Download Problems with Neoclassical Growth Model:

Problems with Neoclassical Growth Model:
1) Assumes Market Clearing
-Equilibrium in all markets
-full employment
-no government intervention
-no control over capital flows
-no control over interest rates
2)
-adjustment is smooth and rapid
3)
-capital accumulation is chief source of growth
-ignores gains from improved resource allocation
-ignores economies of scale gains
4) Result of convergence not apparent for LDC’s
5) Result of stationary distributive shares not true for LDC’s
What do we see in LDC’s?
1) Markets don’t clear
-markets are segmented
-poor information
-transportation costs (poor infrastructure)
-government heavily involved
-tries to control interest rates/capital flows
2) Adjustment is slow, difficult
-internal and external bottlenecks
-government policy impedes economic adjustment
-technology is difficult to get and implement
3) Capital accumulation is only one source of growth in LDC’s
-reallocation of resources improves growth
-opening bottlenecks improves growth
-economies of scale occurs as economy grows
4) Rate of growth is volatile- though high for some countries- the variation is often the result of
external pressure or wide variation in government policy
5) Distribution of income often worsens
Stage of growth: W.W. Rostow
5 broad stages:
1. The traditional society
2. Preconditions for takeoff
3. the take-off
4. drive to maturity
5. age of high mass consumption
The critical preconditions and takeoff were based on “leading sectors”- so that optimal paths
could be determined for the economy-sector by sector.
For developing countries, the first 3 stages are most important-the takeoff is defined as follows:
1) A rise in the rate of investment to GDP form 5% to over 10%
2) the development of one or more manufacturing sectors with a high rate of growth
3) a rapid shift in socio-political structure that encourages the economic change
Chenery/Kusnets: Structural analysis-as economies develop they undergo a structural
transformation. If we know the optimal transformation path, we can set and adjust policy to
achieve sustained growth.
Consider the cross-country regression on pg. 292. There are 3 country types (large, small
manufacturing, and small primary), and 4 categories of income per capita (140-280, 280-560,
560-1120, and 1200-2100). (1970 prices)
There are 4 sources for growth expansion of domestic demand (DD)-export expansion (EE)import substitution (IS) and-technological change (IO)
Notice: 1) Primary goods DD falls as income per capita rises
2) Industrial output rises as income per capita rises
3) Services remain constant as income per capita rises except for small
Manufacturing countries whose industrial sector rises rapidly
Table 3 compares output shares ( ) and sectoral sources of growth (
/ ) for each pattern
against the standard pattern. We see primary exporters with higher shares coming from primary
goods while large countries grow from heavy manufacturers and small manufacturers from light
manufacturers. and non-traded goods.
Structural Transformation: Chenery/Kuenets
Economic analysis of development, chiefly through cross-sectional analysis
I. Transformation of Production:
As economy develops:
1. Industrial sector becomes more important, monotonically
2. Agricultural/primary sector becomes less important, monotonically
3. Service sector becomes more important, but after approximately $1200 per capita
GOP,
it becomes less important. (Indications are that services become more important at
full development stages.
4. Utilities grow very slowly, though monotonically
Sectoral Productivity (relative to national average)
1. Sectoral productivity tends to converge at per capital income above $2000. These
productivities do not converge quickly or monotonically to the national average.
2. Neoclassical growth indicates sectoral productivity should be equal: this seems to happen,
Eventually.
3. W.S. Lewis suggests low agricultural productivity converges to high industrial productivity.
This appears to happen, but not smoothly. Agricultural productivity initially declines, then
turns up at about $2000 per capital GDP.
Composition of Domestic Demand
As a country develops, it demand profile changes.
1. Engles Law is strongly confirmed (
)
2. Government Consumption remains flat (indicating a government cannot pull a country
out of underdevelopment by expenditure- no keynesian demand management here).
3. As consumption falls, gross domestic investment rises-implies an economy wide
willingness to forgo current consumption for future consumption.
Lewis, W.A. “Labor Surplus Model”
Lewis formulation is based on following:
1) A large agricultural sector
2) Large “disguised” unemployment in labor
The “disguised” unemployment suggests
alternatively, labor can be removed from
the agricultural sector without a loss in total output.
This means that labor can be placed in the industrial sector without any opportunity cost-and total
labor productivity with increase since
This is not expected to continue forever, since it is likely that a point will come in which labor
withdrawn from the agricultural sector will have some positive productivity.
How growth occurs: An industrial sector is formed in the economy. It begins to draw labor out
of agricultural at very low cost. As the industrial sector makes profits, it reinvests and grows,
drawing even more labor out of agriculture (at constant cost). Growth during this period is
clearly unbalanced: Industry grows rapidly; agriculture not at all.
At some point, however, enough labor is pulled off the land for total agricultural productivity to
decline- (i.e.
). As this happens, agricultural output falls driving up agricultural prices.
