continue until the level of actual
investment would just equal the level of expected investment. At that level, there is no reason
for firms to adjust their expectations any further. So the general idea of an equilibrium in such
cases is one in which all participants are doing what is best for them, given what they expect
others to do, which in turn matches what others are actually doing.

Figure 4.1: Multiple Equilibria

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FIGURE 4.1
At the point, the value on the x-axis and y-axis are equal, implying in our example that the level
of investment expected is equal to the level the all agents find best. Of the three, D1 and D3 are
stable equilibrium. They are stable because if expectation were slightly changed to a little above
or below these level, firms would adjust their behaviour-increase or decreasing their investment
levels, in a way to bring us back to the original equilibrium. At the middle equilibrium at D2, the
function cuts the 45-degree line from below, and so it is unstable. This is because in our example,
if a little less investment were expected, the equilibrium would be D1, and if a little more, the
equilibrium would move to D3. D2 could therefore be an equilibrium only by chance.
Typically, the S-shaped “privately rational decision function” first increases at an increasing rate
and then at a decreasing rate, as in the diagram. This shape reflects what is thought to be the
typical nature of complementarities. Finally, after most potential investors have been positively
affected and the most important gains have been realized, the rate of increase starts to slow
down.
In general, when jointly profitable investments may not be made without coordination, multiple
equilibria may exist in which the same individuals with access to the same resources and
technologies could find themselves in either a good or a bad situation. In the view of many
development economists, it is very plausible that many of the least developed countries,
including many in sub-Saharan Africa, are essentially caught in such circumstances. Of course,
other problems are also present. For example, political pressures from potential losers in the
modernization process can also prevent shifts to better equilibrium.

4.3. Starting Economic Development: The Big Push model

The most famous coordination failure model in the development literature is that of Big-Push,
pioneered by Paul Rosenstein-Rodaan, who first raised of the basic coordination problems. The
model said that there is coordination failure to attain sustainable development in the developing
countries. Sometimes these market failures lead to a need for public policy intervention.
The following are the major assumption of big-push theory
Factor of production: It assume that there is only one factor of production-labour.

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Factor payment: The labour market has two sectors; it assumes that labour in traditional sector
receive I wage and labour in the modern sector receive W wage. W>I. However, high modern
wages is only one circumstance in which a coordination problem may exist.
Technology: It assumes that there are N types of products, where N is a large number. For each
product in the traditional sector, one worker produces one unit of output. This is a less stringent
assumption than it appears because again we have a certain freedom in choosing our unit of
measurement; if a worker produces three pairs of shoes per day, we call this quantity one unit.
This is a very simple example of constant-returns to- scale production. In the modern sector,
there are increasing returns to scale. He want to introduce increasing returns in a very simple
way. Assume that no product can be produced unless a minimum of, say, F worker are employed.
This is a fixed cost. Because we are keeping things simple to facilitate analysis of the core issues,
we have not put capital explicitly in the model; thus the only way to introduce a fixed cost is to
require a minimum number of workers. After that, there is a linear production function in which
workers are more productive than those in the traditional sector. Thus labor requirements for
producing any product in the modern sector take the form L = F + cQ, where c < 1 is the
marginal labor required for an extra unit of output. The trade-off is that modern workers are more
productive, but only if a significant cost is paid up front. As this fixed cost is amortized over
more units of output, average cost declines, which is the effect of increasing returns to scale. We
assume symmetry: The same production function holds for producing any product in the modern
sector.
Domestic demand: It assumes that each good receives a constant and equal share of
consumption out of national income. The model has only one period and no assets; thus, there is
no saving in the conventional sense. As a result, if national income is Y, then consumers spend an
equal amount, Y/N, on each good.
International supply and demand; It assumes that the economy is closed.
Market stricture: It assume perfect competition in the traditional (cottage industry) sector, with
free entry and no economic profits. Therefore, the price of each good will is 1, the marginal cost
of labor (which is the only input). It assumes that at most, one modern-sector firm can enter each
market.This limitation is a consequence of increasing returns to scale. Given the assumptions
about preferences, the monopolist faces unit-elastic demand, if this monopolist could raise its
price above 1, it would be profitable to do so. However, if price is raised above 1, competition

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from the traditional sector producers will cause the modern-sector firm to lose all of its business.
Therefore, the monopolist will also charge a price of 1 if it decides to enter the market.

