Development Economics

1
Course Objectives

After successful completion of this course students will be able to:

 Explain basic concepts of economic development,

 Discuss various theories and models of economic growth and development,
 Evaluate the efficacy of these theories and models in solving the problems of under
development,
 Analyze the relationship between development theory and practice,
 Describe the features and common characteristics of less developing countries,
 Participate in development policy formulation and evaluation, and
 Differentiate concepts of poverty, inequality and income distribution

Topic One: Introduction

1.1. Definition and Current Interest in Development Studies

Development studies: is an interdisciplinary branch of social science. Development studies is

offered as a specialized master's degree in a number of universities, and, less commonly, as an
undergraduate degree. Comparative focus on international development of human societies
multi-discliplinary social science primary normative object on social, political and economic
issues

Development economics is a branch of economics which deals with economic aspects of the
development process in low income countries.

Development economics is a branch of economics which deals with economic aspects of the
development process in low income countries. Its focus is not only on methods of promoting
economic development, economic growth and structural change but also on improving the
potential for the mass of the population, for example, through health, education and workplace
conditions, whether through public or private channels.

2
1.2. Nature of Development Economic
 The Traditional Economics deals basically with the efficient, least cost allocation of scarce
productive resources and with the optimal growth of these resources overtime so as to
produce an ever-expanding range of goods and services.
 The traditional economics consists of economic theory of classical and neo-classical
economists.

Traditional economics is an approach to economics that emphasizes utility, profit maximization,

market efficiency, and determination of equilibrium.
The traditional economics or economic theory believes in rationality, materialism, self-interest
and individualistic approach in respect of economic decisions. Thus this economics deals the
matters subjectively. This is appropriate for studying:
 Advanced capitalist economies
 Perfect and Complete Markets
 Purely Capitalist Incentives in Decision-making
 Economic Rationality
 The 'Political Economy' is also a branch of economics where a relationship is established
between politics and economics.
 The political economy analyses the social and institutional processes through which certain
groups of economic and political best like feudals, businessmen, industrialists, politicians,
trade unions and bureaucrats etc.
 Political economy is attempt to merge economic analysis with practical politics—to view
economic activity in its political context.
 Influence the scarce productive resources either for their own vest-interests or perhaps for the
interest of the whole economy.
 Development Economics is beyond traditional economics and political economy.
 The Development Economies is something more than neo-classical economics and Political
Economy. And it is concerned with the economic, cultural and political requirements which
are necessary for structural and institutional transformations of entire societies in a manner
that the fruits of economic growth could be provided to the largest segment of the society of
the poor class.

3
 Development economics is the study of how economies are transformed from stagnation to
growth and from low income to high-income status, and overcome problems of absolute
poverty.

4
Topic Two: Economic Growth and Development

2.1 Concepts of Economic Growth and Development

 Schumpeter defines development as a continuous and spontaneous change in the

stationary state which forever alters and displaces the equilibrium state previously
existing while growth is a gradual by a gradual increase in the long run which comes
about by a gradual increase in the rate of saving.

 Kindleberger, economic growth means more output , while economic development

implies both more output and changes in the technical and institutional arrangement by
which it is produced and distributed.

• Friedman defines growth as an expansion of the system in one or more dimensions

without a change in its leading to the structural transformation of social system.

• The concept of development should embrace the major economic and social objectives
and values that society strives for.

Key Differences between Economic Growth and Economic Development

• Economic growth is the positive change in the real output of the country in a particular
span of time economy. Economic Development involves a rise in the level of production
in an economy along with the advancement of technology, improvement in living
standards and so on

• Economic growth is one of the features of economic development.

• Economic growth is an automatic process. Unlike economic development. which is the

outcome of planned and result-oriented activities.

• Economic growth enables an increase in the indicators like GDP, per capita income, etc.
On the other hand, economic development enables improvement in the life expectancy
rate, infant mortality rate, literacy rate and poverty rates.

Three components of economic growth are of prime importance: 1. Capital accumulation,

including all new investments in land, physical equipment, and human resources through

5
improvements in health, education, and job skills 2. Growth in population and hence eventual
growth in the labor force 3. Technological progress—new ways of accomplishing tasks

2.2. Core Values of Development

Three core value of development are

I. Life sustenance- (Ability to meet basic needs) .The basic goods and services, such as
food, clothing, and shelter, that are necessary to sustain an average human being at the
bare minimum level of living.
II. Self –esteem (to be a person). A second universal component of 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.
Self-esteem feeling of worthiness that a society enjoys when its social, political, and
economic systems and institutions promote human values such as respect, dignity,
integrity, and self determination.
III. Freedom from servitude (to be able to choose) : The Freedom is a situation in which a
society has at its disposal a variety of alternatives from which to satisfy its wants and
individuals enjoy real choices according to their preferences.
A third and final universal value that we suggest 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, other people, misery, oppressive institutions, and dogmatic beliefs,
especially that poverty is predestination.
2.3. Meaning and Challenges of Development

• The Three Objectives of Development We may conclude that development is both a

physical reality and a state of mind in which society has, through some combination of
social, economic, and institutional processes, secured the means for obtaining a better life.
Whatever the specific components of this better life, development in all societies must
have at least the following three objectives:
• 1. To increase the availability and widen the distribution of basic life-sustaining goods
such as food, shelter, health, and protection

6
• 2. To raise levels of living, including, in addition to higher incomes, the provision of
more jobs, better education, and greater attention to cultural and human values, all of
which will serve not only to enhance material wellbeing but also to generate greater
individual and national self-esteem
• 3. To expand the range of economic and social choices available to individuals and
nations by freeing them from servitude and dependence not only in relation to other
people and nation-states but also to the forces of ignorance
• There are various obstacles to economic growth and development in developing countries.
Some of the basic obstacles observed in poor nations include;
• A. Vicious circle poverty
• It implies a circular association of forces tending to act and react up on one another in
such a way so as to keep a poor country in a state of poverty

•
Demand side vicious circle
 Low level of income => low level of demand=> low level of investment => back to
deficiency of capital and low productivity

7
 Supply side vicious circle
 Low level of real income=> low rate of saving -> this leads to low rate of investment.
Hence, the process will lead back to capital deficiency and low productivity.
 B. Low rate of capital formation
 In developing nations, shortage of capital is a great obstacle to economic development.
 As the majority of the people in these nations are illiterate and unskilled, they use age-
old methods of production=> low marginal productivity=> low real income=> low
saving=> low investment and capital formation
 Further the consumption level is already low in developing nations hence; it is very
difficult to increase the level of saving (capital stock) by reducing consumption. On the
other hand, the saving of the few rich doesn‘t flow to productive channels but to durable
consumer goods and conspicuous consumption.
C. Socio cultural obstacles

LDCs (least developed countries) have social institutions and attitudes, which are not
conducive or suitable to development.

According to the UN‘s report on the process‘s and problems of industrialization in LDCs,
there are unfavorable factors or elements of social resistance to economic change in
LDCs, which include institutional factors like Rigid stratification of occupations
reinforced by traditional beliefs and values Attitudes involving inferior valuation attached
to business roles, backward social attitudes, Unfavorable political
conditions ,Stratification and classification based on class, religious groups, caste system,
ethnic groups. Etc

D. International forces

Apart from local problems, international problems are also basic causes of poverty. To
begin with historical factors such as colonialism and neo colonialism have played a
significant role in hindering the development of many poor African nations. he gains
from trade have also gone mainly to the developed countries (DC s).Further the
development of the export sector only made other sectors to neglected i.e. most of the
poor nations are basically concerned towards developing exportable agricultural

8
 commodities rather than being concerned about the overall development of their domestic
economy. Apart from this too much dependence on exports has exposed many LDCs‘
economies to international fluctuations in the demand for and prices of their products.
Hence the development efforts of many poor nations were negative.

Foreign investment in most African nations has been mainly directed towards increasing
exportable goods. It has, however, tended to affect the economy adversely because the
levels of productivity, incomes living standards have not risen in the primary sector. Even
in the export sector, the level of real wages of unskilled labor has remained low. The
foreigners have been draining out large amounts of money in the name of profit and
wages of management.

2.4. Measuring Development: Key Indicators

Economic development is measured in four ways:

I. GNP-Gross National Product: refers to the country's total output of final goods and
services. It does not reveal the changes in growth of population. It does not reveal -the
costs to society of environmental pollution. It tells us nothing about the distribution of
income in the economy.