This forces the industrial sector to raise the nominal wage (to maintain the real wage). This
drives profits down; reducing investment and growth.
The solution? Just as the
turns positive, invest in agriculture. This pushes total
agricultural product up, thus agricultural prices fall. This allows the industrial sector to hold the
real wage constant without raising the nominal wage.
The Basic Result: allow growth to be unbalanced initially, but as growth continues it must be
balanced between the industrial and agricultural sectors.
Fei and Ranis (AER, Sept ‘61) formalized the Lewis Model-identified the “shortage point” where
and agricultural prices begin to rise-forcing the industrial sector to increase the
nominal wage. And the “commercialization point” where labor must be paid its MPP .
Myrdal:
Undeveloped countries tend to be specialized in production of primary goods-using largely
unskilled labor. These goods do not have a rapidly rising demand, and have wide fluctuations in
price.
Since population is growing and there is a large surplus labor supply in existence, any
improvement in technology for the primary industries will likely result in lower cost-a benefit to
the primary importing countries.
The advice given is usually to increase the production of primary goods for export-but this is
shortsighted. It is best to increase productivity, thus incomes and living standards. However, the
market production of primary goods-this intervention is needed.
Capital movements have not been helpful either-capital tends to stay in countries with high
ROR’s and low risk. The fact that most 3rd world countries are in need of capital has not been
remedied by the market flow of capital. If anything, they have been hurt as capital flight has
occurred, with 3rd world money flowing to the west.
Labor migration can’t help because the well-developed countries have strict limits on
immigration-thus labor can’t move.
Result: International trade and capital movements are a market transmission mechanism to
reduce the 3rd world’s growth-as the well developed countries grow, the market forces tend to
generate backsetting influences of the underdeveloped world. There are minimal “spread” effects
for the 3rd world.
Thus: intervention is necessary in the international markets to assist underdeveloped countries.
Harris/Todaro Labor Migration Model:
Why does labor migrate from rural to urban sectors, even in the face of high levels of urban
unemployment?
Individuals rationally chose to migrate from the rural sector to the urban sector as a means of
maximizing expected lifetime earnings.
Ex: Urban wage 100 units
Rural wage 50 units
p(finding a job) .20 within 1 yr.
expected urban wage = (urban wage) (P[finding job])
= 100 (.20) = 20 units
= Don’t Migrate
If the government establishes policy to reduce the level of urban unemployment - the problem
may worsen since P(finding a job) rises.
Mathematically:
Laborers chose to migrate based on expected income differential between rural & urban wage:
Where:
V(o) = discounted present value of expected “net” urban-rural income stream over
migrant’s time horizon.
Yu (t) = avg. real income of individual employed in urban sector.
Yr (t) = avg. real income of indiv. empl. in rural sector.
n = number of time periods in migrant’s time horizon.
r = discount rate for migrant’s time preference
p (t) = probability that migrant will secure an urban job at ave. income level in period t.
C (o) = cost of migration
The probability of finding a job p(t) is dependent on finding a job in the previous period:
this implies for given Yu(t) & Yr(t) the longer the migrant is in the city the higher the probability
p of having a job, and this the higher the expected income.
Since _ = p(finding a job in a given time period) it is directly related to the rate of new
employment creation & inversely related to the ration of unemployed job seekers to the number
of existing job opportunities:
_=
gN
S-N
where X is the net rate of urban new job creation, N = level of urban employment
S = total urban labor force.
The expected real income differential “d” is
d=w__-r
Where w = urban wage
r = rural wage
The supply of labor is based on expected real income differential:
S = fs (d)
If we take a government policy that improves the urban wage ( policy is “a”
)
then x = fd (wa)
If urban demand rises as a result of government policy, the increases in urban labor supply is
We know
The absolute number of urban unemployed will increase if the increase in labor supply exceeds
the number of new jobs created if:
Since the elasticity of urban labor supply is typically highly elastic for developing countries, this
situation is likely to occur.
Government policy that is designed to reduce unemployment will result in making it worse.
Paul N Rosenstein - Rodan “The Theory of the Big Push”
1. Complementarity of different industries provides the most important argument
favoring large-scale planned industrialization.
Ex. A hundred workers are put to work in a shoe factory - if they buy only shoes
with their income, the venture will be successful. But, they won’t do this.
So,
alone, the venture will not succeed. However, if a 100,000 workers are put to
work in a variety of wage - good industries, it seems likely they all will
succeed.
This is one aspect of external economics.
- Also since there is complementarily, risk of success is reduced.
- Associated with being in a growing industry.
- Associated with growth in other industries.
Private and social marginal net product tend to diverge. Where individual entrepreneurs perceive
a venture as too risky, it may have social value.