Condition for multiple equilibrium: we can see in the figure 4.2 the multiple equilibria
when the wage is between A and B. At this time we need big push to push the equilibrium at
point B.
Figure 5.2 The Big Push

Figure 4.2, first consider a wage bill line like W1 passing below point A. With this relatively low
modern wage, revenues exceed costs, and the modern firm will pay the fixed cost F and enter the
market. In general, this outcome is more likely if the firm has lower fixed costs or lower

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marginal labor requirements as well as if it pays a lower wage. By assumption, production

functions are the same for each good, so if a modern firm finds it profitable to produce one good,
the same incentives will be present for producing all goods, and the whole economy will
industrialize through market forces alone; demand is now high enough that we end up at point B
for each product. This shows that a coordination failure need not always happen: It depends on
technology and prices (including wages) prevailing in the economy.
If a wage bill line like W2 holds, passing between points A and B, the firm would not enter if it
were the only modern firm to do so in the economy because it would incur losses. But if modern
firms enter in each of the markets, then wages are increased to the modern wage in all markets,
and income expands. We may assume that price remains 1 after industrialization. Note that the
traditional technique still exists and would be profitable with a price higher than 1. So to prevent
traditional firms from entering, modern firms cannot raise prices above 1. The modern firm can
now sell all of its expanded output (at point B), produced by using all of its available labor
allocation (L/N), because it has sufficient demand from workers and entrepreneurs in the other
industrializing product sectors. As can be seen in Figure 4.2, with prevailing wage W2, point B is
profitable after industrialization because it lies above the W2 line. Workers are also at least as
well off as when they worked in the traditional sector because they can afford to purchase an
additional quantity of goods in proportion to their increased wage, and they have changed sectors
voluntarily. All of the output is purchased because all of national income is spent on output.
In general, whenever the wage bill line passes below point A, the market will lead the economy
to modernize, and whenever it passes above A, it will not. The steeper (i.e., more efficient) the
modern-sector production technique or the lower the fixed costs, the more likely it is that the
wage bill will pass below the corresponding point A. If the line passes above B, it makes no sense
to industrialize. But if the wage line passes between points A and B, it is efficient to industrialize,
but the market will not achieve this on its own. Be sure to note that these are three different
wages that might exist depending on conditions in a particular economy at one point in time, not
three wages that occur successively.
The problematic cases occur when the wage bill line passes between A and B, thus creating two
equilibrium: one in which there is industrialization and the society is better off (point B) and one
without industrialization (point A). However, the market will not get us from A to B because of a

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coordination failure. In this case, there is a role for policy in starting economic development and
need big push to push the equilibrium at point B.

Condition for Big-push

There are four conditions for big push
1. Intertemporal effects: The source of the multiple equilibrium is that one firm’s profits
do not capture its external contribution to overall demand for modern-sector products
because it also raises wage income in the future periods when other entering modern
firms will be seeking to sell their own products. When there is a case for a big push,
industrialization makes the society better off (is Pareto-preferred) because first-period
income is decreased only by the fixed cost, but second-period income is sufficiently
increased by both the wage and profits in other product sectors to more than offset this.
Note once again that a part of profits can, in principle, also be subject to income
redistribution. So that everyone may be made better off rather than just some people
made better off and no one made worse off.
2. Urbanization effects. If some of the traditional cottage industry is rural and the
increasing-returns-to-scale manufacturing is urban, urban dwellers’ demand may be more
concentrated in manufactured goods (e.g., foods must be processed to prevent spoilage
due to the time needed for transportation and distribution). If this is the case, one needs a
big push to urbanization to achieve industrialization.
3. Infrastructure effect: The critical point is that when one product sector industrializes, it
increases the size of the market for the use of infrastructure services that would be used
by other product sectors and so makes the provision of these services more profitable.
But it is also possible that efficient industrialization may not take place, even if the
infrastructure is built, if other coordination problems are present.
4. Training effects: There is underinvestment in training facilities because entrepreneurs
know that the workers they train may be enticed away with higher wages offered by rival
firms that do not have to pay these training costs. In any case, relying on expatriate
skilled workers is hardly an adequate solution to a country’s own underdevelopment.

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Increasing return, multiple equilibria and coordination failure

Increasing returns to scale – doubling of the input results in output more than doubling.

– develop specialized suppliers networks

– knowledge spillovers

– improved industry specific infrastructure

These resulted on strategic complementarities among firms. As you can see in the figure below,
we have increasing return production curve. This production curve is different from traditional
diminishing return production curve, which has a declining marginal product.