• GNP makes no effort in including the non-marketable products (bringing up children,

production of home materials, home bakery, etc). Another difficulty in calculating GNP is
double counting

II. GNP per capital-it is the GNP divided by the total population of the country. The real
GNP per capital fails to take problems associated with basic needs like nutrition, health,
sanitation, housing, water and education. The improvement in living standards by
providing basic needs cannot be measured by increase in GNP per capital. The real GNP
per capital is the most widely used measure of economic development
GNI
GNI per capita =
Population
GNIcurrent year
GNI at constant prices =
GNI price deflator

9
 GNI current year  GNI base year
Real Economic Growth = GNI base year

III. Welfare- economic development is regarded as a process whereby there is an increase in

the consumption of goods and services of individual. Welfare as measurement of
development is not free from limitations like the difficulty in the valuation of the output.
This measure is the secular improvement in material well being.

IV. social indicators- are often referred as the basic needs for development. It should be
known that the merit of social indicators is that they are concerned with ends being
human development. The social indicators include health, food, water, sanitation, housing
and the like.

• Economists have tried to measure social indicators of basic needs by taking one, two or three
or more indicators for constructing composite indices of human development.

The Human Development Index (HDI)

Human Development Index (HDI) is an index measuring national socioeconomic development,

based on combining measures of education, health, and adjusted real income per capita.

 The United Nations Development Program (UNDP) defines human development as "a process
of enlarging people's choices.
 The most critical ones are to lead a long and healthy life, to be educated and enjoy a decent
standard of living."
 The HDI summarizes a great deal of social performance in a single composite index
combining three indicators
 longevity (a proxy for health and nutrition)
 education
 living standards.
Longevity: as measured by life expectancy at birth the range is 25 to 85 years
Education attainment as measured by a combination of adult literacy (2/3 weight) and combined
primary, secondary and tertiary enrollment ratios (1/3 weight), the range for both is 0% to 100%

10
Standard of living as measured by real GDP per capita based on Purchasing Power Parity (PPP),
the range is between $100 to $40,000.
For any component of the HDI, the individual indices can be computed according to the general
formula:
Index = Actual value-Minimum value
Maximum Value- Minimum value
• The HDI is not free from certain limitations such as: the three indicators are not the only
indicators of human development, the attachment of weights to each of these items is
arbitrary and others.
• Example: life expectancy at birth for country X is given to be 58 years. The combined
primary secondary and tertiary education attainment is given to be 50%, for the same
country the real per capita GDP is $900.The adult literacy is given to be 30%.Calculate,
a) Life expectancy index
b) Education index
c) GDP index
d) HDI
Solution:
A) Life Expectancy Index= 58-25 = 0.55
85-25
B) Education index = 2/3 (30-0/100-0) + 1/3 (50-0)
(100-0)
= 0.37
C) GDP index = log 900- log 100 = 0.36
log 40, 000-log100
D) HDI = 1/3(0.55) + 1/3(0.37) + 1/3(0.36)
= 0.42

HDI takes the range from 0 to

1. Countries with an HDI value
Below 0.5 are considered to have a low level of human
development Those between 0.5 to 0.8 a medium level and
Those above 0.8 a high level.

11
 The HDI has been used:
 to stimulate national political debate;
 to give priority to human development;
 to highlight disparities within countries; and
 To open new avenues for analysis.
The most widely used measure of the comparative status of socioeconomic development is
presented by the United Nations Development Program (UNDP) in its annual series of Human
Development Reports. The centerpiece of these reports, which were initiated in 1990, is the
construction and refinement of its informative Human Development Index (HDI). The HDI
attempts to rank all countries on a scale of 0 (lowest human development) to 1 (highest human
development) based on three goals or end products of development: longevity as measured by
life expectancy at birth, knowledge as measured by a weighted average of adult literacy (two-
thirds) and gross school enrollment ratio (one third), and standard of living as measured by real
per capita gross domestic product adjusted for the differing purchasing power parity of each
country‘s currency to reflect cost of living and for the assumption of diminishing marginal utility
of income. The HDI ranks countries into four groups: low human development (0.0 to 0.499),
medium human development (0.50 to 0.799), high human development (0.80 to 0.90), and very
high human development (0.90 to 1.0).

Suppose the case of country A, whose 2007 PPP GDP per capita was estimated by the UNDP to
be $1,241, the income index is calculated as follows:
Income index = [log (1,241) - log (100)] divided by [log (40,000) - log (100)] = 0.420
To find the life expectancy (health proxy) index, the UNDP starts with a country‘s current life
expectancy at birth and subtracts 25 years. The latter is the lower goalpost, the lowest that life
expectancy could have been in any country over the previous generation. Then the UNDP
divides the result by 85 years minus 25 years, or 60 years, which represents the range of life
expectancies expected over the previous and next generations. That is, it is anticipated that 85
years is a maximum reasonable life expectancy for a country to try to achieve over the coming
generation. For example, for the case of country A, whose population life expectancy in 2007
was 65.7 years, the life expectancy index is calculated as follows:
Life expectancy index = (65.7 – 25)/ (85 – 25) = 0.678

12
The education index is made up of two parts, with two-thirds weight on literacy and one-third
weight on school enrollment. Because gross school enrollments can exceed 100% (because of
older students going back to school), this index is also capped at 100%. For the case of
Bangladesh, adult literacy is estimated (rather uncertainly) at 53.5%, so
Adult literacy index = (53.5 – 0)/ (100 – 0) = 0.535
For the gross enrollment index, for country A it is estimated that 52.1% of its primary, secondary,
and tertiary age population are enrolled in school, so the country receives the following value:
Gross enrollment index = (52.1 - 0 )/(100 – 0) = 0.521
Then, to get the overall education index, the adult literacy index is multiplied by two-thirds and
the gross enrollment index is multiplied by one-third. This choice reflects the view that literacy is
the fundamental characteristic of an educated person. In the case of Bangladesh, this gives us
Education index = 2 /3 (adult literacy index) + 1 /3 (gross enrollment index)
= 2/ 3 (0.535) + 1 /3 (0.521) = 0.530
In the final index, each of the three components receives equal, or one-third, weight.
Thus HDI=1/3(income index) +1/3 life expectancy index) +1/3(education index)
HDI = 1/ 3 (0.420) + 1/ 3 (0.678) + 1/ 3 (0.530) = 0.543

13
Topic Three: Structural Features and Common Characteristics of the Third World
3.1. Some Classifications of Developing Countries

The most common way to define the developing world is by per capita income. Several
international agencies including the Organization for Economic Cooperation and Development
(OECD) and the United Nations offer classifications of countries by their economic status, but
the best known system is that of the International Bank for Reconstruction and Development
(IBRD), more commonly known as the World Bank. According to the classification development
system used by the World Bank divides countries into four groups on the basis of per capita GNI.
In 2003, these categories were roughly low-income countries lower-middle-income countries
upper-middle-income countries), and highincomecountries ($9,000 or more). Each year, the
boundary between categories rises with inflation. Therefore, based on 2003 price, World Bank
made classification as:

 Low – income economies (< 1000$PCI, 2003 price). These economies are known as
Less Developed Countries (LDCs).
 Lower – middle – income economies ($1,001–3,000), PCI)
 Upper middle income ($3,000–9,000 PCI). Some of the upper middle – income countries
are known as the newly industrialized countries ( eg. Taiwan , Hongkong…).
 High – income economies (Industrial countries) :- ( > $9000,PCI)
Using word bank classification of categories (based on the 2003 price) the following facts can be
reinstated.

 Among OPEC(Organization of Petroleum Exporting Countries) members, high- and

upper-middle-income economies are Kuwait, Libya, Saudi Arabia, Venezuela, the United
Arab Emirates, and Gabon.
 The four Asian tigers, South Korea, Taiwan (China-Taipei), Singapore, and Hong Kong
(the largest investor in and a major recipient of investment from China, and a part of
China since 1997) are included among the newly industrializing countries(NICs).
 Economies of Eastern Europe including Russia (In terms of their income they are in
 the middle- income economies, but economically they are in transitional economies).

14
Beyond World Bank classification other types of traditional classification has been used to
distinguish least developed countries as third world countries. The idea comes from

1st world means- North America, West Europe and Pacific Countries

2nd world means- East Europe socialist countries including Russia

3rd world means- Developing countries of Africa, Asia and Latin America.

Further there is also geographical based classification. Accordingly the world is categorized as
North and South countries:

- The North: - which refers to 1st and 2nd world countries.