(Ex: worker’s education, public transportation)
On the production side the Big Push is needed:
1) due to “indivisabilities” in the production functions
2) the path toward equilibrium is at least as important as a point of equilibrium
3) the allocation of investment (which requires foresight) is not likely to regularly be in
equilibrium due to imperfect foresight. Government planning can provide additional
signals to the investment market, moving to equilibrium
4) markets in underdeveloped economies are also subject to imperfection, thus prices may
not provide the “right” signals
Social overhead capital is the most important indivisibility in development. SOC is
characterized by services that are indirectly productive and become available after long gestation
periods. Its most important aspect is investment opportunities created in other industries. SOC
includes:
1) Power (i.e. electrical)
2) transportation
3) communications
Installations are characterized by sizable initial lumps and low variable cost. Excess capacity
will exist during the initial period. Planning is thus necessary in SOC; normal market forces
cannot solve the problem.
SOC is characterized by 4 indivisibilities:
1) it is indivisable (irreversible) in time
-it must precede other directly productive investments
2) equipment must have high minimum durability (lesser durability is either technically
impossible or much less efficient) -thus it tend to be lumpy
3) it has long gestation periods
4) an irreducible minimum soc mix a condition for getting out into high growth
Planning is necessary due to a likely nonoptimal allocation in investment: chiefly due to:
1) investors maximize the private, not social net marginal product. External economies
are not sufficiently exploited-simultaneous inducement of investment is needed.
2) The lifetime of equipment is long, so the investor’s foresight is likely to be imperfect.
The individual’s risk is reduced in an overall investment program.
3) Due to indivisability (lumpiness) of capital large rather than small changes are
involved. Price mechanisms work chiefly for small changes only.
4) Institutional aspects generate less than perfect price allocations.
Prebisch/Singer “Center-Periphery” Issues
Center=Industrial center=Developed Countries
Periphery=Primary Producer Producers=LDC’s
“If things stay the same, the center will continue to gain from the periphery.”
The Demand Side:
The center, being relatively rich, will spend proportionally less on primary products:
1. Engles’ Law:
2. Technological advance generates a more efficient use of primary inputs, thus demand
for the primary exporters does not grow as fast as developed countries’ output.
The Supply Side:
Increased competition in primary products forces LDC’s to compete for a shrinking export
market. This tends to push prices of primary goods down. Thus it is difficult to finance
development projects out of foreign exchange earnings.
Prebisch argues further that industrial goods are produced in an environment of reduced
competition:
ex: (Monopoly, Oligopoly, unions) So the price of manufactured goods tends to rise or remain
constant over time. Technological progress tends to translate to higher payments to factors,
not lower prices.
The Basis Result: The Terms of Trade tend to turn against primary exporters. More resources are
needed to purchase manufactured goods. Either price supports are needed, or
LDC’s should ignore the old “comparative advantage” and industrialize.
2 counter-arguments:
1. What is an acceptable base year?
2. Quality vs. Quantity
However, one could look at pure quantity measures:
1.
Share of World Exports from LDC’s.
1950 - 34%
1960 - 24%
1971 - 21%
2.
Food as a share of world trade:
1963 - 29%
1973 - 21%
1983 - 11%
Import Substitution Industrialization (ISI)
Chief development strategy of Latin America and India during the 1950's & 60's. Was designed
to improve the output structure of LDCs (and assist the poor) and to improve the political and
economic status of LDCs.
Structural change was a desirable outcome of ISI. Product diversification should have resulted in
economic reorganization; movement away from a feudalistic society - toward a middle class of
technicians, managers, more educated labor.
Historically, LDC’s experienced reduced export demand (thus less exchange earnings) during the
1930's. This reduced industrial imports and created a “natural barrier” to these imports. This led
to Ballasa’s First Stage of ISI - chiefly light industrializations - textiles, lumber, etc.
Post WWII these countries placed high tariffs on industrial imports - Ballasa’s Second Stage:
Heavy industrialization was attempted - steel, chemicals, etc. Here exports are reduced either
through explicit export taxes or through implicit means - ex.: exchange rate effects.
There is also the problem of implementation: To industrialize LDC’s needed capital. Domestic
private sources were weak, so the government created “development bank” to channel public
funds and multilateral agency funds. Also state enterprises were utilized to fill the gaps in major
industries (ex: steel, telecommunications, oil refineries, etc.) This, still, was not enough.
Foreign direct investment was necessary - multinationals were brought in, both for capital and
managerial know-how.
Exchange rates were also used:
1. Exchange rates were deliberately devalued (undervalued) making foreign goods very
expensive.
2. Differential (two, three, & multitiered) exchange rates were applied to various industries
to give protection and to make capital purchases less costly.
Industrial growth was higher than all other sectors: it began to lead: Industry as a % of GDP:
Mexico
Brazil
Argentina
India
Pakistan
Indonesia
S. Korea
1960
29%
35
38
20
14
14
20
After 10 yrs
of ISS
1979
38%
38
46
27
24
33
39
After 20 yrs.
These are nominal values, since initial cost is higher, the 1960 values ten to overstate the
“correct” percentages.