Figure 4.3 A Production Function with Increasing Returns to Scale

A production function with increasing returns to scale results in a upward sloping labor demand
curve. Reasoning: at a higher level of employment, the marginal product of labor is higher
because of complementarities between labor. The marginal product of labor increases with more
employment. Therefore, the marginal product increases and hence also the wage.

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Figure 5.4 Aggregate Labor Demand with Sufficient Increasing Returns to Scale

demand

We impose that increasing returns are so strong that the labor demand curve is steeper than labor
supply. Let us assume that the interest rate increased from r1 to r2. When interest rate increase
the investment decline that reduce the total output. The decline in output shift the labour supply
to outward which reduce both the number of labour and real wage rate. This is the bad
equilibrium due to the decline in an increase in the interest rate. Government can apply various
policy to shift the economy from bad equilibrium to good equilibrium.

Figure 5.5 aggregate labor demands with change in labor supply

A2

Social norm and status quo

Social norm and status quo are the two factors that affect the future development of the given
country. Both determine the future equilibrium. Social norms are the modes of behaviour to
which the majority of society subscribe.

Change in social norm caused by;

– Technological innovation

– Development of new idea

Status quo usually determine whether the new policy undertaken.

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– Most new policy have winner and looser

– The compensation to the losers may be impossible(Valuation, identify loser and

gainers and consistency problems)

Balanced and Unbalanced growth theory

Debates on balanced and unbalanced growth for a long time have become the preoccupations of
development economists.

Balanced growth theory

The term-balanced growth is used in many different senses, but the original exponent of the
balanced growth doctrine had in mind the scale of investment necessary to overcame
indivisibility on both the supply and the demand side of the development process. Balanced
growth refers to the simultaneous coordinated expansion of several sectors. It suggests
investment in diversified fields. The focus of this theory is the expansion of activities to
overcome divergences between the private and social return. Accordingly, the lack of
development in one sector does not impede development in other sector. It has a horizontal and
vertical aspect. Balanced growth is something that can be achieved in the long run.

On the one hand it recognized indivisibilities in supply and complementarities of demand and on
the other it stress the importance of achieving balance between such sector as agriculture and
industry, between the capital-good and consumer goods industries and between social capital and
directly productive activities.

There are four versions in balanced growth theory;

The first version

A single factory even when it uses more efficient methods of production, would fail to set up on
its own because of the smallness of the market outlet for its product. Simultaneous set up of a

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number of factories producing different consumer goods so that they can create enough new
employment and purchasing power.

Second version

Simultaneous investment in consumers’ good industries and social overhead capital. Investment
in the social overhead capital is considered essential because a number of underdeveloped
countries ( Asia and Africa) have inadequate transport and communication facilities and
insufficient power supply.

Third version

The third version emphasizes the simultaneous setting up of industries in the consumer’s goods
sector, social overhead capital, and capital goods sector. It is a comprehensive and integrated
programme of industrialization. For a country to initiate successfully economic development it is
necessary not only to enlarge the size of the market (internal economies) but also to obtain
external economies. External economies arise from simultaneously setting up industries, which
are technically interdependent.

Three balances in the third version;

1. Horizontal balance between different consumer goods

2. The balance between social overhead investment and directly productive activities
both in the consumers’ and capital goods sectors’

3. The vertical balance between the capital goods industries

The fourth version

The fourth version advocates balanced growth of the industrial and agricultural sectors of the
economy. It advocates expansion and broad intersectoral balance between agriculture
manufacturing industries. This is important for input exchange and market creation

There are two distinct versions of the balanced growth doctrine then need considering;

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– One referring to the path of development and the pattern of investment necessary
for the smooth functioning of the economy.

– The other refers to the scale of investment necessary to overcame indivisibilities

in the productive process on both side of the market.

Criticism of the Balanced Growth Theory

• To undertake a vast program of simultaneous, coordinated investment requires large sums

of capital far beyond the reach of the ordinary LDC. Indeed, if the LDCs had such
resources, critics argue, they would not be underdeveloped in the first place. Implicitly,
advocates of the balanced growth approach assume that LDCs will have access to some
form of aid or loans. Critics consider this unrealistic.

• To realize its goals, balanced growth obviously requires a cadre of trained personnel
(entrepreneurs, managers, technicians, skilled labor, etc) to implement the comprehensive
plan of investment. But, these are in scarce supply in LDCs.