- The South:-which refers to developing countries (third world countries).
3.2. The Structure of Third World Economies

A. Ratio of industrial output to total output

According to this criterion, countries with a low ratio of industrial output to total output are
considered underdeveloped. But this ratio tends to increase with the increase in the per-capita
income. Therefore, the degree of industrialization is often a consequence rather than a cause of
economic prosperity in a country.

B. Low ratio of capital to per head of population

Underdeveloped countries compared with the advanced countries are under equipped with
capital in relation to their population and natural resources. Capital is a necessary but not a
sufficient condition of progress. Economic development has much to do with human
endowments, social attitudes,and political conditions.

C. Poverty as the main cause of underdevelopment

It defines an underdeveloped country as one characterized by mass poverty which is chronic and
not the result of some temporary misfortune and by obsolete methods of production and social
organization, which means that poverty is not entirely due to poor natural resources.

D. Low per capital income as compared with the advanced countries

15
According to the United Nations, we use the term underdeveloped country to mean countries in
which per capital real income is low ascompared to the real per capita income of the United
States of America,Canada, Australia and Western Europe.

3.3. Common Characteristics of the Third World

A. General poverty

An underdeveloped country is poverty ridden. Poverty is reflected in low GNP per capital.
According to the most recent estimates, in 2013, 10.7 percent of the world‘s population lived on
less than US$1.90 a day, compared to 12.4 percent in 2012. That‘s down from 35 percent in
1990. Nearly 1.1 billion people have moved out of extreme poverty since 1990. In 2013, 767
million people lived on less than $1.90 a day, down from 1.85 billion in 1990. The extremely
low GNP per capita of low Income economics reflects the extent of poverty in them.

It is not relative poverty but absolute poverty that is more important in assessing underdeveloped
countries. Absolute poverty is measured not only by low income but also by malnutrition, poor
health, clothing, shelter, and lack of education. Thus, absolute poverty is reflected in low living
standards of the people. In such countries, food is the major item of consumption and about 80%
of the income is spent on it as compared with 20% in advanced countries. The vast majority of
the people in LDCs are ill fed, ill clothed, ill housed and ill educated.

B. Agriculture, the main occupation

In underdeveloped countries two-thirds or more of the people live in rural areas and their main
occupation is agriculture. There are large times as many people occupied in agriculture in some
underdeveloped countries as there are in advanced countries. This heavy concentration in
agriculture is a symptom of poverty. Agriculture, as the main occupation, is mostly unproductive.
It is carried on in an old fashion with obsolete and outdated methods of production.

C. A dualistic economy

Almost all underdeveloped countries have a dualistic economy. One is the market economy
which is modern and the other subsistence economy which is backward and mainly agriculture-
oriented. Dualism is also characterized by the existence of an advanced industrial system and an

16
indigenous backward agricultural system. There is also financial dualism consisting of the
unorganized money market charging very high interest rates on loans and the organized money
market with low interest and abundant credit facilities.

D. Underdeveloped natural resources

The natural resources of an underdeveloped country are underdeveloped in the sense that they
are either unutilized or underutilized. A country may by deficient in natural resource, but it
cannot be so in the absolute sense. Although a country may be poor in resources, it is just
possible that in the future it may become rich in resources as a result of the discovery of
presently unknown resources or because new uses may be found for the known resources.

E. Demographic features

One common feature in underdeveloped countries is a rapidly increasing population which adds
a substantial number to the total population every year. Almost all the underdeveloped countries
possess high population growth potential characterized by high birth rate and high but declining
death rate. The advancement made by medical science has resulted in the discovery of marvelous
drugs, theintroduction of better methods of public health, reducedmortality and increased
fertility.An important consequence of high birth rate is that a larger proportionof the total
population is in young age groups. A large percentage ofchildren in the population entail a heavy
burden on the economy whichimplies a large number of dependents who do not produce at all
but doconsume. With many dependents to support, it becomes difficult for theworkers to save for
purposes of investment in capital equipment. It isalso a problem for them to provide their
children with the educationand basic necessities of life that are essential for the
country'seconomic and social progress in the long run.

F. unemployment and Disguised Unemployment

In underdeveloped countries there is vast open unemployment and disguised unemployment. The
unemployment is spreading with urbanization and the spread of education. But the industrial
sector has failed to expand along with the growth of labor force thereby increasing urban
unemployment. Then there are the educated unemployed who fail to get jobs due to structural
rigidities and the lack of manpower planning. Under employment or disguised unemployment is

17
a notable feature of underdeveloped countries. A person is said to be disguised unemployed if his
contribution to output is less than what he can produce byworking for normal hours per day.

G. Economic Backwardness

In under developed countries, particular manifestations of economic backwardness are low labor
efficiency, factor immobility, and limited specialization in occupation and in trade, economic
ignorance, values and social structure that minimize the incentive for economic change.

H. Lack of enterprise and initiative

Entrepreneurial ability is inhibited by the social system which denies opportunities for creative
facilities. The force of custom, the rigidity of status and the distrust of new ideas and of the
exercise of intellectual curiosity, combine to create an atmosphere unfavorable to experiment and
innovation. The small size of the market, lack of capital, absence of private property, absence of
freedom of contract and of law and order hamper enterprise and initiative.

I. Insufficient capital equipment

Underdeveloped countries are characterized as capital poor or low saving and low-investing
economies. There is not only an extremely small capital stock but the current rate of capital
formation is also very low. In most under developed countries, gross investment is only (5-6) %
of GNP. Whereas, in advanced countries, it is about (15-20) %.

J. Technological Backwardness

Their technological backwardness is reflected in the high average cost of production despite low
money wages. Also, it is reflected in the predominance of unskilled and untrained workers and
others.

K. Foreign Trade Orientation

Underdeveloped economies are generally foreign trade oriented. This orientation is reflected in
exports of primary products and imports of consumer goods and machinery. The percentage
share of fuels, minerals, metals, and other primary products in the merchandise exports of the
majority of LDCs is, on the average, about 80 percent as revealed by the recent World Bank data.

18
We then consider ten important features that developing countries tend to have in common, on
average, in comparison with the developed world. In each case, we also discover that behind
these averages are very substantial differences in all of these dimensions among developing
countries that are important to appreciate and take into account in development policy. These
areas are the following:

1. Lower levels of living and productivity

2. Lower levels of human capital

3. Higher levels of inequality and absolute poverty

4. Higher population growth rates

5. Greater social fractionalization

6. Larger rural populations but rapid rural-to-urban migration

7. Lower levels of industrialization

8. Adverse geography

9. Underdeveloped financial and other markets

10. Lingering colonial impacts such as poor institutions and often external dependence.

19
Topic Four: Theories of Economic Development

4.1 The Classical Theory

The Classical School of economic thought was formalized by Adam Smith, Malthus, Ricardo,
Mill and Say, who developed the classical theory of development. However, there are
distinctions in terms of the emphasis laid by each thinker to the classical theory of development.
While Malthus and Mill emphasize the demand side, Smith, Ricardo and Say proposed a supply
side growth models.

Adam Smith's Theory

Adam Smith is regarded as the foremost classical economist. His monumental work, An Enquiry
into the nature and Cause of Wealth of nations published in 1776, was primarily concerned with
the problem of Economics of Development. Though he did not expound and systematic growth
theory, yet a coherent theory have been constructed by later day economists. Smith proposed a
supply-side driven model of growth. briefly we can set out the story via the simplest of
production functions:

Y = ƒ(L, K, T)

where Y is output, L is labor, K is capital and T is land, so output is related to labour and capital
and land inputs. Consequently output growth (gY) was driven by population growth (gL),

investment (gK), land growth (gT) and increases in overall productivity (gƒ). Succinctly:

gY = φ(gƒ, gK, gL, gT)

Assumptions

Smith proposed that

a) Population growth, in the traditional manner of the time, was endogenous. It depended on the
sustenance available to hold the increasing workforce.

b) Investment was also endogenous; determined by the rate of savings (mostly by capitalists);

c) Land growth was dependent on take-over of new lands (e.g. colonization) or technological
improvements of fertility of old lands.

20
d) Technological progress could also increase growth overall; Smith's famous thesis that the
division of labor or specialization improves growth was a fundamental argument.

e) Smith also saw improvements in machinery and international trade as engines of growth as
they facilitated further specialization.

f) He also assumed the existence of perfect competition.

Main Features

Natural law – lassiez-faire and self interest leads to Development. – Adam Smith believed in the
policy of ‗Natural law‘ in economics affairs. He regarded every person as the best judge of his
own interest who should be left to follow it to her own advantage. In furthering her own self
interest she/he would also further the common good. In pursuance of this, each individual was
led by an ‗invisible hand‘. ―It is not to the kindness of the baker but to his self-interest that we
owe our bread‖, said Smith. Since every individual if left free will seek to maximize his own
wealth, therefore all individuals, if left free, will maximize aggregate wealth. Smith was
naturally opposed to any government interventions in industry and commerce. He was a staunch
supporter of free trade and advocated the policy of laissez-faire in economics affairs. The
―invisible hand‖ – the automatic equilibrating mechanism of the perfectly competitive
market tended to maximize national wealth.

Division of Labor – Division of labor increases productivity which depends upon the size of the
market. – Division of labor is the starting point of Smith‘s theory of economic growth. It is
division of labor that results in the greatest improvement in the productive powers of labor. The
attributes of this increase in productivity are (i) the increase in the dexterity or craft of every
worker; (ii) the saving in time to produce goods; and (iii) to the inventions of large number of
labor saving machines. The last cause to increase in productivity stems not from labor but from
capital. Therefore in Smith‘s scheme; it is improved technology that leads to division of labor
which, however, depends on the size of the market.

Process of Capital Accumulation – Division of labor leads to capital accumulation and capital
accumulation leads to economics of development – Smith, however, emphasized that capital
accumulation must precede the introduction of division of labor. He wrote ―As the accumulation
of stock must, in the nature of things, be previous to the division of labor, so that labor can be

21
more and more sub-divided in proportion only as stock is previously more and more
accumulated‖. Like the modern economists, the classical economists regarded capital
accumulation as a necessary condition for economics of development. Hence the problem of
economics of development was largely the ability of the people to save more and invest more in
a country. As Smith said, ―that portion which a person annually saves is immediately employed
as a capital.‖ But since almost all saving resulted from capital investments or the renting of land;
only capitalists and landlords were held to be capable of saving. The laboring classes were
considered to be incapable of saving. This belief was based on the ‗Iron Law of Wages‖. The
classical economists also believed in the existence of ‗wages fund‘. The idea was that ‗wages‘
tend to equal the amount necessary for the subsistence of the laborers. If the total wages fund at
any time becomes higher than the subsistence level, the labor force will increase, competitions
for employment will become willing and wages will come down to the subsistence level.

Why do capitalists make investment? – Investment is made to earn profits – According to

classical economists, investment were made because the capitalists expected to earn profits on
them; and future expectations with regard to profits depended on the present climate for
investment as well as actual profit. But what is the behaviour of profits during the development
process? Smith believed that profits tend to fall with economic progress when the rate of capital
accumulation increases. Increasing competitions among capitalists tends to lower profits. Thus
with the growth of economy‘s capital stock, competition among entrepreneurs for scarce labor
tends to submit up wages and thereby lowers profits.

Interest – Regarding the role of interest in economics of development, Smith wrote that with the
increase in prosperity, progress and populations the rate of interest falls and as a result the supply
of capital is enlarged. The reason being that with the fall in interest rate the moneylenders will
lend more to earn more interest. Thus the quantity of capital for lending will increase with the
fall in the rate of interest. But when the rate of interest falls considerably the moneylenders are
unable to lend more in order to earn more to maintain their standard of living. Under the
circumstances they will themselves start investing and become entrepreneurs. Thus even with the
fall in the rate of interest there is increase in capital accumulation and economic progress.

Agents of Growth – According to Smith, farmers, producers and businessman are the agents of
progress and economic growth. The functions of these three are, however, interrelated. To Smith,

22
development of agriculture leads to increase in construction works, and commerce. When
agricultural surplus arises as a result of economics of development, the demand for commercial
services and manufactured articles rises. This leads to commercial progress and the
establishment of manufactured industries. On the other hand, their development leads to increase
in agricultural productions when farmers use advanced production techniques.

Shortage of natural resources stops growth – According to Smith, the process of growth is
cumulative. When there is prosperity as a result of progress in agriculture, manufacturing
industries and commerce, it leads to capital accumulations, technical progress, increase in
population expansions of markets, division of labor and rise in profits continuously. But this
process is not endless. It is the scarcity of natural resources that finally stops growth.
Competition among businessmen would bring profits as low as possible. Once profits fall, they
continue to fall. Investment also starts declining and the end result of capitalism is the stationary
state. When this happens capital accumulation stops; populations becomes stationery, profits are
the minimum; wages are at the subsistence level; there is no change in per capita income and
production, and the economy reaches the state of stagnation.

A Critical Appraisal or evaluation

Smith‘s model has the great merit of pointing out ‗how economic growth came about and what
factors and policies impede it‘. In particular, he pointed out the importance of parsimony in
saving and capital accumulation; of improved technology, division of labor and expansion of
market in production and of the process of balanced growth in the interdependence of farmers,
traders and producers. Despite these merits, it has certain weaknesses.

1) Rigid division of Society: Smith‘s theory is based on the socio-economic environment

prevailing is Great Britain and certain parts of Europe. It assumes the existence of a rigid
division of society between capitalists (Including land lords) and laborers. But the middle
class occupies an important place in modern society. Thus, this theory neglects the role of
middle class.

2) One sided saving base: According to Smith, Capitalists, landlords and money lenders save.
This is, however, a one-sided base of saving because it did not occur to him that the major
source of savings in our advance society was the income receivers and not the capitalists and
landlords.

23
3) Unrealistic assumption of perfect competition: Smith‘s whole model is based upon the
unrealistic assumption of perfect competition. The laissez-faire policy of perfect competition
is not to be found in any economy. Rather, a number of restrictions are imposed on the
private sector, and on internal and international trade in every country of the world.

4) Neglect of Entrepreneur: Smith neglects the role of entrepreneur is development. This is a

serious defect as his theory. The entrepreneur is the focal point of development, as pointed
out by Schumpeter. It is the entrepreneur who organizes and brings about innovations there
by leading to capital formation.

5) Unrealistic Assumption of Stationery State: Smith is of the view that the end result of a
capitalist economy is the stationery state. It implies that there is change in such an economy
but around a point of equilibrium. There is progress but it is steady, uniform and regular like
a tree. But this explanation of the process of development is not satisfactory because dev.
takes place by ‗fits and starts‘ and is not uniform and steady. Thus the assumption of
stationary state is unrealistic.

The Ricardian Theory

Ricardo presented his view on Economic Development in an unsystematic manner in his book
The Principles of Political Economy and Taxation. Like Smith, Ricardo never propounded any
theory of development; he simply discussed the theory of distribution. However, Smith‘s model
of growth remained the predominant model of Classical Growth. David Ricardo (1817) modified
it by including diminishing returns to land.

Assumptions

The assumptions of his model included: a) all land is used for production of corn, b) law of
diminishing returns operates, c) supply of land is fixed, d) demand for corn is perfectly is elastic,
e) labour and capital are variable inputs, f) state of technical knowledge is given, g) all workers
are paid a subsistence wage, h) supply price and labour is given and constant, i) demand for
labour depends upon accumulations, j) capital accumulation results from profit and k) there is
perfect competition.

Main Features

24
The Ricardian model is based on the interrelation of three groups in the economy. They are
landlords, capitalists and labourers among whom the entire produce of land is distributed.

Rent, Profit and Wages – (a) rent is that portion of the produce of earth which is paid to the
landlord for the use of original and indestructible powers of the soil. It is the difference between
average and marginal product. If all the land had the same properties of unlimited in supply and
uniform in quality, no charge would make for its use. (b) The wage rate is determined by wage
fund divided by number of workers employed at the subsistence level. According to the model,
out of the total corn produced rent has the first right and the residual is distributed between wage
and profit while interest is included in profit.

Capital Accumulation – According to Ricardo capital accumulation is the outcome of profit

because profit leads to saving of wealth which is used for capital formations. Capital formation
depends upon will to save and capacity to save which is more important. The larger the surplus
i.e. profit, the larger will be capacity to save.

i) The Profit Rate - The rate of profit is equal to the ratio of profit to capital employed. But
since capital consists of only working capital, it is equal to the wage bill. So long as the rate
of profit is positive, capital accumulation will take place. In reality, profits depend upon
wages, wages on price of corn and the price of corn depends upon the fertility of the marginal
land. So there is an inverse relation between wages and profits. When due to improvement in
agriculture, production increases, the price of corn falls and subsistence wages also fall and
profits will increase leading to capital accumulation. This will raise demand for labourers
raising wage rate and reducing profits.

ii) Increase in Wages – The wage rate increases when the prices of commodities forming the
subsistence of the workers increase. As the demand for food increases, less fertile land is
brought under control and more labourers are needed raising wage rate. Thus wages would
rise with the increase in the price of corn. In a situation rent also increases, with the decline
of capitalists‘ profit capital accumulation also declines.

iii) Declining profits in other industries – The profits of the farmer regulate the profits of all
other trades. Therefore the money rate of profit earned on capital must be equal both in
agriculture and industry. If profit rate declines in the agricultural sector it will also decline is
the manufacturing industry.