• Critics maintain that it a country had the resources to launch a program of balanced
growth; it would not be under developed in the first place.

Unbalanced growth theory

A major critic of balanced growth doctrine is that it fails to realize the shortage of resource in
developing countries. Hirschman (1958) proposed unbalanced growth theory to solve the
problem of limited resources. He argues that deliberate unbalancing of the economy according to
a pre-designed strategy is the best method of development. When some industries are more
developed than others, the less developed industries are induced to grow or develop. Investment
in projects with the greatest total links, both forward and backward linkages.

He distinguished two types of investment choice-substitution choices and postponement choices.

– Substitution choice s are those which involves a decisions as to whether project A

or B should be undertaken.

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– Postponement choices are those which involves a decision as a sequences of

project A and B-that is which proceed the other

His fundamental thesis is that the question of priority must be resolved on the basis of a
comparative appraisal of the strength with which progress in one area induced progress in
another. In Hirsshiman’s view, the real scarcity in developing countries is not the resource
themselves but the means and ability to bring them into play. Preference should be given to that;
sequence of project which maximizes “induced decision-making”. He illustrated his argument by
considering the relation between Social Capital (SC) and directly productive activity (DPA). He
argues that only that part of social overhead capital or socio-economic infrastructure (SOC)
necessary for directly productive activities (DPA) should be developed.

The case in which SC proceeds DPA he call “development via excess capacity”, and the case in
which DPA proceed SC he labels “development via shortage”. The figure below show DPA in the
vertical access and SC in the horizontal line. The a, b, c curve are negative sloped and convex to
the origin because DPA cost will decrease the greater the availability of SC.

There are two possibilities to maximize resource utilization based on postponement choice.

– development via excess capacity

_ development via shortage

The choice must be based on: the relative strength of entrepreneurial motivation and the response
of the public pressure of the authorities responsible for social capital on the other.

Figure 4.3 Induced decision-making

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CHAPTER FIVE

Linkage between Growth, Inequality and Poverty

The persistent problem of poverty in the developing world has led many to question the
effectiveness of economic growth and development as a means of poverty alleviation.

• There are strong linkage between

– Growth and poverty

– Growth and inequality

– Poverty and inequality

In this section, we will see the first two growths and poverty and growth and inequality.

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Growth and poverty

It seems obvious that economic growth should reduce poverty, yet the issue remains
controversial. Some scholars assert that economic growth does not eliminate poverty and may
exacerbate the problems of the poor. The impact of growth on the poor obviously depends on
how the benefits are distributed across the population.

There are at least five reasons why policies focused toward reducing poverty levels need not lead
to a slower rate of growth.
First, widespread poverty creates conditions in which the poor have no access to credit, are
unable to finance their children’s education, and, in the absence of physical or monetary
investment opportunities, have many children as a source of old-age financial security. Together
these factors cause per capita growth to be less than what it would be if there were greater
equality.
Second, a wealth of empirical data bears witness to the fact that unlike the historical experience
of the now developed countries, the rich in many contemporary poor countries are generally not
noted for their desire to save and invest substantial proportions of their incomes in the local
economy.
Third, the low incomes and low levels of living for the poor, which are manifested in poor
health, nutrition, and education, can lower their economic productivity and thereby lead directly
and indirectly to a slower-growing economy. Strategies to raise the incomes and levels of living
of the poor would therefore contribute not only to their material well-being but also to the
productivity and income of the economy as a whole.
Fourth, raising the income levels of the poor will stimulate an overall increase in the demand
for locally produced necessity products like food and clothing, whereas the rich tend to spend
more of their additional incomes on imported luxury goods. Rising demand for local goods
provides a greater stimulus to local production, local employment, and local investment. Such
demand thus creates the conditions for rapid economic growth and a broader popular
participation in that growth.
Fifth, a reduction of mass poverty can stimulate healthy economic expansion by acting as a
powerful material and psychological incentive to widespread public participation in the
development process.

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In general, the impacts of growth on poverty are mainly influenced by

 The quality of economic growth,

 Macroeconomic performance,

 Structural reforms and initial conditions

Growth and inequality

Why inequality?

The more wealth concentrates creates incentives for economic behaviors that make life miserable
for average people. Social dynamics that frustrate the hopes and dreams of average people and
aggravate the stresses of everyday life. The political power of the extremely wealthy
undermines society’s capacity to overcome modern life’s core problems and challenges.