25
Other Sources of Capital Accumulation: According to Ricardo economic development
depends upon difference between production and consumption. Capital may be increased by an
increased production or by a diminished unproductive consumption. However, the productivity
of labor may be increased through technological changes and better organization. It is in this way
that capital accumulation can be increased. But the use of more machines employs less workers
leading to unemployment. So Ricardo regards technological conditions as given and constant.

a) Taxes:- Taxes are a source of capital accumulation in the hands of government. According to
Ricardo, taxes are to be levied to reduce clear consumption. Otherwise the imposition of
taxes on capitalists land lords and laborers will transfer resources from these groups to the
government, adversely effecting investment. So he does not favor the imposition of taxes.

b) Free Trade:- Ricardo is in favor of free trade. The profit rate can be saved from declining by
importing corn. The capital accumulation therefore continues to be high. In this way the
resources of the world can be used more efficiently through trade.

Stationary State: According to Ricardo there is natural tendency for the rate of profit to fall in
the economy so that the country ultimately reaches the stationary state. When capital
accumulation rises, with increase in profits, production increases which raises the wage fund,
population increases, which raise the demand for corn and its price. Inferior grades of land are
cultivated. Rents on superior land increase and reduce the share of the capitalists and laborers.
Profits decline and wages fall to subsistence. The process of rising rents and falling profits
continues till the output from the marginal land just covers the wages of labor employed and
profits are zero. There is no accumulation of capital, no increase in population and wage rate but
rent is extremely high and there is economic stagnation.

A Critical Appraisal

Though weak in some situations, Ricardo‘s theory is of great importance. He emphasized the
importance of agricultural development in economic growth because industrial development
depends upon it. He emphasizes the importance of high rate ―of profit for economic
development because capital accumulation depends upon it. Modern economists also recognise
this fact.

Saving must be there for higher capital accumulation. He has also given importance to foreign
trade. He was against colonial trade because it depresses the industry of all other countries.
26
He has given us a dynamic theory which analyses the effects of change in different variables on
economic development such as population, wage, rent, profit etc.

Ricardo's portrait however, is somewhat more pessimistic than Smith's. The ultimately dismal
portrait, however, was painted by T.R. Malthus (1796) with his famous claim that population
growth was not so easily checked and would quickly outstrip growth and cause increasing misery
all around. John Stuart Mill improved little upon Ricardo, perhaps only to emphasize the need
for control of population growth to put a brake on declining growth and his view of stationary
states as wonderful things to achieve.

Despite this the theory has certain weaknesses also.

1) Neglects the impact of technology: Ricardo pointed out that improved technology in
industrial field leads to the displacement of labour and other adverse consequences. But
Ricardo failed to visualize the impact that science and technology had on the rapid economic
development of the new developed nations.

2) Wrong Notion of Stationary State: The Ricardian view that the system reaches the
stationary state automatically is baseless because no economy attains the stationary state is
which profits are increasing, production is rising and capital accumulation is taking place.

3) Baseless Notion of Population: The Ricardian view that wage rate can (does) not rise above.
The subsistence level is wrong. In western countries there has been rise in wage rate but
population has decreased.

4) Unnecessary Importance to the law of Diminishing Returns: Ricardian theory is primarily

based on the law of diminishing returns but the rapid increase of farm produce in advanced
nations has proved that Ricardo under-estimated the potentialities of technological progress
is counteracting diminishing returns to land.

5) Impracticable laissez-faire Policy: According to this theory there should be no government

interference and the economy will operate automatically through perfect competition. I
reality no economy is free from government interference and in which perfect competition
prevails.

6) Neglects Institutional factors and Interest-rate: Institutional factors have been assumed as
given but they are crucial in Economic Development and cannot be overlooked. It neglects

27
 rate of interest also the does not regard the interest rate as an independent reward of capital
but includes it in profits. He does not distinguish between capitalist and entrepreneur.

7) Distribution rather than growth theory: The Ricardian model is not a growth theory but a
theory of distribution which determines the share of workers, landlords and capitalists. Even
is this he regards the share of land as primary and the residual as the share of labour and
profit. He did not determine the share of each factor separately.

8) Land also produces goods other that corn: Ricardo believes that one product corn is
produced on land. But this is an old notion because land produces a variety of products other
than corn.

9) Capital and labor not fixed co-efficient: The Ricardian assumption that capital and labour
are fixed co-efficient of production is not correct. This assumption is invalid.

4.2 The Marxian Theory

Marxian theory can also be helpful in properly viewing the problem of rapid population growth
of the less developed countries. Four major points can be made in this regard; (i) the population
growth is taken as a factor influencing the size of the labor force at the removal of capitalist
industry. The unemployed, drawn from this natural growth as also from the non-capitalist
spheres of production like the peasants handicrafts etc., are termed as relative surplus population.

Two, the rapid growth of population is taken as conducive to the expansion of variable capital,
which in turn is meant for increase in employment. (iii) The growth of population is taken not
only as attitude on labor supply and employment but also as related to consumption. In other
words, population is like two sides of a coin, as producers and as consumers. As mentioned
above the growth of population is associated with the growth of variable capital. It follows from
this that ―the growth of variable capital constitutes an outlet for accumulation and at the
same time signifies a growth in consumption. ― (iv)The problem in its present state of large
unemployed population / surplus population is a response of the socio-economic factors inherited
from the past, and that which operates even today in these capitalist / semi-capitalist societies. Its
solution therefore, lies in following a non-capitalist path of development that is one which is not
dependent upon the rate of profit.

28
Thus viewed from the Marxian frame, one can explain the causes of underdevelopment in terms
of the class – relations within these countries and their colonial exploitation. One can also get at
the substance of underdevelopment as also of population problem in terms of this thinking. For
development, it is obviously necessary to break the inhibiting class relations as also to shed off
the colonial past. This will pave the way for an independent non-capitalist development.

There are a number of new classical economists who have written much on economic
development and have devised a variety of growth models. They, however, differ among
themselves, but their general approach is basically the same. We put together what is common
among them as a format for a theory of development. We also take up their relevance to today‘s‘
developing countries.

The essential ingredient of growth is taken as capital accumulation, and savings are regarded as
of great importance for capital formation. The rate of interest is described as the key to savings
as also to investment. Other factors promoting output expansion mentioned are population,
technology and international trade. Development is conceived as being continuous, gradual,
harmonious and cumulative. In the neo-classical frame, increase in capital stock takes place with
increase in savings, which in turn are dependent upon the rate of interest and the level of incomes.

4.3 The Keynesian Theory

The Keynesian theory is not applicable or its applicability is limited to underdeveloped countries.
It only applies to advanced democratic capitalist economies. It is based on the following
assumptions3

1. Cyclical unemployment: The Keynesian theory is based on the existence of cyclical

unemployment, which occurs during a depression. It is caused by deficiency in effective demand.
Unemployment can be removed by an increase in the level of effective demand. But the nature of
unemployment in an undeveloped country is quite different from that in a developed economy.
In such economies unemployment is chronic rather than cyclical. It is not due to lack of effective
demand but is the result of deficiency in capital resources. In such economies unemployment is
chronic rather than cyclical. It is not due to lack of effective demand but is the result of
deficiency in capital resources. Keynes was not concerned with the removal of involuntary
unemployment and the problem of economic instability. So he did not refer to disguised

29
unemployment and its solution. The remedy to the chronic and disguised unemployment is
economic development to which Keynes paid no attention at all. The Keynesian economics is a
short period analysis in which Keynes takes ― as given the existing skill and quantity of
available equipment, the existing technique, the degree of competition the tastes and habits of the
consumer, the activities of supervision and organization as well as social structure. Development
economics, however, is a long period analysis in which the basic factors assumed by Keynes as
given, change over time.

The Keynesian theory is based on the assumption of a closed economy. But underdeveloped
countries are not closed economies. They are open economies in which foreign trade plays a
dominant role in developing them. Such economies primarily depend on the exports of
agricultural and industrial raw materials and the imports of capital goods.

The Keynesian theory assumes an excess supply of labor and other complementary resources in
the economy. The analysis refers to a depression economy where ―the industries,
machines, managers and workers as well as consumption habits, are all there, only wanting to
resume their temporarily suspended functions and role. But in underdeveloped economies there
is no temporary suspension of economic activity. Economic activity is static. Capital, skills,
factor supplies and economic infrastructure are highly lacking. Thus, the assumption on which
the Keynesian theory is based are not applicable to the conditions prevailing in underdeveloped
countries.

4.4 Lewis Theory of Unlimited Supplies of Labor

According to Arthur Lewis, a country with surplus population (labor), and disguised
unemployment, can have the process of capital formation inherent in it. Thus, the surplus
population can be directed from the over populated agricultural sector to that of capital formation.
The unlimited supply of labor thus forms a king of investment from the traditional sector, when
labor – intensive techniques are used, in the modern sector, where its services can be used for
capital formation. Since there is such a large-scale unemployment the wage rate can be kept
constant at a low level. Hence, the surplus (difference between output and labor cost), can be
maximized and invested for further production.

4.5 Balanced Vs Unbalanced Growth Theory

30
Balanced Growth

Nurkse explains that the low level of capital formation is due to deficiency of demand and supply
of capital. This deficiency is caused in turn by lack of capital. Lack of demand results in a small
market for any goods produced on a large scale.

For example, in some backward areas, if a modern shoe factory is established, once the demand
for shoes is met it will reach its saturation point. Also the workers in the shoe factory will not
spend all their money to buy only shoes. They would wish to buy clothes, furniture, etc. But if
there are no factories producing these goods, then the shoe factory cannot expand further. It may
soon have to close down due to lack of demand. Thus, setting up a single industry, according to
Nurkse, is useless, because of the inter-linked nature of demand for various goods by workers in
various industries.

Obviously, the best way to tackle this problem is not by applying capital to one industry, but of a
whole range of industries in a balanced manner. Thus, the various industries in a balanced
manner. Thus, the various industries will complement each other and support each other‘s
growth. Thus balanced growth of investment in goods of mass consumption would break the
vicious circle of poverty. Nukse also supports Lewis‘s model of unlimited supply of labor as a
source of capital formation. Since most underdeveloped countries have large population with
disguised unemployment, this it self could initiate capital formation. The unproductive surplus
workers are being sustained by the productive workers. This shows that there is a surplus over
and above what the productive workers are consuming, which goes to feed the unproductive
workers. If these are removed and employed at the same wage rate in the capital sector then there
can be a more productive use of this surplus labor. Thus, disguised unemployment can be used
for the accumulation of capital by reallocating the surplus labor to the capital sector. Since
industries are complementary to each other, and supplement each other‘s needs, it is necessary to
have investment in all these interconnected industries to ensure a proper growth in the economy.
This theory is criticized on the grounds that since underdeveloped countries suffer from lack of
capital, it is impossible for them invest in one industry much less in a number of industries at the
same time.

31
Nurkse also takes only limited demand conditions as the obstacle to development and has
neglected the supply aspects. He does not show how supply of skills, infrastructure and other
related capital sectors can be developed

Unbalanced growth

Hurschman, a known economist and an advocate of unbalanced growth, argues that a large-scale
application of capital to all industries is impossible because the underdeveloped countries are
themselves deficient in capital. Therefore a better method is to have what is called ―Unbalanced
growth.‖ Two types of investment here are the following:

The infrastructural investments called social overhead capital, (SOC), that is usually provided by
the public sector and (ii) the private sector investment in final goods, which he calls the Directly
Productive Activities, (DPA). Development consists of expanding either of these two activities,
which creates an imbalance, which the other tries to correct. For example, if social overhead
capital expands, the Government will provide the infrastructure and this will encourage the
growth of Directly Productive Activities. The net result will be an increase in Gross National
Product. Another way would be to encourage the growth of the private sectors so that as Directly
Productive Activities expand the need for infrastructure, (such as roads, transport) would create a
demand for social overhead capital. Thus, development is thought of as a series of imbalances
between SOC and DPA; and deliberate unbalancing of the economy would give the necessary
impetus to capital formation.

Limitations of Unbalanced Growth

The doctrine of unbalanced growth is also not free from limitations. Hirschman assumes that
proper investments will be taken up when and where they are required. If the required DPA or
SOC investments are not undertaken, then the imbalance may never be corrected. Also, how
much imbalance is to be created is not specified. The direction, composition and timing of
unbalanced growth is a`lso not given. The problems of lack of technical personnel, raw materials
and basic facilities have been ignored, and may be inadequate to support the unbalanced
growth‘s investment decisions.

32
In a private enterprise or a capitalist economy, investment in capital depends on the profits
expected by the sale of the output. Thus, a private entrepreneur would prefer to invest in that
sector which produces consumer goods, which make for high profits. Left to the market forces,
the economy would therefore, tend to move in favor of the consumer good‘s sector.

Thus, most underdeveloped countries have undertaken planning their development programmes
with the public sector taking the lead in capital formation. A balanced growth of all industries
can be undertaken through plans, and a systematic investment can initiate the process of
economic development.

Since profitability is not the main consideration, the public sector can invest in those
areas/sectors in which private entrepreneurs do not come forward to invest. It can also mobilize
enough public funds, get foreign know-how and collaboration, and thus start the process of
capital formation.

4.6. Dualistic Theories

Dualism is the coexistence of two situations or phenomena (one desirable and the other not) that
are mutually exclusive to different groups of society—for example, extreme poverty and
affluence, modern and traditional economic sectors, growth and stagnation, and higher education
among a few amid large-scale illiteracy

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 peoples 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.

33
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
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.

A dual economy

 Although in the aggregate low income countries have inadequate technology and capital, this is
not true in all sectors. Virtually all low income countries and many middle income countries
are dual economies.
 These economies have a traditional, peasant, agricultural sector, producing primarily for family
or village subsistence. This sector has little or no reproducible capital, uses technologies
handed down for generations, and has low marginal productivity of labor

Topic Five: Economic Growth Models

5.1 Rostow‟s Stages of Economic Growth

34
Based on the experiences of the rich industrialised nations.Concerned with the stages countries
go through to achieved economic growth.

Investment = key to economic growth.With increasing investment, a country will move from a
subsistence-based economy (stage 1) to an economy dominated by the production of consumer
goods and tertiary and quaternary industries (stage 4-5).Rostow‘s model implies that developing
countries need to follow the stages of development experienced by the western industrialised
nations.

1. Traditional Society

• Characterised by

– subsistence economy – output not traded or recorded

– existence of barter

– high levels of agriculture and labour intensive agriculture

.2. Pre-conditions:

– Development of mining industries

– Increase in capital use in agriculture

– Necessity of external funding

– Some growth in savings and investment

3. Take off:

– Increasing industrialisation

– Further growth in savings and investment

– Some regional growth

– Number employed in agriculture declines

4, Drive to Maturity:

35
 – Growth becomes self-sustaining – wealth generation enables further investment in
value adding industry and development

– Industry more diversified

– Increase in levels of technology utilised

5, High Mass Consumption

• Domestic Aggregate Demand is the major determinant of Business (Cycles)

• Consumer durable industries

• Service sector

• new types of durable consumer goods industries become the leading sectors, very high
levels of consumption and physical quality of life are achieved.

5.2 Harrod- Domar Model

The Harrod Domar Growth model is a growth model and not a growth strategy! A model helps
to explain how growth has occurred and how it may occur again in the future. Growth strategies
are the things a government might introduce to replicate the outcome suggested by the model..
Basically, the model suggests that the economy's rate of growth depends on:The level of national
saving (S). The productivity of capital investment (this is known as the capital-output ratio).

Basic Harrod-Domar model says:

• Rate of growth of GDP = Savings ratio / capital output ratio

• Numerical examples: If the savings rate is 10% and the capital output ratio is 2, then a
country would grow at 5% per year.

• Based on the model therefore the rate of growth in an economy can be increased in one of
two ways:

• Increased level of savings in the economy (i.e. gross national savings as a % of GDP)

• Reducing the capital output ratio (i.e. increasing the quality / productivity of capital inputs)

36
• the key limitations / problems of the Harrod-Domar Growth Model?

• Increasing the savings ratio in lower-income countries is not easy. Many developing
countries have low marginal propensities to save. Extra income gained is often spent on
increased consumption rather than saved. Many countries suffer from a persistent domestic
savings gap.