While agreement on the role of growth for poverty reduction is widely shared, this is not the case
for inequality. Some study finds that income growth reduces urban and rural poverty but not
inequality. All changes in aggregate income may not be equally effective in affecting poverty
and inequality.

– first, there may exist an asymmetry in the relationship between changes in

poverty and inequality and changes in income associated with growth and with
recession. For instance, a 1 percent increase in gross national income per capita
(gnipc) may have less effect on poverty or inequality than a 1 percent fall in
gnipc.

– second, the effect of income growth on poverty and inequality may also differ by
policy context.

The kuznets inverted u hypothesis

Professor Kuznets with his inverted “U” hypothesis is the first to study the relationship between
income inequality and economic growth. The kuznets curve hypothesis proposed by economist
simon kuznets in 1955 holds that as incomes grow in the early stages of development, income

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distribution would at first worsen and then improve as a wider segment of the population
participated in the rising national income.

According to his analysis with economic growth:

 income inequality increases at early stages,

 Stabilizes with time and
 Declines in the later stages
A Kuznets curve is the graphical representation of simon kuznets’s hypothesis that economic
inequality increases over time while a country is developing, and then after a certain average
income is attained, inequality begins to decrease.

Figure 5.1: Kuznets curve

Inequality

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Income per capital

Causes of inequality

1. The existence of dualism (industry & agriculture)

 Income grows first in industrial sector with development than in agriculture sector

2. Urban bias in the allocation of financial resources for development by government

 In the later stages of development, per capita income in the agricultural sector also
increases and in the industrial sector it decreases

The Lorenz Curve

Is a diagrammatic way of depicting the income distribution of income in a society. The

horizontal axis shows number of income recipients (in cumulative percentage) or cumulative
percentages of population arranged in increasing order of incomes. Points on this axis refers to
the poorest 20%, the poorest half of the population etc. On the vertical axis we measure the
percentage of national income accruing to any particular fraction of population. The entire figure
is enclosed in a square box with a 450 reference line drawn from the origin to upper right of the
box

Figure 5.2: the Lorenz curve

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ry
unt
c o
n
ive
g
a
of
ve
cur
nz
re
Lo

On the 450 reference line, at any point, the percentage of income received and percentage of
population is the same. The 450 represents perfect equality in the distribution of income. When

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the actual Lorenz curve of a country deviates from the 45 0 reference line, there is some amount of
income inequality as measured by the degree of deviation. The more the Lorenz curve is away
from the diagonal line, the greater the degree of inequality represented. Overall distance between
the diagonal and the Lorenz curve is an indicative of the amount of inequality in income
distribution. The extreme case of perfect inequality is when one person receives all the national
income and others receive non. The Lorenz curve coincides with the bottom horizontal and the
right vertical lines. In general, there are no perfect cases in the real world. The Lorenz curve is
located to the right of the diagonal.

The Gini Coefficient

Gini Coefficient was Formulated by Italian statistician Corrado Gini, an Italian statistician,
demographer and sociologist Corrado Gini in 1912. Sometimes it is called Gini concentration

ration. Gini Coefficient is the most commonly used measure of inequality . It equals to the ratio
of the area between the diagonal line and the Lorenz curve to the total area of the square below
the diagonal. Gini coefficients are aggregate measures of inequality.

Figure 5.3; Gini Coefficient

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Gini Coefficient Ranges from 0 to 1

 0 perfect equality

 1 perfect inequality

 0.5-0.7 high income inequality

 0.2-0.35 relatively equal income distribution

Advantages of Gini Coefficient

 It is a measure of inequality, not a measure of average income or some other variable,

which is unrepresentative of most of the population, such as gross domestic product.

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 Gini coefficients can be used to compare income distributions across different population
sectors as well as countries, for example the Gini coefficient for urban areas differs to
that of rural areas.

 The Gini coefficient is sufficiently simple that it can be compared across countries and be
easily interpreted.

 The Gini coefficient can be used to indicate how the distribution of income has changed
within a country over a period of time, thus it is possible to see if inequality is increasing
or decreasing

Disadvantage of Gini Coefficient

 benefits systems may be different in different countries, for example, some countries give
benefits in the form of money, others use food stamps

 When collecting the income data initially, there will always be systematic and random
errors.

 A major problem with the Gini coefficient is that countries with similar income and Gini
coefficients can still have very different income distributions. Lorenz curve can intersect

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