• Many developing countries lack a sound financial system. Increased saving by households
does not necessarily mean there will be greater funds available for firms to borrow to invest.

• Efficiency gains that reduce the capital/output ratio are difficult to achieve in developing
countries due to weaknesses in human capital, causing capital to be used inefficiently

• Research and development (R&D) needed to improve the capital/output ratio is often under-
funded - this is a cause of market failure

• Borrowing from overseas to fill the savings gap causes external debt repayment problems
later.

• The accumulation of capital will increase if the economy starts growing dynamically – a rise
in capital spending is not necessarily

The main assumptions of the Harrod-Domar models are as follows:

• (i) A full-employment level of income already exists.

• (ii) There is no government interference in the functioning of the economy.

• (iii) The model is based on the assumption of ―closed economy.‖ In other words,
government restrictions on trade and the complications caused by international trade are
ruled out.

• (iv) There are no lags in adjustment of variables i.e., the economic variables such as
savings, investment, income, expenditure adjust themselves completely within the same
period of time.

37
 • (v) The average propensity to save (APS) and marginal propensity to save (MPS) are
equal to each other. APS = MPS or written in symbols,

• S/Y= ∆S/∆Y

5.3 The Solow Model

• is ‗the‘ representative Neo-Classical Growth Model: focusing on savings and investment.

• It explains the long-run evolution of economy quite well with all being held Constant –
Dynamic Model

• Focusing on capacity of Savings to meet the demand for Investment as Capital

Requirements and, beyond, as Capital Accumulation for expansion of Production
capacity

• there is no long-run economic growth in the Solow model

• in the steady state: output, capital, output per person, and consumption per person are all
constant and growth stops

Basic assumption of solow model

• Labor and capital are substitutable

• One composite commodity is produced

• Output is net output after depreciation of capital

• Price and wages are flexible

• There is full employment of labor

• There is constant return to scale

• There is neutral technical progress

• Saving ratio is constant

• Land and capital are two factors of production

38
 • The strengths of the Solow model are:

• It provides a theory that determines how rich a country is in the long run.

• The principle of transition dynamics allows for an understanding of differences in

growth rates across countries.

• The weaknesses of the Solow model are:

• It focuses on investment and capital, while the much more important factor of
TFP is still unexplained.

• It does not explain why different countries have different investment and
productivity rates.

• The model does not provide a theory of sustained long-run economic growth.

5.4. Stylized Facts and Steady State Growth

Stylized model meaning: the opposite of general, a highly stylized model is one which only
tries to reproduce a very specialized time series or economic phenomena

The central problem in understanding economic development and growth is not understanding
the process by which an economy raises its savings rate and increases the rate of physical capital
accumulation. capital accumulation is critical for understanding differences in economic growth
and income across countries.

Five stylized facts of economic growth.

(1) The "residual"( total factor productivity, TFP) rather than factor accumulation accounts for
most of the in-come and growth differences across countries.

(2) Income diverges over the long run.

(3) Factor accumulation is persistent while growth is not, and the growth path of countries
exhibits remarkable variation.

39
( 4) Economic activity is highly concentrated, with all factors of production flowing to the
richest areas.

(5) National policies are closely associated with long-run economic growth rates.

These facts do not support models with diminishing returns, constant returns to scale, some fixed
factor of production, or an emphasis on factor accumulation

Topic Six: History, Expectations and Development

40
Here we want to see how historical forces & expectations shape the overall economic pattern
shown by a country or a region

The two factors that matter growth &development of an economy:

 History
 Expectations

These factors interact & work through two main channels:

Complementarities
Increasing returns

Issues important to understand roles of history & expectations in economic dev‘t

 Complementarities coordination failuresLinkages

 Increasing returns and development
 The role of social norms and status quo

6.1 Complementarities

Complementarity-an action taken by one agent (firm, worker or organization) that increases the
incentives for other agents to take similar actions

► Complementarities often involve investments whose return depends on other investments

being made by other agents

► Congestion-an action taken by one agent that decreases the incentives for other agents to take
similar actions, It is opposite of complementarily.

6.2 Coordination failure, Linkages and policy

Coordination failure A state of affairs in which the inability of agents to coordinate their
behavior (choices) leads to an outcome (equilibrium) that leaves all agents worse off than in an
alternative situation that is also an equilibrium.
Technological Linkage

41
Figure 6.1: linkages and coordinations

Backward and forward linkages: The arrows in the above diagram suggest that one industry
might facilitate the development of another by easing the conditions of production. For example
the steel industry facilitates the development of other industries such as machinery and railways
by increasing the availability of steel and/or by lowering its price. This is an example of a
forward linkage. It works by easing the supply of another product. The steel industry has a
backward linkage to the coal industry, because the expansion of steel industry raises the demand
for coal. Backward linkages are like "pulls" and forward linkages like "pushes".
. Suppose the economy is in a depressed equilibrium, and many of the sectors either do not exist
or are at a very primitive stage. What kind of a policy can bring the economy to a better
equilibrium? The idea of big push, by Rosenstein-Rodan, proposes that we invest simultaneously
in a number of different sectors of the economy. Such a policy requires huge sums of money
(which probably necessitates foreign aid) and the knowledge on the quantitative allocation of
investments across different sectors. In other words, the government must not only have access
to funds to make these investments but also know exactly how much to invest in each sector. Is
this too much to ask?? Yes, most probably. This is one criticism to the big-push idea.
Another criticism to the big-push, by Hirschman, is that this theory does not make use of the fact
that the desired outcome is also an equilibrium. This means that, if incentives are provided
carefully, the market itself will correct the coordination failure. Hirschman suggested that a
country deliberately follow an unbalanced growth policy and promote development of certain

42
key sectors, instead of investing in all of them simultaneously, and let the market respond and
make the other investments.
How should we choose these key (or leading) sectors, if resources are scarce and simultaneous
investment in all sectors is not a feasible option?
1. The number of linkages that a given sector possesses: Look for the largest number of sectors
that will be affected as a result of the development of the chosen sector (nontrivial)
2. The strength and the character of each linkage matter as well. From the point of view of the
sector that benefits from a backward linkage, the linkage raises the price of its output and
stimulates higher production. However, a forward linkage reduces the price of one input among
many. The falling input price may affect more than one sector, therefore the effect may be small
for each sector and may not lead to higher investment in the sector.
For example, an expansion of the shoe industry may turn leather into a profitable business, by
increasing demand. However, it is not clear what the expansion of coal industry might lead to;
there are many possibilities. In a nutshell, backward linkages have more direct and sizable effects.
3. ―Intrinsic profitability‖: Suppose we have two alternatives for a leading sector; highways
and the export sector. Suppose we find that highways mostly have forward linkages whereas the
export sector is richer in backward linkages. Should government pick exports as the leading
sector and invest in its development at the expense of highways? Not necessarily. The
government should invest in highways, because the private sector is more likely to find exporting
profitable compared to operating highways (due to political or economical infeasibility of
charging highway tolls in developing countries). Here, the government maximizes the chances of
overcoming coordination failure by investing in the least profitable activity. Therefore, a leading
sector does not have to be intrinsically profitable (heavy industry, transportation and agriculture
are examples), but it must stimulate other sectors that are profitable
6.3 History versus Expectations

A repeat: history fasten down the equilibrium, while expectation may change it for better or
worse.
• Why we observe that some low equilibrium trap?
• An example of export sector electronic components-human capital investment.
• Externalities and History (figure below)
• The figure can be taken as of two sectors, regions, or countries.

43
Moral from the figure:
–Some time history dominate, some time expectation dominate, depending on how people
coordinate.
–Various coordination mechanisms; whether people want to go first (fashion).
–The importance of entrepreneur and information.

6.4 Increasing returns

• IR: an activity displays increasing return to scale if increasing the scale lowers average cost
• Examples abound. •Increasing return and development (Young, 1928):
–Ability to realize the gains from increasing return depends on the size of the market for the
product;
–the size of market may itself depends on the ability to exploit increasing returns, expand
production and pay out income to employees.

44
6.5 Competition, Multiplicity and International Trade

Economic competition takes place in markets—meeting grounds of intending suppliers and

buyers. Typically, a few sellers compete to attract favorable offers from prospective buyers.
Similarly, intending buyers compete to obtain good offers from suppliers. When a contract is
concluded, the buyer and seller exchange property right in a good, service, or asset. Everyone
interacts voluntarily, motivated by self-interest.

International trade is the purchase and sale of goods and services by companies in different
countries. Consumer goods, raw materials, food, and machinery all are bought and sold in the
international marketplace.

International trade allows countries to expand their markets and access goods and services that
otherwise may not have been available domestically. As a result of international trade, the
market is more competitive. This ultimately results in more competitive pricing and brings a
cheaper product home to the consumer.

45
Topic Seven: Growth, Poverty and Income Distribution

7.1 Inequality and World poverty

• Inequality is a state of being unequal. It considers rich and poor or it wealthiest and poorest
in terms of income. Inequality is one of the most debatable issues in the world of economics
and politics.

• Income distribution is a planned to inform us about the rich and poor or is inform about how
much discrimination exists in a system of price rationing

• Income inequality is the disproportionate distribution of total national income among

households.

• Extreme income inequality leads to economic inefficiency. This is partly because at any
given average income, the higher the inequality, the smaller the fraction of the population
that qualifies for a loan or other credit. Indeed, one definition of relative poverty is the lack
of collateral. When low-income individuals (whether they are absolutely poor or not) cannot
borrow money, they generally cannot adequately educate their children or start and expand a
business

• It is difficult to provide precise definition of what poverty is. Schubert (1992) provides a
universally quoted definition of poverty - the inability to lead a well-mannered life. Some
other authors understand poverty as a state of individual or household having an income or
consumption below a certain standard, usually known as poverty line.

7.2 Size and functional distribution of income

Income inequality is the disproportionate distribution of total national income among
households.

• two principal measures of income distribution for both analytical and quantitative purposes
are

 The personal or size distribution of income and the functional or distributive factor share
distribution of income.

46
 1. Personal orsize distribution of income is the measure most commonly used by
economists.

 It simply deals with individual persons or households and the total incomes they receive.

 The distribution ofincome is according to size classof persons—for example, theshare of

total income accruingto the poorest specific percentageor the richest specificpercentage of a
population—without regard to the sourcesof that income.

 Economists and statisticians therefore like to arrange all individuals by ascending personal
incomes and then divide the total population into distinct groups, or sizes.

 A common method is to divide the population into successive quintiles (fifths) or deciles
(tenths) according to ascending income levels and then determine what proportion of the
total national income is received by each income group

2. The functional distribution of income: measures the return to different factors of production
such as labour ( for which wage is paid), capital(for which interest is paid), land(for which
rent is paid). It also involves profit which is distributed to share holders.

7.3 Measuring of inequality and absolute poverty in the Third world

 The kuznet's Hypothesis

Kuznets curve is a graph reflecting the relationship between a country‘s income per capita and
its equality of income distribution

• He observes that in the early stages of economic growth relative income inequality increases,
stabilizes for a time and then decline in the later stages.

• This is known as the inverted U- shaped hypothesis of income distribution

• Lorenz curve is a common way of analyzing personal income statistics. The more the Lorenz
curve is away from the diagonal,

• Lorenz curve is a graph depicting the variance of the size distribution of income from perfect
equality.

47
• The extreme case of perfect inequality is a situation in which one person receives all of the
national income while everybody else receives nothing. Income inequality can also be
expressed in terms of Gini coefficient.

 Gini coefficient: The Gini Coefficient, which is derived from the Lorenz Curve, can be used
as an indicator of economic development in a country.

• Gini coefficients are aggregate inequality measures and it vary from o (perfect equality) to 1
(perfect inequality).

• Gini coefficients for countries with highly unequal income distribution typically lie between
0.5 and 0.7.

• While Gini coefficients for countries with relatively equal income distribution is lies between
0.2 to 0.5.

• The Gini coefficient of distribution is a better measure of the degree of income inequality. It
varies from 0 to 1.

• A Gini Coefficient of zero means that everyone has the same income, while a Coefficient
of 1 represents a single individual receiving all the income.

The graph given below show the income distribution

48
 Mea
suring Absolute Poverty

Absolute poverty is the situation of being unable or only barely able to meet the subsistence
essentials of food, clothing, and shelter.

The extent of absolute poverty is the number of people who are unable to command sufficient
resources to satisfy basic needs. They are counted as the total number living below a specified
minimum level of real income an international poverty line. That line knows no national
boundaries, is independent of the level of national per capita income, and takes into account
differing price levels by measuring poverty as anyone living on less than $1.25 a day or $2 per
day in PPPdollars.

Absolute poverty is sometimes measured by the number, or ―headcount,‖ H, of those

whose incomes fall below the absolute poverty line, Yp. When the headcount is taken as a
fraction of the total population, N, we define the headcount index is equal to H/N.

Headcount index is the proportion of a country‘s population living below the poverty line.

Total poverty gap (TPG) is the sum of the difference between the poverty line and actual income
levels of all people living below that line.

The TPG—the extent to which the incomes of the poor lie below the poverty line—is found by
adding up the amounts by which each poor person‘s income, Yi, falls below the absolute poverty
line, , as follows:

49
The average poverty gap (APG) is found by dividing the TPG by the total population:

Often we are interested in the size of the poverty gap in relation to the poverty line, so we would
use as our income shortfall measure the normalized poverty gap (NPG): NPG = APG/Yp ; this
measure lies between 0 and 1 and so can be useful when we want a unitless measure of the gap
for easier comparisons

Another important poverty gap measure is the average income shortfall (AIS), which is the total
poverty gap divided by the headcount of the poor: AIS = TPG/H. The AIS tells us the average
amount by which the income of a poor person falls below the poverty line. This measure can also
be divided by the poverty line to yield a fractional measure, the normalized income shortfall
(NIS):

NIS=AIS/Yp

50
7.4 Economic Characteristics of Poverty Groups

So far we have painted a broad picture of the income distribution and poverty problem in
developing countries. We argued that the magnitude of absolute poverty results from a
combination of low per capita incomes and highly unequal distributions of that income. Clearly,
for any given distribution of income, the higher the level of per capita income, the lower the
numbers of the absolutely poor. But higher levels of per capita income are no guarantee of lower
levels of poverty. An understanding of the nature of the size distribution of income is therefore
central to any analysis of the poverty problem in low-income countries. But painting a broad
picture of absolute poverty is not enough. Before we can formulate effective policies and
programs to attack poverty at its source, we need some specific knowledge of these high poverty
groups and their economic characteristics

Rural Poverty

Perhaps the most valid generalizations about the poor are that they are disproportionately
located in rural areas, that they are primarily engaged in agricultural and associated activities,
that they are more likely to be women and children than adult males, and that they are often
concentrated among minority ethnic groups and indigenous peoples. Data from a broad cross
section of developing nations support these generalizations. We find, for example, that about
two-thirds of the very poor scratch out their livelihood from subsistence agriculture either as
small farmers or as low-paid farmworkers. Some of the remaining one-third are also located in
rural areas but engaged in petty services, and others are located on the fringes and in marginal
areas of urban centers, where they engage in various forms of self-employment such as street
hawking, trading, petty services, and small-scale commerce. On the average, we may conclude
that in Africa and Asia, about 80% of all target poverty groups are located in the rural areas

7.5 Women and Poverty

Women make up a substantial majority of the world‘s poor. If we compared the lives of the
inhabitants of the poorest communities throughout the developing world, we would discover that
virtually everywhere, women and children experience the harshest deprivation. They are more
likely to be poor and malnourished and less likely to receive medical services, clean water,
sanitation, and other benefits

51
Women make up a substantial majority of the world‘s poor. If we compared the lives of the
inhabitants of the poorest communities throughout the developing world, we would discover that
virtually everywhere, women and children experience the harshest deprivation. They are more
likely to be poor and malnourished and less likely to receive medical services, clean water,
sanitation, and other benefits. The prevalence of female-headed households, the lower earning
capacity of women, and their limited control over their spouses‘ income all contribute to this
disturbing phenomenon. In addition, women have less access to education, formal-sector
employment, social security, and government employment programs. These facts combine to
ensure that poor women‘s financial resources are meager and unstable relative to men‘s. A
disproportionate number of the ultra-poor live in households headed by women, in which there
are generally no male wage earners. Because the earning potential of women is considerably
below that of their male counterparts, women are more likely to be among the very poor. In
general, women in female-headed households have less education and lower incomes.
Furthermore, the larger the household, the greater the strain on the single parent and the lower
the per capita food expenditure. A portion of the income disparity between male- and female-
headed households can be explained by the large earnings differentials between men and women.
In addition to the fact that women are often paid less for performing similar tasks, in many cases
they are essentially barred from higher-paying occupations. In urban areas, women are much less
likely to obtain formal employment in private companies or public agencies and are frequently
restricted to illegal, low-productivity jobs.

52